STRATEGIC PROFITABILITY ANALYSIS 13-1 Strategy specifies how an organization matches its own capabilities with the opportunities in the marketplace to accomplish its objectives.
13-2 The five key forces to consider in industry analysis are: (a) competitors, (b) potential entrants into the market, (c) equivalent products, (d) bargaining power of customers, and (e) bargaining power of input suppliers.
13-3 Two generic strategies are (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 and (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.
13-4 A customer preference map describes how different competitors perform across various product attributes desired by customers, such as price, quality, customer service and product features.
13-5 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.
13-6 The four key perspectives in the balanced scorecard are: (1) Financial perspective—this perspective evaluates the profitability of the strategy and the creation of shareholder value, (2) Customer perspective—this perspective identifies the targeted customer and market segments and measures the company’s success in these segments, (3) Internal business process perspective—this perspective focuses on internal operations that further both the customer perspective by creating value for customers and the financial perspective by increasing shareholder value, and (4) Learning and growth perspective—this perspective identifies the capabilities the organization must excel at to achieve superior internal processes that create value for customers and shareholders.
13-7 A strategy map is a diagram that describes how an organization creates value by connecting strategic objectives in explicit cause-and-effect relationships with each other in the financial, customer, internal business process, and learning and growth perspectives.
13-8 A good balanced scorecard design has several features:
1. It tells the story of a company’s strategy by articulating a sequence of cause-and-effect relationships.
2. It 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.
3. It places strong emphasis on financial objectives and measures in for-profit companies. Nonfinancial measures are regarded as part of a program to achieve future financial performance.
4. It limits the number of measures to only those that are critical to the implementation of strategy.
5. It highlights suboptimal tradeoffs that managers may make when they fail to consider operational and financial measures together.
13-9 Pitfalls to avoid when implementing a balanced scorecard are:
1. Don’t assume the cause-and-effect linkages are precise; they are merely hypotheses. An organization must gather evidence of these linkages over time.
2. Don’t seek improvements across all of the measures all of the time.
3. Don’t use only objective measures in the balanced scorecard.
4. Don’t fail to consider both costs and benefits of different initiatives before including these initiatives in the balanced scorecard.
5. Don’t ignore nonfinancial measures when evaluating managers and employees.
13-10 Three key components in doing a strategic analysis of operating income are:
1. The growth component which measures the change in operating income attributable solely to the change in quantity of output sold from one year to the next.
2. The price-recovery component which measures the change in operating income attributable solely to changes in the prices of inputs and outputs from one year to the next.
3. The productivity component which measures the change in costs attributable to a change in the quantity and mix of inputs used in the current year relative to the quantity and mix of inputs that would have been used in the previous year to produce current year output.
13-11 An analyst can incorporate other factors such as the growth in the overall market and reductions in selling prices resulting from productivity gains into a strategic analysis of operating income. By doing so, the analyst can attribute the sources of operating income changes to particular factors of interests. For example, the analyst will combine the operating income effects of strategic price reductions and any resulting growth with the productivity component to evaluate a company’s cost leadership strategy.
13-12 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. Discretionary costs arise from periodic (usually annual) decisions regarding the maximum amount to be incurred. They have no measurable cause-and-effect relationship between output and resources used.
13-13 Downsizing (also called rightsizing) is an integrated approach 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 is an attempt to eliminate unused capacity.
13-14 A partial productivity measure is the quantity of output produced divided by the quantity of an individual input used (e.g., direct materials or direct manufacturing labor).
13-15 No. Total factor productivity (TFP) and partial productivity measures work best together because the strengths of one offset weaknesses in the other. TFP measures are comprehensive, consider all inputs together, and explicitly consider economic substitution among inputs. Physical partial productivity measures are easier to calculate and understand and, as in the case of labor productivity, relate directly to employees’ tasks. Partial productivity measures are also easier to compare across different plants and different time periods.
13-16 (15 min.) Balanced scorecard. 1. Ridgecrest’s 2012 strategy is a cost leadership strategy. Ridgecrest plans to grow by producing high-quality boxes at a low cost delivered to customers in a timely manner. Ridgecrest’s boxes are not differentiated, and there are many other manufacturers who produce similar boxes. To succeed, Ridgecrest must produce high-quality boxes at lower costs relative to competitors through productivity and efficiency improvements.
2. Solution Exhibit 13-16A shows the customer preference map for corrugated boxes for Ridgecrest and Mesa on price, timeliness, quality and design.
Solution Exhibit 13-16A
Customer Preference Map for Corrugated Boxes
3. Solution Exhibit 13-16B presents the strategy map for Ridgecrest for 2012.
Solution Exhibit 13-16B
Strategy Map for Ridgecrest for 2012
4. Measures that we would expect to see on a Ridgecrest’s balanced scorecard for 2012 are
These measures evaluate whether Ridgecrest has successfully reduced costs and generated growth through cost leadership.
Market share in corrugated boxes market, (2) number of new customers, (3) customer satisfaction index. The logic is that improvements in these customer measures are leading indicators of whether Ridgecrest’s cost leadership strategy is succeeding with its customers and helping it to achieve superior financial performance.
Internal Business Process Perspective
(1) Productivity, (2) order delivery time, (3) on-time delivery, (4) number of major process improvements.
Improvements in these measures are key drivers of achieving cost leadership and are expected to lead to more satisfied customers and in turn to superior financial performance
Learning and Growth Perspective
(1) Percentage of employees trained in process and quality management, (2) employee satisfaction ratings.
Improvements in these measures aim to improve Ridgecrest’s ability to achieve cost leadership and have a cause-and-effect relationship with improvements in internal business processes, which in turn lead to customer satisfaction and financial performance.
13-17 (20 min.) Analysis of growth, price-recovery, and productivity components (continuation of 13-16). 1. Ridgecrest’s operating income gain is consistent with the cost leadership strategy identified in requirement 1 of Exercise 13-16. The increase in operating income in 2012 was driven by the $150,000 gain in productivity in 2012. Ridgecrest took advantage of its productivity gain to reduce the prices of its boxes and to fuel growth. It increased market share by growing even though the total market size was unchanged.
2. The productivity component measures the change in costs attributable to a change in the quantity and mix of inputs used in a year relative to the quantity and mix of inputs that would have been used in a previous year to produce the current year output. It measures the amount by which operating income increases and costs decrease through the productive use of input quantities. When comparing productivities across years, the productivity calculations use current year input prices in all calculations. Hence, the productivity component is unaffected by input price changes.
The productivity component represents savings in both variable costs and fixed costs. With respect to variable costs, such as direct materials, productivity improvements immediately translate into cost savings. In the case of fixed costs, such as fixed manufacturing conversion costs, productivity gains result only if management takes actions to reduce unused capacity. For example, reengineering manufacturing processes will decrease the capacity needed to produce a given level of output, but it will lead to a productivity gain only if management reduces the unused capacity by, say, selling off the excess capacity.
13-18 (20 min.) Strategy, balanced scorecard, merchandising operation. (Please alert students that in some printed versions of the book there is a typographical error in line 8 of the table. It should read “Administrative cost per customer (Row 7 Row 6)” and not “(Row 8 Row 7).” 1. Roberto & Sons follows a product differentiation strategy. Roberto’s designs are “trendsetting,” its T-shirts are distinctive, and it aims to make its T-shirts a “must have” for each and every teenager. These are all clear signs of a product differentiation strategy, and, to succeed, Roberto must continue to innovate and be able to charge a premium price for its product.
2. Possible key elements of Roberto’s balance scorecard, given its product differentiation strategy:
(1) Increase in operating income from charging higher margins, (2) price premium earned on products.
These measures will indicate whether Roberto has been able to charge premium prices and achieve operating income increases through product differentiation.
(1) Market share in distinctive, name-brand T-shirts, (2) customer satisfaction, (3) new customers, (4) number of mentions of Roberto’s T-shirts in the leading fashion magazines
Roberto’s strategy should result in improvements in these customer measures that help evaluate whether Roberto’s product differentiation strategy is succeeding with its customers. These measures are, in turn, leading indicators of superior financial performance.
Internal Business Process Perspective
(1) Quality of silk-screening (number of colors, use of glitter, durability of the design), (2) frequency of new designs, (3) time between concept and delivery of design
Improvements in these measures are expected to result in more distinctive and trendsetting designs delivered to its customers and in turn, superior financial performance.
Learning and Growth Perspective
(1) Ability to attract and retain talented designers (2) improvements in silk-screening processes, (3) continuous education and skill levels of marketing and sales staff, (4) employee satisfaction.
Improvements in these measures are expected to improve Roberto’s capabilities to produce distinctive designs that have a cause-and-effect relationship with improvements in internal business processes, which in turn lead to customer satisfaction and financial performance.
13-19 (25–30 min.) Strategic analysis of operating income (continuation of 13-18). 1. Operating Income Statement
Direct materials (purchased T-shirts) that would be required in 2011 to sell 246,700 T shirts instead of the 198,000 sold in 2010, assuming the 2010 input-output relationship continued into 2011, equal 249,192 purchased T-shirts . Administrative capacity will not change since adequate capacity exists in 2010 to support year 2011 output and customers.
The cost effects of growth component are
Direct materials costs (249,192 200,000) $10 = $491,920 U
Administrative costs (4,000 – 4,000) $300 = 0
Cost effect of growth $491,920 U
In summary, the net increase in operating income as a result of the growth component equals:
Revenue effect of growth $1,217,500 F
Cost effect of growth 491,920 U
Change in operating income due to growth $ 725,580 F
Direct materials costs (250,000 249,192) $8.50 = $ 6,868 U
Administrative costs (3,750 4,000) $310 = 77,500 F
Change in operating income due to productivity $70,632 F
The change in operating income between 2010 and 2011 can be analyzed as follows:
Cost Effects of
Cost Effect of Productivity
(1) + (2) + (3) + (4)
$ 725,580 F
Change in operating income
3. The analysis of operating income indicates that growth, price-recovery, and productivity all resulted in favorable changes in operating income in 2011. Further, a significant amount of the increase in operating income resulted from Roberto’s product differentiation strategy. The company was able to continue to charge a premium price while growing sales. It was also able to earn additional operating income by improving its productivity.
13-20 (20 min.) Analysis of growth, price-recovery, and productivity components (continuation of 13-19).Effect of the industry-market-size factor on operating income
Of the 48,700-unit (246,700 – 198,000) increase in sales between 2010 and 2011, 19,800 (10% 198,000) units are due to growth in market size, and 28,900 units are due to an increase in market share.
The change in Roberto’s operating income from the industry-market size factor rather than from specific strategic actions is:
$725,580 (the growth component in Exercise 13-19) $ 295,000 F
Effect of product differentiation on operating income
The change in operating income due to:
Increase in the selling price (revenue effect of price recovery) $ 246,700 F
Increase in price of inputs (cost effect of price recovery) 333,788 F
$725,580 (the growth component in Exercise 13-19) 430,580 F
Change in operating income due to product differentiation $1,011,068 F
Effect of cost leadership on operating income
The change in operating income from cost leadership is:
Productivity component $ 70,632 F
The change in operating income between 2010 and 2011 can be summarized as follows:
Change due to industry-market-size $ 295,000 F
Change due to product differentiation 1,011,068 F
Change due to cost leadership 70,632 F
Change in operating income $1,376,700 F
Roberto has been very successful in implementing its product differentiation strategy. Nearly 73% ($1,011,068 $1,376,700) of the increase in operating income during 2011 was due to product differentiation, i.e., the distinctiveness of its T-shirts. It was able to raise prices of its products despite a decline in the cost of the T-shirts purchased. Roberto’s operating income increase in 2011 was also helped by a growth in the overall market and a small productivity improvement, which it did not pass on to its customers in the form of lower prices.
13-21 (15 min.) Identifying and managing unused capacity (continuation of 13 18). 1. The amount and cost of unused capacity at the beginning of year 2011 based on year 2011 production follows: