Strategy, Balanced Scorecard, and Strategic Profitability Analysis CHAPTER 12 Strategy, Balanced Scorecard, and Strategic Profitability Analysis

Chapter 12 learning objectives Recognize which of two generic strategies a company is using Understand what comprises reengineering Understand the four perspectives of the balanced scorecard Analyze changes in operating income to evaluate strategy Identify unused capacity and how to manage it In chapter 12, we’ll be studying various topics regarding strategy. We have 5 learning objectives presented here: Recognize which of two generic strategies a company is using Understand what comprises reengineering Understand the four perspectives of the balanced scorecard Analyze changes in operating income to evaluate strategy Identify unused capacity and how to manage it

Strategy 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. 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.

Industry analysis focuses on five forces Number and strength of competitors Potential entrants to the market Availability of equivalent products Bargaining power of customers Bargaining power of input suppliers Industry analysis focuses on five forces. They are: Number and strength of competitors Potential entrants to the market Availability of equivalent products Bargaining power of customers Bargaining power of input suppliers The collective effect of these forces shapes an organization’s profit potential. In general, profit potential decreases with greater competition, stronger potential entrants, products that are similar and more demanding customers and suppliers.

Two Basic Business Strategies 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. 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. Generally, there are two basic business strategies that a business can follow. They are: 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 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

reengineering 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. 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

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

The Balanced Scorecard 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. The balanced scorecard translates an organization’s mission and strategy into a set of performance measures that provides the framework for implementing its strategy. 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. 1 See Robert S. Kaplan and David P. Norton, The Balance Scorecard Boston: Harvard Business School Press, 1996)

The four Perspectives of a Balanced Scorecard Financial - profits and value created for shareholders Customer – the success of the company in its target market Internal business perspective – the internal operations that create value for customers 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. Here are the four perspectives of a balanced scorecard. The particular measure a company uses to track performance will depend on its strategy. Financial - profits and value created for shareholders Customer – the success of the company in its target market Internal business perspective – the internal operations that create value for customers Learning and growth – the people and systems capabilities that support operations

Strategy maps A strategy map is a useful first step in designing a balanced scorecard. 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 each of the 4 perspectives. In this example of a strategy map, we see a connection between empowering the workforce which helps to align employee and organization goals and improves processes. That, in turn, improves quality and productivity, reduces customer delivery time and helps to meet delivery dates, all of which increase customer satisfaction. Exhibit 12-2 page 478

Four perspectives: Financial Evaluates the profitability of the strategy Uses the most objective measures in the scorecard The other three perspectives eventually feed back into this dimension The financial perspective: Evaluates the profitability of the strategy Uses the most objective measures in the scorecard The other three perspectives eventually feed back into this dimension The chart presented here provides some measures that might be used including operating income from productivity gain or growth, or revenue growth. Exhibit 12-3 page 479

Four perspectives: customer Identifies targeted customer and market segments and measures the company’s success in these segments The customer perspective identifies targeted customer and market segments and measure the company’s success in these segments. The chart presented here provides some measures that might be used including market share, number or new customers and customer-satisfaction ratings. Exhibit 12-3 page 479

four Perspectives: Internal Business Focuses on internal operations that create value for customers which, in turn, will further the financial perspective by increasing shareholder value Includes three subprocesses: Innovation Operations Post-sales service Focuses on internal operations that create value for customers which, in turn, will further the financial perspective by increasing shareholder value. It includes three subprocesses: Innovation Operations Post-sales service On the next slide, we’ll look at some examples of measure that can be used here.

four Perspectives: Internal Business, concluded The chart presented here provides some measures that might be used for internal business objectives including service response time, yield, order-delivery time, on-time delivery, number of improvements, or percentage of processes with advanced controls. Exhibit 12-3 page 479

Four Perspectives: Learning and Growth Identifies the people and information capabilities the organization must excel at to achieve superior internal processes that create value for customers and shareholders The learning and growth perspective identifies the capabilities the organization must excel at to achieve superior internal processes that create value for customers and shareholders The chart presented here provides some measures that might be used including employee-satisfaction ratings, percentage of line workers empowered to manage processes, percentage of employees trained in process and quality management and percentage of manufacturing processes with real-time feedback. Exhibit 12-3 page 479

Balanced Scorecard Implementation 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. A successful balanced scored implementation: 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.

Common Balanced Scorecard Measures The goal is to align the balanced scorecard with company strategy. Here are some common measures found on company scorecards in the service, retail and manufacturing sectors. Exhibit 12-4 page 482

Environmental and social performance and the balanced scorecard 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. Regarding environmental and social performance and the balanced scorecard, 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.

Environmental and social performance and the balanced scorecard, cont’d As was discussed in Chapter 1, many managers are promoting sustainability (the development and implementation of strategies) to achieve: Long-term financial performance Social performance (eliminating employee injuries, improving product safety) Environmental performance (reducing greenhouse gas emissions) As was discussed in Chapter 1, many managers are promoting sustainability (the development and implementation of strategies) to achieve: Long-term financial performance Social performance (eliminating employee injuries, improving product safety) Environmental performance (reducing greenhouse gas emissions) Managers interested in measuring environmental and social performance are incorporating these factors into their balanced scorecards.

Environmental and social performance and the balanced scorecard, concluded 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). 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).

Features of a Good Balanced Scorecard 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. The first two (of five) features of a good balanced scorecard are that it: 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

Features of a Good Balanced Scorecard, cont’d 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. The last 3 (of 5) features of a good balanced scorecard are that it: 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

Pitfalls in implementing a balanced scorecard 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. Some pitfalls in implementing a balanced scorecard include: 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.

Evaluating the success of Strategy and implementation 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. 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. In this case, management may have failed to correctly identify the causal links but did a good job implementing the wrong strategy.

Strategic analysis of operating income Strategic analysis of operating income— three parts: 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. Price-recovery component—measures solely the effect of price changes on revenues and costs to produce and sell the current year quantity. Strategic analysis of operating income—three parts: 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. Price-recovery component—measures solely the effect of price changes on revenues and costs to produce and sell the current year quantity

Strategic analysis of operating income, concluded 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. Strategic analysis of operating income 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.

Revenue Effect of Growth Actual Units of Output Sold in the Current Period Actual Units of Output Sold in the Prior Period = X _ Prior Period Selling Price Throughout these slides, we’ll use values from the textbook example to 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, and The 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 In the first of several formulas used to analyze changes in operating income, we see here the Revenue Effect of Growth. From page 490

Cost Effect of Growth for Variable Costs Units of Input Required to Produce Current Output in the Prior Period Actual Units of Input Used to Produce Prior Period Output = X _ Prior Period Input Price 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. Our next formula presents the calculation to find the cost effect of growth for variable costs. From page 490

Cost Effect of Growth for Fixed Costs Assuming adequate current capacity: This formula presents to calculation for the Cost Effect of Growth for Fixed Costs. Please note that this assumes adequate current capacity. From page 490 (3,750,000 sq cm – 3,750,000 sq cm) X $4.28 per sq cm = $0.00

Revenue Effect of Price Recovery In this formula, we have the calculation for the Revenue Effect of Price Recovery. From page 490 ($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

Cost Effect of Price Recovery for variable costs Here is the Cost Effect of Price Recovery for Variable Costs. From page 491 ($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

Cost Effect of Price Recovery for fixed costs Assuming adequate current capacity: And here is the Cost Effect of Price Recovery for Fixed Costs, again assuming adequate capacity. To calculate the price per unit of capacity, all manufacturing costs other than direct material costs are divided by manufacturing processing capacity. From page 491 $4.35 per sq cm - $4.28 per sq cm) X 3,750,000 sq cm = $262,500 Unfavorable

Cost Effect of Productivity for Variable Costs Here is our formula for the Cost Effect of Productivity for Variable Costs. From page 492 (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

Cost Effect of Productivity for fixed Costs Assuming adequate current capacity: And here is the formula for the Cost Effect of Productivity for Fixed Costs and again, please note that this assumes adequate capacity. From page 492 (3,500,000 sq cm – 3,750,000 sq cm) X $4.35 per sq cm = $1,087,500 Favorable 34

Further analysis of growth, price-recovery and productivity components In this chart, we see the analysis of the growth, price-recovery and productivity components of the changes in operating income that we’ve just calculated. 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. Generally, companies that have been successful at cost leadership will show favorable productivity and growth components. Companies that have successfully differentiated their products will show favorable price-recovery and growth components. Exhibit 12-6 page 493 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.

Downsizing and the management of processing Capacity 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. 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.

Analysis of Unused Capacity: engineered & discretionary costs 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. Discretionary costs have two important features: They 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. To understand unused capacity, we must understand the distinction between engineered costs and discretionary costs. 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. Discretionary costs have two important features: They 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.

Managing Unused Capacity 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. 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.

Terms to learn TERMS TO LEARN PAGE NUMBER REFERENCE Balanced scorecard Cost leadership Page 474 Discretionary costs Page 496 Downsizing Page 497 Engineered costs Growth component Page 489 Partial productivity Page 503 Price-recovery component Product differentiation Productivity

Terms to learn 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