FPAC Part 1 Chapter 02

FPAC Exam Prep Platform
FPAC Part 1: Chapter 2

Strategy
Topic 1: Nature of Strategy………………………………………………………………….. 2-2
Topic 2: Strategic Planning Framework…………………………………………………….2-7
Topic 3: Strategy and Measurement……………………………………………………… 2-22
Topic 4: Risk………………………………………………………………………………… 2-28
©2019. Association for Financial Professionals Table on Contents 2-1

Topic 1: Nature of Strategy

Strategy: Overview
A logical place to start the discussion of information gathering and interpretation is strategy,
because the demands of strategic planning and management drive much of what FP&A does.
Strategy describes how an organization positions itself relative to its competition, deploys its
resources and directs its activities to create and sustain its competitive advantage. This definition
of strategy may sound as if it is oriented only toward for-profit organization, but all organizations,
including not-for-profits, must compete in some sense. Non-profit educational institutions must
compete for students, faculty and funding. Health organizations compete for funding but also
compete against solutions for dealing with a problem—for example, maintaining the status quo or
doing nothing at all.
Since the last quarter of the 20th century, the role of strategy and the nature of competitive
advantage have been intensely discussed, and there are many theories and models. Some
models emphasize the role of planning, while others say that planning is pointless in today’s
dynamic environment and may even deter an organization from responding quickly to changes.
Some models focus inward, on defining core competencies and resources and fitting them to
market opportunities such as unmet needs or underserved geographic or demographic markets.
Some models urge organizations to focus outward and evolve the organization toward external
opportunities. Consequently, this chapter must be a high- level view of this complex terrain. Its
goal is to help FP&A understand the approach to strategy that organizations, especially its own,
adopt.
FP&A’s Role
The role of FP&A in strategic planning will vary. In some organizations FP&A may drive the entire
strategic planning process, calling on the valuable information the function has gathered—and
insight it has created—about the organization, its industry and competitors, and the economy. If
the organization has professional strategic planners, FP&A may support the strategic planning
process by using the organization’s historical performance data to increase the accuracy of
planners’ expectations, projecting financial results of proposed strategies to help assure that the
strategies are indeed leading toward the intended goals.
Since competitors’ strategies are treated as proprietary information, analysts will have to use their
understanding of strategy, the competitor’s history and the industry to make reasonable
assumptions about future competitive actions.
©2019. Association for Financial Professionals Topic 1 2-2

Analysts must also be thoroughly familiar with the hierarchy of financial and operational
performance metrics that senior management has chosen and the way in which various decisions
will affect those metrics. It may be the responsibility of FP&A to point out, in the course of its usual
analytic tasks, when planning conflicts with strategic commitments—for example, when an
expenditure that may look like a good opportunity is actually spending resources to expand
capabilities outside the strategy’s focus or beyond a desired financial leverage
“Whatever FP&A’s role is, analysts must understand what drives the development of the
organization’s strategy and also the strategies of the organization’s competitors.”
What is Strategy?
“Strategy” is often used interchangeably with “strategic planning,” but strategy is different and
more complex than “planning.” Strategy is a pattern of coordinated actions. It has a formal
component— management-endorsed strategies, high-level budgets and approved business unit
plans—and an informal, spontaneous component—an aptitude for spotting opportunities and
challenges as they emerge and quickly initiating a coordinated organizational response.
Strategy is about numbers, about what performance factors must be changed and by how much
to achieve a desired value. They increase in specificity as they are pushed down through the
organization. A strategy must be converted into operating plans for each of the organization’s
major value segments, which will depend on how the organization has structured itself. Each
operating plan requires the creation of functional plans. Each layer of planning adds specificity to
the basic question of what performance is required for the organization to achieve its strategic
goals.
However, strategy is also about culture. Strategy must yoke the organization’s identity and
capacities to its actions—i.e., it must achieve a “strategic fit” between the chosen plan and what
the organization wants to be and what it excels in. It must orient the organization in relation to its
customers and stakeholders and to its competition. It must bridge the distance between the upper
layers of management that are creating the corporate strategy, the division and business unit
heads who must align their strategies with the corporate strategy, and the front-line managers
who must implement functional strategies that will enable the function to play its proper role in
this endeavor.
Strategies are about commitment to a plan, but they are also dynamic. An effective strategy
focuses the organization on certain goals but allows the organization enough latitude to adjust
the “how” of the strategy to local conditions, changes and emerging risks and opportunities. Henry
Mintzberg, a scholar in the discipline of strategy, proposed that a strategy actually exists in three
forms:

Three Forms of Strategy

• Intended, what strategic planners design at the highest level
• Realized, what is actually implemented (Mintzberg estimated that only 10 percent to 30
percent of intended strategies are implemented as designed.)
• Emergent, the way front-line managers adapt the intended strategy to changing environmental
and competitive conditions and opportunities
As the formal strategy is implemented over time, it will be refined. Mintzberg sees strategy as a
learning experience, an evolutionary process of constant tests and adaptations. (Mintzberg in fact
would hold that very young organizations probably should wait to develop a strategy—that it takes
some time competing in the market to understand the organization and its environment to propose
a strategy.)
Organizational Considerations
• The organization’s capabilities and culture. A sustainable strategy aligns not only with an
organization’s capabilities and resources but also with its structure, vision and culture. Some
strategies may require significant change in reporting relationships or how people work
together—from competitive to collaborative relationships. Structure and culture can be very
difficult to change, and even when change is possible, it may take longer than a conventional
strategy cycle lasts. Managers have to consider whether the organization can implement the
level of change the strategy necessitates. Some competitive strategies may cast the
organization as an imitator rather than an innovator—it will create value by imitating directions,
technology or processes pioneered by a competitor. How will managers and employees
accept this new vision and identity?
• Industry forces. An understanding of industry can ensure that the strategy takes into account
unique characteristics—such as industrial cycles, the economic attributes of the industry, and
competitive forces—that affect the plausibility of competitive strategies.
• External or macroenvironment. The macroenvironment will also pose both opportunities
and constraints on competitive strategies. For example, signs of economic recovery may
signal increases in revenue to support strategic initiatives, but they may also signal increased
competition in certain types of industries. Increased regulations surrounding climate change
may mean increased costs that limit earnings but could also support directing the
organization’s attention to new products.

Functions of Strategy
Strategy serves multiple functions:

• It clarifies decision making. A clear strategy reduces the time required to make a business
decision because it limits the number of possible choices. Because of its clearly stated
objectives, options can be objectively analyzed in terms of their effects on, for example,
market share, or earnings before interest and taxes, or cash flows.
• It makes governance clearer. Governance is a framework of rules and practices by which an
organization’s board ensures accountability, fairness and transparency in the organization’s
relationship with all of its stakeholders. Decision makers must be able to provide a good
reason for taking an action counter to the corporate strategy.
• It can increase coordination and cohesion if the planning process was inclusive and if the
strategy is effectively communicated throughout the organization.
• It can force the organization to stretch, to make better use of its strengths, including creativity.
Missions and Values—The Heart and Soul of Strategy
Typically, strategy includes a vision of what the organization would like to look like in the future,
a mission and a set of distinct values. Mission is defined by Mintzberg as “an organization’s basic
function in society, in terms of the products and services it produces for its customers.” Values
are important beliefs or ideals shared by the members of an organization. Consider the following
example.

Case Study
A company operates a chain of physical fitness centers. In its communications to stakeholders, it

has identified itself as one of the top three companies of this type in its market. It talks about the
company’s commitment to improving its clients’ fitness, overall health and sense of well-being by
combining the latest in fitness technology; traditional and nontraditional philosophies of health,
nutrition and exercise; and certified trainers. Its stated mission is to create value for its
shareholders comparable to or above that of its peers, to provide ethical wages and benefits for
its employees and to improve the fitness, health and psychological well-being of its clients. The
company points to certain guiding values:
• Openness. This includes transparency in communication and decision making as well as
openness to nontraditional philosophies.
• Health. Management defines health in a holistic way, focusing on body, mind and spirit.
• Commitment to the well-being of its employees. Aware of problems in this area in
competitors, the company commits to providing benefits, scheduling employee tasks in a way
that will not damage their health and supporting continual learning opportunities and
certification.
What the company does not say is notable as well. The company could have said that it believed
in building physical strength and flexibility to support athletes’ competitive goals, but it did not. It
could have said that its strategy was to make fitness available to a larger number of clients, but it
did not. Missions and values of this sort would take the company in a direction that managers, for
now, choose not to pursue.

Topic 2: Strategic Planning Framework

Strategic Planning Framework: Overview
A common life expectancy for a strategy is three to five years. During its life and at its end, a
strategy is re-examined against changes in stakeholder expectations, the organization itself (its
mission, goals, structure), industry conditions and competitive forces, the economy and the rest
of the external environment that may affect the laws of supply and demand. The strategy may be
adjusted, or a new strategy may be developed. This life cycle is anticipated in the strategic
planning process, which is often depicted as a cycle that is repeated continually.
The organization’s strategy is the output of a process that includes gathering and analyzing
information, setting appropriate goals and planning how to achieve them, and planning how to
monitor, measure and assess the strategy’s effectiveness. Strategies may or may not be
documented in writing, but they must be communicated thoroughly and fully understood, across
and down the organization’s structure. What is traditionally called the “strategic planning
framework” is represented in business literature in different ways but is essentially the iterative
process shown in Exhibit I.A.2-1.
Exhibit I.A.2-1 – Strategic Planning Framework

Nature of Strategy
Some process diagrams start with formulation of the organization’s mission statement and values,
recognizing that there must be some “fit” between the strategy and the organization’s values. For
example, a non-profit foundation focuses its resources on raising money in developed countries
and distributing it in the form of micro-loans to women in developing countries to help them
achieve economic independence. The loans have few requirements and little oversight. Not
surprisingly, the organization emphasizes respect for the autonomy of its clients and trust in their
decisions. For-profits have to create a similar fit: A technology firm that wants to lead its industry
in introducing innovative devices must respect and support innovative employees.
Internal and External Analysis
During the first phase, planners assemble as much information as possible about the company’s
internal environment, the marketplace in which the organization competes and the larger external
environment in which it operates. This understanding contributes to a better “strategic fit” between
the organization and the path it chooses.
It is essential for strategic planners to know:
• Whether the organization has the structure and resources needed to achieve its strategic
goals. An organization may decide to address its gaps through a competency-building
strategy.
• Where the organization will compete (i.e., where the opportunities and challenges are, their
magnitude, their appropriateness for the organization). The nature of the industry and its
competitive factors will suggest what the organization needs to do to be profitable and remain
competitive.
• What external actors can influence the outcome positively or negatively (i.e., the
uncontrollable factors). The variety of external factors that cannot be controlled but can be
anticipated and managed are discussed in the chapter on macroenvironment. For example,
changes in global consumer economies could argue for a strategy that involves locating
products/services closer to their markets.

SWOT Analysis
The SWOT analysis, which was introduced in the 1960s, is a well-known tool for identifying
internal and external factors that could affect an organization’s ability to compete. The SWOT
analysis is a thorough listing of all the internal (Strengths and Weaknesses) and external
(Opportunities and Threats) factors that will affect strategic planning—including the choice of
strategy and the changes and development needed to support the strategy.
The concept of the SWOT analysis is shown in Exhibit I.A.2-2.
Exhibit I.A.2-2 – SWOT Analysis
Internal
External
Advantages Challenges

SWOT Matrix-Explained
The two axes of the traditional SWOT matrix are source (internal or external) and quality
(advantage or disadvantage). This yields four sectors:
• Strengths
Strengths (internal) refer to attributes of the company that improve its ability to compete in its
industry. Strengths could include valuable assets and “good financials” that attract investors
and lenders, such as increasing cash flows, a good free cash flow ratio, and favorable
leverage, liquidity and profitability ratios. It could also include intangibles that may not be
represented in financial statements, such as the potential of products in a development
pipeline.
• Weaknesses
Weaknesses (internal) refer to identifiable gaps in the organization’s performance. They
might be deteriorating buildings and aging technology or “poor financials,” such as poor cash
flow that keeps the company scrambling for short-term cash or poor profitability that leaves
little cash for reinvestment or return to investors. Weaknesses could also include intangibles,
such as a poor relationship with a labor union/works council that results in frequent
disruptions in production or service or a brand image damaged by a recent recall.
• Opportunities
Opportunities (external) refer to industry or economic conditions that favor the organization.
For example, a dominant competitor may be hampered by a product recall that diverts
management attention and financial resources and diminishes customer demand. There may
be a particular market niche that is being underserved but could prove profitable.
• Threats
Threats (external) are industry, economic or other environmental risks that could derail
profitability for all competitors in the market. The introduction of a replacement technology
could decrease demand—for example, in the way that office technology and the Internet
have depressed the printer and fax market.
The following exhibit shows a very brief example of a SWOT analysis for the fitness center
company introduced at the beginning of this chapter.

Exhibit I.A.2-3 – Completed SWOT Analysis for Fitness Center Company
Strengths Weaknesses
● Good financials; access to favorable ● Small footprint at metro centers limits

financing activities (e.g., swimming, running)
● Management team experienced in ● Retention rates for clients
achieving growth
● Conversion rates for new clients
● Loyal, certified trainers/consultants
● Dated-looking identity
● Positive image in press and consumer
agencies
Opportunities Threats
● Favorable real estate market ● Economic downturn

● Growth of interest in employer wellness ● Expansion from major competitor
programs
● Improving household income in
markets, especially in metro markets
SWOT Output
SWOT analysis can also be completed for other companies as part of a competitor analysis. It
does not preclude more extensive analysis of industry factors and competitors that may affect
the choice of strategy.
Some of these analytic approaches are discussed below.
The output of the SWOT analysis should be a better sense of where the organization’s
competitive advantage lies. It may be that:
• It entered the market first, building presence in customers’ minds and developing
relationships with customers, suppliers and distributors that may be hard to untangle.
• Its products can become industry standards, which will automatically capture customers and
slow the emergence of competitive products.
• It can exploit economies of scale to achieve low cost advantage—perhaps by
• dominating the market for materials and suppliers.
• It has excellent data on its customers—understanding what they want, how their needs may
be changing, and how to keep them loyal or prevent them from switching to a competitor.
• It identifies and responds to change more quickly, on an institutional level. It can quickly
reallocate resources to new markets or integrate new technology or processes.
• It has talent, resources, structure and processes to succeed at innovation, changing the rules
of the industry by introducing a new business model or technology.

Goal Setting
The SWOT analysis provides an image of where an organization is at this moment (or in the
immediate future). Strategic planners also need a clear picture of where they want to go—of what
the organization should look like at the end of the planning period. These goals are influenced
by three primary levers of value: earnings, efficient use of assets and the ratio of equity to debt.
However, analysts should be aware that all numbers on financial statements are influenced by
both economic and non-economic performance factors. Thus, an organization’s goals may be
more complex than attaining a specific financial target.
Strategic goals serve multiple purposes:
Why Set Goals?
• To satisfy reporting requirements. Goals are often financial metrics because this
information is required by regulatory agencies and exchanges.
• To encourage progress. Goals should be aspirational, an improvement over current
performance. Strategic goals help ensure that organizations are not static or stuck in the
status quo. This would be a vulnerability since the competition will not be static. The
organization must struggle against competitors for a market of limited size or it must struggle
to increase the market size in some way.
• To signal external stakeholders and motivate internal stakeholders. External
stakeholders, such as investors and lenders, may analyze an organization’s strategic goals
for evidence of an appropriate mixture of management savvy, daring and realism. For
internal stakeholders, the goals focus and motivate performance— often directly, if the
strategic goals are translated into related, specific performance targets.
• To provide a rational and systematic basis for organizational activity. Strategic goals
imply trade-offs. By focusing on certain goals, the organization commits to a well-reasoned,
disciplined focus. Management may have to pass on some opportunities or tactics because
they conflict in the end with the organization’s strategic goals. For example, product design
may want to specify a component to be fabricated in-house, but if objectives have aimed at
increasing productivity and lowering costs by purchasing manufactured components, the
strategy provides a clear direction.
• To measure progress. Successful organizations are usually learning organizations.
Learning organizations are characterized by the sharing of information and experience
among their members and a collaborative, integrated approach to work, but one of their major
traits is a commitment to continuous self-assessment, development and correction. For these
organizations, the process of measuring and analyzing progress toward strategic goals is
another way to ensure learning. In addition to supporting the organization’s growth, periodic
measurement of progress can also serve as an early warning signal that a strategy is not
working as planned. Causes must be identified and addressed by adjusting the strategy or
by reallocating resources.

The process for creating goals is discussed in the next topic, “Strategy and Measurement.”
"From the perspective of FP&A, the most significant strategic goals are financial targets that
represent the degree to which management has succeeded in creating value."
Strategy Development
Strategy is essentially a path leading the organization toward attainment of the stated strategic
goals. The path combines supporting strategies—such as strategies for risk management,
human resource development, capital expenditures and technology—and specific strategic
initiatives. Each of these strategies must be aligned with the organization’s strategic goals.
The goal of expanding market share, for example, may be achieved through multiple strategic
initiatives, such as:
• Developing a new product or process
• Building the organization’s capability or capacity in a particular area
• Reorganizing to flatten the decision-making structure of the organization and enhance its
ability to respond quickly to market changes and opportunities
• Acquisition of competitors
These initiatives are clustered, ordered and phased in over the period of time covered by the
strategic plan. One of the benefits of phasing the strategy is that the strategy can unfold value
and manage uncertainty over time. This approach is described in the “three horizons of growth”
model proposed in The Alchemy of Growth (Baghai, Coley and White). In the diagram in Exhibit
I.A.2-4, the horizontal axis is time and the vertical axis is value produced.
Exhibit I.A.2-4 – Three Horizons of Growth
Source: Luehrman, 1998

Three Horizons of Growth
The shape of each horizon is an arc. At first, business activity consumes resources while
producing little value. Eventually revenue is generated, and value rises. Then, perhaps as a result
of competitive responses, value begins to flatten.
With multiple horizons, the organization can overlap its strategic initiatives. Before the first phase
begins to flatten, the second phase has begun, and those activities are ready to generate value
when the first phase slows. This dynamic is repeated in the third phase. The successes at each
horizon serve as a platform for the next. Although investment and outcomes will vary as the
strategy unfolds, all three horizons must be managed at the same time.
The first strategic horizon focuses on the organization’s current businesses, activities that produce
revenue now. Most of the organization’s resources and attention are on perfecting these core
skills and processes—e.g., on becoming more efficient in production or delivery of service,
increasing market share, or building on a reputation for quality. Investment at this horizon is
measured by short-term impact on sales and profit levels, return on invested capital and cash
flows. Because the core businesses are established, they generate value that sustains the
organization and the early stages of second and third horizon initiatives.
The second strategic horizon focuses on finding ways to apply the organization’s existing
strengths and advantages to emerging opportunities that may become core businesses in the
future. The organization may expand to new but related markets. It may choose to build its market
presence or diversify through acquisitions. Investment at this horizon is measured in net present
value—not immediate return but positive return in the mid-future.
The third strategic horizon is shaped by uncertainty. These opportunities will take time to develop.
They could include development of new technology, an extension into an entirely new market, or
a total reinvention of the organization’s or industry’s model. Resources could be spent on pilot
projects and acquisitions or developments with high
growth potential and high risk. Since the possibility for failure is greater, initiatives may be
clustered around similar areas. If one initiative does not prove fruitful, its value in terms of learning
and experience can be transferred to the other, related initiatives. The clusters can be pruned
over time if initiatives’ promise fails to materialize, if development proves too costly or lengthy, or
if industry or economic conditions change. Investment during this horizon must be carefully
watched so that losses can be minimized, and resources shifted to other initiatives. Success is
not measured in terms of revenue but in ability to meet milestones.
Consider the following example:

Case Study
A company operates ski resorts in one geographic area. Management adopts a strategy that will
sustain its current operations but will also include opportunities for growth. Its first horizon is its
current base of operations. It produces value as a result of a good use of technology, clever
marketing, quality in execution and control of costs. Profit is sufficient to sustain operations at
their current level, provide an acceptable return to investors and fund horizon 2 and 3 initiatives.
The second horizon initiative is based on acquiring resorts outside the company’s primary market
area as they become available. (Developing new resorts would be very capital- intensive and also
intensive in terms of management time, considering possible regulatory and land use issues. The
acquisition of even an under-performing resort would include management who could be trained
to implement the company’s strategy, policies and processes.) Attractive acquisition targets would
be located near major metropolitan areas. With these additional resorts, the company might
achieve greater economies of scale. It might also insulate itself against inevitable periods of poor
snow conditions. Being near large metropolitan areas could support revenue if airfares increased
enough to discourage vacation travel. Moreover, by integrating all of its properties in reward
programs, it could entice skiers from these new markets into visiting its original properties—thus
improving its core businesses.
To support this second horizon in its strategy, management commits to investments in its real
estate and IT functions and begins to document its best practices so that
acquired resorts can become more efficient and more representative of the brand as quickly as
possible.
The third horizon recognizes the possibility that a changing climate and changing patterns in
global development could limit its opportunities for growth. Management therefore begins to study
a number of initiatives that will take time to develop:
• The company begins to discuss potential partnerships with companies with the goal of
increasing the efficiency of snow-making machinery (from the perspective of both fuel and
water consumption) and lengthening the ski season—perhaps by developing new skiing
surfaces. Specific initiatives will be carefully managed to assess at each stage whether the
return on invested capital is still attractive before proceeding.
• Another path to profit may lie in expanding the use of properties beyond vacations and
conferences and beyond traditional boundaries of the resort industry. This will take
considerable research and an analysis of return on investments.
• Management will leverage its expertise by studying the requirements for successful resort
operation in other countries, possible sites, the challenges and the advantages. Funding will
be sufficient to support research, but the decision to proceed will depend on a full financial
analysis at some point in the future.

The Three-Horizons Approach
The three-horizons approach to strategy conforms well to the variety of messages from different
schools of business strategy theory:
• Continuously strengthen core competencies and competitive position
• Develop options that can be adopted or passed on as circumstances at the time indicate
• Train the organization to process change efficiently
• Learn the “rules of the game” and anticipate competitors’ moves
• Try a lot of things and see what works
FP&A may play an important role in supporting decisions about the selection and priority of
initiatives. Models can provide additional information about the impact of the initiatives on financial
statements and the organization’s critical values (e.g., growth in earnings and/or tangible and
intangible assets, operating and/or financial leverage).
Plan Development
Based on the strategy and the organization’s goals, management sets performance expectations
for each of its business units. The business units then develop and propose operating plans that
include their own strategies and initiatives, revenue forecasts, and operating budgets and submit
these for discussion and review by management. The board approves these revised plans. This
strategic planning process is reiterated on a functional level.
FP&A may be directly involved in advising business units on their plans—for example, in
performing headcount projections or risk analyses of revenue and cost projections. They may
also support management review of the plans and prepare presentations of plans for board
meetings. FP&A may also participate in aggregating
operating plans to create a corporate-level business plan used in presenting to banks and
investors.
As a participant in the strategic planning process, FP&A may:
• Conduct its own SWOT analysis. It must identify areas of strength as well as areas in which
capabilities must be developed (e.g., effectiveness of communicating the results of analysis,
developing collaborative relationships with other functions). It can identify opportunities to
add further value to the organization.
• Set its own goals and targets for the period. For example, an FP&A function in an organization
embarking on a growth strategy may set a goal about increasing its involvement in headcount
analyses.
• Implement its own strategic initiatives, which could involve return and risk assessments of
buying a new software application or outsourcing a particular task.
• Allocate budget to strategic priorities.
• Establish a process for reviewing the function’s performance and reporting to management.

Resource Allocation
The selected strategy usually entails difficult decisions about adding, shifting or shedding
resources. The organization may have committed to developing new capabilities and
competencies, which will require additional investment of capital or reprioritization in the current
use of resources. It may have decided to redefine its market focus in terms of consumers,
products offered or geographical presence—a decision that necessitates withdrawing resources
from some areas or closing down these activities entirely. It may have committed to improving
earnings by means of stringent cost cutting and increased productivity. The organization must
consider each activity receiving resources and each allocation decision in terms of its contribution
to the organization’s economic value and its relation to its strategic vision. FP&A may be involved
in analyzing and supporting these decisions.
Increases in resources must be analyzed to forecast impact on specific financial metrics chosen
as goals, such as return on capital employed (ROCE) or return on invested capital (ROIC).
Investing and Allocating Resources
At what point will an investment of resources positively impact this metric?

• How does a proposed acquisition align with the strategic goals? FP&A may support the
performance of due diligence for acquisition targets, including risk and opportunities analysis,
financial statements projections and comparisons of financing options.
• How will increasing the size of the sales force affect net profit when additional and related
increases in costs for support services, such as equipment, hiring and training, are factored
in?
• How can the organization achieve maximum return on investment from capital expenditures?
This could include comparing asset options, contracting terms and leasing/financing. For
example, many of the software solutions organizations rely on today may be purchased
outright or the organization can simply subscribe on a monthly or annual base. This approach,
referred to as software as a service (SaaS), may prove more economical for some
organizations who do not want to allocate limited IT resources to installing, maintaining and
supporting internal systems.
Resource allocation may be analyzed to identify economical ways to create more flexibility—the
ability to move capacity away from areas experiencing a slowdown in demand to areas with
identifiable opportunities. How do the costs of workforce leasing compare to the cost of lower
productivity rates? What are the costs of laying off workers or mothballing plants—if these actions
are even allowed under labor contracts and agreements with local governments?
There are different tools for visualizing the case for investment in business units/lines. The growth-
share matrix and the Nine-Box Matrix are described below.

Growth-Share Matrix
The organization must establish its resource allocation priorities, just like an investor. It must look
at its pieces—divisions, product/service lines, market segments—and discern its best-performing
and least- promising activities. It must also identify activities in rapidly growing markets that may
pose cash flow issues. A tool developed by the Boston Consulting Group called the growth-share
matrix is designed to help organizations analyze their business units or product lines in terms of
their abilities to produce and consume cash. This assessment may be used to guide allocation of
resources, although there are many caveats about its use in this way.
The growth-share matrix is shown in Exhibit I.A.2-5.
Exhibit I.A.2-5 – BCG Growth-Share Matrix

Growth Share Matrix Quadrants
Market growth is directly associated with use of cash—the greater the rate of growth, the greater
the need for cash infusion. Market share is directly associated with cash generation—the larger
the market share, the higher the revenue produced. Market growth may be seen as a future
indicator of the potential of the entire industry or market niche, while market share may be seen
as an indicator of a unit’s current ability to compete in that industry/niche. Both characteristics are
seen as indicators of potential for profitability—not necessarily actual profitability.
Growth-Share Matrix Quadrants
Here are the four quadrants and some considerations about their meaning and use.
• Cash cows are enterprises (business units, product or service lines) that are in low-growth or
declining markets but have a good share of sales. They generate surplus cash, and since they
dominate the market, they probably don’t require additional investment to grow. And investing
in a declining market may not be a top priority. Consequently, cash cows are often seen as a
source of cash to fund activities with greater strategic priority and/or potential. The problem is
that, if it is not carefully tended, the value of a cash cow can be destroyed. And while the
market growth rate is not high now, that may not always be the case. With the arrival of a new
technology or discovery of a new audience, the market growth rate could increase and the
cash cow may become a star.
• Stars are enterprises in a market experiencing growth. They have healthy market shares. Like
cash cows, stars are producing good levels of revenue because of their market position.
Because their markets are still expanding, they will require support to realize their potential
and to protect against competition that will inevitably arise, drawn by the promise of cash.
• Question marks offer possibilities but no certainties. Their market share is low, but the market
itself is growing. Investment would have to focus on building market share, and that could be
expensive.
• Dogs have a small or decreasing share of a not very promising market. It is easy to conclude
that resources should be shifted away from these enterprises in favor of stars and question
marks. As with cash cows, however, there is the potential for serious loss in doing this if the
specific market recovers. Many critics of the growth-share matrix also point out the self-
fulfilling nature of the “dog” designation. Once resources are shifted away from an enterprise
labeled a dog, in all likelihood the enterprise will soon be a dog in fact.
The growth-share matrix may also be used to balance the pieces of a corporation in the same
way that a portfolio is balanced. Cash cows balance the risk in question marks and the resource-
intensiveness of stars. Some dogs may be retained because, while they have limited future
prospects for profitable growth, they are currently quite profitable.

FP&A can characterize the share and trend of each component of the organization’s business by
using internal and external data. An analysis of financial statements over time will support a trend
analysis of a unit’s profitability. Market share data may be purchased from research services but
may also be reported annually by industry trade groups to which the organization belongs. Trade
group data and commentary on market growth may be used to create trend reports.
McKinsey Nine-Box Matrix
A slightly more recent and less problematic model for allocating resources is the McKinsey Nine-
Box Matrix (Gluck, Kaufman and Walleck, 1978). This matrix is shown in Exhibit I.A.2-6. The axes
are similar to those of the growth-share matrix: attractiveness of the industry (market growth rate
in the BCG matrix) and ability to compete within the industry (market share).
Exhibit I.A.2-6 – McKinsey Nine-Box
Source: Gluck, Kaufman and Walleck, 1978

Mckinsey Nine Box Matrix- Explained
The squares with text indicate basic investment options: invest, invest selectively, divest. An
organization should invest its resources in business units that are competing well in growth
industries. It should withhold investment from struggling units in unattractive industries—
industries that are probably past their peaks. Anything in the middle should be considered
carefully, and investment should be driven only by proven earnings potential. Operations in the
shaded areas should not consume much capital. Conversely, operations in the white boxes merit
additional investment.
It is important to note, however, that sometimes an argument can be made for a business unit’s
potential worth—perhaps because of an anticipated change in the economy or a shake-up in the
industry or because management suspects that the unit could be more profitable under different
leadership or a different strategy. It is also possible that a dog can play a supportive role for the
industry success of a star.
Measurement
Measurement is one of the basic laws of the business universe. Here, in the realm of strategy,
measurement of progress in achieving strategic goals motivates the organization and assures
investors and lenders. Regular measurement also provides an early warning when a strategy is
not working. This allows the organization to adjust the strategy without wasting additional
resources.
How the organization will measure progress toward its value goals must be defined during the
planning process. Without planning, the organization may gather performance data that are
irrelevant to its strategic goals, or it may fail to gather data at all. Either scenario inhibits the ability
to report progress internally and externally.
Measurement is discussed further in the next topic.

Topic 3: Strategy and Measurement

Key Performance Indicators
Good management practices and governance require that organizations measure the degree to
which strategic initiatives have succeeded in producing the desired growth in value. Measurement
frameworks have developed around this requirement. The attributes of value have expanded over
the past decades, from performance measured solely by historic accounting measures to a
broader definition of the economic and non-economic factors that drive an organization’s value.
The measurement framework itself includes:
• A goal
• Performance or value drivers that influence every input, process and output needed to attain
that goal
• Metrics that accurately represent satisfactory performance for each driver
It is the organization’s ability to affect these drivers that must be measured. The performance level
needed to attain related value drivers is called a key performance indicator (KPI).
All of these elements—goals, drivers and KPIs—must be aligned. Without alignment, the
organization is measuring the wrong activities. It may seem as if the organization is doing well but
only superficially or in the wrong areas.
This topic looks at frameworks used by organizations to define an organization’s value drivers at
a strategic level.
Defining Value Drivers
An organization must go through a process of self-assessment to identify the right mediators of

value. The process for most organizations today is like the 360° feedback system used in
appraising individual performance. The organization must consider the financial outcomes of its
activities but also the activities themselves and the way they are integrated with each other and
with those affected by them (e.g., customers, shareholders, employees). The organization must
consider the quality of past performance but also how well it is preparing itself for future growth.
Value drivers vary among organizations, both for-profit and non-profit, as shown in Exhibit I.A.2-
7.

Exhibit I.A.2-7 – Value Drivers across Organizations
Banking Energy Retail University
Customer retention Capital expenditure Capital expenditures Tuition payments
Customer Exploration success Store redesign Ability to attract

penetration rate endowments and grants
New stores
Fees generation Refinery capacity Operating costs of
Attraction of new
properties
Asset quality Efficiency of refinery shoppers
use Patents granted
Capital adequacy Store sales
Proven reserves Community satisfaction
Assets under Efficiency in generating
management Costs of developing sales per unit of retail
reserves space
Loan losses
Customer satisfaction
Use of sustainable policy

guidelines in purchasing
Source: Based on PWC-Guide to Key Performance Indicators, 2007
Assessment Tools for Corporate Finance
Two assessment tools for defining these values are discussed here: the EFQM Excellence Model,
which is used widely in Europe, and the Balanced Scorecard, which was initiated in the U.S. but
is used globally. Both emphasize the need to look at the creation of value from different
perspectives and in different time frames (considering future effects as well as past and present
results).
EFQM Excellence Model
The EFQM Excellence Model (shown in Exhibit I.A.2-8) was introduced by the European
Foundation for Quality Management (now operating under its acronym, EFQM). It is a framework
that allows an organization to assess the quality of its inputs (leadership, employees, strategy and
partners), the integration of its processes and the quality of its outputs (effects on the business
itself, its employees, its customers and its society). Its specific focus on the need for leadership
and accountability to society are notable.

Exhibit I.A.2-8 – EFQM Model
The model is built on eight “fundamental concepts” or beliefs and abilities that characterize
successful organizations:
Fundamental Concepts
• Adding value for customers through understanding and meeting current needs and
anticipating future needs
• Creating a sustainable future by adopting goals, policies and programs that consider the
economic, social and environmental effects of an organization’s actions
• Developing organizational capability, or the ability to manage change
• Harnessing creativity and innovation to increase value, levels of performance and stakeholder
satisfaction
• Leading with vision, inspiration and integrity—the ability of management to model the
organization’s core beliefs and ethical principles
• Managing with agility so as to adapt strategy quickly to emerging threats and opportunities
• Succeeding through the talent of people by inclusiveness and empowerment of members of
the organization
• Sustaining outstanding results that meet the short- and long-term needs of internal and
external stakeholders (i.e., producing growth in value, which encourages investment that can
be used to support good jobs and to provide products and services that meet customers’
needs)

Balanced Scorecard
The balanced scorecard, developed in the 1980s and 1990s by Robert Kaplan and David Norton,
is a tool that can be used to support strategic planning and performance measurement. The
concept behind the balanced scorecard as a strategic planning tool is that strategy must focus on
creating and increasing value but an organization’s value is more complex than specific lines on
a financial statement.
Organizations can use the balanced scorecard to gather and analyze information from different
perspectives about what they consider critical to the organization’s success. Information may be
gathered from senior and function/support managers, key customers, suppliers or external
business partners, such as lenders. It can also include analysis of the organization’s previous
financial statements and other reports and performance data from the industry and specific
competitors. The responses and results help isolate value drivers.
Balanced Scorecard Performance Perspectives
Value must be considered from four performance perspectives:

• Financial—the way investors or lenders typically define worth
• Market—the reasons why customers might choose one product/service over that of a
competitor
• Internal processes—the effectiveness of the organization’s value chain (Value chain refers
to the characteristic way in which organizations in an industry organize the various processes
required to produce value. The value chain concept is discussed in Chapter 3, “Organization.”)
• Learning and growth (i.e., the future)—whether the organization is doing things that will
increase its value
The balanced scorecard results yield strategic goals that are focused on creating the right kind of
value. The balanced scorecard is shown in Exhibit I.A.2-9. The bulleted items under each
perspective illustrate the types of value drivers associated with the perception of value in that
area.

Exhibit I.A.2-9 – Balanced Scorecard as a Strategic Tool
Balanced Scorecard Takeaways
Financial stakeholders, such as investors, lenders and those compensated on the basis of the
organization’s financial performance, are interested in its effectiveness in using capital to produce
value in the form of earnings. Is the organization generating profit that is returned and/or
reinvested to increase the value of their holdings? Is the organization being managed in such a
way that the investment is safe? Is the risk-to-benefit ratio appropriate? Are residual risks being
managed? Is debt being managed to ensure optimal return on equity and avoid insolvency?
Customers are looking for products and services that meet their needs, which may be driven by
different factors, such as low cost, brand appeal or prestige, specific user requirements and
reliability. They may also value superior customer care—talking to customer care representatives
who know who they are and everything about their previous business interactions and
preferences, being able to access current information about interactions quickly and easily,
resolving problems quickly without bureaucratic hurdles.
In terms of business processes, the balanced scorecard can reveal if the organization is focusing
its attention and resources on processes that are truly integral to its financial and market success.
If success depends on continual introduction of new products, is the investment in research and
development appropriate? If reliable delivery is important, can the supply chain and infrastructure
guarantee that? If quality is critical, are standards defined? Are employees trained in quality
processes? Is quality monitored and gaps quickly identified, analyzed and corrected?

Fueling future growth in organizational value depends on building a platform for improvement.
What policies and processes will be critical to the organization sustaining (or building) a
competitive edge? For example, if the organization is in a rapidly changing industry or the
organization’s goal is to change its basic business model, are its employees prepared to accept
and implement change quickly and effectively? If a nonprofit's mission is to serve the evolving
needs of its clients, does it have a process in place to identify emerging needs and analyze their
impact on client services?

Topic 4: Risk
Risk Overview for FP&A
ISO (the International Organization for Standardization) defines risk as “the effect of uncertainty
on objectives.” Traditionally, however, risk tends to be seen as a negative event that decreases
the organization’s ability to meet its financial goals. Its impact can be perceived as quantitative
(e.g., a measurable change in market value) and qualitative (e.g., erosion of an organization’s
reputation or a brand’s image). Effects may be short-term or long-term.
From the FP&A perspective, risk is embodied in the degree of volatility in factors that can affect
the organization’s key measures of value, which may include earnings per share, cash flows,
return on capital and the value of portfolios of financial instruments. Both risks and opportunities
must be recognized and managed. Making strategic decisions with an awareness of risk is to
engage in trading the possibility of loss for the possibility of gain. Without risk, there can be no
gain. The “trick” of managing risk is to minimize downside risk (loss) while maximizing upside risk
(gain).
The tasks of risk identification, quantification and management will recur throughout this domain,
at the levels of the organization, industry and macroenvironment. A brief overview of the benefits
and process of risk management is in order, before addressing the role FP&A plays in managing
risk at the strategic level.
Benefits of Risk Management
In general, managing risks helps organizations increase the probability of success, decrease the
chances of failure, and decrease the amount of uncertainty surrounding the organization’s
activities. The discipline of risk management offers other distinct benefits to an organization:
• Implementing risk management processes helps ensure that the organization deals with risk
in a rational and cost-effective manner. An organization cannot control every risk with
complete confidence; risk management helps focus investment in controlling risk in the areas
where additional resources will produce the most value.
• Organizations that actively manage risk are usually more efficient, profitable and transparent.
• They are more likely to maintain compliance with laws and regulations.
• They are more likely to secure capital. Lenders are deeply interested in whether an
organization’s management is properly identifying, quantifying and reporting risk since lenders
are also interested in balancing their loan portfolios. In the same way that the organization
balances its various initiatives, a bank must achieve a certain mix of high- to low-risk loans. If
a lender feels that risks are not being properly managed, they may refuse further funding.

At the same time that the organization is managing risks to its strategy, business plans and
projects, it should also be building competencies that will help the organization capitalize on
opportunities as they arise. This might include flexible manufacturing processes, expandable IT
capability and expanded job skills and knowledge. This section, however, will focus on the
traditional risk management framework.
Risk Management Framework
A risk management framework is a structure for implementing risk management principles and
processes within an organization. It is an iterative structure in which framework components are
designed and implemented, monitored and assessed, and continually improved.
The point of a risk management framework is that risk management activities by themselves are
not sufficient to address the issue of risk. The entire organization, from the board to employees,
must be involved. Expectations must be set, and processes tested to ensure that they fulfill those
expectations.
Enterprise Risk Management Framework
The term enterprise risk management (ERM) is used to describe the process an organization
uses to respond to risk from a strategic to an operational level across all of the organization’s
processes. The ERM framework defined by the Committee of Sponsoring Organizations (COSO)
of the Treadway Commission and PricewaterhouseCoopers in 2004 includes:
• A control environment—the ethical tone of the organization and the way in which these values
are reflected in organizational behavior
• Risk assessment—setting objectives for risk levels and identifying risks and vulnerabilities
• Control activities—policies and procedures that support implementation of plans to manage
risk
• Information and communication—communication of expectations and rules downward
throughout the organization and communication upward to management aimed at improving
practices
• Monitoring—assessing the quality of the system over time
ISO 31000 introduced similar risk management framework guidelines in 2009.
Risk Management
Risk management is defined by the Financial Times as “the process of identifying, quantifying,
and managing the risks that an organization faces.” risk management process itself is illustrated
in different ways. Exhibit I.A.2-10 is a simple example. Each of these steps will be discussed
individually.

Exhibit I.A.2-10 – Risk Management Process
Understand the Organization’s Risk Appetite and Tolerance
Risk appetite and risk tolerance are related terms that seek to describe a specific organization’s
posture in regard to risk. The accounting firm Ernst & Young defines risk appetite as the amount
and type of risk that an organization is able to support in order to achieve its goals. Risk tolerance
refers to a threshold of outcomes (e.g., minimum gains, maximum losses) beyond which the
organization will withdraw from the activity, deeming it too risky.
These characteristics are often products of management style or organizational culture, but they
can also be influenced by the level of the organization’s resources, competitive forces in the
industry or macroeconomic trends. The role of FP&A is to understand management’s risk appetite
and tolerances and include those factors in risk-adjusted projections.
It is also critical that FP&A be prepared to communicate with the board and management when
the organization’s risk posture is unrealistic.

Identify the Organization’s Vulnerabilities and Threats
Vulnerabilities are internal conditions that diminish the organization’s operations capabilities. For
example, lack of proper governance makes the organization vulnerable to fraud, mismanagement
and non-compliance with laws and regulations. Threats are uncertain external factors over which
the organization has little control—for example, a new regulation that will be costly to implement
or the entry of a new competitor. Together, these factors constitute the organization’s risk.
Risks are specific to an organization’s assets and operations and to its industry. They are usually
identified through surveys and workshops at all levels and all functions of the organization. They
may derive from internal or external sources. For example, a sales goal may be missed because
of ineffective account management or because of a downturn in the economy. Risks may be man-
made (e.g., arson or theft) or natural (e.g., damaging storms). ISO 31000 includes a checklist with
a broad range of risks.
One way of classifying risks is by what area of an organization’s activity they affect. This could
include:
• Strategy
This can include both the strategic business decisions management makes and competitive
responses to it. It can also include the effectiveness of the organization’s units or functions
in implementing strategies. For example:
• A movement into a new market is met by a strong reaction by a competitor.
• A critical product development effort does not meet objectives or timelines.
• Economic conditions in a country in which the organization invests and/or operates
deteriorate. This is referred to as country risk, or sovereign risk—the risk associated with
investing in a particular country (Financial Times Lexicon).
• Operations
These risks relate to failure of the organization’s systems and controls that prevent it from
meeting its goals. For example:
• A marketing campaign is ineffective in increasing sales.
• A major quality problem requires a product recall (and possibly triggers lawsuits).
• Changes in regulations increase labor costs.
• A pandemic affects the productivity of the organization’s workforce.
• A hurricane disrupts distribution and causes spoilage for a fresh produce company.

• Financing
These risks affect essential activities in finance, such as managing short-term and long-term
debt, cash reserves, and financial risk management tactics (e.g., portfolio diversification,
hedging strategies). For example:
• Lending rates rise, increasing cost of capital.
• Credit markets become tight, making it harder to secure loans.
• Changes on the financial statement cause the organization to default on loan covenants
(agreements with a lender to meet certain financial tests, such as debt to equity ratio or
tangible net worth). (Covenants are discussed in Part I, Domain B.)
• Capital support for an enterprise, strategy or project is suddenly withdrawn or costs of
funding increase sharply.
• The other party in a credit default swap agreement defaults on its obligations. This is
referred to as counterparty risk, the risk that the other side of a transaction will be unable
to meet its obligations (Financial Times Lexicon).
• Compliance
These risks involve the organization’s obligation to comply with local laws and regulations.
Penalties could be financial or operational—and, in some cases, criminal. For example:
• A pharmaceutical firm is fined for improperly promoting a product and must pay a fine and
change its marketing practices.
• A new workplace safety regulation requires retraining of a sales force, purchase of new
equipment and changes to existing equipment.
• A firm submits false financial information to secure a loan.
• Reputation
The vulnerabilities affected by reputation risks are a firm’s good name and its relationship with
stakeholders (e.g., investors, regulators, customers). For example:
• A firm is found to have given insufficient attention to negative data in product testing.
• Media reports focus on excessive executive salaries or payouts.
• Unfair working conditions at a supplier are reported in the media.
• Management is ill prepared to respond to an emergency because it has neglected to
prepare a plan.
FP&A is directly involved in conducting risk analyses and using risk probabilities in different
models. (This topic is addressed in Part II, Domain B.) Analysts should therefore be familiar with
identified risks, probabilities and impacts. They should also be ready to point out when risks have
not been considered in a management decision. If the risk identification process has not been
conducted, FP&A should urge that a survey be conducted.

Assess Probability, Impact and Confidence in Existing Controls
Probability refers to the degree of likelihood that the event will occur. Impact refers to the
magnitude of damage the event will have on the organization. Confidence in existing controls
refers to an assessment of how well the measures currently in place to protect against a risk. The
unprotected portion is an area of vulnerability. Any gap in the effectiveness of controls must be
addressed in the risk management plan.
Assessments of probability, impact and controls begin with qualitative assessments of risks and
existing controls. The risks and controls are identified and then prioritized or ranked based on
impact and probability. Risk assessment should involve management at all levels since
perceptions of risk vary by perspective. Financial managers will be more attuned to risks that
threaten key financial measures, such as cash flow or earnings. For operations managers, risks
related to employees, processes and assets may be more visible. Risk identification may begin
with workshops and proceed to surveys based on worksheet tools that ask respondent to assess
probability, impact and control effectiveness for a defined list of events.
The result of analyzing this input is often expressed graphically in a risk matrix, one version of
which is shown in Exhibit I.A.2-11.
Exhibit I.A.2-11 – Risk Matrix Example

Quantitative Risk Analysis
An event with high impact and high probability would be considered to pose a high risk, and its
treatment would be prioritized. An event with low impact and low probability would be considered
low risk, and treatment would not, in most organizations, merit significant investment.
Once risks are ranked qualitatively, FP&A professionals can perform a more detailed financial risk
analysis for select medium- or high- ranked risks. This moves into quantitative risk analysis
because it involves determining a numeric impact (such as monetary, volume, headcount, number
of customers, etc.) and estimating a probability. One common quantitative risk formula is expected
value.
Expected value (also called expected monetary value) is the probability of occurrence
multiplied by the impact, which is a monetary value that could be a balance sheet risk, such as
an asset value, or an income statement risk, such as a revenue or an expense risk.
Expected Value = Probability ∗ Impact
Since the impact is expressed as a monetary value, the expected value for each risk is a risk-
weighted monetary value that can be added to other potential risks or positive opportunities to
determine the net impact. Note that with this formula, the probability is an assessment of the
likelihood of the event occurring after taking into consideration any controls that are already in
place.
Other risk measurements split the probability measurement into more subcomponents. For
example, the U.S. Federal Emergency Management Agency (FEMA) illustrates the interaction of
impact, probability and confidence in existing controls using what it calls a risk formula, which is
expressed as:
Risk = Asset Value ∗ Threat Rating ∗ Vulnerability Rating
Risk Formula
In the risk formula:

• Asset value relates to the magnitude of a potential loss or the impact of an event, a balance
sheet risk. However, impact could still also be applied to income statement risk, for example,
business processes whose interruption would create financial loss.
• Threat rating correlates with probability that an event will occur.
• Vulnerability rating correlates with how well the organization has controlled for a specific risk—
how much it has done to diminish impact and occurrence. For example, an organization may
reduce its vulnerability to storm-related interruption in its distribution by decentralizing its
transportation system.

While expected value is more commonly seen for risk and opportunity analyses in the business
world, looking at probability as the combination of both threat and residual vulnerability can help
take into account any efforts that have already been done to control the risk. For example, if the
organization has insurance for this risk, only the amount below the deductible and above the
maximum payout would be at risk.
Exhibit I.A.2-12 shows how expected value is often used to determine an option with the lowest
overall risk or best potential for a net gain, allowing the strategic impact of a decision to be
quantified. In this case, the decision is whether to:
• Build a capability—for example, to build a new plant to produce a product; or
• Buy that capability—for example, to purchase a controlling interest in an organization that
already makes the product.
However, there is a risk in either case that a new government regulation will be put in place that
could affect the return on the investment.
This is a risk to revenue, so it is an income statement risk. The impact is the net present value
(NPV), which is simply the present value (PV) of the revenue less the investment. This is multiplied
by the probability for each line item to calculate the expected value for each line item. Note that
PV and NPV are defined in more detail in Part I, Domain B.
Exhibit I.A.2-12 – Calculating Expected Value
While the organization’s decision to build or buy will not affect the overall probability of the
government regulation occurring, the FP&A professional determines that if a new plant is built, it
can be designed to better accommodate the regulation. In other words, this option has less
vulnerability to the regulation and therefore the probability is adjusted accordingly. The expected
value for each decision is the sum of the expected values for each line item. In the exhibit, a
SUMPRODUCT formula is used to perform both the row multiplication and the column sums in
one calculation. (See the formula bar for an example. Note that this formula can be used to save
time on the exam.

In this case, the build capacity option has a higher expected value, but it also contains the most
risky scenario, one that results in a $30 million loss. Thus the analysis highlights the potential
risks of a given choice. Risk-averse organizations might choose the buy option, while risk-taking
organizations may build to increase the upside potential. Risk treatment is discussed next.
Select Appropriate Risk Treatment
An organization’s options can be summarized as:

• Accept the risk without further action
This is usually the strategy for very low probability/impact events. For example, the sudden
loss of a particular raw material that is plentiful, low-cost, easy to procure from other suppliers
and easy to replace with another material will probably be accepted.
• Avoid entirely
The organization will probably opt to arrange its business to avoid entirely risks that are highly
likely and have a large impact. For example, it will avoid investing in developing a
product/service that requires considerable resources and almost guarantees a price war with
a major, well-positioned and assertive competitor.
• Mitigate (prevent occurrence and/or lessen impact)

These strategies employ tactics to prevent the occurrence of the threat (perhaps by removing
a vulnerability) or to mitigate the damage inflicted when a risk event occurs (perhaps by
implementing an authority check on a funds transfer above a certain amount). Residual risk
is the degree of risk that remains after these controls have been implemented.
When a data center manager installs additional cooling units, the intention is to prevent
overheating that can cause unit failure and loss of service and possibly loss of data. When
the manager decentralizes data operations so that a natural disaster affecting one center will
not take the entire network down, the intention is to minimize the impact of the disaster.
In financial terms, due diligence for a merger or acquisition is an example of a prevention
strategy. Diversification and hedging are common ways to lessen the impact of risk. A
diversified portfolio— of stocks, real estate holdings, patents, pipeline products or strategic
initiatives—balances possible losses or poor performance against possible gains and strong
performance. Hedging is a strategy that directly offsets possible losses in one activity through
investment in another. The result is a reduction in the risk of the initial activity. For example,
a company knows that it must pay a large lump sum in a different currency to a patent holder
in three months. There is a currency exchange risk that a change in rates can increase the
size of the payment. To hedge against or offset this risk, the company buys a forward contract
to lock in the current rate on the necessary currency. The transaction can occur in reverse as
well. Futures, swaps and options are other financial instruments that can be used to hedge
exposure.

• Transfer or share risk

The most common way to transfer risk is through insurance. For a fee (premiums) and certain
conditions, the insurer agrees to accept risk of loss and reimburse the insured. There are other
forms of this risk management strategy, however. If an organization outsources production of
a component to a separate firm, it is transferring some of its operation risk to the other firm.
Note the use of “some.” It is difficult to shed all risks. The outsourcing company has shed the
risk of labor disruptions but incurred the risks associated with lack of control over labor
conditions and the possibility that its good name might be damaged by substandard labor
conditions—commonly called reputational risk. Some firms have contracted with energy
companies to reduce their facilities’ energy consumption. If the energy company is not
successful in decreasing consumption, it pays a larger share of the invoice. If it is successful,
it keeps all or a large share of the energy savings.
Monitor the Effectiveness of Controls and Changes in Conditions
Risk management is an iterative process; the attempt to manage risk continually repeats with the
aim of reducing total or aggregated risk to zero. This is impossible, of course. New risks are
constantly emerging, and management strategies must trade off the reduction of risk achieved
against the cost of the strategy itself. However, an organization’s risks should be mapped at least
annually in order to:
• Confirm that existing risk management strategies have been effective in reducing risk to the
desired level
• Identify and manage new vulnerabilities (e.g., portfolios that have become unbalanced,
difficulty in hiring talent) and emerging threats (e.g., tighter credit markets, loss of market
share to a new competitor)
Strategic Risk
One of the underlying goals in a strategy is for the organization to develop an understanding of
risks in its strategic options and follow an agreed risk level when selecting them. As mentioned
earlier, FP&A supports strategic planning by comparing the value delivered by strategic initiatives
and determining volatility in value and costs over a specific time period. To analyze strategic
options from this perspective, FP&A professionals project patterns of cash flows and expenditures
over a specific time period. Spikes in measures of cash flows and expenses can indicate points
at which a strategic decision must be made—for example, to expand an investment in a new
manufacturing facility because of its value potential or to redirect the organization’s resources to
other initiatives.
Volatility over the defined span of the project, or cumulative volatility, reflects uncertainty about
the value of the project and the degree to which the organization may be able to modify its plans.
Value may be affected by changes in interest rates, expenditures, revenues and the need to
recoup value sooner than expected. Cumulative volatility can be identified through experience,
by gathering data about similar enterprises and by simulations.

Analytical Considerations
The analysis should also consider:

• The organization’s strengths and weaknesses in areas critical to the initiative
• The occurrence of certain risks and their impact from an industry and macro environmental
perspective
• The level to which risk impact can be averted or mitigated or losses offset
An organization may choose to manage its strategic options as a portfolio—choosing, prioritizing
and balancing investments of resources according to value and uncertainty or volatility. The
volatility to value matrix, shown in Exhibit I.A.2-13, applies these two measures to categorize
options into six types. The horizontal axis represents a value- to-cost index, with 1.0 representing
a return equal to cost. The vertical axis represents a range of uncertainty or volatility in returns,
with higher volatility scores at the top.
Exhibit I.A.2-13 – Volatility to Value Matrix
Source: “Strategy as a Portfolio of Options,” Luehrman, 1998
Volatility to Value Matrix: Discussion
In this matrix, both Initiative A and Initiative F have near-zero volatility, probably because the time
for action has arrived. Since Initiative A has a better value-to-cost ratio, the organization will
choose Initiative A. Initiatives B and C are promising, but the greater volatility of Initiative C may
argue for delaying the investment or structuring it to allow for modification or withdrawal. Similarly,
the greater volatility of Initiative D would recommend that it be delayed or avoided entirely.
Decisions will depend on the organization’s strategies and goals, competitive environments and
risk tolerance.

Exhibit I.A.2-14 shows the way in which awareness of risk factors and the organization’s risk
appetite can shape strategy selection. In this case, an organization must decide the best strategy
for realizing the value inherent in an innovative product or process—for example, a new drug. As
indicated by the triangles, the possible advantages and risks increase with each option.
Exhibit I.A.2-14 – Weighing Risk and Advantages of Strategic Options
Option Advantage Risk
1. License the drug to Additional investment (e.g., The potential for significant
another company production, marketing) is not value is sacrificed. There may
required, avoiding significant be additional contractual issues
costs. The company can that erode value as well.
continue to focus on product
development, its core
competency.
2. Outsource sales only Sales-related costs are Profit is tied to performance of

to another company avoided. There is a possible the partner.
higher return from a larger and
more proficient sales force.
3. Enter into a strategic Allied parties can combine Strategic alliances lack the
alliance to form a joint strengths in a flexible manner formality and enforceability of
sales force with to minimize costs and maximize contracts. How can one be sure
another company experience and capabilities. that one’s product is being
properly and legally promoted to
prescribers?
4. Initiate a joint venture Same benefits as with a Disagreements between

to produce, market strategic alliance. partners may hamper business
and distribute the efforts and erode potential.
drug
5. Commercialize the The company controls all return The company loses a significant
drug patent itself on the investment in the investment of equity because of
innovation and bringing it to production, marketing or
market. compliance mistakes.
Source: Adapted from Contemporary Strategy Analysis, Grant, 2005

Managing Risk
It may be possible to manage the inherent risks in any of these options and make the strategy
align with the organization’s risk tolerance. For example, the organization can gather data about
outsourcing strategies followed by peers. Critical attributes of the arrangement and the value
produced in the different examples can be compared. Outsourcing may be discovered to work
only in certain geographical markets or product categories. Annual reports and discussions with
industry experts might reveal that Company A has consistently outperformed Company B in terms
of sales.
In coming chapters, the issue of risk will be examined in the spheres of:
• Organization—how the organization identifies, quantifies and responds to risk in its planning
activities
• Industry—how an organization handles levels of uncertainty
• Macro environment—how an organization tracks and responds to trends as well as “shocks”
that can influence its success

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FPAC Part 1: Chapter 2

Topic 1: Nature of Strategy………………………………………………………………….. 2-2

Topic 2: Strategic Planning Framework…………………………………………………….2-7

Topic 3: Strategy and Measurement……………………………………………………… 2-22

Topic 4: Risk………………………………………………………………………………… 2-28

©2019. Association for Financial Professionals Table on Contents 2-1

Topic 1: Nature of Strategy

©2019. Association for Financial Professionals Topic 1 2-2

©2019. Association for Financial Professionals Topic 1 2-3

Three Forms of Strategy

©2019. Association for Financial Professionals Topic 1 2-4

Strategy serves multiple functions:

Missions and Values—The Heart and Soul of Strategy

©2019. Association for Financial Professionals Topic 1 2-5

A company operates a chain of physical fitness centers. In its communications to stakeholders, it

©2019. Association for Financial Professionals Topic 1 2-6

Topic 2: Strategic Planning Framework

Exhibit I.A.2-1 – Strategic Planning Framework

©2019. Association for Financial Professionals Topic 2 2-7

Internal and External Analysis

©2019. Association for Financial Professionals Topic 2 2-8

Exhibit I.A.2-2 – SWOT Analysis

©2019. Association for Financial Professionals Topic 2 2-9

©2019. Association for Financial Professionals Topic 2 2-10

Exhibit I.A.2-3 – Completed SWOT Analysis for Fitness Center Company

● Good financials; access to favorable ● Small footprint at metro centers limits

● Favorable real estate market ● Economic downturn

©2019. Association for Financial Professionals Topic 2 2-11

Why Set Goals?

©2019. Association for Financial Professionals Topic 2 2-12

Exhibit I.A.2-4 – Three Horizons of Growth

Source: Luehrman, 1998

©2019. Association for Financial Professionals Topic 2 2-13

Three Horizons of Growth

©2019. Association for Financial Professionals Topic 2 2-14

©2019. Association for Financial Professionals Topic 2 2-15

The Three-Horizons Approach

©2019. Association for Financial Professionals Topic 2 2-16

Investing and Allocating Resources

At what point will an investment of resources positively impact this metric?

©2019. Association for Financial Professionals Topic 2 2-17

Exhibit I.A.2-5 – BCG Growth-Share Matrix

©2019. Association for Financial Professionals Topic 2 2-18

Growth Share Matrix Quadrants

Growth-Share Matrix Quadrants

©2019. Association for Financial Professionals Topic 2 2-19

McKinsey Nine-Box Matrix

Exhibit I.A.2-6 – McKinsey Nine-Box

Source: Gluck, Kaufman and Walleck, 1978

©2019. Association for Financial Professionals Topic 2 2-20

Mckinsey Nine Box Matrix- Explained

©2019. Association for Financial Professionals Topic 2 2-21

Topic 3: Strategy and Measurement

Defining Value Drivers

An organization must go through a process of self-assessment to identify the right mediators of

©2019. Association for Financial Professionals Topic 3 2-22

Exhibit I.A.2-7 – Value Drivers across Organizations