chapter 12

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Strategy, Balanced Scorecard,and

Strategic Profitability Analysis


1. Recognize which of two generic strategies a company is using

2. Understand what comprises reengineering

3. Understand the four perspectives of the balanced scorecard

4. Analyze changes in operating income to evaluate strategy

5. Identify unused capacity and how to manage it

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Strategy specifies how an organization matches its own capabilities with the opportunities in the marketplace to accomplish its objectives.

Strategy describes how an organization can create value for its customers while differentiating itself from its competitors.

A thorough understanding of the industry is critical to implementing a successful strategy. Industry analysis focuses on 5 forces.

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1. Number and strength of competitors2. Potential entrants to the market3. Availability of equivalent products4. Bargaining power of customers5. Bargaining power of input suppliers

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1. Product differentiation—an organization’s ability to offer products or services perceived by its customers to be superior and unique relative to the products or services of its competitors.

Competitive advantage: brand loyalty and the willingness of customers to pay high prices.

2. Cost leadership—an organization’s ability to achieve lower costs relative to competitors through productivity and efficiency improvements, elimination of waste, and tight cost control.

Competitive advantage: lower selling prices.

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Reengineering is the fundamental rethinking and redesign of business processes to achieve improvements in critical measures of performance, such as cost, quality, service, speed and customer satisfaction.

Stated another way, reengineering is the redesign of business processes to improve performance by reducing cost and improving quality.

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Many companies have introduced a balanced scorecard to track progress and manage the implementation of their strategies.

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The balanced scorecard translates an organization’s mission and strategy into a set of performance measures that provides the framework for implementing its strategy.1

Not only does the balanced scorecard focus on achieving financial objectives, it also highlights the nonfinancial objectives that an organization must achieve to meet and sustain its financial objectives.

The scorecard measures an organization’s performance from four perspectives.

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1. Financial - profits and value created for shareholders

2. Customer – the success of the company in its target market

3. Internal business perspective – the internal operations that create value for customers

4. Learning and growth – the people and systems capabilities that support operations

The particular measure a company uses to track performance will depend on its strategy.

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Evaluates the profitability of the strategy

Uses the most objective measures in the scorecard

The other three perspectives eventually feed back into this dimension

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Identifies targeted customer and market segments and measures the company’s success in these segments

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Focuses on internal operations that create value for customers which, in turn, will further the financial perspective by increasing shareholder value

Includes three subprocesses:1. Innovation2. Operations3. Post-sales service

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Identifies the people and information capabilities the organization must excel at to achieve superior internal processes that create value for customers and shareholders

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Must have commitment and leadership from top management.

Must be communicated to all employees.

For the balanced scorecard to be effective, managers must view it as a fair way to assess and reward all important aspects of a manager’s performance and promotion prospects.

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Companies are increasingly recognizing that they must earn the right to operate in the communities and countries in which they do business.

Failure to perform adequately on environmental and social processes puts at risk a company’s ability to deliver future value to shareholders.

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As was discussed in Chapter 1, many managers are promoting sustainability (the development and implementation of strategies) to achieve:Long-term financial performanceSocial performance (eliminating employee

injuries, improving product safety)Environmental performance (reducing

greenhouse gas emissions)

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Managers interested in measuring environmental and social performance are incorporating these factors into their balanced scorecards to set priorities for initiatives, guide decisions and actions and fuel discussions around strategies and business models to improve performance.

Companies use a variety of measures including:Cost of preventing and remediating environmental damage (financial); brand image (customer); energy consumption (internal-business); and implementation of ISO 14000 environmental standards (learning and growth).

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1. Tells the story of a firms strategy, articulating a sequence of cause-and-effect relationships—the links among the various perspectives that align implementation of the strategy.2. Helps to communicate the strategy to all members of the organization by translating the strategy into a coherent and linked set of understandable and measurable operational targets.

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3. Must motivate managers to take actions that eventually result in improvements in financial performance.

Applies primarily to for-profit entities, but has some application to not-for-profit entities as well.

4. Limits the number of measures, identifying only the most critical ones.5. Highlights less-than-optimal trade-offs that managers may make when they fail to consider operational and financial measures together.

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Managers should not assume the cause-and-effect linkages are precise: they are merely hypotheses.

Managers should not seek improvements across all of the measures all of the time.

Managers should not use only objective measures: subjective measures are important as well.

Despite challenges of measurement, top management should not ignore nonfinancial measures when evaluating managers and other employees.

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To evaluate how successful a company’s strategy and implementation have been, its management must compare the target and actual performance columns in the balanced scorecard.

If a company does not meet its targets on the two perspectives that are more internally focused (learning and growth, and internal business processes), it may have had a problem with strategy implementation.

If a company performs well in the internally focused perspectives but not customer and financial measures, it may conclude that the strategy was faulty because there was no effect on customers or on long-run financial performance and value creation.

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Strategic analysis of operating income—three parts:

1. Growth component—measures the increase in revenues minus the increase in costs from selling more units in the current year than in the prior year, assuming nothing else has changed.

2. Price-recovery component—measures solely the effect of price changes on revenues and costs to produce and sell the current year quantity.

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Strategic analysis of operating income3. Productivity component—measures how

costs have changed as a result of using fewer/more inputs, a better/worse mix of inputs, and/or more/less capacity to produce current year output compared with the inputs and capacity that would have been used to produce this output in the prior year.

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Throughout these slides, we’ll use values from the textbook exampleto illustrate the formulas:Here, actual units of output sold in the current period are 1,150,000;Actual units of output sold in the prior period are 1,000,000, andThe selling price in the prior period was $23/unit, therefore:(1,150,000 – 1,000,000) x $23 = $3,450,000F Revenue Effect of Growth


3,000,000 sq cm x (1,150,000/1,000,000) – 3,000,000 sq cm x $1.40 input price = $630,000 Unfavorable

The cost effect of growth measures how much costs would have changed in the prior year if production would have been at current year levels. This is done separately for Variable and Fixed costs.


Actual Units of Capacity

in the Prior

Period

Actual Units of capacity in Prior Period to Produce Current Period Output

X

Prior Period Price

per unit of

capacity

CostEffect

OfGrowth

For FixedCosts

=

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Assuming adequate current capacity:

(3,750,000 sq cm – 3,750,000 sq cm) X $4.28 per sq cm = $0.00


Prior Period Selling Price

Current Period Selling Price X

CurrentPeriod Units Sold

RevenueEffect

OfPrice-

Recovery

=

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($22 per unit current year - $23 per unit prior year) X 1,150,000 actual units of output sold in current year = $1,150,000 Unfavorable


Prior Period Input Price

Current Period Input Price X

Units of Input

required to produce Current Period’s Output in the Prior Period

CostEffect

OfPrice-

Recovery for

Variable Costs

=

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($1.50 per sq cm current year - $1.40 per sq cm prior year) X 3,450,000 sq cm required for current year output in prior year = $345,000 Unfavorable


Prior Period Price per Unit

of Capacity

Current Period Price per Unit of Capacity

X

Actual Units of Capacity on

Prior Period to Produce Current

Period’s Output

CostEffect

OfPrice-

Recovery for Fixed

Costs

=

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$4.35 per sq cm - $4.28 per sq cm) X 3,750,000 sq cm = $262,500 Unfavorable


Units of Input Required to

Produce Current Period’s Output

in Prior Period

Actual Units of Input used to Produce Current Period Output

X Input Price in Current Period

CostEffect

OfProductivity for Variable

Costs

=

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(2,900,000 sq cm for current period output – 3,450,000 sq cm for current period output in prior period) X $1.50 per sq cm = $825,000 Favorable


Actual Units of Capacity in Prior

Period to Produce Current Period’s Output

Actual Units of Capacity in Current Period

XPrice Per Unit of

Capacity in Current Period

CostEffect

OfProductivity

for Fixed Costs

=

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(3,500,000 sq cm – 3,750,000 sq cm) X $4.35 per sq cm = $1,087,500 Favorable


Consistent with a cost-leadership strategy, the productivity gains of $1,912,500 in 2013 were a big part of the increase in operating income for prior year to current year. Under different assumptions about the change in selling price, the analysis will attribute different amounts to the different strategies.


Managers can reduce capacity-based fixed costs by measuring and managing unused capacity.

Unused capacity is the amount of productive capacity available over and above the productive capacity employed to meet consumer demand in the current period.

To better understand this concept of unused capacity, it is necessary to distinguish engineered costs from discretionary costs.

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1. Engineered costs result from a cause-and-effect relationship between the cost driver (output) and the (direct or indirect) resources used to produce that output. Engineered costs have a detailed, physically observable and repetitive relationship with output.

2. Discretionary costs have two important features:1. They arise from periodic (usually annual) decisions

regarding the maximum amount to be incurred.2. They have no measurable cause-and-effect

relationship between output and resources used.

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Downsizing (rightsizing) is an integrated approach of configuring processes, products, and people to match costs to the activities that need to be performed to operate effectively and efficiently in the present and future.

Downsizing often means eliminating jobs, which can adversely affect employee morale and the culture of a company.

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TERMS TO LEARN PAGE NUMBER REFERENCE

Balanced scorecard Page 476

Cost leadership Page 474

Discretionary costs Page 496

Downsizing Page 497

Engineered costs Page 496

Growth component Page 489

Partial productivity Page 503

Price-recovery component Page 489

Product differentiation Page 474

Productivity Page 503

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TERMS TO LEARN PAGE NUMBER REFERENCE

Productivity component Page 489

Reengineering Page 475

Rightsizing Page 497

Strategy map Page 477

Total factor productivity Page 504

Unused capacity Page 496

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chapter 12

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