Aligning corporate strategy with financial targets

Whether managing a SME or a large corporation, business success naturally flows from investing in the right growth opportunities to build shareholder value.

Strategy is fundamental to maximising value, and businesses must develop a meaningful strategic framework. This framework must capitalise on those distinctive or unique capabilities which define a firm’s competitive advantage. Often however, traditional planning processes tend to drive out strategic thinking and as a result impair rather than support successful organisational development.

Hamel & Prahalad describe this traditional approach as ‘strategy by form filling’. Strategy becomes an endless exercise in SWOT analysis, Boston and other two-by-two matrixes and five forces models. In other words, it becomes descriptive, deterministic and sterile. Another pitfall are “me too” strategies where firms imitate the perceived successful strategies of market leaders. Such strategies are prone to failure because of the uniqueness of the competitive advantage that underwrites the success of leaders.

Because businesses have to innovate to ensure enduring growth in value, first rate strategic thinking is crucial and should be widely diffused within the firm. In a business context, innovation that does not create economic value (EVA) is not really innovation at all. Management’s challenge is to outperform the competition, and to do this, a business must demonstrate:

  • A vibrant and sustainable competitive advantage, combined with an innovation-based culture which anticipates market changes and rapidly exploits new opportunities.
  • A strong management discipline to ensure economic value is maximised and tough decisions are taken. For example, performance measures must discourage executives from building bigger businesses (assets & turnover) at the expense of destroying shareholder value.

Since strategy fundamentally involves making choices to allocate limited organisational resources one way rather than another, the notion of the opportunity cost of capital must form an essential basis for business strategy formulation. However there is a disturbing trend for New Zealand’s corporations to formulate strategic plans and a growth vision that do not factor in this cost.

In view of strategic planning’s limitations, the case is put here for developing robust business cases and capex appraisals as the crucial link between senior management’s strategic plans and the organisation’s underpinning operating budgets, KPIs and financial targets.

Business cases are normally prepared when a business is looking to expand, while capex appraisals normally pertain to ‘stay in business’ mode. Business case frameworks should encourage decision makers to recognise that organisations, business models and business processes evolve over time, and that new technology progressively displaces old technology. So the emphasis should be on encouraging applied innovation management.

Business case frameworks can promote innovation by requiring different scenarios to be developed – using for the likes of Alexander Osterwalder’s internationally recognised business model canvas. While the focal point of the canvas will be the Value Proposition, this approach requires that Customer, Service Delivery, Resources (capability), Processes, and Costs and Benefits are evaluated for each scenario, and that qualitative assessment of scenarios is undertaken in terms of alignment with business and strategic objectives.

Developing several alternative scenarios for each strategic initiative is an important way of gaining useful insights while providing a benchmark to measure each alternative against for value creation and risk. In the book Decisive the authors found that decision quality improves by a factor of six if a second alternative is considered.

A logical structure is a ‘must’ and a business case should be supported with evidence that withstands critical scrutiny, serves as a useful guide to decision makers and makes accurate predictions. There are core sections that give a business case its logical structure, including Introduction & Overview; Assumptions & Methods; Business Results; Sensitivity & Risk Analysis, and Conclusions & Recommendations.

The business case subject statement describes what the case is about and identifies the different scenarios that will be compared. Assumptions play a crucially important role in a business case, for both the author and recipients alike. A business case will include an Assumptions section, describing the important assumptions in the case. A business case needs to stand on its key assumptions because it predicts the future, which is fundamentally uncertain. Assumptions also play a key role in explaining business case results, and in measuring and reducing uncertainty of projections.

Understanding the assumptions used to develop each alternative is key. All strategic alternatives are premised on assumptions about investment costs; operating costs, benefits and risks.

Many business cases fail to deliver value because the underlying assumptions on which they are built prove to be wrong. There have been many examples of this in New Zealand in recent months. The quality of the strategy formulation and development is greatly improved if the effort is applied to scrutinising assumptions that are used as the basis for the development of the business case. Continually questioning and challenging assumptions is the simple – and – hard prescription for developing sound strategies, robust business cases and overall decision quality.

Key assumptions must be tested using sensitivity and risk analysis. Decision makers that need to determine which scenario to implement, require not only relevant financial metrics, but a good understanding of the likelihood that results will be close – or quite different – to the predicted values. They also need to know which risk factors need to be examined and managed – recognising that all strategic projects involve two types of risk – implementation risk and impact risk. Implementation risk is the risk that the implementation will be delayed and that it will cost more than expected. Impact risk refers to the risk that the proposed action will not deliver the expected benefits.

Risk analysis is best undertaken using integrated Monte Carlo risk simulation and capex software. This technique requires that key assumptions are assigned probability profiles. During the simulation, the process of changing all assumptions and recording the output value is repeated until a picture emerges showing the full range of possible outputs. The simulation usually takes less than two minutes.

The accompanying table outlines a generic “6-D” business case framework that has been systemised into an integrated software application. This system has been automated to enable business cases to be efficiently prepared in-house – avoiding the cost of commissioning an external entity. Key aims are to promote informed decision making, innovative thinking and value trajectory monitoring. In terms of benefits trajectory, the focus of project management so often ceases at the project commissioning stage of the project ‘S’ curve – overlooking the crucial benefits realisation phase.

The capex planning and approval process forms the other essential bridge between strategic plans and the operating targets of the business. Many capex will be of an efficiency improvement nature – favourably impacting opex or revenues. Astute management teams recognise the opportunity to allocate a good chunk of the capex budget to fund innovative and value creating projects as an alternative to allocating funds based on historical use.

American quality control champion Edwards Deming believed that poor capital allocation occurs when a business lacks a well designed capital allocation system – disciplining management to optimise shareholder value.

Consistent leading NZX performer Port of Tauranga (POT) uses capex software to assist capex compilation and priority setting. CFO Stephen Gray manages capex as a limited resource and rejects ad-hoc spreadsheet building as inconsistent, time-wasting and error prone. POT understands that the need to rigorously evaluate alternatives, test assumptions, systematically assess risk and carefully analyse true value, can easily fall through the cracks in the absence of robust systems.

 In summary, investing in a well-designed business case and capex management infrastructure can play a significant role in facilitating the selection and monitoring of strategic initiatives that deliver sustainable business value. Such systems provide an essential link between strategic plans and under-pinning financial targets. M

 

References available on request.

 

Tony Street is a leading strategist and consultant in the field of capital expenditure management. A CA, he is well experienced in large scale, high level corporate capex management.
Jeff Jackson is the Managing Director of Solution Matrix Pacific Ltd, a consulting company specialising in corporate governance, decision analysis and business case development in New Zealand and Australia.

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