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Nowadays, the increasing complexity of business environment has led to the development of Strategic management, and thus more demanding role of management accounting. We'll discuss the case of Dell Inc. to have a clearer view about these concepts
A general approach of Strategic management includes 5 steps:
Establish mission and objectives
Defining missions is the first thing to do in any organisation. Mission refers to overall goal of the organisation, it answers questions such as: "What will our organisation be?" or "What values will we bring to customers?" Therefore, it'll lead the way organisation creating various objectives and strategies. Subsequently, objectives will be "developed to translate these aims into specific commitments" (Atrill, P. and McLaney, E., 2009, p.7). These objectives provide more specific, practical and clearer targets for organisations such as: target market share percentage, return on capital employed (ROCE), profit margin, etc. A clear statement of objectives and missions helps organisations know the right direction to go, and then plan appropriate strategies to ensure they will move exactly on the chosen direction.
For example, we found Dell's mission statement: "to be the most successful computer company in the world at delivering the best customer experience in markets we serve." http://www.dell.com/content/topics/global.aspx/about_dell/investors/main/en/faqs?c=us&l=en#faq8 [Accessed 11th Oct.]. We see that Dell's mission is to provide a high standard quality and service at all markets in which it's operating. This mission will be split into smaller and clearer objectives, for example: adopting latest technologies, continuous development of employees' skills, low price, etc.
The organisation's mission statement is like a promise with stakeholders, especially customers. Here, MA helps Dell assess its available resources (capital, investment, assets) through the presentation of balance sheet, so that Dell can establish reliable and achievable missions. Furthermore, MA plays a vital role of maintaining business ethics, which is very important to gain trust from stakeholders. When it comes to objectives establishing, MA measures the required ROCE, profit margin to provide a clear targets for Dell to achieve.
Undertake position analysis
Organisation needs to define its current position in the market, how well it's doing toward different stakeholders. An accurate position analysis helps organisations establish more practical and precise missions and objectives. When it comes to analysing position, the SWOT framework usually is implemented. Here, the strengths and weaknesses of the organisation will be shown as well as the opportunities and threats caused by external environment.
We can easily see that Dell has many advantages such as: world largest PC maker, completed elimination of middle man, customer-centric approach, brand popularity, etc. These are the foundation of Dell's confidence to set its mission: "most successful company in the world" in quality and service. Let's consider this demonstration of SWOT analysis on Dell:
Source: Quality assurance solution, SWOT analysis of Dell computer. Available from: <http://www.quality-assurance-solutions.com/swot-analysis-of-dell.html> [Accessed 11th Oct.]
Here, MA provides performance measurements through annual financial analysis (gross profit, ROCE, profit margin, liquidity ratios, etc.). Base on these figures, Dell would identify whether its financial performance is strength or weakness. Moreover, Dell may find opportunities using investment appraisal methods: ARR, payback, NPV, and IRR (Atrill, P. and McLaney, E., 2009, p.259) and threats through financial analysis or variance analysis (Atrill, P. and McLaney, E., 2009, p.234, 235)
Identify and assess the strategic options
From the information provided from SWOT, the organisation will identify possible strategies to achieve its objectives. Specifically, it'll use strength exploit the opportunities while avoiding exposing weaknesses to threats. These possible options subsequently will be evaluated based on specific criteria, which have been established by considering organisation's resources and capabilities. (Atrill, P. and McLaney, E., 2009, p.9)
Having a strong position in the industry, Dell find itself should maintain and strengthen this position by exploiting the opportunities. Here, it'll have a range of strategic options: expansion on potential markets like China and India, new products development, reduce costs... Then, they need some criteria to evaluate these options, such as: acceptable amount of cost, time, minimum risk, etc.
MA gathers information for use in developing strategies and plans. Specifically, it'll identify and classify required costs and expected revenue for each option using break-even analysis, which helps Dell have a range of options to develop strategies. Furthermore, MA highlights financial problems and provides possible solutions for the organisation, thus support decision making. For example, when demand becomes increase, MA may recommend eliminating labour redundancy to reduce labour cost or automating processes to increase output.
Select strategic options and formulate plans
In this step, the best strategic options will be selected. However, the strategy is just a destination, how to reach that destination is another important thing. Therefore, particular actions will be planed to make the strategy successful. The plan should include possible adjustments to cope with situations, as well as helping employees know what the job is and how to do it. Here, we see "the overall plan will be broken down into a series of plans, for each element of the business" (Atrill, P. and McLaney, E., 2009, p.9)
Dell is well-known for low cost manufacturing, which is also its strategic and competitive factor. Actually, this was split into many jobs, such as: Technologies development, employees training, disintermediation focus, inventory control and so on. These jobs are then allocated to different departments (R&D, HR, marketing) in respect of an established schedule and requirements.
MA can help Dell select the best financial options using marginal analysis. Subsequently, this option will be adjusted to design efficient process. Here, MA will help by identifying an optimum level of output, required inputs and allocating of limited resources through using techniques such as: break-even analysis, budgeting, full-costing. Furthermore, according to the situation, MA can help Dell cope with changing business environment, do appropriate pricing in a competitive world, and satisfy customers' needs. Here, we see a number of techniques can be used: target costing, costing quality control, kaizen costing, cost plus pricing and so on.
Perform, Review and Control
Here, all the plans and actions will be implemented. Responsible people will control the process and regularly check the outcomes to ensure everything's going as planned. Adjustments will be taken if problems occur during the process or the outcomes don't fit the plan.
Dell always observes and controls process of implementing the strategy, to guarantee the quality of product/service for customers. For example, Dell offers 24/7 online and telephone support for all types of customer, this include system or component procurement, troubleshooting, and maintenance. These provide customers a wider range of options.
MA today doesn't only concern financial terms, but also the non-financial indicators in order to help organisation properly evaluate its performance. Variety of non-financial measurements are being exploited by management accountants nowadays, such as "quality, product innovation, product lifecycle times, delivery times and so on" (Atrill, P. and McLaney, E., 2009, p24). Furthermore, most important thing in this step is: management accountants play a key role in maintaining business ethics, so that the business plan will be implemented, controlled and reviewed properly.
Strategic management is the key concept of all successful organisations. And Management accounting is an important part of this concept. Therefore, an effective management accounting application will contribute considerably to a successful management strategy.
In business, cost is always a significant part of making decision. In making decision, there is relevant and irrelevant cost. In this discussion, we will critically clarify the concept of these costs.
Can be used in making decision, relevant costs are the future costs that vary when we make different decisions.
Opportunity cost: the cost (in monetary value) will be sacrificed by the next best choice in order to carry out a specific goal. It is a relevant factor in decision making process, but will not be treated as an actual cost in any financial statement. Opportunity cost will be considered as a relevant cost in decision making, so it will be added to the total cost of picking an option over another.
For example, you have a spare house, to optimise its value, you are having 2 options: lease it for £2,000/month, or make it a restaurant with the cost £10,000. If you choose to make the restaurant, then £2,000 will be your opportunity cost. The total cost of this decision is: £2,000 + £10,000 = £12,000
Future outlay cost: amount of money needed for the chosen decision to be completed. However, outlay cost isn't always a relevant cost. To be relevant, it must relate to the organisation's objectives; and critically, it must vary with the decision, which means it must change if the decision changes.
Back to example of Opportunity cost, the £10,000 of turning the house into a restaurant is the future outlay cost. If we have other choices instead of running a restaurant, such as: grocery store, bookstore, or showroom..., the cost won't stay at £10,000 anymore. Therefore, it is relevant to the decision.
Irrelevant costs includes all past costs, and non-differential outlay cost that won't vary within different decisions.
Here are different past costs:
Definition & characteristics
The original cost we purchased for something. This value will be change because of depreciation or inflation.
A car was bought with £2,000 in 1990. In 2000, it was sold for £1,000. £2,000 is the historic cost.
Cost invested in the past but hasn't no sign of bringing profit to the company.
Failed researches or experiments, unsuccessful marketing campaign...
Cost attached to a past investment that a company cannot avoid because of complexity or inconvenience.
Maintenance, Rental fee...
Non-differential future outlay cost is the cost required to be paid in the future, but whichever decision is made, it remains the same. This cost type is also irrelevant and thus won't be added to the total cost of a decision.
Let's review our spare house example: whichever business we want it to be, we have to hire builders to build it. The labour cost should be approximately the same and therefore it is an irrelevant outlay cost.
Why do all past costs are irrelevant in decision making? It's because we always make decisions for the future. Consequently, only costs that affect, or change accordingly to the future, should be considered. However, we shouldn't totally ignore the past: how much we paid in the past is not important, but the experience given from the past is always a valuable source for managers to predict the future.
We're going to discuss the interrelation between Costs classification and Break-even analysis, and how accountants exploit this to maximise the company's benefits.
Classification of costs and Break-even Analysis
Classification of costs refers to how a business classifies its different costs in order to deal with these costs properly. One of the ways is based upon the cost behaviour, which means considering how costs response to the change of activity volume. Here, we see 2 main types of cost:
Variable cost (VC): varies according to the activity volume. Example: material cost: the more products a company makes, the more material is needed.
Fixed cost (FC): doesn't change according to the activity volume. Example: rental or storage fee (though activity volume changes, these fees still be constant)
There are also 2 other types:
Stepped cost: as activity volume reaches a particular point, fixed cost will change and back to constant state, until another volume point is reached. Example: additional fee for more space of warehouse.
Semi-variable cost: contains both characteristics of fixed and variable cost. Remain fixed until a specific volume point reached. After reaching that point, it varies according to the output volume. Example: monthly telephone charge is a fixed cost, but after a certain number of calls exceeded, the charge will increase for each additional call made.
There are plenty of financial methods that involved VC and FC, one of them is Break-even analysis. Here, we again recognise the importance of classification of cost into VC and FC, because it will help business to identify Break-even point (BEP), which is where the total sales revenue equal the total cost. Base on this BEP, company will know how much products should be sold within a specific price in order to cover overall cost.
The relationship of VC, FC and BEP is demonstrated in the following equations:
BEP (in number of unit) =
To see more clearly this relationship, we will demonstrate it on chart. Let's consider this example: A company has these following costs:
Total fixed cost for renting building and storage: $20,000
Variable cost per unit: $10/unit
Revenue (price) per unit: $20/unit
ïƒž The total amount of each cost will be as follow:
Unit of output (1)
Total VC ($) = (1) x VC per unit
Total cost ($) = FC + Total VC
Sales ($) = (1) x revenue per unit
The figures are demonstrated in chart as follow:
The FC curve lies horizontally on $20,000 as it stay the same at any value.
The TC curve starts from $20,000 (because FC must be paid even production not occurred), and go upward as we increase output.
The Sales curve start from zero (no product was sold), and go upward as more products were sold.
The Sales meets the TC curve at 2,000 units. This means to cover all costs at the price of $20/unit, the company must produce and sell 2,000 outputs. Any sales achieved above this point will bring profit to the company.
Applications on real world
Break-even analysis is a very useful tool for managers; it is now applied on every part of the world. The usefulness of this tool includes:
Help managers foresee different situations derived from the change of price, fixed or variable cost.
Helpful tool for pricing decision (in association with company's self-observation on capacity, resources, performance objectives...)
Help managers evaluate the feasibility of selling new products.
Useful tool for evaluating a project
The Organisation of Petroleum Exporting Countries (OPEC) is the best example for Break-even analysis use. They extensively exploit this tool to yield the most profits as demand for petrol is continuously rising. They limit the supply of petrol, and set the price as high as possible. This tool helps them to guarantee the highest profit as well as making no closing stock.
Nothing's perfect, so is the break-even analysis. Its limitations are:
Non-linear relationships: in practice, variable costs, revenue and volume tend to fluctuate. Variable cost usually affected by economies of scale (the higher the volume, the lower the cost). While the price per unit may decrease at higher volume, so that companies can sell more.
However, since break-even analysis is based on predicting the future, this tool's still applicable, especially in short-term. Example: planning to sell all movie tickets for a cinema.
Stepped fixed cost: We've discussed about this in the beginning: fixed cost doesn't always stays constant. Therefore, a careful consideration on fixed costs is required to prevent errors.
Multi-product businesses: Break-even analysis only focuses on one product/service, while fixed cost may also involve other products/services. Example: simultaneously, car factories usually produce different models of car...
Break-even analysis's a very useful tool to support managers in decision making. Managers should understand the advantages and disadvantages of this tool to make effective use of it.