Competing On Resources Balance Scorecard

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Competing On Resources Balance Scorecard

  1. 1. Competing on Resources Translating Strategy into Action Balance Scorecard copyright@Vinod Kr Sharma-JIM “ Measuring Performance in the Organization of the Future”
  2. 2. Competing on Resources – Industrial age <ul><li>Massive Physical Assets – capitalization. </li></ul><ul><li>Mass Production – low cost standard products. </li></ul><ul><li>Operations based on Push model. </li></ul><ul><li>Bargaining Power of Buyer very limited. </li></ul><ul><li>Competition limited. </li></ul><ul><li>Internally Focused – operations. </li></ul><ul><li>Emphasis on efficient allocation of financial and physical assets. </li></ul><ul><li>Specialization of functional skills – silos. </li></ul><ul><li>Marketplace local. </li></ul>
  3. 3. <ul><li>Operations governed by production plans through value chain. </li></ul><ul><li>Focus on Cost Control – efficiency. </li></ul><ul><li>Economies of Scale </li></ul><ul><li>Lack integration of Customers & Suppliers. </li></ul><ul><li>Product Life Cycle reasonably long. </li></ul><ul><li>Technology embedded into physical assets facilitating mass production of standard products </li></ul><ul><li>Focus on Profitability – ROCE </li></ul>Competing on Resources – Industrial age
  4. 4. <ul><li>From Industrial Age to…….. </li></ul>… ..Information Age
  5. 5. Competing on Resources – Information age <ul><li>Intangible - Intellectual Assets – less capital intensive. </li></ul><ul><li>Mass Customization – customized offerings. </li></ul><ul><li>Operations based on Pull model. </li></ul><ul><li>Bargaining Power of Buyer very high . </li></ul><ul><li>Competition intense. </li></ul><ul><li>Externally Focused – Customers. </li></ul><ul><li>Emphasis on efficient management of Intangible assets. </li></ul><ul><li>Integrated processes cutting across various functions combining the specialization, speed and efficiency. </li></ul><ul><li>Marketplace – global. </li></ul>
  6. 6. <ul><li>Operations governed by customers action enabling enormous improvements in cost, quality & response time. </li></ul><ul><li>Focus on Cost Reduction – efficiency & effectiveness. </li></ul><ul><li>Economies of Scope & Scale . </li></ul><ul><li>Integrated Supply, Production & Deliveries. </li></ul><ul><li>Product Life Cycle very small . </li></ul><ul><li>Technology leverages the resources facilitating mass customization with customized offerings. </li></ul><ul><li>Focus on sustainability of Profitability – performance </li></ul><ul><li>Efficiency in operations – Competitive Advantage </li></ul>Competing on Resources – Information age
  7. 7. <ul><li>So.. the shift in paradigm was obvious </li></ul>
  8. 8. <ul><li>Total Quality Management - TQM. </li></ul><ul><li>Just in Time production & distribution systems – JIT. </li></ul><ul><li>Time Based Competition. </li></ul><ul><li>Lean Production. </li></ul><ul><li>Lean Enterprise. </li></ul><ul><li>Customer focused organizations – Outside Inn. </li></ul><ul><li>Activity Based Management – ABC Management. </li></ul><ul><li>Empowerment. </li></ul><ul><li>Re-engineering……….. </li></ul><ul><li>Above initiations failed to deliver promised results, as they were fragmented – not linked with the organization’s strategy . </li></ul>Competing for future …… initiatives
  9. 9. <ul><li>Performance Management is the integration of the results of performance measurement into management processes so that results can influence the decisions made by the organization. </li></ul>Performance Management Traditionally Performance – success of companies in 90’s was measured in terms of Return on Investments Operating & Cash Budgets Focus was only on profitability .
  10. 10. Performance Management <ul><li>Such Performance criteria lacked….. </li></ul><ul><li>Various aspects related to sources of future growth. </li></ul><ul><li>Breakthroughs into new avenues so as to sustain the profitability. </li></ul><ul><li>Insight about progress company is making in implementing long term goals. </li></ul><ul><li>Long term focus & focused only on short term financial performance. </li></ul><ul><li>Lacks valuation of company’s intangible & intellectual assets </li></ul>
  11. 11. <ul><li>Financial measures are Lagging indicators failing to capture most of the value that is being created </li></ul><ul><li>Financial measures in isolation are inadequate for setting guidelines for evaluating organization’s path through Competitive Landscape. </li></ul><ul><li>Financial measures fail to provide adequate insights for actions that are to be taken or initiated today that can create future financial value. </li></ul>
  12. 12. <ul><li>It is thus essential to redefine the criteria on the basis of which the performance of any organization is to be measured, and it calls for inclusion of qualitative measures – intangible / intellectual assets within the frame work of financial accounting model of performance management thereby communicating their status i.e. improvements or depletion to stakeholders. </li></ul>
  13. 13. Measurement is the language that gives clarity to vague concepts. Measurement is used to communicate, not to control. Strategy can be described as a series of cause and effect relationships
  14. 14. The Increasing Sophistication of Corporate Performance Measurement Time Sophistication of Measurement Systems Operating measures Traditional accounting measures Quality-related operating measures Activity-based costing Economic value added
  15. 15. New perspective of Performance Management…… <ul><li>Strategy refers to set of hypothesis about cause ‘n’ effect. </li></ul><ul><li>Measurement system should thus establish relationships ( Hypothesis ) among objectives in diverse perspectives explicitly so that the same can be validated. </li></ul>
  16. 16. ? ROCE Customer Loyalty On-Time Delivery Process Quality Process Cycle-Time Employee Skills
  17. 17. <ul><li>ROCE – financial measure. </li></ul><ul><li>Driver for ROCE – expanded sales. </li></ul><ul><li>Driver for expanded sales – customer loyalty . </li></ul><ul><li>Driver for customer loyalty – process efficiency. </li></ul><ul><li>Process efficiency – speed, scale & time </li></ul><ul><li>Driver for process efficiency – shorter cycle time, i.e. efficient internal processes . </li></ul><ul><li>Driver for efficient internal processes – workforce </li></ul><ul><li>Driver for workforce – continuous learning . </li></ul>New perspective of Performance Management……
  18. 18. ROCE Customer Loyalty On-Time Delivery Process Quality Process Cycle-Time Employee Skills Financial Customer Business Process Learning
  19. 19. Balanced Scorecard <ul><li>Balanced Scorecard is a measurement tool that allows the organization to assess progress in implementing strategy. </li></ul><ul><li>The purpose of the Balanced Scorecard is to establish a link between performance measures and a company's strategic vision </li></ul><ul><li>The Balanced Scorecard was developed by Kaplan and Norton in 1992 (Kaplan & Norton, 1992). </li></ul>
  20. 20. Balanced Scorecard <ul><li>Balance Scorecard emphasizes that financial and non-financial measures must be integral part of performance management. </li></ul><ul><li>Balance Scorecard complements financial measures of past performance with measures of the drivers of future performance. </li></ul>
  21. 21. Balanced Scorecard <ul><li>Balance Scorecard is an instrument that facilitates navigation to future competitive success. </li></ul><ul><li>Balance Scorecard emphasizes on achieving financial objectives, besides it also includes the performance drivers of these financial objectives. </li></ul>
  22. 22. The Increasing Sophistication of Corporate Performance Measurement Time Sophistication of Measurement Systems Operating measures Traditional accounting measures Quality-related operating measures Activity-based costing Economic value added Balance Scorecard Value-linked measurements for business strategy, stakeholder needs, process attributes and the business environment
  23. 23. Balanced Scorecard <ul><li>Ties performance measures to corporate strategy </li></ul><ul><li>“ Balance” includes </li></ul><ul><ul><li>short & long term objectives </li></ul></ul><ul><ul><li>financial and non-financial measures </li></ul></ul><ul><ul><li>external & internal measures </li></ul></ul><ul><ul><li>various perspectives </li></ul></ul><ul><li>Purposes of the balanced scorecard include </li></ul><ul><ul><li>clarify & translate vision & strategy </li></ul></ul><ul><ul><li>communicate & link strategic objectives & measures </li></ul></ul><ul><ul><li>plan, set targets & align strategic initiatives </li></ul></ul><ul><ul><li>enhance strategic feedback & learning </li></ul></ul>
  24. 24. <ul><li>The Balance scorecard gets its name from the attempt to balance financial and non financial performance measures to evaluate both short-run and long-run performance in a single report. </li></ul>
  25. 25. <ul><li>Balance Scorecard measures organizational performance across four perspectives: </li></ul><ul><ul><li>Financial Perspective </li></ul></ul><ul><ul><li>Customer Perspective </li></ul></ul><ul><ul><li>Internal Business Perspective </li></ul></ul><ul><ul><li>Learning & Growth Perspective </li></ul></ul><ul><ul><li>Balance Scorecard enables companies to track their financial results while simultaneously monitoring progress in building the capabilities and acquiring the intangible assets that they might need for future growth. </li></ul></ul>Balanced Scorecard
  26. 26. How do we look to our owners and investors? How do we look to our customers? Internal Processes Perspective How efficient and effective are the critical internal processes? Organizational Learning Perspective Are we able to sustain innovation and improvement? Customer Perspective ? Financial Perspective
  27. 27. Strategic Linkages How do we look to our owners and investors? How do we look to our customers? Internal Processes Perspective How efficient and effective are the critical internal processes? Organizational Learning Perspective Are we able to sustain innovation and improvement? Strategic Vision Customer Perspective Financial Perspective
  28. 28. &quot;If we succeed, how will we look to our shareholders?” The Strategy Financial Perspective &quot;To achieve my vision, how must I look to my customers?” Customer Perspective &quot;To satisfy my customers, at which processes must I excel?” Internal Perspective &quot;To achieve my vision, how must my organization learn and improve?” Organization Learning Translate the strategy to operational terms
  29. 29. The Vertical Scorecard Financial Perspective Customer Perspective Internal Processes Perspective Organizational Learning Perspective
  30. 30. Translate the strategy to operational terms
  31. 31. The Balanced Scorecard Strategy Map Improve Shareholder Value Revenue Growth Strategy Productivity Strategy Build the Franchise Increase Customer Value Improve Cost Structure Improve Asset Utilization New Revenue Sources Customer Profitability Cost per Unit Asset Utilization Shareholder Value ROCE Product Leadership Customer Intimacy Operational Excellence Price Quality Time Function- ality Service Relation- ships Brand Customer Value Proposition Image Relationship Product/Service Attributes A Motivated and Prepared Workforce Strategic Competencies Strategic Technologies Climate for Action Financial Perspective Customer Perspective Internal Perspective Learning & Growth Perspective Source: Kaplan & Norton, The Strategy Focused Organization “ Be a Good Corporate Citizen” (Regulatory and Environmental Processes) “ Build the Franchise” (Innovation Processes) “ Achieve Operational Excellence” (Operational Processes) “ Increase Customer Value” (Customer Management Processes)
  32. 33. <ul><li>Companies competing in information age find that financial measures in themselves are inadequate, mainly because they fail appraise and report as to how company creates future value through investments in Customers, Suppliers, Employees, Business Processes and Technology </li></ul>Balanced Scorecard
  33. 34. Balanced Scorecard - logic model
  34. 35. <ul><li>Balance Scorecard measures organizational performance across four perspectives: </li></ul><ul><ul><li>Financial Perspective </li></ul></ul><ul><ul><li>Customer Perspective </li></ul></ul><ul><ul><li>Internal Business Perspective </li></ul></ul><ul><ul><li>Learning & Growth Perspective </li></ul></ul>Balanced Scorecard
  35. 36. Balanced Scorecard <ul><li>Financial Perspective: </li></ul><ul><li>According to financial perspective of the Balance Scorecard mostly financial objectives represents the long term goal of the organization, but should be customized according the business units which are in different stages of their life cycle – growth </li></ul><ul><li>I am saying this mainly because financial objectives can differ significantly at each stage of the business life cycle. </li></ul>
  36. 37. <ul><li>If we look closely then broadly business life cycle can have primarily three stages: </li></ul><ul><ul><li>Growth – early stages, investments, Sales growth </li></ul></ul><ul><ul><li>Sustain – operating income, gross margins - ROCE </li></ul></ul><ul><ul><li>Harvest – cash flows, reduction in WC. </li></ul></ul>Balanced Scorecard- Financial Perspective: <ul><li>From above it is evident that business units operating in different stages of their life cycle can not be evaluated for a common financial metric </li></ul>
  37. 38. <ul><li>Lets now have a look at the various drivers as mentioned earlier at different stages of business life cycle. </li></ul><ul><li>Stages Drivers </li></ul><ul><li>Growth Revenue growth </li></ul><ul><li>Sustain Cost Reduction, Productivity </li></ul><ul><li>Harvest Asset Utilization </li></ul>Balanced Scorecard- Financial Perspective:
  38. 39. <ul><li>Thus to conclude the Financial perspective of the Balance Scorecard enables business units to specify not only the metrics by which long term success should be evaluated and measured, but it also takes into account that variables that are most important in creating and deriving long term sustainability of financial objectives </li></ul>Balanced Scorecard- Financial Perspective:
  39. 40. <ul><li>Financial Perspective: </li></ul><ul><li>“ To succeed financially how should we appear to our Stakeholders” </li></ul><ul><li>Objectives Measures Targets </li></ul><ul><li> Initiatives </li></ul>Balanced Scorecard- Financial Perspective: Objectives: What the strategy is trying to achieve Targets: The level of performance or rate of improvement needed Initiatives: Key action programs required to achieve targets Measures: How success or failure (performance) against objectives is monitored
  40. 41. <ul><li>Objectives: </li></ul><ul><li>What the strategy is trying to achieve </li></ul><ul><li>Increase Shareholders Value. </li></ul>Balanced Scorecard- Financial Perspective: Measures: How success or failure (performance) against objectives is monitored Increase in operating income and Revenue growth Targets: The level of performance or rate of improvement needed Initiatives: Key action programs required to achieve targets Manage cost and unused capacity
  41. 42. Measuring Strategic Financial Themes Harvest Sustain Growth Business Stages in Life Cycle Sales growth rate % revenue from new products, services & customers Revenue Employees Investment ( % of Sales ) R & D ( % of Sales ) Revenue Growth & Mix Cost reduction & Productivity Asset Utilization Strategic Themes Share of targeted customers, % of revenue from new customers, Customer & product profitability Indirect exps. As % of Sales, Cost reduction rates, cost Vs competition Cash -2- cash cycle ratio, Working Capital ratios, ROCE, Assets utilization rates Customer & Product line profitability Unit costs per unit of output, unit cost of per transaction Payback Throughput
  42. 43. Balanced Scorecard- Customer Perspective : <ul><li>Customer Perspective: </li></ul><ul><li>This perspective attempts to identify the customers & the market segment in which company intends to operate and compete. </li></ul><ul><li>This perspective enables companies to identify the sources of revenue for their financial perspective. </li></ul>
  43. 44. Balanced Scorecard- Customer Perspective: <ul><li>Customer Perspective: </li></ul><ul><li>This perspective refers to measures related to customers such as: </li></ul><ul><li>Satisfaction </li></ul><ul><li>Loyalty </li></ul><ul><li>Retention </li></ul><ul><li>Acquisition </li></ul><ul><li>Profitability </li></ul>
  44. 45. Balanced Scorecard- Customer Perspective: <ul><li>Customer Perspective: </li></ul><ul><li>This perspective attempts to explicitly identify the value proposition that company targets to deliver to customers & Market segments, with a view that long-run sustainable superior financial performance can only be achieved by creating and delivering products & services that are valued by customers – Inn Side out 2 Outside Inn </li></ul>
  45. 46. <ul><li>Customer Perspective: </li></ul><ul><li>Objectives Measures Targets </li></ul><ul><li> Initiatives </li></ul>Objectives: What the strategy is trying to achieve Targets: The level of performance or rate of improvement needed Initiatives: Key action programs required to achieve targets Measures: How success or failure (performance) against objectives is monitored Balanced Scorecard- Customer Perspective: &quot;To achieve my vision, how must I look to my customers?”
  46. 47. Objectives: What the strategy is trying to achieve Increase Market Share and Customer Satisfaction Measures: How success or failure (performance) against objectives is monitored Market share in communication network segment & Customer satisfaction survey Targets: The level of performance or rate of improvement needed Initiatives: Key action programs required to achieve targets Identify future needs of customers Balanced Scorecard- Customer Perspective:
  47. 48. Balanced Scorecard- Customer Perspective: <ul><li>Customer Perspective: </li></ul><ul><li>Explicit definition of </li></ul><ul><li>Satisfaction </li></ul><ul><li>Loyalty </li></ul><ul><li>Retention </li></ul><ul><li>Acquisition </li></ul><ul><li>Profitability, along with core outcome measurements in turn helps in defining various associated business processes. </li></ul>
  48. 49. Balanced Scorecard- Customer Perspective: <ul><li>Core outcome measurements categories: </li></ul><ul><ul><li>Market Share </li></ul></ul><ul><ul><li>Customer Retention </li></ul></ul><ul><ul><li>Customer Acquisition </li></ul></ul><ul><ul><li>Customer Satisfaction </li></ul></ul><ul><ul><li>Customer Profitability </li></ul></ul>
  49. 50. Customer Profitability Market Share Customer Satisfaction Customer Acquisition Customer Retention Customer Perspective Core Measures
  50. 51. Balanced Scorecard- Customer Perspective: <ul><li>Customer perspective lays its foundation on the fact that existing and potential customers are not homogenous, by this I mean they have different preferences and accordingly they value the attributes of products and services. </li></ul><ul><li>Some common set of attributes that organizes the value proposition in almost all the industries can be categorized as : </li></ul><ul><ul><li>Product, Service attributes </li></ul></ul><ul><ul><li>Customer Relationship </li></ul></ul><ul><ul><li>Image & Reputation </li></ul></ul>
  51. 52. <ul><li>Customer Value Proposition: </li></ul><ul><li>Value = Product / Service attributes +Image + Relationship </li></ul><ul><li> Functionality </li></ul><ul><li> Quality </li></ul><ul><li>Price </li></ul><ul><li> Time </li></ul>
  52. 53. Balanced Scorecard- Internal Business Process Perspective: <ul><li>Internal Business Process Perspective: </li></ul><ul><li>This perspective attempts to identify the critical processes that need to be excelled so as to meet the expectations of the stakeholders – shareholders & customers etc. </li></ul><ul><li>This perspective lays emphasis on demands for Internal Business process performance that is to be derived from the expectations of specific external attribute </li></ul>
  53. 54. Balanced Scorecard- Internal Business Process Perspective: <ul><li>Internal Business Process Perspective: </li></ul><ul><li>We need to define a complete Internal process Value chain, focused towards identification of current & future consumer's needs. </li></ul><ul><li>This will lead to innovating business processes so as to fulfill the consumer’s expectation in more efficient way. </li></ul>
  54. 55. Balanced Scorecard- Internal Business Process Perspective: <ul><li>Internal Business Process Perspective: </li></ul><ul><li>By innovating I mean focusing not on controlling and improving existing business processes efficiency RATHER </li></ul><ul><li>supplementing Financial Perspective of Balance Scorecard by incorporating measures of Quality </li></ul><ul><li>Yield </li></ul><ul><li>Throughput and Cycle Time </li></ul>
  55. 56. Balanced Scorecard- Internal Business Process Perspective: <ul><li>Internal Business Process Perspective: </li></ul><ul><li>Innovation in Business Processes should result in: </li></ul><ul><li>Improved Quality </li></ul><ul><li>Reduction in Cycle Time </li></ul><ul><li>Increase in Yield </li></ul><ul><li>Maximum Throughput </li></ul><ul><li>Lower Cost </li></ul>
  56. 57. Balanced Scorecard- Internal Business Process Perspective: <ul><li>Internal Business Process Perspective: </li></ul><ul><li>Internal Business Process Perspective of Balance Scorecard focuses in innovating business processes that are unique to an organization enabling to develop competencies which are source of Distinctive and Sustainable Competitive Advantage </li></ul>
  57. 58. <ul><li>Internal Business Process Perspective: </li></ul><ul><li>Objectives Measures Targets </li></ul><ul><li> Initiatives </li></ul>Objectives: What the strategy is trying to achieve Targets: The level of performance or rate of improvement needed Initiatives: Key action programs required to achieve targets Measures: How success or failure (performance) against objectives is monitored Balanced Scorecard- Internal Business Process Perspective: &quot;To satisfy my customers, at which processes must I excel?”
  58. 59. Objectives: Improve manufacturing capability Reduce delivery time to customers Meet specified delivery dates Measures: Percentage of processes with advanced controls Order delivery time On-time delivery Targets: The level of performance or rate of improvement needed Initiatives: Key action programs required to achieve targets Manage cost and unused capacity Balanced Scorecard- IBP Perspective:
  59. 60. <ul><li>Internal Business Process Perspective: </li></ul><ul><li>We all know that each business consists of unique set of resources & business processes that are being leveraged for creating the value for customers leading to accruals of financial outcomes. </li></ul><ul><li>Critical Business Processes within the Value Chain can be categorized as: </li></ul><ul><li>Innovations </li></ul><ul><li>Operations </li></ul><ul><li>After Sales Service </li></ul>Balanced Scorecard- Internal Business Process Perspective:
  60. 61. Aligning the Balanced Scorecard to Strategy <ul><li>Different strategies call for different scorecards. </li></ul><ul><li>What are some of the financial perspective measures? </li></ul><ul><ul><li>Operating income </li></ul></ul><ul><ul><li>Revenue growth </li></ul></ul><ul><ul><li>Cost reduction is some areas </li></ul></ul><ul><ul><li>Return on investment </li></ul></ul>
  61. 62. Aligning the Balanced Scorecard to Strategy <ul><li>What are some of the customer perspective measures? </li></ul><ul><li>Market share </li></ul><ul><li>Customer satisfaction </li></ul><ul><li>Customer retention percentage </li></ul><ul><li>Time taken to fulfill customers requests </li></ul>
  62. 63. Aligning the Balanced Scorecard to Strategy <ul><li>What are some of the internal business perspective measures? </li></ul><ul><li>Innovation Process </li></ul><ul><ul><li>Manufacturing capabilities </li></ul></ul><ul><ul><li>Number of new products or services </li></ul></ul><ul><ul><li>New product development time </li></ul></ul><ul><ul><li>Number of new patents </li></ul></ul>
  63. 64. Aligning the Balanced Scorecard to Strategy <ul><li>What are some of the internal business perspective measures? </li></ul><ul><li>Operations Process </li></ul><ul><ul><li>Yield </li></ul></ul><ul><ul><li>Defect rates </li></ul></ul><ul><ul><li>Time taken to deliver product to customers </li></ul></ul><ul><ul><li>Percentage of on-time delivery </li></ul></ul><ul><ul><li>Setup time </li></ul></ul><ul><ul><li>Manufacturing downtime </li></ul></ul>
  64. 65. Aligning the Balanced Scorecard to Strategy <ul><li>What are some of the internal business perspective measures? </li></ul><ul><li>Post-sales service </li></ul><ul><ul><li>Time taken to replace or repair defective products </li></ul></ul><ul><ul><li>Hours of customer training for using the product </li></ul></ul>
  65. 66. <ul><li>What are some of the learning and growth perspective measures? </li></ul><ul><ul><li>Employee education and skill level </li></ul></ul><ul><ul><li>Employee satisfaction scores </li></ul></ul><ul><ul><li>Employee turnover rates </li></ul></ul><ul><ul><li>Information system availability </li></ul></ul><ul><ul><li>Percentage of processes with advanced controls </li></ul></ul>Aligning the Balanced Scorecard to Strategy
  66. 67. Features of a Good Balanced Scorecard It tells the story of a company’s strategy by articulating a sequence of cause-and-effect relationships. It assists in communicating the strategy to all members of the organization by translating the strategy into a coherent and linked set of measurable operational targets.
  67. 68. Pitfalls When Implementing a Balanced Scorecard What pitfalls should be avoided when implementing a balanced scorecard? Don’t assume the cause-and-effect linkages to be precise. Don’t seek improvements across all measures all the time. Don’t use only objective measures on the scorecard.
  68. 69. Evaluating the Success of a Strategy Assume the following operating incomes: Year 1999 Year 2000 Revenues: (10,00,000 × 26) 2,60,00,000 (11,00,000 × 24) 2,64,00,000 Expenses: Materials 40,50,000 36,31,320 Other 1,60,00,000 1,60,00,000 Operating income 59,50,000 67,68,680
  69. 70. Evaluating the Success of a Strategy <ul><li>How can the increase in operating income of 8,18,680 be evaluated? </li></ul><ul><li>( 67, 68,680 – 59,50,000 ) </li></ul><ul><li>To evaluate the success of its strategy, a company can subdivide the change in operating income into three components: </li></ul><ul><ul><li>Growth </li></ul></ul><ul><ul><li>Price recovery </li></ul></ul><ul><ul><li>Productivity </li></ul></ul>
  70. 71. Growth Component The growth component measures the change in operating income attributable solely to an increase in the quantity of output sold. Assume that for 1999, ABC produced and sold 10,00,000 devices at 26 per unit. During the year 2000, ABC produced and sold 11,00,000 devices at 24 per unit. What is the revenue effect of growth?
  71. 72. Growth Component Revenue effect of growth component = (Actual units of output sold in 2000 – Actual units of output sold in 1999) × Output price in 1999 (11,00,000 – 10,00,000) × 26 = 26,00,000 F This component is favorable because it increases operating income.
  72. 73. Cost Effect of Growth To produce the higher output sold in 2000, more inputs would be needed. The cost increase from growth measures the amount by which costs in 2000 would have increased if the relationship between inputs and outputs that existed in 1999 continued in 2000, and if prices of inputs in 1999 continued in 2000.
  73. 74. Cost Effect of Growth <ul><li>Cost effect of growth component </li></ul><ul><ul><li>Actual units of input or capacity that would have been used in 1999 to produce year 2000 output assuming the same input-output relationship that existed in 1999 </li></ul></ul><ul><ul><li>less Actual units or capacity to produce 1999 output </li></ul></ul><ul><ul><li>Input prices in 1999 </li></ul></ul>
  74. 75. Cost Effect of Growth To produce 11,00,000 units in 2000 compared with the 10,00,000 units produced in 1999 (a 10% increase), ABC would require a proportional increase in direct materials. Assume that 30,00,000 square centimeters of materials were used to produce the 10,00,000 units in 1999 at a cost of 1.35 per square centimeter.
  75. 76. Cost Effect of Growth Also, assume that manufacturing conversion costs, selling and customer service costs and research and development costs were 1,60,00,000 and remained stable during 2000. What is the cost effect of the growth component? 30,00,000 × 110% = 33,00,000 centimeters (33,00,000 – 30,00,000) × 1.35 = 4,05,000 U
  76. 77. Operating Income and Growth What is the net increase in operating income as a result of growth? Revenue effect of growth component 26,00,000 F Cost effect of growth component 4,05,000 U Increase in operating income due to growth component 21,95,000 F
  77. 78. Price-Recovery Component <ul><li>The price recovery component of operating income measures the change in revenues and the changes in costs to produce the 11,00,000 devices manufactured in 2000 as a result of two factors: </li></ul><ul><ul><li>Change in price of the device </li></ul></ul><ul><ul><li>Change in prices of the inputs required to make the device </li></ul></ul>
  78. 79. Price-Recovery Component Revenue effect of price-recovery component = (Output price in 2000 – Output price in 1999) × Actual units of output sold in 2000 What is the revenue effect of the price-recovery component? (24 – 26) × 11,00,000 = 22,00,000 U It is unfavorable because there was a decrease in price between 1999 and 2000.
  79. 80. Price-Recovery Component Cost effect of price-recovery component = (Input prices in 2000 – Input prices in 1999) × Actual units of inputs or capacity that would have been used to produce year 2000 output assuming the same input-output relationship that existed in 1999 Assume that in the year 2000 direct materials costs were 1.31 per square centimeter.
  80. 81. Price-Recovery Component Remember, it was assumed that manufacturing conversion costs, selling, and customer service costs and research and development costs remained stable during 2000. What is the cost effect of the price-recovery component? (1.31 – 1.35) × 33,00,000 = 1,32,000 F
  81. 82. Operating Income and Price-Recovery Component What is the total effect on operating income of the price-recovery component? Revenue effect of price-recovery component 22,00,000 U Cost effect of price-recovery component 1,32,000 F Decrease in operating income due to price-recovery component 20,68,000 U
  82. 83. Productivity Component The productivity component of operating income compares how costs have decreased as a result of using fewer inputs, a better mix of inputs, and less capacity to produce year 2000 output, assuming year 2000 input prices.
  83. 84. Productivity Component <ul><li>Productivity component </li></ul><ul><li>Actual units of inputs or capacity to produce year 2000 output </li></ul><ul><li>Actual units of inputs or capacity that would have been used to produce year 2000 output assuming the same input-output relationship that existed in 1999 </li></ul><ul><li>Input prices in 2000 </li></ul>
  84. 85. Productivity Component Assume that 27,72,000 actual square centimeters of direct materials were used in the year 2000. Actual price was 1.31/square centimeter. Manufacturing conversion costs, selling and customer service costs, and research and development costs remained stable during 2000.
  85. 86. Productivity Component What is the productivity component of cost changes? (27,72,000 – 33,00,000) × 1.31 = 691,680 F There is a 691,680 increase in operating income due to the productivity component.
  86. 87. Change in Operating Income Increase in operating income 8,18,680 Growth component 21,95,000 F Price-recovery component 20,68,000 U Productivity component 6,91,680 F
  87. 88. Engineered and Discretionary Costs Fixed costs are tied to capacity. Fixed costs do not change automatically with changes in the level of the cost driver. How to reduce capacity-based fixed costs? The key is understanding and managing unused capacity.
  88. 89. Engineered Costs Engineered costs result specifically from a clear cause-and effect relationship between output and the resources needed to produce that output. Engineered costs can be variable or fixed in the short run. Selling and customer-service costs are engineered costs that are fixed in the short run.
  89. 90. Discretionary Costs Two important features of discretionary costs: Discretionary costs arise from periodic (usually yearly) decisions regarding the maximum amount to be incurred. Discretionary costs have no clearly measurable cause-and effect relationship between output and resources used.
  90. 91. Discretionary Costs <ul><li>Discretionary costs include: </li></ul><ul><li>Advertising </li></ul><ul><li>Executive training </li></ul><ul><li>Research and development </li></ul><ul><li>Health care </li></ul><ul><li>Legal resources </li></ul><ul><li>Public relations </li></ul>
  91. 92. Relationships between Inputs and Outputs <ul><li>Engineered costs differ from discretionary costs along two key dimensions: </li></ul><ul><ul><li>Type of process </li></ul></ul><ul><ul><li>Level of uncertainty </li></ul></ul>
  92. 93. Relationships between Inputs and Outputs Engineered costs pertain to processes that are detailed, physically observable, and repetitive. Discretionary costs are associated with processes that are sometimes called black boxes , because they are less precise and not well understood.
  93. 94. Relationships between Inputs and Outputs Uncertainty refers to the possibility that an actual amount will deviate from an expected amount. The higher the level of uncertainty about the relationship between resources used and outputs, the less likely a cause-and-effect relationship will exist.
  94. 95. Identifying Unused Capacity Identifying unused capacity is easier for engineered costs than for discretionary costs. The absence of a cause-and-effect relationship makes identifying unused capacity for discretionary costs much more difficult.

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