Documente Academic
Documente Profesional
Documente Cultură
MAIN CAPABILITIES
The aim of this syllabus is broken down into several main capabilities which divide the syllabus and
study guide into discrete sections.
SYLLABUS RATIONALE
This is a narrative explaining how the syllabus is structured and how the main capabilities are linked.
The rationale also explains in further detail what the examination intends to assess and why.
DETAILED SYLLABUS
2|Page
This shows the breakdown of the main capabilities (sections) of the syllabus into subject areas. This
is the blueprint for the detailed study guide.
STUDY GUIDE
This is the main document that students, learning and content providers should use as the basis of
their studies, instruction and materials. Examinations will be based on the detail of the study guide
which comprehensively identifies what could be assessed in any examination session. The study
guide is a precise reflection and breakdown of the syllabus. It is divided into sections based on the
main capabilities identified in the syllabus. These sections are divided into subject areas which
relate to the sub-capabilities included in the detailed syllabus. Subject areas are broken down into
sub-headings which describe the detailed outcomes that could be assessed in examinations. These
outcomes are described using verbs indicating what exams may require students to demonstrate,
and the broad intellectual level at which these may need to be demonstrated (*see intellectual
levels below).
INTELLECTUAL LEVELS
The syllabus is designed to progressively broaden and deepen the knowledge, skills and professional
values demonstrated by the student on their way through the qualification.
The specific capabilities within the detailed syllabuses and study guides are assessed at one of three
intellectual or cognitive levels:
Level 1: Knowledge and comprehension
Level 2: Application and analysis
Level 3: Synthesis and evaluation
Very broadly, these intellectual levels relate to the three cognitive levels at which the Applied
Knowledge, the Applied Skills and the Strategic Professional exams are assessed.
Each subject area in the detailed study guide included in this document is given a 1, 2, or 3
superscript, denoting intellectual level, marked at the end of each relevant line. This gives an
indication of the intellectual depth at which an area could be assessed within the examination.
However, while level 1 broadly equates with Applied Knowledge, level 2 equates to Applied Skills
level 3 to Strategic Professional, some lower level skills can continue to be assessed as the student
progresses through each level. This reflects that at each stage of study there will be a requirement
to broaden, as well as deepen capabilities. It is also possible that occasionally some higher level
capabilities may be assessed at lower levels.
ACCA qualification does not prescribe or recommend any particular number of learning hours for
examinations because study and learning patterns and styles vary greatly between people and
organisations. This also recognises the wide diversity of personal, professional and educational
circumstances in which ACCA students find themselves.
As a member of the International Federation of Accountants, ACCA seeks to enhance the education
recognition of its qualification on both national and international education frameworks, and with
educational authorities and partners globally. In doing so, ACCA aims to ensure that its qualifications
are recognized and valued by governments, regulatory authorities and employers across all sectors.
To this end, ACCA qualifications are currently recognized on the education frameworks in several
countries. Please refer to your national education framework regulator for further information.
Each syllabus contains between 23 and 35 main subject area headings depending on the nature of
the subject and how these areas have been broken down.
Time should be taken to ensure that all the information and exam requirements are properly read
and understood.
The pass mark for all ACCA Qualification examination exams is 50%.
SYLLABUS
AIM
To demonstrate organisational leadership and senior consultancy or advisory capabilities and
relevant professional skills, through the context of an integrated case study.
RELATIONAL DIAGRAM
This diagram shows direct and indirect links between this exam and other exams preceding or
following it. Some exams are directly underpinned by other exams such as Advanced Performance
Management by Performance Management. These links are shown as solid line arrows. Other
5|Page
exams only have indirect relationships with each other such as links existing between the
accounting and auditing papers. The links between these are shown as dotted line arrows. This
diagram indicates where you are expected to have underpinning knowledge and where it would be
useful to review previous learning before undertaking study.
MAIN CAPABILITIES
On successful completion of this paper, candidates should be able to:
A. Apply excellent leadership and ethical skills to set the ‘tone from the top’ and promote a positive
culture within the organisation, adopting a whole organisation perspective in managing
performance and value creation.
B. Evaluate the effectiveness of the governance and agency system of an organisation and recognise
the responsibility of the board or other agents towards their stakeholders, including the
organisation’s social responsibilities and the reporting implications.
C. Evaluate the strategic position of the organisation against the external environment and the
availability of internal resources, to identify feasible strategic options.
D. Analyse the risk profile of the organisation and of any strategic options identified, within a culture
of responsible risk management.
E. Select and apply appropriate information technologies and data analytics, to analyse factors
affecting the organisation’s value chain to identify strategic opportunities and implement
strategic options within a framework of robust IT security controls.
F. Evaluate management reporting and internal control and audit systems to ensure compliance and
the achievement of organisation’s objectives and the safeguarding of organisational assets
G. Apply high level financial techniques from Skills exams in the planning, implementation and
evaluation of strategic options and actions.
H. Enable success through innovative thinking, applying best in class strategies and disruptive
technologies in the management of change; initiating, leading and organising projects, while
effectively managing talent and other business resources.
I. Apply a range of Professional Skills in addressing requirements within the Strategic Leader
examination and in preparation for, or to support, current work experience.
This diagram illustrates the flows and links between the main capabilities (sections) of the syllabus
and should be used as an aid to planning teaching and learning in a structured way.
6|Page
RATIONALE
The syllabus for Strategic Business Leader acts as the key leadership syllabus at the Strategic
Professional level and is a substantial integrated examination. The examination requires candidates
to demonstrate a range of professional skills demanded by effective leaders or in advising or
supporting senior management in directing organisations. The syllabus therefore combines the main
functions of organisations in the context of leadership capability. It draws upon content from all of
the Applied Skills Level exams and the Ethics and Professional Skills Module. The main capabilities of
the Strategic Business Leader syllabus assume essential technical skills and knowledge have been
acquired at the
Applied Knowledge and Applied Skills Levels where some of the core capabilities will have been
learnt, and in particular where governance, internal audit, control, risk, finance, ethics and
management will have been introduced in a subject-specific context. In addition the candidate is
expected to demonstrate wider professional skills in their answers to requirements set in each
examination.
The Strategic Business Leader syllabus is covered in nine main sections with leadership,
professionalism and ethics and corporate governance used as the initial focus for the rest of the
syllabus. Excellent leadership involves having a team of capable and responsible directors, setting an
appropriate ‘tone from the top’ and embedding appropriate corporate and cultural values within
the organisation. This is supported by a sound governance structure and effective management
structures. The syllabus begins by examining leadership and having in place responsible and ethical
leaders, having an awareness of who they are responsible to. This section also covers personal and
professional ethics, ethical frameworks – and professional values – as applied to a senior manager
or adviser’s role and as a guide to appropriate behaviour and conduct in a variety of situations.
Clearly linked to organisational leadership is the existence of an effective governance structure
within organisations in the broad context of the agency relationship. This aspect of the syllabus
focuses on the respective roles and responsibilities of directors, on the committee structures and on
the effective scrutiny of the performance of senior management and their accountabilities,
demonstrating this accountability by reporting more widely and holistically to stakeholders under an
integrated reporting <IR> framework.
It is only once these fundamental organisational structures and values are in place that it is possible
to explore strategy and assess the strategic position of the organisation and to effectively evaluate
the options facing the organisation.
Evaluating strategic options, making strategic choices and implementing strategy requires the
organisation’s leaders, or their advisers, to fully understand the risks involved so the syllabus then
examines the identification, assessment, and control of risk as a key aspect of responsible
leadership and management. The syllabus also includes a section relating to and applying IT and
security controls at all levels of the organisation from strategic considerations including big data,
cloud computing and e-business, through to using IT in the management of information, controlling
organisations, and in financial and organisational operations. This section also focuses on the
growing importance of ‘cyber security’
To support the management of risk the syllabus also addresses organisational control in its wider
context, including internal audit, review, internal control, and feedback to implement and support
effective governance, including compliance issues related to decision-making and decision-support
functions. The syllabus includes financial aspects of managing an organisation, including key finance
and management accounting techniques to analyse performance and to support decision-making.
7|Page
Candidates need to be aware of legal issues and of the financial reporting and taxation implications
of strategic and investment decisions.
The syllabus finally focuses on innovation, performance excellence and change management to
enable organisational success and implement change through effective organisational processes, IT
solutions and project management, including the role of new and disruptive technologies in
transforming the nature of business analysis and transactions. The last section, which links to all the
others, is the Professional Skills section which indicates the range of professional skills that the
candidate must demonstrate in the exam which will make them more employable, or if already in
work, will enhance their opportunities for advancement.
1. Qualities of leadership
B. Governance
1. Agency
4. Reporting to stakeholders
C. Strategy
1. Concepts of strategy
2. Environmental issues
3. Competitive forces
5. Strategic choices
D. Risk
8|Page
1. Finance function
I. Professional skills
1. Communication
2. Commercial acumen
9|Page
3. Analysis
4. Scepticism
5. Evaluation
The broad structure of each case will give candidates information about an organisation from a
range of sources, such as the following:
• Interviews with staff
• Survey results
• Board or organisation reports
• Press articles/website extracts
• Organisation reports and <IR> extracts
• Emails
• Memos
• Spreadsheets
• Pictures
• Figures
• Tables
• Diagrams
The basic structure of each exam will require the candidate to take on various roles of
organisational leaders, consultants or advisers to senior management. Therefore the examination
could include requirements such as found in the following list:
• Analyse the external environment, the organisation model and the internal governance
structures, culture and capabilities of the organisation.
• Assess the position and evaluate the performance of the organisation
• Consider the future outlook for the organisation
• Identify strategic problems and opportunities
• Manage risks and identify appropriate controls
• Make strategic choices
• Evaluate strategic choices using forecasting or decision-making techniques
• Decide on feasible and sustainable solutions using appropriate technologies
• Implement change and innovate responsibly
The examination is of 4 hours duration, but this includes Reading, Planning and Reflection time
(RPRT). This time can be used flexibly at any time during the exam.
2. To allow adequate practice time for case study assessment and revision.
3. To encourage and develop the demonstration of professional skills to support the award of
Professional Skills marks.
In broad terms it is recommended that Education Providers and students should spend 50% more
learning time in preparation for this examination than normally required for other exams at this
level. This includes direct contact time and guided learning time where a taught programme is
delivered, or self-study and revision time where the student is self-taught or uses distance-learning
programmes.
STUDY GUIDE
A. Leadership
1. Qualities of leadership
(a) Explain the role of effective leadership and identify the key leadership traits effective in the
successful formulation and implementation of strategy and change management.[3]
(b) Apply the concepts of entrepreneurship and ‘intrapreuneurship’ to exploit strategic
opportunities and to innovate successfully.[3]
(c) Apply in the context of organisation governance and leadership qualities, the key ethical and
professional values underpinning governance.[3]
B. Governance
1. Agency
(a) Discuss the nature of the principal-agent relationship in the context of governance.[3]
(b) Analyse the issues connected with the separation of ownership and control over organisation
activity.[3]
4. Reporting to stakeholders
13 | P a g e
(a) Discuss the factors that determine organisational policies on reporting to stakeholders, including
stakeholder power and interests.[3]
(b) Assess the role and value of integrated reporting and evaluate the issues concerning accounting
for sustainability.[2]
(c) Advise on the the guiding principles, the typical content elements and the six capitals of an
integrated report, and discuss the usefulness of this information to stakeholders.[3].
(d) Describe and assess the social and environmental impacts that economic activity can have (in
terms of social and environmental ‘footprints’ and environmental reporting).[3]
(e) Describe the main features of internal management systems for underpinning environmental
and sustainability accounting including EMAS and ISO 14000.[2]
(f) Examine how the audit of integrated reports can provide adequate assurance of the relevance
and reliability of organisation reports to stakeholders.[2]
(a) Compare and contrast public sector, private sector, charitable status and non-governmental
(NGO and quasi-NGOs) forms of organisation, including agency relationships, stakeholders’ aims
and objectives and performance criteria.[2]
(b) Assess and evaluate the strategic objectives, leadership and governance arrangements specific
to public sector organisations as contrasted with private sector.[3]
(c) Explain democratic control, political influence and policy implementation in public sector
organisations.[3]
(d) Discuss obligations of the public sector organisations to meet the economy, effectiveness,
efficiency (3 ‘E’s) criteria and promote public value.[3]
C. Strategy
1. Concepts of strategy
(a) Recognise the fundamental nature of strategy and strategic decisions within different
organisational contexts.[2]
(b) Explore the Johnson, Scholes and Whittington model for defining elements of strategic
management – the strategic position, strategic choices and strategy into action.[3]
2. Environmental issues
(a) Assess the macro-environment of an organisation using PESTEL.[3]
(b) Assess the implications of strategic drift. [3]
(c) Evaluate the external key drivers of change likely to affect the structure of a sector or market.[3]
(d) Explore, using Porter’s Diamond, the influence of national competitiveness on the strategic
position of an organisation.[3]
(e) Prepare scenarios reflecting different assumptions about the future environment of an
organisation.[3]
3. Competitive forces
(a) Evaluate the sources of competition in an industry or sector using Porter’s five forces
framework.[3]
(b) Analyse customers and markets including market segmentation[2]
(c) Apply Porter’s value chain to assist organisations to identify value adding activities in order to
create and sustain competitive advantage.[2]
(d) Advise on the role and influence of value networks.[3]
(e) Evaluate the opportunities and threats posed by the environment of an organisation.[2]
5. Strategic choices
(a) Assess the suitability, feasibility and acceptability of different strategic options to an
organisation.[3]
(b) Assess the opportunities and potential problems of pursuing different organisation strategies of
product/market diversification from a national, multinational and global perspective.[3]
(c) Advise on how the 7 ‘P’s, including price-based strategies, differentiation and lock-in can help an
organisation sustain its competitive advantage.[3]
(d) Apply the Boston Consulting Group (BCG) and public sector matrix portfolio models to assist
organisation in managing their organisational portfolios.[3
(e) Recommend generic development directions using the Ansoff matrix.[2]
(f) Assess how internal development, mergers, acquisitions, strategic alliances and franchising can
be used as different methods of pursuing a chosen strategic direction.[3]
D. Risk
(d) Explain and analyse the concepts of spreading and diversifying risk and when this would be
appropriate.[2]
(e) Explain, and assess the importance of, risk transfer, avoidance, reduction and acceptance
(TARA).[3]
(f) Explain and assess the benefits of incurring or accepting some risk as part of competitively
managing an organisation organisation.[3]
(d) Evaluate, and if necessary, recommend improvements or changes to controls over the safeguard
of information technology assets, to ensure the organisation’s ability to meet business
objectives.[3]
1. Finance function
(a) Explain the relationship between an organisation’s financial objectives and its business
strategy.[2]
(b) Discuss how advances in information technology has transformed the finance function and the
role of the finance professional.[2]
(c) Evaluate alternative structures for the finance function using business partnering, outsourcing
and shared or global business services.[3]
18 | P a g e
(b) Assess and advise on how an organisation can be empowered to reach its strategic goals,
improve its results and be more competitive.[3]
I. Professional skills
1. Communication
(a) Inform concisely, objectively, and unambiguously, while being sensitive to cultural differences,
using appropriate media and technology.[3]
(b) Persuade using compelling and logical arguments demonstrating the ability to counter argue
when appropriate.[3]
(c) Clarify and simplify complex issues to convey relevant information in a way that adopts an
appropriate tone and is easily understood by the intended audience.[3]
2. Commercial acumen
(a) Demonstrate awareness of organisational and wider external factors affecting the work of an
individual or a team in contributing to the wider organisational objectives.[3]
20 | P a g e
(b) Use judgement to identify key issues in determining how to address or resolve problems and in
proposing and recommending the solutions to be implemented.[3]
(c) Show insight and perception in understanding work-related and organisational issues, including
the management of conflict, demonstrating acumen in arriving at appropriate solutions or
outcomes.[3]
3. Analysis
(a) Investigate relevant information from a wide range of sources, using a variety of analytical
techniques to establish the reasons and causes of problems, or to identify opportunities or
solutions.[3]
(b) Enquire of individuals or analyse appropriate data sources to obtain suitable evidence to
corroborate or dispute existing beliefs or opinion and come to appropriate conclusions.[3]
(c) Consider information, evidence and findings carefully, reflecting on their implications and how
they can be used in the interests of the department and wider organisational goals.[3]
4. Scepticism
(a) Probe deeply into the underlying reasons for issues and problems, beyond what is immediately
apparent from the usual sources and opinions available.[3]
(b) Question facts, opinions and assertions, by seeking justifications and obtaining sufficient
evidence for their support and acceptance.[3]
(c) Challenge information presented or decisions made, where this is clearly justified, in a
professional and courteous manner; in the wider professional, ethical, organisational, or public
interest.[3]
5. Evaluation
(a) Assess and use professional judgement when considering organisational issues, problems or
when making decisions; taking into account the implications of such decisions on the organisation
and those affected.[3]
(b) Estimate trends or make reasoned forecasts of the implications of external and internal factors
on the organisation, or of the outcomes of decisions available to the organisation.[3]
(c) Appraise facts, opinions and findings objectively, with a view to balancing the costs, risks,
benefits and opportunities, before making or recommending solutions or decisions.[3]
21 | P a g e
1
Introduction to leadership
Context
As you can see from the title of the paper, the leadership of an organisation is crucial to its success.
This chapter looks at the various approaches a leader can adopt.
One of the things you will notice in this chapter (and in many others in this Study Manual) is that
there is no single “best” way to lead an organisation, there are many factors to consider when
deciding on the most “appropriate” approach, particularly when change is required within the
organisation.
Finally, one of the major skills of a leader is the ability to analyse and evaluate information, whilst
being sceptical about its reliability. This allows the leader to make commercially sound decisions and
communicate these to the organisation. These professional skills form a key part of the
examination.
Video introduction
1. Do you know which theory of leadership assumes that leadership capability can be
learned?
2. Can you differentiate between entrepreneurship and intrapreneurship?
3. Why are there different approaches to managing change?
22 | P a g e
1.1 Leadership
1.1.1 Introduction
All organisations need someone in charge. The role of a leader is likely to be particularly important
in times of change or crisis. Much of the SBL paper will be about leading during these situations.
Leadership has been studied by many different writers. The following are some of the main classical
approaches to the subject:
• Style theory
• Contingency/situational theories
• Transformational/transactional leaders
The leader's ability to lead is contingent upon various situational factors, including the leader's
preferred style, the capabilities and behaviours of followers and also various other situational
factors.
A leadership style that is effective in some situations may not be successful in others and a leader
who is very effective at one place and time may become unsuccessful either when transplanted to
another situation or when the factors around them change.
The leader has to give proper and appropriate attention to the three sets of needs.
Tight Flexible
Tight Flexible
The task • Job requires no initiative, routine and repetitive or has a certain • Important tasks with a lon
outcome • Problem-solving or decisio
• Short timescale for completion • Complex work
• Trivial tasks
What kind of leader might be more successful in a company changing from public to private
ownership?
Definition
25 | P a g e
Entrepreneurship is the process of trying to make profit by using initiative and engaging in business
risks.
Famous entrepreneurs include Richard Branson (of the Virgin group) and Anita Roddick (of the Body
Shop).
In the context of a board of directors, who are required to work collectively to make profit for
shareholders in line with the agency concept (which you should be familiar with from your legal and
auditing studies, but that will be scrutinised more in later chapters), a new word has been
developed from the same roots, which is ‘intrapreneurship’.
Definition
Intrapreneurship is the process of individuals trying to make a profit collectively on behalf of
shareholders by using initiative and engaging in business risks.
In principle then, subject to the restraints that working together brings (for example, the need to
collaborate and agree on strategy), directors are encouraged to think like entrepreneurs and try and
drive business through innovation and appropriate risk-taking.
Issues of governance and risk management will be developed later in this study manual. You will see
that in the context of intrapreneurship, risk taking needs to be managed and balanced to the risk
appetite of the shareholders, in order to protect the shareholders’ investment and meet the
requirements of the agency relationship.
Jackie is a sole trader. Kelly is one of three directors of Ship Co. Jackie operates in one region of the
country, whereas Ship co-operates on a national basis.
They have both become aware of a business opportunity to buy a product from Isa. Isa has patented
the product, and claims it will revolutionise its market. Isa is offering sole distribution rights of the
product to one party.
Required:
(a) Define entrepreneurship and intrapreneurship in the context of this business opportunity.
(b) Discuss options that Jackie and Kelly have in this situation.
26 | P a g e
Coercion Explicit use of power through May be successful in crises Least successful unless
edict or state of confusion crisis
1.4.1 Introduction
Culture is both internal and external to an organisation. It is important to understand that culture
has a great influence on how people behave, what they think is right or wrong, how they do things,
etc. Culture can predispose an organisation towards or away from a particular course of action, and
leaders have a major role to play here.
A number of authors have tried to define corporate culture, and also to explain what factors
determine it.
'In organisations there are deep-set beliefs about the way work should be organised, the way
authority should be exercised, people rewarded, people controlled ... these are all aspects of the
culture of an organisation. In simple words you could say that it is “the way we do things round
here”.' (Charles Handy)
Organisational culture consists of the beliefs, attitudes, practices and customs to which people are
exposed during their interaction with an organisation.
It seems obvious that leadership is important in defining and managing organisational culture.
However, initially once a leader is in place at an organisation there is likely to be issues in a leader
defining culture as this is likely to be in place and can be firmly entrenched. The people, formal and
informal systems and work are likely to be set in place and hence difficult to change. Hence a leader
will need to be able to articulate an attractive vision for the organisation in order to facilitate a
cultural change. The leader will often need to make structural changes to the organisation to
achieve a lasting change to the culture. Where there are good interactions between and leader and
employees then the employees will make a greater contribution to team communication and
collaboration and the culture will be healthy and the organisation more likely to be successful.
Johnson, Scholes and Whittington identify the following relationships between the cultural web and
strategy:
Routines and rituals • Are there key rituals which are consistently carried out?
• What does training emphasise?
• What is the purpose of the rituals?
Learn the elements of the cultural web and be able to identify them in a scenario
Poundland is a UK company that sells most of its products for £1, whether food, confectionery,
toothpaste, shampoo, greetings cards and so on. It is seen to provide very good value for money. If
you were in charge of Poundland think what culture and values you would want to have and then
you can compare with the solution to see what Poundland has.
Think where you use these skills already in your job. For example, if you regularly write reports or
letters in your current role that must help with the professional skill ‘Communication’. Look through
the other professional skills and think if these seem familiar already. If you are not sure, here is
some help on what each means.
1.5.1 Communication
ACCA lists the following points in the area of communication:
• Inform concisely, objectively and unambiguously, while being sensitive to cultural differences,
using appropriate media and technology.
• Persuade using compelling and logical arguments, demonstrating the ability to counter argue
when appropriate.
• Clarify and simplify complex issues to convey relevant information in a way that adopts an
appropriate tone and is easily understood by the intended audience.
Several verbs are used in relation to communication:
Definitions
30 | P a g e
Persuade is to advise, even urge and induce someone to believe your point of view
Definitions
Using judgement is demonstrating the ability to form an opinion.
1.5.3 Analysis
ACCA lists the following points about analysis:
• Investigate information from a wide-range of sources, using a variety of analytical techniques to
establish the reasons and causes of problems, or to identify opportunities or solutions
• Enquire of individuals or analyse appropriate data sources to obtain suitable evidence to
corroborate or dispute existing beliefs or opinions and come to appropriate conclusions.
• Consider information, evidence and findings carefully, reflecting on their implications and how
they can be used in the interests of the department and wider organisational goals.
Definitions
Investigate is enquiring systematically.
31 | P a g e
1.5.4 Scepticism
ACCA lists the following considerations:
• Probe deeply into the underlying reasons for issues and problems, beyond what is immediately
apparent from the usual sources and opinions available.
• Question facts, opinions and assertions, by seeking justifications and obtaining sufficient
evidence for their support and acceptance.
• Challenge information presented or decisions made, where this is clearly justified, in a
professional courteous manner, in the wider professional, ethical, organisational or public
interest.
Definition
Scepticism is about showing doubt and questioning facts presented to you.
1.5.5 Evaluation
ACCA lists the following considerations:
• Assess and use professional judgement when considering organisational issues, problems or
when making decisions; taking into account the implications of such decision on the
organisation and those affected.
• Estimate trends or make reasoned forecasts of the implications of internal or external factors on
the organisation, or of the outcomes of decisions available to the organisation.
• Appraise facts, opinions and findings objectively, with a view to balancing the costs, risks,
benefits and opportunities before making or recommending solutions or decisions.
Definition
To evaluate is to assess and to use judgement.
Now that you have read through what each part of the professional skills are, think what
professional skills you are using in your job or elsewhere in your life, what gaps you have and how
you can address any gaps. As examples of how you can start to develop the skills:
• Can you put yourself forward at work, to write reports, memos and letters and gain
Communication skills?
• Reading the financial pages of a newspaper will help you see examples of companies and
organisations that are doing well and poorly. Thinking why a company or organisation has been
successful or not can help your Commercial Acumen. Better still is to think what advice you
would give to assist the company or organisation.
• Think of the sources of information you would need to make a better decision and how you
would use that information. Being able to do this will build up your Analysis skills.
• Look at information that you are given at work or in the financial pages of a newspaper (or even
what you are told by, for example, politicians) and consider what might be wrong with that
information. This will help your Scepticism skills.
• Once you have looked at the previous skills above make your own decision. Make sure you look
at the positive and negative sides to the arguments (the costs, benefits, risks and opportunities)
and then come to a conclusion. This will help your Evaluation skills.
• Use the examples in the last chapter of this Study Manual to help you practice. This will be very
useful for you, though the more you can then perform the skills in real life the better for you in
the exam (and real life!).
Stop and think through the 'story' of this chapter and how it links with other chapters.
Use the Overview to help.
Learning example solutions
Solution 1.1
This kind of change requires a transformational leader as many fundamental things (such as working
practices) will need to change.
Solution 1.2
(a) Entrepreneurship is the process of trying to make profit by using initiative and engaging in
business risks and intrapreneurship is the process of individuals trying to make a profit
collectively on behalf of shareholders by using initiative and engaging in business risks.
(b) Both Jackie and Kelly have similar basic options in this case. They can contract with Isa or they
can choose not to contract with Isa. As Isa has patented the product, if they want their business
to benefit from the opportunities associated with the product, in the short term, their only real
option is to contract with Isa, as it will be difficult to replicate the product without legal
difficulty.
Jackie is a sole trader and can be termed an entrepreneur. In deciding whether to take this
business opportunity, Jackie will assess the risks and rewards to Jackie of doing so, and will
balance this with the costs involved in taking the opportunity and the capacity of Jackie to so do
(ie does Jackie have sufficient contacts to sell the product to etc, in order to make profit). Jackie
will weigh all these factors and make the business decision.
Kelly will have similar factors to consider. However, as Ship Co is a bigger enterprise than
Jackie’s sole tradership it may have greater capacity to distribute and market the product or to
mimic the product than Jackie does, so there might be more considerations in play for Kelly.
In addition, Kelly is one of three directors of Ship Co, so it is likely that these considerations will
be collective, and they will involve considering more than Kelly’s personal risk appetite, but the
risk appetite of the shareholders of Ship Co. In summary, Kelly will view this opportunity in the
same way as Jackie, ie as an opportunity to make profit for the business, but will have to act as
an intrapreneur, acting collaboratively with fellow directors in order to take or decline the
business opportunity.
Solution 1.3
2
Professionalism, ethical codes and the
public interest
Context
We are required as accountants to meet high standards and this is embodied in the idea of
professionalism, which includes knowledge, privilege and responsibility.
One of the main responsibilities is acting in the public interest which leads into the concept of
ethics. In short, this is ‘doing the right thing’. However this isn’t always easy to decide so there are
codes of ethics that guide accountants to try to make the right decision. There are also known
threats to this, such as bribery, that have to be acknowledged and dealt with. Decision-making
frameworks exist to assist making ethical decisions. The environment is an area of concern.
Finally the reporting of an organisation’s activities has become more ‘integrated’, meaning that it
covers more areas than just financial reporting.
Video introduction
35 | P a g e
2.1 Professionalism
The overriding ethical requirement for accountants is that they accept their role in society as a
professional. A professional must meet a higher standard of ethical behaviour than other members
of society in keeping with their perceived higher status.
The public perception of a profession and the subsequent degree to which society is supportive of
the existence of certain roles as being professional in nature will depend upon the extent to which
this higher standard is met.
the standard. All professionals must ensure that, in every endeavour they are involved in, they act
in the public interest.
Public interest
Definition
Public interest is the welfare or well-being of the general public
It is a contentious issue as to the extent to which accountants do act in the public interest.
It is relatively straightforward to be supportive of the role of the accountant.
Accountants:
• Reduce the potential for accounting misstatement and corporate fraud
• Provide managers with information to support decisions
• Provide information to the markets and shareholders
• Provide assurance to the market regarding company operations
• Support capitalism and the economic societal gains of commerce
However, there are arguments that call into question the extent to which their role is positive:
• Accountants are almost always implicated in major corporate failure and financial scandal.
• Shareholders and markets are a very small element of society overall.
• Profit-driven decisions often act against the interest of other stakeholder groups.
The question as to whether accountants act in the public interest often very much depends on what
is meant by public. In as much as this relates to all those coming to the market and involved in the
stock exchanges of the world, there is no doubt that accountants are vital, central players, integral
to the success of market operations.
In as much as the public are viewed in a less qualified and more conventional sense of being the
general public, it is more difficult to argue that accountants support or even relate to the wider
masses in the same way that a doctor or lawyer is a central player in society working for the
common good.
An accountant is accountable to their professional body. The professional body validates the
accountant’s professional qualifications, by allowing the accountant to use designated letters after
their name.
However, accountants also have responsibilities to others, in particular their responsibilities to
employers.
As an employee, the accountant has a contractual and ethical responsibility:
• To abide by their employment contract
• To follow the rules and cultural norms of the workplace
• To comply with the requirements of their employer
• To show a duty of loyalty to their employer and act in the organisation’s best interests (eg by
acting in the best interests of the organisation’s shareholders and other stakeholders)
• To carry out work honestly and not allow personal interests or pressures to outweigh employer
interests
• To keep employer information confidential
If an employer expects an accountant to behave in one way, but their professional body expects
them to do something else, then there is a conflict of interest. This can be difficult to resolve.
For example, if an accountant is asked to misstate financial information in order to hide the poor
performance of the company, this conflicts with his position as a professional.
The ACCA would demand that he/she act in the public interest and uphold standards of
competence, integrity and professional behaviour.
However, he/she is also bound by his/her employment contract which has the implicit requirement
that he/she does any work required by the employer. An employer may put a great deal of pressure
on an employee, such that even someone with high integrity may at least consider breaching
professional principles.
In cases where there is conflict, it is assumed that the professional’s primary duty is to the public
interest rather than the organisation.
There are a number of possible solutions to the conflict between the employer and professional duty:
• Allowing loyalty to the employer to override professional behaviour
• Following professional standards, and risk upsetting the employer
• Resigning from employment on points of professional principle
• Doing as the employer requests, but insisting that the individual’s opposition to the action is
recorded, making it clear that he/she is acting under the influence of others, and would prefer
not to be doing it
Whilst these options seem clear enough, and the most preferable solution would seem to be always
sticking to professional principles, reality is far more difficult.
The accountant has an important role to play in an organisation. An accountant’s skills lie in the
areas of recording, reporting and assuring. Within an organisation an accountant may be
responsible for any of the following:
• Preparing management accounts, budgets and forecasts
• Preparing the year-end financial statements
• Preparing tax returns
• Liaising with the internal and external auditors
• Assisting with recording costs and expenses on projects undertaken by the company
• Investigation of fraud and irregularity
• Preparing reports for senior management and other stakeholders on the performance and
position of the company
• Setting up and monitoring an effective system of internal control
Additionally, in an audit role, the accountant provides assurance to the shareholders that the
financial statements present a true and fair view of the financial performance and position of the
organisation. In the role of auditor, it is particularly important that the accountant is acting in an
independent manner and working to the best of their abilities as the shareholders rely on the audit
report prepared by the accountant.
Auditors must comply with ethical codes of practice to ensure they maintain their independence.
Value-laden role
In order to reduce the controversy over whether accountants act or do not act in the public interest,
accountancy academic Professor Robert Gray calls upon accountants to embrace a wider, more
value-laden role. He chooses the phrase “value-laden” as opposed to “enhanced role” or “improved
39 | P a g e
role” because the traditional view of accountants is that they are value-laden in the sense of being
burdened by values or weighed down by the public need for them to be ethical in their behaviour.
This weight, being too much to bear, leads to accountants acting in ethically questionable ways.
In his modern view of the term, Gray asks the accountant to add values or ethics to their role, again
being weighed down, but this time being willing players in raising the extent to which ethical
behaviour is central to their role.
In order to do this, accountants might:
• Focus more on environmental reporting
• Identify methods of incorporating environmental cost into business decision models
• Enhance the quality of community reporting and incorporating community costs and benefits
into decision models.
Codes of ethics
Relativism relates to the development of ethical guidelines for the modern era. It assumes an
increasingly global nature in business operations, supported through faster communications,
creating a greater sense of interconnectedness between different societies.
In such a world, accountants must continually adapt to different norms and behaviours prevalent in
different cultures. At the same time, the organisation must ensure all members of staff understand
their position as representatives of the corporation and are willing to meet the demands of strict
codes of conduct in their business relationships in line with organisational needs.
Codes of ethics at a corporate and a professional level are a mechanism through which improved
behaviour can be sought and consistency created for the benefit of all stakeholders involved in
business operations.
Integrity
In line with the underlying concepts of governance, integrity is a vital issue for accountants just as it
is for all members of the board of directors. Integrity suggests core characteristics of fairness,
justice, decency and responsibility that are unshakeable in the mind of the accountant and beyond
compromise, regardless of external influence or pressure.
This principle requires members to act in a straightforward and honest manner in all their business
and professional relationships. Someone with integrity inspires trust because they stick to their
principles in all situations. What those principles are will depend on their personal ethical beliefs. In
a professional sense, someone with integrity would be expected to uphold the values of the
profession and abide by relevant laws and guidance.
Objectivity
Remaining focused on the goal of presenting a true and fair view of corporate financial position
requires the accountant to remain detached or independent of the company and any undue
influences. The threats to independence must be recognised and dealt with by the individual or
audit firm. The threats are:
• Self-interest
• Self-review
• Familiarity
• Intimidation
• Advocacy
Objectivity is a state of mind where the only matters considered when making a decision, or forming
an opinion, are those matters relevant to the situation. Personal issues, conflicts, or the influence of
others must be ignored, so that the final opinion given is fair, impartial and justified.
For example, when deciding how to account for a business transaction, the only matters of
relevance should be the facts of the situation and the relevant accounting standards. The effect on
company profits is irrelevant to deciding on the correct accounting treatment.
Confidentiality
41 | P a g e
The IFAC code of ethics has application to all accountants. This includes those who operate as
employees within corporations as well as those that audit those corporations. Confidentiality
therefore has application for accountants in their position as employees but also, possibly more
relevantly, with regard to their relationship as auditors.
Members should respect the confidentiality of their clients and not disclose any client information
to third parties unless they have a legal or professional right or duty to disclose. Accountants will
gain knowledge of client information that is private. Such information should not be disclosed to
anyone else, unless:
• The law demands it (eg suspicion of money laundering or terrorism).
• The client allows it.
• It is in the public interest.
Professional behaviour
It could be argued that professional behaviour is merely a restatement, summary or conclusion to
the code that incorporates the other four principles. However, this would fail to communicate
anything else of significance and therefore the concept of professional behaviour must have a
separate, distinct and meaningful definition. In reality it reminds the accountant of their overriding
purpose as a professional in society. To behave as a professional is to act in the public interest.
The purpose of the code, as stated by the IFAC and its offshoot, the International Ethics Standards
Board for Accountants (IESBA) is to ensure that:
• Public interest is served
• There is a convergence or consistency between diverse professional codes
• The quality of accounting service provision is supported and quality improved
• The efficiency of the capital markets is supported and improved
The job of an accountant is to account, to record, to stand witness to events and, as necessary, to
pass judgement on those events for the benefit of others. Such a description in no way suggests
accountants should be custodians of the heritage of the planet or protectors of bio and social
diversity in the face of increasing prosperity and economic growth through the expansion of
capitalism across the world.
Do you agree?
Integrity
The accountant is asked to support a strategy which seeks to obscure the fact that employees’
health will be seriously put at risk due to a lack of investment in health and safety systems.
Objectivity
The accountant accepts bonuses or bribes to not report the company’s poor environmental record
in polluting the local water supply.
Competence
The accountant is asked to bury losses in the balance sheet so that shareholders are not aware of
the company’s problems and so will not withdraw their investments.
Confidentiality
The accountant as auditor is asked to disclose confidential data to a client about a competitor who
is also an audit client.
43 | P a g e
Public interest
The accountant, aware that the bank is illegally manipulating State interest rates, does not
communicate the fact to the relevant authorities.
The conflict of interest that arises out of these examples relates to the extent to which the personal
interests of the accountant lead him/her to compromise his/her need to act in the interests of
his/her profession. This personal interest may be created through pressure put upon him/her by
senior management or through the promise of financial reward. Conflict of interest is the difference
between personal or self-interest and the interests of the profession.
Conflict must be resolved in some way.
• The first level of defence can be through an automatic response given the existence, and
therefore need to use, the variety of ethical safeguards available.
• A second would relate to the need to think deeply about the situation and possibly apply an
appropriate decision-making framework.
• A third would involve siding with whatever senior management require on the basis that simply
doing what one is told may offer a suitable ethical excuse.
• A fourth would be prevaricating and seeking further advice, although in the end a decision must
be made.
• A fifth would be to simply accept the fundamental human right to act in one’s own self-interest
and do whatever this suggests without the need to agonise over the ethical ramification beyond
this point.
• A sixth would be to extract oneself from the situation by simply refusing to be a party to the
decision.
• A seventh would be to resign in order to create a detachment from the problem.
• An eighth would be to transfer the ethical responsibility to someone else by reporting the
concern to an independent body or the media as a whistleblower.
Ethical threats apply to accountants whether they are working as an employee or are involved as an
auditor of a company. The threats to independence could be used to examine their existence and
possible safeguards. An additional management threat could be included just to expand on the
concern.
• Self-interest threats
• Self-review threats
• Familiarity threats
• Advocacy threats
• Intimidation threats
• Management threats
44 | P a g e
Self-interest threats
Self-interest threats can arise when:
• Gifts or hospitality are received from clients
• Auditors receive a large proportion of fees from one client
• A personal or business relationship exists between auditor and client
• A large amount of additional work is performed as well as the audit
• Financial interests (eg owning shares in a client) exist
Safeguards
• Gifts and hospitality should not be accepted unless the value is clearly insignificant.
• Audit firms should avoid having any one client that makes up a significant proportion of their fee
income.
• The ACCA does not allow any of the following parties to own a direct financial interest in a client
or a material indirect financial interest in a client (eg by investing in a pension scheme that
invests in the client’s shares):
– The audit firm
– A member of the audit team
– The immediate family of a member of the audit team
Self-review threats
• Accountants prepare work which is then audited either by themselves or other members of their
team.
• The accountant is a member of the audit team but previously worked for the client.
Safeguards
• Providing a client with services other than audit is a highly controversial issue. In most cases, it is
fine to provide other services provided independence and objectivity are not affected. For this
reason, the team that performs the audit should be composed of entirely different members to
the one that performs the other services and if objectivity is threatened, the audit firm should
not take on the additional work.
• If in the previous two years, an individual has been a director of the client or involved in any way
with the information being audited they should not be assigned to the audit team.
Familiarity threats
• The auditor audits the company where family or friends work.
• The auditor has been involved in the audit process for many years.
• A former auditor now works for the client company.
45 | P a g e
Safeguards
• No member of the audit team should have a close personal or business relationship with the
client.
• For listed companies the audit partner should not act for longer than five consecutive years and
should not return to this role until a further five years have elapsed.
• An audit partner should not accept a key management position at an audit client until at least
two years have elapsed since his/her involvement in the audit.
Advocacy threats
Examples of advocacy threats include:
• Representing an audit client in a legal case or tax enquiry
• Taking legal action against a client or being sued by a client
Safeguard
Auditors should withdraw from the engagement if they are involved in serious litigation with their
client.
Intimidation threats
This threat is caused by a client being in a position to put pressure on an auditor to prevent them
acting objectively. This could arise from family and personal relationships, litigation or close
business relationships. As a result, the intimidation threat is very closely related to the self-interest
and the advocacy threat so the safeguards are the same.
Management threats
Auditors should be independent of their clients. They should under no circumstances agree to
provide services that result in them either:
• Acting as management of the client or,
• Making management decisions for the client such as helping to recruit staff or designing internal
controls for the client
If they take on management functions, their independence is threatened.
Safeguards
Auditors should ensure that the client accepts responsibility for all management decisions, even
where the audit firm provides a lot of advice. When taking on additional work for clients, auditors
should ensure that they act in an advisory capacity only and do not make decisions and perform
work that is the responsibility of the company’s management.
To corrupt is to intentionally move something away from its intended purpose towards a less
positive or negative state. Corruption occurs when this movement is associated with an individual or
business in social context. The intended purpose is that everyone and every institution should
support the wider good or societal needs collectively. Corruption usually places self-interest above
these needs. It can be viewed as occurring when personal interests threaten or work against the
general principles of good governance or the accountant’s own professional principles.
In a corporate governance context, the board of directors and the accountant may be facilitators of
corrupt behaviour to support personal gain or may become the victims of corrupt actions that work
against company interests. Either position is fraught with problems:
• Facilitating corrupt behaviour leads to exposure to potential legal difficulties and negative
impact on reputation.
• Being a victim of corruption such as fraud will have a negative financial impact.
Bribery is a particular aspect of corruption that is simple to instigate and goes to the heart of self-
interest by appealing to financial gain. Within the governance of the corporation any stakeholder
could be a party to such intrigue:
• Bribing accountants not to report financial position accurately
• Bribing auditors not to report internal control and risk problems
• Bribing key players at client companies to gain customer contracts
• Bribing suppliers not to record product safety defects
• Bribing non-executive directors (NEDs) not to investigate risk issues
• Bribing government officials over passing planning permission
The problem with bribery and corruption is that it circumvents the legal and economic bed-rock
upon which society is founded and continues to operate. It means decisions are not based on an
honest assessment of cost and benefit (why a supplier tender may be accepted as the winning
tender for instance) or upon the laws of supply and demand (price fixing by UK utility companies for
example).
Since the given rules of society no longer apply in such situations where corruption exists this
creates uncertainty in the mind of the decision-maker (board of directors, accountant or
shareholder) as to how they are supposed to make decisions or play the capitalist game.
Uncertainly breeds intransigence or a lack of willingness to be involved in commercial processes and
mistrust, none of which helps the smooth and continual operation of the markets.
It also provides six principles against which a company can evaluate the extent to which it needs to
introduce changes in the way in which it operates:
Proportionality
Actions taken to reduce bribery must be proportional to the extent to which a risk exists. This helps
to sell the idea that, for some companies, the cost of applying with the law may not be overtly
onerous.
Top-level commitment
As with all aspects of ethics, top-level commitment is vital to instil a sense of leadership and
commitment. There is also a veiled threat in this that top management will be held to account for
failures.
Risk assessment
As with any aspect of control, risk management precedes the determination of action and provides
context for investment.
Communication
This involves the formalisation of requirements as a part of the corporate code of ethics. It also
includes the need for communication through training programmes for staff where such issues have
particular resonance.
Due diligence
In an appropriate reference to the auditing concept of due diligence, the law requires the company
to have some common sense in researching the people it does business with prior to entering into
contractual relations. This ensures that companies do not have dealings with those who are actively
involved in corrupt activities. Of course it may be very difficult to be aware of this prior to instigating
negotiations.
Local culture
Cultural norms often blur the distinction between gift giving and an outright bribe. If such
approaches are common it is difficult for the individual to resist or perceive there is anything wrong
with such practices.
Decentralisation
The level of autonomy individuals have affects their ability to carry out corrupt activities and the
likelihood of them being caught.
Commercial pressure
The extent to which competitors carry out bribery and corrupt activities and their level of success in
these areas is problematic. If undue advantage is achieved it may lead to reciprocal activity by the
corporation merely to sustain commercial parity. Money is, as ever, an important factor.
Governments have a central role in ensuring the population and the environment are protected
from the excesses of company activity.
The EU takes this responsibility very seriously, promoting the highest standards through member
state legislation. Penalties vary from country to country but fines and jail terms are possible.
Generally such measures are considered more stringent than those prosecuted in the US.
Other countries around the world have differing views of what is needed in this area. In China the
courts have recently been given the authority to hand down the death penalty to CEOs who fail to
meet the requirements of increasingly tough legislation. This harsh potential remedy has arisen due
to public outrage over the flagrant disregard of the environment by factory owners.
In a recent survey in China, 80% believed that environmental protection was more important than
economic development. The "grow at all costs" strategy of previous decades is fast losing favour as
the costs of such policies are being felt.
The Health Effects Institute estimates that over a million people die prematurely in China every year
as a direct result of air pollution. Particulate levels in Beijing, Guangzhou and some other Chinese
49 | P a g e
cities often rise to as much as seven times the World Health Organization’s air-quality standard, or
twice China’s own, much lower, limits. Pollution from factories in the Pearl River Delta have created
a dead zone that stretches several miles from the river’s mouth out to sea.
One of the most famous corporate code of ethics is that of Google. They have a very powerful
overall statement that starts off ‘Don’t be evil’ which is about providing their users unbiased access
to information, focusing on their needs and giving them the best products and services that Google
can. But it’s also about doing the right thing more generally – following the law, acting honorably,
and treating co-workers with courtesy and respect.
There is a lot more detail, divided up into specific areas e.g. ‘Serve our users’ which covers integrity,
usefulness, privacy, security and responsiveness. ‘Support each other’ is another area. If you want to
know more then we are sure you can work out how to find the information.
51 | P a g e
Tucker has a deep interest in social responsibility and in training managers to operate more ethically
in the execution of their duties. His model includes a recognition that this primary duty is towards
shareholders and their financial needs. This focus is then expanded to include wider ethical
principles. He offers no advice as to the relative importance of each issue, leaving it to the individual
to decide on how much weight they give to each area.
1. Profit
The accountant must reflect on the financial implications of any decision made, commercial or
ethical.
2. Legal
Operating within the legal standard that exists should be a deontological (ie you must follow the
law) duty rather than an issue that is open to compromise.
3. Fair
The decision must consider the extent to which the outcome is fair to differing stakeholders
impacted upon by the decision. Fairness, as an underlying governance principle, is about being
even-handed and just in decisions.
4. Right
Whether the decision is right or not is really the whole point of the ethical decision. It is of course
a very deep and difficult issue. A sense of duty or self-preservation may decide the outcome of
this issue.
5. Environmentally sound
Tucker manages to include specific concern for the planet and its ecology as a decision element. It
could be argued, since no advice is given, that this concern sits on the same level as profit in the
mind of the decision-maker, lifting the environment to become a key factor in the decision.
Diesel petrol is now viewed as being a major polluter of the environment. This has affected the
number of diesel cars being built. An opportunity has come up for an investment company to buy a
diesel car manufacturing plant for £1. Use Tucker’s model to assess the decision to buy a diesel
petrol plant
Footprint
The concept of footprint has more than a passing reference to fossilised dinosaur tracks etched into
rocks on a mountain ridge. It relates to what we leave behind after we are gone, the evidence of our
existence on the planet. Like the dinosaur remains, the belief is that this residue of our passing
should be as small as possible so as to leave the earth in a similar state for future generations to
enjoy.
Environmental footprint
• The impact on planetary animal species, reduction in the variety of species, their habitat and an
increase in extinction rates
• The impact on plant life and in particular the amount of rainforest that remains intact
• The impact on fresh water supply and the contamination of water supply
• The amount of raw materials and minerals that are available to future generations
• The impact on breathable atmosphere and impact of greenhouse gases on global warming
Social footprint
• The impact of contamination and pollution on local community health
• Noise pollution and congestion in the local area
• Evicting communities and the loss of local heritage and culture
• The impact of poor products on customers’ safety
• Employee safety issues at the factory
Footprint is more than simply an impact consideration. It is also a sense that organisational activity
can have a positive effect on local communities and the environment. This suggests that an
evaluation of footprint becomes a need to develop a balanced scorecard of company impact from
both a positive and negative perspective and then attempt to build the positive aspects or at least
develop a zero footprint position.
54 | P a g e
The scope of environmental issues contained within the CERES standards provides the focus for
developing systems to manage CSR. These measures then become the basis for auditing such
systems and finally become the content for environmental reporting.
CERES has a series of current campaigns to encourage investors, businesses and policy makers to
invest $1 trillion in low-carbon energy, manage water resources and improve the disclosure of
investors and companies of sustainability issues, such as climate change risks.
Environmental audit
CERES is the foundation for a strategy and the success of the strategy is evaluated through an
environmental audit carried out by internal auditors, external auditors or specialist consultants.
Such an audit would include:
1. Agreeing and establishing metrics
The scope of metrics can be determined with regard to relevant CERES standards. Within each
area a measurable target must be established for achievement over the future period.
2. Measuring performance against the standard
The control activities of collecting feedback on a level of activity and comparing it to the
applicable target is a part of any audit.
3. Reporting compliance or variation
The audit committee provides a suitable strategic authority for managing the environmental
audit. The need to take remedial action as necessary is inherent within this final stage.
This audit process is better supported if advice is provided as to how to establish metrics and which
tools and techniques could be used to monitor and assess performance. This advice often takes the
form of adopting methodologies used within formal accreditation schemes.
ISO 14000
The International Standards Organisation (ISO) supports the use of CERES standards. The global
accreditation scheme provides suitable credibility and recognition for those involved in
multinational operations. It is a less exacting scheme allowing for internal audit and optional
disclosure of audit findings to shareholders and stakeholders.
ISO 14000 is a series of standards that deal with companies’ effect on the environment and the
means of achieving continual improvement in environmental performance. The standards cover the
following areas:
• Guidance on the establishment, implementation, maintenance and improvement of an
environmental management system and its integration with other management systems
• Guidance on the principles of auditing, managing auditing programmes, conducting quality
management system audits and the competence of environmental auditors
• Guidance on identifying environmental issues and determining their business consequences
• The means of producing reliable and verifiable internal environmental information to assess if
actual performance is meeting the targets set
• Guidance in the general principles, policy, strategy and activities relating to internal and external
environmental communication.
ISO 14000 accreditation therefore further supports the development of high quality accounting
systems in this area and the subsequent quality of environmental reporting. The formalisation of the
approach develops a sense of trust between the organisation and those that rely upon it to deal
with environmental and social concerns.
2.5.2 Sustainability
57 | P a g e
Definition
In 1983, the Bruntland Commission defined sustainability as the ability to meet today’s needs without
sacrificing those of future generations.
The difficulty lies in firstly determining what today’s needs are and what future generations needs
might be. Even if it were possible to make these issues tangible, the challenge is then in deciding
how the requirements of meeting today’s needs might be met without overt negative impact on
planetary needs in the future.
Although the definition offers little beyond a vague sense of sustainability as a concept, most people
would agree that it does embrace concepts of environmental and social footprint and a sense of the
need for self-sufficiency.
Lee is the on the board of Wood plc, a company that produces timber goods. He argues that
promoting sustainability drains shareholder wealth, and that Wood plc should not do it. Explain to
Lee the potential consequences of NOT observing policies that promote sustainability. Professional
skills marks are available for demonstrating communication and evaluation skills.
It might be suggested that there are three types of resources or capital:
Artificial capital
This relates to the goods and services which are produced through the use of critical and sustainable
capital. The goal must be to maximise productivity in this area.
Gray and Bebbington argue that the value-laden role of the accountant should rise to this challenge
and include a number of accounting techniques that may move the corporation towards reducing its
environmental footprint and supporting these three views of planetary capital:
Impact accounting
This is an output-driven analysis of company impact on the environment. It relates to deploying
accounting in order to determine the scope and depth of the impact on critical natural capital.
Flow accounting
Building on impact accounting, the focus broadens to look at the nature and cost of inputs and how
efficiently they are absorbed or used by the organisation. The goal is to reduce the inputs or transfer
them into using renewable sources. Efficiency improvements reduce input use over time.
Management accounting focuses on maximising production and so this idea brings together
consideration of sustainable and artificial capital.
This is not to suggest that the latter two reports are of the same scope and depth as current
financial statements. Their existence does however provide clear evidence of corporate concern for
the environment and offers accountants an opportunity to demonstrate their professional role in
acting in the public interest.
Disclosure
The scope of environmental and social reporting will embrace all environmental activity carried out
by the company:
59 | P a g e
It might be worth exploring what we mean by ‘capitals’ in this context. After all, as an accountant,
isn’t capital a financial sum contributed to a business, on which a return is expected? However,
‘capital’ is also a metaphor for describing other aspects of a business that generate long term value
or describing the mix of inputs to create value. Financial capital is only one input: it provides
resources which the other inputs.
The framework describes the capital as follows.
Manufactured capital Manufactured capital – Manufactured physical objects (as distinct from natural physical objects)
organisation for use in the production of goods or the provision of services, including:
• buildings
• equipment
• infrastructure (such as roads, ports, bridges, and waste and water treatment plants)
Manufactured capital is often created by other organisations, but includes assets manufactured b
organisation for sale or when they are retained for its own use.
Human capital People’s competences, capabilities and experience, and their motivations to innovate, including t
• alignment with and support for an organisation’s governance framework, risk management app
• ability to understand, develop and implement an organisation’s strategy
• loyalties and motivations for improving processes, goods and services, including their ability to
collaborate
Social and The institutions and the relationships within and between communities, groups of stakeholders a
relationship capital the ability to share information to enhance individual and collective well-being. Social and relatio
• shared norms, and common values and behaviours
• key stakeholder relationships, and the trust and willingness to engage that an organisation has
build and protect with external stakeholders
• intangibles associated with the brand and reputation that an organisation has developed
• an organisation’s social licence to operate
Natural capital All renewable and non-renewable environmental resources and processes that provide goods or
past, current or future prosperity of an organisation. It includes:
• air, water, land, minerals and forests
• biodiversity and eco-system health
This requires organisational reporting to be holistic and to answer the question ‘how does it create
value over time?’. There is a legitimate question as to what we mean by ‘value’ in this context: value
for whom? For profit-making organisations, a return on investment is an easy measure of value, but
if we compare ‘outputs’ with ‘outcomes’ their position becomes more mixed.
The underlying model is outlined below:
61 | P a g e
Organisational review and external Within the boundaries of the organisation Ext
environment
From society and the organisation A business model by which inputs are transformed by business Ou
come inputs. activities into outputs. ou
The mission and organisational vision
A governance framework covering:
• Opportunities and risks
• Strategy and resource allocation
• Performance
• Future outlook
The items in bold above, plus the basis of preparation, form the basis of an integrated report. It is
worth considering the differences between outputs and outcomes:
• For a tobacco company the output might be cigars, cigarettes, loose tobacco, pipe tobacco,
snuff, chewing tobacco, or nicotine products for ‘vaping’
• For society, the outcomes of the sale of tobacco products include higher tax revenues, dividends
for investment, increased illnesses and death rates from smoking related diseases (for smokers
and for passive smokers, and the social and economic cost associated with these), the
employment created by tobacco businesses and the families they sustain.
A key concept is the ‘reporting boundary’, which determines what is reported on and the materiality
of the items covered.
Obviously the financial reporting entity is used for financial reporting purposes. Indeed this might be
split into holding company and subsidiary companies. (The whole purpose of consolidated accounts
is to move beyond the simple legal entity to given an integrated and coherent view of a group.)
Risks, opportunities and outcomes attributable to or associated with other entities/stakeholders
beyond the financial reporting entity have a significant effect on the ability of the financial reporting
entity to create value. The reporting entity does not control these elements, but they must be
considered elements is material given the proximity of the risks
• Assess the scope of an extended accounting role that includes a strong ethical element and be
able to discuss the significance of the extended role. (A3a)
• Discuss ethical support for accounting decision-making and be able to recommend the use of
appropriate models. (A3c)
• Analyse the scope of environmental policy and be able to recommend a suitable CSR policy in
this area. (B4d)
• Investigate the nature of integrated environmental reporting and be able to recommend
improvements. (B4e)
• Identify how the use of concepts within integrated reporting can aid an organisation. (B4b)
In many ways this statement is true. Accountants do a job. This job tends to involve producing
financial statements or carrying out reviews of other companies and passing judgement on their
commercial sustainability. Focusing on the role of the accountant within the corporation, it in no
way inherently requires accountants to have any professional or ethical view of stakeholders and
ecological or social sustainability.
And yet, these issues affect everyone on the planet. This being the case the accountant could still
argue that this concern is a private matter for the individual’s conscience and not one that they
should consider during working hours at the office.
However, the accountant is not just an accountant. He/she is also a professional in society. This
being the case, his/her role and livelihood are not confined to being an employee, accepting the
demands of others, of even CFO, determining the commercial future of the company. The
professional has a duty to act in society’s interests, to recognise the demands of his community,
culture, country and civilisation. This suggests a wider remit and the need to act in relation to wider
concerns.
Even here, the responsibility is blurred. In certain sections of South American society, the
decimation of the rain forest is considered to be a national duty in support of national economic
growth, a display of strength to be applauded. In such circumstances, the role of the accountant is
presumably to support the will of the people and restrict himself/herself to looking at the numbers
(or counting the logs of wood).
Solution 2.2
63 | P a g e
Solution 2.3
The company may have lower production costs and may achieve cost leadership if it ignores
sustainability.
However, the company will lose competitive advantage if other producers can persuade
ecologically-aware customers to buy products that are sustainably manufactured.
The opportunity to ‘badge’ the product as environmentally-friendly will be lost (for example,
‘Fairtrade’ and similar initiatives).
Looking to the downstream supply chain, some of the company’s corporate customers may refuse
to do business with it if their CSR policies exclude such producers.
Longer-term, the company may be vulnerable to less friendly tax treatment and losses of
opportunities to apply for government grants if future government policies penalise less
environmentally-friendly companies.
In the very long-term, companies who do not observe sustainability responsibilities will run out of
raw materials completely.
Communication marks are available for discussing this in a manner relevant to a director of the
company (this is both in terms of language and in identifying factors which are relevant to a
director’s decision-making, not simply observing that it is the ‘right’ thing to do).
Evaluation marks are available for identifying the breadth of relevant impacts to the company in the
short, medium and long term. These marks would be restricted if only a few points were made or
the evaluation focused on the short term or the very long term, say.
64 | P a g e
3
Governance and agency
Context
The theories of corporate governance provide a backdrop to understanding the practical scope of
regulation that governs modern stock exchanges. They also assist in improving our understanding of
the relationship between the shareholders of the company and its board of directors. This
relationship has changed over time, as societies have developed, although its fundamental
requirements are timeless in their application.
Agency theory describes the nature of the relationship that exists or should exist between the board
of directors and the shareholders, with a separation between ownership and control.
Be aware of the history behind corporate governance but particularly know the current codes that
exist as they are the most likely for you to need to know in the SBL exam.
Video introduction
3.1 Introduction
65 | P a g e
Interest in the way in which corporations (we often refer to these as ‘companies’) are managed is
increasing. Global Institutions such as the Organisation for Economic Cooperation and Development
(OECD) offer advice to governments with regard to corporate regulation. Governments attempt to
develop and constrain corporations in the interests of their citizens. Corporations are mindful of the
need to regulate themselves, to promote success and avoid scandal. Society demands the products
that corporations produce whilst being concerned over the impact of unregulated activity on their
communities and the planet as a whole.
This widespread interest derives from the increasing status of the corporation as the central player
in the way in which society operates. Corporations generate the products and the wealth that
support or facilitate our way of life. They are the heart of the capitalist model.
This status as a central actor in society has not always existed. It is only in recent history that the
concept of a body managed by one party on behalf of separate, private citizens, virtually divorced
from state control, with a scale to reach beyond a single state’s borders, has existed and therefore
needs to be considered by society and a relationship with that entity defined and managed.
The nature of that relationship, the strengths and opportunities arising from it, balanced against the
faults within it and the threats that derive from it, defines and redefines the nature of societies
within which our lives take place. It affects us every day and will increasingly do so into the future.
The curtain opener to this century, the credit crunch, warns us that without due consideration of
the governance of this relationship, lives may be ruined and nations fall.
It is therefore difficult to understate the significance of corporate governance as a topic for
consideration by each member of society, but particularly by those who operate deep within the
corporation and the capitalist system. Through an understanding of the governance relationships
that exist, accountants can better position themselves to provide advice as to how the organisation
should be managed for the benefit of shareholders, the markets and society as a whole.
Definition
Governance is the system by which companies are directed and controlled in the interest of
shareholders and other stakeholders.
By defining the need for decisions to be made in the interest of shareholders, the board recognises
their legal duty in the way in which the company operates. By recognising the importance of
stakeholders the company promotes the need for a positive relationship to be established.
Such a relationship can lead to:
• Improved sales
• Reduced opposition to corporate activity
• Less regulation of corporations
• Improved profits
• Improved investment
amongst many other gains.
If governance is viewed as having two dimensions, direction and control, then these can be used as
a way of determining the scope of governance and through this to give a deeper sense of its
meaning and application.
Direction
The provision of direction to organisational activity is an internal issue determined by the actions of
the board of directors.
• The need to define roles and responsibilities of the board of directors and top tier management.
• The need to determine policy, practice and programs through which to act.
• The need to determine threats and respond to these through appropriate mechanisms of
internal control.
Control
Exercising control over the corporation is an external activity determined by the actions of
government and regulators.
• The need to pass legislation to provide a framework for operations.
• The need to determine rules of corporate activity through regulation of stock exchanges.
• The need to engage in dialogue with stakeholders, to listen and respond to their concerns.
67 | P a g e
The environmental consultancy group EIRIS calculates UK investors placed over £11 billion in ethical
funds in 2012. This is a 10-fold increase in just over 10 years. On a global basis, institutional
investors have over $13.6 trillion invested with regard to environmental, social or governance
concerns. This is approximately one fifth of all money invested in the market. A survey by the UK
Sustainable Investment and Finance Association in 2011 found “early signs of a step change in the
number of corporate pension funds that are responding to the case for responsible ownership and
68 | P a g e
investment.” Since 2006, $6.5 trillion of capital investment has signed up to the United Nations-
backed Principles for Responsible Investment program.
Around the world, across national and cultural boundaries, there is a commitment to ethical
behaviour in business by those who own businesses, the shareholders. The board of directors,
recognising their agency obligation, must also recognise the importance of these issues.
Direction
This is an internal perspective, looking at the scope of governance activity created by and enacted
through the board of directors.
The scope of governance would include:
• Defining corporate structure and roles
• Ensuring an appropriate professional culture exists within the company
• Establishing programs, policies, procedures and rules for internal control
• Monitoring and adapting as necessary to ensure objectives are met
Control
This is an external perspective, looking at the scope of governance activity imposed on the board of
directors from outside.
The scope of governance would include:
• All forms of legislation including corporate law, health and safety and employee legislation.
• The imposition of stock exchange regulation.
• Accounting and audit standards.
The sense of direction suggests the need for underlying belief systems to be in place so that the
board of directors understands how it should act. The sense of control prompts the need to identify
the scope of governance that is common in the regulation of stock exchanges.
shareholders to invest and may lead to governmental action to force the corporation to move in line
with the types of behaviour expected from it by society.
1. Fairness
A sense of balance or even handedness when dealing with others.
This is particularly true in stakeholder relationships. What is defined as being fair is intangible,
however it relates to a societal perception of what are expected norms of behaviour and a sense
of fairness between differing groups such as the fairness of directors pay in relation to that
received by employees.
2. Openness/Transparency
A sense of lifting the veil from operations, of creating openness in company operations.
Transparency can relate to the communication of financial position and the identification of
investment or corporate risk. Transparency is assisted through disclosure of decision rationale
and the use of regular meetings with shareholders.
3. Innovation
The ability to introduce change into the organisation or with regard to its business positioning.
Innovation is the watch word for organisational success in a fluid, dynamic business environment
and, as a principle of governance, commands the board of directors to act in making measured
changes to product and market activity.
4. Scepticism
This can be viewed as a counter balance to innovative drive on the board of directors. A degree of
cynicism or reluctance to accept a given idea or belief is necessary until such a belief has been
established through reasoned and objective argument. The sense of balance between innovation
and scepticism has implications for the board’s personality and skills base.
5. Independence
The ability to be separate from personal or other influence outside of that prescribed through
your formal role in the organisation.
Independence is as much an issue for directors as it is for auditors. Independence requires a
sense of detachment and relates to the need for clarity in terms of what an individuals’ role
should be.
6. Probity/Honesty
Abiding by the legal standards that exist in society.
It also suggests a more general sense of being an honest player or an individual with high ethics. It
may be said that honesty has a tangible interpretation relating to adhering to the law whereas a
sense of probity is a sense of fair dealing or honesty in a less defined societal sense.
7. Responsibility
This relates to the need to accept liability for one’s actions.
The willingness not to hide behind blame placed on others but rather to accept ones’ own
involvement in the actions of the corporation. A sense of responsibility could be viewed in a
70 | P a g e
limited scope with regard to shareholders needs but should be viewed in a wider sense of
responsibility to country or society as a whole.
8. Accountability
This is a development of responsibility.
Here the sense of accepting liability for our actions is extended to include the need to
demonstrate this sense of responsibility through the communication of actions taken or decisions
reached to interested bodies. Accountability can be seen within the accounts provided to the
market or in the wider nature of disclosure. Directors may also account through the Annual
General Meeting or even in representation at a parliamentary enquiry.
9. Integrity
A building’s integrity relates to its strength or solidity.
An individual can demonstrate integrity through operating to a high moral code of ethics. This
integrity must withstand the influences of self-interest or the pressure placed upon an individual
by others to act in a way that would compromise the integrity of the director.
10. Judgement
This relates to the ability to weigh issues, to have balance and to not be swayed by emotive
issues.
Judgement is supported through information or a formal process of deliberation. Demonstrating
good judgement could be through examination of the performance of the company although in
an ethical sense good judgement requires consideration of fairness and integrity rather than
simply viewing the bottom line.
11. Reputation
Reputation is an outcome of demonstrating adequate adherence to the other underlying
principles. Reputation may be viewed from an individual or entire board or corporate
perspective. If the reputation of the individual is called into question their position on the board
becomes insecure. If the company’s reputation is questioned this can have a long term damaging
effect on profits.
Describe how the application of underlying principles of governance may differ depending upon
whether the organisation is a public listed company or a charity delivering aid effort to communities
around the world. Professional skills marks are available for showing commercial acumen in your
answer.
71 | P a g e
Board composition
• No one person, or group, should be able to dominate the board.
• Should be an appropriate size, and right balance of skills and experience. This includes diversity,
including by gender.
• Oversee induction and training for all directors (likely to be organised by the Chairman, assisted
by the Company Secretary).
Remuneration of directors
• A significant proportion should be performance-related.
• Should consider industry pay levels.
• Enough to attract, retain and motivate.
• Notice periods no longer than 1 year.
Internal control
• The Board should ensure a sound system of controls.
• An annual review of effectiveness of controls is required and should be reported in the Annual
Report.
• There should be an Audit Committee of at least 3 Independent NEDs (Non-Executive Directors).
• The main role of the Audit Committee is liaison with the internal and external auditors on all
matters.
Eighty five percent of the world’s palm oil supply is grown in Indonesia, Malaysia and Papua New
Guinea on industrial plantations. A palm oil mill generates 2.5 metric tons of waste for every metric
ton of palm oil produced. The Indonesian government announced in 2009 its plans to convert about
18 million more hectares of rainforest into palm oil plantations by 2020.
The Rainforest Action Network (RAN) calls the palm oil crop “one of the key causes of rainforest
destruction around the globe.” When rainforests are destroyed it causes social and environmental
problems, including destroying endangered animals’ habitat, like the Sumatran tigers, elephants and
orangutans. Tens of millions of Indonesians rely on rainforests to make a living, and razing
rainforests destroys their livelihoods. Rainforests are the largest carbon sinks on the planet,
according to RAN, and when they are destroyed massive amounts of carbon are released, further
adding to climate change.
In the US, trustees of New York’s pension fund, which owns about $1.9 million worth of the Dunkin’
Donuts stock, filed a shareholder resolution asking the company to address this environmental
problem. As a result the company joined the ranks of companies committed to purchasing its palm
oil from 100 percent sustainable sources. Other companies already agreeing to adopt this practice
include Sara Lee.
Positives
• A sense of brand association with the family
74 | P a g e
• Family expertise and contacts with powerful stakeholder groups such as government
• Strong family culture and staff support and association
• Sense of stability and continuity
• Low agency costs.
Challenges
• The quality of all family members who operate in key positions (they cannot all be good)
• Poor agency relationships if other shareholders exist
• Possible sense of family detachment from others
• Inability to accept wider governance needs and views
• Lack of transparency in governance
Since family structures are very common, in fact the natural progression of growth from a small
company to a listed company, the challenges or problems are often outweighed by the positive
governance outcomes.
Just as each family is unique, so the way it governs the corporation is unique. There is no standard
view of what this influence may embrace.
With regard to global governance and the regulation of markets, family-based structures refers to a
listed company where family members are a dominant force. This domination will relate to their
large shareholding and position as senior managers on the board of directors.
This is a restrictive view of the family concept. Limited companies as opposed to public listed
companies are very often family-based structures. The family in this instance may be the only
shareholders of the organisation and may also be the only members of the board of directors.
Limited companies are almost always beyond the remit of corporate governance consideration
outside of the requirement to meet legal obligations placed on all organisations. Limited family-
based companies do not have agency since the family shareholders run the company. The absence
of agency means that much of governance regulation has no real application.
However, the existence of this kind of private company should be recognised. This creates a dual
meaning to the concept of private and public. Private can mean private in the legal sense of being a
limited company or private in the sense of referring to any institution owned by shareholders rather
than the state. Public can mean publically listed company or an institution owned by the state as in
public sector entity.
In 2008, TV chef Hugh Fearnley-Whittingstall, who presents the ‘River Cottage’ programmes,
proposed a resolution to the AGM of Tesco in order to improve the welfare of farmed chickens, but
only 10% of those voting agreed with him, despite a media campaign backing his views.
Shareholders do not have any real power, and is it not possible for shareholders to instigate
collective action. Discuss.
The internet has improved the ability of shareholders to contact one another and instigate action.
Bradford and Bingley Building Society were forced to float on the London Stock Exchange, despite
the directors opposing this. First Active, a Dublin-based financial institution, was forced into major
executive changes by a concerted campaign fronted by Senator Shane Ross and TV sports
personality Eamon Dunphy. You can read more about these cases on the Internet.
Agency costs
The need for directors to act in accordance with regulation is a price that the directors must accept
and the shareholders must pay for in order to sustain the sense of trust.
These costs include:
• The cost of financial accounting for disclosure
• The cost of audit
• The cost of meetings and dialogue with shareholders
Such monitoring costs will not be enough to sustain the relationship since, in order to act in
accordance with shareholder wishes, the directors own sense of self-interest must be dealt with.
The underlying principles existing in the mindset of high quality strategic managers should be
enough to ensure the directors’ self-interest is not given precedent over shareholders’ needs.
However, by aligning that self-interest in a positive sense with the same objectives as shareholders
(profit and reward) it is more certain that trust can be established and maintained.
There are three types of agency costs:
1. Monitoring costs
2. Directors’ remuneration
3. Residual costs
Agency costs always exist. The extent to which each category is important will depend on a number
of issues.
78 | P a g e
1. Monitoring costs
These could depend on the level of regulation required by the stock exchange or government
within which the company operates. Monitoring costs determined by shareholders will increase
where perceived trust does not exist.
2. Directors’ remuneration
This includes directorial bonuses and share option schemes.
This will usually reflect the need to attract and retain high quality directors. It also depends on the
ability of the director to influence his/her own remuneration package.
3. Residual costs
These are costs that arise out of the use of professional managers to represent shareholders’
interests.
They can be considered as benefits or the expected costs of agency/the trappings of office or
simply perks. They include use of the company flat, car and private jet.
These will generally relate to the industry or social norms that exist for public company directors
in a given country or jurisdiction.
• Suppliers
• Governments
• Communities
• Environment and ecology
Agency and stakeholder theory have similar characteristics:
• They both examine relationships.
• They both identify the importance of trust.
• They both require fundamental principles to exist.
Although stakeholder obligations are often considered to be secondary to the needs of the market
some sense of the existence and influence of stakeholders is essential because of the impact failure
to consider these groups can have on company profit.
Definition
An understanding of the importance of shareholder consideration because of their influence on
profits is termed enlightened self-interest.
3.7.4 Enron
80 | P a g e
Although Enron was certainly not the first documented instance of corporate greed and corruption
in the modern era and although the losses incurred by shareholders and others are less than a tenth
of those that arose from the failure of Lehman brothers, it still is held as the benchmark against
which cases of subsequent governance failure are measured and, more importantly, the governance
regulatory changes that arose following the collapse have had a greater impact on global
governance than any other incident before or since (except the South Seas Bubble).
Enron was a Houston-based energy company led by the cult figure of Ken Lay. During the 1990s Lay
successfully lobbied (through political allies) for deregulation of the energy markets in the US thus
removing them from the tight control of the US government. Once free from these shackles Lay and
champion CEO Jeff Skilling developed Enron into the most successful energy trading company in the
US, controlling the power stations and infrastructure for delivering gas and electricity whilst selling
clients (including state institutions) contracts for energy supply.
Operating in a virtual monopolistic position, controlling the value chain from supply to customer,
gave Enron enormous power and with that power came greed and inevitably corruption.
After seven years of meteoric growth, the bursting of the dot.com bubble in 2000 led to a slump in
share price against which all of Enron’s finances were pinned. On 2nd December 2001 the company
filed for Chapter 11 protection from its shareholders sending shockwaves through global exchanges
from which emerged Sarbanes Oxley 2002 and a variety of changes to UK governance in the Code
revision of 2003.
The 3 year trial that followed, according to John Coffee of Columbia Law School, was as complicated
as “War and Peace”.
The prosecution said:
“The two men at the helm told lie after lie about the financial condition of the firm”.
The defence countered:
“This is not a case of hear no evil, see no evil. This is a case of there was no evil. Mr Skilling did not
lie, cheat or steal.”
Ken Lay was sentenced to 165 years, Jeff Skilling to 275 years.
Once confidence began to wane in the company the share price began to fall, this had an adverse
impact on cash flow as some debts were settled, which then had a negative effect on the share price
thus requiring more debts to be settled and so on.
Enron had massively under-reported just how much debt it had. The financial statements showed
profits when in reality the company was hiding huge debts and losses in the SPEs. When the Enron
share price reached its highest level in August 2001, Enron senior executives started to sell their
own shares, whilst still encouraging investors to buy shares in Enron.
As large numbers of shares were offloaded by Enron executives who knew the true financial
position of the company, the share price started to fall. By the end of November 2001, the news of
the financial losses and mounting debts was made public and the company filed for bankruptcy.
The share price had dropped from a high of US$90 to being worthless.
There were a number of problems at Enron.
Whilst some of the accounting was strictly within the American rules, some of it contravened
accounting standards. Far too much information and control was in the hands of a very small
number of dominant individuals who were also too involved in the day-to-day running of the
business.
There was a lack of internal control and poor risk management. Whilst Enron did have non-
executive directors they did not appear to understand what was happening and clearly did not
question the executive directors sufficiently.
There was a serious failure in the audit function as the auditors, Arthur Andersen, were aware of
what Enron was doing. The role of the auditor is to report to the shareholders on the accuracy of
the financial statements and yet Arthur Andersen was so close to the directors that they were not
fulfilling this obligation.
There are allegations that they assisted Enron in committing some of the illegal accounting. Arthur
Anderson earned a large audit fee as well as a huge amount of fees for non-audit work.
There has always been an opinion in the accountancy profession that if the auditors perform many
other services in addition to the external audit it could compromise their opinion about the accuracy
of the financial statements, as they do not want to upset the directors and risk losing the (usually)
more lucrative non-audit work.
Cadbury 1992
The development of stock exchange regulation in the form that is familiar today began in the UK in
the late 1980s. Adrian Cadbury was asked by the UK government to produce a report and
recommendation following the events of Black Monday October 1987 during which 25% of UK share
value and up to 60% of other global exchange value disappeared during one day of frantic trading.
Cadbury was due to report to Parliament in 1991. Just prior to this another corporate scandal
involving Robert Maxwell and the Mirror Group erupted in the press forcing Cadbury to refocus on
the governance issues surrounding this case.
82 | P a g e
Maxwell operated the Mirror Group as both Chairman and CEO, refusing throughout his tenure to
talk to shareholders whilst mercilessly plundering the employees’ pension fund for cash to prop up
his failing media empire. When Maxwell died, unexpectedly in 1991, the depth of the
misappropriation emerged.
Cadbury’s eventual report therefore focuses on the need for an effective board, the need for
separation of roles at the top of the company and the need to formalise communication with
shareholders.
Greenbury 1995
Greenbury was asked by the UK government to offer advice regarding directorial remuneration,
then, and now, the most contentious issue in all of governance. The backdrop to his report saw the
privatisation of state institutions such as Telecommunications, Gas, Water and Electricity.
As each company transferred from state ownership to floating shares on the London Stock exchange
directors of these utilities awarded themselves huge salary increases in line with their new status as
champions of industry. The public were incensed as to how ex civil servants could become
fabulously rich overnight through no action of their own.
83 | P a g e
Greenbury identified the need for performance-related pay in order to deal with this issue as well as
the need for a formal independent process through which remuneration for directors should be
determined.
Hampel 1998
Hampel brought together the reports of Cadbury and Greenbury in order to create the first
Combined Code of Corporate Governance, a title that survived until 2010.
In addition, he criticised the role of shareholders and in particular Institutional Shareholders such as
Pension Funds and Investment Trusts for failing to take an active role in the management of firms
within which they invested.
Agency is a relationship and as such has two parties both of whom must be actively involved
otherwise the quality of the relationship is diminished.
Today the Hampel report has become the basis for the UK Stewardship Code 2010.
Turnbull 1999
Turnbull recognised the need to improve internal control and risk management in organisations. It
was difficult for him to ignore since the greatest scandal in UK banking history had been all over the
press since 1995. The bank in question was Barings and the instigator of the fraud perpetrated there
was the original “Rogue Trader” Nick Leeson.
In the film “Rogue Trader” Leeson is depicted as a working class lad thrown into the complexity of
the Singapore Futures Market (SIMEX) with little experience and too much responsibility. In fact, he
not only traded for clients, betting on price movements of stocks, but also was in charge of the
trading account used to settle balances at the end of each day. The lack of segregation of duties
inevitably led to Leeson using the bank’s own money to pay back clients who lost in such trades, so
cementing their future custom and draining the coffers of Barings.
Turnbull formalised the need for a review of internal controls and strengthened control disclosure.
Unfortunately his recommendations came too late for Barings which was unable to cover the
trading losses and went bust.
In the early 1990s, Barings expanded into “new” products such as options and futures trading. Nick
Leeson, a British banker, was given the new Singapore branch to manage.
In trading operations, the bank has a front office where the trades are organised and a back office,
where the trades are recorded and accounted for. There should always be segregation of duties
between those trading and those accounting for the trades. This should stop fraudulent traders
doing one thing and recording another.
However, at Barings, Leeson had total control of both the front office and the back office. He
controlled how his trades were being recorded. When members of Leeson’s team made mistakes,
Leeson did not want his staff to be blamed so he hid their mistakes in an account (88888). He could
do this because of the lack of segregation of duties which allowed him to trade and then to record
those trades.
Additionally, there was a lack of understanding of the trades being entered into both by the UK
directors and the auditors.
Leeson used the bank’s money to gamble on the markets, making speculative trades. The 88888
account was used to hide any losses. By the end of 1994, losses in that account amounted to more
than £200 million. The bank allowed him more money to continue trading, although it was unlikely
they knew what he was doing. The fraud reached a climax in January 1995 when he gambled that
the Japanese stock exchange, the Nikkei, would not move significantly overnight. Unfortunately the
Kobe earthquake hit Japan and the stock exchange fell significantly.
Leeson aimed to recoup losses by betting that the stock exchange would recover quickly. It didn’t
and Leeson knew that millions were going to be lost and he fled. By the time the bank understood
the position he had created it was too late
The loss exceeded £800m. This was big enough to wipe out Barings Bank. The bank was eventually
sold for £1.
The bank was destroyed by one trader because the directors didn’t understand the business they
were in or what Leeson was doing. There was a serious lack of internal control over the operations.
Again, there was too much control in one person’s hands and to some extent the auditors failed to
properly understand the situation at the bank.
Despite these problems occurring and the Leeson case being very widely publicised, the same
situation occurred at a French bank, Société Générale in 2007. A banker had opened up a number of
unauthorised positions and that cost the bank almost 5 billion euros.
Higgs 2003
Following on from Sarbanes Oxley (SOX) Higgs identified the lack of courage of independent
directors at Enron to challenge the actions of Ken Lay and Jeff Skilling. The role of the Non-Executive
Directors was accordingly revised.
Tyson 2003
In order to support Higgs, Tyson recommended strengthening recruitment, induction and
performance management as prerequisites of creating and sustaining an effective board.
Smith 2003
Finance at Enron was headed up by Andy Fastow. The ability to trade well beyond the company’s
ability to do so and hide Enron’s financial weakness was his responsibility. This could not be
achieved without the collusion of the auditors (Arthur Anderson) and a compliant Audit Committee.
Smith recommended strengthening the role of the audit committee to ensure it is truly independent
and effective in its operation.
Turnbull 2005
Recognising the changing nature and requirement of governance, Turnbull returned to offer his
advice as to the importance of risk management.
His words went unheeded in the overheating market for credit. The result was the Credit Crunch,
where borrowing was heavily constrained and many economies in the world went into recession.
Customers saw the emergency loan as a sign that the Bank might collapse, and they queued up to
withdraw their money – therefore guaranteeing that it did collapse. The UK Government stepped in
and took over Northern Rock.
Attention was firmly fixed on the housing market and the number of people who were defaulting on
their home loans. Many had borrowed far too much and as house prices started to fall, those who
defaulted were unable to repay their loans, even if their houses were sold. Many banks had sold
their mortgages on to other financial institutions, and it was extremely unclear which banks would
suffer as the mortgage defaults increased. Several banks went out of business, whilst governments
around the world had to decide which were important enough to save from collapse.
In the UK, Royal Bank of Scotland (RBS) had taken a big expansion risk in acquiring ABN Amro – now
it discovered that it had paid far too much, and as a result RBS had to approach the UK Government
for help. Halifax Bank of Scotland (HBOS) was also in trouble in the UK, but seemed to have been
dealt with when Lloyds Bank bought it. However, Lloyds soon found that HBOS was in far worse a
state than it had realised, and now Lloyds itself was in need of a government bail-out.
In the end, the UK Government owned in excess of 80% of RBS and 40% of Lloyds.
Similar problems were happening around the world, including Lehman Brothers which collapsed in
the US after the US government decided not to rescue it. Merrill Lynch also nearly collapsed, but
was rescued by a takeover by Bank of America. It was then discovered that Merrill Lynch was in a lot
worse shape than had been thought, and in addition had promised $5 billion in bonuses to its staff
before the takeover.
Just as in the UK, Bank of America had to seek US Government assistance. Banks became very
reluctant to lend money, fearful of a liquidity crisis. This just helped to slow the global economy
even more, and more loan defaults and company bankruptcies resulted.
The above events resulted in many people questioning the accuracy of financial reporting because
banks went from appearing to be very profitable and safe investments to virtual collapse within
weeks.
Following on from this came questions over the value of an audit process which failed to identify the
banks’ problems. Probably the biggest issues raised have been surrounding the excessive risks taken
by banks, and the bonuses paid to bankers for taking such risks.
The collective outcome of corporate governance failure and regulation in order to counter the root
cause of failure, has been the development of a comprehensive code of corporate governance to
regulate all organisations in the future.
Each section contains a number of principles. These principles are non-negotiable, they must be
adhered to by all those coming to the market. The way in which each principle may be achieved is
detailed through a number of provisions. These provisions are advisory since there may be a
number of ways in which a company can achieve the required principle.
Section C: Accountability
• The board should present a balanced and understandable assessment of the company’s position
and prospects (Cadbury).
• The board is responsible for determining the nature and extent of significant risk and should
maintain sound risk management and internal control systems (Turnbull).
• The board should establish formal and transparent arrangements for audit relationships (Smith).
Eddie, an owner-manager of his own company, has stated that codes of corporate governance have
no application to those organisations that do not have an agency relationship between shareholders
and the board of directors. His manufacturing company does not trade its shares and is owned and
run by himself, so a code of governance does not have any relevance to the management of the
enterprise.
Discuss Eddie’s view. Professional skills marks are available for demonstrating evaluation skills.
An evaluation of the importance of codes is a difficult question to answer since the question itself is
not clear.
It seems inappropriate to evaluate the importance of regulation itself since without any regulation,
legal or stock exchange advisory based, corporations would have complete freedom to act and
governing would be left to director discretion and shareholder pressure.
The evaluation may relate to the importance of codes as opposed to enshrining the regulation
within the legal system.
Here, the evaluation simply looks at the importance of having an effective code that works in its
operation and is supported by all parties in the governance relationship.
Arguments in favour
• Adopting a code improves the level of general control and the quality of decisions made within
the corporation.
• This should improve profitability.
• Adopting a well-regarded code gives investors confidence in corporations and therefore attracts
investment. This is particularly true in promoting overseas investment.
• Quality codes give stakeholders an assurance in the good management of powerful enterprises.
This is particularly true for governments and the general public.
Arguments against
This is difficult since it is difficult to argue against something that is effective. However, in a general
sense:
• Codes are reactive and therefore should not be over relied upon as a mechanism for reducing
greed and fraud.
• Any regulation creates overhead and cost in its implementation.
• This can affect competitiveness on a global basis.
• A single approach to regulation creates an imbalance between those to whom it is necessary and
those to whom it is not.
• A single approach creates imbalance between those who can absorb the cost and those that
cannot.
• Any regulation reduces the freedom of directors to act even if it is in the shareholder’s best
interests.
Some of these criticisms were recognised by Cadbury who decided that the Code should, to a
degree be voluntary, so removing the burden of full adherence for smaller companies.
90 | P a g e
The underlying principles of governance have application to any organisation. They are fundamental
requirements regarding the behaviour of those charged with running the enterprise, whether such
an entity were a for-profit or not-for-profit structure.
However, the emphasis concerning the importance or degree of application may include some
variation. The sense of fairness to stakeholders will have a greater importance for the charity since
its exposure to stakeholders is wider and more central to the purpose and objectives of the
organisation. Equally a sense of probity beyond the need for adherence to legal requirements will
be heightened. Both types of organisation must ensure they operate within the law, but the scope
and nature of legislation applicable to their operation will differ.
Issues relating to judgement will possibly be simpler in the for-profit company given that most
decisions are firmly focused on profit, whereas in the charity strategic judgement involves the
weighing of a number of ethical concerns.
Transparency in the plc will in part relate to the need for full disclosure using recognised accounting
practices, the charity operates to a differing set of disclosure requirements. The reduced sense of
self-interest and scale of director remuneration places a greater emphasis on independence in the
plc, whilst responsibility and accountability may be greater in the charity due to its need to be seen
to reflect the needs of stakeholders rather than simply shareholder requirements.
91 | P a g e
Professional skills marks are gained for demonstrating understanding of the difference between the
types of company.
Solution 3.2
Personal shareholders have very little power, even if they are high profile individuals or have a
strong case to promote.
However, there are some shareholders that do wield a degree of power.
The shareholders with the greatest power are institutional shareholders, as their blocks of shares
are greater than those of smaller, personal shareholders.
Institutional shareholders can, and do, wield influence if they are concerned with the performance
of the company, or actions taken by the company. In the first instance, they can communicate
directly with executives, either by writing a formal letter via the Company Secretary or by discussing
their concerns with individual executives. They can threaten to take further action by calling a
general meeting, subject to holding sufficient shares. Even if they do not have enough shares to call
a meeting, they can mobilise other institutional shareholders to take action with them.
Recent examples of shareholder intervention include the formal objection to remuneration
proposals at the AGM of Barclays Bank in 2012, and the class action against Royal Bank of Scotland
in 2013.
Professional skills marks are available for identifying a type of shareholder which does wield power,
contrary to the statement, and showing that they can take action.
Solution 3.3
In almost all jurisdictions, directors are elected into office by the shareholders, voting collectively at
the annual general meeting (AGM). The exception is in a newly-formed company, where the first
directors are appointed by the founders.
In the UK, the model Articles of Association (the internal constitution of the company) state that
one-third of the directors retire by rotation each year. They do not actually retire, unless they wish
to do so, but must present themselves for re-election at the AGM. If there are no other candidates,
they are re-elected unopposed. In the largest listed companies in the UK, all directors submit
themselves for re-election every year. In practice, it is very difficult for a candidate to be elected if
he or she is not backed by the existing directors, as they can make a recommendation on who the
shareholders should elect (in some countries this is forbidden by law). For this reason, critics of the
system often argue that board membership is a ‘self-fulfilling oligarchy’.
The actual, practical route to board membership is that new directors are usually invited to join the
board by a process called co-option (or co-opting). This can be done to fill a ‘casual vacancy’ when a
board member resigns, is disqualified or dies, or when the board wishes to increase the total
number of directors on the board. They will approach the individual who they think is most suitable
for the job (often following a decision of the Nomination Committee). Depending on the precise
provisions of the Articles of Association, the appointment of the co-opted director will then have to
be formalised through the rotation process at a subsequent general meeting.
92 | P a g e
Solution 3.4
In one sense a code of corporate governance would have no relevance. Such codes are created by
governments or stock exchanges for the regulation of corporations that are trading their shares on a
given exchange. The over-riding purpose is to safeguard the shareholders’ investment and support
the agency relationship.
However, in pursuit of this goal codes provide a wealth of advice or statements of best practice that
seek to improve the way in which the corporation is being managed. Such advice has wide
application to almost any form or organisation even though the scale and importance of such
application may differ.
Key areas of similarity or application include the need to ensure financial and general control. The
code states the need to regularly review controls, this is sound advice for any company listed or
otherwise. Codes also identify the need for formal and rigorous approaches in dealing with
recruitment, induction and training. Any company would benefit from heeding this advice.
Elements of the code, such as the need for independence in board membership and the CEO/Chair
split, are redundant. However, as has been seen in the United States, organisation that previously
were unlisted may grow to a size where listing becomes a necessity and so may decide to
implement codes many years prior to floating the company so as to ensure, when the time comes,
they are fully compliant with all listing requirements. This may suggest the manufacturing company
take a proactive approach to compliance prior to the time when it is actually needed.
Evaluation marks are available for considering a breadth of relevant factors (eg shareholder
protection, management, control and growth).
4
Stakeholders
Context
93 | P a g e
The stakeholders are those that have a stake in the company, such as the shareholders, customers,
staff, suppliers or others that are affected by the company. There are debates as to who are most
important. Customers are very important to organisations but so are employees and shareholders.
Most companies will try to reconcile the conflicting claims of the stakeholders involved to do the
best they can for each. Organisational cultural issues can play an important part here.
Video introduction
4.1 Stakeholders
4.1.1 Introduction
Stakeholders are all those individuals and groups who have some interest in the decisions of the
organisation.
Stakeholders can influence or be influenced by what an organisation does.
Understanding stakeholders is important when developing a strategic plan because the term
includes:
• The groups for whom the organisation is being primarily run, such as shareholders in companies,
patients in hospitals, beneficiaries in charities.
• The groups whose cooperation and support are essential if the organisation is to succeed, such
as employees, customers, lenders.
Key players: These people have power and will exercise it, so any decisions and strategy must be
acceptable to them. Examples include major customers (who could take their business elsewhere),
and the cabin staff of some airlines who know that there are regulations governing the number of
staff on planes and who have a very militant history of industrial action. The key players have to be
handled very carefully and often get exactly what they want.
Keep satisfied: Stakeholders in this segment must be treated with care. They are capable of being
sufficiently provoked, moving into the key player segment if they do not like what the organisation
is doing. Examples include large institutional shareholders and medical staff in hospitals. These
groups have great power in theory but are usually reluctant to exercise it. This means that they can
often lose out in the process of negotiation.
Keep informed: Stakeholders in this segment do not have great ability to influence the strategy, but
they are intensely interested in what the organisation is doing. Although they have little power
themselves, their views might be important in influencing more powerful stakeholders and perhaps
forming alliances with those groups (eg green lobbying groups). They need to be kept informed and,
if possible, 'kept on side'.
Minimal effort: Little power and little interest. Members of this group come at the end of the queue
when decisions are being made.
95 | P a g e
Use Mendelow's matrix to classify the following stakeholder groups for a hospital:
(a) Cleaning staff
(b) Doctors
(c) Patients
(d) Minister of Health
Definition
The ethical stance is the extent to which an organisation will exceed its minimum obligations to
stakeholders and society at large.
Ethics in general is about what is right and wrong. Business ethics also deals with the regulatory
environment and corporate governance issues which determine the minimum obligations of an
organisation towards its stakeholders.
Examples of ethical dilemmas that could easily face organisations include:
• Closing down or relocating operations hurts current employees and, perhaps, suppliers, but is
good news for potential employees at the new location.
96 | P a g e
• Dealing with extortion (where the company is threatened), bribery (paying someone to do
something they should not), grease money (paying someone to do something that they should
be doing anyhow, but who might be stalling), gifts of material value.
• Dealing with the environmental impact of operations.
• Dealing honestly with customers in advertising and in admitting errors promptly.
• Dealing with damage caused by the organisation.
• Deciding whether disreputable governments should be dealt with.
• Deciding whether to enter industries such as arms manufacturing, tobacco and alcohol.
As you can imagine, different organisations take very different stances and there is likely to be a
strong relationship between the ethical stance, the character of an organisation and how strategy is
managed.
Two people each need a kidney or they will die. A third healthy person can provide two kidneys but
would die in the process. We could save two people for the price of one (greatest good for the
greatest number), but few of us are likely to suggest that that would be an ethical act.
Fortunately in business much of the difficult and often unresolvable issues of ethics can be ignored
if we simply focus on the measurable benefits of a business being ethical.
These arguments make the assumption that wrongdoing will be found out. This is increasingly likely
now that the Internet can easily and quickly be used to distribute information, possibly leaked, such
as photographs and documents.
Therefore ethical behaviour will:
• Enhance the organisation's reputation. This will attract the best employees and partners as no-
one wants to work for an organisation whose actions they cannot defend. Customers and
suppliers also prefer to deal with organisations they can trust.
97 | P a g e
• Minimise financial damages and regulatory penalties. All organisations make errors from time to
time, but the financial consequences of these are likely to be smaller if the organisation did not
act negligently to start with and that it admitted to problems quickly and honestly.
• Lower risk: financial damages, punitive damages, loss of the right to trade, loss of customers.
• Lower risk means that finance can be raised more cheaply.
• Cheaper finance implies greater present values on projects and higher share prices.
equitably, to be truthful with its customers, to train the long-term unemployed, contribute to
education and the arts, and help revitalise urban areas of deprivation. Not only does the company
want to achieve these objectives itself, it seeks to encourage others to do so also, so that real
social change takes place.
An example might be found in the 'Body Shop', a supplier of soap, shampoos, make-up and so on.
This was one of the first companies to insist that its products were not tested on animals and that
suppliers in developing countries were given fair prices for their products. This proved popular
with the Body Shop's customers and before long many of their competitors had to follow suit.
4.3.1 Introduction
Corporate Social Responsibility (CSR) is the acceptance by companies that they should be
accountable not only for their financial performance, but also for the impact their activities have on
society and the environment. CSR implies that there is an expectation that businesses will act in the
public interest.
CSR is concerned with the ways in which an organisation exceeds the minimum obligations to
stakeholders specified through regulation and corporate governance.
4.3.2 Examples
In reality, each business is part of the society in which it exists and its actions have both economic
and social effects. It would be practically impossible to isolate the business decisions of corporations
from their economic and social consequences. The effects that businesses have on society and the
environment are known as 'externalities'. For example:
• An airport's externalities include noise and pollution.
• A haulage company may cause damage and congestion on roads and may cause air pollution.
• A school may cause inconvenience for its neighbours as parents take children there in the
morning and collect them again in the evening.
Of course, the law often intervenes to some extent in these matters: noise control, pollution limits,
road tax to pay for road use and parking laws to control cars. CSR looks at what businesses can do to
be a 'good neighbour' beyond what the law stipulates.
So, for example:
• An airport could voluntarily offer its neighbours double glazing to reduce noise disturbance.
• A haulage company could try to restrict lorry movements at rush hour.
• The school could create 'set-down' areas for parents driving children to school.
99 | P a g e
(a) High interest (the hospital is their employer) – Low power (relatively low skilled makes it
easier to replace them) – Keep informed
(b) High interest (the hospital is their employer) – High power (skilled professionals hard to
replace) – Key players
(c) High interest (the hospital is treating them) – Low power (they cannot force the hospital to
do anything) – Keep informed
(d) Low Interest (will leave day-to-day decisions to be made by the hospital) – High power (can
close hospitals, replace chief executives, etc.) – Keep satisfied.
Any strategy followed will need to keep doctors happy and not upset the Minister of Health.
5
Governance scope, reporting, directors and
the public sector
Context
The central players in corporate governance are the board of directors. The way in which they
perform their duties will determine the success or failure of the corporation and shareholders’
investment. Legal and regulatory requirements constrain and focus their activity to ensure that
agency trust is established and maintained.
Having investigated the nature of the board of directors as a whole it is worth considering the
operation of its sub-components, the board committees. Committees evaluate specific governance
concerns and advise the board accordingly. They provide a source of expertise in some areas and a
valuable independent scrutiny function for the shareholders.
The final aspect of governance is to extend the reach of regulation beyond that associated with the
UK. This moves the investigation from establishing a benchmark for regulation to considering the
variety of forms of governance that can be seen in different jurisdictions around the world.
Video introduction
101 | P a g e
Legal requirements
The Companies Act 2006 also provides detailed information on the roles and responsibilities of
directors. A director must act in good faith and in a way that will promote the success of the
company for the benefit of its members as a whole and have regard to:
• The likely consequences of any decision in the long term
• The interests of the company’s employees
• The need to foster business relationships with suppliers, customers and others
• The impact of the company’s operations on the community and the environment
• The desirability of the company maintaining a reputation for high standards of business conduct
• The need to act fairly
The above conditions are part of a director’s statutory obligation. As a point of note, the Companies
Act requires directors to consider the company’s impact on the environment and local community.
This is not to the detriment of company operations, but highlights the importance of considering all
stakeholders in company decisions as a key feature of corporate governance.
Both the chief executive and the non-executive directors report to the chairman. As part of their
role on the nominations committee, the NEDs will also consider if the chairman is the right person
to run the company and will assess his/her performance.
The chairman is the most senior person in the company. As well as running the board, the chairman
is the point of contact for shareholders. This may be a problem if the shareholders or non-executive
directors do not think the chairman is an appropriate person for the job.
Under UK corporate governance, one of the non-executives is appointed as the senior independent
non-executive director (SID). This role gives shareholders an alternative contact if they have a
problem with the chairman.
When the NEDs meet to discuss the performance of the chairman, the SID is likely to organise and
lead the meeting.
This is not to suggest that other jurisdictions follow the example of the unitary board.
Two-tier boards also exist.
Two-tier boards
Two-tier boards consist of:
1. Supervisory tier
The upper tier usually consists of shareholders and stakeholders who have an active interest in
running the corporation or managing their own substantial investment in the enterprise.
2. Management tier
The lower tier consists of executives who manage the day-to-day operations of the organisation
rather than defining strategic direction or dealing with the wider agency relationship.
Problems
• Detachment of executive from strategic input and decisions
• Detachment of the upper tier from the lower tier
• Less expertise on the upper tier
• Larger governance overhead by having two boards
104 | P a g e
Strategy role
To assist the executive in the determination of strategy through their expertise in specific areas. This
role highlights the sense of collective responsibility with the executive for determining the product
and market focus of the company over time.
Scrutiny role
To monitor executive activities on behalf of shareholders. This general scrutiny role is then
developed into recognising the role of NEDs on an audit committee.
Risk role
To assist in the risk management process, defining risks and appropriate strategies. This role
recognises the NED membership on a risk committee.
People role
To act as an independent function for recruitment to the board and director remuneration. This role
recognises NED membership on both nomination and remuneration committees.
NED independence
In order to be seen to make decisions in the interests of shareholders and to operate without undue
influence of the executive, NEDs must adhere to the independence criteria set out in the code:
• They should not have been an employee within the last five years.
105 | P a g e
• They should not have had any business relationships with the company in the last three years.
• They should not have any family members in senior positions at the company.
• Any NED who has been on a board for more than nine years is assumed to no longer be
independent.
• NEDs are only remunerated with a fee for director duties – no profit share or share options.
• They cannot hold cross-directorships – this is where the directors of two companies sit on each
other’s boards as non-executives. Whilst there may be sensible business reasons for this, in
order to promote links between two companies, it also means that two directors are in a
position to reciprocate favours for each individual’s self-interest.
• Any NED representing the views of a major shareholder or being a major shareholder
Some company directors, who want to semi-retire, often resign from being executive directors and
take up positions as non-executive directors. Obviously, these NEDs are not independent.
If a director is not independent, it does not mean that they must leave the board of directors. It
simply means that for corporate governance purposes, that director will not be considered an
independent NED so an additional, independent NED may have to be added to ensure the correct
balance on the board.
Advantages of NEDs
• Provide expertise to the board of directors.
• Operate in a monitoring capacity to curb excessive behaviour of executives.
• Demonstrate decisions are made in shareholders’ best interests.
• Facilitate stakeholder representation on the board.
• Facilitate compromise and create balance on the board.
Disadvantages of NEDs
• Having additional directors increases the size of the board of directors as at least half of the
board must be independent non-executives. This will increase costs and may slow down
decision-making.
• NEDs do not work full time for the company. It is debatable how much they actually know about
the company and how much they can add value.
• Some NEDs are too willing to accept what the executives tell them.
Some years ago, a survey in the US concluded that 50% of large listed companies believed that the
separation of the roles of chief executive officer and chairman was unnecessary and inappropriate.
Why do you think some companies may believe that the separation should not be a requirement of
governance?
Non-executive directors have an important role to play in providing the board of directors with a
wide range of expertise to support strategic decision-making.
July 2012: Veteran action hero Bruce Willis joins the board of directors at beleaguered French drinks
group Belvedere, which owns the Polish-made Sobieski vodka brand.
107 | P a g e
The US actor, who has appeared in ads for Sobieski, "expressed his wish to become a shareholder of
reference alongside its management and to be fully associated with the group’s marketing
strategy". Mr Willis, best known as the vigilante star of the "Die Hard" films, was ratified as a non-
executive director at the company’s annual general meeting. Belvedere has debts of about 550
million euros (800 million dollars) and, at one stage, was placed under bankruptcy protection by a
French court in July 2008.
5.2.1 Induction
Many of the requirements in Section B relate to failures at Enron. A lack of skills of NEDs was cited
as a major weakness within the company and so subsequently featured in the UK Code from 2003.
The induction of new board members is important because:
• It provides them with the skills and information they need.
• It provides assurance that these skills exist.
• It ensures rapid assimilation onto the board.
• It removes the ability of the individual to argue they did not have the information they needed.
• It is culturally appropriate to carry induction out.
The scope of induction should embrace:
Responsibilities
• The scope of applicable legislation
• The scope of applicable regulation
Roles
• Induction into products and markets
• Awareness of financial performance
• Awareness of risks and control structures
• Awareness of key shareholders and stakeholders
108 | P a g e
• Coaching or mentoring
• Learning a new discipline
• Temporary committee membership
• Attending trade exhibitions and conferences
Insider dealing
Insider dealing arises where the director uses his privileged position, and access to confidential
information not available to shareholders, in order to personally gain through share trading. Such
action is a criminal offence because it acts against the free operation of the market and
shareholders within the market. It is a corruption of the principle of free flow of information.
Insider dealing is an offence under the Criminal Justice Act (1993) as is disclosing price-sensitive
information other than in the course of one’s employment and making misleading statements to the
market.
This is a breach of the director’s fiduciary duty and the company can seek to recover the profit the
director has made from the illegal activity.
Conflict of interest
Insider dealing is an example of conflict of interest. The legal interest the director should have is in
meeting the needs of shareholders. His personal financial interest conflicts with this in as much as
shareholders are disadvantaged in not having access to the same information as the director and
being unable to act upon it.
In order to promote the sense of a duty of loyalty, directors should avoid any circumstance where
this loyalty may be called into question. Governance regulation often assist in promoting this idea,
for instance, by requiring directors to publish all personal share dealings with the market as soon as
possible.
Other examples of potential conflict of interest would include a director being party to a cross
directorship or being a director on a board of directors of a customer or supplier company.
Service contracts
Service contracts are employment contracts between the directors and the company. Such
contracts will not differ substantially in their content from the content applicable to any other
employee. Issues of duties, remuneration and other entitlements will all be covered. A key
provision, and one which is hotly contested in governance, is the issue of notice periods.
This is because longer notice periods create an increased level of compensation applicable should
the company or shareholders decide to dispense with the director due to poor performance.
s188 of the Companies Act 2006 states that service contracts between the company and any given
director will require approval by shareholders should they exceed 2 years. The UK Code (B1.6) states
that notice periods should be 1 year or less.
The ICSA advises that any compensation should be purely based on basic salary and, presumably,
have application to legal requirements for compensation alone. In particular, Liquidated Damages
(the provision for enhanced compensation in initial contracts of employment) or phased payments
(to disguise the total sum actually paid) must be avoided.
All directors must act reasonably and not recklessly with regard to their decisions and actions. The
extent to which a legal breach arises will depend on a number of factors including the perceived
level of skill of the director through training, induction and access to information. A wealth of
legislation in relation to health and safety, employee rights and the environment, for example, exist
to define the level of care and skill required by directors and the organisation as a whole.
Failure to operate with regard to either loyalty of care and skill can lead to:
• Criminal prosecution by the state
• Civil action by the company to recover losses.
According to the Companies Act, the following are some situations in which criminal liability can
arise:
• A director who fails to declare an interest in an existing transaction with the company commits
an offence.
• Where the directors fail to prepare a directors’ report for a particular financial year, any director
who failed to take reasonable steps to ensure that a report was prepared commits an offence.
Successful prosecution will usually lead to the removal and disqualification of the director.
Removal of directors
There are many reasons why a director may be removed from office:
• Removed for a disciplinary offence
• Through an agreed departure
• Resignation
• Personal bankruptcy
• Death in service
• Absence for more than six months
• As a result of a provision of successful prosecution under legislation
• Failure to be re-elected at AGM
• Through a simple majority vote made by shareholders.
Disqualification
Directors may be disqualified from acting as a director in the following circumstances:
• A director has been convicted of an offence in connection with the promotion, formation,
management or liquidation of the company
112 | P a g e
• A director has been persistently in default with regard to the Companies Act provisions relating
to the submission of accounts or annual returns
• Where a director has been found guilty of fraudulent trading on the winding up of a company, or
guilty of fraud in relation to the company
• Where a director has been convicted of an offence following the contravention of any
requirement to file returns, accounts or documentation with the Registrar of Companies
• When a company has gone into liquidation and an application has been made to the Secretary of
State on the grounds that conduct renders him/her unfit to be concerned in the management of
a company
• Where an application to disqualify is made by the Secretary of State on the grounds of unfitness
following a report made on the company by official inspectors
Re-election of directors
All directors must offer themselves for re-election by shareholders on a regular basis. This may
involve retirement by rotation with a third of directors standing each year for re-election at the
AGM or may require annual re-election of all board members in large companies.
With regard to retirement by rotation, there are particular requirements for NEDs.
• Review of their position in terms of skills and independence after 6 years
• Review of skills after 9 years with a loss of independent status
Although retirement by rotation is a matter for the internal constitution of each company but not a
part of corporate governance in the UK, it is used in other governance regimes around the world.
The upside is that it creates stability and less pressure on boards to act in the short term. The
downside is that it can lead to complacency or an inability for the shareholders to remove an
unwanted director for a period of time. This final issue was the reason for the change in the UK
following the recent banking crisis.
The only particular limitation that does not require shareholder action is the requirement of the
code that NEDs step down as independent directors at the end of a 9-year term. Even here this does
not actually mean that they can no longer be a part of the board. As previously stated, NEDs can still
remain on the board but cannot vote as independent directors.
Time limitations are best considered through the existence of rolling annual employment contracts.
This means that at any given point in time the maximum amount of compensation payable notice
113 | P a g e
period is 1 year or, hopefully, less. This concept is the same as provided to any employee below the
board level.
Ken has been a non-executive director at Ollp plc, a listed UK company, for nine years and is due to
retire.
Len believes that Ken has much to offer the company and that he should be asked to stand again for
election.
Ren believes that regardless of Ken’s abilities, it is necessary for him to stand down to protect the
needs of the shareholders, who are largely informed institutional shareholders.
Required:
Advise the Board on this matter, drawing a conclusion as to what should be done in Ken’s situation.
Professional skills marks are available for demonstrating commercial acumen and evaluation in
giving your advice.
Carol Bartz was hired as CEO at Yahoo, the internet service provider, in 2009 to replace co-founder
Jerry Yang. The company was in need of some attention, growth had begun to slow and the global
economic downturn did not exempt internet stocks from financial difficulty.
In truth, her performance was mediocre in the position but this hardly warranted Chairman Roy
Bostock calling a clandestine meeting with the rest of the board, without her knowledge, whilst she
was out of town on business.
Whilst sitting in her hotel room, Ms Bartz received a telephone call from the chairman to inform her
that the board had collectively decided to dispense with her services. She had been fired. Hardly an
appropriate way of informing a CEO of such a decision for one of the world’s great corporations and
most visible brands.
Bartz responded by emailing Yahoo’s 14,000 employees to inform them that she’d been fired over
the phone by the board chairman. She closed by wishing all staff her very best and stating what a
pleasure it had been to work with them. A number of senior managers resigned immediately out of
disgust with their board of directors.
The next day Ms Bartz gave an interview to Fortune magazine detailing how Mr Bostock and the
board at Yahoo had handled her removal.
115 | P a g e
The UK code deals with nomination or the recruitment of directors to the board in Section B,
“Effectiveness”. The code is clear concerning the need for a formal, rigorous and transparent
approach to the appointment of new directors to the board.
The importance of nomination or the need to have an ordered approach through which succession
is assured is possibly the most important issue in governance since without succession survival or
continuity of operation of the board is called into question. Despite this it is considered of lesser
significance than some other committees.
The composition of the committee typically includes a majority of NEDs to ensure independence but
therefore also allows for executive involvement since this assists in gaining important perspectives
on top line management being prepared for promotion to the board as well as assisting in the
identification of skills shortages on the board.
Formal, rigorous and transparent relates not just to the need for a defined, independent process of
nomination but also the need to communicate this policy and the rationale behind decisions made
to shareholders.
The nomination committee is responsible for monitoring the board and committees and ensuring
that the structure is appropriate, including reviewing whether a new director needs to be added or
one should be removed. There will necessarily be criteria for the selection of new directors.
It takes time to recruit new people, so the nomination committee needs to be aware of the
importance of succession planning. Many directors’ contracts have notice periods of up to one year,
so they need to consider who may retire or leave and try and ensure that replacements are
considered in advance. It is common to ensure that there are other board members who could step
up to become chief executive if that gap was created.
The nomination committee often arranges induction and training for all directors and facilitates the
use of external executive search agencies to approach potential candidates to see if they are
interested in taking on a board role. This is particularly useful when looking for replacements for the
chairman and non-executive directors as they need to be found from outside the company.
Process of nomination
A formal and rigorous process should embrace the following:
117 | P a g e
Board diversity
The most pressing and contentious issue surrounding nomination is the need to promote greater
board diversity.
On the face of it this seems a simple and reasonable concern which any board should embrace.
Board diversity relates to the need to improve the balance on the board in terms of:
• Gender
• Age
• Ethnic background/culture
• Skills and commercial background
Greater diversity brings with it the promise of improved decision-making through use of a broader
skills base and greater awareness of stakeholder needs such as customers in different global
markets (use of directors with diverse cultural backgrounds). There is also a perception or
reputational benefit in that the company is viewed as being more inclusive, a cultural belief that
runs deep in most capitalist societies.
The contentious element arises as to the clear evidence that most boards of directors are anything
but inclusive, generally consisting of older men drawn from the same social and ethnic culture. The
skills base is often considered secondary to the nepotism in recruitment.
Ted, a non-executive director at X plc, has expressed concern that the nomination process for non-
executives at X plc is limited and that as a result, X plc has a lack of diversity on its board.
Prepare two sides for presentation, with accompanying notes, to the nomination committee at X
plc, identifying practical steps that X plc could take to increase the diversity of the X plc board.
Professional skills marks are available for demonstrating communication skills in conveying relevant
information in an appropriate tone to the nominations committee.
118 | P a g e
A case in point is the number of women who sit on boards of directors. Twenty percent of board
membership is an optimistic estimate. Even if the number is not the problem then the role certainly
is. It is clear that most operate in a non-executive rather than executive capacity suggesting that
glass ceilings exist for women in terms of career development.
The antithesis of this complaint is that if boards are forced to accept more women based on their
gender rather than ability then this cannot do anything other than harm company performance.
Although nomination committees have the responsibility for identifying prospected candidates to
join the board, it is ultimately a board decision as to who should be offered a chair. This is not to say
that shareholders cannot be influential in the selection process.
Urban Outfitters is a company that sells fashion clothing, accessories and home goods. Given the
nature of their business it seemed reasonable to institutional shareholders that the board would
benefit greatly from having a balance between men and women in its composition. Unfortunately,
the entirely male board, headed by the long-term President, Richard Hayne, did not agree. In 2011
shareholders proposed the board produce a report on board diversity. This attracted 22% in support
of the resolution (any vote attracting more than about 15% shareholder interest is considered to be
a serious concern in the less than democratic perception of voting at AGM’s).
The following year, at the 2012 AGM, shareholders proposed the company commit to a policy of
seeking women and minority candidates. This won 38% of the shareholder vote. Nevertheless,
neither this nor the 2011 proposal was adopted by the company.
However, in a rare conciliatory act, the board did decide to recruit one woman to its ranks. The fact
that this was the wife of the President may have muted shareholders’ applause.
In order to achieve these goals he divided his section of the UK Code into two areas. This is now
Section D.
1. Performance-related pay
(a) The need to set challenging targets
Targets against which performance is judged and bonuses awarded should be aligned with
the expectations of shareholders. It should include corporate and individual, financial and
non-financial criteria.
(b) The need to set consistent targets
Consistency is a sense of benchmarking others in setting targets. This could include
benchmarking:
○ Employee or other top flight manager rewards
○ Consistency between executives
○ Benchmarking other industry players
○ Benchmarking market expectations
Links to strategy
Performance indicators must be linked to supporting the strategic direction of the company. The
strategy of the organisation may relate to successfully restructuring the company as a cost control
exercise. In this case performance may be gauged in a financial sense with the director receiving
reward for reducing the cost base by 10% for example.
If strategy were to relate to the successful expansion of the company into a new market or the
successful launch of a new product then performance may be gauged through revenue increase or
through limitations on quality problems with the new product when it is released into the market.
Whatever the strategy is, the remuneration committee must ensure that directors have personal
motives for focusing towards its success and therefore shareholders’ profit needs.
2. To create a formal rigorous and transparent process for determining pay
120 | P a g e
Basic pay
Since performance-related pay should make up the majority of the reward package salary should be
limited by comparison. However, it should be enough in itself to attract and retain executives.
Benchmarking should be used to set pay awards in this area. NEDs are paid a retainer for their
services rather than being salaried and do not participate in performance-related pay schemes.
The negative aspect of basic pay in terms of directors’ behaviour is that it doesn’t in itself motivate.
It is generally recognised in management theory that an awarded level of basic pay is assumed by
staff to be their right and so does little to optimise performance.
Benefits
These could be considered as residual or expected costs in the agency relationship. The size of
deferred benefit through pension schemes is possibly the most contentious part of rewards in this
area. Usual benefits of use of the company fleet of vehicles etc are included here.
The company makes payments into directors’ pension schemes so on retirement the director will
have an income. Usually contributions are a fixed percentage of the directors’ salary. The UK
Corporate Governance Code states that only a director’s basic salary is pensionable.
Where this advice is not followed pension entitlement can be motivational since the achievement of
bonuses can lead to a long-term benefit when it is used as an element in calculating the pension.
The calculation of pension entitlement beyond being based on basic salary is against regulation and
also ethically wrong. Ethically it seems inappropriate that a long-term future benefit can be created
from an event which has already been rewarded in the short term.
Bonuses
Definition
Bonuses are short-term reward schemes that reward risk-taking by directors to create short-term
dividend benefits for shareholders.
Financial performance indicators could be profit-led or have regard to total shareholder returns
during the period. They should be benchmarked to industry performance and the most recent
version of the UK Code includes provision for claw-back if necessary at some future point in time.
Directors’ bonus schemes are useful as a motivating tool. They are a means of ensuring that
directors are working towards the company’s objectives.
Bonuses are often given for increased profits, increased market share, increased sales, reduced
costs, increased margins etc. However, bonuses could also be given for non-financial measures, in
order to align directors’ interests with other stakeholders as well as shareholders.
122 | P a g e
Awarding bonuses for improved customer satisfaction, reduced employee turnover and reduced
pollution levels may all help to motivate directors to consider the wider implications of company
activity, and lead to a stronger and more sustainable company into the future.
Stock options
Stock (share) options are a long-term incentive scheme that rewards control, consistency and steady
growth through high quality strategic decision-making. Options tend to exist over a three-year time
period and are only available to be cashed in at the end of this period. Share price growth during the
period creates the basis for the reward.
When share options are granted to directors it gives them the option of buying shares at a specified
price in the future. The benefit to the directors is that if the share price increases beyond the option
price, the directors can buy shares at less than the market value and then sell them back into the
market to make a profit.
The use of a share option scheme can assist with aligning directors’ performance with what
shareholders want them to achieve. It is a way of dampening the level of risk taking created through
bonus schemes.
If a company is very prosperous and making shareholders very wealthy through the returns being
generated, it seems appropriate to reward directors proportionately with high levels of
remuneration, given the efforts that the board have made in securing those returns for
shareholders.
Can you think of any reasons why this statement may be considered to be incorrect?
Remuneration has always, and probably will always, be a contentious issue.
June 2012: Europe has been shaken by what can only be described as a shareholder spring, a revolt
against the normal tedium of annual general meetings and speeches by the untouchable gods who
look down upon the assembled throng from their leather backed thrones. Shareholders have found
their voice and are waking up to the fact that they do not have to simply sit there and accept
directors’ outrageous remuneration demands.
The UK has seen the most dramatic results of these actions, with three CEOs (at publisher Trinity
Mirror, insurer Aviva and pharmaceutical company AstraZeneca) resigning as shareholders flex their
substantial proxy voting muscle over the excess of directors’ rewards for poor performance.
In keeping with the nature of revolutions, the desire for change is now spreading abroad. In France,
President François Hollande planned to personally slash the pay checks of several CEOs. (In France,
the government owns a large stake in a wide range of companies). Such an approach differs
substantially from the UK where government uses its 80% voting power over the banks much more
judiciously.
4. Financial statements
These should be drawn using International Accounting Standards. Their content including the
notes to the accounts will form the bulk of information communicated to shareholders through
disclosure.
5. Governance section
This section relates to the communication of governance policy and outcomes. It will include
reports from all four committees and identify the extent to which the company has complied with
the requirements of regulation whatever the jurisdiction.
The ACCA offers some advice as to general principles which should be considered by the
organisation in order to improve the quality of disclosure:
Remove boiler-plating
The preface to the code describes "the fungus of boiler-plating" as a major problem in
organisational disclosure. This particularly relates to the governance section of the annual report
and involves the cut and pasting of meaningless standardised phrases from one years’ annual report
to another in order to be seen to be in compliance but without really making any attempt to convey
meaningful information to shareholders.
Stakeholders
In line with the general appreciation of the increasing importance of stakeholder relationships
disclosure should detail the measures taken to support stakeholder needs. A separate CSR section of
the annual report may be used for this purpose.
The question arises as to how prescriptive the law should be in detailing what should be included in
the Business Review and Governance Sections.
The profession of accountancy is based upon understanding the nature of disclosure with regards to
the accounting sections of the annual report. In contrast, there are virtually no legal or mandatory
requirements for the business review and very little solid requirement for disclosure in governance.
Virtually everything is up to the company as to how much it wishes to disclose. It is virtually all
voluntary.
The business case for improving the amount of information the board of directors is willing to
disclose is compelling:
• Better information promotes a sense of transparency and responsibility and accountability
• This can attract investment to the company
• The annual report is a prospectus for global investors as well as local investors.
Information is the lifeblood of an effective market and so more information is in the spirit of good
market operations and good governance.
"There should be a dialogue with shareholders based on the mutual understanding of objectives.
The board as a whole has responsibility for ensuring that a satisfactory dialogue with shareholders
takes place"
The Securities and Exchange Commission is the regulator for companies listed in the United States.
It has recently issued advice to listed companies that they must improve on disclosure regarding CSR
and climate change issues.
As the SEC starts to keep a closer eye on large companies and their long-term impact on the
environment, investors are waking up to the fact that now they have the weight of the regulator
behind them in attempting to force through their environmental and social agenda.
Jack Ehnes, CEO of CalSTRS, which manages $131 billion in assets says,
“We want our companies to closely look at the impact climate change legislation and regulation
have on them, to realistically assess those risks, and to consider the indirect consequences of
climate change-driven regulation and business trends on their activities. The SEC’s guidance outlines
exactly the kind of action we have been asking our portfolio companies to take with regards to the
issues raised by climate change.”
• Investor conferences
• Trade shows
• Website
• Investor Relations Department
The Investor Relations Department is a formal structure used as a first point of contact for
shareholder needs and concerns, ensuring that mundane issues are dealt with without recourse to
involving the leader of the board.
Board of directors
• To use the AGM to provide a balanced and understandable assessment of the company’s
position and prospects
• To use the AGM to provide shareholders with a sense of assurance in the professionalism and
quality of their board of directors
• To use the AGM as a tool to attract further investment in the organisation
Shareholders
• To receive adequate information in order to promote a sense of assurance
• To provide an opportunity to question the board as to strategy and reasonably expect to have
their questions answered
• To vote with regard to resolutions set before the shareholders.
Given Hampel’s reasons for shareholder intervention, could you give a specific example, from each
category of concern, as to a situation in which intervention would be justified?
• Establish clear guidelines on when and how they will escalate their activities as a method of
protecting and enhancing shareholder value
• Be willing to act collectively with other investors where appropriate
• Have a clear policy on voting and disclosure of voting activity
• Report periodically on their stewardship and voting activities
It could be argued that the existence of an agency relationship relies on the success of this code or,
more fundamentally, on the belief of institutional investors that ultimately, as shareholders, they
own and are therefore responsible or liable for corporations in their portfolios.
Traditionally, institutional shareholders have been conservative in nature since any form of
intervention creates instability in the market and can lead to a reduction in the level of confidence
in corporate management. This in turn creates downward pressure on share prices.
Another reason is that the people investing in companies are fund managers and are not investing
their own money but that of others who have invested in a unit trust or pension fund.
Typically companies with good corporate governance perform better than companies that do not
focus on this issue. Potentially there is a financial advantage to implementing good governance
policies. Hence institutional investors may decide to intervene if they believe that the directors are
not running the company properly as this will affect the value of the investment.
Generally, in recent years, institutional shareholders have become much more active
• Corporate governance regulation has encouraged them to use their votes wisely.
• Many institutional investors have seen that improved governance leads to increased share price.
• Those whose funds they are investing are putting more pressure on them to act.
Having said this, many critics would suggest there is still a long way to go.
Minority rights
A final concern in the agency relationship relates to those shareholders who do not have the voting
power or substantial investment required in order to influence the operations of the board.
Small investors are as much a part of the shareholding community as large institutional investors
and yet, as previously identified, not considered important enough to warrant direct consideration
in governance regulation. Hampel and the Stewardship code are not focused towards them.
However, this does not mean they are completely ignored or powerless. The legal framework of a
developed capitalist society will ensure that their rights are supported. The general concept behind
this support is that the needs of the minority shall not be disadvantaged by the actions of the
majority.
This is particularly pertinent when listed companies are family based structures.
Here the family’s voting power means that decisions and resolutions (such as those relating to
potentially excessive directorial pay) will be easily passed and yet, if it can be shown that such
decisions have a negative impact on smaller shareholders, by reducing share price for instance, then
there is some potential for redress in a court of law.
131 | P a g e
Of course, such action by small shareholders may be inhibited by the huge costs and risks relating to
potential legal action. Divesting of shares is a much easier option if the shareholder does not like or
accept the actions of his board.
The broad scope of the term NGO embraces charities such as Oxfam and World Vision but it could
also include pressure groups such as Greenpeace since this is a non-governmental, not for profit
institution.
NGOs are often established by government and funded by government in order to implement a
social policy (like project managing a large scale housing development or creating a committee to
oversee an Olympic Games), where the government does not wish to be seen to be directly
involved. In this instance the degree of governmental control is deliberately weakened although
the link to government is not forgotten through the use of the term Quasi-autonomous non-
governmental organisations or QuaNGO. The loosening of control and reporting can be
problematic and lead to accusations of overt self rather than public interest in the way in which
such organisations make decisions.
Government
As the duly elected representatives of the people, the government could be said to own service
delivery in Administrative departments
Population
As tax payers who fund such services it could be said that the people of the state own the service.
Service users
These may be tax payers and are invariably members of the state and so have a practical sense of
involvement and ownership of services such as Education and Health.
Ministers and civil servants have to balance the demands of different groups and be accountable to
each group for the decisions made.
The concept of value for money was developed in order to create a deeper and more practical sense
of this accountability, monitoring performance in relation to:
Effectiveness: The ability to meet governmental targets in service delivery
Efficiency: The need to maximise output for a given level of monetary input.
Economy: The need to operate within a set budgetary cost constraint and account for finance used
in service delivery.
The level of economic constraint and the nature of target setting for effectiveness are determined
through governmental policy. Efficiency demands tend to increase year on year through the use of
increasingly efficient service delivery methods and technologies. The lack of market mechanism for
determining performance heightens the need for clear performance measures.
Governance arrangements
133 | P a g e
The UK Code for private companies offers advice as to how to run a large enterprise effectively.
Similar advice would seem relevant to any institution regardless of its public/private status.
Without a buoyant stock market to benchmark and evaluate performance, oversight bodies often
exist such as governmental committees, council boards or boards of trustees to ensure public funds
are used in an appropriate way and results are in line with expectations.
The roles of an oversight body would include:
1. Ensuring compliance
This includes compliance with state regulation or government policy on the standard of education
or healthcare where this is appropriate, eg meeting legal requirements for cleanliness in
hospitals.
2. Monitoring Performance
This relates to specific targets of performance and in achieving a level of performance in service
delivery. This might be in terms of achieving a given level of operations and maintaining given
staffing levels at a hospital. Whilst not legal requirements they are important in determining
overall performance.
3. Budgets
The oversight committee will monitor financial performance against budgetary constraints and
consider demands for further funding, acting as an intermediary between the institution and
central government.
4. Appointments
The oversight committee will probably determine recruitment to senior positions at the facility
ensuring independence in the decision and suitability of candidates for the position.
5. Reporting
The oversight committee must support the chain of command by reporting upwards to more
senior governmental ministers.
Lobbying by vested interest parties often distorts this sense of equity and balance. Business
interests with power and financial backing may sway governmental policy towards costly defence
contracts which, although they benefit the companies involved and their employees, may provide
broader benefit if spent on healthcare or education. The sense of inequity is not just in the outcome
of such decisions but in the influence of such groups and their access to governmental decision-
makers, giving small groups power beyond the democratic principle of equal influence for all. They
simply corrupt the principle of democracy through their actions.
Another, deeper influence relates to the political argument as to the extent to which a public sector
should exist at all, and if so, the extent of services covered.
Privatisation of previously state-owned institutions such as those associated with utility provision is
common. Arguments for privatising education and healthcare to bring market forces, competition
and personal financial gain to bear on these services may offer improving choice and quality as well
as reduced collective tax costs.
This is countered by the belief that many such services are difficult to restructure to allow effective
competition to exist and that commercialisation will lead to a polarisation in access to such services
between those that can and cannot afford them.
This impetus for commercialisation arises from a number of sources:
• The spending constraints imposed by financially challenged governments
• Public demand for expenditure constraint, waste reduction in institutions
• Commercial reward structures used for senior management in such institutions
• Use of management and staff from the private sector
• Cultural movement away from state ownership and provision of services.
This change is difficult to implement successfully, because:
• Culture clashes exist in serving a social need and operating with finance as a primary driver
• The influence of major benevolent stakeholders who may resist such moves
• The influence of management and staff many of whom are volunteers
• The ambiguity in opposing objectives of profit and service
• Lack of commercial skills to implement change
The OECD principles reflect this, describing the basic elements of an effective corporate governance
framework.
There are six key areas:
• Ensuring the basis for an effective corporate governance framework
• The rights of shareholders and key ownership functions
• The equitable treatment of shareholders
• The role of stakeholders in corporate governance
• Disclosure and transparency
• The responsibilities of the board
The structure is similar to the UK code of corporate governance – each area is headed by a key
principle and supported by sub-principles. The aim being that these will be used as a reference point
for developing similar governance frameworks that cover all of the essential areas of good
governance.
The International Corporate Governance Network is a US-based institution that operates on a more
detailed, practical, corporate and investor focused level. It is also advisory in creating the conditions
within which global investment opportunity is created. Its advice becomes a shopping list of
characteristics for successful investment. This list is referenced by those seeking investment
opportunities and acted upon by corporations who want investment, adapting the way they sell
themselves to investors by adopting these governance standards.
ICGN standards exist across all areas of governance:
• Use of NEDs and Committees
• Performance related pay
• Risk management policies
• Internal control reviews
• Good CSR policies
The ICGN endorses OECD principles and then adds additional principles that it feels are necessary.
The ICGN principles are compatible with other codes of corporate governance, but are likely to be
more rigorous.
The content of the ICGN principles covers:
• Corporate objective – shareholder returns
• Disclosure and transparency
• Audit
• Shareholders’ ownership responsibilities and voting rights and remedies
• Corporate boards
• Corporate remuneration policies
• Corporate citizenship, stakeholder relations and the ethical conduct of business
• Corporate governance implementation
137 | P a g e
The aim of the ICGN is to create a process of continual improvement in corporate governance
through the provision of latest advice and best practice to global shareholder institutions.
ICGN principles
In a global context, are the OECD and ICGN frameworks too general to be of any practical benefit?
Positives
• Opens markets to global investment
• Provides an assurance of good governance in a market
• Improves company operations based on best practice
• Promotes multinational corporation development
• Reduces the existence of state funded institutions.
Negatives
• Reduces the existence of state funded institutions
• Loss of national sovereignty and self determination
• Job losses and change of company ownership
• Negative societal effect of these issues
• Loss of global diversity in business.
• Evaluate the cases for and against, unitary and two-tier board structures. (B5b)
• Describe and assess the purposes, roles, responsibilities and performance of Non-Executive
Directors (NEDs). (B5c)
• Explain the meanings of ‘diversity’ and critically evaluate issues of diversity on boards of
directors. (B5e)
• Describe and assess the general principles of remunerating directors and how to modify
directors’ behaviour to align with stakeholder interests (B5g)
• Compare and contrast public sector, private sector, charitable status and non-governmental
(NGO and quasi-NGOs) forms of organisation, including agency relationships, stakeholders’ aims
and objectives and performance criteria (B6a)
• Assess and evaluate the strategic objectives, leadership and governance arrangements specific
to public sector organisations as contrasted with private sector (B6b)
• Describe the objectives, content and limitations of, governance codes intended to apply to
multiple national jurisdictions. (B3d)
There are a number of strong arguments for not separating the roles of CEO and chairman. The
issue is still contentious, especially in countries who have yet to fully formalise their governance
regulation. In a logical way it seems inappropriate to have two leaders rather than one. Of course, in
governance the position is that the chairman is the single leader of the board. Those who argue
against the split would argue that although this is a statement in governance, in practice the CEO is
still a leader since he commands the assets and personnel of the company. There therefore appears
to be two people in charge.
The executive relationship of the CEO with the company creates a deep understanding of the
organisations operations and key markets. The chairman is an outsider, a part time manager, whose
knowledge will always be subservient to that of executives. This lack of involvement and knowledge
suggests the CEO should operate as the chairman, as the single leader of the company.
From this sense of a lack of involvement comes arguments relating to loyalty and culture and the
fact that the rest of the board and the rest of the company employees follow the CEO and not the
chairman as the natural leader. The inclusion of a chair above the CEO simply confuses management
at the top of the company.
139 | P a g e
The chairman’s role is relatively straightforward – keep the shareholders happy! Any CEO would be
more than capable of filling this role in addition to their existing workload.
Despite these arguments, on balance, Cadbury insists on the separation in order to secure the
independence and integrity of shareholders relationships through a chairman.
Solution 5.2
As the UK Corporate Governance Code is not legally binding, the company has to ‘comply or
explain’. This is a commitment it gives under the Stock Exchange Listing Rules. So the company has
two options in this situation.
Firstly, it can comply with the Code and replace the existing director with a newly appointed
director. This would be in accordance with Ren’s preference. This would underline the company’s
commitment to corporate governance and send a positive signal to investors. However, the
investors are largely institutional investors who connect with the company and would engage with
an explain process. Choosing an option could deprive the board of the individual’s contribution,
unless it chose to hire him in a consultancy capacity, which might cost more, or prove to be a less
transparent option.
Secondly, it could propose that the director be re-elected by the shareholders, giving full reasons
why the board considered this to be in the best interests of the company. This would be Len’s
preference. The company would be non-compliant with the provisions of the Code but would have
explained the reasons for its proposal. If concerned about the effect of this on perceptions of
governance in the company by investors, the directors could put the matter to a vote at the annual
general meeting. If the company intends to continue to use Ken’s expertise, this might be the most
transparent option, and the easiest option for the shareholders to take action about, if they felt the
arrangement was no longer benefitting the company.
There is precedent for similar action by reputable, comparable companies. For example, this course
of action was taken by Tesco plc in respect of two non-executive board members who were to retire
at the same time. The company gave a full and frank rationale and the directors continued in
service, without any adverse effect on the company’s reputation.
On balance, given the facts in this case, I believe that Len’s argument is most persuasive, and I
would recommend the second option.
Professional marks are available for referring to the commercial reality of Ollp’s situation (informed
shareholders) and for evaluating both sides of the argument and drawing a conclusion.
Solution 5.3
Slide 1 Notes
Recruitment process The Higgs Report itself actually commented that very few NED appointments were made b
• Advertising: an open process.
approach Setting up a formal process of advertising/sourcing followed by interviewing would be a po
• Sourcing: a directed The Nominations Committee can decide on a case-by-case basis whether particular skills sh
140 | P a g e
approach company should be open to seeing who responds to a more general advertisement.
• Interviewing
Slide Bringing in NEDs from other companies should increase diversity on the board with little ri
Adding diversity: A lawyer or accountant might bring a very different view of business to the company.
• Track record at other A self-made entrepreneur may have experience, if not formal qualifications. NEDs drawn fr
companies for-profits will bring a different perspective, perhaps especially in relation to social and env
• Professionals International NEDs bring experience in other countries, particularly if the company has an
• Self-made Occasionally, a company may need specific technical competences outside the scope of the
entrepreneurs new NEDs can help to bring this expertise.
• Public sector/not-for-
profit
• International
experience
• Specific technical
competences
Professional marks are available for using an appropriate format (slide and notes) and using the
correct tone/style in each part.
Solution 5.4
There are a number of problems with this argument, depending upon the extent to which you
accept the capitalist model of society and wealth distribution. It might be argued that excessive
earnings of any individual whilst large parts of the population are subject to hardships might be
considered inappropriate and unethical. This verges on a socialist perspective as to how society
should operate.
The statement also fails to identify any limit to the concept or any sense as to what proportionate
relates to. It could be that, given the company’s earnings run into billions of dollars, the directors’
remunerations should also rise to a similar multiple of around a billion dollars. Again, the argument
would be that this is an excessive reward for any activity given by one party to another.
It could be said, as owners of the company, shareholders can pay their directors whatever they like.
This could be countered by stating that in general company operations shareholders take very little
interest in their investments. Another argument might run along the lines that shareholders are
usually corporations themselves and so it is in the vested interest of directors within those
companies to see pay rise in institutions within their portfolio.
A final argument might relate to the extent to which any human being truly creates wealth or
whether it can only be delivered through the collective responses of all employees and whether
they should share the rewards of growth collectively rather than the huge imbalance in directorial
and staff rewards.
Solution 5.5
141 | P a g e
The CSR report should support the values, mission and objectives of the company while paying due
attention to particular stakeholder needs. This requires a balanced approach, as some stakeholders
would feel profoundly threatened by the very existence of the plant. Bear in mind that CSR
commitments are those that are over and above legal duties. They are the extent to which the
company is prepared to exceed the minimum legitimate claims of stakeholders.
Remember also that although the CSR report is primarily read by shareholders, its important
messages are available to a wider audience, who might access it via the company’s website. Any
disclosures in the report would be compared with commitments already given in the company’s CSR
policy statement.
The following stakeholders’ concerns could be addressed:
Customers: Customers are interested in reliable energy at the right price, and produced in an
environmentally-friendly way.
Shareholders and potential investors: Some investors have portfolios governed by ethical
principles, so the CSR report would be able to reinforce the company’s commitment to produce
clean energy in a safe way, and confirm that the company is not harming the physical environment.
The local community/employees: This could have safety concerns, especially after the Fukishima
disaster. However, the community also provides some or even most of the employees, who might
also be interested in job preservation and new opportunities.
Regulators: Those responsible for regulating the nuclear industry have a duty to safeguard the
interests of the general public, and will be reassured if the company is able to report adherence to
high CSR standards.
These are examples of narrow stakeholders, who are those most directly affected by the company.
A CSR report would also address the concerns of wide stakeholders, such as governments of
neighbouring countries, pressure groups, environmental organisations and others.
Solution 5.6
1. Strategy
The company is investing in acquiring companies that exist in industries or markets outside of its
core expertise. Diversification can be advantageous but carries with it risks that may concern
shareholders.
2. Company performance
The company has underperformed in terms of dividend distribution to shareholders or in terms
of share price growth when benchmarked to equivalent companies.
3. Lack of compliance
The company has been fined by state regulators in relation to a lack of compliance with health
and safety regulation
4. Directors’ remuneration
Directors pay award is a substantial increase on last year despite employees receiving a less
than inflation pay rise.
142 | P a g e
Solution 5.7
The main areas dealt with by the frameworks are already addressed by principles contained in most
developed countries corporate governance codes, or in the case of rules-based jurisdictions, statute
law. However, their application is not as widespread as perhaps thought. For example, in the UK the
right of shareholders to take a derivative action against the board on behalf of the company was
only recently formalised in British law in the Companies Act 2006.
The frameworks enable countries to compare their systems and evaluate their effectiveness using
common criteria.
However, the greatest value in the frameworks lies in their role in developing corporate governance
standards in developing countries, where corporate governance is only beginning to come to
prominence. The governments of these countries and their regulatory bodies are able to build codes
(in principles-based jurisdictions) or laws (in rules-based jurisdictions) with reference to a logical
structure.
Although many of the principles contained in the frameworks are taken for granted in some
countries, attention to some of them is necessary in countries whose economies are emerging and
with companies who are seeking to develop into new markets. Only if governments are seen to
promote certain standards of governance will their companies and other organisations be able to
command the confidence of international investors.
143 | P a g e
6
Strategy concepts
Context
This paper looks at how companies can become successful. Key to this is how they are placed
strategically. If a company is producing a product that everyone can afford and wants to buy and no
other company sells it then they are in a great strategic position. However it is likely that this
position will change over time as other companies see that they could also make money from
producing similar products. Hence companies that are in a good strategic position will try to stay
there, by adding new desirable features, for example.
To see this, look at a successful company, say in the financial press or a company that you like the
product of. You will see in this paper reasons why successful companies succeed and how they can
be threatened as well as why other companies are weaker.
This chapter shows the approaches for organisations to decide their strategy including the rational
planning model.
Video introduction
1. Do you know why an iterative approach to the rational planning process is argued to be better than
the simple linear approach?
2. Can you describe an emergent strategy?
3. To what level of strategy do the decisions to move into a new industry and to outsource the
provision of legal advice belong?
144 | P a g e
Some organisations prefer to use the term 'long-term plan' instead of 'strategy'.
When thinking about a strategic plan, think of a time horizon of around five years and also that the
plan will consider the whole organisation. A strategic plan is certainly not a normal budget which
typically looks only about one year ahead and which is usually set for each department.
The strategic plan will consider matters such as:
• What will the organisation be doing in five years?
• Where will it be operating?
• What will its market be?
Strategic decisions are made under conditions of complexity and uncertainty; they have wide impact
on the organisation and often lead to fundamental change to the business's operations. You will see
that managing those changes successfully is a very important part of strategic planning.
• The industry sector. Public sector organisations are likely to adopt a very formal rational
approach. They tend to have many interested parties (stakeholders) and must account carefully
for decisions made on the public's behalf.
• Nature of the industry. Stable industries might find that logical incrementalism suits best (small
extensions of what has previously worked). Industries undergoing major change might need to
think on a more long-range basis to ensure they make the right decisions for the radically
changed future.
• Urgency of change. If the economy declines rapidly, initially fast emergency decisions might
have to be made, followed by more carefully worked plans for longer-term survival.
• Extent of change. If only one department is affected planning might be less painstaking; if the
whole organisation is affected then a rational approach might be more prudent as major
damage could easily be done if the wrong plan is adopted.
Broadly, 'strategic position' is information gathering, 'strategic choice' means reviewing that
information, and 'strategy into action' is implementation of the chosen strategy.
S = strengths
W = weaknesses
O = opportunities
T = threats
Strengths and weaknesses are internal; opportunities and threats are external.
Once the organisation's position has been appraised, it should be possible to set objectives for the
organisation: specific, measurable achievements for the organisation to aim at. The objectives will
take into account what the stakeholders want and expect, and what might be possible given the
organisation's capabilities and its environment.
For example, shareholders are important stakeholders and they will usually want increasing profits
and dividends. Whether that is possible will depend on factors such as the economy, and the
organisation's success at developing new products or breaking into new markets.
Tesla is one of the first main producers of electric cars. Give one likely strength, weakness,
opportunity and threat for Tesla.
• Evaluation of the above options and choosing a strategy to be followed. This will rarely be a
process for which there is an obviously correct choice. For example, different stakeholders will
have different priorities, there will be different attitudes to risk and return, and there will be
different levels of belief and confidence in the information collected and the analyses
performed.
• Implement any necessary changes in the organisation. These simple seven words might be
misleading because they could imply that implementation is the easy part of the planning
process. In fact, it is in the implementation stage of a strategic plan that the hard work is to be
found. Investigating strategic position and making strategic choices can be carried out in a
comfortable office. Implementation means going out and organising people, convincing
employees to change their ways, finding new suppliers and customers, raising finance,
developing new products and implementing new IT systems. Implementation can last for years.
It is at this stage that many plans fail.
You might have carefully planned a holiday, taking into account your budget, offers from airlines
and hotels, the time and dates you have available. Then you start to try to book your flights and
hotels and discover that your choices might be full or that prices have changed since you last
checked. You would then have to go back and modify your original plan – perhaps to something
radically different.
So, instead of the simple linear approach, it might be more realistic to represent the three stages as:
Supporters of logical incrementalism say that the rational approach is unrealistic and possibly
harmful. They hold this view because:
• It is impossible for any planner to know all the relevant facts that currently exist. For example,
rivals are usually secretive about their plans, so how can we be fully rational when making our
own plans? This problem is sometimes known as 'bounded rationality'.
• Unexpected, unpredictable events will happen over the course of a rational planning period
(typically five years). For example, an outbreak of a new type of flu could seriously affect many
businesses.
• It takes a huge amount of managerial time carefully to look at all the permutations of events that
should be taken into account when planning, and many managers won't consider all of these.
Logical incrementalists therefore take the view that rational planning is therefore inherently flawed,
so it is pointless trying to carry it out. Even worse, it is argued that because the plan has been set
out, people might believe that is it 'correct' and attempt to follow the plan even if it turns out to be
inappropriate.
So, instead of setting out a grand, long-range master plan, logical incrementalists say that
organisations should progress by a continuous series of small adjustments to what they are doing
(increments). That way, organisations will never be locked into inappropriate plans.
• It can encourage a 'head-in-the-sand' attitude: it's not in the plan, so we won't do it; it is in the
plan so we will do it, no matter what.
• It consumes time and money.
6.5.1 Introduction
Definition
Strategic drift is the name given to the phenomenon where strategies develop, usually incrementally,
but fail to achieve a good match with the organisation's environment.
Initially, the incremental changes to strategy match the environment well. Then the environment
changes more radically but the organisation does not respond accurately and strategy and
environment move apart. This is strategic drift. There is no long-term future for an organisation that
does not match its environment and either the organisation has to undergo transformational
change (rapid change to catch up with the environment and achieve a match) or it will fail and die.
Alcatel-Lucent
Based on an article in the Economist 22 June 2013
The type of strategic management an organisation adopts may be influenced by the industry it is in,
the tasks it faces, and so forth. An example if Alactel-Lucent a manufacturer of telecoms equipment.
150 | P a g e
Created from a merger in 2006 from Alcatel of France and Lucent of the US, the combined entity’s
share price has fallen 86%, and has only made a profit in one year, 2011, since the merger. Others in
the industry are in a similar position.
Clearly, this cannot go on, and the company needs a clear direction and focus to return to
profitability and growth. The new chief executive determined to be less of a generalist and focus on
state of the art broadband networks, as the core operation, where demand is anticipated to rise.
The core business will get 85% of the research and development budget. This new core business will
be ‘managed for growth’. The other businesses may be sold or otherwise ‘managed for cash’, with a
cut in R&D, so at least they generate cash. Fixed costs will be cut by US$ 1bn.
The company has bought some time by obtaining a secured loan of US$2bn. The company also plans
to lengthen the maturity of its debt, in other words extend payment terms. The savings should pay
for themselves.
Alcatel-Lucent was a firm that was an end-to-end supplier, doing too many things. (Others in the
sector had specialised earlier.)
Its strategic position was one of too much exposure to too many markets. A detailed strategic,
financial and operational plan to return to profitability had to be put in place to convince investors
and lenders to carry on supporting the company, and to turn it round.
Google
Compare this approach to strategic planning with Google: the company has invested and trialled a
number of different ventures. Its Android operating system for mobile phones has been a huge
success. It has trialled and shut down other ventures. This appears a more experimental approach.
Many major high street retailers have closed down over the last 10 years or so. What have been the
key external influences on this and what are the likely internal factors that may have made the
situation worse?
There are many strengths, weaknesses, opportunities and threats you might give for Tesla, here are
some possibilities:
Strengths – first mover advantage, attractive image, good sales growth
Weaknesses - has to spend a lot of money and hence has a lot of debt, high prices
Opportunities – new models, chance to be a major global player for many years
Threats – major petrol car makers moving to electric cars, running out of cash, lack of a dealer
network
In the exam you may have to look through the exhibits to get some of the analysis, but it is also
thinking what you know about an industry to generate valuable points.
Solution 6.2
The key factor has been the growth of the internet with businesses like Amazon, ASOS, eBay and
others offering a wider choice of products at competitive prices delivered straight to the customer’s
door. Some businesses like Tescos in the UK responded and offered an online food delivery service
whereas most supermarkets did not until years later. These supermarkets were likely to have a
culture that made them reluctant to change and have made errors interpreting the information that
was coming to them. Hence they may have tried to respond in an out-dated way but were not
successful, suffered a strategic drift and eventually went out of business.
152 | P a g e
7
Strategy - environmental issues
Context
In order to see the opportunities that are available and the threats that the company faces it is
necessary to look outside the company. In the external environment there will be large factors, such
as governments and new technology, as well as factors closer to home, such as the company’s
competitors. You will see in this chapter how to start to analyse the factors externally to get a view
of how important they are to the company, whether as a threat or as something that the company
can take advantage of.
Video introduction
1. What are the six groups of environmental influences prescribed by the PESTEL model?
2. Can you list the steps in scenario planning?
3. According to Porter, why do some countries have a reputation for being particularly good
at producing certain goods/services?
7.1.1 Introduction
153 | P a g e
A key part of developing a strategic plan is to investigate and analyse the organisation's strategic
position. An important element of strategic position is the organisation's business environment - the
world in which the organisation operates. There will be factors there which will affect the chance of
success arising from different strategies.
There are a number of factors which will affect all organisations in the same industry in similar ways.
For example, most airlines would be affected in similar ways by:
• A downturn in the economy;
• Changing laws relating to carbon emissions;
• Political unrest in some areas of the world;
These general factors are known as the macro-environment.
Applying PESTEL to the pharmaceutical industry, list a few possible political, economic, social,
technological, environmental/ecological and legal influences.
7.2.1 Introduction
Currently some key drivers pushing change in many industries are:
• The Internet;
• Environmental concerns;
• Economic downturn;
• Biotechnology and health care.
The Study Guide also mentions two specific current environmental effects:
• Industry convergence, and
• Globalisation.
155 | P a g e
Both of these tend to mean that many industries are now dominated by a few very large companies.
That in itself is controversial with some people because a number of companies are now richer (and
perhaps more powerful) than many countries. Additionally, anti-globalisation protestors claim that
multi-national companies destroy local companies.
7.2.2 Examples
An example of industry convergence can be found in media companies, some of whom now own
television channels, telecommunication companies, newspapers, popular websites, and
communication infrastructures such as optical cable networks and broadcasting satellites.
Obviously if you own a satellite you can make that investment very profitable if you use it for
television, telephone and the Internet. However, smaller companies are likely to find it difficult to
compete with these giants.
An example of globalisation can be found in the car industry. For example, if you look at Volkswagen
(based in Germany) in Wikipedia, you are told that:
Volkswagen has 61 production plants and factories in fifteen European countries, along with six
countries in the Americas, Asia and Africa. The Group employs nearly 370,000 people around the
world, who produce a daily output of over 26,600 motor vehicles, and related major components,
for sale in over 150 countries across the globe.
7.3.1 Introduction
It is important that organisations try to make some projections of what might happen in the
environment as their strategy will need to take account of this.
Scenario planning is not attempting to predict the future. Instead it attempts to describe what is
possible and to construct a number of plausible, distinct, alternative futures.
The organisation then has to decide how it would respond to each scenario should it take place.
For example, looking at the economic environment we might think that interest rates could be 2%
to 5%. Looking at technology, we might think that a new product will last between 3 years and 6
years. These could assumptions then be set out in a matrix such as:
Interest rates
2%
6 years Scenario 3
It might be possible to eliminate some of these as unfeasible. For example, a 5% interest rate and a
6-year life might be incompatible. Another scenario might be thought the most probable. The other
two are important to look at because, though perhaps less likely, they represent viable scenarios
that should be investigated further and combined with more variables.
5. Fully expand three or four likely scenarios into a 'full story' and examine them for internal
consistency.
6. Identify and try to deal with issues arising. Games and role play can be useful in testing,
understanding and responding to scenarios.
7.4.1 Introduction
Michael Porter noticed that some countries get a reputation for being particularly good at
producing certain goods or delivering certain services. For example, generally most people agree
that:
• Germany is very good at making cars (VW, BMW, Mercedes, Porsche).
• Japan is good at producing consumer electronics and cameras (Sony, Panasonic, Hitachi, Canon,
Olympus, Nikon etc).
• The west coast of America is very strong in IT.
• France is good at producing cheese and wine.
Porter began to wonder how these reputations and abilities came about.
• Factor conditions
These include:
– Natural resources;
– Climate;
– Communications infrastructure;
– Knowledge bases and logistics systems.
The first two are basic factor conditions; the last two are advanced factor conditions.
It is claimed that having the right factor conditions gives the first advantages. France is good at
wine because of its climate and soil. Greenland is unlikely to ever be a notable wine producer
158 | P a g e
(unless global warming is very severe!). Germany is good at cars because it has coal, steel and a
long tradition of good mechanical engineering.
• Demand conditions
These include:
– Market segmentation of home market;
– Sophistication of buyers;
– Position within product lifecycle in home market;
– Anticipation of buyer needs.
It is argued that success on the world stage first begins with home demand. Companies first make
for the home market, then begin to export. So Scotland is good at making tweed (a heavy woollen
cloth) because their winters are long, wet and cold and the population needed strong, weather-
resistant clothing.
• Firm strategy, structure and rivalry
These include:
– Attitude to short-term profit;
– National culture;
– Level of domestic rivalry.
To become world class you have to become really good at what you do. Rivalry at home will make
you better and better. Willingness to invest long-term and to spend time improving will also
increase the chances of success. Note that Germany has four very strong competing car
companies and this forces each to try harder, making their products good enough to conquer the
world.
• Related and supporting industries
These include:
– Strength of suppliers;
– Quality of suppliers;
A cluster of related industries allows great expertise to be created. So in the USA there are world
leaders in IT such as Microsoft, Apple, Intel, Hewlett Packard, Sun Microsystems. The businesses
help each other to become great. For example, an employee moving from one company to
another in a related field will help that new employer to become better. It is hard to become
world class if you stay in near-isolation, thinking your own thoughts with little input from outside.
Use Porter's Diamond to explain possible reasons for the dominance of the US in the cinema
industry.
Professional skills marks are available for demonstrating evaluation skills in your explanation.
Political
• Government policy towards state health care;
• Government attitude to takeovers of key industries;
• United Nations initiatives for disease eradication.
Economic
• State of the economy affecting funding of health services;
• Interest rates affecting investment in new factories;
• Exchange rates affecting exports;
• How to sell into richer countries at high prices and poorer countries at lower prices.
Social
• Age of population affecting incidence of certain diseases;
• Life styles affecting the incidence of diseases;
• Attitudes towards genetic engineering;
• Attitudes to animal testing.
Technological
• New discoveries and research methodologies;
• New manufacturing methods;
• Genetic engineering.
Ecological
• Toxic waste disposal at manufacturing plants;
• Choosing where to build factories.
Legal
• Laws regarding drug testing and safety;
• Ownership of patents, patent protection and attitude to counterfeit drugs;
• Liability for damage caused by side effects.
Solution 7.2
161 | P a g e
Factor conditions
The US is still the place that many actors, directors, writers etc. go to. This means that there are a lot
of skilled workers available to work in the industry.
Demand conditions
A lot of money is spent by US consumers on seeing films. US cinema studios will be trying to get
consumers to watch their films and so make them attractive to as many people as possible. This
should mean they are attractive to other consumers around the world.
Industry structure
The nature of the cinema industry is moving towards a smaller number of expensive films. This leads
to a situation where only larger film studios will have the money (and be able to accept the risks) to
make an expensive film.
Supporting industries
Film-making relies on many other industries. As well as obvious ones like casting, make-up, design,
there are also financial considerations and so the presence of finance houses is important.
Evaluation marks are available for considering all the relevant factors of Porter’s diamond and for
making appropriate comments about the US film industry in relation to them.
8
Strategy - competitive forces
Context
Competitors and markets are two external factors that this chapter covers in more detail. These are
big threats, or opportunities, that a company faces or has. Get used to analysing them, using the
models available to determine how big the opportunities and threats are.
Video introduction
162 | P a g e
8.1 Industries
8.1.1 Introduction
An industry can be defined as a basic category of business activity. The term can sometimes refer to
a very precise activity (such as tyre manufacturing) or more general (such as the motor industry). An
industry consists of a group of firms selling the same products or services (or close substitutes) or
selling products and services which are used in the final product or service. So we can talk of the:
• Car industry (Ford, Nissan, Citroen, General Motors etc);
• Airline industry (British Airways, Gulf, Quantas etc);
• Accountancy industry (PWC, KPMG, EY etc.).
Note that industry classifications are constantly shifting. For example, the accountancy industry at
one time included management consultancy services. However, these have now largely been
separated out to avoid conflicts of interest and other ethical problems.
The classification of industries can be relevant to organisations when they are deciding where to
locate their operations as they will need suitable expertise for the right price if they are to be
successful. When trying to set up an extractive industry in a well-developed country, it could be
difficult to recruit enough labour because the population has expectations of the higher rates of pay
associated with tertiary industries.
Definition
A strategic group is a term used for group companies within an industry that have similar strategic
characteristics.
Using strategic groups means that the number of rivals to be analysed can be reduced dramatically.
Most attention should be paid to what other members of your strategic group are doing because
their products, customers and operations are likely to be similar.
For example, the motor industry can be divided into strategic groups such as:
• Family cars;
• Executive cars;
• Performance cars.
Porsche and Ferrari do not have to take much notice of Ford, but they might have to take notice of
each other. Similarly Ford, General Motors and Nissan would be part of a strategic group making
everyday cars. They need to watch each other but can fairly safely ignore Ferrari, a company almost
as irrelevant to them as Apple computers.
Be able to assess the threat of rivalry by identifying which strategic group an organisation belongs to
8.2.1 Introduction
All industries grow and shrink over time. Of course, the period over which this happens varies
greatly.
For example, the industry that manufactured colour cathode ray tubes for older televisions probably
lasted about 50 years, from about 1960 until 2010. That industry was overtaken by new liquid
crystal, plasma and LED television screens. Fax machines became popular around 1975 but had
largely (though not quite completely) been replaced by 2005 by emails and attachments.
You might occasionally see another stage, such as saturation, but all have a 'bell-shaped' curve for
revenue.
Understanding lifecycles is important in strategic planning because there is usually little point in
investing in industries which are in the decline phase. When you make strategic decisions, you want
those to deliver good profits over the long term, so you will be looking for industries in the early
stages of their lives: introduction and growth.
But be warned: there is no guarantee that an industry or product will follow a 'typical' pattern. For
example, a product could be introduced, but it is a failure and never enters the growth stage.
However, the main problem is that the lifecycle diagram gives no clue as to how long the maturity
phase will last and when decline will set in. Presumably at some point in the future, mechanical
computer keyboards will become redundant as touch screens become more-user friendly. Similarly,
internal combustion engines may become largely of historical interest only. That process would be
greatly speeded up by a breakthrough in battery technology.
Therefore, although in theory lifecycle diagrams are useful planning devices, they have to be used
with great care as they make rather poor predictors about the future.
Rather than look at the lifecycle as primarily a prediction tool, it is safer to treat the phases as
implying certain market characteristics once you are certain you are in a given phase. Remember,
the model can be applied to industries, firms and products.
Typical characteristics of each phase are as follows:
• Introduction
– The industry is only just being established. Usually there has to be heavy expenditure on
promotional activities (advertising).
– The industry may be seen as a niche. If so, there are unlikely to be many competitors attracted
to it.
– At this point there may be only a few or no competitors. However, some companies will be
carefully watching to see how successful your product is. For example, the Apple iPad was
launched first, now nearly every computer manufacturer has launched a similar product.
– Customers may not be entirely sure why they need the product. Again, advertising and
promotion such as celebrity endorsement will be useful.
– Losses are expected: low volumes and high promotional expenses.
– Early sales figures will be analysed very carefully. The company needs all the information it
can get about how the product is doing. For example, it might be selling better through some
outlets than others.
– The product might have to be withdrawn at this stage if the figures look bad.
• Growth
– An increasing number of customers start to buy the product and reasonable profits can be
made.
– The industry becomes more attractive and new competitors attempt to join. Many have a
deliberate strategy of waiting and watching, then attempting to overtake when the product
proves successful.
– Heavy expenditure on promotion is still needed or the initial company will be left behind.
– In some industries there are competing technologies and it important to win the battle. Blu-
ray video high definition CD technology was developed and backed by Sony and Philips, HD-
DVDs were a rival technology primarily backed by Toshiba. Blu-ray won, and Toshiba
conceded defeat in February 2008, releasing their own Blu-ray disc player in late 2009.
• Maturity
– The industry typically goes through a period of consolidation as firms merge.
– There tends to be considerable price pressure as development and depreciation expenses
become amortised.
– If there are substantial exit costs (for example, costs relating to redundancy or environmental
clean-up) some businesses will stay in so long as they can just cover their marginal costs.
– Consumers become more discerning and knowledgeable.
– Often prices reduce and specification increases at the same time (think about mobile phones).
166 | P a g e
– Update and freshen products to see if you can squeeze another year of profitable life out of
them.
– Weaker companies might leave because the large, often multi-national companies have low
costs that cannot be easily matched.
• Decline
– Decline can be slow and profits can still be made. It is unlikely that new competitors will enter
at this stage, many firms will leave, and you can become a profitable monopoly supplier.
– Customers are buying different products and so total sales are falling. However, some
segments of the market might last for longer, once again giving opportunities for profit.
– The industry may again become a niche.
– If you want to get out of the business, try to find a buyer.
– Be sure that the decline is irreversible. Some products and industries can be rescued.
8.3.1 Introduction
In the previous chapter, you were introduced to PESTEL analysis, which looked at macro-
environmental influences. These were influences that could potentially affect every organisation,
though to different extents. So, if interest rates go up all companies, perhaps with the exception of
banks, suffer.
Michael Porter's five forces model applies to specific industries, so it has 'zoomed-in' somewhat. It
looks at how attractive industries are, and by 'attractive' Porter means how easy it would be to earn
good profits that repay investors for risk and allow the companies in the industry to keep investing
to secure future profitability.
Let's say that you suddenly acquired $500,000 to invest. You should look around at the different
sectors and see which offered you an attractive place for your money. Some industries might be
167 | P a g e
unattractive because they are threatened by new technology and therefore their lives would be
short; others might suffer from cutthroat competition so you know that you would have a difficult
time there.
Porter identified five determinants of market attractiveness:
• competition/rivalry,
• new entrants to the market,
• customer pressure,
• supplier pressure, and the
• threat of substitutes.
To reduce the chance of potential new entrants coming into the market you want to identify or
create barriers to entry. Examples of barriers to entry include:
– High capital costs (greater difficulty raising funds and higher risk)
– High fixed costs meaning that there is a higher risk that break-even is never attained.
– Know-how, implying that the new business has less chance of success due to lack of
knowledge
– Licensing difficulties. For example, in the UK the Government regulates the use of the radio
spectrum and issues broadcasting licenses.
– Complex regulatory regimes which increase know-how, compliance and penalty costs.
– Restricted resources, such as ownership of a patent.
• Customers
Customers can present problems if they are too powerful. For example, if 80% of your output
goes to one customer you will live in fear of losing them and will have to comply with nearly all
their wishes, such as reducing prices. If, however, you have thousands of small individual
customers, each one has relatively little power and you could afford to lose one or two.
Customers also become powerful if there is standardisation within the industry as they can easily
switch to another supplier.
To reduce customer power:
– Try to reduce reliance on one or two by finding other customers also.
– See if you could negotiate a long-term supply contract so that, at least for a while, you are
more secure.
– Try to build up customer loyalty by providing excellent, tailored service.
– Try to introduce switching costs so that your customer will be inconvenienced by switching
supplier. For example, if your IT system is closely integrated with theirs it will take time and
money for them to switch successfully to another supplier.
• Suppliers
Like customers, suppliers can present problems if they are too powerful. For example, a
monopoly supplier of an important component will be able to charge almost any price they want
to.
To reduce supplier power:
– Try not to rely on one. Carry out research to find others.
– See if you could negotiate a long-term supply contract so that, at least for a while, you are
more secure.
– Consider setting up your own supply operation.
– Take over your supplier to get assurance of supply (then you can stop the supplier dealing
with your competitors).
– Look for substitute components and material that you could use.
169 | P a g e
• Substitutes
Substitutes are alternative products which fulfil the same consumer need. For example, mobile
phones are a substitute for land-lines and high speed trains are a substitute for air travel (over
relatively short distances). Substitutes often arise by technological advance. This means that:
– Substitutes often arise unexpectedly;
– Once a successful technology is invented, it is difficult to prevent it spreading.
About the only thing an organisation can do to cope with substitutes is to make use of them too.
Thus many traditional phone companies also have mobile networks, and manufacturers of butter
also manufacture vegetable-based spreads.
In some countries such as Germany, the postal service is in the private sector. Assess which
elements of the five forces might make it an attractive or unattractive industry to enter.
Professional skills marks are available for demonstrating evaluation skills.
Solution 8.1
(a) Coal mining is probably in the decline stage of its lifecycle. Although coal is still used to
provide heat and power in houses/factories its main use is probably in electricity generating
stations. Coal is not as environmentally friendly as other production methods and so
countries are moving away from it.
A company in this industry will need to look at diversifying into new areas.
(b) Digital cameras are probably in the late growth or even the mature stage of the lifecycle. It is
likely that most people who want a digital camera now have one (the market may be
declining due to the increasing quality of cameras built into mobile phones).
Companies in this industry should be looking at new products to sell to consumers since the
product lifecycles are likely to be quite short.
(c) Space tourism is in the introduction stage. Many companies will delay entering the market
until they know that there will definitely be a demand for this service.
Solution 8.2
Competition (New)
There will be many barriers to preventing companies from entering this industry. The main ones will
probably be;
• The amount of capital required to set up a postal service.
• That many customers might be more likely to stick with their existing supplier.
Competition (Existing)
Demand for letter delivery services is falling (due to the increased number of emails sent instead)
and so this industry may be in decline.
The high exit costs (it is difficult to dismantle all the infrastructure) may make companies reluctant
to leave. This means companies chasing fewer customers.
Power of customers
Individuals are likely to have low power, but there may be some large clients that require many
letters to be delivered. These clients may be powerful and so profit from these consumers may not
be as high as expected.
Power of suppliers
This is likely to be the workers in the postal service. Whether they are powerful or not will depend
on the number of staff in trade unions.
Threat of substitutes
As mentioned above, the largest threat is from email, an indirect substitute.
172 | P a g e
The professional skills marks will be allocated for the breadth of your points and relevance to
Porter’s model.
9
Strategy - resources, capabilities and
competences
Context
Strategic capability is an area that looks inside a company or organisation. It is useful to look at the
external environment to see what is happening there but if the organisation is not able to react to it
because it doesn’t have the internal capability then it will either forego an opportunity or not be
able to respond to a threat. You’ll find out about the tools that you can use to analyse an
organisation internally.
You will also see a model called SWOT analysis that helps you look both internally and externally at
a business to get an overall view.
Video introduction
1. Why do you think core competences are regarded as more valuable than unique resources?
2. Can you explain the tree analogy and the ‘tyranny of the strategic business unit’ as described by
Prahalad and Hamel, in the context of core competences?
3. How are services different from products?
173 | P a g e
Definition
Competitive advantage can be defined as above-average returns in the long run. (Porter)
Note the condition of 'long-run': we are not particularly interested in temporary advantages which
can be easily copied or bypassed by competitors.
Just as capabilities have two levels, so too do resources and competences.
174 | P a g e
Threshold resources are the bare minimum resources you need to function, and threshold
competences are minimum competences needed for the organisation to be able to compete. To
make the leap from threshold capabilities to strategic capabilities an organisation needs a
combination of:
• unique resources, and/or
• core competences.
9.2.1 Definition
175 | P a g e
As mentioned above, competitive advantage can be defined as above-average returns in the long
run (Porter).
This also effectively defines 'sustainable competitive advantage' because it includes the condition of
'long-run'. Again, it is important to emphasise that we are not interested in temporary advantages
which can be copied or bypassed by competitors.
For example, it could be argued that Microsoft and Apple have similar resources, but there is
something rather special and innovative about Apple which allows it to be a uniquely successful
company, innovating products such as iPods, iPads, iPhones and iTunes. It is very difficult to analyse
what Apple's distinctive competences are which allow a series of such remarkably successful devices
to be designed, produced and marketed.
Furthermore, unlike resources, core competences do not reduce with use: on the contrary, they are
likely to be enhanced as they are used and shared more and more.
Sustainable competitive advantage need to focus on resources and competences which are:
• Rare (this could include patents or a skill);
• Robust (things that are difficult to imitate). Examples include:
– Complex procedures;
– Uncertainty to outsiders.
• Difficult for a customer to substitute with something else.
A final thing to remember is that the customer must be willing to pay for this unique resource or
core competence.
(c) McDonalds
(d) KPMG
9.3.1 Introduction
The previous chapter introduced the idea of a position-based strategy. In essence this means that an
organisation moves and changes its position and what it does to match the environment. That
approach to strategy arose around 1980. It has the great advantage that at least organisations look
outwards to what is happening around them.
In the early 1990s the position-based approach began to be challenged by two very influential
academics, Prahalad and Hamel. They argued that too much reliance on a position-based approach
can mean that the organisation is lured away from where its strategic capabilities lie. A successful
combination of resources and competences takes years to develop and can be hard to copy.
There is no reason to think that just because an organisation has been successful using one set of
core competences that it can simply abandon those, move to another area of business and replicate
its success there.
Once core competences are abandoned the organisation is starting from scratch again, and will have
to compete with business which might already have strong competences. It might be better to try to
use existing competences to create new markets, products and services.
For example, at one time Kodak made huge profits from producing colour films and paper. It was
probably the leading brand. However, a change in technology, namely the invention of digital
cameras, meant that the colour film market shrank very rapidly. Kodak foresaw that and began to
make digital cameras. It still does make digital cameras but Kodak does not make much profit from
these anymore. Kodak's cameras are relatively basic, performing well, but are essentially
commodities in a market with many competing products. It finds it difficult to compete in the more
complex or professional camera markets, where there are already well-established camera brands
such as Nikon, Olympus, Canon and Pentax. These companies have long-established core
competences in top-quality camera manufacturing.
organisation to see past its strategic business units and to identify what its core competences
actually are. This is what Prahalad and Hamel in fact referred to as the 'tyranny of the SBU'.
This is not so much a model as a checklist of resources. It is sometimes called the '9M's Model', but
don't get obsessed with how many you can remember. Additionally we will add a couple of
resources that don't start with 'M'.
Resources are important in strategic planning because to carry out your plan you need the right
resources. If you do not have them, then either you will have to abandon your plan or obtain the
resources.
• Machinery/manufacturing capability. The business needs the right machinery in the right
location to successfully manufacture. Alternatively, instead of machinery it might decide to sub-
contract its manufacturing, in which case it needs the right subcontractors.
• Money. Adequate finance or the right type is needed. This is covered more fully in Chapter 15.
• Materials. The right materials, of the right quality at the right price, delivered when needed.
• Men and women – human resources. Getting the right people is increasingly difficult in many
businesses. Increasing technical content implies that employees have to be better. A move from
manufacturing to service industries means that more employees have direct contact with
customers, so again employees will have to be better or great damage can be done.
• Make-up (culture). For example, many businesses now need to show innovation and flexibility
and therefore need to adopt cultures and organisational structures which promote these
qualities.
• Markets – what are we providing to whom? Are there enough customers? Have we a good
product range?
• Management information, including Internet technology. Basic computer systems are now a
threshold resource. To provide a better service or better manufacturing, better and cleverer
MIS needs to be developed.
• Management. This is often a severely limited resource in small businesses. The business was
started and is still owned by its founder, but that person does not necessarily have the
management skills to successfully run a larger company. Furthermore, they are reluctant to give
power to professional managers. The same problem is also seen in family businesses where the
founder wants the business to pass to his or her children, but the children have no business
ability.
• Methods (processes). This is really how you organise your resources. For example, what is the
process of dealing with a new order from receipt through manufacture and finally to despatch?
Poor methods will lead to poor results.
Additionally, it is worth noting two other resources which do not easily fit into the M pattern:
• Know-how. This is verging on a competence, but possessing skills and know-how, particularly
relating to complex products and services, is very important.
• Brand/reputation. A company with a strong brand name and a good reputation will find it much
easier to launch new products and to move into other markets.
9.5.1 Introduction
As industries become more complex and progress from primary (extractive), to secondary
(manufacturing), to tertiary (providing services), to quaternary (research) it is clear that industries
inevitably depend increasingly on knowledge such as:
• Know-how;
• Technical knowledge;
• Customer preferences;
• New developments;
• Methodologies;
• Law and regulations.
The knowledge that an organisation has is a resource that may be difficult for other organisations to
acquire and so can be a source of competitive advantage. For this to happen, the organisation must
record the knowledge of its employees and make it available to others.
Knowledge management is the collective and shared experience accumulated through systems,
routines and activities of sharing across the organisation.
Knowledge management looks at:
• Discovering;
• Uncovering;
• Categorising;
• Recording;
• Distributing and sharing;
• Retrieving;
• Levering;
• Updating knowledge.
For example, you could give two managers identical restaurant facilities and one would make that
into a successful and inviting restaurant, but the other manager would create an unpopular
restaurant. The restaurants could even be providing the same food (recipes are explicit knowledge)
but still one would outshine the other because the manager there has competence in recruiting
friendly staff, creating a fun atmosphere and making memorable evenings. But, how can we learn,
describe and record the successful manager's tacit knowledge about how to run a restaurant well? If
we can't record that information it will not be possible to open a second restaurant with any
promise of success. Furthermore, if that manager leaves, he or she takes with them knowledge that
we will find difficult to replace.
Step 1 – Socialisation
Socialisation is the sharing of knowledge through social interactions. For example, discussing
matters with colleagues over lunch in the staff canteen, telling stories about incidents that
happened, debriefing meetings after projects, shadowing managers, coaching. Most of these
activities are relatively informal, but watching and listening as people do their jobs, hearing about
problems or triumphs they have encountered will often give valuable insights to what caused
success or failure.
For example, hearing that the successful restaurant manager organised a birthday cake when it was
realised that it was a customer's birthday is something that might come out in casual conversation
but which might otherwise be overlooked.
182 | P a g e
Step 2 - Externalisation
Step 1 uncovered shared tacit knowledge but did not make it explicit. Two people might now know
that providing unexpected birthday cakes to customers is better than just one knowing, but that is
not enough: we need every restaurant manager and potential restaurant manager to know that.
Therefore, the knowledge has to be made explicit by recording it.
Step 3 - Combination
No new knowledge is created in this stage, but the pieces of tacit knowledge that have been
uncovered and recorded are analysed, combined, codified and more formally recorded, perhaps by
putting it into a database. This step makes it possible to retrieve the knowledge.
It would be a little like taking all the information we had written down about what seems to make a
good restaurant and bringing it together into a handbook that could be easily and effectively used
by all staff.
Step 4 - Internalisation
This turns the explicit knowledge back into tacit knowledge so that people act on that naturally.
Having the 'Good Restaurant Practice Guidebook' created at Step 3 is useful, but we do not want
staff to have to keep going back again and again to refer to it. The methods of behaviour set out in
the guidebook have to become automatic.
9.6.1 Introduction
Porter's value chain sets out all the activities that organisations carry on. It is often presented as
follows:
The answer is that the company must be doing something that customers are willing to pay extra
for. In other words the company is adding value by doing something that its customers couldn't do
themselves or don't want to do themselves.
That value could arise from many sources such as:
• Bringing know-how and expertise to the task
• Bringing economies of scale to operations
• Giving customers flexibility
• Making people feel good because of the brand associations
• Sharing risk.
Porter said that companies must understand where they add value and must ensure that they do
not damage that.
Porter argues that each cost in the business is one of two types:
• Value-adding – the extra cost is outweighed by the extra the customer is willing to pay
• Non-value-adding – the extra cost is not valued by the customer.
For example, if customers come to you because you hold a very extensive range of inventory,
although you might save money by cutting down inventory, you will ultimately lose out because
customers will go elsewhere. In this case, and perhaps rather unusually, holding inventory would be
a value adding activity.
9.6.3 Linkages
Understanding the linkages between activities is also important. For example:
• Spending more on human resource management (for example, on training) might increase the
efficiency of operations.
• Spending more on technology development (for example, on the web site) might increase the
success of sales and marketing.
• Spending more on operations (for example, buying a new machine) might increase the quality of
what is made and so reduce after-sales service.
Above all, remember that whenever something is changed, an organisation must look very carefully
at the effect of the change on its value adding ability: how will customers react?
What elements of the value chain allow McDonalds to charge low prices?
Apple does not make iPads itself. It designs them, has components custom-made (for example by
Arm Holdings, a UK-based company), then the devices are made in huge manufacturing plants in
Asia, then finally sold through a variety of outlets, some of which are Apple's own stores and some
of which are other distributors.
All parts of the value network must operate well and efficiently if good, reliable and innovative
products are going to be made. Each company involved must be adding its own piece of value.
9.9.1 Introduction
Once the organisation has analysed the external and internal environments it should be able to
identify:
• Strengths;
• Weaknesses;
• Opportunities;
• Threats.
Strengths and weaknesses are internal to the organisation: its resources and competences. These
can be real (for example, the company might have exciting new developments in the pipeline), or
they might be perceived by customers (for example, the company has a reputation for poor service).
Opportunities and threats are external: PESTEL effects and the Porter's five forces.
SWOT can be used on its own or it can be a summary of other findings. Be warned, however, that if
you have used PESTEL and found a favourable environmental effect do not waste time by restating
that in a SWOT analysis.
Examples:
Example 1
Opportunity = take over a weak competitor
Strength = surplus cash
That is a good match and should work well.
Example 2
Opportunity = expanding abroad
Weakness = poor marketing and no international experience
Therefore avoid the strategy or find a way of improving marketing and making good the lack of
experience. Perhaps recruitment is needed before the strategy is followed.
187 | P a g e
Example 3
Threat = a powerful foreign competitor is entering your market
Strength = strong brand name and a long tradition
Try to defend your position by emphasising your reliability and tradition. Perhaps a 'buy local'
campaign might work.
Example 4
Threat = new technology
Weakness = poor research and development department.
The company cannot fight this directly from its position of weakness. Perhaps it should withdraw
from the market where it has been 'out-gunned'. Perhaps it could form an alliance with another
company that has some promising products that need to be brought to market.
• Apply Porter’s value chain to assist organisations to identify value adding activities in order to
create and sustain competitive advantage. (C3c)
• Learn the definitions of threshold resources, threshold competences, unique resources and core
competences and be able to identify them in a scenario. (C4a)
• Identify and evaluate the strengths and weaknesses of an organisation and formulate an
appropriate SWOT analysis. (C4d)
(a) The formula for what goes into Coca-Cola has been a secret for many years. This gives the
company a unique resource.
(b) Mercedes Benz has competences in design and engineering allowing them to gain an
advantage over rivals.
(c) McDonalds is successful due to its competences. In particular their ability to control costs. In
addition they are very good at marketing (another competence) which leads to them having a
strong brand (a resource)
(d) KPMG has a great deal of knowledge (a resource) and is very good at managing its transfer
to new employees (a competence).
Solution 9.2
• Procurement – Bulk buying often from other companies in the McDonalds group (lower prices)
• HRM – being able to recruit large numbers of staff at low cost
• Technology – having kitchen equipment which is specialised to cook things in a particular way
• Inbound logistics – using frozen food to cut down on wastage
• Operations – using less-skilled employees to reduce costs
189 | P a g e
10
Strategic choices
Context
Once we have looked externally and then internally for an organisation we can start to think what
the options of the organisation are. We may be able to generate options that we had not considered
before so this can be useful to help decide what to do. We will also be able to generate methods in
which to make the most of the options that are available.
Once we have generated options we need to start choosing the right way to proceed. Here we will
be able to take some strategic actions. We will also look at how to evaluate the strategic options to
get to the best decision.
Video introduction
10.1.1 Review
190 | P a g e
Before going on it might be worth reviewing where we have got to in the strategic planning process.
The rational planning process that we are working through suggested three stages to creating
strategic plans:
So far we have looked in some detail at the strategic position stage in which we gathered internal
and external information. A number of tools were introduced such as PESTEL, 9Ms and the value
chain. The results of this stage can be presented on a SWOT analysis, and this should provide the
organisation with a framework for choosing how to move forward.
10.2.1 Introduction
Porter's generic strategies describe how organisations can achieve competitive advantage. You
should remember that competitive advantage means above-average returns in the long-run.
Colloquially, competitive advantage allows you to keep beating your competitors.
It can be useful to think of 'generic strategy' as a 'fundamental strategy'.
Porter said that there were three generic strategies:
• Cost leadership
• Differentiation
• Focus
We will deal first with cost leadership and differentiation as they represent the first fundamental
decision that has to be made.
In the diagram below, look at the middle case, the average player.
The average player sells ordinary goods into a competitive market. Because the goods are ordinary,
and many similar goods are available, it is not possible to raise their price above the market price. At
the same time, the average player is not a particularly efficient producer, so costs are relatively
high.
The average player is therefore squeezed between high costs and a low selling price, and so is
condemned to making small, miserable profits. Porter referred to the average player as being 'stuck
in the middle'.
Small profits almost certainly mean that this company has no long-term future. More profitable
rivals will be able to afford to invest in new machinery, advertise more intensively and, if need be,
cut their selling prices to put even more pressure on the average player.
The diagram above shows that the differentiator is obtaining a higher selling price for the
differentiated product. Despite costs going up somewhat, the margin has increased from that of the
average player.
Higher profits mean that the company has achieved competitive advantage. Its existence is
relatively secure because the high profits and low costs mean:
• Money can be invested to maintain or increase differentiation. For example, a more advanced
web-site to look after customers better;
• Money can be invested in developing new, special products;
• The pace at which new products can be developed and launched could frighten rivals out of the
market.
In addition, higher profits will give better returns to investors.
10.2.5 Focus
Irrespective of whether a company decides to be a differentiator or a cost leader, it can still decide
whether or not to adopt a focus strategy. A focus strategy means that the company will concentrate
on a small market segment rather than trying to service all market segments.
A focus strategy could be attractive if:
• The company was small and did not have the resources to deal with all segments;
• The segment focussed on was particularly profitable;
• The segment focussed on had little competition from rivals.
Therefore, the company could decide to be:
• A cost leader, without focus;
• A cost leader, with focus;
• A differentiator, without focus;
• A differentiator, with focus.
Differentiators rely for their success on providing what customers want and will be prepared to pay
for. They rely on innovation, flexibility and good service standards. No one would say that costs are
not important, but there would be greater tolerance and flexibility over cost overruns if it were seen
that long-term customer satisfaction and loyalty was achieved. There would probably be a culture
that encouraged debate and participation, because that helps differentiation.
The main danger facing differentiators is imitation. If every producer starts imitating the
differentiated product, then that becomes a standard product in a competitive market.
10.3.1 Introduction
Having decided on an appropriate generic strategy, organisations can then turn to more detailed
matters. This is sometimes known as choosing the organisation's strategic direction, and the
standard model to use is Ansoff's growth vector matrix.
This is a powerful model because it sets out all possible options – meaning that there is great
potential for referring to it in many situations. A convenient way to look at it is that profit-seeking
organisations are always on the look-out for ways to increase their profits, and these quadrants set
out possible options for doing that.
Learn Ansoff’s growth methods and be able to give suggestions to organisations in a given scenario
Efficiency gains will allow higher profits to be made. Often the term is used to mean 'cost cutting',
but it does not necessarily imply job losses (though often does). Note that major cost cutting
without affecting an organisation's ability to keep supplying its products and services can be
difficult.
• Consolidation
Consolidation means that no growth is attempted this year, but that the organisation works hard
to safeguard previous gains. Often if a company has expanded quickly and strongly its service
standards decline. The procedures and processes have not kept pace with sales volume. If the
organisation is not careful it will develop a poor reputation and will begin to lose existing clients.
Product development requires investment, innovation, research and development and knowledge
about what customers really want and need. Companies that are good in market analysis will have
an advantage.
Product development problems for companies include:
• Designing the right products, otherwise the new products may not be successful.
• Competitors could out-design you with even better new products.
• Obtaining the right resources needed to develop new products. For example, a good design or
research team. This could be a sub-contracted function.
• Developing products may be carried out because the consequences of not developing new
products could be unacceptable. Because the company has been forced to develop products it
might not do so enthusiastically or well.
Strategic Impact of new product, process and service developments and innovation.
choice
Cost Innovating in product, service and process can keep costs down. Quicker and simpler processes are che
leadership can also support cost leadership. Furthermore, it is possible to design new products that are cheap to b
cost leadership position.
Differentiation New product, process and service developments can support a differentiation strategy, by focusing on u
ways, Apple did not invent the tablet computer, but by differentiating it so that it appealed to leisure, a
and was easy to use.
197 | P a g e
Focus An innovation can focus on a particular customer group. An example is 121 sport, an ‘app’ for golfers w
and have a golfing professional review this in 24 hours.
Market Although the company is selling more of the same product to existing customers it can innovate by crea
penetration product, easier and more innovative ways to buy the product (eg different pack sizes), creative marketin
distribution networks. Regular incremental changes to the product with improved benefits can help.
Market Product innovation can support entry to a new market. For example, Nokia and Apple have developed s
development their phones to sell to more price sensitive markets. Car manufacturers might adapt their products to to
Product Product development as a strategy focuses on the product itself. Developing new products is key to this
Development than the creation of new features in the product. It can involve the design of new customer experiences
support services.
For example, Apple having designed innovative approach to recorded music (iPod, with the innovative i
developed a new product, the iPhone, and then the iPad. Apple’s strategy had been to take other produ
into a compelling proposition.
Diversification This is taking new products or services to new markets. There may be some core innovations that can b
built on a core competence.
Customers To collaborate with a customer means building up a relationship, and hopefully reducing the c
switch to another supplier. Even though Intel, for example, is a firm separate to Microsoft, the
relationship was very powerful: both supplied makers of hardware.
Similar firms in Firms can share know-how and products without competing with each other, or can market or
adjacent markets products.
10.6.1 Introduction
As was mentioned earlier, market development can be of two types:
• Selling to a different type of customer in the same country;
• Selling to a different country.
Before expanding abroad – the target country should be analysed using the same methods
discussed in earlier chapters (PESTEL, Porter's five forces) to see if it is an attractive place to expand
to. There is no point choosing a country with strong domestic competition, an interfering
government or poor intellectual property rights.
The company should also think about whether its current generic strategy is likely to be successful in
the new market. For example, products that are differentiated strongly for the current market might
not be attractive in the foreign market. This can be difficult to predict and, for example, many large
successful UK retailing chains (eg Tescos) have failed to make a success of opening stores in the USA.
There seems to be something about what UK retailers do and what US shoppers want that means
retailing doesn't transfer well.
Exporting
Exporting is the most conventional and the most common method of entering a new overseas
market.
The advantages of exporting as an expansion route are:
• Companies can try out the new market without facing too many risks.
• Operating costs are relatively small.
• Concentration of production in a single location – economies of scale, consistent product quality.
• Relatively quick to set up.
An organisation has two options for the organisation of its 'field sales' – those who sell the product
or service to the customer:
199 | P a g e
• Indirect exporting: allow local agencies to sell products on a commission basis. Here the
company gets access to the local company's knowledge and contacts, but the company will not
see all of the profits. Additionally, agents might also sell competing products from other
manufacturers.
• Direct exporting: set up local sales offices to sell the home-produced goods overseas. This will
be somewhat slower and more expensive to set up, but the exporter makes direct contact with
customers, the sales offices only sell the exporter's goods and no commission has to be paid.
Overseas production
This is sometime called 'foreign direct investment'. The company sets up a factory in the foreign
country where it manufactures and sells the products.
Advantages are:
• Better local understanding of the products needed.
• Faster delivery of products because they are made near customers.
• Lower production costs (eg lower labour and transportation costs).
• Economies of scale in large markets.
• There might be investment incentives offered by governments.
• Avoidance of trade barriers.
Disadvantages are:
• Capital requirements to build the facilities.
• Understanding local planning, labour, health and safety laws.
• Recruiting, managing and motivating a new, foreign workforce.
• Delay as facilities are made ready before production and sales can begin.
• Occasionally, political turmoil leads to seizure of assets.
Licensing/contract manufacture
In contract manufacturing, a company signs a manufacturing contract with another firm abroad
which makes the product to the company's specifications.
Advantages are:
• Low risk and no large capital requirement.
• Relatively quick to set up.
• Government sometime encourages this type of business through tax breaks.
• Small markets which would not justify their own manufacturing plant can have the products
manufactured locally.
• When the company's own strength lies in marketing rather than manufacturing.
200 | P a g e
Licensing takes contract manufacturing one stage further. Product and service ideas are sold under
licence to overseas companies to allow them to produce and sell products similar to those of the
licenser. The goods are therefore produced locally and sold by the licensee. A licence is often
granted exclusively, to give the licensee some sort of 'sole supplier' status.
Which of the above approaches (geocentric, ethnocentric, polycentric) would be most likely to be
used by the following companies?
(a) McDonalds
(b) KPMG
201 | P a g e
(c) Coca-Cola
Another approach to foreign markets looks at:
• How much to adapt products to local markets (independence);
• How much the company will attempt to coordinate activities across the globe.
A small market share in an old market. Cash negative, with no future. Divest, either by closing it
down or selling to another company.
information insofar as the sellers of companies in these new areas usually know more than the
buyers. However, it can be appreciated that these categories of takeover can allow a company to
expand globally and to present more comprehensive product ranges, thereby allowing the
possibility of increases in shareholder wealth.
One of the main drivers behind the recent bid for Cadbury by Kraft was the access Cadbury has to
many overseas markets, such as the quickly developing economies of countries like India, Brazil and
Mexico where Kraft had poor penetration.
Public sector Popular and delivered well. Governments would usually try to leave this alone.
star:
Golden Done well, but not particularly appreciated. If cuts in expenditure have to be made, these could be th
fleece:
Back drawer Not popular and not done well. Again savings might be possible here if the services are really not need
issue: are needed (tax collecting, perhaps) and the government has to try to create support for these if spen
delivery.
10.10 Diversification
10.10.1 Introduction
The Ansoff matrix was described earlier, and we now have to look at the final quadrant,
diversification, in some more detail.
205 | P a g e
In a diversification strategy, both products and markets change, and inevitably there is a greater risk
that things will go wrong.
Diversification has to be divided into two categories:
1. Related (concentric) diversification, including vertical integration (backward and forward), and
horizontal diversification. Here, there is some sort of connection between the activities of the
businesses.
2. Unrelated (conglomerate) diversification, where there is nothing in common between the
different businesses.
However, if should be said that vertical integration is not currently fashionable. In fast-moving
technological, economic and competitive environments, high expertise, flexibility, speed of reaction
(ideally pro-activity rather than reactivity) are vital, and these qualities are often better met by sub-
contracting. For example, above it was suggested that a phone company might take over a chip
manufacturer to gain differentiation advantages. In reality, however, it will be difficult to make a
success of that. Designing and manufacturing electronic chips is a hugely complex and expensive
operation. The chip company has expertise and economies of scale (because it will work for many
customers), and it is unlikely that the phone company can make full use of these resources.
Sub-contracting and close working-relationships can be used to get skilled suppliers to make
components to order. For example, firms like Nokia and Apple can have specialised chips and other
components made for them by companies like ARM, Intel and Motorola.
Sub-contracting can apply not just to the supply of components and the sale of goods, but to many
other business processes such as IT, accounting and human resources management. It might be
better to strip down your business to the core activities where you can add value, and to outsource
everything else to experts in those activities.
Cost savings and marketing opportunities can also arise with horizontal integration. For example, a
merger of an airline and a hotel business to form an operation such as SAS Radisson. There are
considerable connections between two such companies: both are in the travel industry, both
international, and both can segment their markets into similar business and leisure sectors. A
merger can offer the possibility of cross-marketing, such as offering passengers accommodation in
airport hotels, sharing loyalty point schemes, and integration to provide holiday packages. All of
these offer the possibility of value creation.
exercising managerial power. However, often the new owners do not have the skills to manage
successful change in this new business that has a different culture, its own body of expertise and
know-how, its own constraints and opportunities. As was once said, the most important rule of
takeovers, as with medicine, is 'First, do no harm'.
The only justification for taking over an unrelated business is if the business is presently poorly run
and the new owners believe they can turn it around by applying suitable management expertise.
Normal management approaches should allow profits to be increased or cash flows to be maximised
by the sale of under-utilised assets: take over a poorly-run, therefore cheap business, turn it round,
and sell it at a profit.
10.11.1 Introduction
Once the company has decided on a suitable method of growing (market growth, market
development, product development, diversification development etc.), it then has to decide what
method to use. Should the company:
• Start its own SBU (organic growth);
• Acquire a company already operating in the industry;
• Use a more flexible approach, such as a joint venture?
• Because a premium is often paid on acquisitions, acquisitions usually benefit the shareholders of
the company being acquired not those of the acquiring company. Organic growth can avoid this
problem.
Disadvantages of organic growth
• It is relatively slow;
• The company is likely to make mistakes as it goes about developing new markets and products;
• It might be difficult to access suppliers and customers;
• It might be difficult to access other resources, such as raw materials, and patents if these are
owned by rivals (barriers to entry).
In a typical joint venture, two companies form a third jointly owned company for a specific purpose.
A consortium is when there are more than two parent companies.
Joint ventures and consortia are common whenever major complex projects are to be undertaken.
Although in this text they are listed under foreign expansion, they could also be entirely domestic.
The parent companies can transfer:
• Cash;
• People;
• Machinery and other assets;
• Know-how.
to the joint venture company. Any profits will be shared, as will any proceeds available on exiting
the joint venture.
A relatively recent example was the Airbus consortium that was set up in 1970 to produce
passenger airliners in competition with Boeing. Companies from four European countries were
initially involved. The joint venture was turned into an independent company (EADS) in 2001. EADS
is now traded on six European stock exchanges.
These are cooperative efforts, but somewhat less formal than joint ventures. Good examples are
seen in airline alliances, such as One World and Star Alliance.
Another example is the cooperation between Panasonic and Leica to produce Lumix cameras,
Panasonic's brand of digital cameras. Many Lumix models are fitted with Leica lenses, some are
rebadged as Leica cameras. Panasonic produces all of Leica's branded digital point and shoot
cameras in Japan. The two companies find that their cooperation (one bringing optical technology,
the other electronic technology) allows them to compete with other major digital camera
companies.
Strategic alliances can:
• Share development costs which reduce resource costs of a strategy.
• Make use of existing expertise or technology and often are seen as a good 'learning' exercise
where each partner tries to learn much from the other.
• Bypass government regulations that forbid closer arrangements (eg the airline industry where in
most countries there are limits to the level of control an 'outsider' can have over an airline).
• Allow each member of the alliance to provide customers with better products and services. For
example, the airline alliances, through code sharing, have allowed many airlines to give the
impression of flying to many more countries than they do. You think that you are booked with
one airline, but discover that the plane might belong to another. Nevertheless, it is easier for
passengers to arrange complex trips because of alliances.
10.11.6 Franchising
Franchising is now a very well-established form of expansion. It works very well for both domestic
and overseas expansion and is very popular in the retail industry. Many branches of McDonalds and
United Colours of Benetton are run as franchises. It takes the licensing concept one stage further
with much more involvement between the parties involved.
The following pattern is typical:
• The franchisee purchases a franchise from the franchisor (eg, from McDonalds).
• The franchisor provides help, support, training, raw materials, research and development,
marketing. The franchisor also imposes rules setting out exactly how the franchisee is to run the
business.
• The franchisee pays for the raw materials.
• The franchisee pays a royalty based on sales or profit.
• The franchisor can carry out research and development and marketing which an independent
trader could not afford. Additionally, the franchisor will enjoy economies of scale in purchasing
and manufacturing which are unavailable to small, independent businesses.
These include:
• Vertical hierarchy and chain of command, as much a culture of status seeking. To be fair, many
companies have delayered.
• Horizontal divisions between different business units, where they could share markets,
knowledge.
• Horizontal divisions between functional silos, eg different professionals in a business, for
example marketing not talking to product development.
In other words, it was felt that it was necessary to break down these barriers and replace them with,
for example:
• Interdisciplinary project teams
• Interdepartmental projects
Teams of expert employees are given decision-making authority, thus avoiding decisions being stuck
in a hierarchy. Work might appear “chaotic and freeform”, conducted virtually, using internal social
networking software or shared project spaces (eg Google+). They focus on fluid and adaptive
behaviour, and the role of administration is to support this networking activity.
Arguably, this type of organisation may be more suited to certain environments than others. An
advertising agency may thrive on this type of approach, where the work might be specialist, non-
standard and customised for each client. An oil company, with a huge investment in physical
infrastructure, as well as highly regulated safety procedures, may require bureaucracy.
Characteristics of an effective boundary-less organisation are:
• Speed
• Flexibility (not rigidity masquerading as role clarity)
• Integration, not specialisation (in other words a mixture of professional disciplines)
• Innovation, not control
Based on the knowledge you have gained in earlier chapters, assuming there are no local legal rules
to comply with, what method would you suggest the following companies use to carry out market
development?
(a) Price Waterhouse Coopers
(b) British Airways
(c) Armani
(d) BMW
Professional skills marks are available for demonstrating commercial acumen.
10.12.1 Introduction
Johnson and Scholes suggest that for any option to be considered seriously it must pass three tests.
The option must be:
• Suitable;
• Acceptable;
• Feasible.
10.12.2 Suitability
Suitability is concerned with whether a strategy provides an appropriate answer to the situation
identified in the strategic position stage (corporate appraisal). It should do at least one of the
following:
• Build on strengths and grasp opportunities;
• Address weaknesses and threats;
• Fit in with the organisation's culture;
• Exploit the company's distinctive competences;
• Be consistent with current strategies.
The test of suitability requires an assessment of the extent to which new strategies would fit with
future trends and changes in the environment, and exploit an organisation's capabilities.
The concepts about the strategic position of a company may be used here.
Concept Can give an understanding of: Example of
214 | P a g e
Value chain Opportunities for vertical integration to better coordinate supply and demand Merger or a
10.12.3 Acceptability
Acceptability is concerned with the expected performance outcomes of a strategy in terms of:
• Return.
• Risk.
• Stakeholder reactions: shareholders, employees, customers, suppliers.
• The organisation's mission.
• The organisation's culture.
Techniques useful in understanding the acceptability of strategies include:
Criteria Helps to understand: Examples
Stakeholder reactions: Political dimension of strategy and stakeholder requirements Discussion, negotiatio
215 | P a g e
10.12.4 Feasibility
Feasibility is concerned with whether a strategy can be made to work in practice and looks in detail
into the capabilities of an organisation (resources and competences). The organisation should:
• Have, or have access to, adequate resources and competences: money, management, men and
women, materials, know-how, culture and so on.
• Be able to reach the required level of performance. It must be able to achieve strategic
capability, not just threshold capability.
• Be able to withstand competitive retaliation.
• Have sufficient time.
A useful way of assessing financial feasibility is funds flow forecasting and break-even analysis.
Resource deployment analysis is widely used to identify and assess a company's resources and
competences needed for a particular strategy. It is particularly helpful to judge two things:
Staying in business
• Do we lack any necessary resources?
• Are we performing below threshold capabilities on any activity?
Competing successfully
• Which unique resource already exists?
• Which core competences already exist?
• Could better performance create a core competence?
• What new resources or activities could be unique or core competences?
Private equity
Based on an article in the Economist 22 June 2013
In recent years, ‘private equity’ firms have bought many companies, and increased returns by
reorganising them and re-engineering their financial structure, with more interest bearing debt than
equity. Many private equity houses seek to exit from their investment over a five-year period.
Many claim to improve the workings of the businesses they have purchased, but according to the
Economist ‘operational improvement has often meant little more than colossal bonuses to sitting
chief executives if they meet ambitious growth targets’.
A private equity house that really takes operational improvement seriously is Clayton, Dublier and
Rice (CD&R). Smaller, but older, than other buyout firms, it deploys former senior executives from
large firms to chaperone chief executives. A success was Lexmark, IBM’s former printer business,
216 | P a g e
which was repositioned and its value doubled in six years. Studies claim that firms taken over by
CD&R improve at double the rate of industry peers.
Unlike other private equity firms, where financial engineers get the most bonuses, CD&R
incentivises its operational experts. Focusing on operational excellence, rather than financial
engineering (changing the balance between debt and equity), means that the performance of the
company acquired is not dependent on stock market variables. However it takes longer to generate
returns than pure financial engineering.
(a) Ferrari – Focussed differentiation – they make cars for a limited number of market segments.
(b) Samsung – Differentiation – they make lots of different consumer products but most try to
add value.
(c) McDonalds – Focussed cost leadership – McDonalds make a small range of products and aim
at keeping costs and prices down.
Solution 10.2
(a) McDonalds would follow a mainly ethnocentric approach although it might need to adapt
products in certain countries (eg in India).
217 | P a g e
(b) KPMG would probably follow a geocentric approach. They would need to adapt to local legal
requirements although many accounting and auditing standards will be valid worldwide.
(c) Coca-Cola would also probably follow an ethnocentric approach – a tin of Coca-Cola in any
country is likely to be very similar in taste and size.
Solution 10.3
Solution 10.4
(a) Price Waterhouse Coopers could look to acquire a local accounting firm and then rebrand it as
PWC. Acquiring a company would mean they had quick access to local staff including their
knowledge.
(b) British Airways may look to form an alliance with a local airline. For example allowing
passengers on the local airline to book onward connections on a BA flight. An alliance would be
suitable since conditions may change rapidly within the market, perhaps leading to a different
partner becoming more attractive.
(c) Armani might decide to do indirect exporting, perhaps selling their clothes through existing
upmarket clothes retailers. This would allow them to have a wide geographical coverage
without requiring a lot of investment.
(d) BMW might decide to do direct investment, setting up their own showrooms within a country.
They may do this to emphasise their product differentiation.
A good professional skills mark will be obtained by demonstrating a good understanding of the
different companies and correlating that with the recommended strategy.
218 | P a g e
11
Risk - Identification, assessment and
measurement
Context
Risk management is an important topic in corporate governance. Risk identification considers the
key players in the process and seeks to highlight the nature and depth of the level of risk exposure.
This is vital to moving forward in determining an appropriate risk response.
We have seen that SBL involves thinking about the potential strategies of an organisation and there
is a strong link with the risks involved in any new strategy.
Video introduction
The final step would then be to continuously evaluate the quality of such systems as a part of good
governance.
The reason that risk follows rather than precedes internal control as a governance issue is that the
history of governance focuses firstly on internal control through the work of Turnbull 1999. It is not
until the early years of the 21st century that governance turned its attention fully to developing the
general need for control by improving its focus through risk management.
Deliberation of these issues leads the corporation towards the need for a risk committee and
independent risk managers.
Levels of responsibility
Turnbull makes it clear that risk management is everyone’s responsibility.
He suggests a standard three-tier concept can support this need:
1. Strategic level
This embraces the role of the board in accepting responsibility for risk management, providing
adequate funding and ratifying risk committee advice on strategy. It also necessarily includes the
work of the risk committee.
2. Management level
Departmental managers must interpret the strategic thrust of risk strategy, organise resources and
execute policies and programmes. They will also accept responsibility for ensuring internal control
exist to ensure success. This level also includes the work of the risk manager.
3. Operational level
221 | P a g e
Staff have a personal and continuous responsibility for risk management in their area of operation.
They must be aware of policies, and awake as to actions to take should failure occur. They should be
audible in reporting any perceived or actual problems to their line manager.
The identification of risk as operating at all levels of the company emphasises that success in this
area is a collective concern for all members of management and staff. Failure in the smallest
operational activity can heighten the potential for safety concerns or lead to a potential negative
impact on company reputation. A sense or vigilance matched to capability seems a prerequisite.
Risk awareness and risk attitude become particularly important in ensuring all staff understand their
role in risk management. Training and strong leadership become pressing concerns at the control
environment level of the company.
Consider the scope of threats, at the operational and strategic level, in relation to all
organisational resources.
2. Estimate impact and priority
Consider the possible outcome of risk failure and the extent to which it is likely to occur.
3. Develop solutions
Consider the scope of risk strategies to be deployed
4. Implement risk strategy
Delegated responsibility, allocate finance and organise projects and programmes.
5. Review, adapt and disclose
The use of risk auditors or review by the risk committee
The CEO of L plc, Jay Pano, believes that having a risk committee is excessive in terms of governance
regulation and has suggested extending the role of the audit committee to dealing with risk
management. Discuss this recommendation. Professional skills marks are available for
demonstrating scepticism and evaluation skills in your discussion.
Hurricane Sandy was the worst storm of the 2012 hurricane season. It was also the second most
costly hurricane to ever hit the US with losses totalling $68 billion (the costliest was hurricane
Katrina in 2005).
In Hurricane Sandy’s wake, corporations are reassessing their relationship with physical risk. For
example, in New York, 24,000 restaurant owners “are re-examining their buildings’ infrastructure
and architecture,” adding that “for the first time, many are realizing a need to set up backup power,
communication systems and transportation networks.”
In a further response to the event, PWC produced a report titled "Risk Ready" within which it
suggests the storm created compelling evidence of the need for risk managers and risk committees,
if not audit committees and the board itself, to pay increased attention to environmental risk and,
importantly, consider both visible risks and those that are not immediately obvious such as tidal
storm surges that affected low lying areas of New York city.
Each risk must be evaluated through formal techniques to determine its priority. Priority will
require consideration of the impact of the risk on the corporation and stakeholders as well as an
assessment of the likelihood of risks manifesting into negative corporate events.
Dynamic risk
Corporations do not exist in an unchanging world, nor are they unchanging within their own
operation. There is a spectrum of change across which the organisation can assess its position. This
position will occur somewhere between static and chaos.
Whatever the positioning, it is a given that corporate environments and operations are dynamic. It
is simply the level of dynamism that changes, perhaps according to management style within and
industry norms outside.
Dynamism asks the company to accept that risk management and, within it, risk analysis is a
dynamic or changing process. The risk profile of a corporation that existed in the last decade will be
very different than that that exists today and tomorrow’s risk profile will change again, probably at
an increasing speed of change to a point where society tires of change or the products produced
within the industry.
Market risk
This has a multidimensional feel. Since Turnbull is promoting good governance, market risk could
relate to the threat of negative perception within the exchange and volatility in share price. It could
also relate to the corporation’s market place and so competitive threats and problems of operating
in new commercial markets.
Credit risk
Clearly in 2005 Turnbull would not have expected greater concern over credit availability since this
existed in abundance. Two years later, and continuing on until today, companies struggle to access
sources of finance and suffer from an inability of their customers to meet corporate credit terms.
225 | P a g e
Liquidity risk
This is the outcome of credit risk. Liquidity or cash flow problems can derive from an inability to
access sources of finance, they could relate to problems of customers paying their bills or suppliers
demanding cash payment. They can have stock holding implications, labour wage implications and,
of course, ultimately, survival implications.
Derivative risk
This is the only risk which is not generic for all corporations. It could be considered as a specific
warning to financial services institutions to deal with the hazard arising from investment or trading
decisions. These risks can multiple considerably where complex hedging strategies and futures
trading exist.
All of the above are financial risks.
Legal risk
This relates to the general, global nature of litigation that the corporation is exposed to. It may
suggest the need for appropriate reserves to be set aside in case of major class actions by
disgruntled stakeholders or simply stress the complexity of legal exposure on a global basis and the
increasing litigative nature of many societies.
Technology risk
All companies of any size are, to a greater or lesser extent, dependent on technology. As a threat
this may include the threat of project failure, security breaches or even obsolescence. The pervasive
nature of technology, speed of innovation and how technology intertwines with service delivery and
marketing all suggest this is a major factor for most companies.
Environmental risk
Since the environment has been considered a central plank in CSR policy over the last decade,
management have a heightened interest in this area. So do stakeholders. The impact of failure to
management the environment in the appropriate way could be viewed as a profit related self-
interest risk factor or, given an ethical level of board operation, important in its own right to secure
the planet for future generations’ enjoyment.
All of the above are specific business risks.
Turnbull provides two further categories:
Probity risk
Probity, in this context, is a need to be perceived to operate at the highest level of ethics or at least
to operate in a generally honest way with a sense of fairness and integrity. Failure in many of the
above categories ignites a probity risk in company operations.
226 | P a g e
Reputational risk
Failure in any of the above areas can have a knock-on effect on reputation. The multiplicity of
factors that can trigger it and the intangible nature of its depth and longevity of outcome force the
board to focus on its management.
Strategic risk
Turnbull’s classifications are aimed at the board of directors as major strategic risks. Such a risk has
wide and deep implications, potentially threatens corporate success, needs major investment and
policy should be determined at the highest level.
227 | P a g e
Operational risk
An operational manager is faced with many risks. Health and Safety, technology and the
environment would all affect factory operations. In this sense the nature of risk considered or
impacting on the operational level is the same as that impacting on the board of directors.
A distinction between the two would lie in the fact that operational risk are:
• More selective or limited depending on the area of operation
• Should have a more limited impact as an isolated event.
Transaction risk
If a company enters into a transaction now, but by the time the receivable/payable is received/paid,
the value has changed. They don’t know how much currency they will receive or pay in the future.
Severe exchange losses can have a large impact on the financial statements.
Translation risk
This is a change in the value of a company’s balance sheet if year-end exchange rates have changed.
For example, if they own a foreign exchange subsidiary and the currency weakens, the value of the
subsidiary falls and the subsidiary looks weaker in the accounts.
Economic risk
This is a change in the competitiveness of the company due to longer term changes in exchange
rates. An exchange rate movement can impact the value of operations. A company with many
foreign operations can find this has a major impact.
There are a number of options available to manage currency risk; one of the most common is to
enter into hedging transactions. A company with a US$ debt can enter into a forward contract to sell
the US$ when the debt is received in the future. This fixes the exchange rate and reduces
uncertainty.
228 | P a g e
Political risk
The risk of operating in a particular country may be high. A change in government or sudden
imposition of new laws could make it difficult for the company to operate. This could directly affect
the directors’ ability to run the business, for example, if governments seize assets or charge high
taxes on taking money out of country, it will be difficult for the directors to exercise control over
operations.
Fraud risk
This is the risk of fraud by employees, customers, suppliers or other parties. There are many
different types of fraud, and many reasons why someone may carry it out. The risk of fraud affects
every business but there are certain types of business that are more likely to suffer from fraud,
especially if they deal with a lot of cash, such as banks, shops and charities.
In other words it is apparent that risk is created both within the corporation and through its
interaction with its environment and that this interaction also means that stakeholders will be
affected by negative risk issues within the company. The corporation operates as an open system
with the business environment. The actions of one almost always impact on the other in a positive
or negative way.
For example, if a company causes environmental damage and suffers a loss of reputation together
with legal action culminating in a fine, this will have an impact on other stakeholders:
• Shareholders will be affected due to lower returns as a result of reduced profit, either from the
effect of the fine or because the damage to reputation has reduced the company’s profits
• Directors may find themselves out of a job as ultimately they are responsible for causing the
environmental damage in the first place
• Employees may lose their jobs depending on the impact of the incident on the company’s
operations. They may decide that they don’t want to work for a company with a poor
reputation and leave of their own accord
• Customers may be affected by the fall in reputation and seek supplies elsewhere
• The community is probably affected by the environmental problem
• The planet itself suffers and the wildlife upon it
Industry-specific risks
Some risks will affect particular business sectors. For example, in a recession it is often companies
selling luxury goods that suffer first. Consumers may decide that they do not want to spend money
on new cars and foreign holidays if they are unsure whether their jobs are secure.
In terms of risk management, a risk committee should identify the most important risk
classifications for the organisation, in order to create a framework for considering risk management.
It also helps to assure shareholders if the annual report gives an indication of the main risk areas
that the company has considered.
Mothertongue plc is a language school located in Europe. It offers training courses and translation
services for business and personal customers. It has been offered the opportunity to participate in a
joint venture with a company based in an African country.
The proposal is to set up a new company in the African country. Capital is to be provided by both
participating companies, with any further needs for funding obtained through loans secured on the
new business premises. Initial expenditure involves purchasing the premises and hiring full-time
staff.
After much discussion, the board of directors of Mothertongue plc has decided to carry out a risk
evaluation exercise for the proposed initiative. Some members of the board are concerned that the
required investment will divert resources from expansion in the home market, as plans to open
three new centres will have to be postponed in order to move the joint venture forward.
Identify the types of risk that must be considered by the company.
230 | P a g e
Professional skills marks are available for demonstrating analytical skills in identifying the key areas
of risk in the situation.
The Deep Water Horizon had drilled the deepest well ever sunk in all history at a depth of 35,000
feet prior to the event that overtook it and BP in April 2010. An explosion on the oil rig killed 11
people and ignited a fireball that was visible from 35 miles away. The subsequent collapse of the
structure led to the worst oil spill in US history. The slick spread over 68,000 square miles and
approximated to 4.9 million barrels of crude.
Liability for the disaster will be fought out in the courts for decades, the eventual cost to BP may be
in the region of $20 billion. The event is a reminder of the risks involved in deep sea oil drilling and
the oil industry in general. Understanding the scope and depth of risk is a vital function for any
organisation involved in this area.
Such an approach would appease those who are critical of having a separate risk committee. It
would also ensure that risk is still being dealt with in a formal way by a governance structure. The
232 | P a g e
independence of the audit committee provides a sense of objectivity and trust in the outcome of
their deliberations and it is a relatively small step for them to do this, risk and internal control being
almost inseparable concerns.
The expertise of the committee will ensure that financial risks such as liquidity are adequately dealt
with. This is vital for corporate survival. The committee already exists, removing the need to recruit
and already has the communication infrastructure in place to ensure it is furnished with the
information it needs in order to do the job. These seem very strong reasons for recommending its
use.
Against this view are arguments that the extension of the role places an inappropriate level of
responsibility upon a committee that must, as its first priority, ensure that internal control is
adequately dealt with in the company. Although probably not doubling their workload, it is a major
expansion to their duties. The shareholders of corporations know this and, for this reason, do not
embrace the idea of audit committees being used in this way.
Often audit committees lack the scope of expertise to deal with risk. In particularly the insider
experience of operations to offer insights and advice as to what should be done in areas such as
quality or safety. A separate risk committee would be more likely to have the required scope of
expertise.
Professional skills marks are given for breadth of considerations and putting both sides of the
argument.
Solution 11.2
Synergy risk arises from entering into the joint venture with a third party. It is quite difficult to
assess this, in that the upside and downside consequences will not be known for some time. If the
company goes ahead with the joint venture, the alternative benefits or demerits of ‘going it alone’
will never be known. There may also be some consideration of entering the African market on a
remote basis – offering services without actually establishing a local presence. Many accountancy
colleges, for example, approach overseas markets in this way.
Market risk relates to the ownership of an asset in the foreign country. The future value of this
asset will depend on numerous factors, most of which could probably only be assessed with the
assistance of expert third party advice from a professional firm familiar with local conditions.
Currency risk is a major threat to the business. It relates to numerous aspects of the proposal,
including:
• inbound and outbound capital flows;
• international flows of revenue and expenditure;
• servicing debt repayments.
Country (or sovereign) risk is that which arises from doing business in a country with dissimilar
economic and political characteristics to the home country. We do not know which African country
is the intended host to the new business venture. Some countries in Africa are stable while others
are exceedingly volatile.
233 | P a g e
Interest rate risk may be an issue, depending on the extent to which interest rates in the home and
host states are aligned or otherwise at any given time. This is relevant because Mothertongue
intends to borrow funds. The fact that the loan will be secured on premises purchased in the African
country is another manifestation of market risk.
• Professional skills marks are available for analysing risks relevant to the situation described. You
might score poorly for analysis if you had only addressed risks generic to such a company and
not discussed them in a way specific to Mothertongue’s situation.
12
Managing, monitoring and mitigating risk
Context
Risk assessment and risk strategy are the two essential elements in developing risk policy, whether
this is through a formal risk committee or a task tackled directly by the board of directors. The scope
and depth of approach will depend upon the company’s belief that risk management is a vital part
of corporate governance.
Video introduction
Risk assessment is the second stage in risk analysis. The identification of risk provides the basis for a
formal examination of the depth of risk exposure as a precursor to defining the organisation’s risk
strategy.
The goal is, in part, to prioritise risk to provide board focus with regard to what is truly problematic.
This prioritisation helps to make decisions as to what to do and how much investment needs to be
made in minimising exposure.
There are a number of influences which impact on this assessment process:
Risk appetite
Board culture helps determine the extent to which risk is embraced or mitigated through strategy.
The corporate appetite for risk in seeking out new markets or in embarking on innovative product
development will greatly influence whether it considers such strategies to be risky and what it
decides to do in order to minimise or avoid such risks.
Risk appetite can be seen as a purely individual concern. Each director will have their own set of
needs and beliefs. From this a perception of how much risk they are willing to accept in their
personal and professional lives will develop. This will then influence their opinion on board decisions
and so the decisions made by the company.
This individual perception must then be multiplied across the board and fermented into a collective
/ singular view on board risk taking. This attitude then becomes the company’s risk stance. This is
not to say that in a dynamic environment attitude to risk will constantly shift under business
environmental (PESTEL) pressure.
The emerging belief in how to approach risk management can be positioned on a spectrum of
stances from pessimistic to optimistic, from risk averse to risk seeking.
• Risk averse
At this end of the spectrum a conservative approach is taken. This might suggest a belief in
incremental rather than transformational change, in organic growth rather than growth through
risky global acquisitions, in slowing the pace of change or focusing on cost restructuring rather
than market development.
• Risk seeking
A reversal of the above. Beliefs drive a willingness to take chances in new markets, to operate at
the cutting edge of technology or push the envelope of accepted belief about what is possible in
the company’s industry.
Stakeholder analysis
Risk exposure is the extent to which stakeholders including shareholders may be negatively affected
by a threat or hazard. A stakeholder analysis becomes an inherent part of risk assessment,
235 | P a g e
influenced by corporate positioning in terms of how much it cares about potential negative impact
on local communities, suppliers, governments of customers.
Risk aptitude
The ability of the company to respond to threats will be another major factor in deciding whether to
accept or reject strategies that lead to potential risks. Risk aptitude relates to the asset capability of
the organisation. The finance available and the technologies it can use to deal with potential
environmental disaster should remote probabilities actually materialise into a risk event.
Risk roles
The expertise and independence of risk management is important. The willingness of market traders
in financial services to accept risk for the promise of personal financial reward needs to be qualified
or dampened by a risk committee that is willing and able to counter this cultural driver by applying
limits to the degree of risk that is acceptable in trades, particularly in areas such as futures markets.
Definition
A risk map is a way of communicating risk evaluation pictorially.
A risk map allows users to see risks through a picture rather than a collection of words or numbers.
It may use colour (depicted here in greyscale) to show the intensity of risk impact or probability.
Such a risk map can be described as a ‘heat’ map. Words and/or colour can be used to identify
where the risk is hot (particularly intense for the company). These two types of risk map are
illustrated below. A company is likely to have standard responses depending on where a risk is
plotted (eg avoid critical risks!).
The potential impact on the organisation is assessed to identify the depth of exposure to the threat.
Impact may require the use of experts to consider the consequence of a negative event or the use
of computer based modelling to view the potential outcome. Probabilities are also used to
236 | P a g e
determine the likelihood of the threat materialising over time. Statistics may exist to provide firm
foundation for assessing exposure.
The combination of impact and probability provides a coordinate for plotting the threat on the risk
map and, having determined its position, the risk map points the board towards the nature of
strategy required to deal with the risk.
Imagine you are a member of the risk committee for a multinational oil company. The company is
evaluating the following potential threats and its subsequent possible risk exposure:
1. Possible political regime change leading to the nationalisation of one of their refineries in a
foreign country.
2. Possible environmental disaster through the failure of an oil platform leading to a large law suit
by affected local communities.
3. Volatility and rising oil prices due to market manipulation by a global oil cartel of which we are
not a member.
4. Reducing revenues in important markets due to customers moving towards the use of electric
cars.
Draw a risk map with accompanying notes in relation to each of these risks.
Professional skills marks are available for demonstrating communication skills.
According to the forecasting group Shell, the world will be almost carbon free by the end of the
century. It predicts solar power will become the dominant energy source for the planet by 2100.
Some critics have suggested that, since carbon emissions are set to reach Armageddon levels within
two decades, there won’t be anyone left to verify their prediction.
However, in general, Shell’s forecasting capability, used as a basis for future strategy and risk
management, is considered among the best in the world. It previously accurately predicted the
1970s oil crisis, the end of Apartheid and the fall of the Soviet Union, a fact it kept quiet for a
number of years whilst it snapped up Soviet oil leases.
Transfer
Risk transference relates to the possibility of passing risk exposure to a third party so reducing or
eliminating the threat to the company. Typically transfer is associated with the use of insurance,
transferring the negative potential impact of a threat onto the insurance company. More
significantly, outsourcing decisions and the involvement of suppliers and contractors in company
operations is an appropriate strategy for risk transference.
Avoidance
Transfer or risk onto an insurance company or the use of a supplier to carry out company activity
may be perceived as a risk avoidance strategy. However, avoidance is more associated with the
outright rejection of a project or strategy that creates a risk unacceptable to the board or
shareholders. How unacceptable the strategy is and whether the appropriate response is avoidance
will greatly depend on subjective assessment and risk attitude.
Reduction
The use of an insurance company generally only reduces risk exposure since insurance cover is
always limited in some way. The use of a contractor also reduces risk but rarely removes any sense
of corporate liability for services it pays for. However, risk reduction is normally associated with any
action that might mitigate impact or reduce probability to some extent. In particular, the
development of control systems throughout company operations would be influential in risk
reduction.
Acceptance
The element of exposure beyond the willingness of an insurance company to cover identifies an
element of risk acceptance in company policy. Suppliers may go out of business or may not be able
to fulfil contracts. In this sense the company must also accept some risk in its activities. Beyond
these examples, the very nature of life and corporate operations requires each individual and the
company as a whole to accept some risk in what it does.
Liquidity risk Poor cash flow to pay suppliers Extend credit terms to
Reduce customer credi
Reduce stocks
Risk pooling
In some areas of a business, risks can be reduced by centrally managing transactions and looking for
possibilities to offset positions.
For example, if a company is to receive a US$ debt in some months’ time, it is exposed to currency
risk. When the debt is received it could be worth less than it is worth today if the exchange rate
moves. In a large company there is a chance that at some point, a payment of US$ will be made for
goods. When receiving the US$, it can be deposited in a US$ bank account and then used for the
US$ payment which avoids the exchange risk.
A centralised Treasury function can manage cash inflows and outflows throughout a business,
matching cash surpluses in one sector with cash deficits in other parts of the business.
12.2.2 ALARP
240 | P a g e
Risk strategy is really something that occurs between avoidance and acceptance of risk. The
continuum that operates between these two points sees an interplay of reduction and transference
approaches.
Where, along the line between avoidance and acceptance, strategy plays out, depends in part on
risk attitude. Greater acceptance of risk often leads to greater rewards. Greater avoidance of risk
often leads to fewer rewards.
The concept of ALARP (As Low As is Reasonably Practicable) asks the board to consider how many
activities or risks it considers acceptable, how may it will avoid and how high or low it is willing to
push the remainder through investment in risk management.
ALARP could be viewed as a tool or technique to focus the mind, it could also be simply a statement
used to govern board deliberations, providing a sense of prevailing risk attitude.
Advantages of diversification
• Smoothing of profits, making forward planning easier.
• There may be economies of scale between some sectors, however diverse those sectors are.
Disadvantages of diversification
• Spreading resources and knowledge too thin.
• Being reasonable at many things, but not particularly good at any of them. It is possible to
smooth profits, but at a relatively low average return.
• Investors may question the strategy.
• It is harder to control the business as it grows in size.
• Diversification works best where the business areas are negatively correlated and this means
they are usually very different sectors where the ability to get economies of scale and share
knowledge may be limited.
• Diversification takes away some risk and also takes away some of the returns. If shareholders
want to reduce risk, instead of the company diversifying then maybe it is the shareholders that
should diversify their investments
241 | P a g e
In 2001, the world’s largest brewer of beer, Anheuser-Busch experienced acute operational
problems, rising costs and a sharp decline in productivity due to a "perfect storm" of factors.
An abnormally dry winter in the Pacific Northwest of America led to water shortages and a hike in
the price of supply. The same problem impacted on electricity generators in the region (water being
essential to generation of electricity) leading to spiralling power supply costs.
These higher electricity costs created a reduction in the production of aluminium cans from its key
supplier and at the same time the lack of rain reduced the acreage of barley grown, the key
ingredient in beer production.
Having survived the disaster, Anheuser-Busch refocused its risk management process to consider
risk exposure in combination and the development of appropriate strategies.
242 | P a g e
12.3 ERM
Enterprise Risk Management is the singular existing model for risk management on the global stage.
It was developed in 2004 by the COSO committee predating Turnbull’s defection from control to risk
by a year.
• To identify controls
• To investigate their use and effectiveness
• To report and recommend change.
The development of the role to embrace risk must also be included:
• To identify new risks
• To evaluate exposure to risks
• To evaluate success or suitability of current risk strategy
• To report and recommend change.
Just as with internal audit, risk audit may benefit from the use of an external audit firm to carry out
the task rather than developing the role internally:
• Reduced sense of audit threats, an assurance of independence and objectivity
• Possibly drawing on a wider scope of knowledge
• Reduces costs with no need to permanently employ someone within the company.
To combat these arguments, and therefore suggest the company should use an internal risk auditor:
• It promotes the idea that the company takes the issue seriously
• The internal risk auditor has greater familiarity with systems
• The internal auditor has a more developed sense of support through his contacts with
management within the company
Risk disclosure
The directors have to provide detail on their assessment of internal control in the annual report and
accounts. As risk management is married to internal control, the report may refer to the risk
management processes.
Many large listed companies produce a joint risk management and internal control report. This
identifies the risk management process, the role of the risk committee, the risks the company has
identified as being key to the business and the method of monitoring that risk.
As many listed companies have risk committees, the work of those committees is detailed in the
annual report. This enhances transparency in corporate governance and goes some way in
highlighting to shareholders that the company takes risk management seriously.
The benefits of risk disclosure are therefore the same as for any form of formal disclosure:
• Reduces the agency distance between the directors and the owners
• Provides assurance that the issue is being dealt with
• Communicates what is being done.
244 | P a g e
• Gives shareholders better risk information to incorporate into their investment decisions
• Is more and more an expected part of global governance
The interpretation of risk depends on many factors. It may be that such a loss is manageable or
only short term in duration. Impact could be considered as minor. The likelihood depends on
the prevailing political landscape across the world and where the company’s operations exist.
On balance, given the global scope of oil company operations, this may be deemed likely.
2. Environmental disaster
Another factor in risk management is time. When considered in relation to a limitless future,
such an event, indeed many events, must be thought of as certain. Whether it happens in the
next perceivable time period is an unknown. The impact is major.
3. Oil Prices
This is a certainty given the continued existence of OPEC as such a cartel. Experience in hedging
and commodity management should reduce its impact to a more than manageable level.
4. Electric cars
These are a reality and so the probability is very high. The impact will increase over time. In the
end it is virtually certain that such technology will replace petrol driven vehicles although
increasing electricity costs may slow this process.
Professional skills marks are available for mapping appropriately.
Solution 12.2
246 | P a g e
The exchange rate risk can be transferred by entering into a contract with an international trade
financier, or by entering into derivatives contracts through its own treasury department.
The risk of launching a new product can be transferred in two ways. If the producer has limited
expertise, it could enter into a joint venture with a company that has the relevant expertise, which
would dilute the potential profitability of the launch but perhaps reduce the risk to a more
acceptable level. It could also outsource certain activities associated with the product launch.
However, the risk could not be transferred by insurance, as the risk associated with a product
launch is an example of speculative risk (that is, there is both upside and downside risk).
The risk of theft or damage to inventory could be transferred by entering into a commercial
insurance contract. This would be conditional on the insurance company ensuring that the company
has appropriate physical access and other controls in place. The company could also outsource
security arrangements to an appropriate specialist security company.
13
Management and internal control systems
Context
Once we have assessed the risks that an organisation faces then we will need a control system so
that we can try to keep the risks under control.
This chapter looks at the types of control procedures and their limitations and sees whether an
organisation has a sound system of internal control.
Video introduction
In Japan, many major company structures were traditionally based around banks. Large groups of
companies from many industries would all be financed, and part owned by a major bank, which
would create a strong financial alliance. Cross-shareholdings between companies were common,
and in many cases the companies in the ‘group’ would all supply each other.
In South America, Italy, Spain, and large parts of East Asia (eg Indonesia) the focus is more on family
ownership, with a large percentage of the biggest companies owned and controlled by a small
number of the most powerful families in the country
So the reasons for different approaches to governance existing in different areas of the world relate
to the influence of different types of shareholders and as well as the cultural background to the
development of a capitalistic society.
This suggests:
248 | P a g e
• An increased level of acceptance by society of big business and the way in which businesses
operate because of the tighter fit to cultural norms.
• An increased ability to leverage advantage or gain through successful integration between
stakeholders (banks) and corporations. This can be the basis for competitive advantage of a
nation.
The inverse of this last point is that it must follow that some approaches when viewed on a global
level will be more successful than others. This means that the existence of such variety creates
losers as well as winners in attracting investment.
In particular
• Some jurisdictions suffer higher governance costs through the bureaucracy of regulation.
• Some feel constrained in their ability to take risks due to possible negative shareholder or legal
action.
Those who are disadvantaged in this way may crave the imposition of global governance standards
for use by all corporations so as to create a ‘level playing field’ where everyone plays the game to
the same set of rules.
Definition
COSO defines internal control as “a process, effected by an entity’s board of directors, management
and other personnel. This process is designed to provide reasonable assurance regarding the
achievement of objectives in effectiveness and efficiency of operations, reliability of financial
reporting, and compliance with applicable laws and regulations.” thus reflecting the Turnbull
objectives for such a system.
As a definition it seems rather weak since it is really only defining internal control by stating that it is
a process that operates to a certain end or goal. This is similar to saying that a motor car is an object
used to travel distance without stating that this object is different in its composition to an airplane
or horse.
A more appropriate definition would state that this process of control is defined and implemented
by management as well as being focused towards the managed resources of the company.
More specifically it might draw on the multifaceted sense of control created through the COSO
components and also give a sense of its organic and systemic operation through reference to the
need to adapt, integrate and operate at a human and technical level as given through Turnbull’s
features.
Turnbull 99
Following the collapse of Barings Bank, Turnbull recommends the use of the COSO framework for
control system reviews.
250 | P a g e
Turnbull 99
Recommends the need to reflect on the quality of audit committees and the need for more
organisations to embrace the use of internal auditors.
Control environment
This refers to the need for strategic management involvement in internal control. Control must
begin with the need for strategic leadership and the placement of a scaffold upon which control
systems can be built.
The control environment includes:
HR policies
Roles have to be filled by competent individuals. Strategic management must define HR policies so
as to ensure that appropriate staff are recruited, trained and their performance monitored. Failure
in control is usually stated as being as a result of staff failure rather than systems failure so this
element is important to consider.
lacks the restraining force of appropriate belief systems is more likely to stray into behaviours that
lead the company away from probity, honesty and a sense of professional control.
Virtually all major corporate collapses or scandals are said to have a cultural failure of senior
management at their root.
Control activities
The control environment focuses on what strategic management must accept responsibility for.
Control activities suggest a delegation of control responsibility below this level and therefore the
need for operational managers to develop appropriate, effective control systems, to implement
such systems and continuously monitor and adapt as necessary.
The nature of control activity is dependent on the nature of the organisation. The scope and depth
often depends on the size of the corporation and tend to be industry specific with enough flexibility
to reflect the particular risks faced by a given company.
Value chain analysis provides a suitable framework within which to identify the scope of controls
that should or do exist and then review their quality:
• Primary activities from inbound logistics through operations and out through outbound logistics
and sales.
• Secondary activities such as accounting, IT and procurement services.
There are the detailed control activities that organisations use in order that management’s internal
control objectives are met. They include physical security of assets, reconciliations and
authorisation.
There are several types of control procedure and a useful mnemonic to remember them is CARCAP:
• Comparison
• Authorisation
• Reconciliations
• Computer Controls
• Arithmetical
• Physical
Comparison
This can be a useful way of finding out if there is a problem, for example, by comparing margins or
sales at a company’s different sites to assess if there is anything unusual that stands out. Actual
results can be compared with budgets, or with competitors. Expenses can be compared year on
year, or on a monthly basis, to see if anything unusual has happened.
Authorisation
For key business activities, authorisation should be sought from a director or senior manager to get
permission for the activity first. For example, if the company is buying an expensive new asset this
252 | P a g e
will require authorisation from the board. Likewise, when payments are made, invoices should be
authorised by a manager before the cheque is written and sent.
Reconciliations
These are used frequently to maintain the accuracy of certain items in the account, e.g. bank
reconciliations, control account reconciliations and supplier statement reconciliations. It is a way of
ensuring that the company’s records contain all the necessary information and that assets and
liabilities are not over- or under-stated.
Computer controls
Much, if not all of a company’s information is kept on a computer system. Not every employee will
need access to all of the company’s systems so there should be access restrictions to ensure that
the right people see the necessary information. The use of passwords, backing up data, and logging
details of who has done what are important to ensure that the staff only have access to the data
that they need to do their job and that any sensitive data is kept safe.
Arithmetical
These are very basic controls, such as checking that something adds up correctly. For example, a
computer generated trial balance could be checked by manually adding it up.
Physical
These are controls that are used to protect physical assets against theft or misappropriation.
Controls may include the use of security cameras and guards, locks on offices that contain sensitive
information, and safes and secure storage for cash and other valuable assets.
Such controls are important in all aspects of company operations. However, the most common
association in their application is with the need for financial control. These controls underpin the
provision of high quality financial information.
An assessment of their worth and quality should be considered in relation to:
• The achievement of high quality information which exhibits the characteristics of quality
information
• The achievement of the financial objectives of the company
• Due regard to the limitations of internal control and ways in which such controls may be
subverted
A major aspect of information and communication is the use of reporting systems throughout the
organisation. Reporting becomes the glue that holds the disparate elements of control together
across the company.
Reporting also links directors to shareholders and investors to corporations. Cadbury suggested that
“information is the lifeblood of the market” for this reason.
Monitoring
The final element of the COSO model relates to the importance of control over the controls.
Monitoring refers to the importance of independent auditing outside of the work of operational
managers auditing their own areas of activity. As a COSO element it requires the company to:
• Consider the effectiveness of the audit committee
• Consider the effectiveness of external auditors
• Consider the need for internal audit.
• Consider the effectiveness of internal audit.
These issues are considered in more detail in Chapter 9.
• Whether the objectives of a sound system of internal control are being achieved
• The level of cost of internal control failure
• The extent to which the above limitations are dealt with or minimised in company operations
Ultimately the success of the system can be seen in organisational survival and success. However,
the limitations, particularly unforeseeable events, highlight the inevitable reality that control is
never assured.
India is proud of the emergence of Ranbaxy as its first multinational pharmaceutical company.
However, despite having an illustrious board of directors and a significant foreign and institutional
shareholding to monitor its actions, the company has been bedevilled by internal control and audit
failure.
In 2008, the US Food and Drugs Administration issued warning letters to the company highlighting
their concerns over the quality of drug testing at two Indian plants. By 2009, the Food and Drugs
Administration halted all applications from the company to allow its products to be sold in the US.
This was due, it said, to the company supplying falsified data in its testing results in order to secure
approval of their products.
In May 2013, the company was found guilty of misrepresenting clinical trial data and selling
adulterated drugs in the US. It was fined $500million.
In summing up the judge said senior management had purposely over-ridden essential internal
controls and bypassed internal audit when it suited them to ensure products got to the market on
time.
Responsive externally
Strong systems of internal control should respond to the needs of key parties to whom they are
focused.
They should:
• Firstly respond to the changing needs of shareholders. This suggests that if shareholders believe
credit and liquidity risk to be an important issue, the focus for control investment should be in
these areas.
• Secondly, sound systems should respond to the wider needs of stakeholders. Concerns over
environmental pollution should focus control investment towards environmental management
control systems if this is needed.
Integrated internally
Operational systems must integrate to form a smooth operational flow of output.
Control systems through the value chain must also coordinate to ensure problems at the early
stages in production are recognised and allowed for at later stages.
Integration should extend between levels of operational, tactical and strategic management to
ensure everyone is aware of problems arising and their implications fully understood and dealt with.
Clear reporting channels and quality in information flow will be the mechanism through which
integration is achieved.
Embedded in culture
Embedding involves training and strategic management reinforcement of belief so that actions
become automatic and immediate in response to key control issues such as safety or quality
management.
Embedding control focus in culture reduces the need for formal systems to reinforce its importance
such as the need for supervision or audit of processes. The importance of the issue does not
however mean that it can take anything other than primary importance in the minds of those
involved in control. It is just that assumptions can be made that people understand and deal with
the issue rather than needing to be repeatedly told to deal with safety and quality concerns.
To ensure compliance
This objective is focused towards the shareholders.
A sound system of internal control is a necessary part of good governance and compliance with the
principles of the UK Code (Section C2). So, the shareholders must promote concepts of reviewing
and improving controls in the spirit of owning a well governed organisation that is fit for purpose on
the UK exchange. At a deeper level, sound systems ensure the company is compliant with its legal
obligation to remain a going concern.
Compliance may also relate to specific accreditation goals for quality or compliance with
environmental or health and safety regulation. All are assisted in their achievement through the
existence and maintenance of effective systems.
To improve reporting
Better feedback on operations improves reporting to management internally and increases the
likelihood of effective control occurring.
Improved reporting also has an external meaning relating to improvement in disclosure. This is
achieved through the audit committee report providing shareholders with the information they
need to support investment decisions. It also flows through the dialogue between the board and
shareholders, greasing the operations of the market as Cadbury had requested.
Do you think it would be better to create a definitive list of controls that all organisations in all
industries should evaluate and report on or allow individual companies some latitude in deciding on
the nature of control and the scope of review in their particular industry and circumstance?
On 15th September 2011, rogue trader Kweku Adoboli was arrested on suspicion of perpetrating a
fraud that would cost his employer, the Swiss bank UBS, $2 billion. In the end he would receive a
seven-year prison sentence for his crime.
258 | P a g e
Working closely with its auditors, Ernst and Young, UBS uncovered a series of failures in its internal
control systems that helped to facilitate the trading fraud at the London office of its Global Synthetic
Equities Trading division.
The control failures were rudimentary, a lack of adequate supervision of the traders, a lack of
authorisation necessary for high risk investments, poor communication between departments and a
lack of reconciliation to ensure information about individual trades was accurately reported.
The cost of the losses to the company was equivalent to the savings it had just made in making
3,500 people redundant as a result of the global downturn.
There are arguments in favour of either approach. In support of creating a more rules based,
comprehensive view of control management, it is more likely to be dealt with by corporations since
it is the same standard required of every company and, as with any rules based system, its
compliance would be enshrined in law.
The nature of a definitive list should ensure a comprehensive scope to the review which in turn
should improve the level of control in a company. The costs of compliance would be fairly
distributed, being equally applicable to every organisation in the jurisdiction.
The arguments against would relate to the appropriateness of the list of controls for every company
in the country. In particular, differences in size and industry would create redundancy in the
application of certain elements of the list and the need to review such elements. This redundancy
creates unnecessary bureaucracy and costs.
259 | P a g e
These problems would create resistance to the application of such an approach and a sense of
hostility to governance regulation leading to wilful avoidance. This is not a good outcome for those
who understand the importance of corporate regulation and control.
Solution 13.2
In theory, it should be possible to create a perfect system, assuming the organisation operates in a
relatively static environment in which risks will not change. However, Turnbull refutes any notion
that organisations will do so, as it will usually be subject to risks for which the costs of control
exceed the benefits of eliminating them. For example, it is possible to prevent all trains from passing
red lights, but the cost of installing the necessary technology would not be economically viable. As a
consequence, train operators focus on reducing risks to negligible levels, but not zero.
Turnbull goes on to state that there are many other reasons why internal controls will always be
capable of failure:
• failures of judgement
• human error
• dishonesty, including collusion between trusted individuals
• deliberate circumvention of controls (not necessarily for dishonest purposes...the perpetrator
may wish to get things done more quickly by ignoring control procedures)
• one-off, entirely unpredictable events or series of events
The reality is that nearly all businesses are subject to both internal and external changes that cannot
be predicted. Therefore, internal control systems have to evolve through ongoing review and
redesign.
In the banking industry, three of the greatest risks today were much less important only twenty
years ago – money laundering, insider dealing and identity theft. Control systems can address all of
these, but sometimes only in a reactionary manner.
14
260 | P a g e
Whistleblowing procedures
The audit committee should also review the procedures in place for whistleblowing within the
company. There should be arrangements in place for employees to raise concerns regarding
possible improprieties at the organisation and for these concerns to be independently investigated
and action taken if necessary.
Where there is no internal audit function, the audit committee should consider annually whether
there is a need for an internal audit function and make a recommendation to the board. The
reasons for the absence of such a function should be explained in the annual report.
Practical agreements
• Terms of engagement
• Determination of fees
• Process for selection
• Policy for removal (must be explained to shareholders if this is used)
Threats to independence
1. Self-interest
Acting in self-interest is a natural part of any relationship. Here the threat is as to the extent to
which that self-interest clouds the judgement of the auditor and leads to a situation where the
truthfulness of their disclosure is called into question.
2. Self-review
Any situation in which an individual is placed in a position to assess the quality of their own work
creates a difficult ethical judgement between self-interest in avoiding self-criticism and the need
to remain detached and objective in deliberations and recommendations.
263 | P a g e
3. Familiarity
The existence of personal relationships or a sense of personal allegiance to individuals or
corporations may test the resolve of the auditor to remain goal focused and emotionally
distanced from audit situations and subsequent judgements.
4. Intimidation
Applying pressure to persuade the auditor towards a given opinion may take the form of overt or
covert threat. This could be a threat regarding possible termination of the audit contract as
occurred between Andy Fastow and Arthur Anderson at Enron or could be personal intimidation
of an auditor carrying out their role by the CEO or other finance staff.
5. Advocacy
To advocate is to support a given viewpoint. It also relates to supporting or speaking for another
individual. Auditors often act in an advocacy role, offering impartial advice to shareholders on
board strategic intentions in areas such as takeovers or mergers. The reliance shareholders place
on this sense of impartiality is such that the objectivity of the audit firm’s views cannot be
allowed to be called into question. Removal of familiarity, intimidation and self-interest threats
should go some way to improving the perception of independence in the advocate’s voice.
The audit committee should have the primary responsibility for recommending the appointment,
reappointment and removal of the external auditors. If the board does not accept the audit
committee’s recommendation, it should include in the annual report, and in any papers
recommending appointment or re-appointment, a statement from the audit committee explaining
the recommendation and should set out reasons why the board has taken a different position.
The audit committee should annually assess the qualification, expertise, resources and
independence of external auditors and the effectiveness of the audit process. This review should
cover all aspects of service provided by the audit firm.
The audit committee is also responsible for approving the terms of engagement and the
remuneration of the external auditor. The scope of the audit should be reviewed by the audit
committee and if not satisfied, the audit committee should arrange for further work to be
undertaken. The audit committee should also satisfy itself that the level of audit fee is satisfactory
for the level of work to be undertaken.
Self-interest, self-review and familiarity are all threats to independence and so need to be
deliberated upon by the audit committee.
Could it be argued that these issues, rather than being threats, actually support the quality of
auditor work?
Annual audit
264 | P a g e
The audit committee should ensure that appropriate plans are in place for the external audit at the
start of the audit process. At the end of the audit process, the audit committee should review the
findings of the external auditors’ work. In the course of the review the audit committee should:
• Discuss any major issues that arose and how these have been resolved, and what issues remain
unresolved;
• Review key accounting and audit judgements
• Review levels of errors identified during the audit and obtain explanations as to the nature of
errors and if errors remain unadjusted, why this is the case.
At the end of the audit process, the audit committee can assess the effectiveness of the audit
process.
Non-audit services
The audit committee is responsible for developing the company’s policy in relation to the provision
of non-audit services by the auditor. The aim is to ensure that the provision of non-audit services
does not impair the external auditor’s independence or objectivity.
The committee should consider:
• Whether the skills and experience of the audit firm make it a suitable supplier of the non-audit
service
• Whether there are safeguards in place to eliminate threats to objectivity or independence, or to
reduce them to an acceptable level
• The nature of non-audit services, the related fee levels both individually and in relation to the
audit fee
• The criteria which govern the compensation of the individuals performing the audit.
• If the auditor provides non-audit services, the annual report should explain to shareholders how
auditor objectivity and independence is safeguarded
Auditors are almost inevitably accused of complicity when large scale corporate failure occurs.
In 2011, New York prosecutors contended that the auditing giant, Ernst & Young, stood by while
Lehman Brothers used accounting gimmickry to mask its shaky finances. The accusation was that in
doing so they assisted in perpetrating an accounting fraud that led to the largest corporate collapse
of all time and sparked the global financial crisis.
The lawsuit sought to recover $150 million in fees that Ernst & Young received from 2001 to 2008 as
Lehman’s auditor, plus other unspecified damages.
265 | P a g e
The prosecutor said that for more than seven years leading up to Lehman’s bankruptcy, the
investment bank engaged in fraudulent accounting transactions that Ernst & Young explicitly
approved. The case focused on accounting techniques which temporarily removed as much as $50
billion in assets from the balance sheet in 2008.
"This practice was a house-of-cards business model designed to hide billions in liabilities in the years
before Lehman collapsed," the New York prosecutor said.
The case against Ernst & Young was eventually dropped.
Number of employees
The number of employees may represent a proxy for size of company operations. It may also point
to the importance of internal control in areas such as safety and quality in large scale manufacturing
environments.
New risks
Strategic change or environmental change can change the risk profile faced by a company. The
bankruptcy of UK banks has created new credit and liquidity risks for many corporations that can no
longer secure traditional sources of funding.
Structural changes
Downsizing, restructuring, takeovers or global market development all create conditions within
which the quality of internal control is called into question. Internal auditors must start at the
266 | P a g e
operational level and build control for new areas of operation prior to retiring to their evaluation
function and leaving operational managers to handle day to day control activity.
Review systems
The diversity of COSO suggest the remit within this area could be very varied.
• Management audits
• Project audits
267 | P a g e
• Quality audits
• Environmental audits
• Safety audits
• Accreditation audits
• Legal compliance audits
• Value for money audits
External auditors must be independent so that shareholders can rely on the audit opinion. Internal
auditors are also providing an opinion on the effectiveness of the internal controls of the
organisation, so there needs to be independence so the board can rely on their opinion.
Typically internal auditors report on the company they work for so they can never be completely
independent as they are reliant on the company for their employment.
As such, their independence is bound to be questionable. For example:
• They may ignore frauds because they trust workplace colleagues, or feel sympathy for them.
• They may decide not to report problems for fear of upsetting their bosses, the directors.
• They may decide not to report problems for fear that the company may get into trouble and
they might lose their jobs.
• As internal staff, they may be pressured or intimidated into keeping quiet.
• If they report to directors and directly criticise them, the report may be ignored.
As a result of concerns over independence, the internal audit function could be outsourced to
experts (eg a firm of accountants) although this will bring with it the need for independence in
association with external audit
What matters should be considered in relation to independence when recruiting a new head of
internal audit?
Reporting relationships
In order to maintain objectivity of the internal audit function, the internal audit department needs
to have their independence protected. For this reason, the reporting structure is different from
other organisational departments:
269 | P a g e
• The internal audit function should not report to the board directly but should report to the Audit
Committee. This gives the internal audit process some independence, as they never report
directly to executive directors
• The head of the internal audit department, the Chief Internal Auditor, should have access to the
Chairman, or another very senior non-executive director so that if anything serious has been
discovered, such as a material fraud, then it can be quickly dealt with.
• Where the internal audit team are internal employees, they should have no operational duties,
nor should they have had in the recent past to avoid the possibility that the internal auditor may
have to review work they have been responsible for (self-review threat)
• They should have no major family or personal ties to operational staff or departments on whom
they report (familiarity threat).
When internal audit is outsourced, independence can be improved by following similar guidelines as
with external auditors:
• The same outsource firm should not act as internal auditor for a company for too many years in
a row.
• The outsource firm should not be performing too many other services for the company (as a self-
review or self-interest threat may arise).
• Fee levels should be monitored to ensure that the outsource firm is not too dependent on a
single internal audit client.
Knowing about risks and actually acting in relation to them may not be the same thing.
In 2011, a factory fire killed 259 garment workers in Pakistan, a country where textiles and clothing
make up 68% of exports. Two months later, 112 workers died in a similar fire at a facility in
Bangladesh.
A report from the International Labour Rights Forum (ILRF), entitled Deadly Secrets, states that
companies in the industry know about the risks but refuse to publish the information and inform
employees. It says Bangladesh garment workers are the lowest paid garment workers in the world,
whilst business operators reap the benefit of being the number two garment exporter in the world,
second only to China.
The reports criticism is not limited to those who run the factories, global brands and retailers are
cited as "collectively possessing thousands of confidential factory audits that reveal workplace
hazard and even imminent threats to workers health and safety"
If this is true it highlights the fact that audit as a function cannot operate effectively without senior
management support and willingness to take action as a result of the auditing process.
Turnbull expands upon this to suggest that such a report should include:
• A statement that the board has conducted a review of the effectiveness of the company’s
system of internal controls.
• The terms of reference of the audit committee and an explanation of their role and the authority
delegated to them.
• A section describing the work of the audit committee in discharging its responsibilities. This
should include:
– A summary of the role of the audit committee
– The names and qualifications of all members of the audit committee during the period
– The number of audit committee meetings
– A report on the way the audit committee has discharged its responsibilities
• Where there is no internal audit function, the reasons for this must be stated
271 | P a g e
• Where the board has not accepted the audit committees’ recommendation on the appointment,
reappointment or removal of external auditors, a statement from the audit committee on their
recommendation and why the board has taken a different position.
• An explanation of how auditor objectivity and independence is safeguarded if the auditor
provides non-audit services.
Disclosure emerges from the results of an annual review into the quality of internal audit. This
assessment should consider the information received throughout the year from internal audit and
any other relevant information up to the date the financial statements are signed.
Turnbull states that focus for this annual review should be:
• Changes in the nature and extent of significant risks and the company’s ability to respond to
those risks
• The scope and quality of managements on-going monitoring of risks and internal control and the
work of internal audit (Control environment and Monitoring)
• The extent and frequency of the communication of result of monitoring to the board
(Information and communication)
• The incidences of significant control failings or weaknesses that have been identified and the
extent to which they could result, or have resulted in, a material impact on the financial
performance or position of the company (Control activities)
• The effectiveness of the company’s public reporting processes.
This means that the audit committee should look at any changes that have occurred and the general
quality of COSO factors in pursuit of ensuring the control objective of effective disclosure.
• Clarity
Reports should be appropriately structured for management consumption.
• Conciseness
Necessary levels of summarisation assist in swift absorption of relevant facts.
• Location
In a global information environment access to key reports becomes a preoccupation for
Management Information Systems.
• Confidentiality
Technology must support appropriate security measures to reduce the risk of hacking or general
unauthorised disclosure.
Strategic level
The strategic level of management requires information to assist them in setting long-term strategy
for the organisation and this information will normally come from internal and external sources.
This type of information is needed on a less frequent basis and is less precise than at a tactical or
operational level.
Examples of information include the need for and availability of finance, details about competitors,
analysis of the profitability of the business and information on external threats and opportunities
facing the organisation.
Tactical level
At the tactical and operational level, the type of information that will be required and which will be
useful is that which concerns short-term considerations and is typically more detailed and precise
than that required at the strategic level. This information is usually provided frequently and mainly
comes from internal sources.
Examples of information required at a tactical level include working capital requirements, cash flow
and profit forecasts and information about business productivity.
Operational level
Operational information is used to make sure that specific operational tasks are carried out as
planned.
Examples include results of quality control checks and information about labour hours used to
perform a certain task, processes or jobs
The structure and depth of information supply to management internally is a complex issue for
managers and technologists to consider.
Characteristics that influence such decisions include:
273 | P a g e
• An internal auditor is authorised by those governing the company so it is in the best interests of
the company to answer questions and provide information.
Solution 14.2
If the position is advertised externally, this will almost guarantee independence, unless the recruit
knows the company from previous business dealings or has worked on external audit engagements
for the company’s auditors.
If the position is advertised internally, there are several factors that could compromise
independence, though in all except the largest organisations the target group of recruits would be
narrow, as the organisation would be looking for a qualified accountant with appropriate experience
in auditing.
Individuals who have served for prolonged periods in one or more departments could encounter
a familiarity threat, as they would know and be known to colleagues.
In addition, an individual who had been involved in the design, enhancement or review of internal
systems would have a self-review threat.
Depending on the personalities and hierarchies present in the organisation, there could also
be intimidation threat.
15
Finance in planning and decision-making
Context
Financial analysis is important to us as accountants and is important in order to help to decide
whether we should take on a strategic choice that we have made. There will always be some
uncertainty on whether to go ahead but at least it is worth trying to see if a route is financially
viable. The set-up costs are important to weigh against the ongoing benefits of the strategic options.
Financial analysis will help to analyse the environment and the internal capabilities of the
organisation. We will look at the financial information we have and what we can do with that
information.
We need to consider the role of the finance function and the different options for structuring the
finance function. Once decided we see how an organisation may be financed, covering the
suitability, feasibility and acceptability of alternative sources of finance. Finally we cover a range of
financial techniques used for decision making and to measure performance. This is an area that
provides an opportunity for finance and accounting professionals to influence the direction taken by
277 | P a g e
an organisation and to add value by providing managers with sound financial information and
analysis.
Video introduction
1. How will strategic development be affected if a company has a high level of gearing?
2. Do you know the problems associated with setting budgets?
3. Can you distinguish between a leading KPI and a lagging KPI?
15.1.1 Introduction
Organisations should choose strategies which offer their major stakeholders the best value in
exchange for the resources used.
This statement attempts to be relevant to both profit-seeking and not-for-profit organisations. For
example, a hospital receiving government money should seek to give its patients and the
community the best health care possible. It should also attempt to use the efforts made by its staff
wisely so that wasteful procedures and bureaucracy do not interfere with health care. This is what
the government, as supplier of cash, presumably requires.
In a profit-seeking organisation, such as a commercial company, the main stakeholders are usually
considered to be the company's shareholders, and they are also the suppliers of most capital. The
return they receive (value) is a combination of dividends and increase in share price.
The remainder of this chapter considers profit-seeking organisations only and looks at the
relationship between strategy and finance:
• How much finance?
• What type of finance?
• How should it be spent?
• How can it be controlled?
Definition
Managing for value can be defined as maximising the long-term cash-generating capability of an
organisation.
However, that definition can be a little superficial because the cash generated cannot be separated
from other matters relevant to the financial expectations of stakeholders such as:
• The risk attaching to the company's activities;
• The stability of cash flows and dividends;
• The type of business the organisation is in (and how this fits into the shareholders' portfolios);
• Ethical considerations.
Leaving aside the complexities that would be introduced by diversification into different businesses,
the value generated by a business depends on:
• The financing of the business: debt and equity.
• The investment decisions of the company – for example buying new machinery and deciding
how much working capital to keep.
• The company's operations – its revenue, its variable costs and its fixed costs.
• The tax implications – it is always worth considering the broad tax implications.
Definitions
Cost accounting is the recording and analysis of the costs involved in running a business.
Cost management involves the identification, collection, measurement, classification and reporting
of information for the purpose of cost ascertainment, planning, decision making and control.
Cost control focuses on keeping costs and expenses within limits, for example within budget.
279 | P a g e
Cost reduction programmes attempt to ensure future cost expenditure is lower than past cost
expenditure.
• Identification of the principal budget factor (sometimes known as the key factor or limiting
factor). This is the factor which prevents the organisation from making arbitrarily large profits.
Typically the principal budget factor would be one of:
– Cash available for investment
– Sales volume
– Manufacturing capacity
– Materials.
• The principal budget factor is used to 'drive' the other components of the budget. So, if cash
were the limiting factor, this would limit the extent of business expansion and that would
determine the additional manufacturing and sales that were possible. In turn these would
determine the purchase of material, the amount of labour needed, the distribution resources
used and the sales revenues that could be earned.
• To ensure that all parts of the budget are properly coordinated and that effective
communication takes place, a budget committee drawn from different business areas is often
used when drafting the budget.
• Budgets are then likely to be submitted up through the organisation for challenge, negotiation,
amendment and eventual approval.
• Actual results should be carefully monitored and compared to the budget to:
– See if performance needs to be changed to increase the chance that the budget will be met.
– See if the budget appears to be wrong. If a budget turns out to be obviously unattainable no
matter how hard people try (for example, an economic collapse after the budget was
agreed), if might be better to redraft the budget to set out more achievable targets.
Definition
Standard costs are predetermined costs per unit of output that should be incurred under normal
operating conditions.
Standards provide useful targets for staff to aim at and they usually consist of two components:
• A physical measurement. For example, the kilograms of material needed to make a unit, or the
minutes to produce each unit.
• A value measurement. For example the $/kg of material or the $/hour of labour.
There are a number of ways of setting standards, including:
• Currently attainable standards. These are standards which should be achievable (perhaps with
some effort) under normal operating conditions. They can be very motivating and can give great
satisfaction when achieved.
• Ideal standards. These are based on perfect operating conditions. They are usually impossible to
achieve in the long run and can therefore be demotivating.
• Basic cost standards. These standards are left in place for long periods. Because nowadays
technology and products change rapidly, this approach is not very useful
Material variances
Amount of material actually used compared to the standard amount that – Material of a different quality being
should be used for the actual output achieved, evaluated at the standard – Poor/excellent use of material
cost per unit. – Poor/excellent maintenance of mac
Labour variances
Labour efficiency variance: Amount of hours actually worked compared to – Wrong standard hours per unit
the standard amount that should be worked for the actual output achieved, – Labour of a different ability than ex
evaluated at the standard rate per hour. – Better or poorer training than expe
– Good/poor supervision
– Good/poor machine maintenance s
different efficiency than expected.
Variable overhead rate variance: Amount of variable overhead actually paid – Wrong standard rate/hour
for at actual hourly rate compared to what that amount of variable overhead – Unexpected rate of machine runnin
should have cost if bought at standard hourly rate. – Cost inflation
– Powerful suppliers (energy compan
Variable overhead efficiency variance: Amount of hours machines actually – Wrong standard hours per unit
worked compared to the standard amount they should have worked for the – Machines of a different efficiency th
actual output achieved, evaluated at the standard rate per hour. – Better or poorer staff training than
– Good/poor supervision
– Good/poor machine maintenance s
more or less efficiently than expect
Fixed overhead expenditure variance: Total amount of budgeted fixed – Wrong budget
overheads compared to total actual fixed overheads – Unexpected level of expenditure
Fixed overhead volume variance: Budgeted output (units) compared to – Wrong budget
actual output evaluated at the fixed overhead absorption rate per unit – Different output to what was expec
working a different number of hour
working at a different efficiency to w
283 | P a g e
Sales variances
Favourable
Budgeted profit
Actual profit
This presentation allows management to see easily where the most significant variances occur and
therefore where most investigation and management action is likely to be needed.
Broadly, if things are going according to plan there will be only small variances and little
management attention is needed. However, a large variance implies that something is significantly
different from what was planned and management investigation and perhaps action there is
justified.
This approach is known as 'management by exception'. Management's time is best spent looking for
areas where things seem seriously adrift from the plan: either performance needs to be improved or
the plan modified.
Often a factor of production is limited and the organisation has to decide how to use that factor in
the best way possible so that contribution and profits are maximised.
The technique to use is:
1. Work out the contribution per unit of each product
2. Work out for each product the contribution it earns per unit of scarce resource (an 'earning rate')
3. Rank the products in order of the results from step 2. The higher the earning rate the better.
4. Allocate the scarce resource in the order worked out in step 3.
Peal Ltd produces two products using the same machinery. The hours available on this machine are
limited to 5100. Information regarding the two products is detailed below:
Selling price
Variable cost
Fixed cost
Total costs
Profit
Machine hours
M = 24/8 = $3/hour
N = 15/3 = $5/hour
4. Therefore, make N in preference to M as it has a better earning rate per machine hour. The full
production plan will be:
Make the full budgeted sales of N. This will consume 500 × 3 = 1,500 hours, leaving 5,100 –
1,500 = 3,600
The 3,600 hours left will allow 3,600/8 = 450 units of M to be made.
The total contribution that can be earned is therefore:
M 450 × $24 =
N 500 × $15 =
Product P
287 | P a g e
Buy-in price
Cost to make
Ranking
So, make as much as possible of the products with the highest ranks:
32,000
A company makes three products, R, S and T. Its management accounts show the following:
$ R S
288 | P a g e
The marginal cost is the additional cost caused by the contract. This is where any difficulties are
likely to be found as it is not always easy to identify the relevant cost. As stated at the start of this
section, there is one rule which will invariably lead you to the correct treatment: will the investment
decision alter the cash flows of the organisation? If it does, then the effect is relevant to the
decision.
Altering the cash flow can happen two ways:
• A specific new inflow or outflow
• The absence of an inflow or outflow that would otherwise have occurred.
There are certain effects which are always irrelevant:
• Sunk or past costs. This money has been spent and our current decision will not affect that.
• Book values. These are simply a consequence of past costs and so are irrelevant.
• Depreciation. Again a consequence of past costs
• Reapportionment of existing fixed costs.
Effects which are relevant include:
• Incremental revenues.
• Incremental costs: additional cash outflows caused by the project
• Opportunity costs: revenue foregone as a consequence of the new contract.
Beal Ltd bought a machine 10 years ago for $100,000. Its book value is now $10,000 and it could be
sold for $25,000. The company could use the machinery to produce 1,000 units of a product over
the next year. After one year, the machine could be sold for $12,000
Production/unit would use 1 kg each of two materials. Material type A costing $5/kg and Material
type B costing $10/kilogram. The company has no type A inventory, but has 1,200 kg of B in stock
that had cost $8/kg and which could be sold for $7/kg. The company has no other use for this
material.
If the machine is kept, fixed production overheads of $3,000 will continue to be allocated to it.
Production will take 5,000 direct labour hours. All of these employees would be hired specially at a
cost of £8/hour. Additionally, a supervisor whose salary is $25,000 pa will spend 10% of his time on
the new venture.
Recommend the minimum contract price that should be accepted for the production of 1,000 units.
Professional skills marks are available for demonstrating analysis in your answer.
ABC identifies cost drivers, and groups all the associated costs into cost pools. These are then
related to cost objects: for example some costs may be driven by customer behaviour not
production costs. Customers that buy in bulk may be cheaper to deal with, in terms of order
handling, invoice processing and accounting, than those buying in small quantities. (On the other
hand the discount for bulk purchases may be prohibitive.)
Because of its more forensic approach to how overheads are made up, ABC takes a wider selection
of cost drivers in allocating these to cost objects. It is therefore suited to businesses that are
complex or have a variety of products. It can be applied for example to identifying which customers,
as opposed to which products are profitable. Its chief virtue is its greater scope, and it reflects the
greater proportion of indirect costs and the greater scope for long term variable costs.
In strategic planning, it is therefore likely to be a better predictive tool for doing strategic budgets,
because it covers all the activities of an organisation, and accepts that most costs are variable in the
long run, and are driven by very different process and environmental inputs.
15.4.1 Profitability
Return on capital employed (ROCE)
This is a relative measure that takes account of the 'size' of business.
Formula:
Purpose:
Shows how productively a business is using its capital by relating overall profit performance to the
amount of capital employed in the business.
Meaning:
If ROCE is low/falling:
• Usually a bad sign – the entity is not using its capital efficiently. A low return may result in a loss
if the economy deteriorates.
292 | P a g e
• Need to investigate further – may need to increase operating profit or sell some assets and
invest proceeds elsewhere to earn a higher return.
Comparisons:
• Previous years' ROCE – but be aware that the trend may be distorted by, for example, the timing
of capital issues and the revaluation of assets.
• Entity's target ROCE in budget – if part of the business does not meet target, management may
decide to dispose of it.
• Cost of borrowing – ROCE should exceed any cost of borrowing.
• Other entities in same industry
Interrelationship with other ratios:
Formula:
Purpose:
• To show the margin on each $1 of sales.
Meaning:
• Provides an insight into the relationship between purchasing/production costs and revenues.
Think of the GP% as the 'main spring' that generates profit.
• If gross profit margin is low/declining, this is usually a bad sign.
• Decline may be due to:
– Fall in selling prices (eg due to increased competition, powerful customers).
– Change in sales mix.
– Increase in purchase costs (eg due to powerful suppliers).
– Increase in production costs (materials, labour, overheads).
– Opening inventories overstated (eg due to error in counting/valuation or inventory losses).
– Closing inventories understated.
• However, a decline does not always imply a problem. It could, for example, be due to the launch
of a new product or attempts to increase market share. Both of these might cause a temporary
lower selling price.
Analysis:
• Expected gross profit margin should remain reasonably constant for particular types of business.
• Management can investigate further by looking at breakdown of sales or items of cost as a % of
sales eg labour input.
293 | P a g e
•
Purpose:
• To show overall profitability of the business after deducting all expenses.
Meaning:
• An indicator of control of operating expenses (eg if GP% increases but NP% falls).
Analysis:
• May investigate further by calculating specific expense items as a % of sales, eg
Though fixed costs (eg rent) may not change in line with turnover (eg they may be 'stepped' costs).
15.4.2 Efficiency
To assess how efficiently an organisation is using its resources.
Asset turnover
Formula:
Purpose:
• To show the efficiency of an entity's ability to use its assets to generate sales.
Meaning:
• How many $ turnover are generated by each $ of assets.
Inventory turnover
Formulae:
Purpose:
• To show the number of days of inventories that are being held by the business.
Meaning:
• If days of inventories are increasing, inventories are turning over less quickly. More inventory is
being held compared to sales.
Bad reasons may be:
294 | P a g e
eg fishmonger - 1 or 2 days
Formula:
Purpose:
• To show (average) time (ie number of calendar days) it takes to receive payment from credit
customers.
Meaning:
• If increasing, may be due to:
– Weak credit control (a problem).
– A deliberate policy to attract more trade (not a problem).
– Major customer(s) being allowed different credit terms (eg '3 months interest free credit').
Analysis:
• Compare with stated credit policy (eg '30 days') as set out in terms on invoices.
• Negligible collection period – for supermarkets, retailers and other cash-based businesses that
do not have credit sales.
• May be distorted by:
– VAT or other sales taxes.
– Debt factoring.
– Credit finance agreements.
– Seasonal trading (eg a December year-end may have lower receivables due to falling trade in
holiday period).
295 | P a g e
Formula:
Purpose:
• To represent (average) time (ie number of days) it takes to pay for supplies received on credit.
Meaning:
• If increasing, may be due to liquidity problems, resulting in:
– poor reputation as a slow payer (may not be able to find new suppliers)
– existing suppliers withdrawing supplies (or demanding 'cash on delivery')
– inability to take advantage of cash discounts (can be an expensive means of finance)
– a deliberate policy to take advantage of interest free credit (management must take care with
late payment penalties).
Comparisons:
• Previous years.
• Average suppliers credit terms (on invoice).
Formula:
• The working capital cycle is arrived at by summing up the previous three figures:
Inventory days + Accounts receivable days – Accounts payable days
Purpose:
• To show the amount of working capital, in terms of days, a company needs in order to operate.
Analysis
Generally, the shorter the better.
15.4.3 Liquidity
• Concerns financial stability.
• Indicates entity's ability to meet short-term liabilities from current assets available. There will be
going concern implications if it cannot.
• Two common measures – current ratio and 'quick' ratio.
296 | P a g e
Current ratio
Formula:
Purpose:
• To measure the adequacy of current assets to meet short-term liabilities (without having to raise
additional finance).
Meaning:
• If low/declining, entity may be unable to meet its short-term obligations as they become due.
• If high/increasing, might suggest over-investment in current assets such as inventories or
receivables or cash.
Analysis:
• 1.5:1 ratio – usually taken as the 'norm' (to maintain creditworthiness). Great care must be taken
with any 'norm' (this is just to give some idea of the magnitude of this ratio).
• Consider nature of inventories. If slow-moving, the 'quick ratio' is a better indicator.
• How close is operating overdraft to borrowing limit? Though highly relevant it is unlikely to be
disclosed in financial statements.
Formula:
Purpose:
• To measure immediate liquidity (by eliminating the least liquid assets, ie inventories, from
current assets).
Meaning:
• Sufficiency of resources (receivables and cash), or otherwise, to settle short-term liabilities
(trade payables in particular).
Analysis:
• 1:1 to 0.7:1 ratio – usually taken as the 'norm'.
• Consider operating overdraft and facilities available. (Even with low quick ratio an entity can
settle current liabilities if it has adequate overdraft facilities.)
Gearing ratio
(a)
(b)
• Formula (a) is the more sensitive (because the denominator is smaller).
• Debt includes long-term loans, debenture stock and preferred shares.
• Equity is the 'residual' (ordinary share capital, share premium, accumulated profits, revaluation
and other reserves).
Purpose:
• To measure the proportion of borrowed funds (which earn a fixed return) to equity capital
(shareholders’ funds) and provide information about the financial risk of a company.
High gearing suits entities with relatively stable profits (to meet interest payments) and suitable
assets for security (eg those in hotel/leisure industry).
Interest cover
Formula
Purpose:
• To measure how many times an organisation could pay its interest on borrowings out of current
earnings.
Analysis:
A very low interest cover might indicate that the organisation will have difficulty paying interest as it
becomes due.
Formula:
Purpose:
• A measure of profitability per share.
298 | P a g e
Analysis:
• A new project does not normally generate returns immediately, so a new share issue is often
accompanied by a decrease in EPS.
• EPS depends on earnings subject to accounting policies so need to take care when making
comparisons between entities.
Formula:
Purpose:
• To measure, as a multiple, the quality of current or prospective earnings.
Analysis:
• Shows the number of years it would take to recoup an investment from its share of profit.
• If high, indicates that investors are confident that entity will perform well in the future and
expect faster growth in the future EPS.
Dividend yield
Formula:
Purpose:
• A measure of the actual cash return to shareholders (ie dividend) on their investment.
Dividend cover
Formulae:
The relationship between profits available and dividends payable out of profit:
•
Purpose:
• To show the number of times dividends are covered by profit. (After tax because dividends are
an appropriation of profit after tax.)
• It shows how 'safe' the dividend stream is likely to be in the future. High cover means that a
company should be able to maintain the present level of dividend even if profit falls.
Analysis:
• 'Exceptional' (ie 'one-off') items should be excluded to prevent distortion.
299 | P a g e
You are given the following annual accounts of two incorporated entities in similar areas of business
for the year ended 31st March.
$000
Revenue 400
Operating profit 70
Interest payable 30
Tax 15
Chelsea
$000 $000
Current assets
Inventory 28
Receivables 98
Cash 4
130
Revaluation -
Accumulated profits 60
560
Non-current liabilities
Current liabilities
Trade payables 15
Operating overdraft 20
Proposed dividend 15
65
Be able to calculate and interpret financial ratios to comment on the performance of an organisation
Transaction processing
Providing the systems that enable the organisation to conduct transactions with customers,
suppliers, employees and other stakeholders.
Internal control
• Implementing effective policies and procedures to protect the organisation’s assets, for
example, ensuring appropriate segregation of duties and authorisation procedures.
• Ensuring the accounting system and associated controls are sufficient and robust so that the
accounting information produced is accurate and reliable.
Corporate governance
Ensuring compliance with corporate governance requirements, for example providing information
to shareholders and other stakeholders that provides a true and fair view of the organisation’s
activities and financial results.
Treasury management
To source and select appropriate sources of finance and manage the organisation’s liquidity and
working capital.
303 | P a g e
Outsourcing
Outsourcing involves contracting out an activity or activities to a third party.
Outsourcing may or may not involve offshoring, which is the relocation of the function or activity to
a different country.
When used in relation to the finance function, outsourcing usually involves a specific area, for
example payroll.
Advantages:
• Take advantage of the outsource partner’s expertise
• Lower costs due to the economies of scale enjoyed by the outsource partner
• Flexibility, changes in the volume of service required is able to be accommodated
• Certainty of cost, based on the contracted price
Disadvantages:
304 | P a g e
• Covers entire end-to-end processes, for example from receiving an order to the receipt of
payment
• Aims to implement processes that improve the quality of service and are scalable
• Seeks to establish competitive advantage through innovation
Advantages:
• Can result in process improvements and efficiencies
• Improved service provided to customers
• Encourages innovation
• The advantages of SS also apply
Disadvantages:
• May introduce complexity and bureaucracy dealing with different GBS groups
• Innovations and improvements are likely to be able to be copied by competitors
• The disadvantages of SS also apply
Some organisations use more than one approach. For example, a business may decide to outsource
payroll but to retain other finance activities in-house. This mix and match approach would enable in-
house staff to focus on the areas in which they are most able to provide insight and add value,
rather than on processing tasks able to be performed by others.
Computerised processing When accounting was a manual, paper-based activity transaction processing and the pro
and accounting systems was far more labour intensive and time consuming than it is today.
Today, computerised accounting systems enable huge volumes of transactions to be pro
As technology develops, process improvements often follow, for example electronic dat
reduces the time spent on data entry.
Accounting software programs include accounting and taxation rules, enabling finance d
of a watching brief and enabling the finance department as a whole to spend a higher p
processing activities.
This increased automation has also helped facilitate the shift in the role of the accounta
partner.
Finance professionals are now required to understand the risks presented by a range of
be able to evaluate the controls required.
Real time availability and In many organisations, senior managers require access to information constantly, in rea
analysis of information Management dashboards have been developed that showing key performance indicato
data.
Developments in computing storage capacity, processing power and software have enab
collected, stored and analysed to identify trends and insights.
The internet and cloud The use of internet-based computer systems enables access to data from different locat
computing This allows accountants to perform accounting tasks from any location and to deliver fin
through ‘the cloud’.
Taking a wider view, this increased level of contact and accessibility encourages closer w
clients (for accountants working in practice) or with individuals working in other areas o
working in industry).
Mobile computing and Accountants are increasingly able to access data and perform accounting tasks using mo
mobile accounting smartphones and tablets.
Accounting software packages are starting to become available as mobile applications (‘
tasks to be performed quickly and efficiently from mobile devices.
307 | P a g e
Digital record keeping Many businesses have implemented paperless record keeping storing digital (electronic
rather than paper or ‘hard’ copies. The ability to approve transactions within the accoun
‘sign’ documents digitally has accelerated the move away from paper records.
Digitised record keeping also brings efficiency gains, for example through making docum
sortable and transferable.
The accounting and professional services firm KPMG see the accountant’s role as a business partner
who 'supports the whole business, taking a forward-looking and commercial view supported by a
rich consulting toolkit and high emotional intelligence to help articulate different options and
influence decisions.’ Further to this, KPMG state that ideally the finance business partner would be
‘free from the distraction of core finance work to offer this level of support to their internal
customers’.
15.7.1 Strategy
Definition
308 | P a g e
Johnson and Scholes define strategy as 'the direction and scope of an organisation over the long-
term, which achieves advantage for the organisation through its configuration of resources…'.
Corporate strategy is concerned with the overall purpose and scope of the business and meeting
stakeholder expectations for the business.
Many organisations have more than one identifiable business unit. Business unit strategy is
concerned with strategic decisions for a business unit. These decisions include which products and
services the business unit should offer, how best to meet customer needs, how to gain competitive
advantage and how to create and make the most of new opportunities.
Strategic objectives
As part of the strategic planning process, organisations develop strategic objectives that reflect the
organisation’s strategy. Strategic objectives are organisational goals that convert an organisation’s
mission statement and strategy into specific items to be achieved.
Definition
Financial objectives are targets set by an organisation which will be measured in monetary terms.
For example, if an organisation has a strategic objective ‘To increase market share in country X by
25%’ it is likely that increased marketing spend will be required for country X.
The financial objective ‘Reduce marketing spend for country X by 10%’ would clearly be inconsistent
with the organisation’s strategy.
Therefore, the organisation’s financial objectives must be consistent with the organisation’s strategy
and strategic objectives.
309 | P a g e
Traditionally, most financial objectives would relate to the short-term, for example to the next
month, quarter or year, and strategic objectives would cover a longer time period, for example five
or even ten years.
Today, the pace of change in the environment organisations operate in has reduced the amount of
detailed long-term planning performed by organisations. There is little point producing a very
detailed ten year plan if changes in the business environment render the plan obsolete within a few
years.
Goal congruence
The need for an organisation’s financial objectives to be consistent with their strategy and strategic
objectives is an example of the need for goal congruence.
All organisational objectives or goals, when achieved, should help achieve the organisation’s overall
strategic objectives. This applies to financial objectives and also to other ways in which financial
targets are expressed, for example budgets.
Equity
310 | P a g e
Preference shares
A type of equity but with preferential treatment for dividends over ordinary shares. However,
dividends are still not guaranteed, they are dependent upon profits.
Convertibles
Convertibles start as debentures (long-term loans, fixed interest, usually secured on assets) but
include an option to be converted into equity at a later date.
Convertibles allow investors to adopt a 'wait and see' approach to their investment. If the company
does not do well, they can stick with their safe debentures. If the company is a great success then
they can convert their investment into equity and participate in value gains.
311 | P a g e
Factoring
Factoring involves the sale of accounts receivables to a third party. The company therefore receives
payment more quickly, but receives less as they pay the factor organisation a fee, usually a
percentage of the value of debt factored.
Security available
Generally, lenders prefer their loans to be secured against good quality assets such as land and
buildings. If assets are unable to be offered as security, borrowing may not be an option.
Business risk
Businesses operating in high-risk environments with volatile revenue and / or profit should avoid
high levels of borrowing as they may find themselves unable to meet interest payments. High-risk
ventures are more suited to equity finance as there is no legal obligation to pay equity dividend.
Gearing
The level of a company’s borrowing is measured by the capital gearing ratio (the ratio of debt
finance to equity finance). Investors and lenders do not look favourably on companies with high
gearing (relative to similar companies in the industry).
Operating gearing refers to the proportion of a company’s operating costs that are fixed rather than
variable. The higher the proportion of fixed costs, the higher the operating gearing. Generally, it is
high risk if high financial gearing is combined with high operating gearing.
Voting rights
A large issue of shares to new investors could alter the voting control of a business.
312 | P a g e
Market conditions
If share prices are falling in equity markets companies will be reluctant to sell new shares as the
price achieved is likely to be lower than required, diluting the wealth of existing shareholders. Rights
issues (additional shares are sold to existing shareholders) may be used in these circumstances but
these require current shareholders to be able and willing to commit additional funds to the
company.
Consideration Comment
Suitability Would the potential source of finance fit with the company’s needs and current financing mix?
For example;
If the company is already highly geared would an additional loan be suitable?
If the current owners wish to maintain control, would issuing new equity to new shareholders be s
Acceptability Acceptability relates to risk and return and to the expectations of the parties to the potential finan
Relevant questions could include:
How would the potential source of finance impact profitability and EPS?
Is the potential source of finance acceptable to existing lenders and investors?
What are the expected costs and benefits of the potential source of finance?
Is the level of risk acceptable in the context of the potential reward?
High amounts invested in non-current assets and relatively low amounts invested in current assets is
efficient, but may result in the company needing to juggle cash and struggling to pay suppliers and
on time.
$ million
Non-current assets
Current assets
Inventory 15
Receivables 10
Cash 5
Equity 35
Payables 15
Overdraft
The business grows rapidly, doubling its turnover without raising more equity and without the need
to purchase additional non-current assets. This type of rapid expansion without increasing capital is
sometimes referred to as ‘overtrading’.
How will the statement of financial position look? It is reasonable to assume that if the business is
twice as busy it will require twice the inventory and that its receivables and payables will also
double. Cash or overdraft will be the balancing figure.
The new statement of financial position would therefore be:
$ million
Non-current assets
Current assets
315 | P a g e
Inventory (15 × 2) 30
Receivables (10 × 2) 20
Cash -
Equity 35
Payables (15 × 2) 30
Overdraft (balance) 5
The business has funded its growth using an overdraft. In addition, it is likely that further investment
in non-current assets will be required to enable production levels to be maintained or increase
further.
If external finance is not obtained, the company is likely to experience cash-flow problems.
Therefore, this company would be advised to raise long-term capital to fund the purchase of non-
current assets.
Technique Comment
Payback The payback method involves the calculation of the payback period which is the length of time ta
inflows to equal (‘payback’) the initial investment. If the payback period is less than the organisa
project, then the project is acceptable.
316 | P a g e
Technique Comment
Accounting rate The Accounting Rate of Return is calculated as net profit after charging depreciation and either b
of return (ARR) Capital employed is typically the cost of the initial investment net of any depreciation (net invest
capital. The accounting rate of return is usually calculated over the life of the asset resulting from
Net Present Under the NPV technique, future cash flows are converted into their present day cash equivalen
Value (NPV) can lend and borrow money at 10% per annum, the entity should be equally happy to receive $1
year’s time. All future cash flows are able to be converted into their present value equivalents us
Internal Rate of The IRR is the discount rate which produces a net present value of zero. Therefore, the IRR could
Return (IRR) ‘break even’ discount rate. It shows the maximum value that the cost of capital can reach before
unacceptable. Unfortunately, there is no direct way of calculating the IRR. Various discount rates
discount rate that produces a net present value of zero to be derived.
A company with a cost of capital is 10% is considering a project with the following expected cash
flows.
0 (90,000) 1.000
1 70,000 0.909
2 50,000 0.826
3 50,000 0.751
NPV
On the basis of the calculation above, the project has a strong positive NPV so, from a financial
perspective, should go ahead.
Now assume that due to uncertainty surrounding future cash receipts, 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.
317 | P a g e
NP
On the basis of this calculation the project has a negative risk adjusted NPV so, from a financial
perspective, should NOT go ahead.
• Estimating values for relevant variables and making a decision based on these variables
• Analysing each variable in turn to establish by how much the original estimate can change before
the original decision is reversed. For example, it may be established that the estimated selling
price could fall by up to 10% before the original decision to proceed with a project would be
reversed.
• Considering how likely it is that the original estimate would differ from the actual result, for
example the likelihood of the selling price falling by 10% or more. The maximum possible
change is often expressed as a percentage.
Sensitivity analysis can play an important role in deciding how risk should best be handled.
Assumptions about outcomes and their probabilities are varied and the outcomes monitored.
Usually sensitivity is measured by the percentage that an assumption can be varied before a project
breaks even, though there is no need always to measure to the break-even point.
If the success of a plan seems to be very dependent on the accuracy of a figure, then it might be
worth trying to estimate that figure more accurately so that a better picture of the risks is obtained.
For example, if a project's success depended very critically on the sales volume of a product, then it
might be worth investing more in market research before the organisation become too committed
to the venture.
Machine
Original cost and book values are irrelevant. Using the machine will cause an opportunity cost of $25,000 now but pe
income of $12,000 in one year
Material
Type B - original cost irrelevant. If this contract is not taken up all material would be sold for $7, so 1,000 kg @ $7 will
opportunity cost (cheaper than buying new at $10/kg)
Fixed overheads
Non-incremental, so irrelevant
Labour
Total
The minimum contract price, just to break-even, is therefore $65,000.
Professional skills marks would be available for doing the financial analysis, and drawing an
appropriate conclusion from the results of your analysis. (That is to say, even if you made an error in
your calculations and got the ‘wrong’ solution, you would obtain professional skills marks for making
a recommendation that was consistent with your analysis.)
Solution 15.2
Arsena
Arsena
16
Forecasting
Context
Business forecasting looks forward to the sales and costs that will result from current operations
and the strategic plans an organisation is taking. This can involve a lot of work in order to
understand the likely variations in what can happen. It is highly unlikely that a forecast will turn out
correctly in practice.
It is worthwhile getting used to how to construct a business forecast so that you can explain what is
required. To do this you can use various techniques to help estimate what will happen in the future
and these are covered in this chapter.
Video introduction
322 | P a g e
1. What are the four effects that time series analysis usually recognises?
2. Can you differentiate between uncertainty and risk?
3. Do you know the four approaches that can be used to manage risk?
16.1 Introduction
In addition to its use in strategic decisions, forecasting will also affect the processes of building a
business case (where costs and benefits have to be estimated), investment appraisal, pricing,
dealing with risk and uncertainty, for example, by using decision trees.
It is important for you to be able to evaluate methods of business forecasting, so the emphasis is on
the interpretation of forecast and forecasting techniques, and a knowledge of their limitations
• The technique guarantees to give the best straight line possible for any set of points. You could
supply a set of people's heights and their telephone numbers and it would be possible to show a
straight line relationship between these. Obviously it would not be wise to use that for height
prediction. It is therefore essential to investigate how good the relationship is before relying on
it. This is covered later when the coefficients of correlation and determination are discussed.
• The more points used, the more reliable the results. Anyone can draw a straight line through two
points and it means little. If you can draw a straight line through 10 points you might have
detected a worthwhile relationship between the two variables.
• A good association between two variables does not prove cause and effect. The association
could be accidental or could depend on a third variable. For example, if we saw market share
rise as a company's advertising spend increased we cannot, on that evidence alone, conclude
that the advertising caused the change in market share. Both events might have coincided with
a competitor having production difficulties. In other words, the increase in market share might
have happened without the additional advertising.
• Interpolation is much more reliable than extrapolation. Interpolation is filling the gaps within the
area we have investigated. So, if we know the cost when we make 12,000 units and the cost
when we make 15,000 units, we can probably make a reasonable estimate of the costs when we
make 14,000 units. Extrapolation, on the other hand, is where you use data to predict what will
occur in areas outside the region you have investigated. We have no experimental data for
those areas and, therefore, there is a real risk that things might change there. For example, if
we have never had production of more than 15,000 units, how reliable might estimates of costs
be when output is 20,000 units? Overtime might have to be paid, machines might break down
because they are being used intensively, material might be more expensive to obtain and
production errors might be made.
• Remove other known effects, such as inflation, before performing the analysis, or the results are
likely to be distorted.
If r = 0.9 and therefore r2 is 81% (or 0.81) this implies that 81% of the changes in one variable can be
explained by changes in the other.
Note carefully: this does not mean that 81% of the changes in one is caused by 81% of changes in
the other. Even good correlation does not prove cause and effect.
Explain whether linear regression would be useful for a company such as:
(a) Google
(b) A UK bank lending money to house buyers
Professional skills marks are available for demonstrating commercial acumen in your explanations.
16.3.1 Introduction
A time series shows how an amount changes over time. For example, sales for each month, profits
for a number of years, market share over each quarter.
Because strategic management inevitably implies trying to look into the future, time series analysis
is extremely important. Very often the starting point for predictions will be based on historical
patterns of growth or decline, or a recognition that, in the past, amounts seem to have varied
randomly.
Year Quarter Sales (units) 4-part Moving average 8-part centred moving average
1 1 2,000
2 900
1,250
3 1,000 1,144
1,038
4 1,100 1,050
1,063
2 1 1,150 1,094
1,125
2 1,000 1,126
1,128
3 1,250 1,115
1,103
4 1,110 1,125
1,148
3 1 1,050 1,104
1,060
2 1,180 1,021
983
3 900
326 | P a g e
4 800
Seasonal variations
56 -126 -144
3 33 -9
• The trend.
To find a trend, first decide on a likely periodicity or seasonality. For example, 6 for the trading
days of the week, 4 for seasons of the year. Then ensure that the average is centred on a 'season'.
Above it has been assumed there are four seasons, so 4-part averages are first calculated: 1,250 =
(2,000 + 900 + 1,000 + 1,100)/4. That average is between seasons 2 and 3. To obtain a centred
average, average with the next one: 1,144 = (1,250 + 1,038)/2. Here, the 8-point moving averages
move up and down implying no strong trend.
• Seasonal variations.
Variations are identified by the differences between the actual results and the trend figures.
Again, this table has been designed to show no stable seasonable variations and all seasons show
both positive and negative effects.
The variations calculated for each season are averaged and will provide the basis of seasonal
adjustments to be applied to the predicted trend.
Time series analysis usually concentrates on trends and seasonal variations and ignores cyclical
variations and random variations as being too slow or difficult to warrant investigation.
Once again, if must be emphasised that even if a strong trend has been identified there is no
guarantee that this will continue in the future. For example, a product lifecycle curve might show a
strong growth trend early in a product's life, but then at some point, growth will fall off, and
probably even further in the future, the trend will show decline. Any prediction, even if based on a
large amount of historical data and using recognised and sophisticated techniques, can still be prove
to be very different to the actual results that occur. Judgement has always to be applied when
assessing how much to believe the results.
• The simple moving average method: next period's prediction is based on the latest moving
average and would therefore be predicted to be 1,021.
This averages out the 'ups and downs' in the data, but suffers from two potential problems:
1. The predicted value lags the actual results because so much historical data is included in the
prediction. One could easily argue that 1,021 looks much too high given recent actual results.
2. Every time a new moving average is calculated, the oldest component of the calculation is
removed from the calculation, and a new one taken in. It can be considered as unrealistic and
erratic to drop a reading so abruptly.
• Exponential smoothing. In this approach a weighted average of the last actual result and the last
predicted result is used as the next prediction. The weighting factors used are arbitrary, and
alter how much importance is given to the last actual result and how much to the last estimated
result; this varies how stable or volatile the predictions are. So, if we began the process from
Year 3 Season 2 and used weighting factors of 0.5 and 0.5, the prediction for Season 3 would be:
0.5 × 1,180 + 0.5 × 1,021 = 1,101
The prediction for Season 4 would be:
0.5 × 900 + 0.5 × 1,101 = 1,001
And for Year 4 season 1 would be:
0.5 × 800 + 0.5 × 1,001 = 901
In general, the new prediction will usually not lag behind latest results as much with simple moving
averages, and historical results are not abruptly dropped. Instead, their importance to the
prediction gradually decreases.
How might a toy retailer like "Toys R Us" use time series analysis?
• Uncertainty is when you know that there might be alternative outcomes, but cannot attach a
probability to each of those occurring. There, decisions rely greatly on stakeholders' personal
attitudes to risk – though there might not be agreement. It is particularly important to examine
the bad or worst case scenarios as those can lead to trouble.
• Risk is where probabilities can be assigned to the various outcomes. The normal method of
dealing with risk is to calculate the expected value of the outcome. The expected value is
calculated by multiplying each outcome by the probability of it occurring and then adding up
the results.
If it is estimated a strategy will result in a profit of $5 million with a probability of 0.6 and a profit of
$8 million with a probability of 0.4, then its expected value is:
0.6 × 5 + 0.4 × 8 = $6.2 million
For example:
P Profit $ P × Profit
• A chance point, represented by a circle and with probabilities assigned. There, managers must
rely on the expected value of the outcomes – in the diagram below, the expected monetary
value at point B would be:
0.4 × $10,000 + 0.6 × $15,000 = $4,000 + $9,000 = $13,000
If a large factory is built initially, then income per year will be 0.6 million with a probability of 0.45,
or $1.5 million with a probability of 0.55.
If a small factory is converted to a large factory then the expanded factory receives income
characteristic of a large factory for the second half of its life. If income for the small factory is low for
the first 5 years, then on an upgrade it will be 0.6 million per year for the last 5 years. Similarly, if
income for the small factory is high for the first 5 years, then on an upgrade it will be 1.5 million per
year for the last 5 years.
We are to advise the company whether it should build small or large initially, and if it builds small,
whether or not it should upgrade.
The decision tree is as follows:
Having drawn the decision tree, you then start at the extreme right and gradually work back
through each decision point and chance point.
Point D
Here there is a choice.
• Continue for 5 years at $0.6 million per year = $3.0 million; or
• Upgrade for $4 million to earn 5 years at $1.5 million pa = net income of $3.5 million
So, the better option is to upgrade.
Point E
Here there is a choice.
• Continue for 5 years at $0.4 million per year = $2.0 million; or
• Upgrade for $4 million to earn 5 years at $0.6 million pa = net loss of $1.0 million
So, the better option is not to upgrade
Point B
Everything further to the right of this point is governed by the probabilities of 0.6 and 0.4
Expected monetary value at B =
Point C
Expected monetary value at point C =
0.45 × 10 × 0.6 + 0.55 × 10 × 1.5 = $10.95 million
331 | P a g e
Point A
The choice here is:
Build small, and expected net income will be 5.5 – 4 = $1.5 million
Build large, and expected net income will be 10.95 – 8 = $2.95 million
Final advice
Building large initially results in the highest expected net income of $2.95 million.
Note:
This is not guaranteed and there is a 0.45 probability that a loss of $2 million will be made ($8
million cost for only $6 million income).
Although building small will not give such high expected income, the worst loss that could be made
is $1 million (spend $5 million and receive 10 years of low income at $0.4 pa).
(a) Since Google is operating in a young industry, there may not be that much past data to use.
(b) House buying does not tend to rise or fall in a straight line, instead it tends to follow cycles, and
in this case time series analysis would be more useful.
Commercial acumen marks would depend on how well you have demonstrated your understanding
of the industries and drawn relevant conclusions in relation to them.
Solution 16.2
A large toy retailer may use time series to identify the total amount of toys sold throughout the
year, this would help them to be more efficient by reducing inventory levels.
They could also look to see where a product is in its life cycle, perhaps leading to products being
discontinued.
They might also look at the trend of toy sales in a country, perhaps leading to entry into or exit from
a particular country.
Time series analysis would be more useful than linear regression since toy sales will fluctuate in the
short term (during the year) and the long term (due to recessions etc).
17
Enabling success
Context
The Strategic Business Leader syllabus considers how the success of an organisation may be
enabled. Factors linked to the success of an organisation include:
• How the organisation is structured
• How the organisation uses and reacts to disruptive technologies
• The ability to innovate
• Performance excellence
333 | P a g e
An organisation that relies on the creativity of staff, such as a business that designs cutting-edge
fashion, is unlikely to be suited to a strict hierarchy under which roles are strictly defined and the
chain of command is strictly adhered to. This type of organisation is more likely to be suited to a flat
structure which encourages the sharing of opinions and ideas.
On the other hand, some organisations are best suited by a structure that provides clear lines of
responsibility and requires adherence to a strict hierarchy, for example a police force.
Simple structure
334 | P a g e
This is most likely to be found in small organisations. Power is centralised in the hands of one
person. There are few, if any, support activities. Once the organisation gets larger it will usually
evolve into a functional structure.
Functional structure
Some businesses have a tall-narrow structure, meaning many layers and each supervisor looking
after only a few people. This tended to make vertical communication very slow, could be wasteful of
time (too much supervision and checking) and was slow to react to change. The various
management layers defended their positions and 'perks'. Tasks were very specialist and employees
were inflexible, sticking strictly to their job specifications.
Many firms relatively recently undertook 'flattening' or 'delayering' processes to remove many
grades of middle manager. This produced fewer layers but each supervisor has to look after more
subordinates. Not only did this process save management costs, but the organisations had much
better internal communication and were quicker to react to change. People were more willing to
work in flexible, changing groups. Emphasis was on 'getting the job done'.
Divisional structures
The organisation is broken up into divisions on the basis of:
• Geography (for example, North American and European divisions);
• Products (for example, a commercial vehicle division and a car division);
• Customers (for example, a business customer division and a private customer division).
A divisional structure allows specialisation because often suppliers, customers and production can
be quite different and it is not logical to cram them together. However, there can be a loss of
economies of scale as some functions will suffer duplication.
335 | P a g e
Matrix structure
This structure defies the classical management rule of 'unity of command', meaning that any person
should have only one boss to account to. The matrix structure is often found in project-based
companies.
Project A
Project B X
Project C
Employee X is a quality control person, working on Project B. X has a responsibility to his quality
control boss and to the Project B manager.
You can easily imagine how X comes under pressure from both Project B manager to cut quality
control to help get the project finished on time, and from the quality control manager who wants
proper, thorough tests carried out.
However, the matrix structure does not cause this conflict: it is simply a more honest representation
of the problem. At least X can indicate the formal position to his two managers and say that they are
the best people to solve any problems, rather than pressurising X, who is the most junior of the
three of them.
The matrix structure is supposed to encourage communication and to put emphasis on getting the
job done. There's no point in missing a deadline or producing faulty work. The 'win–win' situation is
producing acceptable work within the deadline. However, it can sometimes cause confusion as to
who has the final say.
Virtual structures
Here there is a core of permanent management and skilled employees. Most functions are sub-
contracted and the job of the permanent staff is to coordinate sub-contractors and customers.
Handy suggested the 'shamrock organisation': a core of essential executives and workers supported
by outside contractors and part-time help. This idea is in line with the current fashion of businesses
concentrating on their core activities and sub-contracting as much of their other functions as they
can.
336 | P a g e
Virtual organisations can react very flexibly to changing circumstances. Most of their costs are
variable.
Centralisation
• Senior management instruct others in decisions to be made.
• This links with the head office role of being a parental developer or synergy manager.
• The main advantage of this approach is it should lead to goal congruence and good coordination.
Decentralisation
• Senior managers leave junior managers to make their own decisions;
• This links with the head office role of portfolio manager.
The main advantages are that:
• Top managers can concentrate on the top decisions, delegating less important ones;
• Junior managers should have a better understanding of the local situation;
• Decisions should be made more quickly because they do not have to be referred up to senior
management;
• Decisions are made by those with proper expertise;
• It motivates junior managers;
• It allows assessment of managerial performance.
However, there is a risk of dysfunctional decision-making, where a sub-unit manager makes a
decision which harms the group.
If decentralisation is used, senior management will need to have some way of knowing if the correct
decisions have been made, this may be through:
• Performance Measures;
• Use of service level agreements;
• Instilling a strong corporate culture.
337 | P a g e
17.2.1 Introduction
Mintzberg divides the organisation into six areas:
• Ideology – the culture of the organisation;
• Strategic apex – senior management;
• Middle line – middle managers;
• Operating core – employees directly involved in producing goods and services;
• Technostructure – providing technical support, devising standard procedures and enforcing a
uniform approach;
• Support staff – providing general support.
The last five can be shown on a diagram as follows:
He argued that the size of these areas varies depending on the type of organisation being described.
The types of organisation include:
Learn Mintzberg's configurations and be able to identify the type of organisation in a scenario
Organisation culture
Culture, described as the ‘way we do things round here’ is the glue which ties everything together,
in terms of a shared understanding of what the organisation is for, how people should behave, the
value system, attitudes to risk. Given culture determines how people think and behave, it is not
339 | P a g e
surprising it comes under management scrutiny. Changes at Barclays, referred to earlier, have
focused on changing the culture of an organisation. It is impossible to write a rule book for every
eventuality: better that people know instinctively what is the right thing to do.
Projects
For key initiatives, staff from different departments can be brought together in project teams to
look at particular initiatives.
This might be ‘sponsored’ by one of the departments but require the active participation of other
departments. A major organisation-wide change like a rebranding exercise is an example.
Definition
340 | P a g e
A disruptive technology is a development in technology that enables a new way of doing things that
has the potential to significantly change traditional business methods and practices.
There are many examples of how developments in internet, cloud and mobile technology have been
used to disrupt traditional business methods and practices.
A few examples are provided below (there are many others):
• The impact of email on postal services
• The use of e-commerce to facilitate online shopping and the creation of online-only retailers and
auction sites, for example Amazon, lastminute.com and ebay
• Digital streaming and download of films, television, radio, music, books, magazines and
newspapers
• The use of mobile technology to create new business models, for example Uber taxis
• Online and mobile banking reducing the need for physical bank branches
• New business models such as price comparison websites
• The use of social media in marketing and customer service delivery
• The use of technology to link service providers and consumers, for example Uber and Deliveroo
Give examples of businesses that are disrupting and might disrupt the traditional market for cars
and transport.
17.3.2 Fintech
Definition
Fintech is a term used to describe the use of technology to disrupt traditional business methods and
practices in financial services and banking.
New companies which utilise mobile technology platforms and applications have emerged,
competing with traditional banks and other financial institutions. Fintech companies offer products
and services including access to loans and other forms of finance, investment opportunities and
banking services.
Fintech companies provide convenience, efficiency, and speed via mobile technology platforms and
applications. Customers, both individuals and businesses, are able to manage their finances from
their mobile device, for example tracking spending, applying for a loan, or selecting investments.
341 | P a g e
Traditional banks, insurance companies and wealth and asset management companies face the risk
of disruption. For example, employers are now able to access technological solutions to offer
employees financial wellness programs as an employee benefit.
Software programs are able to offer financial advice based on the customer’s current financial
position, their needs and their risk appetite. This type of system, sometimes referred to as ‘robo-
advisers’, threatens the role of the traditional financial advisor.
Definition
Talent management is a collection of practices that aims to ensure that an organisation has high
quality people in place to achieve the organisation's objectives.
The talent management process covers employee selection, development, succession planning and
performance management.
Effective talent management that supports the organisation’s overall strategy requires:
• A clear understanding of the organisation’s business strategy
• Identification of any gaps between the talent in place and the talent required to achieve the
organisation’s objectives
• A talent management plan designed to close the gaps, integrated with strategic business plans
• Effective recruitment and promotion decisions
• Goal congruence between individual, team and organisational goals
• Clear performance expectations and effective feedback to manage performance
• Development of talent to enhance performance
• Effective performance management and tracking of workforce effectiveness
Talent management is, therefore, driven by the organisation’s strategy and organisational goals.
Definition
The US National Institute of Standards and Technology (NIST) defines performance excellence as 'an
integrated approach to organisational performance management that results in: (i) Delivery of ever-
improving value to customers and stakeholders, contributing to organisational sustainability. (ii) An
improvement in overall organisational effectiveness and capabilities. (iii) Organisational and personal
learning'.
Malcom Baldrige, a quality management guru and US Secretary of Commerce from 1981 - 1987,
devised the Baldridge model for business performance excellence.
The model includes seven categories, underpinned by the organisation’s core values and concepts.
Leadership
• How do senior management set and communicate the organisation’s vision and values?
• How do senior management create and sustain performance excellence?
• How does the organisation fulfill its governance and corporate social responsibility obligations?
• How do senior management ensure the organisation is a good corporate citizen and that
employees behave legally and ethically?
Strategy
• How does the organisation set its strategic direction?
• Are the strategic objectives clear?
• Do strategic objectives guide and strengthen performance, competitiveness and future success?
• How are strategic risks identified and managed?
• How does the organisation convert strategic objectives into action plans to accomplish the
objectives?
• Are strategies and action plans, covering different areas of the business, aligned?
344 | P a g e
Customers
• How does the organisation gain knowledge about current and future customers and markets?
• How does the organisation keep pace with changes in the market and changing ways of doing
business?
• How are customer relationships and customer satisfaction monitored and managed?
Workforce
• How effective are the systems and processes people work under?
• How effective are the organisation’s human resources (HR) and talent management practices?
• Do recruitment and selection procedures ensure a ‘fit’ between new recruits and the culture (or
desired culture) of the organisation?
• Does the system for employee performance management enable and encourage employee
development?
Operations
• Do the organisation’s business processes create value for customers and other stakeholders?
• Are procedures in place that ensure the risks associated with product and process design are
identified and managed?
• Are services that support operations and operational planning effective, for example disaster
recovery planning for the continuity of operations?
• Do the support processes associated with functions such as finance and facilities management
support operations effectively?
Results
• Does the quality of the products and/or services offered by the organisation generate customer
delight or satisfaction, and customer loyalty?
• Does the organisation produce customer-focused performance results which track customer
satisfaction and retention?
The Baldrige model provides a framework that helps establish answers to fundamental questions
such as:
• Does the organisation have a clear direction and strategy?
• Is the organisation performing to its full potential?
• What areas could and should be improved or changed?
345 | P a g e
When assessing an organisation under the Baldrige model, scores are assigned against each criteria.
The scores enable an assessment to be made of how well the organisation is performing.
The seven criteria are used to assess an organisation's performance, helping the organisation
identify its strengths and areas requiring improvement.
The ultimate aim is to help the organisation reach its strategic goals, improve results and be more
competitive. In this way, the Baldrige model helps an organisation progress towards performance
excellence and towards becoming a world class organisation.
Definition
A world class organisation is recognised as one of the most successful organisation's in the world in
the industry it operates in. The organisation continuously strives to improve and to deliver
exceptional levels of custiomer satisfaction.
Characteristics of world class organisations that are encouraged through application of the Baldrige
model include:
• Visionary leadership
• A culture and values that encourage integrity, social responsibility, innovation and diversity
• Customer-driven excellence
• High levels of organisational and personal learning and development
• A focus on the future, including sustainability
• Employees that are valued and well rewarded
• Organisational agility and flexibility (able to adapt to change)
• Decisions which are based on high-quality information
• Constantly seeking improvement, including processes which are more efficient
• A focus on quality, results and creating value
Definition
The management writer Slack defines a process as 'an arrangement of resources that transforms
inputs into outputs that satisfy (internal or external) customer needs.
Business processes should be designed to add value. Maximising the value added by the process
requires only essential activities to be included in the process.
The two outcomes of a well-designed business process are:
• Increased effectiveness (value for the customer)
• Increased efficiency (lower costs for the business)
Automation
Do what was always done, but now automate the process. For example, wages and salaries being
calculated on computer. Useful enough cost savings and efficiency gains, but no radical change.
Rationalisation
Changing the way process are carried on to remove 'bottlenecks' ie processes which impact
adversely on the organisation. An example could be airlines asking for check-in to be done at home
over the Internet, and boarding passes to be printed there or mailed to a mobile device. Passengers
who have hand luggage only can now completely bypass the check-in desks and their queues.
Harmon’s process-strategy matrix is often used to help decide whether and how a process should be
redesigned. The model is most often used when considering which processes are most suitable for
outsourcing and which should be kept in-house, and perhaps automated or improved in some other
way.
The matrix is shown below.
For Samsung making smartphones, in which quadrants of the matrix is battery manufacturing and
developing the operating system likely to fit?
Solution 17.1
Solution 17.2
Battery manufacturing is likely to fit into the bottom left quadrant of the matrix – it is a reasonably
simple, easy to produce item. So relatively it is low strategic importance and low complexity.
However, development of the operating system is key and will be in the top right quadrant, being
both complex and strategically important.
18
Managing strategic change
Context
It is all well and good to devise a strategic plan. However having a plan doesn’t mean that the
project will be achieved. We need to look at what might stop the organisation changing and
achieving the project and see the types of style that can be adopted to help the organisation change
351 | P a g e
and achieve the project. Ideally we can align the organisation’s structure and resources with the
strategy it is undertaking and its environment.
Video introduction
Adaptation means limited change happening relatively slowly. Most employees and other
stakeholders will cope with this easily. Often the change is so gradual they won't notice it.
Evolution is a large change, or set of changes, happening slowly. Again, in terms of employees, with
proper explanation, support, reassurance and training, this will probably not cause huge problems
Reconstruction is an urgent change of limited impact. Employees will find this more difficult and
unsettling
Revolution means fast radical changes. This sort of change has many risks. If something goes wrong
in the rush, many stakeholders will be adversely affected. Employees are likely to be worried and
confused about their futures in the organisation.
352 | P a g e
When thinking about change, we can identify ‘levers’ or tools available to senior management and
those tasked with implementing the change. We can also identify factors that may hinder or block
the change.
In 2008 Santander Bank wanted to enter the UK banking market and bought three banks, Abbey
National, Bradford and Bingley, and Alliance and Leicester. It decided to combine the three banks
under Santander UK over the space of a year or so. Which of the types of strategic change does this
best fit with?
People The organisation requires people with the skills required to implement the change and to a
revised goals in the new environment.
This may involve:
• Recruitment
• Retraining
• Job redesign
• Redesign of performance and reward systems
As with all things concerning change and people, effective communication is essential.
Organisation To be implemented successfully, a change initiative must have the full support of senior m
Cooperation and collaboration across and between departments is also likely to be require
People and processes should be organised in a way that facilitates the achievement of orga
Management must also ensure that staff have the resources required to carry out their rol
Information Technology It may be possible to use information technology to make processes more efficient.
New information systems that utilise IT are likely to be required, for example to support ne
(KPIs).
Management are likely to require a ‘dashboard’ containing key internal and external perfo
Employees must have easy access to the information they require to perform their roles.
A major fast food chain is considering introducing delivery by bike and/or car. Use the POPIT model
to consider the factors that the fast food chain should take into account.
• Organisational structure. Usually formal, bureaucratic structures resist change by slowing down
the process and defending the current position.
If the driving forces for change, such as management, push harder and harder, then the resisting
forces are likely to push harder the other way. The situation is likely to escalate as people adopt
inflexible positions they are reluctant to negotiate on.
Instead, Lewin says that management should work at weakening the resisting forces. For example,
management might be able to reduce fears about redundancies, or might be able to explain why the
changes are necessary for the organisation's survival.
This model can be used to try and get a subordinate to change the role of their job, by doing the
following:
Build up driving forces by explaining why they will find the new role more interesting, why it will
help their career, it might lead to promotion or a higher salary.
Reduce resisting forces by reassuring the staff member that they will get assistance with the new
tasks if needed, also that some of their existing tasks will now be performed by others so that the
workload is not too heavy.
One classic example of a business that managed to follow Lewin’s three stage model is Continental
Airlines of the USA. In the 1980s and 1990s the business was in the bankruptcy courts. However the
CEO decided to unfreeze the company from being a low cost provider to being a quality airline. He
also changed the culture and offered a reward system to all employees if the company was
successful. Once this started to work out the business ‘refreezed’ the changes. The result of this is
that Continental Airlines was the most admired airline in the world in 2008 according to Fortune
magazine and won the Best Airline in North America for the 5thtime that year.
Education & commu- Group briefings assume Overcoming lack of Time consuming.
nication internalisation of strategic logic information Direction or progre
and trust of top management be unclear
Direction Use of authority to set direction Clarity and speed Risk of lack of accep
and means of change and ill-conceived st
Coercion Explicit use of power through May be successful in crises Least successful un
edict or state of confusion crisis
The diagram attempts to convey that any change has a context: a set of variables, and that these
can be matched to suitable design choices (the approach to managing the change).
Contextual features
• Time – long time or urgent? Can the change be implemented slowly or is it required urgently?
• Scope – how much of the organisation will be affected? All, or just one department?
• Preservation – which aspects are to be retained? For example, if customer service is good, the
organisation will not want to destroy that by inappropriate changes to remuneration.
• Diversity – recognition of separate sub-cultures. Some departments might be more open to
change and learning than others. Some will be more compliant and others more resistant.
• Capability – do abilities exist to cope with the change? If not, they might have to be hired in.
• Capacity – are resources (time, money etc) available?
• Readiness – are staff aware of the need for change and committed to that change? If they are
not convinced that change is needed more persuasion might be needed.
• Power – how much power and authority do the change agents (managers) have? If a person is
asked to organise change but has inadequate power to do so, then the change will probably not
be successful.
357 | P a g e
How might this work in a large acquisition such as Wal-Mart buying Asda in the UK?
Design choices
• Change path: this consists of the types of change, in terms of the extent of change and the speed
of change, that need to be undertaken for the required change outcome to be delivered.
• Change start point: where the change is initiated (eg top-down from management, or bottom-up
from employees).
• Change style: which management style should be adopted – authoritative or participative?
• Change interventions that might be useful: education, communication, cultural interventions.
• Change roles: eg consultants, teams.
Examples
• A very urgent change is likely to employ a fairly authoritative, top-down approach because the
organisation does not have the luxury of time to discuss matters.
• A change affecting the whole organisation will probably be better if a more participative
approach is used to explore all the problems. A consultant might also be employed.
The organisation must align itself These processes may lead to change drivers. Information technology may be a
with its environment by way of a use of mobile technology. There may be internal drivers such as the desire to s
strategic planning process. platform to reduce costs and enable information sharing.
Define the business improvement: Based on the broad proposal for change, a series of options and recommendat
the POPIT model developed. As a result of this process, a change project is identified that covers
including people, organisation structure, process and information technology (
elements can be affected in different ways.
359 | P a g e
For example, a supermarket chain may wish to centralise its call centre and com
operation:
• People: will need to be trained in the new approach to customer service
• The organisation structure, including the job descriptions, performance incen
be in place. Furthermore, people implementing the system must be involved
• Processes. As described above these will need to be designed, and translated
work activities, ensuring all the necessary hand offs are made. There will be
processes can be automated
• Information technology, covering both the hardware infrastructure and syste
The value of the POPIT model is that it looks at all factors that can impact the i
process that involves changes in what people do, how they are managed, and
them. It also focuses attention away from just the IT but ensures the other fac
same time.
Design the business change The business change product is designed and developed in this stage. The chan
processes, new software and training. Each of these components covering the
an integrated way.
Using the POPIT model we can see that the change will not be effective unless
in the change work together.
Implement the change Stakeholder involvement is crucial, and the proposed solution needs to be acce
managing expectations in advance, and communicating the process. The hand
needs to be planned with care, particularly when it comes to systems directly a
IT systems are changed, a handover needs to be planned coherently, data migr
on.
Benefits realisation A change process or new system is expected to offer designed business benefi
savings, service enhancements, or increased revenue as a result of greater traf
not be delivered but ultimately should be measured to assess if the project has
The UK banking sector is going through a slow but significant change process. Having required many
billions of tax payer support, including the nationalisation of two UK banks, the government
requires change. The types of change are wide reaching. One of the issues to face is that ‘banking’ is
basically two businesses:
• Transaction processing and retail banking, which is like a public utility
• High end ‘investment banking’, which involves trading on the money markets etc
This was seen to be problematic, given investment banking is inherently riskier (sometimes referred
to as ‘casino’ banking), but it was using as resources money that people had deposited.
Furthermore, there have been scandals: the ‘fixing’ of the LIBOR rate and the selling of
inappropriate payment protection insurance.
• Some changes are structural, for example the separate demarcation between retail and
investment; the government does not wish to pay for the failings of investment banks. This
affects how banks are organised, and what different businesses do.
360 | P a g e
• Some changes will need to be organisational cultural, and Parliamentary Commission was
concerned by a lack of accountability. Key recommendations are:
– A new Senior Persons Regime, replacing the Approved Persons Regime, to ensure that the
most important responsibilities within banks are assigned to specific, senior individuals so
they can be held fully accountable for their decisions and the standards of their banks in
these areas;
– A new licensing regime underpinned by Banking Standards Rules to ensure those who can do
serious harm are subject to the full range of enforcement powers;
– A new criminal offence for Senior Persons of reckless misconduct in the management of a
bank, carrying a custodial sentence;
– A new remuneration code better to align risks taken and rewards received in remuneration,
with much more remuneration to be deferred and for much longer;
– A new power for the regulator to cancel all outstanding deferred remuneration, along with
unvested pension rights and loss of office or change of control payments, for senior bank
employees in the event of their banks needing taxpayer support, creating a major new
incentive on bankers to avoid such risks.
Remuneration, for example, many bankers were paid bonuses based on their trading performance,
the success of which was likely to take years to unwind. The view was that incentives were
misaligned and that whilst successful risk-taking was rewarded, unsuccessful risk-taking was also
rewarded.
• Changes might be industry wide.
It could affect bank training: the Chartered Banker Institute has worked with retail banks to set
up a professional standards board, and to promote the qualification to help build up a sense of
professional standards
Some have even mooted that more women need to be employed on bank trading floors:
testosterone encourages risk-taking, apparently.
Barclays specifically identified organisational and cultural issues in a report it commissioned. The
Salz Review said the bank needed a "transformational change". Main findings were:
• The bank had become too focused on profit and bonuses rather than the interests of customers.
• Rapid expansion in the years leading up to the financial crisis produced "cultural challenges" at
the bank.
The bank became complex to manage, tending to develop silos with different values and
cultures, but increasingly dominated by the investment banking business (an "over-emphasis"
on short-term financial performance, reinforced by a bonus and pay culture that rewarded
money-making over serving the interests of customers and clients).
• Analyse the culture of an organisation using Balogun and Hope Hailey’s contextual features.
(H5b)
This was a revolution since the change was major (combining the banks into one) and sudden
(happening within one year). Banking is traditionally slow to change so combining three banks
together in such a short space of time was undoubtedly a revolution, and in the end a successful
one.
Solution 18.2
Solution 18.3
Time – Wal-Mart might have decided to change things gradually, as there was no crisis at Asda,
profits levels were acceptable.
362 | P a g e
Scope – Many of the changes may have taken place at higher levels, such as the way that managers
reported. This would affect relatively few people.
Preservation - Many of the day-to-day tasks such as working on the checkouts or putting out
inventory may have been unaffected.
Diversity – For the reasons given above, most people were probably little affected initially.
Capability – Wal-Mart have made a string of acquisitions around the world in the past twenty years
so they the knowledge of how to implement change.
Capacity – Wal-Mart are the largest retailer in the world, they could afford to spend resources
changing Asda.
Readiness – The staff were probably briefed on why changes were necessary.
Power – If the low-skilled employees at Asda had objected to any changes, it would have been
relatively simple to replace them.
19
Project management
Context
In order to achieve success an organisation is likely to undertake a project, or series of projects. This
chapter looks at project management, the people involved, the software used and the detailed
stages of most projects.
Once the project is completed the project needs to be reviewed to see what went well or badly and
the benefits that have been realised.
Video introduction
1. Can you list some questions that are likely to be asked during project definition?
2. What are observable, measurable, quantifiable and financial benefits?
3. Do you know what ‘slippage’ is?
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.
Project management is the integration of all aspects of a project, ensuring that the proper knowledge
and resources are available when and where needed, and above all to ensure that the expected
outcome is produced in a timely, cost-effective manner.
The primary function of the project manager is to manage the trade-offs between performance,
timeliness and cost.
Teambuilding The work is carried out by a team of people often from varied work and social backgrounds. The
364 | P a g e
Expected Expected problems should be avoided by careful design and planning prior to commencement o
problems
Unexpected There should be mechanisms within the project to enable these problems to be resolved quickl
problems projects are addressing novel and unique challenges.
Delayed benefit There is normally no benefit until the work is finished. The 'lead in' time to this can cause a stra
who is also faced with increasing expenditure for no immediate benefit.
Potential for Projects often involve several parties with different interests. This may lead to conflict.
conflict
Project drift The project objectives keep changing, often requiring expensive rework, and ending up with so
designed and not fit for purpose.
Observable benefits
Observable benefits are those that cannot be objectively measured and their assessment depends
on the views of appropriately experienced observers. These benefits relate mainly to matters such
as customer satisfaction and staff morale. They are of relatively little use in initial project
justification because they are so difficult to communicate with any accuracy, but undoubtedly they
can be recognised after projects have been completed. Almost inevitably, efforts are made to try to
measure these 'soft' benefits because then they become easier to deal with and less reliance needs
to be invested in the opinions of the observing experts.
367 | P a g e
It is important to realise that many observable effects are also likely to be unexpected effects. The
very fact that they are unexpected means that no attempt will have been made to measure them;
after the project has been completed they become obvious. This does not mean that effects that are
merely observable or unexpected are unimportant. Some of the most significant benefits and costs
are those that surprise everyone dealing with the project. An example can be seen in a new intranet
and group working software being implemented in a firm of accountants. The expected benefit
might be faster communication, but an unexpected benefit might be the ability to shift routine work
to less expensive staff situated in cheaper areas of the country.
Measurable benefits
This term has a very precise meaning: the benefit can be measured objectively, but it is not possible
to predict how a project will change it. By definition, these benefits are not going to be very useful
when constructing a business case for a project. However, retrospectively, it will be extremely
interesting to see how various measures have moved and these effects will be important in post-
project and post-implementation reviews.
Quantifiable benefits
Here, the extent of the benefits or improvements can be forecast, but may not be in terms of
financial savings. For example, it can be predicted that a change in the production process will lead
to a 10% reduction in electricity usage. But unless the price of electricity can also be predicted it will
be unclear what the financial benefit will be.
Financial benefits
Once changes have been quantified, it should be a reasonably easy step to convert those to financial
effects. It is important that this is done – at least for profit-seeking organisations – and that the
calculations are not distorted to ensure that a project is justified. Typically, net present value or
return on capital calculations will be used to evaluate the financial effects. Sensitivity analysis will be
an essential part of the exercise to identify risk areas and plan for more investigative work to be
done there.
Formulate a cost–benefit analysis of a student trying to decide whether or not to study for ACCA.
Professional skills marks are available for demonstrating analysis skills.
Where are accountants traditionally involved in the phases of a project lifecycle and what do they
have to offer in the other phases?
369 | P a g e
19.3.1 Introduction
This is the person with authority to manage a project. He/she is responsible for the day-to-day
running of the project. Responsibilities usually include managing the budget and work plan,
planning, performance and all project management procedures.
19.3.2 Responsibilities
The project manager is responsible for:
• Ensuring that sufficient resources are available;
• Efficient use of those resources;
• Providing information on the progress of the project;
• Ensuring the project will meet customer needs;
• Helping team members to integrate;
• Supporting team members;
• Leading and inspiring team members;
• Negotiating for resources.
19.3.3 Qualities
Project managers are of key importance to successful projects. The qualities they need are:
Good communicator
The ability to communicate with people at all levels is almost always named as the second most
important skill by project managers and team members. Project leadership calls for clear
communication about goals, responsibility, performance, expectations and feedback.
There is a great deal of value placed on openness and directness. The project leader is also the
team's link to the larger organisation. The leader must have the ability to effectively negotiate and
use persuasion when necessary to ensure the success of the team and project. Through effective
communication, project leaders support individual and team achievements by creating explicit
guidelines for accomplishing results and for the career advancement of team members.
370 | P a g e
Integrity
One of the most important things a project leader must remember is that his or her actions, and not
words, set the method of working for the team. Good leadership demands commitment to, and
demonstration of, ethical practices. Creating standards for ethical behaviour for oneself and living
by these standards, as well as rewarding those who exemplify these practices, are responsibilities of
project managers. In other words, the leader 'walks the talk' and in the process earns trust.
Enthusiasm
Plain and simple, nobody likes managers who are negative – they bring us down. We want leaders
with enthusiasm. We tend to follow people with a can-do attitude, not those who give us 200
reasons why something cannot be done. Enthusiastic leaders are committed to their goals and
express this commitment through optimism.
Empathy
Showing empathy means that 'a project leader acknowledges that we all have a life outside of
work'.
Competence
Leadership competence does not necessarily refer to the project leader's technical abilities in the
core technology of the business. As project management continues to be recognised as a field in,
and of itself, project leaders will be chosen based on their ability to successfully lead others rather
than on technical expertise, as in the past. The ability to challenge, inspire, enable, model and
encourage must be demonstrated if leaders are to be seen as capable and competent.
Teambuilding skills
A team builder can best be defined as a strong person who provides the substance that holds the
team together in common purpose toward the right objective. In order for a team to progress from
a group of strangers to a single cohesive unit, the leader must understand the process and dynamics
required for this transformation. He or she must also know the appropriate leadership style to use
371 | P a g e
during each stage of team development. The leader must also have an understanding of the
different team players styles and how to capitalise on each at the proper time, for the problem at
hand.
Problem-solving skills
Although an effective leader is said to share problem-solving responsibilities with the team, it is
expected of a project leader to have excellent problem-solving skills themselves.
• Time. Time can be controlled and monitored using network diagrams and Gantt charts. These
break down projects into small sections called activities. Each activity is given a target duration,
a start time and a finish time, and is assigned to the person, people, or sub-contractor who is
responsible. Critical path analysis identifies the activities which are critical to finishing the
project on time.
• Quality. Quality measures should be established at the start of the project, eg response time in
an IT system.
Note that concentrating on any one of these factors puts the others at risk. So, for example, if there
is great cost pressure, the project might take longer, the quality could be poor and features could be
dropped.
At some point there will be conflict between the constraints and the manager will need to decide
how to resolve the issues.
19.6 Completion
Post-project review
This examines how the project went in terms of how the project team and how the project manager
performed and identifying what aspects of planning and review went well and what didn't go so
well. Was the project completed within time and budget? Did communications break down at any
stage? Why did slippage occur? Had we the right project team members? What would we do
different next time? The focus here is on the project.
The purpose of a post-project review is four-fold:
1. To support continuous improvement, it is oriented towards the future.
2. To allow for the identification and implementation of corrective actions on the project under
review or in similar projects.
3. To allow for the review of current procedures and the design of better ones to improve future
decisions, to guarantee better implementation and better conformance.
4. To preserve what went well.
Lessons learnt are fed back into the project management system. For example, if the project
estimation was poor, then better methods of estimation might be integrated into the project
management process to help ensure that future estimates are more accurate.
Post-implementation review
This examines what the project achieved (its product or outcome) and should compare the post-
implementation observations and measurements with the hoped-for benefits that were the basis of
the original business case.
The review can comprise:
• Purpose of the project as set out in the project initiation document.
• Benefits envisaged in project initiation document.
• Accomplishment of project objectives.
• Project facilities.
• Scope of work with reasons.
• Benefits achieved.
• Time overrun with reasons.
374 | P a g e
• Completion cost and cost overrun statement with reasons for variations.
• Problems encountered.
• Conclusion.
As part of this review, it will be important to gather information from key stakeholders.
The initial focus here is on the product or outcome produced by the project. Does it meet its
objectives? If not, then any problem will need to be fixed.
Costs include:
• tuition fees
• exam entry fees
• costs of living (if the student is studying overseas)
Benefits include:
• Increased prestige since the student is a professional (Observable)
• Increased salary (Measurable)
• Increased job opportunities (Quantifiable)
• It may be difficult to include any financial benefits that can be accurately predicted.
375 | P a g e
Professional skills marks are available for the quality of your analysis (ie whether it makes sense)
and whether it includes both costs and benefits.
Solution 19.2
Taking a narrow, financial view of an accountant the areas that an accountant is most likely to be
involved in are the financial sides i.e. with the project costs and preparing the business case, with
the accompanying investment appraisal.
However, there are good arguments for accountants being involved throughout:
• Initial screening - to get an idea of the likely financial impact and to be involved as a leader
• Risk assessment – studying this paper will help you a lot!
• Identification and classification of benefits and costs – these will not all be financial and there
will be a lot of uncertainties, but accountants can have a useful impact here
• Preparing the project plan – accountants can tie together the financial and non-financial aspects
20
Technology and data analytics
Context
In this chapter we consider how business organisations use information systems and information
technology to help them achieve their objectives. Almost all organisations rely on information
systems and information technology to perform day-to-day operations.
Developments in information technology, and particularly the internet and associated technologies,
provide many opportunities for business. However, developments in information technology also
present risks for business organisations.
The Strategic Business Leader study guide requires you to understand both the opportunities and
the risks associated with e-business, e-commerce, cloud computing, mobile technology and big
data. We cover all of these areas in this chapter.
376 | P a g e
Video introduction
20.1 E-business
Definition
E-business is the transformation of key business processes through the use of internet technologies.
(Lou Gerstner, former CEO of IBM).
The Strategic Business Leader study guide refers specifically to ‘market models for delivering e-
business’. The names of these models focus on the parties involved in a transaction. You may see
these models referred to as e-business models or as e-commerce models.
Business-to-Consumer (B2C)
When thinking about e-commerce most people think of a business selling to a consumer. This is the
Business-to-Consumer (B2C) model. The most widely known B2C e-commerce business is Amazon.
Business-to-Business (B2B)
Business-to-business (B2B) e-commerce involves a business selling directly to another business. The
transaction may be conducted on the company’s website or could be carried out using Electronic
Data Interchange (EDI).
Consumer-to-Business (C2B)
The consumer-to-business (C2B) model involves a consumer selling products and / or services to a
business. For example there are a number of websites that enable individuals to offer their services
to businesses, such as upwork.com and freelancer.com.
Consumer-to-Consumer (C2C)
Under the consumer-to-consumer (C2C) model a third-party website facilitates the transaction
between two consumers. Auction sites such as eBay provide this facility.
Government-to-Business (G2B)
Under G2B e-business the government transacts with business organisations. Examples include
government auctions and tenders.
Government-to-Citizen (G2C)
Under the G2C model the government interacts directly with individuals (citizens). An example
would be an online service for registering births.
Multiple models
Some organisations use more than one market model. For example, a business may sell direct to
customers using the B2C model and also sell to other retailers using the B2B model.
Definition
The term business model is used to describe how the organisation will be organised and operate to
generate revenue and profit.
A number of different business models have developed based around effective use of e-business.
The academic and management writer Michael Rappa identified a number of web-focused business
models, which we discuss below.
Brokerage
Brokers bring buyers and sellers together and facilitate transactions. A broker usually charges a fee
or commission for each transaction facilitated. Examples of brokers include eBay (an ‘auction
broker’) and PayPal (a ‘transaction broker’).
Advertising
The web advertising model is an extension of the traditional media broadcast model. The website
provides content and/or a platform for others to post content. Advertising, paid for by those placing
the adverts, appears when users access the site. Increasingly, adverts are able to be targeted at
those most likely to be receptive, based on previous online behavior. Examples of the advertising
model include guardian.com and dailymail.co.uk. Google is another example, offering placement on
search results pages. Google is also able to deliver relevant ads, paid for by a third party, when a
user visits a web page.
Infomediary
Data about consumers and their consumption habits are valuable, especially when the data is
analysed and able to be used to target marketing campaigns. An infomediary helps buyers and/or
sellers to understand a market. For example, the supermarket giant Tesco gathers vast quantities of
data from their sales system and shopper loyalty cards. Tesco then acts as an infomediary by selling
this information (excluding personal details) to others.
Merchant
Online merchants are wholesalers and retailers of goods and services. Sales may be made based on
list prices or through auction. Amazon and eBay are examples of merchants that operates solely
over the web. A Bit Vendor is a merchant that deals in digital products and services and conducts
both sales and distribution over the web, for example Apple iTunes Music Store.
379 | P a g e
Affiliate
Under the affiliate model, financial incentives are offered to provide a link on a website (or social
media post) for others to click-through to the merchant site. This is a pay-for-performance model - if
an affiliate does not generate sales it represents no cost to the merchant. Variations include pay-
per-click and revenue sharing programmes. The affiliate model has proven popular in areas such as
the online gambling industry.
Community
The viability of the community model is based on user loyalty. To be effective, users must have a
high investment in both time and emotion. Revenue can be based on the sale of ancillary products
and services or voluntary contributions. The internet is inherently suited to community business
models, as seen in the rise of social networking and open source collaboration. Wikipedia is an
example of the community model. Generating revenue is often the biggest challenge under the
community model.
Subscription
Users are charged a subscription fee for a period of time (eg hourly, daily, monthly or annual) for
access to a service. Many sites combine free content with 'premium' content that requires payment
to access. Subscription fees are incurred irrespective of actual usage rates. Subscription and
advertising models are frequently combined. The Times newspaper follow a subscription model.
Drop shipping
A business model not included in Rappa’s list is drop shipping. Drop shipping involves an
organisation transferring customer orders to another company who fulfills the orders by shipping
the items directly to the customer. Therefore, the drop shipper does not need to hold inventory.
Amazon provides this service for small companies that might struggle to attract customers via their
own website.
A risk of drop shipping is that it is a relatively easy model to replicate, which can result in a crowded
market and low margins. Customers may also decide to go direct to the ‘real’ supplier.
380 | P a g e
Proxy servers act as an intermediary between the outside world and the organisation’s own e-
business infrastructure. A proxy server improves response times by storing the results of user
requests and enabling these results to be reused.
Routers connect different networks together and enable computers within a network to connect to
the internet.
Wireless access points (WAPs) may be incorporated within a router to enable devices to connect to
a network wirelessly.
Firewalls aim to prevent unauthorised activity across an organisation’s e-business infrastructure. A
firewall may comprise a hardware device or a software program, or a combination of both. A
firewall provides a barrier between the organisation’s internal IT infrastructure and the internet.
Encryption devices encode and translate information to and from non-readable forms to prevent
unauthorised disclosure. Encryption hardware devices are used together with associated software.
E-business may impact the activities shown in the value chain in a wide variety of ways.
Inbound logistics
• Automated receipt of goods, for example bar code scanning of goods inwards
• The use of IT in Material Resource Planning
• Just In Time inventory management
Operations
• The use of IT in production lines
• The use of IT Computer Aided Manufacturing (CAM), Computer Integrated Manufacturing (CIM)
and Enterprise Resource Planning (ERM) systems
• Robotics
Outbound logistics
• Computerised production of documentation
• Track-and trace systems
• The use of ‘sat-nav’ in delivery
• The use of Radio-frequency identification (RFID) tags
Firm infrastructure
• The use of IT systems to create and reinforce organisational culture
• Computerised office automation systems
• Accounting system
• Corporate infrastructure
Human resources
• Computerised human resource management (HRM) systems
• The use of e-learning for staff training
Technology development
• The use of technology to obtain a competitive advantage, for example through development of
new production techniques or the development of new products or services
• Computer aided design (CAD)
Procurement
• ‘Procurement’ involves purchasing and related activities such as supplier selection
• E-procurement is a term used to describe the use of information technology in the procurement
process
• E-business includes automated re-ordering systems
• Integrated supply chains utilise Electronic Data Interchange (EDI)
• E-business includes the use of automated reordering which facilitates Just In Time inventory
• The internet and websites has increased transparency in pricing, as has social media which
enables customers to easily ‘compare notes’
• Price comparison websites provide direct comparison of prices
Explain how good relationships with suppliers and an efficient procurement and purchasing process
enables a just-in-time approach to inventory management (which involves holding no inventory or
minimal inventory).
20.3 E-marketing
Information technology including the internet and websites may be utilised in each of the seven
marketing areas or ‘the seven Ps’.
Product
• The product itself may be digital and delivered over the internet, for example e-books
• Product awareness may spread online
• New product opportunities may arise, for example through the use of new technology
Price
• The use of technology may bring efficiencies that facilitate lower prices
• Price awareness is likely to increase
Promotion
• Advertising and marketing is able to be better targeted based on the use of data
• Electronic promotional tools may be used, for example email, text messages and social media
posts
385 | P a g e
• Brand loyalty may reduce as IT makes switching between suppliers easier (for example simply
access a different website)
Place
• Sales may be made online through e-commerce enabled websites
• Customers may access websites anytime, anywhere
People
• Are more accessible, for example through social media and online chat
• Are better informed
Process
• Systems and processes are able to utilise IT to improve efficiency
• Customer Relationship Management (CRM) systems may be used to manage customer
communication
Physical evidence
• May reduce for some products, eg digital downloads
• May be replicated online, for example through downloadable documents
• Many businesses are becoming independent of location, which means where the business is
located is becoming less important.
• It does not matter where the server a website is hosted on is located.
Industry structure
Industry structures are being disrupted, for example travel agents, taxi services.
Definition
The American Marketing Association defines a brand as a name, term, design, symbol, or any other
feature that identifies one seller's good(s) or service(s) as distinct from those of other seller.
A brand may identify one item, a family of items or all items of a particular business or seller.
The brand names 'Apple' and 'Dell' are both relevant to computers. However, each brand is
perceived differently by consumers.
A brand may enjoy strong brand awareness but to have real value the brand must result in some
customers giving preference to that brand, known as brand loyalty. For example, mobile phone
networks tend to have strong brand awareness but many customers will simply choose the provider
who offers what the customer perceives to be the best deal.
• Ensuring the style and branding of the website is consistent with offline branding
How additional selling and distribution channels may impact the brand
• Third-party sellers may continue to sell obsolete or outdated products, potentially damaging the
brand
• Customer reviews and ratings on third-party sites could potentially impact the brand
Brand loyalty
• Brand loyalty may reduce for some products and services, as switching between suppliers online
is usually easier than doing so offline
• Brand loyalty may be reinforced through effective e-marketing
Online advertising
• Banner adverts and other ads placed on websites to attract new customers
• Google Ads
• Ads placed on social media sites such as Facebook, Twitter and LinkedIn
Site registration
• Encouraging users to provide their name and contact details as a registered user of a site, and to
‘opt-in’ to receiving marketing communications
• This information may then be used in subsequent marketing campaigns, for example through
targeted emails and / or text messages
Social media
• Interacting with potential customers
• Attracting the attention of potential customers
• Responding to queries from potential customers
• Joining and interacting with social media groups likely to contain potential new customers
Viral marketing
Posting content that is one or more of creative, amusing, controversial, inspirational, entertaining
and engaging that users feel compelled to share, resulting in the rapid spread of content and raised
awareness
Personalisation
Using ‘cookies’ and other technology to recognise website visitors who are not existing customers
and customising marketing offerings to suit
Big data
• Using big data to establish products and services potential customers value
• Using big data to establish the effectiveness of different marketing techniques
Social media
• Interacting with existing customers providing customer service and support
• Providing product and service information
Personalisation
Using ‘cookies’ and other technology to recognise existing customers visiting the company website
and customising communication to suit
Loyalty schemes
Points and other rewards may be offered based on the volume and / or value of purchases made by
a customer
Satisfaction surveys
Customer satisfaction surveys may be provided to customers via an online link, email or text
message.
Big data
Registration, loyalty schemes, purchase history and other data may be pooled (as ‘Big data’) and
then searched or mined for insights and trends relevant to customer satisfaction and retention.
20.3.5 E-procurement
Procurement is concerned with finding and selecting suppliers, agreeing terms and acquiring goods
and services. E-procurement involves the use of web-based technology in the procurement process.
An e-procurement system aims to streamline all aspects of the purchasing process while applying
controls over spending, supplier selection and product preferences.
Online supplier • Suppliers register their details online, partially or fully setting up their supplier account
registration
Online supplier • eProcurement systems may include the facility for potential suppliers to submit details, b
selection systems
Online credit checks • Credit checks are able to be completed online through a credit check agency
Online supplier • Most organisations now make automated payments, for example through BACS or Faster
payments
Automated ordering • The reorder process may be automated with an order with a specified supplier placed wh
order level
Integrated IT systems • Relationships with key suppliers are becoming closer and deeper, with IT systems increas
communicate directly with each other, blurring the lines between the systems of differen
Electronic data • Electronic data interchange or EDI is a type of B2B e-commerce that involves the use of v
interchange (EDI) technologies to allow two or more organisations to co-ordinate and automate activities
• Paid for placings in searches carried out on search engines such as Google
General controls
General controls relate to the overall control environment, for example access to the organisation’s
network, how software is selected and how systems are developed.
General controls include:
• Controls over access to systems, programmes and data
392 | P a g e
Application controls
Application controls relate to individual systems and applications rather than to the general IT
environment. For example, a company would restrict the ability to revise its chart of accounts in the
general ledger.
Application controls may be categorised as:
• Input controls are intended to ensure that only valid transactions are accepted into a system.
Examples of input controls include control totals and existence checks, for example checking
that an account code exists. Examining source documents to check for appropriate
authorisation may also be considered to be an input control, whereas requiring an additional
user to authorise a transaction or transactions already input would be considered a processing
control.
• Processing controls aim to ensure that only valid transactions are processed and that they are
processed as intended.
• Storage controls are concerned with whether data is stored appropriately and correctly, for
example complying with data protection legislation and maintaining confidentiality of credit
card data
• Output controls check the results of processing are accurate, for example whether a trial
balance report balances.
• The audit trail is a control that enables transactions and system activity to be traced to its origin.
Types of application checks and controls include:
• Completeness checks to ensure all items have been processed from initiation to completion
• Validity checks to ensure only valid data is input or processed
• Identification controls ensure all users are uniquely and irrefutably identified
• Authentication controls provide an authentication mechanism, for example the entering of a
unique code, in the application
393 | P a g e
• Authorisation controls that ensure an appropriate level of authorisation, for example requiring
two senior managers to provide authorisation for a payment above a certain level.
• Input controls that ensure data entering the system is correct and valid.
• Forensic controls that examines data and reports against specified criteria based on
relationships between inputs and outputs.
protected against by a password that combines two unrelated words and includes a combination of
upper- and lower-case letters, numbers and symbols.
Require employees to change passwords regularly.
Extend security beyond the office including to ‘the cloud’
In most organisations, some employees often work from home or on the road using their own
laptops, phones and tablets. It is difficult to extend the same level of security applied to office
computers to these devices, but risk may be reduced. All devices should be required to have the
minimum of anti-virus software, password protection and a firewall. To protect against
unauthorised access to information if a device is mislaid or stolen, it should be possible to delete all
the information (“wipe” it) even when not in possession of the device.
If a business uses cloud computing, where software is provided and documents are stored online,
the organisation must ensure the cloud computing provider takes security measures at least equal
to those of the organisation’s own measures. Also remember that if the provider and / or the cloud
server is based in another country, legal requirements may be different.
Don’t neglect access points (Wi-Fi, portable storage devices)
Removable storage devices pose security risks in two ways. They can introduce malware into your
network and they can be mislaid when containing sensitive information.
Clear policies and procedures are required governing the use of portable storage devices.
Firewalls and other security measures should be configured to ensure Wi-Fi access to company
network is controlled and visitors who may be granted access to the internet via the organisation’s
link are excluded from all internal systems.
Plan for the worst
No system is 100% secure. Plans should be made to limit the impact of any security breach or
system failure.
Plan future steps, for example whether a specialist IT company should be called in.
Consider whether key customers and / or suppliers need to be contacted to explain that there is a
problem. Identify functions able to be continued using other computers, or pen and paper, while
systems are repaired.
Ensure it is clear who is responsible for doing what in an emergency.
The disaster recovery plan should be laid out in a document and delivered in training sessions. It
may incorporate elements of plans for other disasters, such as a fire on your premises. Some
disasters may only require specific sections of the plan to be implemented.
Educate employees
Ensure everyone in the business is aware that security matters and is aware of their responsibilities.
Training sessions, perhaps delivered using e-learning, and written policy documents should ensure
all employees are aware of their responsibilities and encourage adherence to practices such as
regular password changes.
Required responses to common risks, for example not accessing a web link or attachment in an
email from an unfamiliar source, should be reinforced regularly.
395 | P a g e
Non-technical risks include hackers trying to trick employees into revealing details that make the
company’s network vulnerable. For example, a hacker might ask an employee to reveals their user
name and password for a bogus reason.
Keep records and test your security
Security is an ongoing process, not a one-off fix. Therefore, it is important to keep clear records that
provide a clear picture of the control and security measures in place.
Good record keeping will also facilitate regular tests of security and control measures. For example,
it is important to ensure that back-ups are completing as intended and are able to be restored from.
Remember that controls are intended to protect the organisation and help it achieve its objectives.
Therefore, controls and security should be realistic and sensible given the risks they protect against.
No activity is without some risk. Employees, and the organisation as a whole, must be able to
conduct business efficiently. Introducing controls that prevent the business from benefitting from
some aspects of e-business may be counter-productive.
Definition
Cloud computing is a method for delivering information technology services using resources held on
the Internet and accessed through web-based tools and applications.
Traditionally, a business would own and operate their own hardware and software. Cloud
technology enables a business to access data and programs outside of their own computing
environment, stored in 'the cloud' and accessed using the internet.
Essentially, the business rents capacity (server space or access to software) from a cloud service
provider, and connects over the internet. The cloud service provider charges the business a fee,
usually based on usage.
Cloud computing may bring a number of benefits to a business.
Reduced IT costs
The business does not need to purchase expensive server computers and software.
Costs may also be easier to estimate and budget for, as the cost of system upgrades may be
included in the contract with the cloud service provider.
IT staff costs and energy consumption costs may also be reduced.
Reduced administration
396 | P a g e
Time spent on system administration and configuration is likely to reduce, freeing up time to pursue
business objectives.
Flexibility and scalability
Using a cloud service provider enables a business to use the resources they require without the
need to commit significant funds in advance.
Automatic updates
Many cloud computing service providers automatically update software to the latest version and
upgrade servers to provide sufficient processing power.
Business continuity
Protecting data and systems is an important part of business continuity planning. Having data stored
in the cloud provides a back-up in a secure and safe location minimising the risk of data loss and
‘downtime’ due to inaccessible data.
Cloud computing also brings risks.
Loss of some control Information systems and the data they hold and generate are a possible source of compet
over a key resource management in some organisations may not be comfortable handing control of such an im
party.
Reliance on an internet Accessing cloud systems requires access to an internet connection. This is not a major issu
connection internet access is available almost always, but it is a risk that should be considered.
Possible legal and Cloud computing service providers and their servers are often located in a different countr
regulatory issues committing to a provider, the business should investigate where their data will be held and
laws will apply.
Security and data The business must consider how their data will be stored and secured when outsourcing to
protection outlined in the agreement with the cloud service provider in a way that satisfies the organ
security requirements.
Definition
The business writer Alan Coates defines mobile technology as devices that are both transportable and
offer instantaneous access to information.
Today, the term mobile technology is used mainly to describe hand-held devices that are able to
connect to the internet, for example smartphones, tablets and e-book readers.
397 | P a g e
Customer engagement
Mobile technology has enabled businesses to maintain closer relationships with customers.
Customers may be reached through additional channels including social media platforms such as
Facebook and Twitter, and messaging applications such as WhatsApp. Customers are able to
purchase and pay for items direct from their smartphone.
The travel agent Thomas Cook has used VR headsets to enable customers to ‘visit’ different
potential holiday destinations.
Ikea, the furniture and homeware retailer, has plans to use VR to enable customers to try out
different furniture layouts.
Mobile and cloud solutions save time, enabling people to work during what would in the past have
been non-productive time. Efficient workflows, with online storage replacing paper, provide
additional time and cost savings. Many small businesses use cloud-based accounting software
which, for example, enables employee expense claims to be submitted using a smartphone.
Always informed
Mobile-devices and software enable management to remain in touch with their business and
business information wherever and whenever they require. Many senior managers are able to
access a dashboard of key performance indicators (KPIs) whether they are at their desk, in the
warehouse, at home or out for dinner.
Definition
Big data consists of extremely large collections of data (data sets) that may be analysed to reveal
patterns, trends, and associations, especially relating to human behaviour and interaction.
Volume
The huge volume of data generated is a key feature of big data. The volume far exceeds that able to
be handled by a single personal computer or conventional database system.
The reason big data is so big is that it includes all data collected and businesses generate and collect
a vast quantity of data.
For example, a supermarket collects data from loyalty cards swiped at checkouts, details of all
purchases made including when, where, how payment was made, coupons used, details of online
orders, social media account activity and so on.
Variety
Variety refers to the diversity of data including structured and unstructured data.
Structured data is stored in traditional computer file format within defined fields, records and files.
For example, a general ledger transaction record would include fields for the account number, the
date, the amount and a narrative field for a short explanation. Structured data is easily accessible by
well-established database structured query languages.
Unstructured data is data that does not have a pre-defined data-model. It comes in all shapes and
sizes and it is this variety and irregularity which makes it difficult to analyse. Examples of
unstructured data include photographs and videos posted to social media platforms.
Velocity
Velocity refers to the speed at which data sets are growing as data is collected and processed by the
organisation. Velocity is therefore concerned with how quickly the volume of big data grows.
Velocity also refers to the need for data to be processed and analysed quickly to provide
information and insight in time to be used in decision making. The volume and variety of big data
pose challenges to velocity. Big data analytics requires huge quantities of non-uniform data to be
400 | P a g e
analysed in real-time. This requires innovative and powerful forms of processing and analytics to
enable the identification of patterns and other insights.
Big data
Adapted from the Financial Times 26 June 2013
The availability of information, whether obtained from transaction data, social networking and so
on, is potentially transforming how businesses generate information for forecasting purposes. New
techniques, including analysis of ‘big data’ can help businesses “improve business efficiency, spot
trends and opportunities, provide customers with more relevant products and, increasingly, predict
how people, or machines, will behave in the future”.
Data warehousing was the collection of data relevant to immediate business problems. Big data
does more, and covers data from social media, Twitter, CCTV, payment terminals etc. Analytics
exploits the storage power of technology to process data at high speed and detect patterns in it.
Firms at the cutting edge are aiming to integrate internally generated data with externally
generated data (eg Facebook). Not all of this external data is particularly well structured.
The benefits are that businesses can find out in real time what customers are doing, and use analytic
software to replace guesswork and predict more accurately what will happen.
Companies are using this to predict future trends to ‘anticipate changes in demand before they
actually occur’. Having that foreknowledge, provided by ‘predictive analytics’ can mean better
business decisions.
The potential drawback is that data is so complex it can only be recognised by data scientists. Users
and decision-makers need tools that are easy to handle.
Definition
Data analytics involves examining data to find patterns and draw conclusions through analysis and the
application of a process to derive insights.
Big data analytics enables insights to be identified within big data that helps organisations to make
better business decisions.
Data analytics is a scientific process that includes inference. The analyst may use information and
insight obtained from an analysis of big data to derive conclusions.
401 | P a g e
Big data analytics provide the ability to process very large amounts of information. The bigger the
data, the more potential insights it can give in terms of identifying trends and patterns, and in terms
of getting a deeper understanding of customer requirements.
Techniques used in big data analytics include:
• Data mining, which involves analysing data to identify patterns and establish relationships such
as associations (where several events are connected), sequences (where one event leads to
another) and correlations.
• Predictive analytics is a specific type of data mining which aims to predict future events. For
example, the chance of someone being persuaded to purchase a specific item.
• Text analytics involves the scanning of text in documents and emails to identify and extract
useful information, for example looking for key-words that indicate interest in a product.
• Voice analytics is similar to text analytics, but conducted on audio files.
• Statistical analytics uses statistical and mathematical techniques to identify trends, correlations,
patterns and changes in behaviour.
If a decision is taken to implement a new strategy or to implement a new business model speed of
implementation is likely to be important. Cloud solutions make it easier to launch an online store, a
big data platform, or an analytics solution quickly and efficiently.
Better-informed decisions
The decisions people make at their organisations each day can be improved with data. Therefore, it
is important to cultivate a culture that values data and to capitalise on the opportunities big data
and data analytics present.
20.7.5 Using big data and data analytics for decision making
Pricing
Suggestions for data
• Sales levels at different price points
• Changes in sales volumes and revenue at different price points
Aims of data analysis
• Identify behaviour between different types of buyers
• Identify the price most likely to maximise profit
• Identify the overall relationship between demand and price
Marketing
Suggestions for data
403 | P a g e
• Customer data including behavioral, attitudinal and transactional metrics from marketing
campaigns, points of sale, websites, customer surveys, social media, online communities and
loyalty programs.
• Operational data including metrics that measure the quality of marketing processes.
• Financial data from the organisation’s financial systems including sales volume, sales revenue
and profit level.
Aims of data analysis
• Identify new opportunities for effective marketing activities
• Identify the advertising and marketing activities that currently ‘work best’
• Understand the consumer decision-making process
Google Trends
The use of Google Trends is one of the most common ways in which big data is utilised. Google
Trends identifies trending topics by quantifying how often a particular search-term is entered
relative to the total search-volume.
Global marketers can use Google Trends to assess the popularity of certain topics across countries,
languages or other constituencies they might be interested in, or stay informed on what topics are
cool, hip, top-of-mind or relevant to their buyers.
Marketing messages can be adapted to reflect the concerns and interests of different groups of
target customers.
If data is lost or stolen, the organisation may face legal action from individuals who have been
harmed as a consequence. If a competitor gains access to big data and associated analysis, they may
be able to utilise this information for commercial advantage.
A Just-in-time approach to inventory means holding no inventory or very low inventory. Rather than
being held in inventory, items are delivered by suppliers as they are needed. Closer relationships
with key suppliers and an efficient purchasing process (for example through EDI) reduces the time
between an order being placed and items being delivered (lead time). Faster order fulfillment
means orders do not need to be placed with suppliers so far in advance, enabling very low levels of
inventory to be held and encouraging a just-in-time approach.
Solution 20.2
The six I’s model may be applied to Amazon, as shown below. Note that other relevant examples
would be equally as valid, there is no single correct answer to a question requiring practical
application question such as this.
Individualisation: Using purchase history and browsing history to suggest future choices
405 | P a g e
Intelligence: Amending pricing based on popularity to reduce the chances of holding obsolete
inventory
Independence of location: Customers are able to purchase regardless of where they are, for
example by using the Amazon app on their mobile phone
Integration: The purchase process is quick and easy, for example ‘one-click checkout’
Interaction: Targeted email and text messages are able to be sent to customers
Industry structure: Reduced demand in traditional ‘high street’ shops as purchasing online increases
in popularity
21
Professional skills
Context
In the SBL exam, you will not only gain marks for what you know, but how you use what you know
and your interpretation and application of the information you are given. This chapter outlines the
concepts the ACCA uses to describe the skills needed.
However, remember that these are practical skills, and you need to practise using them to be able
to do them well. Therefore, this section also contains cross-references to questions in the rest of the
material where you have used these skills, and other exercises for you to try.
In the ACCA’s specimen exams, the particular professional skills being targeted are outlined, so you
can think through a checklist of the types of issues you need to consider when answering that part
of the question.
Video introduction
21.1 Communication
ACCA lists the following points in the area of communication:
• Inform concisely, objectively and unambiguously, while being sensitive to cultural differences,
using appropriate media and technology.
• Persuade using compelling and logical arguments, demonstrating the ability to counter argue
when appropriate.
• Clarify and simplify complex issues to convey relevant information in a way that adopts an
appropriate tone and is easily understood by the intended audience.
Remember that matters such as ‘intended audience’ and ‘cultural differences’ will be defined by the
case study. The examiners will expect you to take note of who you are supposed to be addressing
and respond accordingly.
Intended audience could range from colleagues at the same level as you, leaders of the company,
shareholders, auditors, the public at large.
As discussed further below, who you are talking to influences how you talk.
You will be expected to demonstrate similar understanding of cultural difference as you would in
real life. Be realistic, not prejudiced or offensive.
In terms of using appropriate media and technology, you will be expected to produce what is asked
for.
This might be slide for a power point or a formal report (or many other things between these
options). Obviously you will be answering on your answer script, but will need to demonstrate
awareness of relevant factors such as that a power point slide would contain few words in large
script. A report would have formal language and structure; an email might be more informal but still
professional.
This is all related to ‘appropriate tone’.
407 | P a g e
Definitions
Inform is to give knowledge
Persuade is to advise, even urge and induce someone to believe your point of view
Obviously this was not a financial example. This was deliberate, to try and make you think about
communication in very basic terms. When communicating with different people, think about what
you can expect them to know already or understand.
Your content could be very different if you are communicating with
• Directors (who might be privy a high level of background information on the subject)
• Shareholders (who will not be privy to the level of operational detail a director would)
408 | P a g e
Communication
Where do you or do you think that you can practice this skill more in real life?
Supermarkets tend to have cash revenue; they are unlikely to have credit customers.
You are not expected to be an expert in every type of industry, but you are expected to think
sensibly about the industry under scrutiny.
Definitions
Using judgement is demonstrating the ability to form an opinion.
Demonstrating judgement can be difficult in exams where you might have a reasonable fear that
the decision you take might be wrong. Remember however, that the marks are available for
the process, not necessarily for the conclusion, so if you make a decision and explain why you have
made it (and your conclusion is not illogical in the context of the case), you should gain commercial
acumen marks.
You are on the nominations committee of Peel plc, a listed company. You are considering two
candidates for a position as non-executive director. Peel plc has three other non-executive directors,
two of whom have experience in the relevant industry and one of whom has more industry-wide
experience. All have been employed at board level for at least 20 years.
Karen is a former employee of Peel plc who has worked in a competitor company for the past ten
years. She has the appropriate qualifications. She has never worked at board level before.
Kelvin is a qualified accountant with experience at board level in a wide range of industries,
although not in the same industry as Peel plc. Kelvin is a personal friend of the CEO of Peel plc, who
has referred him to the nominations committee as he knows that Kelvin is seeking a new challenge.
Required:
Make notes outlining factors which you would consider in choosing between the two candidates
and selecting your preferred candidate for Peel plc.
Professional skills marks are available for demonstrating commercial acumen skills in using your
judgement to evaluate the relative merits of the two candidates.
Solution
Factors relevant to the professional skills element
Here you need to illustrate commercial acumen skills, so for example, identifying that the Peel plc
board needs to bring a balance of the following factors to the board:
• Diversity
• Experience
• Independence
• Innovation
You could make notes identifying the pros and cons of each candidate in relation to the need for
these factors in board balance. This is answering the main part of the question, but demonstrating
that you are doing it in a relevant and company-specific way.
You will also obtain marks for using judgement, ie making a decision on which you feel is the most
appropriate candidate and explaining why. Here there is no single right answer, as both candidates
bring strengths and potential weaknesses. The professional marks are available for you making a
decision and justifying it. This could be Karen, as she is new to board level and may bring innovation
to a potentially stale board, and she is relatively independent from the board but brings experience
410 | P a g e
of both this company and others. Alternatively, it could be Kelvin, on the grounds he brings a
breadth of experience, and the board already has two non-executive specialists in the industry. In
addition, he has board experience, and it might be too risky to appoint someone to a listed board of
directors who has no prior board experience at any level.
The actual decision is less important than the skills you demonstrate in getting there. Failing to
make a decision at all will severely limit your professional marks here, as that is the required skill.
Note the issues of cultural sensitivity here. In the UK it would be considered offensive to suggest
that either Karen or Kelvin is more suitable on the grounds of gender.
Commercial acumen
Where do you or do you think that you can practice this skill more in real life?
21.3 Analysis
ACCA lists the following points about analysis:
• Investigate information from a wide-range of sources, using a variety of analytical techniques to
establish the reasons and causes of problems, or to identify opportunities or solutions
• Enquire of individuals or analyse appropriate data sources to obtain suitable evidence to
corroborate or dispute existing beliefs or opinions and come to appropriate conclusions.
• Consider information, evidence and findings carefully, reflecting on their implications and how
they can be used in the interests of the department and wider organisational goals.
Again, note that the range of information sources are likely to be within the case study material you
are given.
These could be narrative, for example the outcome of surveys or inquiries, a selection of recorded
conversations, a report or a news article.
They might be numeric, for example a set of accounts or a budget.
They might be pictoral/graphic, for example a chart or risk map.
You will be expected to use the information you are given widely in your analysis unless something
is clearly irrelevant. Determining if something is clearly irrelevant is part of analysis, and you might
need to demonstrate that you have concluded it is not relevant to your analysis.
Your analysis might include:
• Thinking
• Comparing
• Prioritising, that is, which are the most relevant sources of information/what is not relevant
• Calculative, for example, working out ratios on a set of figures
411 | P a g e
Definitions
Investigate is enquiring systematically.
You are a member of the audit committee of Stem plc, and you have just received the following
financial information from the finance controller, with the comment that the results are
disappointing. You are aware that it has been a very challenging year due to the emergence of a
competitor and the general increase in raw material prices, which is expected to reverse in the
coming year and that there has therefore been a focus on cash management at board level.
Extract
£m
Revenue 4,304
Purchases 3,588
Closing stock 60
(Loss)/Profit (398)
Required:
Discuss whether you agree with the finance controller’s conclusion.
Professional skills marks are available for demonstrating analysis skills used in reviewing the
information presented.
Solution
Factors relevant to the professional skills element
Here you are being asked to use all the information you have been given to agree or disagree with
the finance director’s conclusion.
You need to do the following:
1. Identify the finance controller’s conclusion, which is that ‘the results are disappointing’.
412 | P a g e
Analysis
Where do you or do you think that you can practice this skill more in real life?
21.4 Scepticism
ACCA lists the following considerations:
• Probe deeply into the underlying reasons for issues and problems, beyond what is immediately
apparent from the usual sources and opinions available.
413 | P a g e
• Question facts, opinions and assertions, by seeking justifications and obtaining sufficient
evidence for their support and acceptance.
• Challenge information presented or decisions made, where this is clearly justified, in a
professional courteous manner, in the wider professional, ethical, organisational or public
interest.
Definition
Scepticism is about showing doubt and questioning facts presented to you.
Learn not to assume that a CEO’s opinion is correct just because he or she is the CEO!
Scepticism is about thinking about whether there is other evidence. You might need to consider
whether there would be likely to be information that the case has not presented you with that you
could recommend referring to.
You might be presented with a series of directors’ views on a subject and be expected to notice that
the views of one board member are not given.
There is a phrase used in colloquial English, ‘the elephant in the room’. This is a reference to an
obvious point that no one is making, or an unpopular view that no one wants to voice. Applying
scepticism in the exam situation, you might have to point out that there is an alternative that has
not been considered.
Remember challenging in a professional manner is likely to involve acknowledging a point and
presenting a counter argument, rather than just presenting a counter argument.
Jane says that a project should not be accepted because it produces a negative NPV. In answering
Jane while demonstrating scepticism, it would be good to:
1. Confirm that it gives a negative NPV and that you acknowledge that she is correct in stating the
company’s usual practice.
2. Point out relevant factors which could influence Jane, such as:
– The subjectivity in choice of discount factor, changing which could create a positive NPV
– The degree of estimation related to particular figures, again which could make a difference to
the overall NPV
– Sensitivity analysis which shows different expectations and projections
Covering both points 1 and 2 shows scepticism and professionalism.
414 | P a g e
The reverse situation could exist. Jane might claim project should be accepted due to positive NPV.
You again, confirm the positive NPV and accept that it is company policy, but go on to point out
environmental factors not capable of being factored in to the NPV which suggest it is not in the
interests of wider society to pursue the project.
You are likely to be offered scepticism marks in a situation where you are specifically being asked to
appraise someone else’s opinion because you will be expected to use facts given to you to present a
counter-argument to that opinion, in a professional manner.
You read the annual report of Citrus plc in which the CEO claims that ‘our staff are some of the
happiest in the industry’.
You are aware of a recent poll conducted internally, where staff gave their job satisfaction high
average rating of 9 out of 10. You are also aware of an external, confidential poll carried out by a
national recruitment agency, which shows a job satisfaction rating across the industry of only 6.
You have been appraised by the HR department of a growing trend of absence due to illness among
the staff, and staff turnover shows an increase in each of the last three years.
Required:
Appraise the CEO’s statement.
Professional skills marks are available for skepticism in analysing the CEO’s comments in the light of
other available data.
Solution
Factors relevant to the professional skills element
On the basis of the internal poll, the CEO’s opinion seems fair as when a comparison is made with
the national poll, staff are giving a satisfaction rating three points higher than the national average.
However, you must also take the following points into consideration:
1. Citrus plc staff are likely to have been polled in the national poll and may give a more honest
answer in a confidential poll conducted by external parties, thus the 3-point gap might be
exaggerated.
2. Increase in absenteeism due to illness could indicate job dissatisfaction, although this would
have to be analysed in the context of known health factors, eg particularly bad year for hay
fever.
3. Increase in employee turnover could also indicate less than absolute satisfaction with the job,
although again, this cannot be absolutely concluded on these bare facts.
Drawing inferences from these different sources and comparing them to the single source the CEO
appears to have drawn a conclusion from is showing scepticism. When addressing this issue, the
candidate who only looked at the internal survey in relation to the CEO’s statement would not score
highly for scepticism. In addition, it is an element of scepticism to note that the other sources of
information should be corroborated with other factors (eg the health factors and the circumstances
surrounding individuals leaving employment).
415 | P a g e
Scepticism
Where do you or do you think that you can practice this skill more in real life?
21.5 Evaluation
ACCA lists the following considerations:
• Assess and use professional judgement when considering organisational issues, problems or
when making decisions; taking into account the implications of such decision on the
organisation and those affected.
• Estimate trends or make reasoned forecasts of the implications of internal or external factors on
the organisation, or of the outcomes of decisions available to the organisation.
• Appraise facts, opinions and findings objectively, with a view to balancing the costs, risks,
benefits and opportunities before making or recommending solutions or decisions.
Definition
To evaluate is to assess and to use judgement.
You should be able to see here that evaluation is about considering all the factors, and recognising
that there might be a variety of outcomes from a decision. It might be necessary to bring emotional
factors into a decision as well as pure financial logic.
A cost cutting exercise might suggest that reducing staff numbers is an appropriate decision, but it
might be necessary to evaluate the impact this might have on company culture and morale, and
ongoing productivity as well and not simply make a financial recommendation.
Bear in mind a synonym of evaluate, ‘weigh’, when trying to evaluate. There is an element of trying
to balance the scales, to weigh up all the relevant factors in making the decision.
There is a cross over with analysis here, as estimating trends and making forecasts could be
considered part of analysis, as discussed above.
You have been presented with the following SWOT analysis for Produce plc.
Strengths Weaknesses
Distribution network Slow to respond to new opportunities
416 | P a g e
Opportunities Threats
Spare capacity in production department Price competition from major competit
The following two options have been presented to the board in relation to the spare capacity:
1. Increase production of existing main product.
2. Diversify into a new product.
Required:
Appraise the two options.
Professional skills marks are available for demonstrating evaluation skills in appraising the options.
Solution
Factors relevant to the professional skills mark element
The key to obtaining evaluation marks is taking into consideration all the information given. Here,
using the SWOT analysis, it can be seen that the company has an opportunity to expand production,
but runs the risk of suffering from its main threat if it takes option 1 and simply produces more of
the same. It would also mean that the company was not responding to any new opportunities,
which is noted as a weakness.
However, if it were to take option 2 and develop a new product, it would potentially be eliminating
a weakness, and capitalising on a strength (a good distribution network for a new product).
Diversifying should reduce the threat of the competitor, as they might not compete in the
diversified market.
This simple analysis has evaluated all the information given above. Failing to consider all the
elements of the SWOT analysis might have reduced a professional skills mark here.
In practice in the exam you might have to evaluate several pieces of information, such as specific
information about the new product and its market, predictions about market trends/competitor
action, differing view of directors, and use them ALL in evaluating the options before you.
Evaluation
Where do you or do you think that you can practice this skill more in real life?
Without looking back in the chapter say which of the following verbs are associated with which
professional skill:
Use judgement/Estimate/Probe/Clarify/Consider
Learning examples
417 | P a g e
Throughout this study manual you will find learning examples which include professional skills
marks elements.
Solution 21.2
Solution 21.3
Solution 21.4
Solution 21.5
Solution 21.6
Communication – clarify
Commercial acumen – use judgement
Analysis – consider
Scepticism – probe
Evaluation – estimate
419 | P a g e
If you struggled on these at all it is worthwhile making sure that you know the five professional skills
and what that means for the verbs (and hence actions) that you will need to take for each skill. The
more automatic this becomes the better for passing the exam.