Accounting and reporting on a cash flow basis CHAPTER 1

1.1 Introduction

Accountants are communicators. Accountancy is the art of communicating financial information about a business entity to users such as shareholders and managers. The communication is generally in the form of financial statements that show in money terms the economic resources under the control of the management. The art lies in selecting the information that is relevant to the user and is reliable.

Shareholders require periodic information that the managers are accounting properly for the resources under their control. This information helps the shareholders to evaluate the performance of the managers. The performance measured by the accountant shows the extent to which the economic resources of the business have grown or diminished during the year.

The shareholders also require information to predict future performance. At present companies are not required to publish forecast financial statements on a regular basis and the shareholders use the report of past performance when making their predictions.

Managers require information in order to control the business and make investment decisions.

Objectives By the end of this chapter, you should be able to: ●  explain the extent to which cash flow accounting satisfies the information needs of shareholders and managers; ●  prepare a cash budget and operating statement of cash flows; ●  explain the characteristics that makes cash flow data a reliable and fair representation; ●  critically discuss the use of cash flow accounting for predicting future dividends.

1.2 Shareholders

Shareholders are external users. As such, they are unable to obtain access to the same amount of detailed historical information as the managers, e.g. total administration costs are disclosed in the published profit and loss account, but not an analysis to show how the figure is made up. Shareholders are also unable to obtain associated information, e.g. budgeted sales and costs. Even though the shareholders own a company, their entitlement to information is restricted.

The information to which shareholders are entitled is restricted to that specified by statute, e.g. the Companies Acts, or by professional regulation, e.g. Financial Reporting Standards, or by market regulations, e.g. Listing requirements. This means that there may be a tension between the amount of information that a shareholder would like to receive and the amount that the directors are prepared to provide. For example, shareholders might consider that forecasts of future cash flows would be helpful in predicting future dividends, but the directors might be concerned that such forecasts could help competitors or make directors open to criticism if forecasts are not met. As a result, this information is not disclosed.

There may also be a tension between the quality of information that shareholders would like to receive and that which directors are prepared to provide. For example, the shareholders might consider that judgements made by the directors in the valuation of long-term contracts should be fully explained, whereas the directors might prefer not to reveal this information given the high risk of error that often attaches to such estimates. In practice, companies tend to compromise: they do not reveal the judgements to the shareholders, but maintain confidence by relying on the auditor to give a clean audit report.

The financial reports presented to the shareholders are also used by other parties such as lenders and trade creditors, and they have come to be regarded as general-purpose reports. However, it may be difficult or impossible to satisfy the needs of all users. For example, users may have different time-scales – shareholders may be interested in the long-term trend of earnings over three years, whereas creditors may be interested in the likelihood of receiving cash within the next three months.

The information needs of the shareholders are regarded as the primary concern. The government perceives shareholders to be important because they provide companies with their economic resources. It is shareholders’ needs that take priority in deciding on the nature and detailed content of the general-purpose reports.¹

1.3 What skills does an accountant require in respect of external reports?

For external reporting purposes the accountant has a two-fold obligation:

●  an obligation to ensure that the financial statements comply with statutory, professional and Listing requirements; this requires the accountant to possess technical expertise;

●  an obligation to ensure that the financial statements present the substance of the commercial transactions the company has entered into; this requires the accountant to have commercial awareness.²

1.4 Managers

Managers are internal users. As such, they have access to detailed financial statements showing the current results, the extent to which these vary from the budgeted results and the future budgeted results. Examples of internal users are sole traders, partners and, in a company context, directors and managers.

There is no statutory restriction on the amount of information that an internal user may receive; the only restriction would be that imposed by the company’s own policy. Frequently, companies operate a ‘need to know’ policy and only the directors see all the financial statements; employees, for example, would be most unlikely to receive information that would assist them in claiming a salary increase – unless, of course, it happened to be a time of recession, when information would be more freely provided by management as a means of containing claims for an increase.

1.5 What skills does an accountant require in respect of internal reports?

For the internal user, the accountant is able to tailor his or her reports. The accountant is required to produce financial statements that are specifically relevant to the user requesting them.

The accountant needs to be skilled in identifying the information that is needed and conveying its implication and meaning to the user. The user needs to be confident that the accountant understands the user’s information needs and will satisfy them in a language that is understandable. The accountant must be a skilled communicator who is able to instil confidence in the user that the information is:

●  relevant to the user’s needs;

●  measured objectively;

●  presented within a time-scale that permits decisions to be made with appropriate information;

●  verifiable, in that it can be confirmed that the report represents the transactions that have taken place;

●  reliable, in that it is as free from bias as is possible;

●  a complete picture of material items;

●  a fair representation of the business transactions and events that have occurred or are being planned.

The accountant is a trained reporter of financial information. Just as for external reporting, the accountant needs commercial awareness. It is important, therefore, that he or she should not operate in isolation.

1.5.1 Accountant’s reporting role

The accountant’s role is to ensure that the information provided is useful for making decisions. For external users, the accountant achieves this by providing a general-purpose financial statement that complies with statute and is reliable. For internal users, this is done by interfacing with the user and establishing exactly what financial information is relevant to the decision that is to be made.

We now consider the steps required to provide relevant information for internal users.

1.6 Procedural steps when reporting to internal users

A number of user steps and accounting action steps can be identified within a financial decision model. These are shown in Figure 1.1.

Note that, although we refer to an accountant/user interface, this is not a single occurrence because the user and accountant interface at each of the user decision steps.

At step 1, the accountant attempts to ensure that the decision is based on the appropriate appraisal methodology. However, the accountant is providing a service to a user and,

Figure 1.1 General financial decision model to illustrate the user/accountant

while the accountant may give guidance, the final decision about methodology rests with the user.

At step 2, the accountant needs to establish the information necessary to support the decision that is to be made.

At step 3, the accountant needs to ensure that the user understands the full impact and financial implications of the accountant’s report taking into account the user’s level of understanding and prior knowledge. This may be overlooked by the accountant, who feels that the task has been completed when the written report has been typed.

It is important to remember in following the model that the accountant is attempting to satisfy the information needs of the individual user rather than those of a ‘user group’. It is tempting to divide users into groups with apparently common information needs, without recognising that a group contains individual users with different information needs. We return to this later in the chapter, but for the moment we continue by studying a situation where the directors of a company are considering a proposed capital investment project.

Let us assume that there are three companies in the retail industry: Retail A Ltd, Retail B Ltd and Retail C Ltd. The directors of each company are considering the purchase of a warehouse. We could assume initially that, because the companies are operating in the same industry and are faced with the same investment decision, they have identical information needs. However, enquiry might establish that the directors of each company have a completely different attitude to, or perception of, the primary business objective.

For example, it might be established that Retail A Ltd is a large company and under the Fisher/Hirshleifer separation theory the directors seek to maximise profits for the benefit of the equity investors; Retail B Ltd is a medium-sized company in which the directors seek to obtain a satisfactory return for the equity shareholders; and Retail C Ltd is a smaller company in which the directors seek to achieve a satisfactory return for a wider range of stakeholders, including, perhaps, the employees as well as the equity shareholders.

The accountant needs to be aware that these differences may have a significant effect on the information required. Let us consider this diagrammatically in the situation where a capital investment decision is to be made, referring particularly to user step 2: ‘Establish with the accountant the information necessary for decision making’.

Figure 1.2 Impact of different user attitudes on the information needed in relation

We can see from Figure 1.2 that the accountant has identified that:

●  the relevant financial data are the same for each of the users, i.e. cash flows; but

●  the appraisal methods selected, i.e. internal rate of return (IRR) and net present value ( NPV), are different; and

●  the appraisal criteria employed by each user, i.e. higher IRR and NPV, are different.

In practice, the user is likely to use more than one appraisal method, as each has advantages and disadvantages. However, we can see that, even when dealing with a single group of apparently homogeneous users, the accountant has first to identify the information needs of the particular user. Only then is the accountant able to identify the relevant financial data and the appropriate report. It is the user’s needs that are predominant.

If the accountant’s view of the appropriate appraisal method or criterion differs from the user’s view, the accountant might decide to report from both views. This approach affords the opportunity to improve the user’s understanding and encourages good practice.

The diagrams can be combined (Figure 1.3) to illustrate the complete process. The user is assumed to be Retail A Ltd, a company that has directors who are profit maximisers.

The accountant is reactive when reporting to an internal user. We observe this characteristic in the Norman example set out in section 1.8. Because the cash flows are identified as relevant to the user, it is these flows that the accountant will record, measure and appraise.

The accountant can also be proactive, by giving the user advice and guidance in areas where the accountant has specific expertise, such as the appraisal method that is most appropriate to the circumstances.

1.7 Agency costs³

The information in Figure 1.2 assumes that the directors have made their investment decision based on the assumed preferences of the shareholders. However, in real life, the directors might also be influenced by how the decision impinges on their own position. If, for example, their remuneration is a fixed salary, they might select not the investment with the highest IRR, but the one that maintains their security of employment. The result might be suboptimal investment and financing decisions based on risk aversion and overretention. To the extent that the potential cash flows have been reduced, there will be an agency cost to the shareholders. This agency cost is an opportunity cost – the amount that was forgone because the decision making was suboptimal – and, as such, it will not be recorded in the books of account and will not appear in the financial statements.

1.8 Illustration of periodic financial statements prepared under the cash flow concept to disclose realised operating cash flows

In the above example of Retail A, B and C, the investment decision for the acquisition of a warehouse was based on an appraisal of cash flows. This raises the question: ‘Why not continue with the cash flow concept and report the financial changes that occur after the investment has been undertaken using that same concept?’

To do this, the company will record the consequent cash flows through a number of subsequent accounting periods; report the cash flows that occur in each financial period; and produce a balance sheet at the end of each of the financial periods. For illustration we follow this procedure in sections 1.8.1 and 1.8.2 for transactions entered into by Mr S. Norman.

1.8.1 Appraisal of the initial investment decision

Mr Norman is considering whether to start up a retail business by acquiring the lease of a shop for five years at a cost of £80,000.

Our first task has been set out in Figure 1.1 above. It is to establish the information that Mr Norman needs, so that we can decide what data need to be collected and measured. Let us assume that, as a result of a discussion with Mr Norman, it has been ascertained that he is a profit satisficer who is looking to achieve at least a 10% return, which represents the time value of money. This indicates that, as illustrated in Figure 1.2:

●  the relevant data to be measured are cash flows, represented by the outflow of cash invested in the lease and the inflow of cash represented by the realised operating cash flows;

●  the appropriate appraisal method is NPV; and

●  the appraisal criterion is a positive NPV using the discount rate of 10%.

Let us further assume that the cash to be invested in the lease is £80,000 and that the realised operating cash flows over the life of the investment in the shop are as shown in Figure 1.4. This shows that there is a forecast of £30,000 annually for five years and a final receipt of £29,000 in 20X6 when he proposes to cease trading.

We already know that Mr Norman’s investment criterion is a positive NPV using a discount factor of 10%. A calculation (Figure 1.5) shows that the investment easily satisfies that criterion.

1.8.2 Preparation of periodic financial statements under the cash flow concept

Having predicted the realised operating cash flows for the purpose of making the investment decision, we can assume that the owner of the business will wish to obtain feedback to evaluate the correctness of the investment decision. He does this by reviewing the actual results on a regular timely basis and comparing these with the predicted forecast. Actual results should be reported quarterly, half-yearly or annually in the same format as used when making the decision in Figure 1.4. The actual results provide management with the feedback information required to audit the initial decision; it is a technique for achieving accountability. However, frequently, companies do not provide a report of actual cash flows to compare with the forecast cash flows, and fail to carry out an audit review.

In some cases, the transactions relating to the investment cannot be readily separated from other transactions, and the information necessary for the audit review of the investment cannot be made available. In other cases, the routine accounting procedures fail to collect such cash flow information because the reporting systems have not been designed to provide financial reports on a cash flow basis; rather, they have been designed to produce reports prepared on an accrual basis.

What would financial reports look like if they were prepared on a cash flow basis?

To illustrate cash flow period accounts, we will prepare half-yearly accounts for Mr Norman. To facilitate a comparison with the forecast that underpinned the investment decision, we will redraft the forecast annual statement on a half-yearly basis. The data for the first year given in Figure 1.4 have therefore been redrafted to provide a forecast for the half-year to 30  June, as shown in Figure  1.6.

We assume that, having applied the net present value appraisal technique to the cash flows and ascertained that the NPV was positive, Mr Norman proceeded to set up the business on 1  January 20X1. He introduced capital of £50,000, acquired a five-year lease for £ 80,000 and paid £6,250 in advance as rent to occupy the property to 31 December 20X1. He has decided to prepare financial statements at half-yearly intervals. The information given in

From this statement we can see that the business generated positive cash flows after the end of February. These are, of course, only the cash flows relating to the trading transactions.

The information in the ‘Total’ row of Figure 1.7 can be extracted to provide the financial statement for the six months ended 30 June 20X1, as shown in Figure 1.9.

The figure of £15,650 needs to be compared with the forecast cash flows used in the investment appraisal. This is a form of auditing. It allows the assumptions made on the initial investment decision to be confirmed. The forecast/actual comparison (based on the information in Figures 1.6 and 1.9) is set out in Figure 1.10.

What are the characteristics of these data that make them relevant?

●  The data are objective. There is no judgement involved in deciding the values to include in the financial statement, as each value or amount represents a verifiable cash transaction with a third party.

●  The data are consistent. The statement incorporates the same cash flows within the periodic financial report of trading as the cash flows that were incorporated within the initial capital investment report. This permits a logical comparison and confirmation that the decision was realistic.

●  The results have a confirmatory value by helping users confirm or correct their past assessments.

●  The results have a predictive value, in that they provide a basis for revising the initial forecasts if necessary.⁴

●  There is no requirement for accounting standards or disclosure of accounting policies that are necessary to regulate accrual accounting practices, e.g. depreciation methods.

1.9 Illustration of preparation of statement of financial position

Although the information set out in Figure 1.10 permits us to compare and evaluate the initial decision, it does not provide a sufficiently sound basis for the following:

●  assessing the stewardship over the total cash funds that have been employed within the business;

●  signalling to management whether its working capital policies are appropriate.

1.9.1 Stewardship

To assess the stewardship over the total cash funds we need to:

(a)    evaluate the effectiveness of the accounting system to make certain that all transactions are recorded;

(b)    extend the cash flow statement to take account of the capital cash flows; and

(c)     prepare a statement of financial position or balance sheet as at 30 June 20X1.

The additional information for (b) and (c) above is set out in Figures 1.11 and 1.12 respectively.

The cash flow statement and statement of financial position, taken together, are a means of assessing stewardship. They identify the movement of all cash and derive a net balance figure. These statements are a normal feature of a sound system of internal control, but they have not been made available to external users.

1.9.2 Working capital policies

By ‘working capital’ we mean the current assets and current liabilities of the business. In addition to providing a means of making management accountable, cash flows are the raw data required by financial managers when making decisions on the management of working capital. One of the decisions would be to set the appropriate terms for credit policy. For example, Figure 1.11 shows that the business will have a £14,350 overdraft at 30 June 20X1.

If this is not acceptable, management will review its working capital by reconsidering the credit given to customers, the credit taken from suppliers, stock-holding levels and the timing of capital cash inflows and outflows.

If, in the example, it were possible to obtain 45 days’ credit from suppliers, then the creditors at 30 June would rise from £37,000 to a new total of £53,500. This increase in trade credit of £16,500 means that half of the May purchases (£33,000/2) would not be paid for until July, which would convert the overdraft of £14,350 into a positive balance of £2,150. As a new business it might not be possible to obtain credit from all of the suppliers. In that case, other steps would be considered, such as phasing the payment for the lease of the warehouse or introducing more capital.

An interesting research report⁵ identified that for small firms survival and stability were the main objectives rather than profit maximisation. This, in turn, meant that cash flow indicators and managing cash flow were seen as crucial to survival. In addition, cash flow information was perceived as important to external bodies such as banks in evaluating performance.

1.10 Treatment of non-current assets in the cash flow model

The statement of financial position in Figure 1.12 does not take into account any unrealised cash flows. Such flows are deemed to occur as a result of any rise or fall in the realisable value of the lease. This could rise if, for example, the annual rent payable under the lease were to be substantially lower than the rate payable under a new lease entered into on 30 June 20X1. It could also fall with the passing of time, with six months having expired by 30 June 20X1. We need to consider this further and examine the possible treatment of non-current assets in the cash flow model.

Using the cash flow approach, we require an independent verification of the realisable value of the lease at 30 June 20X1. If the lease has fallen in value, the difference between the original outlay and the net realisable figure could be treated as a negative unrealised operating cash flow.

For example, if the independent estimate was that the realisable value was £74,000, then the statement of financial position would be prepared as in Figure 1.13. The fall of £6,000 in realisable value is an unrealised cash flow and, while it does not affect the calculation of the net cash balance, it does affect the statement of financial position. Figure 1.13 Statement of financial position as at 30 June 20X1

The additional benefit of the statement of financial position, as revised, is that the owner is able clearly to identify the following:

●  the operating cash inflows of £15,650 that have been realised from the business operations;

●  the operating cash outflow of £6,000 that has not been realised, but has arisen as a result of investing in the lease;

●  the net cash balance of –£14,350;

●  the statement provides a stewardship-orientated report: that is, it is a means of making the management accountable for the cash within its control.

1.11 What are the characteristics of these data that make them reliable?

We have already discussed some characteristics of cash flow reporting which indicate that the data in the financial statements are relevant, e.g. their predictive and confirmatory roles. We now introduce five more characteristics of cash flow statements which indicate that the information is also reliable, i.e. free from bias.⁶ These are prudence, neutrality, completeness, faithful representation and substance over form.

1.11.1 Prudence characteristic

Revenue and profits are included in the cash flow statement only when they are realised. Realisation is deemed to occur when cash is received. In our Norman example, the £172,500 cash received from debtors represents the revenue for the half-year ended 30 June 20X1. This policy is described as prudent because it does not anticipate cash flows: cash flows are recorded only when they actually occur and not when they are reasonably certain to occur. This is one of the factors that distinguishes cash flow from accrual accounting.

1.11.2 Neutrality characteristic

Financial statements are not neutral if, by their selection or presentation of information, they influence the making of a decision in order to achieve a predetermined result or outcome. With cash flow accounting, the information is not subject to management selection criteria.

Cash flow accounting avoids the tension that can arise between prudence and neutrality because, whilst neutrality involves freedom from deliberate or systematic bias, prudence is a potentially biased concept that seeks to ensure that, under conditions of uncertainty, gains and assets are not overstated and losses and liabilities are not understated.⁷

1.11.3 Completeness characteristic

The cash flows can be verified for completeness provided there are adequate internal control procedures in operation. In small and medium-sized enterprises there can be a weakness if one person, typically the owner, has control over the accounting system and is able to under-record cash receipts.

1.11.4 Faithful representation characteristic

Cash flows can be depended upon by users to represent faithfully what they purport to represent provided, of course, that the completeness characteristic has been satisfied.

1.11.5 Substance over form

Cash flow accounting does not necessarily possess this characteristic which requires that transactions should be accounted for and presented in accordance with their substance and economic reality and not merely their legal form.⁸

1.12 Reports to external users

1.12.1 Stewardship orientation

Cash flow accounting provides objective, consistent and prudent financial information about a business’s transactions. It is stewardship-orientated and offers a means of achieving accountability over cash resources and investment decisions.

1.12.2 Prediction orientation

External users are also interested in the ability of a company to pay dividends. It might be thought that the past and current cash flows are the best indicators of future cash flows and dividends. However, the cash flow might be misleading, in that a declining company might sell non-current assets and have a better net cash position than a growing company that buys non-current assets for future use. There is also no matching of cash inflows and outflows, in the sense that a benefit is matched with the sacrifice made to achieve it.

Consequently, it has been accepted accounting practice to view the income statement prepared on the accrual accounting concept as a better predictor of future cash flows to an investor than the cash flow statements that we have illustrated in this chapter.

However, the operating cash flows arising from trading and the cash flows arising from the introduction of capital and the acquisition of non-current assets can become significant to investors, e.g. they may threaten the company’s ability to survive or may indicate growth.

In the next chapter, we revise the preparation of the same three statements using the accrual accounting model.

1.12.3 Going concern

The Financial Reporting Council suggests in its Consultation Paper Going Concern and Financial Reporting⁹ that directors in assessing whether a company is a going concern may prepare monthly cash flow forecasts and monthly budgets covering, as a minimum, the period up to the next statement of financial position date. The forecasts would also be supported by a detailed list of assumptions which underlie them.

Summary

To review our understanding of this chapter, we should ask ourselves the following questions.

How useful is cash flow accounting for internal decision making?

Forecast cash flows are relevant for the appraisal of proposals for capital investment.

Actual cash flows are relevant for the confirmation of the decision for capital investment.

Cash flows are relevant for the management of working capital. Financial managers might have a variety of mathematical models for the efficient use of working capital, but cash flows are the raw data upon which they work.

How useful is cash flow accounting for making management accountable? The cash flow statement is useful for confirming decisions and, together with the statement of financial position, provides a stewardship report. Lee states that ‘Cash flow accounting appears to satisfy the need to supply owners and others with stewardshiporientated information as well as with decision-orientated information.’10 Lee further states that: By reducing judgements in this type of financial report, management can report factually on its stewardship function, whilst at the same time disclosing data of use in the decision-making process. In other words, cash flow reporting eliminates the somewhat artificial segregation of stewardship and decision-making information.11 This is exactly what we saw in our Norman example – the same realised operating cash flow information was used for both the investment decision and financial reporting. However, for stewardship purposes it was necessary to extend the cash flow to include all cash movements and to extend the statement of financial position to include the unrealised cash flows. How useful is cash flow accounting for reporting to external users? Cash flow information is relevant: ●  as a basis for making internal management decisions in relation to both non-current assets and working capital; ●  for stewardship and accountability; and ●  for assessing whether a business is a going concern. Cash flow information is reliable and a fair representation, being: ●  objective; ●  consistent; ● prudent; and ● neutral. However, professional accounting practice requires reports to external users to be on an accrual accounting basis. This is because the accrual accounting profit figure is a better predictor for investors of the future cash flows likely to arise from the dividends paid to them by the business, and of any capital gain on disposal of their investment. It could also be argued that cash flows may not be a fair representation of the commercial substance of transactions, e.g. if a business allowed a year’s credit to all its customers there would be no income recorded.

REVIEW QUESTIONS

1    Explain why it is the user who should determine the information that the accountant collects, measures and reports, rather than the accountant who is the expert in financial information.

2    ‘Yuji Ijiri rejects decision usefulness as the main purpose of accounting and puts in its place accountability. Ijiri sees the accounting relationship as a tripartite one, involving the accountor, the accountee, and the accountant ... the decision useful approach is heavily biased in favour of the accountee ... with little concern for the accountor ... in the central position Ijiri would put fairness.’¹² Discuss Ijiri’s view in the context of cash flow accounting.

3    Discuss the extent to which you consider that accounts for a small businessperson who is carrying on business as a sole trader should be prepared on a cash flow basis.

4    Explain why your decision in question 3 might be different if the business entity were a mediumsized limited company.

5    ‘Realised operating cash flows are only of use for internal management purposes and are irrelevant to investors.’ Discuss.

6    ‘While accountants may be free from bias in the measurement of economic information, they cannot be unbiased in identifying the economic information that they consider to be relevant.’ Discuss.

7    Explain the effect on the statement of financial position in Figure 1.13 if the non-current asset consisted of expenditure on industry-specific machine tools rather than a lease.

8    ‘It is essential that the information in financial statements has a prudent characteristic if the financial statements are to be objective.’ Discuss.

EXERCISES

An extract from the solution is provided on the Companion Website (www.pearsoned.co.uk/elliottelliott) for exercises marked with an asterisk (*).

Question 1

Jane Parker is going to set up a new business on 1 January 20X1. She estimates that her first six months in business will be as follows:

(i)      She will put £150,000 into a bank account for the firm on 1 January 20X1.

(ii)     On 1 January 20X1 she will buy machinery £30,000, motor vehicles £24,000 and premises £75,000, paying for them immediately.

(iii)    All purchases will be effected on credit. She will buy £30,000 goods on 1 January and will pay for these in February. Other purchases will be: rest of January £48,000; February, March, April, May and June £60,000 each month. Other than the £30,000 worth bought in January, all other purchases will be paid for two months after purchase.

(iv)    Sales (all on credit) will be £60,000 for January and £75,000 for each month after. Customers will pay for the goods in the fourth month after purchase, i.e. £60,000 is received in May.

(v)     She will make drawings of £1,200 per month.

(vi)    Wages and salaries will be £2,250 per month and will be paid on the last day of each month.

(vii)   General expenses will be £750 per month, payable in the month following that in which they are incurred.

(viii)  Rates will be paid as follows: for the three months to 31 March 20X1 by cheque on 28 February 20 X1; for the 12 months ended 31 March 20X2 by cheque on 31 July 20X1. Rates are £ 4,800 per annum.

(ix)    She will introduce new capital of £82,500 on 1 April 20X1.

(x)     Insurance covering the 12 months of 20X1 of £2,100 will be paid for by cheque on 30 June 20 X 1.

(xi)    All receipts and payments will be by cheque.

(xii)   Inventory on 30 June 20X1 will be £30,000.

(xiii)  The net realisable value of the vehicles is £19,200, machinery £27,000 and premises £75,000.

Required: Cash flow accounting

(i)    Draft a cash budget (includes bank) month by month for the period January to June, showing clearly the amount of bank balance or overdraft at the end of each month.

(ii)   Draft an operating cash flow statement for the six-month period.

(iii)  Assuming that Jane Parker sought your advice as to whether she should actually set up in business, state what further information you would require.

* Question 2

Mr Norman set up a new business on 1 January 20X8. He invested £50,000 in the new business on that date. The following information is available.

1    Gross profit was 20% of sales. Monthly sales were as follows:

Month	Sales £	Month	Sales £
January	15,000	May	40,000
February	20,000	June	45,000
March	35,000	July	50,000

April     40,000

2    50 % of sales were for cash. Credit customers (50% of sales) pay in month following sale.

3    The supplier allowed one month’s credit.

4    Monthly payments were made for rent and rates £2,200 and wages £600.

5    On 1 January 20X8 the following payments were made: £80,000 for a five-year lease of business premises and £3,500 for insurances on the premises for the year. The realisable value of the lease was estimated to be £76,000 on 30 June 20X8 and £70,000 on 31 December 20X8.

6    Staff sales commission of 2% of sales was paid in the month following the sale.

Required:

(a)   A purchases budget for each of the first six months.

(b)  A cash flow statement for the first six months.

(c)   A statement of operating cash flows and financial position as at 30 June 20X8.

(d)  Write a brief letter to the bank supporting a request for an overdraft.

Question 3

Fred and Sally own a profitable business that deals in windsurfing equipment. They are the only UK agents to import ‘Dryline’ sails from Germany, and in addition to this they sell a variety of boards and miscellaneous equipment that they buy from other dealers in the UK.

Two years ago they diversified into custom-made boards built to individual customer requirements, each of which was supplied with a ‘Dryline’ sail. In order to build the boards, they have had to take over larger premises, which consist of a shop front with a workshop at the rear, and employ two members of staff to help.

Demand is seasonal and Fred and Sally find that there is insufficient work during the winter months to pay rent for the increased accommodation and also wages to the extra two members of staff. The four of them could spend October to March in Lanzarote as windsurf instructors and close the UK operation down in this period. If they did, however, they would lose the ‘Dryline’ agency, as Dryline insists on a retail outlet in the UK for 12 months of the year. Dryline sails constitute 40% of their turnover and carry a 50% mark-up.

Trading has been static and the pattern is expected to continue as follows for 1 April 20X5 to 31  March 20X 6:

Sales of boards and equipment (non-custom-built) with Dryline agency: 1 April–30 September £120,000; of this 30% was paid by credit card, which involved one month’s delay in receiving cash and 4% deduction at source.

Sixty custom-built boards 1 April–30 September £60,000; of this 15% of the sales price was for the sail (a ‘Dryline’ 6 m² sail costs Fred and Sally £100; the average price for a sail of the same size and quality is £150 (cost to them)).

Purchasers of custom-built boards take an average of two months to pay and none pays by credit card.

Sales 1 October–31 March of boards and equipment (non-custom-built) £12,000, 30% by credit card as above.

Six custom-built boards were sold for a total of £6,000 and customers took an unexplainable average of three months to pay in the winter.

Purchases were made monthly and paid for two months in arrears.

The average mark-up on goods for resale excluding ‘Dryline’ sails was 25%. If they lose the agency, they expect that they will continue to sell the same number of sails, but at their average mark-up of 25%. The variable material cost of each custom-made board (excluding the sail) was £500.

Other costs were:

Wages to employees £6,000 p.a. each (gross including insurance).

Rent for premises £6,000 p.a. (six-monthly renewable lease) payable on the first day of each month.

Other miscellaneous costs: 1 April–30 September         £3,000 1 October–31 March        £900.

Bank balance on 1 April was £100.

Salary earnable over whole period in Lanzarote:

Fred and Sally £1,500 each  living accommodation

Two employees £1,500 each  living accommodation

All costs and income accruing evenly over time.

Required:

(i)   Prepare a cash budget for 1 April 20X5 to 31 March 20X6 assuming that:

(a)   Fred and Sally close the business in the winter months.

(b)  They stay open all year.

(ii)  What additional information would you require before you advised Fred and Sally of the best course of action to take?

References

1    Framework for the Preparation and Presentation of Financial Statements, IASC, 1989, para. 10.

2    Ibid., para. 35.

3    G. Whittred and I. Zimmer, Financial Accounting: Incentive Effects and Economic Consequences, Holt, Rinehart & Winston, 1992, p. 27.

4    IASC, op. cit., para. 27.

5    R. Jarvis, J. Kitching, J. Curran and G. Lightfoot, The Financial Management of Small Firms: An Alternative Perspective, ACCA Research Report No. 49, 1996.

6    IASC, op. cit., para. 31.

7    Ibid., para. 36. 8   Ibid., para. 35.

9       Going Concern and Financial Reporting – Proposals V. Revise the Guidance for Directors of Listed Companies. FRC, 2008, para. 29.

10    T.A. Lee, Income and Value Measurement: Theory and Practice (3 rd edition), Van Nostrand Reinhold ( UK), 1985, p.  173.

11    Ibid.

12    D. Solomons, Making Accounting Policy, Oxford University Press, 1986, p. 79.

Chapter 1: Fundamentals of Strategic Management

Chapter Outline

1-1 What Is Strategic Management?

1-1a Intended and Realized Strategies

1-1b Scientifi c and Artistic Perspectives on Strategic Management

1-2 Infl uence on Strategic Management

1-3 Strategic Decisions

1-4 Summary

Key Terms

Review Questions and Exercises

Practice Quiz

Notes

Reading 1-1

Today’s business world is global, Internet driven, and obsessed with
speed. The challenges it creates for strategic managers are often complex,
ambiguous, and unstructured. Add to this the constant allegations
of top management wrongdoings, ethical blunders, and skyrocketing
executive compensation, and it is easy to see why fi rm leaders are under greater
pressure than ever to respond to strategic problems quickly, decisively, and
responsibly. Hence, the need for effective strategic management has never been
more pronounced than it is today. This text presents a framework for addressing
these immediate strategic challenges.
This chapter introduces the notion of strategic management, highlights its
importance, and presents a fi ve-step process for strategically analyzing an organization.
The remaining chapters expand on the various steps in the process, with
special emphasis on their application to ongoing enterprises.
1-1 What Is Strategic Management?
Strategy refers to top management’s plans to develop and sustain competitive
advantage—a state whereby a fi rm’s successful strategies cannot be easily
duplicated by its competitors1—so that the organization’s mission is fulfi lled.2
Following this defi nition, it is assumed that an organization has a plan, its competitive
advantage is understood, and that its members understand the reason
for its existence. These assumptions may appear self-evident, but many strategic
problems can be traced to fundamental misunderstandings associated with
defi ning the strategy. Debates over the nature of the organization’s competitive
advantage, its mission, and whether a strategic plan is really needed can be widespread.
3 Comments such as “We’re too busy to focus on developing a strategy”
or “I’m not exactly sure what my company is really trying to accomplish” can be
overheard in many organizations.
Strategic management is a broader term than strategy and is a process that
includes top management’s analysis of the environment in which the organization
operates prior to formulating a strategy, as well as the plan for implementation
and control of the strategy. The difference between a strategy and the
strategic management process is that the latter includes considering what must
be done before a strategy is formulated through assessing the success of an
implemented strategy. The strategic management process can be summarized in
fi ve steps, each of which is discussed in greater detail in subsequent chapters of
the book (see Figure 1-1).4
1. External analysis: Analyze the opportunities and threats or constraints that exist in
the organization’s external environment, including industry and macroenvironmental
forces.
2. Internal analysis: Analyze the organization’s strengths and weaknesses in its internal
environment. Consider the appropriateness of its mission.
3. Strategy formulation: Formulate strategies that build and sustain competitive
advantage by matching the organization’s strengths and weaknesses with the environment’s
opportunities and threats.
4. Strategy execution: Implement the strategies that have been developed.
5. Strategic control: Measure success and make corrections when the strategies are
not producing the desired outcomes.
Is it necessary to address these steps sequentially? The answer depends on
one’s perspective. Outsiders analyzing a fi rm should apply a systematic approach
that progresses through these steps in order. Doing so develops to a holistic
understanding of the fi rm, its industry, and its strategic challenges.

In organizations, however, strategies are being formulated, implemented, and
controlled simultaneously while external and internal factors are being assessed
and reassessed. In addition, changes in one stage of the strategic management
process will inevitably affect other stages as well. After a planned strategy is
implemented, for example, it often requires modifi cation as conditions change.
Hence, because these steps are so tightly intertwined, insiders treat all of the steps
as a single integrated, ongoing process.5
Consider the strategic management process at a fast-food restaurant chain. At
any given time, top managers are likely assessing changes in consumer taste preferences
and food preparation, analyzing the activities of competitors, working
to overcome fi rm weaknesses, controlling remnants of a strategy implemented
several years ago, implementing a strategy formulated several months ago, and
formulating strategic plans for the future. Although each of these activities can
4 Chapter 1
be linked to a distinct stage in the strategic management process, they occur
simultaneously.
An effective strategy is built on the foundation of the organization’s business
model, the mechanism whereby the organization seeks to earn a profi t by selling
its goods. In a general sense, all fi rms seek to produce a product or service and
sell it at a price higher than its production and overhead costs, thereby generating
a profi t. A business model is stated in greater detail, however. For example, a
magazine publisher might adopt a “subscription model,” an “advertising model,”
or perhaps some combination of the two. Profi ts would be generated primarily
from readers in the former case whereas they would come primarily from
advertisers in the latter case. Needless to say, identifying a fi rm’s business model
is rarely diffi cult at a basic level, but can become more complex when considering
intricate details. Progressive fi rms often devise innovative business models
that extract revenue—and ultimately profi ts—from sources not identifi ed by
competitors.
Developing a successful strategy for the fi rm is not an easy task. Realistically,
a number of factors are typically associated with successful strategies, including
the following:
1. Strategic managers thoroughly understand the competitive environment in which the
organization competes.
2. Strategic managers understand the organization’s resources and how they translate
into strengths and weaknesses.
3. The strategy is consistent with the mission and goals of the organization.
4. Plans for putting the strategy into action are designed with specifi city before it is
implemented.
5. Possible future changes in the proposed strategy (i.e., strategic control) are evaluated
before the strategy is adopted.
Careful consideration of these factors reinforces the interrelatedness of the steps
in the strategic management process. Each factor is most closely associated with
one of the fi ve steps, yet they fi t together like pieces of a puzzle. The details associated
with the success factors—and others—will be discussed in greater detail in
future chapters.
Top managers make effective strategic decisions when they remain informed
of issues that affect their industries, as well as the business world in general.
Information vital to effective strategic decision making can be found in a variety
of publications. In addition to the business sections of most major newspapers,
publications such as Fortune, Business Week, Industry Standard, Strategy+Business,
and Wall Street Journal report on a wide variety of strategic management topics
(see Table 1-1). Not only are these concepts of interest to top managers, but they
are also a concern for employees, supervisors, and middle managers of all organizations.
An appreciation of the organization’s strategy helps all of its members
relate their work assignments more closely to the direction of the organization.
Strategic management is not limited to for-profi t organizations. Top managers
of any organization, regardless of profi t or nonprofi t status, must understand
the organization’s environment and its capabilities and develop strategies
to assist the enterprise in attaining its goals. Drexel University President
Constantine Papadakis, for example, is widely considered to be a leading strategic
thinker among university top executives. The innovative Greek immigrant
promotes Drexel through aggressive marketing, while campaigning for
an all-digital library without books. In many respects, he manages the university
in the same way that other executives manage profi t-seeking enterprises.
Interestingly, his salary in 2005 was about $900,000 per year—not including
Business Model
The economic mechanism
by which a business
hopes to sell its
goods or services and
generate a profi t.
 TA B L E 1-1 Select Onl ine Sources of Business St rategy News
Publication Contact Information
Business Week www.businessweek.com
E-Commerce Times www.ecommercetimes.com
Economist www.economist.com (payment required for full access)
Fast Company www.fastcompany.com
Forbes www.forbes.com
Fortune www.fortune.com
Industry Standard www.thestandard.com(e-commerce)
Strategy+Business www.strategy-business.com (payment required for full access)
Wall Street Journal http://wsj.com (payment required for full access)
income from outside sources—making him one of the highest paid university
presidents in the country.6
1-1a Intended and Realized Strategies
A critical challenge facing organizations is the reality that strategies are not always
implemented as originally planned. Henry Mintzberg introduced two terms to
help clarify the shift that often occurs between the time a strategy is formulated
and the time it is implemented. An intended strategy, that which management
originally planned, may be realized just as it was planned, in a modifi ed form, or
even in an entirely different form. Occasionally, the strategy that management
intends is actually realized, but the intended strategy and the realized strategy,
which is what management actually implements, usually differ.7 Hence, the original
strategy may be realized with desirable or undesirable results, or it may be
modifi ed as changes in the fi rm or the environment become known.
The gap between the intended and realized strategies usually results from
unforeseen environmental or organizational events, better information that was
not available when the strategy was formulated, or an improvement in top management’s
ability to assess its environment. Although it is important for managers
to formulate responsible strategies based on a realistic and thorough assessment
of the fi rm and its environment, things invariably change along the way. Hence, it
is common for such a gap to exist, creating the need for constant strategic action
if a fi rm is to stay on course. Instead of resisting modest strategic changes when
new information is discovered, managers should search for new information and
be willing to make such changes when necessary. This activity is part of strategic
control, the fi nal step in the strategic management process.
1-1b Scientifi c and Artistic Perspectives
on Strategic Management
Top executives should take one of two different perspectives on the approach
to strategic management. Most strategy scholars have endorsed a scientifi c perspective,
whereby strategic managers are encouraged to systematically assess the fi rm’s
external environment and evaluate the pros and cons of myriad alternatives
before formulating strategy. The business environment is seen as largely objective,
analyzable, and at least somewhat predictable. As such, strategic managers
should follow a systematic process of environmental, competitive, and internal
analysis and build the organization’s strategy on this foundation.
According to this perspective, strategic managers should be trained, highly
skilled analytical thinkers capable of digesting a myriad of objective data and translating it into a desired direction for the fi rm. “Strategy scientists” tend to
minimize or reject altogether the role of imagination and creativity in the strategy
process, and are not generally receptive to alternatives that emerge from any
process other than a comprehensive, analytical approach.
Others, however, have a different view. According to the artistic perspective on
strategy, the lack of environmental predictability and the fast pace of change
render elaborate strategy planning as suspect at best. Instead, strategists should
incorporate large doses of creativity and intuition in order to design a comprehensive
strategy for the fi rm.8 Mintzberg’s notion of a craftsman—encompassing
individual skill, dedication, and perfection through mastery of detail—embodies
the artistic model. The strategy artist senses the state of the organization, interprets
its subtleties, and seeks to mold its strategy like a potter molds clay. The
artist visualizes the outcomes associated with various alternatives and ultimately
charts a course based on holistic thinking, intuition, and imagination.9 “Strategy
artists” may even view strategic planning exercises as time poorly spent and may
not be as likely as those in the science school to make the effort necessary to
maximize the value of a formal planning process.10
This text acknowledges the validity of the artistic perspective but emphasizes
the scientifi c view. Creativity and innovation are important and encouraged, but
are most likely to translate into organizational success when they occur as part
of a comprehensive approach to strategic management. Nonetheless, the type of
formal, systematic strategic planning proposed in this text is not without its critics.
Some charge that such models are too complex to apply, or that they apply
only to businesses in highly certain environments.11 Others emphasize that the
stages in the process are so closely interrelated and that considering them as
independent steps may be counterproductive. Still others, such as Mintzberg,
argue that planning models stifl e the creativity and imagination that is central to
formulating an effective strategy.12 Although these views have merit, the comprehensive,
systematic model proposed herein is presented as a proper foundation
for understanding the strategic management process. It does not, however, preclude
the application of other approaches.
1-2 Infl uence on Strategic Management
The roots of the strategic management fi eld can be traced to the 1950s when the
discipline was originally called “business policy.” Today, strategic management is
an eclectic fi eld, drawing upon a variety of theoretical frameworks. Three prominent
perspectives are summarized in Table 1-2 and discussed in this section.
TA B L E 1-2 Theoret ical Perspect ives on Fi rm Per formance
Theoretical Primary Infl uence How Perspective Is Applied
Perspective on Firm Performance to the Case Analysis
Industrial organization Structure of the industry Industry analysis portion of the
(IO) theory external environment
Resource-based theory Firm’s unique combination Analysis of internal strengths
of strategic resources and weaknesses
Contingency theory Fit between the fi rm and Strengths, weaknesses,
its external environment opportunities, and threats
(SWOT) analysis and
SW/OT matrix

Industrial organization (IO), a branch of microeconomics, emphasizes the
infl uence of the industry environment upon the fi rm. The central tenet of industrial
organization theory is the notion that a fi rm must adapt to infl uences in its
industry to survive and prosper; thus, its fi nancial performance is primarily determined
by the success of the industry in which it competes. Industries with favorable
structures offer the greatest opportunity for fi rm profi tability.13 Following
this perspective, it is more important for a fi rm to choose the correct industry
within which to compete than to determine how to compete within a given industry.
Recent research has supported the notion that industry factors tend to play
a dominant role in the performance of most fi rms, except for those that are the
notable industry leaders or losers.14
IO assumes that an organization’s performance and ultimate survival depend
on its ability to adapt to industry forces over which it has little or no control.
According to IO, strategic managers should seek to understand the nature of
the industry and formulate strategies that feed off the industry’s characteristics.15
Because IO focuses on industry forces alone, strategies, resources, and competencies
are assumed to be fairly similar among competitors within a given industry. If
one fi rm deviates from the industry norm and implements a new, successful strategy,
then other fi rms will rapidly mimic the higher performing fi rm by purchasing
the resources, competencies, or management talent that have made the leading
fi rm so profi table. Hence, although the IO perspective emphasizes the industry’s
infl uence on individual fi rms, it is also possible for fi rms to infl uence the strategy
of rivals, and in some cases even modify the structure of the industry.16
Perhaps the opposite of the IO perspective, resource-based theory views performance
primarily as a function of a fi rm’s ability to utilize its resources.17 Although
environmental opportunities and threats are important, a fi rm’s unique resources
comprise the key variables that allow it to develop a distinctive competence, enabling
the fi rm to distinguish itself from its rivals and create competitive advantage.
“Resources” include all of a fi rm’s tangible and intangible assets, such as capital,
equipment, employees, knowledge, and information.18 An organization’s
resources are directly linked to its capabilities, which can create value and ultimately
lead to profi tability for the fi rm. Hence, resource-based theory focuses
primarily on individual fi rms rather than on the competitive environment.
If resources are to be used for sustained competitive advantage—a fi rm’s ability
to enjoy strategic benefi ts over an extended time—those resources must be
valuable, rare, not subject to perfect imitation, and without strategically relevant
substitutes.19 Valuable resources are those that contribute signifi cantly to the
fi rm’s effectiveness and effi ciency. Rare resources are possessed by only a few
competitors, and imperfectly imitable resources cannot be fully duplicated by
rivals. Resources that have no strategically relevant substitutes enable the fi rm to
operate in a manner that cannot be effectively imitated by others, and thereby
sustain high performance.
According to contingency theory, the most profi table fi rms are likely to be those
that develop a benefi cial fi t with their environment. In other words, a strategy is most
likely to be successful when it is consistent with the organization’s mission, its competitive
environment, and its resources. Contingency theory represents a middle
ground perspective that views organizational performance as the joint outcome of
environmental forces and the fi rm’s strategic actions. Firms can become proactive
by choosing to operate in environments where opportunities and threats match
their strengths and weaknesses.20 Should the industry environment change in a
way that is unfavorable to the fi rm, its top managers should consider leaving that
industry and reallocating its resources to other, more favorable industries.
Each of these three perspectives has merit and has been incorporated into the
strategic management process laid out in this text. The industrial organization
view is seen in the industry analysis phase, most directly in Michael Porter’s “fi ve
forces” model. Resource-based theory is applied directly to the internal analysis
phase and the effort to identify an organization’s resources that could lead
to sustained competitive advantage. Contingency theory is seen in the strategic
alternative generation phase, where alternatives are developed to improve the
organization’s fi t with its environment. Hence, multiple perspectives are critical
to a holistic understanding of strategic management.21
1-3 Strategic Decisions
How does one think and act strategically, and who makes the decisions? The
answers to these questions vary across fi rms and may also be infl uenced by factors
such as industry, age of the fi rm, and size of the organization. In general,
however, strategic decisions are marked by four key distinctions.
1. They are based on a systematic, comprehensive analysis of internal attributes and
factors external to the organization. Decisions that address only part of the organization—
perhaps a single functional area—are usually not considered to be strategic
decisions.
2. They are long term and future oriented, but are built on knowledge about the past and
present. Scholars and managers do not always agree on what constitutes the “long
term,” but most agree that it can range anywhere from several years in duration to
more than a decade.
3. They seek to capitalize on favorable situations outside the organization. In general, this
means taking advantage of opportunities that exist for the fi rm, but it also includes
taking measures to minimize the effects of external threats.
4. They involve choices. Although making win-win strategic decisions may be possible,
most involve some degree of trade-off between alternatives, at least in the short run.
For example, raising salaries to retain a skilled workforce can increase wages, and
adding product features or enhancing quality can increase the cost of production.
Such trade-offs, however, may diminish in the long run, as a more skilled, higher
paid workforce may be more productive than a typical workforce, and sales of a
higher quality product may increase, thereby raising sales and potentially profi ts.
Decision makers must understand these complex relationships across the business
spectrum.
Because of these distinctions, strategic decision making is generally reserved
for the top executive and members of the top management team. The chief
executive is the individual ultimately responsible (and generally held responsible)
for the organization’s strategic management, but this person rarely acts
alone. Except in the smallest companies, the CEO relies on a team of top-level
executives—including members of the board of directors, vice presidents, and
various line and staff managers—all of whom play instrumental roles in strategically
managing the fi rm. Generally speaking, the quality of strategic decisions
improves dramatically when more than one capable executive participates in the
process.22
The size of the team on which the top executive relies for strategic input and
support can vary from fi rm to fi rm. Companies organized around functions such
as marketing and production generally involve the heads of the functional departments
in strategic decisions. Very large organizations often employ corporate-level
strategic planning staffs and outside consultants to assist top executives in the
process. The degree of involvement of top and middle managers in the strategic
management process also depends on the personal philosophy of the CEO.23
Some chief executives are known for making quick decisions, whereas others
have a reputation for involving a large number of top managers and others in
the process.
Input to strategic decisions, however, need not be limited to members of the
top management team. To the contrary, obtaining input from others throughout
the organization, either directly or indirectly, can be quite benefi cial. In fact,
most strategic decisions result from the streams of inputs, decisions, and actions
of many people. For example, an employee in a company’s research and development
department attends a trade show where vendors discuss a new product
or production process idea that seems relevant to the company. The employee
relates the idea to the next level manager who, in turn, modifi es and passes it
along to a higher level manager. Eventually, the organization’s marketing and
production managers discuss a version of the idea, and later present it to top
management. The CEO ultimately decides to incorporate the idea into the ongoing
strategic planning process. This example illustrates the indirect involvement
of individuals throughout the organization in the strategic management process.
Top management is ultimately responsible for the fi nal decision, but this decision
is based on a culmination of the ideas, creativity, information, and analyses
of others24 (see Strategy at Work 1-1).
Ethics and social responsibility are also key concerns in strategic decision
making. Simply stated, the moral components and social outcomes associated
with a strategic decision, such as the effects of closing an existing production
facility in search of lower costs abroad, should be considered alongside economic
concerns. These issues are discussed in greater detail in Chapters 6 through 9
under the umbrella of strategy formulation (see Case Analysis 1-1).
S T R A T E G Y A T W O R K 1 - 1
Strategic Decisions
Strategic decisions, by their nature, may be characterized
by considerable risk and uncertainty. Unpredictable environmental
changes can quickly threaten well-conceived
plans. Most strategic decision makers clearly recognize
this danger and learn to adapt. Here are two examples.
1. Like all aircarriers, American Airlines faces a number
of challenges: international terrorism, steadily rising
costs, unstable national economies, uncertain volumes
of domestic traffi c, and protectionist threats
to international traffi c. In the face of these threats,
CEO Robert Crandall suggests that senior managers
rarely know the outcomes of these situations anyway
and should be accustomed to dealing with the uncertainty
associated with critical strategic decisions.
2. Bernard Food Industries Inc. is a fi fty-three-year-old
family-held business of more than 1,500 sugarfree,
low-fat, and low-calorie food products. At fi rst,
the company sold most of its products to hospitals,
nursing homes, and other such institutions. In 1996,
however, Steve Bernard, the founder’s son, decided
to expand the market. Although only a handful of
companies were marketing such products at that
time, Bernard viewed the Web as the future. The
fi rm’s online subsidiary, eDietShop (www.diet-shop.
com) performed extremely well and quintupled retail
sales in the fi rst two years and has continued to grow,
developing into one of its industry’s leaders by the
mid-2000s. As Bernard put it, “We didn’t turn to the
Web because other people were doing it but because
we knew where we wanted our business to go.”
Sources: S. Forster, “Online Brokerage Firms Adopt a ‘Bricks-and-Clicks’
Strategy,” Wall Street Journal Interactive Edition, 6 February 2001;
Anonymous, “Taming the Techno Beast—Technology Is Running Wild.
Learn to Manage Change, or You’ll Get Eaten Alive,” Business Week,
Technology section, 8 June 2000; P. Wright, M. Kroll, and J. A. Parnell,
Strategic Management: Concepts (Upper Saddle River, NJ: Prentice
Hall, 1998); W. M. Carley, “GE and Pratt Agree to Build Engine for
Boeing Jumbo Jet,” Wall Street Journal Interactive Edition, 9 May
1996; J. Cole and C. S. Smith, “Boeing Loses Contest to Become China’s
Partner in Building Plane,” Wall Street Journal Interactive Edition,
2 May 1996.
Case Analysis 1-1
Step 1: Introduction of the Organization
The fi rst step in the case analysis process is to develop familiarity with the organization,
a basic task not directly related to a specifi c theory or set of concepts presented
in this chapter. Analyzing an ongoing enterprise begins with a general introduction
and understanding of the company. When was the organization founded, why, and
by whom? Is any unusual history associated with the organization? Is it privately or
publicly held? What is the company’s mission? Has the mission changed since its
inception?
It is also important at this point to identify the business model on which the organization’s
success is predicated. In other words, what is the basic profi t-generating idea
behind the company? Determining this information is simple for some companies
(Ford, for example, hopes to sell cars and offer consumer fi nancing at a profi t) but may
be complicated for others where revenue streams and competitive advantage are more
diffi cult to identify.
Key Terms
business model
competitive advantage
contingency theory
distinctive competence
industrial organization
intended strategy
realized strategy
resource-based theory
strategic management
strategy
sustained competitive advantage
top management team

1-4 Summary

Top managers face more complex strategic challenges today than ever before.

Strategic management involves analysis of an organization’s external and internal

environments, formulation and implementation of its strategic plan, and

strategic control. These steps in the process are interrelated and typically done

simultaneously in many fi rms.

A fi rm’s intended strategy often requires modifi cation before it has been fully

implemented due to changes in environmental and/or organizational conditions.

Because these changes are often diffi cult to predict, substantial changes in

the environment may transform an organization’s realized strategy into one that

is quite different from its intended strategy.

The strategic management fi eld has been infl uenced by such perspectives as

industrial organization theory, resource-based theory, and contingency theory.

Although they are based on widely varied assumptions about what leads to high

performance, each of these perspectives has merit and contributes to an overall

understanding of the fi eld.

Strategy formulation is the direct responsibility of the CEO, who also relies

on a team of other individuals, including the board of directors, vice presidents,

and various managers. In its fi nal form, a strategic decision is crafted

from the streams of inputs, decisions, and actions of the entire top management

team.

Review Questions and Exercises
1. Is it necessary that the fi ve steps in the strategic management
process be performed sequentially? Why or
why not?
2. What is the difference between an intended strategy
and a realized strategy? Why is this distinction
important?
3. How have outside perspectives infl uenced the development
of the strategic management fi eld?
4. Does the CEO alone make the strategic decisions for
an organization? Explain.
Practice Quiz
True or False
1. A strategy seeks to develop and sustain competitive
advantage.
2. Strategic management refers to formulating successful
strategies for an organization.
3. Each step in the strategic management process is
independent so that changes in one step will not
substantially affect other steps.
4. The intended strategy and the realized strategy can
never be the same.
5. Whereas industrial organization theory emphasizes
the infl uence of industry factors of fi rm performance,
resource-based theory emphasizes the role
of fi rm factors.
6. Strategic decisions are made solely by and are ultimately
the responsibility of the chief executive alone.
Multiple Choice
7. Strategies are formulated in the strategic management
stage that occurs immediately after
A. the assessment of internal strengths and
weaknesses.
B. implementation of the strategy.
C. control of the strategy.
D. none of the above
8. The strategy originally planned by top management
is called the
A. grand strategy.
B. realized strategy.
C. emergent strategy.
D. none of the above
9. The notion that successful fi rms tend to be the
ones that adapt to infl uences in their industries is
based on
A. industrial organization theory.
B. resource-based theory.
C. contingency theory.
D. none of the above
10. The notion of distinctive competence is consistent
with
A. industrial organization theory.
B. resource-based theory.
C. contingency theory.
D. none of the above
11. In order to contribute to sustained competitive
advantage, fi rm resources should be
A. valuable and rare.
B. not subject to perfect imitation.
C. without strategically relevant resources.
D. all of the above.
12. Which of the following is not a characteristic of strategic
decisions?
A. They are long term in nature.
B. They involve choices.
C. They do not involve trade-offs.
D. All of the above are characteristics of strategic
decisions.

12 Chapter 1
1. I. M. Cockburn, R. M. Henderson, and S. Stern, “Untangling
the Origins of Competitive Advantage,” Strategic Management
Journal 21 (2000): 1123–1145.
2. P. Wright, M. Kroll, and J. A. Parnell, Strategic Management:
Concepts (Upper Saddle River, NJ: Prentice Hall, 1998).
3. D. C. Hambrick and J. W. Fredrickson, “Are You Sure You
Have a Strategy?” Academy of Management Executive 15
(2001): 48–59.
4. Based on Wright et al., Strategic Management.
5. A. E. Singer, “Strategy as Moral Philosophy,” Strategic
Management Journal 15 (1994): 191–213.
6. B. Wysocki, Jr., “How Dr. Papadakis Runs a University Like
a Company,” Wall Street Journal (23 February 2005): A1;
P. Fain, “High Pay Makes Headlines,” Chronicle of Higher
Education Online Edition (24 November 2006).
7. H. Mintzberg, “Opening Up the Defi nition of Strategy,” in
J. B. Quinn, H. Mintzberg, and R. M. James, eds., The Strategy
Process (Englewood Cliffs, NJ: Prentice Hall, 1988), 14–15.
8. C. M. Ford and D. M. Gioia, “Factors Infl uencing Creativity
in the Domain of Managerial Decision Making,” Journal of
Management 26 (2001): 705–732.
9. H. Mintzberg, “Crafting Strategy,” Harvard Business Review
65(4) (1987): 66–75.
10. G. Hamel, “Strategy as Revolution,” Harvard Business Review
74(4) (1996): 69–82; B. Huffman, “What Makes a Strategy
Brilliant?” Business Horizons 44(4) (2001): 13–20.
11. H. Courtney, J. Kirkland, and P. Viguerie, “Strategy Under
Uncertainty,” Harvard Business Review (November–
December 1997): 67–79.
12. Hamel, “Strategy as Revolution”; B. Huffman, “What Makes a
Strategy Brilliant?”
13. M. E. Porter, “The Contributions of Industrial Organization to
Strategic Management,” Academy of Management Review 6
(1981): 609–620.
14. G. Hawawini, V. Subramanian, and P. Verdin, “Is Performance
Driven by Industry- or Firm-Specifi c Factors? A New Look
at the Evidence,” Strategic Management Journal 24 (2003):
1–16.
15. J. S. Bain, Industrial Organization (New York: Wiley, 1968);
F. M. Scherer and D. Ross, Industrial Market Structure and
Economic Performance (Boston: Houghton-Miffl in, 1990).
16. A. Seth and H. Thomas, “Theories of the Firm: Implications
for Strategy Research,” Journal of Management Studies 31
(1994): 165–191; J. B. Barney, “Strategic Factor Markets:
Expectations, Luck, and Business Strategy,” Management
Science 42 (1986): 1231–1241.
17. It has been argued that the resource-based perspective
does not qualify as an academic theory. For details
on this exchange, see R. L. Priem and J. E. Butler, “Is the
Resource-Based ‘View’ a Useful Perspective for Strategic
Management Research,” Academy of Management Review
26 (2001): 22–40; J. B. Barney, “Is the Resource-Based
‘View’ a Useful Perspective for Strategic Management
Research? Yes,” Academy of Management Review 26
(2001): 41–56.
18. J. B. Barney, “Looking Inside for Competitive
Advantage,” Academy of Management Executive
19 (1995): 49–61.
19. S. L. Berman, J. Down, and C. W. L. Hill, “Tacit Knowledge
as a Source of Competitive Advantage in the National
Basketball Association,” Academy of Management Journal 45
(2002): 13–32.
20. E. J. Zajac, M. S. Kraatz,and R. K. F. Bresser, “Modeling
the Dynamics of Strategic Fit: A Normative Approach to
Strategic Change,” Strategic Management Journal 21 (2000):
429–453.
21. C. A. Lengnick-Hall and J. A. Wolff, “Similarities and
Contradictions in the Core Logic of Three Strategy Research
Streams,” Strategic Management Journal 20 (1999): 1109–
1132; O. E. Williamson, “Strategy Research: Governance and
Competence Perspectives,” Strategic Management Journal 20
(1999): 1087–1108.
22. T. K. Das and B. Teng, “Cognitive Biases and Strategic
Decision Processes: An Integrative Perspective,” Journal of
Management Studies 36 (1999): 757–778; M. A. Carpenter,
“The Implications of Strategy and Social Context for the
Relationship Between Top Team Management Heterogeneity
and Firm Performance,” Strategic Management Journal 23
(2002): 275–284.
23. A. J. Hillman and M. A. Hitt, “Corporate Political Strategy
Formulation: A Model of Approach, Participation, and
Strategy Decisions,” Academy of Management Review 24
(1999): 825–842.
24. Wright et al., Strategic Management.

R E A D I N G 1 - 1
Insight from strategy+business
Southwest Airline’s Herb Kelleher is widely viewed as an effective organizational leader and strategic thinker.
Under his leadership, the low-cost airline recorded thirty consecutive years of profi ts, a feat unmatched in the
industry. Kelleher provides insight into his philosophy and perspectives on strategy and success in this chapter’s
strategy+business reading.
Herb Kelleher: The Thought Leader Interview
The cofounder and chairman of Southwest Airlines tells why a fi rm’s people are everything.
By Chuck Lucier


The airline industry is a tough place to make
a buck: too many competitors, price-sensitive
customers, high capital intensity, boom-orbust
cyclicality, powerful suppliers, and often
intransigent unions. Nevertheless, Herb Kelleher, the
cofounder and chairman of Southwest Airlines, created
the sort of value that any company leader would envy.
From its start in 1971, Southwest has grown into the
fourth-largest airline in the United States, with 30 consecutive
years of profi tability, in an industry in which no
other company has been profi table for even fi ve straight
years. Total shareholder returns during that period were
almost double the returns for the S&P 500. Southwest
has managed to accrue a market capitalization larger
than that of the rest of the American airlines combined.
Major competitors have tried to imitate Southwest with
clones. Many entrepreneurial startups in the United
States and Europe, including JetBlue and Ryanair, cite
Southwest as their inspiration.
Southwest’s achievements are widely attributed to
its relentless focus. From the start, Southwest’s strategy
has been to draw travelers not from other airlines, but
from cars, buses, and trains, by providing them the least
expensive and fastest service available. To support the
strategy, the company determined to fl y only one type of
airplane, the Boeing 737, and to substitute linear fl ying
for the hub-and-spoke model that has prevailed in the
industry. But at the center of Southwest’s success are
its culture and employees. “Your spirit,” says Mr. Kelleher,
a man fabled for his willingness to party hard with his
staff, is “the most powerful thing of all.”
In recognition of the inspiration he provides all who
study and practice strategy, for his contributions in redefi ning
how companies think about strategy, and for his achievements
in redefi ning an industry, in November 2003 Mr.
Kelleher was granted the Lifetime Achievement Award
by the Strategic Management Society (SMS), the prestigious
global association of academic and corporate
strategists.
At the SMS annual meeting in Baltimore, Md., where
Mr. Kelleher accepted the award, strategy+ business contributing
editor and “Breakthrough Thoughts” co-columnist
Chuck Lucier led a spirited public conversation with Mr.
Kelleher about Southwest’s success.
S+B: Let’s start with some words from your
award. You made an “audacious commitment” to
putting employees fi rst, customers second, and
shareholders third. How did you get away with
that for 20 years?
KELLEHER: When I started out, business school professors
liked to pose a conundrum: Which do you put
fi rst, your employees, your customers, or your shareholders?
As if that were an unanswerable question. My
answer was very easy: You put your employees fi rst. If
you truly treat your employees that way, they will treat
your customers well, your customers will come back, and
that’s what makes your shareholders happy. So there
is no constituency at war with any other constituency.
Ultimately, it’s shareholder value that you’re producing.
S+B: A dollar invested at Southwest’s 1972 initial
public offering is worth $1,400 today. Does that
come solely from putting your employees fi rst?
KELLEHER: We have been successful because we’ve
had a simple strategy. Our people have bought into it.
R E A D I N G 1 - 1
Insight from strategy+business
Southwest Airline’s Herb Kelleher is widely viewed as an effective organizational leader and strategic thinker.
Under his leadership, the low-cost airline recorded thirty consecutive years of profi ts, a feat unmatched in the
industry. Kelleher provides insight into his philosophy and perspectives on strategy and success in this chapter’s
strategy+business reading.
Herb Kelleher: The Thought Leader Interview
The cofounder and chairman of Southwest Airlines tells why a fi rm’s people are everything.
By Chuck Lucier
Source: Reprinted with permission from strategy+business, the award-winning management quarterly published by Booz Allen Hamilton.
http://www.strategy-business.com.

Which Month Baby are you ?

Which Month Baby are you ?

JANUARY BABY
Pretty/handsome. Loves to dress up. Easily bored. Fussy. Seldom shows emotions. Takes time to recover when hurt. Sensitive. Down-to-Earth.

FEBRUARY BABY
Abstract thoughts. Loves reality and abstract. Intelligent and clever. Changing personality. Attractive. sexiest out of everyone. Temperamental. Quiet, shy and humble. Honest and loyal. Determined to reach goals. Loves freedom. Rebellious when restricted. Loves aggressiveness. Too sensitive and easily hurt. Gets angry really easily but does not show it. Dislikes unnecessary things. Loves making friends but rarely shows it. Horny. Daring and stubborn. Ambitious. Realizing dreams and hopes. Sharp. Loves entertainment and leisure. Romantic on the inside not outside. Superstitious and ludicrous. Spendthrift. Tries to learn to show emotions.

MARCH BABY
Attractive personality. sexy. Affectionate Shy and reserved. Secretive. Naturally honest, generous and sympathetic. Loves peace and serenity. Sensitive to others. Great kisser. Easily angered. Trustworthy. Appreciative and returns kindness. Hardly shows emotions. Tends to bottle up feelings. Observant and assesses others.

APRIL BABY
Suave and compromising. Funny and humorous. Stubborn. Very talkative. Calm and cool. Kind and sympathetic. Concerned and detailed. Loyal. Does work well with others. Very confident. Sensitive. Positive Attitude. Thinking generous. Good memory. Clever and knowledgeable. Loves to look for information. Able to cheer everyone up and/or make them laugh. Able to motivate oneself and others. Understanding. Fun to be around. Outgoing. Hyper. Bubbly personality. Secretive. Boy/girl crazy. Loves sports, music, leisure and travelling. Systematic. hot but has brains.

MAY BABY
Stubborn and hard-hearted . Strong-willed and highly motivated. Sharp thoughts. Easily angered. Attracts others and loves attention. Deep feelings. Beautiful physically and mentally. Firm Standpoint. Needs no motivation. Shy towards opposite sex. Easily consoled. Systematic (left brain). Loves to dream. Strong clairvoyance. Understanding. Sickness usually in the ear and neck. Good imagination. Good physical. Weak breathing. Loves literature and the arts. Loves travelling. Dislike being at home. Restless. Not having many children. Hardworking. High spirited.

JUNE BABY
Fun to be with. Secretive. Difficult to fathom and to be understood. Quiet unless excited or tensed. Takes pride in oneself. Has reputation. Easily consoled. Honest. Concerned about people's feelings. Tactful. Friendly. Approachable. Emotional temperamental and unpredictable. Easily hurt. Witty and sparkly. spazzy at times. Not revengeful. Forgiving but never forgets. dislikes nonsensical and unnecessary things. Guides others physically and mentally. Sensitive and forms impressions carefully. Caring and loving. Treats others equally. Strong sense of sympathy. Wary and sharp. Judges people through observations. Hardworking. No difficulties in studying. Loves to be with friends . Always broods about the past and the old friends. Waits for friends. Never looks for friends. Not aggressive unless provoked. Loves to be loved. Easily hurt but takes long to recovr.

JULY BABY
You've got the best personality and are an absolute pleasure to be around. You love to make new friends and be outgoing. You are a great flirt and more than likely have an a very attractive partner. a wicked hottie. It is also more than likely that you have a massive record collection. You have a great choice in films, and may one day become a famous actor/actress yourself -heck, you've got the looks for it!!!

AUGUST BABY
outgoing personality. takes risks. feeds on attention. no self control. kind hearted. self confident. loud and boisterous. VERY revengeful. easy to get along with and talk to. has an "every thing's peachy" attitude. likes talking and singing. loves music. daydreamer. easily distracted. Hates not being trusted. BIG imagination. loves to be loved. hates studying. in need of "that someone". longs for freedom. rebellious when withheld or restricted. lives by "no pain no gain" caring. always a suspect. playful. mysterious. "charming" or "beautiful" to everyone. stubborn. curious. independent. strong willed. a fighter.

SEPTEMBER BABY
Active and dynamic. Decisive and haste but tends to regret. Attractive and affectionate to oneself. Strong mentality. Loves attention. Diplomatic. Consoling, friendly and solves people's problems. Brave and fearless. Adventurous. Loving and caring. Suave and generous. Usually you have many friends. Enjoys to make love. Emotional. Stubborn. Hasty. Good memory. Moving, motivates oneself and others. Loves to travel and explore. Sometimes sexy in a way that only their lover can understand.

OCTOBER BABY
Loves to chat. Loves those who love them. Loves to takes things at the centre. Inner and physical beauty.Gets angry often. Treats friends importantly. Brave and fearless. Always making friends. Easily hurt but recovers easily. Daydreamer. Opinionated. Does not care to control emotions. Unpredictable. Extremely smart, but definitely the hottest AND sexiest of them all.

NOVEMBER BABY
Trustworthy and loyal. Very passionate and dangerous. Wild at times. Knows how to have fun. Sexy and mysterious. Everyone is drawn towards your inner and outer beauty and independent personality. Playful, but secretive. Very emotional and temperamental sometimes. Meets new people easily and very social in a group. Fearless and independent. Can hold their own. Stands out in a crowd. Essentially very smart. Gets hurt on small things from close ones. Very caring and loving to their partner and family. Stubborn. Usually, the greatest men and women are born in this month. If you are already in a relationship with someone in this month, hold on to them because their one of a kind.

DECEMBER BABY
This straight-up means ur the most good-looking person possible... better than all of these other months! Loyal and generous. Patriotic. Competitive in everything. Active in games and interactions. Impatient and hasty. Ambitious. Influential in organizations. Fun to be with. Easy to talk to, though hard to understand. Thinks far with vision, yet complicated to know. Easily influenced by kindness. Polite and soft-spoken. Having lots of ideas. Sensitive. Active mind. Hesitating, tends to delay. Choosy and always wants the best. Temperamental. Funny and humorous. Loves to joke. Good debating skills. Has that someone always on his/her mind. Talkative. Daydreamer. Friendly. Knows how to make friends. Abiding. Able to show character. one guy/girl kind of person. Loveable. Easily hurt !!

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