Using Accounting Information for Strategic Management & Decision Making (2)

Second part of my old paper in 2006. In the first part, I described the relationship of accounting information in the strategic management process in order to make a strategic decision of a corporation. In this second part, I furthermore explain each of accounting function and information: Financial Accounting and Managerial Accounting, with its model for strategic decision making.

Financial Accounting Information for Strategic Decision-Making

In a competition or competitive market, each competitor’s action within the industry can affect the whole structure of the competition in the short term or long term. Each competitor must anticipate the strategy and tactics of one another. If it is not anticipated, a competitor may risk its market share acquired by another competitor’s action such as launching new product promotion, and etc. Therefore, the challenge of Top Management is to anticipate and overcome another competitor’s action. Top Management can derive competitor’s information simply from their financial information, stated in Financial Statement.

We may find the basic information of how well the competitor’s financial performance from their Financial Statement. Assuming this competition is between two public companies that went publicly a long time, and they compete against each other, head to head. Then we pretend to compete company B where they publish Financial Statement for public interests such as regulators, investors, shareholders etc. Instead of reviewing and discovering the new product they will launch, we may start to analyze whether our competitor is growing in sustainability or not, by using basic formula:

Table 2. Sustainable growth formula

The information can be derived from the formulas in Table 2, is whether the competitor can grow in the industry or not? Can it increase market share? How sensitive its sustainable growth to raise outside capital?[1]. When the result showing incremental growth from year to year, it means the competitor has sustainability to compete in short-term or if possible in long term. For our implication, we need to determine our strategy based on information of competitor’s strengths and weaknesses. To simplify this discussion, we will only use one approach for this section based on one element in sustainable growth formula, it is the Asset Turn Over /Management analysis.

• Asset Turn Over/ management - calculating Asset Turnover Ratio or Return on Asset ratio. If the competitor is strong in this area, it means that the competitor is efficient and effective when utilizing its assets to generate sales. Assuming their highest return comes from fixed asset such as machine, building and land, and then we can apply blocking strategy to our competitor by restraining them to access materials from suppliers. A strategic decision can be set by syndication or cooperative partnership with suppliers. This expects the suppliers to give privileges for supplying more or only to our company instead of our competitor. Other strategic decision can be vertical integration, if we do have financial ability, we can acquire supplier(s) in the industry or producing our own supply[2]. These actions will affect our competitors for having difficulties in accessing supply, and then the next expected effect will make them unable to produce. The goal is that we internally will have competitive advantage over our competitor.

Let’s see how Financial Accounting information helps strategic decision-making in banking industry. The most important measurement in banking industry that must be presented in financial report is Capital Adequacy Ratio (CAR). Since Basle Capital Record Accord in 1988, CAR has also become most widely used information for financial market. Why CAR is important? CAR provides an indicator of a bank’s financial condition according to its ability to keep the bank operates based on its own equity/capital adequacy[3]. One of the Bank’s roles in the society is an intermediate institution between debtors (those who need to borrow capital/money) and creditors (those who lend capital/money). A Bank has to maintain its CAR ratio in order to keep savings & deposits of third party (creditors) safe by covering it with Bank’s equity, if the Debtors fail to fulfill their obligation.

How does CAR affect Banking regulation in Indonesia? What is the purpose of analyzing CAR ratio of a bank in competitive context? Well, it has been two years since Bank Indonesia announced Indonesian Banking Landscape (or in Bahasa: Arsitektur Perbankan Indonesia) for 2010, which instructed all banking institutions in Indonesia to obey several requirements to be high performing bank, to be included in top banking leveling[4]. One of the requirements is to maintain CAR ratio above 12% in 5 years consecutively. Hence, the implication happens to be, all banks competing to maintain its CAR ratio. Many banks are looking and approaching strategic partner to invest in their bank. One strategic action can be implemented from this condition, by analyzing and measuring other bank’s financial report and performance, is to acquire (acquisition) the targeted bank, which has low CAR ratio. Or in another move, proposing a merger scenario with other bank, which has the same platform.

Managerial Accounting Information for Strategic Decision-Making

Compared to Financial Accounting information, which enables us to make strategic decision related to external parties, Managerial Accounting information provide us information to determine strategy in operation and other internal issues.

How well our performance in operation and how good is it generating profit? These questions are not only asked by management all the time, it becomes main indicators to evaluate management performance and capability. If the management performs well, they will be compensated respectively as well. Measuring a company’s operation performance can be drawn from its Managerial Accounting information such as working capital, free cash flow, return on asset, return on equity, and EVA. Refer to the earlier assumption, we run a public company which have been existing for a long time. Let’s view on some analysis which can be derived into strategic decision-making:

• Working Capital. A company needs cash to run the operation and also needs materials to produce goods (or services). If all sources of cash and other current asset are funded by our own equity, it will not be a big problem for us. But for a public company, liabilities have significant composition, which affect our power in operation and production. Thus, we are obligated to fulfill our obligation, when it is due or mature on the time being. Working capital calculation is total current assets subtracted by total current liabilities. If the result of Working Capital shows positive number after we have paid our obligations and other liabilities, we can continue operating and producing goods. In other word, our business is surviving and still going on. If it is negative, technically we are unable to continue running the business, and we must pay our debt as well.

Working capital can be negative because of several conditions in current assets side or liabilities side. We will only discuss on current assets side, such as: using more cash to acquire plantation (investment) rather than to buy materials or supplies, lack of ability in collecting account receivables, having bad marketing to generate positive cash flow etc. Having known of these conditions, Top management should make strategic decision to save the company, and apply some strategic decisions in short term such as raising cash by optimizing collection on account receivables[1], or increasing cash sales by running effective and efficient marketing tactic etc.

• Inventory Turn over – inventory ready to be sold. Business needs to keep and maintain inventory to be able to meet customer’s demand. However, keeping inventory in large amount can trouble some companies. Increasing number of inventories is usually followed by increasing number of insurance expense, property taxes, storage costs, etc. The capability of inventory management is a management challenge in this point. Calculation of Inventory Turn Over is dividing Cost of Good Sold by Inventory.

It also depends on the company’s core business. If we manage Food and Beverage restaurant, number of Inventory Turn Over should be high[2]. However, if we run a jet plane manufacturer company, the number of Inventory Turn Over usually low. It is all because of what types of good we are trading on. Food and beverages are daily good consumption, so its Inventory Turn Over is supposed to be high. The Inventory Turn Over of Jet Plan manufacturer should possibly low because Jet Plan is a non-daily good consumption.

Despite on its comparison between two different types of good, a company should compare its Inventory Turn Over number with average industry index. This is also to measure how well we are compared to industry and other competitors. Assume we face problem of lowest Inventory Turn Over number compared to industry average index, we can decide strategically to improve our Inventory Management System. Some alternatives can be taken such as Just In Time method production, or using information technology to improve inventory management, etc.

[1] It is needed another ratio analysis which is Account Receivables Turn Over to asses our efficiency in collecting receivables

[2] This is also needs another ratio which is Number of days’ sales in inventory to measure how many days needed to turn inventory to be COGS and then sell it.

[1] Michael E. Porter. Competitive Strategy: Techniques for analyzing Industries and Competitors. (The Free Press. New York: 1980). Page 66

[2] Jan R. William, et al. Op. Cit. Page 179

[3] Stanley C. W. Salvary. Op. Cit. Page 141

[4] Taken from many sources, and also based on writer’s own experiences in banking