Strategy, Balanced

Scorecard, and Strategic

Profitability Analysis
Chapter 13
Learning Objectives
1. Recognize which of two generic strategies a company
is using and key aspects of reengineering
2. Understand the four perspectives of the balanced
scorecard
3. Analyze changes in operating income to evaluate
strategy
1.Recognize which of two generic strategies a
company is using and key aspects of reengineering

 What is Strategy?
 Strategy describes how an organization matches
its own capabilities with the opportunities in the
marketplace to accomplish its overall
objectives.
 In formulating its strategy, an organization must
thoroughly understand the industry in which it
operates.
 What is Strategy?
 Industry analysis focuses on five forces:

1 Competitors
2 Potential entrants into the market
3 Equivalent products
4 Bargaining power of customers
5 Bargaining power of input suppliers
Generic Strategies
 Two generic strategies that organizations
use are:
1 Product differentiation

2 Cost leadership
 Generic Strategies
1. Product differentiation is 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.
Generic Strategies
2. Cost leadership is 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.
Building Internal Capabilities :
Reengineering
 Reengineering is the fundamental rethinking
of business processes, such as order delivery,
to improve critical performance measures
such as cost, quality, service, speed, and
customer satisfaction.
Reengineering Example
SDN Co. order delivery system:
Customers needs identified Quantities to be shipped
matched against purchase order
Purchase order issued
Shipping documents sent
Production scheduled to Billing Department

Manufacturing completed Invoice issued

Finished goods to inventory Customer payment follow up

Building Internal Capabilities
:e.g. Re-engineering
 Assume that the management of SDN
Corporation, a manufacturer of devices used
in communication networks, decides to
examine the company’s order delivery
system.
Reengineering
 The following was determined:
 Frequently, there is a long waiting time
before production begins in the
manufacturing department.
 Sometimes devices are held in inventory
until a truck is available for shipment.
Reengineering
 If the quantity shipped does not match the
number of devices requested by the customer,
a special shipment is scheduled.
 SDN discovered that the many transfers
across departments slowed down the process
and created delays.
 A multi-functional team reengineered the
order delivery process.
Reengineering
 Under the new system, a customer relationship
manager is responsible for the entire customer
relationship.
 SDN entered into long-term contracts with
customers that specify quantities and prices.
 The customer relationship manager works closely
with the customer and with manufacturing to specify
delivery schedules for the device one month in
advance.
Reengineering
 The schedule of customer orders is sent
electronically to manufacturing.
 Completed devices are to be shipped directly
from the manufacturing plant to customer
sites.
 Each shipment automatically triggers an
invoice to be sent electronically to the
customer.
Implementation of Strategy

 A company must both formulate an effective

strategy and implement it vigorously.
 Management accountants have an important
role to play in the implementation of strategy.
 This role is designing reports to help managers
track progress
2.The Balanced Scorecard
 The balanced scorecard translates an organization’s
mission and strategy into a comprehensive set of
performance measures.
 The balanced scorecard does not focus solely on
achieving financial objectives.
 It highlights the non-financial objectives that an
organization must achieve in order to meet its
financial objectives.
The Balanced Scorecard
 The balanced scorecard gets its name from the
attempt to balance financial and nonfinancial
performance measures to evaluate both short-
run and long-run performance in a single
report.
 Why does the balanced scorecard reduce
manager’s emphasis on short-run financial
performance?
The Balanced Scorecard
 Because the non-financial and operational indicators
measure fundamental changes that a company is
making.
 The financial benefits of these fundamental changes
may not be captured in short-run earnings.
 Strong improvements in nonfinancial measures
signal the prospect of creating economic value in the
future.
Perspectives of the
Balanced Scorecard
 There are four perspectives of the balanced
scorecard:
1 Financial perspective

2 Customer perspective
3 Internal business process perspective
4 Learning and growth perspective
Aligning the Balanced
Scorecard to Strategy
 Different strategies call for different
scorecards.
 What are some of the financial perspective
measures?
– Operating income
– Revenue growth
– Cost reduction is some areas
– Return on investment
Aligning the Balanced
Scorecard to Strategy
 What are some of the customer perspective
measures?
– Market share
– Customer satisfaction
– Customer retention percentage
– Time taken to fulfill customers requests
Aligning the Balanced
Scorecard to Strategy
 What are some of the internal business
perspective measures?
– Innovation Process

Manufacturing capabilities

Number of new products or services

New product development time

Number of new patents
 Aligning the Balanced
Scorecard to Strategy
– Operations Process

Yield

Defect rates

Time taken to deliver product to customers

Percentage of on-time delivery

Setup time

Manufacturing downtime
 Aligning the Balanced
Scorecard to Strategy
– Post-sales service

Time taken to replace or repair defective
products

Hours of customer training for using the
product
Aligning the Balanced
Scorecard to Strategy
 What are some of the learning and growth
perspective measures?
– Employee education and skill level
– Employee satisfaction scores
– Employee turnover rates
– Information system availability
– Percentage of processes with advanced
controls
 Features of a Good
Balanced Scorecard
1 It tells the story of a company’s strategy by
articulating a sequence of cause-and-effect
relationships.
2 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.
 Features of a Good
Balanced Scorecard
3 In for-profit companies, the balanced
scorecard places strong emphasis on financial
objectives and measures.
4 The scorecard limits the number of measures
used by identifying only the most critical
ones.
5 The scorecard highlights suboptimal tradeoffs
that managers may make.
 Pitfalls When Implementing
a Balanced Scorecard
 What pitfalls should be avoided when
implementing a balanced scorecard?
1 Don’t assume the cause-and-effect linkages
to be precise.
2 Don’t seek improvements across all measures
all the time.
3 Don’t use only objective measures on the
scorecard.
 Pitfalls When Implementing
a Balanced Scorecard
4 Don’t fail to consider both costs and benefits
of initiatives such as spending on information
technology and research and development.
5 Don’t ignore nonfinancial measures when
evaluating managers and employees.
 3.Evaluating the Success
of a Strategy
 Assume the following operating incomes:
 Year 1 Year 2 Revenues:
)
(@$26, 1 M $26,000,000 )$26,400,000
(@24, 1.1M

 Expenses:
 Materials 4,050,000 3,631,320
 Other cost 16,000,000 16,000,000
Operating income $ 5,950,000 $ 6,768,680
Evaluating the Success of a Strategy
 How can the increase in operating income
of $818,680 be evaluated?
 To evaluate the success of its strategy, a
company can subdivide the change in
operating income into three components:
1 Growth
2 Price recovery
3 Productivity
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 Year1, Naches produced and sold
1,000,000 devices at $26 per unit.
 During the year Year 2, Naches produced and sold
1,100,000 devices at $24 per unit.
 What is the revenue effect of growth?
Growth Component
 Revenue effect of growth component =
(Actual units of output sold in Yr 2 – Actual
units of output sold in Yr 1) × Output price in
Yr 1

 This component is _____ because it_____

operating income.
Cost Effect of Growth
 To produce the higher output sold in Yr 2
more inputs would have been needed.
 Cost effect of growth component
= (Actual units of input or capacity that would
have been used in Yr2 based on input-output
relationship that existed in Yr1
– Actual units or capacity to produce Yr1
output)
x Input prices in Yr 1
Cost Effect of Growth
 To produce 1,100,000 units in Yr 2 compared with
the 1,000,000 units produced in Yr 1 (a 10%
increase), Naches would require a proportional
increase in direct materials.
 Assume that 3,000,000 square centimeters of
materials were used to produce the 1,000,000 units
in Yr1 at a cost of $1.35 per square centimeter.
 Cost Effect of Growth
 Also, assume that all the capacity, manufacturing
conversion costs, selling and customer service
costs and research and development costs were
$16,000,000 and remained unchanged during Yr
2.
 What is the cost effect of the growth component?
Operating Income and Growth
 What is the net increase in operating income
as a result of growth?
 Revenue effect of growth component

 Cost effect of growth component

 Increase in operating income

 due to growth component
Price-Recovery Component
 The price recovery component of operating
income measures the change in revenues and
the changes in costs to produce the 1,100,000
devices manufactured in Yr2 as a result of
two factors:
– Change in price of the device
– Change in prices of the inputs required to
make the device
Price-Recovery Component
 Revenue effect of price-recovery component =
(Output price in Yr2 – Output price in Yr1) × Actual
units of output sold in Yr2
 What is the revenue effect of the price-recovery
component?
Price-Recovery Component
 Cost effect of price-recovery component = (Input
prices in Yr 2 – Input prices in Yr 1) × Actual units
of inputs or capacity that would have been used to
produce year Yr 2 output assuming the same input-
output relationship that existed in Yr 1
 Assume that in the year 2 direct materials costs were
$1.31 per square centimeter.
Price-Recovery Component
 Remember, it was assumed that
manufacturing conversion costs, selling,
and customer service costs and research
and development costs remained stable
during Yr 2.
 What is the cost effect of the price-
recovery component?
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
 Cost effect of price-recovery component

 Decrease in operating income due to

price-recovery component
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 Yr
2 output, assuming year Yr 2 input prices.
Productivity Component
 Productivity component
= (Actual units of inputs or capacity to produce
year 2 output
– Actual units of inputs or capacity that would
have been used to produce year 2 output
assuming the same input-output relationship
that existed in Year1)
x Input prices in Year 2
Productivity Component
 Assume that 2,772,000 actual square
centimeters of direct materials were used
in the year 2.
 Actual price was $1.31/square centimeter.
 Manufacturing conversion costs, selling and
customer service costs, and research and
development costs remained stable during
Year 2
Productivity Component
 What is the productivity component of cost
changes?
 (2,772,000 – 3,300,000) × $1.31 = $691,680
F
 There is a $691,680 increase in operating
income due to the productivity component.
Change in Operating Income
Increase in operating income
$818,680

Growth Price-recovery Productivity

component component component
$2,195,000 F $2,068,000 U $691,680 F