Making strategic options fly

This article was first published in the July 2012 UK edition of Accounting and Business magazine.

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In the very late 1990s M&S was Britain's most profitable retailer. It was making profits of more than £1bn on sales of just £8bn. In economic terms, given the general competitive state of the retail industry, the company was making abnormally high returns. This was partly a reflection of its previous competitive advantage - brand, reputation, products and so on - but also in part because it was milking its position, underinvesting (lower depreciation), and skimping on customer service.

Newer, nimbler and more aggressive competitors from niche retailers right up to Tesco and Asda were poised to attack its clothing business. And Waitrose, Tesco Finest and Sainsbury were attacking its premium foods business.

Using various strategy matrices at that time and through the early 2000s I monitored M&S's strategic position as shown in this table.

M&S's clothing business was undermined by complacency, and by the early 2000s was really suffering against the competition. During this period, margins and profits at the company collapsed as a result of this weakening competitive position and the rise in rivalry.

Its food business didn't show much innovation throughout the very late 1990s and into the early 2000s. Although that improved greatly post-2005 under Stuart Rose, competition sharpened as its rivals improved their offerings.

In short, M&S's profits collapse and its faltering recovery record very much mirrors, with some lags, the changing strategic position of its individual business streams. The company's profits look unlikely to return to the levels of the last century for the foreseeable future because those elevated returns have returned to a 'normal' level. What was cunning and unique in those halcyon days of bumper profits is no longer so.

So profits and financial returns are closely correlated with external changes, with shifts in relative competitive position and with the extent to which the organisation is cunning or complacent. So when accountants look to the profit and loss (P&L) account as the key performance indicator of the business they are often looking at symptoms rather than causes; the P&L figures don't uncover the real drivers of corporate performance.

By becoming strategically astute, accountants and the finance department as a whole can begin to fulfil their true role as the guardians of shareholder value, rather than being primarily the score-keepers who look after accounting profit.

To turn this role into a reality, financial professionals need to:

• become much more involved in the planning process, by co-ordinating and project-managing it
• apply the strategic option grid (as described in the third article of this series) to help operational managers carry through the 'challenge-and-build' process of refining and testing their options
• champion the role of shareholder value in the business (as described below), not just in business cases but more generally
• be much more effective in influencing key players in the organisation
• spend less time on more pure number crunching and backward-looking work.

Returning to the issue of shareholder value, there are said to be seven key value drivers that propel the net present value of future cash streams of the business: sales growth rate, operating profit margin, three drivers concerned with fixed and working capital, the tax rate, and the cost of capital.

These seven drivers all have an impact on the share price. This impact can be modelled on a relatively simple spreadsheet which discounts forecast cashflows and the 'terminal value' at the end of the planning period to a present value.

If all this is a foreign language to you, then as an accountant there is something that you aren't doing but which you should be: keeping a close track on the value of your business, seeing whether this value is going up year on year (the 'economic profit'), and understanding what is really behind that.

This is a quite different way of looking at finance. It is forward-looking and not confined to just a year at a time. It is also based on a more honest metric: cashflow. It all helps you, in your role as an accountant, to assess the value to the business of new strategic options and decisions.

The first two of the seven value drivers are called 'business value drivers'; they are generally the most important in determining the share price and business value.

If we look first at the more generic business value drivers, we can trace the links as shown below between competitive strategy (boldfaced) and the value drivers a strategically astute accountant should be looking for.

Sales growth rate

• PEST (political, economic, social and technical) factors: lower economic growth reduces the sales growth rate
• Life-cycle effects: maturity dampens price increases, may cause price deflation and lower sales volumes
• Relative competitive advantage: impacts on relative market share and supports premium prices.

Operating profit margin

• Porter's five forces: squeezes prices, pushes up costs and reduces margins
• Relative competitive advantage: protects against discounting, and lowers costs of acquiring new customers and reducing the cost of replacement
• Variables: economies of scale and lower costs.
  

These are merely high level, but it is precisely this kind of analysis that accountants with a strategic role should be undertaking. The two business value drivers of sales growth rate and operating profit margin are a very good start but very generic. An accountant can make them far more specific. So first, a business value driver is defined as anything that generates - directly or indirectly - the cash inflows of a business, now or in the future. A cost driver can be defined in a very similar way as anything which generates - directly or indirectly - the cash outflows of a business, now or in the future.

In the earlier article on the option grid, at 'strategic attractiveness' we were implicitly asking about cashflows, so we should look too at value and cost drivers, but now specifically.

To operationalise these, it is best to try to sketch out a tree of value (and cost) drivers which underpin a particular strategic option. An example is in the value tree graphic shown here. This examines the value drivers for a new form of supermarket trolley which goes in a guaranteed straight line.

The graphic shows an example of value segmentation - that is, economic value which accrues either to different people or in different ways/activities. This process allows indirect and less tangible sources of value to be captured - and ultimately for some 'what if?' approximate valuation to be done. This allows the accountant to capture softer value in business cases. In strategic planning softer value is very common.

Such value trees not only help to cast the net of quantification wider but also, as we drill down to the bottom of that page, in more detail and depth. This methodology has helped me to put an economic value on culture change at BP and on learning and development at a police force, demonstrating the high ratios of value over cost resulting.

The cost driver tree I created had the investment and running costs broken down into losses and damage (big) and trolley retrieval costs (enormous). Drilling down here has begun the process of convincing UK supermarkets to reconsider coin locks.

Using these kinds of pictures can enable accountants to perform a combined strategic and financial analysis of strategic options, project cost breakthroughs and generate far better business cases generally.
Let's now look at how a finance department might develop a strategy for itself.

Current position

What businesses are we in?

• Transactional
• Technical
• Reporting
• Budgeting and financial planning
• Strategic, advisory, influencing
• Process development
• Special projects (for example, cost management)
• What is the current value added and what are the costs?
• Internal customer analysis/costs.
  

Value outsourcing

Options/breakthroughs: 

• Shift resources from traditional activities to strategic.
• Adapt structure and adopt more fluid roles.
• Mindset more commercial, forward-looking, advisory.
  

Vision 

To be regarded as more of a business unit than a functional overhead, a voice championing shareholder value.

Not rocket science

Creating a strategy for a finance department isn't rocket science. It is a very similar process to developing one for any other business or function.
In the future it would be wise to capitalise on your learning. Sadly the provision of short courses on strategy has dried up. In terms of further reading, Wikipedia is excellent and cuts through the terminology, although it is still rather conceptual.

MBA courses can help broaden you conceptually and give you far more confidence. They put a lot of emphasis on strategic thinking - contact me via my website if you have serious interest.

Strategic projects are another excellent way to develop further - for example, major change programmes, secondments, acquisition work and so on. Do trial techniques such as the option grid on these projects.

Let me finish with a story. A group of turkeys were having a day out in Hyde Park. While they were having their lunch (chicken sandwiches), a man came up to them and said, 'Would you like to fly? I can show you how.' They agreed and he took them on a flight around the park, over Buckingham Palace and Big Ben. When they landed, they thanked him and said what a great time they had had, then walked home happily.
What is the one big thing that the turkeys forgot to do?

Dr Tony Grundy is an independent consultant and trainer and lectures at Henley Business School in the UK