Competing On Resources Balance Scorecard

Competing on Competing on ResourcesResourcesTranslating Strategy into Translating Strategy into ActionActionBalance Balance

ScorecardScorecard

copyright@Vinod Kr Sharma-JIMcopyright@Vinod Kr Sharma-JIM

““Measuring Performance in the Measuring Performance in the Organization of the Future”Organization of the Future”

Competing on Resources – Competing on Resources – Industrial ageIndustrial age• Massive Physical AssetsMassive Physical Assets – capitalization. – capitalization.• Mass ProductionMass Production – low cost standard products. – low cost standard products.• Operations based on Operations based on PushPush model. model.• Bargaining Power of Buyer very limited.Bargaining Power of Buyer very limited.• Competition limited.Competition limited.• Internally Focused – operations.Internally Focused – operations.• Emphasis on efficient allocation of financial Emphasis on efficient allocation of financial

and physical assets.and physical assets.• Specialization of functional skills – silos.Specialization of functional skills – silos.• Marketplace local.Marketplace local.

• Operations governed by Operations governed by production plansproduction plans through value chain.through value chain.

• Focus on Cost Control – Focus on Cost Control – efficiency.efficiency.• Economies of ScaleEconomies of Scale• Lack integration of Customers & Suppliers.Lack integration of Customers & Suppliers.• Product Life Cycle reasonably long.Product Life Cycle reasonably long.• Technology embedded into physical assets Technology embedded into physical assets

facilitating mass production of standard facilitating mass production of standard productsproducts

• Focus on Focus on Profitability – ROCEProfitability – ROCE

Competing on Resources – Competing on Resources – Industrial ageIndustrial age

From Industrial Age to……..From Industrial Age to……..

……..Information ..Information AgeAge

Competing on Resources – Competing on Resources – Information ageInformation age• Intangible Intangible - Intellectual Assets – less capital - Intellectual Assets – less capital

intensive.intensive.• Mass CustomizationMass Customization – customized offerings. – customized offerings.• Operations based on Pull model.Operations based on Pull model.• Bargaining Power of Buyer very Bargaining Power of Buyer very highhigh..• Competition intense.Competition intense.• ExternallyExternally Focused – Customers. Focused – Customers.• Emphasis on efficient management of Intangible Emphasis on efficient management of Intangible

assets.assets.• Integrated processesIntegrated processes cutting across various cutting across various

functions combining the specialization, speed and functions combining the specialization, speed and efficiency.efficiency.

• Marketplace – global.Marketplace – global.

• Operations governed by customers action enabling Operations governed by customers action enabling enormous improvements in cost, quality & enormous improvements in cost, quality & response time.response time.

• Focus on Focus on Cost ReductionCost Reduction – efficiency & – efficiency & effectiveness.effectiveness.

• Economies of Economies of Scope & ScaleScope & Scale..• Integrated Supply, Production & Deliveries.Integrated Supply, Production & Deliveries.• Product Life Cycle very Product Life Cycle very smallsmall..• Technology leverages the resources facilitating Technology leverages the resources facilitating

mass customization with customized offerings.mass customization with customized offerings.• Focus on sustainability of Profitability – Focus on sustainability of Profitability –

performanceperformance• Efficiency in operations – Efficiency in operations – Competitive AdvantageCompetitive Advantage

Competing on Resources – Competing on Resources – Information Information ageage

So.. the shift in paradigm was obviousSo.. the shift in paradigm was obvious

• Total Quality Management - TQM.Total Quality Management - TQM.• Just in Time production & distribution systems – JIT.Just in Time production & distribution systems – JIT.• Time Based Competition.Time Based Competition.• Lean Production.Lean Production.• Lean Enterprise.Lean Enterprise.• Customer focused organizations – Outside Inn.Customer focused organizations – Outside Inn.• Activity Based Management – ABC Management.Activity Based Management – ABC Management.• Empowerment.Empowerment.• Re-engineering………..Re-engineering………..

Above initiations failed to deliver promised results, as Above initiations failed to deliver promised results, as they were fragmented –they were fragmented – not linked with the not linked with the

organization’s strategyorganization’s strategy..

Competing for future …… initiativesCompeting for future …… initiatives

Performance Management is the Performance Management is the integrationintegration of the of the results of performance results of performance measurementmeasurement into into

management processes so that results can management processes so that results can influence influence the decisionsthe decisions made by the organization. made by the organization.

Performance Management Performance Management

TraditionallyTraditionally Performance – success of Performance – success of companies in 90’s was measured in terms companies in 90’s was measured in terms

of of Return on InvestmentsReturn on Investments

Operating & Cash BudgetsOperating & Cash BudgetsFocus was only on Focus was only on profitabilityprofitability..

Performance ManagementPerformance Management

• Such Performance criteria lacked…..Such Performance criteria lacked…..• Various aspects related to sources of future Various aspects related to sources of future

growth.growth.• Breakthroughs into new avenues so as to sustain Breakthroughs into new avenues so as to sustain

the profitability.the profitability.• Insight about progress company is making in Insight about progress company is making in

implementing long term goals.implementing long term goals.• Long term focus & focused only on short term Long term focus & focused only on short term

financial performance.financial performance.• Lacks valuation of company’s intangible & Lacks valuation of company’s intangible &

intellectual assetsintellectual assets

Financial measures are Lagging indicators failing to Financial measures are Lagging indicators failing to capture most of the value that is being createdcapture most of the value that is being created

Financial measures in isolation are inadequate for Financial measures in isolation are inadequate for setting guidelines for evaluating organization’s setting guidelines for evaluating organization’s

path through Competitive Landscape.path through Competitive Landscape.

Financial measures fail to provide adequate insights Financial measures fail to provide adequate insights for actions that are to be taken or initiated today for actions that are to be taken or initiated today

that can create future financial value.that can create future financial value.

It is thus essential to redefine the criteria It is thus essential to redefine the criteria on the basis of which the performance of on the basis of which the performance of any organization is to be measured, and any organization is to be measured, and

it calls for inclusion of qualitative it calls for inclusion of qualitative measures – intangible / intellectual measures – intangible / intellectual

assets within the frame work of financial assets within the frame work of financial accounting model of performance accounting model of performance

management thereby communicating management thereby communicating their status i.e. improvements or their status i.e. improvements or

depletion to stakeholders.depletion to stakeholders.

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

The Increasing Sophistication of The Increasing Sophistication of Corporate Performance Corporate Performance MeasurementMeasurement

TimeTime

Sophistication of Sophistication of Measurement Measurement SystemsSystems

Operating measuresOperating measuresTraditional accounting measuresTraditional accounting measures

Quality-related operating measuresQuality-related operating measuresActivity-based costingActivity-based costing

Economic value addedEconomic value added

New perspective of Performance New perspective of Performance Management……Management……

• Strategy refers to set of Strategy refers to set of hypothesishypothesis about cause ‘n’ effect.about cause ‘n’ effect.

• Measurement system should thus Measurement system should thus establish relationships ( establish relationships ( HypothesisHypothesis ) ) among among objectivesobjectives in diverse in diverse perspectives explicitly so that the same perspectives explicitly so that the same can be validated.can be validated.

ROCEROCE

CustomerLoyalty

CustomerLoyalty

On-TimeDeliveryOn-TimeDelivery

ProcessQualityProcessQuality

ProcessCycle-Time

ProcessCycle-Time

EmployeeSkills

EmployeeSkills

• ROCE – financial measure.• Driver for ROCE – expanded sales.• Driver for expanded sales – customer loyalty.• Driver for customer loyalty – process efficiency.• Process efficiency – speed, scale & time• Driver for process efficiency – shorter cycle time,

i.e. efficient internal processes.• Driver for efficient internal processes – workforce• Driver for workforce – continuous learning.

New perspective of Performance New perspective of Performance Management……Management……

ROCEROCEROCEROCE

CustomerCustomerLoyaltyLoyalty

CustomerCustomerLoyaltyLoyalty

On-TimeOn-TimeDeliveryDeliveryOn-TimeOn-TimeDeliveryDelivery

ProcessProcessQualityQualityProcessProcessQualityQuality

ProcessProcessCycle-TimeCycle-Time

ProcessProcessCycle-TimeCycle-Time

EmployeeEmployeeSkillsSkills

EmployeeEmployeeSkillsSkills

FinancialFinancial

CustomerCustomer

Business ProcessBusiness Process

LearningLearning

Balanced ScorecardBalanced Scorecard

• Balanced ScorecardBalanced Scorecard is a measurement tool is a measurement tool that allows the organization to assess progress that allows the organization to assess progress in implementing strategy.in implementing strategy.

• The purpose of the Balanced Scorecard is to The purpose of the Balanced Scorecard is to establish a link between performance establish a link between performance measures and a company's strategic visionmeasures and a company's strategic vision

• The Balanced Scorecard was developed by The Balanced Scorecard was developed by Kaplan and Norton in 1992 (Kaplan & Norton, Kaplan and Norton in 1992 (Kaplan & Norton, 1992). 1992).


• Balance Scorecard emphasizes that Balance Scorecard emphasizes that financial and non-financial measures financial and non-financial measures must be integral part of performance must be integral part of performance management.management.

• Balance Scorecard complements Balance Scorecard complements financial measures of past performance financial measures of past performance with measures of the drivers of future with measures of the drivers of future performance.performance.


• Balance Scorecard is an instrument that Balance Scorecard is an instrument that facilitates navigation to future facilitates navigation to future competitive success.competitive success.

• Balance Scorecard emphasizes on Balance Scorecard emphasizes on achieving financial objectives, besides it achieving financial objectives, besides it also includes the performance drivers of also includes the performance drivers of these financial objectives.these financial objectives.

The Increasing Sophistication of The Increasing Sophistication of Corporate Performance Corporate Performance MeasurementMeasurement

TimeTime

Sophistication of Sophistication of Measurement Measurement SystemsSystems

Operating measuresOperating measuresTraditional accounting measuresTraditional accounting measures

Quality-related operating measuresQuality-related operating measuresActivity-based costingActivity-based costing

Economic value addedEconomic value added

Balance ScorecardBalance Scorecard

Value-linked measurements for Value-linked measurements for business strategy, stakeholder business strategy, stakeholder needs, process attributes and the needs, process attributes and the business environmentbusiness environment


• Ties Ties performance measuresperformance measures to to corporate corporate strategystrategy

• ““Balance” includesBalance” includes– short & long term objectivesshort & long term objectives– financial and non-financial measuresfinancial and non-financial measures– external & internal measuresexternal & internal measures– various perspectivesvarious perspectives

• PurposesPurposes of the balanced scorecard include of the balanced scorecard include– clarify & translate vision & strategyclarify & translate vision & strategy– communicate & link strategic objectives & measurescommunicate & link strategic objectives & measures– plan, set targets & align strategic initiativesplan, set targets & align strategic initiatives– enhance strategic feedback & learningenhance strategic feedback & learning

The Balance scorecard gets its name from The Balance scorecard gets its name from the attempt to balance financial and non the attempt to balance financial and non financial performance measures to financial performance measures to evaluate both short-run and long-run evaluate both short-run and long-run performance in a single report.performance in a single report.

• Balance Scorecard measures Balance Scorecard measures organizational performance across four organizational performance across four perspectives:perspectives:–Financial PerspectiveFinancial Perspective–Customer PerspectiveCustomer Perspective–Internal Business PerspectiveInternal Business Perspective–Learning & Growth PerspectiveLearning & Growth Perspective

Balance Scorecard enables companies to track Balance Scorecard enables companies to track their financial results while simultaneously their financial results while simultaneously monitoring progress in building the capabilities monitoring progress in building the capabilities and acquiring the intangible assets that they and acquiring the intangible assets that they might need for future growth.might need for future growth.


How do we look to ourowners and investors?How do we look to ourowners and investors?

How do we look to our customers?

How do we look to our customers?

Internal Processes Perspective

Internal Processes Perspective

How efficient and effective are the critical

internal processes?

How efficient and effective are the critical

internal processes?

Organizational Learning Perspective

Organizational Learning Perspective

Are we able to sustain innovation and improvement?

Are we able to sustain innovation and improvement?

Customer PerspectiveCustomer Perspective

?

Financial PerspectiveFinancial Perspective

"If we succeed, how will we look to our shareholders?”

"If we succeed, how will we look to our shareholders?”

The Strategy

Financial PerspectiveFinancial Perspective

"To achieve my vision, how must I look to my

customers?”

"To achieve my vision, how must I look to my

customers?”

Customer PerspectiveCustomer Perspective

"To satisfy my customers, at which processes must

I excel?”

"To satisfy my customers, at which processes must

I excel?”

Internal PerspectiveInternal Perspective

"To achieve my vision, how must my organization

learn and improve?”

Organization LearningOrganization Learning

Translate the strategy to Translate the strategy to operational termsoperational terms

The Vertical ScorecardThe Vertical Scorecard

Financial Financial PerspectivePerspective

Customer Customer PerspectivePerspective

Internal ProcessesInternal ProcessesPerspectivePerspective

Organizational LearningOrganizational LearningPerspectivePerspective

Translate the strategy to Translate the strategy to operational termsoperational terms

• Companies competing in information age find Companies competing in information age find that financial measures in themselves are that financial measures in themselves are inadequate, mainly because they fail appraise inadequate, mainly because they fail appraise and report as to how company creates future and report as to how company creates future value through investments in Customers, value through investments in Customers, Suppliers, Employees, Business Processes and Suppliers, Employees, Business Processes and TechnologyTechnology


Balanced Scorecard - logic Balanced Scorecard - logic modelmodel

• Balance Scorecard measures Balance Scorecard measures organizational performance across organizational performance across four perspectives:four perspectives:– Financial PerspectiveFinancial Perspective– Customer PerspectiveCustomer Perspective– Internal Business PerspectiveInternal Business Perspective– Learning & Growth PerspectiveLearning & Growth Perspective


Balanced Balanced ScorecardScorecard• Financial Perspective:Financial Perspective:

According to financial perspective of the According to financial perspective of the Balance Scorecard mostly financial objectives Balance Scorecard mostly financial objectives represents the long term goal of the represents the long term goal of the organization, but should be customized organization, but should be customized according the business units which are in according the business units which are in different stages of their life cycle – different stages of their life cycle – growthgrowth

I am saying this mainly because financial I am saying this mainly because financial objectives can differ significantly at each objectives can differ significantly at each stage of the business life cycle.stage of the business life cycle.

• If we look closely then broadly business If we look closely then broadly business life cycle can have primarily three life cycle can have primarily three stages:stages:– Growth – early stages, investments, Sales Growth – early stages, investments, Sales

growthgrowth– Sustain – operating income, gross margins - Sustain – operating income, gross margins -

ROCEROCE– Harvest – cash flows, reduction in WC.Harvest – cash flows, reduction in WC.

Balanced Scorecard-Balanced Scorecard- Financial Financial Perspective:Perspective:

• From above it is evident that business From above it is evident that business units operating in different stages of units operating in different stages of their life cycle can not be evaluated for their life cycle can not be evaluated for a common financial metrica common financial metric

• Lets now have a look at the various Lets now have a look at the various drivers as mentioned earlier at different drivers as mentioned earlier at different stages of business life cycle.stages of business life cycle.

StagesStages DriversDrivers

GrowthGrowth Revenue growthRevenue growth

SustainSustain Cost Reduction, Cost Reduction, ProductivityProductivity

HarvestHarvest Asset UtilizationAsset Utilization

Balanced Scorecard- Balanced Scorecard- Financial Financial Perspective:Perspective:

• Thus to conclude the Financial Thus to conclude the Financial perspective of the Balance Scorecard perspective of the Balance Scorecard enables business units to specify not enables business units to specify not only the metrics by which long term only the metrics by which long term success should be evaluated and success should be evaluated and measured, but it also takes into account measured, but it also takes into account that variables that are most important that variables that are most important in creating and deriving long term in creating and deriving long term sustainability of financial objectivessustainability of financial objectives

Balanced Scorecard- Balanced Scorecard- Financial Financial Perspective:Perspective:

Balanced Scorecard- Balanced Scorecard- Customer Customer PerspectivePerspective::

• Customer Perspective:Customer Perspective:

This perspective attempts to identify the This perspective attempts to identify the customers & the market segment in customers & the market segment in which company intends to operate and which company intends to operate and compete.compete.

This perspective enables companies to This perspective enables companies to identify the sources of revenue for their identify the sources of revenue for their financial perspective.financial perspective.

Balanced Scorecard-Balanced Scorecard- Customer Customer Perspective:Perspective:• Customer Perspective:Customer Perspective:

This perspective refers to measures This perspective refers to measures related to customers such as:related to customers such as:

SatisfactionSatisfaction

LoyaltyLoyalty

RetentionRetention

Acquisition Acquisition

ProfitabilityProfitability

Balanced Scorecard- Balanced Scorecard- Customer Customer Perspective:Perspective:

• Customer Perspective:Customer Perspective:

Explicit definition of Explicit definition of

SatisfactionSatisfaction

LoyaltyLoyalty

RetentionRetention

Acquisition Acquisition

Profitability, Profitability, along with along with core outcome core outcome measurementsmeasurements in turn helps in in turn helps in

defining defining various associated business various associated business processes.processes.

Balanced Scorecard- Balanced Scorecard- Customer Customer Perspective:Perspective:• Core outcome Core outcome measurementsmeasurements categories: categories:

– Market ShareMarket Share– Customer RetentionCustomer Retention– Customer AcquisitionCustomer Acquisition– Customer SatisfactionCustomer Satisfaction– Customer ProfitabilityCustomer Profitability

Customer ProfitabilityCustomer

Profitability

Market Share

Market Share

Customer SatisfactionCustomer

Satisfaction

Customer AcquisitionCustomer

AcquisitionCustomerRetentionCustomerRetention

Customer Perspective Customer Perspective Core MeasuresCore Measures

• Internal Business Process Internal Business Process Perspective:Perspective:

Innovation in Business Processes should Innovation in Business Processes should result in:result in:

Improved QualityImproved Quality

Reduction in Cycle TimeReduction in Cycle Time

Increase in YieldIncrease in Yield

Maximum ThroughputMaximum Throughput

Lower CostLower Cost

Balanced Scorecard- Balanced Scorecard- Internal Business Internal Business Process Perspective:Process Perspective:

• Internal Business Process Internal Business Process Perspective:Perspective:

Internal Business Process Perspective of Internal Business Process Perspective of Balance Scorecard focuses in innovating Balance Scorecard focuses in innovating business processes that are unique to an business processes that are unique to an organization enabling to develop organization enabling to develop competencies which are source of competencies which are source of Distinctive and Sustainable Competitive Distinctive and Sustainable Competitive AdvantageAdvantage

Balanced Scorecard- Balanced Scorecard- Internal Business Internal Business Process Perspective:Process Perspective:

Aligning the Balanced Scorecard to Aligning the Balanced Scorecard to StrategyStrategy• What are some of the customer

perspective measures?– Market share– Customer satisfaction– Customer retention percentage– Time taken to fulfill customers requests

Features of a Features of a GoodGood Balanced Balanced ScorecardScorecard

It tells the story of a company’s strategy It tells the story of a company’s strategy by articulating a sequence of cause-and-by articulating a sequence of cause-and-effect relationships.effect relationships.

It assists in communicating the strategy to It assists in communicating the strategy to all members of the organization by all members of the organization by translating the strategy into a coherent translating the strategy into a coherent and linked set of measurable operational and linked set of measurable operational targets.targets.

Pitfalls Pitfalls When Implementing a When Implementing a Balanced ScorecardBalanced ScorecardWhat pitfalls should be avoided when What pitfalls should be avoided when implementing a balanced scorecard?implementing a balanced scorecard?

Don’t assume the cause-and-effect linkages Don’t assume the cause-and-effect linkages to be precise. to be precise.

Don’t seek improvements across all Don’t seek improvements across all measures all the time.measures all the time.

Don’t use only objective measures on the Don’t use only objective measures on the scorecard.scorecard.

Evaluating the Success of a StrategyEvaluating the Success of a Strategy

Assume the following operating incomes: Assume the following operating incomes: Year 1999Year 1999 Year 2000 Year 2000 Revenues: Revenues: (10,00,000 × 26)(10,00,000 × 26) 2,60,00,000 2,60,00,000 (11,00,000 × 24)(11,00,000 × 24)

2,64,00,0002,64,00,000Expenses: Expenses: MaterialsMaterials 40,50,000 40,50,000

36,31,320 36,31,320 OtherOther 1,60,00,0001,60,00,000

1,60,00,0001,60,00,000 Operating incomeOperating income 59,50,000 59,50,000

67,68,68067,68,680

Evaluating the Success of a StrategyEvaluating the Success of a Strategy

How can the increase in operating income How can the increase in operating income of 8,18,680 be evaluated?of 8,18,680 be evaluated?( 67, 68,680 – 59,50,000 )( 67, 68,680 – 59,50,000 )To evaluate the success of its strategy, a To evaluate the success of its strategy, a company can subdivide the change in company can subdivide the change in operating income into three components:operating income into three components:1 GrowthGrowth2 Price recoveryPrice recovery3 ProductivityProductivity

Growth ComponentGrowth Component

The growth component measures the The growth component measures the change in operating income attributable change in operating income attributable solely to an increase in the quantity of solely to an increase in the quantity of output sold.output sold.

Assume that for 1999, ABC produced and Assume that for 1999, ABC produced and sold 10,00,000 devices at 26 per unit.sold 10,00,000 devices at 26 per unit.

During the year 2000, ABC produced and During the year 2000, ABC produced and sold 11,00,000 devices at 24 per unit.sold 11,00,000 devices at 24 per unit.What is the revenue effect of growth?What is the revenue effect of growth?

Growth ComponentGrowth Component

Revenue effect of growth component = Revenue effect of growth component =

(Actual units of output sold in 2000 – (Actual units of output sold in 2000 – Actual units of output sold in 1999) × Actual units of output sold in 1999) × Output price in 1999Output price in 1999

(11,00,000 – 10,00,000) × 26 = (11,00,000 – 10,00,000) × 26 = 26,00,000 26,00,000 FF

This component is favorable because it This component is favorable because it increases operating income.increases operating income.

Cost Effect of GrowthCost Effect of Growth

To produce the higher output sold in 2000, To produce the higher output sold in 2000, more inputs would be needed.more inputs would be needed.

The cost increase from growth measures The cost increase from growth measures the amount by which costs in 2000 would the amount by which costs in 2000 would have increased if the relationship between have increased if the relationship between inputs and outputs that existed in 1999 inputs and outputs that existed in 1999 continued in 2000, and if prices of inputs continued in 2000, and if prices of inputs in 1999 continued in 2000.in 1999 continued in 2000.


Cost effect of growth componentCost effect of growth component=Actual units of input or capacity that would Actual units of input or capacity that would

have been used in 1999 to produce year have been used in 1999 to produce year 2000 output assuming the same input-output 2000 output assuming the same input-output relationship that existed in 1999relationship that existed in 1999less Actual units or capacity to produce 1999 outputless Actual units or capacity to produce 1999 output

x Input prices in 1999Input prices in 1999


To produce 11,00,000 units in 2000 To produce 11,00,000 units in 2000 compared with the 10,00,000 units compared with the 10,00,000 units produced in 1999 (a 10% increase), ABC produced in 1999 (a 10% increase), ABC would require a proportional increase in would require a proportional increase in direct materials.direct materials.

Assume that 30,00,000 square Assume that 30,00,000 square centimeters of materials were used to centimeters of materials were used to produce the 10,00,000 units in 1999 at a produce the 10,00,000 units in 1999 at a cost of 1.35 per square centimeter.cost of 1.35 per square centimeter.


Also, assume that manufacturing Also, assume that manufacturing conversion costs, selling and customer conversion costs, selling and customer service costs and research and service costs and research and development costs were 1,60,00,000 and development costs were 1,60,00,000 and remained stable during 2000.remained stable during 2000.What is the cost effect of the growth What is the cost effect of the growth component?component?30,00,000 × 110% = 33,00,000 30,00,000 × 110% = 33,00,000 centimeterscentimeters(33,00,000 – 30,00,000) × 1.35 = 4,05,000 (33,00,000 – 30,00,000) × 1.35 = 4,05,000 UU

Operating Income and GrowthOperating Income and GrowthWhat is the net increase in operating What is the net increase in operating income as a result of growth?income as a result of growth?

Revenue effect of Revenue effect of growth componentgrowth component 26,00,000 26,00,000 F Cost effect of growth F Cost effect of growth componentcomponent 4,05,000 4,05,000 UU Increase in operating income Increase in operating income due to growth component due to growth component 21,95,000 F21,95,000 F

Price-Recovery ComponentPrice-Recovery Component

The price recovery component of The price recovery component of operating income measures the change in operating income measures the change in revenues and the changes in costs to revenues and the changes in costs to produce the 11,00,000 devices produce the 11,00,000 devices manufactured in 2000 as a result of two manufactured in 2000 as a result of two factors:factors:– Change in price of the deviceChange in price of the device– Change in prices of the inputs required to Change in prices of the inputs required to

make the devicemake the device


Revenue effect of price-recovery Revenue effect of price-recovery component = (Output price in 2000 – component = (Output price in 2000 – Output price in 1999) × Actual units of Output price in 1999) × Actual units of output sold in 2000output sold in 2000What is the revenue effect of the price-What is the revenue effect of the price-recovery component?recovery component?(24 – 26) × 11,00,000 = 22,00,000 U(24 – 26) × 11,00,000 = 22,00,000 UIt is unfavorable because there was a It is unfavorable because there was a decrease in price between 1999 and 2000.decrease in price between 1999 and 2000.


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 1999Assume that in the year 2000 direct materials costs were 1.31 per square centimeter.


Remember, it was assumed that Remember, it was assumed that manufacturing conversion costs, selling, manufacturing conversion costs, selling, and customer service costs and research and customer service costs and research and development costs remained stable and development costs remained stable during 2000.during 2000.

What is the cost effect of the price-What is the cost effect of the price-recovery component?recovery component?

(1.31 – 1.35) × 33,00,000 = 1,32,000 F(1.31 – 1.35) × 33,00,000 = 1,32,000 F

Operating Income and Price-Operating Income and Price-Recovery ComponentRecovery Component

What is the total effect on operating What is the total effect on operating income of the price-recovery component? income of the price-recovery component? Revenue effect of price-recovery Revenue effect of price-recovery component component 22,00,000 U 22,00,000 U Cost effect of price-recovery componentCost effect of price-recovery component

1,32,000 F Decrease in operating income 1,32,000 F Decrease in operating income due to price-due to price-recovery componentrecovery component 20,68,000 U20,68,000 U

Productivity ComponentProductivity Component

The productivity component of operating The productivity component of operating income compares how costs have income compares how costs have decreased as a result of using fewer decreased as a result of using fewer inputs, a better mix of inputs, and less inputs, a better mix of inputs, and less capacity to produce year 2000 output, capacity to produce year 2000 output, assuming year 2000 input prices.assuming year 2000 input prices.


Productivity component Productivity component = Actual units of inputs or capacity to Actual units of inputs or capacity to

produce year 2000 outputproduce year 2000 output– Actual units of inputs or capacity that Actual units of inputs or capacity that

would have been used to produce year would have been used to produce year 2000 output assuming the same input-2000 output assuming the same input-output relationship that existed in 1999output relationship that existed in 1999

x Input prices in 2000Input prices in 2000


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.


What is the productivity component of cost What is the productivity component of cost changes?changes?

(27,72,000 – 33,00,000) × 1.31 = 691,680 (27,72,000 – 33,00,000) × 1.31 = 691,680 FF

There is a 691,680 increase in operating There is a 691,680 increase in operating income due to the productivity income due to the productivity component.component.

Change in Operating IncomeChange in Operating Income

Increase in operating incomeIncrease in operating income8,18,680 8,18,680

Increase in operating incomeIncrease in operating income8,18,680 8,18,680

GrowthGrowthcomponentcomponent21,95,000 F21,95,000 F

GrowthGrowthcomponentcomponent21,95,000 F21,95,000 F

Price-recoveryPrice-recoverycomponentcomponent

20,68,000 U20,68,000 U

Price-recoveryPrice-recoverycomponentcomponent

20,68,000 U20,68,000 U

ProductivityProductivitycomponentcomponent 6,91,680 F6,91,680 F

ProductivityProductivitycomponentcomponent 6,91,680 F6,91,680 F

Engineered and Discretionary CostsEngineered and Discretionary Costs

Fixed costs are tied to capacity.Fixed costs are tied to capacity.

Fixed costs do not change automatically Fixed costs do not change automatically with changes in the level of the cost with changes in the level of the cost driver.driver.

How to reduce capacity-based fixed costs?How to reduce capacity-based fixed costs?

The key is understanding and managing The key is understanding and managing unused capacity.unused capacity.

Engineered CostsEngineered Costs

Engineered costs result specifically from a Engineered costs result specifically from a clear cause-and effect relationship clear cause-and effect relationship between output and the resources needed between output and the resources needed to produce that output.to produce that output.

Engineered costs can be variable or fixed Engineered costs can be variable or fixed in the short run.in the short run.

Selling and customer-service costs are Selling and customer-service costs are engineered costs that are fixed in the engineered costs that are fixed in the short run.short run.

Discretionary CostsDiscretionary Costs

Two important features of discretionary Two important features of discretionary costs:costs:

Discretionary costs arise from periodic Discretionary costs arise from periodic (usually yearly) decisions regarding the (usually yearly) decisions regarding the maximum amount to be incurred.maximum amount to be incurred.

Discretionary costs have no clearly Discretionary costs have no clearly measurable cause-and effect relationship measurable cause-and effect relationship between output and resources used.between output and resources used.

Discretionary Costs

Discretionary costs include:Discretionary costs include:– AdvertisingAdvertising– Executive trainingExecutive training– Research and developmentResearch and development– Health careHealth care– Legal resourcesLegal resources– Public relationsPublic relations

Relationships between Inputs and Relationships between Inputs and OutputsOutputs

Engineered costs differ from discretionary Engineered costs differ from discretionary costs along two key dimensions:costs along two key dimensions:1 Type of processType of process2 Level of uncertaintyLevel of uncertainty


Engineered costs pertain to processes that Engineered costs pertain to processes that are detailed, physically observable, and are detailed, physically observable, and repetitive.repetitive.

Discretionary costs are associated with Discretionary costs are associated with processes that are sometimes called processes that are sometimes called black black boxesboxes, , because they are less precise and because they are less precise and not well understood.not well understood.


Uncertainty refers to the possibility that an Uncertainty refers to the possibility that an actual amount will deviate from an actual amount will deviate from an expected amount.expected amount.

The higher the level of uncertainty about The higher the level of uncertainty about the relationship between resources used the relationship between resources used and outputs, the less likely a cause-and-and outputs, the less likely a cause-and-effect relationship will exist.effect relationship will exist.

Identifying Unused CapacityIdentifying Unused Capacity

Identifying unused capacity is easier for Identifying unused capacity is easier for engineered costs than for discretionary engineered costs than for discretionary costs.costs.

The absence of a cause-and-effect The absence of a cause-and-effect relationship makes identifying unused relationship makes identifying unused capacity for discretionary costs much capacity for discretionary costs much more difficult.more difficult.