2-3. Accounting and Tax Practices (Strategic Analysis)1 Terry Merton, CPA, hardly noticed the bright sunshine as she drove down the freeway in late October, 2007 on her way to her job as controller for a small manufacturing company in her hometown of Brightside, California. She was contemplating the prospect of starting an accounting and tax practice. Although quite satisfied with her present employment, she was very excited about the possibility of owning her own business. Prior to her present position, Terry had worked for four years in the small business division of a Big 5 public accounting firm's Brightside office and had dreamed of opening her own practice. Terry had decided that 2008 is the year her dream will become a reality. Arriving at her office early, Terry began to think about the possible market segments she might serve and the types of tax and accounting problems these potential clients might have. For instance, Terry might simply establish a tax practice which would focus on serving individuals who typically require only simple return preparation. Serving this target market segment would mean preparing simple tax returns, such as form 1040 and other schedules commonly completed for individuals along with the 1040. On the other hand, Terry could establish both a tax and accounting practice. This would mean she would serve both individuals and small businesses, although her primary target market would be small businesses. Pursuing this alternative would mean that she would render tax services for individuals, small businesses, estates, trusts and pension plans. Further, she would provide compilation, review and audit services for small businesses, as well as advice on designing accounting information systems. Terry knew that her first step would be to identify the market segment she wished to serve. To be successful, she would have to serve the selected target market very well. Once she identified her target market segment, Terry could then make a decision about her competitive strategy -- whether to implement a cost leadership of differentiation strategy. Pursuing a cost leadership strategy meant that she would attract clients by keeping her prices (and her costs) low. At the same time, Terry would still be attentive to providing quality service on a timely basis. She would compete on the basis of price and monitor costs to be sure they were kept low. Pursuing the differentiation strategy meant providing services which are considered to be unique. Differentiating her product probably meant that Terry would provide above- average service and develop a more personal relationship with clients. With the differentiation strategy, Terry would be able to charge above-average prices for the services provided to clients and would not have to be as attentive to cost control as she would under the cost leadership strategy. In considering which strategy to pursue, Terry thought about a nationally known provider of tax preparation services for individuals, which had offices located throughout the U.S. This national firm used television, radio and billboard advertising to present 17 reasons why taxpayers should do business with their firm. Terry was certain that the national firm had a costly centralized administrative structure. The firm's tax preparers were typically not CPA's, but were graduates of a training program conducted by the firm. Terry felt that this nationally-known firm was pursuing a differentiation strategy, since it emphasized the 17 reasons but did not emphasize low price. If Terry selected the individual tax market, she could employ the cost leadership strategy. The limited tax expertise required would allow Terry to remain at her present employment. She would hire Jim Wallace, an experienced semi-retired preparer of uncomplicated tax returns. Terry would locate her tax practice in a storefront in a nearby shopping mall. Rent was very low there, and there was a high volume of pedestrian traffic 1 Prepared by Jack M. Ruhl and Jerry G. Kreuze, American Accounting Association, 1997. Used with permission. 2-6 Chapter 02 - Implementing Strategy: The Value Chain, the Balanced Scorecard, and the Strategy Map past the location. Given this heavy pedestrian traffic, Terry reasoned that she would incur little advertising cost. Terry expected that her costs could be kept low compared with the nationally-known firm for two reasons: (1) she would provide minimal training for Jim and (2) she would have minimal administrative and advertising costs. Now, Terry thought about the small business market. Here, Terry thought about using the differentiation strategy. With the differentiation strategy, the services she would provide would be significantly different from the services provided by competitors. Terry would differentiate herself along a number of dimensions, many of which related to her extensive experience with the Brightside business community. First from her experience working in a Big 5 firm's small business division, Terry is acquainted with all the bankers in town. She knows how to prepare financial presentations for clients seeking loans in such a way that the loan applications are almost always approved. She also is familiar with virtually all the small business rental property in town, and can direct clients to the most reasonably priced locations. Finally, she is thoroughly familiar with the operation of a small business and can provide extremely useful insights to small business owners. Terry would provide small businesses with many reasons to patronize her new firm. If the small business strategy is pursued, Terry will leave her $40,000/year controller position to become the principal employee of Startup, Inc. Terry would like to finance her new business start-up costs entirely from her personal savings. This is not possible, however, since she just recently purchased a new automobile for cash, which left her with a savings account balance of only $2,400. She will need a business loan to cover start-up costs including the purchase of a computer and software. Prior to contacting Bill Andersen, the loan officer at a nearby bank, Terry prepares some preliminary profit estimates. Terry's estimates of the revenues and costs associated with each strategy for the first year of operation, 2008, are presented in exhibit 1. Terry projects revenues of $67,500 (450 Clients at $150/client) and $91,350 (203 clients at $450/client) under the cost leadership and differentiation strategies, respectively (see exhibit 1). Supplies average $10 per client and constitute the only variable costs for Startup, Inc. The fixed expenses vary between the strategies in several respects: 1. If she pursues the small business strategy, Terry will incur significantly higher liability insurance costs each year than she would under the cost leadership strategy. This is due to the fact that she has much more liability exposure since she will be doing attest work (reviews and audits). 2. Annual computer software costs will be greater under the small business strategy. This is because each year Terry will purchase specialized CD-ROM tax preparation disks needed to properly prepare the estate and trust returns. Additional software is also needed if she wishes to advise clients with regard to pensions. 3. If she pursues the small business strategy, Terry will incur additional expense for club membership dues and entertainment expenses compared with the cost leadership strategy. This is due to the fact that Terry knows that she can develop the estate and trust work through social contacts with bankers and attorneys. 4. Under the individual tax strategy, Terry will continue in her present employment position. She will hire Jim Wallace for $500/week. Although not a CPA, Jim is approaching retirement at the public accounting firm where Terry had been employed. Jim would be happy to work part-time at Startup, Inc. Terry is impressed with Jim's qualifications and is confident he could prepare uncomplicated tax returns. The differentiation strategy, however, will entail more complicated tax return preparations, which are beyond Jim's capabilities. Under the small business strategy, Terry would resign from her controller position and work full-time for Startup, Inc., drawing a salary of $600 per week. 5. Terry's home has a very large attached apartment which she presently leases to two college students at a rent of $500 per month. The students' lease expires on December 31, 20X0. Under the small business strategy, she will not renew the lease. Instead, she will set up the offices of Startup, Inc. in the apartment. Under the cost leadership provider strategy, the students would continue to occupy the apartment, since space in a nearby strip mall will be leased for Startup's offices. The strip mall space would provide needed pedestrian traffic 2-7 Chapter 02 - Implementing Strategy: The Value Chain, the Balanced Scorecard, and the Strategy Map and high visibility for Startup, Inc., and avoid traffic congestion in Terry's residential neighborhood. 6. Anticipating the complexity of clients under the small business strategy and considering the fact that she has been out of public accounting for three years, Terry estimates $8,000 in annual training costs. Minimal training costs are projected with the individual tax strategy since Jim Wallace already possesses the necessary experience, and the level of tax expertise required is minimal. OBTAINING A BUSINESS LOAN Terry faxed the financial projections in Exhibit 1 to Bill Andersen in early November 2007. As a loan officer, Bill must follow a set of specific guidelines in making his loan approval decisions. If Bill approves too many loans which ultimately are "bad," he will be dismissed from his job. For all loan applications, he must be able to justify after-the-fact his decision to the bank's board of directors, based largely on the loan applicant's financial statements. In assessing the credit worthiness of Terry's loan application, Bill plans to use operating income before depreciation and working capital as surrogates for cash-paying ability. Terry will offer her nearly new automobile as collateral. The bank's policy is to approve loans only if the annual payments are less than the beginning working capital balance and the projected before depreciation operating income for the next 12 months. The bank has also instituted a policy to have all loans due and payable on demand at the end of any calendar year if the payee is not in compliance with the original loan requirements. Bill's bank has a maximum loan period for startup companies of five years. At an interest rate of ten percent per annum, Startup, Inc. qualifies for an $8,000 maximum loan requiring a $2,110 annual payment. Consequently Startup's December 31 working capital balance and annual operating income (before depreciation expense) must not fall below $2,110, or the bank loan becomes due and payable. REQUIRED: 1. From Bill Andersen's perspective, which practice strategy is better? Why? 2. From a managerial and strategic planning perspective, which practice strategy should Terry pursue? Why? 2-8