Consulting in financial management

14.7 Accounting systems and budgetary control

Financial consultants may be invited to assist their clients in the development of accounting systems by means of which various transactions are recorded, collected and classified, entered into the various ledgers and books of account, and finally used to prepare the organization’s formal financial statements. This, however, is the work of qualified accountants, and consultants who are not also accountants should recommend that their clients obtain proper professional assistance in this area.

Budgetary versus accounting systems

Consultants participating in general management services activities are likely to be asked to assist in the design of budgetary systems rather than formal accounting systems. The emphasis here will be on management accounting – methods of collecting and analysing data to support internal decision-making rather than formal financial reporting. Both the objectives and the methods of management accounting are different from those of financial accounting, and the difference is essentially one of timeliness versus accuracy. Financial accounting emphasizes accuracy and detail, but produces reports that are historic. If decisions are made only when formal financial accounts are available, it is likely to be too late for those decisions to be effective. Clients need information quickly to support their decision-making, and in this context information that is approximate but timely is of far more value than information that is accurate but late.

The budgetary and control system will differ from company to company and should be developed for the individual organization rather than bought “off the shelf”. For most manufacturing companies, the component parts will include:

–a profit plan;

–the capital investment budget;

–wage and salary budgets;

–purchasing budgets and inventory control procedures;

–manufacturing direct cost budgets;

–general overhead budgets;

–sales, marketing and promotion budgets;

–recruitment and training budgets;

–the overall cash budget.

Most of these budgets will be further broken down by division and by department, reflecting the structure of the company.

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Budgetary control

The consultant needs to keep in mind the multiple objectives that underlie any system of budgetary control. They are:

●that expenditures of funds and commitments of resources resulting from decisions in the various operating areas do not reach an overall aggregate that places an unacceptable strain on the company’s financial structure and resources;

●that all revenue and cost items be planned and coordinated in order to ensure a positive stream of earnings and cash flows, and to guarantee the organization’s liquidity;

●that all actual revenue, cost and expense items can be monitored and compared with budgeted levels, and the variances understood and corrected.

One consequence of the recent recession and the resulting strain on corporate cash flows has been a growing temptation to depart from list prices and to accept any order that appears to cover direct costs and to make at least a contribution to overheads. This places a renewed emphasis upon the distinction between full and marginal costs as a basis for pricing and output decisions.

The issue is clearly not well understood by many managers. Enthusiasts of marginal costing point to situations in which the company will clearly maximize its cash flow by taking decisions on a contribution basis. Others point out that in the long run an organization can stay viable only by ensuring that all of its costs are safely covered by its revenues. Both are of course correct. Marginal costing should not be the basis of pricing strategy, but it may still be valid to use it in tactical decisions. The key is to understand the importance of lead times and opportunity costs. Although it has been said that in the long run no costs are fixed, on a shorter time scale most of them are in fact fixed, and any additional contribution to covering them is welcome. The consultant can be of great help in identifying appropriate time scales for the various categories of decision.

The contribution concept is not only used in making pricing decisions and in deciding whether or not to accept a particular order. It is also widely used in making decisions about product mix. These decisions lie on the borderline between finance/accounting and production/operations, and like many other borderline decisions are often made on the basis of imperfect knowledge and misconceptions. Most managers will readily accept the logic of trying to maximize the production of those product lines on which the contribution appears to be greatest. Developments in the operations area, however, increasingly raise questions about the validity of this approach in some important cases. Where scarce capacity in some particular process acts as a bottleneck, it is the contribution per product per unit of scarce resource time that should be the basis for decision-making. Consultants will find that this is yet another area in which they may have to educate clients – and should note

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that there are some excellent and enjoyable computer-based simulation games to assist them.

Consultants must be acutely aware that designing a budgetary control and management information system involves much more than itemizing the budgets needed and deciding how often they should be prepared. Attention will have to be given to the company’s organizational structure and existing procedures. In a large company it may be necessary to create a number of profit centres or investment centres, or even to designate some divisions as nearautonomous strategic business units. In smaller organizations, a simple cost-centre approach is likely to be used.

Once the organizational structure is agreed, it will be necessary to design procedures for the collection and submission of data for the development and review of budgets by higher authorities and for the determination of corrective action. Paper forms and/or data processing programs and documentation must be selected. In this, as in most other areas, the development of the new procedures will involve a partnership between the consultants and key company people from the finance, organization development, data processing and personnel departments, while line managers must be consulted at all stages to ensure that the completed system meets all their needs. Finally, the consultant will be actively involved in training company staff to operate the new procedures and will probably remain on call until the system has been successfully implemented.

14.8 Financial management under inflation

At the time of writing (2001), inflation is not an immediate problem in any of the major industrialized countries. In the countries of Western Europe and North America, the rate of increase in both producer and consumer price levels is below 3 per cent per annum, and in Japan it is actually negative. In such conditions inflation can be ignored in business decision-making without disastrous consequences.

Companies that operate in other parts of the world, however, need to take inflation more seriously, particularly if they anticipate making capital investments in such areas. In many parts of Latin America and in the countries of the former USSR, the rate of price escalation is erratic and has often approached hyperinflation in recent years. Few managers fully understand how to take anticipated inflation into account in their planning and budgeting.

Inflation accounting

The aspect of inflation that has been most widely discussed in business circles is its impact on reported earnings. Conventional accounting permits only the original purchase value of capital goods and of inventory items to be used in calculating operating earnings. The resulting profits figure is therefore seriously

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overstated because the calculation of profit has not made proper provision for the replenishment of inventory or for the replacement of capital assets as they wear out. There has been widespread debate concerning the introduction of new accounting rules that would provide for inflation adjustment and thus generate a lower but more realistic earnings figure.

Much of the inflation accounting debate has hinged upon the method of adjustment to be used. All the proposed systems seek to establish the use of more realistic current values of assets rather than the historic (original) ones, but differ in their methods.

One approach, the replacement cost or current cost method, necessitates finding the current price in the market of equipment similar to that being used, and using this current market price as the basis for depreciation.

An alternative method – index adjustment or current purchasing power – retains the historic purchase price as its basis but multiplies this historic price each year by a factor obtained from an inflation index to give a new depreciation base.

The first method is clearly more accurate but administratively tedious and costly; the second method is more approximate but much easier to apply.

Up to now, the inflation accounting debate has been largely sterile for three reasons:

●Accountants have been unable to agree as to which adjustment method should be used.

●Some accountants do not accept any form of inflation adjustment, believing that any such system would turn accounting into a highly arbitrary and inexact process.

●Most serious of all, very few tax authorities will accept inflation-adjustment accounts for the determination of corporate tax liabilities. Until such accounts are acceptable for tax-reporting purposes, it is unlikely that many companies will be willing to adopt them as the primary reporting vehicle.

Financial operations under inflation

Successful management under high inflation is not simply a matter of changing accounting procedures. There are practical operating steps to be taken. Consultants can provide services to clients in many areas, primarily the following:

●the development of forecasts of inflation rate, either by primary analysis on the basis of monetary aggregates or by combining the forecasts available from official bodies and financial institutions;

●the incorporation of inflation expectations in the company’s strategic planning procedures;

●the modification of capital investment analysis procedures to take explicit and systematic account of inflation expectations, particularly inflation differentials where wage costs, for example, are expected to rise more quickly than selling prices;

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●the review of working capital management procedures, in recognition of the increased need to speed up the conversion of financial assets and to minimize unproductive cash balances under inflationary conditions;

●the recognition of the close relationship between inflation rates and interest rates, and the anticipation of likely interest rate changes in planning the company’s capital structure;

●continuing emphasis upon the close relationship between inflation rates and changes in the value of currencies in the foreign exchange markets leading to an increase in the importance of management of foreign currency exposure.

Although inflation rates are currently below their peaks in most OECD countries, this area is likely to be one of uncertainty and concern for many years to come. Yet many executives still find it difficult to think logically about inflation or its effects, and attempt to ignore it – with grave results. The educational requirement in this area is one of the greatest challenges facing the financial consultant.

14.9Cross-border operations and the use of external financial markets

Where the client company is engaged in any form of cross-border operation, either selling its products and services in foreign countries or purchasing some of its own materials from foreign suppliers, a number of important additional complications arise. Many of the issues involved are unfamiliar to corporate executives. The field of international finance is, then, a fruitful one for the consultant with the requisite expertise.

The most important issues arising in this area can be grouped under three subheadings, as follows:

–determining foreign exchange exposure;

–hedging techniques and decisions;

–using external money and capital markets.

Determining foreign exchange exposure

Very few companies engaged in cross-border trading are able to invoice their products and purchase their imported supplies entirely in their own domestic currency. As soon as sales are invoiced in a foreign currency, or the company contracts to purchase items priced in a foreign currency, a foreign exchange exposure exists. Many companies are unable to identify the exact extent of their exposure, and a consultant may be of considerable assistance here. The confusion that exists in many companies arises from the fact that there are three

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distinct kinds of foreign exchange exposure. The consultant needs to understand them all and to be able to assist the client in recognizing them, determining their relative importance and deciding what to do about them.

Many multinational companies, especially those whose headquarters are located in the United States, are much concerned with translation exposure: the risk of gain or loss when the assets, liabilities and earnings of a subsidiary are “translated” from the foreign currency in which the subsidiary’s books are kept into the parent currency (US dollars). Such losses are real in so far as they influence the parent’s overall reported profit and loss, and taxes on income. In another sense, however, they are unreal, in that they arise from a particular accounting convention, and that a change to a different accounting basis may change a translation loss into a translation gain. The consultant must be familiar with the current rules of the client’s national taxation authorities and the degree of freedom permitted under those rules. Where there is no freedom of manoeuvre under the regulations, it may be necessary to advise the client to change the currency denomination of his or her liabilities to minimize the translation exposure.

Transaction exposure is simpler to understand and affects all companies that engage in international trade. Whenever a company commits itself to a transaction

– whether a sale or a purchase denominated in a foreign currency – there exists the risk of gain or loss if the value of that foreign currency changes in relation to the company’s own domestic currency. If a Swiss company supplies pharmaceutical drugs to a British buyer, giving 90 days’ credit and invoicing in pounds sterling, then that Swiss exporter will make a loss if the value of the pound falls relative to the Swiss franc during 90 days: the number of pounds received by the seller will buy fewer francs. The exporter’s home currency cash flow is reduced, and the loss in this case is clearly a real one. The consultant will probably not need to become much involved in the determination of exposures of this type: most companies are aware of their transaction exposures. They may still, however, be unsure what to do about them.

The third type of exposure, which is now increasingly referred to as economic exposure, is more complex. It deals with the impact of an exchange rate change upon the organization’s overall long-turn profitability, rather than simply its effect upon currently outstanding transactions. Assume, for example, that a Swiss exporter sells watches to a distributor in the United States, and that the value of the dollar now falls abruptly against the Swiss franc. The immediate effect may be a transaction loss if a recent shipment of watches, invoiced in dollars, has not yet been paid for. The longer-term effect is much more serious: the Swiss manufacturer must choose between keeping the same dollar price, which will now yield fewer francs for every watch sold or, alternatively, holding the price in Swiss francs constant, which means increasing the dollar selling price, probably losing sales and market share to competitors from lower-cost countries. The need for professional advice in this area is clear.

It is surprising to recall that when early editions of this book were being prepared the size of the currency market was unknown. Best estimates

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suggested that total transactions in the foreign exchange markets probably amounted to something like US$200 billion per working day, a very large amount of money. The first systematic measurement of the market (by the Bank of International Settlement) was undertaken only in 1989 and published in early 1990. It revealed that transaction volume had reached US$650 billion per day. By early 1993 the market was approaching 1 trillion dollars, and by the year 2000 had reached almost US$1.5 trillion. These astonishing figures mean that total currency transactions in a year are more than ten times the total world trade in goods and services. It is therefore questionable whether the central banks of the world – even when acting together – can hope to control these markets effectively.

The importance of understanding and managing currency exposure was even more clearly underlined by the events of September 1992. During the previous 18 months there had been increasing reason to believe that, at least in Western Europe, exchange rate volatility could be discounted: the Portuguese escudo and the pound had joined the exchange rate mechanism (ERM) of the European Monetary System, and both the Swedish krona and the Finnish markka had been linked to the ECU. It appeared that both the actual and the prospective members of the then European Community were moving rapidly towards currency unification. The need for currency management was expected to diminish accordingly.

The wave of speculation that was triggered by the Danish referendum dramatically changed the nature of the currency markets. Within a very few days the lira and the pound had left the ERM, the Spanish peseta had been devalued within the mechanism, the Swedish krona and the markka had been cut loose from their ties to the ECU, and the French franc was under heavy downward pressure. Volatility, which had been unusually low for more than a year, rose to its highest level since the collapse of the dollar in 1985. The lesson is clear. The currency market is unpredictable, and its size makes it unmanageable. Companies cannot afford to ignore or be complacent about their exchange exposures.

It is important to emphasize that the problems of exchange risk exposure have not disappeared with the introduction of the single European currency, the euro. Currency transaction exposure has certainly been eliminated between two countries that are both members of the euro zone. The euro continues to float relative to other world currencies, however, and to date has been distinctly volatile. The hopes of those advocates of the single currency who expected the euro to have the strength and stability of the German mark have not been fulfilled. A proposal by the previous German foreign minister that the euro should have at least published target ranges against the dollar and yen was promptly turned down as impractical by the European Central Bank (ECB). More recently – and apparently reluctantly – the ECB has had to enter the market to prevent further falls in the value of the euro against the dollar. Foreign exchange management, in short, remains a key part of a company’s overall risk management.

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Hedging techniques and decisions

Once the foreign exchange exposures have been determined, the next step is to decide whether they should be hedged or covered, and if so, how. Many companies turn to their commercial banks for advice. The local bank manager, however, probably has no experience of, or special training in, foreign exchange management. Consequently, his or her advice is likely to be highly conservative. Many bankers tell their clients: “You are in the business of making and selling products, not speculating in the foreign exchange markets. You should therefore cover all outstanding exposures by buying or selling the foreign currency in the forward market.”

Any consultant working in this area should realize that this advice is an oversimplified answer to a very complex problem. A policy of 100 per cent cover by using the forward market does at least lock in a known rate of exchange, but not necessarily an advantageous one. Using the forward market can in fact be considered just as much a speculation as holding an open (uncovered) foreign exchange position: both policies will ultimately provide either a gain or a loss, depending upon the relation between the forward price when the transaction was generated and the spot price on the day the transaction matures. Beware of textbooks offering formulae that claim to calculate the cost of hedging at the time the transaction is undertaken: the cost can only be calculated retrospectively when the final spot price is known.

The most important service that the consultant can provide in this area is to show the client that there are no simple golden rules or magic formulae available, and that foreign exchange operations require a systematic step- by-step analysis and decision process. The required steps are as follows:

(1)Determine overall foreign exchange exposures and distinguish between the different types of exposure as described above.

(2)Evaluate these exposure positions in the light of the best available forecasts and expectations concerning foreign exchange price movements, and decide if there are serious exposures that may produce foreign exchange losses. If so, hedging will have to be considered. For most companies, it will only be practical to cover transaction exposures on a continuing basis.

(3)Consider the possibility of hedging the exposures by operational means, rather than purely financial ones. A company that regularly exports goods to Italy and invoices those sales in lire, for example, may be able to offset this exposure by purchasing some of its own raw materials and supplies from Italian companies. Another method, particularly useful for large transnational companies with a high level of intra-group transactions, is “leading and lagging”: a deliberate acceleration of some payments and delay of others in order to take advantage of expected exchange rate movements.

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(4)If operational hedging is not possible and some form of financial operation is to be used, the next question is whether the risk is so serious as to require 100 per cent cover, or whether partial hedging is acceptable. The specialized services that supply foreign exchange forecasts can usually advise on this point.

(5)Obtain from the banks the best available quotation for a forward transaction, and compare this with management’s expectations about what might happen to the spot rate. For example, suppose a British company has an exposure in Swiss francs, and the exposed position is expected to continue for 90 days. The spot rate is, say, £1 = 2.42 Swiss francs, but the banks quote a 90-day forward outright bid rate of £1 = 2.55 Swiss francs, a significant forward discount on the franc. The question now is not whether the Swiss franc will fall, but whether the spot price in 90 days’ time will be above 2.55. If it is expected to fall further, then the transaction should be covered. If it is expected to fall, but only to, say, 2.47, then it will be cheaper not to cover the transaction.

The consultant will find that many client companies, including some that have been making regular use of the forward markets for hedging purposes and consider themselves quite sophisticated in this area, do not realize that it is possible to achieve the same result by using the money markets. For example, a company that is based in Switzerland, but sells regularly to the United Kingdom and invoices in sterling, will have regular “long” sterling exposure. Rather than hedge such exposures by selling the pounds forward, the company could borrow pounds in the London money market, use those pounds to buy Swiss francs, and use the francs for working capital purposes. The pound borrowing creates a sterling liability which offsets the long sterling position arising from the exports. The consultant should be able to show the client how to compare the cost of such an operation with conventional hedging and to explain that when the local currency generated (Swiss francs in this example) can be used to repay an existing overdraft or credit line, the interest saving may be enough to make this the least-cost form of cover.

The period since 1982 has seen the development of another and quite different approach to foreign exchange hedging in the form of the currency option. Active trading in such options started in the Philadelphia Stock Exchange, and has spread rapidly. Other exchanges (Chicago, London) are offering similar facilities and, even more significantly, major banks are selling such options on a custom-tailored basis. The option is essentially different from any other form of hedging in that its use is indeed optional – the option holder has the right to buy or sell currency at a stated price if he or she chooses. There is no obligation to exercise the option if it is not advantageous to do so. This approach therefore offers a degree of protection if the currency movement is adverse, coupled with the possibility of making a profit if the movement is in a favourable direction. The pricing of options is very complex, and the markets have unique procedures and jargon.

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The option form is still not well understood by many treasurers, some of whom consider it to be an exotic instrument that can only be used by people with advanced degrees in mathematics. This is particularly unfortunate in that the basic option is now being supplemented by more specialized derivatives such as the “double option”, the “average rate” option, the “knockout” or “exploding” option and the “compound” option. These are important developments, and can be used to solve some kinds of exposure in particularly effective ways.

Space limitations preclude the examination of all of these recent developments, but one in particular will be described to illustrate the kinds of feature they offer. Many companies export their products to foreign buyers on a regular basis. Consider, for instance, a British company that exports monthly consignments to a buyer in Germany, and invoices the sales in German marks. The exchange rate of the pound to the mark fluctuates. In months in which the mark is strong the company makes additional sterling profits, while in months in which sterling has strengthened against the mark the company loses out. However, the company’s overall profit at the end of the year will not depend upon the exchange rate at any particular point in time but on the average pound/mark exchange rate over the year. The development of a form of currency option based upon the average rate enables the company to hedge its real exposure position. Compared with the alternative of hedging with options on each individual shipment, the cost saving will be about 40 per cent.

Here again there is an opportunity for the consultant to perform a valuable service. The client needs to be assured that options and other recent derivative financial instruments are both relevant (even for small companies) and readily available. But even once the client has accepted the usefulness of such techniques, the pace of development is such that he or she will have great difficulty in keeping up to date. There is a need for continuing assistance here.

Using external money and capital markets

Small companies in most countries automatically and quite logically look to commercial banks in their own country as the usual source of external funds. As companies grow in size and sophistication, however, the possibility of using external financial markets presents itself. Corporate management will initially have little knowledge about such markets, and may believe them to be exotic, perhaps dangerous or open only to the multinational giants. This is a further area, therefore, in which the management consultant’s role is primarily an educational one.

The consultant can point out to the client that there are a number of international financial markets – the Eurocurrency market (sometimes called the Eurodollar market, although the dollar segment is only a part of it), the Eurobond market, and several foreign bond markets – existing in various centres, particularly New York, London, the Swiss and German financial centres, and Tokyo. The various international bond markets cater primarily to

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the “high-quality” borrower and a relatively small company may find access difficult. The Eurocurrency markets, however, despite their ability to accommodate single transactions of US$5 billion or more on a syndicated basis, are readily accessible to the medium-sized company, both as a source of loan funds and as a temporary investment medium for corporate cash that will later be needed as working capital.

Banks operating in the Eurocurrency market often pay a slightly higher interest rate on funds deposited than the domestic banks, and at the same time may charge a slightly lower rate on the loans they make. This is a perfectly logical outcome of the fact that the Eurobanks have cost structures that are significantly different from those of domestic banks, the most important difference being the absence of any reserve requirements against their deposits. Their lower operating costs allow them to work with a smaller spread between their borrowing and lending costs than can domestic banks, and their customers benefit accordingly.

It is important that the client understands, however, that these markets involve additional risks as well as opportunities. Virtually all lending in the Eurocurrency market, and a significant part of the issues in the Eurobond market, are made at floating interest rates. The borrowing rate is not fixed for the life of the financing, but is tied to market rates and re-set every three or six months. The rate is typically a fixed spread – a half per cent or more – above the London inter-bank offered rate (LIBOR), the wholesale cost of funds in the inter-bank market. When the LIBOR rate is around 5 per cent this may not seem threatening, but it should be remembered that during the early 1980s LIBOR went over 20 per cent. If the client does decide to use floating rate financing, it is necessary to think seriously about risk management.

The consultant should also be aware of a particularly interesting financing technique that barely existed a decade ago, but which is now extremely important: the medium-term note (MTN). These notes are in effect bonds, but are issued under an ongoing agreement with a specific bank or dealer. The total financing undertaken by a large company operating in the euro MTN market may be US$1 billion or more. At the other extreme, however, an MTN programme can be mounted in a domestic market, often by quite modestly sized companies, with individual issues of as little as US$5 million. Most of the notes are issued with a maturity of between 2 and 5 years. MTN is in fact the most flexible of all forms of financing. Each issue under the programme can be tailored to fit a perceived “window of opportunity” as it arises, using whatever coupon, maturity and currency best match the current preferences of the market. Given the flexibility, speed and low issuing costs of this vehicle, it is hardly surprising that in less than ten years it has reached a size that rivals that of the established Eurobond market itself.

Nevertheless, the area is a complex one, and the consultant will have to guide the client through a mass of new terms and procedures. There is much for the consultant to learn in this rapidly developing field of professional services.

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Consulting work involving the client’s marketing activities differs in several ways from that dealing with other functions. It is in its marketing that the firm finds itself in contact with external entities (competitors and customers) having an independent existence. The firm’s survival depends on how well it manages to adapt to the market conditions influenced by the activities of these entities.

One of the paradoxes of the marketing function is that when it is looked at closely it tends to disappear, like a stream going underground. It is first found at the very highest level of the firm, in its overall strategy formulation. It then resurfaces in the organization and management of the various market-related activities: sales, advertising, product development, market research, and so on. This leaves a definite gap in the organization chart. Matters concerning the firm’s overall strategy, of which marketing strategy is an important part, can only be decided at the topmost level of the organization, while running the various activities is predominantly a middle management function. As compared with his or her counterparts in the other management functions (production, finance, and so on), this leaves the senior marketing manager in a somewhat ambiguous position, and the same necessarily applies to a management consultant working with this manager. Because marketing is integral to the success or failure of the enterprise, it affects and is interdependent with every other business discipline.

A consulting assignment that embraces the marketing function will usually develop into two quite separate tasks, one at the strategy formulation level and the other at the activities or implementation level. These two tasks are treated separately below. It is convenient here, however, to note briefly a third type of consulting activity.

The third type is market research, the study of the prospects and performance of a firm’s products in the market. Market research consultants do not necessarily carry out marketing consultancy, but their findings can notably affect strategic direction. However, marketing management consulting assignments may involve some market research to verify (or invalidate) the client’s

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