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Module 9: Strategy and the Balanced Scorecard

Overview

Module 9 ties all previous modules together into a method for facilitating decision-making and performance evaluation. In this module, you focus on the Balanced Scorecard (BSC) as a management tool for the implementation of a chosen strategy. You learn about the Balanced Scorecard approach to gathering financial and nonfinancial information, and how to apply the resulting scores in strategic decision-making. The module also provides an opportunity for you to use the BSC to create solutions to performance evaluation deficiencies in a given business situation.
Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required.
Assignment reminder

Assignment 3 is due this week (see Course Schedule). Be sure to allocate time to complete and submit the assignment by the deadline.
Topic outline and learning objectives

9.1 Strategy evaluation and the Balanced Scorecard

Explain how the four Balanced Scorecard perspectives are used to evaluate the success of a strategy. (Level 2) Explain how the Balanced Scorecard can be used to evaluate risk management strategy, and how good governance contributes to risk management. (Level 2) Identify similarities between the Balanced Scorecard measures and measures used to assess corporate sustainability. (Level 2) Describe the process required to implement and apply the Balanced Scorecard. (Level 1) Evaluate outcomes of strategic initiatives using the stoplight system. (Level 1) Evaluate change in operating income resulting from implementation of strategic components: growth, product differentiation, and cost leadership or productivity. (Level 1) Analyze specific productivity and capacity control strategies to achieve Balanced Scorecard objectives. (Level 1)

9.2 BSC application to enterprise risk management

9.3 BSC and corporate sustainability

9.4 Implementation of the BSC 9.5 Evaluating outcomes of strategic initiatives 9.6 Strategic analysis of operating income

9.7 Specific control strategies

Module summary Print this module

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9.1 Strategy evaluation and the Balanced Scorecard

Learning objective

Explain how the four Balanced Scorecard perspectives are used to evaluate the success of a strategy. (Level 2)

Required reading

Chapter 13, pages 642-648 (Be sure to review the overview of strategy on pages 656-657.) Online article: The Balanced Scorecard

LEVEL 2

According to Kaplan and Norton (2004)1, the Balanced Scorecard (BSC) translates an organizations mission and strategy into a comprehensive set of performance measures that provide a framework for evaluating its strategy implementation. Rather than the traditional financial measures of ROI, which are used to evaluate management and corporate performance, the BSC uses both financial and nonfinancial measures in four perspectives: Financial Evaluates the profitability of a strategy from growth in the revenue streams or reduction of costs, and uses the more traditional measures such as return on capital employed, operating income, and revenue growth. Customer Evaluates whether the company is achieving success in meeting customer needs through identifying a customer value proposition (that is, by answering the question, who are we to the customer?), and utilizes measures such as customer satisfaction, number of new customers, increase in market share, and so on. Internal business process Evaluates the effectiveness and efficiency of managing the internal operations or value chain. This perspective focuses on three principle sub-processes: innovation, operations, and post-sales service. Learning and growth Focuses on the area of intellectual capital, comprised of human, structural, and relational capital. This measure includes employee training and cultural attitudes. The Balanced Scorecard aligns the organization with corporate strategy by linking strategic goals and objectives (see Exhibit 13-1, page 644). Exhibit 13-2 (page 647) identifies typical BSC measures that are used to determine the level of success of the strategy implementation. A typical Balanced Scorecard identifies the objectives for each perspective, determines how they will be measured (the measures), decides which initiatives management will implement, and defines target and actual results. Exhibit 9.1-1 provides an example of a BSC measure from the financial perspective. Note that the purpose of initiatives is to assist in achieving the target.
Exhibit 9.1-1: BSC measures financial perspective

Objectives

Measures

Initiatives

Target

Actual

Increased shareholder value Operating income Manage costs and unused capacity $2,000,000 $2,012,500 Companies can use a methodology to highlight successes and areas for improvement. One such tool is as a stoplight system (described in detail in Topic 9.5) in which the target is broken into three categories. Green represents meeting expectations, yellow represents results slightly below the desired target ($1,850,000 $2,000,000 in Exhibit 9.1-1), and red represents a problem area to be addressed (income <$1,850,000 in the exhibit). Activity 9.1-1: Balanced Scorecard strategies Try Activity 9.1-1 to test your understanding of how BSC strategies and measures relate to a companys goals and initiatives. For additional information and examples of how the scorecard is used in several organizations, go to the Balanced Scorecard
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Institute. The BSC is an evolving topic. This presentation of the learning and growth perspective focuses on product development. However, the Balanced Scorecard Institute and the 5th edition of your textbook describe learning and growth as the valuation of intellectual capital, focusing on employee training and cultural attitudes. Your knowledge of this perspective should be based on the material in the textbook and the module notes.

R.S. Kaplan and D. P. Norton, Strategy Maps: Converting Intangible Assets into Tangible Outcomes, Boston: Harvard Business School Press, 2004.

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9.2 BSC application to enterprise risk management

Learning objective

Explain how the Balanced Scorecard can be used to evaluate enterprise risk management strategy, and how good governance contributes to risk management. (Level 2)

Required reading

Chapter 13, pages 648-652

LEVEL 2

The business landscape has changed since the 1996 advent of the Balanced Scorecard (BSC), which in turn has led to changes in the functionality and purpose of the BSC. Originally designed solely as an advanced performance measurement system, the BSC has come to play a deeper role in the development of corporate strategy. It now connects strategy with budgeting to establish for the first time a true link between resource needs and strategy needs. Enterprise risk management (ERM) is a fundamental issue for many organizations, especially those involved in global operations. The BSC can be used to evaluate the effectiveness of an organizations ERM strategy, the stewardship function of management, corporate competitiveness including productivity, cost leadership, business process and capacity utilization, and corporate governance (see Exhibit 13-3 on page 652). The textbook on pages 649-651 provides an illustration of how the BSC can be used to assess the success of an ERM strategy to manage the corporate supply-chain.

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9.3 BSC and corporate sustainability

Learning objective

Identify the similarities between the Balanced Scorecard measures and measures used to assess corporate sustainability. (Level 2)

Required reading

Chapter 13, pages 653-655

The textbook on page 653 states that corporate sustainability creates long-term shareholder value by embracing opportunities and managing risks derived from economic, social, and environmental developments. The implementation of best practices in this area has been linked to increased recognition by investors. A quantitative measure used to determine this increased market valuation is Tobins q, measured as the sum of the balance sheet value of debt plus all equity divided by the total assets. This result is statistically different for companies found to be more sustainable than others. The findings are also associated with companies that have higher sales growth. The T-q analysis can also be used to link the earnings response co-efficient (ERC, studied in accounting theory), which indicates that the market reacts more strongly to news from companies with higher growth possibilities than from those rated lower on the growth scale. The three dimensions of sustainability (economic, environmental, and social) can also be applied to the BSC. The economic link lies in measures that include product protection, intellectual capital management, internal process improvement, and customer responsiveness. Measures to control environmental risks such as hazardous waste disposal and fuel efficiency can be implemented into the BSC, as well as social measures that deal with human capital development. Each of these measures connect the BSC with policies developed to sustain growth and manage risks.

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9.4 Implementation of the BSC

Learning objective

Describe the process required to implement and apply the Balanced Scorecard. (Level 1)

Required reading

Chapter 13, pages 656-661 (to Evaluating Strategic Success Focus on Operating Income)

Successfully implementing a BSC requires commitment and leadership from top management. Usually, an implementation team is put together to conduct interviews with senior managers to gather input used for developing objectives, measures, and buy-in. The goal is to achieve consensus on objectives and to establish a cause-and-effect linkage across objectives at both senior and middle management levels. Once the measures are developed, senior managers meet with middle-level managers to finalize the scorecard, to determine who is responsible for each area and/or objective, and to decide how the measures will be attained. The textbook lists features of a good BSC (page 658) and also lists pitfalls to avoid when implementing a BSC on pages 658-659. One of the advantages of implementing the BSC is that it allows management to determine the impact of initiatives on company performance. For example, reengineering is a tool that can be used to implement initiatives that will impact an organizations performance targets. Reengineering is a fundamental rethinking and redesign of business processes to achieve improvements in critical measures of performance. It can reduce costs, increase quality, and increase customer satisfaction. This is then reflected in the BSC at the internal business process level. The training required to implement the reengineering is reflected in the learning and growth perspective and could also be mapped to show its impact on the customer perspective. When changes also reduce costs and increase revenue (for example, through increased customer satisfaction), the effect would show up in the financial perspective.

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9.5 Evaluating outcomes of strategic initiatives

Learning objective

Evaluate outcomes of strategic initiatives using the stoplight system. (Level 1)

LEVEL 1

Managers can compare the Balanced Scorecard to actual results using the target stoplight system. In this process, post mortems are held where management identifies problems results showing in the yellow- and red-light ranges and looks for ways to improve operations. The following example changes the data for CXI given in the text (Exhibit 13-5, page 662) to illustrate the value stoplight analysis can provide in identifying problems and focusing attention on critical data.
Example 9.5-1: Setting targets for stoplight at Chipset

Assume the following changes in the actual performance data for Chipset: Operating income from productivity gain: Operating income from growth: Market share in network segment: Customer satisfaction rating: $2,512,500 $2,400,000 5.50% 74.50%

Using this data, first determine the ranges for the three stoplight categories green, yellow, and red for each target performance measure. This target-setting process is key to the effective use of the system. (Productivity gain and income from growth are part of profitability analysis, discussed in Topic 9.6.) For the CXI data, green-light data ranges could be as follows: Operating income from productivity gain: Operating income from growth: Market share in network segment: Customer satisfaction rating: any result above $2,000,000 any result above $3,000,000 any result above 6.0% any result above 90.0%

Green-light data is considered favorable, and amounts in this category are not usually considered to be of concern. However, green-light results are reviewed to ensure that there are no problems with the target-setting process. For example, if the operating income from productivity gain was twice or three times as large as expected, this may indicate a problem with setting targets. Yellow-light data ranges for this example could be as follows: Operating income from productivity gain: Operating income from growth: Market share in network segment: Customer satisfaction rating: any result between $1,000,000 and $1,999,999 any result between $2,500,000 and $2,999,999 any result between 3% and 6.0% any result between 75% and 90.0%

This is a range of values; the key is to use professional judgment in determining the appropriate range. Yellow light data highlights areas that may be trending in a negative direction, so managers need to be aware of them.

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Red-light data for this example could be as follows: Operating income from productivity gain: Operating income from growth: Market share in network segment: Customer satisfaction rating: any result below $1,000,000 any result below $2,500,000 any result below 3% any result below 75%

Red-light data is set as any number below a certain measure. Amounts in the red-light range are highlighted as areas where managers should focus their concern. Exhibit 9.5-1 shows a printout of the section of the BSC analysis highlighted using the stoplight system.
Exhibit 9.5-1: Stoplight system

Objectives Financial Perspective Increase shareholder value

Measures Operating income from productivity gain Operating income from growth

Initiatives

Target Performance

Actual Performance

Manage costs Build strong customer relations Identify future needs of customers Increase customer focus of sales organization

$ 2,000,000.00 $ 3,000,000.00

$ 2,512,500.00 $ 2,400,000.00

Customer Perspective Increase market share Market share in network segment 6% 5.50%

CustomerIncrease customer satisfaction satisfaction ratings

90%

74.50%

The goal when evaluating the results of a strategy using the BSC is to isolate operating numbers related to the strategy from other causes. For example, increases in operating income could result from growth in the overall economy as opposed to the successful implementation of the strategy. A methodology for performing a detailed analysis of operating income is addressed in the following topic.

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Updated August 18, 2010, MA2-10-IB01

9.6 Strategic analysis of operating income

Learning objective

Evaluate change in operating income resulting from implementation of strategic components: growth, product differentiation, and cost leadership or productivity. (Level 1)

Required reading

Chapter 13, pages 661-670

LEVEL 1

Each organization has a different strategy and therefore requires different sets of measures. For example, government organizations do not have a profit orientation, and non-government organizations (NGOs) are required to meet the goals of different constituency groups. For an example of this type of BSC see Exhibit 13-7 on pages 669-670, which shows a Balanced Scorecard used at the Canadian Institute of Health Information. For evaluating implementation of strategies such as cost leadership, product differentiation, and growth, managers can use a strategic analysis of operating income over a minimum of two years. This is done by breaking down changes in operating income from one year to the next into the following components:

Revenue and cost effects of growth Revenue and cost effects of price-recovery Cost effect of productivity

Exhibit 13-6 on page 664 shows the overall strategic analysis of profitability for the CXI scenario. It explains the $2,500,000 increase in operating income by breaking it down into its component parts.

Growth component
The growth component measures change in revenue and costs based on changes in units sold or produced, with all other variables being the same as the previous year. By isolating the change in units, the analysis looks at the impact of the change in growth on revenue.

Revenue effect of growth

Revenue effect of growth component (Actual units of output sold in the current period Actual units of output sold in the last period) Selling price in the last period

Maintaining the selling price of the last period isolates the increase in revenue resulting from the change in units sold.

Cost effect of growth

(Actual units of input or capacity that would have used to produce current period output assuming the same input-output relationship that existed in the last period

Cost effect of growth component

Actual units of input or capacity to produce the last period output)

Input prices in the last period

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Maintaining the input-output relationship in the last period input prices isolates the increase in cost resulting from the growth in sales between the last period and the current period. Since fixed costs do not change, variable direct-material costs are isolated from fixed costs (including conversion and R&D costs). This approach assumes that the company is still operating within its relevant range.

Price-recovery component
The price-recovery component of operating income measures the change in revenues and the change in costs to produce the given level of current output resulting from the change, assuming the relationship of input-output remains constant. This isolates the change in revenue due solely to the change in selling price.

Revenue effect of price recovery

Actual units of output sold in the current period

Revenue effect of product differentiation component

(Selling price in the current period

Selling price in the last period)

Cost effect of price recovery

This component focuses on the effect of changes in prices of input and also incorporates changes in fixed costs or conversion costs. Actual units of inputs or capacity that would have been used to produce in the current period output assuming the same input-output relationship that existed in the last period

Cost effect of product differentiation component

(Input prices in the current period

Input prices in the last period)

Productivity component
The productivity component analysis uses current-year prices to isolate the change in costs between the current and past year caused solely by the changes in quantities, mix, and capacity of inputs. Actual units of inputs or capacity that would have been used to produce the current period output assuming the same input-output relationship that existed in the last period)

Productivity/cost leadership component

(Actual units of input or capacity to produce the current period input

Current period prices

Conclusion Companies that have chosen a cost-leadership strategy would be more likely to focus on productivity and growth components, while companies following a differentiation strategy would see more changes in price-recovery and growth components.

Further analysis
An organization may wish to further analyze the results to factor out industry or market forces from strategic forces. Market growth can lead to an increase in sales, regardless of whether the company implemented a successful growth strategy.

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Assume the market growth rate in the industry was 10% and total sales for the company increased from 1,000,000 to 1,150,000 (which is 15%). The company could factor out the impact of industry growth (1,000,000 x 10% = 100,000) from the 150,000-unit increase in company sales (1,150,000 1,000,000). Thus the actual growth (From Exhibit 13-6, column 2) would yield the following:

Revenue and cost effects of growth component in 2010

Increase in company sales beyond the increase due to growth) divided by (total increase in company sales 50,000 units 150,000 units The following computer illustration uses Excel and the stoplight method to perform a basic analysis of operating income. = Growth due to increase in share of the market

Revenue and cost effects of growth component in 2010 $3,420,000 F

1,140,000 F

Computer illustration 9.6-1: Analysis of operating income

Solution

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Computer illustration 9.6-1: Analysis of operating income

This computer illustration uses conditional formatting techniques and basic analysis to communicate the organizations ability to achieve target performance. Refer to the following information: Halsey and Company sells womens clothing. Halseys strategy is to offer a wide range of clothes and excellent service and to charge a premium price. The following information is available for 20X9-20X10. (For simplicity, assume Halsey sells only one piece of clothing): 20X9 Pieces of clothing purchased and sold Average selling price Average cost per piece of clothing Selling and customer-service capacity (customers) Selling and customer-service costs Selling and customer-service capacity cost per customer Purchasing and administrative capacity measured by the number of distinct clothing designs purchased Purchasing and administrative costs Purchasing and administrative capacity cost per distinct design 40,000 $72.00 $48.00 51,000 $8.40 980 20X10 40,000 $70.80 $49.20 43,000 $8.28 850

$428,400 $356,040

$294,000 $244,800 $300 $288

Total selling and customer-service costs depend on the number of customers that Halsey has created capacity to support, not the actual number of customers that Halsey services. Total purchasing and administrative costs depend on purchasing and administrative capacity that Halsey has created (defined in terms of the number of distinct clothing designs that Halsey can purchase and administer). Purchasing and administration costs do not depend on the actual number of clothing pieces purchased. Halsey purchased 930 distinct designs in 20X9 and 820 distinct designs in 20X10. Market-wide prices for clothing and the market size were unchanged in 20X9 and 20X10. At the start of 20X10, Halsey planned to increase operating income by 10% over the operating income in 20X9. Required 1. Calculate Halseys operating income in 20X9 and 20X10. 2. Calculate the growth, price-recovery, and productive components on changes in operating income between 20X9 and 20X10. 3. Does the strategic analysis of operating income indicate Halsey was successful in implementing its premium price and product differentiation strategy in 20X10? Explain. Source: Adapted from Horngren, 4th Canadian Edition, 13-30, p. 549
Material provided

File MA2M9P1 containing a partially completed worksheet M9P1, the solution worksheet M9P1S, the Balanced Scorecard on a worksheet called Balanced Scorecard, and the solution to the Balanced Scorecard portion on a worksheet called Balanced Scorecard sol
Required

Answer requirement 1 based on the information given. Then, using the spreadsheets, answer the remaining requirements. Complete the Balanced Scorecard tab by linking to M9P1S.
Procedure

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Start Excel. Open the file MA2M9P1. 1. Review the data table (A4 to I 23) and note that it replicates the information given in the question. 2. Complete a comparative income statement for Halsey and Company for the year ended December 31, 20X10, using the template found at A26 to I41 and the information in the data table. 3. Using the formulas given in the text on pages 664-665, complete Part 3 entitled "Revenue and Cost Effects of Growth" in section A43 to H54. 4. To apply conditional formatting to this section, highlight the appropriate cell or group of cells. Click Format, then Conditional Formatting and follow the instructions. (For Excel 2007, click on the Conditional formatting icon within the Home tab.) Choose green for positive results, yellow for results that may require further research, and red for values that are of concern. Judgment is required in choosing specific conditions. For example, for the variance analysis: For Revenues: values >0, choose green; values <0, choose red; and, values = 0, choose yellow. For Costs: values >0, choose red; values <0, choose green; and, values = 0, choose yellow. 5. Using the formulas given in the text on page 665-666, complete Part 3 entitled "Revenue and Cost Effects of Price Recovery" in section A56 to H67. 6. Using the formulas given in the text on pages 666-667, complete Part 3 entitled "Cost Effects of Productivity" in section A70 to H79. 7. For both "Revenue and Cost Effects of Price Recovery" and "Cost Effects of Productivity," use the same conditional formatting logic as for "Revenue and Cost Effect of Growth." 8. Complete the Strategic Analysis of Productivity using formulas and concepts given on pages 667-668, using section A82 to K96 in M9P1. The final product should look like Exhibit 13-6 on page 664. Use columns E, G, and I to indicate whether the variance is favorable or unfavorable by entering either an F or a U where appropriate. Where appropriate, use the If function to ensure the validity of the calculations (re cells C93 and J93). 9. Indicate the total change in operating income in cell F95 using cell G95 to indicate favorable or unfavorable. 10. To use the conditional formatting commands, first highlight the appropriate cell or section and follow the guidelines as given in Step 4. Note that there are two key issues when using conditional formatting. The first is to make the judgment call on where the relevant numbers will be deciding at what point a value is ok, when it requires caution, and when it becomes a problem. The second issue is taking care to isolate changes in revenue from changes in cost. 11. Click OK. Then open the Balanced Scorecard tab. In column H, create formulas (H8, H12) that reference the M9P1S tab to fill in the actual numbers achieved on the scorecard. Note that the amounts for cells H16, H20, and H25 have been filled in for you. 12. Use the conditional formatting again for each cell that contains an actual amount, using judgment to determine the appropriate values.

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Computer illustration 9.6-1 Solution

The Balance Scorecard analysis shows the following with stoplight formatting.

Conclusion

The analysis of operating income indicates that a significant amount of the increase in operating income resulted from productivity gains rather than product differentiation. The company was unable to charge a premium price for its clothes. Thus, the strategic analysis of operating income indicates that Halsey has not been successful at implementing its premium price and product differentiation strategy, despite the fact that operating income increased by more than 10% between 20X6 and 20X7. Halsey could not pass on increases in purchase costs to its customers via higher prices. Halsey must either reconsider its strategy or focus managers on increasing margins and growing market share by offering better product variety and superb customer service. The stoplight score indicates that management needs to do a more detailed analysis of the Increase in shareholder value section and the market share numbers. These numbers show areas of concern and indicate that the company did not actually achieve their product differentiation. Have the needs of the market changed? What other issues may be indicated? The cost savings on improved internal business processes were acceptable; however, given the supposed increase in quality and subsequent decline in customer service expectations, the learning and growth numbers should be analyzed further.

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9.7 Specific control strategies

Learning objective

Analyze specific productivity and capacity control strategies to achieve Balanced Scorecard objectives. (Level 1)

Required reading

Chapter 13, pages 670-677

LEVEL 1

Productivity measures
Productivity measures the relationship between actual inputs (quantity and costs) and actual outputs produced. The lower the input for a given level of output, the greater the productivity achieved. Partial productivity focuses on one productivity component, such as direct materials. The following ratio measures the level of output to the level of input used. Partial productivity = Quantity of output produced Quantity of input used

The higher the ratio, the greater the productivity achieved.

Evaluating changes in partial productivity

It is important to separate variable from fixed productivity changes. A reduction in variable costs immediately lowers overall cost, while fixed costs tend to be based on a minimum capacity, so lowering the capacity used does not necessarily reduce total costs. Changes from the previous year can be used to determine percentage change for the current year as in Exhibit 13-8 on page 671. Percentage change = Partial productivity current year Partial productivity previous year Partial productivity previous year

Total-factor productivity (TFP)

Partial productivity measures individual inputs and isolates relevant factors of importance to managers, but fails to determine the overall impact on productivity by the mix of inputs. Total-factor productivity = Quantity of output produced Costs of all inputs used

Total-factor productivity considers all inputs simultaneously and assesses the tradeoffs made based on current input prices. To compare the changes over time, TFP benchmarks against the company for the previous year but maintains the current year prices to control for changes in price. Total factor productivity for current year using current year prices = Quantity of output produced in current year Cost of inputs used in current year based on current year prices

This is compared to the previous years input required to produce the the current level of output.

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Benchmark TFP

Quantity of output produced in current year Cost of inputs that would have been used in previous year to produce current year output

From this, you can compute the percentage change in total factor productivity Percentage change in TFP = TFP (current year) TFP (previous year) TFP (previous year)

Using both total-factor and partial productivity measures

These measures work well together, as the strengths of one are the weaknesses of the other. While partial productivity measures identify changes in specific factors, they fail to identify the impact on overall productivity. Total-factor productivity measures provide numbers across the company. However, increased productivity in one area can cause decreased productivity in another, which can remain hidden when the total-factor number is used. The total-factor number is more like a snapshot, and usually needs further analysis to provide useable information. Both measures can be used across time as they both measure physical inputs that can be tracked. This allows the organization to identify improvements over time, and the results can ultimately be tied to productivity-based bonus and compensation systems.
Ethical considerations

Since productivity measures can be used in productivity-based compensation systems, they can create incentives for individual managers to manipulate information for their own gain, and this would be counterproductive to achieving the organizational goals. Both the Balanced Scorecard and productivity measures must be designed and implemented in such a way that managers are not able to manipulate the system. This problem is often solved by ensuring transparency of information and process. The steps in creating the BSC should be designed to demonstrate openness and to incorporate feedback, allowing each manager to have a say in developing the BSC measures and goals.

Capacity control measures

Unlike variable costs, fixed costs are tied to capacity. Managers can control capacity by understanding engineered costs and discretionary costs. Engineered costs result from cause-and-effect relationships between output (cost driver) and direct or indirect resources used to produce that output. Direct materials are an example of direct engineered costs. Conversion costs include factory overhead needed to produce a given level of output and are an example of indirect engineered costs, which are tied to capacity in the short-run. Discretionary costs arise from periodic (usually yearly) decisions regarding maximum amounts to be incurred, and have no measurable cause-and-effect relationship between output and resources consumed. Discretionary costs are under managements discretion to incur or not in the short-run and can usually be eliminated in the short-run without hurting sales.
Relationships between inputs and outputs

Engineered costs are related to processes that are detailed, physically observable, and repetitive (such as manufacturing or customer service activities), while discretionary costs are less precise and not as tied to processes. Further, discretionary costs are less certain. As defined in the text, uncertainty refers to the possibility that an actual amount will deviate from an expected amount. The higher the level of uncertainty, the less likely a cause-and-effect relationship will exist. See Exhibit 139 on page 675 for a summary of engineered and discretionary costs.
Unused capacity for engineered and discretionary overhead costs

Engineered unused manufacturing capacity costs can be calculated by taking the maximum capacity and subtracting current output, then multiplying by the conversion cost rate. Using the example in the text, the maximum capacity is 1,875,000 units and current production is 1,450,000, resulting in unused capacity cost as follows: (Maximum capacity Current production) x Indirect engineered cost (1,875,000 1,450,000) x $6.20 = $2,635,000.00 The absence of cause-and-effect relationships make discretionary costs more difficult to relate to used or unused capacity.

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Managing unused capacity

Managers prefer to operate close to capacity in order to allocate fixed costs over more units. When the organization isnt operating at capacity, fixed costs are higher per unit. A company has two options for managing unused capacity it can eliminate the unused capacity by downsizing (also known as rightsizing) or attempt to use the unused capacity by growing revenues. Many companies have focused on the first approach to reduce costs and increase efficiency by reconfiguring processes and by reducing products and human resources. Before downsizing, an organization must consider future growth expectations and the impact of reductions on quality and efficiencies. For example, if Air Canada reduced its workforce by 30%, a complete analysis would involve all aspects of the Balanced Scorecard, which also considers the impact of such a staff reduction on internal business processes, employee morale, and customer satisfaction. The reduction in workforce could increase the wait-time for ticket processing and baggage claim, leading to decreased efficiencies, less customer satisfaction, and decreased morale of remaining employees. The second approach, growing revenues, can be accomplished by decreasing selling prices and increasing sales or by developing new products. For example, unused space can be rented out to achieve higher revenues.
Ethical issues and downsizing

When considering options regarding unused capacity and downsizing, it is important to ensure that all effects of such decisions have been taken into account, including effects on all stakeholders. Downsizing can have a profound effect on workers and communities. People living in small, one-industry towns are particularly vulnerable to the negative effects of downsizing. Care must be taken to mitigate negative effects these events may have on workers. For example, have employees been given fair notice? Has the company provided counseling and training for new opportunities? Has the company ensured that workers have the opportunity to qualify for the appropriate pension or unemployment insurance? The organization also needs to make sure that it has lived up to any previous commitments. For example, often when a large employer comes into a small community, that community provides tax incentives to the company in exchange for the employment opportunities for the townspeople. Also, the company may have provided certain employees with employment commitments in order to obtain their skills. While not all of these commitments are legally enforceable, they do create legitimate expectations regarding the subsequent actions of the organization.

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Module 9 self-test
Question 1
Exercise 13-18, pages 686-687 Solution

Question 2
a. Exercise 13-16, page 686 b. Exercise 13-17, page 686 Solution

Question 3
Problem 13-22, pages 687-688 Solution

Question 4
Problem 13-30, page 690 Problem 13-31, page 690 Problem 13-32, page 690 Solution

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Self-test 9 Solution 1

13-18 Strategy, Balanced Scorecard

1. Meredith Corporation follows a product differentiation strategy in 2009. Merediths D4H machine is distinct from its competitors and generally regarded as superior to competitors products. To succeed, Meredith must continue to differentiate its product and charge a premium price. Balanced Scorecard measures for 2009 follow: Financial Perspective (1) Increase in operating income from charging higher margins, (2) price premium earned on products. These measures indicate whether Meredith has been able to charge premium prices and achieve operating income increases through product differentiation.

2.

Customer Perspective (1) Market share in high-end special-purpose textile machines, (2) customer satisfaction, (3) new customers. Merediths strategy should result in improvements in these customer measures that help evaluate whether Merediths product differentiation strategy is succeeding with its customers. These measures are leading indicators of superior financial performance.

Internal Business Process Perspective (1) Manufacturing quality, (2) new product features added, (3) order delivery time. Improvements in these measures are expected to result in more distinctive products delivered to its customers and in turn superior financial performance. Learning and Growth Perspective (1) Development time for designing new machines, (2) improvements in manufacturing processes, (3) employee education and skill levels, (4) employee satisfaction. Improvements in these measures are likely to improve Merediths capabilities to produce distinctive products that have a cause-and-effect relationship with improvements in internal business processes, which in turn lead to customer satisfaction and financial performance.

Self-test 9 Solution 2

13-16 Balanced Scorecard.

1. La Quintas 2009 strategy is a cost leadership strategy. La Quinta plans to grow by producing high-quality boxes at a low cost delivered to customers in a timely manner. La Quintas boxes are not differentiated, and there are many other manufacturers who produce similar boxes. To succeed, La Quinta must achieve lower costs relative to competitors through productivity and efficiency improvements. Measures that we would expect to see on La Quintas Balanced Scorecard for 2009 are

2.

Financial Perspective (1) Operating income from productivity gain, (2) operating income from growth, (3) cost reductions in key areas. These measures evaluate whether La Quinta has successfully reduced costs and generated growth through cost leadership. Customer Perspective (1) Market share, (2) new customers, (3) customer satisfaction index, (4) customer retention, The logic is that improvements in these customer measures are leading indicators of superior financial performance. Internal Business Process Perspective (1) Yield, (2) productivity, (3) order delivery time, (4) on-time delivery. Improvements in these measures are expected to lead to more satisfied customers and in turn to superior financial performance. Learning and Growth Perspective (1) Percentage of employees trained in process and quality management, (2) employee satisfaction, (3) number of major process improvements. Improvements in these measures have a cause-and-effect relationship with improvements in internal business processes, which in turn lead to customer satisfaction and financial performance.

13-17 Analysis of growth, price-recovery, and productivity components (continuation of 13-16)

1. La Quintas operating income gain is consistent with the cost leadership strategy identified in requirement 1 of Exercise 13-16. The increase in operating income in 2009 was driven by the $140,000 gain in productivity in 2009. La Quinta took advantage of its productivity gain to reduce the prices of its boxes and to fuel growth. It increased market share by growing even though the total market size was unchanged. The productivity component measures the change in costs attributable to a change in the quantity and mix of inputs used in a year relative to the quantity and mix of inputs that would have been used in a previous year to produce the current year output. It measures the amount by which operating income increases and costs decrease through the productive use of input quantities. When comparing productivities across years, the productivity calculations use current year input prices in all calculations. Hence, the productivity component is unaffected by input price changes.

2.

The productivity component represents savings in both variable costs and fixed costs. With respect to variable costs, such as direct materials, productivity improvements immediately translate into cost savings. In the case of fixed costs, such as fixed manufacturing conversion costs, productivity gains result only if management takes actions to reduce unused capacity. For example, reengineering manufacturing processes will decrease the capacity needed to produce a given level of output, but it will lead to a productivity gain only if management reduces the unused capacity by, say, selling off the excess capacity.

Self-test 9 Solution 3

13-22 Balanced Scorecard

Perspectives Financial Strategic Objectives Increase shareholder value Performance Measures Earnings per share Net income Return on assets Return on sales Return on equity Product cost per unit Customer cost per unit Profit per salesperson Number of new customers Percentage of customers retained Customer profitability

Increase profit generated by each salesperson Customer Acquire new customers Retain customers Develop profitable customers Internal Business Process Improve manufacturing quality Introduce new products Minimize invoice error rate On-time delivery by suppliers Increase proprietary products Learning and Growth Increase information system capabilities Enhance employee skills

Percentage of defective product units Percentage of error-free invoices Percentage of on-time deliveries by suppliers Number of patents

Percentage of processes with real-time feedback Average job-related training hours per employee

Self-test 9 Solution 4

13-30 Balanced Scorecard and strategy

1. Dransfield currently follows a cost leadership strategy, which is reflected in its lower price compared to Yorunt Manufacturing. The electronic component ZP98 is similar to products offered by competitors. In the internal business process perspective, Dransfield needs to set targets for decreasing the percentage of defective products sold and then identify measures that would be leading indicators of achieving this goal. For example, in the learning and growth perspective, Dransfield may want to measure the percentage of employees trained in quality management and the percentage of manufacturing processes with real-time feedback. The logic is that improvements in these measures will drive quality improvements and so reduce the percentage of defective products sold. To achieve its goals, items that Dransfield could include under each perspective of the Balanced Scorecard follow:
Operatingincomefromproductivityandqualityimprovement Operatingincomefromgrowth Revenuegrowth Marketshareinelectroniccomponents Numberofadditionalcustomers Customersatisfactionratings Percentageofdefectiveproductssold Orderdeliverytime Ontimedelivery Numberofmajorimprovementsinmanufacturingprocess Employeesatisfactionratings Percentageofemployeestrainedinqualitymanagement Percentageoflineworkersempoweredtomanageprocesses Percentageofmanufacturingprocesseswithrealtimefeedback

2.

FinancialPerspective

CustomerPerspective

InternalBusinessProcess Perspective

LearningandGrowth Perspective

13-31 Strategic analysis of operating income (continuation of 13-30)

1.

Operating income for each year is as follows:

Revenue($445,000;$506,250) Less:Salesreturns($44500;$50225) Netrevenue Costs Directmaterialscosts($102,500;$103,125) Conversioncosts Sellingandcustomerservicecosts Advertisingcosts Totalcosts Operatingincome Changeinoperatingincome 2008 $220,000 22,000 198,000 2009 $312,500 11,250 301,250

25,000 31,250 128,000 184,000 4,000 4,180 20,000 24,000 177,000 243,430 $21,000 $57,820 $36,820F

2.

The Growth Component Selling Actual units of Actual units of Revenue effect = output sold output sold price of growth in 2009 in 2008 in 2008
= (6,025 4,500) $44 = $67,100 F

Units of input Actual units of required Cost effect Input to produce inputs price of growth = 2009 output used to produce for variable costs in 2008 2008 output in 2008

Actual units of capacity in 2008 if adequate to produce 2009 output in 2008 Actual units Cost effect of OR capacity growth for = If 2008 capacity inadequate ofin 2008 fixed costs to produce 2009 output in 2008, units of capacity required to produce 2009 output in 2008

Price per unit of capacity in 2008

Direct materials costs that would be required in 2009 to produce 6,025 units instead of the 4,500 units produced in 2008, assuming the 2008 input-output relationship 2,500 6,025 ). Conversion costs and continued into 2009, equal 3,347.22 kilograms ( 4,500 selling and customer-service costs will not change since adequate capacity exists in 2008 to support year 2009 output and customers.

Advertising costs are discretionary costs and would not change in 2008 if Dransfield had to produce and sell the higher 2009 volume in 2008. The cost effects of growth component are:
Direct materials costs Conversion costs Selling & cust.-serv. costs Advertising costs Cost effect of growth (3,374.22 2,500) (8,000 8,000) (60 60) (1-1)

$10 $16 $66.67 $20,000

= = = =

$ 8,472 U 0 0 0 $ 8,472 U

In summary, the net increase in operating income as a result of the growth component equals:
Revenue effect of growth Cost effect of growth Change in operating income due to growth $67,100 F 8,472 U $58,628 F

The Price-Recovery Component

Revenue effect of Selling price Selling price = price-recovery in 2009 in 2008

Actual units of output sold in 2009

Cost effect of price-recovery for = variable costs

= ($50 $44) 6,025 = $36,150 F Units of input Input Input required to price in price in produce 2009 output 2008 2009 in 2008

Cost effect of price-recovery for = fixed costs

Price per Price per unit of unit of capacity capacity in 2009 in 2008

Actual units of capacity in 2008, if adequate to produce 2009 output in 2008 OR If 2008 capacity inadequate to produce 2009 output in 2008, units of capacity required to produce 2009 output in 2008

Direct materials costs Conversion costs Selling and customer-service costs Advertising costs Cost effect of price-recovery

($10 $10) ($23 $16) ($69.67 $66.67) ($24,000 $20,000)

3,347.22 = $ 0 8,000 = 56,000 U 60 = 180 U 1= 4,000 U $60,180 U

In summary, the net increase in operating income as a result of the price-recovery component equals: Revenue effect of price recovery $36,150 F Cost effect of price recovery 60,180 U Change in operating income due to price recovery 24,030 U

The Productivity Component Actual units of Units of input Cost effect of Input input used required to productivity for = to produce produce 2009 price 2009 output ouput in 2008 variable costs in 2009
Actual units of capacity in 2008, if adequate to produce 2009 output in 2008 Price per Cost effect of Actual units of OR productivity for = capacity in If 2008 capacity inadequate unit of 2009 capacity fixed costs to produce 2009 output in 2008, in 2009 units of capacity required to produce 2009 output in 2008

The productivity component of cost changes are Direct materials costs (3,125 3,347.22) Conversion costs (8,000 8,000) Selling and customer-service costs (60 60) Advertising costs (1 1) Change in operating income due to productivity

$10 $23 $69.67 $24,000

= = = =

$2,222 F 0 0 0 $2,222 F

The change in operating income between 2008 and 2009 can be analyzed as follows:
Revenueand CostEffects ofGrowth Component in2009 (2) $67,100F 8,472U $58,628F Income Revenueand Statement CostEffectsof CostEffectof Amounts PriceRecovery Productivity in2009 Component Component (5)= in2009 in2009 (1)+(2)+(3)+(4) (4) (3) $36,150F $301,250 60,180U $2,222F 243,430 $24,030U $2,222F $57,820 $36,820 F

Revenues Costs Operatingincome

Income Statement Amounts in2008 (1) $198,000 177,000 $21,000

Change in operating income 3. The analysis of operating income indicates that a significant amount of the increase in operating income resulted from Dransfields cost leadership strategy. The company was able to improve quality and grow sales. The price recovery component indicates that selling prices increased in line with the market but Dransfields costs increased even faster, particularly the price of conversion cost capacity, as Dransfield focused on improving quality. The benefit of this improved quality came in the form of higher sales that more than offset the spending on quality.

13-32 Analysis of growth, price-recovery, and productivity components (continuation of 13-31)

Effect of the industry market-size factor on operating income Of the 1,525 increase in sales from 4,500 to 6,025 units, 8% or 360 (8% 4,500) units are due to growth in market size, and 1,165 (1,525 360) units are due to an increase in market share. The change in Dransfields operating income from the industry-market size factor rather than from specific strategic actions is: 360 $58,628 (the growth component in Exercise 13-31) $13,840 F 1,525 Effect of product differentiation on operating income
The change in operating income due to: Increase in the selling price of ZP98 (revenue effect of price recovery) Increase in price of inputs (cost effect of price recovery) Change in operating income due to product differentiation $36,150 F 60,180 U $24,030 U

Effect of cost leadership on operating income

The change in operating income from cost leadership is: Productivity component Growth in market share due to cost leadership $58,628 (the growth component in Exercise 13-31) Change in operating income due to cost leadership $ 2,222 F

1,165 1,525

44,788 F $47,010 F

The change in operating income between 2008 and 2009 can be summarized as follows:
Change due to industry market size Change due to product differentiation Change due to cost leadership Change in operating income $13,840 F 24,030 U 47,010 F $36,820 F

A thoughtful student might argue that the $24,030 U price-recovery variance could also be thought of as part of the productivity variance. Why? Because a large component of this cost is from conversion costs incurred to improve quality, which is more closely associated with productivity and process improvement rather than product development and product differentiation. Under this assumption, the change in operating income between 2008 and 2009 can be summarized as follows:
Change due to market industry size Change due to product differentiation Change due to cost leadership ($47,010 $24,030) Change in operating income $13,840 F 0 22,980 F $36,820 F

Dransfield has been successful in implementing its cost leadership strategy. The increase in operating income during 2009 was due to quality improvements and sales growth. Dransfields operating income increase in 2009 was also helped by a growth in the overall market size.

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Module 9 summary
Explain how the four Balanced Scorecard perspectives are used to evaluate the success of a strategy.
The four perspectives are: financial, customer, internal business processes, and learning and growth.

Explain how the Balanced Scorecard can be used to evaluate risk management strategy, and how good governance contributes to risk management
The BSC can be used to evaluate the effectiveness of an organizations ERM strategy.

Identify similarities between the Balanced Scorecard measures and measures used to assess corporate sustainability
Corporate sustainability creates long-term shareholder value by embracing opportunities and managing risks derived from economic, social, and environmental developments.

Describe the process required to implement and apply the Balanced Scorecard
Successfully implementing a BSC requires commitment and leadership from top management

Evaluate the outcomes of strategic initiatives using the stoplight system

The target stoplight system is a method of evaluating the results of the Balanced Scorecard effort that isolates areas for further analysis.

Evaluate change in operating income resulting from implementation of strategic components: growth, product differentiation, and cost leadership or productivity
Growth

Revenue effect of growth = (Actual units sold in current year Actual units sold in previous year) x Previous year selling price. Cost effect of growth = (Actual units of input that would have been used in current year based on previous years relationship Actual units of input to produce previous years output) x Previous years prices.
Price-recovery

Revenue effect of product differentiation = (Selling price in current year Selling price in previous year) x Actual units sold in current year. Cost effect of product differentiation = (Input price in current year Input price in previous year) x Actual units of input/ output that would have been used to produce current year output assuming the same relationship as previous year.
Productivity

Productivity/cost leadership component = (Actual units input/capacity to produce for current year Actual units of inputs/ capacity that would have been used to produce current year assuming same relationship as previous year) x Current year prices.

Identify unused capacity, and design recommendations to deal with that capacity

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Fixed costs are tied to capacity. There are two types of fixed costs engineered and discretionary. Engineered costs have a direct relationship with outputs. Discretionary costs are periodic costs with no measurable cause-effect relationship to output. Manage unused capacity by downsizing. Use unused capacity to increase revenues.

Analyze specific productivity and capacity control strategies to achieve Balanced Scorecard objectives
Partial productivity = Quantity of output produced Quantity of input used

The higher the ratio, the greater the productivity achieved. Total factor productivity = Quantity of output produced Costs of all inputs used

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