Identifying and Leveraging Value Drivers to Create Wealth

This module identifies and explains important tools or value drivers that mangers can use to create wealth for shareholders. These include Activity-Based Cost Management, Benchmarking, Value Chain Analysis, Target Costing, and Balanced Scorecard. A common characteristic of these value drivers is that each of them aims at securing a sustainable competitive advantage for a company.

Creating Wealth through Sustainable Competitive Advantage

Creating wealth for its shareholders is the key objective of every corporate management. Companies strive to create wealth by securing a sustainable competitive advantage. Competitive advantage is creating better customer value for the same or lower cost than offered by competitors or creating equivalent value for lower cost than offered by competitors. Three general strategies available for increasing customer value to achieve competitive advantage are cost leadership, product differentiation and focusing. Cost Leadership The objective of a cost leadership strategy is to provide the same or better value to customers at a lower cost than offered by competitors. This is done by minimizing customer sacrifice. For example, a company might redesign a product so that fewer parts are needed, lowering production costs and the costs of maintaining the product after purchase. Differentiation A differentiation strategy tries to increase customer value by increasing what the customer receives (customer realization). A competitive advantage is created by providing something to the customers that is not provided by competitors. The difference with competitors product can be functional, aesthetic or stylistic. However, the customers should perceive the difference as important and at the same time the value added to the customer must exceed the cost of providing the differentiation. Examples: providing on-site repair service. Focusing Under focusing strategy, a firm chooses specific segments of the market in which the core competencies of the firm are superior to those of its competitors. Alternatively, the firm selects markets and customers that appear attractive and then develops the capabilities to serve these targeted segments. Strategic Positioning is the process of selecting the optimal mix of these three general strategic approaches. The mix is selected with the objective of creating a sustainable competitive advantage. Strategic management of costs serves an important role in achieving a sustainable competitive advantage. This is particularly applicable to commodity type industries where it

is difficult to adopt a product differentiation strategy. For this purpose, a basic understanding of different types of costs and their behavior is necessary.

Understanding Costs
There are many different types of costs and at different times organizations put more or less emphasis on them. When times are good, companies often focus on selling as much as they can, with costs taking a backseat. But when times get tough, the emphasis usually shifts to costs and cutting them. Managers must understand costs in order to interpret and act on accounting information. Accounting reports contain a variety of cost concepts and terms that managers need to understand to run their operations. Costs are classified in different ways depending on the purpose. For product costing purposes costs are classified into different elements of cost such as material cost, labour cost and other expenses. These are further classified into direct and indirect costs depending on their association with the object whose cost is being determined. All indirect costs (material, labour and other costs) are generally known as Overhead. For external reporting purposes, costs are classified into manufacturing costs, general and administrative costs and selling costs. Functional grouping of costs under manufacturing, selling and administrative costs, though important for external financial reporting, is not useful for budgeting, planning, cost control and decision making. For these purposes, we need to understand cost behavior i.e. how the costs change in relation to changes in the level of activity. Based on their behavior with respect to changes in the output, costs can be classified into Fixed Costs, Variable costs and Mixed costs (semi-variable or semi-fixed costs). Armed with an understanding of the behavior of costs with respect to changes in volume, managers can determine the Break-even Level (level of output where there is no loss and no profit i.e. where total revenue is equal to total cost), the required level of output to achieve a profit target and in general prepare a profit plan for the coming year. Other important tools that managers use to implement the firms broad strategy and to facilitate achievement of sustainable competitive advantage are Activity-Based Cost Management, Benchmarking, Value Chain Analysis, Target Costing, and Balanced Scorecard.

Activity-Based Cost Management

Cost leadership strategy requires appropriate product pricing and accurate cost assignment. Focus is, therefore, shifting from functional-based cost management systems to activity-based cost management systems. A functional- based cost accounting system assumes that all costs can be classified as fixed or variable with respect to changes in the units or volume of product produced. Thus units of product, or other drivers highly correlated with units produced, such as direct labour hours and machine hours are the only drivers assumed to be of importance.

Functional-based cost systems serve to ascertain costs only for financial reporting. They do not cover broader cost definitions used for value-chain analysis. Activity-based cost (ABC) systems have evolved in response to significant changes in the competitive business environment faced by both manufacturing and service firms. An ABC system improves the quality, content, relevance and timing of cost information. In the functional system, the emphasis is on managing costs. In the ABC system, the emphasis is on management of activities with the objective of improving value received by the customer and the profit received by the company in providing this value. The underlying assumption of ABC is that resources are consumed by different activities such as setting up of equipment, movement of materials, running of machines, quality control, etc. In an ABC system, costs are first assigned to activities and then to cost objects.

Benchmarking
Benchmarking is the process by which a firm identifies its critical success factors, studies the best practices of other firms (or other units within a firm) for achieving these critical success factors, and then implements improvements in the firms processes to match or beat the performance of those competitors. Benchmarking was first implemented by Xerox Corporation in the late 1970s. Some firms are recognized as leaders, and therefore benchmarks, in selected areas as shown below.

Customer Service

Innovation and Product Development 3M Apple Computer Sony

Quality

Corporate Social Responsibility Merck Johnson& Johnson General Electric

FedEx Home Depot Amazon.com

Toyota Motorola IBM

Value Chain
Successful pursuit of a sound strategic position requires an understanding of the industrial value chain. Industrial value chain is the linked set of value-creating activities from basic raw materials to the disposal of the finished product by end-use customers. For example, a possible value chain for the petroleum industry is shown below: -------------------------------------------------------------------------------------------------------------Oil Exploration Firm B Oil Refining -------------------------------------------------------------------------------------------------------------Oil Distribution Firm A Gas Distribution Firm C Service Stations -------------------------------------------------------------------------------------------------------------End-Use Customer

Product Disposal Different firms participate in different portions of the value chain. Some firms in computermanufacturing industry focus on manufacture of chips (Texas Instruments), others on manufacturing processors (intel), hard drives (Seagate), monitors (Sony). Some companies ( IBM, Compaq) assemble both manufactured and purchased parts, while others (Dell) assemble only purchased components. Regardless of its position in the value chain, to create and sustain a competitive advantage, a firm must understand the entire value chain and not just the portion in which it operates. Thus, breaking down the value chain into its strategically relevant activities is basic to successful implementation of cost leadership and differentiation strategies. It must also be understood that there exist complex linkages and interrelationships among activities both within and beyond the firm. These are internal linkages and external linkages. Internal linkages are relationships among activities that are performed within a firms portion of the value chain. External linkages, on the other hand, describe the relationship of a firms value-chain activities that are performed with its suppliers and customers. External linkages, therefore, are of two types: supplier linkages and customer linkages. Understanding the entire value-chain helps a firm in effective strategic cost management. For example, knowing the revenues and costs of the different stages may reveal the need to forward or backward integrate to increase overall economic performance. Alternatively, it may reveal that divestiture and a narrowing of participation in the industrial value-chain is a good strategy. Knowing the supplier power and the buyer power can also have a significant effect on how external linkages are exploited. Supplier and buyer power can be assessed for a company by comparing the percentage of profits earned in the industrial value chain with the percentages earned by suppliers and by customers. For example, if the profit earned by a refiner is Rs.1.50 per liter of petrol and the profit earned by a network of service stations that buy the petrol from the refiner is Re. 0.50 per liter, the percentage of profit earned in this segment of the value chain by the downstage stream is 25 percent (Re.0.50/Rs.2.00) while the refiner earns 75 percent of the profit. Buyer power is weak relative to the refiner. If the return on assets being earned by the service station segment is high, this may reveal that integrating forward is both desirable and possible. To exploit its internal and external linkages, a firm must identify its activities and select those that can be used to produce or sustain a competitive advantage. The selection process requires knowledge of the cost and value of each activity. For strategic analysis, activities are classified as organizational activities and operational activities and the costs of these activities are determined by organizational and operational cost drivers. Organizational Activities and Cost Drivers Organizational activities are of two types: structural and executional. Structural activities are activities that determine the underlying economic structure of the organization. Executional activities are activities that define the processes and capabilities of

an organization and are thus directly related to the ability of the organization to execute successfully. Organizational cost drivers are structural and executional factors that determine the long-term cost structure of an organization. Thus there are two types of organizational drivers: structural cost drivers and executional cost drivers. Possible structural and executional activities with their cost drivers are listed below: Structural Activities Building plants Management structuring Grouping employees Complexity Structural Cost Drivers Number of plants, scale, and degree of centralization Management style and philosophy Number and type of work units Number of product lines, number of unique processes, Number of unique parts, degree of complexity Scope, buying power, selling power

Vertically integrating Selecting and using process technologies

Types of process technologies, experience

Executional Activities Using employees Providing quality Providing plant layout Designing and producing products Providing capacity

Executional Cost Drivers Degree of involvement Quality management approach Plant layout efficiency Product configuration Capacity utilization

Among the structural drivers are the familiar drivers of scale, scope, experience, technology and complexity. An interesting property of structural cost drivers is that more is not always better. Moreover, the efficient level of a structural driver can change as has happened in the steel industry. Executional cost drivers have been of greater interest and emphasis in recent times. Considerable management effort is being spent on improving operational efficiency by improving the way things are done in an organization. Examples of measures taken are employee empowerment, total quality management, process value analysis, life-cycle assessment etc. Cost of using employees decreases as employee involvement increases. Operational Activities and Drivers

Operational activities are day-to-day activities performed as a result of the structure and processes selected by the organization. Examples include receiving and inspecting incoming parts, moving materials, shipping products, testing new products, servicing products, and setting up equipment. Operational cost drivers (activity drivers) are those factors that drive the cost of operational activities. They include such factors as number of parts, number of moves, number of products, number of customer orders, and the number of returned products. Operational activities and drivers are the focus of activity-based costing. Possible operational activities and their drivers are listed below: Unit-Level Activities Grinding parts Assembling parts Drilling holes Using materials Using power Batch-Level Activities Setting up equipment Moving batches Inspecting batches Reworking products Product-Level Activities Redesigning products Expediting Scheduling Testing products Unit-Level Drivers Grinding machine hours Assembly labor hours Drilling machine hours Pounds of material Number of kilowatt-hours Batch-Level Drivers Number of setups Number of moves Inspection hours Number of defective units Product-Level Drivers Number of change orders Number of late orders Number of different products Number of procedures

The structural and executional activities define the number and nature of the day-to-day activities performed within the organization. For example, if an organization decides to produce more than one product at a facility, then this structural choice produces a need for scheduling, a product-level activity. Similarly providing a plant layout defines the nature and extent of the material handling activity (usually a batch-level activity). Furthermore, although organizational activities define operational activities, analysis of operational activities and drivers can be used to suggest strategic choices of organizational activities and drivers. For example, knowing that the number of moves is a measure of consumption of the material handling activity by individual products may suggest that resource spending can be reduced if the plant layout is redesigned to reduce the number of moves needed. Operational and organizational activities and their associated drivers are strongly interrelated as shown below:

Organizational Activity (Selecting and using process technologies)

Operational Driver (Number of moves)

Structural Cost Driver (JIT: Type of process technology)

Operational Activity (Moving material)

Value-Chain Analysis
Value-chain analysis is identifying and exploiting internal and external linkages with the objective of strengthening a firms strategic position. The exploitation of linkages relies on analyzing how costs and other non-financial factors vary as different bundles of activities are considered. New approaches to differentiation may be adopted. If the emphasis is on cost leadership, long-term cost reduction is sought to be achieved by managing organizational and operational cost drivers. Competitive cost advantage will result only when the cost drivers are controlled better than competitors. Exploiting Internal Linkages The internal value-chain activities include design, development, production, marketing and servicing. Exploiting internal linkages means that relationships between activities are assessed and used to reduce costs and increase value. Knowledge of cost drivers of activities is crucial for understanding and exploiting linkages. If design engineers know that that the number of parts is a cost driver for various production activities (such as material usage, direct labour usage, assembly, inspection, material handling, and purchasing); service activities (such as repairs, warranty), they can work toward redesigning the product and reducing the number of parts in order to reduce the cost of production and service. The activity based costing model and knowledge of activity cost behaviour are powerful and integral components of strategic cost management. Strategic cost analysis also involves analysis of cost incurred on one activity to save on the cost of other activities.

Exploiting Supplier Linkages Suppliers provide inputs and, as a consequence, can have a significant effect on a users strategic positioning. If a company adopts a total quality control approach to differentiate and reduce overall quality costs, it will require production of defect-free products. It will strongly depend on its suppliers ability to supply defect-free parts. To avoid weakening its strategic position, a firm must carefully choose its suppliers. Managing Procurement Costs The following two steps are required to encourage purchasing managers to choose suppliers whose quality, reliability and delivery performance are acceptable. 1. Costs associated with quality, reliability and late deliveries are added to the purchase costs. Purchasing managers are then required to evaluate suppliers based on total cost, not just purchase price. 2. Supplier costs are assigned to products using causal relationship. Activity-based costing is the key to both the steps. In the first step, suppliers are defined as a cost object and costs relating to purchase, quality, reliability and delivery performance are traced to suppliers. In the second case, products are the cost objects, and supplier costs are traced to specific products. By accurately tracing supplier costs to products, a better understanding of product profitability is produced, and product designers are more capable of choosing among competing product designs. Exploring Customer Linkages Customers can also have a significant influence on a firms strategic position. Choosing market segments is one of the principal elements that define strategic position. A firm having idle capacity may contemplate selling a medium-level quality product to low-end dealers for a special low price. This could threaten the main channels of distribution for the product and may cause long-term damage to companys profitability.

Target Costing
Target costing is a tool that has resulted directly from the intensely competitive markets in many industries. It is an approach to costing which identifies an estimated price customers are willing to pay and then compute a target cost to earn the desired profit. Target price, calculated, using information from customers and competitors forms the basis for calculating the target cost. Target cost per unit is the target price per unit minus the target operating income per unit. Target operating income per unit is the operating income that a company aims to earn per unit of product or service sold. Target cost per unit is the estimated long-run cost per unit of a product or service that enables the company to achieve its target operating income per unit when selling at the target price. All future costs, variable and fixed must be included because in the long run, a companys prices and revenues must recover all its costs. Target cost per unit is often lower than the

existing full cost per unit of the product. To achieve target cost per unit and target operating income per unit, the company must reduce the cost of making its products. For achieving a sustainable competitive advantage and to create wealth, management has to work on four key areas: financials, customers, internal business processes, and learning and growth. Managing costs is a part of the financial perspective. The concept of balanced scorecard is used to integrate thinking and action on all these perspectives

Balanced Scorecard
Financial measures such as profitability reflect only a partial, and frequently only a shortterm measure of the firms progress. There are some non-financial perspectives to which the management has to pay attention to achieve competitive success. The balanced scorecard translates an organizations objectives and performance measures for four different perspectives: financial, customer, internal business processes, and, learning and growth. It is an effective way of implementing and managing a companys strategy. Strategy identifies and defines managements desired relationships among the four perspectives. Strategy translation, on the other hand, means specifying objectives, measures, targets and initiatives for each perspective. Example Strategy Financial Perspective Objective Performance Measure Target Initiatives Growing revenue by introducing new products Percentage of revenue from sale of new products 20% of revenue for the coming year from new products How this is to be accomplished? The how will involve the other three perspectives. The capabilities in the customer segment, internal processes, and organizational capabilities that will permit the realization of revenue growth objective must be identified. Revenue growth

Thus, the financial objectives serve as the focus for the objectives, measures and initiatives of the other three perspectives. There is also the need to carefully define the relationships among the four perspectives so that strategy becomes visible and operational. Financial Perspective

This perspective establishes the long and short-term financial objectives expected from the organizations strategy and simultaneously describes the economic consequences of actions taken in the other three perspectives. Financial perspective has three key themes: revenue growth, cost reduction and asset utilization, on the basis of which specific operational objectives and measures are developed. The three key themes are constrained by the managers need to manage risks. Objectives Revenue Growth Increase the number of new products Create new applications Develop new customers and markets Adopt a new pricing strategy Cost Reduction Reduce the product cost Reduce unit customer cost Reduce distribution channel cost Asset Utilization Improve asset utilization Return on Investment Economic value added Unit product cost Unit customer cost Cost per distribution channel Percentage of revenues from new products Percentage of revenue from new applications Percentage of revenue from new sources Product and customer profitability Measures

Customer Perspective This perspective defines the customer and market segments in which the business unit will compete and describe the way that value is created for customers. The customer perspective is the source of the revenue component for the financial objectives. Objectives under this perspective include some core objectives and measures that drive the creation of customer value and thus drive the core outcomes. Objectives Core Increase market share Increase customer retention Percentage of market Percent growth of existing customers Percent of repeating customers Number of new customers Ratings from customer surveys Customer profitability Measures

Increase customer acquisition Increase customer satisfaction Increase customer profitability

Customer Value Decrease price Decrease post-purchase cost Improve product functionality Improving product quality Increase delivery reliability Improve product image and reputation Process Perspective The internal business process perspective describes the internal processes needed to provide value for customers and owners. Processes are the means by which strategies are executed. Process perspective entails the identification of critical processes needed that affect customer and shareholder satisfaction. To provide the framework needed for this perspective, a process value chain is identified. The process value chain is made up of three processes: the innovation process, the operations process and the post-sales process. The innovation process anticipates the emerging and potential needs of customers and creates new products and services to satisfy those needs. It represents what is called the long-wave of value creation. The operation process produces and delivers existing products and services to customers. It begins with a customer order and ends up with the delivery of the product or service. It is the short-wave of value creation. The post-sales service process provides critical and responsive services to customers after the product or service has been delivered. Objectives Innovation Increase the number of new products Number of new products/total number of products Percent revenue from proprietary products Time to market (from start to finish) Measures Price Post-purchase cost Rating from customer surveys Percent returns on-time delivery and ageing schedule Rating from customer surveys

Increase revenue from proprietary products

Decrease product development cycle time Operations Increase process quality

Quality costs, Output yields, Percent of defective units Unit cost trends

Increase process efficiency

Output/Input(s) Increase process time Post-Sales Service Increase service quality First-pass yields (percent of customer requests resolved with a single service call Cost trends, Output/Inputs Cycle time (time from receipt of customer request to the time when customer problem is solved) Cycle time and velocity, MCE

Increase service efficiency Increase service time

Learning and Growth Perspective The learning and growth (infrastructure) perspective defines the capabilities that an organization needs to create long-term growth and improvement. This perspective is concerned with three enabling factors: employee capabilities, information system capabilities and employee attitudes (motivation, empowerment and alignment). These factors enable processes to be executed efficiently. This perspective is the source of capabilities that enable the achievement of other three perspectives objectives. Objectives Measures

Increase employee capabilities

Employee satisfaction ratings Employee turnover percentages Employee productivity (revenue per employee) Hours of training Strategic job coverage ratio (percentage of critical job requirements filled) Suggestions per employee Suggestions implemented per employee Percentage of processes with realtime feedback capabilities Percentage of customer-facing employees with on-line access to customer and producer information

Increase motivation and alignment

Increase information system capabilities

Linking Measures to Strategy

The objectives and measures of the four perspectives are linked by a series of cause-andeffect relationships. The cause and effect relationships serve to integrate the lead and lag measures. Lead measures are supposed to cause outcomes (the lag measures). They also help in making a strategy testable. The testability of strategy is achieved by restating the strategy into a set of cause-and effect hypotheses that are expressed by way of a sequence of if-then statements. Example If employee skills are upgraded and if the manufacturing process is redesigned, then manufacturing cycle time will be decreased. If cycle time decreases, then delivery reliability will improve and process costs will decrease. If delivery reliability improves, then customer retention will increase. If customer retention increases, then market share will increase If market share increases, then sales will increase If sales increases and costs decrease, then profits will increase If profits increase, then shareholder value will increase. These if-then statements can be presented in the form of a causal flow diagram to depict the strategy at work. The claimed relationships between cause and effect can be checked or tested to see if the strategy produces the expected results. The strategy may fail to achieve the desired results due to (i) implementation problems or (ii) an invalid strategy