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The Institute of Chartered Accountants in England and Wales

BUSINESS ANALYSIS
Advanced Stage Technical Integration Level

For exams in 2014

Study Manual

www.icaew.com
Business Analysis
The Institute of Chartered Accountants in England and Wales

ISBN: 978-0-85760-870-3
Previous ISBN: 978-0-85760-473-6
First edition 2007
Seventh edition 2013

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any
form or by any means, electronic, mechanical, photocopying or otherwise, without the prior written permission of
the publisher.

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A catalogue record for this book is available from the British Library

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Your learning materials are printed on paper obtained from traceable, sustainable sources.

The Institute of Chartered Accountants in England and Wales


Welcome to ICAEW
I am delighted to welcome you as a student studying our chartered accountancy qualification, the ACA.

The ACA will open doors to a highly rewarding career as a financial expert or business leader. Once you
are an ICAEW member, you will join over 138,000 others around the world who work at the highest
levels across all industry sectors, providing valuable financial and business advice. Some of our earlier
members formed today's global Big Four firms, and you can find an ICAEW Chartered Accountant on
the boards of 80% of the UK FTSE 100 companies.

We are here to help you every step of the way. As part of a worldwide network of over 19,000 students,
you will have access to a range of resources including the online student community, where you can
interact with fellow students, and our student support team. Take a look at the key resources on page ix.

I wish you the very best of luck with your studies and look forward to supporting you throughout your
career.

Michael Izza
Chief Executive
ICAEW

iii
iv
Contents

Introduction vii
Business Analysis viii
Key resources ix
Skills assessment guide x
Faculties and Special Interest Groups xviii

ICAEW publications for further reading xix

1 Strategic analysis 1

2 Business risk management 71

3 Cost analysis and control 123

4 Investment appraisal 157

5 Business and securities valuation 193

6 Cost of capital and financial structuring 237

7 Financial engineering 311

8 International financial management 363


Mathematical tables 391
Index 397

v
vi
1 Introduction
1.1 What is Business Analysis and how does it fit within the ACA Advanced
Stage?
Structure
The ACA syllabus has been designed to develop core technical, commercial, and ethical skills and
knowledge in a structured and rigorous manner.
The diagram below shows the twelve modules at the ACA Professional Stage, where the focus is on the
acquisition and application of technical skills and knowledge, and the ACA Advanced Stage which
comprises two technical integration modules and the Case Study.

The knowledge level


The Business and Finance paper provides an introduction to how a business is managed and financed,
and the external environment that it faces. It also explains the role of the professional accountant. The
Management Information paper introduces costing and budgeting, and also looks at working capital
and performance management.
Progression to ACA application level
The knowledge base that is put into place here will be taken further in two application stage modules.
The Business Strategy paper looks at how businesses develop their strategies for products, markets and
management of internal resources and risks. The Financial Management paper examines the key
financial decisions that businesses take, relating to investment, financing and dividend payments, and
also how businesses manage their financial risks.
Progression to ACA Advanced Stage
The Advanced Stage papers Business Reporting (BR) and Business Change (BC) then take things
further again. The aims of BR are to ensure that students can apply analysis techniques, technical
knowledge and professional skills to resolve real-life compliance issues faced by businesses. In the BC
paper the aim is to ensure that students can provide technical advice in respect of issues arising in
business transformations eg mergers and acquisitions.
The above illustrates how the knowledge base of accounting gives a platform from which a progression
of skills and technical expertise is developed.

Introduction vii
2 Business Analysis
2.1 Module aim
The aim of the Business Reporting paper is:
To ensure that candidates can apply analysis techniques, technical knowledge and professional
skills to resolve real-life compliance issues faced by businesses.
Candidates may be put, for example, in the role of a preparer of financial statements, or other corporate
reports such as on sustainability and corporate responsibility, an advisor or in an assurance role facing
business issues where there are reporting implications. Compliance issues relating to taxation will also
feature in this module.
Candidates will be required to use professional judgement to identify and evaluate alternatives and
determine the appropriate solution(s) to compliance issues, giving due consideration to the commercial
impact of their recommendations.
The aim of the Business Change paper is:
To ensure that candidates can provide technical advice in respect of issues arising in business
transformations, mergers, acquisitions, alliances and disposals.
Candidates will be required to analyse and interpret both external and internal financial and non-
financial data in order to plan for change and provide advice. In undertaking this analysis candidates will
be expected to evaluate the impact of stakeholder influences on the data, including the impact of
choice of reporting policies.
Taxation and practical business techniques are particularly important in this module, where business
techniques include aspects of business strategy, business finance, performance management and
costing. There will also be financial reporting, assurance, ethical and legal implications to be considered
when developing and assessing strategic and business plans.

2.2 Specification grid


This grid shows the relative weightings of subjects within each module and should guide the relative
study time spent on each. Over time the marks available in the assessment will equate to the weightings
below, while slight variations may occur in individual assessments to enable suitably rigorous questions
to be set.
BR BC
Weighting (%) Weighting (%)
Ethics and law 5 10 5 10
Taxation 20 30 25 35
Audit and assurance 30 40 10 20
Corporate reporting 30 40 15 25
Business analysis 0 30 35

viii Business Analysis


3 Key Resources
STUDENT SUPPORT TEAM
T +44 (0)1908 248 250
E studentsupport@icaew.com
STUDENT WEBSITE
icaew.com/students student homepage
icaew.com/exams exam applications, deadlines, regulations and more
icaew.com/cpl credit for prior learning/exemptions
icaew.com/examresources examiners comments, syllabus, past papers, study guides and more
icaew.com/examresults exam results
TUITION
If you are receiving structured tuition, make sure you know how and when you can contact your tutors
for extra help.
If you aren't receiving structured tuition and are interested in classroom, online or distance learning
tuition, take a look at our tuition providers in your area on icaew.com/exams
ONLINE STUDENT COMMUNITY
The online student community allows you to ask questions, gain study and exam advice from fellow
ACA and CFAB students and access our free webinars. There are also regular Ask an Expert and Ask a
Tutor sessions to help you with key technical topics and exam papers. Access the community at
icaew.com/studentcommunity
THE LIBRARY & INFORMATION SERVICES (LIS)
The Library and Information Service (LIS) is ICAEW's world-leading accountancy and business library.
You have access to a range of resources free of charge via the library website, including the catalogue,
LibCat. icaew.com/library

Introduction ix
4 Skills assessment guide
4.1 Introduction
As a Chartered Accountant in the business world, you will require the knowledge and skills to interpret
financial and other numerical and business data, and communicate the underlying issues to your clients.
In a similar way to the required knowledge, the ACA syllabus has been designed to develop your
professional skills in a progressive manner. These skills are broadly categorised as:
Assimilating and using information
Structuring problems and solutions
Applying judgement
Drawing conclusions and making recommendations

4.2 Assessing your professional skills

Initial Professional Development

BR

BC

Advance Stage
TAX FR technical integration

FA A&A

Professional Stage
application level
ETHICS Case Study
FM
Technical

Professional Stage BS
knowledge level

Skills

The work experience requirements for students provide a framework to develop appropriate work
experience, completion of which is essential in order to qualify for membership. Work experience is also
an essential component for examination preparation.
The work experience framework is built around five key skills:
Business awareness being aware of the internal and external issues and pressure for change facing
an organisation and assessing an organisation's performance.
Technical and functional expertise applying syllabus learning outcomes and where appropriate,
further technical knowledge to real situations.
Ethics and professionalism recognising issues, using knowledge and experience to assess
implications, making confident decisions and recommendations.
Professional judgement making recommendations and adding value with appropriate, targeted
and relevant solutions.

x Business Analysis
Personal effectiveness developing, maintaining and exercising skills and personal attributes
necessary for the role and responsibilities.
The examinations, and in particular the Advanced Stage, embrace all of these skills.
The link between work experience and the examinations is demonstrated by the skills development
grids produced by the examiners.
This will help students see that their practical knowledge and skills gained in the workplace feed back
into the exam room and vice-versa.

4.3 Assessment grids


The following pages set out the learning outcomes for Business Analysis that are addressed under each
of the four skills areas. In addition, for each skills area, there is a description of:
The specific skills that are assessed
How these skills are assessed
Using these grids will enable you to determine how the examination paper will be structured and to
consider whether your knowledge of Business Analysis is sufficiently strong to enable you to apply it in
the required manner.

Introduction xi
xii Business Analysis
4.4 Technical knowledge
The table contained in this section shows the technical knowledge covered in the ACA Syllabus by
module.
For each individual standard the level of knowledge required in the relevant Professional Stage module
and at the Advanced Stage is shown.
The knowledge levels are defined as follows:
Level D
An awareness of the scope of the standard.
Level C
A general knowledge with a basic understanding of the subject matter and training in its application
sufficient to identify significant issues and evaluate their potential implications or impact.
Level B
A working knowledge with a broad understanding of the subject matter and a level of experience in the
application thereof sufficient to apply the subject matter in straightforward circumstances.
Level A
A thorough knowledge with a solid understanding of the subject matter and experience in the
application thereof sufficient to exercise reasonable professional judgement in the application of the
subject matter in those circumstances generally encountered by Chartered Accountants.
Key to other symbols:
the knowledge level reached is assumed to be continued

Business Analysis
Professional Stage

Advanced Stage
Management

Management
Information

Business &

Financial

Strategy
Business
Finance

Topic

STRATEGIC ANALYSIS
Environmental and market analysis tools
PESTEL analysis C A
Porter's five forces B A
Product life cycle B A
Boston consulting group matrix B A
Competitor analysis B A
Positional and other analysis tools
Resource audit C A
Resource-based strategy C A
Value chain analysis B A
SWOT analysis C A
Gap analysis C A
Marketing analysis A
Competitive advantage A
Benchmarking A
Directional policy matrix B
Business process analysis B A
Strategic risk analysis A
Balanced scorecard C A

Introduction xiii
Professional Stage

Advanced Stage
Management

Management
Information

Business &

Financial

Strategy
Business
Finance
Topic

STRATEGIC CHOICE
Strategy formulation, evaluation and choice C A
Business risk management C A
Financial analysis and data analysis A
Stakeholder analysis B A
Objectives and stakeholders preferences C B
Corporate responsibility and sustainability C B A
STRATEGIC IMPLEMENTATION
Business plans C B A
Organisational structure C B A
Information management C B A
Change management A
Project management A
COST ANALYSIS FOR DECISION MAKING
Costing
Cost classification A
Costing systems direct, marginal, absorption B
Activity based costing (ABC) C B
Break even analysis B A
Multi-product break even analysis B
Budgeting and performance management B A
Pricing
Pricing decisions B A
Transfer pricing B A
BUSINESS AND SHAREHOLDER VALUE
Valuation Techniques
Income dividend yield B A
Income P/E B A
Income discounted cash flow B A
Asset based measures B A
Options approach
Shareholder value
Value based management (VBM)
Value drivers B A
Shareholder value analysis (SVA) B A
Short and long term growth rates and terminal values A
Economic profit A
Cash flow return on investment (CFROI) A
Total shareholder return (TSR) A
Market value added (MVA) A
INVESTMENT APPRAISAL AND BASIC RISK ANALYSIS
Project appraisal
NPV B A
IRR B A
Payback B A
Relevant cash flows A
Tax and inflation A
Replacement Analysis A
Capital rationing A
Adjusted present value (APV) A
Assessing risk

xiv Business Analysis


Professional Stage

Advanced Stage
Management

Management
Information

Business &

Financial

Strategy
Business
Finance
Topic

Project appraisal and sensitivity analysis B A


Project appraisal and simulation B A
Expected values B A
Scenario planning A
Gap analysis B
Continuous vs. event risk B
FINANCIAL ANALYSIS
Cost of capital
Cost of equity B A
Cost of debt B A
Cost of preference shares B A
Cost of bank loans B A
Weighted average cost of capital (WACC) B A
Effective interest rates A
Splitting convertibles into equity and debt elements A
Public sector discount rates A
Portfolio theory and CAPM
Portfolio theory B A
CAPM B A
APT and MCPM A
CAPM and cost of capital B A
International cost of capital A
Bonds
Bond pricing using NPV A
Yields to maturity A
Duration and price volatility A
Convexity A
Term structure of interest rates A
Corporate borrowing and default risk A
SOURCES OF FINANCE AND FINANCING ARRANGEMENTS
Short, medium and long term sources of finance B A
Loan agreement conditions (warranties; covenants;
guarantees) B A
Raising capital B A
Gearing and capital structure A
Loan agreements and covenants A
Dividend policy A
Financing reconstructions (eg: group reconstruction, spin B A
off, purchase of own shares, use of distributable profits)
Working capital management C A
FINANCIAL ENGINEERING
Futures, options and swaps
Options B A
Interest rate futures B A
Interest rate options B A
Interest forward rate agreements (FRAs) B A
Interest rate swaps B A
Foreign exchange
Currency forward contracts B A
Currency money market cover B A
Currency options B A

Introduction xv
Professional Stage

Advanced Stage
Management

Management
Information

Business &

Financial

Strategy
Business
Finance
Topic

Currency swaps B A
Operational techniques for managing currency risk B A
Theoretical determinants of foreign exchange rates B A
Option value
Value of a call and put option C
Black Scholes option pricing model B
Binomial Option Pricing Model B
Real options C B

xvi Business Analysis


Ethics Codes and Standards

Ethics Codes and Standards Level Professional Stage modules

IFAC Code of Ethics for Professional Accountants A Assurance


(parts A, B and C and Definitions) Business and Finance
Law
Principles of Taxation
ICAEW Code of Ethics A Audit and Assurance
Business Strategy
Financial Reporting
Taxation
APB Ethical Standards 15 (revised) A Assurance
Provisions Available to Small Entities (revised) Audit and Assurance

Introduction xvii
5 Faculties and Special Interest Groups
The faculties and special interest groups are specialist bodies within the ICAEW which offer members
networking opportunities, influence and recognition within clearly defined areas of technical expertise.
As well as providing accurate and timely technical analysis, they lead the way in many professional and
wider business issues through stimulating debate, shaping policy and encouraging good practice. Their
value is endorsed by over 40,000 members of ICAEW who currently belong to one or more of the seven
faculties:
Audit and Assurance
Corporate Finance
Finance and Management
Financial Reporting
Financial Services
Information Technology
Tax
The special interest groups provide practical support, information and representation for chartered
accountants working within a range of industry sectors, including:
Charity and Voluntary sector
Entertainment and Media
Farming and Rural Business
Forensic
Healthcare
Interim Management
Non-Executive Directors
Public Sector
Solicitors
Tourism and Hospitality
Valuation
Students can register free of charge for provisional membership of one special interest group and
receive a monthly complimentary e-newsletter from one faculty of your choice. To find out more and to
access a range of free resources, visit icaew.com/facultiesandsigs

xviii Business Analysis


6 ICAEW publications for further reading
ICAEW produces publications and guidance for its students and members on a variety of technical and
business topics. This list of publications has been prepared for students who wish to undertake further
reading in a particular subject area and is by no means exhaustive. You are not required to study these
publications for your exams. For a full list of publications, or to access any of the publications listed
below, visit the Technical Resources section of the ICAEW website at icaew.com
ICAEW no longer prints a Members Handbook. ICAEW regulations, standards and guidance are
available at icaew.com/regulations This area includes regulations and guidance relevant to the regulated
areas of audit, investment business and insolvency as well as materials that was previously in the
handbook.
The TECH and AUDIT series of technical releases are another source of guidance available to members
and students. Visit icaew.com/technicalreleases for the most up-to-date releases.

Audit and Assurance Faculty icaew.com/aaf


Right First Time with the Clarified ISAs, ICAEW 2010, ISBN 978-0-85760-063-9
Clarified ISAs provide many opportunities for practitioners in terms of potential efficiencies, better
documentation, better reporting to clients, and enhanced audit quality overall.
This modular guide has been developed by ICAEW's ISA implementation sub-group to help
medium-sized and smaller firms implement the clarified ISAs and take advantage of these
opportunities. This modular guide is designed to give users the choice of either downloading the
publication in its entirety, or downloading specific modules on which they want to focus.
An international edition is also available.
Quality Control in the Audit Environment, ICAEW 2010, ISBN 0-497-80857-605-5
The publication identifies seven key areas for firms to consider. Illustrative policies and procedures
are provided for selected aspects of each key area, including some examples for sole practitioners.
The guide also includes an appendix with answers to a number of frequently asked questions on
the standard.
An international edition is also available.
The Audit of Related Parties in Practice, ICAEW 2010, ISBN 978-1-84125-565-6
This practical guide to the audit of related party relationships and transactions is set in the context
of the significant change in approach that is required under the revised ISA and highlights the
importance of planning, the need to involve the entire audit team in this, to assign staff with the
appropriate level of experience to audit this area and upfront discussions with the client to identify
related parties.
An international edition is also available.
Alternatives to Audit ICAEW, 2009, ISBN 978-1-84152-819-9
In August 2006, the ICAEW Audit and Assurance Faculty began a two-year consultation on a new
assurance service (the ICAEW Assurance Service), an alternative to audit based on the idea of
limited assurance introduced by the International Auditing and Assurance Standards Board (IAASB).
This report presents findings from the practical experience of providing the ICAEW Assurance
Service over the subsequent two years and views of users of financial information that help in
assessing the relevance of the service to their needs.
Companies Act 2006 Auditor related requirements and regulations third edition March
2012 ICAEW, 2012, ISBN 978-0-85760-442-2
This third edition of the guide provides a brief summary of the key sections in the Companies Act
2006 (the Act) which relate directly to the rights and duties of auditors. It covers the various types
of reports issued by auditors in accordance with the Act. It is designed to be a signposting tool for

Introduction xix
practitioners and identifies the other pieces of guidance issued by ICAEW, APB, FRC, POB and
others to support implementation of the Act.
Auditing in a group context: practical considerations for auditors ICAEW, 2008, ISBN 978-1-
84152-628-7
The guide describes special considerations for auditors at each stage of the group audit's cycle.
While no decisions have been taken on UK adoption of the IAASB's clarity ISAs, the publication also
covers matters in the IAASB's revised and redrafted 'ISA 600 Special Considerations Audits of
Group Financial Statements (Including the Work of Component Auditors)'. The revised publication
contains suggestions for both group auditors and component auditors.

Corporate Finance Faculty icaew.com/corpfinfac


Private equity demystified an explanatory guide Second Edition, Financing Change Initiative,
ICAEW, March 2010, John Gilligan and Mike Wright
This guide summarises the findings of academic work on private equity transactions from around
the world. Hard copies of the abstract and full report are free and are also available by download
from icaew.com/thoughtleadership
Best Practice Guidelines
The Corporate Finance Faculty publishes a series of guidelines on best-practice, regulatory trends
and technical issues. Authored by leading practitioners in corporate finance, they are succinct and
clear overviews of emerging issues in UK corporate finance. icaew.com/corpfinfac
Corporate Financier magazine, ISSN 1367-4544
The award-winning Corporate Financier magazine is published ten times a year for members,
stakeholders and key associates of ICAEW's Corporate Finance Faculty.
Aimed at professionals, investors and company directors involved in corporate finance, it covers a
wide range of emerging regulatory, commercial and professional development issues.
The magazine includes features, news, analysis and research, written by experts, experienced
editors and professional journalists.
In 2011, three major themes were introduced: Innovation & Corporate Finance; Financing
Entrepreneurship; and Deal Leadership.

Corporate governance icaew.com/corporategovernance


The UK Corporate Governance Code 2010
The UK Corporate Governance Code (formerly the Combined Code) sets out standards of good
practice in relation to board leadership and effectiveness, remuneration, accountability and
relations with shareholders. All companies with a Premium Listing of equity shares in the UK are
required under the Listing Rules to report on how they have applied the UK Corporate Governance
Code in their annual report and accounts.
The first version of the UK Corporate Governance Code was produced in 1992 by the Cadbury
Committee. In May 2010 the Financial Reporting Council issued a new edition of the Code which
applies to financial years beginning on or after 29 June 2010.
The UK Corporate Governance Code contains broad principles and more specific provisions. Listed
companies are required to report on how they have applied the main principles of the Code, and
either to confirm that they have complied with the Code's provisions or where they have not to
provide an explanation.
Internal Control: Revised Guidance on Internal Control for Directors on the Combined Code
(now the UK Corporate Governance Code)
Originally published in 1999, the Turnbull guidance was revised and updated in October 2005,
following a review by the Financial Reporting Council. The updated guidance applies to listed
companies for financial years beginning on or after 1 January 2006.

xx Business Analysis
The FRC Guidance on Audit Committees (formerly known as The Smith Guidance)
First published by the Financial Reporting Council in January 2003, and most recently updated in
2010. It is intended to assist company boards when implementing the sections of the UK
Corporate Governance Code dealing with audit committees and to assist directors serving on audit
committees in carrying out their role. Companies are encouraged to use the 2010 edition of the
guidance with effect from 30 April 2011.
The UK Stewardship Code
The UK Stewardship Code was published in July 2010. It aims to enhance the quality of
engagement between institutional investors and companies to help improve long-term returns to
shareholders and the efficient exercise of governance responsibilities by setting out good practice
on engagement with investee companies to which the Financial Reporting Council believes
institutional investors should aspire.
A report summarising the actions being taken by the Financial Reporting Council and explaining
how the UK Stewardship Code is intended to operate was also published in July 2010.

Corporate responsibility icaew.com/corporateresponsibility


Sustainable Business January 2009
The new thought leadership prospectus acts as a framework for the work that ICAEW do in
sustainability/corporate responsibility. It argues that any system that is sustainable needs accurate
and reliable information to help it learn and adapt, which is where the accounting profession plays
an important role. A downloadable pdf is available at icaew.com/sustainablebusiness
Environmental issues in annual financial statements ICAEW, May 2009, ISBN 978-1-84152-610-2
This report is a joint initiative with the Environment Agency. It is aimed at business accountants
who prepare, use or audit the financial statements in statutory annual reports and accounts, or
who advise or sit on the boards of the UK companies and public sector organisations. It offers
practical advice on measuring and disclosing environmental performance. A downloadable pdf is
available at icaew.com/sustainablebusiness
ESRC seminar series When worlds collide: contested paradigms of corporate responsibility
ICAEW, in conjunction with the British Academy of Management, won an Economic and Social
Research Council grant to run a seminar series which aims to bring academics and the business
community together to tackle some of the big challenges in corporate responsibility.
icaew.com/corporateresponsibility
The Business Sustainability Programme (BSP)
The Business Sustainability Programme is an e-learning package for accountants and business
professionals who want to learn about the business case for sustainability. The course is spread
across five modules taking users from definitions of sustainability and corporate responsibility,
through case studies and finally towards developing an individually tailored sustainability strategy
for their business. The first two modules are free to everyone. For more information and to
download a brochure visit icaew.com/bsp

Ethics icaew.com/ethics
Code of Ethics
The Code of Ethics helps ICAEW members meet these obligations by providing them with ethical
guidance. The Code applies to all members, students, affiliates, employees of member firms and,
where applicable, member firms, in all of their professional and business activities, whether
remunerated or voluntary.
Instilling integrity in organisations ICAEW June 2009
Practical guidance aimed at directors and management to assist them in instilling integrity in their
organisations. This document may also be helpful to audit firms discussing this topic with clients
and individuals seeking to address issues in this area with their employers.

Introduction xxi
Reporting with Integrity ICAEW May 2007, ISBN 978-1-84152-455-9
This publication brings ideas from a variety of disciplines, in order to obtain a more comprehensive
understanding of what is meant by integrity, both as a concept and in practice. Moreover, because
this report sees reporting with integrity as a joint endeavour of individuals, organisations and
professions, including the accounting profession, the concept of integrity is considered in all these
contexts.

Finance and Management Faculty icaew.com/fmfac


Finance's role in the organisation November 2009, ISBN 978-1-84152-855-7
This considers the challenges of designing successful organisations, written by Rick Payne, who
leads the faculty's finance direction programme.
Investment appraisal SR27: December 2009, ISBN 978-1-84152-854-4
This special report looks at the key issues and advises managers on how they can contribute
effectively to decision making and control during the process of investment appraisal.
Starting a business SR28: March 2010, ISBN 978-1-84152-984-2
This report provides accountants with a realistic and motivational overview of what to consider
when starting a business.
Developing a vision for your business SR30: September 2010, ISBN 978-0-85760-054-7
This special report looks at what makes a good vision, the benefits of having one, the role of the FD
in the process, leadership, storytelling and the use of visions in medium-sized businesses.
Finance transformation the outsourcing perspective SR31: December 2010, ISBN 978-0-
85760-079-0
The authors of this outsourcing special report share their expertise on topics including service level
agreements, people management, and innovation and technology.
The Finance Function: A Framework for Analysis September 2011, ISBN 978-0-85760-285-5
This report is a source of reference for those analysing or researching the role of the finance
function and provides a foundation for considering the key challenges involved, written by Rick
Payne, who leads the faculty's finance direction programme.

Financial Reporting Faculty icaew.com/frfac


EU Implementation of IFRS and the Fair Value Directive ICAEW, October 2007, ISBN 978-1-
84152-519-8
The most comprehensive assessment to date of compliance with the requirements of IFRS and the
overall quality of IFRS financial reporting.
The Financial Reporting Faculty makes available to students copies of its highly-regarded factsheets
on UK GAAP and IFRS issues, as well as its journal, By All Accounts, at icaew.com/frfac

Financial Services Faculty icaew.com/fsf


Audit of banks: lessons from the crisis, (Inspiring Confidence in Financial Services initiative)
ICAEW, June 2010 ISBN 978-0-85760-051-6
This research has looked into the role played by bank auditors and examined improvements that
can be made in light of lessons learned from the financial crisis. The project has included the
publication of stakeholder feedback and development of a final report.
Measurement in financial services, (Inspiring Confidence in Financial Services initiative) ICAEW,
March 2008, ISBN 978-1-84152-546-4
This report suggests that more work is required on matching measurement practices in the
financial services industry to the needs of different users of financial information, despite the fact

xxii Business Analysis


that the financial services industry has the greatest concentration of measurement and modelling
skills of any industry. A downloadable pdf is available at icaew.com/thoughtleadership
Skilled Persons' Guidance Reporting Under s166 Financial Services and Markets Act 2000
(Interim Technical Release FSF 01/08)
This interim guidance was issued by ICAEW in April 2008 as a revision to TECH 20/30 to assist
chartered accountants and other professionals who are requested to report under s166 Financial
Services and Markets Act 2000. A downloadable pdf is available at icaew.com/technicalreleases

Information Technology Faculty icaew.com/itfac


The IT Faculty provides ongoing advice and guidance that will help students in their studies and their
work. The online community (ion.icaew.com/itcountshome) provides regular free updates as well as a
link to the faculty's Twitter feed which provides helpful updates and links to relevant articles. The
following publications should also be of interest to students:
Make the move to cloud computing ICAEW, 2012, ISBN 978-0-85760-617-4
Cloud computing in its purest form is pay-as-you-go IT, online and on demand. The IT capabilities
provided as a service to businesses include: single software applications or software suites; online
software development platforms; and virtual computing infrastructure, ranging from data storage
to computer grids.
Bringing employee personal devices into the business - a guide to IT consumerisation ICAEW,
2012, ISBN 978-0-85760-443-9
The gap between business and consumer technology has been growing over the last few years,
with the consumer market now leading in terms of ease of use and portability.
Making the most of social media - a practical guide for your business ICAEW, 2011, ISBN 978-
0-85760-286-2
This guide will enable the business manager to develop a philosophy that allies social media's
potential with the business's objectives and capabilities, to set objectives and protect against
pitfalls, and then to take the first practical steps in a mass communications medium very different
from any that British business has encountered before.

Tax Faculty icaew.com/taxfac


The Tax Faculty runs a Younger Members Tax Club which provides informal presentations, discussions
and socialising. All young professionals interested in tax are welcome to attend. See the website for
more details icaew.com/taxfac
Tax news service
You can keep up with the tax news as it develops on the Tax Faculty's news site
icaew.com/taxnews. And you can subscribe to the free newswire which gives you a weekly round
up. For more details visit icaew.com/taxfac
Demystifying XBRL
This booklet, produced jointly by KPMG, the Tax Faculty and the Information Technology Faculty,
explains exactly what iXBRL is all about and what must be done in order to e-file corporation tax
returns using the new standard.
Implementing XBRL
This booklet, produced jointly by Thompson Reuters, the Tax Faculty and the Information
Technology Faculty, is a practical guide for accountants in business and practice, and follows on
from Demystifying XBRL.

Introduction xxiii
TAXline Tax Practice series of detailed briefings on current topics:
TAXline Tax Practice 27
Let property a brief guide by Rebecca Cave (published November 2011)
TAXline Tax Practice 26
The new pension rules by Anne Redston (published July 2011)
TAXline Tax Practice 25
Tax Credits by Robin Williamson (published April 2011)
TAXline Tax Practice No 23
HMRC Powers an overview of the new powers and penalties regime by Paula Clemett (published
October 2010)

xxiv Business Analysis


CHAPTER 1

Strategic analysis

Introduction
Topic List
1 Overview of analysis tools
2 Overview of data analysis
3 Overview of strategic implementation
4 Ethics and corporate responsibility issues
5 Integrating the use of analysis tools in a complex scenario
Summary and Self-test
Answers to Self-test
Answers to Interactive questions

1
Introduction

Learning objectives Tick off

Demonstrate a detailed understanding and application of the analysis tools studied at the
Professional stage
Demonstrate the ability to integrate business strategy with financial strategy in a complex
scenario
Demonstrate detailed understanding of how business strategy decisions can impact on
financial strategy decisions in a complex scenario
Demonstrate a detailed understanding and application of the management of strategic
implementation studied at the Professional stage

2 Business Analysis
1 Overview of analysis tools C
H
A
Section overview P
T
This section reviews the analysis tools that were covered in the Professional stage Business Strategy E
paper. Detailed knowledge of these techniques is critical at the Advanced stage and you should R
refer to earlier materials for an in-depth analysis of each of them. Project management techniques
were not covered in earlier material.
1
Most of the critical tools for strategic analysis were covered in detail at the Professional stage. You
are likely to be required to demonstrate your knowledge and application of the techniques
reviewed in this section in a more integrated scenario.

1.1 Environmental and market analysis tools

1.1.1 PESTEL analysis


The PESTEL framework is used to analyse the macro-environment into the following segments:
Political
Economic
Socio-cultural
Technological
Environmental protection
Legal
This analysis is a useful checklist for general environmental factors, although in the real world they are
obviously all interlinked. Any single environmental development can have implications for all six PESTEL
segments. In particular, political, social and economic affairs tend to be closely intertwined. Given that
case studies at this level are likely to be quite involved, you should not waste time trying to impose
unnecessary divisions on any environmental analysis the important thing is substance.

Case example: Greece


We shall cover the Euro crisis in more detail later in the text. For now, Greece is an obvious example of
how PESTEL factors are interlinked. Greece's future within the Euro (and the economic impacts of its
departure and the wider uncertainties about the Euro's future that will result) will depend on the ability
of its government to deliver an economic package that satisfies financial market opinion. The political
situation in Greece is in turn influenced by the level of social discontent and the social impacts of the
reduction of economic activity within the country.

1.1.2 Porter's five forces


The competitive environment is structured by five forces:
Threat of new entrants
Threat of substitute products or services
Bargaining power of customers
Bargaining power of suppliers
Rivalry amongst current competitors in the industry
These forces influence the state of competition in an industry, which collectively determine the profit
potential of the industry as a whole.
A word of caution about using the five forces model though its very comprehensiveness can
encourage users to feel that all factors have been duly considered and dealt with. Unfortunately, this is
never the case. Any analysis must pursue as high a degree of objectivity as possible. If there is too
much subjectivity unfounded complacency will result.

Strategic analysis 3
Interactive question 1: The tea industry [Difficulty level: Intermediate]
The tea industry is characterised by oversupply, with a surplus of about 80,000 tonnes a year. Tea
estates 'swallow capital, and the return is not as attractive as in industries such as technology or services'.
Tea is auctioned in London and prices are the same in absolute terms as they were 15 years ago. Tea is
produced in Africa and India, Sri Lanka and China. Because of the huge capital investment involved, the
most recent investments have been quasi-governmental, such as those by the Commonwealth
Development Corporation in ailing estates in East Africa. There is no simple demarcation between
buyers and sellers. Tea-bag manufacturers own their own estates, as well as buying in tea from outside
sources.
In 1997 tea prices were described in India at least, as being 'exceptionally firm ... The shortage and high
prices of coffee have also raised demand for tea which remains the cheapest of all beverages in spite of
the recent rise in prices. Demand from Russia, Poland, Iran and Iraq are expected to rise.'
Requirements
(a) Carry out a five forces analysis.
(b) Thinking ahead, suggest a possible strategy for a tea-grower owning a number of estates which has
traditionally sold its tea at auction.
See Answer at the end of this chapter.

1.1.3 Product life cycle


The product life cycle concept holds that products have a life cycle and that a product demonstrates
different characteristics of profit and investment at each stage in its life cycle. The life cycle concept is a
model, not a prediction (not all products pass through each stage of the life cycle). It enables a firm to
examine its portfolio of goods and services as a whole.
The stages in a product's life cycle are:
Introduction
Development and growth
Maturity
Decline
During strategic planning, products should be assessed in three ways:
The stage of the life cycle the product has reached
The product's remaining life (how much longer will it contribute to profits)
How urgent is the need to innovate (to develop new and improved products)

Case example: Volkswagen


Under Ferdinand Piech, the desire to make rapid progress led to two important products the Golf and
the Passat, which moved through their model life cycles in parallel. They were redesigned together and
reached obsolescence at the same time. This led to overload in showrooms when the new products
were launched.

4 Business Analysis
1.1.4 Boston matrix C
The Boston Consulting Group developed a matrix that assesses businesses in terms of potential cash H
A
generation and cash expenditure requirements. Strategic business units are categorised in terms of P
market growth rate and relative market share. T
E
The matrix is as follows. R

Market share

High Low 1

Market High Stars Question marks


growth Low Cash cows Dogs

A company's portfolio should be balanced, with cash cows providing finance for stars and question
marks, and a minimum of dogs.
One of the main problems with the matrix is that it is built around cash flows but innovative capacity
may be the critical resource, particularly in such industries as electronics and cars.
The BCG matrix can be paralleled with the product life cycle as products develop from question marks,
through stars and then cash cows as they enter maturity and finally dogs as the product declines. Such a
development is clearly very stylised.

1.1.5 Competitor analysis


As the name suggests, competitor analysis is an assessment of the strengths and weaknesses of current
and potential competitors. This is an important strategic tool it helps management to understand
their competitive advantages or disadvantages relative to competitors and provides an informed basis to
develop strategies to create or strengthen future competitive advantage.
The main challenge with competitor analysis is determining how to obtain critical information that is
reliable, up-to-date and available legally!

Interactive question 2: Competitor analysis [Difficulty level: Intermediate]


LBG is a manufacturer of specialist stage cosmetics that are specifically targeted at the theatre and film
industries. Recent developments in the quality of the chemicals used in these products have enabled
LBG to expand its product range and to price the products at a premium level.
However, LBG is concerned about the rapid growth of this specialist industry. New competitors have
been attracted by the premium prices charged by existing players to the extent that over capacity is an
increasing threat.
LBG is keen to protect its market leader status, and its current market share of approximately 40%,
despite evidence that the market is maturing. LBG feels it should know more about its competitors, both
new and existing in order to maintain its industry status.
Requirements
(a) In what ways would LBG benefit from conducting a formal competitor analysis?
(b) What are the main stages in conducting a formal competitor analysis and what important
information should be obtained by LBG at each stage of the analysis?
See Answer at the end of this chapter.

Strategic analysis 5
1.2 Positional and other analysis tools
1.2.1 SWOT analysis
SWOT analysis strengths, weaknesses, opportunities, threats combines environmental analysis with
internal appraisal to assess the firm's current and future strategic fit (or lack of it) with the environment.
A complete awareness of the organisation's environment and its internal capacities is necessary for a
rational consideration of future strategy, but it is not sufficient. The threads must be drawn together so
that potential strategies may be developed and assessed.

Strengths Weaknesses
Internal
to the M
company a Conversion
t
c
h
i
Exist n
independently g Conversion
of the
company
Opportunities Threats

Remember that strengths and weaknesses identified by internal personnel are only relevant if they are
perceived as such by the organisation's consumers. Strengths that cannot be matched with an available
opportunity are of limited value and likewise with opportunities that cannot be matched with strengths.
Threats can sometimes be converted into opportunities which can then be matched with strengths.
Weaknesses may also be converted into strengths which can be matched with opportunities.

1.2.2 Resource audit


As the name suggests, resource audits identify the resources available to an organisation. These
resources can be categorised as financial, human, intangible or physical. By determining what resources
they have, companies can identify what additional resources are required to pursue its chosen strategy.

1.2.3 Value chain analysis


The value chain describes those activities of the organisation that add value to purchased inputs.
Primary activities are involved in the production of goods and services; support activities provide
necessary assistance; and linkages are the relationships between activities.
As well as using the value chain to establish where it creates value for the customer, an organisation can
also use the model in other strategically valuable ways, including the identification of critical success
factors and opportunities to use information strategically. For example, an organisation can use the
value chain to secure competitive advantage by inventing new or better ways to perform tasks;
combining activities in new or better ways; managing the linkages in its own value chain; or by
managing the linkages in the value system.

1.2.4 Gap analysis


This tool enables organisations to study what they are doing currently and where they want to go in the
future. Gap analysis can be conducted from the perspective of the organisation, the direction of the
business, the processes of the business and information technology. It provides a starting point for
measuring the amount of time, money and human resources required to achieve a particular outcome.
It can also be used for new products, to identify gaps in the market.

1.2.5 Benchmarking
Benchmarking enables organisations to meet industry standards by copying others. It is less valuable as
a source of innovation but is a good way to challenge existing ways of doing things. It involves

6 Business Analysis
comparing your own performance with recognised targets, such as industry averages, and allows you to
identify areas where you are performing relatively well and areas where your relative performance is C
below expectations. H
A
When carrying out benchmarking exercises, you should be asking such questions as: P
T
Why are these products or services provided at all? E
Why are they provided in that particular way? R
What are the examples of best practice elsewhere?
How should activities be reshaped in the light of these comparisons?
1

1.2.6 Directional policy matrix


This matrix resembles the Boston matrix but measures the attractiveness of the market and your
company's strength to pursue it. Recommendations based on the position of these two elements are
shown below.

Business strengths

High Low

Market High Invest Grow


attractiveness Low Harvest Divest

1.2.7 Business process analysis


This tool helps organisations improve how they conduct their functions and activities with a view to
reducing costs, improving the efficient use of resources and giving better support to customers. The
idea is to concentrate on and re-think activities that create value for customers whilst removing any
activities that do not add value.

1.2.8 Strategic risk analysis


This involves recognising and assessing risks faced by the organisation, developing strategies to manage
them and mitigating risks using managerial resources. Strategies include transferring risk to other
parties, avoiding the risk altogether, reducing negative effects of the risk and accepting some or all of
the consequences of a particular risk.

1.2.9 Balanced scorecard


The balanced scorecard emphasises the need for a broad range of key performance indicators (KPIs) and
builds a rational structure that reflects longer-term prospects as well as immediate performance.
The balanced scorecard focuses on four different perspectives.

Perspective Question Explanation

Customer What do existing and Gives rise to targets that matter to customers:
new customers value cost, quality, delivery, inspection, handling and
from us? so on.
Internal What processes must we Aims to improve internal processes and decision
business excel at to achieve our making.
financial and customer
objectives?
Innovation Can we continue to Considers the business's capacity to maintain its
and learning improve and create future competitive position through the acquisition of
value? new skills and the development of new products.
Financial How do we create value Covers traditional measures such as growth,
for our shareholders? profitability and shareholder value but set
through talking to the shareholder or
shareholders directly.

Strategic analysis 7
The scorecard is balanced in the sense that managers are required to think in terms of all four
perspectives to prevent improvements being made in one area at the expense of another.

1.2.10 Corporate responsibility


An important element of assessing a business may be the extent to which it fulfils corporate
responsibility targets that it sets itself, or which society expects it to achieve.
Carroll & Buchholtz (2000, cited in Jobber, 2007) argued that there are four main 'layers' of corporate
responsibility.
Economic responsibilities
Companies have economic responsibilities to shareholders demanding a good return, to employees
wanting fair employment conditions and customers seeking good-quality products at a fair price.
Businesses are formed to be properly functioning economic units and so economic responsibilities form
the basis of all others.
Legal responsibilities
Since laws codify society's moral views, obeying these laws must be the foundation of compliance with
social responsibilities. Although in all societies corporations will have some legal responsibilities, there is
perhaps more emphasis on them in continental Europe than in the Anglo-American economies. In
Anglo-American economies the focus of discussion has often been whether many legal responsibilities
are unnecessary burdens on business.
Ethical responsibilities
These are responsibilities that require corporations to act in a fair and just way even if the law does not
compel them to do so.
Philanthropic responsibilities
According to Carroll & Buchholtz (2000), these are desired rather than being required of businesses.
They include charitable donations, contributions to local communities and providing employees with
the chances to improve their own lives.
Sustainability
Much of the discussion about corporate responsibility has focused on businesses' commitment to
sustainability, ensuring that development meets the needs of the present without compromising the
ability of future generations to meet their own needs.
The influential Brundtland report of 1987 emphasised that sustainability should involve developing
strategies so that the organisation only uses resources at a rate that allows them to be replenished (in
order to ensure that they will continue to be available). At the same time emissions of waste should be
confined to levels that do not exceed the capacity of the environment to absorb them.
The Brundtland report defined sustainable development as 'not a fixed state of harmony, but rather a
process of change in which the exploitation of resources, the direction of investments, the orientation of
technological development and institutional change are made consistent with future as well as present
needs.'
We shall consider corporate responsibility and sustainability in more detail in Section 4 of this chapter.

Worked example: Measurement of sustainability


Dow Jones Sustainability Index
The Dow Jones Sustainability Index is one of a number of global indexes that have been developed to
assess corporate sustainability. The creators of the index argue that corporate sustainability is attractive
to investors, because it aims to increase long-term shareholder value by gearing strategies and
management to harness the potential for sustainability products and services whilst also reducing and
avoiding sustainability costs and risks. Companies included in the index as sustainability leaders are
expected to show superior performance and favourable risk and return profiles.
The index is designed to provide quantification of sustainability strategies and management of
sustainability opportunities, risks and costs. A corporate sustainability assessment is carried out, and

8 Business Analysis
companies are ranked and selected for the index if they are among the sustainability leaders in their
field. The assessment uses the following criteria: C
H
Dimension Criteria A
P
Economic Corporate governance T
E
Codes of conduct/Compliance
R
Risk and crisis management
Customer relationship management
1
Innovation management
Industry specific criteria
Environment Environmental management system
Climate strategy
Product stewardship
Biodiversity
Industry specific criteria
Social Human capital development
Talent attraction and retention
Occupational health and safety
Stakeholder engagement
Social reporting
Industry specific criteria

Once the initial assessment has taken place, companies' performance is monitored. They are removed
from the index if their performance is judged unsatisfactory. A key aspect of this monitoring is seeing
how the company copes with crisis situations that carry a serious reputation risk.
Recent supersector leaders in the Dow Jones index have included Pearson, the leader in the Media
sector. Principal areas in which Pearson reports its environmental and sustainability performance
include:

Property management Pearson has targets to reduce energy use and is investing in renewable
energy at some of its sites.
Business travel Ways in which Pearson is trying to reduce air travel include upgrading
video-conferencing facilities.
Climate neutrality Initiatives include a carbon management programme focusing on
energy efficiency in buildings, use of renewable energy sources and
establishing partnerships that deliver carbon offsets.
Supply chain Pearson has introduced various initiatives to improve resource efficiency,
such as using the whole tree rather than part of the tree, reducing the
base weight of papers used and custom publishing. Environmental
responsibility is included in contracts between Pearson and its suppliers.
Pearson collects environmental data on the papers it purchases. It holds
training sessions for production teams around the world and discusses
its approach to paper purchasing with various stakeholders. Pearson has
also sought accreditation from the Forest Stewardship Council.
Employee Green messages are a regular part of Pearson's internal communications.
engagement It uses green teams volunteers working to improve environmental
practice. An intranet site offers ideas for carbon reductions, links to local
green groups and performance reports. Pearson's books, magazines and
newspapers cover climate change.

Strategic analysis 9
2 Overview of data analysis

Section overview
This section reviews the data analysis skills that you covered in Business Strategy at the Professional
Stage. These techniques are even more important at the Advanced Stage with its requirements to
analyse more complex scenarios. A lack of meaningful analysis remains a common weakness at the
Advanced Stage.

2.1 Data analysis skills required


The examiners are looking for you to demonstrate the following skills:
Choosing analytical tools that are appropriate in the context of the question eg financial ratios,
KPIs, break-even calculations
Carrying out the relevant calculations
Interpreting the resulting information to demonstrate an understanding of the story behind the
numbers and communicating that analysis succinctly
Analysing the wider consequences and implications of the numerical data, for example a fall in
production costs perhaps harming product quality
Exercising judgement to draw conclusions and/or produce sensible recommendations
Looking beyond the information provided at what additional information may be useful to
generate a better analysis/understanding and at any reservations regarding the
data/techniques/assumptions applied
Linking different pieces of data to explain trends or outcomes
Highlighting weaknesses or omissions in the data provided
Discussing cause and effect relationships eg identifying underlying causes of changes in the data

2.2 Key weaknesses in answers


The following list highlights weaknesses commonly identified in exam answers and suggests ways to
address these:
1 Restating facts or numbers without applying them to the context of the question
A common failing is to explain what has happened rather than why, eg stating that sales have
grown by 15% in the period but not indicating why they have done so.
Solution: Including the word 'because' in your answer changes the 'what' into a 'why'. In most
cases a good answer passes the 'because' test, eg 'Market share has fallen from 35% to 29%
because of the entry of a new lower-cost competitor.'
The 'because' should be related to specific information in the scenario, demonstrating that you
have understood the relationship between the financial/quantitative information and the business
issues.
2 Failing to use the additional information from the scenario in answers, resulting in generic
answers that could apply to any company rather than the one in the scenario
Solution: Make specific points, focusing on the particular organisation and relating to the
circumstances in the scenario.
eg 'falling R&D expenditure may be a problem for XYZ Ltd because it has built market share on the
basis of its innovative products.'

10 Business Analysis
3 Interpreting figures/results in isolation
C
Solution: Link the figures/analysis eg if market share has increased but gross margins have H
decreased, the company may have made a decision to reduce the selling price as part of a market A
penetration strategy. P
T
4 Focusing on a narrow range of measures E
R
Financial measures alone will not provide the full picture and are often the result of other factors,
not the cause.
Solution: Your answer should, where possible, address a variety of performance indicators. Use the 1
balanced scorecard headings to help you consider a wider range of measures. Remember that
these measures will often help you understand what is causing the strategy to succeed or fail.
5 Failing to use numerical analysis to support the rest of your answer
The data analysis element may be one of the first requirements. Conclusions that you draw from
this will help in answering later parts of the question.
Solution: Consider where else in your answer the analysis may be relevant / how you can 'make
the numbers talk'.
Eg if the data analysis shows that the business is currently loss making and that sales and
profitability are forecast to decline further, then the business cannot afford to do nothing. Any new
strategy that is expected to address this decline or increase returns should be acceptable to the
shareholders.
6 Failing to explain trends in the data by identifying cause and effect relationships.
Solution: Examine the information from different perspectives. This may, for example, include
analysing information into ratios or percentages based on the data provided.
Eg where sales revenues are growing by (say) 10% per year but the number of branches/outlets is
growing by 15% per year then calculating the sales per branch/outlet will show that sales per
branch is, on average, falling. Thus, growth in overall sales revenue may be due to investment in
more outlets, rather than generic growth in sales per branch because of improved efficiency or
stronger market conditions. Alternatively sales revenue growth might be analysed in relation to
volume growth, changes in selling prices and changes in sales mix. Analysis of this data may reveal
the relative causes (quantitatively) of sales revenue growth from each of these underlying factors.
7 Failing to achieve a reasonable balance between numerical and descriptive analysis
Some weak answers are almost entirely descriptive. Other weak answers include enough
calculations, but their descriptive analysis is little more than stating which numbers have gone up
and which have gone down.
Solution: Both numerical and descriptive analysis are important and need due emphasis. Two
possible approaches are:
(1) Set out a comprehensive numerical analysis at the beginning of the answer or in an
appendix with workings (eg in a table). Then produce the descriptive interpretation of these
numbers.
(2) Mix the numerical analysis with the descriptive analysis by producing calculations as each
issue arises.
In general approach (1) tends to produce better answers with a more systematic evaluation of the
issues. The numerical analysis tends to be more comprehensive and better thought out, with
clearer workings. However if you use approach (1) make sure that you are careful with your time
allocation. If you spend too much time on calculations, you may not have enough time to produce
sufficient descriptive analysis.

Strategic analysis 11
8 Failing to understand how IFRS reported profit may fail to reflect the underlying
performance of the business
Solution: Question whether changes in profit, as measured by IFRS, reflect changes in underlying
performance. Consider for instance that good strategic decisions may take some time to be
reflected in reported profit, which may even fall in the short-term.

2.3 Recommended approach


The following is a suggestion for the approach to adopt when tackling data analysis:
Step 1: Review scenario and requirements
Step 2: Decide what analysis is appropriate
Step 3: Produce the necessary calculations
Step 4: Interpret your analysis
Step 5: State the additional information required
The steps that cause most problems are Steps 3 and 4.

2.4 WHAT-HOW-WHY-WHEN-SO WHAT analysis


It is difficult to produce a universal approach but one tool which includes both numerical and
descriptive elements is: WHAT-HOW-WHY-WHEN-SO WHAT Analysis.
WHAT Look at WHAT has happened overall (eg revenue has increased by 21%).
HOW Analyse the available data in more detail to obtain a better understanding of HOW the
WHAT element occurred (eg sales prices have risen by 10% and monthly sales
volumes have risen by 10% following the price change).
WHY Look for the underlying causes of the HOW element, which may be part of the data
provided in the question (eg there have been significant product improvements
introduced during the year with additional features compared to competitors. This
has meant that a higher price can be charged but has also resulted in an increase in
demand despite this increased price).
WHEN If you're assessing the impact of changes in strategy over time or in making
comparisons it is important to know WHEN changes occurred. (eg If the price and
volume changes above occurred half way through the year, then the increase in sales
revenues for the current year may be limited to say 10.5%, but the changes will be
more significant in next year's figures).
SO WHAT The above steps analyse and interpret the nature of the data provided and attempt to
identify and explain the underlying causes of any changes in the data. The next stage
is to ask the question 'so what are the consequences of our analysis for deciding on
the future business strategy?' (eg what are the consequences for profit of the 10%
increases in sales price and sales volume after considering the variable cost increases
arising from the product improvements and volume increases? How have competitors
responded with price changes and improvements in their own products which may
make the consequences next year different from those which occurred this year?).

2.5 Issues with accounts


When carrying out data analysis, you will need to use what you've learnt specifically about analysing
financial statements, in particular:
Distortions and creative accounting policies, such as income smoothing or understated provisions
The factors determining important figures in the accounts, in particular operating profit.
Adjustments may be needed to the figures reported in the financial accounts before data analysis can be
carried out. These may include re-measurement to market value and recognising assets or liabilities that
are not included in the accounts. If you are analysing the income statement you may need to strip out
non-operating or non-recurring items from results to be able to make a fairer comparison over time.

12 Business Analysis
3 Overview of strategic implementation C
H
A
Section overview P
T
This section continues the revision of strategic issues from the Professional Stage Business Strategy E
paper. R

Most of the techniques described were covered in detail in Business Strategy, so you may need to
go back to your materials from that paper. However project management is not currently covered
1
in Business Strategy, and therefore we discuss it here in greater depth.

3.1 Business planning


3.1.1 Strategic planning and business planning
A business's strategic plan or corporate plan provides the long-term framework for its activities.
However if business strategies are to be implemented successfully, the corporate plan needs to be
supported by shorter-term business plans, typically over one year. These short-term plans:
Co-ordinate the roles of different functions so that they are consistent with strategic objectives
Give confidence to stakeholders such as finance providers or important customers
Help to ensure the accountability of operational managers
The planning of implementation should include resource planning, operations planning and
organisation structure and control systems.

3.1.2 Advantages and disadvantages of formal business planning


The advantages of a formal system of business planning are as follows

Advantages Comment

Identifies risks Planning helps in managing these risks.


Forces managers to Planning can encourage creativity and initiative by tapping the ideas
think of the management team.
Forces decision-making Businesses cannot remain static they have to cope with changes in
the environment. A business plan draws attention to the need to
change and adapt, not just to 'stand still' and survive.
Better control Management control can be better exercised if targets are explicit.
Enforces consistency at Long-term, medium-term and short-term objectives, plans and
all levels controls can be made consistent with one another. Otherwise,
strategies can be rendered ineffective by budgeting systems and
performance measures which have no strategic content.
Public knowledge Drucker has argued that an entrepreneur who builds a long-lasting
business has 'a theory of the business' which informs his or her
business decisions. In large organisations, that theory of the business
has to become public knowledge, as decisions cannot be taken only
by one person.
Time horizon Some plans are needed for the long term.
Co-ordinates Activities of different business functions need to be directed towards a
common goal.
Clarifies objectives Managers are forced to define what they want to achieve.
Allocates responsibility A plan shows people where they fit in.

However there are disadvantages of planning for strategy implementation in a structured way. You may
remember that Mintzberg in his book The Rise and Fall of Strategic Planning made a number of criticisms
of a structured approach to planning the implementation of strategy, and these are worth revisiting.

Strategic analysis 13
Problem Comments

Practical failure Empirical studies have not proved that formal planning processes
contribute to success.
Routine and Strategic planning occurs often in an annual cycle. But a firm 'cannot allow
regular itself to wait every year for the month of February to address its problems.'
Reduces initiative Formal planning discourages strategic thinking. Once a plan is locked in
place, people are unwilling to question it.
Internal politics The assumption of 'objectivity' in evaluation ignores political battles
between different managers and departments.
Exaggerates Managers are not all-knowing, and there are limits to the extent to which
power they can control the behaviour of the organisation.

3.1.3 Freewheeling opportunism


The opposite approach to formal business planning is freewheeling opportunism. This approach
suggests firms should not bother with formal plans and should exploit opportunities as they arise.
The advantages of this approach are claimed to be that good opportunities are not lost, it is easier to
adapt to change and it encourages a more flexible, creative attitude.
However the lack of formal planning means there is no co-ordinating framework for the organisation,
so that some opportunities get missed anyway. It can also mean that the firm ends up reacting all the
time rather than developing proactively.

3.2 Organisational structure


3.2.1 Purposes of organisational structure
Organisational design or structure implies a framework or mechanism intended to do the following:
Link individuals in an established network of relationships so that authority, responsibility and
communications can be controlled, using the concept of hierarchy.
Group together (in any appropriate way) the tasks required to fulfil the objectives of the
organisation, and allocate them to suitable individuals or groups.
Give each individual or group the authority required to perform the allocated functions, while
controlling behaviour and resources in the interests of the organisation as a whole.
Co-ordinate the objectives and activities of separate units, so that overall aims are achieved
without gaps or overlaps in the flow of work required.
Facilitate the flow of work, information and other resources required, through planning, control
and other systems.
Developing an appropriate structure requires consideration of three areas:
Organisational configuration the primary groupings of staff into departments or divisions.
Centralisation/Decentralisation where the responsibility for decision making lies.
Management systems the make-up of the senior management team, eg the corporate board,
and the methods they use to govern the organisation. This also includes the processes used to
monitor financial results, to arrive at strategic decisions and to manage risk.

3.2.2 Characteristics of organisational structure


Hierarchy
Within the organisation's hierarchy there will be lines of authority or chains of command, running from
senior management vertically downwards through the organisation, connecting the various levels of
managers.

14 Business Analysis
The chain of command not only represents the decision making hierarchy, it also provides a defined
channel for formal communication up and down the organisation. C
H
Decisions on chains of command must also take into account the following issues. A
P
Communications can become distorted as more layers are added to the chain of command. T
E
Long chains of command will increase the amount of time taken for information to reach the R
relevant decision makers.
Long chains of command distance junior managers from thinking and decision making at the
top, and limit development into a general management role. Managers may therefore become 1
frustrated and de-motivated, and may leave the organisation in search of flatter organisations and
greater opportunities for responsibility.
Tall and flat organisations
A tall organisation is one which, in relation to its size, has a large number of management levels. A flat
organisation is one which, in relation to its size, has a smaller number of hierarchical levels.

Chief
executive
MD

Divisional
directors Senior
management
Department
heads
Section
heads Middle
management
Assistants MD

Foremen Department
Supervisory
heads
management
Charge hands
Supervisors

Workers Workers

Tall and flat organisations


A tall organisation structure might be inefficient, despite the advantages of a narrow span of control and
the possibility of graduated promotions. Tall structures can impose rigid supervision and control and
therefore block initiative and ruin the motivation of subordinates.
Flat organisations have become more common as a result of the current fashion for delayering and
empowerment.
Empowerment
Empowerment means making workers (and particularly work teams) responsible for achieving, and
even setting, work targets, with the freedom to make decisions about how they are to be achieved.
Empowerment goes hand in hand with the following developments.
Delayering or a cut in the number of levels (and managers) in the chain of command.
Flexibility, since giving responsibility to the people closest to the products and customer
encourages responsiveness.
New technology, since there are more 'knowledge workers'. Such people need less supervision,
being better able to identify and control the means to clearly understood ends.

Strategic analysis 15
Establishing control in an empowered culture can be achieved perhaps through:
Standardisation of processes, with clear guidelines (eg bank lending).
Cultural control, so that everyone accepts the responsibilities that come with empowerment.
Team working.

3.2.3 Structure and strategy


Which comes first, strategy or structure?
The top-down approach says that management decide the strategy then build or revise
organisational structure to implement it.
The bottom-up view is that the strategy a firm follows emerges from, or depends on, its structure
or that the structure limits the choice of strategy.
In practice structure and strategy will feed off each other. Restructuring will be required to implement
new strategies and structures may develop more informally in response to environmental challenges.
Restructuring may also involve new possibilities and business initiatives.

3.2.4 Centralisation of organisations


Centralisation and decentralisation refer to the degree to which authority is delegated in an
organisation, and therefore the level at which decisions are taken in the management hierarchy. There
are several issues.
In some businesses, authority is centralised and decisions are taken at the top. In a small
business, the owner-manager may take all the decisions. However, in a hospital environment, 'life
or death' decisions are taken at 'operations level'.
Some businesses have regional offices with decision autonomy. In other businesses, decisions of
any significance have to be referred back to head office.
Operations might be decentralised, but standards might be set centrally and distributed
throughout the organisation.
Goold and Campbell conducted a study of a large number of high profile diversified companies to
examine how different companies cope with the problem of managing diversity. They discovered
three main philosophies and three corresponding styles of strategic management.

Philosophy Example Style of management

Core businesses 'The company commits itself to a few Strategic planning style
industries and sets out to win big in those
industries.'
Manageable businesses 'The emphasis is on selecting businesses for Financial control style
the portfolio which can be effectively
managed using short-term financial
controls...' The businesses have few linkages
with each other, should be in relatively
stable competitive environments and
should not involve large or long-term
investment decisions.
Diverse businesses 'The centre seeks to build a portfolio that Strategic control style
spreads risk across industries and
geographic areas as well as ensuring that
the portfolio is balanced in terms of
growth, profitability and cash flow.'

16 Business Analysis
Goold and Campbell describe the features of the different styles of central management in terms of their
management structures. C
H
Style of central Features A
P
management T
E
Strategic planning Entails the centre participating in, and influencing, the strategies of the core R
businesses. The centre establishes a planning process and contributes to
strategic thinking. Rather less emphasis is placed on financial controls, and
performance targets are set flexibly and reviewed within the context of long- 1
term progress.
Strategic control Concerned with the plans of its business units but believes in autonomy for
business unit managers. Plans are therefore made locally but reviewed in a
formal planning process to upgrade the quality of the thinking. The centre
does not advocate strategies or interfere with major decisions but maintains
control through financial targets and strategic objectives.
Financial control As the name suggests, focuses on annual profit targets. There are no long-
term planning documents and no strategy documents. The role of the centre is
limited to approving budgets and monitoring performance.

3.2.5 Evolution of organisational structures


Organisations are responding to the following developments in the business environment:

Development Features

Growth of knowledge work 'Today's economy runs on knowledge and most companies work
assiduously to capitalise on that fact. They use cross-functional teams,
customer- or product-focused business units, and workgroups.'
(Wenger and Snyder, 2000).
Delayering A reduction in the number of levels in the management hierarchy.

Communications Organisational life has been revolutionised by email and network


technology technology.

Core/periphery Some firms have been changing the structure of their workforces for
the sake of greater flexibility, eg a core of full-time permanent staff
and periphery part-timers and temporary or contract workers.

Business Process Re-engineering (BPR)


Business Process Re-engineering means selection of areas of business activity in which repeatable and
repeated sets of activities are undertaken, and the development of improved understanding of how they
operate and of the scope for radical redesign with a view to creating and delivering better customer
value.
(CIMA Official Terminology)
There are three common themes.
The need to make radical changes to the entire organisation. Changing conditions 'impact all
functions of the company and lead to a radically different way of doing business.'
The need to change functional hierarchies.
The need to address the problem of fragmented staff roles: 'roles have become specialised with
the result that staff are only responsible for a small part of an overall task. This can result in loss of
accountability for a finished task, de-skilling of work and the need for highly complex scheduling
systems.'

Strategic analysis 17
Properly implemented BPR may help an organisation reduce costs, improve customer services, cut
down on the complexity of the business and improve internal communication.
(a) At best it may bring about new insights into the objectives of the organisation and how best to
achieve them.
(b) At worst, BPR is simply a synonym for squeezing costs (usually through redundancies). Many
organisations have taken it too far and become so 'lean' that they cannot respond when demand
begins to rise.
The horizontal organisation
Based on business process re-engineering, the horizontal organisation is a technique which breaks down
'vertical' departmental boundaries, and claims to eliminate the hierarchies of command and control.
Instead management is based on processes.

Characteristic Comment

Structure Organisation structure is based on cross-functional processes rather than tasks


or geography.
Team Teams, not individuals, are the basis of this approach.
Ownership A process owner is responsible for the whole process.
Customers Customers drive the process: the process owner puts customer-performance
first.

The process focuses the organisation on the customer. However, the customer may be at the receiving
end of several 'core' processes. Also the process owner should be the person or group that controls the
process. Where, however, a horizontal structure is in place, the responsibility for taking control action is
not always clear.

3.3 Information management


3.3.1 Information at different levels
To function effectively, organisations need different levels of information and therefore must operate
different types of information systems. The activities of strategic planning, management control and
operational control each have their own information requirements. Senior managers need the
operational systems to summarise data to aid their decision-making.

3.3.2 Types of information


Strategic information is used to plan the objectives of the organisation, and to assess whether the
objectives are being met in practice. Such information includes overall profitability, the profitability of
different segments of the business, future market prospects, the availability and cost of raising new
funds, total cash needs, total manning levels and capital equipment needs.
Tactical information is used to decide how the resources of the business should be employed, and
to monitor how they are being employed. Such information includes productivity measurements,
budgetary control or variance analysis reports, cash flow forecasts, staffing levels and profit results within
a particular department of the organisation and short-term purchasing requirements.
Operational information is used to ensure that specific operational tasks are planned and carried out
as intended.

3.3.3 Qualities of good information


You may remember the mnemonic ACCURATE as an easy way to remember the qualities of good
information. ACCURATE can also be used as a framework when describing how poor information can be
improved.

18 Business Analysis
Feature Examples of possible improvements
C
Accurate Use computerised systems with automatic input checks rather than manual H
A
systems. P
Allow sufficient time for collation and analysis of data if pinpoint accuracy is T
E
crucial. R
Incorporate elements of probability within projections so that the required
response to different future scenarios can be assessed.
1
Complete Include past data as a reference point for future projections.
Include any planned developments, such as new products.
Information about future demand would be more useful than information
about past demand.
Include external data.
Cost-beneficial Consider whether the benefit of having the information is greater than the cost
of obtaining it.
User-targeted Summarise information and present it together with relevant ratios or
percentages.
Relevant Define the purpose of the report clearly. It may be trying to fulfil too many
purposes at once. Perhaps several shorter reports would be more effective.
Include exception reporting, where only those items that are worthy of note
and the control actions taken by more junior managers to deal with them are
reported.
Authoritative Use reliable sources and experienced personnel.
Explain the method of derivation if some figures are derived from other figures.
Timely Speed up Information collection and analysis by production managers,
probably by the introduction of better information systems.
Easy-to-use Use graphical presentation, allowing trends to be quickly assimilated and
relevant action decided upon.
Devise a 'house style' for reports.

3.3.4 Information strategies


The information systems (IS) strategy refers to the long-term plan concerned with exploiting IS and IT
either to support business strategies or create new strategic options. It needs to ensure that information
is obtained, retained, distributed and made available for implementing strategy in all areas of an
organisation's activities.
The IS strategy is supported by:
The information technology (IT) strategy which involves deciding how information needs will be
met by balancing supply and demand of funds and facilities, and the development of programmes
to supply IT.
The information management (IM) strategy which aims to ensure that information is provided
to users and that redundant information is not being produced.
A coherent strategy is required because information technology is a high cost activity. IT costs include
hardware and software costs, implementation costs associated with a new systems development and
day-to-day costs such as salaries and accommodation. Many organisations invest large amounts of
money in IS, but not always wisely. The unmanaged proliferation of IT is likely to lead to expensive
mistakes.

Strategic analysis 19
More fundamentally an organisation's information systems may not only support corporate and
business strategy. They may also help determine corporate/business strategy. For example:
IS/IT/IM may provide a possible source of competitive advantage. This could involve new
technology not yet available to others or simply using existing technology in a different way.
The information system may help in formulating business strategy by providing information from
internal and external sources.
Developments in IT may provide new channels for distributing and collecting information, and /or
for conducting transactions eg the internet.
Some common ways in which IS/IT/IM have had a major impact on organisations are explained below.
(a) The type of products or services that are made and sold
For example, industrial markets have seen the emergence of robots and local area networks for
office information systems. Technological changes can be relatively minor, such as the introduction
of tennis and squash rackets with graphite frames, fluoride toothpaste and turbo-powered car
engines.
(b) The way in which products are made
There is a continuing trend towards the use of automation and computer aided design and
manufacture. The manufacturing environment is undergoing rapid changes with the growth of
advanced manufacturing technology.
(c) The way in which services are provided
High-street banks encourage customers to use 'hole-in-the-wall' cash dispensers, or telephone or
internet banking. Most shops now use computerised Point of Sale terminals at cash desks. Many
organisations use e-commerce: selling products and services over the internet.
(d) The way in which markets are identified
Database systems make it much easier to analyse the market place.
(e) The way in which employees are mobilised
Technology encourages workforce empowerment. Using technology frequently requires changes
in working methods.
(f) The way in which firms are managed
An empowered workforce often leads to the 'delayering' of organisational hierarchies (in other
words, the reduction of management layers).

3.4 Change management


3.4.1 Factors promoting change
Strategic analysis may identify material changes in the business environment to which an organisation
has to respond, including changes in competitor behaviour, customer buying patterns or technology.
These will feed through into changes the organisation makes or the services it provides.
There may also be powerful internal drivers of change including changes in leadership style. Internal
change may also be required to respond to external challenges, for example greater centralisation to
allow more efficient decision-making.

3.4.2 Types of change


Change can take the form of a series of small steps (incremental change). At the other extreme it could
be transformational change, characterised by major, significant change being introduced relatively
quickly. Change may follow a series of carefully planned steps or it may consist of continuous
adjustment to the environment.

20 Business Analysis
3.4.3 Focus of change
C
Change may focus at one of three main levels. H
A
Organisational culture the focus is on the social and informal processes that promote the ethos P
of the organisation. T
E
Restructuring covering reporting lines and how people work together. R
Individual emphasis on improving individual skill levels, attitudes and motivation.

1
3.4.4 Change processes
The following steps will normally apply in any process of major change.

Step 1
Determine need or desire for change in a particular area.

Step 2
Prepare a tentative plan. Brainstorming sessions are a good idea, since alternatives for change should be
considered.

Step 3
Analyse probable reactions to the change.

Step 4
Make a final decision from the choice of alternative options. The decision may be taken either by group
problem-solving (participative) or by a manager on his own (coercive).

Step 5
Establish a timetable for change.
'Coerced' changes can probably be implemented faster, without time for discussions.
Speed of implementation that is achievable will depend on the likely reactions of the people
affected.
Identify those in favour of the change, and perhaps set up a pilot programme involving them. Talk
with any others likely to resist the change.

Step 6
Communicate the plan for change. This is really a continuous process, beginning at Step 1 and going
through to Step 7.

Step 7
Implement the change.

Step 8
Review the change. This requires continuous evaluation.
Alternatively the Lewin/Schein three-stage model of change identifies key steps as unfreeze, move and
refreeze.

UNFREEZE MOVE
REFREEZE
Existing behaviour Attitudinal/behavioural
New behaviour
change
Step 1
Unfreeze is concerned mainly with selling the change, giving individuals or groups a motive for
changing their attitudes, values, behaviour, systems or structures.

Step 2
Move is the second stage, mainly concerned with identifying what the new, desirable behaviour or
norm should be, communicating it and encouraging individuals and groups to 'own' the new attitude or
behaviour. This might involve the adoption of a new culture.

Strategic analysis 21
Step 3
Refreeze is the final stage, implying consolidation or reinforcement of the new behaviour. Positive
reinforcement (praise and reward) or negative reinforcement (sanctions applied to those who deviate
from the new behaviour) may be used.

3.4.5 Strategic change


Gouillart and Kelly's Gemini 4Rs framework demonstrates how strategic change can be worked through
all aspects of an organisation's identity.
Reframing involves fundamental questions about what the organisation is and what it is for:
Achieve mobilisation: Create the will and desire to change.
Create the vision of where the organisation is going.
Build a measurement system that will set targets and measure progress.
Restructuring is about the organisation's structure, but is also likely to involve cultural changes:
Construct an economic model to show in detail how value is created and where resources should
be deployed.
Align the physical infrastructure with the overall plan.
Redesign the work architecture so that processes interact to create value.
Revitalising is the process of securing a good fit with the environment:
Achieve market focus.
Invent new businesses.
Change the rules of competition by exploiting technology.
Renewal ensures that the people in the organisation support the change process and acquire the
necessary skills to contribute to it:
Create a reward system in order to motivate.
Build individual learning.
Develop the organisation and its adaptive capability.

3.5 Project management


3.5.1 What is a project?

Definitions
A project is 'an undertaking that has a beginning and an end and is carried out to meet established
goals within cost, schedule and quality objectives'. (Haynes, Project Management)
Resources are the money, facilities, supplies, services and people allocated to the project.

In general, the work which organisations undertake involves either operations or projects. Operations
and projects are planned, controlled and executed. So how are projects distinguished from 'ordinary
work'?

Projects Operations

Have a defined beginning and end On-going


Have resources allocated specifically to them, Resources used 'full-time'
although often on a shared basis
Are intended to be done only once (eg organising A mixture of many recurring tasks
the 2010 London Marathon the 2011 event is a
separate project)
Follow a plan towards a clear intended end-result Goals and deadlines are more general
Often cut across organisational and functional lines Usually follows the organisation or
functional structure

22 Business Analysis
Common examples of projects include:
C
Producing a new product, service or object H
Changing the structure of an organisation A
Developing or modifying a new information system P
T
Implementing a new business procedure or process
E
R
3.5.2 What is project management?

1
Definition
Project management is the combination of systems, techniques, and people used to control and
monitor activities undertaken within the project. Project management co-ordinates the resources
necessary to complete the project successfully.

Objective Comment

Quality The end result should conform to the project specification. In other words,
the result should achieve what the project was supposed to do.
Budget The project should be completed without exceeding authorised expenditure.
Timescale The progress of the project must follow the planned process, so that the
'result' is ready for use at the agreed date. As time is money, proper time
management can help contain costs.

Projects present some management challenges.

Challenge Comment

Teambuilding The work is carried out by a team of people often from varied work and
social backgrounds. The team must 'gel' quickly and be able to
communicate effectively with each other.
Expected Expected problems should be avoided by careful design and planning
problems prior to commencement of work.
Unexpected There should be mechanisms within the project to enable these problems
problems to be resolved quickly and efficiently.
Delayed benefit There is normally no benefit until the work is finished. The 'lead in' time to
this can cause a strain on the eventual recipient who is also faced with
increasing expenditure for no immediate benefit.
Specialists Contributions made by specialists are of differing importance at each
stage.
Potential for Projects often involve several parties with different interests. This may lead
conflict to conflict.

Project management ensures responsibilities are clearly defined and that resources are focussed on
specific objectives. The project management process also provides a structure for communicating
within and across organisational boundaries.
All projects require a person who is ultimately responsible for delivering the required outcome. This
person (whether officially given the title or not) is the project manager.

Strategic analysis 23
3.5.3 The project life cycle
The life cycle concept can be useful in the management of projects, since it breaks the whole down into
more easily manageable parts. This is particularly applicable to the allocation and management of
resources, since their type and quantity vary from phase to phase.
Maylor (Project Management) describes four phases or stages: this is the 4D model.

Stage in project life cycle Component Activities


Define the project Conceptualisation Produce a clear and definitive statement
of needs
Analysis Identify what has to be done and check
its feasibility
Design the project Planning Show how the needs will be met
Justification Compute costs and benefits
Agreement Obtain sponsor agreement
Deliver the project Start up Assemble resources and people
(Do it!)
Execution Carry out planned project activities
Completion Success or abandonment
Handover Output passed to sponsor/user
Develop the process Review Identify outcomes for all stakeholders
Feedback Document lessons and improvements for
future use

(1) Define the project


Larger projects are likely to involve the creation of a project brief or terms of reference for
discussion. A project initiation document may be prepared, if it is decided to continue with the
project. This will include a statement of requirements, a statement of the vision for the project
and a business case.
(2) Design the project
There are several techniques used for scheduling and time planning, such as network analysis and
Gantt charts (diagram below). This stage also deals with the need to plan for cost, quality and risk
using techniques such as risk assessment, resource budgeting, and cost budgeting.

Month January February


Activity w/c 7 14 21 28 4
Week 1 2 3 4 5

Plan
Actual
Gantt chart

24 Business Analysis
(3) Deliver the project
C
This is the operational phase of the project. Planning will continue as required in order to control H
agreed changes and to deal with unforeseen circumstances, but the main emphasis is on getting A
the work done. P
T
There are several important themes. E
R
Management and leadership: People management assumes a greater importance as the size
of the project work force increases.
Control: Time, cost and quality must be kept under control, as must the tendency for 1
changes to proliferate.
Supply chain: All the aspects of logistics management must be implemented, especially with
projects involving significant physical output.
Problems and decisions: Problems are bound to arise and must be solved sensibly and
expeditiously. Complex problems will require careful analysis using the scientific tools of
decision theory.
(4) Develop the process
Improve the way the organisation and project teams cope with projects:
Completion: All activities must be properly and promptly finished; care must be taken that
contractors do not either leave small things undone or, if paid by time, spin things out for as
long as possible.
Documentation must be completed: This is important on any project but it is vital if there are
quality certification issues or it is necessary to provide the user with operating documentation.
Project systems must be closed down, but in a proper fashion: In particular, the project
accounts and any special accounting systems must remain in operation and under control
until all costs have been posted but must then be closed down to avoid improper posting.
Handover must take place where the project has been managed for a client under contract:
At some point the client must formally accept that the contract is complete and take
responsibility for any future action that may be required, such as the operation and
maintenance of a system.
Immediate review is required to provide staff with immediate feedback on performance and
to identify short-term needs such as staff training or remedial action for procedure failures.

3.5.4 The role of the project manager

Definition
Project manager: The person who takes ultimate responsibility for ensuring the desired result of the
project is achieved on time and within budget.

The duties of a project manager are summarised below.

Duty Comment

Outline planning Project planning (eg targets, sequencing):


Developing project targets such as overall costs or timescale needed
(eg project should take 20 weeks).
Dividing the project into activities and placing these activities into
the right sequence.
Developing a framework for procedures and structures needed to
manage the project.
Detailed planning Break work into pieces, scheduling, assessing resource requirements.

Strategic analysis 25
Duty Comment

Obtain necessary Resources may already exist within the organisation or may have to be
resources bought in. Resource requirements unforeseen at the planning stage will
probably have to be authorised separately by the project board or
project sponsor.
Team building Build cohesion and team spirit.
Communication The project manager must let superiors know what is going on, and
ensure that members of the project team are properly briefed.
Co-ordinating project Between the project team and users, and other external parties (eg
activities suppliers of hardware and software).
Monitoring and The project manager should estimate the causes for each departure from
control the standard, and take corrective measures.
Problem-resolution Even with the best planning, unforeseen problems may arise.
Quality control There is often a short-sighted trade-off between getting the project out
on time and the project's quality.

3.5.5 Network or critical path analysis


Network or critical path analysis (CPA) may be defined as a diagrammatic representation of the
interrelation over time of the activities involved in a project and the subsequent analysis of those
activities in terms of time, cost and risk.
fill boil add
1 2 4 water 5
kettle water
get cup add coffee
3
Network for black coffee, no sugar

The figure above shows an extremely simple network diagram for making a cup of coffee. It shows that
some activities logically follow others (boil water after filling kettle) and some can take place at the same
time (getting cup and adding coffee while water is boiling).
Obviously in the case of a complex project there would be far more activities and a far more complex
network, but the principle is the same.
CPA allows the network to be analysed in the first instance in terms of time, which enables the
minimum project time to be determined and the critical path, ie the longest path through the network.
Any delays to activities on the critical path delay the whole project. Subsequently the network can be
analysed in terms of cost, eg the effect on cost of accelerating activities.
The basic analysis assumes the times for each activity are known with certainty. Variability in activity
times (ie risk) can be analysed using PERT (project evaluation and review technique) which can forecast
likely outcomes and the probability of a particular outcome occurring. This is particularly useful when
trying to assess the impact of potential delays in terms of time and cost.

26 Business Analysis
4 Ethics and corporate responsibility issues C
H
A
Section overview P
T
In this section we recap the factors you need to consider if any questions in your exam include E
ethical issues. This section therefore deals with the Accountant in Business. Further ethical issues R
are covered in an Auditing context in the Audit and Assurance learning materials. Corporate social
responsibility and sustainability issues are covered in the Business Strategy learning materials.
1
Advanced Stage will include more complex ethical dilemmas than Professional Stage, for example
where the ethical issue and the appropriate course of action involve multiple considerations.
Nevertheless much of the basic guidance still applies.

4.1 Ethical stances of organisations


Ethics can be defined as the moral principles that determine individual or business conduct, or
behaviour that is deemed acceptable in the society or context.
An organisation can adopt a range of ethical stances:
Meet minimum legal obligations and concentrate on short-term shareholder interests.
Recognise that long-term shareholder wealth may be increased by well-managed relationships with
other stakeholders.
Go beyond minimum legal and corporate governance obligations to include explicitly the interests
of other stakeholders in setting mission, objectives and strategy. In this context issues such as
environmental protection, sustainability of resources, selling arms to tyrannical regimes, paying
bribes to secure contracts, using child labour etc would be considered.
Public sector organisations, charities, etc where the interests of shareholders are not relevant.

4.2 Regulating ethical behaviour


Ethical business regulation operates in two ways:
1 Forbidding or constraining certain types of conduct or decisions: eg most organisations have
regulations forbidding ethically inappropriate use of their IT systems. Similarly many will forbid the
offering or taking of inducements in order to secure contracts.
2 Disclosure of certain facts or decisions: eg because the board sets its own pay they disclose it,
and sometimes the reasons behind the awards, to shareholders in the final accounts.
The following codes are potentially binding on you as a trainee Chartered Accountant.
The Auditing Practices Board (APB)
Ethical standards for Auditors concerned with assuring their integrity and independence in the
audit of financial statements and in how fees are levied.
Ethical standards for Reporting Accountants concerned with the integrity and independence of
accountants involved in writing investment circulars.
The ICAEW Code of Ethics for members
Five fundamental principles:
1 Integrity: Straightforward and honest in business and professional relationships.
2 Objectivity: Not allow bias, conflict of interest or influence of others to override professional or
business judgement.
3 Professional competence and due care: Be aware of all prevailing knowledge necessary to give
professional service and apply the same diligently to affairs of clients in accordance with technical
and professional standards.

Strategic analysis 27
4 Confidentiality: Respect the confidentiality of information acquired as a consequence of
professional or business engagements and not use the information for personal advantage or that
of third parties.
5 Professional behaviour: Comply with laws and regulations and not discredit the profession.

4.3 ICAEW Code of Ethics for Professional accountants working in business


Investors, creditors, employers, the business community, government and the public may rely on the
work of professional accountants in business in the context of:
Preparation and reporting of financial and other information
Providing effective financial management
Competent advice on a variety of business-related matters
The more senior the position held, the greater the ability and opportunity to influence events, practices
and attitudes.
A professional accountant in business is expected to encourage an ethics-based culture in an
employing organisation, which emphasises the importance that senior management places on ethical
behaviour.

4.3.1 Threats
The Code outlines areas where there may be conflict for professional accountants in business between
furthering the legitimate aims of their organisation and their absolute duty to comply with the
fundamental principles:
(a) Self-interest Financial interests, loans or guarantees; incentive compensation arrangements;
inappropriate personal use of corporate assets; concern over employment security; commercial
pressure from outside the employing organisation.
(b) Self-review Business decisions or data being subject to review and justification by the same
professional accountant in business responsible for making those decisions or preparing that data.
(c) Advocacy When furthering the legitimate goals and objectives of their employing organisations,
professional accountants in business may promote the organisation's position, provided any
statements made are neither false nor misleading. Such actions generally would not create an
advocacy threat.
(d) Familiarity A professional accountant in business in a position to influence financial or non-
financial reporting or business decisions having an immediate or close family member who is in a
position to benefit from that influence; long association with business contacts influencing business
decisions; acceptance of a gift or preferential treatment, unless the value is clearly insignificant.
(e) Intimidation Threat of dismissal or replacement of the professional accountant or a close or
immediate family member, over a disagreement about the application of an accounting principle
or the way in which financial information is to be reported; a dominant personality attempting to
influence the decision making process, for example with regard to the awarding of contracts or the
application of an accounting principle.

4.3.2 Safeguards
To comply with the Code, professional accountants are required to consider whether their actions or
relationships might constitute threats to their adherence to the fundamental principles. Where these are
significant, they must implement safeguards.
These safeguards might be generic, created by the profession or regulation, or be developed in the
working environment by the individual or their organisation.
If effective safeguards are not possible, professional accountants are required to refrain from the action
or relationship in question.
The Code sets out the types of safeguards in the work environment which might be applied to
overcome these threats:
The employing organisation's systems of corporate oversight or other oversight structures.

28 Business Analysis
The employing organisation's ethics and conduct programmes.
C
Recruitment procedures in the employing organisation emphasising the importance of employing H
high calibre competent staff. A
P
Strong internal controls. T
E
Appropriate disciplinary processes. R
Leadership that stresses the importance of ethical behaviour and the expectation that employees
will act in an ethical manner.
1
Policies and procedures to implement and monitor the quality of employee performance.
Timely communication of the employing organisation's policies and procedures, including any
changes to them, to all employees, and appropriate training and education on such policies and
procedures.
Policies and procedures to empower and encourage employees to communicate to senior levels
within the employing organisation any ethical issues that concern them without fear of retribution.
Consultation with another appropriate professional accountant.

4.3.3 Action required in unethical circumstances


In circumstances where a professional accountant in business believes that unethical behaviour or
actions by others will continue to occur within the employing organisation, they should consider
seeking legal advice.
In extreme situations where all available safeguards have been exhausted and it is not possible to reduce
the threat to an acceptable level, a professional accountant in business may conclude that it is
appropriate to disassociate from the task and/or resign from the employing organisation.

4.4 Impact of ethics on strategy


Ethics may impact upon strategy in various ways:
In the formulation of strategic objectives, some firms will not consider lines of business for ethical
reasons.
External appraisal will need to consider the ethical climate in which the firm operates. This will raise
expectations of its behaviour.
Internal appraisal: Management should consider whether present operations are 'sustainable', ie
consistent with present and future ethical expectations.
Strategy selection: Management should consider the ethical implications of proposed strategies
before selecting and implementing them.

4.4.1 Conflict between ethics and business


Potential areas for conflict between ethics and business strategy include:
Cultivating and benefiting from relationships with legislators and governments: Such
relationships may lead politicians to ignore the national interest (eg of the people who elected
them) to further their own personal interests.
Fairness of labour contracts: Firms can use their power to exploit workers, including child labour,
and subject them to unethical treatment in areas where jobs are scarce.
Privacy of customers and employees: Modern databases enable tracking of spending for
marketing purposes or discriminating between customers on basis of their value. Staff can be
subject to background checks and monitored through their use of email and the location of their
mobile phones.
Terms of trade with suppliers: Large firms may pay poor prices or demand long credit periods
and other payments from weak suppliers. This has been a particular criticism of large retail food

Strategic analysis 29
stores in North America and Europe, who are blamed for the impoverishment of farmers at home
and in developing countries.
Product and production problems: These include the environmental impacts of the production
itself, product testing on animals or humans, the manufacture of products with adverse impacts
on health and the impact on the environment when products are thrown away.
Prices to customers: Powerful suppliers of scarce products such as energy, life saving drugs or
petrol, are able to charge high prices that exclude poorer individuals or nations. Examples here
include anti-aids drugs to Africa or purified water to developing countries.
Managing cross cultural businesses: Different countries of operation or different ethnic groups
within the domestic environment can present ethical issues affecting what products are made, how
staff are treated, dress conventions, observance of religion and promotional methods.
Marketing. There is the basic argument that marketing persuades people to buy what they don't
need. However this stance assumes superiority of judgement over the consumers who buy the
products. A key issue is the ends to which marketing is put. Marketing can be used to promote
ecologically responsible ways of life, but it can also be used to promote unhealthy products such as
cigarettes, alcohol and fatty foods. Some promotion techniques have also been criticised for
attempting to brainwash consumers, encouraging anti-social behaviour and upsetting observers.

4.5 What will the ethics requirement involve?


Possible ethical problems that you may find in questions include:
The impact of ethics on strategies and strategic choice, as discussed above
Conflicts of interest amongst stakeholders
Attempts to mislead key stakeholders (by disclosure or non-disclosure of information)
Doubtful accounting or commercial business practices
Facilitation of unethical strategies
Inappropriate pressure to achieve results
Conflict between the accountant's professional obligations and the responsibilities to the
organisation
Lack of professional independence eg personal financial interest in business proposals
Actions contrary to law, regulation and/or technical and professional standards
Some of these issues are not clear-cut. You need to develop a balanced argument, using appropriate
ethical language and discussing relevant professional principles.

4.6 Recommended approach


The following is a suggested list of factors to consider when tackling questions involving ethical issues:
(1) Is there a legal issue (criminal or civil law)?
(2) Do any other codes or professional principles apply? (eg is the individual with the ethical dilemma
a professional accountant?)
(3) Upon which stakeholders does the decision/action impact?
(4) What are the implications in terms of:
Transparency
Effect
Fairness
(5) If the proposed action/decision is not taken, what are the issues?
(6) What are the alternative actions that could be taken and what are the consequences of each course
of action ?
(7) Are there any sustainability issues?

30 Business Analysis
Key weaknesses in answering ethical questions include:
C
(1) Failing to identify the ethical issue (eg transparency) H
(2) Failing to use ethical language A
P
(3) Quoting chunks of the ICAEW's ethical code without applying it to the scenario T
E
(4) Failing to identify appropriate safeguards
R
(5) Applying professional accountants' ethical codes to individuals in the scenario who are not
accountants
(6) Failing to distinguish between the ethical responsibilities of the individual and those of the 1
organisation
(7) Concluding by asserting an opinion that is not supported by clear justification on ethical grounds
stating 'X should be done because it is right' is insufficient

4.7 Corporate responsibility


4.7.1 Reasons for pursuing corporate responsibility
We mentioned corporate responsibility (CR) or corporate social responsibility earlier in this chapter.
Businesses face a number of pressures to widen the scope of their accountability.
(a) Stakeholder pressures
Businesses face pressures from various different stakeholder groups to consider their wider
responsibilities. Stakeholders include communities (particularly where operations are based),
customers (product safety issues), suppliers and supply chain participants and competitors. Issues
such as plant closures, pollution, job creation, sourcing, etc can have powerful social effects for
good or ill on these stakeholders. Without the support of stakeholders a business will find its ability
to operate is impaired and this will damage performance. Stakeholders also include governments
facing political pressures. Adopting CR voluntarily may be more flexible, and in the end less costly,
than having it imposed by statute.
(b) Corporate reputation
Increasingly a business must have the reputation of being a responsible business that enhances
long-term shareholder value by addressing the needs of its stakeholders employees, customers,
suppliers, the community and the environment. Sponsorship and community involvement can
reflect well on the business and attract ethical customers.
(c) Staff motivation
A commitment to CR helps establish values and mission within the organisation, which may help
attract and retain staff.
(d) Business issues
CR initiatives may provide opportunities to enter new markets or build new core competencies.
Businesses can achieve lower costs through using resources more efficiently, and not having to
incur costs of remediation if they have negatively affected the environment.

4.7.2 Scope of corporate responsibility


The scope of CR varies from business to business. Factors frequently included are:
Health and safety: This includes workplace injury, customer and supplier injury and harm to third
parties.
Environmental protection: Energy use, emissions (notably carbon dioxide), water use and
pollution, impact of product on environment, recycling of materials and heat.
Staff welfare: Issues such as stress at work, personal development, achieving work/life balances
through flexibility, equal opportunities for disadvantaged or minority groups.
Customer welfare: Through content and description of products, non-exclusion of customer
groups, fair dealing and treatment.

Strategic analysis 31
Supply-chain management: Insisting that providers of bought-in supplies also have appropriate
CR policies, ethical trading, elimination of pollution and un-recycled packaging, eliminating
exploitative labour practices amongst contractors.
Ethical conduct: Staff codes for interpersonal behaviour, prohibitions on uses of data and IT,
management forbidden from offering bribes to win contracts, ensuring non-exploitation of staff.
Engagement with social causes: This includes secondment of management and staff, charitable
donations, provision of free products to the needy, involvement in the local community, support
for outreach projects such as cultural improvement or education.

4.7.3 Strategic approaches to corporate responsibility


An organisation can adopt different strategic approaches to corporate responsibility:

Proactive strategy A business is prepared to take full responsibility for its actions. For example a
company which discovers a fault in a product and recalls the product without being
forced to, before any injury or damage is caused, acts in a proactive way.
Reactive strategy This involves allowing a situation to continue unresolved until the public,
government or consumer groups find out about it.
Defence strategy This involves minimising or attempting to avoid additional obligations arising from
a particular problem.
Accommodation This approach involves taking responsibility for actions, perhaps when one of the
strategy following occurs:
Encouragement from special interest groups
Perception that a failure to act will result in government intervention

Case example: Approaching corporate responsibility


The Deloitte (2008) guide 'The risk intelligent approach to corporate responsibility and sustainability'
suggests that corporate responsibility can be approached from a perspective of risk management, seeing
corporate responsibility issues as providing opportunities as well as dangers. This should in turn mean
that the organisation's approach to these issues is aligned and integrated with strategic initiatives in
other parts of the business.
Deloitte recommends a nine stage approach:

1 Understanding the This includes assessing regulatory trends, benchmarking against


present competitor activity, finding out what is important to stakeholders,
understanding all the CR activity currently happening in the
organisation
2 Envisioning the future Assessing the legacy the organisation wishes to leave. This will mean
integrating CR activities with business strategies, for example a
publishing company sending its employees to libraries and schools,
or donating books
3 Planning the journey CR issues should be prioritised using a gap analysis between current
and future states, and the organisation and its competitors. Assess
opportunities for action, risks of inaction and not achieving objectives
4 Planning and building The human resource element is vital, including example set and
oversight by senior management. CR achievements should be built
into performance reviews and remuneration. Assess availability of
grants and tax concessions for green behaviour. Also consider
broadening stakeholder base and organisation's ethical culture
5 Execution Develop in controlled fashion, enhancing governance procedures
related to implementation
6 Review and revision Develop metrics to measure activities. Use hard data rather than
impressions, though stakeholder feedback is important

32 Business Analysis
7 Reporting and A CSR development programme may mean reporting on CR needs to
communicating be revamped. The organisation could report in accordance with C
H
various external reporting standards or produce customised reports
A
8 Assuring internally Adapt measures used internally to assess CR development to monitor P
T
how the organisation is doing. Use internal resources such as internal
E
audit, legal, health and safety and human resources to assist in R
development
9 Assure externally When CR reaches a certain level, seek verification from outside the
organisation of assertions in CR report 1

Case example: Corporate responsibility programme

Scottish Power's corporate responsibility programme has been developed from multi-stakeholder
consultation. The stakeholders emphasised the need for the company to prioritise its most significant
social and environmental impacts. This consultation identified 12 impacts, and Scottish Power's
corporate responsibility report detailed what had been done to address these:
(a) Provision of energy
Scottish Power was involved in a competition to develop carbon capture and storage. It spent 456
million in refurbishing its electrical network and committed 20 million investment to its
hydroelectric plant.
(b) Health and safety
The Lost-Time Accident rate fell for the fifth successive year. Its Children's safety education
programme won two major awards.
(c) Customer experience
Scottish Power achieved the highest satisfaction rating for on-line energy service in the market and
was ranked the second UK gas supplier. Its customer base increased by 4%.
(d) Climate change and emission to air
Scottish Power's Green Energy Trust awarded 232,809 to 20 small renewable energy projects. It
entered a contract to supply all Debenhams' properties with electricity generated from green
sources and met 57% of its carbon emission reduction programme through customer energy
efficiency programme.
(e) Waste and resource usage
Scottish Power increased its investment in oil containment and received a Queen's Award in the
Sustainable Development category.
(f) Biodiversity
The company took steps to allow the public to watch wildfowl. A cable pipeline was drilled below
the Dovey Estuary to avoid disturbance to a site of Special Scientific Interest.
(g) Sites, siting and infrastructure
Scottish Power completed connections to more renewable energy sources and implemented a
programme to keep parts of its network underground in Snowdonia.
(h) Employee experience
The company launched two new employee share plans. Staff participated in community
development programmes that provided training for young people.

Strategic analysis 33
(i) Customers with special circumstances
Scottish Power contributed 1 million to the Scottish Power Energy People Trust. It launched a new
social tariff that combined low prices with energy efficiency advice and measures to take vulnerable
customers out of fuel poverty.
(j) Community
Over 58,000 primary schoolchildren benefited from Powerwise, Scottish Power's classroom safety
education programme.
(k) Procurement
Scottish Power developed a group-wide responsible procurement policy and spent 74 million on
customer energy efficiency measures.
(l) Economic
Scottish Power provided employability training to 68 Skillseekers during the year.

4.8 Corporate citizenship


Corporate citizenship is the business strategy that shapes the values underpinning a company's mission
and the choices made each day by its executives, managers and employees as they engage with society.
Three core principles define the essence of corporate citizenship, and every company should apply them
in a manner appropriate to its distinct needs: minimizing harm, maximizing benefit, and being
accountable and responsive to stakeholders. (Boston Center for Corporate Citizenship)
Much of the debate in recent years about corporate responsibility has been framed in terms of
corporate citizenship, partly because of unease about using words like ethics and responsibility in the
context of business decisions. Discussion of corporate citizenship also often has political undertones,
with corporations acting instead of governments that cannot or will not act to deal effectively with
problems.

Case examples: Corporate citizenship

Companies have devised a number of different definitions of corporate citizenship.

Abbott Laboratories
Global citizenship reflects how a company advances its business objectives, engages its stakeholders,
implements its policies, applies its social investment and philanthropy, and exercises its influence to
make productive contributions to society.
At Abbott, global citizenship also means thoughtfully balancing financial, environmental and social
responsibilities with providing quality health care worldwide. Our programmes include public
education, environment, health and safety, and access to health care. These efforts reflect an
engagement and partnership with stakeholders in the pursuit of sustainable solutions to challenges
facing the global community.

AT&T
For AT&T, corporate citizenship means caring about the communities it is involved with, keeping the
environment healthy, making AT&T a safe and rewarding place to work and behaving ethically in all its
business dealings.

Coca-Cola
Responsible corporate citizenship is at the heart of The Coca-Cola Promise, which is based on four core
values in the marketplace, the workplace, the environment and the community:

Marketplace. We will adhere to the highest ethical standards, knowing that the quality of our
products, the integrity of our brands and the dedication of our people build trust and strengthen
relationships. We will serve the people who enjoy our brands through innovation, superb customer
service, and respect for the unique customs and cultures in the communities where we do business.

34 Business Analysis
Workplace. We will treat each other with dignity, fairness and respect. We will foster an inclusive
environment that encourages all employees to develop and perform to their fullest potential, C
consistent with a commitment to human rights in our workplace. The Coca-Cola workplace will be H
A
a place where everyone's ideas and contributions are valued, and where responsibility and
P
accountability are encouraged and rewarded. T
E
Environment. We will conduct our business in ways that protect and preserve the environment. R
We will integrate principles of environmental stewardship and sustainable development into our
business decisions and processes.
1
Community. We will contribute our time, expertise and resources to help develop sustainable
communities in partnership with local leaders. We will seek to improve the quality of life through
locally-relevant initiatives wherever we do business.
DHL
DHL takes its definition of Corporate Citizenship from the World Economic Forum: Corporate citizenship
is about the contribution a company makes to society through its core business activities, its social
investment and philanthropy programs, and its engagement in public policy.
Texas Instruments
Beyond the bottom line, the worth of a corporation is reflected in its impact in the community. At TI,
our philosophy is simple and dates back to our founding fathers. Giving back to the communities where
we operate makes them better places to live and work, in turn making them better places to do
business. TI takes its commitment seriously and actively participates in community involvement through
three ways philanthropy, civic leadership and public policy and grass roots efforts.

4.9 Sustainability
We defined sustainability earlier in this chapter, using the widely accepted Brundtland report definition
of ensuring that the needs of the present are met without compromising the ability of future
generations to meet their own needs.
One approach to sustainability is known as the triple bottom line (or 'TBL', '3BL', or 'People, Planet,
Profit') approach.

People means balancing up the interests of different stakeholders and not automatically
prioritising shareholder needs.
Planet means ensuring that the business's activities are environmentally sustainable.
Profit is the accounting measure of the returns of the business.
A similar approach to thinking about sustainability issues is to differentiate three different types of
sustainability:

Issues Examples

Social Health and safety, workers' rights (in the business itself and its supply chain), pay
and benefits, diversity and equal opportunities, impacts of product use, responsible
marketing, data protection and privacy, community investment, and
bribery/corruption
Environmental Climate change, pollution, emissions levels, waste, use of natural resources, impacts
of product use, compliance with environmental legislation, air quality
Economic Economic stability and growth, job provision, local economic development, healthy
competition, compliance with governance structures, transparency, long-term
viability of businesses, investment in innovation/NPD

Strategic analysis 35
4.10 Environmental and social reporting
A business may provide social and environmental data as part of its external reporting. Reports generally
include narrative and numerical information about impact. Narrative information includes objectives,
explanations and reasons why targets have or have not been achieved. Reports can also address
concerns of specific internal or external stakeholders. Useful numerical measures can include pollution
amounts, resources consumed or land use.

Case example: Environmental and social reporting

BT's Social and Environmental Report for the year ended 31 March 2011 complies with the Global
Reporting Initiative Guidelines (discussed below). To give an overview of the company's social and
environmental performance, the report selects 12 non-financial key performance indicators.

(a) Customer service 3% increase in service quality

(b) Employee engagement index (measure of success of BT's relationship with employees) a small rise
to 3.61 out of 5

(c) Diversity BT maintains a top 10 placement in 4 out of 5 major diversity benchmarks

(d) Health and safety lost time injury rate up from 0.209 cases per 100,000 working hours to 0.225
cases per 100,000 working hours

(e) Health and safety sickness and absence rate down from 2.46% calendar days lost due to
sickness/absence to 2.41% calendar days lost

(f) Supplier relationship success 86% satisfaction

(g) Ethical trading (a measure of the application of BT's supply chain human rights standard) 70 risk
assessments with 100% follow-up

(h) Community effectiveness (such as charity partnerships and support for learning and skills and
helping people get on-line) rated at 98%

(i) BT's investment in community improvements is 1.9% of pre-tax profits

(j) Global warming CO2 emissions fell from 653,000 to 628,000 tonnes

(k) Waste to landfill and recycling (a measure of use of resources) reduction of 69%

(l) Ethical performance a small increase to 4.16 out of 5 in a measure designed to assess employee
awareness and training, compliance with the company's ethical code and behaviour with integrity

4.10.1 Global Reporting Initiative


Earlier papers covered The Global Reporting Initiative (GRI), a reporting framework that arose from the
need to address the failure of current governance structures to respond to changes in the global
economy.
The GRI aims to develop transparency, accountability, reporting and sustainable development. Its vision
is that reporting on economic, environmental and social importance should become as routine and
comparable as financial reporting.
The GRI published revised guidelines in 2006.
The main section of the Guidelines sets out the framework of a sustainability report. It consists of five
sections.
(a) Strategy and analysis. Description of the reporting organisation's strategy with regard to
sustainability, including a statement from the CEO. In addition, there should be a description of key
impacts, risks and opportunities. This section should focus firstly on key impacts on sustainability
and associated challenges and opportunities, and how the organisation has addressed the

36 Business Analysis
challenges and opportunities. It should secondly focus on the impact of sustainability risks, trends
and opportunities on the long-term prospects and financial performance of the organisation. C
H
(b) Organisational profile. Overview of the reporting organisation's structure, operations, and A
markets served and scale. P
T
(c) Report parameters. Details of the time and content of the report, including the process for E
R
defining the report content and identifying the stakeholders that the organisation expects to use
the report. Details should also be given of the policy and current practice for seeking external
assurance for the report.
1
(d) Governance, commitments and engagement structure and management systems. Description
of governance structure and practice, and statements of mission and codes of conduct relevant to
economic, environmental and social performance. The report should give a description of charters,
principles or initiatives to which the organisation subscribes or which the organisation endorses.
The report should also list the stakeholder groups with which it engages and detail its approaches
to stakeholder engagement.

(e) Performance indicators. Measures of the impact or effect of the reporting organisation divided
into integrated indicators.
The GRI structures performance indicators according to a hierarchy of category and aspect.

Category Aspect
Environmental Materials
Water
Biodiversity
Emissions, effluents, and waste
Products and services
Compliance
Transport
Overall
Human rights Investment and procurement practices
Non-discrimination
Freedom of association and collective
bargaining
Child labour
Forced and compulsory labour
Security practices
Indigenous rights
Scale of assessment
Remediation of grievances
Labour practices and decent work Employment
Labour/management relations
Occupational health and safety
Training and education
Diversity and equal opportunity
Equal remuneration for women and men
Society Local community
Corruption
Role in public policy
Anti-competitive behaviour
Compliance
Product responsibility Customer health and safety
Products and service labelling
Marketing communications
Customer privacy
Compliance

Strategic analysis 37
Category Aspect
Economic Economic performance
Market presence
Indirect economic impacts

4.10.2 Integrated reporting


In September 2011 the International Integrated Reporting Council launched a discussion document
st
Towards Integrated Reporting Communicating Value in the 21 Century.
The aim of integrated reporting that the document promoted was to demonstrate the linkage between
strategy, governance and financial performance and the social, environmental and economic context
within which the business operates. By making these connections, businesses should be able to take
more sustainable decisions, helping to ensure the effective allocation of scarce resources. Investors and
other stakeholders should better understand how an organisation is really performing. In particular they
should make a meaningful assessment of the long-term viability of the organisation's business model
and its strategy.
Integrated reporting should also achieve the simplification of accounts, with excessive detail being
removed and critical information being highlighted.
Integrated reporting is designed to make visible the capitals (resources and relationships) on which the
organisation depends, how the organisation uses those capitals and its impact upon them.

Capital

Financial Funds available for use in production obtained


through financing or generated through
operations

Manufactured Manufactured physical objects used in


production or service provision:

Buildings
Equipment
Infrastructure
Human Skills, experience and motivation to innovate:

Alignment and support for organisation's


governance framework and ethical values
Ability to understand and implement
organisation's strategies
Loyalties and motivations for improvements
Intellectual Intangibles providing competitive advantage:

Patents, copyrights, software and


organisation systems
Brand and reputation

38 Business Analysis
Capital
C
H
Natural Input to goods and services and what activities
A
impact: P
T
Water, land, minerals and forests E
R
Biodiversity and eco-system health
Social Institutions and relationships within each
community stakeholder group and network to 1
enhance well-being:

Common values and behaviours


Key relationships
Social licence to operate
A number of guiding principles underpin the content and presentation of an integrated report:

Strategic objectives Insights into strategic objectives, strategies and


how they relate to other components in
business model. Report also how organisation
uses resources and relationships.

Connectivity of information Links between different components of business


model, external factors and resources and
relationships upon which organisation depends.
Examples include how changes in market
environment influence strategy and how
strategies link to key performance and risk
indicators and remuneration.

Future orientation Management expectations about the future and


other information to help organisation's users
assess prospects. Information should include
balancing of short- and long-term interests,
where organisation will go and how it will get
there, and critical enablers, challenges and
barriers.

Responsiveness and stakeholder inclusiveness Insight into organisation's relationships with


stakeholders and how organisation takes
account of and responds to their needs.

Conciseness, reliability and materiality Provision of important and reliable information


with less significant information being disclosed
elsewhere.

The content elements follow on from the guiding principles:

Organisational overview and business model


Operating context, including risks and opportunities, resources and relationships
Strategic objectives and strategies including risk management, and also the extent to which
sustainability considerations are embedded into strategy to provide clear advantage
Governance and remuneration
Performance against strategic objectives, impacts on resources and relationships and external factors
impacting on performance
Future outlook, including how well organisation is equipped to respond to future environment,
repercussions of future plans, actions required and uncertainties

Strategic analysis 39
4.11 Auditing environmental sustainability
An environmental audit is an evaluation of how well an entity, its management and equipment are
performing, with the aim of helping to safeguard the environment by facilitating management control
of environmental practices and assessing compliance with entity policies and external regulations.
Environmental auditing is also used for auditing the truth and fairness of an environmental report rather
than the organisation itself.
An environmental audit may be undertaken as part of obtaining or maintaining external accreditation,
such as the BSI's ISO 14001 standard.
In practice environmental audits may cover a number of different areas, The scope of the audit will
depend on each individual organisation. Often the audit will be a general review of the organisation's
environmental policy. On other occasions the audit will focus on specific aspects of environmental
performance (waste disposal, emissions, water management, energy consumption) or particular
locations, activities or processes.
There are other specific aspects of the approach to environmental auditing which are worth mentioning.
(a) Environmental Impact Assessments (EIAs)
These are required, under an EU directive, for all major projects which require planning permission
and have a material effect on the environment. The EIA process can be incorporated into any
environmental auditing strategy.
(b) Environmental surveys
These are a good way of starting the audit process, by looking at the organisation as a whole in
environmental terms. This helps to identify areas for further development, problems, potential
hazards and so forth.
(c) Environmental SWOT analysis
A 'strengths, weaknesses, opportunities, threats' analysis is useful as the environmental audit
strategy is being developed. This can only be done later in the process, when the organisation has
been examined in much more detail.
(d) Environmental Quality Management (EQM)
This is seen as part of TQM (Total Quality Management) and it should be built into an
environmental management system. Such a strategy has been adopted by companies such as IBM,
Dow Chemicals and by the Rhone-Poulenc Environmental Index, which has indices for levels of
water, air and other waste products.
(e) Eco-audit
The European Commission has adopted a proposal for a regulation for a voluntary community
environmental auditing scheme, known as the eco-audit scheme. The scheme aims to promote
improvements in company environmental performance and to provide the public with information
about these improvements. Once registered, a company will have to comply with certain on-going
obligations involving disclosure and audit.
(f) Eco-labelling
Developed in Germany, this voluntary scheme will indicate those EU products which meet the
highest environmental standards, probably as the result of an EQM system. It is suggested that
eco-audit must come before an eco-label can be given.
(g) BS 7750 Environmental Management Systems
BS 7750 also ties in with eco-audits and eco-labelling and with the quality BSI standard BS 5750.
Achieving BS 7750 is likely to be a first step in the eco-audit process.
(h) Supplier audits
They ensure that goods and services bought in by an organisation meet the standards applied by
that organisation.

40 Business Analysis
4.11.1 Environmental audit stages
C
There are three main stages in most environmental audits. H
A
(a) Establishing the metrics P
T
The greater the variety of metrics, the more information provided. However measuring against a E
number of metrics could result in a costly audit. R

(b) Measuring planned or desirable performance against actual performance


This is an important aspect of a system. Some metrics will be objective, for example the level of 1
carbon emissions or plastic bag issues can be measured. However other aspects, for example public
perceptions, cannot be measured objectively and may therefore be difficult to measure precisely.

(c) Reporting the results of the audit


Important decisions will include the form of the report and how widely it should be distributed, in
particular whether the organisation's annual report should include a report by the auditors.

4.11.2 Auditor concerns


(a) Board and management having good understanding of the environmental impact and related
legislation of the organisation's activities in areas such as buildings, transport, products, packaging
and waste.
(b) Adoption and communication of adequate policies and procedures to ensure compliance with
relevant standards and laws.
(c) Adoption of appropriate environmental information systems.
(d) Adoption and review of progress against quantifiable targets.
(e) Assessment of whether progress is being made economically and efficiently.
(f) Implementation of previous recommendations of improvements to processes or systems.
(g) True, fair and complete reporting of environmental activities.

5 Integrating the use of analysis tools in a complex scenario

Section overview
In reality, analysis tools will not be used in isolation. At the Advanced stage, you will be expected
to demonstrate your ability to use several tools to evaluate a complex scenario. This section
makes use of a lengthy exam-standard case study to integrate the use of a number of tools. The
case study also contains financial elements, illustrating how business strategy integrates with
financial strategy.
At this Advanced level of your studies, you are expected to have gained a detailed understanding
of the tools that were reviewed in Section 1. The important skills you are now required to
demonstrate are how to apply these models in a complex scenario and integrate them with other
strategies in order to mirror a real life situation.

5.1 Preparing to tackle a case study


Companies encounter complex scenarios all the time in real life. The important thing to remember is
that no two cases are ever the same each one must be treated on its own merits. However, there are
some fundamental questions you should ask when reading through the scenario you are faced with in
the exam.
What is the company's main line of business?
What is its current strategy?

Strategic analysis 41
What are its long-term objectives?
Are there any global issues to consider?
How is the company performing financially?
Are there any obvious areas for improvement?
Does the company have any particular strengths that could be further exploited?
Are there any limited resources that may affect the company's ability to fulfil its objectives?
What are competitors doing?
Are there any potential conflicts between objectives for example, financial strategy versus
marketing strategy?
As much as possible, try to treat case studies as you would problems in your own workplace or that of a
client think about how decisions taken to solve one problem might impact on other areas of the
business, whether certain decisions will contradict company strategy or affect market perception, the
potential financial implications of different actions, and whether proposed courses of action will align
with company culture. Look for the issues you would normally consider in a work situation. If you are
given financial information, make sure you use it, whether to establish profit margins, growth or general
financial health.

5.2 Worked example


The following case study is an example of how different analytical tools can be used in a business
situation and illustrates the need to use financial information to evaluate company performance.

Worked example: Body Beautiful


John and Kate Dempsey are the joint owners and managers of Body Beautiful Ltd, which is based in the
UK. The firm, which was formed in 20X2, is in the ladies' body care business, buying products from
various manufacturers based almost exclusively outside the UK, including Japan, Malaysia and mainland
China. More recently, the firm has also started to source products from European countries, most
notably France and Spain. The firm concentrates mainly on smaller value items such as body lotions,
nail care products and facial treatments. Its customers are mainly wholesalers and spa facilities in the
UK.
John and Kate borrowed heavily from the bank in order to purchase the business. Due to the success of
Body Beautiful, they have managed to pay off this initial loan, and have expanded their premises
considerably. The main premises are now a state-of-the-art warehouse and distribution centre, through
which all their goods pass this is owned on a freehold basis by the firm, rather than the leased
premises with which it started out.
Business is booming. Sales are now in excess of 15 million per annum, the result of a steady growth of
approximately 30% each year and there are no indications that this will not continue. Despite this,
however, Body Beautiful's sales only account for approximately 45% of the market, so there is
considerable potential for market growth. The firm operates very efficiently with a total of 25 staff
(excluding John and Kate), an increase of 60% on initial employee numbers. All but three of these
employees are warehouse and distribution staff. Kate, the Managing Director, is concerned solely with
the marketing side of the business, using her contacts from her previous role as senior salesperson in the
body care subsidiary of a large group of companies, and is assisted by the three non-warehouse staff
who concentrate on smaller clients. John, the other director, takes care of day-to-day operations,
including administration, warehouse and distribution operations, and financial management. As the
business continues to grow, more staff will be inevitable, particularly to support the distribution
function, and it is estimated that the payroll will comprise 50 (non-director) employees within the next
three years.
Body Beautiful's success can be attributed to several factors. First, Kate is an expert marketer with
numerous contacts in the trade. Her popularity and close working relationship with clients has been a
major contributor to sales growth. Customer loyalty is encouraged by the excellent customer service
that Kate and John provide, through their accessibility and personal attention.

42 Business Analysis
As all products are purchased from foreign manufacturers, it has been essential to keep a close eye on
currency rate movements. John has been especially astute, taking advantage of the relative strength of C
sterling against the euro for European supplies. There have been more problems with the Asian H
A
suppliers however. Most of their products are priced in US dollars and the weakness of this currency
P
against sterling has prevented John negotiating low prices. The currency situations are always subject to T
change however, and it is John's task to take appropriate action to protect Body Beautiful from major E
fluctuations. R

Kate has developed strong links with suppliers and until recently has tried to maintain only a small
number to keep lines of communication and control as simple as possible. Most of the suppliers have
1
been linked with the firm since its inception in 20X2, thus providing Body Beautiful with reliable and
good quality products. Body Beautiful often has exclusive access to certain products. One example is
its sole UK distribution rights to a French anti-wrinkle cream whose excellent results in product trials
have made it a very sought after product. The success of and demand for this product has further
encouraged customer loyalty. Kate realises that as customer demand for all of their products increases
the firm will have to find additional suppliers and has already started sourcing products from new
manufacturers.
Body Beautiful is in the fortunate position of having no immediate competitors. Many of the small
competitors in the body care industry have opted to concentrate on other aspects of the business, such
as the supply of small electrical items (for example, foot spas and face steamers) or the increasingly
lucrative men's products. Some also sell spa furniture such as massage tables and mobile product
trolleys. A number of small firms have even left the industry altogether. Several large international
companies who manufacture body care products also buy merchandise from Body Beautiful but sell it to
high street retailers for domestic consumer purchase rather than directly to wholesalers and spas. These
companies do not see Body Beautiful as a threat, given their relative sizes.
Rather than using the manufacturers' own brand names and packaging, Body Beautiful has registered its
own brand name for its main products and repackages them in its own distinctive green and gold
wrapping. The directors have found that this has generated even more customer loyalty and has even
allowed them to charge a premium price. Both Kate and John believe that part of the firm's success has
been down to spending minimal amounts on administrative expenses. Most of the products are
outsourced, with value being added mainly through branding and high levels of customer service. Kate
and John believe that strategy is not necessarily about beating the competition but in serving customers'
needs. The firm has also established a strong relationship with a leading chain of health clubs,
providing its clubs with good quality, low cost body lotions and shower gels to be sold under their own-
brand label. Although margins are small, volume more than makes up for this.
Due to the considerable increase in sales, Body Beautiful has had to incur significant investment costs,
including building the new warehouse facilities, increased inventory-holding costs, upgrading computer
systems to handle customers orders, inventory control and financial matters, and despatch vehicles such
as larger delivery lorries and fork-lift trucks for the warehouse. Such expenditure could not be financed
from operating cash flows but the firm's bank was willing to lend the necessary funds given its ability to
pay off previous loans ahead of schedule.
Despite the firm's obvious success so far, Kate and John are still keen to pursue further growth, driven
more by an appetite for enhanced personal reputation rather than wealth accumulation. However, they
are concerned that the rapid growth enjoyed by the firm in the last five years is not sustainable and they
are therefore looking for other ways to expand. Their accountant has produced the following
information for them to consider.

Strategic analysis 43
Body Beautiful Ltd Financial and operational details
20X5 20X6 20X7 20X8
(forecast)
'000 '000 '000 '000
Sales 8,402 11,259 15,200 20,064
Cost of sales 5,297 7,474 10,826 14,428
Marketing 840 970 1,064 1,203
Distribution 1,008 1,126 1,216 1,404
Administration 100 113 167 321
Interest on loans 0 281 432 1,128
Operating profit 1,157 1,295 1,495 1,580
Non-current assets 1,826 4,825 8,192 16,854
Inventory 840 1,287 2,124 3,745
Long-term loan 0 3,513 5,088 12,538

Total staff (incl. directors) 20 23 27 40


Number of suppliers 20 30 60 80
Range of products 40 95 120 145

Operating profit % 13.8 11.5 9.8 7.9

Requirements
You are Kate and John's accountant.
(a) Prepare a report which evaluates the current position of the firm and highlights any financial and
strategic issues concerning future development that you believe should be brought to the directors'
attention.
(b) Prepare a report for Kate that identifies and assesses the strategies they might consider in their
quest to further develop the firm.
(c) Kate and John appear to be very keen for the firm to grow even more. Identify reasons for
potential corporate decline and suggest ways that Kate and John could avoid them in the context
of the case study.
(d) At the moment, the firm appears to have been growing steadily and successfully. Demonstrate
how Kate and John have managed to achieve this success using value chain analysis.

Solution
This is a large case study with a lot of information in it. You will need to look carefully at the table of
data in order to get a good grip on this question. You might find that SWOT would form a good basis
for thinking about the information you are given.
The question calls for a report: make sure you write and set out your answer in a suitable format.
It is clear from a glance at the data table that sales, cost of sales and borrowing have all risen rapidly and
are expected to continue to rise. Two minutes with a calculator will reveal the relative rates of increase,
which are very significant indeed. One thing you should always check is whether interest rates change
from year to year and/or as loans get larger.
Make sure you analyse and apply the quantitative data properly. Analysis should extend beyond the
calculation of financial ratios. Obvious and unsupported statements such as asserting that a particular
ratio has increased, should be avoided. Skills at this level should include analysis and interpretation
which explains the data in operational, financial and strategic terms to the full extent of the available
information. Also be prepared to identify possible strategic action that could be taken to resolve any
issues and its potential impact on the data in future.

44 Business Analysis
(a) To: Managing Director, Body Beautiful Ltd
From: Accountant C
Date: December 20X7 H
A
Subject: Body Beautiful Ltd current position and prospects
P
1 Current situation T
E
Trading R

The last three years' trading results show impressive growth in sales, which is forecast to
continue into 20X8. Unfortunately, cost of sales, which is by far the largest expense item, has
1
risen at an even faster rate; this trend is also forecast to continue. The effect of this
disproportionate rate of increase has been ameliorated by lower rates of increase in other costs,
but has led to relatively slow growth in profits as compared to the growth in sales. In fact, the
operating profit percentage is forecast to be only 7.9% in 20X8, whereas in 20X5 it was 13.8%.
Costs
Cost of sales. The relative rise in cost of sales may be caused, at least in part, by the
expansion of the product range, the number of lines having more than trebled since 20X5.
It might be worth examining the margins achieved on each line to establish whether the
product range might be trimmed. This may also have a desirable effect on the amount of
capital tied up in inventories, which has increased by more than 400% since 20X5. Also, as
cost of sales contains some fixed costs, one would expect all other things being equal that
cost of sales would increase more slowly than sales as the business expands.
Distribution and marketing. Distribution and marketing costs have risen much more slowly
than cost of sales and slower even than sales. While the level of marketing costs may be
regarded as subject to some discretion, holding distribution costs down to an increase of only
39% when sales have more than doubled is a significant achievement.
Finance costs. The expansion of the business has largely been financed by borrowing. Total
indebtedness is comfortably lower than the value of non-current assets alone, but the interest
payments have risen to 2.8% of sales and are expected to rise to 5.6% of the much increased
sales forecast for 20X8. This is partly because borrowing itself will more than double, but there
is also an increase in the rate of interest forecast, presumably reflecting the bank's
perception of increasing risk as the company's borrowing expands. This should be borne in
mind if further expansion of premises is considered: leasing may turn out to be cheaper.
Administration. Administration remains the smallest category of cost, though these costs are
expected to increase in line with turnover presumably as a result of the intended growth in
staff numbers.
2 Issues for the future
2.1 Competition
At the moment, Body Beautiful is not significantly challenged by competitors: larger
body care product companies sell into the consumer market and smaller ones specialise
in other product ranges. It would not be wise to plan for the future on the basis that this
will continue indefinitely. Even if the current rate of growth is not maintained, it will not
be long before the company is challenged, either by a start-up business or by an
established company seeking further growth. The company's relationship with the health
club chain will already have brought it to the attention of the larger players.
2.2 Business cycle
You have argued that your market segment is recession-proof. This is unlikely to be the
case. You have not so far encountered a downturn. Much of your trade is in superior
quality, branded products for which you are able to charge premium prices. In the event
of a recession, it is likely that your customers would seek to contain or reduce their
costs by buying cheaper goods. If you were able to supply them, your margins would
be eroded; if you were not you would lose the business altogether.
2.3 Suppliers
The expansion of your product range means that you now deal with four times the
number of suppliers you bought from three years ago. Part of your success has been built

Strategic analysis 45
on strong relationships with your suppliers: these relationships will be difficult to establish
with the new suppliers simply because there are so many of them. This may affect the
reliability of your deliveries, the discounts you receive and your access to newly
developed premium products. These effects are particularly likely to occur if competitors
enter your chosen markets.
2.4 Management
The company has expanded to a size many times larger than it was when it was set up,
but the management structure has remained the same. It seems unlikely that this can
continue much longer. The volume of transactions alone is likely to generate a scale of
managerial work that two people cannot handle; there is also the whole field of human
resource management to consider. Staff numbers are planned to increase by 50% in
20X8. Payroll administration, recruitment, selection, and other aspects of personnel
management are likely to become more and more time consuming. It would also be
appropriate to consider the potential for ill-health to affect the smooth operation of the
business: having greater managerial capacity would provide the organisation with the
flexibility to deal with absence through ill-health. It is probably time to think about
taking on at least one person who can undertake some of the more routine management
and administrative functions. This could also have the advantage of releasing some of
your own time to allow consideration of strategic issues in greater depth.
2.5 Currency exchange rates
Most of your purchases are paid for in foreign currency. The dollar and euro exchange
rates have been reasonably stable, but this may not be the case in the future. As the
volume of your business expands, it may become practical for you to use your bank's
services to hedge against unfavourable exchange rate movements.
3 Conclusion
Your business continues to expand, but your cost structures might benefit from close
attention. This is particularly true of cost of sales and finance charges. Management structure
is another matter that needs consideration. There are also a number of possible developments
in the business environment that could affect the continuing success of the business. You
should give some thought to the possibilities of recession, adverse exchange rate movements
and increased competition.
(b) This question lends itself to an answer based on the various strategic option models that you
should be very familiar with. The scenario gives a lot of detail that is relevant when considering the
various possible routes to growth, so a fairly careful answer plan would be a good idea here.
It is important to discuss longer-term strategies as well as quick, tactical courses of action. Focusing
on the long-term future of the business is more realistic and will demonstrate your business
acumen. If you focus only on the short term, this suggests a lack of appreciation for business
planning. Make sure you also integrate potential strategies by considering the financial implications
for many companies, finance is often the stumbling block when putting development proposals
together.
To: Managing Director, Body Beautiful Ltd
From: Accountant
Date: December 20X7
Subject: Body Beautiful Ltd possible development strategies
1 Current limitations
At the moment you have 45% of your chosen market, which must be deemed as a dominant
share. While there is still some potential for further organic growth in like-for-like sales, you are
probably justified in doubting that this could be a major source of expansion. It is likely that
you would have to base such growth on price competitiveness: you may be able to do this
reasonably profitably if you can exploit purchasing economies of scale, but you may feel that
there are more inviting routes to growth than further market penetration based on a cost-
focus.
However, before leaving this topic completely, it is worth mentioning the possibility of a
differentiation focus strategy. I have already remarked on the recent rapid growth in the
number of products you offer and recommended a review of profitability: this might lead

46 Business Analysis
you to concentrate much of your attention on the high margin items you sell under your
own brand. You could aim for a two component business: branded goods selling at high C
prices and your supply of own-brand items in high volumes to your main health club H
customer. A
P
2 Product-market options T
E
2.1 Product development R
At the moment, you sell a range of body care items to wholesalers and spa facilities,
mostly for trade use; your product range includes goods sold both under your company's
brand and some sold as own brand items by a leading health club chain. Possible scope 1
for product development lies in the category of goods sold into your market by your
smaller competitors, such as small electrical goods and men's products. These items
would complement your existing range. However, any future introduction of new
products should only be contemplated in the light of the review of profitability already
recommended.
It would be inappropriate for you to contemplate a move into spa furnishings, since
these high-value items are so very different in nature from your existing range. You
would probably have to establish completely new supplier relationships and the items
themselves may incur significant costs in fitting and after-sales service.
More adventurous product development, such as selling a line of hair care products,
would put you in competition with major international companies. You might be able to
source low cost, unbranded supplies, but there could well be product safety issues to
contend with. This option should not be discarded, but needs careful consideration.
2.2 Market development
There are two principal new markets you might consider.
First, you might consider providing other health club chains with goods to sell under
their own brands. You would, of course have to consider how this might affect your
relationship with your existing retail chain customer. This would be low margin business,
but you have already found that the volumes make up for this: an expansion should
increase your purchasing power and enhance your margins by reducing your purchase
costs. This strategy could also be applied to supermarket and department store chains.
Second, you might consider international expansion. This would require some careful
market research to assess such things as distribution chains, competition and consumer
preferences, but there is considerable potential here. Attendance at one of the many
European beauty care industry trade fairs would be a good way to start.

2.3 Diversification
Diversification is a high risk strategy and none of the options seems appropriate for you.
A move into a completely new market with new products would not build on any of your
strengths and would expose you to established competition. A vertical move up or
down the value system has more to recommend it, since you would be able to build on
your current market experience, but there would be significant disadvantages to such a
move.
A move upstream into manufacturing would put you in competition with your current
suppliers. You would not be operating on the same scale as them and therefore you
would expect your costs to be higher. It is possible that you could find and exploit a
manufacturing niche, perhaps producing a small number of similar lines that you
currently have difficulty in sourcing, but this does not seem to offer much prospect for
achieving your aim of continued substantial growth. If you contemplate manufacturing,
you should certainly think in terms of off-shore production, perhaps by entering into
outsourcing agreements. This would significantly reduce the capital requirement.
A move downstream into retailing would be even more difficult. You have no
experience of retail operations, so your bank would be unlikely to provide the capital to
acquire a chain of outlets; this means that you would have to build the new business by
organic growth, which would necessarily be a slow process. Such a move would require
you to learn all the skills involved in retailing and to source a much larger range of
products.

Strategic analysis 47
3 Methods of growth
3.1 Acquisition
I have already mentioned the relatively slowness of organic growth. More rapid growth
can often be achieved by the acquisition of an appropriate existing business. This might
be an attractive option for expansion within your existing markets and as an alternative
to the product development route mentioned above. Acquisition could also be a route to
rapid implementation of the international expansion and manufacturing niche strategies.
3.2 Joint venture/strategic alliance
A joint venture or strategic alliance might be an alternative route to expansion. The
difference between the two concepts is that the former involves the creation of a new,
jointly owned business entity, while the latter is based on the shared use of an asset, thus
spreading its costs and creating scale economies from the increased rate of use. Either of
these approaches could be a relatively low risk route to international expansion, for
example. A joint venture might be arranged with an existing customer or supplier, while
a form of strategic alliance might be created by the use of a foreign commercial agent.
The drawback of these vehicles from your point of view would be that you would have to
share control, which might not be an attractive prospect.
4 Conclusions
Either a cost focus or a differentiation focus could be a route to further market penetration,
though growth by these means would probably be slow.
There do not seem to be good prospects for expansion based on product development.
You may wish to look more closely at the two possibilities for market development I have
described: further manufacturing for own brand retailers and a foreign venture. Acquisition or
joint venture might be worth further examination as means to the latter end.
The only diversification strategy that seems worthy of further examination seems to be the
development of a manufacturing niche. Acquisition could also be a means of implementing
this idea.
(c) The question emphasises 'the context of the case study' scenario. This is a pretty clear indication
that your answer should not be confined to a discussion of theory!
Significant increases in inventories and debt have taken place as part of Kate and John's pursuit of
growth. The consequent increase in fixed costs makes the business much less resilient. Another
obvious point to make is that Kate's management style, while highly suitable to a small business, is
likely to become less appropriate as the business expands.
Much research has been done on why successful businesses decline and fail: for example, Altman's
Z score offers a rule of thumb for predicting failure from key financial ratios.
We have already noted that Kate and John's drive for expansion has led them to very significant
increases in borrowing and in the level of inventories. The consequent rise in operational gearing
means that they will be poorly placed if their business turns out to be less recession-proof than they
believe it to be. In any case, the profitability of the business appears to be declining, which will
make servicing debt more difficult. A high level of gearing and overtrading are two management
mistakes that are made regularly: there seems to be some danger that Kate and John are on course
to fall into these errors. They must pay close attention to cash flows and reduce inventories as far as
possible, implementing the product line review already discussed.
It was mentioned earlier that hedging foreign currency may become necessary if currency rates
become more volatile this will require specialist knowledge that John is unlikely to have. He
should consider the possibility of employing a specialist financial manager to deal with such
matters and the day-to-day financial issues that arise. The bank has already expressed some
reservations over the increase in debt by charging higher interest rates. Given that all of Body
Beautiful's supplies come from overseas, this rate may also be reflecting the firm's greater exposure
to currency movements as purchases increase to cope with demand. Currency stability is unlikely
to last it is important that John is seen to be addressing this issue through the employment of a
financial manager and the use of currency hedging techniques to reduce inevitable risks.

48 Business Analysis
Kate and John's desire to promote the growth of the business seems to be their principal strategic
idea. Wisely, they have taken advice on possible future courses of action, but there must be some C
doubt about their ability to put them into action. They display the drive, market knowledge and H
A
tactical agility of the typical entrepreneur; unfortunately, these qualities are rarely combined with
P
the ability to plan and control the operations of the much larger business they aspire to. T
E
The business has grown to the point at which they need good quality management support and
R
advice, but they may not be temperamentally suited to working in this way. Several symptoms of
poor top management relate to a general situation of dominance by one powerful individual. They
need help and the business needs more structure and systems that will support its routine
1
operations without hampering its agility and innovation.
Kate and John will also have to keep a close eye on the conditions in their chosen markets. They
have been very fortunate in that they have encountered little competition so far. They should not
count on this continuing indefinitely: one of the major international companies may consider it
worthwhile to attack the spa market, for example, perhaps by offering a wider range of products or
better prices. It would be easy for a large company to drive them out of business. Similarly, the
relationship with the health club chain for which they produce own-brand goods is unequal; the
chain may decide to cut the margins they allow in the same way that the UK supermarkets do to
their suppliers.
(d) The question emphasises Kate and John's success and it would make sense, therefore, to confine an
answer to those parts of the value chain that have been managed in a way that contributes to that
success. However, an over-strict interpretation of the question requirement is not always a good
idea. Do not be afraid to add a few sentences that might seem to be marginal to such an
interpretation.
Marketing and sales is an obvious place to start among the primary activities, as Kate is basically a
very successful saleswoman.
Primary activities
Kate is a very successful saleswoman and the marketing and sales activity of the company, resting
in her hands as it does, must be regarded as a major source of the company's success. She has
created good relationships with key customers, not least by her determination to provide excellent
service. She has also successfully established both the Body Beautiful brand, which offers enhanced
margins and a bulk, own-brand supply to a chain of health clubs, which gives volume sales and the
advantages of bulk purchasing.
We might consider operations and both inbound and outbound logistics together. Kate has
invested substantially in storage and packing facilities and John has managed the company's staff
so as to provide a high quality of service: we must presume that this includes accurate and prompt
deliveries. All three of these activities form an important basis for the company's success.
The final primary activity is service, in the sense of after-sales service. The company's products are
generally too simple to require very much of this, but no doubt prompt attention to returns, when
required, contributes to its overall reputation.
Secondary activities
Procurement is also an activity into which Kate has put considerable effort and from which the
company derives great advantage. Kate sources products entirely from outside the UK and has
overcome problems of foreign exchange, international trade regulation and national culture to do
so successfully, having negotiated a number of favourable prices.
Technology development at Body Beautiful has two aspects. The development of the product
range continues apace, possibly to the extent that some rationalisation is required, as discussed
earlier. This might be counted a mixed success for this reason. The continuing development of
systems and utilisation of resources (such as those in the warehouse) has allowed the company to
expand its operations smoothly and without constraint. However, there is some concern about the
level of debt and thus fixed costs that has developed. Overall, this activity continues to need careful
management if it is not to become an important weakness.
Human resource management is also an activity worthy of some attention. Staff turnover has
been low, which is a good sign, but staff numbers are expected to double over the next three years
and it is therefore unlikely that this will continue. John will have to pay careful attention to

Strategic analysis 49
recruitment and training and be prepared for a higher level of turnover as numbers increase. There
is also the problem of managerial capacity already discussed: the business needs increased
managerial support of a high calibre.
Firm infrastructure in terms of specialist services such as legal advice is, no doubt, bought in as
required. There is however, a growing need for more in-house capacity for such activities as
planning, financial control and, possibly, as the scale of operations increases, quality management.

5.2.1 General observations about the worked example


There are no definitive answers to case study questions. You can probably think of other issues that
could be discussed in the Body Beautiful Ltd case study above. You should concentrate on how various
analytical tools can be used to assess the business position and how potential strategies interact with
one another in the context of the case. You are not being tested on how many theories you can
memorise it is your ability to apply appropriate theories to particular situations and integrate them
with other aspects of the business that the examiner is interested in. It is also important to use the data
in the question to support the argument and advice being given. This might include quantitative
analysis of the data in order then to provide a richer qualitative explanation of what is happening in the
business.
You will notice in the case study above that frequent reference was made to financial management
issues this is very important. Given that Body Beautiful had already taken on additional debt and was
considerably exposed to currency rate risk, formal financial management procedures are necessary to
secure the firm's continued success in the future. It was mentioned that two of the most common
managerial mistakes were overgearing and overtrading this is often the case because managers focus
too much on business strategy and not enough on the financial implications.

Interactive question 3: WG plc [Difficulty level: Intermediate]


Introduction
WG plc was formed four years ago following the merger of two large pharmaceutical companies. Prior
to the merger the two companies had been competitors: they believed that by combining forces the
shareholders of each company would benefit from increased profits arising from the rationalisation of
manufacturing facilities, distribution networks, and concentration of resources towards more focused
research and development.
With operating outlets in Europe, Asia, the United States of America and Africa, WG plc regards itself as
a global company. It employs approximately 50,000 people worldwide and has developed a wide
portfolio of products. Its profits before tax last year increased by 20% and represented approximately
35% of revenue. The company declared that its earnings and dividends per share in the same period
increased by 15% over the previous financial year.
All manufacturers of pharmaceutical products claim that their pricing policies need to be set at a level to
achieve high profitability in order to attract funds from investors. They argue that this is necessary to
meet their high research and development commitments. In recent years, WG plc and other
pharmaceutical manufacturers have encountered public and governmental challenges to their high
levels of profitability.
WG plc encounters strong competition from other world-class pharmaceutical manufacturers but these
are few in number. High research and development costs present a major obstacle to potential
competitors tempted to enter the industry.
Mission and objectives
The directors of WG plc have defined their overall corporate mission as being to 'combat disease by
developing innovative medicines and services and providing them to healthcare organisations for the
treatment of patients worldwide'.
The directors have confirmed their main objective is to sustain profitability while achieving the
company's overall mission. They have also explained that WG plc aims to work towards eliminating
those diseases for which the company is engaged in providing treatments. Achievement of the

50 Business Analysis
profitability objective is continually threatened by patents coming to the end of their lives. Patents give
the sole right to make, use and sell a new product for a limited period. C
H
Product development A
P
A large proportion of the company's turnover in recent years has been derived from one particular drug. T
The patent for this drug expires next year and it is expected that its sales at that time will represent no E
more than 10% of total revenue. Four years ago, the sales of this drug produced almost half the R
company's entire revenue.
A new product, Coffstop, has now completed its rigorous development phases and is being marketed to
1
pharmaceutical stores throughout the world by WG plc. It is in competition with a similar drug, Peffstill,
produced and marketed by a direct competitor of WG plc. Medical research and opinion has concluded
that Coffstop is generally more effective than Peffstill in treating the condition for which they are
intended. Both drugs are available over the counter from pharmacies. The directors of WG plc are
optimistic that Coffstop will become very popular because of its improved effectiveness over other
market products.
The retail market price of Coffstop is 1.50 per bottle, compared with 10 per bottle of Peffstill.
However, the recommended dosage of Coffstop is six times more than that for Peffstill. The bought-in
costs per bottle to the retail pharmacist are 0.50 and 7.40 for Coffstop and Peffstill respectively. Initial
indications to the management of WG plc are that retail pharmacists tend to prefer to stock Peffstill on
the basis that it achieves 2.6 times the level of gross contribution per bottle compared with Coffstop.
It is estimated that the cost to the retailer of holding Coffstop is 0.40 per bottle and 0.80 for Peffstill.
The availability of shelf space is a limiting factor for most retailers. The shelf area occupied by each
bottle of Coffstop is 18 square centimetres and 60 square centimetres for each bottle of Peffstill. Early
indications show that the average weekly sales volume for retail outlets stocking both products are 120
bottles of Coffstop and 20 bottles of Peffstill.
Market development
WG plc has experienced slow growth in its mature markets of Western Europe, North America and
Japan. These markets contribute 80% of overall revenue but their governments have reduced
expenditure on pharmaceutical products in recent years. The company has encountered a rapid sales
increase in its expanding markets of Eastern Europe, South America, the Asia Pacific region, India, Africa
and the Middle East. The directors of the company hold the view that increasing population growth in
these markets is likely to provide substantial opportunities for the company over the next two decades.
Research and development
Almost 15% of WG plc's revenue last year was spent on research and development. WG plc has the
largest research and development organisation of all pharmaceutical companies worldwide.
Much research is sponsored by national governments and world health organisations. A major piece of
research which has recently been undertaken relates to new treatments for malaria as the disease is now
demonstrating some resistance to existing treatments. WG plc has established a 'donation programme'
for the new drug in virulent areas for the disease. This means that the company is donating batches of
the drug to the health organisations in these areas. The cost of this programme is offset by the sales of
the new drug in other areas of the world by making it available to people proposing to travel to the
regions where malaria is widespread.
Requirements
(a) Evaluate the nature and importance of the market threat which WG plc would face if it failed to
provide sufficient resources for product development.
(b) WG plc's main objective is to sustain profitability through developing innovative medicines and
services for treating patients worldwide. The company also aims to eliminate disease.
Discuss the nature of the five competitive forces (identified by Porter) which are exerted on WG plc
in satisfying both these objectives at the same time.
(c) (i) Demonstrate whether Coffstop can provide a higher contribution to the retailer than Peffstill by
using:
(1) Cost Volume Profit analysis, taking account of the gross contribution per limiting factor.

Strategic analysis 51
(2) Direct Product Profitability analysis after charging holding costs.
(ii) Explain how WG plc can market Coffstop to improve its competitive position.
(d) Discuss the practical issues which the directors of WG plc would need to consider if the company
entered a strategic alliance with a competitor for the joint development of future pharmaceutical
products.
See Answer at the end of this chapter.

52 Business Analysis
Summary and Self-test C
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T
E
R
Summary

Strategic analysis 53
Self-test
1 Pamper Products Ltd
Pamper Products Ltd was purchased as part of a management buy-out in 1996 by two brothers,
Peter and David Sample. The company buys nail care and cosmetic products from a variety of
suppliers in order to supply chemists and other retailers. Peter Sample was the Sales Director of the
business before the buy-out and David was an accountant working in practice at the time.
David organised the finance by re-mortgaging both of their houses and borrowing further from the
bank. He has continued to deal with the financial and administrative areas of the company whereas
Peter is totally involved with suppliers and customers.
Peter was always an excellent salesman and his commitment to customer service is second to none.
He deals personally with all of the major customers and has an excellent relationship with them.
Peter has a similar commitment to his suppliers. He has tried to limit the number of suppliers, but
as the company has grown he has been forced to deal with a growing supplier base. Most of the
purchases are from either the Far East or Europe. Initial concentration on a few major suppliers has
ensured that Pamper Products has been able to have exclusive access to some products.
The company buys its products from a variety of manufacturers but markets them under its own
brand name; it is able to charge premium prices for these products as a result of having created a
trusted brand.
The company has gone from strength to strength in the years since the management buy-out with
revenue increasing on average by over 20% per annum. This has led to an increased number of
suppliers and an increase in staff from seven in 1996 to 22 currently. The company has also
expanded physically and has recently rented a new warehouse, investing in a state of the art
inventory control system and a new computer system.
The initial bank loan was paid off according to its terms by 2001 but recently a further loan has
had to be taken out in order to finance the expansion.
Peter is committed to even further expansion but David is concerned that the company's systems
and finances cannot keep up with the rate of sales growth and would prefer a period of
consolidation. As an accountant David is happy with the financial controls and performance
measures that he has built into the system, but is concerned that possibly other non-financial
measures might be just as important, particularly as the company continues to expand.
Requirements
(a) Explain to David the most common reasons why companies may fail and suggest ways in
which Pamper Products Ltd could avoid them.
(b) Using the balanced scorecard approach, suggest other non-financial performance indicators
that Pamper Products Ltd could use to monitor its overall performance as it continues to
expand.
2 Two Wheels
Two Wheels is a private UK company founded in 1932 which produces bicycles for the general
market. It is managed by Darius Young, the grandson of its founder. The shares are totally owned
by the family, with Darius and his wife controlling just under half of the shares, the rest being held
by other members of the family. When the company was founded, the bicycles were targeted
mainly at people who could not afford to buy motor vehicles then a relative luxury but who
needed transportation to get them to work or for local travel. Initially the company was a regional
producer focusing on markets in Central England but over the next 75 years Two Wheels
transformed itself into a national company. Two Wheels took advantage of changes in fashion and
periodically introduced new models focusing on different market segments. Its first diversification
was into making racing bicycles, which still account for 16% of its volume output. Most of these
bicycles are very expensive to produce. They are made of specialist light-weight metals and are
often custom-built for specific riders, most of the sales being made on a direct basis. Members of
amateur cycling clubs contact the company directly with their orders and this minimises
distribution costs, so making these machines more affordable to the customers. Two Wheels'

54 Business Analysis
reputation has been enhanced by this highly profitable product. The company has seen no reason
to change its branding policy and these products are still sold under the 'Two Wheels' brand name. C
H
During the 1980s the company responded to the demand for more sporty leisure machines. A
Mountain bikes had become the fashion and Two Wheels designed and produced some models P
which appealed to the cheaper end of the market. These products, although robust and stylish, T
E
were relatively cheap and were aimed at families with teenage children and who could not afford
R
to spend large sums of money on the more sophisticated models. The company is currently selling
nearly 30% of its output to this market segment. Most of the sales are through specialist bicycle
shops, although about 25% of these mountain bikes sales are made through a national retail chain
1
of bicycle and motor vehicle accessories stores. Apart from those sold via this retail network, under
the retail brand name, the mountain bikes were also sold under the Two Wheels brand. With the
advent of fitness clubs the company saw an opening for the provision of cycling machines for the
health club and gymnasium market. These machines were sold at a premium price but they still
accounted for only 4% of total volume sales of the company. The main product group for the
company was still its basic bicycle it is the entry model for most families who are buying bicycles
for teenagers and for those people who still use bicycles as a means of transportation as distinct
from seeing them as entertainment or fun machines. The product is standardised, with few
differentiating features, and as such can be produced relatively cheaply. About 80% of this
segment is sold through the same national retail chain mentioned above with reference to
mountain bike sales. These bicycles in fact are built for the retail chain and marketed under their
brand name. This appears to be advantageous to Two Wheels because it guarantees them a given
level of business without their being responsible for either distribution or promotion. This segment,
however, is now seeing increasing competition from cheaper overseas imports.
The company had historically made reasonable profits and most of these were re-invested in the
company's production facilities, increasing capacity substantially. However, throughout the late
1990s, Two Wheels has seen its market being eroded. Sales have fallen gradually, mainly because
the total United Kingdom market for bicycles has been in decline, but also because of increased
competition from foreign suppliers. The high value of sterling has encouraged imports.
Surprisingly, during this period Two Wheels actually increased its share of domestic output. This is
due to the fact that it has been prepared to accept lower margins so as to maintain sales and, in
addition, a few UK producers had decided to exit the market and move into other, more attractive
product lines.
By early in the year 20X8 the company has seen its profits continue to fall. It now has a debt to the
bank of 7 million, having been unable to pay for all recent, new capital expenditure out of
retained earnings. (Table One gives some financial information about the recent performance of
Two Wheels.)
There are now very few UK manufacturers of bicycles who concentrate solely on producing
bicycles. Most have a diversified portfolio and can count on other product groups to support the
bicycle sector when demand is poor. However, Two Wheels has continued to focus entirely on this
specialised product range. It is surviving basically because it has built up a strong reputation for
reliable products and because the Young family has, until recently, been content with a level of
profits which would be unacceptable to a public company that had external shareholders to
consider. However, it is now becoming apparent that unless some radical action is taken the
company cannot hope to survive. The bank will now only make loans if Two Wheels can find a
suitable strategy to provide it with a higher and more acceptable level of profit. If the company is
to retain its independence (and it is questionable whether any company will really want to acquire
it in its current position) it has to consider radical change. Its only experience is within the bicycle
industry and therefore it appears to be logical that it should stay in this field in some form or other.
Darius Young has examined ways to improve the profitability of the company. He is of the opinion
that if Two Wheels becomes more successful it could become a desirable acquisition for other
companies. However, currently the company will not attract bidders unless it is at a low price.
Darius has looked at the profile of his products and wonders whether any rationalisation could help
to improve performance. He has also decided to look at the potential for overseas marketing.
Having examined statistics on current world production and sales statistics he has identified that
the real growth areas for bicycles are in the Far East. China alone supports a bigger market for
bicycles than the whole of Europe and North America. India and Pakistan have also developed a
significant demand for bicycles. Darius decided to visit some of these markets and he has returned

Strategic analysis 55
full of enthusiasm for committing Two Wheels to operate in these Far Eastern markets or in India
and Pakistan. Whilst Darius considers that exporting from the UK might be a viable option, he has
become increasingly attracted to manufacturing in the Far East, particularly in China. He believes
that transportation costs could prove to be a disadvantage to exporting for Two Wheels. He
estimates that costs for shipping and insurance could add about 20% to the final selling price.
Furthermore, he is concerned about the discrepancy between labour costs in the United Kingdom
and in China. Wage rates, including social costs in China appear to be about 25% of those in the
UK and these costs account for approximately 30% of the total production costs.
Darius has summoned a meeting of all the shareholders to persuade them to agree to plan to
manufacture, or at least assemble, bicycles in China. The other shareholders are not quite so
enthusiastic. They feel that this strategy is too risky. The company has never been involved in
overseas business and now they are being asked to sanction a strategy which by-passes the
exporting stage and commits them to significant expenditure overseas. Darius is convinced that
the bank will lend them the necessary capital, given the attractiveness of these overseas markets.
The other shareholders are more in favour of a gradual process. They want to improve the position
within the United Kingdom market first rather than leap into the unknown. They also believe that
diversification into other non-bicycle products might be less risky than venturing overseas. They
know the UK market but overseas is an unknown area. Darius has decided that it is time he sought
some professional advice for the company. A management consultant, Molly Dunn, has been
retained. She is a qualified accountant who also has an MBA from a prestigious business school.
Table One: Information concerning Two Wheels' current sales and financial performance
Financial years to 31 March 20X6/20X7 20X7/20X8 20X8/20X9
(estimated)
Mountain bikes
Volume 27,000 24,000 22,000
Direct costs '000 3,780 3,600 3,410
Revenue '000 4,590 4,200 3,850
Standard bicycles
Volume 45,000 40,000 36,000
Direct costs '000 4,050 3,600 3,312
Revenue 4,500 3,800 3,412
Racing bicycles
Volume 14,400 12,800 13,200
Direct costs '000 7,560 7,360 7,986
Revenue 10,080 9,280 9,900
Exercise bicycles
Volume 3,600 3,500 3,450
Direct costs '000 1,062 1,137.5 1,155.75
Revenue '000 1,224 1,277.5 1,259.25
Indirect costs '000:
Distribution 282 290 362
Promotion 484 407 346
Administration and other 1,209 1,234 1,456
Interest on loan 560 560
Profit before tax '000 1,967 369 (166.5)

Requirements
Acting in the role of Molly Dunn:
(a) Write a report, evaluating the current strategies being pursued by Two Wheels for its different
market segments, using appropriate theoretical models to support your analysis.
(b) Identify and explain the key factors which should be taken into consideration before Two
Wheels decides on developing manufacturing/assembly facilities in China.
(c) Write briefing notes to the shareholders, explaining the advantages to the company of
concentrating solely on the production of bicycles and also the opportunities which may be
available by pursuing a strategy of diversification.

56 Business Analysis
Answers to Self-test C
H
A
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T
1 Pamper Products Ltd E
R
(a) There have been many attempts to find a methodology to predict corporate decline, or
companies at risk of decline. This interest in the subject means that the main reasons for
corporate decline are heavily documented. There are many reasons why companies fail and in 1
most cases it will be due to a combination of such reasons.
Sales and profitability
Declining profitability is a clear reason for the eventual failure of a company. A decline in
profits is not always accompanied by a decrease in sales volume, but this is often the case. As
sales fall, the same level of fixed costs must be paid from reduced revenue, inevitably reducing
profits. Also, if a company expects increases in sales volume that do not materialise, this will
also cut profits if the company has invested further, in staff, plant and inventories, for
example. An important implication of this for Pamper Products is that a close eye must be
kept on costs of all kinds. The need to seek out low cost suppliers may be of particular
relevance, considering the past policy of only dealing with a few of those available.
Gearing and liquidity
As a company's borrowing increases, so do the costs of servicing loans. This can significantly
increase the risk of the company and in extreme cases if the loans or debentures are not
serviced they could be called in and the company put into liquidation. The Sample brothers
have borrowed extensively, so they should take great care over this. Allied to this problem is
that of a decrease in liquidity. A company can still be profitable but if it cannot pay its debts as
they fall due then eventually it will fail. One particular problem here is where seemingly
growing companies fall foul of overtrading. This occurs when sales are increasing and
therefore, so are inventory-holding costs and payments to suppliers but these costs are not
being matched in cash terms by money received from customers. Pamper Products has
expanded rapidly and has avoided this problem so far, but the brothers must continue to take
care of their cashflow.
Suppliers and customers
A company can appear to be successful, but if it is over-reliant on a few suppliers or customers
then the failure of one of these parties can have a disastrous knock-on effect. If a principal
supplier fails, this will have a major effect on the ability of the company to supply its own
customers. The loss of a major customer means a significant fall in turnover and cashflow. This
calls for close management attention.
Management
So far we have considered largely financial reasons for company failure; however, Argenti
argues that many causes of corporate failure are due to poor management. For example, an
autocratic chief executive, a passive board of directors and a weak finance director is a
common scenario of corporate failure. Finally, there is always the issue of complacency. If a
company is seemingly successful, then senior management may become complacent about
performance, growth and innovation, which will eventually lead to a loss of market share and
declining revenues. The implications for Pamper Products are obvious.

Strategic analysis 57
(b) (The balanced scorecard is a useful and popular model, both in the exam and in the real
world. Make sure you have learned and understood the nature of the four perspectives and
expect to have to suggest relevant possible measures for each one.)
A balanced scorecard considers performance indicators for a business within four
perspectives:
The financial perspective
The customer perspective
The internal business perspective
The innovation and learning perspective
While these four categories may be regarded as widely applicable, it is important to
understand that different organisations will require different measures for each if the
approach is to be useful. For example, a woodworking business would almost certainly be
very concerned about the safe use of its machinery: this would hardly be a topic of concern
for most financial service businesses, however.
Product safety is likely to be an important concern for Pamper Products, dealing as it does in
cosmetics.
As David is quite happy with the financial performance measures we will concentrate on the
other three perspectives.
Customer perspective
Performance measures in this area should measure how satisfied the customers are with the
quality of product and level of service provided by the company. Possible performance
measures might include:
Sales returns levels
Percentage of customers who do not return for repeat business
Levels of customer complaints
Internal business perspective
This perspective is concerned with the efficiency of the company's internal systems. Possible
performance measures might include:
Percentage of products returned to suppliers
Percentage of sales of products exclusive to Pamper Products
Labour turnover levels
Total number of suppliers
Innovation and learning perspective
This perspective is concerned with how the business is developing and moving forward, both
in its products and in its methods. Possible performance measures might include:
Time taken to introduce a new product
Percentage of sales revenue generated by products introduced within the last year
Extent of management training undertaken
2 Two Wheels
(a) Report
To: Darius Young, Managing Director
From: Molly Dunn, Management Consultant
Date: x-x-xxxx
Subject: Evaluation of Two Wheels Company strategies
Introduction
This report is designed to consider the different strategies that Two Wheels is following in its
different markets and to evaluate each of these individual strategies given the information
provided for the last two years and the current year's estimated figures.

58 Business Analysis
In overall terms Two Wheels has seen a decline in demand for its products, with demand
expected to fall by 17% from the period 20X6/X7 to 20X8/X9. Revenue is expected to fall by C
9.6% by 20X8/X9. Direct costs are an increasingly large proportion of sales revenue and are H
A
expected to reach 86% of revenue in the current year, a rise of over five percentage points
P
over the period. Together with a dramatic expected increase in indirect costs of 38% over the T
period this has resulted in Two Wheels' profit of 1,967,000 in 20X6/X7 being turned into an E
expected loss of 166,500 by 20X8/X9. This performance is unacceptable. R

Two Wheels has four distinct market sectors racing bicycles, mountain bikes, health clubs
and basic bicycles with distinctly different strategies being followed for each market;
1
therefore I will consider each market in turn.
Background
Two Wheels is a private, family-owned company which is now a national producer of bicycles.
Some of its products are sold under its own brand name whereas others are sold through a
national retail chain under its retail brand name. Over the last few years Two Wheels has seen
its market being eroded with increasing competition from cheaper overseas imports. The
overall UK market for bicycles is in decline and this has been made worse by the high value of
sterling encouraging imports from foreign suppliers. However, during this period Two Wheels
has been able to increase its share of domestic output by accepting lower profit margins in
order to maintain sales. Two Wheels concentrates its efforts solely on the bicycle market and
has a strong reputation for reliable products.
Each individual market that Two Wheels operates in will now be considered in turn in the light
of this background information.
Racing bicycles
Two Wheels has been making racing bicycles for many years and this area currently accounts
for approximately 16% of its volume output and almost 50% of its sales revenue. This is the
only sector of Two Wheels' business where the volume of sales is expected to increase this
year. This sector is by far the most profitable of Two Wheels' market areas, although
anticipated revenue has fallen by 2% over the period considered and direct costs of
production have increased by an expected 5.6%. However, this area still remains profitable
and although the bicycles are expensive to produce, some being custom-made, the
distribution costs in this sector are minimised by the policy of taking direct orders from
amateur cycling clubs. These racing bicycles are marketed under the Two Wheels brand name
and have enhanced its reputation.
Two Wheels appears to have followed a successful strategy of premium pricing in this market
and has differentiated the product by the policy of producing custom-made bicycles. Despite
the cost increases, the margins in this sector are still healthy with clear potential for volume
and revenue growth. Any potential for increasing UK market share in this area or diversifying
into sales of racing bicycles overseas should seriously be considered as this is clearly the most
successful part of the current business.
This area of the business could be described as a cash cow according to the BCG growth-
share matrix as Two Wheels' market share is relatively high and the market is growing slowly.
Mountain bikes
Two Wheels moved into this fashion area in the 1980s producing relatively cheap models and
currently this sector accounts for 30% of Two Wheels' output but only 23% of revenue. The
volume of sales is expected to decline by 19% over the period considered and revenue to
decline by 16%. However, direct costs of production have increased each year and are
anticipated to be 89% of revenue for mountain bikes in the current year. Despite increases in
costs and decreases in revenue this sector remains relatively profitable in relation to other
market sectors of the business.
About 75% of these mountain bike sales are made under the Two Wheels brand name
through specialist bicycle shops. The remaining sales are made through a national retail
chain of bicycle and motor vehicle accessories stores under the retailer's own brand name.

Strategic analysis 59
Two Wheels' pricing policy of charging relatively low prices for the mountain bikes is a
strategy of penetration pricing; however, in order for this to be successful, Two Wheels
needs to be able to compete on costs. The increases in direct costs will tend to invalidate this
policy as Two Wheels does not appear to have the production capacity to achieve the
economies of scale necessary to maintain profit margins as sales volumes decline and
cheaper foreign imports pose a threat.
As Two Wheels has been so successful in its premium pricing policy in the racing bike market,
and the majority of the mountain bikes are also marketed under the Two Wheels brand name,
the company should consider moving away from the low price market for mountain bikes.
If the mountain bikes produced are promoted as being of high quality based upon the well-
respected brand name of Two Wheels in the racing bike market, the company may be able to
attract customers prepared to pay a higher price due to the quality of the product.
This area of Two Wheels' business certainly appears to have potential but if changes in both
the stabilisation of costs and marketing and pricing policy are not made it would appear that
profits from this sector will continue to decline.
Exercise bicycles
The health club market for exercise bicycles plays only a small part in Two Wheels' business
currently with only 4% of total volume sales. As this is a niche market it is possible to have a
premium pricing policy; this sector has been consistently profitable over the period,
although margins have reduced to an expected 8% for the current year. Part of the reason for
the fall in profitability is, as with other areas of the business, the escalation of costs which in
the current year represent 92% of the sales value of the exercise bicycles.
This market sector is different from Two Wheels' other areas as it is a diversification into a
different line of business. The exercise bicycles will have some similarities to the other bicycles
manufactured but the market characteristics are very different. Health clubs are a completely
different type of customer from those for the other sectors. Sales volume is expected to show
a slight fall in the current year since Two Wheels do not produce a full range of exercise
equipment, which the market seems to prefer in its suppliers. Therefore, Two Wheels might
consider diversifying into production of other fitness equipment such as running machines
and cross trainers. This market appears to be potentially profitable but currently Two Wheels is
too small a player to take advantage of it in full.
Standard bicycles
The main product of the group, the standard bicycle, accounts for about 50% of the output
volume and is therefore still the core of the business. However, the margins in this area are
the main cause of Two Wheels' overall fall in profitability. Sales volume has decreased by 20%
over the past two years but sales revenue has fallen by even more, at 24%, as a result of
reducing price in an attempt to maintain sales levels in the face of increasing competition
from cheaper overseas imports. In the current year the margin has fallen to 2.9%, from 10%
two years ago. In 20X6/X7 the production cost per bicycle was 90 but this has increased to
92 per bicycle in the current year. In addition to this the selling price has reduced from 100
two years ago to just under 95 currently.
About 80% of these bicycles are supplied to a national retail chain supplying bicycles and
motor accessories and marketed under the chain's own brand name. As Two Wheels is heavily
dependent upon the retail chain it may be that the retailer is forcing prices down using its
buying power.
Two Wheels' strategy in this market appears to have been one of competing on both cost
and price. Unfortunately, it appears not to have worked. Prices are coming down and costs
are rising. This area of the business is now being subsidised by the other more profitable but
smaller markets.
There is no real brand association with the basic bicycles as the majority is sold under the
retailer's brand name. Therefore it might be difficult for Two Wheels to disassociate itself from
the retailer and sell directly, although it may be possible to build on the brand association
from the racing bicycle market. According to the BCG growth-share matrix the basic bicycle
market could be categorised as a dog as the UK market in this area does not appear to be
growing and Two Wheels appear to have a relatively low market share.

60 Business Analysis
If Two Wheels is to improve profitability in this market it must decrease costs, probably move
away from dependence on the retailer and attempt to differentiate its product in some way. C
Withdrawal from this market could be considered although as it is such a significant element H
A
of the business this may be a dangerous strategy and should only be considered when all
P
other options have been examined. T
E
Indirect costs
R
A further worrying area of the business is in the escalating indirect costs. Over the two years
there has been a staggering increase of 38% in total indirect costs. Distribution costs are up
by 28% although this may be understandable given the nature of the direct sales of the racing 1
bicycles and exercise bicycles.
Administration costs have also increased by 20% over the last two years which, given the
decrease in sales volumes, appears unusual.
Promotion costs have, however, fallen and this must be rectified if Two Wheels is to
capitalise on its brand name and increase sales volumes.
Loan interest is unavoidable but worryingly high as in the current year interest cover is only
0.70 times, an unsustainable level in the long run.
Conclusion
Two Wheels currently has a wide range of strategies, a premium pricing policy for racing
bicycles and exercise bicycles, and an attempt to be a cost leader at the lower end of the
market with its basic and mountain bikes. Production costs must be brought under control
before any rationalisation of strategies can be considered.
It would appear that Two Wheels' strengths lie in its strong reputation and brand association
in the racing bicycle market. If this can be extended to the mountain bike market and a
premium pricing policy introduced here with market differentiation based upon the quality
of the product, then this could produce significant improvements in the mountain bike
market.
A further potentially successful market is that of the health club equipment if the production
range can be extended. The basic bicycle market could be improved with more control of
direct costs but as the UK market is not expanding and the strategy has been one of cost
leader, which has not succeeded, then it may be necessary to consider withdrawal from this
market.
It would appear that the future of ABC lies with the quality products as Two Wheels does not
appear to have the production capacity to achieve the cost economies necessary for a
successful cost leader strategy at the lower end of the market.
(b) (To some extent our answer is unstructured, addressing salient points in no particular order. If
you prefer a more structured approach, you could use the PESTEL and Porter's Five Forces
concepts to produce something like an environmental analysis. You would have to cover the
same ground, but you may find this approach more fruitful if you are wondering just how to
get started.)
When considering any potential investment many factors must be taken into account but
when considering such a major change in strategy as the managing director is proposing then
there must be a wide ranging review of the key factors.
Operations
Let us first consider the operational aspects of the development of a manufacturing or
assembly facility in China. The proposal is based upon the large demand for bicycles
perceived in the Far East, the cheaper labour which would reduce production costs and the
reduction in transportation costs.
As far as the demand for bicycles is concerned, the view of the market appears to be that of
the managing director and there is no evidence that any market research activities have
been carried out. What type of bicycles is in demand in China and can Two Wheels produce
bicycles that satisfy this demand? If the bicycles required are not the same as those currently
manufactured by Two Wheels there may be significant costs involved in re-design and
changes to the manufacturing processes.

Strategic analysis 61
The labour cost aspect must be put into perspective. Labour costs only account for 30% of
the total production cost therefore the cheaper labour would only lead to a maximum
decrease in production costs of 22.5%. The labour issue should be considered further how
does the productivity of bicycle manufacturing employees in China compare to that in the
UK?
If productivity is significantly lower in China then this could wipe out any cost benefit.
The transportation costs of bicycles from the UK to China are obviously significant.
However, if the proposed facility is set up in China instead there are still likely to be significant
transportation costs since China covers a vast area and demand is likely to be spread widely.
This internal transportation cost should not be ignored.
Two Wheels must consider other operational aspects of setting up a manufacturing facility in
China. Can the correct components be purchased at a competitive price and be delivered on
time? What type and amount of marketing expenses will there be? Two Wheels must also
question its ability to run such an operation as it has no experience in even trading with
other countries, let alone setting up a full scale operation in one, particularly one as distant
and unknown as China.
Finance
Two Wheels must also consider financial aspects. The company has very low profit levels
currently and a large debt outstanding. How does it propose to raise the finance necessary
for such a major investment? Would the finance be raised in this country or in China? Are
there opportunities for a UK company to raise major finance in China? Would a joint venture
with a Chinese company be a viable option?
Further financial problems will concern the remittance of funds back to the UK and any
foreign exchange risks that Two Wheels may face. Many countries restrict the amount of
their currency that can be taken out of the country and as Two Wheels is so short of funds it
will clearly require any profits to be remitted back to the UK. Two Wheels should also consider
the foreign exchange risks that are associated with any form of trade with foreign countries. If
the Chinese currency moves against sterling then Two Wheels could be subjected to large
foreign exchange losses.
Risk
Political risk is a further important area that should be considered. How stable is the Chinese
government? What is their attitude to foreign investors, are they encouraged or are there
sanctions which will make operations more difficult and expensive?
Analysis
Many of the key factors involved in this proposal can be addressed through a PESTEL analysis
(social, legal, economic, political and technological aspects). Analysis of social factors will help
to define the market, determine the type of bicycle required and clarify the potential customer
and method of marketing and sale. Legal factors will include dealing with suppliers, contracts
for setting up a factory and employment issues. Economic factors will help to define the
demand structure, inflation rates, interest rates and availability of finance. Political issues will
be of great importance in a country such as China which has large state control. From the
technological viewpoint, particularly if there is a demand for Two Wheels' more high-tech
products, such as the racing bicycle, does the technology exist in China or must it be
exported?
(c) Briefing notes on advantages of concentration on bicycle production or diversification
Advantages of concentrating on bicycle production
Two Wheels has been in the bicycle manufacturing business for many decades and
therefore has the skills and competences necessary to operate in this area. These skills
might not necessarily be easily transferred to other markets such as production of other
fitness equipment.
The fact that Two Wheels specialises in the production of bicycles, albeit of different
types, would argue that the company obtains some economies of scale from just this
type of production. As direct costs are increasing there is some doubt about these
economies of scale but diversification into another field may reduce margins even more.

62 Business Analysis
It could be argued that Two Wheels should stick to its core activities and not be side-
tracked into other areas in which it has limited experience. This will also be of benefit in C
developing value chain relationships. H
A
By remaining within the bicycle industry the Two Wheels brand name can be cultivated. P
Its value in other sectors must be doubted. T
E
Advantages of diversification R

If the bicycle market is in decline or faced with significant competition from cheaper
foreign imports then there may be gains to be made in other markets. 1
Other markets, such as the health and fitness club market, may offer higher gains than
the bicycle market although the risks may also be greater because of factors such as
changes in technology.
If Two Wheels were to diversify, this would reduce the risk of becoming involved in an
individual market area that may decline and would give the company greater flexibility
to deal with changes in fashion and technology.
It is possible that Two Wheels could use its current distribution networks in order to
market a different range of products.
New products may have greater potential to provide technological or commercial
advantages to the company.
Conclusion
The theory behind diversification for large companies is that there is no need for a company
to do this simply to reduce the risk of just being in one industry as the shareholders are quite
capable of doing this on their own behalf by owning a portfolio of shares. However, for a
private family-owned company that is experiencing problems with profitability, a move into a
new area is enticing. For Two Wheels, given its core expertise, diversification should only be
considered if it is believed that there are no future gains to be made from its current markets
and that moves into non-core areas are likely to be successful.

Strategic analysis 63
Answers to Interactive questions

Answer to Interactive question 1


(a) Here are some ideas. Barriers to entry are high. There are plenty of substitute products (coffee),
competitive rivalry is high because of the difficulty of stockpiling products. Customer bargaining
power is high, but supplier power is low: all it needs is capital, the right sort of land and labour.
(b) One possible strategy would be to 'get in touch with the consumer' directly. Rather than selling
tea at auction, which means that the product is not differentiated from those of all the other tea-
growers, this particular tea-grower could market directly to the consumer. One way of doing this
could be the use of a mail order system, offering specialist teas delivered directly to the consumer.
The service could be advertised in magazines initially those with a moderate distribution aimed at
the type of customer who is likely to purchase specialist teas (for example, magazines sent out to
premier credit card customers). The tea grower should not be too ambitious with this new project
too early, given the need to set up reliable ordering and distribution systems, but should also
maintain its practice of selling some of his tea at auction. This should guarantee a minimum
income whilst the new venture is being developed. In an industry with vast over-supply, tea
growers must increasingly focus on how to make their product more attractive to the market. An
excellent strategy for doing this is to appeal directly to the consumers themselves.

Answer to Interactive question 2


(a) LBG should gather as much information as possible about its competitors, as both new and
existing competitors are one of the main elements in its immediate task environment. A formal
process of information gathering and analysis provides the best route to thorough coverage
without unnecessary duplication, as such a process can be designed to address specific objectives.
Reliance on information gathered on an opportunistic basis is unwise, as there is no guarantee that
LBG will obtain the specific information it requires.
The fact that a formal approach to competitor analysis should make LBG more knowledgeable
about who its competitors are and what they are doing can only be advantageous. The philosophy
that 'knowledge is power' certainly applies here. In a maturing industry, it is essential that LBG
knows who and what pose potential threats to its current position it is only through this
knowledge that LBG will be able to take steps to counteract these threats. As the profitability of a
firm is influenced by the competitive environment, it is only through understanding this
environment that LBG can hope to continue its success.
The knowledge gained from conducting a formal competitive analysis will allow LBG to adjust its
strategy to meet the challenges posed by competitors' behaviour. If, for example, competitors are
attempting to reduce margins to attract customers, LBG would have to decide whether competing
on price is a strategy it would like to pursue, or whether it would prefer to maintain its reputation
for quality, premium products. Even if it decides to maintain its current strategy, it is important that
LBG knows what its competitors are doing in order to gauge the threats and potential
opportunities that may arise from their behaviour.
(b) The first stage in the competitor analysis process is the identification of who the main competitors
are. LBG should be careful here as it is operating in a specialised niche market. Although there are
many manufacturers of branded cosmetics, many of these will be aimed at the high street
customer. As LBG manufactures specifically for the theatre and movie industry, it should focus only
on those firms that produce similar products aimed at the same market.
Once LBG has established who its main competitors are, it should focus on competitors' goals, such
as financial goals, attitude to risk and whether managerial beliefs affect their companies' goals. Are
competitors more interested in quantity rather than quality? Are their managers more intent on
them being renowned for low price rather than premium products? The use of a model such as
Porter's five forces might be useful here. Different firms in the same industry will have different
strategies, therefore it is important to establish how sophisticated competitors' strategies are and
hence how much threat they are likely to pose.

64 Business Analysis
If possible, LBG should try to establish the aims and objectives of its competitors. Many cosmetics
companies market to various sectors, such as the high street, catwalk, theatre and movie industries. C
What is important for LBG to establish is the relative importance of the movie and theatre industry H
A
markets to their competitors. Are they just a sideline, in which case the products may be subsidised
P
by the more profitable main product lines, or are they the main focus of the business? T
E
Establishing competitors' assumptions about the industry is essential as this will play a large part in
R
determining their future activity. For example, a competitor that strongly believed that the industry
was reaching over capacity might consider leaving the industry altogether. This is linked to the
relative importance of the industry to competitors' overall strategy. If movie and theatre cosmetics
1
are only a sideline, the competitor may be more inclined to 'walk away' and concentrate its
resources elsewhere. As such assumptions exist mainly in the heads of senior managers, it may be
difficult to obtain, and LBG may have to rely on opportunistic behaviour to gather details.
In a specialist industry such as the one that LBG operates in, competitive advantage depends
largely on the possession of unique competences and assets. Establishing the extent to which
competitors have these is the next stage in the investigation. In the movie and theatre cosmetics
industry, the use of new technologies to develop and bring new and improved products to market
is particularly important. The ability to work closely with companies responsible for new cinematic
techniques is also essential, to allow knowledge-building of how new techniques can affect the
effectiveness of the cosmetics.
Once LBG has gathered the information above, it should be able to begin the process of predicting
how competitors might behave in a range of possible future circumstances, including changes
brought about by LBG's own potential future strategies. What should be borne in mind is that
competitor analysis is not a 'once and for all' process it is a continuous activity that is essential to
the future prosperity of LBG.

Answer to Interactive question 3


In our answer to part (a) we have referred to product development in connection with the Ansoff
matrix. Part (b) calls for application of the five competitive forces, and the question even tells you it is
Porter's model in case you need a memory jogger! The numerical analysis in part (c) points you in the
direction of contribution per limiting factor. Our answer includes a reference to the importance of
inventory turnover in the analysis. You should have few difficulties in applying the marketing mix for
part (c)(ii). Part (d) requires a discussion of the practical issues surrounding strategic alliances. This does
not necessarily call for an assessment of the advantages and disadvantages of such alliances, although
an analysis along these lines may have been appropriate and would have earned marks if it clearly
addressed practical issues.
(a) Product development and market threat
(i) Growth. A successful business must develop its products and manufacturing methods on a
regular basis if it is to maintain market share. This calls for strategic decisions on the part of
WG plc. Its stated objectives include to develop innovative medicines and services, which it
can only do by investing in development.
(ii) Competition. Product development has the advantage that it forces competitors to innovate
and discourages newcomers with significant barriers to entry. If WG's existing products were
to fall in price and it did not have new products (such as Coffstop) to fall back on, its
profitability would suffer. The expiry of patents and the opening up of a product and its
market to competitors also highlights the danger of lack of innovation. Sales from previously
central products will fall. In the case of WG, a product which previously accounted for nearly
half its revenue is expected to contribute only 10% in future.
(iii) Innovation. Failure to invest in research and development in such an innovative and dynamic
sector is therefore of paramount importance. Nobody expects scientific or medical research
to stand still while there are still diseases that need cures, or where existing cures are being
resisted by new strains. A company that rests on its laurels, enjoys high profitability and seems
to give little back will at the very least suffer a grave image problem.

Strategic analysis 65
(iv) Shareholders in a pharmaceutical company should expect to see investment in research and
development, but will also want to see more immediate profitability. The decision about the
relative size of investment and payments for shareholders each year is a trade-off that the
directors will have to make, when balancing long and short-term performance issues.
WG does have significant production facilities, with much of its research being sponsored. The
investment in research into malaria treatments has paid off, in that the company is able to
donate supplies of the medicine to overseas areas. This will do a great deal to enhance WG's
reputation worldwide.
(v) Cash flows contributed by the products in WG's portfolio can be illustrated using the Boston
Consulting Group Growth Share Matrix. This model demonstrates that, depending upon a
product's individual life cycle, that product will go through stages of cash generating ability.
Staple products are known as 'cash cows' they have a high market share in a stable market,
and can provide the cash resources to invest in the development of 'stars', which are those
products which achieve a high market share in a high growth market. Coffstop may have the
potential to become a star, and WG must make sure that there are others in the pipeline.
For the reasons outlined above, investment is crucial in maintaining market share and the
appropriate resources must be allocated. The expense and the risks associated with
significant investment in research and development must, however, be taken into account. It
may take several years for the benefits of investment to be felt on sales and profits, so the
products chosen for development must be carefully selected.
(b) Conflicting objectives and the Five Forces
This part of the question was concerned with application of Porter's Five Forces model, so a straight
repetition of the model is not enough. You need to consider which of the forces are most
applicable to the company and their effect on objectives.
The twin aims of sustained profitability through development of innovative medicines, and the
elimination of disease, are contradictory when taken to the logical extreme. If all disease was
eradicated, then WG would have no market in the long term.
The overall corporate mission aims to reflect a short-term responsibility to shareholders, as well as
recognition of wider social responsibility. Investment in developing markets overseas, such as the
donation of the malaria treatment, will impact on profits. Public and government challenges to
high levels of profitability reflect the fact that WG is expected to contribute to furthering
knowledge, perhaps via collaboration with universities or research institutes. This will reduce WG's
profitability while new products and markets are developed, but it will be aware of the latest
developments and should be able to capitalise on them in the future.
Porter's model of the five competitive forces shows those factors which collectively determine the
potential of the industry as a whole. Some industries have bigger profit potential than others. The
pharmaceutical industry is one such profitable sector, because competition is relatively restricted
by the significant levels of research and development that are required.
Competitive forces and their applicability to WG's objectives
(i) Threat of new entrants. This is not a significant threat for WG. It is the product of a merger
and enjoys significant economies of scale that a competitor is unlikely to be able to match.
Manufacturing and research facilities operated by WG are amongst the largest in the industry
and its distribution network is global. A new entrant would have to build up a large market
share very quickly to be able to sustain its cost structure and hence profitability. World class
pharmaceutical manufacturers are few in number.
WG has built up a good reputation for its products and is likely to have strong customer
loyalty. Its brands may crowd out the opposition, and patent rights give it breathing space
to develop further products, as discussed above in part (a). Access to sources of raw materials
on favourable terms may include a long-term, low-price supply contract.
(ii) Bargaining power of customers. Customers usually want better quality products at the
lowest possible price. If they are successful in getting this, WG's profitability will be affected.
It has to concentrate its efforts on creating a strong brand image so that customers are not
tempted to shop around, especially when patent restrictions are lifted. The price awareness
of customers will vary. When product quality is important to the customer, as it is likely to be

66 Business Analysis
in the market for medicines, the customer is likely to be less price sensitive and so WG will be
more profitable. C
H
Customer demand for long running profitable products may divert production resources from A
developing more innovative products, but if such long running products are 'cash cows' they P
may also be able to contribute towards development of disease-eradicating 'stars'. T
E
(iii) Bargaining power of suppliers. WG can access supplies on a global basis and is therefore R
unlikely to be controlled by an individual supplier. A supplier is unlikely to be able to demand
higher prices from WG. This depends on factors such as the technical specification of the
products being supplied, and how important a particular supplier's products are for WG. 1
Where there are just one or two dominant suppliers, they may be able to charge monopoly
prices.
The development of innovative products and working towards the eradication of disease does
depend very strongly upon an adequate supply of technical specialists and expertise.
Research scientists are likely to be able to exert some bargaining power over WG when
negotiating salaries. The few world-class companies will be competing for the best human
resources, which could be limited in supply.
(iv) Existing levels of competition. There are only a few players in WG's market. Competitor
activity usually means price competition, advertising battles, sales promotion campaigns,
new products, improved levels of service and provision of guarantees or warranties.
Competition can help an industry to expand by stimulating demand.
The level of competition found in the pharmaceutical industry is likely to be less intense than
that found in other sectors, and firms will try to avoid competing on price. Competition is
likely to be centred on innovation and research activities, as has already been discussed. This
keeps WG ahead of the competition and moves it further towards the eventual eradication of
disease.
(v) Substitute products. These are unlikely to come from another industry, but will arise when
patents run out and competitors can start making their own version of a successful product.
Again, the vital importance of research and development must be stressed.
(c) CVP and DPP analysis
(i) The calculations in this part of the question are very simple, but do not confuse CVP and DPP.
(1) Retail pharmacists prefer Peffstill because they calculate that it achieves a 2.60
contribution compared to 1.00 for Coffstop. This analysis ignored the fact that Peffstill
comes in a bigger bottle and so takes up more shelf space. Cost volume profit analysis
demonstrates the contribution achievable with regard to the limiting factor (retailers'
shelf space) as follows.
Peffstill Coffstop

Selling price 10.00 1.50
Cost per bottle for retailer 7.40 0.50
Contribution per bottle 2.60 1.00
Sq cms shelf space per bottle 60 18
Contribution per sq cm in pence 4.33 5.56
Coffstop generates the most contribution per unit of limiting factor for the retailer.
A retailer who stocks both products should give as much space to Coffstop as possible.
Coffstop also sells more per week on average.

Strategic analysis 67
(2) Applying direct product profitability to weekly sales, thereby taking all costs into
account:
Peffstill Coffstop

Contribution per bottle as above 2.60 1.00
Holding costs 0.80 0.40
Net contribution per bottle 1.80 0.60
Contribution % of sales price 18% 40%
Shelf area required per week 60 sq cm 20 18 sq cm 120 bottles
bottles
= 1,200 sq cm 2,160 sq cm
The total weekly contribution 36.00 72.00
Per unit of shelf area 3.00p 3.33p
This analysis gives the same result for the retailer as cost volume profit analysis, indicating
that Coffstop should still be the preferred product of the retailers. The shelf area required
per week is the minimum that should be allocated to each product by reference to
average sales.
It should be noted that inventory turnover is also a relevant consideration WG plc
may offer to replenish the retailer's shelves twice a week, thereby halving the amount of
space needed to support the same sales volume. This will increase the amount of
contribution per scarce resource.
(ii) The marketing strategy of Coffstop can be planned with reference to the marketing mix.
Product
Medical research and opinion has shown that Coffstop is the more effective product, and
therefore brings a better 'package of benefits' for the customer. WG plc has a strong
reputation with a wide portfolio of products, which Coffstop should be linked with in the
customer's perception.
Price
Coffstop is cheaper per bottle, which will encourage customers to purchase it, if only on a trial
basis. The customer must have six times as much dosage of Coffstop as Peffstill, making the
comparable prices 9 and 10 respectively. Therefore, on price Coffstop has an advantage.
Peffstill may respond by dropping its price, or promoting the convenience of having to buy
only one bottle, but customers have come to expect discounts for buying in bulk. The fact
that Coffstop is cheaper as well as being a better product than Peffstill would appear to give it
a significant advantage.
Place
Retailers may decide to stock Coffstop instead of Peffstill, or at least reduce their stocks of
Peffstill while Coffstop is introduced to the customers.
Both drugs are available over the counter from pharmacies and so it is possible to start selling
Coffstop through supermarkets, who sell cough medicines (assuming that Coffstop is a cough
medicine the scenario is not specific) and often have their own in-house pharmacies. This
will enable WG to reach an even larger market.
Promotion
The promotion campaign should highlight price and product benefits. Television advertising
for cough and cold medicines is common, often on a seasonal basis, so this may be an
appropriate product launch medium. Radio advertising, coupons, and free trial sizes are all
possible promotional activities. Giving medicines away to the general public may be frowned
upon, especially if Coffstop should be carefully administered, but free trial packs could be a
suitable promotional tool when introducing the product to doctors.
Literature and posters detailing Coffstop's benefits could be distributed to doctors' surgeries
and pharmacies. Making the packaging attractive while containing the expected safety
features (child-proof caps, for example) will be a task for WG's marketing or design
department.

68 Business Analysis
(d) Strategic alliances
C
(i) Efficiency. WG is the product of a merger, which has enabled it to achieve economies of H
scale. Without going so far as another merger or takeover, a strategic alliance may offer A
benefits to WG, for example in the value chain. WG's expertise in production and research P
may be supplemented by the other's marketing and distribution facility. Complementary T
E
competences can be exploited to mutual advantage.
R
(ii) Knowledge. Alliances can also be a learning exercise for each partner. An alliance with a
university would provide a good example, with WG taking on trainees or work experience
placements from the science faculties. New technology offers many uncertainties as well as 1
opportunities, so the funding of expensive research via an alliance can spread the risks.
(iii) Goal congruence. Practical considerations include potential conflicts of interest between the
parties. Disagreements may arise over profit shares, resources invested, management issues
(including project management and resource management), products to be developed and
marketing strategy. The alliance must be entered into on a contractual basis so that each
party is clear about its rights and responsibilities.
(iv) Reputation. Regulatory bodies may be concerned that a strategic alliance between dominant
market players could be anti-competitive, and the venture may be subject to investigation
before it is allowed to go ahead. The parties to the alliance must make sure that they have
fully researched the implications of their venture for the industry to be able to present their
case favourably to the regulator.
(v) Partnership. Resource investment includes consideration of share of expenses and tangibles
such as capital contribution, but also intangibles such as expertise. Joint ownership of patents
for products that are developed by an alliance could be fertile ground for arguments about
fair share of returns, unless the agreement is carefully and thoroughly worded. Such alliances
may therefore involve significant legal bills.
(vi) People. Management issues also involve staff considerations. Staff loyalty may be tested, and
confidentiality of individual business processes may be threatened. It may take a while for
trust to be built up, but the benefits of such an alliance are likely to make the practical
considerations a hurdle worth clearing.

Strategic analysis 69
70 Business Analysis
CHAPTER 2

Business risk management

Introduction
Topic List
1 A review of risk management issues
2 Enterprise risk management
3 Risk management and control systems
4 The risk management process
5 Establishing the context
6 Risk identification
7 Risk assessment
8 Risk profiling
9 Risk quantification and consolidation
10 Risk responses
11 Implementation of plans
12 Risk monitoring and control
Summary and Self-test
Answers to Self-test
Answers to Interactive questions

71
Introduction

Learning objectives Tick off

Demonstrate a detailed understanding and application of risk assessment issues

Demonstrate a detailed understanding and application of the various steps involved in


constructing a risk management plan, including establishing context, identifying risk and the
assessment and quantification of risk

Demonstrate a detailed understanding of the limitations of risk management

Demonstrate a detailed understanding of enterprise risk management, its framework and its
benefits

72 Business Analysis
1 A review of risk management issues

Section overview
Risk, and internal management's attitude towards it, has a considerable bearing on the way in
which different organisations conduct their business that is, their business strategy.
The risk of an organisation, whether genuine or perceived, has a direct effect on a firm's cost of
capital, the rates of interest it pays on its loans, and therefore the types of projects it can pursue.
This section reviews the risk management issues that were covered in the Business Strategy paper
at the Professional stage.
C
H
1.1 Risk and uncertainty A
P
Risk and uncertainty must always be taken into account in strategic planning. Many areas of risk and T
uncertainty are exogenous that is, outside the control of the organisation. E
R
1.1.1 Risk
Risk is sometimes used to describe situations where outcomes are not known, but their probabilities can 2
be estimated. (This is the underlying principle behind insurance.)

1.1.2 Uncertainty
Uncertainty is present when the outcome cannot be predicted or assigned probabilities. For example,
many insurance companies exclude 'war damage, riots and civil commotion' from their insurance cover.

1.2 Risk and managers


It is worth noting that shareholders and managers have different approaches to risk.
Shareholders can spread risk over a number of investments.
Managers' careers tend to be bound up with the success or failure of one particular company, so
managers are therefore likely to be more risk averse than shareholders might be.

1.3 Risk appetite


Because risk management is bound up with strategy, how organisations deal with risk will not only be
determined by events and the information available about events, but also management perceptions
or appetite to take risk. These factors will also influence risk culture, the values and practices that
influence how an organisation deals with risk in its day-to-day operations.

1.3.1 Personal views


Surveys suggest that managers acknowledge the emotional satisfaction from successful risk-taking,
although this is unlikely to be the most important influence on appetite.

1.3.2 Response to shareholder demand


Shareholders demand a level of return that is consistent with taking a certain level of risk. Managers will
respond to these expectations by viewing risk-taking as a key part of decision-making.

1.3.3 Organisational influences


Organisational influences may be important, and these are not necessarily just a response to shareholder
concerns. Organisational attitudes may be influenced by significant losses in the past, changes in
regulation and best practice, or even changing views of the benefits risk management can bring.

Business risk management 73


1.3.4 National influences
There is some evidence that national culture influences attitudes towards risk and uncertainty. Surveys
suggest that attitudes to risk vary nationally according to how much people are shielded from the
consequences of adverse events.

1.3.5 Cultural influences


Adams argued that there are four viewpoints that are key determinants in how risks are viewed.

Viewpoints Features

Fatalists Think they have no control over their own lives and hence risk management is
pointless.
Hierarchists Most likely to exist in a bureaucratic organisation, with formal structures and
procedures. Will emphasise risk reduction through formal risk management
procedures.
Individualists Seek to control their environment rather than let their environment control them.
Often found in small, single-person dominated organisations with less formal
structures, and hence risk management too will be informal, if indeed it is considered
at all.
Egalitarians Loyal to groups but have little respect for procedures. Often found in charities and
public sector, non-profit making activities, prefer sharing risks as widely as possible,
or transfer of risks to those best able to bear them.

1.4 Risk aversion and risk toleration


Aversion and seeking are two different attitudes towards risk.
Aversion focuses on the risk level. An organisation should not undertake an activity if it results in
higher risk, unless the higher level of return that compensates for the risk is acceptable.
Seeking focuses on the return level. An activity should be undertaken if it results in higher returns,
even if the resulting risk level is also higher.

1.5 Conformance and performance


The International Federation of Accountants (IFAC) has highlighted two aspects of risk management
which can be seen as linking in with risk aversion and risk seeking.
(a) Conformance focuses on controlling pure (only downside) strategic risks. It highlights compliance
with laws and regulations, best practice governance codes, fiduciary responsibilities, accountability
and the provision of assurance to stakeholders in general. It also includes ensuring the effectiveness
of the risk analysis, management and reporting processes and that the organisation is working
effectively and efficiently to achieve its goals.
(b) Performance focuses on taking advantage of opportunities to increase overall returns within a
business. It includes policies and procedures that focus on alignment of opportunities and risks,
strategy, value creation and resource utilisation, and guides an organisation's decision-making.
IFAC guidance states that risk management should seek to reconcile performance and conformance
the two enhance each other. Case studies and surveys commissioned by IFAC have shown that many
people believe that organisations focus too much on compliance, and not enough on strategy and
building a business. IFAC's 2004 report Enterprise Governance; Getting the balance right showed that
though compliance is necessary to avoid failure, it cannot ensure success.

74 Business Analysis
Interactive question 1: Nature and extent of risks [Difficulty level: Intermediate]
In the context of a major confectionery and non-alcoholic beverage company identify the nature and
potential extent of six risks that the company might face. (These risks should be specific to the industry
in question.)
See Answer at the end of this chapter.

1.6 Sources of risk


Sources of risk are dealt with in detail in Chapter 4 Investment appraisal, in the context of international
investment for example, political and cultural risks, and translation, transaction and economic C
exposure. Chapter 7 Financial engineering covers risks that arise due to changes in interest rates and H
foreign exchange rates, and steps that can be taken to reduce the risks. A
P
T
1.6.1 Sources of risk and uncertainty E
R
Risk Comment

Physical Earthquakes, fire, flooding, equipment breakdown. In the long term, 2


climatic changes: global warming, drought (relevant to water firms).

Economic Assumptions about the economic environment may be incorrect. Not


even the government forecasts are correct.

Business Lowering of entry barriers (eg new technology); changes in


customer/supplier industries leading to changed relative power; new
competitors and factors internal to the firm (eg culture);
management misunderstanding of core competences; volatile cash
flows; uncertain returns; changed investor perceptions increasing the
required rate of return.

Product life cycle Different risks exist at different stages of the life cycle.

Political Nationalisation, sanctions, civil war, political instability all of these


can have an impact on the business.

Financial Can be affected by changes in interest rates, economic climate,


gearing, bad debt risk, liquidity, insolvency.

Case example: GlaxoSmithKline disclosure of key risks


In its 2012 annual report, GlaxoSmithKline (GSK) one of the world's largest pharmaceutical companies
identified a number of key risks that may have a significant impact on business performance and
ultimately the value of shareholders' investment in the company.
'There are risks and uncertainties relevant to the Group's business, financial condition and results of
operations that may affect the Group's performance and ability to achieve its objectives. The factors
below are among those that the Group believes could cause its actual results to differ materially from
expected and historical results:
Risk that R & D will not deliver commercially successful new products.
Risks of failing to secure and protect intellectual property rights, including failure to obtain effective
intellectual property protection and expiry of intellectual property rights protection.

Business risk management 75


Risk to patient or consumer as a result of the failure by GSK, its contractors or suppliers to comply
with good manufacturing practice regulations in commercial manufacturing or through inadequate
governance of quality through product development.
Risk of interruption of product supply.
Risk that the Group may fail to secure adequate pricing/reimbursement for its products or existing
regimes of pricing laws and regulations become more unfavourable.
Risks arising from non-compliance with laws and regulations affecting the Group.
Risk of exposure to various external political and economic conditions, as well as natural disasters,
that may impact the Group's performance and ability to achieve its objectives.
Risks from alliances and acquisitions, including risk of assuming significant debt, becoming subject
to unknown or contingent liabilities, failing to realise expected benefits and problems with
integration.
Risk associated with financial reporting and disclosure and changes to financial reporting standards,
including having to account for changes in market valuation of certain financial instruments before
gains/losses are realised and volatility from deferred tax on inter-company inventory.
Risk that as the Group's business models change over time, the Group's existing tax policies and
operating models will no longer be appropriate, or that significant losses arise from treasury
investments.
Risk of failing to create a corporate environment opposed to corruption or failing to instil business
practices that prevent corruption and comply with anti-corruption legislation.
Risk of substantial adverse outcomes of litigation and government investigations. Key areas of
concern include product liability, anti-trust and sales and marketing litigation.
Risk of ineffectively managing environment, health, safety and sustainability objectives and
requirements.
Risk from Group's sales of products to a small number of wholesalers (large exposure to credit
risks).
Risk of exposing business critical or sensitive data due to inadequate data governance or
information systems security.
Later in this chapter we shall examine the ways in which GlaxoSmithKline manages these risks.

1.7 Business risk and financial risk


1.7.1 Business risk
Business risk, as the name suggests, is the risk associated with the day-to-day operations of a particular
company. It relates to the variability of operating cash flows, the company's exposure to markets,
competitors, exchange rates and so on. It is part of the company's overall systematic (or undiversifiable)
risk and can be divided into:
Strategic risk
Operational risk
Hazard risk

Case example: Clinton Cards

Strategic risks are risks that relate to the fundamental decisions that the directors take about the future
of the organisation. These can include adopting the wrong strategy at the wrong time or failing to
adopt the right strategy quickly enough.
In May 2012 Clinton Cards, the high street chain specialising in greeting cards, was forced to go into
administration. Although aggressive tactics by its principal supplier, American Greetings, precipitated its
failure, it was also a consequence of the increasing pressure that Clinton had come under from

76 Business Analysis
supermarkets and on-line retailers, such as Funky Pigeon and Moonpig, that sell personalised on-line
greetings cards.
At one stage Clinton owned 1,145 shops and controlled 25% of the greetings card market. However it
rapidly declined from a pre-tax profit of 24.1m in 2009 to a loss of 10.6m in 2011. Clinton failed to
adapt quickly enough to the demand for e-cards, relying for too long on the belief that most people
preferred sending and receiving real cards in the post. By the time it launched its own e-card business, it
was up against firmly established rivals such as Moonpig. Clinton also relied on a large high street
presence, reinforcing it by buying up high street rival, Birthdays. Its logic was that cards were a
secondary purchase and it therefore had to be where shoppers went. Again however it failed to realise
the implications of increased online shopping early enough and kept expanding for too long. The result
was a 80m a year rental bill.
Nevertheless there still appeared to be some life in the model Clinton followed. Ironically a subsidiary of
C
American Greetings acquired the brand, assets and about half the stores that were still open in June H
2012. A
P
T
E
1.7.2 Financial risk R

Financial risk can be seen from different points of view:


2
The company as a whole. If a company borrows excessively, it may have insufficient funds to
meet interest and capital repayments, which may eventually force it into liquidation.
Lenders. If a company to whom money has been lent goes into liquidation, the lenders may not
be paid in full. Companies considered to be a risky investment will be charged higher rates of
interest to compensate lenders for the possibility of default.
Ordinary shareholders. This group is at the bottom of the list for payment in the event of a
company winding up. The lower the profits, and the higher the level of gearing, the greater the
risk that is faced by ordinary shareholders.

1.7.3 Relationship between business and financial risk


Business risk is borne by both the firm's equity holders and providers of debt, as it is the risk associated
with investing in the firm in whatever capacity. The only way that either party can get rid of the
business risk is to withdraw its investment in the firm.
Financial risk, on the other hand, is borne entirely by equity holders. This is due to the fact that payment
to debt holders (ie interest) takes precedence over dividends to shareholders. The more debt there is in
the firm's capital structure, the greater the financial risk to equity holders as the increased interest
burden coming out of earnings reduces the likelihood that there will be sufficient funds remaining from
which to pay a dividend. Debt holders do not bear financial risk, as they know there is a legal obligation
on the firm to meet their interest commitments.

Case example: Thomas Cook


A key risk highlighted in Thomas Cook's 2011 annual report was a reduction in demand for products
and services due to the downturn in the global economy. Thomas Cook combated this risk by using a
flexible and asset-light business model. Its features included aircraft operating leases with staggered
maturity profiles, minimisation of committed hotel capacity, being able to make changes in capacity late
in the booking season and tight cost discipline.

1.8 Continuous v event risk


Continuous risk as the name suggests is risk that companies face all the time, simply by virtue of being
in business. Multinationals, for example, face the continuous risk of foreign currencies moving in the
wrong direction and the political risks of operating in different countries. These risks must be
continuously monitored as part of the company's general risk management policy.

Business risk management 77


Event risk is the risk of suffering excessive financial losses due to severe and sudden shocks arising from,
for example, human error, natural disasters or stock market crashes. Event risks are difficult to predict
but once these events have happened there will be inevitable consequences, such as liquidity problems.
Event risk is often characterised by contagion that is, one event can precipitate other events whose
effects spread across markets and end up affecting everyone. Companies can prepare for event risk by
carrying out regular stress testing, which involves generating credible worst-case scenarios that show
how particular events could affect all relevant markets. It is essential for companies to have crisis
management processes in place, covering such crucial areas as communication and leadership.

Case example: Texas fertiliser plant disaster


An explosion and fire at a Texas fertiliser plant killed 15 people and injured at least 160 in what
appeared to be the worst US industrial disaster since the 2010 Upper Big Branch mine accident in West
Virginia.
A fire tore through the facility, sparking an explosion that destroyed dozens of homes in the 2,700-
person town of West, 80 miles south of Dallas and 20 miles north of Waco, late on Wednesday.
West Fertilizer is an anhydrous ammonia facility, a spokesman for the Texas Department of Public Safety
said. The gas is used to make nitrogen fertiliser, which is applied by farmers directly to the soil to boost
crop yields.
The plant, owned by Adair Grain which is also based in the town of West, was fined $2,300 by the
Environmental Protection Agency (EPA) in 2006 for failing to have a risk management plan that met
federal standards, records show.
According to the EPA website a risk management plan "includes an executive summary, registration
information, off-site consequence analysis, five-year accident history, prevention program and
emergency response program."
In a statement about the incident, President Barack Obama said: "A tight-knit community has been
shaken, and good, hard-working people have lost their lives."
Source: FT.com, April 18, 2013

Case example: The global credit crunch


A credit crunch is a crisis caused by banks being too nervous to lend money to customers or to each
other. When they do lend, they will charge higher rates of interest to cover their risk.
One of the first obvious high-profile casualties of the recent global credit crisis was New Century
Financial the second largest sub-prime lender in the United States which filed for Chapter 11
bankruptcy in early 2007. By August 2007, credit turmoil had hit financial markets across the world.
In September 2007 in the UK, Northern Rock applied to the Bank of England for emergency funding
after struggling to raise cash. This led to Northern Rock savers rushing to empty their accounts as shares
in the bank plummeted. In February 2008 the UK Chancellor of the Exchequer, Alistair Darling,
announced that Northern Rock was to be nationalised.
Years of lax lending on the part of the financial institutions inflated a huge debt bubble as people
borrowed cheap money and ploughed it into property. Lenders were quite free with their funds
particularly in the US where billions of dollars of 'Ninja' mortgages (no income, no job or assets) were
sold to people with weak credit ratings (sub-prime borrowers). The idea was that if these sub-prime
borrowers had trouble with repayments, rising house prices would allow them to remortgage their
property. This was a good idea when US Central Bank interest rates were low but such a situation
could not last. In June 2004, following an interest rate low of 1%, rates in the US started to climb and
house prices fell in response. Borrowers began to default on mortgage payments and the seeds of a
global financial crisis were sown.
The global crisis stemmed from the way in which debt was sold on to investors. The US banking sector
packaged sub-prime home loans into mortgage-backed securities known as collateralised debt
obligations (CDOs). These were sold on to hedge funds and investment banks that saw them as a

78 Business Analysis
good way of generating high returns. However when borrowers started to default on their loans, the
value of these investments plummeted, leading to huge losses by banks on a global scale.
In the UK, many banks had invested large sums of money in sub-prime backed investments and have
had to write off billions of pounds in losses. On 22 April 2008, the day after the Bank of England
unveiled a 50 billion bailout scheme to aid banks and ease the mortgage market, Royal Bank of
Scotland (RBS) admitted that loan losses hit 1.25 billion in just six weeks. In August 2008, RBS
reported a pre-tax loss of 691 million (after writing down 5.9 billion on investments hit by the credit
crunch) one of the biggest losses in UK corporate history. At the beginning of 2009, RBS announced
that it expected to suffer a loss of up to 28 billion as a result of the credit crunch. On 3 March 2008, it
was reported that HSBC was writing off sub-prime loans at the rate of $51 million per day.
A number of critics went back to basics and highlighted lending by banks to customers who could not
supply sufficient assurance that they could repay debt. To quote Paul Moore, former Head of Group
C
Regulatory Risk at HBOS: H
A
'There must have been a very high risk if you lend money to people who have no jobs, no provable
P
income and no assets. If you lend that money to buy an asset which is worth the same or even less than T
the amount of the loan and secure that loan on the value of that asset purchased, and then assume that E
asset will always continue to rise in value, you must be pretty much close to delusional.' R

Some critics have focused on the doubtful quality of the CDOs and other investments. These products
appear to have been imperfectly understood by many in the financial sector. However they created
2
positions in the trading books of banks that were hugely vulnerable to shifts in confidence and liquidity.
Others have focused on the increasing complexity in the financial sector caused by the variety of the
securities sold. The 2009 Turner review highlighted a complex chain of relationships between multiple
institutions. However the results were that 'most of the risks (were still left) somewhere on the balance
sheets of banks but in a much more complex and less transparent fashion.' Turner also highlighted the
growth of the relative size of the financial sector, accompanied by very high growth in the debt and
leverage of financial institutions, which increased the impact of financial sector instability on the real
economy.
Other experts highlighted the role of governance. The 2009 Walker report commented that 'why
different banks operating in the same geography, in the same financial and market environment and
under the same regulatory arrangements generated such massively different outcomes can only be fully
explained in terms of differences in the way they were run.'
In June 2010 the Independent Commission on Banking in the UK (the Vickers Commission, chaired by
economist Sir John Vickers) was set up by the incoming Coalition government. It produced its final
report in September 2011. The report recommended that UK banks' domestic retail operations
(operations concerned with customer deposits, business lending and the transmission of money) should
be ring-fenced from their wholesale and investment operations. Retail banking activities should be
carried out by separate subsidiaries within banking groups, with the ring-fenced part of the bank having
its own board and being legally and operationally separate from the parent bank. Ring-fenced banks
should have a capital cushion of up to 20%.
Non-retail parts of banking groups should be allowed to fail. The report anticipated that this would
mean that their cost of capital went up. However the lack of guaranteed government support for
investment activities should mean that banks were less likely to take excessive risks in this area.
Banks were given until 2019 to implement these requirements fully, a period felt by some
commentators to be very lengthy. The time period was set to coincide with the international capital
requirements changes being introduced by the Basel regulators.

1.9 Managing risk in business strategy and financial strategy


Traditionally, management teams tend to be risk-averse that is, they prefer less risk and are prepared
to take steps to reduce any potential risks arising from either being in business in general or from
specific projects that the company undertakes. The objective of risk management is ultimately to have
procedures in place that will reduce these risks to a level that is acceptable to the company and its
shareholders. However, setting up and maintaining these procedures takes time, money and human
resources, all of which are limited within any organisation.

Business risk management 79


Case example: Tesco
Tesco has the following approach to interest rate and foreign currency risk management.
'Interest rate risk management Our objective is to limit the impact to our profit and loss from rising
interest rates. Forward rate agreements, interest rate swaps, caps and floors may be used to achieve the
desired mix of fixed and floating rate debt.
'Our policy is to fix interest rates for the year on a minimum of 40% of actual and projected debt
interest costs of the Group excluding Tesco Bank. At the year-end the percentage of interest-bearing
debt at fixed rates was 75% (2012 90%). The remaining balance of our debt is in floating rate form.
'Foreign currency risk management Our principal objective is to reduce the effect of exchange rate
volatility on operating margins. Transactional currency exposuresare managed, typically using
forward purchases or sales of foreign currencies and currency options...we only hedge a proportion of
the investment in our international subsidiaries as well as ensuring that each subsidiary is appropriately
hedged in respect of its non-functional currency assets'
Source: Tesco Annual Report and Financial Statements, 2013

2 Enterprise risk management

Section overview
Enterprise risk management provides a coherent framework for organisations to deal with risk,
based on such components as internal environment, objective setting and event identification.
The framework is designed to identify potential events that may affect the entity and manage risks
to be within its risk appetite.

2.1 Nature of enterprise risk management

Definition
Enterprise risk management is a process, effected by an entity's board of directors, management and
other personnel, applied in strategy setting and across the enterprise, designed to identify potential
events that may affect the entity and manage risks to be within its risk appetite, to provide reasonable
assurance regarding the achievement of entity objectives. COSO

The Committee of Sponsoring Organisations of the Treadway Commission (COSO) goes on to expand
its definition. It states that enterprise risk management has the following characteristics.
(a) It is a process, a means to an end, which should ideally be intertwined with existing operations
and exist for fundamental business reasons.
(b) It is operated by people at every level of the organisation and is not just paperwork. It provides a
mechanism helping people to understand risk, their responsibilities and levels of authority.
(c) It is applied in strategy setting, with management considering the risks in alternative strategies.
(d) It is applied across the enterprise. This means it takes into account activities at all levels of the
organisation from enterprise-level activities such as strategic planning and resource allocation, to
business unit activities and business processes. It includes taking an entity level portfolio view of
risk. Each unit manager assesses the risk for his unit. Senior management ultimately consider these
unit risks and also interrelated risks. Ultimately, they will assess whether the overall risk portfolio is
consistent with the organisation's risk appetite.

80 Business Analysis
(e) It is designed to identify events potentially affecting the entity and manage risk within its risk
appetite, the amount of risk it is prepared to accept in pursuit of value. The risk appetite should be
aligned with the desired return from a strategy.
(f) It provides reasonable assurance to an entity's management and board. Assurance can at best be
reasonable since risk relates to the uncertain future.
(g) It is geared to the achievement of objectives in a number of categories, including supporting the
organisation's mission, making effective and efficient use of the organisation's resources, ensuring
reporting is reliable, and complying with applicable laws and regulations.
Because these characteristics are broadly defined, they can be applied across different types of
organisations, industries and sectors. Whatever the organisation, the framework focuses on
achievement of objectives.
C
An approach based on objectives contrasts with a procedural approach based on rules, codes or H
procedures. A procedural approach aims to eliminate or control risk by requiring conformity with the A
rules. However, a procedural approach cannot eliminate the possibility of risks arising because of poor P
management decisions, human error, fraud or unforeseen circumstances arising. T
E
R

2.2 Framework of enterprise risk management


The COSO Framework consists of eight interrelated components. 2

Objective setting
Event identification
Risk assessment
Risk response
Internal environment or control environment
Control activities or procedures
Information and communication
Monitoring

Case example: Enterprise risk management


Different commentators have developed guidance on enterprise risk management in different ways.
Ernst and Young identified six components of risk management:
Risk strategy
Risk management processes
Appropriate culture and capability
Risk management functions
Enabling technologies
Governance
Ernst and Young suggests that risk management should focus on what shareholders consider to be vital
for the business. Companies should establish what shareholders think affects company value, link risks to
value drivers, determine shareholders' preferred treatment of risks and communicate what the company
is doing.

Business risk management 81


2.3 Benefits of enterprise risk management
COSO highlights a number of advantages of adopting the process of enterprise risk management.

Alignment of risk appetite and The Framework demonstrates to managers the need to
strategy consider risk toleration. They then set objectives aligned
with business strategy and develop mechanisms to manage
the accompanying risks and to ensure risk management
becomes part of the culture of the organisation, embedded
into all its processes and activities.
Link growth, risk and return Risk is part of value creation, and organisations will seek a
given level of return for the level of risk tolerated.
Choose best risk response Enterprise risk management helps the organisation select
whether to reduce, eliminate or transfer risk.
Minimise surprises and losses By identifying potential loss-inducing events, the
organisation can reduce the occurrence of unexpected
problems.
Identify and manage risks across As indicated above, the Framework means that managers
the organisation can understand and aggregate connected risks. It also
means that risk management is seen as everyone's
responsibility, experience and practice is shared across the
business and a common set of tools and techniques is used.
Provide responses to multiple For example, risks associated with purchasing, over- and
risks under-supply, prices and dubious supply sources might be
reduced by an inventory control system that is integrated
with suppliers.
Seize opportunities By considering events as well as risks, managers can identify
opportunities as well as losses.
Rationalise capital Enterprise risk management allows management to allocate
capital better and make a sounder assessment of capital
needs.

2.4 Risk architecture


In its 1999 report Enhancing Shareholder Wealth by Better Managing Business Risk the International
Federation of Accountants argued for the development of a risk architecture within which risk
management processes could be developed. The architecture involves designing and implementing
organisational structures, systems and processes to manage risk. This is a slightly different
framework to that of enterprise risk management.
IFAC argued that developing a risk architecture is not just a response to risk but marks an organisational
shift, changing the way the organisation:
Organises itself
Assigns accountability
Builds risk management as a core competency
Implements continuous, real-time risk management
Best practice, IFAC argued, is to develop a highly integrated approach to risk management, using a
common language, shared tools and techniques and periodic assessments of the risk profile for the
entire organisation. Integration is particularly important when most units have many risks in common,
and when there is significant interdependency between units. It is vital when managers are trying to
achieve a shared corporate vision.
The risk architecture developed by IFAC has eight components:
Acceptance of a risk management framework
Commitment from executives

82 Business Analysis
Establishment of a risk response strategy
Assignment of responsibility for risk management process
Resourcing
Communication and training
Reinforcing risk cultures through human resources mechanisms
Monitoring of the risk management process
IFAC identified four components of risk management:
Structure to facilitate the identification and communication of risk
Resources sufficient to support implementation
Culture reinforcing decision-making processes
Tools and techniques developed to enable organisation-wide management of risk
C
H
2.5 The Turnbull report A
P
The Turnbull report (published 1999, revised 2005) aims to provide guidance on risk management and T
control systems to supplement the broad outlines set out in the Combined Code (now the UK E
R
Corporate Governance Code). Turnbull emphasises the importance of the evolution of a system of
internal control to take account of new and emerging risks, control failures, market expectations or
changes in the company's circumstances or business objectives. Evolution requires regular and
systematic assessment of the risks facing the business. 2

2.6 Risk resourcing


Whatever the division of responsibilities for risk management, the organisation needs to think carefully
about how risk management is resourced; sufficient resources will be required to implement and
monitor risk management (including the resources required to obtain the necessary information).
Consideration will be given not only to the expenditure required, but also the human resources in
terms of skills and experience.

Case example: Intercontinental Hotel Group (IHG)


IHG's risk report describes the elements of its approach to enterprise risk management:
Policies and standards formal documentation of the approach, controls and actions for IHG
employees when dealing with specific risks. These set out accountability for risks, relevant roles and
responsibilities and actions that are measurable or auditable.
Ways of working practical aspects of risk management such as tools, templates, systems, forums
and behaviours, which help management bring the policies and standards to life.
Training and communication face-to-face and online learning programmes to provide
appropriate skills and knowledge and regular communication to raise awareness.
Operate and control ongoing operational activities and control measures to comply with
policies and standards and to manage risk.
Risk financing consideration of the financial impact of risks and ensuring that arrangements are
in place usually insurance coverage or budgetary funds.
Monitor and report the collection and analysis of management information to evaluate the
effectiveness of the risk profile, policies and standards, ways of working, training and
communications and risk financing activities.

Business risk management 83


3 Risk management and control systems

Section overview
This section discusses the underlying features of risk and control systems.
Consideration of risk issues should be an integral part of board agendas.
The board's risk committee and the risk management function are also key players in managing
risk.
There are various methods that can be used to promote awareness of risk and control issues within
a company.
The Turnbull report stresses the importance of embedding risk management and control systems
within business processes.

3.1 Board responsibilities


If effective risk management is to be embedded within a company, the board must oversee its
establishment. The board should consider on a regular basis:
The nature and extent of the risks facing the company
The extent and categories of acceptable risks
The likelihood of the risks materialising
The company's ability to reduce the incidence and impact of risks that do materialise
The costs of operating particular controls versus their benefits
The Walker report in 2009 highlighted that the monitoring role of the board in financial sector
institutions was particularly important because of the speed and scale of change in this sector:
'The whole board needs to be attentive to developments in the risk space to a degree far exceeding that
in non-financial business.'
Ownership of the risk management and internal control system is a vital part of the chief executive's
overall responsibility for the company. The chief executive must consider in particular the risk and
control environment, focusing amongst other things on how his or her example promotes a good
culture. The chief executive should also monitor other directors and senior staff, particularly those whose
actions can put the company at significant risk.
As well as explicit responsibilities, the board's role in 'setting the tone' and demonstrating clearly that
they respect the need for effective control systems is a very important part of risk management. This
includes respecting the need for separation of duties between managers carrying out executive duties,
and non-executive directors and staff responsible for monitoring them.

3.1.1 Review of board's role


Following on from the revisions to UK corporate guidance in 2010, the Financial Reporting Council
undertook a review of how boards were approaching their responsibilities, with a view perhaps to
revising the Turnbull guidance originally published in 1999. The consultation found that boards' focus
on risk had changed significantly over the last decade and the approaches and techniques that they
used were developing rapidly.
The main points arising from the consultation included the following:
Boards should aim for better risk taking, but this did not necessarily mean less risk taking as risk
taking is essential to entrepreneurship.
Different board committees are appropriate for different industries. The decision on appropriate
committee structure should be left to individual boards rather than making a risk committee
compulsory for everyone. A risk committee is appropriate for companies in the financial sector and
separate committees are commonly used by companies in the pharmaceutical and extractive
industries, which are exposed to significant safety, environmental or regulatory risks. Examples in
these industries include compliance committees and corporate responsibility committees.

84 Business Analysis
Responsibility for monitoring internal controls and risk management could be delegated to board
committees, but the whole board should retain strategic responsibility for risk decision-taking.
Boards need to understand how risk exposure might change as a result of changes in strategy and
the operating environment.
Boards need to focus on individual risks capable of undermining the strategy or long-term viability
of the company or damaging its reputation. Reputation risk requires greater attention, partly
because failures can be publicised widely and quickly in the global information environment. Boards
need to have robust crisis management plans.
Boards should not just focus on net or residual risk, but need to understand exposure to the
combination of risks faced, before risk management policies are implemented.
It could be difficult to decide how much information about risks boards need, and in particular
when a particular risk should be brought to the board's attention. C
H
Organisations need transparency and clear lines of reporting and accountability. A
P
Investors are increasingly seeking more meaningful reporting on risk, for example an integrated T
discussion of business model, strategy, key risks and mitigation. Investors also want to know how E
R
companies' exposure to risk is changing.

Case example: HBOS 2

The issue of separation of duties was highlighted in February 2009 by the testimony of Paul Moore,
former head of the group regulatory risk at HBOS, to the UK House of Commons' Treasury Select
Committee. Moore commented:
'There has been a completely inadequate separation and balance of powers between the executive
and all those accountable for overseeing their actions and reining them in ie internal control functions
such as finance, risk, compliance and internal audit, non-executive Chairmen and Directors, external
auditors, the FSA, shareholders and politicians.
There is no doubt that you can have the best governance processes in the world but if they are carried
out in a culture of greed, unethical behaviour and indisposition to challenge they will fail.'

3.2 Risk committee


Boards also need to consider whether there should be a separate board committee, with responsibility for
monitoring and supervising risk identification and management. If the board doesn't have a separate
committee, under the UK Corporate Governance Code the audit committee will be responsible for risk
management.
Consideration of risk certainly falls within the remit of the audit committee. However there are a number
of arguments in favour of having a separate risk committee.
(a) A risk management committee can be staffed by executive directors, whereas an audit committee
under corporate governance best practice should be staffed by non-executive directors. However if
there are doubts about the competence and good faith of executive management, it will be more
appropriate for the risk committee to be staffed by non-executive directors.

(b) As a key role of the audit committee will be to liaise with the external auditors, much of their time
could be focused on financial risks.

(c) A risk committee can take the lead in driving changes in practice, whereas an audit committee will
have a purely monitoring role, checking that a satisfactory risk management policy exists.
Morris in An Accountant's Guide to Risk Management suggests that written terms of reference might
include the following:
Approving the organisation's risk management strategy and risk management policy.

Reviewing reports on key risks prepared by business operating units, management and the board.

Monitoring overall exposure to risk and ensuring it remains within limits set by the board.

Business risk management 85


Assessing the effectiveness of the organisation's risk management systems.

Providing early warning to the board on emerging risk issues and significant changes in the
company's exposure to risks.

In conjunction with the audit committee, reviewing the company's statement on internal control
with reference to risk management, prior to endorsement by the board.
Note that the focus is on supervision and monitoring rather than the committee having responsibility for
implementation of policies.
Having a separate risk committee can aid the board in its responsibility for ensuring that adequate risk
management systems are in place. The application of risk management policies will then be the
responsibility of operational managers, and perhaps specialist risk management personnel.

Case example: Intercontinental Hotel Group (IHG)


The board of IHG has of course, ultimate responsibility for the group's strategy, risk management and
internal control and reviewing their effectiveness. The audit committee carries out an annual review of
the risk management system. In addition, the company's Risk Working Group, which is chaired by the
Company Secretary and comprises the Global Heads of Strategy, Risk Management and Internal Audit,
takes an active role in overseeing the most significant risks to IHG. Risks identified in the regions and
corporate functions are consolidated, refined and calibrated against a strategic view of risks by the Risk
Working Group. Major risks are discussed to gain agreement on the risk descriptions, ownership and
actions, before final presentation to the audit committee and Board. The Risk Working Group monitors
changes to the major risks and the progress of actions on a quarterly basis, to ensure these risks are
appropriately managed and emerging risks are identified.

3.2.1 Risk committees in the financial sector


The Walker report recommended that FTSE-100 bank or life insurance companies should establish a risk
committee. Reasons for this recommendation included the need to avoid over-burdening the audit
committee, and to draw a distinction between the largely backward looking focus of the audit
committee, and the need for forward-looking focus of determining risk appetite and from this
monitoring appropriate limits on exposures and concentrations. The committee should have a majority
of non-executive directors. Any executive risk committee should be overseen by the board risk
committee.
Walker recommended that the committee should concentrate on the fundamental prudential risks for
the institution: leverage, liquidity risk, interest rate and currency risk, credit/counterparty risks and other
market risks. It should advise the board on current risk exposures and future risk strategy, and the
establishment of a supportive risk culture.
The committee should regularly review and approve the measures and methodology used to assess risk.
A variety of measures should be used. The risk committee should also advise the remuneration
committee on risk weightings to be applied to performance objectives incorporated within the incentive
structure for executive directors.

3.3 Risk management personnel


3.3.1 Risk specialists
Most individuals have little time for looking after their personal safety and security, still less for searching
the market for the most suitable insurances. They frequently employ agents to help manage some of
their risks.
A specialist advising on management of personal risks can work only as well as the client allows. A good
specialist will ask for information and for co-operation with the expert surveys that enable him to
provide a proper service. He will ensure that the client understands what safety measures are required
and he will see that they are put into practice.

86 Business Analysis
3.3.2 Risk manager
The risk manager will need technical skills in credit, market, and operational risk. Leadership and
persuasive skills are likely to be necessary to overcome resistance from those who believe that risk
management is an attempt to stifle initiative.
Lam (Enterprise Risk Management) includes a detailed description of this role, and the COSO framework
also has a list of responsibilities. Combining these sources we can say that the risk manager is typically
responsible for:
(a) Providing the overall leadership, vision and direction for enterprise risk management.

(b) Establishing an integrated risk management framework for all aspects of risk across the
organisation, integrating enterprise risk management with other business planning and
management activities and framing authority and accountability for enterprise risk management in C
business units. H
A
(c) Promoting an enterprise risk management competence throughout the entity, including P
facilitating development of technical enterprise risk management expertise, helping managers align T
E
risk responses with the entity's risk tolerances and developing appropriate controls.
R
(d) Developing risk management policies, including the quantification of management's risk appetite
through specific risk limits, defining roles and responsibilities, ensuring compliance with codes,
regulations and statutes and participating in setting goals for implementation. 2

(e) Establishing a common risk management language that includes common measures around
likelihood and impact, and common risk categories. Developing the analytical systems and data
management capabilities to support the risk management programme.

(f) Implementing a set of risk indicators and reports including losses and incidents, key risk
exposures, and early warning indicators. Facilitating managers' development of reporting
protocols, including quantitative and qualitative thresholds, and monitoring the reporting process.

(g) Dealing with insurance companies: an important task because of increased premium costs,
restrictions in the cover available (will the risks be excluded from cover) and the need for
negotiations with insurance companies if claims arise. If insurers require it demonstrating that the
organisation is taking steps actively to manage its risks. Arranging financing schemes such as self-
insurance or captive insurance.

(h) Allocating economic capital to business activities based on risk, and optimising the company's
risk portfolio through business activities and risk transfer strategies.

(i) Reporting to the chief executive on progress and recommending action as needed.
Communicating the company's risk profile to key stakeholders such as the board of directors,
regulators, stock analysts, rating agencies and business partners.
The risk manager's contribution will be judged by how much he increases the value of the organisation.
The specialist knowledge a risk manager has should allow the risk manager to assess long-term risk and
hazard outcomes and therefore decide what resources should be allocated to combating risk.
Clearly certain strategic risks are likely to have the biggest impact on corporate value. Therefore a risk
manager's role may include management of these strategic risks. These may include those having a
fundamental effect on future operations such as mergers and acquisitions or risks that have the potential
to cause large adverse impacts such as currency hedging and major investments. In financial institutions
the Walker report highlighted the assessment of whether product launches or the pricing of risk in a
particular transaction was consistent with the risk tolerance determined by the risk committee.
The Walker report stressed the need for provisions enhancing the independence of the chief risk officer,
for example rights of access to the chairman of the risk committee and removal from office to require
the agreement of the whole board.
Walker highlighted the need for effective reporting. The risk committee's report should be a separate
report in the annual accounts and include details of risk exposures and risk appetite for banking and
trading exposures, and the effectiveness of the risk management process. Some detail should be given
of the stress-testing of risk.

Business risk management 87


Case example: HBOS
The role of the risk manager in banks was highlighted in February 2009 by the evidence given to the UK
House of Commons' Treasury Select Committee enquiry into the banking system by Paul Moore, the ex
head of Group Regulatory Risk at HBOS. Moore had allegedly been sacked by Sir James Crosby, Chief
Executive Officer at HBOS. As a result of Moore making his allegations, Sir James resigned as deputy
chairman of London city watchdog, the Financial Services Authority.
Moore stated that in his role he 'felt a bit like being a man in a rowing boat trying to slow down an oil
tanker'. He said that he had told the board that its sales culture was out of balance with its systems and
controls. The bank was growing too fast, did not accept challenges to policy, and was a serious risk to
financial stability and consumer protection. The reason why Moore was ignored and others were afraid
to speak up was, he alleged, that the balance of powers was weighted towards executive directors, not
just in HBOS but in other banks as well.
'I believe that, had there been highly competent risk and compliance managers in all the banks, carrying
rigorous oversight, properly protected and supported by a truly independent non-executive, the
external auditor and the FSA, they would have felt comfortable and protected to challenge the practices
of the executive without fear for their own positions. If this had been the case, I am also confident that
we would not have got into the current crisis.'
Moore was replaced by a Group Risk Director who had never previously been a risk manager. The new
head had been a sales manager and was allegedly appointed by the Chief Executive Officer without
other board members having much, if any, say in the appointment.
During the time that Paul Moore was head of Group Regulatory Risk, the Financial Services Authority
had raised its own concerns about practices at HBOS and had kept a watching brief over the bank. In
December 2004 the Authority noted that although the group 'had made good progress in addressing
the risks highlighted in February 2004, the group risk functions still needed to enhance their ability to
influence the business'. In June 2006 the Authority stated that whilst the group had improved its
framework, it still had concerns: 'The growth strategy of the group posed risks to the whole group and
these risks must be managed and mitigated.'
At the end of the week in which Paul Moore's evidence was published, Lloyds, which had taken HBOS
over, issued a profit warning in relation to HBOS for 2008 for losses of over 10 billion.

3.3.3 Risk management function


Larger companies may have a bigger risk management function whose responsibilities are wider than a
single risk manager or risk specialist. The Institute of Risk Management's Risk Management standard lists
the main responsibilities of the risk management function:
Setting policy and strategy for risk management

Primary champion of risk management at a strategic and operational level

Building a risk aware culture within the organisation including appropriate education

Establishing internal risk policy and structures for business units

Designing and reviewing processes for risk management

Coordinating the various functional activities which advise on risk management issues within an
organisation

Developing risk response processes, including contingency and business continuity programmes

Preparing reports on risks for the board and stakeholders

3.4 Procedures for embedding risk


Employees cannot be expected to avoid risks if they are not aware that they exist in the first place.
Embedding a risk management frame of mind into an organisation's culture requires top-down
communications on what the risk philosophy is and what is expected of the organisation's employees.

88 Business Analysis
Case example: Internal communications programme
Here is an example of an internal communications programme slightly adapted from an example in the
COSO Framework.
Internal communications programme
Management discusses risks and associated risk responses in regular briefings with employees.
Management regularly communicates entity-wide risks in employee communications such as
newsletters, an intranet.
Enterprise risk management policies, standards, and procedures are made readily available to
employees along with clear statements requiring compliance.
Management requires employees to consult with others across the organisation as appropriate C
when new events are identified. H
A
Induction sessions for new employees include information and literature on the company's risk P
management philosophy and enterprise risk management programme. T
E
Existing employees are required to take workshops and/or refresher courses on the organisation's R
enterprise risk management initiatives.
The risk management philosophy is reinforced in regular and ongoing internal communication
2
programmes and through specific communication programmes to reinforce tenets of the
company's culture.

3.4.1 Human resource procedures


The COSO framework also recommends certain organisational measures for spreading ownership of risk
management.
(a) Enterprise risk management should be an explicit or implicit part of everyone's job description.
(b) Personnel should understand the need to resist pressure from superiors to participate in improper
activities, and channels outside normal reporting lines should be available to permit reporting such
circumstances.
(c) Managers should provide appropriate incentives. This may entail setting performance targets and
tying results to performance pay.

3.4.2 Training
Aside from practical matters like showing employees which buttons to press or how to find out the
information they need, training should include explanation of why things should be done in the way
that the trainer recommends. If employees are asked to carry out a new type of check but are not told
why there is every chance that they won't bother to do it, because they don't understand its relevance.
It just seems to mean more work for them and to slow up the process for everyone.

3.4.3 Risk policy statement


Organisations ought to have a statement of risk policy and strategy that is distributed to all managers
and staff.

3.4.4 Risk register


Organisations should have formal methods of collecting together information on risk and response. A
risk register lists and prioritises the main risks an organisation faces, and is used as the basis for decision-
making on how to deal with risks. The register also details who is responsible for dealing with risks and
the actions taken. The register should show the risk levels before and after control action is taken, to
facilitate a cost-benefit analysis of controls.

Business risk management 89


3.5 Control systems
The Turnbull report emphasises the importance of control systems in effectively managing risks. The
report provides a helpful summary of the main purposes of an internal control system.
Turnbull comments that internal control consists of 'the policies, processes, tasks, behaviours and other
aspects of a company that taken together:
(a) Facilitate its effective and efficient operation by enabling it to respond appropriately to significant
business, operational, financial, compliance and other risks to achieving the company's objectives.
This includes the safeguarding of assets from inappropriate use or from loss and fraud and ensuring
that liabilities are identified and managed.
(b) Help ensure the quality of internal and external reporting. This requires the maintenance of proper
records and processes that generate a flow of timely, relevant and reliable information from within
and without the organisation.
(c) Help ensure compliance with applicable laws and regulations, and also with internal policies with
respect to the conduct of business.
The Turnbull report also summarises the key characteristics of the internal control systems. They should:
Be embedded in the operations of the company and form part of its culture.
Be capable of responding quickly to evolving risks within the business.
Include procedures for reporting immediately to management significant control failings and
weaknesses together with control action being taken.
The system should include control activities, information and communication processes and processes
for monitoring the continued effectiveness of the system of internal control.
The Turnbull report goes on to say that a sound system of internal control reduces but does not
eliminate the possibilities of losses arising from poorly-judged decisions, human error, deliberate
circumvention of controls, management override of controls and unforeseeable circumstances. Systems
will provide reasonable (not absolute) assurance that the company will not be hindered in achieving its
business objectives and in the orderly and legitimate conduct of its business, but won't provide certain
protection against all possible problems.

4 The risk management process

Section overview
This section introduces a commonly used framework for assessing and managing risk.
The individual steps in the process will be discussed in detail in following sections.

Another commonly used framework for assessing and managing risk involves the following processes.
Establishing the context
Risk identification
Risk assessment
Risk profiling
Risk quantification
Risk responses
Implementation of plans
We will consider these processes in the next few sections. In real life, none of these processes are easy
what is considered to be a risk by some might not be seen as such by others which can lead to disputes
over which risks should be given priority. Quantification of an item that is essentially subjective is never
going to be straightforward in itself, putting a value on different risks is a subjective process.

90 Business Analysis
5 Establishing the context

Section overview
This is the first stage in the risk management process.
This step includes establishing both the internal and external contexts, the risk criteria and the
structure for risk analysis.
By performing this step, you are laying the foundations on which the entire risk management
process is based.

Before any risk can actually be identified, you have to establish the context within which risk will be C
assessed that is, you have to determine the domain within which assessment will take place. For H
example, management may only be interested in identifying financial risks, which means that those A
P
responsible for gathering information will concentrate on that area of risk only.
T
E
5.1 Establish the internal context R
Risk is essentially the chance that an event will occur that will prevent the company from meeting its
objectives. Therefore, in order to understand the risks, you must first identify the objectives. By doing
so you will ensure that decisions taken to reduce risk still support the overall goals of the organisation 2
which encourages long-term and strategic thinking.

Case example: Owner managed restaurant


A small restaurant employs a full-time chef, an apprentice chef and two waiters. Business is slow and
cash flow becoming a problem, therefore the owner decides he will have to let the apprentice chef and
one of the waiters go.
Four months later, the restaurant wins a five-year contract to supply lunches to a local firm and business
in general picks up with the opening of a new office block in close proximity to the restaurant's
premises. The restaurant owner had been preparing for the new contract, having tendered for it several
months before paying off the apprentice chef and the waiter, and was aware of the imminent opening
of the office block.
The owner then had problems of a different kind. The chef could not cope with both the contracted
lunches and the general improvement in business, nor could the waiter deal with a full restaurant on his
own. The apprentice chef had already found alternative employment, as had the previous waiter. The
owner was forced to take on a less experienced apprentice who then had to be trained by the already
overworked chef and another waiter who was unfamiliar with the general operations of the restaurant.
In context, the restaurant owner should have tried to find alternative means of dealing with what he
must have known to be a temporary cash flow problem, rather than getting rid of staff in whose
training time and money had already been invested.
When trying to establish the internal context, business owners should also consider such issues as:
Internal culture. Are staff likely to be resistant to change?
Existing business capabilities, such as people, equipment and processes

5.2 Establish the external context


The external context is the overall environment in which the business operates, including an
understanding of the perceptions that clients or customers have of the business. This could take the
form of a SWOT analysis. It should also cover such issues as external regulations that the business must
comply with.

Business risk management 91


5.3 Establish the risk management context
In order to correctly identify risks associated with a project, you must first define the project's limits,
objectives and scope.

Case example: Accountancy body


Due to expansion of staff and necessary documentation, the student support and education
departments of a professional accountancy body are moving into larger office premises. Before the
move takes place, the head of administration who is taking charge of the move undertakes a risk
assessment of the relocation.
The risk management context includes:
The main objective: to move staff, furniture, equipment and documentation to the new premises
with a minimum of disruption to student services and production of examination papers.
Ensure the security and confidentiality of the examination papers held at the current premises
which will be transferred in locked safes to the new location.
An overall timeframe (including planning, liaison with telephone companies, etc) of three months.
A budget of 25,000 for use of external relocation support.
This risk management context provides sufficient information with which the head of administration can
assess the risks associated with the relocation, particularly those that impact on the primary objective of
minimising disruption to student services and production of examination papers.

5.4 Develop risk criteria


This step allows the business to identify unacceptable levels of risk, or, looking at it another way, to
define acceptable levels of risk for a specific project. These risk levels can be more closely defined as the
process progresses.
In the case study above, for example, it would be completely unacceptable for the confidentiality and
security of the examination papers to be compromised, therefore this documentation must be kept in
locked safes and transported using professional safe movers.

5.5 Define the structure for risk analysis


The final stage in the establishment of context is to define the structure for risk analysis. This involves
isolating the risk categories that need to be managed, which can then be assessed individually. This will
allow for greater depth and accuracy when identifying important risks.

6 Risk identification

Section overview
Before being able to establish risk management processes, you must identify the risks that your
organisation actually faces.
Some risks may be familiar to the organisation; others may not.
This step is a continuous process; as the business environment changes, so do the risks faced by
organisations operating in that environment.

No-one can manage a risk without first being aware that it exists. Some knowledge of perils, what items
they can affect and how, is helpful to improve awareness of whether familiar risks (potential sources
and causes of loss) are present, and the extent to which they could harm a particular person or
organisation. The risk manager should also keep an eye open for unfamiliar risks which may be present.

92 Business Analysis
Actively identifying the risks before they crystallise makes it easier to think of methods that can be used
to manage them.
Risk identification is a continuous process, so that new risks and changes affecting existing risks may be
identified quickly and dealt with appropriately, before they can cause unacceptable losses.

6.1 Risk conditions


Means of identifying conditions leading to risks (potential sources of loss) include:
(a) Physical inspection, which will show up risks such as poor housekeeping (for example, rubbish left
on floors, for people to slip on and to sustain fires).
(b) Enquiries, from which the frequency and extent of product quality controls and checks on new
employees' references, for example, can be ascertained. C
H
(c) Checking a copy of every letter and memo issued in the organisation for early indications of major A
changes and new projects. P
T
(d) Brainstorming with representatives of different departments. E
R
(e) Checklists ensuring risk areas are not missed.
(f) Benchmarking against other sections within the organisation or external experiences.
2

6.2 Event identification


A key aspect of risk identification, emphasised by the Committee of Sponsoring Organisations of the
Treadway Commission's report Enterprise Risk Management Framework, is identification of events that
could impact upon implementation of strategy or achievement of objectives.
Events analysis includes identification of:
(a) External events such as economic changes, political developments or technological advances.
(b) Internal events such as equipment problems, human error or difficulties with products.
(c) Leading event indicators. By monitoring data correlated to events, organisations identify the
existence of conditions that could give rise to an event, for example customers who have balances
outstanding beyond a certain length of time being very likely to default on those balances.
(d) Trends and root causes. Once these have been identified, management may find that assessment
and treatment of causes is a more effective solution than acting on individual events once they
occur.
(e) Escalation triggers, certain events happening or levels being reached that require immediate
action.
(f) Event interdependencies, identifying how one event can trigger another and how events can
occur concurrently. For example, a decision to defer investment in an improved distribution system
might mean that downtime increases and operating costs go up.
Once events have been identified, they can be classified horizontally across the whole organisation and
vertically within operating units. By doing this management can gain a better understanding of the
interrelationships between events, gaining enhanced information as a basis for risk assessment.

7 Risk assessment

Section overview
The fundamental difficulty in assessing risk is determining how often this particular risk may occur.
Statistical information is not available on all manner of past incidents.
The financial benefits of risk management are dependent on how and the frequency with which
risk assessment is performed.

Business risk management 93


It is not always simple to forecast the financial effect of a possible disaster, as it is not until after a loss
that extra expenses, inconveniences and loss of time can be recognised. Even then it can be difficult to
identify all of them.
Organisations will probably keep more detailed records of their activities and the unit costs involved, but
it is unlikely that any organisation can predict the full cost of every loss that might befall it with
certainty.

8 Risk profiling

Section overview
It is important for organisations to group risks according to their likelihood and potential impact.
This process is very useful when setting priorities for putting risk mitigation processes in place.

This stage involves using the results of a risk assessment to group risks into risk families. One way of
doing this is a likelihood/consequences matrix.

Consequences
Low High
Loss of suppliers Loss of senior or specialist
staff
Low Loss of sales to competitor
Loss of sales due to
Likelihood

macroeconomic factors
Loss of lower-level staff Loss of key customers
Failure of computer systems
High

This profile can then be used to set priorities for risk mitigation.

9 Risk quantification and consolidation

Section overview
The quantification of risk is necessary to estimate how much the organisation stands to lose in the
event of a particular risk occurring.
For physical assets, quantification is often fairly straightforward; however exposure of financial and
intangible assets is more difficult to put a monetary figure on.
The individual risks that have been identified in different parts of the business must be
consolidated (ie aggregated) to establish the risk at the corporate level.

Risks that require more analysis can be quantified, where possible results or losses and probabilities are
calculated and distributions or confidence limits added on. From this exercise is derived the following
key data.
Average or expected result or loss
Frequency of losses
Chances of losses
Largest predictable loss

94 Business Analysis
to which the organisation could be exposed by a particular risk. The risk manager must also be able to
estimate the effects of each possible cause of loss, as some of the effects that he needs to consider may
not be insured against.
The likely frequency of losses from any particular cause can be predicted with some degree of
confidence, from studying available records. This confidence margin can be improved by including the
likely effects of changed circumstances in the calculation, once they are identified and quantified. Risk
managers must therefore be aware of the possibility of the increase of an existing risk, or the
introduction of a new risk, affecting the probability and/or possible frequency of losses from another
cause.
Often quantification of losses will not involve statistical techniques, but a simple single estimate of what
would be lost if adverse events or circumstances occur. For example, if an accountancy firm had a client
that generated a fixed fee each year, the loss would be the contribution (fees lost less labour and other
C
variable costs saved). H
A
Ultimately the risk manager will need to know the frequency and magnitude of losses that could place
P
the organisation in serious difficulty. T
E
R
9.1 Exposure of physical assets
Exposures with physical assets may include:
2
Total value of the assets, for example the value of items stolen from a safe.
Costs of repair, if for example an accident occurs.
Change of value of an asset, for example property depreciating in value because of a new airport
development nearby.
Decrease in revenues, for example loss of rent through a rental property being unlettable for a
period.
Costs of unused capacity, costs incurred by spare capacity that is taken as a precaution but does
not end up being used.

9.2 Exposure of financial assets


Whilst the risk of trading shares and most forms of debt might be that their values fall to zero, this is not
necessarily true of futures (where losses could be unlimited) and options (whose losses are limited to the
option premium). In addition anyone who is exposed to loss as a result of price rises is in theory
exposed to the risk of infinite loss, since prices could rise indefinitely.

Case example: Banking crisis


The 2009 Turner report highlighted faulty measurement techniques as a reason why many financial
institutions underestimated their risk position. The required capital for their trading activities was
excessively light. Turner also highlighted the rapid growth of off balance sheet vehicles that were highly
leveraged but were not included in standard risk measures. However the crisis demonstrated the
economic risks of these vehicles, with liquidity commitments and reputational concerns requiring banks
to take the assets back onto their balance sheets, increasing measured leverage significantly.
Turner also saw the complexity of the techniques as itself being a problem. 'The very complexity of the
mathematics used to measure and manage risk made it increasingly difficult for top management and
boards to assess and exercise judgements over risks being taken. Mathematical sophistication ended up
not containing risk, but providing false assurance that other prima facie indicators of increasing risk (eg
rapid credit extension and balance sheet growth) could be safely ignored.'

Business risk management 95


9.3 Exposure of human assets
9.3.1 Death or serious injury
The most severe risk to employees is the risk of death or serious injury. The loss to the employee's family,
for which the organisation may be liable, could be the future value of their expected income stream,
mitigated by any benefits available but enhanced by other losses that arise as a result of death, for
example loss of any available tax allowance. Alternatively it could be measured by the expenditure
required to fulfil the needs of the deceased's dependent family. For less serious injuries, the costs of
medical care may be the relevant figure.

9.3.2 Key persons


Certain individuals may make a significant contribution to the office because of their knowledge, skills or
business contacts. One measure of this loss will be the present value of the individual's contribution
(attributable earnings less remuneration). Indirect costs may include the effect on other staff of the loss
of the key person (decreased productivity or indeed the costs of their own departure).

9.3.3 Business discontinuation losses


If a director, partner or senior employee dies or departs, there may be costs of having to cope with the
disruption, including even the costs of dissolution if local law requires termination of a partnership on
the departure of a single partner.

9.4 Risk consolidation


Risk that has been analysed or quantified at the division or subsidiary level needs to be aggregated at
the corporate level and grouped into categories. This aggregation will be required as part of the overall
review of risk that the board needs to undertake. The process of risk categorisation also enables the risks
categorised together to be managed by the use of common control systems.

10 Risk responses

Section overview
Although organisations operating in the same industry may face similar risks, the ways in which
they respond to these risks can differ significantly.
Risk responses depend on such factors as the potential impact of the risk on the organisation and
management's attitude towards risk.
The four main responses to risk are: avoidance, reduction, transfer and acceptance.

Once risks have been identified, assessed and quantified, decisions must be taken as to how to respond
to these risks. Methods of dealing with risk include avoidance, reduction, retention and transfer.
Risk response can be linked into the likelihood/consequences matrix and also the organisation's appetite
for risk-taking.

96 Business Analysis
Consequences
Low High

Accept or absorb Transfer


Risks are not significant. Insure risk or implement contingency
Low Keep under review, but costs plans. Reduction of severity of risk will
of dealing with risks unlikely minimise insurance premiums.
to be worth the benefits.
Likelihood

Reduce or manage Avoid or control


Take some action, eg self- Take immediate action to reduce
High insurance to deal with severity and frequency of losses, eg
frequency of losses. insurance, charging higher prices to C
H
customers or ultimately abandoning A
activities. P
T
E
10.1 Avoidance of risk R
Organisations will often consider whether risk can be avoided and if so whether avoidance is desirable
that is, will the possible savings from losses avoided be greater than the advantages that can be gained
by not taking any measures and running the risk? 2

An extreme form of avoiding business risk is terminating operations altogether for example, operations
in politically volatile countries where the risks of loss (including loss of life) are considered to be too
great or the costs of security too high.

Case example: Toyota


Toyota responded to concerns over the safety of its cars by recalling millions of models worldwide
during 2009 and 2010. Sales of a number of models were suspended in the USA. Although Toyota's
actions aimed to resolve the risks to health and safety, it may have been less effective in mitigating the
risks to its reputation. Commentators highlighted an initial reluctance to admit the problem and poor
communication of what it intended to do to regain control of the situation. The impact threatened car
sales and share price, with investors reluctant to hold Toyota shares because of the level of uncertainties
involved.

10.2 Reduction of risk


Often risks can be avoided in part, or reduced, but not avoided altogether. This is true of many business
risks, where the risks of launching a new product can be reduced by market research, advertising and so
on.
Other risk reduction measures include contingency planning and loss control.

Case example: Pearson


Pearson highlights the risks to its intellectual property and proprietary rights as potential major
constraints on its ability to grow. Pearson seeks to mitigate these risks through general vigilance, co-
operation with other publishers and trade associations, advances in technology and taking legal action.
The group has developed data rights management standards and monitoring programs, and has
established a piracy task force to identify weaknesses and remediate breaches. Pearson also monitors in
each market developments in copyright and intellectual property law.

10.2.1 Contingency planning


Contingency planning involves identifying the post-loss needs of the business, drawing up plans in
advance and reviewing them regularly to take account of changes in the business. The process has
three basic constituents.

Business risk management 97


Information How, for example, do you turn off the sprinklers once the
fire is extinguished? All the information that will need to
be available during and after the event should be gathered
in advance.
Responsibilities The plan should lay down what is to be done by whom.

Practice Unless the plan has been tested there is no guarantee that
it will work. A full-scale test may not always be possible;
simulations, however, should be as realistic as possible and
should be taken seriously by all involved.

Case example: London emergency services


Before and since the London bombings in 2005, the London emergency services have held regular
simulation exercises of how they would react in an emergency situation. Usually held at weekends,
these simulation exercises often take place in tube stations, using hundreds of 'extras' to play the parts
of injured members of the public. Such exercises are vital to test the way in which, and how quickly,
the emergency services will deal with terrorist attacks.

10.2.2 Loss control


Control of losses also requires careful advance planning. There are two main aspects to good loss
control: the physical and the psychological.
There are many physical devices that can be installed to minimise losses when harmful events
actually occur. Sprinklers, fire extinguishers, escape stairways, burglar alarms and machine guards
are obvious examples. It is not enough however to install such devices. They will need to be
inspected and maintained regularly.
The key psychological factors are awareness and commitment. Every person in the business should
be made aware that losses are possible and that they can be controlled.

10.3 Accepting risks


Risk acceptance or retention is where the organisation bears the risk itself, and if an unfavourable
outcome occurs, it will suffer the full loss. Risk retention is inevitable to some extent. However good
the organisation's risk identification and assessment processes are, there will always be some unexpected
risk. Other reasons for risk retention are that the risk is considered to be insignificant or the cost of
avoiding the risk is considered to be too great compared with the potential loss that could be incurred.
The decision of whether to retain or transfer risks depends firstly on whether there is anyone to transfer
a risk to. The answer is more likely to be 'no' for an individual than for an organisation, because:
Individuals have more small risks than do organisations and the administrative costs of transferring
and carrying them can make the exercise impractical for the insurer; and
The individual has smaller resources to find a carrier.
In the last resort, organisations usually have customers to pass their risks or losses to, up to a point, and
individuals do not.

10.4 Transfer of risk


Alternatively, risks can be transferred to other internal departments or externally to suppliers,
customers or insurers. Risk transfer can even be to the State.
Decisions to transfer risk should not be made without careful checking to ensure that as many
influencing factors as possible have been included in the assessment. A decision not to rectify the
design of a product, because rectification could be as expensive as paying any claims from disgruntled
customers, is in fact a decision to transfer the risk to the customers without their knowledge: it may not
take into account the possibility of courts awarding exemplary damages to someone injured by the
product, to discourage people from taking similar decisions in the future.

98 Business Analysis
Internal risk transfer can also cause problems if it is away from departments with more 'clout' (for
example, sales) and towards departments, such as finance, that may be presumed to downplay risks
excessively.

10.4.1 Hold harmless agreements


A hold harmless agreement is an agreement between two or more parties defining an obligation to
make good the liability, loss or damage incurred.

10.4.2 Limitation of liability


Some contracts, in which one party accepts strict liability up to a set limit, or liability which is wider than
the law would normally impose, follow very ancient customs. Examples are contracts for carriage of
passengers or goods by air or sea.
C
H
10.4.3 Legal and other restrictions on transferring risks A
P
The first restriction is that a supplier or customer may refuse to enter a contract unless your organisation
T
agrees to take a particular risk. This depends on the trading relationship between the firms concerned, E
and not a little on economics: how many suppliers could supply the item or service in question, for R
example, and how great is your need for the item?

10.4.4 Risk sharing 2

Risks can be partly held and partly transferred to someone else. An example is an insurance policy,
where the insurer pays any losses incurred by the policyholder above a certain amount.
Risk-sharing arrangements can be very significant in business strategy. For example, in a joint venture
arrangement, each participant's risk can be limited to what it is prepared to bear.

Interactive question 2: VSYS [Difficulty level: Intermediate]


VSYS Inc manufactures a range of computer products from its single factory located in a medium-sized
town in central USA. About 20% of the working population are employed at VSYS, and the company
has a reputation for being a good employer with specific focus on maintaining and enhancing benefits
for its employees.
Although the company is profitable, the recent management accounts show falling margins with the
possibility of a loss being made next year; the first in the 25 year history of the company. The main
reasons for the falling profits have been identified as increasing competition from manufacturers in the
Far East, and ongoing quality control issues with several key manufacturers. A recent feasibility study
shows that moving production to a Far Eastern country would enable VSYS to take advantage of lower
labour costs and proximity to suppliers of high quality components. The administration and marketing
functions would remain at their current location.
Movement of production systems to the Far East is seen as a particular problem for VSYS. Specific areas
of concern include:
(a) Obtaining and maintaining supplies from new suppliers
(b) Setting up production lines with new workforce and new machinery
(c) Maintaining sufficient inventory of materials to meet demand when the delivery times are
uncertain
(d) Implementing any necessary revisions to the management accounting systems
However, the Board is confident that the move will be successful and looks forward to a positive
response from workers and shareholders.
Requirement
Assess the risks associated with the decision to outsource to the Far East, and briefly recommend ways in
which these risks can be controlled.
See Answer at the end of this chapter.

Business risk management 99


10.5 Risk pooling and diversification
Risk pooling and diversification involves using portfolio theory to manage risks. You may remember that
portfolio theory is an important part of an organisation's financial strategy, but its principles can be
applied to non-financial risks as well.
Risk pooling or diversification involves creating a portfolio of different risks based on a number of events,
which, if some turn out well others will turn out badly, and the average outcome will be neutral. What
an organisation has to do is to avoid having all its risks positively correlated which means that
everything will turn out extremely well or extremely badly.
One means of diversification may be geographical diversification across countries at different stages of
the trade cycle.
In addition, although diversification may sound good in theory, the company may have insufficient
expertise in the product or geographical markets into which it diversifies and it may be vulnerable to
competition from other companies that focus on a specific market or product type.

Interactive question 3: Budget airline [Difficulty level: Intermediate]


A budget airline that offers low cost short-haul flights is considering the provision of flights to a country
with a volatile political environment, where public spending on such facilities as airports is often
withdrawn without warning. There is also a history of foreign planes being grounded for no apparent
reason and being forbidden to leave the country for several days. Market research has shown that
despite these problems there is considerable demand for low cost flights to this country.
Requirement
Identify potential risk strategies that could be adopted by the airline's management.
See Answer at the end of this chapter.

11 Implementation of plans

Section overview
Once risks have been identified, assessed and quantified, and the approaches to risk have been
decided, the task of putting the plans into action begins.
Implementation should be treated as a separate project with clear objectives and success criteria.

Implementation of the risk management process helps to clarify what ongoing actions should be taken
beyond the planning stage to ensure that the process is implemented in a manner that is beneficial to
the management team. The implementation process helps to ensure that you get the best risk
protection for the amount invested in the risk and other management processes.
The implementation process focuses on the process itself rather than the risks of a particular project.
This step should be ongoing, focusing on the performance of the risk management process and the way
in which it is integrated with other processes relevant to the project in question.
Organisations need to treat the implementation stage as a separate project with clear objectives and
success criteria, clear planning, proper resourcing and effective monitoring and control.

Case example: Tesco Principal risks


In the Corporate governance section of its 2013 Annual Report and Financial Statements, Tesco provides
a summary of the principal risks it faces, and for each risk it identifies key controls and mitigating factors.
The principal risks identified are:
Business strategy risk if the Group follows the wrong direction, or if strategic direction is not
effectively communicated or implemented, the business may suffer.

100 Business Analysis


Financial strategy risk risks relate to an incorrect or unclear financial strategy and the failure to
achieve financial plans.
Competition and consolidation risk failure to compete on areas including price, product range,
quality and service in increasing UK and overseas retail markets could impact on the Group's market
share and adversely affect its financial results.
The consolidation of competitors, key geographical areas or markets through mergers or trade
agreements could also adversely affect Tesco's market share.
Reputational risk Failure to protect the Group's reputation and brand in the face of ethical, legal and
moral challenges could lead to a loss of trust and confidence, a decline in customer base, and could
therefore affect the Group's ability to recruit and retain good staff.
Performance risk in the business Risk that business units underperform against plan and against
C
competitors, and that business fails to meet the stated strategy. H
A
Property risk Continuing acquisition and development of property sites carries inherent risk; targets to
P
deliver new space may not be achieved; challenges may arise in relation to finding suitable sites, T
obtaining planning or other consents, and compliance with design and construction standards in E
different countries. R

Economic risks In each country where it operates, Tesco is affected by the underlying economic
environment and the fiscal measures which apply to the retail sector.
2
Political and regulatory risks In each country in which it operates, Tesco could be affected by legal
and regulatory changes, increased scrutiny by competition authorities, and political developments
relevant to domestic trade and the retail sector.
Product safety Failures to ensure product safety could damage customer trust and confidence,
affecting Tesco's customer base and therefore financial results.
IT systems and infrastructure Any significant failure in the IT processes of Tesco's retail operations
would impact its ability to trade. Failure to invest appropriately in IT could increase its vulnerability to
attack, constrain the growth of the business, and fail to safeguard personnel, supplier or customer data.
People Failure to attract, retain, develop and motivate the best people, with the right capabilities at all
levels could limit the Group's ability to succeed.
Group Treasury Failure to ensure the availability of funds to meet the needs of the business, or to
manage interest or exchange rate fluctuations could limit the Group's ability to trade profitably.
Tesco's financial risks are separately identified as: funding and liquidity, interest rate risk, foreign
currency risk, and credit risk.
Tesco Bank the impact on the Group of financial risks taken by Tesco Bank.
Pensions The Group's IAS 19 deficit could increase if there is a fall in corporate bond yields which is
not offset by an increase in the pension scheme's assets. There are also risks of legal and regulatory
changes introducing more burdensome requirements.
Fraud, compliance and internal controls As the business develops new platforms and grows both in
size and geographical scope, the potential for fraud and dishonest activity by our suppliers, customers
and employees increases.
Business continuity and crisis management A major incident, or activism, could have an impact on
staff and customer safety, or the Group's ability to trade.
Source: Tesco Annual Report and Financial Statements, 2013

Business risk management 101


12 Risk monitoring and control

Section overview
The risk management process is an on-going one risks must be continually monitored to
determine any change in profile which may lead to procedures to control these risks being altered.
This step can be thought of as an audit of the overall risk management process, where expected
and actual results are compared and recommendations made for any remedial action to be taken.
Just because risk management procedures are in place does not mean that companies are immune
from the effects of risk such procedures may reduce the impacts of risk but will not eliminate
them completely.
It is important to know when sufficient risk management procedures are in place, otherwise the
process would never be completed.

12.1 Monitoring of risk management plans


All risk management plans must be monitored to ensure that they are achieving the desired results and
that changes to the project's risk profile are reflected.
To assess the effectiveness of risk management plans, you need to establish standards and benchmarks
against which results should be measured. Standards can come from such sources as industry
regulations or the industry leader.
Once the standards and benchmarks have been established, the risk management plan can be
measured continually against them over time to allow actual performance to be compared with
expected performance which in turn can be used to adjust below-standard results.
In order to determine when adjustments to performance should take place, you should establish a
threshold (or 'trigger point') which represents a sufficient change in risk exposure to warrant another risk
analysis being carried out. Risk management is a continuous process and those responsible for handling
risk should be prepared to treat it as such.
As with any process, evaluation of risk management plans is essential to ensure they are performing to
expectations. Managers and stakeholders in the risk management process should consider such areas
as:
How successful was the plan and were the benefits and costs at the predicted level?
In the light of the above, are any changes needed to improve the plan?
Would the plan have benefited from the availability of additional information?
You can think of risk monitoring as being similar to an audit of the risk management process. Various
tests will be carried out to determine whether individual controls are working properly and
recommendations made in the light of results. However, unlike auditing, risk management monitoring
does not take place only on an annual basis. Risk monitoring is a continuous process.

12.2 Board monitoring of control systems


As well as monitoring specific plans, the board needs to have procedures in place for reviewing the
effectiveness of systems taken as a whole. Turnbull suggests that boards should regularly receive and
review reports and information on internal control, concentrating on:
What the risks are and strategies for identifying, evaluating and managing them.
The effectiveness of the management and internal control systems in the management of risk, in
particular how risks are monitored and how any weaknesses have been dealt with.
Whether actions are being taken to reduce the risks found.
Whether the results indicate that internal control should be monitored more extensively.

102 Business Analysis


In addition, when directors are considering annually the disclosures they are required to make about
internal controls, the Turnbull report states they should conduct an annual review of internal control.
This should be wider-ranging than the regular review; in particular it should cover:
The changes since the last assessment in risks faced, and the company's ability to respond to
changes in its business environment.
The scope and quality of management's monitoring of risk and internal control, and of the work of
internal audit, or consideration of the need for an internal audit function if the company does not
have one.
The extent and frequency of reports to the board.
Significant controls, failings and weaknesses which have or might have material impacts upon the
accounts. C
H
The effectiveness of the public reporting processes. A
P
T
Case example: Basel Committee E
R
Since 1974 the Basel Committee on Banking Supervision has made important recommendations
affecting risk management and internal controls operated by banks.
The Basel II accords were particularly important in establishing risk management and capital adequacy 2
requirements.
The Committee highlighted the need for boards to treat the analysis of a bank's current and future
capital requirements in relation to its strategic objectives as a vital element of the strategic planning
process. Control systems should relate risk to the bank's required capital levels. The board or senior
management should understand and approve control systems such as credit rating systems. Banks
should use methods such as value at risk models that capture general market risks and specific risk
exposures of portfolios.
The Committee stressed the importance of banks having an operational risk management function that
develops strategies, codifies policies and procedures for the whole organisation and designs and
implements assessment methodology and risk reporting systems. It is particularly important for banks to
establish and maintain adequate systems and controls sufficient to give management and supervisors
the confidence that their valuation estimates are prudent and reliable.
Banks' risk assessment systems (including the internal validation processes) must be subject to regular review
by external auditors and/or supervisors. The regular review of the overall risk management process should
cover:
The adequacy of the documentation of the risk management system and process
The organisation of the risk control unit
The integration of counterparty credit risk measures into daily risk management
The approval process for counterparty credit risk models
The validation of any significant change in the risk measurement process
The scope of counterparty credit risks captured by the risk measurement model
The integrity of the management information system
The accuracy and completeness of position data
The verification of the consistency, timeliness and reliability of data sources used to run internal
models, including the independence of such data sources
The accuracy and appropriateness of volatility and correlation assumptions
The accuracy of valuation and risk transformation calculations
The verification of the model's accuracy through frequent testing and review of results

Business risk management 103


The most recent guidance, Basel III, published in December 2010 and updated in June 2011, focused on
capital and liquidity standards. Basel III established higher minimum capital levels and tightened the
rules on the definition of capital. In particular it focused on raising capital requirements for trading and
complex securitisation processes, which have been a major source of losses. It also introduced measures
to strengthen the capital requirements for counterparty credit exposures, arising from banks' derivatives,
repo and securities' financing activities. The capital requirements were supplemented by a leverage ratio
requirement, aiming to limit the risk of destabilising deleveraging processes and introducing additional
safeguards against model risk and measurement error.
The Committee also introduced for the first time global liquidity standards, noting that the difficulties
experienced by banks were sometimes due to lapses in the basic principles of liquidity risk management.
The liquidity standards have two objectives, firstly ensuring that banks have enough liquidity to survive
an 'acute stress scenario' lasting one month. The second objective is concerned with the longer-time
horizon, creating incentives for banks to use more stable sources of funding.
Other requirements aim to limit the shocks caused to financial systems by the impact of cycles. These
include promoting disclosure of expected losses, conserving capital above the minimum requirements
and adjustment of the capital buffer range when there are signs that credit has grown to excessive
levels.
Basel III has been seen as building on the risk management requirements of Basel II, in particular
promoting an enterprise risk management approach.
The US Federal Reserve announced in December 2011 that it would implement virtually all of the Basel
III rules.
Further details about the reports of the Basel Committee are on the website of the Bank for International
Settlements: www.bis.org/list/bcbs/index.htm

12.3 Reporting on risk management


The Turnbull Report laid down minimum expected guidelines for disclosure on risk management and
corporate governance. The Report was intended to encourage best practices, and stated that publicly
traded companies should report on the risks they faced and outline the risks.
The Turnbull Report requires the following disclosures.
The governing body of the company (generally the board of directors) should acknowledge
responsibility for internal control systems.
An ongoing system should be in place for identifying, evaluating and managing significant risks.
An annual process should be in place for reviewing the effectiveness of the internal control systems.
There should be a process to deal with the internal control aspects of any significant problems
disclosed in the annual report and accounts.

Case example: GlaxoSmithKline risk management


We have already discussed the key risks facing GlaxoSmithKline (GSK) according to its 2012 annual
report. The report goes into detail about how risks are being managed.

Risk Mitigation

R and D not delivering Reorganisation of R and D department into smaller units, to


commercial new products encourage entrepreneurialism and accountability. Collaboration
with partners in academia, biotechnology companies and other
pharmaceutical companies and consultation with payers and
patients.
Failure to protect intellectual Use of a global patents group to oversee processes and monitor
property rights new developments in patent law, in particular litigation processes
to ensure successful enforcement and defence of patents.

104 Business Analysis


Risk Mitigation

Product quality failures causing Adoption of Quality Management System throughout supply
risk to the patient or consumer chain and lifecycle of products. Oversight by a Chief Product
Quality Officer and Quality Council that examines emerging risks,
shares experience and cascades what has been learnt over the
group. Assignment of quality staff to each business unit.
Interruption of product supply Assessment of standing of suppliers, safety stocks and backup
supply arrangements and, if possible, avoidance of dependence
on a single supplier.
Inability to obtain adequate Demonstration, particularly to governments of value of medicines.
prices Exploration of different pricing models for innovative products. C
H
Restructuring of business to take advantage of growth A
opportunities. P
T
Non-compliance with laws and Continuously changing internal control framework to take into E
regulations account changes in commercial model, marketplace, guidance R
and regulations. Oversight by a chief regulatory officer and
regulatory governance board. Involvement of Medical
Governance Ethical Committee to ensure application of principles 2
of good medical science, integrity and ethics. Global code of
practice for marketing and promotional activities. Policies ensuring
adherence to economic sanctions and export control laws.
Exposure to political and Diversification mitigates exposure to local risks. Assignment of a
economic risks and natural cross-business team to manage European economic risks, which
disasters has developed response plans to different European economic
events. Reduction of exposure in key countries, including
exercising caution in counterparty exposures and proactively
managing liquidity positions.
Alliances and acquisitions Due diligence procedures, review of major transactions by
difficulties management boards and management of integration by
Corporate Strategy group, with integration team being appointed
for each acquisition.
Financial reporting risks Testing of design and operating effectiveness of key management
controls, working with advisers to ensure Group up-to-date with
latest developments. Procedures for review and sign-off across
group and by senior management.
Tax and treasury losses Monitoring of current debates to anticipate changes in tax law,
use of compliance policies and procedures and engagement of
advisers to review application. Use of simplified intellectual
property ownership model to give greater certainty in application
of transfer pricing.
GSK's treasury department does not act as a profit centre, to
reduce risks. Treasury risk is managed by a detailed set of
management policies that is reviewed and approved annually by
board.
Failure to comply with anti- Global anti-bribery programme that includes global policy,
corruption legislation ongoing training and requirements relating to due diligence,
contracting and oversight. Stronger controls over interactions
with government officials and business development transactions.
Dedicated team drives implementation of programme, supported
by extended team of functional experts.

Business risk management 105


Risk Mitigation

Adverse outcome of litigation Focus on patient safety in drug development. Medical governance
and government investigations system involving Global Safety Board and Chief Medical Officer
responsible, amongst other things, for safeguarding human
subjects in tests. Dispute management procedures aiming to
resolve disputes early.
Non-compliance with health, Emphasis on culture where employees feel valued, along with
safety and environment procedures to minimise hazards. Reduction of water and energy
requirements consumption and hazardous waste, and reporting in corporate
responsibility report.
Credit risk from large customers Monitoring of financial information and credit ratings, and review
of credit limits.
IT security breaches Assessment of changes in risk environment, review of policies and
controls and routine training of employees.

However the systems and controls that GSK had in place failed to prevent a police investigation into
corrupt activities by some of its Chinese executives.

12.4 Limitations of risk management plans


As with all business processes, regardless of their quality, risk management plans have their limitations.
They are only as good as the information that is used to construct them in the first place remember
the old adage 'rubbish in rubbish out'? If risks are not assessed properly, then a great deal of time and
resources could be wasted in dealing with the risk of losses that in fact are highly unlikely to occur
time and resources that could have been more gainfully employed elsewhere. While it is possible for
unlikely events to occur, if a risk is highly unlikely to happen then it may be better to simply accept the
risk and deal with any losses if and when they arise. Some organisations over-estimate what such
processes should be able to achieve to the extent that work is suspended until the risk management
process is considered to be complete.
At the other extreme, there are organisations who believe themselves to be immune from losses
resulting from business risk simply because they have risk management processes in place.
Complacency is one of the worst enemies of successful businesses. As mentioned above, risk
management processes must be continually monitored for any weaknesses just like the business
environment itself, they are not static instruments.
Such is the focus on risk and its consequences in today's business that there is a danger of management
spending so long thinking about the negative aspects of projects that they forget about the positive
aspects. Just as the human body loses its ability to fight infection if it is locked in a sterile environment
for a long period of time, so do businesses lose their resilience for dealing with risk if they become
obsessed with trying to avoid it. Make sure you control risk but do not let risk control you.

Interactive question 4: LP [Difficulty level: Intermediate]


LP manufactures and supplies a wide range of different clothing to retail customers from 150 stores
located in three different countries in the Eurozone.
In order to increase sales, a new internet site is being developed which will sell LP's entire range of
clothes using 3D revolving dummies to display the clothes on screen. The site will use some new
compression software to download the large media files to purchasers' PCs so that the clothes can be
viewed. This move is partly in response to environmental scanning which indicated a new competitor,
PVO, will be opening an unknown number of stores in the next six months.
As a cost cutting move, the directors are considering delaying LP's new range of clothes by one year.
Sales are currently in excess of expectations and the directors are unwilling to move away from
potentially profitable lines.

106 Business Analysis


Requirement
Explain the business risks affecting LP and briefly describe how these risks can be managed.
See Answer at the end of this chapter.

Case example: BP
The impact of the oil spill in the Gulf of Mexico on BP was a significant news story in much of 2010. On
3 August 2010 the US government stated that the oil spill in the Gulf of Mexico was officially the
biggest leak ever, with an estimated 4.9 million barrels of oil leaked before the well was capped in July
2010. The consequences of the spill included the departure of BP's chief executive, Tony Hayward. BP
created a compensation fund of $20bn and had paid out a further $8bn in the clean-up campaign by C
the end of 2010. H
A
The results of BP's own internal investigation were published in September 2010. It blamed a 'sequence P
of failures involving a number of different parties', that is BP and two other companies working on the T
well, although both of the other companies criticised this report. Problems highlighted by the BP report E
included 'a complex and interlinked series of mechanical failures, human judgements, engineering R
design, operational implementation and team interfaces.'
Critics have pointed to other operational problems BP has had, from the explosion at its Texas City
2
refinery to the temporary shut-down at Prudhoe Bay. CNN news quoted an employee who had worked
at both locations as saying that no-one should be surprised by the 2010 disaster: 'The mantra was 'Can
we cut costs by 10%.' Transocean, one of the other companies criticised in BP's September 2010 report,
also blamed BP for cost-cutting. Transocean was quoted by Associated Press as commenting: 'In both its
design and construction BP made a series of cost-saving decisions that increased risk in some cases
severely.'
The US Commission that reported on BP in January 2011 found that BP did not have adequate controls
in place, and that its failures were systemic and likely to recur. The report apportioned blame between
the various companies involved, although it emphasised BP had overall responsibility. The report
highlighted failures of management of decision-making processes, lack of communication and training
and failure to integrate the cultures and procedures of the different companies involved in the drilling.
The report drew attention to the failure of BP's engineering team to conduct a formal, disciplined
analysis of the risk factors on the prospects for a successful cement job and also the failure to address
risks created by late changes to well design and procedures. The report highlighted the flawed design
for the cement used to seal the bottom of the well, that the test of the seal was judged successful
despite identifying problems, and the workers' failure to recognise the first signs of the impending blow-
out. The commission found that decisions were taken to choose less costly alternative procedures. These
were not subject to strict scrutiny that required rigorous analysis and proof that they were as safe as the
more expensive regular procedures.
The report also blamed inadequate government oversight and regulation, with the agency responsible
lacking staff who were able to provide effective oversight. Many aspects of control over drilling
operations were left to the oil industry to decide. There were no industry requirements for the test that
was misinterpreted, nor for testing the cement that was essential for well stability. When BP contacted
the agency to ask for a permit to set the plug so deep in the well, the agency made the same mistake as
BP, focusing on the engineering review of the well design and paying far less attention to the decisions
regarding procedures during the drilling of the well.
On the basis of what BP has published however, its risk management approach did not appear to differ
greatly from other oil companies, and from many other large organisations across the globe. For
example BP had sophisticated risk assessment processes in place. In 2007 it completed 50 major
accident risk assessments. The assessments identified high-level risks that, if they occurred, would have a
major effect on people and the environment. BP's monitoring procedures included the work carried out
by the safety, ethics and environment assurance committee. The committee's work encompassed all
non-financial risks.
BP's systems also received external backing. Accreditations BP held included ISO 14001 at major
operating sites, reporting to GRI A+ standard and assurance by Ernst and Young to AA100AS principles
of inclusivity, materiality and responsiveness.

Business risk management 107


It's possible that BP relied on generally accepted risk management practices which had become less
effective over time.
In February 2012 BP announced a 14% rise in dividends, after profits for 2011 of $23.9bn, compared
with a $4.9bn loss in 2010. In July 2012, however, BP set aside an additional $847m provision to pay for
the 2010 disaster, raising the potential cost to $38bn. Second quarter figures for 2012 showed a 35%
fall in underlying profits. The $38bn included $14bn in costs to restore over 4,000 miles of shoreline
and $8.8bn in compensation payments, although it had been reduced by $4bn following settlements
with partners in the venture. BP also still faced 'significant uncertainty' as it had not yet reached a
settlement with the US Department of Justice. The company had however resumed drilling in the Gulf
of Mexico.
In April 2012, former BP engineer, Kurt Mix, was arrested on charges of intentionally destroying text
messages between himself and a supervisor, containing details about how attempts to cap the leaking
well were going.

108 Business Analysis


Summary and Self-test

Summary

C
H
A
P
T
E
R

Business risk management 109


Self-test
1 ANG
ANG is a road haulage contractor. The company specialises in collection and delivery of large or
heavy items such as railway locomotives and sections of bridges from the manufacturer to the
customer. The company owns 49 road vehicles of different sizes to enable transportation of the
different goods.
ANG's risk management policy is based on taking out insurance. As well as the standard employer
and third party liability classes of insurance, ANG also insures against damage to road infrastructure
such as bridges and tunnels from its own vehicles or as a result of goods being carried becoming
unstable and falling off ANG's lorries.
ANG's terms and conditions of carriage note that radioactive goods will not be transported under
any circumstances. Explosives are carried, but only where the owner accepts liability on their own
insurance.
Contingency planning is limited; the board of ANG believes that if any risks do occur, then ANG
has sufficient vehicles to continue operations.
The Board of ANG is also considering a new venture for the same day delivery of goods where the
distance to travel is more than its existing fleet of road vehicles could travel in one day. This
venture involves the purchase of surplus 'Hercules' transport 'planes from the army. The board has
recently decided to make the purchase of the 'planes because they are being offered at a
substantial discount. Marketing activities will commence next month.
Requirements
(a) Explain the elements of a risk management framework in an organisation.
(b) Explain the risk management strategies available to an organisation.
(c) Evaluate the risk management strategy of ANG, explaining any amendments that you think
are necessary.
2 HOOD
HOOD sells a wide range of coats, anoraks, waterproof trousers and similar outdoor clothing from
its 56 stores located in one country. The company is profitable, although the gross profit in some
stores has declined recently for no apparent reason.
Each store uses EPOS to maintain control of inventory and provides the facility to use EFTPOS for
payments. However, about 55% of all transactions are still made in cash. Details of sales made
and inventories below re-order levels are transferred to head office on a daily basis where
management reports are also prepared.
Inventory is ordered centrally from head office, details of requirements being obtained from the
daily management information provided by each store. Orders are sent to suppliers in the post,
with stock arriving at each store approximately 10 days after the re-order level is reached.
Recent newspaper reports indicate that one of the chemicals used to waterproof garments releases
toxic fumes after prolonged exposure to sunlight. The board of HOOD is investigating the claim,
but is currently treating it with some degree of scepticism. The product range has generally sold
well, although there has been little innovation in terms of garment design in the last four years.
Requirements
(a) Identify the different risks facing HOOD, placing the risks into suitable categories.
(b) Discuss the potential effect of each risk on the organisation, describing how the impact of that
risk may be minimised.
3 LinesRUs
The LinesRUs Company is responsible for maintaining the railway infrastructure for the rail network
in a large European country. Main areas of responsibility for the company include:
Ensuring that the railway tracks are safe
Signalling equipment is installed correctly and works properly
Maintenance of overhead power lines for electric trains

110 Business Analysis


Income is fixed each year dependent on the number of train services being operated and is paid via
a central rail authority. The company is granted a sole franchise each year to provide services on
the rail network.
Work is scheduled in accordance with the amount of income, and to provide LinesRUs with an
acceptable operating profit. Any additional work over and above standard maintenance (eg due to
foreseen factors such as bridges being damaged by road vehicles and unforeseen factors such as
car drivers falling asleep and driving their cars onto railway tracks) is negotiated separately and
additional income obtained to repair the infrastructure in these situations.
A lot of maintenance work is relatively simple (eg tightening nuts and bolts holding railway tracks
together) but is extremely important as an error may result in a train leaving the rails and crashing.
The board of LinesRUs is aware of many of these risks and attempts to include them in a risk
management policy.
C
However, recently a train was derailed causing the death of 27 passengers. Initial investigations H
A
show that faulty maintenance was the cause of the derailment. One of the unforeseen
P
consequences of the crash has been a fall in the numbers of people using trains with a subsequent T
fall in income for train operators. LinesRUs are being sued by the train operators for loss of income, E
and the national press are suggesting LinesRUs must be incompetent and are calling for a re- R
evaluation of the method of providing maintenance on the rail network.
Requirements
2
(a) Advise the directors of LinesRUs of the main stages of a structured risk analysis approach that
will be appropriate to the company's needs.
(b) Using the Transfer Avoid Reduce Accept framework, construct four possible strategies for
managing the risk that rail crashes could occur. Your answer should describe each strategy
and explain how each might be applied in the case.

Business risk management 111


Answers to Self-test

1 ANG
(a) Risk management structure
The organisation needs a structure to facilitate and communicate information about risks.
A system such as an intranet or groupware product would be suitable as it connects all the
individuals in an organisation, allowing access to shared databases where information about
risks can be stored.
Resources
Sufficient resources are required to support effective risk management. This means that the
board of an organisation must allocate an appropriate budget for risk management, and
then the budget should be spent on appropriate areas. The appointment of a risk
management officer will help to ensure budgeted amounts are spent appropriately.
Risk culture
The culture of the organisation should be developed as far as possible to ensure employees
are aware of risk and to act to avoid risks where possible. Having a risk avoidance culture
will help to ensure that management decisions taken focus on and avoid important risks.
Tools and techniques
Appropriate tools and techniques are available in the organisation to enable the efficient and
consistent management of risks across an organisation. Tools and techniques available
may include obtaining appropriate insurance against risks and having a clear risk
management policy in place.
(b) Avoidance
In this situation, the organisation attempts to determine whether the possible losses avoided
from not undertaking a risky activity are greater than the advantages that can be gained
from carrying out the activity. If the losses avoided appear to outweigh the benefits of
carrying out the activity, then the activity may not take place. In an extreme situation, entire
sections of the business may be closed down if the risk or loss is considered to be too great.
Reduction
Risks are avoided in part but not reduced to zero. For example, the risk of launching a new
product can be reduced by obtaining market research on possible demand for the product
prior to manufacture and launch.
Risk reduction will also involve contingency planning to ensure that if a risk does crystallise,
then the damage from that risk is minimised. For example, most companies will have a
contingency plan against their computer systems failing. Files will be backed-up regularly, and
alternative processing locations will be available if one centre becomes unavailable eg due to
fire or flood.
Acceptance
Risk retention is where the organisation bears the risk itself. This means that if the
unfavourable outcome occurs, then the organisation will suffer the full loss of that event.
Risk retention normally occurs in two situations. First, where some risk occurs which the
organisation's risk management policy did not detect. Second, where risk was classified as
insignificant or the cost of the risk was deemed to be too great compared to the
likelihood of that risk occurring.
Risk retention may also involve self-insurance. This means that funds are placed into some
fund against risks actually occurring.

112 Business Analysis


Transfer
The last risk management strategy is to transfer the risk to a third party. The most
commonly used risk transfer policy is take out insurance against a risk occurring. However,
risks may also be transferred to other third parties, often without the knowledge of that
party. For example, there may be a minimal risk of errors occurring in some software. The
cost of carrying out additional testing may be more than any compensation that may be
payable if the error occurs and the customer makes a successful complaint. In this situation,
risk has been transferred to the customer without the customer's knowledge.
(c) Transfer
The overall risk management strategy of ANG appears to be one of risk transfer. This is the
policy adopted by most businesses and is wholly appropriate given the likelihood of many
risks occurring is low, but if they do occur then significant expenditure would be C
involved. For example, if a load did fall off one of ANG's lorries, then the damage caused H
A
could be considerable, not only to the load itself, but also to other vehicles, people and even
P
the roads being used. ANG would not be able to operate legally without this insurance, T
and so it is essential to obtain it. E
R
Insurance
Whether ANG needs to insure against damage to roads, bridges and so on, is unclear. The
government of the country is normally responsible for maintaining the transport 2
infrastructure. ANG could probably withdraw this insurance and effectively transfer the risk
to the government. Some cost savings would accrue from this move.
Self-insurance
It appears that ANG effectively self-insures against loss of vehicles in respect of being able to
provide a replacement vehicle at short notice. This may be acceptable in the case of individual
losses. However, it may be inappropriate in situations where, for example, a significant
number of ANG's vehicles are destroyed in a fire or flood. Where haulage contracts are
signed for time critical delivery of goods, then some reciprocal agreement with another
haulage company may be appropriate.
Avoidance
The decision by ANG to avoid risk completely in the transfer of hazardous materials seems
sensible. There has been some bad publicity about the transfer of radioactive goods by road,
and the potential for claims, particularly if an accident occurred in an area of high population
density, could be excessive and the damage to ANG's reputation would be considerable. In
the case of explosives, ANG would need to ensure that the contract for carriage clearly stated
that the owner of the goods was responsible for insurance. ANG may also want to obtain a
copy of the insurance contract to confirm this.
Risk acceptance
There appears to be some risk in purchasing the transport 'planes prior to any market
appraisal of the new venture. Normally the risk of a new venture would be reduced by
carrying out market research prior to significant expenditure being incurred. The board
would normally be advised to check whether there was a demand for this service prior to
expenditure being committed.
Published accounts, internal accounts and budgets are a fertile source of information.
The more carefully costs are allocated to each department, the easier it should be to calculate
additional costs which would be incurred in a given emergency, which budgets will be
affected and how quickly necessary funds can be made available.
Detailed plans of site and buildings will show potential bottlenecks in fire escape routes,
obstructions which might make difficulties for fire engines and problems of access which
could occur for both the site and its neighbours from fire, explosion, or escaping gas.
Physical inspection of buildings and machines (and perhaps of personnel, in the medical
sense, and of their working practices) should take place on a regular basis.

Business risk management 113


2 HOOD
Risk can be defined as the possibility that events or results will turn out differently from what is
expected.
(a) The risks facing the HOOD Company are outlined below.
Operational risks
These are risks relating to the business's day-to-day operations.
(i) Accounting irregularities
The unexplained fall in gross profit in some stores may be indicative of fraud or other
accounting irregularities. Low gross profit in itself may be caused by incorrect
inventory values or loss of sale income. Incorrect stock levels in turn can be caused by
incorrect inventory counting or actual stealing of inventory by employees. Similarly,
loss of sales income could result from accounting errors or employees fraudulently
removing cash from the business rather than recording it as a sale.
(ii) Systems
Technical risks relate to the technology being used by the company to run its business.
(1) Backup
Transferring data to head office at the end of each day will be inadequate for
backup purposes. Failure of computer systems during the day will still result in loss
of that day's transaction data.
(2) Delays in inventory ordering
Although stock information is collected using the EPOS system, re-ordering of
inventory takes a significant amount of time. Transferring data to head office for
central purchasing may result in some discounts on purchase. However, the average
10 days before inventory is received at the store could result in the company
running out of inventory.
Non-business risks
These are risks that arise for reasons beyond the normal operations of the company or the
business environment within which it operates.
(i) Production
The possibility of sunlight making some of HOOD Company's products potentially
dangerous may give rise to loss of sales, also stock recall.
(ii) Event
HOOD may be vulnerable to losses in a warehouse fire.
Business risks
External risks relate to the business; they are essentially uncontrollable by the company.
(i) Macro-economic risk
The company is dependent on one market sector and vulnerable to competition in that
sector.
(ii) Product demand
The most important social change is probably a change in fashion. HOOD has not
changed its product designs for four years indicating some lack of investment in this
area. Given that fashions tend to change more frequently than every four years, HOOD
may experience falling sales as customers seek new designs for their outdoor clothing.
HOOD may also be vulnerable to seasonal variations in demand.

114 Business Analysis


(iii) Corporate reputation
Risks in this category relate to the overall perception of HOOD in the marketplace as a
supplier of (hopefully) good quality clothing. However, this reputation could be
damaged by problems with the manufacturing process and a consequent high level of
returns.
Profiling
By identifying and profiling the effects of the risks, HOOD can assess what the consequences
might be, and hence what steps (if any) are desirable to mitigate or avoid the consequences.
(b) The potential effects of the risks on HOOD and methods of overcoming those risks are
explained below.
Operational risks C
H
(i) Accounting irregularities A
P
The potential effect on HOOD is loss of income either from inventory not being T
available for sale or cash not being recorded. The overall amount is unlikely to be E
significant as employees would be concerned about being caught stealing. R

The risk can be minimised by introducing additional controls including the necessity of
producing a receipt for each sale and the agreement of cash received to the till roll
2
by the shop manager. Loss of inventory may be identified by more frequent inventory
checks in the stores or closed-circuit television.
(ii) Systems
(1) Backup
The potential effect on HOOD is relatively minor; details of one shop's sales could
be lost for part of one day. However, the cash from sales would still be available,
limiting the actual loss.
Additional procedures could be implemented to back up transactions as they
occur, using online links to head office. The relative cost of providing these links
compared to the likelihood of error occurring will help HOOD decide whether to
implement this solution.
(2) Delays in inventory ordering
The potential effect on HOOD is immediate loss of sales as customers cannot
purchase the garments that they require. In the longer term, if stock outs become
more frequent, customers may not visit the store because they believe goods will
not be available.
The risk can be minimised by letting the stores order goods directly from the
manufacturer, using an extension of the EPOS system. Costs incurred relate to the
provision of internet access for the shops and possible increase in cost of goods
supplied. However, this may be acceptable compared to overall loss of reputation.
Non-business risks
(i) Production
The effect on HOOD is the possibility of having to reimburse customers and the loss of
income from the product until the problems are resolved.
The risk can be minimised by HOOD taking the claim seriously and investigating its
validity, rather than ignoring it. For the future, guarantees should be obtained from
suppliers to confirm that products are safe and insurance taken out against possible
claims from customers for damage or distress.

Business risk management 115


(ii) Event
The main effects of a warehouse fire will be a loss of inventory and the incurring of
costs to replace it. There will also be a loss of sales as the inventory is not there to fulfil
customer demand, and perhaps also a loss of subsequent sales as customers continue to
shop elsewhere.
Potential losses of sales could be avoided by holding contingency inventory elsewhere,
and losses from the fire could be reduced by insurance.
External risks
(i) Macro-economic risk
The potential effect on HOOD largely depends on HOOD's ability to provide an
appropriate selection of clothes. It is unlikely that demand for coats etc will fall to zero,
so some sales will be expected. However, an increase in competition may result in falling
sales, and without some diversification, this will automatically affect the overall sales of
HOOD.
HOOD can minimise the risk in two ways: by diversifying into other areas. Given that
the company sells outdoor clothes, then commencing sales of other outdoor goods such
as camping equipment may be one way of diversifying risk. It can also look to reduce
operational gearing, fixed cost as a proportion of turnover.
(ii) Product demand
Again the risk of loss of demand and business to competitors may undermine HOOD's
ability to continue in business.
This risk can be minimised by having a broad strategy to maintain and develop the
brand of HOOD. Not updating the product range would appear to be a mistake in this
context as the brand may be devalued as products may not meet changing tastes of
customers. The board must therefore allocate appropriate investment funds to updating
the products and introduce new products to maintain the company's image.
(iii) Corporate reputation
As well as immediate losses of contribution from products that have been returned,
HOOD faces the consequence of loss of future sales from customers who believe their
products no longer offer quality. Other clothing retailers have found this to be very
serious; a reputation for quality, once lost, undoubtedly cannot easily be regained.
The potential effect of a drop in overall corporate reputation will be falling sales for
HOOD, resulting eventually in a going concern problem.
HOOD can guard against this loss of reputation by enhanced quality control
procedures, and introducing processes such as total quality management.
3 LinesRUs
(a) Risk identification
Risks cannot be managed without first realising that they exist. Managers need to maintain a
list of known or familiar risks and the extent to which they can harm the organisation or
people within it. Managers also need to be aware that unfamiliar risks may exist and maintain
vigilance in case these risks occur. Risk identification is an ongoing process so that new risks
and changes affecting existing risks may be identified quickly and dealt with appropriately
before they result in unacceptable losses.
LinesRUs appear to have identified some risks in their risk management policy. However,
other risks do occur and managers within LinesRUs must be able to identify and respond to
those risks quickly.
Risk assessment
It may be difficult to forecast the financial effects of a risk until after a disaster has occurred.
Areas such as extra expenses, inconvenience and loss of time can then be recognised, even
if they were not thought of in initial risk analysis. In a severe situation, damage to the
company's reputation could result in LinesRUs becoming bankrupt.

116 Business Analysis


In this situation, there has been a loss of confidence in the company, the extent of which may
not have been foreseen. This has resulted in additional expense in terms of lost passengers
legal advice will be needed to determine whether LinesRUs is liable and whether the
company's insurance meets this liability. It is also uncertain what the additional time and
cost of repairing the track will be and whether LinesRUs can claim additional income for this
work.
Sources of information to ensure that the risk can be minimised may include obtaining
regular reports from train operators on the state of the rail infrastructure and monitoring
news feeds such as Reuters for early indication of potential disasters. LinesRUs should file
appropriate reports of physical inspection of track as evidence of maintenance work carried
out.
Risk profiling
C
This stage involves using the results of risk assessment to group risks into families. A H
A
consequence matrix is one method of doing this.
P
T
Likelihood Consequences E
R
Low High
High Loss of lower level staff Loss of senior staff
2
Low Loss of suppliers Major rail disaster affecting reputation of
company
Major rail disaster not the
company's fault Loss of computer data on maintenance work
Loss of franchise

The analysis will be incomplete for LinesRUs because not all risks can be identified.
Risk quantification
Risks that require more detailed analysis can be quantified, and, where possible, results and
probabilities calculated. The result of calculations will show average or expected result or loss,
frequency of losses, chances of losses and largest predictable loss to which LinesRUs could be
exposed by a particular risk.
Unfortunately, many of the risks facing LinesRUs are significant. So while quantification can
be enhanced by past events such as drivers falling asleep, they appear to be one-off situations
meaning that the actual event may not occur again. However, the adverse effects of the risk in
terms of costs necessary to repair the rail infrastructure will be helpful, enabling LinesRUs to
ensure that appropriate insurance is available effectively guarding against loss by transferring
the risk.
Risk consolidation
Risks analysed at the divisional or subsidiary level need to be aggregated at the corporate
level. This aggregation will be required as part of the overall review of risk that the board
needs to undertake. Systems should identify changes in risks as soon as they occur,
enabling management to monitor risks regularly and undertake annual reviews of the way
that organisation deals with risk.
There is no information on the organisational structure of LinesRUs. Given the risky nature of
the company's business, LinesRUs is likely to be an independent legal entity to ensure that no
other companies are adversely affected should LinesRUs go out of business.

(b) Risk responses


Transfer
The risk is transferred to a third party. As noted above, this may not be possible if insurers are
not willing to accept the risk. Alternative methods of risk transfer may have to be considered
including asking the state for some form of insurance.

Business risk management 117


Avoidance
LinesRUs may consider whether the risk can be avoided. However, given that maintenance
work must continue and that errors are always possible, then the risk may crystallise.
Avoidance is not possible.
The only method of avoidance would appear to be termination of operations. This again
may not be appropriate given this would close LinesRUs's business.

Reduction
The risk can be reduced by taking appropriate measures. In the case of LinesRUs these will
include regular training for maintenance staff. Management should use other methods such
as newsletters to raise awareness of the importance of work being carried out and the
potential consequences of error. There should be maintenance and enforcement of
appropriate disciplinary procedures where breaches of work practices have been identified.

LinesRUs may also consider loss control options. These may include hiring of lawyers to
defend LinesRUs and release of publicity material on the work of LinesRUs showing extent of
maintenance normally carried out.

Acceptance
This is where the organisation retains the risk and if an unfavourable outcome occurs it will
suffer the full loss. In the case of the rail crash, LinesRUs may have to retain the risk if suitable
insurance cannot be found. Given the uncertainties regarding the costs resulting from the
unfavourable outcome, insurers may be unwilling to insure for this type of event.

118 Business Analysis


Answers to Interactive questions

Answer to Interactive question 1


Note: This is not an exhaustive list you may have thought of different examples that are equally
relevant.
Seasonality of business most purchases are likely to be associated with seasons. Easter and
Christmas are major seasons for the confectionery business, but there may be dips at other times of
the year. C
H
Impulse buying a large proportion of confectionery purchases are made on impulse. If economic A
changes reduced the amount of impulse buying due to consumers having less money to spend P
this could have a major effect on profits. T
E
Supply of raw materials sugar is a major raw material used in the manufacture of confectionery R
and non-alcoholic beverages. There may be a risk of relying too heavily on one major source of
supply of sugar and other raw materials necessary for the continued production of products.
2
Competition the confectionery and non-alcoholic beverages markets are highly competitive. If
there is a particular product that contributes a large proportion of sales revenue, there is a
considerable risk that a rival company will bring out a similar product and take some of the market
share. The extent of this risk will depend very much on the power of the brand.
Role of food in public health with lots of publicity about levels of obesity, children's eating
habits, heart disease and diabetes, there is a significant threat to the confectionery and fizzy drinks
markets. There is potential for governments to restrict advertising of certain products and to
impose additional taxes on confectionery and fizzy drinks, which could make marketing more
difficult. This could have a significant downward effect on sales and profits. Consumer tastes may
change for health-related reasons. If the company is unable to respond, this will also result in
declining sales or margins.
Product recalls and incorrect labelling of merchandise the confectionery industry is
particularly susceptible to the risk of product recalls and incorrect labelling. The necessary publicity
given to the potential consequences of nut allergies, for example, has led to much stricter
regulation of labelling information. There have been instances of products being recalled due to
failure to include warnings of nut content on labels. It is not just the product recall itself that is
expensive the potentially damaging effect on the company's reputation could have an even
greater impact. Although product recalls are infrequent, their considerable impact is such that very
tight internal controls are necessary to prevent their occurrence.

Answer to Interactive question 2


Possible non-compliance with laws USA
The possible reduction in the workforce in the USA will mean that many employees will be entitled to
some redundancy pay. There is the possibility of breach of employment law in processing and payment
of pay. Internal audit will need to review any redundancy calculations on a test basis to ensure that
employment law has been complied with.
Possible non-compliance with laws Far East
Establishing a factory in the Far East will mean that VSYS will have to comply with the laws and
regulations of a foreign country. The directors must ensure that the law in the country is understood,
possibly by hiring local solicitors.
Overall risks from new systems
Setting up a new factory in the Far East will also mean establishing new management and financial
accounting systems in that country. Risks inherent in establishing those systems may be minimised by
exporting the systems currently being used in the USA. However, it is unlikely that no modifications will

Business risk management 119


be necessary, as new systems will be necessary to meet the specific situation in the new location. New
systems always provide a risk of failure or incorrect reporting due to lack of adequate testing or
implementation problems. Internal audit will need to review the systems in detail to try to minimise the
errors that occur.
Communication risks Far East to USA
Establishing a new production location will mean that regular management and other reports will be
sent between two geographically diverse locations. This new communication system will run risks such
as communications being lost or intercepted en route. The board will need to ensure that appropriate
encryption systems are introduced across the communication system to minimise these risks.
Board control
Geographical distance from the USA to the Far East may limit the board's ability to maintain appropriate
control of the new production location. The risk is that the new factory may manufacture the computer
components correctly, but fail to meet its own constraints regarding mix of components produced or
timescales for production. To maintain adequate control, a director may have to be appointed to be in
residence at the new factory to ensure both locations are attempting to meet the objectives of VSYS.

Answer to Interactive question 3


Risk avoidance
The airline could abandon plans to offer services to this country.
Risk reduction
Invite the host government to be a partner in the venture.
Seek written assurances from the host government that the airport to be used will be fully
maintained to international safety standards and that planes will not be prevented from taking
off without good and communicated reasons.
Have contingency plans in place to adequately deal with any operational problems while in
the country for example, contacts with local coach company to ensure transport to hotels if
passengers have to spend another night in the country before the plane can take off; deals
with local hotels to provide any necessary accommodation.
If the new service is likely to boost the country's economy due to, for example, an increase in
visitors, it may be worth trying to lobby the country's government for a change in policy.
Risk transfer
Have adequate insurance in place to cover the cost of any planes being grounded.
Consider setting up an alliance with an airline located in the country in question, with the
service being offered in that airline's name but with a codeshare arrangement.
Risk retention
Accept the possibility that airports may not be properly maintained or planes may be
grounded, and the accompanying costs.

120 Business Analysis


Answer to Interactive question 4
Business risks
These are risks that a company's performance could be better or worse than expected.
(a) The new business venture to sell clothes on the internet using 3D models to display the
clothes.
There is the risk that demand will be far short of that anticipated or that costs of developing the
internet site will significantly exceed budget.
LP should have assessed the 3D project for feasibility. Budgets should have been established and
actual expenditure regularly compared with budgets. If actual expenditure is unavoidably
significantly in excess of budget, the board should consider whether the project should continue.
Thorough testing procedures should have been built into the plan, and these should ensure that C
the site is capable of coping with anticipated demand. Once the site is operational, LP should H
A
monitor the level of sales generated by obtaining customer feedback through the site, and P
comparing sales generated with the costs of keeping the site updated. T
E
(b) Product obsolescence R
The decision to lengthen the time of sale for each product may appear to decrease development
costs. However, the board of LP must also take into account demand for the goods. The fashion
industry tends to issue new clothes and designs every few months, and certainly in temperate 2
climates, fashions will change according to the season. There is a risk that not amending the style
of products sold will reduce sales far in excess of the reduction in expenditure. The overall going
concern of the company may also be adversely affected if customers perceive the clothes to be 'out
of date' and change to other suppliers.
LP should monitor the performance of products in detail, and look for evidence of falling sales
and other evidence that its products are viewed as old-fashioned, for example adverse customer or
press comment. The board should also consider whether work on developing new products should
continue to some extent, so that new lines can be launched quickly if demand falls.
(c) New competition
The new company PVO appears to be aggressively attacking LP's market place. While the overall
effect of the new competitor is difficult to determine, having a new range of clothes available is
likely to attract customers with little if any brand loyalty to LP.
LP should make sure that competitor activity is carefully monitored and responses are made to
known or predicted competitor activity, for an example an advertising campaign to counter new
products being launched by the competitor. LP's board should also review very regularly the
performance of products which are most vulnerable to competitor activity and decide whether to
invest more in these or concentrate on other less vulnerable products.

Business risk management 121


122 Business Analysis
CHAPTER 3

Cost analysis and control

Introduction
Topic List
1 Overview of cost accounting techniques
2 Limitations of traditional management accounting techniques
3 Cost reduction
4 The supply chain
5 Business process re-engineering
6 Outsourcing
Summary and Self-test
Answers to Self-test
Answers to Interactive questions

123
Introduction

Learning objectives Tick off

Demonstrate a detailed knowledge and understanding of the cost accounting techniques


studied at the Professional stage
Demonstrate and apply knowledge of multi-product break even analysis through
calculations and interpretation of results

Demonstrate a detailed understanding of the issues surrounding cost reduction

Demonstrate a detailed understanding of techniques that may be used in a strategy to


reduce costs, including the supply chain, business process re-engineering and
outsourcing
Demonstrate a detailed understanding of the linkages between costs, quality, marketing
and strategy

124 Business Analysis


1 Overview of cost accounting techniques

Section overview
This section reviews some of the costing techniques that were covered in the Management
Information paper at the Professional stage, including cost classification, costing systems, activity
based costing (ABC) and break even analysis.
Cost classification is the separation of various costs into different categories, such as fixed, variable
and semi-variable. Costs can be classified for various reasons, including inventory valuation,
planning and decision-making, and control.
Costing systems include direct, marginal and absorption costing for calculating unit costs.
ABC is a specific costing system for allocating overheads according to the activities that cause (or
drive) the costs.
Break even analysis or cost-volume-profit (CVP) analysis is the study of the interrelationships
between costs, volume and profit at various levels of activity.
The main difference between multi- and single-product break even analysis is that the former
relies on the product mix that is, the ratio in which different products are sold.
Unlike single product analysis, there is no single break even point for multiple products the
answer will change depending on the assumed product mix.

C
H
1.1 Cost classification A
P
Probably the best way to revise cost classification is to revisit the table you were introduced to in your
T
Management Information studies. E
R

Cost analysis and control 125


Financial information

Management accounting
Financial accounting
Internal management
Aggregate information
for external reporting information for planning,
control and decision-making

Classification for planning Classification for control


Cost objects
and decision-making System of responsibility
Requires knowledge of accounting segregates controllable
Cost units cost behaviour patterns costs and uncontrollable costs
Basic control unit
for costing purposes

Fixed cost Variable cost Semi-variable cost


Classification for inventory Not affected by Changes in line Partly affected by
valuation and profit measurement
changes in activity with level of activity changes in activity
Cost elements = materials,
labour and other expenses

Direct cost or Indirect cost or


prime cost Product cost Period cost
overhead
Allocated to value Deducted as
can be traced in cannot be traced
in full to cost of inventory until expenses in a
full to cost object
object being sold particular period
being costed
costed

Make sure you are familiar with all these classifications.

1.2 Costing systems


One of the purposes of the following costing systems is to calculate the cost of a unit of output which
can ultimately be used to set the selling price.

1.2.1 Absorption costing


With absorption costing, a unit of output is valued at full cost that is, the prime cost plus an absorbed
share of production overhead costs.

1.2.2 Marginal costing


Marginal costing is an alternative to absorption costing, where only variable costs are included in the
valuation of units. All fixed costs are treated as period costs and written off against sales revenue in the
period in which they are incurred.
The difference in unit valuations using the two methods lies in the treatment of the fixed costs.
The absorption cost of sales will include some fixed costs from a previous period (included in opening
inventory) whilst all fixed costs are written off as expenses in the year of incurrence with marginal
costing.

126 Business Analysis


Interactive question 1: Absorption and marginal costing [Difficulty level: Easy]
Hamilton Ltd manufactures and sells a single product, the Feronda, which has a selling price of 150 per
unit and variable costs of 70 per unit. During the months of July and August, the following details are
available.
July August
Fixed production costs 110,000 110,000
Production 2,000 units 2,500 units
Sales 1,500 units 3,000 units

Hamilton Ltd normally expects to produce 2,200 units and fixed production costs were budgeted at
110,000, which are absorbed on a per unit basis. There were no opening inventories in July.
Requirements
(a) Determine the profit for both July and August using
(i) Absorption costing and
(ii) Marginal costing.
(b) Demonstrate why the profits under each method are different.
See Answer at the end of this chapter.

1.2.3 Activity Based Costing (ABC)


ABC is an alternative approach to absorption costing. Cost drivers that is, those activities that cause
C
costs in the first place are identified and overheads are assigned to products or services based on the H
number of the cost drivers generated by each. More than one cost might have the same cost driver, so A
costs associated with the same driver are gathered into cost pools and then allocated using the P
appropriate driver. The product costs resulting from ABC should be more accurate than those under T
E
absorption costing as overheads are allocated on a more objective basis. Try the question below to
R
make sure you remember the principles and procedures of ABC.

Interactive question 2: Activity Based Costing [Difficulty level: Easy] 3

Tammy plc currently makes and sells four products, cost and output details of which are below.
Product Alpha Bravo Echo Oscar
Output (units) 500 300 400 200
Cost per unit ():
Material 60 42 80 100
Labour 32 20 35 50
Activities:
Number of set ups 20 15 30 35
Number of times materials
handled 3 4 2 6
Number of orders 11 12 16 25
Number of spare parts 15 20 10 15
required

Total overhead costs ()


Set up costs 25,000
Material handling 69,000
Ordering costs 32,000
Engineering costs 45,000
171,000

Requirements
(a) Using the information in the question, what is the most suitable cost driver for each overhead cost?
(b) Calculate the total product cost for each of the four products, showing all workings.
See Answer at the end of this chapter.

Cost analysis and control 127


1.3 Break even analysis
Break even analysis is the study of the inter-relationships between costs, volume and profit at various
levels of activity. The study of break even analysis requires understanding, application and
interpretation of various formulae which are summarised below.
You will notice from the chart that break even analysis is also used for decision making purposes where
there are limiting factors, such as make or buy decisions. Remember that the most important figure for
decision making is contribution if a product is making a contribution towards fixed costs then
production should continue, as overall profit will be reduced (or loss increased) if this contribution is
lost.

Breakeven analysis or
Cost-Volume-Profit (CVP)
analysis

Contribution =
Sales price Variable cost

Contribution ratio
Breakeven point (BEP) Limiting factor
Contribution
= No profit and no loss = analysis
Sales

Fixed costs Fixed costs Maximise the


BEP in units = BEP in =
Contribution per unit Contribution ratio contribution per
unit of limiting
factor

Margin of safety Make or buy


Budgeted sales BEP decision
= 100%
Budgeted sales

Break even chart


Depicts the profit or loss
over a range of activities

Contribution break even chart


Includes the variable cost line so
that contribution is highlighted

Interactive question 3: Break even analysis [Difficulty level: Easy]


Bonzo plc manufactures and sells roller skates. Current sales volume is 20,000 pairs of roller skates per
annum. Selling price and variable cost details per pair is shown below.

Selling price 55.00
Variable costs 25.00
Total fixed costs per annum are:

Marketing 75,000
Salaries 200,000
Other 150,000

128 Business Analysis


Requirements
(a) How many pairs of roller skates have to be sold in one year for Bonzo plc to break even?
(b) What is the current margin of safety in terms of number of pairs of skates sold?
(c) Bonzo plc has decided to increase its marketing campaign, which means spending an extra
40,000 on marketing. Selling price of the roller skates will also increase to 65. If Bonzo plc
wishes to make a profit of 25,000, how much sales revenue must be generated from the sale of
roller skates?
See Answer at the end of this chapter.

1.4 Multi-product break even analysis


The key issue with multi-product break even problems is determining the mix in which the products are
sold and reducing it to the lowest common denominator. For example, if 500 units of Product X and
250 units of Product Y are sold, then the mix in which the two products are sold is 2:1. This mix is used
to define a standard batch which can be used to determine a break even point in terms of number of
batches. Once this has been determined, the number of batches can then be converted into the
number of units of each product that must be sold at the break even point.

Worked example: Multi-product break even analysis


Toodiloo Ltd manufactures and sells two types of microwave oven the Silver Star oven and the Gold
Senator combination oven and grill. The following information is available for the two models. C
Silver Star Gold Senator H
Sales volume in units 5,000 3,000 A
P
Per unit: T
Selling price 65.00 90.00 E
Variable costs 45.00 60.00 R

Direct fixed costs are 40,000 for the Silver Star and 30,000 for the Gold Senator. General fixed costs,
which can only be avoided if neither model is sold, are 63,000.
3
Requirement
Calculate how many units of each model would have to be sold for Toodiloo Ltd to cover all its fixed
costs.

Solution
As with all break even questions, the first thing to do is to establish the contribution per unit:
Silver Star Gold Senator

Selling price 65.00 90.00
Variable costs 45.00 60.00
Contribution per unit 20.00 30.00
The key to multi-product break even analysis is to look at the product mix. In this case we are told that
Toodiloo sells 5,000 units of the Silver Star and 3,000 units of the Gold Senator, giving a product mix
ratio of 5:3. A standard batch can therefore be assumed to comprise five Silver Star and three Gold
Senator, which will give a total contribution towards total fixed costs of 190 (5 20.00 + 3 30.00).

Cost analysis and control 129


Using the total contribution per standard batch, we can calculate the number of batches that have to be
sold in order to break even:
Total fixed cos ts
Break even point in batches =
Contribution per batch

133,000
=
190
= 700 batches
How many units of each model will have to be sold in order to break even? Remember that in every
batch, five units of the Silver Star are sold and three units of the Gold Senator. Therefore, in order to
break even, Toodiloo will have to sell:
Silver Star: 5 700 = 3,500 units
Gold Senator: 3 700 = 2,100 units
Check:
Silver Star Gold Total
Senator

Contribution per unit 20.00 30.00
Total contribution 70,000 63,000 133,000
Fixed costs:
Direct 40,000 30,000 70,000
General 63,000
Total profit/(loss) NIL
Note: You will have probably noticed that this break even number of batches and units will only work if
the product mix remains at 5:3. As soon as the product mix changes you will have to calculate a new
break even point. As you might expect, an increase in the proportion of sales of products with a higher
contribution will normally reduce the break even point, while an increase in the proportion of sales of
products with a lower contribution will normally increase the break even point.

Interactive question 4: Multi-product break even analysis [Difficulty level: Easy]


Netcord Ltd produces and sells three different types of tennis racquet the McEnrova, the Grafassi and
the Federdal. The sales and costs forecast for the next period are as follows.
McEnrova Grafassi Federdal Total
Sales units 8,000 6,000 4,000

Sales revenue 320,000 360,000 400,000
Variable costs 176,000 228,000 280,000
Contribution 144,000 132,000 120,000 396,000
Total fixed costs 306,900
Net profit 89,100

Total fixed costs can only be avoided if all models are eliminated.
Requirement
How many units of each model must be sold in order for Netcord Ltd to break even and what is the
break even sales revenue?
See Answer at the end of this chapter.

130 Business Analysis


2 Limitations of traditional management accounting
techniques

Section overview
It has been argued that traditional management accounting systems are inadequate for a
modern business environment that focuses on marketing, customer service, employee
involvement and total quality.
This section summarises the main problems with the traditional systems that you have covered in
earlier studies.

2.1 Short-term financial measures


Pressures to keep costs under control have emphasised the need for relevant and informative cost data
that is produced promptly. In addition these costs need to be compared with benefits, and this cannot
just be done on financial grounds. The qualitative benefits can be extremely important (for example
better product quality) and there may also be non-financial quantitative benefits. These may not
necessarily be easy to quantify (for example shorter set-up times, improved capacity utilisation).
However much of the output of traditional management accounting consists of short-term financial
performance measures such as costs, variances and so on. Many of these are produced too long after
the event and are too narrowly focused. A much wider view is now necessary.
C
H
2.2 Cost accounting methods A
P
Traditional cost accounting traces raw materials to various production stages via WIP, to the next stage T
and finally to finished goods, resulting in literally thousands of transaction entries. With just-in-time E
R
systems, production flows through the factory on a continual basis with near-zero inventories and very
low batch sizes and so such transaction entries become needlessly complicated and uninformative. Cost
accounting and recording systems must therefore be greatly simplified in the modern environment.
3
Backflush costing is one possible approach.

2.3 Performance measures


Traditional management accounting performance measures can produce the wrong type of responses.
In particular resulting in unnecessary cost increase.

Measurement Response Consequence of action

Purchase price variance Buy in greater bulk to reduce unit Excess inventories
price
Higher holding costs
Quality and reliability of
delivery times ignored
Labour efficiency variance Encourage greater output Possibly excess inventories of
the wrong products
Machine utilisation Encourage more running time Possibly excess inventories of
the wrong products
Cost of scrap Rework items to reduce scrap Production flow held up by re-
working
Scrap factor included in Supervisor aims to achieve actual No motivation to get it right
standard costs scrap = standard scrap first time

Cost analysis and control 131


Measurement Response Consequence of action

Traditional absorption Produce more output to reduce Excess inventories, possibly of


costing unit costs and/or over recover unwanted products
overhead
Cost centre reporting Management focus is on cost Lack of attention to activities
centre activities, not overheads where cost reduction
possibilities might exist

2.4 Timing
The cost of a product is substantially determined when it is being designed, not when it is in
production. The materials that will be used, the machines and labour required, are largely determined at
the design stage. In the car industry it is estimated that 85% of all future product costs are determined
by the end of the testing stage. Management accountants, however, continue to direct their efforts to
the production stage.

2.5 Controllability
Only a small proportion of 'direct costs' are genuinely controllable in the short term. It has been argued
that controllable direct costs are about 10% of total costs, whereas controllable overhead costs
represent about 27%. It has been suggested that the reason why, in spite of this, accountants do not
devote nearly three times as much effort to analysing overhead costs as they devote to direct costs is
because overheads are more difficult to measure.

2.6 Customers
Many costs are driven by customers (delivery costs, discounts, after-sales service and so on), but
conventional cost accounting does not recognise this. Companies may be trading with certain
customers at a loss but not realise it because costs are not analysed in a way that would reveal it.

2.7 The solution


Whether all, or any, of the above criticisms are well founded is, of course, debatable. What is
indisputable, however, is that changes are taking place in management accounting and business
processes in order to meet the challenge of modern developments.

3 Cost reduction

Section overview
Cost reduction has become increasingly important in an increasingly competitive world. In order
to remain competitive, companies have had to keep prices low and the only other way to
influence the bottom line is to squeeze costs as far as possible.
There are numerous cost reduction programmes that a company can use and various ways in
which they can be implemented. It is a matter of what is most suitable for the company, given its
other objectives.
In order that cost reduction programmes are successful, companies should be keenly aware of the
effect that cost reduction has, not just on its reported financial results, but also on marketing,
strategy and quality.
Cost reduction should be viewed as an on-going exercise rather than being a panic reaction to a
profit crisis.

132 Business Analysis


Case example: IKEA
The chief executive of the IKEA furniture chain famously travels economy class on all flights, whether
long or short haul, thus giving lower grades of director and manager no choice but to follow suit. On a
trip to the United States, the chief executive reportedly cut out a voucher for cut-price car hire in an in-
flight magazine and handed it to his management colleague who was travelling with him. The colleague
was expected to present the voucher to the car hire desk at their destination airport to obtain the
discount. This approach to cost reduction by the chief executive reinforces IKEA's market positioning
strategy as a low cost, no frills store.
In this section we will look at both cost reduction and cost control, and the lengths some companies will
go to in the quest to achieve them.

3.1 Introduction
st
Cost reduction has become the battle-cry of the 21 Century. As prices are slashed in a bid to remain
competitive, companies have to find other ways of boosting profits. The only other way to affect the
bottom line is to squeeze costs as far as possible and, hopefully, more effectively than competitors.
One of most quantifiable means of reducing costs is to tackle fixed costs. We talked about fixed costs
briefly in Section 1 and you will have dealt with them in detail in earlier studies. Fixed costs are those
costs that cannot be avoided regardless of activity levels if you can find a way of getting rid of some of
the sources of fixed costs permanently then you are on the way to a successful cost reduction
programme.
C
The best way to reduce costs is to develop a culture within the organisation whereby everyone thinks H
strategically about cost reduction. How do you reduce costs? Quite simply by avoiding them as much A
as possible. Of course that is easier said than done but if employees can be educated to actively seek P
ways to reduce costs then this will be a move in the right direction. T
E
R
3.2 Cost reduction techniques
As with all business decisions, there are right ways and wrong ways to approach cost reduction. The 3
right techniques will result in greater efficiency of company spending; the wrong ones could lead to
costs being cut that are in fact necessary for the maintenance of quality and company value. There is
often a fine line between necessary costs and unnecessary ones but taking a systematic approach to cost
reduction can help managers stay on the right side of that line.
Effective cost reduction techniques start with establishing what the programme is trying to achieve. If a
company does not know why it is cutting costs then it will have no idea where to cut costs. Companies
try to reduce costs for many reasons, such as to allow the price of a product or service to be cut without
affecting margins, to eliminate unnecessary spending and to create additional cash reserves. Ultimately
the aim is to maximise shareholders' wealth, therefore it is important that the correct costs are targeted
for reduction.
There are numerous ways in which companies can institute plans to reduce costs, including across the
board reductions, prioritised reductions and departmental reductions. Across the board reductions
could include the implementation of a new travel policy whereby all staff must travel economy class (as
we have seen is the case with IKEA) while prioritised reductions may include a strategy to reduce
pollution in order to avoid pollution tax.
Whatever techniques are used, if they are the right ones they can teach a company to be more
economical while maintaining its levels of service and quality. By forcing companies to regularly review
spending at all levels, cost reduction techniques allows companies to become more streamlined.
Sections 46 examine some techniques that are used in the modern business world to address such
issues as cost reduction and increased efficiency.

Cost analysis and control 133


3.3 Which costs should be cut?
This depends on the type of business you are in, but the easiest way to cut costs is to focus firstly on
those expenses that are common to all companies. Gas and electricity, postage, stationery and
telephone charges are all obvious targets. The trick is to encourage all staff to participate, not demand it.
For example, notices posted next to light switches asking staff to 'switch off after use' are likely to be
more effective than a dictatorial memo demanding that staff should be more careful about using power.
If cutting the more obvious costs does not achieve the required effect, management will have to adopt a
more innovative approach, focusing on individual departments' spending. Whilst cutting such expenses
as telephone charges and stationery can be fairly straightforward, dealing with departmental costs is
more problematic. Not only do you have the issue that departments feel they are being victimised,
there is also the potential for seriously damaging the company's day to day operations and pursuit of
objectives. If staffing levels are cut, for example, it will be more difficult to maintain product or service
quality. Cutting inventory levels too far could result in the company being unable to fulfil delivery
promises. That is why management must understand how different costs affect profitability and the
extent to which each cost category can be reduced before the company's operations are adversely
affected.

Case example: Ryanair


Ryanair, a low cost airline based in Ireland, is well known for its cost cutting exercises. Keeping costs
down is part of Ryanair's overall strategy which means that when the company releases a statement of
further cost cutting schemes no-one is surprised. When asked in 2002 what was 'the gospel according
to Ryanair', the company's chief financial officer responded that it was to continually ask if Ryanair could
do what it was doing at a reduced cost.
At its first quarter results presentation in 2006, the company revealed that, while it had the lowest
revenue per passenger out of the eight airlines with which it compared itself, it also had the highest
operating margin (18%). Between 2000 and 2006, Ryanair managed to reduce its unit operating costs
by 40%.
Ryanair recognised that the cost category with greatest potential for reduction was flight operating
costs. In response to this Ryanair's cost cutting exercises have included charging passengers to check in
bags in an attempt to reduce baggage handling costs and encouraging passengers to make greater use
of web-based check-in. Ryanair has decided to remove check-in staff completely. The use of e-business
helped to eliminate approximately 12% of turnover costs, including travel agents' commission.
Overall Ryanair's cost reduction programme appears to have been successful over the last decade for the
company with its operating costs repeatedly increasing at a slower rate than its passenger revenues. In
2010 Ryanair announced a 319m profit and by 2012 annual profits had risen to 503m.
However Ryanair's reputation has come under significantly more pressure over the last few years.
Possibly the heaviest criticisms that Ryanair has faced were a result of the delays to flights caused by the
Icelandic volcanic ash in April 2010. Ryanair initially stated that refunds would be limited to the same
amount that passengers paid for their tickets. Lawyers and consumer groups questioned the legality of
this policy and Ryanair later backed down, saying it would refund all reasonable expenses to passengers.
(To be fair some other airlines also initially took a harsh stance towards passenger claims and later
retreated.)
Ryanair has also been criticised by the Office of Fair Trading for being 'puerile and childish' over its credit
card payment policy. Ryanair adds fees when customers use all but one type of credit card to pay
online. However because it offers a prepaid booking service with a Mastercard prepaid card (not the
most-used credit card) it is able to advertise cheap fares that don't include extra credit card charges.
More generally Ryanair's policy of charging for a large number of optional extras has come under
heavier criticism.
In March 2011 Ryanair was found to have breached European Union regulations that companies selling
goods online must offer customers the facility to complain via email. However Ryanair did not provide
email contact details, meaning that customer complaints had to be by letter, fax or by phoning
Ryanair's premium rate telephone number.
In February 2012 two UK newspaper ads for Ryanair were banned after complaints that they were sexist
and treated women as objects. The Advertising Standards Authority ruled that the women's appearance,

134 Business Analysis


stance and gaze, together with the wording of the advert, linked female cabin crew with sexually
suggestive behaviour and thus breached the advertising practice code. This was not the first time that
Ryanair had fallen foul of the code in this area. A few years previously it had had to withdraw an advert
of a model dressed as a schoolgirl with the headline 'hottest back to school fares'.
Also in 2012 Ryanair attempted again to purchase its principal rival, Aer Lingus. A previous bid in 2006
had been disallowed by the European Commission. Ryanair already owned 30% of Aer Lingus and the
bid was prompted by the Irish government's plans to sell its 25% share in Aer Lingus. In June 2012
however Aer Lingus advised its shareholders to reject the bid, again on the grounds that it might not be
allowed by the competition authorities. After the bid was made, shares in Aer Lingus rose 15.4%, but
this was well short of the 38% premium that Ryanair offered, reflecting market doubts about the offer.

3.4 Implementing cost reduction programmes


As with choosing techniques, there is a right way and a wrong way to implement cost reduction
programmes. Cost reduction is inevitably a sensitive area and the wrong approach can alienate staff,
reduce motivation and have a detrimental effect on company harmony. A good cost reduction
programme is as much about damage limitation as cutting costs.
Effective cost reduction programmes should result from thorough management planning, a detailed
understanding of how company expenses can affect not just the bottom line but the overall quality of
the product or service and a vision of where the company is heading. Cost reduction is not about
reporting smaller numbers in the income statement it should be the culmination of extensive
planning, thought and participation by directors, management and employees. Directors should not
C
automatically assume that the most obvious cuts are the right ones. An innovative approach is often
H
more successful than the usual 'we have to cut costs by 10% across the board' requirement. A
P
Cost reduction programmes, as mentioned above, are ultimately implemented to improve profitability
T
without improving revenue figures. Any improvements in revenue will further enhance profits. E
Programmes should be integrated into the overall company strategy, not introduced on an ad hoc basis. R

Case example: Kraft and Cadbury 3


Kraft took over Cadbury in February 2010 and by July 2010 more than 100 senior Cadbury staff had left,
including Cadbury's Chairman, Chief Executive and Chief Finance Officer, also Cadbury's Marketing
Director and Chief Strategy Officer. A company spokesman commented that this amount of change was
not unusual when two companies merged. Critics pointed out that none of the top jobs subsequent to
the acquisition had gone to Cadbury staff.
Kraft also completed the controversial closure of Cadbury's Somerdale factory at Keynsham, which had
been planned before the acquisition, and moved production to Poland. In May 2010 Kraft announced it
intended to cut 379 million from operational costs. These savings would be generated by changes to
IT and back office operations, and process, manufacturing and supply chain improvements.

3.5 Potential problems with cost reduction programmes


While companies seek to reduce costs to remain competitive, taking the process too far can have
adverse effects. Managers have to think about the extent to which cost reduction can be sustained
before the business starts to suffer in other ways. Companies whose marketing strategies are based on
low costs will probably get away with cost cutting for longer but if you work in an organisation that has
always promoted high quality goods and services, it is unlikely that extreme cost reduction programmes
will be viewed positively either by customers or the financial markets. Regardless of how it is marketed,
cost reduction is seen by outsiders as not only reducing expenditure but reducing quality and service as
well.
Always bear in mind that cost reduction, whilst tempting in order to get ahead of competitors, should
only be undertaken to the extent that it adds value to the company. As soon as shareholders' wealth
starts to suffer the programme should be halted.

Cost analysis and control 135


Case example: Public sector cost cutting
How to cut public sector expenditure has been the subject of considerable debate in the UK, due to the
perceived need to reduce the public sector deficit.
Techniques that have been suggested as particularly relevant for the public sector include the
application of lean manufacturing principles to ensure that expenditure that does not add value is not
undertaken, and quality management techniques such as Six sigma that aim to eliminate errors in
service delivery. Improving procurement skills has been identified as another priority area, given that the
public sector is a huge buyer of products and services. Improvements in the transparency and quality of
publicly available information will, it's claimed, help stimulate performance, as will using other countries'
performance as 'competitive' benchmarks.
One area in which public sector expenditure may increase is on cost-cutting consultants. A story in the
Daily Telegraph in July 2010 claimed that public sector bodies could recruit up to 200 cost-cutting
consultants on wages of up to 1,000 a day. Doug Baird, Managing Director of consultants Interim
Partners, claimed that:
'Experienced efficiency experts do not come cheap, but they can deliver a huge return on investment
and improve service delivery. A poorly executed cost-cutting programme can leave staff demoralised
and undermine productivity.'

3.6 Summary of cost reduction


Cost reduction should not be a one-off exercise. Companies should continually review their costs to
determine whether the same level of operations, service and quality could be maintained while reducing
costs. Innovation is often the key to successful cost reduction programmes management should not
automatically assume that the most obvious areas for cost reduction are always going to be the right
ones. There should be focus not only on the costs themselves but also on in-house procedures and
processes. Despite this, however, companies should pay close attention to how far they can take their
cost reduction programmes before performance both financial and operational is adversely affected.

Case example: Svenska Handelsbanken


Swedish bank, Svenska Handelsbanken's, low costs are the product of several factors:
(a) Small head office staff, and a flat, simple hierarchy.
(b) People in regions and branches are self sufficient and well-trained and are measured by competitive
results, which has produced an attitude keen to weed out unwarranted expenses.
(c) Lower credit losses because front line staff feel more concerned to make sure that the information
on which they base lending decisions is correct.
(d) Central services and costs are negotiated rather than allocated.
(e) Internet technology is used to reduce costs, with the benefit accruing to the customer's own
branch.
The European Vice President of Svenska Handelsbanken believes that 'devolving responsibility for results,
turning cost centres into profit centres; squeezing central costs, using technology and eradicating the
budgeting "cost entitlement" mentality are just some of the actions we have taken to place costs under
constant pressure'.

136 Business Analysis


4 The supply chain

Section overview
Whatever the exact nature of supplier bargaining power, many firms aim to build closer
relationships for the sake of efficiency.
A firm can make strategic gains from managing stakeholder relationships, such as those with
customers and suppliers.
Supply chain management is about optimising the activities of companies working together to
produce goods and services. Supply chain relationships are becoming increasingly more co-
operative rather than adversarial.

4.1 Introduction
Market and competitive demands are, however, compressing lead times and businesses are reducing
inventories, holding costs and excess capacity. Linkages between businesses in the supply chain must
therefore become much tighter.
This has had major consequences on the distribution methods of companies in these supply chains,
delivering to their customers on a just in time (JIT) basis. The adversarial, arms length relationship with a
supplier has been replaced by one which is characterised by closer co-operation.

C
4.2 Supply chain management H
A
Supply chain management is about optimising the activities of companies working together to produce P
goods and services. T
E
Supply chain management (SCM) is a means by which the firm aims to manage the chain from input R
resources to the consumer. It involves the following.
Reduction in the number of suppliers.
3
Reduction in customers served, in some cases, for the sake of focus, and concentration of the
company's resources on customers of high potential value.
Price and inventory co-ordination. Firms co-ordinate their price and inventory policies to avoid
problems and bottlenecks caused by short-term surges in demand, such as promotions.
Linked computer systems electronic data interchange saves on paperwork and warehousing
expense.
Early supplier involvement in product development and component design.
Logistics design. Hewlett-Packard restructured its distribution system by enabling certain product
components to be added at the distribution warehouse rather than at the central factory, for
example user-manuals which are specific to the market (ie user manuals in French would be added
at the French distribution centre).
Joint problem solving.
Supplier representative on site.
Point to note: The aim is to co-ordinate the whole chain, from raw material suppliers to end customers.
The chain should be considered as a network rather than a pipeline a network of vendors support a
network of customers, with third parties such as transport firms helping to link the companies.
As well as tactical issues, what might be the underlying strategic concerns?
Close partnerships are needed with suppliers whose components are essential for the business unit.
A firm should choose suppliers with a distinctive competence similar to its own. A firm selling
'cheap and cheerful' goods will want suppliers who are able to supply 'cheap and cheerful'
subcomponents.

Cost analysis and control 137


Problems with the partnership approach to supply chain management are these.
Each partner needs to remain competitive in the long term
There is a possible loss of flexibility
The relative bargaining power may make partnership unnecessary
Arguments about sharing profits

5 Business process re-engineering

Section overview
Business process re-engineering involves focusing attention inwards to consider how business
processes can be redesigned or re-engineered to improve efficiency.
This section examines the business process re-engineering concept in detail, including looking at
the types of organisations that might employ this process to improve efficiency and reduce costs.

5.1 General overview


Business process re-engineering (BPR) involves focusing attention inwards to consider how business
processes can be redesigned or re-engineered to improve efficiency. It can lead to fundamental changes
in the way an organisation functions. Properly implemented BPR may help an organisation to reduce
costs, improve customer services, cut down on the complexity of the business and improve internal
communication.
At best it may bring about new insights into the objectives of the organisation and how best to
achieve them.
At worst, BPR is simply a synonym for squeezing costs (usually through redundancies). Many
organisations have taken it too far and become so 'lean' that they cannot respond when demand
begins to rise.
The main writing on the subject is Hammer and Champy's Reengineering the Corporation (1993), from
which the following definition is taken.

Definition
Business process re-engineering (BPR) is the fundamental rethinking and radical redesign of business
processes to achieve dramatic improvements in critical contemporary measures of performance, such as
cost, quality, service and speed.

The key words here are fundamental, radical, dramatic and process.
Fundamental and radical indicate that BPR is somewhat akin to zero base budgeting: it starts by
asking basic questions such as 'why do we do what we do', without making any assumptions or
looking back to what has always been done in the past.
Dramatic means that BPR should achieve 'quantum leaps in performance', not just marginal,
incremental improvements.
Process. BPR recognises that there is a need to change functional hierarchies: 'existing hierarchies
have evolved into functional departments that encourage functional excellence but which do not
work well together in meeting customers' requirements' (Rupert Booth, Management Accounting,
1994).
A process is a collection of activities that takes one or more kinds of input and creates an output.
For example, order fulfilment is a process that takes an order as its input and results in the delivery of
the ordered goods. Part of this process is the manufacture of the goods, but under BPR the aim of
manufacturing is not merely to make the goods. Manufacturing should aim to deliver the goods that

138 Business Analysis


were ordered, and any aspect of the manufacturing process that hinders this aim should be re-
engineered. The first question to ask might be 'Do they need to be manufactured at all?'
A re-engineered process has certain characteristics.
Often several jobs are combined into one
Workers often make decisions
The steps in the process are performed in a logical order
Work is performed where it makes most sense
Checks and controls may be reduced, and quality 'built-in'
One manager provides a single point of contact
The advantages of centralised and decentralised operations are combined

Case example: Car manufacturer


Based on a problem at a major car manufacturer.
A company employs 25 staff to perform the standard accounting task of matching goods received notes
with orders and then with invoices. About 80% of their time is spent trying to find out why 20% of the
set of three documents do not agree.
One way of improving the situation would have been to computerise the existing process to facilitate
matching. This would have helped, but BPR went further: why accept any incorrect orders at all? What if
all the orders are entered onto a computerised database? When goods arrive at the goods inwards
department they either agree to goods that have been ordered or they don't. It's as simple as that.
Goods that agree to an order are accepted and paid for. Goods that are not agreed are sent back to the
C
supplier. There are no files of unmatched items and time is not wasted trying to sort out these files. H
A
P
T
E
5.2 Examples of business process re-engineering R

Some organisations have redesigned their structures on the lines of business processes, adopting BPR to
avoid all the co-ordination problems caused by reciprocal interdependence.
3
A move from a traditional functional plant layout to a JIT cellular product layout is a simple
example.
Elimination of non-value-adding activities. Consider a materials handling process, which
incorporates scheduling production, storing materials, processing purchase orders, inspecting
materials and paying suppliers.
This process could be re-engineered by sending the production schedule direct to nominated
suppliers with whom contracts are set up to ensure that materials are delivered in accordance with
the production schedule and that their quality is guaranteed (by supplier inspection before
delivery).
Such re-engineering should result in the elimination or permanent reduction of the non-value-
added activities of storing, purchasing and inspection.
Be prepared to apply your knowledge of BPR to a particular scenario or to examples that you are
aware of from your reading or own experience. The examiner has stated that good answers often
draw on the candidate's own experience in the context of the question set.

Interactive question 5: Business process re-engineering [Difficulty level: Intermediate]


AB Ltd was established over a century ago and manufactures water pumps of various kinds. Until
recently it has been successful, but imports of higher quality pumps at lower prices are now rapidly
eroding its market share. The managing director feels helpless in the face of this onslaught from
international competitors and is frantically searching for a solution to the problem. In his desperation, he
consults a range of management journals and comes across what seems to be a wonder cure by the
name of Business Process Re-engineering (BPR). According to the article, the use of BPR has already
transformed the performance of a significant number of companies in the USA which were mentioned
in the article, and is now being widely adopted by European companies. Unfortunately, the remainder

Cost analysis and control 139


of the article which purports to explain BPR is full of management jargon and he is left with only a
vague idea of how it works.
Requirements
(a) Explain the nature of BPR and describe how it might be applied to a manufacturing company like
AB Ltd.
(b) Describe the major pitfalls for managers attempting to re-engineer their organisations.
See Answer at the end of this chapter.

5.3 Implications of BPR for accounting systems


Issue Implication

Performance Performance measures must be built around processes not departments: this may
measurement affect the design of responsibility centres.
Reporting There is a need to identify where value is being added.
Activity ABC might be used to model the business processes.
Structure The complexity of the reporting system will depend on the organisational
structure. Arguably the reports should be designed round the process teams, if
there are independent process teams.
Variances New variances may have to be developed.

6 Outsourcing

Section overview
Often money and other resources are wasted trying to perform operations in which the
organisation in question has little or no expertise.
Outsourcing may be the answer to this problem organisations are increasingly turning to
external experts to perform such functions.
One particular example is the outsourcing of IT services which will be considered in this section.

6.1 The use of outsourcing in business


Outsourcing can be defined as the use of external suppliers as a source of finished products,
components or services. Use of outsourcing has been driven often by it being the most cost-effective
way of providing a service, particularly for smaller organisations.
In addition the supplier of the outsourced service can provide specialist expertise which is not available
in-house or it would not be worth maintaining in-house.
Outsourcing should have also the major advantage of reducing the workload or the organisation's
managers, thus freeing more time to concentrate on core competences.
Generally speaking, outsourcing is appropriate for peripheral activities: to attempt to outsource core
competences would be to invite the collapse of the organisation. However, it can be difficult to identify
with clarity just what are an organisation's core competences and it is not too difficult to imagine an
organisation whose core competence was, in fact, outsourcing. Certainly, the motor manufacturing
industry seems to be moving in this direction.
A further advantage of outsourcing is that external suppliers may capture economies of scale and
experience effects that mean that costs may be reduced by using their services rather than in-house
provision.
Getting the best out of outsourcing depends on successful relationship management rather than
through the use of formal control systems.

140 Business Analysis


6.2 Successful outsourcing
Successful outsourcing depends on three things.
The ability to specify with precision what is to be supplied: this involves both educating suppliers
about the strategic significance of their role and motivating them to high standards of
performance.
The ability to measure what is actually supplied and thus establish the degree of conformity with
specification.
The ability to make adjustments elsewhere if specification is not achieved.
There are also practical considerations relating to outsourcing.
It can save on costs by making use of supplier economies of scale.
It can increase effectiveness where the supplier deploys higher levels of expertise.
It can lead to loss of control, particularly over quality.
It means giving up an area of threshold competence that may be difficult to reacquire.
Outsourcing of non-core activities is widely acknowledged as having the potential to achieve important
cost savings. However, some organisations are wary of delegating control of business functions to
outsiders because of the difficulty of assessing the cost-effectiveness of what is purchased: cost should
be fairly clear, but the quality of what is purchased is extremely difficult to assess in advance. The
adoption of quality standards may help to overcome this problem. By utilising such standards,
businesses will have more confidence in the quality of the service being provided and suppliers will
know what is expected of them.
C
H
Case example: Mars and Cadbury's A
P
' chocolate confectionery companies in the UK will sell Easter eggs promoting their brands and T
products every spring. Mars, for instance, will provide chocolate eggs containing mini Mars products, or E
in packaging highlighting Mars products around the egg. The reason that you might be tempted to buy R
one of these eggs is because it has Mars products associated with it. Mars therefore doesn't have to
produce the egg itself that activity can be outsourced. After all, it would be expensive to maintain
production facilities for chocolate eggs for only a couple of months a year. 3

On the other hand, Cadbury has focused on marketing and sales activities to develop the Cadbury's
Crme Egg into a product that is sold all year round, thereby making the operation viable. The decision
whether or not to outsource can often be bound strongly to an organisation's competitive strategy and
focuses on how strategic the activity is to the organisation.'

The extract above was written before Kraft's acquisition of Cadbury in 2010. After the acquisition Kraft
went ahead with the controversial plan to close Cadbury's Keynsham plant, but pledged there would be
no further closures of manufacturing sites in the UK, and no further compulsory redundancies in
manufacturing in the UK in the next two years.

Interactive question 6: Outsourcing [Difficulty level: Intermediate]


Bonanza plc is a financial services company that offers a credit card service on a global scale. Bonanza
currently operates in more than 100 countries and offers a telephone customer service facility. Due to
changes in technology and pressure from competitors' activities, Bonanza has set up a call centre facility
to handle customer queries, and is increasingly outsourcing this facility to locations offering lower labour
costs. However, this has led to staff unrest due to the loss of UK jobs and there have been an increasing
number of customer complaints about the level of service from the call centres, owing mainly to a lack
of helpfulness and general language difficulties.
Bonanza is in a dilemma and is wondering if the customer service function should have been retained
in-house.

Cost analysis and control 141


Requirement
What are the advantages and disadvantages of outsourcing the customer enquiry function?
See Answer at the end of this chapter.

6.3 The value chain, core competences and outsourcing


Core competences are the basis for the creation of value; activities from which the organisation does not
derive significant value may be outsourced.
The purpose of value chain analysis is to understand how the company creates value. It is unlikely that
any business has more than a handful of activities in which it outperforms its competitors. There is clear
link here with the idea of core competences: a core competence will enable the company to create
value in a way that its competitors cannot imitate. These value activities are the basis of the company's
unique offering.
There is a strong case for examining the possibilities of outsourcing non-core activities so that
management can concentrate on what the company does best.

6.4 Outsourcing IT/IS services


This section looks at a specific example of outsourcing namely IT/IS services and the advantages and
disadvantages of outsourcing such a key business function.
The arrangement varies according to the circumstances of both organisations.

Outsourcing arrangement

Feature Timeshare Service Facilities Management (FM)

What is it? Access to an Focus on An outside agency manages the


external specific organisation's IS/IT facilities. The
processing system function, eg client retains equipment but all
on a time-used payroll services provided by FM company
basis

Management Mostly retained Some retained Very little retained


responsibility

Focus Operational A function Strategic

Timescale Short-term Medium-term Long-term

Justification Cost savings More efficient Access to expertise; better service;


management can focus on core
business activities

Managing such arrangements involves deciding what will be outsourced, choosing a supplier and the
supplier relationship.

6.4.1 How to determine what will be outsourced?


What is the system's strategic importance? A third party IT specialist cannot be expected to possess
specific business knowledge.
Functions with only limited interfaces are most easily outsourced, eg payroll.
Do we know enough about the system to manage the arrangement?
Are our requirements likely to change?
The arrangement is incorporated in a contract sometimes referred to as the Service Level Contract (SLC)
or Service Level Agreement (SLA).

142 Business Analysis


Element Comment

Service level Minimum levels of service with penalties for example:


Response time to requests for assistance/information
System 'uptime' percentage
Deadlines for performing relevant tasks
Exit route Arrangements for an exit route, transfer to another supplier or move
back in-house.
Timescale When does the contract expire? Is the timescale suitable for the
organisation's needs or should it be renegotiated?
Software ownership This covers software licensing, security and copyright (if new software is
to be developed).
Dependencies If related services are outsourced, the level of service quality agreed
should group these services together.
Employment issues If the organisation's IT staff are to move to the third party, employer
responsibilities must be specified clearly.

Case example: Barclays


In January 2010 Barclays decided to bring IT application development back in-house after deciding not
C
to renew a 400m outsourcing agreement with Accenture after 6 years. 230 staff that had moved to
H
Accenture at the start of the agreement were to move back to Barclays. Around the same time Barclays A
also decided to bring the management of its desktop facilities back in-house. P
T
The decision to return application development in-house resulted from a strategic review and a desire to E
have the most efficient model that supported its business. Commentators suggested that Barclays had R
faced a situation where the costs of outsourcing had significantly increased because of the extra
expensive services added on to the original outsourcing contract. It might have reached the point where
it had become more cost-effective to take the work back in-house. 3

6.5 Current trends in outsourcing


In an effort to cut costs, many organisations are now outsourcing activities both near shore (such as
Eastern Europe) and offshore (such as the Far East and India).
Improvements in technology and telecommunications and more willingness for managers to manage
people they can't see have fuelled this trend.
Before taking the decision to outsource overseas, a number of points should be considered.
(a) Environmental (location, infrastructure, risk, cultural compatibility, time differences)
(b) Labour (experience in relevant fields, language barriers, size of labour market)
(c) Management (remote management)
(d) Bad press associated with the perception of jobs leaving the home country

Case example: Call centres


The inside of a call centre will look virtually the same wherever it is in the world, similar headsets,
hardware and software being used, for example. With pressure to provide adequate customer service at
low cost, many organisations are closing call centres in parts of Western Europe and relocating to low-
cost countries and regions, such as India and South Africa.
It is claimed that savings on call centre costs range from 35% to 55% for near shore outsourcing and
50% to 75% for offshore outsourcing.

Cost analysis and control 143


6.5.1 Outsourcing to Eastern Europe
The newly-enlarged EU is providing organisations in Western Europe with a range of outsourcing
opportunities. The vast manufacturing facilities that were used to produce for the massive Soviet market,
many of which have been re-equipped, provide the opportunity for manufacturing to be outsourced.
At the moment, labour is relatively cheap in Eastern Europe, and it is closer than the Far East an
important consideration in today's rapidly-moving environment. The fact that English is widely taught
and the existence of a Western culture are added attractions.
There are problems associated with outsourcing to Eastern Europe, however. Operations in many
countries are bound by an excess of red tape, for example, and current political and market uncertainty
in Russia could constrain growth there for some time.

Case example: DHL


In September 2003, DHL, the logistics firm, announced it was shifting its data centre in Britain and parts
of its IT operations in Switzerland to a state-of-the-art services centre in Prague that will oversee all of
the organisation's European IT operations.

6.5.2 Outsourcing to India


Moving back-office functions 'offshore' began in earnest in the early 1990s when organisations such as
American Express, British Airways, General Electric and Swissair set up their own 'captive' outsourcing
operations in India.
The low labour cost in India has always made the outsourcing option attractive. But not only is it cheap,
it is highly skilled. India has one of the most developed education systems in the world. One third of
college graduates speak more than two languages fluently and of the two million graduates per annum,
80% speak English. These language skills, along with improved telecomms capabilities, make it an ideal
choice for call centres. GE, Accenture and IBM have all set up call centres in India.
The vast majority of service jobs being outsourced offshore are paper-based back office ones that can be
digitalised and telecommunicated anywhere around the world, and routine telephone enquiries that can
be bundled together into call centres.

Case example: UK companies outsourcing to India


The number of UK companies outsourcing to near shore or offshore destinations rose from 47% to 57%
in 2007 with all of them using India at least once as the offshore destination of choice. Phil Morris,
managing director of EquaTerra for Europe (an advisory company), explained that India offered all of
the economic advantages that companies were looking for, the legacy of an education system and
somewhere where there is relatively good English.
However in 2011 a trend appeared to be developing for call centre jobs to be moved back to the UK. In
July 2011 telecommunications company, New Call Telecom, announced that it was moving one of its
call centres from India back to the UK. The main reason for this decision was increased salaries and
property and accommodation costs in India.
Also in July 2011 the bank Santander announced it was moving its call centres back to the UK in an
effort to please customers. Santander's chief executive commented that customers had said that this
issue was the most important factor in terms of their satisfaction with the bank. Reports suggested that
Santander had had one of the worse complaints records in the banking industry in 2011.

144 Business Analysis


Summary and Self-test

Summary

Traditional management As more and more


accounting techniques have organisations strive to
numerous limitations in the reduce costs, new
face of the ever-changing techniques have evolved to
business environment. help increase business
efficiency.
C
H
A
P
T
E
R

3
Business process Outsourcing may be
re-engineering focuses employed by organisations
attention on the internal to avoid wasting resources
functions of the on functions that can be
organisation to determine better provided by experts.
how these functions can be
redesigned to improve
efficiency.

Cost analysis and control 145


Self-test
1 Conrad Furniture
Conrad Furniture Company produces good quality furniture in a central workshop and sells it
through its 10 retail stores across the UK. The furniture is manufactured to a high standard and
appeals to customers looking for excellent quality but without the 'frills' expected of a bespoke
manufacturer. Conrad's main expenses are materials for the furniture, direct labour and rental
costs for the retail stores. It holds very little inventory and has been advertising heavily in good
quality home magazines.
With a recent downturn in the furniture market, Conrad is becoming concerned about its cost
levels and the increasing popularity of cheaper furniture. Competitors appear to be moving their
retail outlets away from the high street to out of town malls in a bid to reduce rental costs. As a
result, Conrad's management is considering an intensive cost reduction programme to keep
Conrad competitive in the furniture market.
Requirement
Advise Conrad's management team on the issues they should consider when devising the cost
reduction programme.
2 ABC
ABC has a chain of 20 supermarkets. When inventory items reach their re-order level in a
supermarket the in-store computerised inventory system informs the inventory clerk. The clerk then
raises a request daily to the ABC central warehouse for replenishment of inventories via fax or e-
mail. If the local warehouse has available inventory, it is forwarded to the supermarket within 24
hours of receiving the request. If the local warehouse cannot replenish the inventory from its
inventory holding, it raises a purchase order to one of its suppliers. The supplier delivers the
inventory to the warehouse and the warehouse then delivers the required inventory to the
supermarkets within the area. The ABC area warehouse staff conduct all business communication
with suppliers.
ABC recently contracted an IT consultant to analyse and make recommendations concerning their
current supply chain briefly described above. Following the initial investigation the consultant
reported.
'To enable an established traditional company like ABC to develop a virtual supply chain system it
may be necessary to employ a business process re-engineering (BPR) approach.'
Requirement
With reference to the above scenario, describe what is meant by a business process re-engineering
approach.
3 Controlling outsourcing costs
Explain how control can be exercised over the cost of outsourced services.
4 Coming up Roses
Maggie Flowers is the owner of Coming up Roses, a company specialising in growing plants for
sale to garden centres and to specialist garden designers. With the growth in home ownership and
an increase in leisure time this sector of the economy has seemed recession-proof. The company
has grown over the past 10 years and now has 30 employees, several glasshouses and a turnover of
almost 5 million. The company is located on one site near to a rapidly expanding urban area. The
site is relatively large but there is no room for expansion. If the company is to increase its profits as
a garden nursery it must either acquire additional land for growing plants or it must direct more of
its sales to the ultimate user (the general public) and move away from sales to other intermediaries
(the garden centres) and so obtain higher margins.
Maggie is annoyed when she sees garden centres putting large margins on her products for re-sale.
Why can't Coming up Roses take advantage of these profits, she wonders? She is now
contemplating re-focusing her activities on selling plants and not producing them. It has been
suggested that she turns her growing areas into a garden centre, buying in from other specialist
nurseries and transforming her glasshouse space into selling areas. There is a large market nearby,
with several new housing developments, all generating a huge demand for horticultural products.

146 Business Analysis


Maggie has read that the further one moves downstream in the business chain into dealing
directly with the consumer the greater is the profit margin. She is very tempted by this strategy,
but is not fully convinced of the wisdom of such a move.
Requirements
(a) Examine the arguments that may be used to support or reject such a 'buy instead of grow'
strategy for Coming up Roses.
(b) Outsourcing has become a popular strategy for many companies in attempting to reduce
their commitment to non-core activities. Identify the main management problems such a
policy might generate.

C
H
A
P
T
E
R

Cost analysis and control 147


Answers to Self-test

1 Conrad Furniture
The first thing Conrad has to consider is its future positioning in the market. It is neither appealing
to the top quality bespoke market nor to the customers looking for low prices. If it still wants to be
seen as offering 'middle of the road' quality it should be able to get away with a certain amount of
cost reduction, as there does not appear to be any great expectations from customers. However, if
it does not want to compromise its quality reputation, it should guard against cutting costs too
much, as there comes a point when customers will start to notice differences in the furniture and in
the levels of service.
Conrad has noticed that competitors are moving their retail outlets away from the high street to
save rental costs. This may seem like a good idea but Conrad should determine whether they are
actually in direct competition with these retailers. Are they offering similar quality of products and
similar levels of service? Would Conrad's customers be prepared to switch to these retailers on the
basis of cost alone? Remaining in the high street may be more expensive but might give Conrad
an advantage over these other retailers by being easily accessible, which could lead to more
custom. Conrad should also consider how its customers would view a move to a retail park or
mall. Would it adversely affect its reputation as being a provider of good quality and service?
Retail parks may not be prestigious enough for some customers, although this should not be too
much of a problem given that most of Conrad's customers are looking for excellent quality but
'without the frills'.
A move to an entirely different type of location may affect Conrad's marketing strategy. Is one of
its marketing ploys the fact that the stores are easily accessible, in town centre locations? If so
and if this is the reason the stores attract a lot of trade relocation may not be such a good idea.
Conrad has identified its other main costs as being materials and labour. While these are obvious
targets for a cost reduction programme, Conrad should think about whether using cheaper
materials will affect the quality of its furniture. Likewise, if the manufacture of furniture relies on
specialist labour, it may be difficult to get people of such calibre at a cheaper price. Conrad might
want to consider whether its current sources of materials are offering the best deals in terms of
price but should think carefully before deciding whether cheaper materials could be used. For a
company whose reputation is based on quality, this could be disastrous.
Advertising in expensive magazines may be something to consider. Does this advertising generate
large amounts of revenue? Are expensive magazines reaching the type of customer that Conrad
attracts or is the company being too ambitious? There may be better ways of reaching potential
customers, although Conrad should guard against opting for the cheapest option simply on the
grounds of cost. If it starts advertising in what might be seen as lower quality magazines, this may
again harm its reputation.
Conrad should guard against panicking about costs and take an organised approach to the
programme. While it is correct to be concerned about its cost levels, it should think about the
effects of cutting certain costs on its strategy. The most obvious costs are not always the ones that
should be cut in Conrad's case the materials, labour and rent. Conrad should look at all costs to
determine where the savings could best be made. Are there too many layers of management? Is
there potential for savings in electricity, gas and telephone charges? Just focusing on certain costs
means there is a danger of these costs cut to the extent that the business cannot operate properly.
2 ABC
Business Process Re-engineering (BPR) is the fundamental rethinking and radical design of
business processes to achieve dramatic improvements in critical contemporary measures of
performance, such as cost, quality, service and speed.
In other words, BPR involves significant change in the business rather than minimal or incremental
changes to processes. This is essentially different from procedures such as automation where
existing processes are simply computerised. Although some improvements in speed may be
obtained, the processes are essentially the same. For example, the local warehouse could use EDI to
send an order to the supplier, which may be quicker than email. However, the process of sending
the order and receiving the goods to the warehouse is the same.

148 Business Analysis


Using BPR, the actual reasons for the business processes being used can be queried, and where
necessary replaced with more efficient processes. For example, rather than inventory being ordered
from the store via the central warehouse, the supplier could monitor inventories in each store using
an extranet. When goods reach re-order level, the supplier is aware of this and can send goods
directly to the store. Not only does this provide inventory replenishment much more quickly, it is
also more cost effective for the supplier as the central warehouse effectively becomes redundant.
Key features of BPR involve the willingness of the organisation to accept change and the ability to
use new technologies to achieve those changes. In the example, ABC may have to clearly explain
the benefits to staff from the new systems, to ensure that they are accepted. ABC may also need to
obtain additional skills in terms of IT and ability to implement and use those systems. New
hardware and software will also certainly be required. The aim of BPR is to provide radical
improvements in efficiency and cost savings of up to 90%. Amending the supply chain as noted
above will help to achieve these benefits.
3 Controlling outsourcing costs
The most significant controls will need to be implemented at the planning stage of the
process of outsourcing a service.
The organisation should document details of the level and quality of the service it requires
from the external organisation.
External organisations should then be invited to tender for providing the service. A
documented policy as to the tendering process is required and should cover factors such as
the number of bids required, whether the bids should be sealed and so on.
The organisation must confirm a price for the service with the successful bidder. C
H
On-going control involves ensuring that the service delivered is actually of the contracted A
level and quality (for example, a service level agreement). P
T
The organisation must also give consideration to drawing up policies to deal with problems E
which could arise in the following areas. R

(i) Judging the quality of service provided


(ii) Approving any costs in excess of those agreed 3

(iii) Including a get-out clause in the contract (to be used if the contractor becomes
complacent following a desire by the organisation to build up a long-term relationship)
(iv) Including a price increase clause in the contract (for example, due to inflation or
variations in the quantity of throughput subject to outsourcing)
(v) Reducing prices if the level of service is lower than anticipated
4 Coming up Roses
(a) Coming up Roses is currently profitable and growing. However, the opportunities for
additional growth are limited on the current site. The options are either to acquire new
land or to switch from the current strategy of growing in order to sell to distributors to one of
buying plants from other suppliers to sell direct to the public. There are arguments both for
and against this proposed new strategy.
Arguments for buying instead of growing
Probably the main argument for the proposed switch in strategy would be the higher profit
margins that would be available. At the moment, Maggie is unable to obtain good margins
on her output because she is selling to commercial purchasers who will inevitably seek the
best value for money they can achieve, squeezing Maggie's margins against her production
costs. By moving down the value chain, Maggie could escape this price pressure, since garden
centre products are 'lifestyle' rather than essential purchases and many customers are not
particularly price-sensitive when making such purchases.
At the same time, Maggie could reverse her current position. She would be buying from a
number of specialist nurseries and could seek the best terms available. These could be lower
than her own current production costs, especially where large suppliers are achieving greater
economies of scale than she can in her existing scale of operations.

Cost analysis and control 149


At the same time, Maggie would have access to a wider range of products from general and
specialist suppliers. This would enhance the attractiveness of her garden centre at little cost.
She would be able to make use of her suppliers' expertise in cultivating delicate or exotic
plants in that they would both produce saleable specimens for her and provide advice on how
best to keep and display them.
Arguments against buying instead of growing
Perhaps the most persuasive argument against this strategy is that of core competences. At
the moment, Maggie and the Coming up Roses staff have expertise in growing plants; they
are not used to the processes involved either in buying plants from other suppliers or in selling
to the general public. Not only would working practices have to change, but there may also
be a requirement for new staff with selling rather than horticultural skills.
A further major hurdle is that Maggie would have to finance considerable capital investment
in order to convert the glasshouses into a suitable garden centre.
By buying plants from other suppliers rather than growing them, Coming up Roses risks losing
a degree of control over the quality of the products that it sells. If poor quality products are
sold to the public, this will reflect on Coming up Roses rather than on the original supplier.
It could be argued that Coming up Roses risks disruption to its supplies if it moves away from
growing its own plants. However, as the intention is to buy from a number of suppliers, this is
probably not a major problem. There might also be the fear that if Coming up Roses is not
successful in this new retail operation it may not be able to re-enter the production market.
However as the expertise, technology and capital cost requirements of production are fairly
low, it should not be too difficult a task to re-enter the production market if required.
(b) Outsourcing
Outsourcing enables organisations to concentrate resources on their value-adding core
activities. Despite the popularity of this strategy, however, there are a number of problems
that management may face when outsourcing.
One of the main problems is that of lack of direct control. If a function of a business is
outsourced, its management loses direct managerial control over it. The danger is that this
may result in a poor quality of service, which may require expense and time to remedy.
If outsourcing is to be used successfully, then management must negotiate carefully and set
up systems for review and monitoring of the contract and the services provided under it.
There must also be a system set up for dealing with disputes over quality or service.
A further potential problem related to lack of direct control is that of responsibility. If an
activity is dealt with in-house, then there will be an individual who is directly responsible for
that activity who will report to management on it. If there are problems, the individual
responsible is clearly identifiable. However, if the activity is outsourced it may be harder to
determine who is responsible in the outsourcing agency and therefore disputes may be
harder to settle.
A further problem is the loss of internal competences that accompanies outsourcing. Staff
may leave or be transferred, and those who remain will lose their skills. Plant and equipment
also will be sold or transferred. Finally, this surrender of competence prevents further
improvement in the outsourced function.

150 Business Analysis


Answers to Interactive questions

Answer to Interactive question 1


WORKINGS
Budgeted fixed production cos ts
(1) Fixed production costs absorbed per unit =
Budgeted production

110,000
=
2,200

= 50 per unit
Therefore full cost (absorption cost) per unit = 50 + 70 = 120
(2) Under-/over-absorption of overheads
July August
Actual production 2,000 2,500
Expected production 2,200 2,200
(Under-)/over-production (200) 300
Fixed costs per unit 50 50
(Under-)/over-absorption (10,000) 15,000
Income statements absorption costing
July August C
H
A
Sales (150 per unit) 225,000 450,000 P
Cost of sales: T
Opening inventory Nil 60,000 E
Production 240,000 300,000 R
Less: closing inventory (60,000) Nil
(180,000) (360,000)
Gross profit 45,000 90,000 3
(Under-)/over-absorption (10,000) 15,000
35,000 105,000

Income statements marginal costing


July August

Sales 225,000 450,000
Cost of sales
Opening inventory Nil 35,000
Production 140,000 175,000
Less closing inventory (35,000) Nil
(105,000) (210,000)
Contribution 120,000 240,000
Less fixed costs (110,000) (110,000)
Net profit 10,000 130,000
Difference in profits
July August


Absorption cost profit 35,000 105,000
(Increase)/decrease in
inventory and fixed costs
charged against sales (25,000) 25,000 (500 50)
Marginal cost profit 10,000 130,000
Profits are different under each method due to the fixed costs that are included in closing inventory
with absorption costing.

Cost analysis and control 151


Answer to Interactive question 2
(a)
Overhead cost Cost driver
Set up costs Number of set ups
Materials handling costs Number of times materials handled
Ordering costs Number of orders
Engineering costs Number of spare parts required
(b) Set-up costs per unit

=
(Number of setups per product / Total number of setups) Total set up cos ts
Number of units produced

[(20 / 100) 25,000]


Alpha = = 10.00/unit
500

[(15 / 100) 25,000]


Bravo = = 12.50/unit
300
[(30 / 100) 25,000]
Echo = = 18.75/unit
400
[(35 / 100) 25,000]
Oscar = = 43.75/unit
200
Material handling costs per unit =
(Number of times mats handled per product / Total times mats handled) Total handling cos ts
Number of units produced

[(3 / 15) 69,000]


Alpha = = 27.60/unit
500
Bravo = 61.33/unit
Echo = 23.00/unit
Oscar = 138.00/unit

Ordering costs per unit =


No of orders per product / total no of orders) Total ordering cos ts
Number of units produced

[(11/ 64) 32,000]


Alpha = = 11.00/unit
500
Bravo = 20.00/unit
Echo = 20.00/unit
Oscar = 62.50/unit
Engineering costs/unit =
(No of spare parts per product / total spare parts) Total engineering cos ts
Number of units produced

[(15 / 60) 45,000]


Alpha = =22.50/unit
500
Bravo = 50.00/unit
Echo = 18.75/unit
Oscar = 56.25/unit

152 Business Analysis


Total cost per unit
Alpha Bravo Echo Oscar

Direct costs:
Material 60.00 42.00 80.00 100.00
Labour 32.00 20.00 35.00 50.00
Other costs:
Set-up costs 10.00 12.50 18.75 43.75
Material handling costs 27.60 61.33 23.00 138.00
Ordering costs 11.00 20.00 20.00 62.50
Engineering costs 22.50 50.00 18.75 56.25
163.10 205.83 195.50 450.50
Note: Remember to include the direct costs that were given in the question when calculating the
total cost per unit. This is a common mistake in exam situations.

Answer to Interactive question 3


Total fixed cos ts 425,000
(a) Break even point = = =14,167 pairs of roller skates
Contribution / unit (55 25)

(b) Margin of safety = Current sales units Break even sales units
= 20,000 14,167
= 5,833 pairs of roller skates (29%)
C
Total fixed cos ts Re quired profit H
(c) Required sales revenue to ensure a profit of 25,000: = A
Contribution ratio
P
T
where:
E
Contribution per unit R
Contribution ratio =
Selling price per unit

(65 25) 3
=
65
40
=
65

465,000 25,000
Required sales revenue =
(40 / 65)

= 796,250

Answer to Interactive question 4


The first step is to calculate contribution per unit:
McEnrova Grafassi Federdal
Total sales units 8,000 6,000 4,000
Total contribution () 144,000 132,000 120,000
Contribution per unit 18 22 30
The lowest common denominator for the sales mix is 4:3:2. Assume that sale of racquets in the next
period will be in this mix.
Total contribution for the standard batch is 198 (4 18 + 3 22 + 2 30).
306,900
Break even point in batches = = 1,550 batches
198

Cost analysis and control 153


The number of units of each model that has to be sold in order to break even is:
McEnrova: 1,550 4 = 6,200
Grafassi: 1,550 3 = 4,650
Federdal: 1,550 2 = 3,100
The break even point in terms of sales revenue is:

McEnrova 248,000 (40 6,200)
Grafassi 279,000 (60 4,650)
Federdal 310,000 (100 3,100)
837,000
Check:
McEnrova Grafassi Federdal Total
Sales units 6,200 4,650 3,100
Contribution per unit 18 22 30
Total Contribution () 111,600 102,300 93,000 306,900
Total Fixed Costs () 306,900
Profit/(loss) NIL

Answer to Interactive question 5


(a) The nature of BPR and its application to AB Ltd
A process is 'a collection of activities that takes one or more types of input and creates output that
is of value to the customer'.
Part of this process is manufacture of goods, and so is relevant to AB Ltd. However, a process is
more than just manufacturing, it involves the ordering and delivery of goods to the customer.
Arguably, AB Ltd does not need to manufacture. All aspects of the process, from ordering to
delivery, must be considered.
Key features of BPR
(i) Focus on the outcome, not the task.
(ii) Ignore the current way of doing business. For example, AB Ltd may be divided into
departments. The current organisation structure is not relevant to the process. Indeed having
a large number of departments may make the process harder to manage, as it is split between
several different responsibilities. The same customer's order may be passed from department
to department.
(iii) Carefully determine how to use technology. IT has often been used to automate existing
processes rather than redesign new ones. This means that AB Ltd must have an information
strategy for the company as a whole.
(iv) Review job design. Scientific management split jobs into their smallest components. BPR
suggests that, in some cases, enlarged jobs are more efficient if they lead to fewer people
being involved in the process.
(v) Do the work where it makes most sense. This might affect where sales order processing and
credit controls are carried out.
(vi) Work must be done in logical sequence. This can affect factory layout but also the sequence of
clerical activities.
(vii) Those who perform the process should manage it. The distinction between managers and
workers should be eroded; decision aids such as expert systems should be provided.
(viii) Information provision should be included in the work that produces it.
(ix) The customer should have a single point of contact in the organisation.
In effect, BPR requires the asking of the fundamental question: 'If we were starting from scratch,
what would we do?'

154 Business Analysis


(b) Pitfalls
(i) BPR is an all or nothing proposition. It is thus expensive and risky, requiring major expenditure
on consultancy, investment in IT systems and disruption. It is not worth doing unless there is a
good reason.
(ii) AB Ltd is concerned about overseas competition. There may be other competitive responses
more appropriate than BPR, such as improving quality, outsourcing, a focus strategy or a
differentiation strategy.
(iii) Implementation is difficult, as organisations fail to think through what they are trying to
achieve, and the process becomes captured by departmental interest groups. In AB Ltd, the
production director, sales director and finance director may well conflict. The customer may
deal with all three of them.
(iv) Managers take a departmental view, rather than the view of the business as a whole.
(v) BPR becomes associated only with across the board cost cutting rather than a fundamental re-
evaluation of the business. Managers will fight very hard to avoid any threats to their position.
(vi) Management consultants responsible for the ideas often fail to come up with realistic
strategies for implementation. Managers are thus left with a BPR formula that they may not
fully understand and have to implement it in a hostile work environment.

Answer to Interactive question 6


Outsourcing has always been a feature of business life. It is the natural way to fit a business into the
upstream supply chain, for both goods and services. 'Make or buy' is a classic cost accounting
problem. Also, it has long been used by businesses too small to be able to establish in-house sources of C
highly specialised or expensive goods and services such as legal services and safety equipment. H
A
More recently, in an increasingly competitive and globalised business environment, outsourcing has P
become popular largely because it holds out the promise of reduced costs. Cost reductions become T
E
possible for two main reasons. First, the provider may be able to achieve economies of scale by
R
concentrating some aspect of the production or service process. Second, particularly in work employing
low-skilled labour, a major employer is better placed to exert downward pressure on wage rates than
are a large number of businesses employing a few staff each, especially when casual, part-time or
3
temporary work patterns predominate.
A further potential advantage is the increased effectiveness that can arise from greater specialisation.
This can be achieved both by the supplier, who concentrates on a particular type of work, and by the
purchaser, whose executives are liberated from the management of peripheral activities.
Bonanza seems to be in the middle of outsourcing its call-centre operation and is wondering how far to
take it. It could certainly expect to achieve the cost reductions mentioned above. It is now quite
common for call centre work to be outsourced to countries with lower labour costs, such as India.
However, there have been complaints from customers about poor service, so the potential for
improved efficiency has not yet been achieved. This may illustrate an important disadvantage of
outsourcing, which is the potential for loss of control of the work involved.
The significance of this loss extends beyond concerns about quality. There is also a loss of managerial
expertise relating to the outsourced function or activity. This means that when changes occur in the
market or the environment, it may be much more difficult to plan a suitable response. It will be
necessary to consult with the service providers concerned and, naturally enough, they will have their
own priorities that affect their stance.
The customer dissatisfaction and staff union resistance illustrate a further disadvantage to outsourcing,
which is its potential for generating stakeholder concern. It is natural enough that staff union
organisers should be opposed to anything that threatens their members' livelihood and their own status.
Managing this opposition would be difficult enough; when customers find a reason to be sympathetic
to the unions' stand, Bonanza is likely to find itself having to adjust its policy.
Stakeholder concern about outsourcing was of particular importance to British Airways in 2005, when a
dispute arose at Gate Gourmet, its Heathrow in-flight catering supplier. Gate Gourmet had, in fact, been
spun off from BA some years previously. The dispute caused extensive delays to BA flights out of
Heathrow, not merely because of disruption to catering supplies, but because BA's baggage handlers,
many of whom were related to Gate Gourmet staff, stopped work in sympathy.

Cost analysis and control 155


156 Business Analysis
CHAPTER 4

Investment appraisal

Introduction
Topic List
1 Overview of investment appraisal techniques
2 Adjusted present value
3 Modified internal rate of return
4 Real options
5 Firms with product options
6 Investment appraisal and risk
7 International investment appraisal
Summary and Self-test
Answers to Self-test
Answers to Interactive questions

157
Introduction

Learning objectives Tick off

Demonstrate a detailed understanding and application of the investment appraisal


techniques studied at the Professional stage that is, Payback, Accounting Rate of Return,
Net Present Value and Internal Rate of Return
Apply advanced knowledge and understanding of Modified Internal Rate of Return and
Adjusted Present Value through calculations. These techniques were also covered at the
Professional stage
Demonstrate and apply more advanced knowledge of real options, including the options
to abandon, expand, delay and redeploy
Demonstrate and apply detailed knowledge of the quantitative and qualitative issues
surrounding international investment appraisal

158 Business Analysis


1 Overview of investment appraisal techniques

Section overview
This section reviews investment appraisal techniques that were covered in detail at the Professional
stage. Detailed knowledge of Payback, Accounting Rate of Return (ARR), Net Present Value (NPV),
Internal Rate of Return (IRR) and Adjusted Present Value (APV) are still expected at the Advanced
stage and you should refer to earlier materials for an in-depth analysis of each of these techniques.

1.1 Summary of techniques


1.1.1 Payback period
Payback is the amount of time it takes to recover the cash paid for the initial investment that is, the
time it takes for cash inflows = cash outflows. The project will be feasible if actual payback period is less
than (<) predetermined acceptable payback period.

1.1.2 Discounted payback


The discounted payback period is the time it will take before a project's cumulative NPV turns from
being negative to being positive. A company can set a target discounted payback period (say, five years)
and choose not to undertake any projects with a period in excess of this target.

1.1.3 Accounting rate of return (ARR)


This can be calculated in two ways:
Average annual profit from investment
ARR = 100
Initial investment

Average annual profit from investment


Or 100
Average investment

Initial outlay Scrap value


where average investment =
2
Note: profit is after depreciation
C
Project will be feasible if project ARR is greater than (>) predetermined minimum acceptable ARR. H
A
P
1.1.4 Net present value (NPV) T
E
The net present value of a prospective project with a life of N years is defined as follows. R
N NCFt
NPV -i
t 0
t 1 (1 k) 4
where:
NCFt is the net cash flow that is received in period t
k is the cost of capital for the project
i0 is the initial investment
Firms should invest in projects whose NPV > 0 and should not invest in those projects whose NPV 0.

1.1.5 Internal rate of return (IRR)


The internal rate of return in any investment is the discount rate that equates the present value of its
expected net revenue stream to its initial outlay. For normal projects (that is, initial investment followed
by a series of cash inflows), the project is feasible if IRR > cost of capital. The main problem with IRR is
that it assumes that cash flows will be reinvested at the IRR rather than at the cost of capital.

Investment appraisal 159


1.2 Other issues inflation and taxation
1.2.1 Inflation
The relationship between money rate of return, real rate of return and inflation rate is as follows.
(1 + m) = (1 + r) (1 + i)
Where: m is the money rate of return
r is the real rate of return
i is the inflation rate
If cash flows are stated in money terms, they should be discounted at the money rate; if cash flows are
stated in real terms, they should be discounted at the real rate.

1.2.2 Taxation
Tax writing-down allowances (WDA) are available on non-current assets which allows a company's tax
bill to be reduced. Unless told otherwise, WDA will be 20% reducing balance and tax is paid on profits
in the same year.

Interactive question 1: Investment appraisal techniques [Difficulty level: Easy]


Robbie plc is considering investing in a new piece of machinery which will cost 500,000. The
company has already spent 15,000 on exploratory work on the new machine.
Net cash inflows from the machine are expected to be 200,000 per annum. The machine has a useful
life of four years after which it will be sold for 50,000. Depreciation is charged on the straight-line
basis and Robbie plc's cost of capital is 10%.
Requirement
Calculate the following.
(i) Payback period
(ii) Accounting Rate of Return
(iii) Net Present Value
(iv) Internal Rate of Return
See Answer at the end of this chapter.

Interactive question 2: NPV with inflation and taxation [Difficulty level: Intermediate]
Bazza plc is considering the purchase of some new equipment on 31 December 20X0 which will cost
350,000. The equipment has a useful life of five years and a scrap value on 31 December 20X5 of
60,000.
Annual cash inflows generated from the equipment are expected to be 110,000, with operating cash
outflows of 15,000 per annum.
Inflation is running at 4% per annum over the life of the project and tax allowances are available on a
20% reducing balance basis. Tax is paid in the same year as the profits on which the tax is charged.
Corporation tax rate is 23% per annum and there is no writing-down allowance in the year of sale.
Bazza's cost of capital is 12%.
Requirement
Calculate the NPV of the project based on the above information and advise Bazza plc on whether the
project should be undertaken.
See Answer at the end of this chapter.

160 Business Analysis


2 Adjusted present value

Section overview
Adjusted Present Value (APV) combines the ungeared value of a cash flow stream with the tax
effect of any borrowings as a separate element of value.

The adjusted present value (APV) calculation starts with the valuation of a company without debt then,
as debt is added to the firm, considers the net effect on firm value by looking at the benefits and costs
of borrowing. The primary benefit of borrowing is assumed to be the tax benefit (interest is tax
deductible) whilst the main cost of borrowing is the added risk of bankruptcy.
The decision rule is to accept the project as long as its total worth is greater than the outlay required.

2.1 Estimating the value of the firm with APV


The value of the firm is estimated in three steps. The first step is to estimate the value of the firm with
no gearing. The present value of the interest tax savings generated by borrowing a given amount of
money is then considered. Finally, an evaluation of the effect of borrowing the said amount on the
probability of the firm going bankrupt is carried out, together with the expected cost of bankruptcy.

Worked example: APV valuation


A company has a current annual cash flow to the firm of 10m which is expected to grow at 3% in
perpetuity.
The equity beta of the company is 1.2; market debt to equity ratio is 80%; and the tax rate is 23%.
The company has 120 million debt. The risk premium for the market portfolio is 8% and the risk-free
interest rate is 6%. What is the value of the firm using the APV method?

Solution
(i) Calculate the ungeared beta using the following formula:
D(1 T)
e = a (1 + )
E C
H
Where: A
P
e = beta of equity in the geared firm
T
a = ungeared (asset) beta E
R
D = market value of debt
E = market value of equity
4
T = corporate tax rate
1.2 = a [1 + (0.8) (1 0.23)]
1.2 = 1.616a
a = 0.74
(ii) Estimate ungeared cost of equity using CAPM:
Ungeared cost of equity = 6% + 0.74(8%) = 11.92%, say 12%
(iii) Calculate value of ungeared firm:
FCFF0 (1 g) (1 T)NOI(1 g)
VU
k e,u g k e,u g

Investment appraisal 161


where:
FCFF is free cash flow of the firm
ke, u is the cost of capital of the ungeared firm
NOI is net operating income before interest and tax
g is the growth rate
T is the corporate tax rate
Using the free cash flow to the firm that we have been given as 10m and the growth rate of 3%,
the ungeared firm value is estimated as:
Ungeared firm value = (1 0.23) 10 1.03/ (0.12 0.03) = 88.1 million
(iv) Tax benefits from debt:
The tax benefits from debt are computed based on the company's existing sterling debt of 120m
and the tax rate of 23%:
Expected tax benefits in perpetuity = Tax rate (Debt) = 0.23(120) = 27.6m
(v) Estimate the value of the firm:
Value of geared firm = Ungeared firm value + PV of tax benefits = 88.1m + 27.6m = 115.7m
What should be remembered is that the true worth of the tax shield may be zero (Miller's 1977
conclusion). Although this is still subject to empirical testing in the real world, the value of the tax
shield, while maybe not zero, may be substantially less than that suggested by Modigliani and
Miller's with-tax analysis. Where this is the case, the APV method may have little benefit over the
NPV method.

Interactive question 3: APV valuation [Difficulty level: Intermediate]


Mega Millions Inc is considering investing in a project with annual after-tax cash flows of 2.5 million
per annum for five years. Initial investment cost is 8 million.
The debt capacity of the company will increase by 10 million over the life of the project, with issue
costs of debt of 300,000. Interest rates are expected to remain at 8% for the duration of the project.
The existing cost of equity for the company is 14% and the current ratio of market value of debt: market
value of equity is 1:3. Corporation tax is 23% and the company's current equity beta is 1.178. The risk
free rate of interest is 7% and the market risk premium is 6%.
Requirement
Calculate the APV of the project and recommend whether Mega Millions should undertake the
investment with the proposed method of financing.
See Answer at the end of this chapter.

3 Modified internal rate of return

Section overview
The modified internal rate of return (MIRR) is the IRR that would result without the assumption
that project proceeds are reinvested at the IRR rate.

In comparing the IRR to the NPV criterion in Section 1 above, we identified the assumption of
reinvestment rate as one of the problems with the IRR. A way to resolve this problem is to allow the
specification of the reinvestment rate. This modification is known as the modified internal rate of return
(MIRR).

162 Business Analysis


3.1 Calculating the MIRR

Worked example: Modified IRR


Consider a project requiring an initial investment of $24,500, with cash inflows of $15,000 in years 1
and 2 and cash inflows of $3,000 in years 3 and 4. The cost of capital is 10%.

Solution
If we calculate the IRR:
Discount Present Discount Present
Year Cash flow factor value factor value
$ 10% $ 25% $
0 (24,500) 1.000 (24,500) 1.000 (24,500)
1 15,000 0.909 13,635 0.800 12,000
2 15,000 0.826 12,390 0.640 9,600
3 3,000 0.751 2,253 0.512 1,536
4 3,000 0.683 2,049 0.410 1,230
5,827 (134)
5,827
IRR = 10% + (25% 10%) = 24.7%
5,827 134
The MIRR is calculated on the basis of investing the inflows at the cost of capital.
The table below shows the values of the inflows if they were immediately reinvested at 10%. For
example the $15,000 received at the end of year 1 could be reinvested for three years at 10% pa
(multiply by 1.1 1.1 1.1 = 1.331).
Interest rate Amount when
Year Cash inflows multiplier reinvested
$ $
1 15,000 1.331 19,965
2 15,000 1.21 18,150
3 3,000 1.1 3,300
4 3,000 1.0 3,000
44,415
C
The total cash outflow in year 0 ($24,500) is compared with the possible inflow at year 4, and the H
resulting figure of: A
P
24,500 T
= 0.552 E
44,415
R
is the discount factor in year 4. By looking along the year 4 row in present value tables you will see that
this gives a return of 16%. This means that the $44,415 received in year 4 is equivalent to $24,500 in
year 0 if the discount rate is 16%. 4

Alternatively, instead of using discount tables, we can calculate the MIRR as follows.
44,415
Total return = = 1.813
24,500

4
MIRR = 1.813 1
= 1.16 1
= 16%
In theory the MIRR of 16% will be a better measure than the IRR of 24.7% (see below).

Investment appraisal 163


3.2 Decision criterion
The decision criterion of the MIRR is the same as the IRR that is:
If MIRR is larger than the required rate of return: ACCEPT
If MIRR is lower than the required rate of return: REJECT

Interactive question 4: Modified IRR [Difficulty level: Easy]


The following cash flows are relevant for a project:
Year 0 Year 1 Year 2 Year 3
Cash outflows () 10,000 0 0 0
Cash inflows () 0 3,000 5,000 7,000
If the discount rate is 10% what is the modified internal rate of return?
See Answer at the end of this chapter.

3.3 Advantages of modified internal rate of return


There are two main technical advantages to the MIRR. First, it avoids any potential problems with
multiple IRRs, and additionally, it will not provide decision-making advice concerning mutually exclusive
projects that conflicts with the NPV decision. The second problem arises as a result of the IRR decision
being incorrectly based on the assumption that cash flows would be reinvested at the IRR. With MIRR, it
is assumed that cash flows are reinvested at the project's opportunity cost of capital, which is consistent
with NPV calculations.
MIRR could be seen as being the best of both worlds, as it is underpinned by NPV, but at the same time
presents results in the more understandable percentage format.

3.4 Disadvantages of modified internal rate of return


However, MIRR, like all rate of return methods, suffers from the problem that it may lead an investor to
reject a project which has a lower rate of return but, because of its size, generates a larger increase in
wealth.
In the same way, a high-return project with a short life may be preferred over a lower-return project
with a longer life.

4 Real options

Section overview
Real options give the right to the management of a company to make decisions when it is
profitable for the company. Real options were covered at the Professional stage. However, the
topic is taken further at the Advanced stage by providing greater detail of the types of options
available and also considering the process of how to value such options.
Real options are not derivative instruments in the way that traded options such as those for
interest rate and foreign currency hedging are. Real options are very useful in the context of
selecting strategies.

A real option is the right, but not the obligation, to undertake a business decision, such as capital
investment for example, the option to open a new branch is a real option. Unlike financial options,
real options are not tradable for example, the company cannot sell the right to open another branch
to a third party. While the term 'real option' is relatively new, businesses have been making such
decisions for a long time.

164 Business Analysis


This type of option is not a derivative instrument, in the same way as foreign currency and interest rate
options. Real options pertain to physical or tangible options (that is, choice) hence the name. For
example, with research and development, firms have the option (choice) to expand, contract or
abandon activities in a particular area in the future. Pharmaceutical companies such as GlaxoSmithKline
are making such choices all the time.
Real options can have a significant effect on the valuation of potential investments, but are typically
ignored in standard discounted cash flow analysis, where a single expected NPV is computed.
In this section we review the various options embedded in projects and provide examples. In Chapter 7
we illustrate how to estimate the value of real options using the Black-Scholes method.

4.1 Option to delay


When a firm has exclusive rights to a project or product for a specific period, it can delay taking this
project or product until a later date. A traditional investment analysis just answers the question of
whether the project is a 'good' one if taken at a particular point in time eg today. Thus, the fact that a
project is not selected today either because its NPV is negative, or its IRR is less than its cost of capital,
does not mean that the rights to this project are not valuable.
Take a situation where a company is considering paying an amount C to acquire a licence to mine
copper. The company needs to invest an extra amount I in order to start operations. The company has
three years over which to develop the mine, otherwise it will lose the licence. Suppose that today
copper prices are low and the NPV from developing the mine is negative. The company may decide not
to start the operation today, but it has the option to start any time over the next three years provided
that the NPV is positive. Thus the company has paid a premium C to acquire an American-style option
on the present value of the cash flows from operation, with an exercise price equal to the additional
investment (I). The value of the option to delay is therefore:
NPV = PV I if PV > I
NPV = 0 otherwise
The payoff of the option to delay is shown below and it is the same as the payoff of a call option: the
only difference being that the underlying is the present value and the exercise price is the additional
investment.

C
H
A
P
T
E
R

4.2 Option to expand


The option to expand exists when firms invest in projects which allow them to make further investments
in the future or to enter new markets. The initial project may be found in terms of its NPV as not worth
undertaking. However, when the option to expand is taken into account, the NPV may become positive
and the project worthwhile. The initial investment may be seen as the premium required to acquire the
option to expand.

Investment appraisal 165


Expansion will normally require an additional investment, call it I . The extra investment will be
undertaken only if the present value from the expansion will be higher than the additional investment,
ie when PV > I . If PV I , the expansion will not take place. Thus the option to expand is again a call
option of the present value of the firm with an exercise price equal to the value of the additional
investment.

4.3 Option to abandon


Whereas traditional capital budgeting analysis assumes that a project will operate in each year of its
lifetime, the firm may have the option to cease a project during its life. This option is known as an
abandonment option. Abandonment options, which are the right to sell the cash flows over the
remainder of the project's life for some salvage value, are like American put options. When the present
value of the remaining cash flows (PV) falls below the liquidation value (L) , the asset may be sold.
Abandonment is effectively the exercising of a put option. These options are particularly important for
large capital intensive projects such as nuclear plants, airlines, and railroads. They are also important for
projects involving new products where their acceptance in the market is uncertain and companies
would like to switch to more profitable alternative uses.

166 Business Analysis


4.4 Option to redeploy
The option to redeploy exists when the company can use its assets for activities other than the original
one. The switch from one activity to another will happen if the PV of cash flows from the new activity
exceeds the costs of switching. The option to abandon is a special case of an option to redeploy.
These options are particularly important in agricultural settings. For example, a beef producer will value
the option to switch between various feed sources, preferring to use the cheapest acceptable alternative.
These options are also valuable in the utility industry. An electric utility, for example, may have the
option to switch between various fuel sources to produce electricity. In particular, consider an electric
utility that has the choice of building a coal-fired plant or a plant that burns either coal or gas.
Nave implementation of discounted cash flow analysis might suggest that the coal-fired plant be
constructed since it is considerably cheaper. Whereas the dual plant costs more, it provides greater
flexibility. Management has the ability to select which fuel to use and can switch back and forth
depending on energy conditions and the relative prices of coal and gas. The value of this operating
option should be taken into account.

4.5 Valuation of real options


The valuation of options will be dealt with in Chapter 7 Financial Engineering.

5 Firms with product options

Section overview
A product option is where the firm has the ability to sell a product in the future but does not have
the obligation to do so.
Traditional valuation techniques may not be suitable for such organisations.
The option-based approach to valuation may be more suitable.

Examples of product options are patents and copyrights, and firms owning natural resources. Firms that
have product options are often research and technology-based.
C
When a firm has a product option that is not currently generating cash flow, there is a risk that a
H
discounted cash flow approach to valuation will not fully reflect the full value of the option. This is A
because a DCF approach may not incorporate all the possible future cash flows of the company. P
T
E
5.1 Problems with traditional DCF techniques R

In the context of a product option, the DCF approach is not fully appropriate, for the following reasons.
The options represent a current asset of the business, but are not generating any cash flows. 4

Any cash flows expected to be generated by the product could be outside of the detailed
forecasting period.

5.2 Possible solutions to the valuation problem


There are three possible methods of valuing product options.
Value the option on the open market. This is only possible if there is a traded market in such
options. If there is no active market or if the option is difficult to separate from the other operations
of the firm, this approach is probably not feasible.
Use a traditional DCF framework and factor in a higher growth rate than would be justified given
the existing assets of the firm. The problem with this is that any growth rate used will be
subjective. In addition, it expresses contingent cash flows as expected cash flows.
Use an option-based approach to valuation. This is considered below.

Investment appraisal 167


5.3 Use of option pricing models
The principles of option pricing are discussed in detail in Chapter 7 Financial Engineering.

5.3.1 Problems with using option pricing models to value product options
The problems of using option pricing models, such as Black-Scholes, are as follows.
They need the underlying asset to be traded. This is because the model is based on the principle
of arbitrage, which means that the underlying asset must be easy to buy and sell. This is not a
problem when valuing options on quoted shares. However, the underlying asset in the context of
product options will not be traded, meaning that arbitrage is not possible.
They assume that the price of the underlying asset follows a continuous pattern. While this
may be a reasonable approximation most of the time for quoted shares, it is clearly inappropriate
in the context of product options. The impact of this is that the model will undervalue deeply out-
of-the-money options, since it will underestimate the probability of a sudden large increase in the
value of the underlying asset.
They assume that the standard deviation of price of the underlying asset is known and does
not vary over the life of the option. While this may be a reasonable assumption in the context of
short-dated equity options, it is not appropriate for long-term product options.
They assume that exercise occurs at a precise point in time. In the case of product options,
exercise may occur over a long period of time. For example, if a firm has the right to mine natural
resources, it will take time to extract the resources. This will reduce the present value of the asset.

5.3.2 Using option pricing models to value product patents


When valuing product patents as options, the key inputs for an option pricing will need to be identified,
being the underlying asset price, the strike price, the expected volatility of the underlying asset price
and the time to expiry. The following approach could be adopted.
Identify the value of the underlying asset. This will be based on the expected cash flows that the
asset can generate. Given the uncertain nature of the cash flows and the distant time periods in
which they may arise, it clearly will be difficult to value the underlying asset precisely.
Identify the standard deviation of the cash flows above. Again this will be difficult to identify,
owing to changes in the potential market for the product, changes in technology and so on. It
would, however, be possible to use techniques such as scenario analysis. The higher the standard
deviation, the more valuable the asset.
Identify the exercise price of the option. This is the cost of investing in the resources needed to
produce the asset. It is typically assumed that this remains constant in present value terms, with
any uncertainty being reflected in the cash flows of the asset.
Identify the expiry date of the option. This is when the patent expires. Any cash flows after this
date are expected to have an NPV of zero, since there will be generic competition after patent
protection ends.
Identify the cost of delay. If the product is not implemented immediately, this will reduce the
value of the cash flows from the project as competing products will enter the market in future
years.
A similar approach could be adapted to valuing other product options, such as natural resources. Where a
company is investing in research and development, but has no patents developed, the same approach will
apply, but the value of the option is clearly even more uncertain due to the greater uncertainty of the
inputs.

168 Business Analysis


6 Investment appraisal and risk

Section overview
Risk was covered in detail in Chapter 2 and was also dealt with in the Professional stage Financial
Management paper. This section deals with risk from the viewpoint of how it affects investment
appraisal.
Risk can be applied to a situation where there are several possible outcomes and, on the basis of
past relevant experience, probabilities can be assigned to the various outcomes that could prevail.
Uncertainty can be applied to a situation where there are several possible outcomes but there is
little past relevant experience to enable the probability of the possible outcomes to be predicted.
There is a wide range of techniques for incorporating risk into project appraisal. This section
examines the use of sensitivity analysis and expected values as ways of incorporating risk.

A distinction should be made between the terms risk and uncertainty.

Risk Several possible outcomes


On basis of past relevant experience, assign probabilities to outcomes

Uncertainty Future possible outcomes


Little past experience, thus difficult to assign probabilities to outcomes

A risky situation is one where we can say that there is a 70% probability that returns from a project will
be in excess of 100,000 but a 30% probability that returns will be less than 100,000. If however, no
information can be provided on the returns from the project, we are faced with an uncertain situation.

In general, risky projects are those whose future cash flows, and hence the project returns, are likely to
be variable. The greater the variability is, the greater the risk. The problem of risk may be more acute
with capital investment decisions than other decisions for the following reasons.
Estimates of capital expenditure might be for several years ahead, such as for major construction
projects. Actual costs may escalate well above budget as the work progresses.
Estimates of benefits will be for several years ahead sometimes 10, 15 or 20 years ahead or even C
longer, and such long-term estimates can at best be approximations. H
A
An investment decision may be significant in scale compared to most operating decisions. P
T
A major investment may be part of a new business strategy, or new venture, which may be more E
uncertain than operating decisions which are part of an ongoing strategy. R

6.1 Sensitivity analysis 4


Sensitivity analysis assesses how responsive the project's NPV is to changes in the variables used to
calculate the NPV. One particular approach to sensitivity analysis the certainty-equivalent approach
involves the conversion of the expected cash flows of the project to riskless equivalent amounts.
The basic approach of sensitivity analysis in the context of an investment decision is to calculate the
project's NPV under alternative assumptions to determine how sensitive it is to changing conditions. An
indication is thus provided of those variables to which the NPV is most sensitive and the extent to which
those variables would need to change before the investment results in a negative NPV.
The NPV could depend on a number of uncertain independent variables.
Selling price
Sales volume
Cost of capital
Initial cost
Operating costs

Investment appraisal 169


Benefits
Cost savings
Residual value
Sensitivity analysis therefore provides an indication of why a project might fail. Management should
review critical variables to assess whether or not there is a strong possibility of events occurring which
will lead to a negative NPV. Management should also pay particular attention to controlling those
variables to which the NPV is particularly sensitive, once the decision has been taken to accept the
investment.
A simple approach to deciding which variables the NPV is particularly sensitive to is to calculate the
sensitivity of each variable.
NPV
Sensitivity = %
Pr esent value of project var iable

The lower the percentage, the more sensitive is NPV to that project variable as the variable would need
to change by a smaller amount to make the project non-viable.

Worked example: Sensitivity analysis


Kenney Co is considering a project with the folowing cash flows.
Year Initial investment Variable costs Cash inflows Net cash
flows
'000 '000 '000 '000
0 7,000
1 (2,000) 6,500 4,500
2 (2,000) 6,500 4,500

Cash flows arise from selling 650,000 units at 10 per unit. Kenney Co has a cost of capital of 8%.
Requirement
Measure the sensitivity of the project to change in variables.

Solution
The PVs of the cash flow are as follows.
Discount PV of initial PV of variable PV of cash PV of net
Year factor 8% investment costs inflows cash flow
'000 '000 '000 '000
0 1.000 (7,000) (7,000)
1 0.926 (1,852) 6,019 4,167
2 0.857 (1,714) 5,571 3,857
(7,000) (3,566) 11,590 1,024
The project has a positive NPV and would appear to be worthwhile. The sensitivity of each project variable
is as follows.

(a) Initial investment


1,024
Sensitivity = 100 = 14.6%
7,000

(b) Sales volume


1,024
Sensitivity = 100 = 12.8%
11,590 3,566

(c) Selling price


1,024
Sensitivity = 100 = 8.8%
11,590

170 Business Analysis


(d) Variable costs
1,024
Sensitivity = 100 = 28.7%
3,566

(e) Cost of capital. We need to calculate the IRR of the project. Let us try discount rates of 15% and 20%.
Net cash Discount Discount
Year flow factor PV factor PV
15% 20%
'000 '000 '000
0 (7,000) 1 (7,000) 1 (7,000)
1 4,500 0.870 3,915 0.833 3,749
2 4,500 0.756 3,402 0.694 3,123
NPV 317 NPV (128)

317 _
IRR = 0.15 + (0.20 0.15) = 18.56%
317 128

The cost of capital can therefore increase by 132% before the NPV becomes negative.
The elements to which the NPV appears to be most sensitive are the selling price followed by the
sales volume. Management should thus pay particular attention to these factors so that they can be
carefully monitored.

6.1.1 Weakness of this approach to sensitivity analysis


These are as follows:
The method requires that changes in each key variable are isolated. However, management is more
interested in the combination of the effects of changes in two or more key variables.
Looking at factors in isolation is unrealistic since they are often interdependent.
Sensitivity analysis does not examine the probability that any particular variation in costs or
revenues might occur.
C
Critical factors may be those over which managers have no control. H
A
In itself it does not provide a decision rule. Parameters defining acceptability must be laid down by P
the managers. T
E
R
Interactive question 5: Sensitivity analysis [Difficulty level: Easy]
Nevers Ure Co has a cost of capital of 8% and is considering a project with the following 'most-likely'
4
cash flows.
Year Purchase of plant Running costs Cost savings

0 (7,000)
1 2,000 6,000
2 2,500 7,000
Requirement
Measure the sensitivity (in percentages) of the project to changes in the levels of expected costs and
savings.
See Answer at the end of this chapter.

Investment appraisal 171


6.2 The certainty-equivalent approach

Worked example: Certainty-equivalent approach


Dark Ages Co, whose cost of capital is 10%, is considering a project with the following expected cash
flows.
Year Cash flow Discount factor Present value
10%
$ $
0 (9,000) 1.000 (9,000)
1 7,000 0.909 6,363
2 5,000 0.826 4,130
3 5,000 0.751 3,755
NPV + 5,248

The project seems to be clearly worthwhile. However, because of the uncertainty about the future cash
receipts, the management decides to reduce them to 'certainty-equivalents' by taking only 70%, 60%
and 50% of the Years 1, 2 and 3 cash flows respectively. (Note that this method of risk adjustment
allows for different risk factors in each year of the project.) These 'certainty-equivalents' should then be
discounted at a risk free rate.
Requirement
On the basis of the information set out above, assess whether the project is worthwhile. Assume that the
risk free rate is 5%.

Solution
The risk-adjusted NPV of the project is as follows.
Year Cash flow Discount factor Present value
5%
$ $
0 (9,000) 1.000 (9,000)
1 4,900 0.952 4,667
2 3,000 0.826 2,721
3 2,500 0.864 2,160
NPV 548

The project appears to be worthwhile after adjusting for uncertainty and should be accepted.

6.3 Probability analysis


A probability analysis of expected cash flows can often be estimated and used both to calculate
expected NPV and to measure risk. The standard deviation of the NPV can be calculated to assess risk
when the construction of probability distributions is complex.
A probability distribution of 'expected cash flows' can often be estimated, recognising there are several
possible outcomes, not just one. This may be used to do the following.

Step 1 Calculate an expected value of NPV

Step 2 Measure risk, for example in the following ways


By calculating the worst possible outcome and its probability
By calculating the probability that the project will fail to achieve a positive NPV

172 Business Analysis


Worked example: Probability estimates of cash flows
A company is considering a project involving the outlay of 300,000 which it estimates will generate
cash flows over its two year life at the probabilities shown in the following table.
Year 1
Cash flows Probability

100,000 0.25
200,000 0.50
300,000 0.25
1.00
Year 2
If cash flow in Year 1 is: there is a probability of: that the cash flow in Year 2 will
be:

100,000 0.25 Nil
0.50 100,000
0.25 200,000
1.00
200,000 0.25 100,000
0.50 200,000
0.25 300,000
1.00
300,000 0.25 200,000
0.50 300,000
0.25 350,000
1.00

The company's cost of capital is 10%.


Requirement
Calculate the expected value (EV) of the project's NPV and the probability that the NPV will be negative.

Solution
Step 1 Calculate expected value of the NPV
First, we need to draw up a probability distribution of the expected cash flows. We begin by calculating C
the present values of the cash flows. H
A
Year Cash Discount Present P
flow factor value T
10% E
'000 '000 R
1 100 0.909 90.9
1 200 0.909 181.8
1 300 0.909 272.7 4
2 100 0.826 82.6
2 200 0.826 165.2
2 300 0.826 247.8
2 350 0.826 289.1

Investment appraisal 173


Year 1 PV of Probability Year 2 PV of Probability Joint Total PV of EV of PV of
cash flow cash flow probability cash inflows cash inflows
'000 '000 '000 '000
(a) (b) (c) (d) (b) (d) (a) + (c)
90.9 0.25 0.0 0.25 0.0625 90.9 5.681
90.9 0.25 82.6 0.50 0.1250 173.5 21.688
90.9 0.25 165.2 0.25 0.0625 256.1 16.006
181.8 0.50 82.6 0.25 0.1250 264.4 33.050
181.8 0.50 165.2 0.50 0.2500 347.0 86.750
181.8 0.50 247.8 0.25 0.1250 429.6 53.700
272.7 0.25 165.2 0.25 0.0625 437.9 27.369
272.7 0.25 247.8 0.50 0.1250 520.5 65.063
272.7 0.25 289.1 0.25 0.0625 561.8 35.113 3
344.420

EV of PV of cash inflows 344,420
Less: project cost 300,000
EV of NPV 44,420

Step 2 Measure risk

Since the EV of the NPV is positive, the project should go ahead unless the risk is unacceptably high. The
probability that the project will have a negative NPV is the probability that the total PV of cash inflows is
less than 300,000. From the column headed 'Total PV of cash inflows' we can establish that this
probability is 0.0625 + 0.125 + 0.0625 + 0.125 = 0.375 or 37.5%. This might be considered an
unacceptably high risk.

6.3.1 Problems with expected values


There are the following problems with using expected values in making investment decisions.
An investment may be one-off, and 'expected' NPV may never actually occur.
Assigning probabilities to events is highly subjective.
Expected values do not evaluate the range of possible NPV outcomes.

7 International investment appraisal

Section overview
International investment appraisal was covered briefly at the Professional stage but is analysed in
more depth here.
Many of the projects that companies appraise may have an international dimension. Companies
that undertake overseas projects are exposed to such risks as exchange rate movements, political,
cultural, litigation and taxation risks, all of which will be considered in this section.
Investment appraisal techniques for multinational companies must therefore incorporate these
additional complexities into the decision-making process.

With international investment appraisal, multinational companies must take into account factors that
affect the behaviour of the economies of those countries which have an impact on their projects. For
example, in appraising a tourist development, a company may be making assumptions about the
number of tourists from abroad who may be visiting. This will be affected by such factors as interest
rates, tax rates and inflation in the countries from which tourists may visit. If interest and tax rates rise,
potential tourists will have less money to spend and spending on such luxuries as foreign holidays may
decline. Exchange rates will also have an impact on the number of foreign visitors for example, there
would be an increase in the number of UK visitors to the USA if the pound strengthened significantly
against the US dollar.

174 Business Analysis


7.1 Effects of exchange rate assumptions on project values
Changes in exchange rates are as important as the underlying profitability in selecting an overseas
project.
In a domestic project the NPV was calculated using the formula:
n NCF TV
NPV = t + n -I
t 0
t = 1 1+ WACC 1+ WACC n
where:
NCF is net cash flow
WACC is the weighted average cost of capital
TV is the terminal value
I is the initial investment
When a project in a foreign country is assessed we must take into account some specific considerations
such as local taxes, double taxation agreements, and political risk that affect the present value of the
project. The main consideration of course in an international project is the exchange rate risk, that is the
risk that arises from the fact that the cash flows are denominated in a foreign currency. An appraisal of
an international project requires estimates of the exchange rate.

7.1.1 Calculating NPV for international projects


There are two alternative methods for calculating the NPV from an overseas project. For a UK company
investing overseas, we can:
(a) Convert the project cash flows into sterling and then discount at a sterling discount rate to
calculate the NPV in sterling terms;
(b) Discount the cash flows in the host country's currency from the project at an adjusted discount rate
for that currency, and then convert the resulting NPV at the spot exchange rate.

Worked example: Overseas investment appraisal


Bromwich plc, a UK company, is considering undertaking a new project in Portugal. This will require
initial capital expenditure of 1,250m, with no scrap value envisaged at the end of the five-year lifespan.
C
There will also be an initial working capital requirement of 500m, which will be recovered at the end of
H
the project. The initial capital will therefore be 1,750m. Pre-tax net cash inflows of 800m are A
expected to be generated each year from the project. P
T
Company tax will be charged in Portugal at a rate of 40%, with depreciation on a straight-line basis E
being an allowable deduction for tax purposes. Portuguese tax is paid at the end of the year following R
that in which the taxable profits arise.
There is a double taxation agreement between the UK and Portugal, which means that no UK tax will be
4
payable on the project profits.
The current / spot rate is 1.6, and the euro is expected to appreciate against the by 5% per year.
A project of similar risk recently undertaken by Bromwich plc in the UK had a required post-tax rate of
return of 10%.
Requirement
Calculate the present value of the project.

Investment appraisal 175


Solution
Method 1 conversion of flows into sterling and discounting at the sterling discount rate
0 1 2 3 4 5 6
Euro flows (m)
Capital 1750 500
Net cash flows 800 800 800 800 800
Depreciation 250 250 250 250 250
Tax 220 220 220 220 220
1750 800 580 580 580 1080 220
Exchange rate 1.60 1.52 1.44 1.37 1.30 1.24 1.18
/
Cash flows in
sterling 1093.75 526.32 401.66 422.80 445.05 872.34 187.05
Discount factor 1.000 0.909 0.826 0.751 0.683 0.621 0.564
PV* 1093.75 478.47 331.95 317.66 303.98 541.65 105.59
NPV in sterling 774.37
*
using unrounded discount rates

Interactive question 6: International investment appraisal [Difficulty level: Intermediate]


Donegal, a UK company, is considering whether to establish a subsidiary in Ruritania (where the
currency is the $), at a cost of $2,400,000. This would be represented by non-current assets of
$2,000,000 and working capital of $400,000. The subsidiary would produce a product which would
achieve annual sales of $1,600,000 and incur cash expenditures of $1,000,000 a year.
The company has a planning horizon of four years, at the end of which it expects the realisable value of
the subsidiary's non-current assets to be $800,000. It expects also to be able to sell the rights to make
the product for $500,000 at the end of four years.
It is the company's policy to remit the maximum funds possible to the parent company at the end of each
year.
Tax is payable at the rate of 35% in Ruritania and is payable one year in arrears.
Tax allowable depreciation is at a rate of 20% on a straight line basis on all non-current assets.
Administration costs of 100,000 per annum will be incurred each year in the UK over the expected life
of the project.
The UK taxation rate on UK income and expenditure is 23%, payable one year in arrears. Assume there
is full double taxation relief in operation between the UK and Ruritania.
The Ruritanian $: exchange rate is 5:1.
The company's cost of capital for the project is 10%.
Requirement
Calculate the NPV of the project.
See Answer at the end of this chapter.

Method 2 discounting foreign cash flows at an adjusted discount rate


When we use the second method we need to find the cost of capital for the project in the host country.
If we are to keep the cash flows in euros, and they need to be discounted at a rate that takes account of
both the UK discount rate (10%) and the rate at which the exchange rate is expected to decrease (5%).
As this is an application of the international Fisher effect which is covered in Chapter 7 Financial
Engineering, we will demonstrate the calculations for this method in that chapter.

176 Business Analysis


7.1.2 The effect of exchange rates on NPV
Now that we have created a framework for the analysis of the effects of exchange rate changes on the
net present value from an overseas project we can calculate the impact of exchange rate changes on the
sterling denominated NPV of a project.
When there is a devaluation of sterling relative to a foreign currency, the sterling value of the cash flows
increases and the NPV increases. The opposite happens when the domestic currency appreciates. In this
case the sterling value of the cash flows declines and the NPV of the project in sterling declines. The
relationship between NPV in sterling and the exchange rate is shown in the diagram below (where 'e' is
the exchange rate):

NPV

0 e

Worked example: Effect of changes in the exchange rate


Calculate the NPV for the Portugal project of Bromwich plc (see previous worked example on overseas
investment appraisal for details) under three different scenarios.
(a) The exchange rate remains constant at 1.60 for the duration of the project
(b) Sterling appreciates 5 per cent every year
(c) Sterling depreciates 5 per cent every year.

Solution
The NPV under the three scenarios is given in the table below.
Cash flows in m
Constant C
H
Cash flows exchange Sterling depreciates 5% Sterling appreciates 5%
A
Period in m rate per year per year P
0 1750 1093.75 1093.75 1093.75 T
1 E
800 500 526.32 476.19
R
2 580 362.5 401.66 328.80
3 580 362.5 422.80 313.14
4 580 362.5 445.05 298.23 4
5 1080 675 872.34 528.88
6 220 137.5 187.05 102.60
Present
value in 521.83 774.38 320.32
sterling

7.2 Forecasting cash flows from overseas projects

7.2.1 Effect on exports


When a multinational company sets up a subsidiary in another country, in which it already exports, the
relevant cash flows for the evaluation of the project should take into account the loss of export earnings
in the particular country. The NPV of the project should take explicit account of this potential loss by
deducting the loss of export earnings from the relevant net cash flows.

Investment appraisal 177


7.2.2 Taxes
Taxes play an important role in the investment appraisal as they can affect the viability of a project. The
main aspects of taxation in an international context are:
Corporate taxes in the host country
Investment allowances in the host country
Withholding taxes in the host country
Double taxation relief in the home country
Foreign tax credits in the home country
The importance of taxation in corporate decision-making is demonstrated by the use of tax havens by
some multinationals as a means of deferring tax on funds prior to their repatriation or reinvestment.
A tax haven is likely to have the following characteristics.
(a) Tax on foreign investment or sales income earned by resident companies, and withholding tax on
dividends paid to the parent, should be low.
(b) There should be a stable government and a stable currency.
(c) There should be adequate financial services support facilities.
The international aspects of the effects of taxes on investment appraisal are covered fully in the
Advanced stage Tax Study Manual.
For example, suppose that the tax rate on profits in the Federal West Asian Republic is 20% and the
UK corporation tax is 23%, and there is a double taxation agreement between the two countries. A
subsidiary of a UK firm operating in the Federal West Asian Republic earns the equivalent of 1 million in
profit, and therefore pays 200,000 in tax on profits. When the profits are remitted to the UK, the UK
parent can claim a credit of 200,000 against the full UK tax charge of 230,000, and hence will only
pay 30,000.

7.2.3 Subsidies
Many countries offer concessionary loans to multinational companies in order to entice them to invest in
the country. The benefit from such concessionary loans should be included in the NPV calculation. The
benefit of a concessionary loan is the difference between the repayment when borrowing under market
conditions and the repayment under the concessionary loan.

7.2.4 Exchange restrictions


In calculating the NPV of an overseas project, only the proportion of cash flows that are expected to be
repatriated should be included in the calculation of the NPV.

7.2.5 Impact of transaction costs on NPV for international projects


Transaction costs are incurred when companies invest abroad due to currency conversion or other
administrative expenses. These should also be taken into account.

7.3 Transaction, translation and economic exposure


7.3.1 Transaction exposure
Transaction exposure occurs when a company has a future transaction that will be settled in a foreign
currency. This gives rise to a foreign exchange exposure. The cost of foreign obligations could rise as a
result of the home currency weakening, or the home currency value of foreign revenues could
depreciate as a result of a stronger home currency.

7.3.2 Translation exposure


Translation exposure occurs in multinational corporations that have foreign subsidiaries with assets and
liabilities denominated in foreign currency. Translation exposure occurs because the value of these
amounts is eventually stated as per IAS 21 in the presentation currency (normally the domestic currency
of the parent) in the company's financial statements. In general, as exchange rates change, the home
currency value of the foreign subsidiaries' assets and liabilities will change. Such changes can result in

178 Business Analysis


translation losses or gains, which will be recognised in financial statements. The nature and structure of
the subsidiaries' assets and liabilities determine the extent of translation exposure to the parent
company.
It could be argued that translation exposure does not constitute a risk to an organisation as it is simply
an accounting problem and does not affect the inflow or outflow of cash. The extent to which it
constitutes a risk depends on the significance placed on the published accounting numbers.

7.3.3 Economic exposure


Economic exposure is the degree to which the present value of a firm's future cash flows is affected by
fluctuations in exchange rates.
It differs from transaction exposure in that exchange rate changes may affect the value of the firm even
though the firm is not involved in foreign currency transactions. Consider, for example, a UK
manufacturer producing a product for the UK market only. It does not use any imported materials and
does not export to other countries. The manufacturer does not have transaction exposure but does
have economic exposure as an appreciation of the pound in relation to other currencies may make
imports cheaper, potentially leading to UK consumers preferring the products of overseas competitors.
Revenue and profits will therefore fall.
Even when the exchange rate of the home currency remains constant, exporting firms still face
economic exposure. Consider a UK manufacturer that exports to the US and whose main competitor is a
Japanese firm. A devaluation of the yen relative to the US dollar will make Japanese imports cheaper in
the US, thus reducing demand for UK goods. The dollar/sterling exchange rate has not moved, but the
UK manufacturer is still experiencing economic exposure.

7.4 Political risk


Political risk was covered at the Professional stage. However, it is useful to remind ourselves of its
meaning and how it may affect a company's position.

Definition
Political risk is the possibility that political actions in another country will affect the investing company's
value and position.

C
H
A
As soon as a multinational company decides to operate in another country, it is exposing itself to P
political risk. Host countries' governments, in an attempt to protect domestic industries or to protect T
their countries from exploitation, may impose such measures as quotas, tariffs or legal safety and quality E
standards, which can affect the efficient and effective operation of the multinational's activities. R

Multinationals can assess the extent of political risk by considering such factors as government stability,
level of import restrictions and economic stability in the country in which it proposes to invest. 4

7.5 Cultural risk


Cultural risk was considered briefly at the Professional stage but is examined in more detail here.
Cultural risk affects the products and services produced and the way in which organisations are
managed and staffed. Businesses should take cultural risks into account when deciding where to sell
abroad and the extent to which activities should be centralised.
Whenever a business operates in a foreign country, it exposes itself to the additional uncertainty of
dealing with unfamiliar languages, customs and laws. Communications between parties may be difficult
and business opportunities jeopardised through ignorance of how transactions should be conducted. In
Asian countries for example, a business card must be presented with both hands and the recipient
should study it briefly rather than just putting it into a briefcase or pocket. Any other behaviour is
considered to be rude and may get business relationships off on the wrong footing.

Investment appraisal 179


Businesses should familiarise themselves with:
Cultures and practices of customers and consumers in different markets
Media and distribution systems in host countries
Different ways of doing business overseas
The degree to which national cultural differences matter for the product concerned
The degree to which a firm can use its own national culture as a selling point

7.5.1 Deciding which markets to enter


Making the right choices about which markets to enter is a key element in dealing with cultural risk.
Some products are extremely sensitive to the environmental differences, which bring about the need
for adaptation; others are not at all sensitive to these differences, in which case standardisation is
possible.

Environmentally sensitive Environmentally insensitive

Adaptation necessary Standardisation possible


Fashion clothes Industrial and agricultural products
(commodity type products)
Convenience foods World market products, eg jeans

7.5.2 Management of human resources


The balance between local and expatriate staff must be managed. There are a number of influences.
The availability of technical skills such as financial management
The need for control
The importance of product and company experience
The need to provide promotion opportunities
Costs associated with expatriates such as travel and higher salaries
Cultural factors
For an international company, which has to think globally as well as act locally, there are a number of
problems.
Do you employ mainly expatriate staff to control local operations?
Do you employ local managers, with the possible loss of central control?
Is there such a thing as the global manager, equally at home in different cultures?

7.6 Litigation risk


Litigation risks can be reduced by keeping abreast of changes, acting as a good corporate citizen and
lobbying. Failure to do so may result in infringements of local laws and policies, potentially leading to
costly lawsuits.

7.6.1 Legal impacts


Companies may face government legislation or action in any jurisdiction that extend over the whole
range of activities. Important areas may include:
Export and import controls for political, environmental or health and safety reasons. Such controls
may not be overt but instead take the form of bureaucratic procedures designed to discourage
international trade or protect home producers.
Favourable trade status for particular countries for example, EU membership.
Acceptance of international trademark, copyright and patent conventions. Not all countries
recognise such international conventions.
Restrictions on promotional messages, methods and media.

180 Business Analysis


One example of the problems of enforcing intellectual property legislation in certain markets is the case
of Imperial Tobacco. The British company had major problems enforcing its rights in Indonesia where a
local company, Sumatra, stole the trademark of Imperial Tobacco's premium cigarette brand, Davidoff.
The problem was not with the law, but its enforcement, and it took a ruling by the Indonesian Supreme
Court to enforce Imperial Tobacco's rights.

7.6.2 Dealing with legal risks


Consequences of non-compliance. Businesses that fail to comply with the law run the risk of legal
penalties and bad publicity. Issues of legal standards and costs have significant implications for
companies that trade internationally. Companies that meet a strict set of standards in one country
may be accused of hypocrisy if their practices are laxer elsewhere. High costs of compliance may
ultimately lead to enforced relocation.
Keep up to date with likely changes in policy, despite the fact that policies in many areas may be
slow to change in reality.
Good citizenship compliance with best practice and being responsive to ethical concerns can
help to minimise the risk of government intervention. Today's best practice often becomes
tomorrow's legislation.
Ensure that the company keeps abreast of changes in the law and that staff are kept fully informed.

C
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Investment appraisal 181


Summary and Self-test

Summary

182 Business Analysis


Self-test
1 A project has the following estimated cash flows:
Year 0 Year 1 Year 2 Year 3 Year 4
Initial investment -75,000 0 0 0 0
Net cash inflows 0 19,000 25,000 30,000 32,000
What is the modified internal rate of return if the project's cost of capital is 8%? Based on this
information, should the company invest in the project? Give reasons for your answer.
2 PG plc
PG plc is considering investing in a new project in Canada which will have a life of four years.
The initial investment is C$150,000, including working capital. The net after-tax cash flows which
the project will generate are C$60,000 per annum for Years 1, 2 and 3 and C$45,000 in Year 4.
The terminal value of the project is estimated at C$50,000, net of tax.
The current spot rate of C$ against sterling is 1.7000. Economic forecasters expect sterling to
strengthen against the Canadian dollar by 5% per annum over the next four years.
The company evaluates UK projects of similar risk at 14%.
Requirement
Calculate the NPV of the Canadian project.
3 Muggins plc
Muggins plc is evaluating a project to produce a new product. The product has an expected life of
four years. Costs associated with the product are expected to be as follows.
Variable costs per unit
Labour: 30
Materials:
6kg of material X at 1.64 per kg
3 units of component Y at 4.20 per unit
Other variable costs 4.40
Indirect costs each year
C
Apportionment of head office salaries 118,000 H
A
Apportionment of general building occupancy 168,000 P
T
Other overheads 80,000 of which 60,000 represent additional cash expenditures (including rent E
of machinery). R

To manufacture the product a production manager will have to be recruited at an annual gross
cost of 34,000 and one assistant manager, whose current annual salary is 30,000, will be
4
transferred from another department, where he will be replaced by a new appointee at a cost of
27,000 a year.
The necessary machinery will be rented. It will be installed in the company's factory. This will take
up space that would otherwise be rented to another local company for 135,000 a year. This rent
(for the factory space) is not subject to any uncertainty, as a binding four-year lease would be
created.
60,000 kg of material X are already in inventory, at a purchase value of 98,400. They have no use
other than the manufacture of the new product. Their disposal value is 50,000.

Investment appraisal 183


Expected sales volumes of the product, at the proposed selling price of 125 a unit, are as follows.
Year Expected sales
Units
1 10,000
2 18,000
3 18,000
4 19,000
All sales and costs will be on a cash basis and should be assumed to occur at the end of the year.
Ignore taxation.
The company requires that certainty-equivalent cash flows have a positive NPV at a discount rate of
14%. Adjustment factors to arrive at certainty-equivalent amounts are as follows.
Year Costs Benefits
1 1.1 0.9
2 1.3 0.8
3 1.4 0.7
4 1.5 0.6
Requirement
Assess on financial grounds whether the project is acceptable.
4 Zedland Postal Services
The general manager of the nationalised postal service of a small country, Zedland, wishes to
introduce a new service. This service would offer same-day delivery of letters and parcels posted
before 10am within a distance of 150km. The service would require 100 new vans costing $8,000
each and 20 trucks costing $18,000 each. 180 new workers would be employed at an average
annual wage of $13,000 and five managers at average annual salaries of $20,000 would be moved
from their existing duties, where they would not be replaced.
Two postal rates are proposed. In the first year of operation letters will cost $0.525 and parcels
$5.25. Market research undertaken at a cost of $50,000 forecasts that demand will average 15,000
letters each working day and 500 parcels each working day during the first year, and 20,000 letters
a day and 750 parcels a day thereafter. There is a five day working week and a 52 week year.
Annual running and maintenance costs on similar new vans and trucks are estimated in the first
year of operation to be $2,000 a van and $1,000 a truck. Annual running and maintenance costs
on new vans and trucks will increase by 25% a year. Vehicles are depreciated over a five year
period on a straight line basis. Depreciation is tax allowable and the vehicles will have negligible
scrap value at the end of five years. Advertising in year one will cost $1,300,000 and year two
$263,000. There will be no advertising after year two. Existing premises will be used for the new
service but additional costs of $150,000 a year will be incurred in year 1.
All the above data are based on price levels in the first year and exclude any inflation effects. Staff
and premises costs are expected to rise because of inflation by approximately 5% a year during the
five year planning horizon of the postal service. The government of Zedland will not allow the
prices charged by nationalised industries to increase by more than 5%.
Nationalised industries are normally required by the government to earn at least an annual after tax
return of 5% on average investment and to achieve, on average, at least zero net present value on
their investments.
The new service would be financed half with internally generated funds and half by borrowing on
the capital market at an interest rate of 12% a year. The opportunity cost of capital for the postal
service is estimated to be 14% a year. Corporate taxes in Zedland, to which the postal service is
subject, are at the rate of 30% for annual profits of up to $500,000 and 40% for the balance in
excess of $500,000. Tax is payable one year in arrears. The postal service's taxable profits from
existing activities exceed $10,000,000 a year. All transactions may be assumed to be on a cash
basis and to occur at the end of the year with the exception of the initial investment which would
be required almost immediately.

184 Business Analysis


Requirements
Acting as an independent consultant prepare a report advising whether the new postal service
should be introduced. Include in your report a discussion of other factors that might need to be
taken into account before a final decision is made on the introduction of the new postal service.
State clearly any assumptions that you make.

C
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T
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Investment appraisal 185


Answers to Self-test

1 PVOUTFLOWS = I0 = 75,000
3 2
TV = 19,000 x 1.08 + 25,000 1.08 + 30,000 x 1.08 + 32,000
= 117,495

117,495 0.25
MIRR 1 0.1188 or 11.88%
75,000
As MIRR > required rate of return (8%), the company should accept the project.
2 PG plc
Year 0 Year 1 Year 2 Year 3 Year 4
Investment C$'000 (150) 50
After tax cash flows C$'000 60 60 60 45
Net cash C$'000 (150) 60 60 60 95
Exchange rate 1.7000 1.7850 1.8743 1.9680 2.0664

Net cash '000 (88.24) 33.61 32.01 30.49 45.97


14% discount factors 1.000 0.877 0.769 0.675 0.592
PV in '000 (88.24) 29.48 24.62 20.58 27.21
NPV in '000 13.65

3 Muggins plc
Certainty-equivalent cash flows
Year 1 Year 2 Year 3 Year 4
'000 '000 '000 '000
Sales (W1) 1,125 1,800 1,575 1,425

Material X (W2) 50 230 248 280


Other variable costs (W3) 517 1,100 1,184 1,340
Management salaries (W4) 67 79 85 92
Rental: opportunity cost 135 135 135 135
Other overheads 66 78 84 90
835 1,622 1,736 1,937
Sales less cash costs 290 178 (161) (512)
Discount factor at 14% 0.877 0.769 0.675 0.592
Present value 254 137 (109) (303)

The net present value is -21,000, so the project is not acceptable.


WORKINGS
Year 1 10,000 125 0.9
(1) Sales
Year 2 18,000 125 0.8
Year 3 18,000 125 0.7
Year 4 19,000 125 0.6
(2) Material X Year 1 50,000 opportunity cost
Year 2 18,000 6 1.64 1.3
Year 3 18,000 6 1.64 1.4
Year 4 19,000 6 1.64 1.5
(3) Other variable costs Per unit: 30 + 3 + (3 4.20) + 4.40 = 47
Year 1 10,000 47 1.1
Year 2 18,000 47 1.3
Year 3 18,000 47 1.4
Year 4 19,000 47 1.5

186 Business Analysis


(4) Management salaries Year 1 34,000 + 27,000 = 61,000 1.1
Year 2 61,000 1.3
Year 3 61,000 1.4
Year 4 61,000 1.5
4 Zedland Postal Services
From: A N Accountant
To: The Board of directors
Date: 1 April 20X9
Subject: Proposed new same day service
Introduction
This report considers whether the proposed new service will meet the two targets of a return on
investment of at least 5% and a non-negative net present value. It also considers other factors
which may be relevant. Calculations are set out in the Appendix.
Recommendation
The proposed new service has an annual average return on average investment of 30%, but it
has a negative net present value ($24,000). Because projects must meet both targets to be
acceptable, it is recommended that the service is not provided. However, this is subject to the
further factors considered below.
Non-financial factors
The proposed service might well be of great value to the public. It should perhaps be provided on
that ground.
If the postal service's other projects have large positive net present values, it might be possible to
net them off against the negative net present value here, to give an acceptable overall result. This
is, of course, tantamount to cross-subsidisation.
It may be that charges could be increased and/or costs reduced, so that the net present value
could become positive.
Before any final decision is taken, the reliability of all forecasts should be reviewed, and a
sensitivity analysis should be carried out.
APPENDIX C
H
1 Return on average investment A
P
Year 1 2 3 4 5 T
$'000 $'000 $'000 $'000 $'000 E
R
Revenue
Letters 2,048 2,867 3,010 3,160 3,318
Parcels 682 1,075 1,129 1,185 1,244 4
2,730 3,942 4,139 4,345 4,562
Expenses
Staff 2,340 2,457 2,580 2,709 2,844
Premises 150 158 165 174 182
Vehicle maintenance
Vans 200 250 313 391 488
Trucks 20 25 31 39 49
Advertising 1,300 263
Depreciation 232 232 232 232 232
4,242 3,385 3,321 3,545 3,795
Revenue less expenses (1,512) 557 818 800 767
Taxation (40%) 605 (223) (327) (320) (307)
Profit after tax (907) 334 491 480 460

Investment appraisal 187


Total profit after tax = $858,000

Average profit after tax = $858,000/5 = $171,600

Average investment =$1,160,000/2 = $580,000

$171,600
Average annual after tax return on investment = 100% = 30%
$580,000

2 Net present value


Year 0 1 2 3 4 5 6
$'000 $'000 $'000 $'000 $'000 $'000 $'000
Revenue less expenses (1,512) 557 818 800 767
Add depreciation 232 232 232 232 232
Taxation 605 (223) (327) (320) (307)
Initial investment (1,160)
Cash flow (1,160) (1,280) 1,394 827 705 679 (307)
Discount factor (14%) 1 0.877 0.769 0.675 0.592 0.519 0.456
Present value (1,160) (1,123) 1,072 558 417 352 (140)
Net present value = ($24,000).
3 Assumptions made

(a) The inflation rate, for both revenue per unit and costs (excluding depreciation) will
be 5%.

(b) The cost of preliminary research is to be ignored, as it has already been incurred.

(c) If the five managers were not needed for this new service, they would remain in their
present posts rather than being made redundant.

(d) Return on average investment is to be computed ignoring financing costs.

188 Business Analysis


Answers to Interactive questions

Answer to Interactive question 1


Note: The exploratory work of 15,000 is a sunk cost and is therefore not relevant when appraising the
project.
(i) Payback period
In this case, the payback period will be the amount of time it will take Robbie plc to earn
500,000.
Cumulative
Year Cash flow cash flow

1 200,000 200,000
2 200,000 400,000
3 200,000 600,000
Payback is therefore 2 years + (100,000/200,000) = 2.5 years
(ii) Accounting rate of return (ARR)
Average Accounting Pr ofit
ARR
Average Investment

Accounting Profit = Cash flow Depreciation


Cost Re sale value
Depreciation
Useful life
500,000 50,000
=
4
= 112,500pa
Average profit per annum = 200,000 112,500
= 87,500 C
H
Cost Re sale value A
Average Investment =
2 P
T
500,000 50,000 E
= = 275,000 per annum R
2

87,500
ARR = 31.8%
275,000 4

(iii) Net present value


Year 0 Year 1 Year 2 Year 3 Year 4

Initial investment (500,000)
Cash flow 200,000 200,000 200,000 200,000
Resale proceeds 50,000
Net cash flow (500,000) 200,000 200,000 200,000 250,000
Discount factor (10%) 1.000 0.909 0.826 0.751 0.683
Discounted cash flow (500,000) 181,800 165,200 150,200 170,750

NPV = 167,950
(iv) Internal rate of return (IRR)
To calculate IRR, we generally find one discount rate with a positive NPV and another discount rate
that results in NPV being negative. This is generally carried out using trial and error.

Investment appraisal 189


We already have a positive NPV when the discount rate is 10%. When trial and error is applied, we
find that NPV at a 30% discount rate is (49,300).
167,950
IRR = 10 + (30 10)
(167,950 49,300)

IRR = 25.5%

Answer to Interactive question 2


WORKINGS (all figures in )
(1) Tax writing-down allowances (WDA)
Year WDA/Written-down value Tax saved
at 23%
20X0 350,000
WDA (20%) (70,000) 16,100
20X1 280,000
WDA (56,000) 12,880
20X2 224,000
WDA (44,800) 10,304
20X3 179,200
WDA (35,840) 8,243
20X4 143,360
WDA (28,672) 6,595
20X5 114,688
Proceeds (60,000)
Balancing all 54,688 12,578
(2) Inflation computations
20X1 20X2 20X3 20X4 20X5
Net cash inflows 95,000 98,800 102,752 106,862 111,136
(3) Tax computations
20X1 20X2 20X3 20X4 20X5
Tax at 23% of net
cash inflows 21,850 22,724 23,633 24,578 25,561

NPV calculation
20X0 20X1 20X2 20X3 20X4 20X5
Initial (350,000)
Investment
Cash (net) 95,000 98,800 102,752 106,862 111,136
Tax (23%) (21,850) (22,724) (23,633) (24,578) (25,561)
WDA/Bal all 16,100 12,880 10,304 8,243 6,595 12,578
Sale 60,000
(333,900) 86,030 86,380 87,362 88,879 158,153
Dis. factor 1.000 0.893 0.797 0.712 0.636 0.567
DCF (333,900) 76,825 68,845 62,202 56,527 89,673
NPV = 20,172
As NPV is positive, the project is feasible and should be undertaken.

190 Business Analysis


Answer to Interactive question 3
Step 1 Calculate NPV of the project with the original cost of equity with no gearing.
Ungeared beta
D(1 T)
e = a (1 + )
E
1.178 = a (1 + (1 (1 0.23/3)))
a = 0.94
Ungeared cost of equity (using CAPM)
= Rf + a market premium
= 7 + 0.94 6
= 12.6% (say 13%)
Discounted cash flow using 13% as the discount rate
Year 0 12345
m m m m m m
Initial investment (8)
Annual cash flow 2.5 2.5 2.5 2.5 2.5
Annuity factor (13% for 5 years) = 3.517
NPV = (8m) + 3.517 2.5m = 0.79m

Step 2 Calculate the present value of the tax shield from debt financing.
Interest payable = 10m 8% = 0.8m
Tax saved = 0.8 23% = 0.184m
Discount at cost of debt (8%) over 5 years = 0.184 3.993
= 0.735m

Step 3 Issue costs = 300,000


APV = 0.79m 0.3m + 0.74m
C
= 1.23m H
A
As APV is positive, the project should be undertaken with the proposed method of P
financing. T
E
R
Answer to Interactive question 4
PVOUTFLOWS = 10,000
4
Value of inflows if reinvested at the 10% cost of capital
Interest rate Amount when
Year Cash inflows multiplier reinvested

1 3,000 1.21 3,630
2 5,000 1.1 5,500
3 7,000 1.0 7,000
16,130
3
MIRR = (16,130/10,000) 1 = 17.28%

[The IRR for the project is 20.13%. The reason it is higher is because the IRR assumes a reinvestment rate
of 20.13% rather than 10% which we have used.]

Investment appraisal 191


Answer to Interactive question 5
The PVs of the cash flows are as follows.
Year Discount factor PV of plant PV of running PV of savings PV of net cash
8% cost costs flow

0 1.000 (7,000) (7,000)
1 0.926 (1,852) 5,556 3,704
2 0.857 (2,143) 5,999 3,856
(7,000) (3,995) 11,555 560

The project has a positive NPV and would appear to be worthwhile. Sensitivity of the project to changes
in the levels of expected costs and savings is as follows.
560
(a) Plant costs sensitivity = 100 8%
7,000

560
(b) Running costs sensitivity = 100 14%
3,995

560
(c) Savings sensitivity = 100 4.8%
11,555

Answer to Interactive question 6


Time
0 1 2 3 4 5
$'000 cash flows
Sales receipts 1,600 1,600 1,600 1,600
Costs (1,000) (1,000) (1,000) (1,000)
Tax allowable depreciation (brought
in to calculate taxable profit) (400) (400) (400) (400)
$ taxable profit 200 200 200 200
Taxation (70) (70) (70) (70)
Add back tax allowable depreciation
(as not a cash flow) 400 400 400 400
Capital expenditure (2,000)
Scrap value 800
Tax on scrap value (W1) (140)
Terminal value 500
Tax on terminal value (175)
Working capital (400) 400
(2,400) 600 530 530 2,230 (385)
Exchange rates 5:1 5:1 5:1 5:1 5:1
'000 cash flows
From/(to) Ruritania (480) 120 106 106 446 (77)
Additional UK expenses/income (100) (100) (100) (100)
UK tax effect of UK expenses/income 23 23 23 23
Net sterling cash flows (480) 20 29 29 369 (54)
UK discount factors 1 0.909 0.826 0.751 0.683 0.621
Present values (480) 18.2 24.0 21.8 252.0 (33.5)

NPV = (197,500), therefore the company should not proceed.

WORKINGS
(1) Tax is payable on $400,000 as tax written down value = $2,000,000 (4 $400,000) = $400,000

192 Business Analysis


CHAPTER 5

Business and securities


valuation

Introduction
Topic List
1 Valuation techniques
2 Company valuation: general principles
3 Valuing acquisitions
4 Valuing debt
5 Unquoted companies and start-ups
Summary and Self-test
Answers to Self-test
Answers to Interactive questions

193
Introduction

Learning objectives Tick off

Demonstrate a detailed understanding and application of different methods of business


and securities valuation, including asset-based, income-based and cash-based methods
Demonstrate a detailed knowledge and understanding of when the use of each valuation
technique is most appropriate
Apply appropriate techniques to the valuation of acquisitions and mergers and
demonstrate ability to perform relevant calculations to value such activities

Demonstrate a detailed understanding and application of methods of valuing debt

194 Business Analysis


1 Valuation techniques

Section overview
This section looks at the valuation techniques you may be required to use in an exam situation.
You should be familiar with the Shareholder value analysis (SVA) technique that was covered in
the Professional stage Financial Management paper.

1.1 Shareholder value


1.1.1 Value-based management (VBM)
VBM starts with the philosophy that the value of a company is measured by its discounted future cash
flows. Value is created only when companies invest capital at returns that exceed the cost of that
capital. VBM extends this philosophy by focusing on how companies use the idea of value creation to
make both major strategic and everyday operating decisions. So VBM is an approach to management
that aligns the strategic, operational and management processes to focus management decision-making
on what activities create value.

1.1.2 Value drivers


A value driver is any variable that affects the value of the company. They should be ranked in terms of
their impact on value and responsibility assigned to individuals who can help the organisation meet its
targets. Value drivers can be difficult to identify as it requires an organisation to think about its
processes in a different way and existing reporting systems are often not equipped to supply the
necessary information. It has been suggested that a good way of relating a range of value drivers is to
use scenario analysis (covered in Chapter 2). It is a way of assessing the impact of different sets of
mutually consistent assumptions on the value of a company or its business units.

1.1.3 Shareholder value analysis (SVA)


SVA is the process of analysing how certain decisions affect the net present value of cash to
shareholders. At the corporate level it provides a framework for evaluating options for improving
shareholder value by determining the trade-offs between reinvesting cash in the company, distributing
cash to shareholders and investing in new businesses.
SVA consists of three primary analyses:
Determining the present value of the costs of all investments using the appropriate cost of capital
Estimating the economic value of the business by discounting its expected cash flows to find their
present values
Determining the economic value of the business by finding the difference between the above
elements

1.1.4 Economic Value Added (EVA)


EVA = Net Operating Profit after Tax (NOPAT) WACC Capital Employed C
H
OR
A
EVA = (ROIC WACC) Capital Employed (where ROIC = Return on invested capital) P
T
E
R

Business and securities valuation 195


Case example: EVA
The derivation of EVA can be illustrated using an example.
Year 20X5 20X6

Sales 2,000
Expenses other than interest 800
Depreciation 300
Earnings before interest and taxes (EBIT) 900
Taxes on EBIT @ 23% 207
Earnings before interest and after taxes (NOPAT) 693

Current assets less excess cash and securities 400 380


Non-interest bearing current liabilities 100 120
Adjusted net working capital 300 260

Gross property, plant and equipment 3,200 3,500


Accumulated depreciation 1,000 1,300
Net property, plant and equipment 2,200 2,200

Invested capital 2,500 2,460


Return on invested capital (NOPAT/invested capital) 27.72%
Based on previous year's invested capital

The calculation of EVA takes place as follows.

EVA calculation: Method 1


Invested capital 2,500
Times cost of capital 12%
Capital charge 300

NOPAT 693
Less capital charge (300)
EVA 393

EVA calculation: Method 2


ROIC 27.72%
Less: cost of capital 12%
Excess return 15.72%

Invested capital 2,500


Times: excess return 15.72%
EVA 393

Essentially EVA is an estimate of the amount by which earnings exceed or fall short of the required
minimum rate of return for shareholders or lenders at similar risk. It can be used at divisional as well as
corporate level and is based on the idea that a business must cover both its operating costs and its
capital costs. It can be used for such purposes as capital budgeting, performance measurement and
corporate valuation.
The NOPAT figure should not be that taken directly from the financial statements, but will contain
numerous adjustments (eg current values rather than historic costs, R & D expenditure, unusual items)
to make the figure more meaningful in the context of a valuation.

The use of EVA to value a company will be discussed in Section 3.4 of this chapter.

196 Business Analysis


1.1.5 Cash flow return on investment (CFROI)
This technique is an Economic Profit (Cash Flow) based valuation framework.
CFROI is a real rate of return measure (that is, it excludes inflation) that identifies the relationship
between the cash generated by a business relative to the cash invested in it. It represents the discount
rate at which the discounted future annual cash flows expected to be generated over the useful life of a
firm's assets are equal to the current cash value of the firm's net operating assets.
CFROI can be used at divisional level and can also be applied to privately held firms.

1.1.6 Market value added (MVA)


The MVA of a company is defined as:
MVA = Market value of debt + Market value of equity Book value of equity
The MVA shows how much the management of a company has added to the value of the capital
contributed by the capital providers.
The MVA is related to EVA because MVA is simply the present value of the future EVAs of the company.
If the market value and the book value of debt is the same, then the MVA simply measures the
difference between the market value of common stock and the equity capital of the firm.
A firm's equity MVA is sometimes expressed as a market to book ratio:

MVA
book value
The higher the MVA the better for the company as a high MVA indicates that the company has created
wealth for its shareholders.
The main problem with MVA is that it does not take opportunity cost of capital into account, nor does it
account for intermediate cash returns to shareholders.

1.1.7 Total shareholder return


This technique measures the change in capital value of a listed company over a period (typically at least
one year) plus cash payouts to shareholders expressed as a percentage of the initial share price at the
start of the period. The formula is:

(Share price at end - share price at beginning) Cash paid to shareholders


TSR =
Share price at beginning

The cash payouts to shareholders will include regular and special dividends, share buy-backs and any
other cash payments.
Its very nature prevents TSR being used for organisations that are not listed. It can be easily compared
across companies of different