Strategic Managerial Accounting – A Primer for the IT Professional

Gopal Saxena

• Publisher: Business Expert Press
• Year: 2017
• ISBN:
  9781631575846
• Topic: Business
• Subtopic: Managerial Accounting
• Index: Business

This book, probably the first written from the perspective of software professionals, attempts to introduce them to the mysteries of strategic managerial accounting (SMA). The common view in the industry is that "accounting is for the accountants", despite the fact that IT professionals are regularly confronted by financial situations such as project pricing, performance measurement, risk estimation, costs allocation etc. While it is desirable and even necessary that every proposal be vetted by respective specialists, the speed and reliability of the process could improve if the people who originate the proposal had knowledge of the fundamentals that go into the decision making. Unfortunately most books on management accounting, whether strategic or otherwise, are written from the perspective of the manufacturing industry. The IT and services industry on the other hand has a unique cost structure, quite distinct from manufacturing, which needs to be dealt with from a different perspective. This book focuses on SMA in context of the IT software industry, and seeks to equip the IT professional with some basics of SMA to assist them in making more informed decisions.

CHAPTER 1

Introduction to Strategic Managerial Accounting

Accountants are in the past, managers are in the present, and leaders are in the future.

—Paul Orfalea¹

Case Study

This was the second quarter in a row that Smart Pro Inc. (SPI) was forced to issue a profit warning, this time indicating that its Q3 operating profit could fall 24 percent y/y (year on year). Within a week of the announcement, the market shaved off 6 percent from the stock value. The stock has been down 15 percent over the past six months. At the emergency board meeting convened just prior to the announcement, the board had taken the chief financial officer (CFO) to task for failing to stem the profitability decline. The CFO on the other hand reported that both the revenue targets approved by the board in the current financial year’s budget had not only been met but also exceeded. The company was therefore faced with the embarrassing situation of having to pay out hefty bonuses despite falling profits.

In hindsight, the decision to set revenue and expense targets in the budget seemed to be a hasty decision, but it made a lot of sense at the time it was taken. Previously, the company had zealously pursued profitability and their better-than-average operating profits bore testimony to the success of their strategy. However, competition from low-cost “me-too” start-ups had started eroding SPI’s margins and market share. There was no alternative but to go after market share.

The CFO was also painfully aware of the conversation he had had with the newly hired Managerial Accountant at the time of the budgeting exercise where he had raised the issue of strategic cost management or SCM. The company had to decide whether it wanted to be a cost leader or a differentiator, and the budgeting exercise should reflect that policy. However, his suggestions involved allocating funds for reorganizing the company’s departments to better utilize resources and reduce bench costs; venturing into more value-added areas; and retraining. With margins already under pressure, the CFO was sure that a budget that reflected higher expenditure would never get past the board.

Analysis of results clearly established that the near-term weakness in margins was driven by competitive pressure in all segments, particularly from competitors from China and India. Nevertheless, SPI’s market presence was intact because its volume actually improved on y/y basis. However, the Managerial Accountant’s cost–benefit analysis elicited another interesting fact—if the company had fine-tuned its revenue targets with profitability goals, the cost of refusing low-cost business may have been less than the bonuses the company had to pay for achieving higher sales targets.

There was also the nagging doubt that executives were gaming the budgeting process—projecting lower targets so that they could earn larger bonuses. One indication of this fact was that due to the cyclical nature of information technology (IT) spend, the previous year had seen a 9 percent growth in IT spend. However, SPI’s budget had factored only 4 percent increase over the previous year, in line with the growth trend in their past budgets.

Jim, one of the most respected members of the board had this advice for the CEO: “Look, if you go on the path of least resistance and settle for a conservative, achievable budget, you will never take risks and in the process risk missing key opportunities. You will be a lagger and eventually you will be acquired or destroyed. Don’t blame your people. Question your budgeting process or better still, ditch it! Your forecasts are all wrong because you want one figure that is a target, a forecast and a resource allocation number. That will never work—there will always be other motivations and agendas that distort the number.”

Managerial Accounting versus Financial Accounting

The most commonly available financial information about a commercial operation is the financial report, which is the record of the company’s revenue and expense as well as assets and liabilities. While this information is of interest to financial analysts, lenders, and other external stakeholders of a company, it is of limited use to the company’s managers when it comes to making financial decisions such as pricing a product or making new investments in plant and machinery. This book is meant to provide managers with an understanding of the implications of making financial decisions that have a bearing on the future profitability of the company. Furthermore, like a good detective novel, a financial report often hides more information than it reveals. It is therefore necessary to generate more comprehensive information about the company’s operations that will be of help in managerial decision making. Managerial Accounting (MA) deals with this aspect. Unfortunately, while there is an abundance of literature related to the manufacturing industry, the services industry, specifically the IT industry, has largely been ignored. This book attempts to fill in this gap.

The distinction between Managerial Accounting and Financial Accounting is highlighted by The Institute of Management Accountants (IMA), which defines Managerial Accounting as:

A value-adding continuous improvement process of planning, designing, measuring and operating both financial and non-financial information systems that guides management action, motivates behavior and supports & creates the cultural values necessary to achieve an organization’s strategic, tactical and operating objectives.

According to this definition, MA is responsible for information systems that have far-reaching impact on the affairs of the company. Unlike FA, neither the objective of MA (plan, design, measure, and operate financial and nonfinancial information systems) nor the expected outcome (actions and behavior aligned to the organization’s objectives) is restricted to the domain of finance. It concerns the entire operations of the company. An organization entrusts the funds of the business with many individuals who have been assigned certain decision rights and have the responsibility to deliver certain results. Business funds need to be applied judiciously to acquire other resources—people, material, machines, and time; these individuals adopt various strategies to combine the resources with unique capabilities and competencies in order to optimize resource use and maximize output. The “value-adding, continuous improvement process” that it is, implies the role of MA as much broader in scope than FA. It combines financial and cost accounting, performance evaluation and analysis, planning, and decision support; it provides management with necessary tools and techniques to identify and manage internal and external risks; analyze vast amounts of data; and use them for planning, budgeting, performance evaluation, control, and decision-making.

MA has transitioned from an information processing system to a more pervasive, business solution framework for various reasons, many of which are more acutely felt in the technology industry: constant price pressure; growth pressure; cost squeeze; disruptive technology; availability of big data and data analytics tools; network economies; and above all, the impact of a volatile, uncertain, complex, and ambiguous world. It is therefore important that every manager in the software industry be equipped with the skills to use this business solution framework.

Most FA statements one comes across, such as balance sheets, profit and loss statements, and cash flow statements, are generally meant for external use, for example, for the shareholders, tax departments, creditors, and analysts. MA statements on the other hand are meant for internal use by the company’s managers and are therefore catered to their specific needs. This distinction leads to important differences between FA and MA:

(a)

Standards: As FA is primarily meant for external agencies, it is important to have consistency in reporting of financial data. For this purpose, every country has Generally Accepted Accounting Principles (GAAP) that are required to be followed when reporting financial data. MA, however, is meant for the internal use of a company, and therefore can be tailored to meet the specific needs of that company. This implies that: MA can be as detailed as required by the company’s management, whereas FA only needs to comply with the applicable GAAP. MA can include nonmonetary information such as effort hours and bandwidth usage and all information need not be converted into dollars. FA deals strictly with monetary information. In fact, due to this restriction, some companies have attempted to monetize such intangibles as employee worth and brand worth so as to include it in their financial statements.

(b)

Past versus Future: FA reports past transactions of a company, whereas MA is forward looking and is meant as a tool for assisting in making decisions about the future of the company. Cost measurement and performance evaluation roles use historical data, whereas the planning and decision support roles are predictive.

MA is used for various objectives, for example, product costing and pricing, planning and budgeting, performance evaluation, and administrative control. Let us examine each of these objectives in more detail:

(a)	Product/Service Costing and Pricing: It is critical for a company to accurately determine the cost of producing and selling each product because it has a direct bearing on its profitability. As we will see later in the book, there are different types of costs, some of which have to be allocated based on criteria set by the management. Therefore, determining the true cost of a product is not as straightforward as it may seem at first glance.
(b)	Decision Support: MA supports competitive decision-making by collating, processing, and communicating required information, both financial and nonfinancial. The key assets of a commercial enterprise that impart competitive advantage to it are its Resources, Capabilities, and Competencies. The role of MA lies in providing decision support continuously and consistently to (a) optimize resource utilization, (b) build and improve efficient business processes that create unique capabilities, and (c) build core competencies in order to sustain competitive advantage. It is also critical for a company to accurately determine the cost of producing and selling each product or service because it has a direct bearing on its profitability. Therefore, determining the true cost of a product or service is not as straightforward as it may seem at first glance. For example, how would you take into account the cost of services of the staff in human resources (HR) and Finance functions who indirectly contribute to the manufacture of the product/delivery of the service?
(c)	Planning and Budgeting: Every company prepares plans based on the expectations of their shareholders and translates them into budgets or performance targets of different departments. For example, the marketing department may break down the revenue target into subtargets based on products, regions, and sales executives; the production department may break down the revenue target into efforthours business unit-wise or even project-wise; while the finance department may prepare cash flow and profitability targets. Even HR departments can have revenue targets based on the numbers of hours of training they have organized for employees valued at a market-based hourly rate.
(d)	Performance Evaluation: The performance of managers and different departments/units of a company can be measured by comparing actual figures to budgeted figures. This can be used to determine the compensation of managers and controlling the operations of different units. Here too, it is important not only to set proper performance parameters but also to apply the correct metrics that will optimize operational efficiency. Setting performance-based rewards may be the most challenging job, which is in the realm of MA. In a classic Harvard Business Review (HBR) article (1993), Alfie Kohn claimed that “studies … have conclusively shown that people who expect to receive a reward for completing a task successfully simply do not perform as well as those who expect no reward.” Performance reviews are the most stressful and performance rewards the most demoralizing and yet most software companies believe that they have no choice but to go through the same year after year. In 2004, Page and Brin instituted the Founders’ Award in Google Inc. for those who made significant contributions to the organization. This award is rarely given out as the idea backfired, because those who did not get the award felt overlooked.
(e)	Administrative Control: The operations of a company require monitoring and periodic course corrections. MA reports convey up-to-date information about the company’s operations, which help a company to carry out course corrections and plan future actions. Individuals tend to maximize their self-interest (such as easier jobs, higher salaries, and more perks) and control systems are required to align their interest with the organization’s goal of maximizing firm value. Such control systems should help monitor and motivate the right behavior. Performance metrics, incentive schemes, career progression plans, performance review, performance audit, and surveillance and security systems are all part of the control systems. Internal accounting systems are also part of this control system.

Role of Strategic Managerial Accounting

Simmonds (1988) was the first to define Strategic Managerial Accounting (SMA) as “the provision and analysis of management accounting data about a business and its competitors which is of use in the development and monitoring of the strategy of that business.” According to Innes (1998),² SMA is concerned with the provision of information to support the strategic decisions in the organizations. Cooper and Kaplan (1988)³ i...

Table of contents

• Cover
• Title
• Copyright
• Preface
• Note on the IT Software Industry
• Chapter 1. Introduction to Strategic Managerial Accounting
• Chapter 2. Nature of Costs
• Chapter 3. Allocation of Costs
• Chapter 4. Capital Budgeting and Enterprise Risk Management
• Chapter 5. Performance Metrics for High Growth Software Service Companies
• Chapter 6. Tracking and Measuring Innovation
• Chapter 7. Measuring Company Performance and Survivability in the Online Environment
• Chapter 8. Employee Performance—Significance and Evaluation
• Appendix 1: Case Study
• Appendix 2: Responsibility Centers
• Appendix 3: Multisided Platforms: Business and Revenue Models of Online Companies
• Endnotes
• References
• Index
• Adpage