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M09_ATRI3622_06_SE_C09.QXD 356 CHAPTER 9 5/29/09 3:32 PM Page 356 STRATEGIC MANAGEMENT ACCOUNTING Figure 9.11 Two approaches to determining shareholder value Both EVA® and SVA can provide a measure of shareholder value. Total business value can be derived either by discounting the free cash flows over time or by discounting the EVA® flows over time and adding the capital invested. Whichever approach is used, the market value of borrowings must then be deducted to derive shareholder value. Let us go through a simple example to illustrate this point. Example 9.5 Leo Ltd has just been formed and has been financed by a £20 million issue of share capital and a £10 million issue of loan notes. The proceeds of the issue have been invested in non-current (fixed) assets with a life of three years and during this period these assets will depreciate by £10 million per year. The operating profit after tax is expected to be £15 million each year. There will be no replacement of non-current assets during the three-year period and no investment in working capital. At the end of the three years, the business will be wound up and the non-current assets will have no residual value. The required rate of return by investors is 10 per cent. The SVA approach to determining shareholder value will be as follows: Year 1 2 3 Free cash flows £m 25.0* 25.0 25.0 Discount rate Present value 10% £m 0.91 22.8 0.83 20.7 0.75 18.7 Total business value 62.2 Loan notes ( 10.0 ) Shareholder value 52.2 * The free cash flows will be the operating profit after tax plus the depreciation charge (that is, £15m + £10m). In this case, there are no replacement non-current assets against which the depreciation charge can be netted off. It must therefore be added back. M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 357 MEASURING SHAREHOLDER VALUE The EVA® approach to determining shareholder value will be as follows: Year Opening capital Capital charge Operating profit EVA® Discount Present value invested (C) (10% × C) after tax rate 10% of EVA® £m £m £m £m £m 1 30.0* 3.0 15.0 12.0 0.91 10.9 2 20.0 2.0 15.0 13.0 0.83 10.8 3 10.0 1.0 15.0 14.0 0.75 10.5 32.2 Opening capital 30.0 62.2 Loan notes ( 10.0 ) Shareholder value 52.2 * The capital invested decreases each year by the depreciation charge (that is, £10 million). EVA® or SVA? Although both EVA® and SVA are consistent with the objective of maximising shareholder wealth and, in theory, should produce the same decisions and results, the supporters of EVA® claim that this measure has a number of practical advantages over SVA. One such advantage is that EVA® sits more comfortably with the conventional financial reporting systems and financial reports. There is no need to develop entirely new systems to implement EVA® as it can be calculated by making a few adjustments to the conventional income statement and statement of financial position. It is also claimed that EVA® is more useful as a basis for rewarding managers. Both EVA® and SVA support the idea that management rewards should be linked to increases in shareholder value. This should ensure that the interests of managers are closely aligned to the interests of shareholders. Under the SVA approach, management rewards will be determined on the basis of the contribution made to the generation of long-term cash flows. However, there are practical problems in using SVA for this purpose. Activity 9.12 What are the practical problems that may arise when using SVA calculations to reward managers? (Hint: Think about how SVA is calculated.) The SVA approach measures changes in shareholder value by reference to predicted changes in future cash flows and it is unwise to pay managers on the basis of predicted rather than actual achievements. If the predictions are optimistic, the effect will be that the business rewards optimism rather than real achievement. There is also a risk that unscrupulous managers will manipulate predicted future cash flows in order to increase their rewards. Under EVA®, managers can receive bonuses based on actual achievement during a particular period. If management rewards are linked to a single period, however, there is a danger that managers will pay undue attention to increasing EVA® during this period rather than over the long term. The objective should be to maximise EVA® over 357 M09_ATRI3622_06_SE_C09.QXD 358 CHAPTER 9 5/29/09 3:32 PM Page 358 STRATEGIC MANAGEMENT ACCOUNTING the longer term. Where a business has a stable level of sales revenue, operating assets and borrowing, a current-period focus is likely to be less of a problem than where these elements are unstable over time. A stable pattern of operations minimises the risk that improvements in EVA® during the current period are achieved at the expense of future periods. Nevertheless, any reward system for managers must encourage a long-term perspective and so rewards should be based on the ability of managers to improve EVA® over a number of years rather than a single year. Real World 9.13 describes the way in which one business uses EVA® to reward its managers. REAL WORLD 9.13 Rewarding managers Hanson PLC, a major supplier of heavy building materials, adopts a bonus system for its directors based on EVA®. EVA® generated is accumulated in a ‘bonus bank’ and the directors are paid a portion of the EVA® bonus bank during a particular year; the remainder is carried forward for payment in future years. The following is an extract from the 2006 annual report of the business. Annual bonus scheme The annual bonus scheme for the Executive Directors and other senior executives is aligned with changes in shareholder value through the economic value added methodology. The main principle of economic value added is to recognise that over time a company should generate returns in excess of its cost of capital – the return that lenders and shareholders expect of the Company each year. The annual bonus scheme is calibrated by reference to target levels of bonus and, for the Executive Directors and other senior executives, works on a bonus banking arrangement whereby each year the improvement in the group’s overall economic value added for that year determines whether there is a bonus bank addition or deduction. Following the addition or deduction, the participant receives one-third of the accumulated bonus bank. There is neither a cap (maximum addition into the bonus bank each year) nor a floor (maximum deduction from the bonus bank each year). The bonus bank has two main functions; firstly it ensures that individuals do not make shortterm decisions such as deferring essential expenditure from one year to the next and receive a bonus for doing so; and secondly, the bonus bank can act as a retention tool. For 2006, the target level of bonus for A J Murray was 62.5% of basic salary and for G Dransfield 37.5% of basic salary. No bonus entitlement arose for J C Nicholls who left the Company on October 31, 2006. Improvement in the group’s overall economic value added for the year to December 31, 2006 determined the bonus bank addition for the Executive Directors. The strong operating and profit performance in 2006 led to improvement in the group’s economic value added and resulted in additions to the bonus bank of 69.4% of basic salary for A J Murray and 41.6% of basic salary for G Dransfield. The bonuses paid in respect of the year to December 31, 2006 to the Executive Directors were £509,262 for A J Murray and £161,986 for G Dransfield. Source: Hanson PLC Annual Report 2006, www.hanson.biz. It is worth noting that Stern Stewart believes that bonuses, calculated as a percentage of EVA®, should form a very large part of the total remuneration package for managers. Thus, the higher the EVA® figure, the higher the rewards to managers – with no upper limits. The philosophy is that EVA® should make managers wealthy provided it makes shareholders extremely wealthy. A bonus system should encompass as many managers as possible in order to encourage a widespread commitment to implementing EVA®. M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 359 JUST ANOTHER FAD? Just another fad? The techniques described in this chapter are all potentially valuable to a business, but their successful implementation is far from certain. According to one source, failure rates are as high as 60 per cent (see reference 4 at the end of the chapter). A depressingly common scenario is that a new technique will be enthusiastically adopted but, within a short while, disillusionment will set in. Managers will decide that the technique does not meet their requirements and so it will be abandoned. In some businesses, a pattern of adoption, disillusionment and abandonment of new techniques may develop. Where this occurs, employees are likely to become sceptical and to dismiss any newly-adopted technique as simply a passing fad. Introducing a new technique is likely to be costly and can cause considerable upheaval. Managers must, therefore, tread carefully. They must try to identify the potential problems, as well as the benefits, that may accrue from its adoption. The main problems that lie in wait are: l the excessive optimism that managers often have in their ability to implement a new technique that will quickly yield good results; l the assumption that others will share the enthusiasm felt for a new technique; l the failure to acknowledge that there will be losers as well as winners when a new technique is implemented (see reference 4 at the end of the chapter). Managers must be realistic about what can be achieved from a new technique and must accept that resistance to its introduction is likely. They must not underestimate what it will take to ensure a successful outcome. Self-assessment question 9.1 You have recently heard a fellow student talking about strategic management accounting as follows: 1 ‘Identifying cost-saving measures really needs to be left to accountants. Non-experts tend to cause problems when they attempt it.’ 2 ‘Customer profitability analysis is about finding out which of your customers are the more profitable businesses and trying to encourage the ones that are more profitable to place orders. This is to avoid having customers that go bankrupt.’ 3 ‘Shareholder value analysis (SVA) tries to give shareholders their returns in the form that they like. Some shareholders prefer dividends and others prefer profits to be ploughed back.’ 4 ‘EVA® stands for “equity value analysis” and is an alternative name for SVA.’ 5 ‘The “balanced scorecard” is the American name for what people in the UK call a statement of financial position (balance sheet).’ Required: Critically comment on the student’s statements, explaining any technical terms. The answer to this question can be found in Appendix B at the back of the book. 359 M09_ATRI3622_06_SE_C09.QXD 360 CHAPTER 9 5/29/09 3:32 PM Page 360 STRATEGIC MANAGEMENT ACCOUNTING SUMMARY The main points in this chapter may be summarised as follows: Strategic management accounting (SMA) l SMA is concerned with providing information to support strategic plans and decisions. l It is more outward looking, more concerned with outperforming the competition and more concerned with monitoring progress towards strategic objectives than conventional management accounting. Facing outwards l Competitor analysis examines the objectives, strategies, assumptions and resource capabilities of competitors. l Customer profitability analysis assesses the profitability of each customer or type of customer to the business. Competitive advantage through cost leadership l Total life-cycle costing is concerned with tracking and reporting all costs relating to l l l l a product from the beginning to the end of its life. Target costing is a market-based approach to managing costs that is used at the planning stage. – It attempts to reduce costs so that the market price covers the cost plus an acceptable profit. – It distinguishes between activities that add value and those that do not; it may be possible to save costs by eliminating or reducing the cost of the non-value-adding ones. Kaizen costing is concerned with continual and gradual cost reduction and is used at the production stage. Costs may be managed without using sophisticated techniques if: – There is a shared responsibility for managing costs. – Discussion of costs becomes an everyday activity. – Costs are managed locally. – Benchmarking is used at regular intervals. – The focus is on managing rather than reducing costs. Value chain analysis involves analysing the various activities in the product life cycle to identify and try to eliminate non-value-added activities. Translating strategies into action l The balanced scorecard is a management tool that uses financial and non-financial measures to assess progress towards objectives. l It has four aspects: financial, customer, internal business process, and learning and growth. l It encourages a balanced approach to managing the business. Measuring shareholder value l Shareholder value is seen as the key objective of most businesses. l Two approaches used to measure shareholder value are shareholder value analysis (SVA) and economic value added (EVA®). l Shareholder value analysis (SVA) is based on the concept of net present value analysis. l It identifies key value drivers for generating shareholder value. M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 361 FURTHER READING l Economic value added is a means of measuring whether the returns generated by the business exceed the required returns of investors. EVA® = NOPAT − (R × C) where NOPAT = net operating profit after tax R = required returns from investors C = capital invested (that is, the net assets of the business). ‘ Key terms Competitor analysis p. 319 Customer profitability analysis (CPA) p. 323 Lean manufacturing p. 329 Value chain analysis p. 330 Value drivers p. 334 Balanced scorecard p. 334 Shareholder value analysis (SVA) p. 344 Free cash flows p. 344 Economic value added (EVA®) p. 350 References 1 Crawford, D. and Baveja, S., ‘In search of new value for the support operation’, ft.com, 27 July 2006. 2 Hopwood, A., ‘Costs count in the strategic agenda’, ft.com, 13 August 2002. 3 Kaplan, R. and Norton, D., The Balanced Scorecard, Harvard Business School Press, 1996. 4 Bruce, R., ‘Tread a careful path between creative hope and blind faith’, ft.com, 2 February 2006. Further reading If you would like to explore topics covered in this chapter in more depth, we recommend the following books: Bhimani, A., Horngren, C., Datar, S. and Foster, G., Management and Cost Accounting, 4th edn, FT Prentice Hall, 2008, chapter 22. McWatters, C., Zimmerman, J. and Morse, D., Management Accounting: Analysis and Interpretation, FT Prentice Hall, 2008, chapter 4. Kaplan, R. and Norton, D., The Balanced Scorecard, Harvard Business School Press, 1996. Mills, R., The Dynamics of Shareholder Value, Mars Business Associates, 1998. Stern, J. and Shelly, J., The EVA Challenge, John Wiley, 2001. 361 M09_ATRI3622_06_SE_C09.QXD 362 CHAPTER 9 5/29/09 3:32 PM Page 362 STRATEGIC MANAGEMENT ACCOUNTING REVIEW QUESTIONS Answers to these questions can be found in Appendix C at the back of the book. 9.1 How does strategic management accounting differ from its more traditional counterpart? 9.2 Both Customer A and Customer B buy 1,000 units of your business’s service each year, paying the same price per unit. Why might your business regard Customer A as a desirable customer, but not Customer B? 9.3 What is the principle on which shareholder value analysis is based? 9.4 What are the four main areas on which the balanced scorecard is based? EXERCISES Exercises 9.4 to 9.8 are more advanced than 9.1 to 9.3. Those with a coloured number have answers in Appendix D at the back of the book. If you wish to try more exercises, visit the students’ side of the Companion Website at www.pearsoned.co.uk/atrillmclaney. 9.1 Aires plc was recently formed and issued 80 million £0.50 shares at nominal value and loan notes of £24m. The business used the proceeds from the capital issues to purchase the remaining lease on some commercial properties that are rented out to small businesses. The lease will expire in four years’ time and during that period the operating profits are expected to be £12m each year. At the end of the four years, the business will be wound up and the lease will have no residual value. The required rate of return by investors is 12 per cent. Required: Calculate the expected shareholder value generated by the business over the four years, using (a) the SVA approach (b) the EVA® approach. 9.2 You have recently heard someone making the following statement about competitor profitability analysis (CPA). ‘CPA is an assessment of how profitable competitors are, that is carried out in an attempt to establish a benchmark by which one’s own business’s success can be measured. Usually most of the information for this can be found in the competitors’ annual report and financial statements. Usually competitors are willing to provide information about their financial results so that any gaps in the CPA can be filled in.’ Required: Comment on this statement. 9.3 Sharma plc makes one standard product for which it charges the same basic price of £20 a unit, though discounts are allowed to certain customers. The business is in the process of carrying out a profitability analysis of all of its customers during the financial year just ended. M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 363 EXERCISES Information about Lopez Ltd, one of Sharma’s customers, is as follows: Discount on sales price Number of products sold Manufacturing cost Number of sales orders Number of deliveries Distance travelled to deliver Number of sales visits from Sharma’s staff 5% 40,000 units £12 a unit 22 22 120 miles 30 Sharma uses an activity-based approach to ascribing costs to customers, as follows: Cost pool Order handling Delivery costs Customer sales visits Cost driver Number of orders Miles travelled Number of visits Rate £75 an order £1.50 a mile £230 a visit Lopez Ltd usually takes two months’ credit, of which the cost to Sharma is estimated at 2 per cent per month. Required: Calculate the profit that Sharma plc derived from sales to Lopez Ltd during last year. 9.4 (a) The shareholder value approach to managing businesses is different to the stakeholder approach to managing businesses. In the latter case, the different stakeholders of the business (employees, customers, suppliers and so on) are considered as being of equal importance and so the interests of shareholders will not dominate. Is it possible for these two approaches to managing businesses to co-exist in harmony within a particular economy? (b) It has often been argued that businesses are overcapitalised. If this is true, what might be the reasons for businesses having too much capital and how can EVA® help avoid this problem? 9.5 Virgo plc is considering introducing a system of EVA® and wants its managers to focus on the longer term rather than simply focus on the year-to-year EVA® results. The business is seeking your advice as to how a management bonus system could be arranged so as to ensure that the longer term is taken into account. The business is also unclear as to how much of the managers’ pay should be paid in the form of a bonus and when such bonuses should be paid. Finally, the business is unclear as to where the balance between individual performance and corporate performance should be struck within any bonus system. The finance director has recently produced figures that show that if Virgo plc had used EVA® over the past three years, the results would have been as follows: 2006 2007 2008 £25m (profit) £20m (loss) £10m (profit) Required: Set out your recommendations for a suitable bonus system for the divisional managers of the business. 9.6 Leo plc is considering entering a new market. A new product has been developed at a cost of £5m and is now ready for production. The market is growing and estimates from the finance department concerning future sales revenue of the new product are as follows: 363 M09_ATRI3622_06_SE_C09.QXD 364 CHAPTER 9 5/29/09 3:32 PM Page 364 STRATEGIC MANAGEMENT ACCOUNTING Year 1 2 3 4 5 Sales revenue £m 30 36 40 48 60 After Year 5, sales revenues are expected to stabilise at the Year 5 level. You are told that: l The operating profit margin from the new market is likely to be a constant 20 per cent of sales revenue. l The cash tax rate is 25 per cent of operating profit. l Replacement non-current asset investment (RNCAI) will be in line with the annual depreci- ation charge each year. l Additional non-current asset investment (ANCAI) over the next five years will be 15 per cent of sales revenue growth. l Additional working capital investment (AWCI) for each year over the next five years will be 10 per cent of sales revenue growth. The business has a cost of capital of 12 per cent. The new market is considered to be no more risky than the markets in which the business already has a presence. Required: Using an SVA approach, indicate the effect of entering the new market on shareholder value. (Workings should be to one decimal place.) 9.7 Pisces plc produced the following statement of financial position (balance sheet) and income statement at the end of the third year of trading: Statement of financial position as at the end of the third year £m Non-current assets Property Machinery and equipment Motor vans Marketable investments Current assets Inventories Trade receivables Cash Total assets Equity Share capital Reserves Non-current liabilities Loan notes Current liabilities Trade payables 40.0 80.0 18.6 9.0 147.6 45.8 64.6 1.0 111.4 259.0 80.0 36.5 116.5 80.0 62.5 259.0 M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 365 EXERCISES Income statement for the third year Sales revenue Cost of sales Gross profit Wages Depreciation of machinery and equipment R&D costs Allowance for trade receivables Operating loss Income from investments Interest payable Ordinary loss before taxation Restructuring costs Loss before taxation Tax Loss for the year £m 231.5 (143.2 ) 88.3 (43.5) (14.8) (40.0) (10.5 ) (20.5) 0.6 (19.9) (0.8 ) (20.7) (6.0 ) (26.7) – (26.7 ) An analysis of the underlying records reveals the following: 1 R&D costs relate to the development of a new product in the previous year. These costs are written off over a 2-year period (starting last year). However, this is a prudent approach and the benefits are expected to last for 16 years. 2 The allowance for trade receivables (bad debts) was created this year and the amount of the provision is very high. A more realistic figure for the allowance would be £4 million. 3 Restructuring costs were incurred at the beginning of the year and are expected to provide benefits for an infinite period. 4 The business has a 7 per cent required rate of return for investors. Required: Calculate the EVA® for the business for the third year of trading. 9.8 Aquarius plc has estimated the following free cash flows for its five-year planning period: Year 1 2 3 4 5 Free cash flows £m 35 38 45 49 53 Required: How might it be possible to check the accuracy of these figures? What internal and external sources of information might be used to see whether the figures are realistic? 365