UNIVERSITY OF RWANDA

COLLEGE OF BUSINESS AND ECONOMICS

SCHOOL OF BUSINESS —DEPARTMENT OF MANAGEMENT
BSc Accounting, Year 3, Ac. Year 2022/2023

STRATEGIC MANAGEMENT
ACCOUNTING
Facilitator Mr. Idrissa NDIZEYE

JULY 2022

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 Table of contents

Chapter I: NATURE, MEANING AND SCOPE OF STRATEGIC MANAGEMENT

ACCOUNTING 1
1.1. AN OVERVIEW OF MANAGEMENT ACCOUNTING....................................................1
1.1.1. What is management accounting?......................................................................................1
1.1.2. Value creation as primary purpose of management accounting.........................................1
1.1.3. Evolution and changes in management accounting focus and practices............................2
1.2. ORIGIN OF STRATEGIC MANAGEMENT ACCOUNTING...........................................3
1.2.1. Impact of the changing business environment on management accounting.......................3
1.2.2. Criticisms of traditional management accounting techniques............................................7
1.2.3. The search for the new management techniques to cope with the changes........................8
1.2.4. Responses to the changing business environment: birth of SMA......................................8
1.3. MEANING AND SCOPE OF STRATEGIC MANAGEMENT ACCOUNTING...............9
1.3.1. Definition of strategic management accounting.................................................................9
1.3.2. Scope of strategic management accounting......................................................................11
1.4. STRATEGIC MANAGEMENT ACCOUNTING TECHNIQUES AND PRACTICES....12
1.4.1. Strategic management accounting techniques..................................................................12
1.4.2. Application of strategic management accounting.............................................................12
Chapter II: STRATEGIC MANAGEMENT ACCOUNTING AND BUSINESS
STRATEGY 16
2.1. NEED FOR SMA IN THE STRATEGIC MANAGEMENT PROCESS...........................16
2.1.1. Introduction to strategic management...............................................................................16
2.1.2. Mission, vision, and objectives.........................................................................................17
2.1.3. Corporate appraisal...........................................................................................................17
2.1.4. Strategy development and implementation.......................................................................19
2.1.5. Approaches to strategy implementation...........................................................................20
2.1.6. Freewheeling opportunism...............................................................................................21
2.2. THE ROLE OF SMA IN THE ACHIEVEMENT OF BUSINESS STRATEGY...............21
2.2.1. Strategies for competitive advantage................................................................................21
2.2.2. The role of strategic management accounting in achieving business strategy.................25
Chapter III: STRATEGIC COSTING AND PRICING FOR COMPETITIVE
ADVANTAGE 28
3.1. INTRODUCTION...............................................................................................................28
3.1.1. Characteristics of costing and pricing in the traditional way............................................28
3.1.2. Characteristics of costing and pricing in the new environment........................................28
3.1.3. Customer satisfaction as a top priority in the new environment.......................................29
3.2. STRATEGIC PRODUCT COSTING FOR COMPETITIVE ADVANTAGE...................31
3.2.1. Activity-based costing......................................................................................................31
3.2.2. Target costing...................................................................................................................36
3.2.3. Kaizen costing...................................................................................................................39
3.2.4. Life-cycle costing.............................................................................................................42
3.3. STRATEGIC COST MANAGEMENT FOR COMPETITIVE ADVANTAGE................46
3.3.1. Introduction to cost management system..........................................................................46

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3.3.2. Strategic cost management...............................................................................................49
3.3.3. Total quality management (TQM)....................................................................................52
3.3.4. Activity-based management (ABM).................................................................................55
3.3.5. Just-in-time (JIT) manufacturing......................................................................................57
3.3.6. Lean production and learning accounting.........................................................................59
3.3.7. Theory of constraints and throughput accounting............................................................61
3.3.8. Business process re-engineering and continuous improvement.......................................63
3.3.9. Benchmarking...................................................................................................................66
3.3.10. Contingency theory.........................................................................................................68
3.4. STRATEGIC PRODUCT PRICING FOR COMPETITIVE ADVANTAGE....................68
3.4.1. Basic pricing concepts......................................................................................................68
3.4.2. Pricing goal and influencing factors.................................................................................69
3.4.3. Approaches to base price setting (3Cs).............................................................................71
3.4.4. Pricing strategies...............................................................................................................82
3.4.5. Initiating and driving the price changes............................................................................86
REFERENCES 90
EXERCISES 91

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 Chapter I: NATURE, MEANING AND SCOPE OF STRATEGIC MANAGEMENT
ACCOUNTING
1.1. AN OVERVIEW OF MANAGEMENT ACCOUNTING
1.1.1. What is management accounting?
Accounting is the process of identifying, measuring, recording, classifying, summarising and
communicating financial information about an entity to permit informed judgements and
decisions by users of the information.
Many would argue that those who manage an organisation on a day-to-day basis are the
foremost users of accounting information about that organisation. The description management
is a collective term for all those persons who have responsibilities for making judgements and
decisions within an organisation. Because they have close involvement with the business, they
have access to a wide range of information (much of which may be confidential within the
organisation) and will seek those aspects of the information which are most relevant to their
particular judgements and decisions. Management accounting is a specialist branch of
accounting which has developed to serve the particular needs of management. The managers of
a business carry out functions of planning, decision making and control. Management
accounting supports these management functions by directing attention, keeping the score and
solving problems.

All forms of accounting, including management accounting, are concerned with collecting and
analysing financial information and then communicating this information to those making
decisions. For accounting information to be useful for decision making, the accountant must be
clear about for whom the information is being prepared and for what purpose it will be used. In
practice there are various groups of people (known as ‘user groups’) with an interest in a
particular organisation, in the sense of needing to make decisions about that organisation.

Managers are responsible for running the business, and their decisions and actions play an
important role in determining its success. Planning for the future and exercising day-to-day
control over a business involves a wide range of decisions being made. For example, managers
may need information to help them decide whether to:
 develop new products or services;
 increase or decrease the price or quantity of existing products or services;
 borrow money to help finance the business;
 increase or decrease the operating capacity of the business ;
 change the methods of purchasing, production or distribution.
As management decisions are broad in scope, the accounting information provided to managers
must also be wide-ranging. Accounting information should help in identifying and assessing
the financial consequences of decisions such as those listed above.

1.1.2. Value creation as primary purpose of management accounting

Value creation is a central focus for contemporary managers and can refer to both customer
value and shareholder value. The customer value is the value that a customer places on the
particular features of a product and shareholder value is the value that shareholders (owners)
place on a business.

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Customers have always been a key concern for organisations. However, it is only in recent
years that managers have come to recognise explicitly that understanding customer value and
satisfying customers is critical to achieving increased sales and market share, and therefore to
achieving shareholder value.

Shareholder value is also a key focus for managers and involves improving the worth of the
business from shareholders’ perspective. So what is important to shareholders? Shareholders
are usually interested in increased profitability, increased share price, and dividends, and
management is charged with the responsibility of delivering this. However, increasing
customer value comes at a cost and, at times, managers may need to make trade-offs between
undertaking actions that increase customer value, and actions that increase shareholder value.
To enhance the customer value or shareholder value, managers need to understand what drives
value. That is, they need to understand and make decisions about the activities or aspects of
their business that lead to improvements in customer value or shareholder value.

The effective and efficient use of the resources is essential to value creation and management
accounting provides information to assist managers to perform this role. Effectiveness focuses
managers on successful achievement of an objective, whereas efficiency focuses managers on
achieving the objective with the least possible consumption of resources.
Resources include not only the financial resources of the organisation, but also non-financial
resources such as information, work processes, employees, committed customers and suppliers.
Non-financial resources determine the capabilities and competencies of an organisation, which
allow it to survive and prosper in an increasingly turbulent global environment.

1.1.3. Evolution and changes in management accounting focus and practices

The origins of today’s management accounting can be traced back to the Industrial Revolution
of the nineteenth century. Prior to the 1950s, the focus was on cost accounting, primarily for
inventory valuation, and financial control, and the emphasis was on management accountant as
a scorekeeper for management. Cost accounting, rather than management accounting, was the
name given to this area of accounting. According to Johnson and Kaplan (1987), most of the
management accounting practices that were in use in the mid-1980s had been developed by
1925, and for the next 60 years there was a slow-down, or even a halt, in management
accounting innovation. They argued that this stagnation could be attributed mainly to the
demand for product cost information for external financial accounting reports.

Between 1950 and 1965, the term management accounting began to be used, and referred to
the provision of information to management for planning and control. The separation of the
ownership and management of organizations created a need for the owners of a business to
monitor the effective stewardship of their investment. This need has led to the development of
financial accounting, generating a published report for investors and creditors summarising
financial position of company. Statutory obligations were established requiring companies to
publish audited annual financial statements in conformity with a set of rules known as GAAP,
which were developed by regulators.
The preparation of published external financial accounting statements required that costs be
allocated between cost of goods sold and inventories. Cost accounting emerged to meet this
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requirement. Simple procedures were established to allocate costs to products that were
objective and verifiable for financial accounting purposes. Such costs, however, were not
sufficiently accurate for decision-making purposes and for distinguishing between profitable
and unprofitable products and services. Johnson and Kaplan argued that the product costs
derived for financial accounting purposes were also being used for management accounting
purposes. They concluded that managers did not have to yield the design of management
accounting systems to financial accountants and auditors.

Separate systems could have been maintained for managerial and financial accounting
purposes, but the high cost of information collection meant that the costs of maintaining two
systems exceeded the additional benefits. Thus, companies relied primarily on the same
information as that used for external financial reporting to manage their internal operations.
Johnson and Kaplan claimed that, over the years, organizations had become fixated on the cost
systems of the 1920s. Furthermore, when the information systems were automated in the
1960s, the system designers merely automated the manual systems that were developed in the
1920s.
From the mid-1980s, the focus of management accounting moved to waste reduction, and new
techniques involving process analysis and cost management were added to the existing range
of management accounting techniques. Johnson and Kaplan concluded that the lack of
management accounting innovation over the decades, and the failure to respond to its changing
environment, resulted in a situation in the mid-1980s where firms were using management
accounting systems that were obsolete and no longer relevant to the changing competitive and
manufacturing environment
From the mid-1990s, the focus of management accounting started to shift towards the broader
techniques of resource management, and focused on the creation of customer value and
shareholder value through the effective use of resources. In the 21st century management
accounting has not abandoned the concepts of cost accounting and financial control, nor the
provision of information for planning and control. These objectives now form part of the
broader function of resource management. Management accounting still involves many of the
techniques that were developed in past decades, such as budgets and basic product costing
principles, but these are now supplemented by modern technologies that better assist managers
in value creation.

1.2. ORIGIN OF STRATEGIC management accounting

1.2.1. Impact of the changing business environment on management accounting
The global competition, deregulation, growth in the service industries, declines in product life
cycles, advances in manufacturing and information technologies, environmental issues and a
competitive environment requiring companies to become more customer driven, have changed
the nature of the business environment. These changes have significantly altered the ways in
which firms operate, which in turn, have resulted in changes in management accounting
practices since the 1980-1990s decade.

1.2.1.1. Global competition

The last few decades have brought turbulences in the business environment. The reductions in
tariffs and duties on imports and exports, and dramatic improvements in transportation and
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communication systems, have resulted in many firms operating in a global market. Prior to
this, many organisations operated in a protected competitive environment.
Barriers of communication and geographical distance, and sometimes protected markets,
limited the ability of overseas companies to compete in domestic markets. There was little
incentive for firms to maximise efficiency and improve management practices, or to minimize
costs, as cost increases could often be passed on to customers. During the 1990s, however,
organizations began to encounter severe competition from overseas competitors that offered
high-quality products at low prices.
Manufacturing companies can now establish global networks for acquiring raw materials and
distributing goods overseas, and service organisations can communicate with overseas offices
instantaneously using video conferencing technologies.
These changes have enabled competitors to gain access to domestic markets throughout the
world. Nowadays, organizations have to compete against the best companies in the world. This
new competitive environment has increased the demand for cost information relating to cost
management and profitability analysis by product lines and geographical locations.

1.2.1.2. Growth in the service industry

In many countries, the service sector exceeds 50 per cent of GDP. For example, in 2010 the
service sector in the UK and USA was approximately 75% of GDP. Before the 1990s many
service organizations, such as those operating in the airlines, utilities and financial service
industries, were either government owned monopolies or operated in a highly regulated,
protected and non-competitive environment. These organizations were not subject to any great
pressure to improve the quality and efficiency of their operations or to improve profitability by
eliminating services or products that were making losses. Prices were set to cover operating
costs and provide a predetermined return on capital. Hence, cost increases could often be
absorbed by increasing the prices of the services. Little attention was therefore given to
developing cost systems that accurately measured the costs and profitability of individual
services.

Privatisation of government-controlled companies and deregulation have completely changed

the competitive environment in which service companies operate. Pricing and competitive
restrictions have been virtually eliminated. Deregulation, intensive competition and an
expanding product range create the need for service organizations to focus on cost management
and develop management accounting information systems that enable them to understand their
cost base and determine the sources of profitability for their products, customers and markets.
One of the major features of the business environment in recent decades has been the growth in
the service sector and the growth of management accounting within service organizations.

1.2.1.3. Changing product life cycles

A product’s life cycle is a period of time from initial expenditure on research and development
to the time at which support to customers is withdrawn. Intensive global competition and
technological innovation, combined with increasingly discriminating and sophisticated
customer demands, have resulted in a dramatic decline in product life cycles. This means that
organisations have to work harder to develop new products and services and have less
opportunity to recoup costs and generate profit before the decline of the product or service.
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Therefore, to be successful companies must now speed up the rate at which they introduce new
products to the market. Being later to the market than the competitors can have a dramatic
effect on product profitability.
In many industries a large fraction of a product’s life cycle costs are determined by decisions
made early in its life cycle. This has created a need for management accounting to place greater
emphasis on providing information at the design stage because many of the costs are
committed or locked in at this time. Therefore, to compete successfully, companies must be
able to manage their costs effectively at the design stage, have the capability to adapt to new,
different and changing customer requirements and reduce the time to market of new and
modified products.

1.2.1.4. Advances in manufacturing technologies

Excellence in manufacturing can provide a competitive weapon to compete in sophisticated
worldwide markets. In order to compete effectively, companies must be capable of
manufacturing innovative products of high quality at a low cost, and also provide a first-class
customer service. At the same time, they must have the flexibility to cope with short product
life cycles, demands for greater product variety from more discriminating customers and
increasing international competition.
World-class manufacturing companies have responded to these competitive demands by
replacing traditional production systems with lean manufacturing systems that seek to reduce
waste by implementing just-in-time (JIT) production systems, focusing on quality, simplifying
processes and investing in advanced manufacturing technologies (AMTs). The major features
of these new systems and their implications for management accounting will be described in
chapter 3.

1.2.1.5. Environmental issues

Customers are no longer satisfied if companies simply comply with the legal requirements of
undertaking their activities. They expect company managers to be more proactive in terms of
their social responsibility, safety and environmental issues. The environmental management
accounting is becoming increasingly important in many organizations.
There are several reasons for this.
 First, environmental costs can be large for some industrial sectors.
 Second, regulatory requirements involving huge fines for non-compliance have increased
significantly. Therefore, selecting the least costly method of compliance has become a
major objective.
 Third, society is demanding that companies focus on being more environmentally friendly.
Companies are finding that becoming a good social citizen and being environmentally
responsible improves their image and enhances their ability to sell their products and
services.
These developments have created the need for companies to develop systems of measuring and
reporting environmental costs, the consumption of scarce environmental resources and details
of hazardous materials used or pollutants emitted to the environment. Knowledge of
environmental costs, and their causes, provides the information that managers need to redesign
processes to minimize the usage of scarce environmental resources and the emission pollutants
and to also make more sensitive environmental decisions.
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1.2.1.6. The impact of information technology
Since the use of information technology (IT) to support business activities has increased
dramatically and the development of electronic business communication technologies known
as e-business, e-commerce or internet commerce have had a major impact. For example,
consumers are more discerning in their purchases because they can access the internet to
compare the relative merits of different products. Internet trading also allows buyers and sellers
to undertake transactions from diverse locations in different parts of the world.

E-commerce (such as bar coding) has allowed considerable cost savings to be made by
streamlining business processes and has generated extra revenues from the adept use of online
sales facilities (such as ticketless airline bookings and internet banking). The proficient use of
e-commerce has given many companies a competitive advantage. One advanced IT application
that has had a considerable impact on business information systems is enterprise resource
planning systems (ERPS). An ERPS comprises a set of integrated software applications
modules that aim to control all information flows within a company. Users can use their
personal computers (PCs) to access the organization’s database and follow developments
almost as they happen. Using real time data enables managers to analyse information quickly
and thus continually improve the efficiencies of processes. A major feature of ERPS systems is
that all data are entered only once, typically where they originate.

The introduction of ERPS has the potential to have a significant impact on the work of
management accountants. In particular, it substantially reduces routine information gathering
and the processing of information. Instead of managers asking management accountants for
information, they can access the system to derive the information they require directly and do
their own analyzes. This has freed accountants to adopt the role of advisers and internal
consultants to the business. Management accountants have now become more involved in
interpreting the information generated from the ERPS and providing business support for
managers.

1.2.1.7. Customer orientation

The improvement in technology has given more information to the customer allowing the
customer to make better informed decisions about which products and services they wish to
buy and also to allow the customer to be more proactive in selecting products and services
which are tailored specifically for them. In particular, the empowerment of the customers has
resulted in three key challenges for businesses:
1) Prices are being forced down because customers are able to find a much wider source
of alternatives.
2) Quality is being forced up as businesses compete to attract the customer
3) Greater variety in the product/service offering is necessary to attract the customer.
The above developments have forced organisations to consider their position in their markets,
their prices and their costs in a different way than they had done in the past.
In order to survive in today’s competitive environment companies have had to become more
customer driven and to recognize that customers are crucial to their future success. This has
resulted in companies making customer satisfaction an overriding priority and to focus on
identifying and achieving the key success factors that are necessary to be successful in today’s
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competitive environment. These key success factors that focus on customer satisfaction and
new management approaches are discussed in chapter 3 Costing and pricing for competitive
advantage.

1.2.2. Criticisms of traditional management accounting techniques

During the late 1980s, the criticisms of management accounting practices in place were widely
publicised in the professional and academic accounting literature. A typical example is the
Johnson and Kaplan’s book (1987) whose title was Relevance Lost: The Rise and Fall of
Management Accounting, was published. An enormous amount of publicity was generated by
this book as a result of the authors’ criticisms of management accounting. Many other
commentators also concluded that management accounting was in crisis and that fundamental
changes in practice were required. They began to recognise that management accounting was
not adapting to changes in the modern business environment and as such was not fulfilling its
function to aid managers (Johnson and Kaplan, 1987; Bromwich and Bhimani, 1989, 1996).

The principal criticisms are as follows:

1. Conventional management accounting techniques do not meet the needs of today’s
manufacturing and competitive environment.
2. Traditional product costing systems provide misleading information for decision-making
purposes.
3. Management accounting practices follow, and have become subservient to, financial
accounting requirements.
4. Management accounting focuses almost entirely on internal activities, and relatively little
attention is given to the external environment in which the business operates.

Examples of the areas where traditional management accounting techniques were found
to be less than adequate to cope with the changing business environment:
 Absorption of overheads. The traditional product costing tends to be absorption costing,
absorbing the overheads on a labour hour basis. In a modern environment, an ABC is more
appropriate.
 Process costing. The traditional approach to cost accounting in a manufacturing business
involves accounting for costs process by process as raw materials are transformed into
finished goods. In the modern environment with just-in-time systems there is very little
work-in-progress and the conventional process costing approach involves a great deal of
work but again little. A back flush costing approach would be more appropriate.
 Designing costs of production. The focus of traditional management accounting tends to
be on reduced costs at the production stage, whereas most costs tends to be determined at
the design stage.
 Focusing on production costs. Many costs are driven by customers (such as delivery costs
and discounts), but traditional management accounting tends to focus on production costs.
It may not therefore be realised that the company is trading with some customers at a loss.
A customer profitability analysis (CPA) approach would be more appropriate.
 Variance analysis. Traditional variance analysis tends to focus on the direct costs rather
than on overheads which are more controllable than direct costs.

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1.2.3. The search for the new management techniques to cope with the changes
Since the mid-1980s management accounting practitioners and academics have sought to
modify and implement new techniques that are relevant to the ever-changing environment
which will ensure that management accounting regains its relevance. According to Johnson and
Kaplan (1987), the term strategic management accounting was introduced into academic
literature before the “crisis in management accounting” which converted strategic management
accounting into more than merely a desperate attempt to regain “lost relevance”.

By the mid-1990s Kaplan (1994a) stated that:

‘The past 10 years have seen a revolution in management accounting theory and practice. The seeds of the
revolution can be seen in publications in the early to mid-1980s that identified the failings and obsolescence of
existing cost and performance measurement systems. Since that time we have seen remarkable innovations in
management accounting; even more remarkable has been the speed with which the new concepts have become
widely known, accepted and implemented in practice and integrated into a large number of educational
programmes.’

Traditionally management accounting has been characterised as providing information to aid

managers internally in a firm and as such the focus of the management accounting systems has
also tended to be internally oriented. However, successful management of a business depends
on having a successful business strategy. It has been argued that if the business strategy gives
the organisation its competitive edge, then the management accounting should reflect that
strategy as closely as possible. The traditional emphasis on costs and revenues may not achieve
this aim. What really matters is the influence of the external environment.

In a bid to improve the quality of management accounting information for managers it was
necessary to focus more widely on the external environment of the firm and thus the concept of
strategic management accounting evolved. Strategic management accounting has been
advocated as a potential area of development that would enhance the future contribution of
management accounting by focusing on factors outside the organisation but which have a
significant effect on its success.

1.2.4. Responses to the changing business environment: birth of SMA

The business community acknowledged that the activities of their competitors should influence
the formulation of their corporate strategy. They remembered that they did not operate in a
vacuum and once more became aware of the importance of their environment; businesses can
be fundamentally affected by the actions of their competitors.
To cope with the changes in business environment described above, many firms realised
the need to improve the product or service quality, delivery responsiveness, cost
performance, and ultimately market share and profits. This has led to organisations
adopting some of the new management structures, as summarised below:
Changes in the business Organisational responses: Management accounting
environment structures, systems and responses (scope widened)
practices
–Increased global – Flatter organisational structures – ABC systems
competitiveness – Employee empowerment – ABB systems
–Deregulation of the – Team-based structures – Measures of shareholder value
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 service sector —banks, – Computerised production – Performance measurement
communications, systems systems such as balanced
utilities – ERP systems scorecards, and benchmarking
–Privatisation/ – e-commerce technologies – Cost management systems:
commercialisation of – Real-time reporting systems ABM, BPR, managing
public service providers – Supply chain management throughput, life cycle
–Reduced tariffs on – Increased focus on key sources management and target costing
imports of customer value, such as – Time management
–Growth of the service quality, delivery and innovation – Customer profitability analysis
sector – Increased focus on continuous – Supplier cost analysis
improvement – Information to support
– Environmental management environmental and social
systems responsibility

When management accounting first developed, it was concerned with technical matters such as
labour and product costs, progressing to capital investment appraisal. Following on from this, it
has embraced the effects of human behaviour on management accounting practices. In addition
to its technical and behavioural aspects, it has also developed a strategic perspective, SMA.
Now (strategic) management accounting involves the provision of information, which is
externally oriented, market-driven and customer-focused and provides managers with a range
of techniques and tools to facilitate strategically-oriented decision making.

1.3. MEANING AND SCOPE OF STRATEGIC MANAGEMENT ACCOUNTING

1.3.1. Definition of strategic management accounting
In view of the fact that strategic management accounting is still a fairly new topic there is no
generally agreed set of concepts and techniques that can help us define precisely what is meant
by this term. However, some key features of this new topic can be identified, and new
accounting techniques, which are seen as useful for strategic decision-making have emerged.

Simmonds (1981,1982), who first coined the term strategic management accounting, viewed it
as the provision and analysis of management accounting data about the business and its
competitors which is of use in the development and monitoring of strategy of that business. He
demonstrated that basic management accounting tools can be used to develop and monitor
business strategy. In his opinion, management accounting is able to expand its horizon and
provide the precision needed to evaluate strategic options. Although his work does not provide
a clearly defined theoretical framework, he does show how management accounting can be
used to benefit an organization’s competitive position by going beyond traditional marketing
functions. He views profits as emerging not from internal efficiencies but from the firm’s
competitive partitioning in its markets.
Bromwich (1990), a principal advocate of SMA, has attempted to develop SMA to consider the
benefits, which products offer to customers, and how these contribute to sustainable
competitive advantage. Bromwich sought to compare the relative cost of products attributes or
characteristics with what the customer is willing to pay for them. Products are seen to as
comprising of a package of attributes which they offer to customers. It is these attributes that
actually constitutes commodities, and, which appeal to customers so that they buy the product.
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The attributed might include a range of quality elements such as:
(1) operating performance variables;
(2) reliability and warranty arrangements;
(3) physical features;
(4) service factors such as after-sale service and assurance of supply.
He finally provided the following definition: SMA is the provision and analysis of financial
information on the firm’s product markets and competitors’ costs and cost structures and the
monitoring of the enterprise’s strategies and those of its competitors in these markets over a
number of periods.

Building on Porter’s value chain work, Shank and Govindarajan (1988, 1992); contributed
their more tangible concept of strategic cost management. By using activity-based costing,
these authors analyse the value chain for strategic cost drivers. In 1995, Roslender has
identified target costing as falling within the domain of SMA. The justification for this is the
external focus and that it is a market driven approach to product pricing and cost management.

Lord (1996) argued that although elements of strategic management accounting are already
evident in corporate practice, the information may not have been quantified in accounting
terms or perhaps was not gathered and analyzed by management accountants. Instead, the
collection and use of information is part of the operational management of that particular
organization. Because of the lack of consensus on what constitutes strategic management
accounting,
Lord reviewed the literature and identified several strands that have been used to characterise
SMA. They include:
(1) Collection of competitor information––extensions of traditional management accounting’s
internal focus to include external information about competitors;
(2) Matching of accounting emphasis with strategic position–– the relationship between the
strategic position chosen by a firm and the expected emphasis on management accounting;
(3) Exploitation of cost reduction opportunities–– gaining the competitive advantage by
analysing ways to decrease costs and/or enhance the differentiation of a firm’s products,
through exploiting linkages in the value chain and optimising cost drivers.

Innes (1998) defines SMA as the provision of information to support the strategic decisions in
organisation. Strategic decisions usually involve long-term, have a significant effect on the
organisation, and although they may have an internal element, they also have an eternal
element. Adopting this definition suggests that the provision of information that supports an
organisation’s major long-term decisions, such as the use of ABC information for product
profitability analysis, falls within the domain of strategic management accounting.
Bhimani and Keshtvarz’s (1999) study shows that organizations do not view themselves as
engaging in strategic management accounting. They find that management accountants desire a
greater involvement in strategic planning activities, rather than just providing information.

The contribution of Roslender (1995); Roslender and Hart (2002, 2003) return to the quest for
a generic framework, which after almost 30 years of academic discourse, is still to be
developed. Like Simmonds, they also treat strategic management accounting as “a generic
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approach to strategic positioning”. By using the term ‘accounting for strategic positioning’,
they stress the interdependencies of marketing and management accounting in this field, and
elaborate on the interdisciplinary interfaces and synergies of combining both disciplines so as
to optimize accounting for competitive positioning.

Hoque (2003) described SMA as ‘a process of identifying, gathering, choosing and analysing
accounting data for helping the management team to make strategic decisions and to assess
organisational effectiveness’. The same description as the one provided by Hoque is given by
the ACCA in its P5 Advanced Performance Management (2015): SMA refers to the ‘full range
of management accounting practices used to provide a guide to the strategic direction of an
organisation’.

Despite the lack of an accepted framework and the multifaceted nature of SMA, we think that
the definition provided in chartered institute of management accountants official terminology
(2005) covers the domain of SMA. ‘SMA is a form of management accounting in which
emphasis is placed on information which relates to factors external to the firm, as well as
non-financial information and internally generated information”.

1.3.2. Scope of strategic management accounting

We saw that one of the elements of strategic management accounting involves the provision of
information for the formulation of an organisation’s strategy and managing strategy
implementation. In many instances, SMA may involve new applications of existing approaches
rather than new techniques. For example, SMA that attempts to measure competitors’ or
suppliers’ costs may well use the same sort of techniques that you have learnt in management
or cost accounting. Yet the context of the cost analysis will be different because strategic
management seeks to establish relative market positions and relative costs. Indeed, an
awareness of competitive conditions is the main distinguishing feature of strategic management
accounting compared with more traditional management accounting.
Key differences between traditional and strategic approach to management accounting
Scope Traditional approach Strategic approach
Reporting – Whole organisation – Strategic business unit
unit
Focus – Internal and Financial focus – External and Value focus
Pricing and – Products – Products, customers and markets
Profitability – Profit motives short-term – Profit motive longer-term
analysis – Pricing short-term cost orientated – Pricing market driven and strategic
Approach to – Ex-post cost control via – Ex-ante cost control based on targeted,
cost analysis department/ product costing future, life-long costing set to attain a
systems required profit level at market set price.
– Period based manufacturing costs – Process/activity costing based on
and monthly departmental analysis of multiple cost drivers studied
budgets. Volume the principal cost in a specific context
driver – Cost analysis embraces supplier firms in
– Cost analysis set within value chain
organisational boundary
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 – Cost control orientation – Customer value orientation
Performance – Performance measurement – Multidimensional performance
Appraisal financial measurement and benchmarking
Investment – Financial evaluation with strict – Strategic analysis using multiple models
appraisal criteria to promote decisions based on
judgement
Ownership – Stand alone under control of the – Part of a wider MIS with team
and accountant ownership of strategic review process
accounting – Accounting and operational – ERP and accounting systems integration
information information separate

We are now in a position to separate the coverage of traditional management accounting and
that of strategic management accounting. SMA is concerned with providing information to
support the organisation’s strategic plans and decisions for value creation; it is more outwards
looking, more concerned with outperforming competition and more concerned with monitoring
progress towards strategic objectives than traditional management accounting, which mainly
focuses on the internal and quantitative information for operational management.

1.4. STRATEGIC MANAGEMENT ACCOUNTING TECHNIQUES AND PRACTICES

1.4.1. Strategic management accounting techniques
For the purpose of this module, the techniques used by managers to align the management
accounting information with the strategic direction of organisation are discussed as follows:
 Strategic costing and pricing for competitive advantage (Target costing, ABC, Kaizen
costing, Total life-cycle costing, New product pricing strategies, Product mix pricing
strategies, Price adjustment strategies, Initiating price changes, Customer’s reaction to price
changes, Competitor’s reaction to price changes, Responding to competitor’s price
changes)
 Strategic positioning analysis (Environmental analysis using SWOT and PESTEL, Cost
driver analysis, Value chain costs analysis, Product profitability analysis, Competitor
analysis, Customer profitability analysis)
 Strategic performance measurement (financial, Non-financial, and mixed: concept of
shareholder value maximization, Financial ratios, NPV, IRR, MIRR (Modified Internal
Rate of Return), Profitability index, transfer pricing and Divisional performance measures,
Economic Value Added (EVA), Share Value Analysis (SVA), Market Value Analysis
(MVA), Balanced scorecard.

1.4.2. Application of strategic management accounting

1.4.2.1. Surveys of strategic management accounting practices
Many organisations formally or informally combine their strategic concerns and priorities with
management accounting information in controlling their operational activities and engaging in
longer-term decision-making.
Little research has been undertaken on the extent to which companies use SMA practices. A
notable exception is a survey undertaken by Guilding, Craven and Tayles (2000). The survey
consisted of a sample of 314 large companies comprising 63 from the UK, 127 from the USA

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and 124 from New Zealand.
Guilding, Craven and Tayles acknowledge the difficulty in identifying what are generally
accepted as constituting strategic management accounting practices. Based on a review of the
literature they identified 12 strategic management accounting practices.
The criteria that they used for identifying the practices were that they must exhibit one or more
of the following characteristics: environmental or marketing orientation; focus on competitors;
and long-term, forward-looking orientation. The average usage of the identified practices and
their perceived merits are reported below (ranked according to their frequency use):
1. Competitive position monitoring
2. Strategic pricing
3. Competitor performance appraisal based on published financial statements
4. Competitor cost assessment
5. Strategic costing
6. Quality costing
7. Target costing
8. Value chain costing
9. Brand value monitoring
10. Life cycle costing
11. Attribute costing
12. Brand value budgeting
The definitions of some terms given to the respondents participating in the survey are:
 Competitive position monitoring. The analysis of competitor positions within the industry
by assessing and monitoring trends in competitor sales, market share, volume, unit costs
and return on sales. This information can provide a basis for the assessment of a
competitor’s market strategy.
 Strategic pricing. The analysis of strategic factors in the pricing decision process. These
factors may include: competitor price reaction; price elasticity; market growth; economies
of scale and experience.
 Competitor performance appraisal based on published financial statements. The
numerical analysis of a competitor’s published statements as part of an assessment of the
competitor’s key sources of competitive advantage.
 Competitor cost assessment. The provision of regularly updated estimates of a
competitor’s costs based on, for example, appraisal of facilities, technology, economies of
scale. Sources include direct observation, mutual suppliers, mutual customers and ex-
employees.
 Strategic costing. The use of cost data based on strategic and marketing information to
develop and identify superior strategies that will sustain a competitive advantage.
 Value-chain costing. An activity-based costing approach where costs are allocated to
activities required to design, procure, produce, market, distribute and service a product or
service.
 Brand value monitoring. The financial valuation of a brand through the assessment of
brand strength factors such as: leadership; stability; market; internationality; trend; support;
and protection combined with historical brand profits.

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 Attribute costing The costing of specific product attributes that appeal to customers.
Attributes that may be costed include: operating performance variables; reliability;
warranty arrangements; the degree of finish and trim; assurance of supply and after sales
service.
 Brand value budgeting The use of brand value as a basis for managerial decisions on the
allocation of resources to support/enhance a brand position, thus placing attention on
management dialogue on brand issues.

1.4.2.2. Difficulties of SMA applicability

While the term strategic management accounting is specific to the extent that it connotes the
integration of external with internal financial and non-financial information, it is also used as
an umbrella term to include cost management approaches such as life-cycle costing, value-
chain analysis, target costing, activity-based management, quality costing and the balanced
scorecard among others.

Given that these approaches to managing costs have very particular roots where they are found
to be present, it should not come as a surprise that strategic management accounting is
deployed in some organisations in ways that are highly enterprise specific.
Diverse notions of SMA exist. Although management accounting techniques such as standard
costing, cost–volume–profit analysis, responsibility accounting and activity based accounting
can be accorded quite precise definitions, their deployment and the roles they play within
organisations tend to be contextually determined. SMA should likewise not be expected to
evidence a level of operational rigour that is standard across systems or organisations since it
represents a variety of different management possibilities.

Despite the definitions earlier, SMA is not a tightly defined performance improvement model.
It is a flexible, broad ‘umbrella’ term which means different things to different organizations.
However, there is some agreement as to its content and this centres around its external focus.
Given the importance of business competitors, information about their operations (such as
pricing, product costs, sales volumes and market share) is vital to the formulation of effective
competitive strategies.

Benchmarking provides a different kind of external intelligence; participating organizations

volunteer information about themselves in order to identify best practice. Also, provided ABC
information is available, it is possible to estimate and rank customers according to their
importance to the business. This internally generated ‘customer profitability analysis’ is a
relatively new management accounting activity. Cost reduction exercises (such as kaizen
costing, value analysis and the reduction of non-value-adding activities under ABM) can also
count as SMA techniques, as can value chain analysis. All the other techniques included in this
module are identified as part of an SMA approach.

Unfortunately, the SMA’s external nature poses problems in its execution. Other than in a
benchmarking situation, businesses are understandably most unwilling to share information
with their competitors. Consequently, the information has to be gathered in other ways.
Suppliers of one company may also supply its competitors and it may be possible to gain some
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information regarding competitors from the sales personnel of their mutual suppliers.
Published accounts and reports are another source of information but these are limited by the
aggregated nature of their content. Newspaper articles also give little away. ‘Poaching’
competitors’ employees is another possible way of gaining intelligence but it can be a risky and
expensive tactic.

One of the characteristics of SMA is the exploitation of cost reduction opportunities but this
gets more and more difficult with each success. For example, moving from a defect rate of one
in a million to one in 10 million is harder to achieve than moving from a defect rate of one in a
hundred thousand to one in a million. Also, the removal of non-value adding activities may
result in unforeseen circumstances. Consider the closure of a subsidized works canteen;
although there is no direct link to customer value, the operatives who have enjoyed this facility
over the years may well be significantly demotivated by its demise. Consequently, process
efficiency may diminish to an extent which reverses the envisaged savings with a net negative
result on the bottom line.

There is one other important point which should be considered. This section of the chapter on
SMA has assumed that external intelligence is essential to the formulation of effective strategy.
But what if corporate strategy is not always formulated (freewheeling opportunism)? Suppose
it just evolves incrementally, reacting to changes internal and external to the business, over
long periods of time. So, if strategy is not explicitly formulated, there is no need for any formal
gathering of information about the external environment; SMA becomes unnecessary! In
reality, corporate strategy is both formulated and incrementally created; companies experience
both aspects of this essential function.

End-of-chapter questions
1. What have researchers found about the definition of what strategic management accounting
means?
2. What are the key changes faced by businesses which have helped to shape strategic
management accounting?
3. Discuss the extent to which ‘strategic management accounting’ represents a new dimension
of management accounting.
4. As the management accountant of an international distribution company, you have been
asked to make a brief presentation to the company’s senior management on the nature and
coverage of SMA. Prepare some notes on the content of the proposed presentation which
should:
(i) discuss the coverage of SMA;
(ii) analyse the claimed advantages of SMA;
(iii) discuss the possible problems of implementing SMA within the company.

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 Chapter II: STRATEGIC MANAGEMENT ACCOUNTING AND BUSINESS
STRATEGY
2.1. NEED FOR SMA IN THE STRATEGIC MANAGEMENT PROCESS
2.1.1. Introduction to strategic management
2.1.1.1. Hierarchy of management
a) Strategic planning
This is the process of developing the long-term plans for the company. Example, what new
products to launch? what new markets to develop? This sort of planning, together with the
decision making involved will be done at Board level. It tends to be more outline rather than
detailed planning.
b) Tactical planning or Management control
This is the more detailed, short-term planning (for example, the one year budgets) in order to
ensure resources are obtained and used effectively in order to achieve the long-term plan of the
company. For example, how many staff will the company need next year? The control will be
exercised against budget using, for example, variance analysis.
c) Operational control
This is the day-to-day management of the business in order to ensure that specific tasks are
carried out effectively and efficiently. For example, ensuring that budgeted production is
achieved each day. The information used will be detailed and will be quantitative, but of purely
in monetary terms.

2.1.1.2. Meaning of strategic management

Strategic management is a continuous process that evaluates and controls the business and the
industries in which an organization is involved; evaluates its competitors and sets goals and
strategies to meet all existing and potential competitors; and then re-evaluates strategies on a
regular basis to determine how it has been implemented and whether it was successful or needs
replacement.

2.1.1.3. Strategic management process

It is vital that businesses develop plans for the future. Whatever a business is trying to achieve,
it is unlikely to come about unless its managers are clear what the future direction of the
business is going to be. The development of plans involves the following key steps:
1. Establish mission, vision and objectives
2. Undertake a position analysis
3. Identify and assess the strategic options
4. Select strategic options and formulate plans
5. Perform, review and control

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2.1.2. Mission, vision, and objectives
A mission statement defines the purpose and boundaries of the organisation. A vision is the
desired future state or aspiration of an organisation. While not all organisations specify a
mission statement and vision, they all have some form of objectives.
Objectives (or goals) are specific statements of what the organisation aims to achieve, often
quantified and relating to a specific period of time. Many organisations focus their objectives
around some of the following: profitability, growth, cost minimisation, product leadership,
innovation, product quality, quality of service, community service, employee welfare,
environmental responsibility. The mission statement sets out the ultimate purpose of the
business. It is a broad statement of intent, whereas the strategic objectives are more specific
and will usually include quantifiable goals.

2.1.3. Corporate appraisal

2.1.3.1. Position audit
Position analysis involves an assessment of where the business is currently placed in relation to
where it wants to be, as set out in its mission and strategic objectives. A position audit assesses
the strengths and weaknesses of the company, asking ‘what are good at? ‘What are bad at? In
particular, existing products will all be reviewed and consideration given as to which products
should be continued and promoted, and which products should perhaps be phased out or
abandoned. One thing which should be considered currently in relation to each product is as to
where positioned currently it is on its “product life cycle”. The Boston Consulting Group
(BCG) matrix and Ansoff product-market matrix can help in position audit.

BCG matrix uses the Question mark or Problem child, Stars, Cash cows, and Dog.

2.1.3.2. External environment analysis

There is a framework to help organisations assess their broad environment: PESTEL analysis
(or PESTLE). This is an examination of the political, economic, socio-cultural, technological,
legal and ecological issues in the external business environment.
Political influences include trade regulations and tariffs; social welfare policies.
Economic influences include: business cycles; interest rates; money supply; inflation;
unemployment; disposable income; availability and cost of energy; the internationalisation of
business. Taken together these economic factors determine how easy – or not – it is to be.
Socio-cultural influences include demand and taste issues, and how tastes and preferences
change over time. Specific influences include: demographics (for e.g, an ageing population in
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advanced societies); social mobility – will people move in order to work, or stay where they are
even if unemployed and relying on state support? To some extent this is now a political issue,
with free movement of labour across the community, e.g regional integration); lifestyle
changes (for example, the desire to retire earlier, and general changes in people’s views about
work/life balance); concern for the environment, including waste disposal, recycling and
energy consumption.
Technological issues include government spending on research, the quality of academic
research and the ‘brain drain’ (when large numbers of educated and highly skilled people leave
their own country to live and work in another one where pay and conditions are better); the
focus on technology, and support for invention and innovation; the pace of technological
change and the creation of technology-enabled; industries.
Ecological issues include global warming and climate change; animal welfare; waste, such as
unnecessary packaging.
Legal issues include legislation about trade practices and competition; environmental-
protection legislation, such as new laws on recycling and waste-disposal industries;
employment law, such as that regarding employment protection and discrimination.

Having examined the external environment, we should now consider the competition the
organisation faces. Few businesses have no competition, and most seek to develop and keep a
competitive advantage over their rivals. They aim to be different or better in ways that appeal
to their customers. An analysis tool that helps to evaluate an industry’s profitability and hence
its attractiveness is Porter’s five forces model especially when launching a new product. In the
centre is the competitive battleground, where rivals compete and competitive strategies are
developed. Organisations seek to understand the nature of their competitive environment.
Additionally, they will be in a stronger position if they understand the interplay of the five
forces and can develop defences against the threats they pose.

Ansoff’s matrix is commonly used by businesses that have growth as their main objective, and
is used to focus managements’ attention on the four main alternative strategic options available
for growth:
EXISTING PRODUCTS NEW PRODUCTS
EXISTING MARKETS Markets penetration Product development diversification
NEW MARKETS Market development Diversification

2.1.3.3. Internal environment analysis

External environment creates opportunities and threats and can give an ‘outside-in’ stimulus to
the development of strategy. The PESTEL analysis results are integrated into SWOT analysis.
Successful strategies depend on something else as well: the capability of the organisation to
perform. Capabilities refer to the firm's ability to utilize its resources effectively. An example
of a capability is ability to bring a product to market faster than competitors. Such capabilities
are embedded in the routines of the organization and are not easily documented as procedures
and thus are difficult for competitors to replicate. Therefore, in this internal analysis we ask:
Can an organisation continue to change its capability so that it constantly fits the environment
in which it operates? Can it always be innovative in the way it exploits this capability?

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We saw in Business Analysis, Chapter 2, that the firm’s resources and capabilities together
form its distinctive competencies. Resources and capabilities are the building blocks upon
which an organization create and execute value-adding strategy so that an organization can
earn reasonable returns and achieve strategic competitiveness. Competency may be categorized
as core and non-core depending on the nature of capabilities.
Resources

Distinctive Cost advantage or Value

competencies Differentiation advantage creation

Capabilities

MOST analysis technique examines the current Mission, Objectives, Strategy and Tactics, and
considers whether these are clearly defined and supported within the organisation.
A clear mission driving the organisation forward, a set of measurable objectives and a coherent
strategy will enhance the capability of the organisation and be a source of strength. On the
other hand, where there is a lack of direction, unclear objectives and an ill-defined strategy the
internal capability is less effective and we have a source of weakness.

2.1.4. Strategy development and implementation

A strategy is simply a course of action to achieve a specific outcome. Strategic planning is
concerned with the formulation, evaluation and selection of the strategies for the purpose of
developing a long-term course of action.
Having carried out a position audit and environmental analysis, the task is then to develop the
strategy in order to:
1) convert weaknesses into strengths;
2) convert threats into opportunities; and
3) match strengths with opportunities.
This exercise is commonly undertaken with use of SWOT analysis
Internal to company S W
External to company O T
We describe the process of developing and implementing the business strategy in three stages:
Strategic analysis
 External analysis to identify opportunities and threats
 Internal analysis to identify strengths and weaknesses
 Stakeholders analysis to identify key objectives and to assess power and interest of
different groups
 Gap analysis to identify the difference between desired and expected performance

Strategic choice
Strategies are required to close the gap. The types of strategy that may be considered in order
to fill the gap are:

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  Competitive strategy––for each business unit (cost saving/greater efficiency)
 Directions for growth––which markets/products should be invested in
 Whether expansion should be achieved by organic growth/acquisition/or some form of
joint arrangement
 Withdrawal

Strategic implementation
 Formulation of detailed plans and budgets
 Target setting for Key Performance Indicators (KPIs)
 Monitoring and control
Planning and control systems are a vital element of management accounting. As part of
strategy implementation, organisations need to put in place plans to set the direction of the
organisation, and control systems to ensure that operations are proceeding according to plan.
Planning and control systems provide the framework for effective resource management to
generate customer and shareholder value.

2.1.5. Approaches to strategy implementation

The strategic plan will be formulated at Board level. Once it has been prepared, it will normally
be the managers of the company who will be expected to implement it. This then becomes the
second tier of decision-making (management control/tactical planning). Within the context of
implementation of change plan or strategies we come across four different approaches:
1. Logical Incrementalism (planned change management & emergent change management)
2. Radical or Transformative change
3. Punctuated Equilibrium Model
4. Organisational Development Models

Implementation process
Stage 1 Organizing or structuring. Example: Should the organization be split into various
distinct geographical operational divisions, national or international? How autonomous should
divisions be?
Stage 2. Resource planning. This consists of enabling an organization’s resources that should
support the chosen strategy. Example: appropriate human resources and fixed assets need to
be acquired.
Stage 3. Managing change. Mostly strategic planning and implementation involves change
and naturally, people have tendency to continue on particular course of action until something
goes wrong or a person is forced to question his or her actions.
So managing change, in particular employees’ fears and resistance, is crucial. Successful
implementation will rely on the successful management of the change to the new strategy. This
will involve not only the management of the systems and structures of the organization, but
also the management of its people and routines.
This will involve two elements, namely:
 overcoming resistance to change from staff; and
 leading staff in a manner that encourages them to make the change successful.

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2.1.6. Freewheeling opportunism
The research findings revealed that the attainment of an appropriate match or ‘fit’ between an
organisation’s environment and its strategy has positive effects on organisation’s performance.
It is, nevertheless, not always necessary for strategic planning to be a formal process for it to be
effective. In other words, it is possible to do without strategic plans and operate a system
whereby opportunities are exploited as they arise. This is known as freewheeling opportunism.
The main possible advantages of this approach are that
(1) Opportunities can be seized as they arise, whereas
(2) A rigid planning framework might impose restrictions so that the opportunities are lost.
There are however the disadvantages:
(1) It cannot guarantee that all opportunities are identified and appraised;
(2) It emphasises the profit motive to the exclusion of other considerations.

2.2. THE ROLE OF SMA IN THE ACHIEVEMENT OF BUSINESS STRATEGY

The Oxford English Dictionary defines strategy in general terms as, ‘A plan of action or policy
designed to achieve a major or overall aim.’ Further to this, in the second edition of his book
Strategic Management Accounting, 2003, Hoque refines this in a specific business context as,
‘An integrated set of actions aimed at securing a sustainable competitive advantage. The term
strategic management accounting is used to describe the process of provision and analysis of
management accounting data about a business and its competitors for use in developing and
monitoring business strategy. This section discusses the need for SMA information by the
business managers while developing and implementing the strategy.

2.2.1. Strategies for competitive advantage

2.2.1.1. Factors influencing organisational strategy
The following figure summarises the factors that influence the organisational strategy.
Figure: Factors influencing organizational strategy

2.2.1.2. Developing competitive advantage

Competitive advantage can be secured through two primary routes: product manufacturing and
marketing route. Product manufacturing route reflects core competences, special capabilities,
superior product design, etc. Marketing route reflects marketing mix application, positioning,
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offering a bundle of benefits or value to the customer, etc. The product-making route and the
marketing route are obviously not exclusive to each other; they are, in fact, complementary to
or supporting or reinforcing each other.

A corporate strategy can consist of various individual strategies like product strategy, pricing
strategy, promotion strategy, distribution strategy, competition strategy, etc. Many forms of
competition exist. But these strategies or the way a company competes is not the only key to,
or the complete course for success. There are at least three other strategic factors which are
essential for creation of a competitive advantage which can be sustained over time. These
three factors are: how to compete (basics), i.e., business assets and skills, where to compete,
i.e., product-market selection, and whom to compete against, i.e., competitor position.

First, for securing competitive advantage, corporate strategy should be based on appropriate
assets, skills and capabilities. Important business assets are customer base, quality reputation,
good management or company image, proper engineering or skilled staff, etc. For example, a
product strategy for an industrial good without proper design, manufacturing and quality
control capabilities will not deliver the results or any sustainability to the product or quality.
Special assets and skills of a company can also be termed as core competence or distinctive
competence of the company.
According to Hamel and Prahalad (1990), advantages of companies and businesses are based
on core competence of these companies, and therefore, developing and managing core
competence are the keys to strategic success. Core competences, however, are not the only
sources of competitive advantage.
The next important factor is the choice of the target product-market. A well-planned strategy
duly supported by assets and skills may not succeed because it does not work in a particular
market. But, these assets adversely affected the taste perception which was considered to be the
most important factor in the market.
The third important factor for competitive advantage is competitor position. The objective or
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goal here is to employ a strategy to thwart competitors who may lack strength in relevant assets
and skills or is weak in some other strategic applications. For example, flight safety is
important to airline passengers: so, if an airline is perceived to be strong on safety, then a
competitive advantage can exist in terms of provision of flight safety or better flight security.

2.2.1.3. Sustainable competitive advantage

A sustainable competitive advantage occurs when an organization acquires or develops an
attribute or combination of attributes that allows it to outperform its competitors. These
attributes can include access to natural resources or access to highly trained and skilled
personnel human resources.
Figure: Five criteria for competitive advantage

Types and examples of sustainable competitive advantages

Low cost provider/ Low pricing. Economies of scale and efficient operations can help a
company keep competition out by being the low cost provider. Being the low cost provider can
be a significant barrier to entry. In addition, low pricing done consistently can build brand
loyalty be a huge competitive advantage.
Market or pricing power. A company that has the ability to increase prices without losing
market share is said to have pricing power. Companies that have pricing power are usually
taking advantage of high barriers to entry or have earned the dominant position in their market.
Powerful brands. It takes a large investment in time and money to build a brand. It takes very
little to destroy it. A good brand is invaluable because it causes customers to prefer the brand
over competitors. Being the market leader and having a great corporate reputation can be part
of a powerful brand and a competitive advantage.
Strategic assets. Patents, trademarks, copy rights, domain names, and long term contracts
would be examples of strategic assets that provide sustainable competitive advantages.
Companies with excellent research and development might have valuable strategic assets.
Barriers to entry. Cost advantages of an existing company over a new company is the most
common barrier to entry. High investment costs (i.e. new factories) and government
regulations are common impediments to companies trying to enter new markets. High barriers
to entry sometimes create monopolies or near monopolies (i.e. utility companies).
Adapting product line. A product that never changes is ripe for competition. A product line
that can evolve allows for improved or complementary follow up products that keeps
customers coming back for the “new” and improved version (i.e. Apple iPhone) and possibly
some accessories to go with it.
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Product differentiation. A unique product or service builds customer loyalty and is less likely
to lose market share to a competitor than an advantage based on cost. The quality, number of
models, flexibility in ordering (i.e. custom orders), and customer service are all aspects that can
positively differentiate a product or service.
Outstanding management (People). There is always intangible of outstanding management.
This is hard to quantify, but there are winners and losers. Winners seem to make the right
decisions at the right time. They somehow motivate and get the most out of their employees,
particularly when facing challenges.

2.2.1.4. Deciding an organisational strategy to pursue

The strategies of an organisation specify the direction that the organisation intends to take over
the long term, to meet its mission and achieve its objectives. The strategies will focus on ways
to manage the organisation’s resources to create value for customers and shareholders. In
formulating an organisation’s strategies, major decisions include:
 In what business will we operate?
 How should we compete in that business?
 What systems and structures should we have in place to support our strategies?

The first decision involves formulating corporate strategy. The corporate strategy involves
making choices about the types of businesses in which the organisation as a whole will operate.
This includes decisions about what businesses to divest or acquire, and how best to structure
and finance the company. In publicly listed companies, the choice of corporate strategy is
heavily influenced by expectations of major shareholders and the share market.
The second type of decision involves business strategy. Business (or competitive) strategy is
concerned with the way that a business competes within its chosen market. If an organisation
consists of several different business units, each with its own distinct market, then there will be
a competitive strategy developed for each unit. In that case, to create the shareholder value a
business must develop and manage its sources of competitive advantage.

Competitive advantage refers to advantages that a business may have over another, which are
difficult to imitate. Porter suggests that a firm can gain a sustainable competitive advantage
through adopting a business strategy of cost leadership or product differentiation. When a firm
is a low-cost producer, this allows the business to sell its goods or services at a lower price than
competitors (cost leadership). Alternatively, firms may derive competitive advantage by
offering goods or services that have characteristics that are superior to those offered by
competitors (product differentiation). Forms of product differentiation include superior quality,
customer service, delivery performance and product features such as innovation. Within the
one industry, there may be successful cost leaders and successful differentiators.
Businesses that choose to place a greater emphasis on cost leadership may achieve this in
several ways, such as through economies of scale in production, superior process technology,
tight cost control and cost minimisation in areas such as marketing, production, research and
development, and customer service.

When a differentiation strategy is followed, the emphasis is on creating some characteristic of

the good or service that is perceived by customers as unique. Successful differentiators are able
24 | P a g e
to set selling prices that more than offset the cost of the added product features that are valued
by customers. Differentiation may be on the basis of a number of characteristics such as high
quality products, strong brand image, superior customer service, and product innovation.
Many firms will develop a business strategy that emphasises both cost leadership and some
form of differentiation. However, a firm may choose to place greater emphasis on either type
of competitive strategy.
The third question is concerned with strategy implementation, which involves planning and
managing the implementation of strategies. This can include introducing new structures and
systems, such as setting up new business units, implementing new production processes,
implementing new software packages, developing new marketing approaches, and introducing
innovative human resource management policies.

2.2.2. The role of strategic management accounting in achieving business strategy

2.2.2.1. Strategic planning
Strategic planning involves making corporate strategy decisions about the types of businesses
and markets in which the organisation operates, and the business (or competitive) strategy
decisions about how the business is to compete within its particular markets.
Strategic planning draws on a wide range of management accounting information from the
costing, budgeting and performance measurement systems, as well as information from special
studies internal and external to the organisation.

2.2.2.2. Implementing strategies

Once strategies have been formulated, managers at all levels of the organisation share the
responsibility for implementing them. Management accountants can play an important role in
this process using the planning and control systems described below. Long-term plans need to
be linked to the budgeting system, to produce annual budgets that support the organisation’s
strategies. Likewise, performance measurement systems can be used to compare actual
outcomes to budgets and other targets that focus on the organisation’s strategic objectives.

The successful management of a business depends on having a successful business strategy. It

has been argued that if the business strategy gives the organisation its competitive edge, then
the management accounting should reflect that strategy as closely as possible. In other words,
to be an effective contributor to strategy, the management accounting information should be
shaped around the organisation’s sources of competitive advantage. The traditional emphasis
on costs and revenues may not achieve this aim. What really matters is the influence of the
external environment.
Strategy usually includes planning to achieve a better performance than competitors. It is
argued that management accounting should show the extent to which the organisation is
beating its competitors. Market share, market prospects and the impact of product mix would
all be useful information to include in a management accounting report as factors contributing
to sales, profits and cash flows.
Advocates of strategic management accounting seek to provide financial and other related
information on competitors’ costs and cost structures so that the company’s strategies may be
monitored against those of its competitors. Furthermore, there is a need for new forms of
internal analysis and accounting processes that will help management devise better strategies.
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There is strong support for this general direction of strategic management accounting but less
agreement on how it may be achieved.
Another way of looking at the influence of the external environment is to consider competitive
advantage in costs. If the business has an influential position as a purchaser of goods and
services, then its strategy may include an aggressive policy of negotiating contracts for those
goods and services. The just-in-time strategy of ordering goods from suppliers to arrive
exactly when they are needed may put strains on the suppliers and force up their costs,
increasing the price of the goods. The concept of a value chain has been proposed to describe
how the corporate strategy affects the entire chain of value-creating activities. Strategic
management accounting might show that Frw 1 saved at one point in the chain has been offset
by an extra Frw 2 incurred at another stage.

It is not necessary to abandon all that has been learned in the cost accounting and management
accounting. Advocates of strategic management accounting would relate the accounting
technique to the strategic aims of the business. Take the example of two companies, one of
which is aiming to achieve cost leadership while the other is focusing on product
differentiation. The use of standard costing in assessing performance is very important to the
cost leadership company but relatively unimportant to the product differentiation company.
Analysis of marketing costs may not be so important in a cost leadership setting but is
absolutely essential to the product differentiation situation.
In part two of this module (strategic performance measurement), you will discuss the balanced
scorecard approach which requires an organisation to translate its vision and strategy into four
perspectives that are logically connected each other: financial focus, customer focus, internal
business processes, and learning and growth.
The Balanced Scorecard – for translating a strategy into operational processes

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The companies are encouraged to develop the performance indicators under each of these
headings which provide a complete view of the company’s performance as illustrated in the
following figure. In short, SMA plays an important role in formulating and supporting the
overall strategy of an organization by developing an integrated framework of performance
measurement.

Figure: Illustration of how strategic management accounting supports business strategy

Source: European academic research - Vol. II, Issue 8 / November 2014

End-of-chapter questions
1. Define ‘business strategy’.
2. Compare the vision and mission of two companies and evaluate the degree to which their
strategies are likely to be similar.
3. How does strategic management accounting make use of information about competitors?
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 Chapter III: STRATEGIC COSTING AND PRICING FOR COMPETITIVE
ADVANTAGE

3.1. INTRODUCTION
Chapter one discussed major changes that led to a much more fast-changing and competitive
environment which in turn has radically altered the way in which businesses are managed. This
chapter considers some costing and pricing techniques that have been developed to help the
businesses maintain their competitiveness.

3.1.1. Characteristics of costing and pricing in the traditional way

The traditional and still widely used approach to product costing and pricing was developed
around the time of the Industrial Revolution, when industry was characterised by:
 Direct-labour-intensive and direct-labour-paced production. Labour was at the heart of
production. Where machinery was used, it was to support the efforts of direct labour, and
the speed of production was dictated by direct labour.
 A low level of overheads relative to direct costs. Little was spent on power, personnel
services, machinery (leading to low depreciation charges) and other areas typical of the
overheads of modern businesses.
 A relatively uncompetitive market. Transport difficulties, limited industrial production
worldwide and a lack of knowledge by customers of competitors’ prices meant that
businesses could prosper without being too scientific in costing and pricing their output.
Customers tended to accept what the supplier offered, rather than demanding precisely
what they wanted.

3.1.2. Characteristics of costing and pricing in the new environment

The world of industrial production has fundamentally altered and is now characterised by:
 Capital-intensive and machine-paced production. Machines are at the heart of much
production, including service provision. Most labour supports the efforts of machines, for
example technically maintaining them. Also, machines often dictate the pace of production.
 A high level of overheads relative to direct costs. Modern businesses tend to have very high
depreciation, servicing and power costs. There are also high costs of a nature scarcely
envisaged in the early days of industrial production, such as personnel and staff training
costs. At the same time, there are very low (sometimes no) direct labour costs. Although
direct material cost often remains an important element of total cost, more efficient
production methods lead to less waste and, therefore, less total material cost, again tending
to make overheads more dominant.
 A highly competitive, international market. Production, much of it highly sophisticated, is
carried out worldwide. Transport, including fast airfreight, is relatively cheap. Fax,
telephone and, particularly, the internet ensure that potential customers can quickly and
cheaply find the prices of a range of suppliers. Markets now tend to be highly price
competitive. Customers increasingly demand products custom made to their own
requirements. This means that businesses need to know their product costs with a greater
degree of accuracy than historically has been the case. Businesses also need to take a
considered and informed approach to pricing their output.

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3.1.3. Customer satisfaction as a top priority in the new environment
The key success factors which the organizations must concentrate on to provide customer
satisfaction are cost, quality, reliability, delivery and the choice of innovative new products. In
addition, firms are attempting to increase customer satisfaction by adopting a philosophy of
continuous improvement to reduce costs and improve quality, reliability and delivery.
Figure: Focus on customer satisfaction

Key success factors

Cost efficiency Continuous
Quality-Time improvement
Innovation

Customer
satisfaction
as a top
priority

Total value chain Employee

analysis empowerment

Critical success factors (CSFs), sometimes referred to as strategic factors or key factors for
success, are those which are crucial for organisational success. When strategists consciously
look for such factors and take them into consideration for strategic management, they are likely
to be more successful, while putting in relatively less efforts.

3.1.3.1. Cost efficiency

Keeping costs low and being cost efficient provides an organization with a strong competitive
advantage. Increased competition has also made decision errors, due to poor cost information,
more potentially hazardous to an organization. Many companies have become aware of the
need to improve their cost systems so that they can produce more accurate cost information to
determine the cost of their products and services, monitor trends in costs over time, pinpoint
loss-making activities and analyze profits by products, sales outlets, customers and markets.

3.1.3.2. Quality
In addition to demanding low costs, customers are demanding high quality products and
services. Most companies are responding to this by focusing on total quality management
(TQM). TQM is a term used to describe a situation where all business functions are involved in
a process of continuous quality improvement that focuses on delivering products or services of
consistently high quality in a timely fashion. The emphasis on TQM has created fresh demands
on the management accounting function to measure and evaluate the quality of products and
services and the activities that produce them.

3.1.3.3. Time as a competitive weapon

Organizations are also seeking to increase customer satisfaction by providing a speedier
response to customer requests, ensuring 100 per cent on-time delivery and reducing the time
taken to develop and bring new products to market. For these reasons management accounting

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systems now place more emphasis on time-based measures, such as cycle time. This is the
length of time from start to completion of a product or service. It consists of the sum of
processing time, move time, wait time and inspection time. Only processing time adds value to
the product, and the remaining activities are non-value added activities in the sense that they
can be reduced or eliminated without altering the product’s service potential to the customer.
Organizations are therefore focusing on minimizing cycle time by reducing the time spent on
such activities. The management accounting system has an important role to play in this
process by identifying and reporting on the time devoted to value added and non-value added
activities. Cycle time measures have also become important for service organizations. For
example, the time taken to process mortgage loan applications by financial organizations can
be considerable, involving substantial non-value added waiting time. Reducing the time to
process applications enhances customer satisfaction and creates the potential for increasing
sales revenue.

3.1.3.4. Innovation and continuous improvement

To be successful companies must develop a steady stream of innovative new products and
services and have the capability to adapt to changing customer requirements. Management
accounting information systems have begun to report performance measures relating to
innovation. Examples include:
 the total launch time for new products/services;
 an assessment of the key characteristics of new products relative to those of competitors;
 feedback on customer satisfaction with the new features and characteristics of newly
introduced products and the number of new products launched.
Organizations are also attempting to enhance customer satisfaction by adopting a philosophy of
continuous improvement. Traditionally, organizations have sought to study activities and
establish standard operating procedures. Management accountants developed systems and
measurements that compared actual results with predetermined standards. This process created
a climate whereby the predetermined standards represented a target to be achieved and
maintained. In today’s competitive environment, companies must adopt a philosophy of
continuous improvement, an ongoing process that involves a continuous search to reduce costs,
eliminate waste and improve the quality and performance of activities that increase customer
value or satisfaction. Management accounting supports continuous improvement by identifying
opportunities for change and then reporting on the progress of the methods that have been
implemented.

Benchmarking is a technique that is increasingly being adopted as a mechanism for achieving

continuous improvement. It is a continuous process of measuring a firm’s products, services or
activities against the other best performing organizations, either internal or external to the firm.
The objective is to ascertain how the processes and activities can be improved. Ideally,
benchmarking should involve an external focus on the latest developments, best practice and
model examples that can be incorporated within various operations of business organizations.
It therefore represents the ideal way of moving forward and achieving high competitive
standards.
In their quest for the continuous improvement of organizational activities, managers have
found that they need to rely more on the people closest to the operating processes and
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customers, to develop new approaches to performing activities. This has led to employees
being provided with relevant information to enable them to make continuous improvements to
the output of processes. Allowing employees to take such actions without the authorization by
superiors has come to be known as employee empowerment.
It is argued that by empowering employees and giving them relevant information they will be
able to respond faster to customers, increase process flexibility, reduce cycle time and improve
morale. Management accounting is therefore moving from its traditional emphasis on
providing information to managers to monitor the activities of employees, to providing
information to employees to empower them to focus on the continuous improvement of
activities.

3.2. STRATEGIC PRODUCT COSTING FOR COMPETITIVE ADVANTAGE

In every business, the owners and managers need to know what their product or service costs to
deliver and what they can sell it for. They want to make strategic decisions that maximize their
profits, and they require information to do this. The truth is that you cannot decide what to do
unless you know the cost. We explain some of the costing techniques that have been proposed
for gaining a competitive advantage in cost control. Although the techniques are described
separately, in practice they are interrelated as explained by Cooper and Slagmulder (2003).

3.2.1. Activity-based costing

3.2.1.1. Meaning and objectives of activity based costing
CIMA defines ABC as, ‘cost attribution to cost units on the basis of benefit received from
indirect activities e.g. ordering, setting up, assuring quality.’ One more definition of ABC is,
‘the collection of financial and operational performance information tracing the significant
activities of the firm to product costs.’

The following are the objectives of Activity Based Costing.

 To remove the distortions in computation of total costs as seen in the traditional costing
system and bring more accuracy in the computation of costs of products and services.
 To help in decision making by accurately computing the costs of products and services.
 To identify various activities in the production process and further identify the value
adding activities.
 To distribute overheads on the basis of activities.
 To focus on high cost activities.
 To identify the opportunities for improvement and reduction of costs.
 To eliminate non value adding activities.

Under activity-based costing, overhead costs are initially budgeted for activities, sometimes
termed activity cost pools, such as machine usage, inspections, moving, production setups, and
engineering activities.
Activity-based costing is a better, more accurate way of allocating overhead that uses multiple
overhead rates based on different activities. Activities are the types of work, or actions,
involved in a manufacturing or service process. For example, assembly, inspection, and
engineering design functions are activities that might be used to allocate overhead.

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3.2.1.2. What drives the costs?
ABC aims to overcome the kind of problem just described by tracing the cost of all support
activities directly to particular products or services. The cost of the support activities makes up
the total overheads cost. The outcome of this tracing exercise is to provide a more realistic, and
more finely measured, account of the overhead cost element for a particular product or service.
To implement a system of ABC, managers must begin by carefully examining the business’s
operations. They will need to identify:
1. Each of the various support activities involved in the process of making products or
providing services;
2. The costs to be attributed to each support activity; and
3. The factors that cause a change in the costs of each support activity, that is, the cost
drivers.
Identifying the cost drivers is a vital element of a successful ABC system. They have a cause-
and-effect relationship with activity costs and so are used as a basis for attaching activity costs
to a particular product or service.

Examples of cost drivers

Activity Cost drivers
Ordering Number of receiving order
Delivery Number of deliveries
Order taking Number of purchase orders
Deliveries Kilometres travelled per delivery
Customer visit Number of customers' visits
Placing orders Number placing orders for purchase
Bottles returns Number of returning or empty bottles
Product handling Number material handling hours
Lab our transactions Amount of labour cost incurred
Inspection Number of inspections
Delivery Number of physical delivery and receipt of goods

3.2.1.3. Attributing overheads

Once the various support activities, their costs and the factors that drive these costs, have been
identified, ABC requires:
1. An overhead cost pool to be established for each activity (cost driver) in which all of the
costs caused by that driver are placed.
2. All costs associated with each support activity to be allocated to the relevant cost pool.
3. The total cost in each pool to then be charged to output (Products A, B, C, and so on), using
the cost driver identified, according to the extent to which each unit of output ‘drove’ those
costs.
The final step identified involves dividing the amount in each cost pool by the estimated total
usage of the cost driver to derive a cost per unit of the cost driver. This unit cost figure is then
multiplied by the number of units of the cost driver used by a particular product, or service, to
determine the amount of overhead cost to be attached to it.

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Figure: Summary of Activity-based costing approach

3.2.1.4. ABC versus the traditional approach

Realisation that overheads do not just occur, but that they are caused by activities –such as
holding products in stores – that ‘drive’ the costs, is at the heart of ABC. The traditional
approach is that direct labour hours are the cost driver, which probably used to be true. ABC
recognises that this is often not the case.
We can see that there is a basic philosophical difference between the traditional and the ABC
approaches. Traditionally we tend to think of overheads as rendering a service to cost units, the
cost of which must be charged to those units. ABC sees overheads as being caused by
activities, and so it is the cost units that cause the activities that must be charged with the costs
that they cause.

Allocating overhead costs to cost pools, as is necessary with ABC, contrasts with traditional
approach, where the overheads are normally allocated to production departments cost centres).
In both cases, however, the overheads are then charged to cost units (goods or services).
 With the traditional approach, overheads are apportioned to the product departments (cost
centres). Each department then derives an overhead recovery rate, typically overheads per
direct labour hour. Overheads would then be applied to units of output according to how
many direct labour hours were worked on them.
 With ABC, the overheads are analysed into cost pools, with one cost pool for each cost
driver. The overheads are then charged to units of output, through activity cost driver rates.
These rates are an attempt to represent the extent to which each cost unit is believed to
cause the particular part of the overheads.
Cost pools are much the same as cost centres, except that cost pools are linked to a particular
activity, rather than being more general, as is the case with cost centres in traditional product
costing.

3.2.1.5. ABC and service industries

Much of our discussion of ABC has concentrated on the manufacturing industry, perhaps
because early users of ABC were manufacturing businesses. In fact, ABC is possibly even
more relevant to service industries because, in the absence of a direct material element, a
service business’s total cost is likely to be largely made up of overheads.
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3.2.1.6. Benefits and Criticisms of ABC
Benefits of ABC
Through the direct tracing of cost to products in the way described, ABC seeks to establish
more accurate costs for each unit of product or service. This should help managers in assessing
product profitability and in making decisions concerning pricing and the appropriate product
mix. Other benefits, however, may also flow from adopting an ABC approach. ABC may be
useful for a firm.
1. First, multiple products are needed. ABC offers no increase in product costing accuracy for
a single-product setting.
2. Second, there must be product diversity. If products consume non-unit-level activities in
the same proportion as unit-level activities, then ABC assignments will be the same as
functional-based assignments.
3. Third, non-unit-level overhead must be a significant percentage of production cost. If it is
not, then it hardly matters how it is assigned. Thus, firms that have plants with multiple
products, high product diversity, and significant non-unit-level overhead are candidates for
an ABC system.
Critics of ABC
ABC is a significant improvement over the volume based systems for reasons explained in
above. However, critics of ABC argue that
1. analysing the overheads in order to identify cost drivers is time consuming and costly, and
that the benefit of doing so, in terms of more accurate product costing and the potential for
cost control, does not justify the cost of carrying out the analysis.
2. like full costing, ABC does not provide relevant information for decision-making.
3. ABC alone cannot handle the design needs in the twenty-first century for at least four
reasons:
a. ABC does not handle uncertainty. Since uncertainty is inherent in design, it is vital to
understand how uncertainty can affect the solutions.
b. By using large cost pools, the direct association of costs with their respective activities
leads to a lack of process information.
c. The relationships among products, processes, and production costs are not clearly
delineated.
d. ABC does not facilitate any ways of simulating changes to see how the changes work.

Illustration: Company A produces two products: H and L. Both are produced on the same
equipment and use similar processes. The products differ by volumes. Product H is a high-
volume product while L is a low-volume product. Details of product inputs, output and the cost
of activities are as follows:
Machine Direct Annual Total Total direct Number of Number
hours per labour hours output machine labour hours purchase of set-
unit per unit (units) hours orders ups
Product L 2 4 1,000 2,000 4,000 80 40
Product H 2 4 10,000 20,000 40,000 160 60
11,000 22,000 44,000 240 100
The cost of the activities is as follows:
£
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Volume-related 110,000
Purchasing-related 120,000
Set-up-related 210,000
440,000
Required: Calculate the cost per unit of each product under traditional volume-based costing
system and activity-based costing system.

Solution: Allocation of the overheads to the product L and H

(a) Traditional volume-based costing system

£
Cost-centre allocated costs 440,000
Overhead rate per machine hour £440,000/22,000 hours 20
Overhead rate per direct labour hour £440,000/44,000 hours 10
Cost per unit: L (2 machine hours at 20 or 4 DLHs) 40
H (at £10 per hour) 40
Total cost allocated to products: L £40*1,000 40,000
H £40*10,000 400,000

(b) ABC system

Activities
Volume-related Purchasing-related Set-up-related
Costs traced to activities £110,000 £120,000 £210,000
Consumption of activities* 22,000 machine hrs 240 purchase orders £100 set-ups
Cost per unit of consumption £5 per machine hr £500 per order £2,100 per set-up
Costs traced to products: L= £5*2,000=£10,000 £500*80=40,000 £2,100*40=84,000
H= £5*20,000=£100,000 £500*160=80000 £2,100*60=126,000
Cost per units: Product L= (£10,000+£40,000+£84,000)/1,000 units=£134
Product H= £100,000+£80,000+£126,000)10,000 units=£30.60
* cost drivers
Comparing the results under traditional costing and ABC system
Traditional costing system (£) ABC system (£)
Product L (low-volume product) 40.00 134.00
Product H (high-volume product) 40.00 30.60
With the traditional system, the high-volume product H costs the same to produce as the low-
volume product L. This is because the high-volume products in total consume ten times the
number of machine hours required by their low-volume counterparts. Consequently, £400000
overheads are allocated to product H and £40,000 to L, but, since the volume for product H is
ten times higher, the unit costs are the same.

You can see that both systems adopt the two-stage allocation process. In the first stage,
traditional cost systems allocate overheads to production departments, whereas ABC systems
assign overheads to each major activity (rather than departments). With ABC systems, many
activity based cost pools (cost centres) are established, whereas with traditional systems,
overheads tend to be pooled by departments. This can result in extensive reapportionments of
35 | P a g e
service department costs to ensure that all overheads are allocated to production departments.
Therefore, traditional costing systems use fewer cost pools. ABC systems establish separate
cost pools for support (service) activities such as materials handling and maintenance. The
costs of these activities are assigned directly to products through cost driver rates. Therefore,
reapportionment of service department costs is avoided.

3.2.2. Target costing

Traditionally it has been the cost of producing an item that has driven the selling price –– the
first step was to estimate the production cost and then to decide on a selling price. However,
this approach ignored the effect of the selling price on the demand for the product; and also
gave no direct incentive to reduce costs.

3.2.2.1. Meaning and process of target costing

Target costing is a method of determining the cost of a product or service based on the price
(target price) that customers are willing to pay. The conceptual idea behind target costing is to
balance the needs of the customers with the profit need of the company. That is why it is
defined as “a structured approach to determining the cost at which a proposed product with
specified functionality and quality must be produced, to generate a desired level of profitability
at its anticipated selling price”.
Target costing is used to motivate cost reduction. The Consortium for advanced manufacturing
—International utilises the following definition: ‘Target costing is a system of profit planning
and cost management that is price driven, customer focused, design cantered and cross-
functional. Target costing initiates cost management at the earliest stages of product
development and applies it throughout the product life-cycle by actively involving the entire
value chain.’

There are three cost reduction methods generally used in target costing: reverse engineering,
value analysis and Process improvement.
(i) Reverse engineering tears down the competitor’s products with the objective of discovering
more design features that create cost reductions.
(ii) Value analysis attempts to assess the value placed on various product functions by
customers. If the price customers are willing to pay for a particular function is less than its
cost, the function is a candidate for elimination. Another possibility is to find ways to
reduce cost of providing the function, e.g. using common components. Both reverse
engineering and value analysis focus on product design to achieve cost reductions.
(iii) The processes used to produce and market the product are also sources of potential cost
reduction. Thus, redesigning processes to improve their efficiency can also contribute to
achieving the needed cost reductions.

The steps involved in target costing process are:

1. Determine a product specification of which an adequate sales volume is estimated.
2. Set a selling price at which the organisation will be able to achieve a desired market share.
3. Estimate the required profit based on return on sales or return on investment.
4. Calculate the target cost = target selling price – target profit.

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5. Compile an estimated cost for the product based on the anticipated design specification and
current cost levels.
6. Calculate target cost gap = estimated cost – target cost.
7. Make efforts to close the gap. This is more likely to be successful if efforts are made to
'design out' costs prior to production, rather than to 'control out' costs during the production
phase.
8. Negotiate with the customer before making the decision about whether to go ahead with the
project.

Target costing is a systematic approach to establish product cost goals based on market driven
standards. It is a strategic management process for reducing costs at early stages of product
planning and design. Target costing begins with identifying customer needs and calculating an
acceptable target sales price for the product. Working backward from the sales price,
companies establish an acceptable target profit and calculate the target cost.
For example, if a company normally expects a mark-up on cost of 50% and estimates that a
new product will sell successfully at a price of $12, then the maximum cost of production
should be $8: Cost + Mark-up = Selling price;
100% 50% 150%
$8 $4 $12

3.2.2.2. Target costing versus Traditional costing

Target costing Traditional costing

Production Specification Production Specification

Target Price and volume Product design

Target profit Estimated cost

Target cost Target cost

Product design Target price

Target costing is different from standard costing and other traditional costing techniques. The
standard costs are determined by design ― driven standards with less emphasis on what the
market will pay (engineered costs + desired mark-up = desired sales price). Similarly, full cost
costing (absorption costing), marginal costing, and opportunity costing begin with a given cost
and add a mark-up to determine the selling price. In contrast, target costs are determined by
market driven standards (target sales price- target profit- Target cost).

Target prices are set in order to achieve a desired market share. Deduction of a desired profit
margin produces the cost that has to be achieved. Design specifications and production
methods are examined to establish ways in which the target cost can be met without reducing
the value of the product to the customer. Such an approach is likely to offer greater competitive
advantage than cost plus pricing, being far more strategically orientated as it takes account of

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the external environment.

3.2.2.3. Target costing versus Activity-based costing

Target costing provides two concepts that ABC does not offer explicitly. One is the way
products are being priced and the other is to turn away from cost cutting to cost elimination via
design and planning. These two points are important paradigm shifts:
1. From cost-plus pricing to market-based pricing. In target costing, customers and
competitors drive market prices. The company sets the target profit and the resulting cost
(target price - target profit) is the targeted cost the company must meet. It is rooted in the
fact that in the marketplace, customers have many high-quality products to choose from;
the price of these products may therefore be the only significant competitive edge for a
company.
2. From cost-cutting during production to cost control during design. As we have seen, it
is widely noted in the literature that during the design phase (concept, design/engineering,
and testing), most of the basis for the costs is formed. Target costing takes this into account
and is proactive rather than reactive in its management focus. Target costing also requires a
shift (1) from an internal to an external focus, (2) from an internal vantage point to listening
to the customer, and (3) from independent efforts to interdependent efforts, but these shifts
are not limited for target costing.
Illustration 1
Projected lifetime sales volume 300,000 Units
$
Target selling price of the product 800
Target profit margin (30% of selling price) 240
Target cost ($800-$240) 560
compare
Projected cost 700

Analysis of the projected cost before and after the target costing:
Before After
Manufacturing cost $ $
Direct materials (bought in parts) 390 325
Direct labour 100 80
Direct machining costs 20 20
Ordering and receiving 8 2
Quality assurance 60 50
Rework 15 6
Engineering and design 10 8
603 491
Non-manufacturing costs
Marketing 40 25
Distribution 30 20
After-sales service and warranty costs 27 19
97 64
Total cost 700 555

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3.2.3. Kaizen costing
3.2.3.1. Meaning of kaizen costing
The word kaizen is a Japanese word meaning continuous improvement. Kaizen costing is a
cost-reduction system that is applied to a product in production. It comes from the combination
of the Japanese characters ‘kai’ which means ‘change’ and ‘zen’ which means ‘good,’/ ‘better’.
The word ‘kaizen’ translates to ‘continuous improvement’ or ‘change for the better’ and aims
to improve productivity by making gradual changes to the entire manufacturing process. Some
of the cost-reduction strategies employed involve producing cheaper re-designs, eliminating
waste and reducing process costs. Ensuring the quality control, using more efficient equipment,
utilizing new technological advances and standardizing work are additional elements.

Yasuhiro et al. (2007) defined kaizen costing as “the maintenance of present cost levels for
products currently being manufactured via systematic efforts to achieve the desired cost level.”
Moden has described two types of kaizen costing:
 Asset and organisation specific kaizen costing activities planned according to the
exigencies of each deal
 Product model specific costing activities carried out in special projects with added
emphasis on value analysis
Kaizen costing is applied to products that are already in production phase. Prior to kaizen
costing, when the products are under development phase, target costing is applied. ‘Kaizen
costing is based on the belief that nothing is ever perfect, so improvements and reductions in
the variable costs are always possible’

A Japanese concept ‘Kaizen’ refers to the continuous improvement through small betterments
in technology. Improvement means a process of always seeking ways to improve existing
process and tasks. Whereas target costing is used during the design phase of a product of a new
product, kaizen costing is used during the manufacturing phase. Once the product design and
the production process have been agreed, the production phase can begin.

Kaizen costing may be used to manage the efficiency of this phase. Kaizen costing system
involves teamwork by employees continually looking for ways of reducing costs and
improving quality. The objective of ‘continuous improvement’ philosophy is to develop
attitude of permanent improvement because nothing is considered “good enough”. Kaizen
costing is most consistent with saying ‘slow and steady wins the race’

3.2.3.2. Wastes reduction achieved through kaizen costing

Kaizen costing is closely associated with lean manufacturing, which is committed to the
elimination of waste through continuous improvement. A classic example of kaizen philosophy
is the production system developed at the Japanese car manufacturer TOYOTA.
Toyota identified 7 main types of waste in a production environment.
Over-production–– Over-production refers to producing more than what is needed. Over-
production is considered a waste because it costs the company money to produce it and it
lowers the quality of the product if it sits on the shelf. The solution for over-production is to
stop producing materials and only produce what can be immediately sold or shipped.
Waiting time–– Waiting refers to the waste of goods that are not moving. As you already may
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be aware, much of a product's life is spent waiting for the next phase. The reason this is
considered a waste is because the good should never be waiting. If they are waiting it is due to
poor material flow, long production runs, or travel distances.
Transportation (of materials and work-in progress)–– Moving your product from one location
adds no value to your product. Many products are damaged or lost, causing a waste of money.
Transporting also requires the use of material handlers, and this also adds no value to the
product. This is one waste that is difficult to reduce or eliminate. Mapping the flow of your
product may be one way you can gain a greater understanding of the transportation phase and
learn how to reduce the costs.
Inappropriate production processing–– Several companies purchase high precision equipment
to do a simple job. High precision equipment often leads to over-production of goods. This can
also encompass using the wrong suppliers or the wrong process to do a job.
Unnecessary inventory–– Excessive inventory is a direct result of overproduction and waiting.
Having excessive inventory will lead to increased lead times, limited floor space, and poor
communication. Too much inventory often masks problems from other areas as well.
Unnecessary/excess motion (of materials or people)–– This phase is often related to
behaviour-based safety. It is the unnecessary bending, stretching, walking, lifting and reaching
of an employee. Often the motion is not due to the employees behaviour, but the machine they
are operating may be manufactured poorly and the employee is unable to turn a knob (or
something similar) without using poor ergonomics.
Defects–– Defects in the manufacturing process are a tremendous cost to a company. Any
small defect directly impacts your bottom line and effects inventory, scheduling, inspection,
and other factors.

By evaluating the seven wastes, you can determine where your company is lacking and where
you can reduce or eliminate waste altogether. Toyota implemented this production system
program and reduced costs and lead-time and improved the quality of their products. Now,
Toyota is one of the world's largest companies.

3.2.3.3. Kaizen costing versus standard costing

To understand Kaizen costing, one first needs to grasp standard costing methodology. The
typical standard costing approach works by designing a product first, and computing costs by
taking into account material, labour and overhead. The resulting figure is set as the product
cost.
The standard cost is set and revised on a yearly basis. Cost deviation analysis involves
checking to see whether the projected cost estimates tally with the final figures. Manufacturing
procedures are assumed to be static.
In contrast, Kaizen costing is based around improving the manufacturing process on a
continual basis, with changes being implemented throughout the year. Cost-reduction targets
are set on a monthly basis. The goal here is to reduce the difference between profit estimates
and target profits. The cost deviation analysis done in Kaizen costing examines the difference
between the target Kaizen costs and the actual cost reduction achieved. The basic idea here is
to make tiny incremental cost reductions on a continual basis in a product’s life cycle.
Since the goal is to reduce costs on a monthly basis, every department in the company makes
an effort to introduce operational changes on a daily basis. The Kaizen approach calls for
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analyzing every part of the process and generating ideas on how they can be further improved.
Kaizen costing takes into account aspects such as time-saving strategies, employee efficiency
and wastage reduction while incorporating better equipment and materials.

3.2.3.4. Kaizen costing versus Target costing

 Kaizen costing is applied during manufacturing stage whereas target costing is during
planning stage.
 Kaizen costing focuses on production processes whereas target costing focuses on the
product.
 Kaizen costing aims to reduce costs of processes by a pre-specified amount relying on
employee empowerment.

3.2.3.5. Reasons for success and failure

Benefits of Kaizen Costing
There are certain benefits of Kaizen costing which are followed in various Japanese companies
which are listed below:
(i) Focus on customers: The Kaizen philosophy has only one prime objective of customers’
satisfaction. Kaizen permits no middle ground its either you provide best products and
customer satisfaction or not. All the activities should aim at providing customer with whatever
he wants and should help the firm long term objective of customers’ satisfaction at the same
time building up good relationship. It is a responsibility of each and every person working in a
Kaizen company to make sure that the product is up to the mark and it satisfies customers need.
(ii) Make improvements continuously: There is not a best way to do a thing, there is still a
better way. In a Kaizen company, the search for excellence just does not end. We should work
on the improvement implemented and see if we can make it even more effective.
(iii) Acknowledge problems openly: Every company has certain problems related to finance,
competition, change in demand etc. Kaizen companies are no exception, but by fostering an
appropriately supportive, constructive culture it becomes easier for any team to get its problem
in the open. The whole organization works as a team to solve the problem. The problems are
openly shared by the management with the employees which avoids rumours. It simply means
fight with your problems don’t run away from them.
(iv) Promote openness: There seems to be less functional ring fencing i.e. only the senior
managers have private cabins. Otherwise the workplace is generally open and in many
companies even the dress code and canteen for everyone is the same.
(v) Create work teams : Each individual in a Kaizen company belongs to work team headed
by a leader. Working in various overlapping teams draws employees into corporate life and
reinforces the mutual understanding.
(vi) Cross functional teams : Kaizen states that no individual or team has all the required skill
and knowledge to complete a task. Cross-functional teams help in getting all the valuable
information’s from the view of all the related people. It calls for letting ideas to flow as wide as
running on moon.
Example of Kaizen costing at Kappa Packaging, a major UK packaging business
Kappa Packaging has a factory at Stalybridge where it makes, among other things, packaging
(cardboard cartons) for glass bottles containing alcoholic drinks. In 2002, Kappa introduced a
new approach to reducing the amount of waste paper and cardboard. Before this, the business
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wasted 14.6 per cent of its raw materials used. This figure was taken as the base against which
improvements would be measured.
Improvements were made at Kappa as a result of:
 making staff more aware of the waste problem;
 requiring staff to monitor the amount of waste for which they were individually
responsible; and
 establishing a kaizen team to find ways of reducing waste.
As a result of kaizen savings, Kappa was able to reduce waste from 14.6 per cent to 13.1 per
cent in 2002 and 11 per cent in 2003. The business estimates that each 1 per cent waste saving
was worth £110,000 a year. So, by the end of 2003, Kappa was saving about £400,000 a year,
relative to 2001, that is, over £2,000 per employee each year.
Source: Taken from ‘Accurate measurement of process waste leads to reduced costs’,
www.envirowise.gov.uk, 2003.

Reasons for failure

While in most of the organisations Kaizen System has produced dramatic results/substantial
improvements, still it was surprised to notice that the same had failed. While analysing the
causes of the failure of the established Kaizen System, the following major reasons have been
found contributed to it:
 Lack of interest and supported from Top Management.
 Lack of proper motivation by Management.
 Lack of proper training of Listening Skills, Presentation Skills, Communication Skills etc.
to the participants.
 Criticising the efforts of failures by the Group members.
 Ignoring the basic concept ‘Improvements is a part of daily routine' by all concerned.
 Lot of work pressure on the participants, especially at the time of year end/handling the
crisis situation, resulting sidelining the Kaizen completely.

3.2.4. Life-cycle costing

3.2.4.1. What is life cycle costing?
Every product goes through a life cycle:
(1) Development. The product has a research and development stage where costs are incurred
but no revenue is generated.
(2) Introduction. The product is introduced to the market. Potential customers will be unaware
of the product or service, and the organisation may have to spend further on advertising to
bring the product or service to the attention of the market.
(3) Growth. The product gains a bigger market as demand builds up. Sales revenues increase
and the product begins to make a profit.
(4) Maturity. Eventually, the growth in demand for the product will slow down and it will
enter a period of relative maturity. It will continue to be profitable. The product may be
modified or improved, as a means of sustaining its demand.
(5) At some stage, the market will have bought enough of the product and it will therefore
reach 'saturation point'. Demand will start to fall. Eventually it will become a loss-maker

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 and this is the time when the organisation should decide to stop selling the product or
service.

Life cycle costing is the accumulation of costs over a product's entire life. A product's life cycle
costs are incurred from its design stage through development to market launch, production
and sales, and finally to its eventual withdrawal from the market. The component elements
of a product's cost over its life cycle could therefore include the following.
1. Research & development costs (design, testing, production process and equipment)
2. The cost of purchasing any technical data required
3. Training costs (including initial operator training and skills updating)
4. Production costs
5. Distribution costs. Transportation and handling costs
6. Marketing costs (customer service, field maintenance, brand promotion)
7. Inventory costs (holding spare parts, warehousing and so on)
8. Retirement and disposal costs. Costs occurring at the end of a product's life
Life cycle costs can apply to services, customers and projects as well as to physical products.

3.2.3.2. Purpose of life cycle costing

As most concepts, LCC has evolved over time, and today LCC serves three main purposes:
1. LCC can be an effective engineering tool for providing decision support in the design and
procurement of major open systems, infrastructure, and so on. This was the original intent
for which it was developed.
2. LCC overcomes many of the shortcomings of traditional cost accounting and can therefore
give useful cost insights in cost accounting and management.
3. LCC has re-emerged as a design and engineering tool for environmental purposes.

3.2.3.3. Life cycle costing versus other costing technique

To understand the relevance of total life cycle costing, consider what even the bible says about
cost planning. ‘For which of you, intending to build a tower, does not sit down first, and count
the cost, whether he has enough money to finish it; says Jesus (Luke 14:28)’.

Traditional cost accumulation systems are based on the financial accounting year and tend to
dissect a product's life cycle into a series of 12-month periods. This means that traditional
management accounting systems do not accumulate costs over a product's entire life cycle and
do not therefore assess a product's profitability over its entire life. Instead they do it on a
periodic basis. Life cycle costing, on the other hand, tracks and accumulates actual costs and
revenues attributable to each product over the entire product life cycle. Therefore, the total
profitability of any given product can be determined.

Target costing is seen as a part of a total life-cycle costing approach, in that cost savings are
sought at a very early stage in the life cycle, during the pre-production phase.

Kaizen costing is closely associated with lean manufacturing, which is committed to the
elimination of waste through continuous improvement. With kaizen costing, efforts are made to
reduce the unit manufacturing cost of the particular product or service under review, if possible
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taking it below the unit cost in the previous period. Target percentage reductions can be set.
Usually, production workers are encouraged to identify ways of reducing costs. This is
something that the hands-on experience of those workers may enable them to do. Even though
the scope to reduce costs is limited at the production stage, valuable savings can still be made.

Kaizen costing is linked to total life-cycle costing and focuses on cost saving during the
production phase. Since this is a relatively late stage in the life cycle (from a cost control point
of view), only relatively small cost savings can be made in the production phase. Also, the
major production-phase cost savings should already have been made through target costing.

However, whereas target costing and kaizen costing are each concerned with only a single
phase; total life-cycle costing covers all three phases of the product life cycle. Life-cycle
costing starts from the premise that the total (or whole) life cycle of a product or service has
three phases as illustrated in the following figure.

Figure: Relationship between costs committed and costs incurred

A product's life cycle costs are incurred from its design stage through development to market
launch, production and sales, and finally to its eventual withdrawal from the market. The above
figure shows the three main phases in the product’s life cycle:
1. Pre-production phase. This is the period that precedes production of the product or service
for sale. During this phase, research and development – both of the product or service and
of the market – is conducted. The product or service is invented/ designed and so is the
means of production. The phase culminates with acquiring and setting up the necessary
production facilities and with advertising and promotion.
2. Production phase comes next, being the one in which the product is made and sold or the
service is rendered to customers.
3. Post-production phase comes last. Once the manufacturing facilities have been established,
it may not be economic to revise the design but merely to deal with the problem through
after-sales service procedures. Therefore, during this phase, any costs necessary to correct
faults that arose with products or services that have been sold (after-sales service) are
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 incurred. There would also be the costs of closing production at the end of the product’s or
service’s life cycle, such as the cost of decommissioning production facilities. Since after-
sales service will tend to arise from as early as the first product or service being sold and
probably, therefore, well before the last one is sold, this phase would typically overlap with
the manufacturing/service-rendering phase.
Businesses often seem to consider environmental costs alongside the more obvious financial
costs involved in the life of a product. In some types of business, particularly those engaged in
an advanced-manufacturing environment, it is estimated that a very high proportion (as much
as 80 per cent) of the total costs that will be incurred over the total life of a particular product
are either incurred or committed at the pre-production phase.

In short, this new perspective on the LCC idea entails three shifts and an improvement:
1. From a partial focus to holistic thinking
2. From structure orientation to process orientation
3. From cost allocation to cost tracing
4. Managing risk and uncertainty realistically

Illustration: Fit Company specialises in the manufacture of a small range of hi-tech products
for the fitness market. They are currently considering the development of a new type of fitness
monitor, which would be the first of its kind in the market. It would take one year to develop,
with sales then commencing at the beginning of the second year. The product is expected to
have a life cycle of two years, before it is replaced with a technologically superior product. The
following cost estimates have been made.
Year 1 Year 2 Year 3
Units manufactured and sold 100,000 200,000
Research and development costs $160,000
Product design costs $800,000
Marketing costs $1,200,000 $1,000,000 $1,750,000
Manufacturing costs:
Variable cost per unit $40 $42
Fixed production costs $650,000 $1,290,000
Distribution costs:
Variable cost per unit $4 $4.50
Fixed distribution costs $120,000 $120,000
Selling costs:
Variable cost per unit $3 $3.20
Fixed selling costs $180,000 $180,000
Administration costs $200,000 $900,000 $1,500,000
Note: You should ignore the time value of money
Required: (a) Discuss the benefits of life cycle costing; (b) Calculate the life cycle cost per unit
Solution
(a) Benefits of life cycle costing
1. The visibility of ALL costs is increased, rather than just costs relating to one period. This
facilitates better decision-making.
2. Individual profitability for products is more accurate because of this. This facilitates
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 performance appraisal and decision-making, and means that prices can be determined with
better knowledge of the true costs.
3. More accurate feedback can take place when assessing whether new products are a success
or a failure, since the costs of researching, developing and designing those products are also
taken into account.
Note: Other valid benefits are welcome (see purpose of LCC)
(b) Life cycle cost per unit
$
R & D costs 160,000
Product design costs 800,000
Marketing costs 3,950,000
Fixed production costs 1,940,000
Fixed distribution costs 240,000
Fixed selling costs 360,000
Administration costs 2,600,000
Variable manufacturing costs 12,400,000 i.e (100,000 x $40 + 200,000 x $42)
Variable distribution costs 1,300,000 i.e (100,000 x $4 + 200,000 x $4.50)
Variable selling costs 940,000 i.e (100,000 x $3 + 200,000 x $3.20)
Total costs 24,690,000
Therefore cost per unit = $24,690,000/300,000 = $82.30

3.3. STRATEGIC COST MANAGEMENT FOR COMPETITIVE ADVANTAGE

3.3.1. Introduction to cost management system
3.3.1.1. Defining a cost management system
A cost management system (CMS) consists of a set of formal methods developed for planning
and controlling an organization’s cost-generating activities relative to its short-term objectives
and long-term strategies. Business entities face two major challenges:
 achieving profitability in the short run, and
 maintaining a competitive position in the long run.

An effective CMS provides managers the information needed to meet both of these challenges.
Core
Competencies

COST Organizational
Organizational MANAGEMENT Plans and
Performance SYSTEM Strategies

Organizational
Threats and
Opportunities
The CMS helps provide information useful to managing an organization’s core competencies

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so the organization can exploit perceived opportunities in the marketplace and develop tactics
and strategies to fend off threats. Similarly, the CMS links plans and strategies to actual
organizational performance.

3.3.1.2. Dual focus of a cost management system

The information generated from the CMS should benefit all functional areas of the entity. CMS
should integrate information from all areas of the firm and provide managers faster access to
more cost information that is relevant, detailed, and appropriate for short-term and long-term
decision-making.
Short-run Long-run
Objective Organizational efficiency Survival
Focus Specific costs: Cost categories:
 manufacturing  customers
 service  suppliers
 marketing  products
 administration  distribution channels
Important characteristics Timely Periodic
of information Accurate Reasonably accurate
Highly specific Broad focus
Short term Long term

The above table provides a summary of the differences in the information requirements for
organizational success in both the short run and the long run. In the short run, revenues must
exceed costs and the organization must make efficient use of its resources relative to the
revenues that are generated. Specific cost information is needed and must be delivered in a
timely fashion to an individual who is in a position to influence the cost. Short-run information
requirements are often described as relating to organizational efficiency.
Meeting the long-run objective of survival depends on acquiring the right inputs from the right
suppliers, selling the right mix of products to the right customers, and using the most
appropriate channels of distribution. These decisions require only periodic information that is
reasonably accurate.

3.3.1.3. The roles of a cost management system

Crossing all functional areas, a CMS can be viewed as having six primary goals:
 to develop reasonably accurate product costs, especially through the use of cost drivers (or
activities that have direct cause-and-effect relationships with costs);
 to assess product/service life cycle performance;
 to improve understanding of processes and activities;
 to control costs;
 to measure performance; and
 to allow the pursuit of organizational strategies.

The product/service costs generated by the CMS are the inputs to managerial processes.
These costs are used to
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 plan,
 prepare financial statements,
 assess individual product/service profitability and periodic profitability,
 establish prices for cost-plus contracts, and
 create a basis for performance measurements.
If the costs generated by the CMS are not reasonably accurate, the execution of the preceding
processes will be inappropriate for control and decision-making purposes.

3.3.1.4. Management accounting and ethical behaviour

Management accounting practices were developed to provide information that assists managers
to maximize future profits. It was, however, pointed out that it is too simplistic to assume that
the only objective of a business firm is to maximize profits. The profit maximization objective
should be constrained by the need for firms to also give high priority to their social
responsibilities and ensure that their employees adopt high standards of ethical behaviour. A
code of ethics has now become an essential part of corporate culture. Identification of what is
acceptable ethical behaviour has attracted much attention in recent years.

Performance measurement systems are widely used to financially reward managers on the basis
of their performance in reducing costs or increasing sales or profits. This has resulted in many
managers in the financial services sector taking actions to increase sales or profits when such
actions have resulted in providing high risk loans that caused the financial crises in the banking
sector.
Many would argue that they were motivated by personal greed to increase the reported sales
revenues and profits and thus their bonus, without considering the adverse long-term
implications of their actions. It could be argued, however, that they were engaging in
organizationally desirable behaviour by seeking to maximize profits because the reward system
strongly encouraged them to increase sales or profits. An alternative view is that they were
engaging in unethical actions.

So where should the blame be assigned? Is the reward system at fault or the unethical
behaviour? Or both? Professional accounting organizations also play an important role in
promoting a high standard of ethical behaviour by their members. Both of the professional
bodies representing management accountants, in the UK (Chartered Institute of Management
Accountants), and in the USA (Institute of Management Accountants), have issued a code of
ethical guidelines for their members and established mechanisms for monitoring and enforcing
professional ethics.

The guidelines are concerned with ensuring that accountants follow fundamental principles
relating to:
1. integrity (being honest and not being a party to any falsification);
2. objectivity (not being biased or prejudiced);
3. confidentiality and professional competence and due care (maintaining the skills required
to ensure a competent professional service);
4. compliance with relevant laws and regulations.

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3.3.1.5. Cost control, cost reduction, and cost management
One of the important functions of cost accounting is cost control and cost reduction. Cost
control is a process of either reducing costs while maintaining the same levels of productivity,
or maintaining costs while increasing levels of productivity through economies of scale or
efficiencies in producing goods or services. For this reason, cost control is more accurately
considered as cost improvement.
Cost control implies various actions taken in order to ensure that the cost do not rise beyond a
particular level while cost reduction means reducing the existing cost of production. For
example, if the present costs are Frw 1,000 per unit, attempts can be made to reduce it to bring
it down below Frw 1,000.
The term ‘cost management’ identifies, collects, measures, classifies and reports information
that is useful to managers and other internal users in cost ascertainment, planning, controlling
and decision-making. Cost management aims to produce and provide information to internal
users and personnel working in the organization.

3.3.2. Strategic cost management

3.3.2.1. What is strategic cost management?
In the contemporary business environment, cost management has become a critical survival
skill for many organizations. But it is not sufficient to simply reduce costs; instead, costs must
be managed strategically.
Many authors have stressed that the strategic importance of cost management has drastically
increased in the recent years due to intense competition. According to Cooper and Slagmulder
(1997a) customers in highly competitive markets expect that each generation of products
presents improvements. These improvements may include: improved quality, improved
functionality or reduced prices. Any of these improvements alone or any combination of them
urge a firm to manage its costs to stay profitable.The Concept of Strategic Cost Management
Cooper and Slagmulder (1998a) argued that strategic cost management is “the application of
cost management techniques so that they simultaneously improve the strategic position of a
firm and reduce costs”. They suggest three sorts of cost management initiative, based on
whether the impact on the organization’s competitive position is positive, negative or neutral.

Cooper (1995a) argued that strategic cost management needs to include all aspects of
production and delivering the product; the supply of purchased parts, the design of products
and the manufacturing of these products. So, strategic cost management should be inherent to
each stage of a product’s life cycle, i.e. during the development, manufacturing, distribution
and during the service lifetime of a product.
Strategic cost management is the use of cost data to develop and identify superior strategies
that will produce a sustainable competitive advantage. Therefore, a sophisticated understanding
of an organization’s cost structure can go a long way in the search for sustainable competitive
advantage. Shank and Govindarajan (1993) defined SCM as “the managerial use of cost
information explicitly directed at one or more of the four stages of strategic management:
1) formulating strategies,
2) communicating those strategies throughout the organization,
3) developing and carrying out tactics to implement the strategies, and
4) developing and implementing controls to monitor the success of objectives”.
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According to Horvath and Brokemper (1998:585), strategic cost management has emerged as a
key element to attain and sustain a strategic competitive advantage through long-term
anticipation and formation of costs level, costs structure, and costs behaviour pattern for
products, processes, and recourses. For this purpose, strategic cost management must provide
managers with different information.

In strategic cost management, we explain how costs can be reduced by links between customer
and supplier as well as cost initiatives within the organisation. Strategic cost management sees
products, processes, and resources themselves as creative objects for attaining a strategic
competitive advantage. This goal may not be achieved based on traditional cost management.
They also argue that strategic cost management must determine and analyze long-term cost
determinants (economics of scale, experience, etc.) and their influence on costs level, costs
structure, and costs behaviour pattern.

Finally, strategic cost management should begin with participation during R&D and design
stages of the product in order to avoid the costs early in the product life cycle. Hence, the term
strategic cost management has a broad focus, it is not confined to the continuous reduction of
costs and controlling of costs and it is far more concerned with management’s use of cost
information for decision-making.

3.3.2.2. Concerns and objectives of strategic cost management

In the past, the primary concern of cost management was cost. However, traditional cost
management may not be adaptable to the events related to the trends and changes in business
environment. Today, cost and revenue management is the present role of strategic cost
management. Strategic cost management primary concern will not only be cost management
but also increase revenues, improve productivity and customer satisfaction, and the same time
improve the strategic position of the company.

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3.3.2.3. Traditional cost management versus Strategic cost management
Strategic cost management must bridge the gap between cost and value as well as
between the language of the market and the language of the business. Traditional cost
management during faced many criticisms. However, strategic cost management faces a
future that will be unique and rewarding compared to its current realities. The difference
between traditional cost management and strategic cost management is explained below:
Traditional cost management Strategic cost management
Focus Internal External
Perspective Value-added Value chain
Cost analysis- In term of: product, customer, and In terms of the various stages of the overall
way function value chain of which the firm is a part
With a strongly internal focus With a strongly external focus
Value added is a key concept Value-added is seen as a dangerously
narrow concept
Cost analysis- Three objectives will apply, Although the three objectives are
objective without regard to the strategic always present, the design of cost
context: Score keeping, attention management system changes
directing, and problem solving. dramatically depending on the basic
strategic positioning of the firm: either
under a cost leadership strategy, or
under a product differentiation strategy.
Cost driver A single fundamental cost driver Multiple cost drivers such as: Structural
concept pervades literature - cost is a drivers (e.g. scale, scope, experience,
function of volume. Applied too technology, complexity); Executional
often only at the overall firm drivers (e.g. participative management,
level. total quality management) Each value
activity has a set of unique cost drivers
Cost Cost reduction approached via Cost containment is a function of the cost
containment responsibility centres or product driver(s) regulating each value activity.
philosophy cost issues
Primary concern Cost impact Cost/Value/Revenue relationship
Key disciplines Finance/Accounting Marketing/Economies
Primary role Scorekeeper Analyst and consultant
Management Follower/reactive Risk-averse Leader/proactive Comfortable with
responsibility ambiguity

The emergence of strategic cost management results from a blending of three underlying
themes, each taken from the strategic management literature:
1. Value chain analysis
2. Strategic positioning analysis
3. Cost driver analysis
Each of these three themes represents a stream of research and analysis in which cost
information is cast in a light very different from that in which it is viewed in conventional
management accounting.

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3.3.2.4. Strategic cost analysis
Strategic cost analysis explains the tools that managers need. It examines the different methods
of calculating cost, techniques for controlling and monitoring costs, and ways to integrate cost
data and strategy into every aspect of the organization. It helps companies identify, analyze and
use strategically important resources for continuing success. Strategic cost analysis focuses on
an organization’s various activities, identifies the reasons for their costs, and financially
evaluates strategies for creating a sustainable competitive advantage.
The technique provides organizations with the total costs and revenues of strategic decisions.
This requires creative thinking, and managers need to identify and solve problems from an
integrative and cross-functional viewpoint. The examples of strategic cost analysis include:
 Deciding on product mixes and production volumes
 Outsourcing decisions
 Cost reductions
 Investment and profit growth in different markets
 Responses to suppliers’ and competitors’ activities
 Changes in consumer demand

3.3.3. Total quality management (TQM)

3.3.3.1. Concept of TQM and its underlying principles
The success of Japanese companies in recent years has caused intense interest in Japanese
styles of management. One aspect of Japanese management is the approach of ‘get it right first
time’. In this spirit, total quality management has the customer as its focal point. Quality is
defined as fully satisfying agreed customer requirements at the lowest internal price. Quality
may include a number of different attributes, such as:
 Availability – can it be delivered when I want it?
 Reliability – will it work first time every time?
 Responsiveness – will the supplier be reasonably flexible?
 Competence – do the necessary skills and knowledge exist to perform the service?
 Communication – can I contact the supplier easily and do they speak my language?
 Credibility – do they inspire confidence?
 Security – are their systems and procedures secure?

Total quality management is a philosophy of continuously improving the quality of all the
products and processes in response to continuous feedback for meeting the customers’
requirements. It aims to do things right the first time, rather than need to fix problems after
they emerge (A company should avoid defects rather than correct them). Its basic objective is
customer satisfaction. The elements of TQM are
Total Quality involves everyone and all activities in the company (Mobilizing the
whole organization to achieve quality continuously and economically)
Quality Understanding and meeting the customer’ requirements (satisfying the customers
first time every time)
Management Quality can and must be managed (Avoid defects rather than correct them)
TQM is a vision based, customer focused, prevention oriented, continuously improvement
strategy based on scientific approach adopted by cost conscious people committed to satisfy
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the customers first time every time. It aims at managing an organization so that it excels in
areas important to the customer.

The philosophy of TQM rests on the following principles:

1. Clear exposition of the benefits of a project
2. Total employee involvement
3. Process measurement.
4. Involvement of all customers and contributors
5. Elimination of irrelevant data
6. Understanding the needs of the whole process
7. Use of graphical and pictorial techniques to achieve understanding
8. Establishment of performance specifications and targets
9. Use of errors to prompt continuous improvement
10. Use of statistics to tell people how well they are doing

In the competitive environment in which most businesses operate, a failure to deliver quality
will lead to customers going to another supplier. Therefore, businesses need to establish
procedures that promote the quality of their output, either by preventing quality problems in the
first place or by dealing with them when they occur.
The use of the TQM approach is seen as the key to improving profitability because there is a
cost associated with failing to meet quality standards in products and services. Such costs could
arise through loss of customers, claims for refunds in respect of defective supplies, and the
work of putting right mistakes. If costs can be controlled through TQM, then profits will
increase. Those who are enthusiastic for TQM believe that it is possible to obtain defect-free
work first time on a consistent basis. That may be an idealistic target but to have such a target
encourages a culture where prevention of error is a key feature of the operations. This activity
of improving quality to improve profits will itself cause cost to be incurred.

3.3.3.2. Cost of quality

The term cost of quality is a collective name for all costs incurred in achieving a quality
product or service. Quality costs been seen as falling into four main categories: prevention
cost, appraisal cost, internal failure cost and external failure cost.
1. Prevention costs: costs of any action taken to prevent or reduce defects and failures before
they occur. They include the quality planning, quality assurance, training on quality issues
and determining specifications for incoming materials, for processes carried out in the
operations of the business and for finished products. Some types of prevention costs might
be incurred during the pre-production phase of the product life cycle, where the production
process could be designed in such a way as to avoid potential quality problems with the
output.
2. Appraisal costs: costs of assessing the quality that has been achieved (costs of evaluating
suppliers and obtaining an evaluation by customer). These are concerned with inspecting
equipment, monitoring incoming materials and supplies, work in progress and finished
products to try to avoid substandard products from reaching the customer, and collecting
information from customers on satisfaction with goods and services.
3. Internal failure costs: costs arising within the organisation due to a failure to achieve the
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 quality standards specified before delivery to customers. Examples of internal failure costs
are: waste, scrap, rectification, re-inspection of rectified work and analysis of the causes of
failure.
4. External failure costs: costs associated with rectifying quality problems with products
(error or defect) that have passed outside the organisation to the customer. There is also the
cost to the business of its loss of reputation from having passed substandard products to the
customer. Examples of external failure costs include: repairs, warranty claims, complaints,
returns, product liability litigation and loss of customer goodwill.
Prevention costs and appraisal costs are subject to management influence or control. Internal
and external failure costs are the consequences of weaknesses in prevention or appraisal.

The traditional picture of quality control is that in the absence of quality control, failures occur
which create failure costs. Detection of failure relies on checking after the failure has occurred.
The checking process involves further checking costs. With quality controls in place, as
prevention work is undertaken, the costs of failure should begin to fall. At the outset, the
prevention costs will be additional to the costs of checking for failures, but as confidence
grows, and the frequency of failure decreases, the need for checking should diminish. The
quality exercise will be successful in cost terms if there is a reduction in total cost over the
three headings of prevention, appraisal and failure costs.

TQM ideas are widely practised and there are many non-financial performance measures being
used in business organisations. Measuring the cost of quality is a relatively undeveloped area
although a few businesses have a well-developed approach. The management accountant as
scorekeeper is ideally placed to record and monitor cost of quality, but many of the initiatives
emerging are in special units within an organisation which are separate from the ‘traditional’
management accounting functions. Management accountants may need to be proactive in
seeking out new ways of applying their generic skills.

3.3.3.3.
A quality cost report details the prevention costs, appraisal costs, and internal failure cost and
external failure cost that arise from company’s current level of defective products or services.
Companies often construct a quality cost report that provides an estimate of the financial
consequences of the company’s current level of defects. A company can reduce its total quality
cost by focusing its efforts on prevention and appraisal. The cost savings from reduced defects
usually swamp the costs of the additional prevention and appraisal efforts.

Example of quality cost report (amounts are in $)

Manufac Limited Company
Quality Cost Report
For the Year 1 & 2
Year 2 Year 1
Amount Percent Amount Percent
Prevention cost 1,000,000 2.00% 650,000 1.30%
Appraisal costs 1,500,000 3.00% 1,200,000 2.40%
Internal failure costs 3,000,000 6.00% 2,000,000 4.00%
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External failure costs 2,000,000 4.00% 5,150,000 10.30%
Total quality cost 7,500,000 15.00% 9,000,000 18.00%

Prevention cost increased by ($1,000,000 – $650,000) = $350,000

Appraisal cost increased by ($1,500,000 – $1,200,000) = $300,000
Internal failure cost ($3,000,000 – $2,000,000) = $1,000,000
Total Increase = $1,650,000
External failure cost decreased by = 5,150,000 – $2,000,000 = $3,150,000
Net quality cost benefit = $3,150,000 – $1,650,000 = $1,500,000

Several things should be noted from the data in the quality cost report. First, note that the
quality costs are poorly distributed in both years, with most of costs being traceable to either
internal or external failure. The external failure costs are particularly high in year 1 in
comparison to other costs. Second, note that the company increased its spending on prevention
and appraisal activities in year 2. As a result, internal failure costs went up in that year (from
$2 million in first year to $3 million in year 2), but external failure costs dropped sharply (from
$5.15 million in year 1 to $3 million in year 2). Because of the increase in appraisal activates in
year 2, more defects were caught inside the company before being delivered to the customers.
This resulted in more cost for scrap, rework, and so forth, but saved huge amounts in warranty
repairs, warranty replacements, and external failure costs. Third, note that as a result of greater
emphasis on prevention and appraisal, total quality cost decreased in year 2.
As continued emphasis is placed on prevention and appraisal in future years, total quality cost
should continue to decrease. That is, future increases in prevention and appraisal costs should
be more than offset by decreases in failure costs. Moreover, appraisal costs should also
decrease as more effort is placed into prevention.

3.3.4. Activity-based management (ABM)

ABM is a system of management which uses ABC information to support and improve
decision making. Examples: cost reduction, cost modelling and customer profitability analysis.
Activity-based management encourages continuous improvement by allowing managers to
consider the strategic impact of activities and to plan the incentives that will encourage
operational teams to implement the desired strategy. A system of Activity-based management
would produce the following output in relation to any potential management decision:
 information on the cost of activities and business processes
 the cost of activities that do not add value, such as wastage
 performance measures based on activities, such as a scorecard
 projected costs of products and services
 cost drivers.

3.3.4.1. Cost driver analysis

Cost driver analysis is concerned with determining what the actual drivers of activity costs are
within your operations. The most popular type of analysis for this is activity based costing
(ABC) which a ims to establish what indirect causes can be related to specific activities. This
has a bearing on strategic cost management since cost drivers can actually be determined by

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both structural cost drivers and executional cost drivers.
 Structural cost drivers relate to strategic management choices the company undertakes in
relation to actual structure of their operations (scale and scope) as well as the complexity of
their products and technologies used. A more complex working environment (products,
technologies and production) leads to higher structural costs.
 Executional cost drivers relate to the actual operational processes and norms within
operation. The effective use of staff, process layouts, just-in-time processes, etc. all have a
bearing on the cost of executing activities within the firm.
ABC and ABM allow the management accountant to play a key part in maximising value from
resources because of the level of understanding of key activity and cost information.
Figure: Activity-based management approach

ABC, through the processes of pooling of activity costs and the identification of cost drivers,
can lead to a range of applications. These include the identification of spare capacity and the
fostering of cost reduction by comparing the resources required under ABC with the resources
that are currently provided. This provides a platform for the development of activity-based
budgeting in which the resource relationships identified by ABC are used to project future
resource requirements.

3.3.4.2. Application of activity-based management

ABC has attracted a considerable amount of interest because it provides not only a basis for
calculating more accurate product costs but also a mechanism for managing costs. An ABC
system focuses management's attention on the underlying causes of costs. It assumes that
resource consuming activities cause costs and that products incur costs through the activities
they require for design, engineering, manufacturing, marketing, delivery, invoicing and
servicing. By collecting and reporting on the significant activities in which a business engages,
it is possible to understand and manage costs more effectively.
With an ABC system, costs are managed in the long term by controlling the activities that drive
them. In other words, the aim is to manage the activities rather than costs. By managing the
forces that cause the activities (i.e. the cost drivers), costs will be managed in the long term.
The application of activity-based systems may have the greatest potential for contributing to
cost management, budgeting, control and performance evaluation.
3.3.5. Just-in-time (JIT) manufacturing
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3.3.5.1. Meaning and origin
‘Just in time’ is a management model that aims to improve manufacturing efficiency. It is a set
of principles and practices based on the philosophy that firms should hold little or no inventory
beyond that required for immediate production or distribution. It aims at reducing machine set-
up times, accepting only perfect incoming resources, allowing no deviation from standards and
matching output exactly to the demands of the customer. That is, a manufacturer should receive
raw materials or parts from its suppliers perhaps just hours before they will be used in
production, and the firm’s output should be shipped to its customers as soon after completion
as possible—without holding onto a stock of either raw goods or finished products. With JIT,
every activity occurs exactly at the time needed for effective execution, and the activity always
happens exactly as planned. It reduces stockholding costs, minimises idle time for production
resources and creates a demand-driven business.

JIT began in Japan in the 1950s, an era when American workers produced approximately nine
times as much as Japanese workers. Taiichi Ohno of the Toyota Motor Company visited
American car manufacturers to learn how his organization could match American productivity.
However, he was not impressed by what he saw. Fortunately, during that visit he was inspired
by the simple operation of a drinks vending machine. Each time a customer paid for and
removed a drink from the machine, a replacement drink automatically took its place. An empty
receptacle triggered the appearance of new stock. Ohno built the now famous Toyota
production system around this simple process.

Over the years, JIT has developed significantly. Originally, it was a ‘top-down’ process
imposed on employees by management but its current sophistication depends on the proactive
interventions of an empowered workforce. Every single worker has personal responsibility for
efficiency and quality; the workers are motivated by having psychological ownership of their
roles and wholeheartedly endorse the philosophy of continuous improvement and personal
development. It is also worth noting that one of the basic foundations of this model is ‘respect
for the individual worker’, a fact often overlooked by students of this very important system.

3.3.5.2. Objectives
The common perception of JIT is that its main objective is the elimination of stocks. Those
who operate it know that it embraces much more than this. A more complete list of its
objectives includes the achievement of:
 zero defects;
 zero waste;
 zero inventory;
 zero lead times;
 smooth continuous flow processes;
 flexible manufacturing.

The first four of these lend themselves to measurement by performance indicators. JIT systems
are most suitable for high-volume, repetitive manufacturing, although they can be adapted for
less repetitive production. They work best when the manufacturing schedule is stable for

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reasonably long periods of time (months rather than days). On the production line, the system
operates by each workstation requesting materials to work on from the previous workstation.
This is referred to as a ‘pull’ system and no workstation is allowed to ‘push’ its output down
the line to the next operation. Incidentally, each workstation is responsible for ensuring the
quality of its outputs; no ‘external’ inspection teams are used.

3.3.5.3. Features of JIT

The major features of a JIT production system are:
1. The rearrangement of the production process into production cells consisting of different
types of equipment that are used to manufacture a given product.
2. Reducing set-up times (i.e. the amount of time required to adjust equipment settings and to
retool for the production of a different product).
3. Increased emphasis on total quality management that seeks to eliminate defective
production.
4. Production cell workers are trained to multi-task so that they can perform a variety of
operations and tasks.
5. The adoption of JIT purchasing techniques, whereby the delivery of materials immediately
precedes demand or use.
6. The modification of management accounting performance measures and product costing
systems so that they support the JIT production systems.

3.3.5.4. Comparison of JIT Approaches with Traditional

In practice, JIT has often been expressed as a holistic management system aimed at reducing
waste, maximizing cost efficiency, and securing a competitive advantage. Thus, a number of
additional conditions are considered necessary for the successful implementation of JIT. These
include small lot sizes, short setup and changeover times, efficient and effective quality
controls, and perhaps most of all, designing the whole production process to minimize backups
and maximize the efficiency of human and machine labour.

Dealing with problems as soon as they arise makes the company both efficient and effective.
JIT is active in the following four areas of manufacturing:
 product design;
 process design;
 human/organization elements;
 manufacturing planning and control.

Comparison of JIT Approaches with Traditional

Traditional JIT
1. Push-through system 1. Pull-through system
2. Significant inventories 2. Insignificant inventories
3. Large supplier base 3. Small supplier base
4. Short-term supplier contracts 4. Long-term supplier contracts
5. Departmental structure 5. Cellular structure
6. Specialized labour 6. Multi-skilled labour

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7. Centralized services 7. Decentralized services
8. Low employee involvement 8. High employee involvement
9. Supervisory management style 9. Facilitating management style
10. Acceptable quality level 10. Total quality control
11. Sellers’ market 11. Buyers’ market
12. Value-added focus 12. Value-chain focus

3.3.6. Lean production and learning accounting

3.3.6.1. What is meant by lean production?
A lean organisation is one that takes into consideration the value to customers and strongly
focuses on its key processes for increasing the same in a continuous manner. So, the ultimate
idea and goal of lean manufacturing and production is to provide proper and perfect value to
the customers through a perfect process, which creates perfect value and reduces the waste to
zero level.
Lean manufacturing technique is conceptually different from the traditional manufacturing
process. While traditional manufacturing process is based on the very perception of inventory
but lean manufacturing on the other hand calls for zero inventory level and considers carrying
inventory is a waste. According to the lean manufacturing concept, customers only pay for the
value-added activities, which create value to the products and services to be supplied to them
and not for any non-value added activities or mistakes by the organization. The lean production
/manufacturing concept has changed the concept of manufacturing and it made the organization
to define the value of the product from the point of view of the customer’s, and not from the
point of view of internal manufacturing, only. Successful implementation of lean
manufacturing calls for a clear demarcation between a lean production system and an ordinary
manufacturing/production system.

3.3.6.2. The learning-curve effect

Where an activity undertaken by direct workers has been unchanged for some time, and the
workers are experienced at performing it, the standard labour time will normally stay
unchanged. However, where a new activity is introduced, or new workers are involved with
performing an existing activity, a learning-curve effect will normally occur.

The first unit of output takes a long time to produce. As experience is gained, the worker takes
less time to produce each unit of output. The rate of reduction in the time taken will, however,
decrease as experience is gained. Thus, for example, the reduction in time taken between the
first and second unit produced will be much bigger than the reduction between, say, the ninth
and the tenth. Eventually, the rate of reduction in time taken will reduce to zero so that each
unit will take as long as the preceding one. At this point, the point where the curve becomes
horizontal (the bottom right of the graph), the learning-curve effect will have been eliminated
and a steady, long-term standard time for the activity will have been established.

The learning-curve effect seems to have little to do with whether workers are skilled or
unskilled; if they are unfamiliar with the task, the learning-curve effect will arise. Practical
experience shows that learning curves show remarkable regularity and, therefore, predictability

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from one activity to the next.
The learning-curve effect applies equally well to activities involved with providing a service
(such as dealing with an insurance claim in an insurance business) as to manufacturing-type
activities (like upholstering an armchair by hand in a furniture making business). Clearly, the
learning-curve effect must be taken into account when setting standards, and when interpreting
any adverse labour efficiency variances, where a new process and/or new personnel are
involved.
The areas in which the application of learning curve can help a manufacturing
organisation are:
(i) Improvement of productivity: as the experience is gained the performance of workers
improves, time taken per unit reduces and thus his productivity goes up.
(ii) Cost predictions: Learning curve provides better cost predictions to enable price
quotations to be preferred for potential orders.
(iii) Work scheduling: learning curve enables us to predict the inputs required more
effectively and helps in the preparation of accurate delivery schedules.
(iv) Standards setting: If budgets and standards are set without considering learning curve, it
is meaningless because variances will arise.

There are two approaches to analyse the learning curve effect: Tabular approach and Algebraic
approach. To illustrate, let us use the example of an 80% learning curve.
When an 80% learning curve occurs, the cumulative average time required per unit of output is
reduced to 80% of the previous cumulative average time when output is doubled. If the first
unit of output of a new product required 100 hours, an 80% learning curve applies:
Tabular method
Cumulative Average cumulative Cumulative total Incremental Incremental
number of units time per unit (hours) time (hours) number of units total time
1 100 100  
2 80 160 1 60
4 64 256 2 96
8 51.2 409.6 4 153.6
16 40.96 655.36 8 245.76
32 32.768 1048.576 16 393.216
64 26.2144 1677.722 32 629.1456
128 20.9715 2684.355 64 1006.633

Algebraic method
Learning curve formula is as follows: Y = axb
Y = cumulative average time per unit to produce x units
a = the time taken for the first unit of output
x = the cumulative number of units produced
b = the index of learning (log LR/log2) =log of learning rate/log2
LR = the learning rate as a decimal

With our 80% learning curve, for example we calculate the time it takes to produce 8 units.

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Y= 100*8b

3.3.6.3. Lean accounting

Lean manufacturing involves slimming down and eliminating any unnecessary procedure or
resource. The aim is to find the essential resources and essential procedures and use only these.
Waste in production has to be identified and eliminated. Lean accounting assumes profit is
from maximizing flow on actual demand (pull signals) from customers; waste is any resource
that impedes flow. Control is achieved through attention to flow and waste and excess capacity
provides flexibility. The team then prepares a cost analysis for calculating the cost of the value
stream, which replaces the standard costing system. With this transition, value stream
profitability and contribution margin become the basis for business decisions.
3.3.7. Theory of constraints and throughput accounting
3.3.7.1. Nature and meaning of the theory of constraints
A constraint is a restriction that is preventing a company achieving its goal. Constraints can be
internal or external. Internal ones are usually production related whilst external ones could be
supplier related, e.g. the inability to purchase sufficient raw materials.
Constraints are also referred to as ‘bottlenecks’. Bottleneck resource or binding constraint –
an activity which has a lower capacity than preceding or subsequent activities, thereby limiting
throughput. The bottlenecks can be departments, teams or machines which are already working
at full capacity and cannot handle any extra demand. Managers are usually aware of which
bottleneck is having the largest negative effect on the rate of output.

In order to ensure the identified bottleneck works at maximum efficiency, buffer stocks of
work-in-progress are maintained on either side of it. This is in order to prevent the output rate
decreasing and causing knock-on effects all the way down the line when any unforeseen
problems arise. The buffer stocks minimize the effects of any problems elsewhere by providing
time in which to put the problem right. This is one way of managing risk; managers must
exercise judgement as to the quantity of buffer stocks held.

3.3.7.2. Origin
The originator of this theory, Dr Eliyahu Goldratt, described it at length in his 1984 book, The
Goal (which is in the form of a novel). He said: ‘every real system, such as a business, must
have within it at least one constraint. If this were not the case then the system could produce
unlimited amounts of whatever it was striving for, profit in the case of a business.’
The objective of TOC is to increase throughput contribution while decreasing investments and
operating costs. The theory of constraints considers short-run time horizons and assumes other
current operating costs to be fixed costs. The key steps in managing bottleneck resources are as
follows:
 Step 1. Recognise that the bottleneck resource determines throughput contribution of the
plant as a whole.

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 Step 2. Search and find the bottleneck resource by identifying resources with large
quantities of stock waiting to be worked on.
 Step 3. Keep the bottleneck operation busy and subordinate all non-bottleneck resources to
the bottleneck resource. That is, the needs of the bottleneck resource determine the
production schedule of non-bottleneck resources.
Step 3 represents a key notion: to maximise overall contribution margin, the plant must
maximise contribution margin (in this case, throughput contribution) of the constrained or
bottleneck resource. For this reason, step 3 suggests that the bottleneck machine always be
kept running, not waiting for jobs. To achieve this, companies often maintain a small buffer
stock of jobs waiting for the bottleneck machine. The bottleneck machine sets the pace for
all non-bottleneck machines. That is, the output at the non-bottleneck operations are tied or
linked to the needs of the bottleneck machine. For example, workers at non-bottleneck
machines are not motivated to improve their productivity if the additional output cannot be
processed by the bottleneck machine. Producing more non-bottleneck output only creates
excess stock; it does not increase throughput contribution.
 Step 4. Take actions to increase bottleneck efficiency and capacity – the objective is to
increase throughput contribution minus the incremental costs of taking such actions. The
management accountant plays a key role in step 4 by calculating throughput contribution,
identifying relevant and irrelevant costs and doing a cost–benefit analysis of alternative
actions to increase bottleneck efficiency and capacity.

3.3.7.3. Throughput account as a performance measurement system

Cambridge advanced learner’s dictionary defines the term throughput as ‘an amount of work,
etc. done in a particular period of time.’ Eg. We need to improve our throughput because
demand is high at present.
Throughput accounting (TA) is an approach to accounting which is largely in sympathy with
the JIT philosophy. It is a product management system which aims to maximise throughput,
and therefore cash generation from sales, rather than profit.
In essence, TA assumes that a manager has a given set of resources available. These comprise
existing buildings, capital equipment and labour force. Using these resources, purchased
materials and parts must be processed to generate sales revenue. Given this scenario the most
appropriate financial objective to set for doing this is the maximisation of throughput (Goldratt
and Cox, 1984) which is defined as: sales revenue less direct material cost.

The concept of throughput accounting has been developed from TOC as an alternative system
of cost and management accounting in a JIT environment. Throughput accounting is the
performance measurement system associated with the theory of constraints. It is important to
note that it is not a cost accounting system; it does not attempt to attach variable and fixed costs
to products. Throughput accounting measures the speed at which throughput is generated
by products. It uses three key measures:
 Throughput contribution: this is the ‘money’ generated by production/sales in a given
time period. It is equal to sales revenue minus direct materials costs (T=SR – RM). Unless
sales occur, throughput is zero; generating products for stock kept in a warehouse does not
create any throughput.
 Investment: This is the value of the money tied up in the system. It can be represented by
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 inventory and other net current asset items such as debtors. It may also take the form of
fixed assets such as buildings and machinery.
 Operational expenses: This is the cost of converting raw material inventory into finished
products. It covers all expenses including items such as maintenance of buildings and
machinery, insurances and lease payments. Note that it also includes labour costs
(specifically excluded from the throughput contribution defined above).

The theory of constraints aims to increase the throughput contribution whilst decreasing
operational expenses and the amount of investment in inventory. However, it may be that
businesses trading in highly seasonal markets decide to increase their finished goods inventory
prior to their major selling season. This may temporarily decrease their throughput on a
monthly or quarterly basis but, because none of their demand is left unsatisfied, the annual
throughput will be increased. (A firm manufacturing the red dye used to colour winter heating
oil could purposely stockpile it in the summer.) Thus, the concept of throughput accounting
can be seen to be more applicable to a company with only small seasonal fluctuations in the
demand for its products.
When making important decisions, managers of companies striving to meet their ‘goal’ should
consider the following questions:
 To what extent will my decision increase throughput?
 To what extent will my decision reduce investment?
 To what extent will my decision reduce operating expenses?
Criticisms
The main drawback of the theory of constraints is that only one constraint can be tackled at a
time. The activities involved are carried out in serial fashion and cannot be performed in
parallel. If big improvements in performance are needed urgently, this is probably not the best
technique to use.

3.3.8. Business process re-engineering and continuous improvement

3.3.8.1. Definitions
In today’s competitive environment, corporations are being required to find new and improved
methods of doing business. Re-engineering plays a critical role in the strategic management
process to help organisations significantly change. The goal is to develop and create superior
business processes to produce unique goods and services customers’ value highly.

Business process re-engineering is a business management strategy, originally pioneered in the

early 1990s, focusing on the analysis and design of workflows and processes within an
organization. BPR aims to help organizations fundamentally rethink how they do their work in
order to dramatically improve customer service, cut operational costs, and become world class
competitors. BPR seeks to help companies radically restructure their organizations by focusing
on the ground-up design of their business processes.

Figure: BPR process

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According to Davenport (1990), a business process is a set of logically related tasks performed
to achieve a defined business outcome. Re-engineering emphasized a holistic focus on business
objectives and how processes related to them, encouraging full-scale recreation of processes
rather than iterative optimization of sub-processes.

Hammer and Champy (1993) provided the following definitions:

 Process is a structured, measured set of activities designed to produce a specified output
for a particular customer or market. It implies a strong emphasis on how work is done
within an organization. Each process is composed of related steps or activities that use
people, information, and other resources to create value for customers.
 Reengineering is the fundamental rethinking and radical redesign of business processes to
achieve dramatic improvements in critical contemporary measures of performance such as
cost, quality, service and speed.
 Business process reengineering is the fundamental rethinking and radical redesign of the
business processes to achieve dramatic improvements in critical, contemporary measures
of performance, such as cost, quality, service and speed. BPR is also known as business
process redesign, business transformation, or business process change management.

3.3.8.2. Objectives and process of BPR

Competition is continuously increasing with respect to price, quality and selection, service and
promptness of delivery. The factors that cause competition to intensify are mainly the removal
of barriers, international cooperation, and technological innovations. All these changes impose
the need for organizational transformation, where the entire processes, organization climate
and organization structure are changed.

Business process re-engineering involves a dramatic redesign of business processes,

organisation structures and use of technology to achieve breakthroughs in business

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competitiveness. When applying the BPR management technique to a business organization the
implementation team effort is focused on the following objectives:
 Customer focus. Customer service oriented processes aiming to eliminate customer
complaints.
 Speed. Dramatic compression of the time it takes to complete a task for key business
processes. For instance, if process before BPR had an average cycle time 5 hours, after
BPR the average cycle time should be cut down to half an hour.
 Compression. Cutting major tasks of cost and capital, throughout the value chain.
Organizing the processes a company develops transparency throughout the operational
level reducing cost. For instance the decision to buy a large amount of raw material at 50%
discount is connected to eleven cross checkings in the organizational structure from cash
flow, inventory, to production planning and marketing. These checkings become easily
implemented within the cross-functional teams, optimizing the decision making and cutting
operational cost.
 Flexibility. Adaptive processes and structures to changing conditions and competition.
Being closer to the customer the company can develop the awareness mechanisms to
rapidly spot the weak points and adapt to new requirements of the market.
 Quality. Obsession with the superior service and value to the customers. The level of
quality is always the same controlled and monitored by the processes, and does not depend
mainly on the person, who servicing the customer.
 Innovation. Leadership through imaginative change providing to organization competitive
advantage.
 Productivity. Improve drastically effectiveness and efficiency. In order to achieve the
above mentioned objectives the following BPR project methodology is proposed.

3.3.8.3. Advantages of BPR

The advocates of business process re-engineering explain that, while concentrating on
innovations such as TQM and JIT, businesses were retaining the traditional ways of working in
functional groups. Quality teams were given the task of creating new ways of working within
their specific areas or functions. In contrast, business process re-engineering concentrates on
the process rather than the function.
The advocates of business process re-engineering emphasise three goals: customer satisfaction,
market domination and increased profitability. To win the claim to be a world leader requires
success in all three. The business therefore has to identify the core business processes which
drive it and to think in terms of process enhancement. Identifying the core business process and
‘reading the market’ helps the company to find a ‘break point’ where a change in the business
process can cause a significant positive reaction in the market and take the company into a
leadership position.
The benefits claimed are that operations can be streamlined, and consequently costs can be cut,
while creating process excellence in all key aspects of the organisation.
For some business, re-engineering may be too drastic, especially when new products are being
introduced. Continuous quality improvement may be a more achievable target, where analysis
of strengths and weaknesses is used to identify short-term achievable improvements on an
incremental basis.

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3.3.9. Benchmarking
3.3.9.1. Definition and meaning
Dictionary defines a benchmark as “a standard or a point of reference against which things may
be compared and by which something can be measured or judged”.
Benchmarking is defined “as the continuous, systematic process of measuring one’s output
and/or work processes against the toughest competitors or those recognized best in the
industry.”
Benchmarking is an approach of setting goals and measuring productivity based on best
industry practices. Benchmarking helps in improving performance by learning from best
practices and the processes by which they are achieved. It involves regularly comparing
different aspects of performance with the best practices, identifying gaps and finding out novel
methods to not only reduce the gaps but to improve the situations so that the gaps are positive
for the organization.
Benchmarking is periodical exercise for continuous improvement within the organization so
that the organization does not lag behind in the dynamic business environment. Benchmarking
should not be treated as just comparison. It is necessary to have a point of reference to know
how well one is doing. In a business environment with cut-throat competition it is necessary to
gain edge over their competitors.

Benchmarking helps organization to get ahead of competition. Benchmarking is the comparing

of a firm’s performance with that of industry best practices, with the intention of improving
performance. Comparing the results with a competitor helps the management to get a goal that
is both desirable and achievable but provides no clue on how the goals are to be achieved. It is
a comparison of work progress that tells us how the competitor follows a process which
produce outstanding results and this is the essence of benchmarking.

3.3.9.2. Purpose of benchmarking

The purpose of benchmarking is to help management understand how well the firm is carrying
out its key activities and how its performance compares with competitors and with other
organisations who carry out similar operations.
3.3.9.3. Types of benchmarking
The benchmarking are mainly categorised into two internal and external benchmarking. Also
benchmarking reference may be functional, product, financial and strategic position.
1. Internal benchmarking. It involves looking within the organization to determine other
departments, locations and projects which have similar activities and then defining the best
practices amongst them. It involves seeking partners from within the same organization. For
example, from business units located in different areas. The main advantages of internal
benchmarking are that access to sensitive data and information are easier; standardized data
is often readily available; and usually less time and resources are needed. There maybe
fewer barriers to implementation as practices maybe relatively easy to transfer across the
same organization. However real innovation may be lacking and best in class performance
is more likely to be found through external benchmarking.
2. External benchmarking. It involves seeking help of outside organizations that are known
to be best in class. External benchmarking provides opportunities of learning from those
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 who are at the leading edge, although it must be remembered that not every best practice
solution can be transferred to others. In addition, this type of benchmarking may take up
more time and resource to ensure the comparability of data and information, the credibility
of the findings and the development of sound recommendations.
a. Generic benchmarking- comparing with organizations that have similar processes.
b. Functional benchmarking- used when organizations look to benchmark with partners
drawn from different business sectors or areas of activity to find ways of improving
similar functions or work processes. This sort of benchmarking can lead to innovation
and dramatic improvements.
c. Product benchmarking-examining the products, services and processes of competitors
and then comparing them with their own.
d. Compatible industry benchmarking-compatible industry include those companies that
are not directly competing for the same customer. It make comparisons within A general
industry category.
e. Strategic benchmarking-It involves a systematic process by which a company seeks to
improve their overall performance by examining the long-term strategies, comparing
high-level aspects such as developing new products and services, core competencies etc.
f. Global benchmarking - It is a benchmarking through which distinction in international
culture, business processes and trade practices across companies are bridged and their
ramification for business process improvement are understood and utilized. globalization
and advances in information technology leads to use this type of benchmarking.

3.3.9.4. Methodology, merits and demerits of benchmarking

The benchmarking implementation typically involves the following stages:
 identification of problem areas
 identification of other industries with similar processes, and from then the industry leaders
 detailed surveying of the other company’s business practices
 implementation of new, improved business practices
 monitoring of improvement
On one hand, the important merits of benchmarking are summarised as follows:
(a) I t increases customer satisfaction.
(b) It leads to significant cost savings and improvements in products and services.
(c) I t helps in improving strategic planning by providing assessment of strengths and
weaknesses of current process.

On the other hand, the demerits of benchmarking are:

(a) I t increases the diversity of information which must be monitored by management. This
increases the potential for information overload.
(b) I t may reduce managerial motivation if they are compared with a better resourced rival.
(c) There is a danger that confidentiality of data will be compromised.
(d) It encourages management to focus on increasing the efficiency of their existing business
instead of developing new lines of business. As it is said, benchmarking is the refuge of the
manager who’s afraid of the future.
(e) Successful benchmarking firms may find that they are later overloaded with requests for

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 information form much less able firms whom they can learn little.

3.3.10. Contingency theory

The word ‘contingency’ means ‘condition’. Management accounting approach is conditioned
by (contingent upon) the situation. This is sometimes described in terms of a ‘contingency
theory’ of management accounting. The contingency theory of management accounting
describes the process of creating a control system for a given set of purposes. In this the
contingency theory of management accounting we explain how management accounting
methods have developed in a variety of ways depending on the judgements or decisions
required.
The contingency theory approach to management accounting is based on the idea that there is
no universally appropriate accounting system applicable to all organizations in all
circumstances. Efficient systems depend on the awareness of the designer of the specific
environmental factors, which influence their creation.
The idea for thinking about management accounting in terms of contingency theory comes
from a study of management and the ways in which management structures are created.
Researchers have shown that management structures depend on factors such as the size of the
organisation, the production technology and the competitiveness of the industry. These are the
contingencies (conditions) that shape the management structure. All these differences lead to
different judgements and decisions, and hence different approaches to identifying, measuring
and communicating accounting data.

3.4. STRATEGIC PRODUCT PRICING FOR COMPETITIVE ADVANTAGE

3.4.1. Basic pricing concepts
3.4.1.1 What is meant by pricing?
Pricing is the system of determining the price of a good or a service. A price is a component of
an exchange or transaction that takes place between two parties and refers to what must be
given up by one party (buyer) in order to obtain something offered by another party (seller).
Price should not be confused with the notion of cost as ‘I paid a high cost for buying my new
laptop’. However, these are different concepts. Price is the amount of money that a buyer pays
to acquire products or services or some combination of a product from a seller. Cost concerns
the seller’s investment in the product being exchanged with a buyer. Obviously all other
elements of marketing mix represent costs, price is the only element that produces revenue, and
thus, it influences their decisions.

One of the most important decisions that any business has to make is what prices to charge for
its products and services. If it sets too low, profits may be insufficient for it to survive in the
medium/ long term and if too high, customers will look elsewhere and sales may be lost to
competitors and profits may again be insufficient. In both cases, you will not make a profit. In
short, if it gets its pricing wrong it may go out of business! Proper pricing of an organisation's
products or services is essential to its profitability and hence its survival.

3.4.1.2. Pricing for the short run

Short-run pricing decisions typically have a time horizon of less than a year and include
decisions such as
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(i) pricing a one-time-only special order with no long-run implications and
(ii) adjusting product mix and output volume in a competitive market.

There are two key factors affect short-run pricing:

1. Many costs are irrelevant in short-run pricing decisions but relevant in the long run.
2. Short-run pricing is opportunistic. Prices are decreased when demand is weak and
competition is strong and increased when demand is strong and competition is weak.

3.4.1.3. Pricing for the long run

Long-run pricing decisions have a time horizon of a year or longer and include pricing a
product in a market where there is some leeway in setting price.
Many pricing decisions are made for the long run. Buyers prefer stable prices over an extended
time horizon. A stable price reduces the need for continuous monitoring of suppliers’ prices.
Greater price stability also improves planning and builds long-run buyer–seller relationships.
For that reason, a pricing strategy begins with a clear statement of goals and ends with an
adaptive or corrective mechanism.

3.4.1.4. Price determination process

(1) In pricing, an organization first must decide on its pricing goal.
(2) The next step is to set the base price for a product.
(3) The final step involves designing pricing strategies that are compatible with the rest of the
marketing mix. Many strategic questions must be answered:
 Will our company compete on the basis of price or other factors?
 What kind of discount schedule (if any) should be adopted?

3.4.2. Pricing goal and influencing factors

3.4.2.1. Pricing objectives
The main goals in pricing are oriented toward either profit, sales or maintaining the status quo:
1. Profit-oriented, to: (a) achieve target or on net sales; (b) Maximise profits.
2. Sales oriented, to: (a) Increase sales; (b) Maintain or Increase market-share.
3. Status-quo-oriented, to: (a) Stabilise prices; (b) Meet competition.
3.4.2.1. Factors influencing pricing decisions
(a) Internal factors to consider when setting price
Marketing objectives. The marketing objective may be survival, current profit maximization,
market share leadership, product quality leadership.
Marketing mix strategy. Price is the only one of the marketing mixes tools that a company
uses to achieve its marketing objectives. Price decisions must be coordinated with product
design, distribution, and promotion decisions to form a consistent and effective marketing
programme.
Each market segment can become a target market and would require a unique marketing mix
for the organization to exploit it property.
The marketing mix is the set of controllable variables that the firm can use to influence the
buyers’ responses. The variables are commonly grouped into four classes: “the four Ps –
product, price, promotion and place (or distribution).
Market mix strategies:
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Product Price Promotion Place
- Brand name - Level - Sales promotion - Distribution channels
- Packaging - Discounts - Personal selling - Distribution coverage
- Features - Allowances - Publicity - Outlet locations
- Options - Payment terms - Advertising - Sales territories
- Quality - Delivery options - Inventory levels
- Warranty - Inventory locations
- Service
- Style appeal

Organisational considerations. Management must decide within the organisation who should
set the prices. In small companies, top management usually makes all the pricing decisions. In
industrial markets, however, sales person often enter into the process by negotiating certain
aspects of the contract and therefore price.
Cost. Costs are another internal factor that set the floor for price that the company can change.
Companies want to charge a price that covers all its cost for producing, distributing, and selling
the product, and provides a fair rate return for its efforts and risk.
(b) External factors to consider when setting price
Market and demand. Whereas costs set the lower limit of prices, the market and demand set
the upper limit. Pricing freedom varies with different types of markets:
 Pure competition –– a market in which many buyers and sellers trade in a uniform
commodity and no single buyer or seller has much effect on the going market price
 Monopolistic competition –– a market in which many buyers and sellers trade over a
range of prices rather than a single market price, sellers try to develop differentiated offers.
 Oligopolistic competition –– a market consisting of few sellers only and they are highly
sensitive to each other’s pricing and marketing strategies.
 Pure monopoly –– a market in which there is a single seller, it may be a government
monopoly, a private regulated monopoly, or a private non-regulated monopoly.
The level of demand also affects the pricing decisions of product:
 Demand curve––shows the number of units the market will buy in a given time period at
different prices.
 Price elasticity– measures the sensitivity of demand to changes in price (price/demand
relationship)
 Demand is inelastic––if it hardly changes with a small change in price. For example (a)
buyers are less price-sensitive when the product they are buying is unique or high quality,
prestige, or exclusiveness; (b) buyers are less price- sensitive when substitute products are
hard to find or cannot easily be compared; (c) buyers are less price-sensitive when total
expenditure for a product is low relative to their income or the cost is shared by another
party.
 Demand is elastic––if it changes greatly with a small change in price.
Competitor’s costs, prices and offer. Company needs to benchmark its costs, prices, and
offers against its competitors, so that it can use them as a starting point for its own pricing.
Company also needs to learn its competitor’s reaction to the firm’s pricing moves. Example, if
you are considering to buy a canon camera, you may evaluate the price of comparable products
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such as Nikon, Panasonic, etc.
Other external factors. Other external factors that need to be considered include:
 Economic conditions. These may be boom or recession, inflation, or interest rates
 Reseller’s policies. They must be considered especially if they do not match the supplier’s.
Will the set prices give resellers a fair profit and encourage their support?
 Government. It has regulatory power to impose law that will influence on pricing decision

3.4.3. Approaches to base price setting (3Cs)

3.4.3.1. Major factors influencing the pricing decisions
Many companies make a tremendous effort to analyze their costs and prices believing that cost-
plus pricing is the most critical component of their new venture. It is not. Some companies,
however, understand that it is possible to charge a low price to stimulate demand and meet
customer needs while relentlessly managing costs to earn a profit. Therefore, without a clear
identification of clients and competitors, pricing can be erroneously set and either repel clients
or attract competitors. The company’s prices are set based on 3Cs as discussed below.

(1) Customers. Customers influence price through their effect on the demand for a product or
service, based on factors such as the features of a product and its quality. Companies must
always examine pricing decisions through the eyes of their customers and then manage costs to
earn a profit.
(b) Competitors. No business operates in a vacuum. Companies must always be aware of the
actions of their competitors. At one extreme, alternative or substitute products of competitors
hurt demand and force a company to lower prices. At the other extreme, a company without a
competitor is free to set higher prices. When there are competitors, companies try to learn
about competitors’ technologies, plant capacities, and operating strategies to estimate
competitors’ costs—valuable information when setting prices. Because competition spans
international borders, fluctuations in exchange rates between different countries’ currencies
affect costs and pricing decisions.
(c) Costs. Costs influence prices because they affect supply. The lower the cost of producing a
product, the greater the quantity of product the company is willing to supply. Generally, as
companies increase supply, the cost of producing an additional unit initially declines but
eventually increases. Companies supply products as long as the revenue from selling additional
units exceeds the cost of producing them. Managers who understand the cost of producing
products set prices that make the products attractive to customers while maximizing operating
income.

However, there is no single pricing basis applied alone. Surveys indicate that companies weigh
customers, competitors, and costs differently when making pricing decisions.
 Companies operating in a perfectly competitive market sell very similar commodity-type
products (such as wheat, rice, steel) have no control over setting prices and must accept the
price determined by a market consisting of many participants. Cost information is only
helpful in deciding the quantity of output to produce to maximize operating income.
 In less-competitive markets (eg those for cameras, televisions, cellular phones), products
are differentiated, and all three factors affect prices. The value customers place on a

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 product and the prices charged for competing products affect demand, and the costs of
producing and delivering the product influence supply. As competition lessens even more,
the key factor affecting pricing decisions is the customer’s willingness to pay based on the
value that customers place on the product or service, not costs or competitors.
 In the case of monopolies, a monopolist has no competitors and has much more leeway to
set high prices. Nevertheless, there are limits. The higher the price a monopolist sets, the
lower the demand for the monopolist’s product as customers seek substitute products.

3.4.3.2. Cost based pricing

Using cost-plus pricing, the selling price is calculated by estimating the cost per unit of a
product and adding an appropriate percentage mark-up. A primary consideration will be as to
what is to be regarded as the cost.

Product Cost Price Value Customers

(a) Full cost-plus pricing

Full cost-plus pricing is a method of determining the sales price by calculating the full cost of
the product and adding a percentage mark-up for profit. Where does this percentage come
from? The answer is that it depends very much on the type of business and the type of product.
Where the market is competitive, mark-up percentages will be low and the organisation relies
for its success on a high volume of sales activity.

In some industries, or for some products, there appears to be a ‘normal’ mark-up which all
companies apply fairly closely. This ‘normal’ mark-up may be so characteristic that it is used
by the auditor as a check on how reasonable the gross profit amount appears and is also used
by the tax authorities as a check on whether all sales and profit are being declared for taxation
purposes. For those businesses which are in a position to apply cost-plus pricing, it may
encourage stability in the pricing structure because other businesses in the same industry may
be in a position to predict the behaviour of competitors. Companies in an industry will know
the mix of variable and fixed costs in the industry and will therefore have a good idea of how
competitors’ profits will be affected by a change of price.

Advantages of full cost-plus pricing

(i) It is a quick, simple and cheap method of pricing which can be delegated to junior
managers.
(ii) The size of the profit margin can be varied, a decision based on a price in excess of full cost
should ensure that a company working at normal capacity will cover all of its fixed costs
and make a profit.
Disadvantages of full cost-plus pricing
(i) It fails to recognise that since demand may be determining price, there will be a profit-
maximising combination of price and demand.
(ii) There may be a need to adjust prices to market and demand conditions.
(iii) Budgeted output volume needs to be established. Output volume is a key factor in the
overhead absorption rate.
(iv)A suitable basis for overhead absorption must be selected, especially where a business
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 produces more than one product.

(b) Marginal cost-plus pricing

In the short term, a business may decide to accept a price that is lower than full cost providing
the price offered is greater than the variable cost, so that there is a contribution to fixed
overhead costs. This reflects the economist’s position that a business will continue to sell
providing the marginal revenue exceeds the marginal cost. It is therefore called marginal cost
pricing. The most likely situation is that a customer, knowing that the business has spare
capacity, will offer a contract at a reduced price to take up some of the spare capacity. The
manager will accept the offer provided there is a contribution to fixed costs and profits and
providing no additional fixed costs are incurred because of the extra contract.

Marginal cost-plus pricing or mark-up pricing involves adding a profit margin to the marginal
cost of production/sales. In other words, the price is determined by calculating the marginal (or
incremental) cost of producing a unit and adding a mark-up. Whereas a full cost-plus approach
to pricing draws attention to net profit and the net profit margin, a variable cost-plus approach
to pricing draws attention to gross profit and the gross profit margin, or contribution.
Advantages of marginal cost-plus pricing
(i) It is a simple and easy method to use.
(ii) The mark-up percentage can be varied, and so mark-up pricing can be adjusted to reflect
demand conditions.
(iii) It draws management attention to contribution, and the effects of higher or lower sales
volumes on profit. For example, if a product costs $10 per unit and a mark-up of 150%
($15) is added to reach a price of $25 per unit, management should be clearly aware that
every additional $1 of sales revenue would add 60 cents to contribution and profit ($15 ÷
$25 = $0.60).
(iv)In practice, mark-up pricing is used in businesses where there is a readily-identifiable basic
variable cost. Retail industries are the most obvious example, and it is quite common for
the prices of goods in shops to be fixed by adding a mark-up (20% or 33.3%, say) to the
purchase cost.
Disadvantages of marginal cost-plus pricing
(i) Although the size of the mark-up can be varied in accordance with demand conditions, it
does not ensure that sufficient attention is paid to demand conditions, competitors' prices
and profit maximisation.
(ii) It ignores fixed overheads in the pricing decision, but the sales price must be sufficiently
high to ensure that a profit is made after covering fixed costs.

Full cost pricing vs. Marginal cost pricing

Perhaps the most important criticism of full cost pricing is that it fails to recognise that since
sales demand may be determined by the sales price, there will be a profit-maximising
combination of price and demand. A full cost based approach to pricing will be most unlikely,
except by coincidence or 'luck', to arrive at the profit-maximising price. In contrast, a marginal
costing approach to looking at costs and prices would be more likely to help with identifying a
profit-maximising price.

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Illustration on cost-based pricing
A new product is being launched, and the following costs have been estimated:
Materials : $10 per unit
Labour : $8
Variable overheads : $5
Fixed overheads have been estimated to be $50,000 per year, and the budgeted production is
10,000 units per year. Calculate the price based on:
(a) Full cost –plus 20%
(b) Marginal cost-plus 40%
Solution
(a) (b)
Materials 10.00 Materials 10.00
Labour 8.00 Labour 8.00
Variable overheads 5.00 Variable overheads 5.00
Fixed overheads (50,000÷10,000) 5.00 Marginal cost 23.00
Full cost 28.00 Profit 9.20
Profit 5.60 Selling price $32.20
Selling price $33.60

3.4.3.3. Value based pricing

Value based pricing is setting price based on buyers perceptions of value rather than on the
seller’s cost. The company sets its target price based on the customer perceptions of the
product value. The targeted value and price then drive decisions about design and what costs
can be incurred. It is a reversed process compared to cost based pricing.
Customers Value Price Cost Product

Value pricing strategies mean offering just the right combination of quality and goods service
at a fair price. In many instances this has resulted in the situations companies either overcharge
or undercharge the product. Company using this approach must find out what value the buyer
assigns to different competitive offers.
We saw earlier that, as the starting point of the target costing approach to cost management, a
target selling price needs to be identified. Using market research and so on, a target unit selling
price and a planned sales volume are set. This is the combination of price and quantity
demanded that the business would derive from its estimation of the product’s demand function.
Thus, the target price is the market-determined price that the business seeks to meet, in terms
of costs and profit margin.
If for instance a firm sets itself a target of earning 20 per cent on the $30m capital employed in
the business, and if total annual costs are expected to amount to $60m, then the percentage
added to cost of production to arrive at selling price would be determined as follows:

This is not as simple as it looks, because cost of production varies with the quantity produced,
which in turn depends on sales, which are affected by the price charged.

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Customer analysis. There are three sets of strategic questions that are used to analyse
customers – segmentation, motivation and unmet needs.
Segmentation: sets of strategic questions include the following:
• Who are the biggest, most profitable existing customers and who are the most attractive
potential customers?
• Do the customers fall into any logical groups on the basis of characteristics, needs or
motivations?
• Can the market be segmented into groups requiring a unique business strategy?
Motivation: motivation concerns the customers’ selection and use of their favourite brands, the
elements of the product or service that they value most, the customers’ objectives and the
changes that are occurring in customer motivation.
Unmet needs: considers why some customers are dissatisfied and some are changing brands or
suppliers. The analysis looks at the needs not being met that the customer is aware of.

How buyers obtain prices? Several methods are widely used for communicating price, for
example:
 A price list is made available.
 Prices are quoted on request, based on an internal price list not available to customers.
 Individual quotations based on specially prepared estimates are made on request.
 Potential suppliers submit sealed bids or tenders.
 By negotiation.
 Purchases are made at auction, or by reverse auction.

3.4.3.4. Competition based pricing

There have been marketplaces around the world for thousands of years. A marketplace is an
actual or virtual area where goods and services are exchanged. The following questions should
be answered in a market analysis: (i) What is your business's marketplace? Is it limited
physically? (ii) Is there a virtual marketplace for what you sell? Are you able to compete within
it?
(a) Going rate pricing
Price setting is based largely on following competitor’s prices. This approach is popular; firms
feel that the going rate represents the collective wisdom of the industry concerning the price
that yields a fair return. They also feel that holding to the going rate price will prevent harmful
price wars.

(b) Sealed bid pricing

The firm sets prices based on how it thinks competitors will price rather than on its own costs
or demand estimates. Here, the firm wants to win a contract through tender and wining the
contract requires lower than other competitors. Yet the firm cannot set its price below a certain
level to harm its position.
The main obstacle in the use of formal bidding theory is guessing the probability of getting the
contract at various bidding levels. This estimating exercise requires information about what the
competitors are likely to bid, and to know all about this is really a difficult task. Therefore, the
concern has to rely on conjecture, trade gossip or past bidding history.
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3.4.3.5. Economic theory of pricing or optimal pricing or profit-maximisation model
The determination of optimal price can be considered under different market structures that we
already explained: perfect competition, monopolistic competition, duopoly, monopoly. The
optimum selling price is the price at which marginal revenue equals marginal cost.
Problems with applying economic theory
(1) Difficult and costly to derive reasonably accurate estimates of demand.
(2) Difficult to estimate cost functions to determine marginal cost at different output levels for
many different products.
(3) Demand is influenced by other factors besides price.
(4) Profit maximization assumed – firms may pursue other goals.

A. Optimal pricing –– Tabular approach

One major disadvantage of a cost-plus approach to pricing is that it completely ignores the
possible effect of the selling price on the level of demand. For many products (but not all), it is
the case that a higher selling price will result in lower demand, and vice-versa. It could
therefore be worthwhile to reduce the selling price and sell more –– provided of course that this
resulted in a higher total profit.

a) The Price/Demand Relationship

(i) Demand and Product life cycle
Demand
The market price of a good is determined by both the supply and demand for it. In 1890, an
English economist Alfred Marshall published his work “Principles of Economics” which was
one of the earlier writings on how both supply and demand interacted to determine price.
Today, the supply-demand model is one of the fundamental concepts of economics. The price
level of a good essentially is determined by the point at which, called “equilibrium”.
Product life cycle
Products and services, like human beings, have a life cycle. This is represented by the generic
curve (draw it yourselves). The length of the life cycle varies considerably from a year. The
product life cycle is divided into four basic stages; each stage has different aims and
expectations. Price is a major variable over the product life cycle. Depending on market
structure and demand, different pricing strategies will be appropriate for different stages in the
cycle as described below.
Stage 1 –– Introductory phase: demand will be low when a product is first launched onto the
market, and heavy advertising expenditure will usually be required to bring it to consumers’
attention. The aim is to establish the product in the market, which means achieving a certain
critical mass within a certain period of time. The critical mass is the sales volume that must be
achieved in order to make the product viable in the medium term. Depending on the nature of
the product, a price penetration policy may be adopted in order to reach the critical mass
quickly. On the other hand the market may be skimmed and so a high introductory price may
be set.
Stage 2 –– Growth: once the hurdle of the introductory stage has been successfully negotiated,
the product enters the growth stage, where demand shows a steady and often rapid increase.
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The cost per unit falls because of economies of scale with the greater level of production. The
aim at this stage is to establish a large market share and to perhaps become the market leader.
Market share is easier to obtain during the growth stage because the market is growing and
increased market share does not have to be gained by taking sales from another company. In a
more mature market, market share has to be poached from competitors and their reaction may
be unpleasant as they try to hold on to their market share. During growth stage competitors will
enter the market, some of which will not survive into the maturity stage. Despite the fact that
competing products will be launched into the growing market and pricing is often keen in order
to gain market share, it is usually the most profitable stage for the initial supplier.
Stage 3 –– Maturity: the increase in demand slows down in this stage, as the product reaches
the mass market. The sales curve flattens out and eventually begins to fall. As market maturity
is reached the organisation becomes more interested in minimising elasticity. Products have to
be differentiated in order to maintain their position in the market and new users for mature
products need to be found to keep demand high. Generally, profits will be lower than during
the growth stage.
Stage 4 –– Decline: when the market reaches saturation point, the product’s sales curve begins
to decline. When the market declines price wars erupt as organisations with products which
have elastic demand seek to maintain full utilisation of their production capacity. Profits can
still be made during the early part of this stage, and the products will be managed to generate
cash for newer products. This will determine how prices are set. Eventually rapidly falling
sales inevitably result in losses for all suppliers who stay in the market. This particular product
has effectively come to the end of its life cycle, and alternative investment opportunities must
be pursued.
Despite the recent general tendency to shorter life cycles, the length of any particular stage
within the cycle and the total length of the life cycle itself will depend on the type of product or
service being marketed. Although the curve will be characterised by a sustained rise, followed
by levelling out and falling away, the precise shape of the curve can vary considerably.

(ii) Price Elasticity of Demand (PED)

Demand curve shows the number of units the market will buy in a given time period at
different prices. The slope of the line is the critical factor for a pricing decision. Economic
theory argues that the higher the price of a good, the lower will be the quantity demanded and
vice-versa. This is true of many products, but the effect of selling price on demand will be
different for different products. The effect of selling price on demand is also likely to be
different for the same product at different levels of selling price. In practice, organisations will
have only a rough idea of the shape of their demand curve: there will only be a limited amount
of data about quantities sold at certain prices over a period of time and, of course, factors other
than price might affect demand. Because any conclusions drawn from such data can only give
an indication of likely future behaviour, management skill and expertise are also needed.

Despite this limitation, an awareness of the concept of elasticity can assist management with
pricing decisions. A measure of the size of the effect (responsiveness) on demand of a change
in selling price is called the ‘price elasticity of demand’ (PED)

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A high PED ( means the demand is very sensitive to changes in price, or elastic. In
other words, a fall in price increases demand considerably, so that total revenue increases, but
an increase in price decreases demand substantially, so that total revenue falls. On the other
hand, a low PED ( means the demand is not very sensitive to changes in price, or
inelastic. In other words, a fall in price will increase demand, but not by a sufficient amount to
maintain the previous revenue level, yet a rise in price will increase total revenue.

Factors affecting price elasticity: When making decisions on products, markets and
competitors, other factors, including the following, should be considered:
 Scope of the market –– the larger the defined market, the more inelastic is the demand for
the broader definition of product.
 Information within the market–– consumers may not know of the competing products in
sufficient time to reassess their purchasing behaviour.
 Availability of substitute –– the less the differentiation between competing products, the
greater the price elasticity of those products: differentiated products benefit from customer
awareness and preference, so their demand patterns tend to be more inelastic.
 Complementary products–– the inter-dependency of products results in price inelasticity,
because the volume sales of the dependent good rely on sales of the primary good. The
consumer will make a purchase of the complementary product in order to achieve
satisfaction from the primary good.
 Disposable income–– the relative wealth of the consumers over time affects the total
demand in the economy. Luxury goods tend to have a high price elasticity, while
necessities are usually inelastic.
 Necessities–– demand for basic items such as milk, bread, salt, etc., tend to be very price
inelastic.
 Habit–– items consumers buy out of habit, such as cigarettes are usually price inelastic.

b) Optimal selling price

The monopolist's profit maximizing level of output is found by equating its marginal revenue
with its marginal cost, which is the same profit maximizing condition that a perfectly
competitive firm uses to determine its equilibrium level of output. Indeed, the condition that
marginal revenue equal marginal cost is used to determine the profit maximizing level of
output of every firm, regardless of the market structure in which the firm is operating. In order
to determine the profit maximizing level of output, the monopolist will need to supplement its
information about market demand and prices with data on its costs of production for different
levels of output.

B. Optimal pricing –– Equation approach

In point (A) above, we have presented the price/demand relationship as a table, and used these
figures to calculate the optimum level of selling price from those variable. In principle, it
would be possible to have an equation relating the selling price to the demand, and to then
solve the problem algebraically.
The model used to determine an optimal selling price is based on the economic theory that
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profit is maximised at the output level where marginal cost is equal to marginal revenue. Full
use of the model requires a knowledge of calculus, which is outside the scope of this topic
(calculus is an area of advanced mathematics in which continually changing values are
studied). However, you are expected to understand the following basic principles:
 The basic price equation
 Marginal revenue equation
 Marginal cost

a) Price/Demand equation
You may be asked to derive the price/demand equation from information given, or alternatively
we may be given the equation. If you are asked to derive the equation yourself, think always
that the relationship is linear as follows:
P ($)

Q (Units)

The basic price equation will therefore be of the form:

where
P = Price
Q = quantity demanded at price P
a and b are constants where:
a = theoretical maximum price (if the price is set at “a” or above, the demand will be zero
b = the change in price required to change demand by 1 unit (the gradient of the line = the
slope of the curve), mathematically,

For example if you are told that demand falls by 25 units for every increase in price of Rwf 1,
then

 The marginal revenue equation can be found by doubling the value of b :

 The marginal cost is the variable cost of production.

b) Optimal selling price

Having identified the price/demand relationship it is easy to derive the equation for the revenue
at any level –– the total revenue will equal to PQ. We could then show on a graph the total
revenue and total costs for any level of demand. Our objective is to maximise profit. We can do
this by calculating the marginal revenue and marginal cost, and using the fact that the profit is
maximised when MR = MC.
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 Q

To obtain the profit maximising output quantity, we start by recognizing that profit is equal to
total revenue (TR) minus total cost (TC). Given a table of costs and revenues at each quantity,
we can either compute equations or plot the data directly on a graph. Finding the profit-
maximizing output is as simple as finding the output at which profit reaches its maximum, is
represented by output Q on graph.

There are two graphical ways of determining that Q is optimal. First, the profit curve is at its
maximum at this point (A). Secondly, at the point (B) the tangent on the total cost curve (TC)
is parallel to the total revenue curve (TR), meaning that the surplus of revenue net of costs
(B,C) is at its greatest. Because total revenue minus total costs is equal to profit, the line
segment C,B is equal in length to the line segment A, Q. Computing the price at which to sell
the product requires knowledge of the firm's demand curve. The price at which quantity
demanded equals profit-maximizing output is the optimum price to sell the product.

An alternative argument says that for each unit sold, marginal profit (Mπ) equals marginal
revenue (MR) minus marginal cost (MC). Then, if marginal revenue is greater than marginal
cost, marginal profit is positive, and if marginal revenue is less than marginal cost, marginal
profit is negative. When marginal revenue equals marginal cost, marginal profit is zero. Since
total profit increases when marginal profit is positive and total profit decreases when marginal
profit is negative, it must reach a maximum where marginal profit is zero –– or where marginal
cost equals marginal revenue. If there are two points where this occurs, maximum profit is
achieved where the producer has collected positive profit up until the intersection of MR and
MC (where zero profit is collected), but would not continue to after, as opposed to vice versa,
which represents a profit minimum.
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If the industry is perfectly competitive, the firm faces a demand curve (D) that is identical to its
Marginal revenue curve (MR), and this is a horizontal line at a price determined by industry
supply and demand. Average total costs are represented by curve ATC. Total economic profits
are represented by area P, A, B, C. The optimum quantity (Q) is the same as the optimum
quantity (Q) in the first diagram (TR = TC).
If the firm is operating in a non-competitive market, minor changes would have to be made to
the diagrams. For example, the Marginal Revenue would have a negative gradient, due to the
overall market demand curve. In a non-competitive environment, more complicated profit
maximization solutions involve the use of game theory.

It is worthwhile a firm producing and selling further units where the increase in revenue gained
from the sale of the next unit exceeds the cost of making it (i.e. the marginal revenue exceeds
the marginal cost). However if the cost of the next unit outweighs the revenue that could be
earned from it (i.e. the marginal cost exceeds the marginal revenue), production would not be
worthwhile. A firm should therefore produce units up to the point where the marginal revenue
equals the marginal cost

Example 1. Maximum demand for a company’s product M is 100,000 units per annum. The
demand will be reduced by 40 units for every increase of $1 in the selling price. The company has
determined that profit is maximised at a sales volume of 42,000 units per annum. What is the profit-
maximising selling price for product M?
Solution
In the demand equation
where P = price
Q = quantity demanded
a,b = constants
Maximum demand is achieved when the product is free, that is, when P = 0
When price = 0, demand, Q = 100,000 0 = a - 100,000b (i)
When price = 1, demand, Q = 99,960 1 = a - 99,960b (ii)

Subtract 1 = 40b
b = 0.025

Substitute in (i) a = 100,000 x 0.025

= 2,500

The demand equation for product M is therefore P = 2,500 - 0.025b

When Q = 42,000 units, P = 2,500 - (0.025 x 42,000)
=1,450
Therefore, the profit-maximising selling price is $1,450 per unit.

Example 2. Another product, K, incurs a total cost of $10 per unit sold, as follows.
$ per unit
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Variable selling cost 4
Variable production cost 2
Fixed selling cost 3
Fixed selling and administration 1
Total cost 10
The marginal revenue (MR) and demand functions for product K are:
MR = 200 - 0.4Q
P = 200 - 0.2Q
Where P = price, Q = quantity demanded per period
What is the profit-maximising selling price of product K & what quantity will be sold per period at
this price?
Solution
Marginal cost per unit of product K = variable cost per unit = $6
Profit is maximised when marginal cost= marginal revenue i.e. when 6 = 200 - 0.4Q
Q = 485
When Q = 485, P = 200 - (0.2 x 485) = 103
Therefore, the profit-maximum selling price is $103 per unit, at which price 485 units will be
sold per period.

Limitations of the profit-maximisation model

The profit-maximisation model does make some attempt to take account of the relationship
between the price of a product and the resulting demand, but it is of limited practical use
because of the following limitations:
 It is unlikely that organisations will be able to determine the demand function for their
products or services with any degree of accuracy.
 Majority of organisations aim to achieve a target profit, rather than the theoretical
maximum profit.
 Determining an accurate and reliable f igure for marginal or variable cost poses difficulties
for the management accountant.
 Unit marginal costs are likely to vary depending on the quantity sold. For example, bulk
(lumpy assets) discounts may reduce the unit materials cost for higher output volumes.
 Other factors, in addition to price, will affect the demand, for example, the level of
advertising or changes in the income of customers.

3.4.4. Pricing strategies

Pricing strategy is defined as a broad plan of action by which an organisation intends to reach
its goal. There are various type of pricing strategies which firm can adopt.

3.4.4.1. New product or market entry pricing strategies

(a) Product policy
Product policy plays a very significant and crucial role in the product establishment and its
growth in the market. The marketer has to keep in mind the product policy decision while
introducing a product. It acts as a tool in the hands of the marketer.
Product decision is a very conscious decision made by a company for a product. There are

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many different decisions. At one extreme there are such things as a minor modification of the
label or colour of the package. At the other extreme, there are such things as diversification
into new business fields, either through internal R&D or mergers and acquisitions.

(b) Price skimming strategy

It involves setting a high price for a new product to skim maximum revenues layer by layer
from the segments willing to pay the high price: the company makes fewer but more profitable
sales. Skimming price strategy works under the following conditions:
(i) A sufficient number of buyers have a high current demand;
(ii) The unit costs of producing a small volume are not so high that they cancel advantage of
charging more;
(iii) The high initial price does not attract more competitors to market (competitors should not
be able to enter the market easily and undercut the high price);
(iv) The high price communicates the image of a superior product (Product’s quality and
image must support its higher price and enough buyers must want the product at that
price).

(c) Penetration pricing strategy

It is setting a low price for a new product in order to attract a large number of buyers and to
gain large market share. Penetration pricing works under the following conditions:
(i) market is highly price-sensitive and a low price stimulates market growth;
(ii) production and distribution costs fall as sales volume increases (as a result of accumulated
production experience); and
(iii) a low price discourages actual and potential competition

(d) Relationship between product life cycle and pricing

All products tend to go through a five-phase cycle of development: introduction, growth,
development, saturation and eventually decline. Pricing policy can vary dramatically
depending on where on the product life cycle a product has reached.
In the early stages of the life cycle prices are often provisional and might be changed. Sales
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organisations may pursue policies of skimming in the early stages of the life cycle, meaning
that because their capacity is limited supplies are relatively scarce, so they can charge high
prices for the limited output. As the capacity increases and other suppliers offer similar
products so they move towards much lower penetration pricing to increase market share.
Buyers will thus notice big differences in price over the life cycles of products.

3.4.4.2. Product mix pricing strategies

a) Product line pricing
It involves setting the price steps between various products in a product line based on cost
differences between the products, customer evaluations of different features, and competitor’s
prices. For example, a man’s clothing store might carry men’s suits at three price levels, 150
Frw, 250 Frw, and 350 Frw. A seller’s task is to establish perceived quality differences (low,
average, high quality) that support the price differences.
b) Optional product pricing
It involves the pricing of optional or accessory products along with a main product.
An example is automatic window control, power steering, and CD player of automobile.
c) Captive product pricing
It is setting a price for products that must be used along with a main product, such as blades for
a razor and firm for a camera. Producers of the main product offer them at low prices and set
high mark-up on the supplies. Examples are HP makes very low profit on its printers but very
high margins on printer cartridges and other supplies. In service, it is called two-part pricing
where the price of the services is broken into a fixed fee and a variable usage rate; telephone
service for example.
d) By-product pricing
This involves setting a price for by-product in order to make the main product’s price more
competitive. Manufacturer seeks a market for by-product and accepts any price that covers
more than the cost of storing and delivering them. This practice allows the seller to reduce the
main product’s price to make it more competitive.
e) Product bundling pricing
Seller combines products and offer the bundle at a reduced price. Example, toothpaste with
toothbrush in order to promote toothbrush sales those consumers might if not buy due to its
poor design or quality.

3.4.4.3. Price adjustment strategies

Price-adjustment strategies account for customer differences and start changing situations, and
strategies for initiating and responding to price changes
a) Discount and allowance pricing
Quantity discount –– a price reduction to buyers who buy in large volumes
Trade or Functional discount –– a price reduction offered by the seller to trade channel
members who perform certain functions such as selling, storing, and record keeping.
Cash discount –– a price reduction to buyers who pay their bills within a specified period of
time, (after first deducting trade and quantity discounts from the base price)
Seasonal discount –– a price reduction to buyers who buy merchandise or services out of
season. Seasonal discounts allow the seller to keep production steady during an entire year.
Allowance –– Allowances are another type of reduction from the list price. For example, trade-
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in allowances are price reductions given for turning in an old item when buying a new one.
Trade-in allowances are most common in the automobile industry but are also given for other
durable goods. Promotional allowances are payments or price reductions to reward dealers for
participating in advertising and sales support programs.

b) Segmented pricing
Selling a product or service at two or more prices, where the difference in prices is not based
on differences in costs. Possible forms include:
Customer segment pricing –– different customers pay different prices for the same product or
service.
Product form pricing –– different versions of the product are priced differently but not
according to differences in their costs.
Location pricing –– company charges different prices for different locations, even though the
cost of offering each location is the same.
Time pricing –– prices vary by seasons, the month, the day, or even the hour

c) Psychological pricing
Psychological pricing encourages purchases based on emotional rather than rational responses.
It is used most often at the retail level but of limited use for industrial product.
Odd-Even pricing –– a practice by ending the price with certain numbers in order to influence
buyers’ perceptions of the price or the product:
A product priced at odd ending (e.g. 99.99 Frw) will foster certain psychological perception
that the product is less than 100 Frw and is a bargain.
A product price with even ending (e.g. 200.00 Frw) will influence a customer to view the
product as being a high quality, premium brand.
Note: The odd pricing is often used to suggest a bargain, while even pricing is used more in
prestige, fashion stores
Prestige pricing –– to set the price at an artificially high level to provide prestige or a quality
image. For example, perfume, liquor, etc

d) Promotional pricing
This is temporarily pricing products below the list price, and sometimes even below cost, to
increase short-term sales.
Loss leader pricing –– to set price below the usual mark-up, near cost or below cost. It is used
by supermarket or departmental stores to attract customers to the store in the hope that they
will buy other items. This form of “loss-leader” pricing is not illegal unless it persists for a
long time with the goal of eliminating competition (predatory pricing). Remember that
predatory pricing is selling at unreasonably low prices to lessen competition.
Price discrimination –– the use of different prices for different customers. It is illegal if a
price advantage is granted to one, but not another, where both compete and the articles are
similar. Granting promotional allowances must be done on a proportionate basis to all
customers.
Special event pricing –– involves advertise sales or price-cutting linked to a holiday, season,
or event.
Cash rebates –– seller offer cash rebate to consumers who buy the product from them within a
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specific time period.
Low interest financing/longer warranties/free maintenance –– this is offered by
manufacturers to reduce the customer’s price.
Discount –– seller may simply offer discounts from normal prices to increase sales and reduce
inventories.

e) Geographical pricing strategies

Price adapted to different part of the country, such as:
F.O.B. point-of-production pricing –– price quoted at factory and buyer pays transportation.
FOB destination pricing –– a price indicating that the producer is absorbing shipping cost. It
is used to attract distance customers. FOB means Free On Board.
FOB origin pricing –– a geographical pricing strategy in which goods are placed free on
board a carrier and the customer pays the freight from the factory to the destination.
Freight absorption pricing –– company absorbs all or part of the actual freight charges in
order to get the business.
Freight-absorption pricing –– seller absorbs transport cost to penetrate market.
Uniform delivery pricing –– company charges the same price plus freight to all customers
regardless of their location. This works if transportation costs small.
Zone pricing –– the company set up two or more zones, all customers within a zone pay the
same total price, and this is higher in the more distant zones.
Zone-delivered pricing –– set same price within several zones, e.g. Maritimes

3.4.5. Initiating and driving the price changes

Deciding to pursue the price advantage launches a company on a transformational journey that
can touch almost every aspect of its business system. Capturing the price advantage is not
about a handful of clever pricing tips and tricks. Instead, it requires a change in mindset and
capabilities in marketing, sales, operations, finance, and any other part of the organization that
touches pricing decisions. After developing their pricing structures and strategies, companies
often face situation in which they must initiate price changes or respond to price changes by
competition.

3.4.5.1. Initiating price changes

a) Initiate price cut (reasons)
 Excess plant capacity
 Decline market share
 Intend to dominate market through lower costs
b) Initiate price increase (reasons)
 Cost inflation
 Over demand

3.4.5.2. Customers’ reaction to price changes

a) Price cut
 Current models are being replaced by newer models
 Faulty product

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  The firm is in financial trouble
 Price will come down even further
 Quantity has been reduced
b) Price increase
 Strong demand
 Product quality is exceptionally good
 Suppliers are profiteering. A profiteer is a person who takes advantage of a situation in
which other people are suffering to make a profit, often by selling at a high price goods
which are difficult to obtain

3.4.5.3. Competitors’ reaction to price changes

 The company is trying to steal market share
 The company is doing poorly and trying to boost its sales
 Want the whole industry to cut prices to increase total demand.

3.4.5.4. Responding to competitors’ price changes

a) Maintain price: believing that it would lose too much profit if price reduced, it would not
lose much market share, and it could regain market share when necessary
b) Maintain price and add value: leader could improve its product, its services and its
communications. Firm may find it more profitable to improve quality than to cut price and
operate at a lower margin.
c) Reduced price: drop its price to match competition. It might do so if (1) its costs fall with
volume (2) it would lose market share because the market is price sensitive (3) it would be hard
to rebuild market share once it is lost.
d) Increase price and improve quality: raise price to cover rising costs, while improving
quality to justify higher prices.
e) Launch a low price fighter line: add lower price items to the line or create a separate lower
price brand.
End-of-chapter questions
1. How does target costing help maintain competitive advantage?
2. How does life-cycle costing help maintain competitive advantage?
3. What is ‘kaizen costing’?
4. How does lean accounting help maintain competitive advantage?
5. How does value chain analysis help maintain competitive advantage?
6. How does activity-based management develop out of activity-based costing?
7. What is the management philosophy represented by total quality management?
8. What are the main components of the cost of quality?
9. What is the stated purpose of ‘business process re-engineering’?
10. What are the three goals of business process re-engineering?
True or False questions
1. The market price is determined by the buyer’s behaviour but not by the seller’s willingness
to supply the product.
True False
2. In the consumer market, consumer demand is a function of price.

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True False
3. Competitor’s prices are not important in setting a selling price for a product as long as the
price covers the seller’s costs.
True False
4. Typically, elastic demand favours higher prices.
True False
5. When producers manufacture a unique product, they usually set a penetration price.
True False
6. A penetration pricing strategy never involves selling a product below cost.
True False
7. A skimming price strategy typically is used in the maturity stage of the product life cycle.
True False
8. Trying to maintain stable prices makes good sense for the maturity stage of a product life
cycle.
True False
9. Cash discounts discriminate between buyers who pay their bills slowly from those who pay
their bills quickly.
True False
10. Price discrimination is legal when there is no apparent harm to competition.
True False

Multiple choices questions

1. Which of the following is an example of a price?
a) Rent
b) A lease payment on a new car
c) Annual salary
d) All of the above
2. Costs that do not change with changes in the number of units sold are called ………......
costs.
a) variable
b) fixed
c) major
d) minor
3. Average total cost per unit is found by:
a) variable cost per unit times average fixed cost per unit
b) variable cost per unit minus average fixed cost per unit
c) variable cost per unit plus average fixed cost per unit
d) variable cost per unit divided by the average fixed cost per unit
4. If a product costs a retailer $3.50 and the retailer sells this product for $4.10, the retailer’s
mark-up on selling price is approximately:
a) 17.1 percent
b) 16.2 percent
c) 14.6 percent
d) none of the above
5. If a producer has a selling price of $23 and a variable cost per unit of $18, the producer’s
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contribution margin per unit is approximately:
a) $5.00
b) $41.00
c) $1.28
d) none of the above
6. In which stage of the product life cycle is a price skimming strategy most likely to be used?
a) Introduction
b) Growth
c) Maturity
d) Decline
7. Which of the following is a pricing strategy that can be used by a seller to a buyer?
a) Price shading
b) Volume discounting
c) Cash discounting
d) All of the above
8. When JOMA ltd charges different prices at its stores within the same district for the same
products, this is a form of price segmentation based on:
a) usage segments
b) time segments
c) customization
d) geographic segments

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 EXERCISES
Question 1. The budgeted overheads and cost driver volumes of XYZ are as follows.
Cost pool Budgeted Cost driver Budgeted
overheads ($) volume
Material procurement 580,000 No. of orders 1,100
Material handling 250,000 No. of movements 680
Set-up 415,000 No. of set ups 520
Maintenance 970,000 Maintenance hours 8,400
Quality control 176,000 No. of inspection 900
Machinery 720,000 No. of machine hours 24,000
The company has produced a batch of 2,600 components of AX-15, its material cost was
$130,000 and labour cost $245,000. The usage activities of the said batch are as follows.
Material orders: 26, maintenance hours: 690, material movements: 18, inspection: 28, set ups:
25, machine hours: 1,800.
Required: Calculate the cost driver rates that are used for tracing appropriate amount of
overheads to the said batch and ascertain the cost of batch of components using ABC.
Solution
Cost pool Budgeted Budgeted Cost driver OH Input Batch cost
overheads ($) volume rate ($) for batch
Direct materials cost     130,000.00
Direct labour cost     250,000.00
Material procurement 580,000 1,100 527.27 26 13,709.02
Material handling 250,000 680 367.65 18 6,617.70
Set-up 415,000 520 798.08 25 19,952.00
Maintenance 970,000 8,400 115.48 690 79,681.20
Quality control 176,000 900 195.56 28 5,475.68
Machinery 720,000 24,000 30.00 1,800 54,000.00
Total cost of the batch 559,435.60
Total number in a batch 2,600.00
Cost per unit in a batch 215.17
Question 2. Ferris Corporation makes a single product—a fire-resistant commercial filing
cabinet—that it sells to office furniture distributors. The company has a simple ABC system
that it uses for internal decision making. The company has two overhead departments whose
costs are listed below:
Manufacturing overhead $500,000
Selling and administrative overhead 300,000
Total overhead costs $800,000
The company’s ABC system has the following activity cost pools and activity measures:
Activity Cost Pool Activity Measure
Assembling units Number of units
Processing orders Number of orders
Supporting customers Number of customers
Other Not applicable
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Costs assigned to the “Other” activity cost pool have no activity measure; they consist of the
costs of unused capacity and organization-sustaining costs—neither of which are assigned to
orders, customers, or the product. Ferris Corporation distributes the costs of manufacturing
overhead and of selling and administrative overhead to the activity cost pools based on
employee interviews, the results of which are reported below:
Distribution of resource consumption across activity cost pools
Assembling Processing Supporting Other Total
Units Orders Customers
Manufacturing overhead 50% 35% 5% 10% 100%
Selling and administrative overhead 10% 45% 25% 20% 100%
Total activity 1,000 units 250 orders 100 customers
Required:
1. Perform the first-stage allocation of overhead costs to the activity cost pools.
2. Compute activity rates for the activity cost pools
3. OfficeMart is one of Ferris Corporation’s customers. Last year, OfficeMart ordered filing
cabinets four different times. OfficeMart ordered a total of 80 filing cabinets during the
year. Construct a table showing the overhead costs attributable to OfficeMart.
4. The selling price of a filing cabinet is $595. The cost of direct materials is $180 per filing
cabinet; direct labour is $50 per filing cabinet. What is the customer margin of OfficeMart?
Suggested answer
1. The first-stage allocation of costs to the activity cost pools appears below:
Activity cost pools
Assembling Processing Supporting Other Total
Units Orders Customers
Manufacturing overhead $250,000 $175,000 $25,000 $50,000 $500,000
Selling and administrative overhead 30,000 135,000 75,000 60,000 300,000
Total cost $280,000 $310,000 $100,000 $110,000 $800,000
2. The activity rates for the activity cost pools are:
(a) (b) (a) ÷ (b)
Activity Cost Pools Total Cost Total Activity Activity Rate
Assembling units $280,000 1,000 units $280 per unit
Processing orders $310,000 250 orders $1,240 per order
Supporting customers $100,000 100 customers $1,000 per customer
3. The overhead cost attributable to OfficeMart would be computed as follows:
(a) (b) (a) * (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Assembling units $280 per unit 80 units $22,400
Processing orders $1,240 per order 4 orders $4,960
Supporting customers $1,000 per customer 1 customer $1,000
4. The customer margin can be computed as follows:
Sales ($595 per unit * 80 units) $47,600
Costs:
Direct materials ($180 per unit * 80 units) $14,400

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Direct labour ($50 per unit * 80 units) 4,000
Unit-related overhead (above) 22,400
Order-related overhead (above) 4,960
Customer-related overhead (above) 1,000 46,760
Customer margin $ 840
Question 3. Hobylett ltd is about to launch a new product on which it requires a pre-tax ROI of
30% per annum. Buildings and equipment needed for production will cost $5,000,000. The
expected sales are 40,000 units per annum at a selling price of $67.50 per unit. Calculate the
target cost.
Suggested answer

Question 4. Edward Co assembles and sells many types of radio. It is considering extending its
product range to include digital radios. These radios produce a better sound quality than
traditional radios and have a large number of potential additional features not possible with the
previous technologies (station scanning, more choice, one touch tuning, station identification
text and song identification text etc).
A radio is produced by assembly workers assembling a variety of components. Production
overheads are currently absorbed into product costs on an assembly labour hour basis.
Edward Co is considering a target costing approach for its new digital radio product.
Required:
a. Briefly describe the target costing process that Edward Co should undertake.
b. Explain the benefits to Edward Co of adopting a target costing approach at such an early
stage in the product development process.
c. Assuming a cost gap was identified in the process, outline possible steps Edward Co could
take to reduce this gap.
A selling price of $44 has been set in order to compete with a similar radio on the market that
has comparable features to Edward Co’s intended product. The board have agreed that the
acceptable margin (after allowing for all production costs) should be 20%.
Cost information for the new radio is as follows:
Component 1 (Circuit board) – these are bought in and cost $4·10 each. They are bought in
batches of 4,000 and additional delivery costs are $2,400 per batch.
Component 2 (Wiring) – in an ideal situation 25 cm of wiring is needed for each completed
radio. However, there is some waste involved in the process as wire is occasionally cut to the
wrong length or is damaged in the assembly process. Edward Co estimates that 2% of the
purchased wire is lost in the assembly process. Wire costs $0·50 per metre to buy.
Other material – other materials cost $8.10 per radio.
Assembly labour – these are skilled people who are difficult to recruit and retain. Edward Co
has more staff of this type than needed but is prepared to carry this extra cost in return for the
security it gives the business. It takes 30 minutes to assemble a radio and the assembly workers
are paid $12·60 per hour. It is estimated that 10% of hours paid to the assembly workers is for
idle time.

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Production Overheads – recent historic cost analysis has revealed the following production
overhead data:
Total production overhead Total assembly labour hours
$ hours
Month 1 620,000 19,000
Month 2 700,000 23,000
Fixed production overheads are absorbed on an assembly hour basis based on normal annual
activity levels. In a typical year 240,000 assembly hours will be worked by Edward Co.
Required:
(d) Calculate the expected cost per unit for the radio and identify any cost gap that might exist.
Suggested answer
(a) Target costing process
Target costing begins by specifying a product an organisation wishes to sell. This will involve
extensive customer analysis, considering which features customers value and which they do
not. Ideally only those features valued by customers will be included in the product design.
The price at which the product can be sold at is then considered. This will take in to account
the competitor products and the market conditions expected at the time that the product will be
launched. Hence a heavy emphasis is placed on external analysis before any consideration is
made of the internal cost of the product.
From the above price a desired margin is deducted. This can be a gross or a net margin. This
leaves the cost target. An organisation will need to meet this target if their desired margin is to
be met.
Costs for the product are then calculated and compared to the cost target mentioned above.
If it appears that this cost cannot be achieved then the difference (shortfall) is called a cost gap.
This gap would have to be closed, by some form of cost reduction, if the desired margin is to
be achieved.
(b) Benefits of adopting target costing
 The organisation will have an early external focus to its product development. Businesses
have to compete with others (competitors) and an early consideration of this will tend to
make them more successful. Traditional approaches (by calculating the cost and then
adding a margin to get a selling price) are often far too internally driven.
 Only those features that are of value to customers will be included in the product design.
Target costing at an early stage considers carefully the product that is intended. Features
that are unlikely to be valued by the customer will be excluded. This is often insufficiently
considered in cost plus methodologies.
 Cost control will begin much earlier in the process. If it is clear at the design stage that a
cost gap exists then more can be done to close it by the design team. Traditionally, cost
control takes place at the ‘cost incurring’ stage, which is often far too late to make a
significant impact on a product that is too expensive to make.
 Costs per unit are often lower under a target costing environment. This enhances
profitability. Target costing has been shown to reduce product cost by between 20% and
40% depending on product and market conditions. In traditional cost plus systems an
organisation may not be fully aware of the constraints in the external environment until

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 after the production has started. Cost reduction at this point is much more difficult as many
of the costs are ‘designed in’ to the product.
 It is often argued that target costing reduces the time taken to get a product to market.
Under traditional methodologies there are often lengthy delays whilst a team goes ‘back to
the drawing board’. Target costing, because it has an early external focus, tends to help get
things right first time and this reduces the time to market.
(c) Steps to reduce a cost gap
Review radio features
Remove features from the radio that add to cost but do not significantly add value to the
product when viewed by the customer. This should reduce cost but not the achievable selling
price. This can be referred to as value engineering or value analysis.
Team approach
Cost reduction works best when a team approach is adopted. Edward Limited should bring
together members of the marketing, design, assembly and distribution teams to allow
discussion of methods to reduce costs. Open discussion and brainstorming are useful
approaches here.
Review the whole supplier chain
Each step in the supply chain should be reviewed, possibly with the aid of staff questionnaires,
to identify areas of likely cost savings. Areas which are identified by staff as being likely cost
saving areas can then be focussed on by the team. For example, the questionnaire might ask
‘are there more than five potential suppliers for this component?’ Clearly a ‘yes’ response to
this question will mean that there is the potential for tendering or price competition.

Components
Edward Limited should look at the significant costs involved in components. New suppliers
could be sought or different materials could be used. Care would be needed not to damage the
perceived value of the product. Efficiency improvements should also be possible by reducing
waste or idle time that might exist. Avoid, where possible, non-standard parts in the design.
Assembly workers
Productivity gains may be possible by changing working practices or by de-skilling the
process. Automation is increasingly common in assembly and manufacturing and Edward
Limited should investigate what is possible here to reduce the costs.
The learning curve may ultimately help to close the cost gap by reducing labour costs per unit.
Clearly reducing the percentage of idle time will reduce product costs. Better management,
smoother work flow and staff incentives could all help here. Focusing on continuous
improvement in production processes may help.
Overheads
Productivity increases would also help here by spreading fixed overheads over a greater
number of units. Equally Edward Limited should consider an activity based costing approach
to its overhead allocation, this may reveal more favourable cost allocations for the digital radio
or ideas for reducing costs in the business.

(d) Cost per unit and cost gap calculation

$ per unit

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 4.70

0.128

Material – other 8.10

7.00

10.00

6.00

Total cost 35.928

35.20

Cost gap = Total cost-Desired cost 0.728

Working
Production overhead cost
Using a high low method
Extra overhead cost between month 1 and 2 $80,000
Extra assembly hours 4,000
Variable cost per hour $20/hr
Monthly fixed production overhead $700,000 – (23,000 x $20/hr) $240,000
Annual fixed production overhead ($240,000 x 12) $2,880,000

Question 5. Assume that an automotive parts division engages in a setup activity for the
subassemblies that it produces. The value-added standard for this activity calls for zero setup
hours with a cost of $0 per batch of subassemblies. Assume that in the prior year, the company
used eight hours to set up each batch at a cost of $18 per hour. The actual setup cost per batch
was $144 ($18 × 8 hrs.). This was also the non-value-added cost. For the coming quarter, the
company is planning to implement a new setup method developed by its industrial engineers
that is expected to reduce setup time by 25 percent.
Thus, the planned cost reduction is $36 per batch. The kaizen standard per batch is now $108:
six hours per setup with a standard cost of $18 per hour, or, to look at it another way, the actual
prior-year cost less the targeted reduction ($144 – $36). Now, suppose that the actual cost
achieved after implementing the new production process is $108. The actual improvements
expected did materialize, and the new minimum standard is $108 per batch, locking in the
improvements. Until further improvements are achieved, setup costs should be no more than
$108 per setup. For subsequent periods, additional improvements would be sought and a new
kaizen standard defined. The ultimate objective is to reduce setup time and cost to zero through
a series of kaizen improvements.

Question 6. Wargrin designs, develops and sells many PC games. Games have a short lifecycle
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lasting around three years only. Performance of the games is measured by reference to the
profits made in each of the expected three years of popularity. Wargrin accepts a net profit of
35% of turnover as reasonable. A rate of contribution (sales price less variable cost) of 75% is
also considered acceptable.
Wargrin has a large centralised development department which carries out all the design work
before it passes the completed game to the sales and distribution department to market and
distribute the product.
Wargrin has developed a brand new game called Stealth and this has the following budgeted
performance figures. The selling price of Stealth will be a constant $30 per game. Analysis of
the costs show that at a volume of 10,000 units a total cost of $130,000 is expected. However
at a volume of 14,000 units a total cost of $150,000 is expected. If volumes exceed 15,000
units the fixed costs will increase by 50%.
Stealth’s budgeted volumes are as follows:
Year 1 Year 2 Year 3
Sales volume 8,000 units 16,000 units 4,000 units

In addition, marketing costs for Stealth will be $60,000 in year one and $40,000 in year two.
Design and development costs are all incurred before the game is launched and has cost
$300,000 for Stealth. These costs are written off to the income statement as incurred (i.e.
before year 1 above).
Required:
(a) Explain the principles behind lifecycle costing and briefly state why Wargrin in particular
should consider these lifecycle principles.
(b) Produce the budgeted results for the game ‘Stealth’ and briefly assess the game’s expected
performance, taking into account the whole lifecycle of the game.
Suggested answer
(a) Lifecycle costing
Lifecycle costing is a concept which traces all costs to a product over its complete lifecycle,
from design through to cessation. It recognises that for many products there are significant
costs to be incurred in the early stages of its lifecycle. This is probably very true for Wargrin
Limited. The design and development of software is a long and complicated process and it is
likely that the costs involved would be very significant.
The profitability of a product can then be assessed taking all costs into consideration.
It is also likely that adopting lifecycle costing would improve decision-making and cost
control. The early development costs would have to be seen in the context of the expected
trading results, therefore preventing a serious over spend at this stage or under pricing at the
launch point.
(b) Budgeted results for game
Year 1 ($) Year 2 ($) Year 3 ($) Total ($)
Sales 240,000 480,000 120,000 840,000
Variable cost (W1) 40,000 80,000 20,000 140,000
Fixed cost (W1) 80,000 120,000 80,000 280,000
Marketing cost 60,000 40,000 _______ 100,000
Profit 60,000 240,000 20,000 320,000

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On the face of it the game will generate profits in each of its three years of life. Games only
have a short lifecycle as the game players are likely to become bored of the game and move on
to something new.
The pattern of sales follows a classic product lifecycle with poor levels of sales towards the end
of the life of the game.
The Stealth product has generated $320,000 of profit over its three year life measured on a
traditional basis. This represents 40% of turnover – ahead of its target. Indeed it shows a
positive net profit in each of its years on existence.
The contribution level is steady at around 83% indicating reasonable control and reliability of
the production processes. This figure is better than the stated target.
Considering traditional performance management concepts, Wargrin Limited is likely to be
relatively happy with the game’s performance.
However, the initial design and development costs were incurred and were significant at
$300,000 and are ignored in the annual profit calculations. Taking these into consideration, the
game only just broke even, making a small $20,000 profit. Whether this is enough is debatable,
it represents only 2.4% of sales for example. In order to properly assess the performance of a
product the whole lifecycle needs to be considered.

Workings
W1 Split of variable and fixed cost for Stealth
Volume Cost $
High 14,000 units 150,000
Low 10,000 units 130,000
Difference 4,000 units 20,000
Variable cost per unit = $20,000/4,000 unit = $5 per unit
Total cost = fixed cost + variable cost
$150,000 = fixed cost + (14,000 x $5)
$150,000 = fixed cost +$70,000
Fixed cost = $80,000 (and $120,000 if volume exceeds 15,000 units in a year)

Question 7. A company is planning a new product. Market research information suggests that
the product should sell 10,000 units at $21.00/unit. The company seeks to make a mark-up of
40% product cost. It is estimated that the lifetime costs of the product will be as follows:
(i) Design and development costs $50,000
(ii) Manufacturing costs $10/unit
(iii) End of life costs $20,000
The company estimates that if it were to spend an additional $15,000 on design, manufacturing
costs/unit could be reduced.
Required
(a) What is the target cost of the product?
(b) What is the original lifecycle cost per unit and is the product worth making on that basis?
(c) If the additional amount were spent on design, what is the maximum manufacturing cost per
unit that could be tolerated if the company is to earn its required mark-up?
Solution:
The target cost of the product can be calculated as follows:
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(a) Cost + Mark-up = Selling price
Cost + Mark-up = Selling price;
100% 40% 140%
$15 $6 $21

(b) The original life cycle cost per unit = ($50,000 + (10,000 x $10) + $20,000)/10,000 = $17
This cost/unit is above the target cost per unit, so the product is not worth making.
(c) Maximum total cost per unit = $15. Some of this will be caused by the design and end of
life costs: ($50,000 + $15,000 + $20,000)/10,000 = $8.50. Thus, the maximum manufacturing
cost per unit would have to fall from $10 to ($15-8.50) = $6.50.
Question 8. Solaris specialises in the manufacture of solar panels. It is planning to introduce a
new slimline solar panel specially designed for small houses. Development of the new panel is
to begin shortly and Solaris is in the process of determining the price of the panel. It expects
the new product to have the following costs.
Year 1 Year 2 Year 3 Year 4
Units manufactured and sold 2,000 15,000 20,000 5,000
$ $ $ $
R&D costs 1,900,000 100,000 - -
Marketing costs 100,000 75,000 50,000 10,000
Production cost per unit 500 450 400 450
Customer service costs per unit 50 40 40 40
Disposal of specialist equipment 300,000

The Marketing Director believes that customers will be prepared to pay $500 for a solar panel
but the Financial Director believes this will not cover all of the costs throughout the lifecycle.
Required: Calculate the cost per unit looking at the whole life cycle and comment on the
suggested price.
Answer
Lifecycle costs
$'000
R&D (1,900 + 100) 2,000
Marketing (100 + 75 + 50 + 10) 235
Production (1,000 + 6,750 + 8,000 + 2,250) 18,000
Customer service (100 + 600 + 800 + 200) 1,700
Disposal 300
Total lifecycle costs 22,235
Total production ('000 units) 42
Cost per unit 529.4
The total lifecycle costs are $529.40 per solar panel which is higher than the price proposed by
the marketing director. Solaris will either have to charge a higher price or look at ways to
reduce costs. It may be difficult to increase the price if customers are price sensitive and are not
prepared to pay more. Costs could be reduced by analysing each part of the costs throughout
the life cycle and actively seeking cost savings. For example, using different materials, using
cheaper staff or acquiring more efficient technology.

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Question 9. A product has a four year life-cycle. The costs in each year are shown below.
Calculate the total life-cycle cost and categorise them into each type of cost.
Year 1 2 3 4
R&D 300
Design 200
Product costs 75 90 90
Marketing costs 70 50 30
Distribution costs 20 27 24
Customer Service costs 15 23 30
Question 10.
Year Development Introduction Growth Maturity Decline
R&D 200
Marketing costs ($ million) 50 40 20 4
Production costs per unit $4 $3.50 $3 $3.20
Production volume 2m 5m 10m 4m

The CEO says that a price of $54 should be charged to cover costs and has produced the
following schedule to support it:
$m
Amortise R & D 200/4 50
Marketing costs 50
Production costs 2mx4 8
Total costs 108
Total production 2m
Cost per unit (108/2) = $54
Calculate the life-cycle cost of the product and suggest an alternative price.

Question 11. Discuss the extent to which activity-based cost management and business process
re-engineering fall within the domain of management accountants. What do you consider to be
the main limitations of these approaches?
Question 12. Strategic management accounting is merely good management accounting’.
Critically assess this statement.
Question 13. A company is reviewing its total quality management programme, which does
not appear to be making the progress expected. Problems have been identified in:
 Fear of exposing weaknesses in the organisation.
 Lack of commitment from senior executives.
 Seeing it as someone else’s problem.
How could the management accountant help in addressing these problems (300 words)?

Question 14. Jerry Goff, president of Harmony Electronics, was concerned about the end-of-
the-year marketing report that he had just received. According to Emily Hagood, marketing
manager, a price decrease for the coming year was again needed to maintain the company’s
annual sales volume of integrated circuit boards. This would make a bad situation worse.
The current selling price of $18 per unit was producing a $2-per-unit profit—half the

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customary $4-per-unit profit. Foreign competitors keep reducing their prices. To match the
latest reduction would reduce the price from $18 to $14. This would put the price below the
cost to produce and sell it. How could the foreign firms sell for such a low price? Determined
to find out if there were problems with the company’s operations, Jerry decided to hire Jan
Booth, a well-known consultant who specializes in methods of continuous improvement. Jan
indicated that she felt that an activity-based management system needed to be implemented.
After three weeks, Jan had identified the following activities and costs:
Batch-level activities:
Setting up equipment $125,000
Materials handling 180,000
Inspecting products 122,000
Product-sustaining activities:
Engineering support 120,000
Handling customer complaints 100,000
Filling warranties 170,000
Storing goods 80,000
Expediting goods 75,000
Unit-level activities:
Using materials 500,000
Using power 48,000
Manual insertion labour a
250,000
Other direct labour 150,000
Total costs $1,920,000b
a
Diodes, resistors, and integrated circuits are inserted manually into the circuit board.
b
This total cost produces a unit cost of $16 for last year’s sales volume.

Jan reported that some preliminary activity analysis shows that per-unit costs can be reduced
by at least $7. Since Emily had indicated that the market share (sales volume) for the boards
could be increased by 50 percent if the price could be reduced to $12, Jerry became quite
excited.
Required:
1. What is activity-based management? What connection does it have to continuous
improvement
2. Identify as many non-value-added costs as possible. Compute the cost savings per unit that
would be realized if these costs were eliminated. Was Jan correct in her preliminary cost
reduction assessment? Discuss actions that the company can take to reduce or eliminate the
non-value-added activities.
3. Compute the target cost required to maintain current market share while earning a profit of
$4 per unit. Now, compute the target cost required to expand sales by 50 percent. How
much cost reduction would be required to achieve each target?
4. Assume that Jan suggested that kaizen costing be used to help reduce costs. The first
suggested kaizen initiative is described by the following: switching to automated insertion
would save $60,000 of engineering support and $90,000 of direct labor. Now, what is the
total potential cost reduction per unit available? With these additional reductions, can
Harmony Electronics achieve the target cost to maintain current sales? To increase it by
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 50%? What form of activity analysis is this kaizen initiative: reduction, sharing, elimination,
or selection?
5. Calculate income based on current sales, prices, and costs. Now, calculate the income using
a $14 price and a $12 price, assuming that the maximum cost reduction possible is achieved
(including Requirement 4’s kaizen reduction). What price should be selected?

Question 15. A company budgets to make 20,000 units, which have a variable cost of
production of $4 per unit. Fixed production costs are $60,000 per annum. If the selling price is
to be 40% higher than full cost, what is the selling price of the product using the full cost-plus
method?
Solution

Question 16. A product has the following costs.

$
Direct materials 5
Direct labour 3
Variable overheads 7
Fixed overheads are $10,000 per month. Budgeted sales per month are 400 units to allow the
product to break even.
Required: Determine the profit margin which needs to be added to marginal cost to allow the
product to break even.
Answer
Breakeven point is when total contribution equals fixed costs.
At breakeven point, $10,000 = 400 (price – $15); therefore, price = $15+$25 = $40

Question 17. The managers of Keny ltd have established that the price demand relationship is
as follows:
Selling price per unit Demand
16.0 100
15.5 200
15.0 300
14.5 400
14.0 500
13.5 600
13.0 700
They have also established that the cost per unit for production of jars coffee is as follows:
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Quantity Cost per unit
100 14.0
200 13.9
300 13.8
400 13.7
500 13.6
600 13.5
700 13.4
800 13.3
900 13.2
Required: Determine the optimal selling in order to maximise profit
Selling price Demand Cost Total Total Total Marginal Marginal
per unit per unit revenue cost profit revenue cost

Note: Whichever way you choose to calculate the optimum selling price in the above example,
do be aware that it occurs at the point where marginal revenue equals marginal cost.

Suggested answer
Profit maximisation – Tabular approach
Unit selling Demand Cost per Total Total Total Marginal Marginal
price unit revenue cost profit revenue cost
16.0 100 14.0 1,600 1,400 200 1,600 1,400
15.5 200 13.9 3,100 2,780 320 1,500 1,380
15.0 300 13.8 4,500 4,140 360 1,400 1,360
14.5 400 13.7 5,800 5,480 320 1,300 1,340
14.0 500 13.6 7,000 6,800 200 1,200 1,320
13.5 600 13.5 8,100 8,100 0 1,100 1,300
13.0 700 13.4 9,100 9,380 (280) 1,000 1,280
Optimum selling price is $15 per unit
Question 18. Using the figure from the above example 2, calculate the price elasticity of
demand (PED)
a) If the current selling price is $16 per unit
b) If the current selling price is $15 per unit
Solution
a) Calculation of the price elasticity of b) Calculation of the price elasticity of
demand demand

Question 19. A company sells an article at $12 per unit and has a demand of 16,000 units at
this price. If the selling price were to be increased by $1 per unit, it is estimated that the
demand will fall by 2,500 units. On the assumption that the price/demand relationship is linear,
derive the equation relating the selling price to the demand.
Suggested answer

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Question 20. A company currently has a demand for one of its products of 2,000 units at a
selling price of $30 per unit. It has been determined that a reduction in selling price of $1 will
result in additional sales of 100 units. The costs of production are $1,000 (fixed) together with
a variable cost of $20 per unit. Calculate the selling price per unit at which the profit will be
maximised. Note: the formula for Marginal revenue is MR = a – 2bQ
Suggested answer

Question 21. At a selling price of $100 per unit the company will sell 20,000 units per annum.
For every $2 change in the selling price, the demand will change by 2,000 units. The costs
comprise a fixed cost of $100,000 together with a variable cost of $5 per unit.
Calculate the selling price per unit that will result in maximum profit per annum and the
amount of that profit.
Suggested answer

Total contribution
Less: Fixed costs 100,000
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Maximum profit $3,206,250
Question 22. Hyper has budgeted to make 50,000 units of its product, Fimm. The variable cost
of a Fimm is $5 and annual fixed costs are expected to be $150,000. The financial director of
Hyper has suggested that a profit margin of 25% on full cost should be charged for every
product sold. The marketing director has challenged the wisdom of this suggestion, and has
produced the following estimates of sales demand for Fimms.
Price per unit Demand
$ Units
9 42,000
10 38,000
11 35,000
12 32,000
13 27,000
Required
(a) Calculate the profit for the year if a full cost price is charged.
(b) Calculate the profit-maximising price.
Assume in both (a) and (b) that 50,000 units of Fimm are produced regardless of sales volume.
Suggested answer
(a) (i) The full cost per unit is $5 variable cost plus $3 fixed costs, ie $8 in total. A 25% mark-
up on this cost gives a selling price of $10 per unit so that sales demand would be 38,000 units.
(Production is given: 50,000 units.)
$ $
Profit (absorption costing)
Sales 380,000
Costs of production (50,000 units)
Variable (50,000 × $5) 250,000
Fixed (50,000 × $3) 150,000
400,000
Less increase in inventory (12,000 units × 8) (96,000)
Cost of sales 304,000
Profit 76,000
(ii) Profit using marginal costing instead of absorption costing, so that fixed overhead costs
are written off in the period they occur, would be as follows. (The 38,000-unit demand level is
chosen for comparison.)
$
Contribution (38,000 × $(10 – 5)) 190,000
Fixed costs 150,000
Profit 40,000
Since the company cannot go on indefinitely producing an output volume in excess of sales
volume, this profit figure is more indicative of the profitability of Fimms in the longer term.

(b) A profit-maximising price is one which gives the greatest net (relevant) cash flow, which
in this case is the contribution-maximising price.
Price Unit contribution Demand Total contribution
$ $ Units $
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9 4 42,000 168,000
10 5 38,000 190,000
11 6 35,000 210,000
12 7 32,000 224,000
13 8 27,000 216,000
The profit maximising price is $12, with annual sales demand of 32,000 units.
This example shows that a cost based price is unlikely to be the profit-maximising price,
and that a marginal costing approach, calculating the total contribution at a variety of
different selling prices, will be more helpful for establishing what the profit-maximising price
ought to be.
Question 23. A company produces a single product and operates in a market where it has to
lower the selling price of all units if it wishes to sell more. The costing and marketing
department have provided the following information:
 The current demand is 1,000 units per month, at a selling price of $10 per unit
 It is estimated that for every $1 change in the selling price, the demand will change by
100 units
 The variable costs of production are $0.60 per unit and the fixed costs are $5,000 per
month.
Required:
a) Derive the price/demand equation
b) Calculate the optimal selling price per unit to achieve maximum profit and the amount of
that profit
Note: The marginal revenue is given by 20 – 0.02Q, where Q is demand.
Question 24. ABC plc is about to launch a new product. Facilities will allow the company to
produce up to 20 units per week. The marketing department has estimated that at a price of
£8,000 no units will be sold, but for each £150 reduction in price one additional unit per week
will be sold.
Fixed costs associated with manufacture are expected to be £12,000 per week. Variable costs
are expected to be £4,000 per unit for each of the first 10 units; thereafter each unit will cost
£400 more than the preceding one. The most profitable level of output per week for the new
product is
(A) 10 units
(B) 11 units
(C) 13 units
(D) 14 units
(E) 20 units
Question 25. Market research by Company A has revealed that the maximum demand for
product R is 50,000 units each year, and that demand will reduce by 50 units for every £1 that
the selling price is increased. Based on this information, Company A has calculated that the
profit-maximising level of sales for product R for the coming year is 35,000 units.
This price at which these units will be sold is:
(A) £100
(B) £300
(C) £500
(D) £700
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(E) £900
Question 26. Another product manufactured by company A is product M. At a price of £700
for product M there would be zero demand, and for every £40 reduction in the selling price the
demand would increase by 100 units. The variable cost of producing a unit of product M is
£60. Company A knows that if the demand equation for product M is represented by p = a - bx,
where p is the selling price and x is the quantity demanded at price p, then the marginal
revenue (MR) for product M can be represented by MR = a - 2bx. The profit-maximising
output of product M is:
(A) 100 units
(B) 700 units
(C) 800 units
(D) 1,600 units
(E) 1,750 units
Question 27. A company is considering the pricing of one of its products. It has already
carried out some market research with the following results:
 The quantity demanded at a price of $100 will be 1,000 units
 The quantity demanded will increase/decrease by 100 units for every $50 decrease/increase in
selling price
 The marginal cost of each unit is $35
Note that if Selling Price (P) = a – bx then Marginal Revenue = a – 2bx
Calculate the selling price that maximises company profit.
Question 28. H is launching a new product which it expects to incur a variable cost of $14 per
unit. The company has completed some market research to try to determine the optimum
selling price with the following results. If the price charged was to be $25 per unit, then the
demand would be 1,000 units each period. For every $1 increase in the selling price, demand
would reduce by 100 units each period. For every $1 reduction in the selling price, the demand
would increase by 100 units each period.
Calculate the optimum selling price.
Note: If Price (P) = a - bx, then marginal revenue = a – 2bx
Question 29. Woodner Ltd provides a standard service. It is able to provide a maximum of 100
units of this service each week. Experience shows that at a price of £100, no units of the
service would be sold. For every £5 below this price, the business is able to sell 10 more units.
For example, at a price of £95, 10 units would be sold, at £90, 20 units would be sold, and so
on. The business’s fixed costs total £2,500 a week. Variable costs are £20 per unit over the
entire range of possible output. The market is such that it is not feasible to charge different
prices to different customers.
Required: What is the most profitable level of output of the service?
Question 30. B Ltd manufactures blodgets. It has been ascertained that the market for blodgets
is as follows:
 at unit price £20, no blodgets are demanded or sold;
 at unit price nil, 5,000 blodgets are demanded;
 for price levels intermediate between £20 and nil there is a linear relationship between price
and demand.
The variable cost of manufacturing a blodget is £5 at all levels of output.

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Required: Calculate the unit selling prices which will: (a) maximise revenue; and (b)
maximise profit
Question 31. A firm faces the following average revenue (demand) curve: P = 100 - 0.01Q
Where Q is weekly production and P is price, measured in cents per unit. The firm’s cost
function is given by C = 50Q + 30,000. Assuming the firm maximizes profits,
a) What is the level of production, price, and total profit per week?
b) If the government decides to levy a tax of 10 cents per unit on this product, what will be the
new level of production, price, and profit?
Question 32. The following table shows the demand curve facing a monopolist who produces at
a constant marginal cost of $10
Price Quantity
27 0
24 2
21 4
18 6
15 8
12 10
9 12
6 14
3 16
0 18
a) Calculate the firm’s marginal revenue curve
b) What are the firm’s profit-maximizing output and price? What is its profit?
c) What would the equilibrium price and quantity be in a competitive industry?
d) What would the social gain be if this monopolist were forced to produce and price at the
competitive equilibrium? Who would gain and lose as a result?
Open-ended questions on monopoly
A. A monopolist is producing at a point at which marginal cost exceeds marginal revenue. How
should it adjust its output to increase profit?
b. Why is there no market supply curve under conditions of monopoly?
c. Why might a firm have monopoly power even if it is not the only producer in the market?
d. What are some of the sources of monopoly power? Give an example of each
e. What factors determine the amount of monopoly power an individual firm is likely to have?
Explain each one briefly
f. Why will a monopolist’s output increase if the government forces it to lower its price? If the
government wants to set a price ceiling that maximizes the monopolist’s output, what price
should it set?
Question 33. The GB Company manufactures a variety of electric motors. The business is
currently operating at about 70 per cent of capacity and is earning a satisfactory return on
investment. International Industries (II) has approached the management of GB with an offer to
buy 120,000 units of an electric motor. II manufactures a motor that is almost identical to GB’s
motor, but a fire at the II plant has shut down its manufacturing operations. II needs the
120,000 motors over the next four months to meet commitments to its regular customers; II is
prepared to pay £19 each for the motors, which it will collect from the GB plant.
GB’s product cost, based on current planned cost for the motor, is:

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 £
Direct materials 5.00
Direct labour (variable) 6.00
Manufacturing overheads 9.00
Total 20.00
Manufacturing overheads are applied to production at the rate of £18.00 a direct labour hour.
This overheads rate is made up of the following components:
£
Variable factory overhead 6.00
Fixed factory overhead –– direct 8.00
–– allocated 4.00
Applied manufacturing overhead rate 18.00
Additional costs usually incurred in connection with sales of electric motors include sales
commissions of 5 per cent and freight expense of £1.00 a unit.
In determining selling prices, GB adds a 40 per cent mark-up to the product cost. This provides
a suggested selling price of £28 for the motor. The marketing department, however, has set the
current selling price at £27.00 to maintain market share. The order would, however, require
additional fixed factory overheads of £15,000 a month in the form of supervision and clerical
costs. If management accepts the order, 30,000 motors will be manufactured and delivered to II
each month for the next four months.
Required:
a) Prepare a financial evaluation showing the impact of accepting the International Industries
order. What is the minimum unit price that the business’s management could accept
without reducing its operating profit?
b) State clearly any assumptions contained in the analysis of (a) above and discuss any other
organisational or strategic factors that GB should consider.

Question 34. Leisure Furniture Ltd produces furniture for hotels and public houses using
specific designs prepared by firms of interior design consultants. Business is brisk and the
market is highly competitive with a number of rival companies tendering for work. The
company’s pricing policy, based on marginal costing (variable costing) techniques, is
generating high sales.
The main activity of Home Furniture Ltd is the production of a limited range of standard
lounge suites for household use. The company also offers a service constructing furniture to
customers’ designs. This work is undertaken to utilise any spare capacity. The main customers
of the company are the major chains of furniture retailers. Due to recession, consumer spending
on household durables has decreased recently and, as a result, the company is experiencing a
significant reduction in orders for its standard lounge suites. The market is unlikely to improve
within the next year. The company’s pricing policy is to add a percentage mark-up to total cost.
Required: Explain why different pricing policies may be appropriate in different
circumstances, illustrating your answer by reference to Leisure Furniture Ltd and Home
Furniture Ltd.

Question 35. A manufacturer of toothpaste has estimated the price at which the product will
sell, making use of market surveys and consumer analysis. A profit margin has been set.
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Finally a target cost has been established by subtracting the expected profit from the estimated
selling price. The plant manager and the research and development unit have been asked to
design the product in such a way that it can be produced within the target cost.
A rival manufacturer of toothpaste takes a different approach. Here the selling price is again
estimated from market surveys and consumer analysis and a profit margin is set. However, the
product design is then accepted on the recommendation of the research and development unit
and the plant manager focuses on a programme of continuous improvement which will keep
costs within acceptable limits.
Is there a role for management accounting in either of these situations? Explain.

Question 36. Melcher Company produces and sells small household appliances. A few years
ago, it designed and developed a new hand-held mixer, named the “Mixalot.” The Mixalot can
be used to mix milkshakes and light batter. With the mincer attachment, it can mince up to a
cup of vegetables or fruits. The Mixalot was very different from the standard table model
Melcher mixer. Because of this, over $250,000 was spent on design and development. Another
$50,000 was spent on consumer focus groups, in which prototypes of the Mixalot were kitchen
tested by consumers. It was in those groups that safety problems surfaced. For example, one of
the testers sliced his hand. This necessitated adding a plastic guard around the blade. Molding
and attaching the blade would add $1.50 to prime costs of the Mixalot, which had originally
been estimated to cost $3.50 to produce.

Information regarding the first five years of operations is as follows:

Year 1 Year 2 Year 3 Year 4 Year 5
Unit sales 25,000 150,000 400,000 400,000 135,000
Price $15 $20 $20 $18 $15
Prime cost $125,000 $600,000 $1,640,000 $1,640,000 $526,500
Setup cost $5,000 $9,600 $80,000 $80,000 $12,000
Purchase of special equipment $65,000 — — — —
Expediting — $15,000 $40,000 $35,000 —
Rework $12,500 $45,000 $60,000 $60,000 $6,750
Other overhead $50,000 $300,000 $800,000 $800,000 $270,000
Warranty repair $6,250 $7,500 $10,000 $10,000 $3,375
Commissions (5%) $18,750 $150,000 $400,000 $360,000 $ 101,250
Advertising $250,000 $150,000 $100,000 $100,000 $25,000

During the first year, Melcher’s prime costs included the safety guard. The special equipment
was for molding and attaching the guard. It had a life of five years with no salvage value.
Required:
1) What is the cost of goods sold per unit for the Mixalot in each of the five years?
2) What marketing expenses were associated with the Mixalot in each of the five years?
Calculate them on a per-unit basis.
3) Calculate operating income for the Mixalot in each of the five years. Then, compare all
costs to revenues for the Mixalot over the entire product life cycle. Was the Mixalot
profitable?

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4) Discuss the pricing strategy of Melcher Company for the Mixalot, initially and over the
product life cycle.
Solution
1.
Year 1 Year 2 Year 3 Year 4 Year 5
Prime cost ($) 125,000 600,000 1,640,000 1,640,000 526,500
Setup cost ($) 5,000 9,600 80,000 80,000 12,000
Depreciation on special equipment ($) 13,000 13,000 13,000 13,000 13,000
Expediting ($) — 15,000 40,000 35,000 —
Rework ($) 12,500 45,000 60,000 60,000 6,750
Other overhead ($) 50,000 300,000 800,000 800,000 270,000
Total COGS ($) 205,500 982,600 2,633,000 2,628,000 828,250
Divided by units 25,000 150,000 400,00 400,000 135,000
Unit COGS 8.22 6.55 6.58 6.57 6.14
2.
Year 1 Year 2 Year 3 Year 4 Year 5
Warranty repair ($) 6,250 7,500 10,000 10,000 3,375
Commissions (5%) ($) 18,750 150,000 400,000 360,000 101,250
Advertising ($) 250,000 150,000 100,000 100,000 25,000
Total marketing expenses ($) 275,000 307,500 510,000 470,000 129,625
Divided by units 25,000 150,000 400,000 400,000 135,000
Unit marketing expense ($) 11.00 2.05 1.28 1.18 0.96
3.
Year 1 Year 2 Year 3 Year 4 Year 5
$ $ $ $ $
Sales 375,000 3,000,000 8,000,000 7,200,000 2,025,000
Less: COGS 205,500 982,600 2,633,000 2,628,000 828,250
Gross profit 169,500 2,017,400 5,367,000 4,572,000 1,196,750
Less: Marketing expenses 275,000 307,500 510,000 470,000 129,625
Operating income (loss) (105,500) 1,709,900 4,857,000 4,102,000 1,067,125
Five-year operating income 11,630,525
Less: Design and development expenses 300,000
Excess of revenue over all costs 11,330,525
Yes, the Mixalot was profitable over the 5-year cycle, even after the design and development
expenses were subtracted. Note that these expenses do not appear on the operating income
statement required for external reporting.
5. The initial price set for the Mixalot was $15. This is the lowest price of those charged
during the 5-year period. It appears that Melcher Company was using a penetration pricing
strategy for the Mixalot. This makes sense given that the Mixalot was not a radically new
product, i.e., there were other appliances on the market that could do what the Mixalot
could do. There were blenders to mix milkshakes, knives and chopping boards to cut up
vegetables, and food processors to mix and chop. Melcher Company needed to get the
Mixalot out into actual kitchens to build demand. Notice, too, the large marketing
expenditures in the first year to create awareness. This also helps to support price increases
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 down the line. Finally, by the fifth year, the Mixalot is in the declining stage of the product
life cycle. Probably other companies have begun producing competing products, and the
number of new Mixalots demanded has declined.
Chapter Four Strategic positioning analysis

4.1 Environmental Analysis

PESTEL analysis
Now we are going to look at the environmental influences in organizations. We are first going
to look at the macro-environmental influences, then influences specific to a particular market,
and finally, influences specific to a particular organization within that market.
The macro-environmental influences can be remembered by the acronym PESTEL. It stands
for:
• Political
• Economic
• Social
• Technological
• Ecological
• Legal.
You may have known this previously as PEST, but now we slit apart political and legal and
there is an extra “E” for Ecological, which for many organizations is becoming a major
concern. Note that it doesn’t much matter whether something like a tax rate is regarded as
being political or economic: the important point is to have recognized a tax rate or a new tax as
something which might affect the organization.
Examples of PESTEL factors:
• Political: elections and changes of government, war, European Union expansion.
• Economic: interest rates, tax rates, exchange rates, economic boom or recession
• Social: nowadays the main social trend arises from changes in populations. In most western
countries the birth rate has fallen and there is an increasing proportion of elderly people. This
can affect recruitment but it can also affect the economies of companies that they have to
support a larger number of retirees. It can of course affect the marketing of products. Products
suited to older people may become more popular while those suited to younger people may
become less popular.
• Technological: technological changes often come out of the blue, but once they are invented
there is really no turning back. Think how the internet has profoundly affected the fortunes of
organizations like travel agents. I think how banks have responded by may be closing branches
and encouraging their clients to do more and more banking online.
• Ecological: carbon emission restrictions/taxes, more stringent laws governing air and water
solution, concern about the possible effects of global warming.
• Legal: health and safety legislation, equality legislation, regulation of industries.

4.2 SWOT ANALYSIS

A SWOT analysis can either be used in its own right or it can be used as a summary sheet on
which other findings are placed. SWOT stands for:
• Strengths
• Weaknesses
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• Opportunities
• Threats
Strengths and weakness are internal to the organization. For example, an organization might
have strong resources in finance and weak resources in marketing. Opportunities and threats
are external. For example there may be political threats, but the economy might be looking up
and might provide opportunities.

Those political and economic factors could have a reason from a PESTLE analysis
Strength Weakness

Look for opportunities that Look for strategies which

make use of the strength addresses the weakness
Opportunities Once
the

Look for strategies which use Defensive look for strategies

Threat strength to overcome /avoid which avoid threat and
threat minimise the effect of
weakness

strength, weaknesses, opportunities, and threats have been summarized an organization then
has to decide what to do with them.
Certain things match well. For example, if there is an opportunity which is matched by strength
then the organization should try to make use of that strength. However if the opportunity
depended on using an area in which the company was weak, then the chances of success there
are relatively low. Either avoid that opportunity or look for strategies which address the
weakness.
Similarly, if there is a particular threat which is matched by strength then it should be relatively
easy for the company to overcome that threat. But if there is a threat in an area where the
company is particularly weak, then the company could be in some difficulty. For example the
threat might be coming from overseas imports which are particularly low cost. If our
organization is weak in manufacturing so that its costs are relatively high because of inefficient
machinery it’s not easy to see what the company can do to fight that threat and it will be
particularly vulnerable in that area. Perhaps what it should do instead of fighting the imports
face on is to try to avoid the whole conflict by, for example, moving up market. Note, however,
that if it is going to move up market it must be strong in the areas of research, development,
quality, and innovation.

4.2.1 SWOT analysis and performance management

Corporate appraisal (SWOT analysis) helps an organisation identify the opportunities and
threats it faces, and therefore also helps it evaluate the potential strategic options it could
pursue. In this respect, corporate appraisal can make an important contribution to improving an
organisation's performance. It can also help an organisation identify the key aspects of its
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performance which need measuring.
When developing its strategic plans, it is important for an organisation to understand its
strengths and weaknesses, and to be aware of the opportunities and threats it faces. SWOT
analysis (corporate appraisal) is covered in Paper P3, so you should already be familiar with it
as a model. It combines the results of the internal analysis and external environmental analysis
into a single framework for assessing an organisation's strengths and weaknesses, and the
opportunities and threats offered by the environment. In this way, corporate appraisal allows an
organisation to understand its current strategic position as part of preparing its strategic plan.
SWOT analysis summarises the key issues from the business environment and the strategic
capability of an organisation that are most likely to impact on strategy development
4.2.2 SWOT analysis
Effective SWOT analysis does not simply require a categorisation of information; it also
requires some evaluation of the relative importance of the various factors under
consideration.
(a) These features are only of relevance if they are perceived to exist by the consumers.
Listing
corporate features that internal personnel regard as strengths/weaknesses is of little relevance if
they are not perceived as such by the organisation's consumers.
(b) In the same vein, threats and opportunities are conditions presented by the external
environment
and they should be independent of the firm. SWOT analysis can then be used to guide strategy
formulation. The internal and external appraisals should be brought together so that an
organisation can develop its strategies from identifying its own strengthsand weaknesses, and
from identifying the opportunities and threats presented by the wider macro environment.
Strengths should be built on and consolidated, while strategies to address any weaknesses can
be drawn up. Similarly, strategies should be developed to exploit opportunities, and to provide
contingencies against the threats which have been identified.

Internal to the Strength Weakness

company
Conversion

Conversion
External to the Opportunities Threats
company

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4.2.3 SWOT analysis and strategic planning
SWOT analysis is usually seen as a key part of strategic analysis. An organisation needs to
understand its current strategic position, before evaluating the strategic options available to it.
SWOT analysis helps an organisation achieve this understanding in two ways:
(a) It helps the organisation analyse the things it does particularly well (strengths) or badly
(weaknesses) at present.
(b) It helps to identify the factors that may give the organisation potential to grow and increase
its
profits (opportunities) or may make its position weaker (threats). In this context, it is important
to bear in mind what SWOT analysis is for. It is intended to summarise a strategic situation,
with a view to deciding what the organisation should do next. Understanding the key
opportunities and threats facing an organisation helps its managers identify realistic options
from which to choose an appropriate strategy for the firm. A strategy could be drawn up to
consolidate the organisation's strengths, improve on its weaknesses, exploit the opportunities
available to it, and deal with the threats it faces.
However, it is also important to remember some of the dangers relating to SWOT exercises. As
Johnson etal highlight in Fundamentals of Strategy: 'A SWOT exercise can generate very long
lists of apparent strengths, weaknesses, opportunities and threats, whereas what matters is to be
clear about what is really important and what is less important. So prioritisation of issues
matters.'
Johnson et al also highlight two key points, which could be important for SWOT exercises in
relation to performance management:
(a) Focus on strengths and weaknesses that differ in relative terms compared to competitors
and leave out areas where the organisation is at par with competitors.
(b) Focus on opportunities and threats that are directly relevant for the specific organisation
and
industry.
4.2.4 SWOT analysis and the performance management process
The previous sub-section highlights that SWOT analysis is intended to help an organisation
decide what to do next. In this respect, it also plays an important role in the performance
management process. Earlier in the chapter we noted that performance management can be
defined as any activity designed to improve an organisation's performance and ensure that its
goals are being met.
By identifying opportunities and threats, and helping to identify the strategic choices to pursue,
SWOT analysis plays an important part in the planning activity designed to improve an
organisation's performance.
More specifically, SWOT analysis also assists the performance management process by:
(a) Identifying shortcomings (weaknesses) or limiting factors that need to be addressed (this
links
back to Johnson et al's point about the importance of focusing on areas of weakness relative to
competitors)
(b) Identifying CSFs which will allow KPIs to be created and monitored
(c) Determining the information needs of the business to measure and report on the KPIs
(d) Setting targets; an organisation should consider what targets would allow it to build on its
strengths and/or take advantage of opportunities, as well as minimising its weaknesses and the
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threats it faces. Equally, however, a consideration of an organisation's strengths and
weaknesses, and the opportunities and threats it faces, will also allow the organisation to assess
whether targets which
have already been suggested are realistic and achievable.
4.2.5 SWOT analysis and performance measurement
As well as helping an organisation decide what to do next, SWOT analysis helps identify the
key aspects of performance which an organisation needs to measure.
For example, an organisation may have identified its strengths to be: its reliable products, its
well respected brand name, and the fact it sells its products at competitive prices. However, this
also suggests that in order for the organisation to continue to perform well it must maintain its
product reliability, reputation and brand name, and it must continue to sell its products at
competitive prices.
In turn, in order for the organisation to know whether or not it is achieving its aims it has to
measure how well it is performing in these key areas. For example, its key performance
measures should include a measure of product reliability, and a comparison of its prices with
competitors' prices.
Similarly, if an organisation has identified that one of its weaknesses is its low standard of
customer
service, then it will be keen to convert this weakness into a strength by improving its levels of
customer service. Equally, however, it will be crucial for the organisation to measure customer
service levels and customer satisfaction, to assess whether or not service levels are improving
in the way that the organisation wants.
4.3 Cost Driver Analysis
To reflect today's more complex business environment, recognition must be given to the fact
that costs are created and incurred because their cost drivers occur at different levels. Cost
driver analysis investigates, quantifies and explains the relationships between cost drivers and
their related costs.
Classification level Cause of cost Types of cost Necessity of cost
Unit level costs Production/acquisition Direct materials Once for each unit
of a single unit of Direct labour produced
product or delivery of
single unit of service
Batch level costs A group of things Purchase orders Once for each batch
being made, handled Set-ups produced
or processed Inspection
Product/process level Development, Equipment Supports a product
costs production or maintenance type or a process
acquisition of different Product development
items
Organisational/facility Building Supports the overall
costs depreciation production or
Organisational service
advertising process

Traditionally it has been assumed that if costs did not vary with changes in production at the
unit level, they were fixed rather than variable. The analysis above shows this assumption to be
false, and that costs vary for reasons other than production volume. To determine an accurate
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estimate of product or service cost, costs should be accumulated at each successively higher
level of costs.
Unit level costs are allocated over number of units produced, batch level costs over the number
of units in the batch and product level costs over the number of units produced by the product
line. These costs are all related to units of product (merely at different levels) and so can be
gathered together at the product level to match with revenue. Organisational level costs are not
product related, however, and so should simply be deducted from net revenue. Such an
approach gives a far greater insight into product profitability.
4.4 COST ANALYSIS
4.4.1 Standard costing
Standard costs are predetermined costs per unit of output that should be incurred under normal
operating conditions. Even if the use of standard costs does not progress to variance analysis,
‘standards’ are needed for budgeting.
It is essential to know how much material and how many hours it will take to produce planned
output and what these resources will cost.
Probably the best standards to use are ‘currently attainable standards’. These should be
achievable under normal operating conditions without being too easy.
4.4.2 Variance analysis
Variance analysis is a common way to try to find reasons for discrepancies between actual and
budgeted performance. Just because a production department used more material than might
have been expected does not mean that that the operations in the production department was at
fault. The purchasing department might have bought poor material, machines might be old and
unreliable thus wasting some material, cheaper and worse staff might have been forced on the
department and these people make errors.
Material variances
The variances Potential causes
Material price variance (MPV):
Quantity of material actually used at actual price compared to what that quantity of material
would cost if bought at standard price/unit.
• Wrong standard cost/unit of material
• Poor/excellent buying
• Price changes since the standard was set
• Exchange rate movements altering the price of imported material
MPV = (SP – AP) AQ
SP = Standard price
AP = Actual price
AQ = Actual quantity

Material usage variance (MUV):

The physical amount of material actually used compared to the standard amount that should be
used for the actual output achieved, evaluated at the standard cost per unit.
• Wrong standard usage/unit of production
• Poor/excellent use of material
• Material of different quality
• Poor machine maintenance
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• Poor staff training
MUV = (SQ – AQ) SP
Where SQ is the standard quantity

Labour variances
The variances Potential causes
Labour rate variance (LRV):
The actual coast of labour paid for compared to what that amount labour should have cost if
paid at the standard hourly rate.
• Wrong standard rate/hour
• Wage inflation
• A different mix of labour eg better, more expensive people
LRV = (SR – AR) ALH
SR = standard rate
AR = Actual rate
ALH = actual Labour hours
Labour efficiency variance (LEV):
Number of hours actually worked compared to the standard number of hours that should be
worked for the actual output achieved, evaluated at the standard rate per hour.
• Wrong standard hours per unit
• A different mix of labour
• Better or worse training than expected
• Good/poor supervision
LEV = (SLH – ALH) SR
Where SLH is the standard labour hour

Labour idle time variance LITV:

Hours actually worked compared to hours paid for, evaluated at the standard rate per hour
• Poor supervision
• Machine breakdown
• Lack of material
• Poor job scheduling
LITV = (Hours paid – actual hours) SR
Variable overhead variances
The variances Potential causes
Variable overhead rate variance VORV:
Amount of variable overhead actually paid, compared to what those hours of variable overhead
should have cost if bought at standard hourly rate.
• Wrong standard rate/hour
• Different machines being used
• Unexpected inflation relating to machine running.
VORV = (SOR – AOR) AOH
SOR = standard overhead rate
AOR actual overhead rate
AOH = Actual overhead hours
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Variable overhead efficiency variance (VOEV):
Number of hours actually worked compared to the standard number of hours for the actual
output achieved, evaluated at the standard rate per hour.
• Wrong standard hours per unit
• Machines of a differ ent efficiency than expected.
• Good/poor supervision
• Good/poor machine maintenance.
VOEV = (SOH – AOH) SOR
Where SOH is the standard overhead hours
Fixed overhead Expenditure variances (FOEV)
The variances Potential causes
Fixed overhead expenditure variance:
Total amount of budgeted fixed overheads compared to total actual fixed overheads
• Wrong budget
• Unexpected level of expenditure
FOEV = budgeted fixed overheads – actual overheads
Fixed overhead volume variance (FOVV):
Actual output in units compared to budgeted output (units), evaluated at the fixed overhead
absorption rate per unit
• Wrong budget
• Different output to what was expected.
FOVV = (SO – AO) SFOR
SO = standard output
AO = actual output
SFOR = standard fixed overhead rate
Sales variances
The variances Potential causes
Sales price variance:
Actual volume sold times difference between actual and budgeted selling price
• Wrong budget
• Different selling price to what was expected.
Sales volume variance:
Actual volume sold compared to budget volume, evaluated at budgeted contribution per unit or
at budgeted profit per unit.
• Wrong budget
• Different selling price to what was expected (affects demand)
• Change in marketing
• Economic changes
4.6 Operating statement
Once variances have been calculated they can be conveniently displayed on an operating
statement.
Typically this reconciles budgeted profits or contribution to actual profit.

Example:
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Company produces and sells one product only, the Thing, the standard cost for one unit being
asfollows.
$
Direct material A – 10 kilograms at $20 per kg 200
Direct material B – 5 litres at $6 per litre 30
Direct wages – 5 hours at $6 per hour 30
Fixed production overhead 50
Total standard cost 310
The fixed overhead included in the standard cost is based on an expected monthly output of
900 units. Fixed production overhead is absorbed on the basis of direct labour hours.
During April the actual results were as follows.
Production 800 units
Material A 7,800 kg used, costing $159,900
Material B 4,300 litres used, costing $23,650
Direct wages 4,200 hours worked for $24,150
Fixed production overhead $47,000
Required
(a) Calculate price and usage variances for each material.
(b) Calculate labour rate and efficiency variances.
(c) Calculate fixed production overhead expenditure and volume variances and then subdivide
the volume variance.
swer
(a) Price variance – A
$
7,800 kgs should have cost (at $20) 156,000
but did cost 159,900
Price variance 3,900 (A)
Usage variance – A
800 units should have used (at 10 kgs) 8,000 kgs
but did use 7,800 kgs
Usage variance in kgs 200 (F)
standard cost per kilogram at $20
Usage variance in $ $4,000 (F)
Price variance – B

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 $
4,300 litres should have cost (at $6) 25,800
but did cost 23,650
Price variance 2,150 (F)
Usage variance – B
$
800 units should have used (at 5 ) 4,000
but did use 4,300
Usage variance in litres 300 (A)
standard cost per litre × $6
Usage variance in $ $1,800 (A)

(b) Labour rate variance

$
4,200 hours should have cost (at $6) 25,200
but did cost 24,150
Rate variance 1,050 (F)
Labour efficiency variance
800 units should have taken (at 5 hrs) 4,000 hrs
but did take 4,200 hrs
Efficiency variance in hours 200 (A)
standard rate per hour × $6
Efficiency variance in $ $1,200 (A)
(c) Fixed overhead expenditure variance
$
Budgeted expenditure ($50 x 900) 45,000
Actual expenditure 47,000
Expenditure variance 2,000 (A)
Fixed overhead volume variance
$
Budgeted production at standard rate (900x $50) 45,000
Actual production at standard rate (800 x $50) 40,000
Volume variance 5,000 (A)
Fixed overhead volume efficiency variance
$

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800 units should have taken (at 5 hrs) 4,000 hrs
but did take 4,200 hrs
Volume efficiency variance in hours 200 (A)
standard absorption rate per hour at $10
Volume efficiency variance $2,000 (A)
Fixed overhead volume capacity variance
Budgeted hours 4,500 hrs
Actual hours 4,200 hrs
Volume capacity variance in hours 300 (A)
standard absorption rate per hour ($50 ÷ 5) at $10 $3,000 (A)
Variance F avourable Adverse Calculation
4.7 Value Chain Analysis
4.7.1 The value chain
A more sophisticated model of business integration is the value chain. It offers a bird's eye
view of the firm, of what it does and the way in which its business activities are organised.
Business activities are not the same as business functions, however.
(a) Functions are the familiar departments of a business (production, finance and so on) and
reflect the formal organisation structure and the distribution of labour.
(b) Activities are what actually goes on, and the work that is done. A single activity can be
performed by a number of functions in sequence. Activities are the means by which a firm
creates value in its products. Activities incur costs and, in combination with other activities,
provide a product or service, which earns revenue.
For example, most organisations need to secure resources from the environment. This activity
can be called procurement. Procurement will involve more departments than purchasing;
however, accounts will certainly be involved and possibly production and quality assurance.
The ultimate value a firm creates is measured by the amount customers are willing to pay
for its
products or services above the cost of carrying out value activities. A firm is profitable if the
realised value to customers exceeds the collective cost of performing the activities.
According to Porter, the value activities of any firm can be divided into nine types and then
analysed into a value chain. This is a model of activities (which procure inputs, process
them and add value to them in some way, to generate outputs for customers) and the
relationships between them.
Activities
Primary activities are directly related to production, sales, marketing, delivery and service.
Activity Comment
Inbound logistics Receiving, handling and storing inputs to the production system:
warehousing, transport, inventory control and so on
Operations Convert resource inputs into a final product; resource inputs are not
only
materials; people are a resource, especially in service industries; note
that

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 this is not just applicable to manufacturing firms, hence the careful
choice
of name; service companies also have operations
Outbound logistics Delivering the product to customers; this may include storage, testing,
bulk
transport, packaging, delivery and so on
Marketing and sales Informing customers about the product, persuading them to buy it,
and
enabling them to do so: advertising, promotion and so on
After-sales service Installing products, repairing them, upgrading them, providing spare
parts
and so forth

Support activities provide purchased inputs, human resources, technology and infrastructural
functions to support the primary activities. The first three tend to provide specific elements of
support to the primary activities.
Activity Comment
Procurement Acquire the resource inputs to the primary activities (eg purchase of
materials, subcomponents equipment)
Technology Product design, improving processes and/or resource utilisation
development
Human resource Recruiting, training, developing and rewarding people
management
Firm infrastructure General management, planning, finance, quality control, public and
legal
affairs: these activities normally support the chain as a whole rather
than
individual activities and are crucially important to an organisation's
strategic
capability in all primary activities

Linkages
Linkagesconnect the activities of the value chain, wherever they take place.
(a) Activities in the value chain affect one another. For example, more costly product design
or
better quality production might reduce the need for after-sales service.
(b) Linkages require co-ordination. For example, just-in-time requires smooth functioning of
operations, outbound logistics and service activities, such as installation. Because activities can
be spread across departments, rather than corresponding to neat, organisation chart boundaries,
managing them for best effect can be extremely difficult. Cost control can be a particular
problem. The dispersion of activities also complicates the management of linkages.
4.7.2 Why Is Value Chain AnalysisImportant?
There are three main sets of reasons why value chain analysis is important in this era of rapid
globalisation. They are: With the growing division of labour and the global dispersion of the
production of components, systemic competitiveness has become increasingly important
Efficiency in production is only a necessary condition for successfully penetrating global
markets
Entry into global markets which allows for sustained income growth – that is, making the best
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of globalisation - requires an understanding of dynamic factors within the whole value chain
Key elements of value chain analysis
Barriers to entry and rent
The value chain is an important construct for understanding the distribution of returns arising
from design, production, marketing, coordination and recycling. Essentially, the primary
returns accrue to those parties who are able to protect themselves from competition. This
ability to insulate activities can be encapsulated by the concept of rent, which arises from the
possession of scarce attributes and involves barriers toentry.
There are a variety of forms of rent. The focus of much of the literature, entrepreneurial
energies and government policies is on what is called economic rents. The classical economists
(such as Ricardo) argued that economic rent accrues on the basis of unequal ownership/access
or control over an existing scarce resource (eg. land). However as Schumpeter showed, scarcity
can be constructed through purposive action, and hence an entrepreneurial surplus can accrue
to those who create this scarcity. For Schumpeter this is essentially what happens when
entrepreneurs innovate, creating ‘new combinations’ or conditions, which provide greater
returns from the price of a product than are required to meet the cost of the innovation. These
returns to innovation are a form of super profit and act as an inducement to replication by other
entrepreneurs also seeking to acquire a part of this profit.
In summary, economic rent
 arises in the case of differential productivity of factors (including entrepreneurship)
and barriers to entry (that is, scarcity)
 takes various forms within the firm, including technological capabilities, organisational
capabilities, skills and marketing capabilities (such as brand names). (These cluster of
attributes are often discussed in relation to dynamic capabilities and core competences
in the literature).
 but they may also arise from purposeful activities taking place between groups of
firms – these are referred
 The process of competition – the search for ‘new combinations’ to allow entrepreneurs
to escape the tyranny of the normal rate of profit, and the subsequent bidding away of
this economic rent by competitors – fuels the innovation process which drives
capitalism forward. As more Competitiveness pressure
and more countries have developed their capabilities in
industrial activities, so barriers to entry in production have fallen and the competitive
pressures have heightened. This has become particularly apparent since China, with its
abundant supplies of educated labour, entered the world market in the mid-1980s.10 It
is this, too, which underlies the falling terms of trade in manufactures of developing
countries (see Figure 5 in Part 1 above)to as relational rents.
 Consequently, it is sometimes argued that the primary economic rents in the chain of
production are increasingly to be found in areas outside of production, such as design,
Production Marketing since
Design and marketing. Yet, as we shall see, this is too simple a conclusion,
branding
even within production some activities involve greater barriers to entry. The pervasive
trend, as we shall see is towards control over disembodied activities in the value chain.
Competitive Pressures in the Value Chain

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Competitive pressure
Economic rent arises in the case of differential productivity of factors and barriers to entry.
There are a variety of forms of economic rent prevalent in the global economy; Some are
endogenous and are “constructed” by the firm and are classical Schumpeterian rents:
Technology rents – having command over scarce technologies
Human resource rents – having access to better skills than competitors
Organisational rents – possessing superior forms of internal organisation
Marketing rents – possessing better marketing capabilities and/or valuable brand names Other
rents are endogenous to the chain, and are constructed by groups of firms:
Relational rents – having superior quality relationships with suppliers and customers. But rents
can also be exogenous to the chain and arise through the bounty of nature:
Resource rents – access to scarce natural resource. Producers can also gain from the rents
provided by parties external to the chain.
Policy rents – operating in an environment of efficient government; constructing barriers to the
entry of competitors
Infrastructural rents – access to high quality infrastructural inputs such as telecommunications
Financial rents – access to finance on better terms than competitors.
Rents are dynamic – new rents will be added over time, and existing areas of rent will be
eroded through the forces of competition
Governance A second consideration which helps to transform the value chain from an
heuristic to an analytical concept is that the various activities in the chain – within firms and in
the division of labour between firms – are subject to what Gereffi has usefully termed
‘governance’ (Gereffi, 1994). Value chains imply repetitiveness of linkage interactions.
Governance ensures that interactions between firms along a value chain exhibit some reflection
of organisation rather than being simply random.
Value chains are governed when parameters requiring product, process, and logistic
qualification are set which have consequences up or down the value chain encompassing
bundles of activities, actors, roles, and functions. This is not necessarily the same thing as the
co-ordination of activities by various actors within a value chain. Value chains are coordinated
at different places in the linkages in order to ensure these consequences (intra firm, inter firm,
regional) are managed in particular ways. Power asymmetry is thus central to value chain
governance.
Value system Activities and linkages that add value do not stop at the organisation's
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boundaries. For example, when a restaurant serves a meal, the quality of the ingredients –
although the cook chooses them – is determined by the grower. The grower has added value,
and the grower's success in growing produce of good quality is as important to the customer's
ultimate satisfaction as the skills of the chef. A firm's value chain is connected to what
Porter calls a value system. How an organisation can use the value chain to secure competitive
advantage. The value chain provides a framework for understanding the nature and location of
the skills and competences in an organisation that provide the basis for its competitive
advantage.
Equally, the value chain provides a framework for cost analysis. Assigning operating costs and
assets to value activities is the starting point of cost analysis, so that improvements can then be
made or cost advantages defended. For example, if an organisation discovers that it has a cost
advantage over its competitors based on the efficiency of its production facilities (operations),
it needs to ensure its production facilities remain superior to those of its competitors so that it
can maintain its advantage over them.
The value chain can help an organisation to secure competitive advantage in a number of ways:
(a) Invent new or better ways to do activities
(b) Combine activities in new or better ways
(c) Manage the linkages in its own value chain
(d) Manage the linkages in the value system
4.7.3 The value chain and performance management
Value chain analysis helps an organisation identify the activities and processes which create
value for its customers, and therefore those activities which an activity needs to perform more
effectively than its competitors.
This has two important implications for performance measurement and performance
management.
(a) The organisation needs to ensure that it is measuring its performance in those key areas
which
create value for its customers (in effect, its critical success factors). If it is not currently doing
so,
this suggests the organisation needs to revise its performance measures and performance
measurement systems, because it needs to know how well it is performing in these key areas.
(b) In order to assess how effectively it is performing activities and processes, an organisation
needsto compare its performance against others. This suggests that benchmarking could be
useful here.
4.7.4 Porter’s value chain
Porter’s value chain is used to examine how a business makes profits or margin

Firm’s infrastructure

Technical development
Human resource management

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Procurement

Inbound Operations Outbound Marketing Services

logistic logistic

Across the bottom of the diagram, are set out inbound logistics, operations, outbound logistics,
marketing and sales, and service. These are the primary activities. More or less these activities
will equate to direct costs.

At the top of the diagram are firm infrastructure, technology development, human resource
management, and procurement. These are the support activities. By and large they equate to
indirect costs. It has to be stressed that activities are shown in the diagram. However, every
activity has an associated cost, and if all activities are represented there, so should all costs, and
these could be allocated and apportioned, and so mapped to somewhere on to this diagram.
Rent, for example could be apportioned over the operations that is the factory, the warehouse,
head office, and the marketing and sales department. Similarly with depreciation, heating costs,
wages and salaries.

So, all the organization’s costs can appear on this diagram. Let’s say these amounted to $10
million. The goods and services produced by the organization will be sold, let’s say for $15
million. How come therefore buyers are willing to spend $15 million on what cost the
organization only $10 million? For what possible reason are customers willing to spend an
extra $5 million over and above what the goods or services cost to produce? The extra $5
million has to be explained somehow. It is known as ‘value-added’, and it is explained by
arguing that the organization accomplishes more for its customers than simply carrying out the
activities and incurring the costs that can be spread over the sections of the value chain.
The organization must be doing something else. For example, it could be bringing skills and
know-how to the process. Effectively it is bringing competences to the process. It could bring
convenience to the buyer, allowing the buyer to keep everything bought from the organization
as a variable cost rather than taking on board many of the fixed costs. It may bring economies
of scale and the buyer is willing to pay for this because it will be impossible for the buyer to
replicate these on a smaller scale.

The organization must understand what it is that adds value, as this is the reason it can make
profits. Furthermore, the organization must understand how the different sections of the value
chain are linked. It could be, for example, that if more were spent on human resource
management perhaps less would need to be spent on operations because employees are better
trained. If more were spent on technology development perhaps less could be spend on after
sales service because the quality of the finish goods was higher. Understanding the value chain
is essential for organizations so that they know how their profit is generated. It has to be said,
however, that sometimes organizations make mistakes identifying what it is about their
activities that adds, value for the customer and they make changes which reduce their ability to
make profits.

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4.8 Customer profitability analysis
4.8.1 Meaning of customer profitability analysis
Customer profitability analysis is an analysis of the total sales revenue generated from a
customer or customer group, less all the costs that are incurred in servicing that customer
group. Or
Customer profitability analysis (CPA) is an analysis of the revenue streams and service costs
associated with specific customers or customer groups to identify the profitability of servicing
those customers.
'An immediate impact of introducing any level of strategic management accounting into
virtually every organisation is to destroy totally any illusion that the same level of profit is
derived from all customers'.
Different customer costs can arise out of the following.
Order size
Sales mix
Order processing
Transport costs (eg if a just in time (JIT) production system requires frequent deliveries)
Management time
Cash flow problems (eg increased overdraft interest) caused by slow payers
Order complexity (eg if the order has to be sent out in several stages)
Inventory holding costs can relate to specify customers
The customer's negotiating strength
The total costs of servicing customers can vary depending on how customers are serviced.
(a) Volume discounts. A customer who places one large order is given a discount, presumably
because it benefits the supplier to do so (eg savings on administrative overhead in processing
the
orders – as identified by an activity based costing system).
(b) Different rates charged by power companies to domestic as opposed to business users.
This in
part reflects the administrative overhead of dealing with individual customers. In practice,
many
domestic consumers benefit from cross-subsidy.
Customer profitability is the 'total sales revenue generated from a customer or customer group,
less all the costs that are incurred in servicing that customer or customer group.'
It is possible to analyse customer profitability over a single period but more useful to look at a
longer time scale. Such a multi period approach fits in with the idea of relationship
marketing, with its emphasis on customer retention for the longer term. Customer profitability
analysis focuses on profits generated by customers and suggests that profit doesnot
automatically increase with sales revenue. CPA can benefit a company in the following
ways.
It enables a company to focus resources on the most profitable areas
It identifies unexpected differences in profitability between customers
It helps quantify the financial impact of proposed changes
It helps highlight the cost of obtaining new customers and the benefit of retaining existing
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customers
It helps to highlight whether product development or market development is to be preferred
An appreciation of the costs of servicing clients assists in negotiations with customers
4.8.2 The customer lifecycle
Thecustomer lifecycle concept is less developed than the equivalent product and industry
lifecycle
models, but it can be useful to consider the following matters.
(a) Promotional expense relating to a single customer is likely to be heavily front-loaded: it
is much cheaper to retain a customer than to attract one.
(b) It is likely that sales to a customer will start at a low level and increase to a higher level as
the
customer gains confidence, though this is not certain and will vary from industry to industry.
(c) A customer who purchases a basic or commodity product initially may move on to more
differentiated products later.
(d) In consumer markets, career progression is likely to provide the individual with steadily
increasing amounts of disposable income, while the family lifecycle will indicate the ranging
nature of likely purchases as time passes.
Any attempt to estimate lifecycle costs and revenues should also consider existing and
potential
environmental impacts, including, in particular, the likely actions of competitors and the
potential for product and process innovation
4.8.3 Understanding the customer
The strategic customer The strategic customer is the entity that decides to make the purchase,
not the end user. Many goods and services are purchased, not by their end users but by
intermediaries such as retailers, sales agents and procurement department staff. Where this
pattern applies, the supplier has to take account of the influence of the intermediary; indeed,
the intermediary is the strategic customer, not the end user, and it is the intermediary's
requirements that are of primary strategic importance. The requirements of the end user are
important, but subordinate in many cases to those of the intermediary.
4.8.4 Customers value – critical success factors
Critical success factors are product features that are particularly valued by customers.
Customers purchase products and services because they value the things the products and
services
provide them with. This may be a relatively simple satisfaction, as when motorists buy petrol,
or it may include a wide range of both tangible and intangible benefits. Many products are,
in fact, complexpackages of features that their producers have worked hard to assemble. The
intangibles among these features are often collectively referred to as brand values. Consider a
wristwatch, for example. It would be a mistake to imagine that most wristwatches are bought
because they tell the time. They also reflect the taste, self-image and status of the purchaser.
There is likely to be a wide range of opinion among customers as to the features of a product
that provide them with the greatest satisfaction, but, equally, it is also likely that some features
will be widelyregarded as particularly important. These features, the satisfactions they
provide and the demands they make on the organisation's way of doing business constitute
critical success factors: the organization must get these things right if it is to be successful in
what it does.
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Thus, for a producer of luxury goods, manufacturing quality would undoubtedly be a critical
success factor, but ensuring that an air of luxury pervaded its retail outlets would be just as
important.
Critical success factors (CSFs) are those product features that are particularly valued by a
group of
customers and, therefore, where the organisation must excel to outperform competitors.
An article titled 'Defining manager's information requirements' (2006) written by Jim Stone
provides an in-depth look at the role of critical success factors in business strategy. It would be
worth taking the time to study this article.
There are important messages connected with this concept. First, value must be assessed
through theeyes of the customer, not those of the designer or professional specialist. Second,
resources should be deployed so as to achieve high performance in critical success factors.
This also illustrates the importance of aligning external forces (customer desires) with internal
factors (resources).
An organisation can measure how well it is achieving the critical success factors through the
use of keyperformance indicators (KPIs). CSFs represent 'what' an organisation needs to do
in order to be successful. KPIs are the measures then used to assess whether or not the CSFs
are being achieved.
Key performance indicators (KPIs) are quantifiable measurements that management can use
to monitor and control progress towards achieving its critical success factors.
In practice, the term KPI tends to be overused and can describe almost any kind of
measurement.
However, in order to be useful they should clearly identify the information needs required to
demonstrate how well the organisation is doing in achieving its overall strategy. They should:
 Reflect the performance and progress of the organisation
Be measurable
 Be comparable – ie can be compared to a standard such as budgeted figures, or prior year
data
 Be usable – ie provide data that can be acted upon
For example, an organisation may have a critical success factor of providing the highest level
of customer service. Appropriate KPIs may relate to the speed of the delivery time, the number
of repeat business transactions from existing customers, or the scores achieved in customer
satisfaction surveys.
4.8.5 Reviewing the customer portfolio
The customer base is an asset to be invested in, as future benefits will come from existing
customers, but not all customers are as important as others. It will help you in evaluating the
customer portfolio if you consider the customer base as an asset worth investing in.
A marketing audit involves a review of an organisation's products and markets, the marketing
environment, and its marketing system and operations. The profitability of each product and
each market should be assessed, and the costs of different marketing activities established.
Information obtained about markets
(a) Size of the customer base. Does the organisation sell to a large number of small customers
or a
small number of big customers?

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(b) Size of individual orders. The organisation might sell its products in many small orders, or
it
might have large individual orders. Delivery costs can be compared with order sizes.
c) Sales revenue and profitability. The performance of individual products can be compared.
An
imbalance between sales and profits over various product ranges can be potentially dangerous.
(d) Segments. An analysis of sales and profitability into export markets and domestic markets.
(e) Market share. Estimated share of the market obtained by each product group.
(f) Growth. Sales growth and contribution growth over the previous four years or so, for each
product group.
(g) Whether the demand for certain products is growing, stable or likely to decline.
(h) Whether demand is price sensitive or not.
(i) Whether there is a growing tendency for the market to become fragmented, with more
specialist
and 'custom-made' products.
Information about current marketing activities
 Comparative pricing
 Advertising effectiveness
Effectiveness of distribution network
 Attitudes to the product, in comparison with competitors
4.9 Competitor analysis
The dynamic nature of competition may be considered using a variety of concepts.
The cycle of competition describes the typical development of the relationship between an
established firm and a new challenger.
Hyper-competition is an unstable state of constantly shifting short-term advantage.
The industry life cycle has the following phases: inception, growth, shakeout/maturity and
decline. Each phase has typical implications for customers, competitors, products and profits.
Strategic group analysis examines the strategic space occupied by groups of close
competitors in order to identify potential competitive advantage.
The five forces model is a very useful tool for analysing the nature of competition within an
industry, but it is essentially static: it does not focus on the dynamic nature of the business
environment. The nature of competition is that future developments are not controllable by a
single firm; each competitor will exercise its own influence on what happens. The business
environment is therefore subject to constant change.
Strategic managers must attempt to forecast what form this change is likely to take, since it is
their
responsibility to make plans that will be appropriate under future conditions.
Cycle of competition
An incumbent firm already operating successfully in an industry improves existing barriers
to entry and erects new ones. Any challenger firm wishing to enter the industry must attempt
to overcome these barriers. This does not necessarily mean attacking the market leader head-
on. This is a risky strategy in any case, because of the incumbent firm's resources in cash,
promotion and innovation. Instead, the challenger may attack smaller regional firms or
companies of similar size to itself that are vulnerable through lack of resources or poor

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management.
Military analogies have been used to describe the challenger's attacking options.
(a) The head-on attack matches the target's marketing mix in detail, product for product and
so on. A limited frontal attack may concentrate on selected desirable customers.
(b) The flank attack is mounted upon a market segment, geographic region or area of
technology that the target has neglected.
(c) The encirclement attack consists of as large a number of simultaneous flank attacks as
possible in order to overwhelm the target.
(d) The bypass attack is indirect and unaggressive. It focuses on unrelated products, new
geographic areas and technical leap-frogging to advance in the market.
(e) Guerrilla attack consists of a series of aggressive, short-term moves to demoralise,
unbalance and destabilise the opponent. Tactics include drastic price cuts, poaching staff,
political lobbying and short bursts of promotional activity.
The response
If the incumbent makes no response to the initial campaign, the challenger will widen its attack
to other, related or vulnerable market segments, using similar methods to those outlined above.
On the other hand, the incumbent may respond; this will often be by means that amount to
reinforcing the barriers to entry, such as increasing promotional spending.
Military analogies have also been used to describe defensive strategies for market leaders.
(a) Position defencerelies upon not changing anything. This does not work very well.
(b) Mobile defenceuses market broadening and diversification.
(c) Flanking defenceis needed to respond to attacks on secondary markets with growth
potential.
(d) Contraction defenceinvolves withdrawal from vulnerable markets and those with low
potential. It may amount to surrender.
(e) Pre-emptive defencegathers information on potential attacks and then uses competitive
advantage to strike first. Product innovation and aggressive promotion are important features.
A challenger faced with such moves may decide to start a price war. The disadvantage of this
is that it will erode the company's own margins as well as those of the incumbent, but it does
have the potential to reshape the market and redistribute longer-term market share.
Fighting back
An incumbent faced with a vigorous and resourceful challenger may decide in turn to attack
the entrant'sown base, perhaps by cutting prices in its strongest market. This may cause the
challenger to move on towards entry into another attractive market as it seeks to expand.
Resource implications
Both attacking and defending require the deployment of cash and strategic skill. In particular,
extending competition to new geographical and national markets can raise the risks and costs
involved in operating.
Hypercompetition
It is possible for competition in an industry to cycle fairly slowly, with extended periods of
stability. This allows the careful building of competitive advantages that are difficult to imitate.
Hypercompetition, by contrast, is a condition of constant competitive change. It is created by
frequent, boldly aggressive competitive moves. This state makes it impossible for a firm to
create lasting competitive advantage; firms that accept this will deliberately disrupt any
stability that develops in order to deny long-term advantage to their competitors. Under these
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conditions, continuing success depends on effective exploitation of a series of short-term
moves.
The industry life cycle
Industries may display a lifecycle: this will affect and interact with the five forces.
Later in this Study Text, we will discuss the concept of the product life cycle: this is a well
established strategic and marketing tool. It may be possible to discern an industry life cycle,
which will have wider implications for the nature of competition and competitive advantage.
This cycle reflects changes indemand and the spread of technical knowledge among
producers. Innovation creates new industry, and this is normally achieved through product
innovation. Later, innovation shifts to processes in order to maintain margins. A summary of
the overall progress of the industry lifecycle is illustrated below.to the extent that it inhibits
rivalry.
Inception Growth Shakeout/maturity Decline
Product Basic, no Improved Standardised Varied quality but
characteristics standards design and product with little fairly
established quality, differentiation undifferentiated
differentiated
Competitors None to few Many Competition Few remain.
entrants increases, weaker Competition may
players leave be on price
(shakeout)
Buyers Early adopters, More Mass market, Enthusiasts,
prosperous, customers brand switching traditionalists,
curious must be attracted and common sophisticates
induced aware
Profit Negative – high Good, Eroding under Variable
first mover possibly pressure of
advantage starting to competition
decline
Technology No standards Technologies Technology is Technology is
established become more understood across understood across
standardised the industry the industry
Product Small scale batch Mass Long production Overcapacity.
processes production. production. runs. Cost Production is
Specialised Distribution efficiency reduced
distributors networks critical
expanded

Each phase has different implications for competitive behaviour and corporate strategy eg if an
industry is growing, the organisations in that industry can grow as the market develops. In a
mature industry, growth can only be achieved by stealing market share from other competitors
and typically the market becomes more fragmented.
Costs faced by organisations will also vary at different stages in the industry lifecycle. For
example,
research and development costs will be very high in the inception phase. Production costs may
be low during the maturity stage as processes have been refined and contracts negotiated, but
marketing expenditure may be high in order to protect market share.
4.9. Financial returns to an industry also vary according to the lifecycle stage.
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The shakeout and maturity phases are often presented together due to the strong overlap
between the two. The following table presents both phases separately to illustrate how the
characteristics of the industry subtly change between shakeout and maturity. The shakeout
phase is characterised by a slowing in market growth which leads to weaker players being
forced out of the industry. By the time the industry reaches maturity, fewer players remain, but
they are forced to compete more fiercely to increase revenue by gaining market share

Sales Volume
Inception Growth Shakeout Maturity Decline

Time
The shakeout and maturity phases are often presented together due to the strong overlap
between the two. The following table presents both phases separately to illustrate how the
characteristics of the industry subtly change between shakeout and maturity. The shakeout
phase is characterised by a slowing in market growth which leads to weaker players being
forced out of the industry. By the time the industry reaches maturity, fewer players remain, but
they are forced to compete more fiercely to increase revenue by gaining market share.
Inception Growth Shakeout Maturity Decline
Customers Experimenters, Early Growing Mass market, Price
innovators adopters selectivity of Products competition
purchase well Commodity
known product
R&D High Extend Seek lower Low
product cost
before methods of
competition supply to
access
new markets
Company Early mover React to Potential Battles over Cost control
Production more consolidation market share. or
focused competitors through Seek cost exit
with taking over reduction.
increased rivals. Long Long
marketing production production
mass runs runs
production
Competitors A few More Many Depending Price-based
No major entrants competitors, on competition,
barriers to to the market price cutting industry, a fewer
entry but few competitors
weeding out large
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 of competitors
weaker Difficult for
players newcomers
to
dislodge
entrenched
companies
Profitability Low or Growing Levelling off Stable, high Falling,
negative, as an or unless
investment under cost control
pressure

The industry life cycle has strategic implications for organisations operating in that industry.
Management must pursue different strategies at each stage.
Inception stage
Attract trend-setting buyer groups by promotion of technical novelty or fashion
Price high (skim) to cash in on novelty, or price low (penetration) to gain adoption and high
initial
share
Support product despite poor current financial results
Review investment program periodically in light of success of launch (eg delay or bring
forward
capacity increases)
Build channels of distribution
Monitor success of rival technologies and competitor products
Growth stage
Ensure capacity expands sufficiently to meet firm's target market share objectives
Penetrate market, possibly by reducing price
Maintain barriers to entry (eg fight patent infringements, keep price competitive)
High promotion of benefits to attract early majority of potential buyers
Build brand awareness to resist impact from new entrants
Ensure investors are aware of potential of new products to ensure support for financial
strategy
Search for additional markets and product refinements (ie market penetration)
Consider methods of expanding and reducing costs of production (eg contract manufacturing
overseas, building own factory in a low cost location)
Product development
Shakeout phase
Monitor industry for potential mergers and rationalisationbehaviour
Periodic review of production and financial forecasts in light of sales growth rates
Shift business model from customer acquisition to extracting revenue from existing customers
Seek to extend growth by finding new markets or technologies
Maturity phase
Maximise current financial returns from product
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Defend market position by matching pricing and promotion of rivals
Modify markets by positioning product to gain acceptance from non-buyers (eg new outlets or
suggested new uses)
Modify the product to make it cheaper or of greater benefit
Intensify distribution
Leverage the existing customer database to gain additional incomes
Engage in integration activities with rivals (eg mergers, mutual agreements on competition)
Ensure successor industries are ready for launch to pick up market
Decline phase
Harvest cash flows by minimising spending on promotion or product refinement
Simplify range by weeding out variations
Narrow distribution to target loyal customers and reduce stocking costs
Evaluate exit barriers and identify the optimum time to leave the industry (eg leases ending,
need
for renewal investment)
Seek potential exit strategy (eg buyer for business, firms willing to buy licencesetc)
The response of competitors is particularly important – there may be threats as they attempt to
defend their position, or opportunities, eg when a competitor leaves the market.
Inception Growth Maturity Decline
Product Correct any Ensure product Product Assess if it is
problems in quality is efficiency possible to
product design maintained Cost control modify product
Improve despite volume Quality control so that life
features to growth (minimise cycle is started
develop Look at ways to defective again
competitive improve quality products)
advantage and design to Only the most
sustain productive/
competitive efficient firms
advantage will survive
Marketing Establish product Market Marketing Advertising
position and penetration aimed at and promotion
target Establish maintaining is minimised
markets market customer
Develop niche for loyalty
product product
awareness Establish brand
(advertising; loyalty: heavy
promotion) media use,
product samples
and other
promotions
Establish
distribution
capabilities to
support
increased

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 production
HR Establish staff Training and Personnel Staff
requirements development of incentives to transferred to
Recruiting staff to deal with improve products in
staff competitive productivity earlier stages
pressures as and efficiency of life cycle
competition gets
tougher
Finance Arrange funding Liquidation
for (worst case
product scenario)
development and
marketing
Assess capital
requirements for
production
facilities
which may be
needed for
increased
capacity
in growth phase

The industry life cycle model is an important concept that may illuminate some aspects of
strategic
thought. Like other models, it has some value for analysis, for forecasting trends and for
suggesting
possible courses of action, but it would be a mistake to attempt to apply it to all industries at all
times.
Proper attention must always be paid to current circumstances and options.
4.10 Strategic group analysis
Five forces analysis deals with the competitive environment in broad industry-wide terms. It
is possible to refine this by considering strategic groups. These are made up of organisations
with similar strategic characteristics, following similar strategies or competing on similar
bases. Such groups arise for a variety of reasons, such as barriers to entry or the attractiveness
of particular market segments. The strategic space pertaining to a strategic group is defined by
two or three common strategic characteristics. Here are some examples of such characteristics.
Product diversity
Geographical coverage
Extent of branding
Pricing policy
Product quality
Distribution method
Target market segment
A series of 2-axis maps may be drawn up, using selected pairs of these characteristics to define
both the extent of the strategic space and any unfilled gaps that exist within it. (A similar
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technique is used for specific products and is illustrated later in this chapter: this is product
positioning.)
The identification of potential competitive advantage is the reason foranalysing strategic
groups. It improves knowledge of competitors and shows gaps in the organisation's current
segments of operations.
It may also reveal opportunities for migration to more favourable segments. Strategic problems
may also be revealed.
Industry convergence
A couple of contemporary environmental influences should be mentioned. The first is industry
convergence. Here industries which had historically been separate for some reason come
together so that more diverse others products or services are now offered by the same supplier.
Examples can be airlines which now offer car hire, hotels, and insurance.

Technology can form a big part in the convergence of industries. For example in a
telecommunications industry whose considerable convergence between landline, mobiles, and
voice over internet telephone providers. There is increasing convergences of products which
provide mobile phone access, WiFi access, music, photographs, diaries (think of the Apple
iPhone which will do all of these things. You can also see convergence in complementary
products. If a company makes digital camera it might also be worthwhile for it to offer printers
and computers. The pressure to converge, can be driven by consumers, who may want to go to
only one source for a variety of products, or it could be driven by production and convergence
of the products and technology which can lead to cost benefits.

The international dimension

The second contemporary influence to be aware of is the international dimension. More and
more organizations have global presence. Products and services are converging so that the
same products can be found in many countries. This gives the producers great cost advantages,
not only in purchasing raw materials but also to cover the research and development and
marketing costs.
Local companies can also manufacture their products where it is cheapest to do so. Note that
when a company enjoys sales on a global basis it is also usually facing competition on a global
basis, and many weaker companies find it difficult to compete in that fierce environment.
Because many of the global businesses are very large and significant, governments can also
take an interest in their activities. In particular, valuable grants can be offered to companies to
encourage them to open manufacturing plants in certain countries. Additionally, governments
may sometime protect their home industries against the foreign competition.

You will probably be aware that some people feel that large multi-national companies are bad
for society. Anti-globalization protesters claim that these vary large companies stifle and
exploit local economies, reduce consumer choice, have an undue influence on how countries
are run and are too concerned with making profit when they should give more attention to
social and ecological issues.
Whether or not you believe large multinationals are good or bad, you should be aware that it is
usually important for these companies to be aware of certain stakeholders’ views.

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 Porter’s diamond
Still dealing with the international dimension, it is clear that many countries enjoy reputations
for certain products and services. For example:
• Germany is associated with good car making
• Japan is strong with respect to micro-electronics and cameras.
• France is strong with respect to wine.
• The UK (at least until recently!) was associated with a strong financial services industry
Michael Porter began to wonder how countries can achieve such international reputations and
he concluded that there were four influences.

Factor conditions: Some countries enjoy natural advantages. For example, France starts with an
advantage wine. Germany has an abundance of iron ore, ready to be used in the car and other
industries. Climate and natural resources are known as basic factors. In addition, countries can
develop advanced factors such as their transport infrastructure, telecommunications, and
educational system. Germany, for example, has a strong tradition in engineering training and
education and this gives their car industry great assistance.
Demand conditions: The first step in developing a global presence is to start at home and the
impetus to do this is known as (home) demand conditions. So, it is argued that Germany
produces good cars because initially the German people demanded good solid engineering. The
UK had been a major trading and manufacturing nation until the mid-1900s and this led to the
development of skilled financial services and law firms to support international commerce.

Firms’ strategy, structure and rivalry. Concentrate on rivalry: having a monopoly in the home
market is unlikely to give you a major world presence. To be world beating you have to be
really good at home and this home excellence will allow you to complete against the best of the
world. Germany is perhaps really good in making cars because it has within that country
Volkswagen, Mercedes, BMW and Porsche, all of are good companies competing with one
another, and this allows them to become world-class.

Related and supporting industries. Successful industries often enjoy the benefits arising from a
cluster of related and supporting industries. For example in the West Coast of America there
are software firms, hardware firms and research institutes. Employees move around from one
firm to another and a whole centre of expertise is developed. Similarly, in Scotland in the
Scotch whisky industry, farmers can provide the grain; peat suppliers provide peat to give the
spirit flavour. There are factories which produce or recondition the barrels, and there are large,
efficient bottling plants. Not only do these related and supporting industries from efficient
clusters of industries, but also they can work together so that the products become
differentiated and uniquely good.

Porter’s five forces

Porter’s five forces model is a popular and useful framework with which to analyse industry
attractiveness. Industry attractiveness refers to how easy a business will find it to make
reasonable profits. By ‘reasonable profits, we mean profits large enough to compensate
investors for their risks and also to make enough money to reinvest to keep the company
successful. We should be looking for sustainable success. in the wine industry because of its
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climate and soil. Finland, however, is never likely to be good at producing

POTENTIAL
ENTRANTS
SUPPLIERS
COMPETITIORS/ BUYERS
RIVALRY

SUBSTITUTES

Rivalry: Competition, or rivalry, can range from:

• Perfect competition, where sellers have no choice as to the selling price that is charged – they
have to charge the market price. to
• Monopoly, where sellers have much more choice as to what price to charge. Changes in price
will normally alter demand, revenue and profits. But remember, just because you have a
monopoly doesn’t mean you will make profits. You might be the monopoly supplier of
something nobody wants. By and large the nearer an industry gets to a monopoly the easier
time its participants will have. Therefore, provided its legal, it could therefore be a useful
strategy to take over a rival or to force it out of business by perhaps lowering prices
temporarily. Governments tend to be wary of companies which establish powerful monopolies
(Microsoft got into trouble over Internet Explorer which it included with its Windows
operating system, making it very difficult for other browsers to compete). Most jurisdictions
have anti-monopoly or antitrust legislation.
• Buyer pressure. If buyers are very powerful then they can exert pressure on prices, quality
and delivery times. Selling almost all output to a few powerful buyers will be an uncomfortable
situation. The more buyers you have, and the harder it is for them to switch between different
suppliers the better.
Businesses should try to build in switching costs, that is real costs or impediments that mean
that buyers will prefer to stay with existing suppliers. Another way of trying to decrease buyer
pressure is to try to enter long-term contracts with major customers. You might have to
compromise on price, but get greater certainty of sales.
• Supplier pressure. Similarly, when you are buying goods from suppliers, if you have to buy a
special component from a monopoly supplier you will be in an uncomfortable position. That
supplier can raise prices almost arbitrarily and you have to pay what they ask. Even worse, that
supplier could be taken over by one of your competitors and then you will have no supplies at
all. Ideally firms should try to multi-source, and if they get really worried about assurance of
supply they should think about setting up their own supply operation or perhaps taking over an
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existing supplier.
• New/potential entrants. Potential entrants are sitting on the edge of the industry and may be
attracted in if they can see that good profits can be made. Anything which keeps out potential
entrants is known as a barrier to entry. Barriers to entry include:
• A legal monopoly within the business. This is rare, but is sometimes seen. For example, many
postal services operate as monopolies.
• Regulation and licence requirements can make it hard for potential entrants to get into some
business sectors. For example, setting up as a bank is relatively difficult because of the various
regulatory authorities that have to give their permission,
• The need for high capital expenditure increases risk and the difficulty of raising finance.
• Know-how. Some businesses are complex and acquiring the necessary skills and knowhow
can deter new entrants.
• Unique, patented processes. If you own a unique, valuable patent, no one else can use it and
so your position is protected. Some pharmaceutical companies can make use of drug patents to
secure their positions.
• Substitute products usually arise by the advance of technology. Often the appearance of
substitutes will surprise a business and take it off guard. For example, landline telephone
companies thought that they were almost in a monopoly position because of the huge cost of
entry to the market: digging up roads and laying landlines into our houses, apartments, and
businesses would have been a considerable barrier to entry. However, then mobile telephones,
cell phone technology, was invented and good telephone coverage could be achieved with
much less expense. There is not much a business can do here. Once technology is invented it
can’t really be send back. Most old industries have to join the new industries to maintain their
market share. So now, many conventional telephone companies also have mobile phone
networks in an attempt to retain their overall market share in telecommunications.

4.11 Product profitability analysis

Product Profitability compares individual products to one another from a post-allocated
perspective. Viewing product margins from this perspective allows an institution to accurately
see how profitable each product is and how it compares to other products. This helps an
institution gain a more accurate picture of how products are contributing to the overall net
interest margin.

Product profitability is designed with the following built-in features:

Funds Transfer Pricing
Enables an institution to allocate funds in a fair, predetermined manner and helps the institution
gain a more accurate picture of how individual products are contributing to the overall net
interest margin.
Revenue and Expense Allocation Rules
Provides built-in, standard allocation rules based on industry best practices. These rules can be
customized by the institution as needed.
Capital Allocation Methods
Enables an institution to determine historical and forecasted return on equity (ROE)
calculations using simple-to- complex capital allocations.
Profit Forecasting
Provides forecasting tools for analyzing multiple profit scenarios both pre- and post-allocated.
Activity Based Costing (ABC)

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Provides a two-stage allocation process that allocates resources to the activities that consume
them, then to the products that benefited from the activities.
Report Wizard
Generates standard or custom reports in seconds.
User-Defined Graphs
Provides customized, full-color graphs that are easy to understand and visually appealing.

4.12 Financial performance

Product profitability is an innovative business intelligence solution that enables diverse
financial institutions to maximize their performance and profits with accessible, accurate, and
timely decision support and business intelligence information. Setting up and managing this
cost accounting system is simple. The client support team sets up an institution’s custom chart
of accounts, allocation rules, and funds transfer pricing method, and also provides introductory
training.
Product profitability, simply defined, is the difference between the revenues earned from, and
the total costs associated with, a product over a specified period of time. Product Profitability
Analysis
Product profitability analysis requires that all relevant costs are traced to products and then
matched to their corresponding revenues. Such analysis can then inform wide range of
management decisions such as product pricing and product portfolio analysis.
Achieving Product Profitability
 Looking beyond revenue and gross margins to uncover hidden profits and losses.
 By factoring in the real costs associated with each product, you are able to make
adjustments.
 Requires a level of accuracy and granularity.
 Requires accurate data capture and analysis at every point.
 Modelling your business processes so that you are able to make good decisions that
lead to profitable adjustments.
Benefits of Product Profitability
 A clear view of which products and product mixes are cost effective. In addition to
managing current results the analysis can refine product pricing strategies
 Single source of product data that can be utilized across the enterprise to facilitate atrue
common reporting platform for product profitability
 Real-time analytic capability of what discounts can be given to customers while
accurately assessing the impact on margins to ensure margin protection
 Provide ‘what-if’ analysis for changes in the cost base allowing for re-forecasting
andpreparation for changeable commodity markets
 Identify areas of growth in margin not just in revenue and accurately
forecastprofitability of new products and proposed product mixes

Profit Parameters
Gross Margin = Revenue – Cost of goods sold.
All costs are manufacturing costs. Some of them are fixed costs.
Contribution margin = Revenue – Variable costs
Some variable costs are manufacturing costs, but some may be non-manufacturing costs. None
are fixed costs.

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Gross margin percent = Gross margin/Revenue
Contribution margin percent = Contribution margin/Revenue
Profit Accounting Model
• The fundamental accounting equation
Profit = Revenues – Costs
Revenue = SP * units sold
SP = selling price
Costs = FC + VC(units manufactured)
FC = fixed cost
VC = unit variable costs
Cost-Volume-Profit Analysis
Changes in the level of revenues and costs arise only because of changes in the number of
product (or service) units produced and sold.
Total costs can be divided into a fixed component and a component that is variable with
respect to the level of output.
Case Study – Cost-Volume-Profit Analysis
A Company manufactures and sells pens. Present sales output is 5,000,000 per year at a selling
price of frw.5 per unit. Fixed costs are frw 9,000,000 per year. Variable costs are frw2 per unit
Absolute Profitability
Absolute profitability measures the impact on the organization’s overall profits of adding or
dropping a particular segment such as a product or customer – without making any other
changes
Computing Absolute Profitability
For an Existing Segment
Compare the revenues that would be lost from dropping that segment to the costs that wouldbe
avoided.
For a New Segment
Compare the additional revenues from adding that segment to the costs that would be incurred
Relative Profitability
Relative profitability is concerned with ranking products, customers, and other business
segments to determine which should be emphasized in an environment of scarce
Managers are interested in ranking segments if a constraint forces them to make trade-offs
among segments.
In the absence of a constraint, all segments that are absolutely profitable should be pursued.
Relative Profitability
Here is information developed by themanagement of Matrix, Inc. concerning its twosegments
Product positioning
A product's positioning defines how it is intended to be perceived by customers and how it
differs from current and potential competing products. It is not always possible to identify a
market segment where there is no direct competitor, and a marketing problem for the firm will
be the creation of some form of product differentiation (real or imagined) in the marketing
mix of the product. The aim is to make the customer perceive the product as different from its
competitors.
A perceptual map of product positioning can be used to identify gaps in the market. This
example mightsuggest that there could be potential in the market for a low-price high-quality
bargain brand. A company that carries out such an analysis might decide to conduct further
research to find out whether there is scope in the market for a new product which would be
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targeted at a market position where there are few or no rivals. (A firm successfully pursuing
cost leadership might be in a good position to offer a bargain brand.)
Topical questions
1. Explain the environmental analysis using PESTEL
2. Explain the application of SWOT analysis in the strategic planning
3. Explain the primary and supporting activities of value chain analysis
4. Critique the porter’s value chain model
5. Comment on the different costs that affect customer profitability analysis
6. Explain the customer life cycle
7. Explain the different techniques that can be used to compete in the market
8. Write short notes on the following
a. Life cycle of industry
b. Strategic group analysis
c. Porter’s diamond model
d. Porter’s five force model
9. A company has prepared the following standard cost card:
$ per unit
Materials (4 kg at $4.50 per kg) 18
Labour (5 hrs at $5 per hr) 25
Variable overheads (5 hrs at $2 per hr) 10
Fixed overheads (5 hrs at $3 per hr) 15
$68
Budgeted selling price $75 per unit.
Budgeted production 8,700 units
Budgeted sales 8,000 units
There is no opening inventory
The actual results are as follows:
Sales: 8,400 units for $613,200
Production: 8,900 units with the following costs:
Materials (35,464 kg) 163,455
Labour (Paid 45,400hrs; worked 44,100 hrs) 224,515
Variable overheads 87,348
Fixed overheads 134,074
Required: carry out a cost analysis

CHAPTER FIVE: STRATEGIC PERFORMANCE MEASUREMENTS: FINANCIAL,

NON-FINANCIAL, AND MIXED
5.1 Introduction to planning and control
5.1.1 Definitions
Planning and control are fundamental aspects of performance management.
Strategic planning is concerned with:
 Where an organisation wants to be (usually expressed in terms of its objectives) and

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  How it will get there (strategies)

Control is concerned with monitoring the achievement of objectives and suggesting corrective 
action.
5.1.2 Planning and control at different levels within an organization
Planning and control takes place at different levels within an organisation. 
The performance hierarchy operates in the following order:
(1) Mission
(2) Strategic (corporate) plans and objectives
(3) Tactical plans and objectives
(4) Operational plans and targets. 
5.1.3 Mission
A mission statement outlines the broad direction that an organization will follow and
summarizes the reasons and values that underlie that organization.
A mission should be:
 Memorable
 Enduring, i.e. the statement should not change unless the entity's mission changes
 A guide for employees to work towards the accomplishment of the mission
 Addressed to a number of stakeholder groups, for example shareholders, employees and 
customers.

The mission forms a key part of the planning process and should enhance organizational perfor
mance:
 It acts as a source of inspiration and ideas for the organisation’s detailed plans and obje
ctives.
 It can be used to assess the suitability of any proposed plans in terms of their fit with th
e organization’s mission.
 It can impact the day to day workings of an organisation, guiding the organisational cult
ure and business practices used.

A change in the mission statement may result in new performance measures being established
to monitor the achievement (or otherwise) of the new mission.
5.1.4 Strategic, Tactical and Operational plans
To enable an organization to fulfill its mission, the mission must be translated into strategic,
tactical and operational plans. Each level should be consistent with the one above. This process
will involve moving from general broad aims to more specific objectives and ultimately to
detail targets.
Strategic planning is usually, but not always, concerned with the long-term.
It raises the question of which business shall we be in?  For
example, a company specialising in production and sale of tobacco
products may forecast a declining market for these products and may therefore decide to chang
e its objectives to allow a progressive move into the leisure industry, which it considers to be e
xpanding.
Strategic planning is characterized by the following:
 long-term

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  considers the whole organization as well as individual SBUs
 matches the activities of an organisation to its external environment
 matches the activities of an organisation to its resource capability and specifies future re
source requirements
 will be affected by the expectations and values of all stakeholders, 
not just shareholders
 Its complexity distinguishes strategic management from other aspects of management i
n an organization. There are several  reasons for this including: 
- it involves a high degree of uncertainty
- it is likely to require an integrated approach to management
- it may involve major change in the organization.

Quite apart from strategic planning, the management of an organisation has to undertake a regu
lar series of decisions on matters that are purely tactical, operational and short-
term in character. Such decisions:
 are usually based on a given set of assets and resources
 do not usually involve the scope of an organization’s activities
 rarely involve major change in the organization
 are unlikely to involve major elements of uncertainty and the techniques used to help m
ake such decisions often seek to  minimize the impact of any uncertainty
 Use standard management accounting techniques such as cost-volume-profit
analysis, limiting factor analysis and linear programming.

5.1.5 The role of performance management in planning and control

Performance management is any activity that is designed to improve the organization’s
performance and ensure that its goals are met.
 Planning will take place first to establish an appropriate mission and objectives.
 Performance management techniques will then be used to ensure that the most appropri
ate strategy is defined and executed in order to achieve the organization’s mission and o
bjectives.
 Finally, performance management will aim to measure whether the mission and objecti
ves are being achieved and to recommend any improvement strategies that are required.

Performance management aims to direct and support the performance of all employees and
departments so that the organization’s goals are achieved. Therefore, any performance
management system should be linked to performance measures at different levels of the
hierarchy.
One model of performance management that helps to link the different levels of the hierarchy i
s the performance pyramid. The performance pyramid derives from the idea that an
organization operates at different levels, each of which has a different focus. However, it is that
these levels support each other.
It translates objectives from the top down and measures from the bottom up, the aim being that
these are coordinated and support each other.
5.1.6 The role of strategic (corporate) planning in clarifying corporate objectives
Corporate objectives concern the business as whole and focus on the desired performance and

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results that a business intends to achieve. The first stage of the strategic planning process,
strategic analysis will generate a range of objectives, typically relating to:
 maximization of shareholder wealth
 maximization of sales
 growth
 survival
 research and development
 leadership
 quality of service
 contented workforce
 Respect for the environment.

These need to be clarified in two respects:
 conflicts need to be resolved, e.g. profit versus environmental  concerns
 To facilitate implementation and control, objectives need to be translated into SMART 
(specific, measurable, achievable, relevant and time bound) targets.

Illustration
A statement such as “maximize profits” would be of little use in corporate planning terms.
The following would be far more helpful:
 achieve a growth in EPS of 5% pa over the coming ten year period
 obtain a turnover of $10 million within six years
 Launch at least two new products per year.

5.1.7 The role of strategic (corporate) planning in checking towards the objectives set
It is not enough merely to make plans and implement them.
 The results of the plans have to be compared against stated objectives to assess the
firm’s performance
 Action can then be taken to remedy any shortfalls in performance

Strategic (corporate) planning is not a once-in-every-ten-years activity, but an ongoing process

which must react quickly to the changing circumstances of the firm and of the environment.
5.1.8 Objectives, critical success factors and key performance indicators
Once an organisation has established its objectives, it needs to identify the key factors and proc
esses that will enable it to achieve those objectives.
Critical success factors (CSFs) are the vital areas where things must go right for the business in
order for them to achieve their strategic objectives. The achievement of CSFs should allow the
organization to cope better than rivals with any changes in the competitive environment and to
maximize performance.
Key Performance Indicators (KPIs) are the measures which indicate whether or not the CSFs
are being achieved.
Illustration
A news papers delivery service, such as DHL, may have an objective to increase revenue by
5% year on year. The business will establish CSFs and KPIs which are aligned to the
achievement of this objective, for example:

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CSFs KPIs
Speed collection from customers after their Collection from customers within three hours
request for news papers to be delivered of receiving the orders in any part of the
country for orders received before 2:00 pm on
a working day
Rapid and reliable delivery Next day delivery for destinations within
Kigali or delivery within 2 days for
destinations outside kigali

The organization will need to have in place the core competences that are required to achieve
the CSFs, i.e. something that they are able to do that is difficult for competitors to follow.
KPIs are essential to the achievement of strategy since what gets measured gets done, i.e.
things that are measured get done more often than things that are not measured.
Care must be taken when choosing what to measure and report. An unbalanced set of indicators
may be valid for fulfilling the short term needs of the organization but will not necessarily
result in long term success. The balanced scorecard approach will seek to address this and is
discussed in the later pages.
The strategic management accountant plays a key role in performance management helping to
determine the financial implications of an organization’s activities and decisions and in
ensuring that these activities are focused on shareholders’ need for profit.
5.1.9 The triple bottom line
Whilst all businesses are used to monitoring their profit figures, there are also environmental
and social aspects to consider in the long term. The triple bottom line focuses on economic,
environmental and social areas of concern.
Economic performance focuses on monitoring the financial performance of the organization to
ensure its continued prosperity and fulfillment of shareholders’ needs.
Environment performance focuses on reducing waste, increasing recycling and using energy
efficient equipment.
Social performance focuses on contributing by company to community projects.
5.1.10 Gap analysis
Gap analysis is carried out as the final part of strategic analysis. It identifies the planning gap.
This is the difference between the desired and the expected performance. The planning gap is
often measured in terms of demand but may also be reported in terms of earnings, return on
capital employed etc.
5.1.11 Current issues and trends in performance management
The area of performance management is constantly evolving. The techniques and systems used
today are very different from those of 50 years ago and there are current issues and pressures
which are likely to lead to further developments:
 changes in technology may have a significant impact on measuring  performance
 a recognition that there is a broader picture than just financial  performance
 issues relating to governance

The availability of more data does not automatically mean that there is more useful
information. It is still important to ensure that the data is interpreted to ensure that it is useful.
Performance management is about more than the information produced. However much
information is provided, what is important is how it is used and how the organization acts in
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response to it.
There is a growing recognition that the performance of organizations depends on more than
purely financial performance. There has been a significant growth in the use of non-financial
measures of performance. Techniques have been developed to enable measurement of
performance in a number of different dimensions, and this trend looks set to continue.
Examples are the balanced scorecard and the performance prism. Historically, the focus of
performance management has been on outputs of the organization’s activities. Organizations
are now beginning to focus on outcomes, or achievements, and then using output measures to
achieve those outcomes. In addition, there is recognition that everyone in the organization
needs to be involved in performance management; there is also a need to extent involvement
outside the organization to the entire supply chain, as organizations recognize that others have
an influence on their performance.
Over recent years, the issue of corporate governance has become a major area for concern in
many countries. Organizations are now under increased pressure to demonstrate that they are
effectively managed. This has led to pressure to demonstrate improvements in performance,
more demands for accountability from external agencies, legislation and regulation relating to
performance reporting and companies are looking for ways to measure and report on
improvements in governance.
5.2 Performance measurement techniques
Performance measurement is the monitoring of budgets or targets against actual results to
establish how well the business and its employees are functioning as a whole and as
individuals.
Performance measurements can relate to short-term objectives (e.g. cost control) or longer-
term measures (e.g. customer satisfaction).The performance measurement techniques are:
financial, non-financial, balanced scorecard, benchmarking.
5.2.1 External factors affecting performance measurement
External factors may be an important influence on an organization’s ability to achieve
objectives. In particular market conditions and government policy will be outside of the control
of the organization’s management and will need to be carefully monitored to ensure forecasts
remain accurate.
Economic and market conditions
Any performance measure that is used by a business will need to be flexible to allow for peaks
and troughs in economic and market conditions that are beyond the control of the business or
the specific employee or manager.
The actions of competitors must also be considered. For example, demand may decrease if a
competitor reduces its prices or launches a successful advertising campaign.
Government regulation
The government can have a direct effect on the workings of a private sector organization by
introducing regulations or by having departments that monitor business activity.
If a private sector organization is affected by government regulation then the performance
measures should take account of this externally imposed limitation i.e. a sales team target
should not exceed a quota or exceed/undercut a price set by the government.
Public Sector organizations are owned and controlled by the government (or local
government). They aim to provide public services, often free at the point of delivery. Their
purpose is to provide a quality service to the public, for example a state school, the provision of
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water and sewerage services, refuse collections. The measurement of performance is much
harder for public sector organization the standard of the service will be based on opinions or
feelings and not necessarily fact.
If we are trying to compare the performance of a private organization with that of a public
organization the differences in strategy need to be considered. This can be seen in the
summarized table below showing the differences between a private school and a state school.
Strategic feature Private school State school
General strategic goal competitiveness Achievement of mission
values Innovation, creativity, Accountability to public
goodwill, recognition integrity, fairness
Desired outcome Customer satisfaction Customer satisfaction
stakeholders Fee payers Taxpayers, inspectors,
legislators
Budget defined by Customer demand Leadership, legislators,
planners
Key success factors Growth rate, earnings, market Best management practices,
share, uniqueness, advanced standardization, economies of
technology scales, standardized
technology

5.2.2 Financial performance measures

Financial performance measures are used to monitor the inflows (revenue) and outflows (costs)
and the overall management of money in the business. These measures focus on information
available from the Statement of profit or loss and Statement of financial position of a business.
Financial measures can be used to record the performance of cost centers, profit centers and
investment centers within a responsibility accounting system but they can also be used to
assess the overall performance of the organization. For example, if cost reduction or cost
control is identified as a critical success factor, cost based performance measures might be an
appropriate performance indicator to be used.
Cost based performance measures can be calculated as a simple cost per unit of output. The
organization will have to determine its policy for establishing cost per unit for performance
measurement purposes. The chosen method should then be applied consistently. One of the
tools used to measure financial performance of a company is ratios. Ratios such as liquidity
ratios, profitability rations, efficiency ratios, and gearing ratios have been discussed in previous
modules; few of them are discussed here.
Measuring profitability
The primary objective of a profit seeking company is to maximize profitability. A business
needs to make a profit to be able to provide a return to any investors and to be able to grow the
business by reinvestment.
Three profitability ratios are often used to monitor the achievement of this objective:
 Return on capital employed (ROCE) = operating profit ÷ (noncurrent liabilities + total
equity) %
 Return on sales (ROS) = operating profit ÷ revenue %
 Gross margin = gross profit ÷ revenue %

NOTE: Operating profit is profit before interest and tax and after nonproduction overheads

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have been charged.
Return on capital employed (ROCE)
There are two metrics required to calculate the Return on Capital Employed - earnings before
interest and tax and capital employed. Earnings before interest and tax (EBIT), also known as
operating income, shows how much a company earns from its operations alone without regard
to interest or taxes. EBIT is calculated by subtracting cost of goods sold and operating
expenses from revenues.
Capital employed is the sum of shareholders ‘equity and debt liabilities. Also, it can be
simplified as total assets minus current liabilities. Instead of using capital employed at an
arbitrary point in time, analysts and investors often calculate ROCE based on the average
capital employed, which takes the average of opening and closing capital employed for the
time period.
This is a key measure of profitability as an investor will want to know the likely return from
any investment made.
ROCE is the operating profit as a percentage of capital employed. It provides a measure of how
much profit is generated from each $1 of capital employed in the business.
Operating profit (profit before interest) is being compared to long term debt (noncurrent
liabilities) plus the equity invested in the business.
Operating profit represents what is available to pay interest due to debt and dividends to
shareholders so the figures used are comparing like for like.
A high ROCE is desirable. An increase in ROCE could be achieved by:
 Increasing profit, e.g. through an increase in sales price or through better control of
costs.
 Reducing capital employed, e.g. through the repayment of long term debt.

Return on sales (operating margin) or

This is the operating profit as a percentage of revenue. A high return is desirable. It indicates
that either sales prices and or volumes are high or that costs are being kept well under control.
Asset turnover
Asset turnover = Revenue ÷ Capital employed
The asset turnover measures how much revenue is generated from each $1 of capital employed
in the business.
A high asset turnover is desirable. An increase in the asset turnover could be achieved by:
 Increasing revenue, e.g. through the launch of new products or a successful advertising
campaign.
 Reducing capital employed, e.g. through the repayment of long term debt.

Having the ROS and Asset Turnover,

ROCE = ROS x Asset turnover
ROCE = [(operating profit ÷ revenues) x 100] x (revenues x capital employed)
This can be useful if only partial information is available. For example if the ROS and Asset
turnover ratios are known then the ROCE can be calculated
Illustration: ROCE, ROS, and asset turnover
X Y
Revenue 80,000 200,000

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Operating profit 10,000 10,000
Capital employed 50,000 50,000
It is possible to calculate ROCE, ROS and Asset turnover from the above information to
examine the relationship between these 3 ratios.
Company X
ROCE = 10,000 ÷ 50,000 × 100 = 20%
ROS = 10,000 ÷ 80,000 × 100 = 12.5%
Asset turnover = 80,000 ÷ 50,000 = 1.6
ROCE = ROS × Asset turnover = 0.125 × 1.6 = 0.2 = 20%
Company Y
ROCE = 10,000 ÷ 50,000 × 100 = 20%
ROS = 10,000 ÷ 200,000 × 100 = 5%
Asset turnover = 200,000 ÷ 50,0000 = 4
ROS = ROCE ÷ Asset turnover = 0.2 ÷ 4 = 0.05 = 5%
Gross margin
The gross margin focuses on the trading activity of a business as it is the gross profit (revenue
less cost of sales) as a percentage of revenue.
A high gross margin is desirable. It indicates that either sales prices and or volumes are high or
that production costs are being kept well under control.
Earnings per Share
Investors who buy shares in a company want to be able to compare the benefits from their
investment with the amount they have paid, or intend to pay for their shares. There are two
measures of benefits to the investors. One is profit for the period (usually named earnings when
referring to the profits available for equity shareholders). The other is the dividend which is an
amount of cash that is paid to the shareholders. Profit indicates wealth created by business. The
wealth may be accumulated in the business or else paid out in the form of dividend. EPS is a
financial ratio, which divides earnings available to equity shareholders by the total number of
shares issued over a certain period of time. The EPS formula indicates a company’s ability to
produce net profits for equity shareholders.
Earnings per Share = profit after tax for ordinary shareholders ÷ number of issued ordinary
shares
Note: some accountant use outstanding ordinary shares.
Earnings before Interest, Tax, Depreciation and Amortization (EBITDA)
EBITDA is increasingly used by analysts as approximate measures of cash flow because it
removes the non-cash expenses of depreciation and amortization from profit. The reason
appears to be a desire to get away from the subjectivity of accruals-based profit and closer to
cash flow as something objectively measured. EBITDA is a measure of a company's operating
performance. Essentially, it's a way to evaluate a company's performance without having to
factor in financing decisions, accounting decisions or tax environments. EBITDA is calculated
by adding back the non-cash expenses of depreciation and amortization to a firm's operating
profit
Alternatively, you can also calculate EBITDA by taking a company's net profit and adding
back interest, taxes, depreciation, and amortization.
EBIDTA allows analysts to focus on the outcome of operating decisions while excluding the
impacts of non-operating decisions like interest expenses (a financing decision), tax rates (a
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governmental decision), or large non-cash items like depreciation and amortization (an
accounting decision). By minimizing the non-operating effects that are unique to each
company, EBITDA allows investors to focus on operating profitability as a singular measure of
performance.  Such analysis is particularly important when comparing similar companies
across a single industry, or companies operating in different tax brackets.
EBITDA Margin measures a company's earnings before interest, taxes, depreciation, and
amortization as a percentage of its total revenue.  Because EBITDA is a measure of how much
cash came in the door, EBITDA margin is a measure of how much cash profit a company made
in a year relative to its total sales. The formula for EBITDA margin is:
EBITDA Margin = EBITDA / Total Revenue
Illustration: Assume Company X annual income statement (in francs)
sales 11,000,000
Less: cost of sales (6,000,000)
Gross profit 5,000,000
Less operating expenses:
salaries (1,000,000)
Rent (1,000,000)
depreciation (150,000)
Amortization (50,000)
EBIT 2,800,000
Interest expenses (100,000)
EBT 2,700,000
Tax (30% x 2,700,000) (810,000)
Net income 1,890,000

EBITDA = 1,890,000 + 810,000 + 100,000 + 50,000 + 150,000 = 3,000,000

EBITDA Margin = (3,000,000 / 11,000,000) x 100 = 27.2%
It means that this company is able to turn 27.2% of its revenue into cash profit during the year.
Note: Ratios are useful when the actual results are compared to the standards or set targets.
Residual Income
It is the net operating income above some minimum return on operating assets. It is the net
operating income earned less the minimum required return on average operating assets.
Residual income was developed as an alternative to the return on investment measurement to
overcome some problems of ROI. Residual income encourages managers to make profitable
investments that would be rejected by managers using ROI.
Residual income = net operating income – (average operating assets x minimum required rate
of return)
Illustration:
The retail division of Zephyr inc. has average operating assets of $ 100,000 and is required to
earn a return of 20% on these assets. In the current period, the division earns $ 30,000.
Calculate residual income.
Minimum return required = 100,000 x 20% = 20,000
Residual income = 30,000 – 20,000 = 10,000
Methods of evaluating capital investment
Net Present Value Method
NPV method has been covered in the previous modules, here it is discussed briefly.
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NPV is one of the techniques of capital investment appraisal. It takes into account all cash
flows over the life of the project and makes allowance for the time value of money.
The idea of applying the concept of time value of money is to recognize the reward needed
from a project to compensate for the lost opportunity. For example, receiving $1 million today
is much better than $1 million received five years from now. If the money is received today, it
can be invested and earn interest, so it will be worth more than $1 million in five years’ time.
The process of calculating present value is called Discounting. The interest rate used is called
the discount rate.
NPV Value of a project is equal to the present value of the cash inflows minus the present
value of cash outflows, all discounted at the cost of capital.
NPV analysis is used to help determine how much an investment, project, or any series of cash
flows is worth
The cost of capital can be:
- If the project is to be financed only by borrowing from the banks, then the cost of
capital is the rate of interest that a bank would charge for a new a loan.
- If the project is to be financed by issuing of new share capital, then the cost of capital is
the dividend yield required by investors.
- If the project is to be financed by cash that has been saved within the business, then the
shareholders have allowed this saving rather than take dividend, so the cost of capital is
the opportunity cost reflected in the dividend yield.

Note: Cash flows are calculated as profit before deducting depreciation and amortization
The net present value decision rule:
- Where the net present value of the project is positive, accept the project
- Where the net present value is the project is negative, reject the project
- Where the net present value of the project is zero, the project is acceptable in meeting
the cost of capital but gives no surplus to its owners.

Illustration
years Cash flows Discount factor
outlay 120,000
1 60,000 0.909
2 60,000 0.826
3 60,000 0.751

Assume a discounting rate of 10%.

NPV = [(60,000 x 0.909) + (60,000 x 0.826) + (60,000 x 0.751)] – 120,000 = 29,160
When the discount factor is not given, NPV can be calculated using discount factors obtained
from tables of discount factors or it can be calculated using the following formula:

Where:
Z1 = Cash flow in time 1

Z2 = Cash flow in time 2

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r = Discount rate

X0 = Cash outflow in time 0 (i.e. the purchase price / initial investment)

Internal Rate of Return

The internal rate of return is another method in capital investment appraisal which uses the
time value of money but results in an answer expressed in percentage form. It is a discount rate
which leads to a net present value of zero, where the present value of the cash inflows exactly
equals the cash outflows.
The internal rate of return (IRR) is the discount rate at which the present value of the cash
flows generated by the project is equal to the present value of the capital invested, so that the
net present value of the project is zero.
Method of calculating IRR
When you are not using a computer, or spreadsheet, calculation of IRR involves a process of
repeated guessing of the discount rate until the present value of the cash flows generated is
equal to the capital investment. It should be noted that the NPV can be decreased by increasing
the discount rate and the NPV can be increased by decreasing the discount rate
Then the IRR =
Lower of the pair of discount rates + (NPV at lower rate / difference between the NPVs) x
difference in rates
Considering the illustration on NPV, assume lower discount rate of 20 % and higher discount
rate of 24%. NPV at discount rate of 20% is + 6,360 and NPV at discount rate of 24% is –
1,200.
So, IRR = 20% + (6,360/7,560) x 4 = 23.365%
Internal rate of return decision rule
The decision rule is that a project is acceptable where the internal rate of return is greater than
the cost of capital. Under those conditions the net present value of the project will be positive.
A project is not acceptable where the internal rate of return is less than the cost of capital.
Under those conditions the net present value of the project will be negative. Where the IRR of
the project is equal to the cost of capital, the project is acceptable in meeting the required rate
of return of those investing in the business but gives no surplus to its owners.
Profitability Index
An organization may need to make a choice between two projects which are mutually
exclusive (perhaps because there is only sufficient demand in the market for the output of one
of the projects, or because there is a limited physical capacity which will not allow both).
Attention is then required in using the net present value and the internal rate of return as
decision criteria. In many cases they give the same answer on relatively ranking the projects.
In case two mutually exclusive projects, one has a higher NPV and the other has a higher IRR,
and if the aim of the business is to maximize net present value, the one further decision rule
may be helpful, based on the profitability index.
The profitability index is the present value of cash flows (discounted at the cost of capital)
divided by the present value of the investment intended to produce those cash flows. The
project with the highest probability index will give the highest net present value for the amount
of investment funding available.

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Profitability index = present value of cash inflows/present value of cash outflows
Illustration
projects Initial Cash flows
investment
Year 1 Year 2 Year 3
A 120,000 96,000 48,000 12,000
B 120,000 12,000 60,000 108,000

project NPV at 12% IRR

A 12,521 20.2%
B 15,419 17.6%

Answer:
Project A: probability index = 132,521/120,000 = 1.10
Project B: probability index = 135,419/120,000 = 1.13
This confirms that, of the two, project B is preferable at cost of capital of 12%.
5.2.3 Nonfinancial performance indicators (NFPIs)
Although profit cannot be ignored as it is the main objective of commercial organizations,
critical success factors (CSFs) and key performance indicators (KPIs) should not focus on
profit alone. The view is that a range of performance indicators should be used and these
should be a mix of financial and nonfinancial measures.
Examples of Nonfinancial Performance Indicators (NFPI) include:
 measurements of customer satisfaction e.g. returning customers, reduction in
complaints
 Resource utilisation e.g. is the machines being operated for all the available hours and
producing output as efficiently as possible?
 Measurement of quality e.g. reduction in conformance and non conformance costs.

The large variety in types of businesses means that there are many NFPIs. Each business will
have its own set of NFPIs that provide relevant measures of the success of the business.
However, NFPIs can be grouped together into 2 broad groups:
 Productivity
 Quality

Productivity
A productivity measure is a measure of the efficiency of an operation; it is also referred to as
resource utilization. It relates the goods or services produced to the resources used, and
therefore ultimately the cost incurred to produce the output. The most productive or efficient
operation is one that produces the maximum output for any given set of resource inputs or
alternatively uses the minimum inputs for any given quantity or quality of output.
Examples of resource utilization:
 Hotel – the cost of the bed linen used in each room compared to the number of times
the linen can be used before it needs to be disposed of, time taken to clean and set fair a
room.
 Car sales team – Sales per employee, Sales per square metre of available floor space,
average length of time a second hand car (e.g. taken as part exchange) remains unsold
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Types of productivity measures
Productivity measures are usually given in terms of labor efficiency. However productivity
measures are not restricted to labor and can also be expressed in terms of other resource inputs
of the organization such as the machine hours used for production.
Productivity is often analysed using three control ratios:
Production volume ratio
The production/volume ratio assesses the overall production relative to the plan or budget. A
ratio in excess of 100% indicates that overall production is above planned levels and below
100% indicates a shortfall compared to plans.
The production/volume ratio =
Actual output measured in standard hours
—————————————————— × 100
Budgeted production hours
Capacity ratio
The capacity ratio provides information in terms of the hours of working time that have been
possible in a period.
The capacity ratio =
Actual production hours worked
————————————— × 100
Budgeted production hours
A ratio in excess of 100% indicates that more hours have been worked than were in the budget
and below 100% less hours have been worked than in the budget.
Efficiency ratio
The efficiency ratio is a useful indicator of productivity based on output compared with inputs.
The efficiency ratio =
Actual output measured in standard hours
—————————————————— × 100
Actual production hours worked
A ratio in excess of 100% indicates that the workforce have been more efficient than the
budget predicted and below 100% less efficient than in the budget.
Illustration
Suppose that the budgeted output for a period is 2,000 units and the budgeted time for the
production of these units is 200 hours. The actual output in the period is 2,300 units and the
actual time worked by the labour force is 180 hours.
Required:
Calculate how productive the work force has been.
Production/volume ratio
Actual output measured in standard hours
———————————————————— × 100
Budgeted production hours
200 hours
Standard hours per unit = ————— = 0.1 hours per unit of output
2,000 units
Actual output measured in standard hours = 2,300 units × 0.1 hours = 230 standard hours
230
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Production/volume ratio = —— × 100 = 115%
200
This shows that production is 15% up on planned production levels.

Capacity ratio=
Actual production hours worked
————————————— × 100
Budgeted production hours
180
Capacity ratio = —— × 100 = 90%
200
Therefore this organization had only 90% of the production hours anticipated available for
production.
Efficiency ratio

Actual output measured in standard hours

———————————————————— × 100
Actual production hours worked
230
Efficiency ratio = —— × 100 = 127.78%
180
The workers were expected to produce 10 units per hour, the standard hour.
Therefore, in the 180 hours worked it would be expected that 1,800 units would be produced. In
fact 2,300 units were produced. This is 27.78% more than anticipated.
NB: production/volume ratio = capacity ratio × efficiency ratio
Productivity measures are not restricted to use in manufacturing industries but can be adapted
for use in both the service and public sectors.
Quality
Quality is an issue whether manufacturing products or providing a service. Poor quality products
or services will lead to a loss of business and damage to the businesses reputation. Targets of an
appropriate level need to be set. Examples of NFPIs that could be used to monitor quality both
from an internal and external (customer) perspectives include:
• Wastage levels
• Internal reworking of finished products
• Customer complaints
• Speed of delivery
• Accuracy of delivery
• Number of returns
• Repeat sales
• New customers
• Growth in sales
• Labour turnover
• Staff absences
• Evaluation of development plans
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• Job satisfaction
• Overtime working
• Product improvements
• Sales from new products
• Cost of research and development
• Cleanliness
• Tidiness
• Meeting staff needs
• Meeting government targets on emissions.
Problems with nonfinancial performance indicators
The use of NFPI measures is now common place, but it is not without problems:
 Setting up and operating a system involving a wide range of performance indicators can
be time-consuming and costly
 It can be a complex system that managers may find difficult to understand
 There is no clear set of NFPIs that the organization must use – it will have to select those
that seem to be most appropriate
 The scope for comparison with other organizations is limited as few businesses use
precisely the same NFPIs as the organization under review.

5.2.4 The balanced scorecard

To get an effective system of performance appraisal a business should use a combination of
financial and nonfinancial measures. One of the major developments in performance
measurement techniques that has been widely adopted is the balanced scorecard.
The concept was developed by Kaplan and Norton in 1993 at Harvard. It is a device for
planning that enables managers to set a range of targets linked with appropriate objectives and
performance measures.
The framework looks at the strategy and performance of an organization from four points of
view, known in the model as four perspectives:
 Financial
 Customer
 Internal (process) efficiency
 Learning and growth.

Financial perspective
This focuses on satisfying shareholder value. Appropriate performance measures would include:
• Return on capital employed
• Return on shareholders’ funds.
Customer perspective
This is an attempt to measure the customer’s view of the organization by measuring customer
satisfaction. Examples of relevant performance measures would include:
• Customer satisfaction with timeliness
• Customer loyalty.
Internal perspective (process efficiency)
This aims to measure the organization’s output in terms of technical excellence and consumer
needs. Indicators here would include:
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• Unit costs
• Quality measurement.
Learning and growth perspective
This focuses on the need for continual improvement of existing products and techniques and
developing new ones to meet customers’ changing needs.
A measure would include the percentage of revenue attributable to new products.
Example of a balanced scorecard
Objectives Measures Target Actual
performance performance
Financial perspective Gain in income 5,000,000 5,520,000
Revenue growth 6% 6.48%
Customer perspective New customers 5 6
Customer satisfaction 90% 87%
Internal process Yield 78% 79%
perspective On-time delivery 92% 90%
Learning & growth Employees trained 90% 92%
perspective Employees satisfaction 80% 88%
It helps communicate the strategy to all members of the organization by translating the strategy
into a coherent and linked set of understandable targets.
Activity
For each perspective of the balanced scorecard, suggest and explain one performance measure
that could be used by a company that provides a passenger transport service, e.g. a taxi company
or a train company.
Customer perspective
 Performance measure: percentage of services arriving on time
 Reason for monitoring: ontime service is important to the customer
Internal business perspective
Performance measure: percentage of time for which vehicles are unavailable due to breakdown,
maintenance etc.
Reason for monitoring: maximising vehicle availability is important for achievement of service
targets
Learning and growth perspective
Performance measure: Training days per employee
Reason for monitoring: Need to keep employees updated with safety regulations, first aid and
emergency procedures, etc.
Financial perspective
Performance measure: Operating profit per month
Reason for monitoring: Achievement of budgetary profit target
Note: other performance measures for each perspective would be equally acceptable.
Advantages and disadvantages of the Balanced Scorecard
The advantages of the approach include the following:
 It looks at performance from the point of view of the four perspectives outlined above,
not just from the narrow view of the shareholders as traditional analysis would.
 Managers are unlikely to be able to distort the performance measure.
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  Bad performance is more difficult to hide as more performance indicators are being
measured.
 It should lead to the longterm success of the business rather than focusing on shortterm
improvements.
 It focuses on key performance indicators. The process of identifying these indicators can
make senior managers question strategy and focus on the core elements of the business.
 As the core elements of the business change, the performance indicators can be changed
accordingly. It is therefore a flexible measure.

The disadvantages of the model include the following:

 It can involve a large number of calculations which may make performance
measurement time-consuming and costly to operate.
 The selection of performance indicators under each of the four perspectives is subjective.
 This in turn will make comparisons with the performance of other organizations difficult
to achieve satisfactorily.
 The weighting used to arrive at an overall index of performance are arbitrary and may
need to be arrived at by trial and error
5.2.5 Benchmarking

Benchmarking is a technique that is increasingly being adopted as a mechanism for continuous

improvement.
Benchmarking is a process of measuring the organization’s operations, products and services
against those of competitors recognized as market leaders, in order to establish targets which
will provide a competitive advantage. Or
Benchmarking is the establishment, through data gathering, of targets and comparators that
permit relative levels of performance (and particular areas of underperformance) to be
identified. The adoption of identified best practices should improve performance.
It therefore requires organizations to:
 Identify what they do and why they do it
 have knowledge of what the industry does and in particular what competitors do
 be fully committed to achieving best practice

Any activity can be benchmarked and an organization should focus on those:

 That are central to business strategy
 Where significant improvement is required without increasing resources
 Where staff are committed and eager for improvement

The basic idea of benchmarking is that performance should be assessed through a comparison of
the organization’s own products or services, performance and practices with 'best practice'
elsewhere. The reasons for benchmarking may be summarized as:
 To receive an alarm call about the need for change
 Learning from others in order to improve performance
 Gaining a competitive edge (in the private sector)
 Improving services (in the public sector).

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There are several types and levels of benchmarking, which are mainly defined by whom an
organization chooses to measure itself against.
These include:
Internal benchmarking. With internal benchmarking, other units or departments in the same
organization are used as the benchmark. This might be possible if the organization is large and
divided into a number of similar regional divisions. Internal benchmarking is also widely used
within government. In the UK for example, there is a Public Sector Benchmarking Service that
maintains a database of performance measures. Public sector organizations, such as fire stations
and hospitals, can compare their own performance with the best in the country.
Competitive benchmarking. With competitive benchmarking, the most successful competitors
are used as the benchmark. Competitors are unlikely to provide willingly any information for
comparison, but it might be possible to observe competitor performance (for example, how
quickly a competitor processes customer orders). A competitor's product might be dismantled in
order to learn about its internal design and its performance: this technique of benchmarking is
called reverse engineering.
Functional benchmarking. In functional benchmarking, comparisons are made with a similar
function (for example selling, order handling, despatch) in other organisations that are not direct
competitors. For example, a fast food restaurant operator might compare its buying function
with buying in a supermarket chain.
Strategic benchmarking. Strategic benchmarking is a form of competitive benchmarking
aimed at reaching decisions for strategic action and organizational change. Companies in the
same industry might agree to join a collaborative benchmarking process, managed by an
independent third party such as a trade organization. With this type of benchmarking, each
company in the scheme submits data about their performance to the scheme organizer. The
organizer calculates average performance figures for the industry as a whole from the data
supplied. Each participant in the scheme is then supplied with the industry average data, which it
can use to assess its own performance.
The following steps are required in a systematic benchmarking exercise:
 planning
 analysis
 action
 Review

Planning includes selecting the activity to be benchmarked, involving fully the staff engaged
with that activity and identifying the key stages of the activity relating to inputs, outputs and
outcomes. It is important to establish the benchmark to a level of ‘best practice’.
Analysis includes identifying the extent to which the organization is under performing and to
stimulate ideas as to how this can be met.
This may include whether new processes or methods are required. Implementation concerns the
use of an action plan to achieve the improvement or the maintenance of the pre determined
standards. Management should ensure that resources are made available to meet the objectives
set.
Action involves putting an appropriate plan into force in order to improve performance in the
benchmarked areas.
Review includes monitoring progress against the plan and reviewing the appropriateness of the
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performance measure.
In practice, businesses establishing benchmarks will use a variety of information sources for
their programmes. The most relevant and useful information would be that from a benchmarking
partner. Such partnerships can be organized through trade associations and interfirm comparison
links.
All organizations can benefit with comparisons with others. Ideally, it should be judged against
best practice wherever that may be found. Benchmarking analysis can provide such
comparisons of the resources, competences in separate activities and overall competence of the
organization.
CHAPTER FOUR: STRATEGIC POSITIONING ANALYSIS

4.1 Environmental Analysis

PESTEL analysis
Now we are going to look at the environmental influences in organizations. We are first going
to look at the macro-environmental influences, then influences specific to a particular market,
and finally, influences specific to a particular organization within that market.
The macro-environmental influences can be remembered by the acronym PESTEL. It stands
for:
• Political
• Economic
• Social
• Technological
• Ecological
• Legal.
You may have known this previously as PEST, but now we slit apart political and legal and
there is an extra “E” for Ecological, which for many organizations is becoming a major
concern. Note that it doesn’t much matter whether something like a tax rate is regarded as
being political or economic: the important point is to have recognized a tax rate or a new tax as
something which might affect the organization.
Examples of PESTEL factors:
• Political: elections and changes of government, war, European Union expansion.
• Economic: interest rates, tax rates, exchange rates, economic boom or recession
• Social: nowadays the main social trend arises from changes in populations. In most western
countries the birth rate has fallen and there is an increasing proportion of elderly people. This
can affect recruitment but it can also affect the economies of companies that they have to
support a larger number of retirees. It can of course affect the marketing of products. Products
suited to older people may become more popular while those suited to younger people may
become less popular.
• Technological: technological changes often come out of the blue, but once they are invented
there is really no turning back. Think how the internet has profoundly affected the fortunes of
organizations like travel agents. I think how banks have responded by may be closing branches
and encouraging their clients to do more and more banking online.
• Ecological: carbon emission restrictions/taxes, more stringent laws governing air and water
solution, concern about the possible effects of global warming.

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• Legal: health and safety legislation, equality legislation, regulation of industries.

4.2 SWOT ANALYSIS

A SWOT analysis can either be used in its own right or it can be used as a summary sheet on
which other findings are placed. SWOT stands for:
• Strengths
• Weaknesses
• Opportunities
• Threats
Strengths and weakness are internal to the organization. For example, an organization might
have strong resources in finance and weak resources in marketing. Opportunities and threats
are external. For example there may be political threats, but the economy might be looking up
and might provide opportunities.

Those political and economic factors could have a reason from a PESTLE analysis
Strength Weakness

Look for opportunities that Look for strategies which

make use of the strength addresses the weakness
Opportunities Once
the

Look for strategies which use Defensive look for strategies

Threat strength to overcome /avoid which avoid threat and
threat minimise the effect of
weakness

strength, weaknesses, opportunities, and threats have been summarized an organization then
has to decide what to do with them.
Certain things match well. For example, if there is an opportunity which is matched by strength
then the organization should try to make use of that strength. However if the opportunity
depended on using an area in which the company was weak, then the chances of success there
are relatively low. Either avoid that opportunity or look for strategies which address the
weakness.
Similarly, if there is a particular threat which is matched by strength then it should be relatively
easy for the company to overcome that threat. But if there is a threat in an area where the
company is particularly weak, then the company could be in some difficulty. For example the
threat might be coming from overseas imports which are particularly low cost. If our
organization is weak in manufacturing so that its costs are relatively high because of inefficient
machinery it’s not easy to see what the company can do to fight that threat and it will be
particularly vulnerable in that area. Perhaps what it should do instead of fighting the imports
face on is to try to avoid the whole conflict by, for example, moving up market. Note, however,
that if it is going to move up market it must be strong in the areas of research, development,
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quality, and innovation.

4.2.1 SWOT analysis and performance management

Corporate appraisal (SWOT analysis) helps an organisation identify the opportunities and
threats it faces, and therefore also helps it evaluate the potential strategic options it could
pursue. In this respect, corporate appraisal can make an important contribution to improving an
organisation's performance. It can also help an organisation identify the key aspects of its
performance which need measuring.
When developing its strategic plans, it is important for an organisation to understand its
strengths and weaknesses, and to be aware of the opportunities and threats it faces. SWOT
analysis (corporate appraisal) is covered in Paper P3, so you should already be familiar with it
as a model. It combines the results of the internal analysis and external environmental analysis
into a single framework for assessing an organisation's strengths and weaknesses, and the
opportunities and threats offered by the environment. In this way, corporate appraisal allows an
organisation to understand its current strategic position as part of preparing its strategic plan.
SWOT analysis summarises the key issues from the business environment and the strategic
capability of an organisation that are most likely to impact on strategy development
4.2.2 SWOT analysis
Effective SWOT analysis does not simply require a categorisation of information; it also
requires some evaluation of the relative importance of the various factors under
consideration.
(a) These features are only of relevance if they are perceived to exist by the consumers.
Listing
corporate features that internal personnel regard as strengths/weaknesses is of little relevance if
they are not perceived as such by the organisation's consumers.
(b) In the same vein, threats and opportunities are conditions presented by the external
environment
and they should be independent of the firm. SWOT analysis can then be used to guide strategy
formulation. The internal and external appraisals should be brought together so that an
organisation can develop its strategies from identifying its own strengthsand weaknesses, and
from identifying the opportunities and threats presented by the wider macro environment.
Strengths should be built on and consolidated, while strategies to address any weaknesses can
be drawn up. Similarly, strategies should be developed to exploit opportunities, and to provide
contingencies against the threats which have been identified.

Internal to the Strength Weakness

company
Conversion

Conversion

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External to the Opportunities Threats
company

4.2.3 SWOT analysis and strategic planning

SWOT analysis is usually seen as a key part of strategic analysis. An organisation needs to
understand its current strategic position, before evaluating the strategic options available to it.
SWOT analysis helps an organisation achieve this understanding in two ways:
(a) It helps the organisation analyse the things it does particularly well (strengths) or badly
(weaknesses) at present.
(b) It helps to identify the factors that may give the organisation potential to grow and increase
its
profits (opportunities) or may make its position weaker (threats). In this context, it is important
to bear in mind what SWOT analysis is for. It is intended to summarise a strategic situation,
with a view to deciding what the organisation should do next. Understanding the key
opportunities and threats facing an organisation helps its managers identify realistic options
from which to choose an appropriate strategy for the firm. A strategy could be drawn up to
consolidate the organisation's strengths, improve on its weaknesses, exploit the opportunities
available to it, and deal with the threats it faces.
However, it is also important to remember some of the dangers relating to SWOT exercises. As
Johnson etal highlight in Fundamentals of Strategy: 'A SWOT exercise can generate very long
lists of apparent strengths, weaknesses, opportunities and threats, whereas what matters is to be
clear about what is really important and what is less important. So prioritisation of issues
matters.'
Johnson et al also highlight two key points, which could be important for SWOT exercises in
relation to performance management:
(a) Focus on strengths and weaknesses that differ in relative terms compared to competitors
and leave out areas where the organisation is at par with competitors.
(b) Focus on opportunities and threats that are directly relevant for the specific organisation
and
industry.
4.2.4 SWOT analysis and the performance management process
The previous sub-section highlights that SWOT analysis is intended to help an organisation
decide what to do next. In this respect, it also plays an important role in the performance
management process. Earlier in the chapter we noted that performance management can be
defined as any activity designed to improve an organisation's performance and ensure that its
goals are being met.
By identifying opportunities and threats, and helping to identify the strategic choices to pursue,
SWOT analysis plays an important part in the planning activity designed to improve an
organisation's performance.
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More specifically, SWOT analysis also assists the performance management process by:
(a) Identifying shortcomings (weaknesses) or limiting factors that need to be addressed (this
links
back to Johnson et al's point about the importance of focusing on areas of weakness relative to
competitors)
(b) Identifying CSFs which will allow KPIs to be created and monitored
(c) Determining the information needs of the business to measure and report on the KPIs
(d) Setting targets; an organisation should consider what targets would allow it to build on its
strengths and/or take advantage of opportunities, as well as minimising its weaknesses and the
threats it faces. Equally, however, a consideration of an organisation's strengths and
weaknesses, and the opportunities and threats it faces, will also allow the organisation to assess
whether targets which
have already been suggested are realistic and achievable.
4.2.5 SWOT analysis and performance measurement
As well as helping an organisation decide what to do next, SWOT analysis helps identify the
key aspects of performance which an organisation needs to measure.
For example, an organisation may have identified its strengths to be: its reliable products, its
well respected brand name, and the fact it sells its products at competitive prices. However, this
also suggests that in order for the organisation to continue to perform well it must maintain its
product reliability, reputation and brand name, and it must continue to sell its products at
competitive prices.
In turn, in order for the organisation to know whether or not it is achieving its aims it has to
measure how well it is performing in these key areas. For example, its key performance
measures should include a measure of product reliability, and a comparison of its prices with
competitors' prices.
Similarly, if an organisation has identified that one of its weaknesses is its low standard of
customer
service, then it will be keen to convert this weakness into a strength by improving its levels of
customer service. Equally, however, it will be crucial for the organisation to measure customer
service levels and customer satisfaction, to assess whether or not service levels are improving
in the way that the organisation wants.
4.3 Cost Driver Analysis
To reflect today's more complex business environment, recognition must be given to the fact
that costs are created and incurred because their cost drivers occur at different levels. Cost
driver analysis investigates, quantifies and explains the relationships between cost drivers and
their related costs.
Classification level Cause of cost Types of cost Necessity of cost
Unit level costs Production/acquisition Direct materials Once for each unit
of a single unit of Direct labour produced
product or delivery of
single unit of service
Batch level costs A group of things Purchase orders Once for each batch
being made, handled Set-ups produced
or processed Inspection
Product/process level Development, Equipment Supports a product
costs production or maintenance type or a process
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 acquisition of different Product development
items
Organisational/facility Building Supports the overall
costs depreciation production or
Organisational service
advertising process

Traditionally it has been assumed that if costs did not vary with changes in production at the
unit level, they were fixed rather than variable. The analysis above shows this assumption to be
false, and that costs vary for reasons other than production volume. To determine an accurate
estimate of product or service cost, costs should be accumulated at each successively higher
level of costs.
Unit level costs are allocated over number of units produced, batch level costs over the number
of units in the batch and product level costs over the number of units produced by the product
line. These costs are all related to units of product (merely at different levels) and so can be
gathered together at the product level to match with revenue. Organisational level costs are not
product related, however, and so should simply be deducted from net revenue. Such an
approach gives a far greater insight into product profitability.
4.4 COST ANALYSIS
4.4.1 Standard costing
Standard costs are predetermined costs per unit of output that should be incurred under normal
operating conditions. Even if the use of standard costs does not progress to variance analysis,
‘standards’ are needed for budgeting.
It is essential to know how much material and how many hours it will take to produce planned
output and what these resources will cost.
Probably the best standards to use are ‘currently attainable standards’. These should be
achievable under normal operating conditions without being too easy.
4.4.2 Variance analysis
Variance analysis is a common way to try to find reasons for discrepancies between actual and
budgeted performance. Just because a production department used more material than might
have been expected does not mean that that the operations in the production department was at
fault. The purchasing department might have bought poor material, machines might be old and
unreliable thus wasting some material, cheaper and worse staff might have been forced on the
department and these people make errors.
Material variances
The variances Potential causes
Material price variance (MPV):
Quantity of material actually used at actual price compared to what that quantity of material
would cost if bought at standard price/unit.
• Wrong standard cost/unit of material
• Poor/excellent buying
• Price changes since the standard was set
• Exchange rate movements altering the price of imported material
MPV = (SP – AP) AQ
SP = Standard price

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AP = Actual price
AQ = Actual quantity

Material usage variance (MUV):

The physical amount of material actually used compared to the standard amount that should be
used for the actual output achieved, evaluated at the standard cost per unit.
• Wrong standard usage/unit of production
• Poor/excellent use of material
• Material of different quality
• Poor machine maintenance
• Poor staff training
MUV = (SQ – AQ) SP
Where SQ is the standard quantity

Labour variances
The variances Potential causes
Labour rate variance (LRV):
The actual coast of labour paid for compared to what that amount labour should have cost if
paid at the standard hourly rate.
• Wrong standard rate/hour
• Wage inflation
• A different mix of labour eg better, more expensive people
LRV = (SR – AR) ALH
SR = standard rate
AR = Actual rate
ALH = actual Labour hours
Labour efficiency variance (LEV):
Number of hours actually worked compared to the standard number of hours that should be
worked for the actual output achieved, evaluated at the standard rate per hour.
• Wrong standard hours per unit
• A different mix of labour
• Better or worse training than expected
• Good/poor supervision
LEV = (SLH – ALH) SR
Where SLH is the standard labour hour

Labour idle time variance LITV:

Hours actually worked compared to hours paid for, evaluated at the standard rate per hour
• Poor supervision
• Machine breakdown
• Lack of material
• Poor job scheduling
LITV = (Hours paid – actual hours) SR
Variable overhead variances
The variances Potential causes
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Variable overhead rate variance VORV:
Amount of variable overhead actually paid, compared to what those hours of variable overhead
should have cost if bought at standard hourly rate.
• Wrong standard rate/hour
• Different machines being used
• Unexpected inflation relating to machine running.
VORV = (SOR – AOR) AOH
SOR = standard overhead rate
AOR actual overhead rate
AOH = Actual overhead hours

Variable overhead efficiency variance (VOEV):

Number of hours actually worked compared to the standard number of hours for the actual
output achieved, evaluated at the standard rate per hour.
• Wrong standard hours per unit
• Machines of a differ ent efficiency than expected.
• Good/poor supervision
• Good/poor machine maintenance.
VOEV = (SOH – AOH) SOR
Where SOH is the standard overhead hours
Fixed overhead Expenditure variances (FOEV)
The variances Potential causes
Fixed overhead expenditure variance:
Total amount of budgeted fixed overheads compared to total actual fixed overheads
• Wrong budget
• Unexpected level of expenditure
FOEV = budgeted fixed overheads – actual overheads
Fixed overhead volume variance (FOVV):
Actual output in units compared to budgeted output (units), evaluated at the fixed overhead
absorption rate per unit
• Wrong budget
• Different output to what was expected.
FOVV = (SO – AO) SFOR
SO = standard output
AO = actual output
SFOR = standard fixed overhead rate
Sales variances
The variances Potential causes
Sales price variance:
Actual volume sold times difference between actual and budgeted selling price
• Wrong budget
• Different selling price to what was expected.
Sales volume variance:
Actual volume sold compared to budget volume, evaluated at budgeted contribution per unit or
at budgeted profit per unit.
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• Wrong budget
• Different selling price to what was expected (affects demand)
• Change in marketing
• Economic changes
4.6 Operating statement
Once variances have been calculated they can be conveniently displayed on an operating
statement.
Typically this reconciles budgeted profits or contribution to actual profit.

Example:
Company produces and sells one product only, the Thing, the standard cost for one unit being
asfollows.
$
Direct material A – 10 kilograms at $20 per kg 200
Direct material B – 5 litres at $6 per litre 30
Direct wages – 5 hours at $6 per hour 30
Fixed production overhead 50
Total standard cost 310
The fixed overhead included in the standard cost is based on an expected monthly output of
900 units. Fixed production overhead is absorbed on the basis of direct labour hours.
During April the actual results were as follows.
Production 800 units
Material A 7,800 kg used, costing $159,900
Material B 4,300 litres used, costing $23,650
Direct wages 4,200 hours worked for $24,150
Fixed production overhead $47,000
Required
(a) Calculate price and usage variances for each material.
(b) Calculate labour rate and efficiency variances.
(c) Calculate fixed production overhead expenditure and volume variances and then subdivide
the volume variance.
swer
(a) Price variance – A
$
7,800 kgs should have cost (at $20) 156,000
but did cost 159,900

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Price variance 3,900 (A)
Usage variance – A
800 units should have used (at 10 kgs) 8,000 kgs
but did use 7,800 kgs
Usage variance in kgs 200 (F)
standard cost per kilogram at $20
Usage variance in $ $4,000 (F)
Price variance – B
$
4,300 litres should have cost (at $6) 25,800
but did cost 23,650
Price variance 2,150 (F)
Usage variance – B
$
800 units should have used (at 5 ) 4,000
but did use 4,300
Usage variance in litres 300 (A)
standard cost per litre × $6
Usage variance in $ $1,800 (A)

(b) Labour rate variance

$
4,200 hours should have cost (at $6) 25,200
but did cost 24,150
Rate variance 1,050 (F)
Labour efficiency variance
800 units should have taken (at 5 hrs) 4,000 hrs
but did take 4,200 hrs
Efficiency variance in hours 200 (A)
standard rate per hour × $6
Efficiency variance in $ $1,200 (A)
(c) Fixed overhead expenditure variance
$
Budgeted expenditure ($50 x 900) 45,000
Actual expenditure 47,000

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Expenditure variance 2,000 (A)
Fixed overhead volume variance
$
Budgeted production at standard rate (900x $50) 45,000
Actual production at standard rate (800 x $50) 40,000
Volume variance 5,000 (A)
Fixed overhead volume efficiency variance
$
800 units should have taken (at 5 hrs) 4,000 hrs
but did take 4,200 hrs
Volume efficiency variance in hours 200 (A)
standard absorption rate per hour at $10
Volume efficiency variance $2,000 (A)
Fixed overhead volume capacity variance
Budgeted hours 4,500 hrs
Actual hours 4,200 hrs
Volume capacity variance in hours 300 (A)
standard absorption rate per hour ($50 ÷ 5) at $10 $3,000 (A)
Variance F avourable Adverse Calculation
4.7 Value Chain Analysis
4.7.1 The value chain
A more sophisticated model of business integration is the value chain. It offers a bird's eye
view of the firm, of what it does and the way in which its business activities are organised.
Business activities are not the same as business functions, however.
(a) Functions are the familiar departments of a business (production, finance and so on) and
reflect the formal organisation structure and the distribution of labour.
(b) Activities are what actually goes on, and the work that is done. A single activity can be
performed by a number of functions in sequence. Activities are the means by which a firm
creates value in its products. Activities incur costs and, in combination with other activities,
provide a product or service, which earns revenue.
For example, most organisations need to secure resources from the environment. This activity
can be called procurement. Procurement will involve more departments than purchasing;
however, accounts will certainly be involved and possibly production and quality assurance.
The ultimate value a firm creates is measured by the amount customers are willing to pay
for its
products or services above the cost of carrying out value activities. A firm is profitable if the
realised value to customers exceeds the collective cost of performing the activities.
According to Porter, the value activities of any firm can be divided into nine types and then
analysed into a value chain. This is a model of activities (which procure inputs, process
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them and add value to them in some way, to generate outputs for customers) and the
relationships between them.
Activities
Primary activities are directly related to production, sales, marketing, delivery and service.
Activity Comment
Inbound logistics Receiving, handling and storing inputs to the production system:
warehousing, transport, inventory control and so on
Operations Convert resource inputs into a final product; resource inputs are not
only
materials; people are a resource, especially in service industries; note
that
this is not just applicable to manufacturing firms, hence the careful
choice
of name; service companies also have operations
Outbound logistics Delivering the product to customers; this may include storage, testing,
bulk
transport, packaging, delivery and so on
Marketing and sales Informing customers about the product, persuading them to buy it,
and
enabling them to do so: advertising, promotion and so on
After-sales service Installing products, repairing them, upgrading them, providing spare
parts
and so forth

Support activities provide purchased inputs, human resources, technology and infrastructural
functions to support the primary activities. The first three tend to provide specific elements of
support to the primary activities.
Activity Comment
Procurement Acquire the resource inputs to the primary activities (eg purchase of
materials, subcomponents equipment)
Technology Product design, improving processes and/or resource utilisation
development
Human resource Recruiting, training, developing and rewarding people
management
Firm infrastructure General management, planning, finance, quality control, public and
legal
affairs: these activities normally support the chain as a whole rather
than
individual activities and are crucially important to an organisation's
strategic
capability in all primary activities

Linkages
Linkagesconnect the activities of the value chain, wherever they take place.
(a) Activities in the value chain affect one another. For example, more costly product design
or
better quality production might reduce the need for after-sales service.
(b) Linkages require co-ordination. For example, just-in-time requires smooth functioning of
operations, outbound logistics and service activities, such as installation. Because activities can
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be spread across departments, rather than corresponding to neat, organisation chart boundaries,
managing them for best effect can be extremely difficult. Cost control can be a particular
problem. The dispersion of activities also complicates the management of linkages.
4.7.2 Why Is Value Chain AnalysisImportant?
There are three main sets of reasons why value chain analysis is important in this era of rapid
globalisation. They are: With the growing division of labour and the global dispersion of the
production of components, systemic competitiveness has become increasingly important
Efficiency in production is only a necessary condition for successfully penetrating global
markets
Entry into global markets which allows for sustained income growth – that is, making the best
of globalisation - requires an understanding of dynamic factors within the whole value chain
Key elements of value chain analysis
Barriers to entry and rent
The value chain is an important construct for understanding the distribution of returns arising
from design, production, marketing, coordination and recycling. Essentially, the primary
returns accrue to those parties who are able to protect themselves from competition. This
ability to insulate activities can be encapsulated by the concept of rent, which arises from the
possession of scarce attributes and involves barriers toentry.
There are a variety of forms of rent. The focus of much of the literature, entrepreneurial
energies and government policies is on what is called economic rents. The classical economists
(such as Ricardo) argued that economic rent accrues on the basis of unequal ownership/access
or control over an existing scarce resource (eg. land). However as Schumpeter showed, scarcity
can be constructed through purposive action, and hence an entrepreneurial surplus can accrue
to those who create this scarcity. For Schumpeter this is essentially what happens when
entrepreneurs innovate, creating ‘new combinations’ or conditions, which provide greater
returns from the price of a product than are required to meet the cost of the innovation. These
returns to innovation are a form of super profit and act as an inducement to replication by other
entrepreneurs also seeking to acquire a part of this profit.
In summary, economic rent
 arises in the case of differential productivity of factors (including entrepreneurship)
and barriers to entry (that is, scarcity)
 takes various forms within the firm, including technological capabilities, organisational
capabilities, skills and marketing capabilities (such as brand names). (These cluster of
attributes are often discussed in relation to dynamic capabilities and core competences
in the literature).
 but they may also arise from purposeful activities taking place between groups of
firms – these are referred
 The process of competition – the search for ‘new combinations’ to allow entrepreneurs
to escape the tyranny of the normal rate of profit, and the subsequent bidding away of
this economic rent by competitors – fuels the innovation process which drives
capitalism forward. As more and more countries have developed their capabilities in
industrial activities, so barriers to entry in production have fallen and the competitive
pressures have heightened. This has become particularly apparent since China, with its
abundant supplies of educated labour, entered the world market in the mid-1980s.10 It

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 is this, too, which underlies the falling terms of trade in manufactures of developing
countries (see Figure 5 in Part 1 above)to as relational rents.
 Consequently, it is sometimes argued that the primary economic rents in the chain of
production are increasingly to be found in areas outside of production, such as design,
branding and marketing. Yet, as we shall see, this is too simple a conclusion, since
even within production some activities involve greater barriers to entry. The pervasive
trend, as we shall see is towards control over disembodied activities in the value chain.
Competitive Pressures in the Value Chain

Competitiveness pressure

Production Marketing
Design

Economic rent arises in the case of differential productivity of factors and barriers to entry.
There are a variety of forms of economic rent prevalent in the global economy; Some are
endogenous and are “constructed” by the firm and are classical Schumpeterian rents:
Competitive pressure
Technology rents – having command over scarce technologies
Human resource rents – having access to better skills than competitors
Organisational rents – possessing superior forms of internal organisation
Marketing rents – possessing better marketing capabilities and/or valuable brand names Other
rents are endogenous to the chain, and are constructed by groups of firms:
Relational rents – having superior quality relationships with suppliers and customers. But rents
can also be exogenous to the chain and arise through the bounty of nature:
Resource rents – access to scarce natural resource. Producers can also gain from the rents
provided by parties external to the chain.
Policy rents – operating in an environment of efficient government; constructing barriers to the
entry of competitors
Infrastructural rents – access to high quality infrastructural inputs such as telecommunications
Financial rents – access to finance on better terms than competitors.
Rents are dynamic – new rents will be added over time, and existing areas of rent will be
eroded through the forces of competition
Governance A second consideration which helps to transform the value chain from an
heuristic to an analytical concept is that the various activities in the chain – within firms and in
the division of labour between firms – are subject to what Gereffi has usefully termed
‘governance’ (Gereffi, 1994). Value chains imply repetitiveness of linkage interactions.
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Governance ensures that interactions between firms along a value chain exhibit some reflection
of organisation rather than being simply random.
Value chains are governed when parameters requiring product, process, and logistic
qualification are set which have consequences up or down the value chain encompassing
bundles of activities, actors, roles, and functions. This is not necessarily the same thing as the
co-ordination of activities by various actors within a value chain. Value chains are coordinated
at different places in the linkages in order to ensure these consequences (intra firm, inter firm,
regional) are managed in particular ways. Power asymmetry is thus central to value chain
governance.
Value system Activities and linkages that add value do not stop at the organisation's
boundaries. For example, when a restaurant serves a meal, the quality of the ingredients –
although the cook chooses them – is determined by the grower. The grower has added value,
and the grower's success in growing produce of good quality is as important to the customer's
ultimate satisfaction as the skills of the chef. A firm's value chain is connected to what
Porter calls a value system. How an organisation can use the value chain to secure competitive
advantage. The value chain provides a framework for understanding the nature and location of
the skills and competences in an organisation that provide the basis for its competitive
advantage.
Equally, the value chain provides a framework for cost analysis. Assigning operating costs and
assets to value activities is the starting point of cost analysis, so that improvements can then be
made or cost advantages defended. For example, if an organisation discovers that it has a cost
advantage over its competitors based on the efficiency of its production facilities (operations),
it needs to ensure its production facilities remain superior to those of its competitors so that it
can maintain its advantage over them.
The value chain can help an organisation to secure competitive advantage in a number of ways:
(a) Invent new or better ways to do activities
(b) Combine activities in new or better ways
(c) Manage the linkages in its own value chain
(d) Manage the linkages in the value system
4.7.3 The value chain and performance management
Value chain analysis helps an organisation identify the activities and processes which create
value for its customers, and therefore those activities which an activity needs to perform more
effectively than its competitors.
This has two important implications for performance measurement and performance
management.
(a) The organisation needs to ensure that it is measuring its performance in those key areas
which
create value for its customers (in effect, its critical success factors). If it is not currently doing
so,
this suggests the organisation needs to revise its performance measures and performance
measurement systems, because it needs to know how well it is performing in these key areas.
(b) In order to assess how effectively it is performing activities and processes, an organisation
needsto compare its performance against others. This suggests that benchmarking could be
useful here.
4.7.4 Porter’s value chain
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Porter’s value chain is used to examine how a business makes profits or margin

Firm’s infrastructure

Technical development
Human resource management

Procurement

Inbound Operations Outbound Marketing Services

logistic logistic

Across the bottom of the diagram, are set out inbound logistics, operations, outbound logistics,
marketing and sales, and service. These are the primary activities. More or less these activities
will equate to direct costs.

At the top of the diagram are firm infrastructure, technology development, human resource
management, and procurement. These are the support activities. By and large they equate to
indirect costs. It has to be stressed that activities are shown in the diagram. However, every
activity has an associated cost, and if all activities are represented there, so should all costs, and
these could be allocated and apportioned, and so mapped to somewhere on to this diagram.
Rent, for example could be apportioned over the operations that is the factory, the warehouse,
head office, and the marketing and sales department. Similarly with depreciation, heating costs,
wages and salaries.

So, all the organization’s costs can appear on this diagram. Let’s say these amounted to $10
million. The goods and services produced by the organization will be sold, let’s say for $15
million. How come therefore buyers are willing to spend $15 million on what cost the
organization only $10 million? For what possible reason are customers willing to spend an
extra $5 million over and above what the goods or services cost to produce? The extra $5
million has to be explained somehow. It is known as ‘value-added’, and it is explained by
arguing that the organization accomplishes more for its customers than simply carrying out the
activities and incurring the costs that can be spread over the sections of the value chain.
The organization must be doing something else. For example, it could be bringing skills and
know-how to the process. Effectively it is bringing competences to the process. It could bring
convenience to the buyer, allowing the buyer to keep everything bought from the organization
as a variable cost rather than taking on board many of the fixed costs. It may bring economies
of scale and the buyer is willing to pay for this because it will be impossible for the buyer to
replicate these on a smaller scale.

The organization must understand what it is that adds value, as this is the reason it can make
profits. Furthermore, the organization must understand how the different sections of the value

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chain are linked. It could be, for example, that if more were spent on human resource
management perhaps less would need to be spent on operations because employees are better
trained. If more were spent on technology development perhaps less could be spend on after
sales service because the quality of the finish goods was higher. Understanding the value chain
is essential for organizations so that they know how their profit is generated. It has to be said,
however, that sometimes organizations make mistakes identifying what it is about their
activities that adds, value for the customer and they make changes which reduce their ability to
make profits.

4.8 Customer profitability analysis

4.8.1 Meaning of customer profitability analysis
Customer profitability analysis is an analysis of the total sales revenue generated from a
customer or customer group, less all the costs that are incurred in servicing that customer
group. Or
Customer profitability analysis (CPA) is an analysis of the revenue streams and service costs
associated with specific customers or customer groups to identify the profitability of servicing
those customers.
'An immediate impact of introducing any level of strategic management accounting into
virtually every organisation is to destroy totally any illusion that the same level of profit is
derived from all customers'.
Different customer costs can arise out of the following.
Order size
Sales mix
Order processing
Transport costs (eg if a just in time (JIT) production system requires frequent deliveries)
Management time
Cash flow problems (eg increased overdraft interest) caused by slow payers
Order complexity (eg if the order has to be sent out in several stages)
Inventory holding costs can relate to specify customers
The customer's negotiating strength
The total costs of servicing customers can vary depending on how customers are serviced.
(a) Volume discounts. A customer who places one large order is given a discount, presumably
because it benefits the supplier to do so (eg savings on administrative overhead in processing
the
orders – as identified by an activity based costing system).
(b) Different rates charged by power companies to domestic as opposed to business users.
This in
part reflects the administrative overhead of dealing with individual customers. In practice,
many
domestic consumers benefit from cross-subsidy.
Customer profitability is the 'total sales revenue generated from a customer or customer group,
less all the costs that are incurred in servicing that customer or customer group.'
It is possible to analyse customer profitability over a single period but more useful to look at a

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longer time scale. Such a multi period approach fits in with the idea of relationship
marketing, with its emphasis on customer retention for the longer term. Customer profitability
analysis focuses on profits generated by customers and suggests that profit doesnot
automatically increase with sales revenue. CPA can benefit a company in the following
ways.
It enables a company to focus resources on the most profitable areas
It identifies unexpected differences in profitability between customers
It helps quantify the financial impact of proposed changes
It helps highlight the cost of obtaining new customers and the benefit of retaining existing
customers
It helps to highlight whether product development or market development is to be preferred
An appreciation of the costs of servicing clients assists in negotiations with customers
4.8.2 The customer lifecycle
Thecustomer lifecycle concept is less developed than the equivalent product and industry
lifecycle
models, but it can be useful to consider the following matters.
(a) Promotional expense relating to a single customer is likely to be heavily front-loaded: it
is much cheaper to retain a customer than to attract one.
(b) It is likely that sales to a customer will start at a low level and increase to a higher level as
the
customer gains confidence, though this is not certain and will vary from industry to industry.
(c) A customer who purchases a basic or commodity product initially may move on to more
differentiated products later.
(d) In consumer markets, career progression is likely to provide the individual with steadily
increasing amounts of disposable income, while the family lifecycle will indicate the ranging
nature of likely purchases as time passes.
Any attempt to estimate lifecycle costs and revenues should also consider existing and
potential
environmental impacts, including, in particular, the likely actions of competitors and the
potential for product and process innovation
4.8.3 Understanding the customer
The strategic customer The strategic customer is the entity that decides to make the purchase,
not the end user. Many goods and services are purchased, not by their end users but by
intermediaries such as retailers, sales agents and procurement department staff. Where this
pattern applies, the supplier has to take account of the influence of the intermediary; indeed,
the intermediary is the strategic customer, not the end user, and it is the intermediary's
requirements that are of primary strategic importance. The requirements of the end user are
important, but subordinate in many cases to those of the intermediary.
4.8.4 Customers value – critical success factors
Critical success factors are product features that are particularly valued by customers.
Customers purchase products and services because they value the things the products and
services
provide them with. This may be a relatively simple satisfaction, as when motorists buy petrol,
or it may include a wide range of both tangible and intangible benefits. Many products are,

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in fact, complexpackages of features that their producers have worked hard to assemble. The
intangibles among these features are often collectively referred to as brand values. Consider a
wristwatch, for example. It would be a mistake to imagine that most wristwatches are bought
because they tell the time. They also reflect the taste, self-image and status of the purchaser.
There is likely to be a wide range of opinion among customers as to the features of a product
that provide them with the greatest satisfaction, but, equally, it is also likely that some features
will be widelyregarded as particularly important. These features, the satisfactions they
provide and the demands they make on the organisation's way of doing business constitute
critical success factors: the organization must get these things right if it is to be successful in
what it does.
Thus, for a producer of luxury goods, manufacturing quality would undoubtedly be a critical
success factor, but ensuring that an air of luxury pervaded its retail outlets would be just as
important.
Critical success factors (CSFs) are those product features that are particularly valued by a
group of
customers and, therefore, where the organisation must excel to outperform competitors.
An article titled 'Defining manager's information requirements' (2006) written by Jim Stone
provides an in-depth look at the role of critical success factors in business strategy. It would be
worth taking the time to study this article.
There are important messages connected with this concept. First, value must be assessed
through theeyes of the customer, not those of the designer or professional specialist. Second,
resources should be deployed so as to achieve high performance in critical success factors.
This also illustrates the importance of aligning external forces (customer desires) with internal
factors (resources).
An organisation can measure how well it is achieving the critical success factors through the
use of keyperformance indicators (KPIs). CSFs represent 'what' an organisation needs to do
in order to be successful. KPIs are the measures then used to assess whether or not the CSFs
are being achieved.
Key performance indicators (KPIs) are quantifiable measurements that management can use
to monitor and control progress towards achieving its critical success factors.
In practice, the term KPI tends to be overused and can describe almost any kind of
measurement.
However, in order to be useful they should clearly identify the information needs required to
demonstrate how well the organisation is doing in achieving its overall strategy. They should:
 Reflect the performance and progress of the organisation
Be measurable
 Be comparable – ie can be compared to a standard such as budgeted figures, or prior year
data
 Be usable – ie provide data that can be acted upon
For example, an organisation may have a critical success factor of providing the highest level
of customer service. Appropriate KPIs may relate to the speed of the delivery time, the number
of repeat business transactions from existing customers, or the scores achieved in customer
satisfaction surveys.
4.8.5 Reviewing the customer portfolio

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The customer base is an asset to be invested in, as future benefits will come from existing
customers, but not all customers are as important as others. It will help you in evaluating the
customer portfolio if you consider the customer base as an asset worth investing in.
A marketing audit involves a review of an organisation's products and markets, the marketing
environment, and its marketing system and operations. The profitability of each product and
each market should be assessed, and the costs of different marketing activities established.
Information obtained about markets
(a) Size of the customer base. Does the organisation sell to a large number of small customers
or a
small number of big customers?
(b) Size of individual orders. The organisation might sell its products in many small orders, or
it
might have large individual orders. Delivery costs can be compared with order sizes.
c) Sales revenue and profitability. The performance of individual products can be compared.
An
imbalance between sales and profits over various product ranges can be potentially dangerous.
(d) Segments. An analysis of sales and profitability into export markets and domestic markets.
(e) Market share. Estimated share of the market obtained by each product group.
(f) Growth. Sales growth and contribution growth over the previous four years or so, for each
product group.
(g) Whether the demand for certain products is growing, stable or likely to decline.
(h) Whether demand is price sensitive or not.
(i) Whether there is a growing tendency for the market to become fragmented, with more
specialist
and 'custom-made' products.
Information about current marketing activities
 Comparative pricing
 Advertising effectiveness
Effectiveness of distribution network
 Attitudes to the product, in comparison with competitors
4.9 Competitor analysis
The dynamic nature of competition may be considered using a variety of concepts.
The cycle of competition describes the typical development of the relationship between an
established firm and a new challenger.
Hyper-competition is an unstable state of constantly shifting short-term advantage.
The industry life cycle has the following phases: inception, growth, shakeout/maturity and
decline. Each phase has typical implications for customers, competitors, products and profits.
Strategic group analysis examines the strategic space occupied by groups of close
competitors in order to identify potential competitive advantage.
The five forces model is a very useful tool for analysing the nature of competition within an
industry, but it is essentially static: it does not focus on the dynamic nature of the business
environment. The nature of competition is that future developments are not controllable by a
single firm; each competitor will exercise its own influence on what happens. The business
environment is therefore subject to constant change.

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Strategic managers must attempt to forecast what form this change is likely to take, since it is
their
responsibility to make plans that will be appropriate under future conditions.
Cycle of competition
An incumbent firm already operating successfully in an industry improves existing barriers
to entry and erects new ones. Any challenger firm wishing to enter the industry must attempt
to overcome these barriers. This does not necessarily mean attacking the market leader head-
on. This is a risky strategy in any case, because of the incumbent firm's resources in cash,
promotion and innovation. Instead, the challenger may attack smaller regional firms or
companies of similar size to itself that are vulnerable through lack of resources or poor
management.
Military analogies have been used to describe the challenger's attacking options.
(a) The head-on attack matches the target's marketing mix in detail, product for product and
so on. A limited frontal attack may concentrate on selected desirable customers.
(b) The flank attack is mounted upon a market segment, geographic region or area of
technology that the target has neglected.
(c) The encirclement attack consists of as large a number of simultaneous flank attacks as
possible in order to overwhelm the target.
(d) The bypass attack is indirect and unaggressive. It focuses on unrelated products, new
geographic areas and technical leap-frogging to advance in the market.
(e) Guerrilla attack consists of a series of aggressive, short-term moves to demoralise,
unbalance and destabilise the opponent. Tactics include drastic price cuts, poaching staff,
political lobbying and short bursts of promotional activity.
The response
If the incumbent makes no response to the initial campaign, the challenger will widen its attack
to other, related or vulnerable market segments, using similar methods to those outlined above.
On the other hand, the incumbent may respond; this will often be by means that amount to
reinforcing the barriers to entry, such as increasing promotional spending.
Military analogies have also been used to describe defensive strategies for market leaders.
(a) Position defencerelies upon not changing anything. This does not work very well.
(b) Mobile defenceuses market broadening and diversification.
(c) Flanking defenceis needed to respond to attacks on secondary markets with growth
potential.
(d) Contraction defenceinvolves withdrawal from vulnerable markets and those with low
potential. It may amount to surrender.
(e) Pre-emptive defencegathers information on potential attacks and then uses competitive
advantage to strike first. Product innovation and aggressive promotion are important features.
A challenger faced with such moves may decide to start a price war. The disadvantage of this
is that it will erode the company's own margins as well as those of the incumbent, but it does
have the potential to reshape the market and redistribute longer-term market share.
Fighting back
An incumbent faced with a vigorous and resourceful challenger may decide in turn to attack
the entrant'sown base, perhaps by cutting prices in its strongest market. This may cause the
challenger to move on towards entry into another attractive market as it seeks to expand.
Resource implications
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Both attacking and defending require the deployment of cash and strategic skill. In particular,
extending competition to new geographical and national markets can raise the risks and costs
involved in operating.
Hypercompetition
It is possible for competition in an industry to cycle fairly slowly, with extended periods of
stability. This allows the careful building of competitive advantages that are difficult to imitate.
Hypercompetition, by contrast, is a condition of constant competitive change. It is created by
frequent, boldly aggressive competitive moves. This state makes it impossible for a firm to
create lasting competitive advantage; firms that accept this will deliberately disrupt any
stability that develops in order to deny long-term advantage to their competitors. Under these
conditions, continuing success depends on effective exploitation of a series of short-term
moves.
The industry life cycle
Industries may display a lifecycle: this will affect and interact with the five forces.
Later in this Study Text, we will discuss the concept of the product life cycle: this is a well
established strategic and marketing tool. It may be possible to discern an industry life cycle,
which will have wider implications for the nature of competition and competitive advantage.
This cycle reflects changes indemand and the spread of technical knowledge among
producers. Innovation creates new industry, and this is normally achieved through product
innovation. Later, innovation shifts to processes in order to maintain margins. A summary of
the overall progress of the industry lifecycle is illustrated below.to the extent that it inhibits
rivalry.
Inception Growth Shakeout/maturity Decline
Product Basic, no Improved Standardised Varied quality but
characteristics standards design and product with little fairly
established quality, differentiation undifferentiated
differentiated
Competitors None to few Many Competition Few remain.
entrants increases, weaker Competition may
players leave be on price
(shakeout)
Buyers Early adopters, More Mass market, Enthusiasts,
prosperous, customers brand switching traditionalists,
curious must be attracted and common sophisticates
induced aware
Profit Negative – high Good, Eroding under Variable
first mover possibly pressure of
advantage starting to competition
decline
Technology No standards Technologies Technology is Technology is
established become more understood across understood across
standardised the industry the industry
Product Small scale batch Mass Long production Overcapacity.
processes production. production. runs. Cost Production is
Specialised Distribution efficiency reduced
distributors networks critical
expanded

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Each phase has different implications for competitive behaviour and corporate strategy eg if an
industry is growing, the organisations in that industry can grow as the market develops. In a
mature industry, growth can only be achieved by stealing market share from other competitors
and typically the market becomes more fragmented.
Costs faced by organisations will also vary at different stages in the industry lifecycle. For
example,
research and development costs will be very high in the inception phase. Production costs may
be low during the maturity stage as processes have been refined and contracts negotiated, but
marketing expenditure may be high in order to protect market share.
4.9. Financial returns to an industry also vary according to the lifecycle stage.
The shakeout and maturity phases are often presented together due to the strong overlap
between the two. The following table presents both phases separately to illustrate how the
characteristics of the industry subtly change between shakeout and maturity. The shakeout
phase is characterised by a slowing in market growth which leads to weaker players being
forced out of the industry. By the time the industry reaches maturity, fewer players remain, but
they are forced to compete more fiercely to increase revenue by gaining market share

Sales Volume
Inception Growth Shakeout Maturity Decline

Time
The shakeout and maturity phases are often presented together due to the strong overlap
between the two. The following table presents both phases separately to illustrate how the
characteristics of the industry subtly change between shakeout and maturity. The shakeout
phase is characterised by a slowing in market growth which leads to weaker players being
forced out of the industry. By the time the industry reaches maturity, fewer players remain, but
they are forced to compete more fiercely to increase revenue by gaining market share.
Inception Growth Shakeout Maturity Decline
Customers Experimenters, Early Growing Mass market, Price
innovators adopters selectivity of Products competition
purchase well Commodity
known product
R&D High Extend Seek lower Low
product cost
before methods of
competition supply to
access
new markets
Company Early mover React to Potential Battles over Cost control

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 Production more consolidation market share. or
focused competitors through Seek cost exit
with taking over reduction.
increased rivals. Long Long
marketing production production
mass runs runs
production
Competitors A few More Many Depending Price-based
No major entrants competitors, on competition,
barriers to to the market price cutting industry, a fewer
entry but few competitors
weeding out large
of competitors
weaker Difficult for
players newcomers
to
dislodge
entrenched
companies
Profitability Low or Growing Levelling off Stable, high Falling,
negative, as an or unless
investment under cost control
pressure

The industry life cycle has strategic implications for organisations operating in that industry.
Management must pursue different strategies at each stage.
Inception stage
Attract trend-setting buyer groups by promotion of technical novelty or fashion
Price high (skim) to cash in on novelty, or price low (penetration) to gain adoption and high
initial
share
Support product despite poor current financial results
Review investment program periodically in light of success of launch (eg delay or bring
forward
capacity increases)
Build channels of distribution
Monitor success of rival technologies and competitor products
Growth stage
Ensure capacity expands sufficiently to meet firm's target market share objectives
Penetrate market, possibly by reducing price
Maintain barriers to entry (eg fight patent infringements, keep price competitive)
High promotion of benefits to attract early majority of potential buyers
Build brand awareness to resist impact from new entrants
Ensure investors are aware of potential of new products to ensure support for financial
strategy
Search for additional markets and product refinements (ie market penetration)
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Consider methods of expanding and reducing costs of production (eg contract manufacturing
overseas, building own factory in a low cost location)
Product development
Shakeout phase
Monitor industry for potential mergers and rationalisationbehaviour
Periodic review of production and financial forecasts in light of sales growth rates
Shift business model from customer acquisition to extracting revenue from existing customers
Seek to extend growth by finding new markets or technologies
Maturity phase
Maximise current financial returns from product
Defend market position by matching pricing and promotion of rivals
Modify markets by positioning product to gain acceptance from non-buyers (eg new outlets or
suggested new uses)
Modify the product to make it cheaper or of greater benefit
Intensify distribution
Leverage the existing customer database to gain additional incomes
Engage in integration activities with rivals (eg mergers, mutual agreements on competition)
Ensure successor industries are ready for launch to pick up market
Decline phase
Harvest cash flows by minimising spending on promotion or product refinement
Simplify range by weeding out variations
Narrow distribution to target loyal customers and reduce stocking costs
Evaluate exit barriers and identify the optimum time to leave the industry (eg leases ending,
need
for renewal investment)
Seek potential exit strategy (eg buyer for business, firms willing to buy licencesetc)
The response of competitors is particularly important – there may be threats as they attempt to
defend their position, or opportunities, eg when a competitor leaves the market.
Inception Growth Maturity Decline
Product Correct any Ensure product Product Assess if it is
problems in quality is efficiency possible to
product design maintained Cost control modify product
Improve despite volume Quality control so that life
features to growth (minimise cycle is started
develop Look at ways to defective again
competitive improve quality products)
advantage and design to Only the most
sustain productive/
competitive efficient firms
advantage will survive
Marketing Establish product Market Marketing Advertising
position and penetration aimed at and promotion
target Establish maintaining is minimised
markets market customer
Develop niche for loyalty

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 product product
awareness Establish brand
(advertising; loyalty: heavy
promotion) media use,
product samples
and other
promotions
Establish
distribution
capabilities to
support
increased
production
HR Establish staff Training and Personnel Staff
requirements development of incentives to transferred to
Recruiting staff to deal with improve products in
staff competitive productivity earlier stages
pressures as and efficiency of life cycle
competition gets
tougher
Finance Arrange funding Liquidation
for (worst case
product scenario)
development and
marketing
Assess capital
requirements for
production
facilities
which may be
needed for
increased
capacity
in growth phase

The industry life cycle model is an important concept that may illuminate some aspects of
strategic
thought. Like other models, it has some value for analysis, for forecasting trends and for
suggesting
possible courses of action, but it would be a mistake to attempt to apply it to all industries at all
times.
Proper attention must always be paid to current circumstances and options.
4.10 Strategic group analysis
Five forces analysis deals with the competitive environment in broad industry-wide terms. It
is possible to refine this by considering strategic groups. These are made up of organisations
with similar strategic characteristics, following similar strategies or competing on similar
bases. Such groups arise for a variety of reasons, such as barriers to entry or the attractiveness
of particular market segments. The strategic space pertaining to a strategic group is defined by
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two or three common strategic characteristics. Here are some examples of such characteristics.
Product diversity
Geographical coverage
Extent of branding
Pricing policy
Product quality
Distribution method
Target market segment
A series of 2-axis maps may be drawn up, using selected pairs of these characteristics to define
both the extent of the strategic space and any unfilled gaps that exist within it. (A similar
technique is used for specific products and is illustrated later in this chapter: this is product
positioning.)
The identification of potential competitive advantage is the reason foranalysing strategic
groups. It improves knowledge of competitors and shows gaps in the organisation's current
segments of operations.
It may also reveal opportunities for migration to more favourable segments. Strategic problems
may also be revealed.
Industry convergence
A couple of contemporary environmental influences should be mentioned. The first is industry
convergence. Here industries which had historically been separate for some reason come
together so that more diverse others products or services are now offered by the same supplier.
Examples can be airlines which now offer car hire, hotels, and insurance.

Technology can form a big part in the convergence of industries. For example in a
telecommunications industry whose considerable convergence between landline, mobiles, and
voice over internet telephone providers. There is increasing convergences of products which
provide mobile phone access, WiFi access, music, photographs, diaries (think of the Apple
iPhone which will do all of these things. You can also see convergence in complementary
products. If a company makes digital camera it might also be worthwhile for it to offer printers
and computers. The pressure to converge, can be driven by consumers, who may want to go to
only one source for a variety of products, or it could be driven by production and convergence
of the products and technology which can lead to cost benefits.

The international dimension

The second contemporary influence to be aware of is the international dimension. More and
more organizations have global presence. Products and services are converging so that the
same products can be found in many countries. This gives the producers great cost advantages,
not only in purchasing raw materials but also to cover the research and development and
marketing costs.
Local companies can also manufacture their products where it is cheapest to do so. Note that
when a company enjoys sales on a global basis it is also usually facing competition on a global
basis, and many weaker companies find it difficult to compete in that fierce environment.
Because many of the global businesses are very large and significant, governments can also
take an interest in their activities. In particular, valuable grants can be offered to companies to

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encourage them to open manufacturing plants in certain countries. Additionally, governments
may sometime protect their home industries against the foreign competition.

You will probably be aware that some people feel that large multi-national companies are bad
for society. Anti-globalization protesters claim that these vary large companies stifle and
exploit local economies, reduce consumer choice, have an undue influence on how countries
are run and are too concerned with making profit when they should give more attention to
social and ecological issues.
Whether or not you believe large multinationals are good or bad, you should be aware that it is
usually important for these companies to be aware of certain stakeholders’ views.

Porter’s diamond
Still dealing with the international dimension, it is clear that many countries enjoy reputations
for certain products and services. For example:
• Germany is associated with good car making
• Japan is strong with respect to micro-electronics and cameras.
• France is strong with respect to wine.
• The UK (at least until recently!) was associated with a strong financial services industry
Michael Porter began to wonder how countries can achieve such international reputations and
he concluded that there were four influences.

Factor conditions: Some countries enjoy natural advantages. For example, France starts with an
advantage wine. Germany has an abundance of iron ore, ready to be used in the car and other
industries. Climate and natural resources are known as basic factors. In addition, countries can
develop advanced factors such as their transport infrastructure, telecommunications, and
educational system. Germany, for example, has a strong tradition in engineering training and
education and this gives their car industry great assistance.
Demand conditions: The first step in developing a global presence is to start at home and the
impetus to do this is known as (home) demand conditions. So, it is argued that Germany
produces good cars because initially the German people demanded good solid engineering. The
UK had been a major trading and manufacturing nation until the mid-1900s and this led to the
development of skilled financial services and law firms to support international commerce.

Firms’ strategy, structure and rivalry. Concentrate on rivalry: having a monopoly in the home
market is unlikely to give you a major world presence. To be world beating you have to be
really good at home and this home excellence will allow you to complete against the best of the
world. Germany is perhaps really good in making cars because it has within that country
Volkswagen, Mercedes, BMW and Porsche, all of are good companies competing with one
another, and this allows them to become world-class.

Related and supporting industries. Successful industries often enjoy the benefits arising from a
cluster of related and supporting industries. For example in the West Coast of America there
are software firms, hardware firms and research institutes. Employees move around from one
firm to another and a whole centre of expertise is developed. Similarly, in Scotland in the
Scotch whisky industry, farmers can provide the grain; peat suppliers provide peat to give the
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spirit flavour. There are factories which produce or recondition the barrels, and there are large,
efficient bottling plants. Not only do these related and supporting industries from efficient
clusters of industries, but also they can work together so that the products become
differentiated and uniquely good.

Porter’s five forces

Porter’s five forces model is a popular and useful framework with which to analyse industry
attractiveness. Industry attractiveness refers to how easy a business will find it to make
reasonable profits. By ‘reasonable profits, we mean profits large enough to compensate
investors for their risks and also to make enough money to reinvest to keep the company
successful. We should be looking for sustainable success. in the wine industry because of its
climate and soil. Finland, however, is never likely to be good at producing

POTENTIAL
ENTRANTS
SUPPLIERS
COMPETITIORS/ BUYERS
RIVALRY

SUBSTITUTES

Rivalry: Competition, or rivalry, can range from:

• Perfect competition, where sellers have no choice as to the selling price that is charged – they
have to charge the market price. to
• Monopoly, where sellers have much more choice as to what price to charge. Changes in price
will normally alter demand, revenue and profits. But remember, just because you have a
monopoly doesn’t mean you will make profits. You might be the monopoly supplier of
something nobody wants. By and large the nearer an industry gets to a monopoly the easier
time its participants will have. Therefore, provided its legal, it could therefore be a useful
strategy to take over a rival or to force it out of business by perhaps lowering prices
temporarily. Governments tend to be wary of companies which establish powerful monopolies
(Microsoft got into trouble over Internet Explorer which it included with its Windows
operating system, making it very difficult for other browsers to compete). Most jurisdictions
have anti-monopoly or antitrust legislation.
• Buyer pressure. If buyers are very powerful then they can exert pressure on prices, quality
and delivery times. Selling almost all output to a few powerful buyers will be an uncomfortable
situation. The more buyers you have, and the harder it is for them to switch between different
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suppliers the better.
Businesses should try to build in switching costs, that is real costs or impediments that mean
that buyers will prefer to stay with existing suppliers. Another way of trying to decrease buyer
pressure is to try to enter long-term contracts with major customers. You might have to
compromise on price, but get greater certainty of sales.
• Supplier pressure. Similarly, when you are buying goods from suppliers, if you have to buy a
special component from a monopoly supplier you will be in an uncomfortable position. That
supplier can raise prices almost arbitrarily and you have to pay what they ask. Even worse, that
supplier could be taken over by one of your competitors and then you will have no supplies at
all. Ideally firms should try to multi-source, and if they get really worried about assurance of
supply they should think about setting up their own supply operation or perhaps taking over an
existing supplier.
• New/potential entrants. Potential entrants are sitting on the edge of the industry and may be
attracted in if they can see that good profits can be made. Anything which keeps out potential
entrants is known as a barrier to entry. Barriers to entry include:
• A legal monopoly within the business. This is rare, but is sometimes seen. For example, many
postal services operate as monopolies.
• Regulation and licence requirements can make it hard for potential entrants to get into some
business sectors. For example, setting up as a bank is relatively difficult because of the various
regulatory authorities that have to give their permission,
• The need for high capital expenditure increases risk and the difficulty of raising finance.
• Know-how. Some businesses are complex and acquiring the necessary skills and knowhow
can deter new entrants.
• Unique, patented processes. If you own a unique, valuable patent, no one else can use it and
so your position is protected. Some pharmaceutical companies can make use of drug patents to
secure their positions.
• Substitute products usually arise by the advance of technology. Often the appearance of
substitutes will surprise a business and take it off guard. For example, landline telephone
companies thought that they were almost in a monopoly position because of the huge cost of
entry to the market: digging up roads and laying landlines into our houses, apartments, and
businesses would have been a considerable barrier to entry. However, then mobile telephones,
cell phone technology, was invented and good telephone coverage could be achieved with
much less expense. There is not much a business can do here. Once technology is invented it
can’t really be send back. Most old industries have to join the new industries to maintain their
market share. So now, many conventional telephone companies also have mobile phone
networks in an attempt to retain their overall market share in telecommunications.

4.11 Product profitability analysis

Product Profitability compares individual products to one another from a post-allocated
perspective. Viewing product margins from this perspective allows an institution to accurately
see how profitable each product is and how it compares to other products. This helps an
institution gain a more accurate picture of how products are contributing to the overall net
interest margin.

Product profitability is designed with the following built-in features:

Funds Transfer Pricing
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Enables an institution to allocate funds in a fair, predetermined manner and helps the institution
gain a more accurate picture of how individual products are contributing to the overall net
interest margin.
Revenue and Expense Allocation Rules
Provides built-in, standard allocation rules based on industry best practices. These rules can be
customized by the institution as needed.
Capital Allocation Methods
Enables an institution to determine historical and forecasted return on equity (ROE)
calculations using simple-to- complex capital allocations.
Profit Forecasting
Provides forecasting tools for analyzing multiple profit scenarios both pre- and post-allocated.
Activity Based Costing (ABC)
Provides a two-stage allocation process that allocates resources to the activities that consume
them, then to the products that benefited from the activities.
Report Wizard
Generates standard or custom reports in seconds.
User-Defined Graphs
Provides customized, full-color graphs that are easy to understand and visually appealing.

4.12 Financial performance

Product profitability is an innovative business intelligence solution that enables diverse
financial institutions to maximize their performance and profits with accessible, accurate, and
timely decision support and business intelligence information. Setting up and managing this
cost accounting system is simple. The client support team sets up an institution’s custom chart
of accounts, allocation rules, and funds transfer pricing method, and also provides introductory
training.
Product profitability, simply defined, is the difference between the revenues earned from, and
the total costs associated with, a product over a specified period of time. Product Profitability
Analysis
Product profitability analysis requires that all relevant costs are traced to products and then
matched to their corresponding revenues. Such analysis can then inform wide range of
management decisions such as product pricing and product portfolio analysis.
Achieving Product Profitability
 Looking beyond revenue and gross margins to uncover hidden profits and losses.
 By factoring in the real costs associated with each product, you are able to make
adjustments.
 Requires a level of accuracy and granularity.
 Requires accurate data capture and analysis at every point.
 Modelling your business processes so that you are able to make good decisions that
lead to profitable adjustments.
Benefits of Product Profitability
 A clear view of which products and product mixes are cost effective. In addition to
managing current results the analysis can refine product pricing strategies
 Single source of product data that can be utilized across the enterprise to facilitate atrue
common reporting platform for product profitability
 Real-time analytic capability of what discounts can be given to customers while
accurately assessing the impact on margins to ensure margin protection

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  Provide ‘what-if’ analysis for changes in the cost base allowing for re-forecasting
andpreparation for changeable commodity markets
 Identify areas of growth in margin not just in revenue and accurately
forecastprofitability of new products and proposed product mixes

Profit Parameters
Gross Margin = Revenue – Cost of goods sold.
All costs are manufacturing costs. Some of them are fixed costs.
Contribution margin = Revenue – Variable costs
Some variable costs are manufacturing costs, but some may be non-manufacturing costs. None
are fixed costs.
Gross margin percent = Gross margin/Revenue
Contribution margin percent = Contribution margin/Revenue
Profit Accounting Model
• The fundamental accounting equation
Profit = Revenues – Costs
Revenue = SP * units sold
SP = selling price
Costs = FC + VC(units manufactured)
FC = fixed cost
VC = unit variable costs
Cost-Volume-Profit Analysis
Changes in the level of revenues and costs arise only because of changes in the number of
product (or service) units produced and sold.
Total costs can be divided into a fixed component and a component that is variable with
respect to the level of output.
Case Study – Cost-Volume-Profit Analysis
A Company manufactures and sells pens. Present sales output is 5,000,000 per year at a selling
price of frw.5 per unit. Fixed costs are frw 9,000,000 per year. Variable costs are frw2 per unit
Absolute Profitability
Absolute profitability measures the impact on the organization’s overall profits of adding or
dropping a particular segment such as a product or customer – without making any other
changes
Computing Absolute Profitability
For an Existing Segment
Compare the revenues that would be lost from dropping that segment to the costs that wouldbe
avoided.
For a New Segment
Compare the additional revenues from adding that segment to the costs that would be incurred
Relative Profitability
Relative profitability is concerned with ranking products, customers, and other business
segments to determine which should be emphasized in an environment of scarce
Managers are interested in ranking segments if a constraint forces them to make trade-offs
among segments.
In the absence of a constraint, all segments that are absolutely profitable should be pursued.
Relative Profitability
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Here is information developed by themanagement of Matrix, Inc. concerning its twosegments
Product positioning
A product's positioning defines how it is intended to be perceived by customers and how it
differs from current and potential competing products. It is not always possible to identify a
market segment where there is no direct competitor, and a marketing problem for the firm will
be the creation of some form of product differentiation (real or imagined) in the marketing
mix of the product. The aim is to make the customer perceive the product as different from its
competitors.
A perceptual map of product positioning can be used to identify gaps in the market. This
example mightsuggest that there could be potential in the market for a low-price high-quality
bargain brand. A company that carries out such an analysis might decide to conduct further
research to find out whether there is scope in the market for a new product which would be
targeted at a market position where there are few or no rivals. (A firm successfully pursuing
cost leadership might be in a good position to offer a bargain brand.)
Topical questions
10. Explain the environmental analysis using PESTEL
11. Explain the application of SWOT analysis in the strategic planning
12. Explain the primary and supporting activities of value chain analysis
13. Critique the porter’s value chain model
14. Comment on the different costs that affect customer profitability analysis
15. Explain the customer life cycle
16. Explain the different techniques that can be used to compete in the market
17. Write short notes on the following
e. Life cycle of industry
f. Strategic group analysis
g. Porter’s diamond model
h. Porter’s five force model
18. A company has prepared the following standard cost card:
$ per unit
Materials (4 kg at $4.50 per kg) 18
Labour (5 hrs at $5 per hr) 25
Variable overheads (5 hrs at $2 per hr) 10
Fixed overheads (5 hrs at $3 per hr) 15
$68
Budgeted selling price $75 per unit.
Budgeted production 8,700 units
Budgeted sales 8,000 units
There is no opening inventory
The actual results are as follows:
Sales: 8,400 units for $613,200
Production: 8,900 units with the following costs:
Materials (35,464 kg) 163,455
Labour (Paid 45,400hrs; worked 44,100 hrs) 224,515
Variable overheads 87,348
Fixed overheads 134,074
Required: carry out a cost analysis

CHAPTER FIVE: STRATEGIC PERFORMANCE MEASUREMENTS: FINANCIAL,

NON-FINANCIAL, AND MIXED
5.1 Introduction to planning and control
5.1.1 Definitions
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Planning and control are fundamental aspects of performance management.
Strategic planning is concerned with:
 Where an organisation wants to be (usually expressed in terms of its objectives) and
 How it will get there (strategies)

Control is concerned with monitoring the achievement of objectives and suggesting corrective 
action.
5.1.2 Planning and control at different levels within an organization
Planning and control takes place at different levels within an organisation. 
The performance hierarchy operates in the following order:
(1) Mission
(2) Strategic (corporate) plans and objectives
(3) Tactical plans and objectives
(4) Operational plans and targets. 
5.1.3 Mission
A mission statement outlines the broad direction that an organization will follow and
summarizes the reasons and values that underlie that organization.
A mission should be:
 Memorable
 Enduring, i.e. the statement should not change unless the entity's mission changes
 A guide for employees to work towards the accomplishment of the mission
 Addressed to a number of stakeholder groups, for example shareholders, employees and 
customers.

The mission forms a key part of the planning process and should enhance organizational perfor
mance:
 It acts as a source of inspiration and ideas for the organisation’s detailed plans and obje
ctives.
 It can be used to assess the suitability of any proposed plans in terms of their fit with th
e organization’s mission.
 It can impact the day to day workings of an organisation, guiding the organisational cult
ure and business practices used.

A change in the mission statement may result in new performance measures being established
to monitor the achievement (or otherwise) of the new mission.
5.1.4 Strategic, Tactical and Operational plans
To enable an organization to fulfill its mission, the mission must be translated into strategic,
tactical and operational plans. Each level should be consistent with the one above. This process
will involve moving from general broad aims to more specific objectives and ultimately to
detail targets.
Strategic planning is usually, but not always, concerned with the long-term.
It raises the question of which business shall we be in?  For
example, a company specialising in production and sale of tobacco
products may forecast a declining market for these products and may therefore decide to chang
e its objectives to allow a progressive move into the leisure industry, which it considers to be e

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xpanding.
Strategic planning is characterized by the following:
 long-term
 considers the whole organization as well as individual SBUs
 matches the activities of an organisation to its external environment
 matches the activities of an organisation to its resource capability and specifies future re
source requirements
 will be affected by the expectations and values of all stakeholders, 
not just shareholders
 Its complexity distinguishes strategic management from other aspects of management i
n an organization. There are several  reasons for this including: 
- it involves a high degree of uncertainty
- it is likely to require an integrated approach to management
- it may involve major change in the organization.

Quite apart from strategic planning, the management of an organisation has to undertake a regu
lar series of decisions on matters that are purely tactical, operational and short-
term in character. Such decisions:
 are usually based on a given set of assets and resources
 do not usually involve the scope of an organization’s activities
 rarely involve major change in the organization
 are unlikely to involve major elements of uncertainty and the techniques used to help m
ake such decisions often seek to  minimize the impact of any uncertainty
 Use standard management accounting techniques such as cost-volume-profit
analysis, limiting factor analysis and linear programming.

5.1.5 The role of performance management in planning and control

Performance management is any activity that is designed to improve the organization’s
performance and ensure that its goals are met.
 Planning will take place first to establish an appropriate mission and objectives.
 Performance management techniques will then be used to ensure that the most appropri
ate strategy is defined and executed in order to achieve the organization’s mission and o
bjectives.
 Finally, performance management will aim to measure whether the mission and objecti
ves are being achieved and to recommend any improvement strategies that are required.

Performance management aims to direct and support the performance of all employees and
departments so that the organization’s goals are achieved. Therefore, any performance
management system should be linked to performance measures at different levels of the
hierarchy.
One model of performance management that helps to link the different levels of the hierarchy i
s the performance pyramid. The performance pyramid derives from the idea that an
organization operates at different levels, each of which has a different focus. However, it is that
these levels support each other.
It translates objectives from the top down and measures from the bottom up, the aim being that
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these are coordinated and support each other.
5.1.6 The role of strategic (corporate) planning in clarifying corporate objectives
Corporate objectives concern the business as whole and focus on the desired performance and
results that a business intends to achieve. The first stage of the strategic planning process,
strategic analysis will generate a range of objectives, typically relating to:
 maximization of shareholder wealth
 maximization of sales
 growth
 survival
 research and development
 leadership
 quality of service
 contented workforce
 Respect for the environment.

These need to be clarified in two respects:
 conflicts need to be resolved, e.g. profit versus environmental  concerns
 To facilitate implementation and control, objectives need to be translated into SMART 
(specific, measurable, achievable, relevant and time bound) targets.

Illustration
A statement such as “maximize profits” would be of little use in corporate planning terms.
The following would be far more helpful:
 achieve a growth in EPS of 5% pa over the coming ten year period
 obtain a turnover of $10 million within six years
 Launch at least two new products per year.

5.1.7 The role of strategic (corporate) planning in checking towards the objectives set
It is not enough merely to make plans and implement them.
 The results of the plans have to be compared against stated objectives to assess the
firm’s performance
 Action can then be taken to remedy any shortfalls in performance

Strategic (corporate) planning is not a once-in-every-ten-years activity, but an ongoing process

which must react quickly to the changing circumstances of the firm and of the environment.
5.1.8 Objectives, critical success factors and key performance indicators
Once an organisation has established its objectives, it needs to identify the key factors and proc
esses that will enable it to achieve those objectives.
Critical success factors (CSFs) are the vital areas where things must go right for the business in
order for them to achieve their strategic objectives. The achievement of CSFs should allow the
organization to cope better than rivals with any changes in the competitive environment and to
maximize performance.
Key Performance Indicators (KPIs) are the measures which indicate whether or not the CSFs
are being achieved.
Illustration

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A news papers delivery service, such as DHL, may have an objective to increase revenue by
5% year on year. The business will establish CSFs and KPIs which are aligned to the
achievement of this objective, for example:
CSFs KPIs
Speed collection from customers after their Collection from customers within three hours
request for news papers to be delivered of receiving the orders in any part of the
country for orders received before 2:00 pm on
a working day
Rapid and reliable delivery Next day delivery for destinations within
Kigali or delivery within 2 days for
destinations outside kigali

The organization will need to have in place the core competences that are required to achieve
the CSFs, i.e. something that they are able to do that is difficult for competitors to follow.
KPIs are essential to the achievement of strategy since what gets measured gets done, i.e.
things that are measured get done more often than things that are not measured.
Care must be taken when choosing what to measure and report. An unbalanced set of indicators
may be valid for fulfilling the short term needs of the organization but will not necessarily
result in long term success. The balanced scorecard approach will seek to address this and is
discussed in the later pages.
The strategic management accountant plays a key role in performance management helping to
determine the financial implications of an organization’s activities and decisions and in
ensuring that these activities are focused on shareholders’ need for profit.
5.1.9 The triple bottom line
Whilst all businesses are used to monitoring their profit figures, there are also environmental
and social aspects to consider in the long term. The triple bottom line focuses on economic,
environmental and social areas of concern.
Economic performance focuses on monitoring the financial performance of the organization to
ensure its continued prosperity and fulfillment of shareholders’ needs.
Environment performance focuses on reducing waste, increasing recycling and using energy
efficient equipment.
Social performance focuses on contributing by company to community projects.
5.1.10 Gap analysis
Gap analysis is carried out as the final part of strategic analysis. It identifies the planning gap.
This is the difference between the desired and the expected performance. The planning gap is
often measured in terms of demand but may also be reported in terms of earnings, return on
capital employed etc.
5.1.11 Current issues and trends in performance management
The area of performance management is constantly evolving. The techniques and systems used
today are very different from those of 50 years ago and there are current issues and pressures
which are likely to lead to further developments:
 changes in technology may have a significant impact on measuring  performance
 a recognition that there is a broader picture than just financial  performance
 issues relating to governance

The availability of more data does not automatically mean that there is more useful
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information. It is still important to ensure that the data is interpreted to ensure that it is useful.
Performance management is about more than the information produced. However much
information is provided, what is important is how it is used and how the organization acts in
response to it.
There is a growing recognition that the performance of organizations depends on more than
purely financial performance. There has been a significant growth in the use of non-financial
measures of performance. Techniques have been developed to enable measurement of
performance in a number of different dimensions, and this trend looks set to continue.
Examples are the balanced scorecard and the performance prism. Historically, the focus of
performance management has been on outputs of the organization’s activities. Organizations
are now beginning to focus on outcomes, or achievements, and then using output measures to
achieve those outcomes. In addition, there is recognition that everyone in the organization
needs to be involved in performance management; there is also a need to extent involvement
outside the organization to the entire supply chain, as organizations recognize that others have
an influence on their performance.
Over recent years, the issue of corporate governance has become a major area for concern in
many countries. Organizations are now under increased pressure to demonstrate that they are
effectively managed. This has led to pressure to demonstrate improvements in performance,
more demands for accountability from external agencies, legislation and regulation relating to
performance reporting and companies are looking for ways to measure and report on
improvements in governance.
5.2 Performance measurement techniques
Performance measurement is the monitoring of budgets or targets against actual results to
establish how well the business and its employees are functioning as a whole and as
individuals.
Performance measurements can relate to short-term objectives (e.g. cost control) or longer-
term measures (e.g. customer satisfaction).The performance measurement techniques are:
financial, non-financial, balanced scorecard, benchmarking.
5.2.1 External factors affecting performance measurement
External factors may be an important influence on an organization’s ability to achieve
objectives. In particular market conditions and government policy will be outside of the control
of the organization’s management and will need to be carefully monitored to ensure forecasts
remain accurate.
Economic and market conditions
Any performance measure that is used by a business will need to be flexible to allow for peaks
and troughs in economic and market conditions that are beyond the control of the business or
the specific employee or manager.
The actions of competitors must also be considered. For example, demand may decrease if a
competitor reduces its prices or launches a successful advertising campaign.
Government regulation
The government can have a direct effect on the workings of a private sector organization by
introducing regulations or by having departments that monitor business activity.
If a private sector organization is affected by government regulation then the performance
measures should take account of this externally imposed limitation i.e. a sales team target
should not exceed a quota or exceed/undercut a price set by the government.
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Public Sector organizations are owned and controlled by the government (or local
government). They aim to provide public services, often free at the point of delivery. Their
purpose is to provide a quality service to the public, for example a state school, the provision of
water and sewerage services, refuse collections. The measurement of performance is much
harder for public sector organization the standard of the service will be based on opinions or
feelings and not necessarily fact.
If we are trying to compare the performance of a private organization with that of a public
organization the differences in strategy need to be considered. This can be seen in the
summarized table below showing the differences between a private school and a state school.
Strategic feature Private school State school
General strategic goal competitiveness Achievement of mission
values Innovation, creativity, Accountability to public
goodwill, recognition integrity, fairness
Desired outcome Customer satisfaction Customer satisfaction
stakeholders Fee payers Taxpayers, inspectors,
legislators
Budget defined by Customer demand Leadership, legislators,
planners
Key success factors Growth rate, earnings, market Best management practices,
share, uniqueness, advanced standardization, economies of
technology scales, standardized
technology

5.2.2 Financial performance measures

Financial performance measures are used to monitor the inflows (revenue) and outflows (costs)
and the overall management of money in the business. These measures focus on information
available from the Statement of profit or loss and Statement of financial position of a business.
Financial measures can be used to record the performance of cost centers, profit centers and
investment centers within a responsibility accounting system but they can also be used to
assess the overall performance of the organization. For example, if cost reduction or cost
control is identified as a critical success factor, cost based performance measures might be an
appropriate performance indicator to be used.
Cost based performance measures can be calculated as a simple cost per unit of output. The
organization will have to determine its policy for establishing cost per unit for performance
measurement purposes. The chosen method should then be applied consistently. One of the
tools used to measure financial performance of a company is ratios. Ratios such as liquidity
ratios, profitability rations, efficiency ratios, and gearing ratios have been discussed in previous
modules; few of them are discussed here.
Measuring profitability
The primary objective of a profit seeking company is to maximize profitability. A business
needs to make a profit to be able to provide a return to any investors and to be able to grow the
business by reinvestment.
Three profitability ratios are often used to monitor the achievement of this objective:
 Return on capital employed (ROCE) = operating profit ÷ (noncurrent liabilities + total
equity) %
 Return on sales (ROS) = operating profit ÷ revenue %

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  Gross margin = gross profit ÷ revenue %

NOTE: Operating profit is profit before interest and tax and after nonproduction overheads
have been charged.
Return on capital employed (ROCE)
There are two metrics required to calculate the Return on Capital Employed - earnings before
interest and tax and capital employed. Earnings before interest and tax (EBIT), also known as
operating income, shows how much a company earns from its operations alone without regard
to interest or taxes. EBIT is calculated by subtracting cost of goods sold and operating
expenses from revenues.
Capital employed is the sum of shareholders ‘equity and debt liabilities. Also, it can be
simplified as total assets minus current liabilities. Instead of using capital employed at an
arbitrary point in time, analysts and investors often calculate ROCE based on the average
capital employed, which takes the average of opening and closing capital employed for the
time period.
This is a key measure of profitability as an investor will want to know the likely return from
any investment made.
ROCE is the operating profit as a percentage of capital employed. It provides a measure of how
much profit is generated from each $1 of capital employed in the business.
Operating profit (profit before interest) is being compared to long term debt (noncurrent
liabilities) plus the equity invested in the business.
Operating profit represents what is available to pay interest due to debt and dividends to
shareholders so the figures used are comparing like for like.
A high ROCE is desirable. An increase in ROCE could be achieved by:
 Increasing profit, e.g. through an increase in sales price or through better control of
costs.
 Reducing capital employed, e.g. through the repayment of long term debt.

Return on sales (operating margin) or

This is the operating profit as a percentage of revenue. A high return is desirable. It indicates
that either sales prices and or volumes are high or that costs are being kept well under control.
Asset turnover
Asset turnover = Revenue ÷ Capital employed
The asset turnover measures how much revenue is generated from each $1 of capital employed
in the business.
A high asset turnover is desirable. An increase in the asset turnover could be achieved by:
 Increasing revenue, e.g. through the launch of new products or a successful advertising
campaign.
 Reducing capital employed, e.g. through the repayment of long term debt.

Having the ROS and Asset Turnover,

ROCE = ROS x Asset turnover
ROCE = [(operating profit ÷ revenues) x 100] x (revenues x capital employed)
This can be useful if only partial information is available. For example if the ROS and Asset
turnover ratios are known then the ROCE can be calculated
Illustration: ROCE, ROS, and asset turnover
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 X Y
Revenue 80,000 200,000
Operating profit 10,000 10,000
Capital employed 50,000 50,000
It is possible to calculate ROCE, ROS and Asset turnover from the above information to
examine the relationship between these 3 ratios.
Company X
ROCE = 10,000 ÷ 50,000 × 100 = 20%
ROS = 10,000 ÷ 80,000 × 100 = 12.5%
Asset turnover = 80,000 ÷ 50,000 = 1.6
ROCE = ROS × Asset turnover = 0.125 × 1.6 = 0.2 = 20%
Company Y
ROCE = 10,000 ÷ 50,000 × 100 = 20%
ROS = 10,000 ÷ 200,000 × 100 = 5%
Asset turnover = 200,000 ÷ 50,0000 = 4
ROS = ROCE ÷ Asset turnover = 0.2 ÷ 4 = 0.05 = 5%
Gross margin
The gross margin focuses on the trading activity of a business as it is the gross profit (revenue
less cost of sales) as a percentage of revenue.
A high gross margin is desirable. It indicates that either sales prices and or volumes are high or
that production costs are being kept well under control.
Earnings per Share
Investors who buy shares in a company want to be able to compare the benefits from their
investment with the amount they have paid, or intend to pay for their shares. There are two
measures of benefits to the investors. One is profit for the period (usually named earnings when
referring to the profits available for equity shareholders). The other is the dividend which is an
amount of cash that is paid to the shareholders. Profit indicates wealth created by business. The
wealth may be accumulated in the business or else paid out in the form of dividend. EPS is a
financial ratio, which divides earnings available to equity shareholders by the total number of
shares issued over a certain period of time. The EPS formula indicates a company’s ability to
produce net profits for equity shareholders.
Earnings per Share = profit after tax for ordinary shareholders ÷ number of issued ordinary
shares
Note: some accountant use outstanding ordinary shares.
Earnings before Interest, Tax, Depreciation and Amortization (EBITDA)
EBITDA is increasingly used by analysts as approximate measures of cash flow because it
removes the non-cash expenses of depreciation and amortization from profit. The reason
appears to be a desire to get away from the subjectivity of accruals-based profit and closer to
cash flow as something objectively measured. EBITDA is a measure of a company's operating
performance. Essentially, it's a way to evaluate a company's performance without having to
factor in financing decisions, accounting decisions or tax environments. EBITDA is calculated
by adding back the non-cash expenses of depreciation and amortization to a firm's operating
profit
Alternatively, you can also calculate EBITDA by taking a company's net profit and adding
back interest, taxes, depreciation, and amortization.
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EBIDTA allows analysts to focus on the outcome of operating decisions while excluding the
impacts of non-operating decisions like interest expenses (a financing decision), tax rates (a
governmental decision), or large non-cash items like depreciation and amortization (an
accounting decision). By minimizing the non-operating effects that are unique to each
company, EBITDA allows investors to focus on operating profitability as a singular measure of
performance.  Such analysis is particularly important when comparing similar companies
across a single industry, or companies operating in different tax brackets.
EBITDA Margin measures a company's earnings before interest, taxes, depreciation, and
amortization as a percentage of its total revenue.  Because EBITDA is a measure of how much
cash came in the door, EBITDA margin is a measure of how much cash profit a company made
in a year relative to its total sales. The formula for EBITDA margin is:
EBITDA Margin = EBITDA / Total Revenue
Illustration: Assume Company X annual income statement (in francs)
sales 11,000,000
Less: cost of sales (6,000,000)
Gross profit 5,000,000
Less operating expenses:
salaries (1,000,000)
Rent (1,000,000)
depreciation (150,000)
Amortization (50,000)
EBIT 2,800,000
Interest expenses (100,000)
EBT 2,700,000
Tax (30% x 2,700,000) (810,000)
Net income 1,890,000

EBITDA = 1,890,000 + 810,000 + 100,000 + 50,000 + 150,000 = 3,000,000

EBITDA Margin = (3,000,000 / 11,000,000) x 100 = 27.2%
It means that this company is able to turn 27.2% of its revenue into cash profit during the year.
Note: Ratios are useful when the actual results are compared to the standards or set targets.
Residual Income
It is the net operating income above some minimum return on operating assets. It is the net
operating income earned less the minimum required return on average operating assets.
Residual income was developed as an alternative to the return on investment measurement to
overcome some problems of ROI. Residual income encourages managers to make profitable
investments that would be rejected by managers using ROI.
Residual income = net operating income – (average operating assets x minimum required rate
of return)
Illustration:
The retail division of Zephyr inc. has average operating assets of $ 100,000 and is required to
earn a return of 20% on these assets. In the current period, the division earns $ 30,000.
Calculate residual income.
Minimum return required = 100,000 x 20% = 20,000
Residual income = 30,000 – 20,000 = 10,000
Methods of evaluating capital investment
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Net Present Value Method
NPV method has been covered in the previous modules, here it is discussed briefly.
NPV is one of the techniques of capital investment appraisal. It takes into account all cash
flows over the life of the project and makes allowance for the time value of money.
The idea of applying the concept of time value of money is to recognize the reward needed
from a project to compensate for the lost opportunity. For example, receiving $1 million today
is much better than $1 million received five years from now. If the money is received today, it
can be invested and earn interest, so it will be worth more than $1 million in five years’ time.
The process of calculating present value is called Discounting. The interest rate used is called
the discount rate.
NPV Value of a project is equal to the present value of the cash inflows minus the present
value of cash outflows, all discounted at the cost of capital.
NPV analysis is used to help determine how much an investment, project, or any series of cash
flows is worth
The cost of capital can be:
- If the project is to be financed only by borrowing from the banks, then the cost of
capital is the rate of interest that a bank would charge for a new a loan.
- If the project is to be financed by issuing of new share capital, then the cost of capital is
the dividend yield required by investors.
- If the project is to be financed by cash that has been saved within the business, then the
shareholders have allowed this saving rather than take dividend, so the cost of capital is
the opportunity cost reflected in the dividend yield.

Note: Cash flows are calculated as profit before deducting depreciation and amortization
The net present value decision rule:
- Where the net present value of the project is positive, accept the project
- Where the net present value is the project is negative, reject the project
- Where the net present value of the project is zero, the project is acceptable in meeting
the cost of capital but gives no surplus to its owners.

Illustration
years Cash flows Discount factor
outlay 120,000
1 60,000 0.909
2 60,000 0.826
3 60,000 0.751

Assume a discounting rate of 10%.

NPV = [(60,000 x 0.909) + (60,000 x 0.826) + (60,000 x 0.751)] – 120,000 = 29,160
When the discount factor is not given, NPV can be calculated using discount factors obtained
from tables of discount factors or it can be calculated using the following formula:

Where:
Z1 = Cash flow in time 1
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Z2 = Cash flow in time 2

r = Discount rate

X0 = Cash outflow in time 0 (i.e. the purchase price / initial investment)

Internal Rate of Return

The internal rate of return is another method in capital investment appraisal which uses the
time value of money but results in an answer expressed in percentage form. It is a discount rate
which leads to a net present value of zero, where the present value of the cash inflows exactly
equals the cash outflows.
The internal rate of return (IRR) is the discount rate at which the present value of the cash
flows generated by the project is equal to the present value of the capital invested, so that the
net present value of the project is zero.
Method of calculating IRR
When you are not using a computer, or spreadsheet, calculation of IRR involves a process of
repeated guessing of the discount rate until the present value of the cash flows generated is
equal to the capital investment. It should be noted that the NPV can be decreased by increasing
the discount rate and the NPV can be increased by decreasing the discount rate
Then the IRR =
Lower of the pair of discount rates + (NPV at lower rate / difference between the NPVs) x
difference in rates
Considering the illustration on NPV, assume lower discount rate of 20 % and higher discount
rate of 24%. NPV at discount rate of 20% is + 6,360 and NPV at discount rate of 24% is –
1,200.
So, IRR = 20% + (6,360/7,560) x 4 = 23.365%
Internal rate of return decision rule
The decision rule is that a project is acceptable where the internal rate of return is greater than
the cost of capital. Under those conditions the net present value of the project will be positive.
A project is not acceptable where the internal rate of return is less than the cost of capital.
Under those conditions the net present value of the project will be negative. Where the IRR of
the project is equal to the cost of capital, the project is acceptable in meeting the required rate
of return of those investing in the business but gives no surplus to its owners.
Profitability Index
An organization may need to make a choice between two projects which are mutually
exclusive (perhaps because there is only sufficient demand in the market for the output of one
of the projects, or because there is a limited physical capacity which will not allow both).
Attention is then required in using the net present value and the internal rate of return as
decision criteria. In many cases they give the same answer on relatively ranking the projects.
In case two mutually exclusive projects, one has a higher NPV and the other has a higher IRR,
and if the aim of the business is to maximize net present value, the one further decision rule
may be helpful, based on the profitability index.
The profitability index is the present value of cash flows (discounted at the cost of capital)
divided by the present value of the investment intended to produce those cash flows. The
project with the highest probability index will give the highest net present value for the amount
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of investment funding available.
Profitability index = present value of cash inflows/present value of cash outflows
Illustration
projects Initial Cash flows
investment
Year 1 Year 2 Year 3
A 120,000 96,000 48,000 12,000
B 120,000 12,000 60,000 108,000

project NPV at 12% IRR

A 12,521 20.2%
B 15,419 17.6%

Answer:
Project A: probability index = 132,521/120,000 = 1.10
Project B: probability index = 135,419/120,000 = 1.13
This confirms that, of the two, project B is preferable at cost of capital of 12%.
5.2.3 Nonfinancial performance indicators (NFPIs)
Although profit cannot be ignored as it is the main objective of commercial organizations,
critical success factors (CSFs) and key performance indicators (KPIs) should not focus on
profit alone. The view is that a range of performance indicators should be used and these
should be a mix of financial and nonfinancial measures.
Examples of Nonfinancial Performance Indicators (NFPI) include:
 measurements of customer satisfaction e.g. returning customers, reduction in
complaints
 Resource utilisation e.g. is the machines being operated for all the available hours and
producing output as efficiently as possible?
 Measurement of quality e.g. reduction in conformance and non conformance costs.

The large variety in types of businesses means that there are many NFPIs. Each business will
have its own set of NFPIs that provide relevant measures of the success of the business.
However, NFPIs can be grouped together into 2 broad groups:
 Productivity
 Quality

Productivity
A productivity measure is a measure of the efficiency of an operation; it is also referred to as
resource utilization. It relates the goods or services produced to the resources used, and
therefore ultimately the cost incurred to produce the output. The most productive or efficient
operation is one that produces the maximum output for any given set of resource inputs or
alternatively uses the minimum inputs for any given quantity or quality of output.
Examples of resource utilization:
 Hotel – the cost of the bed linen used in each room compared to the number of times
the linen can be used before it needs to be disposed of, time taken to clean and set fair a
room.

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  Car sales team – Sales per employee, Sales per square metre of available floor space,
average length of time a second hand car (e.g. taken as part exchange) remains unsold

Types of productivity measures

Productivity measures are usually given in terms of labor efficiency. However productivity
measures are not restricted to labor and can also be expressed in terms of other resource inputs
of the organization such as the machine hours used for production.
Productivity is often analysed using three control ratios:
Production volume ratio
The production/volume ratio assesses the overall production relative to the plan or budget. A
ratio in excess of 100% indicates that overall production is above planned levels and below
100% indicates a shortfall compared to plans.
The production/volume ratio =
Actual output measured in standard hours
—————————————————— × 100
Budgeted production hours
Capacity ratio
The capacity ratio provides information in terms of the hours of working time that have been
possible in a period.
The capacity ratio =
Actual production hours worked
————————————— × 100
Budgeted production hours
A ratio in excess of 100% indicates that more hours have been worked than were in the budget
and below 100% less hours have been worked than in the budget.
Efficiency ratio
The efficiency ratio is a useful indicator of productivity based on output compared with inputs.
The efficiency ratio =
Actual output measured in standard hours
—————————————————— × 100
Actual production hours worked
A ratio in excess of 100% indicates that the workforce have been more efficient than the
budget predicted and below 100% less efficient than in the budget.
Illustration
Suppose that the budgeted output for a period is 2,000 units and the budgeted time for the
production of these units is 200 hours. The actual output in the period is 2,300 units and the
actual time worked by the labour force is 180 hours.
Required:
Calculate how productive the work force has been.
Production/volume ratio
Actual output measured in standard hours
———————————————————— × 100
Budgeted production hours
200 hours
Standard hours per unit = ————— = 0.1 hours per unit of output

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 2,000 units
Actual output measured in standard hours = 2,300 units × 0.1 hours = 230 standard hours
230
Production/volume ratio = —— × 100 = 115%
200
This shows that production is 15% up on planned production levels.

Capacity ratio=
Actual production hours worked
————————————— × 100
Budgeted production hours
180
Capacity ratio = —— × 100 = 90%
200
Therefore this organization had only 90% of the production hours anticipated available for
production.
Efficiency ratio

Actual output measured in standard hours

———————————————————— × 100
Actual production hours worked
230
Efficiency ratio = —— × 100 = 127.78%
180
The workers were expected to produce 10 units per hour, the standard hour.
Therefore, in the 180 hours worked it would be expected that 1,800 units would be produced. In
fact 2,300 units were produced. This is 27.78% more than anticipated.
NB: production/volume ratio = capacity ratio × efficiency ratio
Productivity measures are not restricted to use in manufacturing industries but can be adapted
for use in both the service and public sectors.
Quality
Quality is an issue whether manufacturing products or providing a service. Poor quality products
or services will lead to a loss of business and damage to the businesses reputation. Targets of an
appropriate level need to be set. Examples of NFPIs that could be used to monitor quality both
from an internal and external (customer) perspectives include:
• Wastage levels
• Internal reworking of finished products
• Customer complaints
• Speed of delivery
• Accuracy of delivery
• Number of returns
• Repeat sales
• New customers
• Growth in sales
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• Labour turnover
• Staff absences
• Evaluation of development plans
• Job satisfaction
• Overtime working
• Product improvements
• Sales from new products
• Cost of research and development
• Cleanliness
• Tidiness
• Meeting staff needs
• Meeting government targets on emissions.
Problems with nonfinancial performance indicators
The use of NFPI measures is now common place, but it is not without problems:
 Setting up and operating a system involving a wide range of performance indicators can
be time-consuming and costly
 It can be a complex system that managers may find difficult to understand
 There is no clear set of NFPIs that the organization must use – it will have to select those
that seem to be most appropriate
 The scope for comparison with other organizations is limited as few businesses use
precisely the same NFPIs as the organization under review.

5.2.4 The balanced scorecard

To get an effective system of performance appraisal a business should use a combination of
financial and nonfinancial measures. One of the major developments in performance
measurement techniques that has been widely adopted is the balanced scorecard.
The concept was developed by Kaplan and Norton in 1993 at Harvard. It is a device for
planning that enables managers to set a range of targets linked with appropriate objectives and
performance measures.
The framework looks at the strategy and performance of an organization from four points of
view, known in the model as four perspectives:
 Financial
 Customer
 Internal (process) efficiency
 Learning and growth.

Financial perspective
This focuses on satisfying shareholder value. Appropriate performance measures would include:
• Return on capital employed
• Return on shareholders’ funds.
Customer perspective
This is an attempt to measure the customer’s view of the organization by measuring customer
satisfaction. Examples of relevant performance measures would include:
• Customer satisfaction with timeliness
• Customer loyalty.
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Internal perspective (process efficiency)
This aims to measure the organization’s output in terms of technical excellence and consumer
needs. Indicators here would include:
• Unit costs
• Quality measurement.
Learning and growth perspective
This focuses on the need for continual improvement of existing products and techniques and
developing new ones to meet customers’ changing needs.
A measure would include the percentage of revenue attributable to new products.
Example of a balanced scorecard
Objectives Measures Target Actual
performance performance
Financial perspective Gain in income 5,000,000 5,520,000
Revenue growth 6% 6.48%
Customer perspective New customers 5 6
Customer satisfaction 90% 87%
Internal process Yield 78% 79%
perspective On-time delivery 92% 90%
Learning & growth Employees trained 90% 92%
perspective Employees satisfaction 80% 88%
It helps communicate the strategy to all members of the organization by translating the strategy
into a coherent and linked set of understandable targets.
Activity
For each perspective of the balanced scorecard, suggest and explain one performance measure
that could be used by a company that provides a passenger transport service, e.g. a taxi company
or a train company.
Customer perspective
 Performance measure: percentage of services arriving on time
 Reason for monitoring: ontime service is important to the customer
Internal business perspective
Performance measure: percentage of time for which vehicles are unavailable due to breakdown,
maintenance etc.
Reason for monitoring: maximising vehicle availability is important for achievement of service
targets
Learning and growth perspective
Performance measure: Training days per employee
Reason for monitoring: Need to keep employees updated with safety regulations, first aid and
emergency procedures, etc.
Financial perspective
Performance measure: Operating profit per month
Reason for monitoring: Achievement of budgetary profit target
Note: other performance measures for each perspective would be equally acceptable.
Advantages and disadvantages of the Balanced Scorecard
The advantages of the approach include the following:
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  It looks at performance from the point of view of the four perspectives outlined above,
not just from the narrow view of the shareholders as traditional analysis would.
 Managers are unlikely to be able to distort the performance measure.
 Bad performance is more difficult to hide as more performance indicators are being
measured.
 It should lead to the longterm success of the business rather than focusing on shortterm
improvements.
 It focuses on key performance indicators. The process of identifying these indicators can
make senior managers question strategy and focus on the core elements of the business.
 As the core elements of the business change, the performance indicators can be changed
accordingly. It is therefore a flexible measure.

The disadvantages of the model include the following:

 It can involve a large number of calculations which may make performance
measurement time-consuming and costly to operate.
 The selection of performance indicators under each of the four perspectives is subjective.
 This in turn will make comparisons with the performance of other organizations difficult
to achieve satisfactorily.
 The weighting used to arrive at an overall index of performance are arbitrary and may
need to be arrived at by trial and error
5.2.6 Benchmarking

Benchmarking is a technique that is increasingly being adopted as a mechanism for continuous

improvement.
Benchmarking is a process of measuring the organization’s operations, products and services
against those of competitors recognized as market leaders, in order to establish targets which
will provide a competitive advantage. Or
Benchmarking is the establishment, through data gathering, of targets and comparators that
permit relative levels of performance (and particular areas of underperformance) to be
identified. The adoption of identified best practices should improve performance.
It therefore requires organizations to:
 Identify what they do and why they do it
 have knowledge of what the industry does and in particular what competitors do
 be fully committed to achieving best practice

Any activity can be benchmarked and an organization should focus on those:

 That are central to business strategy
 Where significant improvement is required without increasing resources
 Where staff are committed and eager for improvement

The basic idea of benchmarking is that performance should be assessed through a comparison of
the organization’s own products or services, performance and practices with 'best practice'
elsewhere. The reasons for benchmarking may be summarized as:
 To receive an alarm call about the need for change
 Learning from others in order to improve performance

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  Gaining a competitive edge (in the private sector)
 Improving services (in the public sector).

There are several types and levels of benchmarking, which are mainly defined by whom an
organization chooses to measure itself against.
These include:
Internal benchmarking. With internal benchmarking, other units or departments in the same
organization are used as the benchmark. This might be possible if the organization is large and
divided into a number of similar regional divisions. Internal benchmarking is also widely used
within government. In the UK for example, there is a Public Sector Benchmarking Service that
maintains a database of performance measures. Public sector organizations, such as fire stations
and hospitals, can compare their own performance with the best in the country.
Competitive benchmarking. With competitive benchmarking, the most successful competitors
are used as the benchmark. Competitors are unlikely to provide willingly any information for
comparison, but it might be possible to observe competitor performance (for example, how
quickly a competitor processes customer orders). A competitor's product might be dismantled in
order to learn about its internal design and its performance: this technique of benchmarking is
called reverse engineering.
Functional benchmarking. In functional benchmarking, comparisons are made with a similar
function (for example selling, order handling, despatch) in other organisations that are not direct
competitors. For example, a fast food restaurant operator might compare its buying function
with buying in a supermarket chain.
Strategic benchmarking. Strategic benchmarking is a form of competitive benchmarking
aimed at reaching decisions for strategic action and organizational change. Companies in the
same industry might agree to join a collaborative benchmarking process, managed by an
independent third party such as a trade organization. With this type of benchmarking, each
company in the scheme submits data about their performance to the scheme organizer. The
organizer calculates average performance figures for the industry as a whole from the data
supplied. Each participant in the scheme is then supplied with the industry average data, which it
can use to assess its own performance.
The following steps are required in a systematic benchmarking exercise:
 planning
 analysis
 action
 Review

Planning includes selecting the activity to be benchmarked, involving fully the staff engaged
with that activity and identifying the key stages of the activity relating to inputs, outputs and
outcomes. It is important to establish the benchmark to a level of ‘best practice’.
Analysis includes identifying the extent to which the organization is under performing and to
stimulate ideas as to how this can be met.
This may include whether new processes or methods are required. Implementation concerns the
use of an action plan to achieve the improvement or the maintenance of the pre determined
standards. Management should ensure that resources are made available to meet the objectives
set.

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Action involves putting an appropriate plan into force in order to improve performance in the
benchmarked areas.
Review includes monitoring progress against the plan and reviewing the appropriateness of the
performance measure.
In practice, businesses establishing benchmarks will use a variety of information sources for
their programmes. The most relevant and useful information would be that from a benchmarking
partner. Such partnerships can be organized through trade associations and interfirm comparison
links.
All organizations can benefit with comparisons with others. Ideally, it should be judged against
best practice wherever that may be found. Benchmarking analysis can provide such
comparisons of the resources, competences in separate activities and overall competence of the
organization.
References
ACCA paper 5 Advanced Performance Management, complete text, Kaplan publishing (2015),
UK
Financial and Management Accounting: An Introduction by Pauline Weetman (2006), Pearson
Education Limited, UK

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