You are on page 1of 101

ACCA NOTES - P3

CONTENTS

Strategic Position

Chapter 1 Business Strategy Page 2


Chapter 2 Stakeholders & Ethics Page 6
Chapter 3 Environmental Issues-External Environment Analysis Page 9

Chapter 4 Internal Environment Analysis Page 17

Strategic Choices/Options

Chapter 5 Strategic Choices Page 26

Strategic Action/Implementation

Chapter 6 Organizing for success Page 39


Chapter 7 Strategic change management Page 44

Business and process change

Chapter 8 Business process Change Page 46

Information Technology

Chapter 9 Information technology Page53

People

Chapter 10 Leadership & Human Resource Management Page 63

Project management

Chapter 11 Project Management Page 67

Financial Analysis

Chapter 12 Forecasting and Finance Page 73

1|Page
Chapter 1

Business Strategy

Overview:

Strategy

Levels of strategy
Context of Strategy
Context of Strategy
Strategic Lenses
delibrate & Emergent Strategies

Strategy: the direction of an organization over the long term to achieve advantage in a changing
environment through the configurations of resources and competences with the aim of fulfilling
stakeholders expectations.

Levels of strategy:

1. Corporate Strategy: 2. Business/competitive strategy: 3. Operational Strategy:

Its the overall scope and Its about how to compete in market. Its the arrangement of
direction of the organization It can take two forms: resources for successful
and how value will be added. implementation of business
Also includes allocation of a) Cost leadership: selling the same strategy OR how the
corporate resources product as competitors for lower component parts of the
price (be cheap) business deliver effectively
such as marketing and
b) Differentiation: Selling the finance.
product which is different from
competitors. Product is unique(be
better)

Strategic Decisions:

Strategic
Strategic position Strategic choices
Implementation

2|Page
Some key terms are as follows:

- Strategies: are developed in order to achieve desired outcome

- Vision: The ideal future position of the company

- Mission: The determination that the company wishes to achieve its vision-its also the purpose of
the organization.

- Mission statement: A document on which the mission is formally stated. It gives substance and
clarity to a vision.

- Goals: The intentions behind decisions or actions.it is the aim or purpose and supports the mission-
Goals should be SMART

- Objectives: is a more specific aim or purpose and will probably be quantified

An objective must be:

Specific
Measureable
Achievable Realistic
Time Bound

- Strategic capabilities: flow from resources and competences. Unique resources and core
competences create competitive advantages

- Strategic control: has two parts: monitoring the effectiveness of strategies and actions; and taking
corrective actions when required

- strategic drift: particularly affects organisations which have experienced a long period of relative
continuity during which strategy has either remained unchanged or changed incrementally to react
to relatively minor changes in the external environment or industry.

Organisation continuing to pursue a strategy which progressively fails to address the changing
strategic position of the organisation and this failure leads to deterioration in organisational
performance. This is known as strategic drift.

3|Page
Context of strategy: The organizational setting in which strategy is developed

As strategy changes with different types of organizations, so it is very important to know about all
types. Possible contexts include:
Small business Multinational The public sector Not for profit organization

Limited product Diverse products, Constraints on funding, Diverse sources of funds,


range, markets and processes and commitment to service strong underlying values
resources (especially markets, with provision and the need and purpose
financial) but significant resources to demonstrate value
significant pressure and multiple
from competitors operations

Strategy Lenses:

This model argues that strategy can be set in different ways:

1. Strategy as design: 2. Strategy as experience: 3. Strategy as ideas:

Here a strategy is driven from Here the strategy is basically Strategy based on innovation,
the top in order to meet the repeating what has been done in diversity of ideas, informal
objective of organization. a past. an adaptation of what has interaction and experimentation.
rational, top-down process worked in the past based on Managers create the context but
rational managers, clear experience, assumptions, must prevent strategic drift.
objectives, machine like decisions to satisfice rather than
system optimize

4|Page
Intention, Emergence and realization:

Strategies should never be set in a stone. No one is capable of gathering all the relevant fact and making
correct predictions. Random local, national and world events will intervene and mess up a carefully
thought out strategy.

Deliberate strategy tended strategy


The terminology on this diagram is as follows:

Intended strategy was the original plan.

Usually some parts of that are unrealised. They are abandoned either because there are changes
on the environment, or we ind that we dont have the resources to carry them out. .

Deliberate strategy is what you intended to do and actually did.

Emergent strategies become apparent as time passes and new opportunities or threats have to
be dealt with. This is the most important term in the diagram.

The realised strategy is therefore the result of some strategies which were planned from the
start, some strategies which were abandoned, and additional strategies which gradually
emerged over the planning horizon.

The fact that the realised strategy will rarely be the same as the intended strategy does not
mean that there must be a fault in the strategic planning process. It simply indicates that,
obviously, the future is not perfectly predictable.

End of Chapter

5|Page
Chapter 2:

Stakeholders & Ethics:

Overview:

Stakeholders Ethics Other Areas

Medelows Stakeholder Ethical Stance Corporate Social


Mapping Ethical dilemmas Responsibility(CSR)
Corportae Governance
Integrated Reporting (IR)

Stakeholders: group or individuals whose interest are directly affected by activities of an organization.
E.g.

Internal: interacts daily with the organization


Connected: frequent interaction with the company
External: occasional interaction with organization

Mendelows stakeholders model: to identify and manage stakeholders according to their expectations.

Power: in an influential position?

Interest: is a stakeholder affected by the decision?

The detail is:

high Low

key players-Strategy Keep informed-they


High must be acceptable to can influence more
them powerful stakeholders

keep satisfied-can
low minimal effort-Ignore
become key players

Ethics:

Ethics are ideas about right and wrong that set standards for conduct. Ethics are important to business
because society considers such things important. There are also rules of professional conduct to
consider. Ideas of right and wrong have become more fluid and less absolute. As a result there is a
greater scrutiny of organizations behaviour since it is likely to be less subject to definitive internal rules.

6|Page
Ethical stance: The extent to which an organization will exceed its minimum obligation to stakeholders.

- Short term stakeholder interest: obey the letter of the law

- Long term stakeholder interest: behave ethically to enhance image and reduce pressure for regulation

- Multiple stakeholder obligations: the expectations of other groups of stakeholders may be


considered, as well as any right they may have

- Shaper of society: really restricted to public sector organizations; businesses should not sacrifice their
commercial viability

Ethical Dilemmas: Conflicting views of the organizations responsibilities create ethical dilemmas for
managers at all levels.

Examples are;

- Dealing with corrupt or unpleasant regimes


- Honesty in disclosing information
- Employees-cost or opportunity for them?
- Corrupt payments to officials-bribery or gift? The local culture must be considered.
-

Corporate Social Responsibility:

Corporate Social responsibility (CSR) centers on the approach taken by organizations to provide benefit
to society in general rather than specific stakeholders.
Examples of CSR include:
a. Acting ecologically
b. Fair employment policies
c. Charitable donation

Corporate Governance:

It is the conduct of the organizations senior management. Its the way the organizations are run and
controlled.

Where the management of a business is separated from its ownership by the employment of
professional managers; the mangers are considered to be the Agents of the owners. The Agency theory
is concerned with adverse selection and moral hazards, the problem that arise as a result of the
separation of ownership and control. In many organizations, corporate governance takes the form of
chain of responsibilities and accountability.

- Abuses have led to a range of measures to improve corporate governance.

7|Page
- Non-Executive directors(NEDs) have a particular role to play being independent of management

Integrated Reporting:

An integrated report is a concise communication about how an organizations strategy, governance,


performance and prospects lead to the creation of value over the short, medium and long term (IIRC
draft framework, April 2013).

Integrated Reporting & Strategy:

Financial reports have long been part of business culture. The content, structure and rules for
constructing these reports are still important. For most organizations, growth and profitability are still
significant goals. However, the development of approaches such as the balanced business scorecard has
prompted companies to set performance measures in non-financial areas, such as customer satisfaction
and process efficiency.

However, within the normal financial reporting framework, there is no place for the company to report
its progress (or lack of it) in these important non-financial areas. The integrated report provides the
opportunity for the organization to restate its mission and how its strategy addresses this mission.
Central to this will be a discussion of the CSFs and the KPIs which have been identified to measure
business performance. KPIs will have associated performance objectives which can be reported in the
integrated report. Thus, the report not only restates the KPI and its associated performance objective, it
also reports on whether that performance objective has been met and, if it has not, discusses reasons
for failure and the actions which are being taken to ensure that this objective is met in the next
reporting period. If it fails to meet these targets, then it will explain how this failure is being addressed.

However, an integrated report should be more than a summary of information from other
communications; it should explicitly connect the information to communicate how value is created.
Thus current and potential stakeholders should have better information about the future value of the
organization in which they are interested. Through a restatement of the mission statement,
stakeholders will also have the direction and purpose of the organization emphasized and re-affirmed.

End of chapter

8|Page
Chapter 3

Environmental Issues-External Environment Analysis (Threats & Opportunities)

Overview:

Macro Environment Competitiors &


Industrial Analysis other Areas
Analysis Customers
PESTEL Analysis Porter's 5 froces industry lifecycle Porter's Diamond
Analysis Segmentation Model(Nation'slcom
Marketing Mix petitiveness )
Critical Succes scenario building
Factors

Important Terms:

- Customer: User whose needs define the product of the business. Different customers have different
preferences e.g. some are cost conscious, some are quality conscious etc.

- Competitors: The businesses operating in the same industry and same segment.

- Industry: is a group of firms selling the same products or close substitutes

- Sector: is similar but includes public sector organizations (for example public and private schools
are both in the education sector)

- Substitute product: is a good or service produced by another industry which satisfies the same
customer needs e.g. tea and coffee are substitutes.

- Convergence: when one industrys product starts to satisfy the needs of the product of other
industry e.g. cell phones has replaced the alarm clocks.

- Strategic group: refers to organizations in the same sector which are competing using similar
strategies. There may be a number of strategic groups within the same industry. For example, there
are many shops that sell coffee; however they are not all competing with each other directly. Within
this industry there are at least three strategic groups.

Strategic groups contain organisations with similar strategic characteristics that define their
strategic space. E.g. Product diversity, Geographical coverage, Branding, Pricing policy, Product
quality, distributions, Target segment etc.

9|Page
- Hyper competition: A condition of constant competitive change, with frequent boldly aggressive
moves. No firm can create lasting competitive advantage and success depends on effective short-
term moves.

Introduction to External Environment Analysis:


In earlier chapters we saw that organizations need to satisfy their key stakeholders.
Organizations do this by setting objectives. If these objectives are achieved the stakeholders will be kept
happy.

Once these objectives are set, the organization then needs to decide how to meet the objectives and
need to define the strategy. For that,It is important that the organization considers what is going on in
the outside world.

The business environment is the world in which the organization operates.

1. Macro Environment Analysis

Macro factors are those factors which affect all businesses in one industry.

The model used In P3 for Macro Analysis is PESTEL

PESTEL Analysis:

It considers the following 6 external factors:

1. Political Factors: e.g. change in government policy, tax incentives, instability of government etc.
2. Economic Factors: e.g. disposable income, inflation rates , employment rates, international
trade etc.
3. Social Factors: Demography (average age, ethnicity, family structure, geography, culture,
lifestyle etc.
4. Technological Factors: e.g. awareness of stakeholders about technology, new products and
services become available, new media for communication with customers etc.
5. Environmental Factors: awareness of stakeholders about environment, green policies, pressure
groups, environmental risk, legislation etc.
6. Legal Factors: e.g. health & safety laws, employment law, data protection act etc.

- All above factors are interlinked


- All PESTEL factors help an organization to identify its threats and opportunities in the external
environment.

Four aspects of globalization are key drivers of change in the macro-environment:

1. Market globalization-converging tastes; improving communications


2. Cost globalization-economies of scale and experience
3. Government policy-increasingly sympathetic to free trade
4. Global c competition- high levels of international trade encourage global competition

10 | P a g e
2. Industrial Analysis
Industry is the immediate business environment of firms producing similar goods.
For industrial analysis the model used in P3 is Porters 5 forces analysis.

Porters Five Forces Analysis:

This model is used to assess the attractiveness or profit potential of a company.

It consider 5 forces acting on the industry

Porter says that five forces together determine the long-term profit potential of an industry

1. Bargaining power of suppliers 2. Threat of new entrants 3. Bargaining power of


customers
Depends on: This is limited by barriers to entry:
- Number of suppliers - Economies of scale Depends on:
- Threats to suppliers industry - Product differentiation - Volume bought
- Number of customers in - Patent rights - Scope for substitution
industry - Access to resources - Switching costs
- Scope for substitution - Access to distribution channels - Purchasing skills
- Switching costs - Switching costs - Importance of quality
- Selling skills
4. Rivalry among current competitors 5. Threat from substitute product

Depends on: A substitute is produced by a different industry but


- Market growth satisfies the same needs
- Buyers ease of switching
- Spare capacity
- Exit barriers
- Uncertainty about competitor's strategy

- Any of the above force if not favourable, it will be very difficult to earn profits.
- IT has characteristics that can affect all five competitive forces e.g. IT can raise barriers to entry etc.

3. Competitors & Customers

Cycle of competition:

A companys competitive advantage may erode because of fast changes in the environment such as new
technologies, globalization and deregulation. Organisations respond to the erosion of their competitive
position and create a cycle of competition the cycle may result in the escalation of competition such
as price wars, attack on the home market etc.

It is the speed of the cycle that plays an important role.

11 | P a g e
If the process is slow, competition in the particular sector or industry settles down.
If the speed of cycle is high, hyper-competition arises, yielding an unstable and constantly shifting
environment that leads to short term advantages.

Industry lifecycle:

Stages Inception Growth Maturity/ Decline


shakeout
Product Basic no standard Better, more Superior, Varied quality but
established sophisticated, standardized fairly
differentiated undifferentiated
Competitors None of the Many entrants Competition Few remain,
above increases, weaker Competition may
player leave be on price
Buyers Early adopter, More customer Mass market traditional,
prosperous attracted and Brand switching sophisticated
curious must be aware common
induced
Profits Negative- high Good, possibly Ending under Variable
first mover starting to decline pressure of
advantage competition

Marketing and Marketing Mix:

Understanding and anticipating customers needs and meeting these customers needs in a profitable
manner.The organization must decide:

- What target markets should be selected for development


- How to offer its product or service
- How to establish a marketing system and organization
- How to develop. implement and control a marketing plan

The organization must commit itself to supplying what customers need. This is called a marketing
orientation, and marketers employ the marketing mix.

7 Ps of Marketing Mix (Way to success)

If marketing mix is perfect, the product will be successful.

1. Product: should address the needs of customers


2. Price: value for money
3. Place: easily accessible to customers-e.g. online
4. Promotion: communication with customers about the product
5. People: who can provide service according to the expectation of customer
6. Process: convenient for customers
7. Physical evidence: impression even before availing the service

12 | P a g e
(Last 3; people, process, physical evidence is applicable to service business only)

Segmentation:

is the subdividing of a market into increasingly homogeneous(customers having similar needs)


subgroups of customers. Basis may be;

- Geographic area
- Preference of quality/price
- Household status
- Religion/ethnicity
- Social class/lifestyle/income

Segment should be;

- Measurable
- Accessible, and can be accessed profitably
- Stable
- Potentially profitable
- Susceptible to a distinct marketing mix

Important: A firm should only develop a unique marketing mix for a valid segment

Target market: it is one or more segments selected for special attention by a company.

Options are;

Same product to whole market UNDIFFERENTIATED Marketing


Specialized product for one segment only - CONCENTRATED Marketing
Several versions for many segments - DIFFERENTIATED Marketing

Assessing the market segment:

The following factors needs to be considered:

- Volume/size of the segment


- Sustainability
- Profitability/price

Final on External Environment:

Strategic customer

is the purchaser of the product offered. This may not be the end user. The end users requirements are
important. but those of any intermediary purchaser are of primary strategic importance.

Critical success factors

13 | P a g e
Are those product features that are particularly valued by a group of customers and, therefore, where
the organization must outperform competitors? E.g. quality of the product etc.

Opportunities and threats:


Information about the environment may be summarized as opportunities and threats.

Threats

The most immediate threats probably emerge from the immediate industry: the five forces are a good
guide. The wider PESTEL environment must also be monitored, but threats may be more difficult to
recognize.

Opportunities

Opportunities often take the form of strategic gaps such as:

- Potential substitutes for existing products


- Different strategic customers via new distribution methods such as the Internet.
- Potential complementary products

4. Other Areas:

Nations competitive advantage:

In P3 Porters Diamond model is used to assess the competitive advantage of the nations

Porters Diamond Model:

Companies based in certain countries seem to be more competitive than companies from other
countries. Porters diamond looks at why.

Porter comes up with 4 reasons for this:

1. Factor conditions
2. Firm strategy, structure and rivalry
3. Demand conditions
4. Related and supporting industries.

14 | P a g e
Factor conditions Demand conditions
These include: These include:
Basic factors: like Natural resources, Climate
etc. and; - Market segmentation of home market
Advanced factors: like Communications - Sophistication of buyers
infrastructure, Knowledge bases and logistics - Position within product life-cycle in home
systems. market
- Anticipation of buyer needs
Firm strategy, structure and rivalry Related and supporting industries
These include: These include:
- Strength of suppliers
- Attitude to short-term profit - Quality of suppliers
- National culture Important: You can also add one more heading while
- Level of domestic rivalry. answering the exam question i-e, government support.
-

Scenario planning (Environment in Future):

It is important that organizations try to make some projections of what might happen as their strategy
will need to take account of this.

A scenario is a detailed and consistent view of how the environment might develop in the future. They
are particularly useful when two possibilities cannot both occur.

- Macro scenarios consider possible futures overall.


- Industry scenarios look in more detail at a single industry.

For example there is a possibility that a new government policy could be passed which will make
trading conditions more difficult for a company.

Three scenarios could be prepared. What to do if :

- The new policy is introduced

15 | P a g e
- The new policy is not introduced
- A compromise law is passed

Note that only one of the above three can happen.

Scenario planning is useful as it forces managers to consider what might happen. Scenarios can then be
drawn up for those situations which would have the most effect on the organisation.

The problems with this approach are:


- The time and cost of preparing scenarios and most of the scenarios will not actually occur.
- There may still be unexpected major environmental influences.
Steps Scenario construction (For Exam Questions)

1. Identify drivers of change


2. Arrange drivers in a viable framework
3. Produce 7-9 mini-scenarios
4. Group mini scenarios into 2-3 comprehensive scenarios
5. Write up the scenarios
6. Identify issues arising

End of chapter

16 | P a g e
Chapter 4

Internal Environment Analysis (Strategic Capability-to identify strength and weaknesses)

Overview:

Internal Analysis

culture
value chain
Resource based strategy (Postion audit,resource audits,CSF,KPIs and Benchmarking, understanding
Resources and competences)
Mission statement
Knowledge management
SWOT analysis

1. Culture:

Types of culture:

- Power culture: Decision making is centralized. It is observed in small family businesses or


personality influenced businesses.
- Role culture: procedures are more important. Mostly observed in large organizations e.g. public
sector or banks etc.
- Task culture: task/results are more important than procedure.

The culture is dependent on the type of organization

Analyzing the culture of an organization:

Model to be used is Culture Web

It has 7 elements:

- Rituals & Routines: a task performed periodically (business as well as non-business)-daily


behaviours etc.
- Symbols: Symbolizing the position of an individual-can be verbal or visual e.g. logos, expensive cars,
special dining rooms, personal assistants, language, titles etc.
- Control Systems: it is the identification of the basis of performance measurement system and
rewards-what is most closely monitored in an organization? Punishment or reward system? What
processes has the strongest/weakest controls.
- Organizational structure: formal or informal, tall or flat, centralized or decentralized.
- Power Culture: who is the most important/influential position in the organization?
- Stories: background, beliefs about stakeholders and belief of stakeholders about organization

17 | P a g e
- Paradigm: overall beliefs. It reinforces the other elements of culture web-overall conclusion of all
above points.

2. Value Chain Analysis:

Value chain describes the activities within and around an organization that create a product or a service.

Value chain analysis is the analysis of an organization by breaking it down into strategically significant
activities that add value to product/services.

Porter analyzed the various activities of an organization into a value chain. This is a model of value
activities and the relationships between them.

Primary activities: Secondary/Support Activities:


1. Inbound logistics: deals with delivery of raw 1. Procurement: right price, right quantity, right
materials, handling and storage of raw quality, right time, right supplier
materials. 2. Technological Development: computer aided
2. Operations: conversion of raw material into design, computer aided manufacturing
finished goods. 3. HRM: hiring, training, appraisal, dismissal
3. Outbound logistics: storage of finished goods, 4. Firm Infrastructure: tall/flat,
ordering systems, delivery to customers centralized/decentralized, formal/informal
4. Marketing & sales: communication with
customers to inform about product.
5. Services: after sale services e.g. warranties,
installing products.

- All activities of value chain are linked


- May be used to highlight strengths and weaknesses
- Linked with competitive strategy(cost leadership, differentiation)
- IT can affect value chain to improve it-exam question may ask to suggest improvement based on
value chain.

18 | P a g e
Important terms:

- Upstream supply chain: the link between organization and its supplier-procurement, inbound
logistics
- Downstream supply chain: the relation between organization and its customers-outbound logistics,
marketing & sales, services.

- A company's value chain is not bounded by a company's borders, its connected to what
Porter describes as a value system.

Value chain and Effect of IT (very Important for exam questions):


There is no problem at all seeing how information technology could be used in each activity:

19 | P a g e
However, just because IT can be used does not mean that value will be added, and if value is not added
profits cannot be improved. Inappropriate use of IT could harm a companys prospects. For example,
there is little point in automating production if what your customers cherish are hand-made,
individualized products.

3. Resource based strategy:

Managers need to understand the internal resources and competences of an organization to enable
them to formulate and implement a strategy. In particular they need to know if they are adequate and
suitable.

Understanding resources and competences:

Same as competitors or easy to copy Different from competitors or difficult


to copy
Resources Basic resource Unique resource
(things we have)

Competences Threshold competence Core competence


(ability to do
something)
Required to address the basic needs of They provide competitive advantage
customers

Important terms:

- Position based strategy (finding the resources to meet the environment): requires the organization
to analyze the environment and position itself with appropriate competences and resources to
compete.

- Resource based strategy (find the environment that fits our capabilities): takes the approach that
sustainable competitive advantage comes through possession of distinctive resources:
(a) Physical resources (asset infrastructure, rights to raw materials); and/or
(b) Competences (skills, knowledge etc. especially for service companies)

- Dynamic capabilities: are an organizations abilities to develop and change competences to meet the
needs of rapidly changing environment.

- Resource audit: to identify the resources in place. Uses Ms model:

Ms Model:
Manpower: An analysis of human resources
Money: An analysis of financial resources
Machinery: An analysis of operational resources
Materials: Purchasing and suppliers factors
Markets: Issues of marketing and distribution to the customers

20 | P a g e
Management: The corporate, tactical and operational stewardship of the company
Methods: Processes used to create outputs from inputs
Make Up: Organizational structure and culture
Management Information Systems: Strategic use of IT and IS.

Limiting factors:
Every organisation operates under resource constraints. There is never enough money or skilled labour
or key components supplies etc. If there is a limiting factor, it must be identified and quantified.

A limiting factor or key factor is 'a factor which at any time or over a period may limit the activity of an
entity, often one where there is shortage or difficulty of supply'.

Examples of limiting factors are:


(a) a shortage of labour skills and/or hours;
(b) a limited availability of raw materials;
(c) lack of money;
(d) a lack of demand for products or services.

Critical Success Factors, KPIs & Benchmarking:

CSF KPIs Benchmarking

Important terms: Managing CSFs:


- Critical success factors: are those product features 1. Identify CSF
that are particularly valued by a group of customers 2. Measure CSF using (KPIs- Key
and, therefore, where the organization must excel to performance indicator)
outperform competitors. e.g. highest level of customer 3. Target setting (Benchmark)
service 4. Identify the problem areas
5. Take corrective actions
- Key performance indicators (KPIs): are quantifiable 6. Re-measure KPI
measures that management can use to monitor and
control progress toward achieving CSFs. If the CSF is
highest level of customer service then KPI can be the
speed of delivery times or the number of repeat
customers etc.

21 | P a g e
Benchmarking:

Benchmarking is: Advantages of benchmarking


advantages
- data gathering, of targets and - Assess existing resources
comparators; - Manager involvement
- identifying relative levels of performance - Focus on improvement
(and particularly areas of - Sharing information
underperformance);
- Adoption of identified best practices to Disadvantages of benchmarking
improve performance.
- Too much focus on efficiency rather than effectiveness
Benchmarking therefore enables a firm to: - Looks at now not the future
- meet industry standards by copying - Targets and comparisons may not reveal best practice
others, (i.e. what not why!)
- challenge existing ways of doing things - Always on catch up when innovation (i.e. a bypass
- assess current resources and competences strategy) would be more effective
- Useful information not freely available
-

Types of Benchmarking:

1. Historical benchmarking: comparison of current against past performance


2. Industrial/Sector benchmarking: across the industry/similar providers
3. Best in class benchmarking: look for the best practice out of industry

Mission Statement:

Mission statements are formal documents that Contents of mission statement:


state the organisations mission. They are to be effective a corporate mission must contain the
published within organisation to promote following four components:
desired behavior, support for strategy and
purpose, adherence to core values and - Purpose: Why (business rationale) and for whom the
adoption of policies and standards of organization exists (e.g. shareholders).
behaviour. - Strategic goals: The commercial logic of the
organisation (e.g. cost leadership or differentiation)
Advantages of mission statement - Standards: Organizational policy and norms of
- providing a rationale as to why the behaviour, which help staff, decide what to do on a
organization exists day-to-day basis to carry out the strategy (i.e. translate
- communicating clearly a companys chosen purpose and strategy into actionable policies)
market, and its role within it - Values: How it relates to its stakeholders, often
- promoting goal congruence encompassed in its culture.
- acting as a trigger for objective setting
-

22 | P a g e
Knowledge management:
To capture + organize + make widely available the knowledge the organization has.

Organisational knowledge is the collective and shared experience accumulated through systems, routines
and activities of sharing across the organisation.

As organisations become more complex and larger the need to share and pool what people know becomes
more of a challenge but more important for sustainable competitive advantage.

Information technology is beginning to provide systems for the capture of and management of knowledge.

Knowledge can be:


Explicit which is objective and codified and transmitted in formal ways
Tacit which is personal and context specific and is therefore hard to formalise and transmit.
In order to be successful organisations must establish competencies in transmitting both types of knowledge.

To do this an organisation may seek to be a learning organisation that:


(a) recognizes the significance of peoples intuition
(b) welcomes different/conflicting view; and
(c) makes experimentation the norm

Truly innovative companies are the ones that can modify and enlarge the knowledge of individuals to cause a
spiral of interaction between tacit and explicit knowledge.

Socialisation the informal Externalisation converts tacit


process by which individuals knowledge into explicit knowledge
share and transmit their tacit (eg writing down procedures,
knowledge (eg coffee machine sharing leads through a CRM
chat). system); this is a very difficult
process to organise and control.
Internalisation the learning Combination brings together
process by which individuals separate elements of explicit
acquire explicit knowledge and knowledge into larger, more
turn it into their own tacit coherent systems and little or no
knowledge (eg accessing an knowledge is tacit (eg knowledge
intranet, attending briefings, management is active and effective
reading news sheets, using CRM and part of the organisations
systems) culture).

Learning Organizations/organizations learning:

The learning organisation is an ideal towards which organisations should evolve in order to respond to
contemporary pressures. It is characterised by a view that both collective and individual learning is key to
organisational success. A learning organisation is one which is capable of continual regeneration based on
the knowledge, experience and skills of individuals working in an organisational culture which encourages

23 | P a g e
mutual questioning and challenge. It emphasises the potential capability of an organisation to regenerate
from within.
Advocates of the learning organisation suggest that the collective knowledge of all the individuals within an
organisation greatly exceeds what the organisation knows in its formal documentation, filing and
information systems. They suggest that it is the responsibility of management to encourage processes which
reveal the knowledge of individuals and encourage the sharing of this knowledge. Hence the learning
organisation is closely connected with the principles of knowledge management, the other strand in the
CEOs policy statement. As a result of free-flowing knowledge, individuals within an organisation become
more sensitive to the changes happening around them and this helps them contribute to identifying
opportunities and threats in the external environment and also to them developing strategies to tackle these
threats or to exploit the opportunities.

- Developing a system to ensure that organizations is able to identify significant changes in strategic
position earliest possible-the organizations which can do this are calledlearning organizations.

- It may be possible via managing knowledge (developing + sharing)

- Organization must be able to adapt to situations that require significant strategic changes.

Cost efficiency:

Cost efficiency is fundamental to strategic capability: the public sector demands value for money, while in
the private sector, price competition makes cost efficiency fundamental to survival. Cost efficiency is
achieved in four main ways.

Economies of scale unit costs fall with size of an organization through sharing fixed costs and
specialization efficiencies and other economies (eg bulk discounts).

Experience efficiencies come through repetition and organizational learning

Product/process design products and processes can be changed to minimize costs (e.g.
standardized components and use of robotics in car assembly)

Supply costs cheaper supplies will reduce the cost base which may include options such as sourcing
overseas, outsourcing or indeed the company manufacturing components/making raw materials itself.

24 | P a g e
SWOT analysis (combination of external & internal Analysis):

The SWOT analysis combines the results of the environmental analysis and the internal appraisal into
one framework for assessing the firm's current and future strategic fit.

Important term:
To maintain competitive advantage resources need to have value, rarity, robustness and non-
substitutability

End of chapter

25 | P a g e
Chapter 5

Strategic Choices

Overview:

How to compete/business
How to grow? corporate strategy
unit strategy?

Porter's generic strategies Direction of growth (Ansoff value creation-Parent &


strategy clock matrix &TOWS matrix) SBUs
Methods of growth corporate portfolio
(BCG,the public sector
matrix,ashridge model)
Success criteria (SFA)
other topics (including
detail on diversification,
globalization, exporting and
overseas business.)

26 | P a g e
1. How to Compete: The model used in P3 are:

a) Porters competitive strategies: Its b) Strategic Clock: The concept of generic strategies were
about the choice between how to developed by Bowman when he described the strategic
compete in market. It can take two options within the diagram below.
forms:

c) Cost leadership: selling the same product


as competitors for lower price (be cheap)

d) Differentiation: Selling the product which


is different from competitors. Product is
unique(be better)

e) Focus (niche) Strategy: If a firm lacks the


resources to dominate the broad (or
mass) market, it can seek to dominate a
niche within the markets.

Focus can be used in a variety of ways.


(a) Meeting the needs of a particular buyer Price-based strategies: Strategies 1 and 2 are price-based
group strategies.
(b) Focusing on excellence in a particular (a) A no frills strategy is aimed at the most price-conscious.
technology or stage in the production process (b) A low price strategy offers better value than competitors.
(c) Limiting operations to a small
geographical area Differentiation strategies: Strategies 3, 4 and 5 are all
differentiation strategies. Each one represents a different
Advantages include: tradeoff between market share (with its cost advantages) and
margin (with its direct impact on profit).
(a) Allow firms with limited resources to build
a sustainable competitive advantage. The above strategies need to be made sustainable by:
(b) Provides a strategy for coping with a (a) price based low margins, no frills targeting or price war
fragmented market. backed by significant
financial resources
The drawbacks of focus include: (b) differentiation by focusing on a difference valued by
customers
(a) Increases risk due to focus upon limited (c) lock in making your product industry standard
range of operations.
(b) Growth of firm will be restricted to In circumstances of hyper competition different strategies
growth of the target segment. may be needed based on unpredictability, flexibility and
(c) Danger that firm may lose direction if its attacking competitors weaknesses.
focus becomes blurred. In other circumstances collaboration may be a strategy (eg
network organizations or alliances.

27 | P a g e
2. How to Grow: Covers;

a) direction of growth( Ansoff and TOWS matrix)


b) methods of growth

a) Direction of Growth/Strategic Direction


AnsOffs/Product-market Matrix: To evaluate alternative strategic options

TOWS Matrix: an alternative of Ansoff matrix

Strengths Weaknesses

Opportunity SO WO
use strengths to exploit Overcome weaknesses to
opportunities exploit opportunity
Threat ST WT
Using strengths to Overcome weakness to
counter threat counter threat

b) Methods of growth:

Internal development: Internal development (or organic growth) involves the use of retained profit
and new borrowings (or equity) to finance the development of new business units or products within
the firm.

Advantages include:
(a) Minimises disruption to activities due to there being no need for post-merger rationalisation and
integration.

28 | P a g e
(b) Provides opportunities for personal development of staff.
(c) Avoids need for high initial capital.
(d) May be cheaper because no acquisition premium is required.

Drawbacks include:
(a) More risky than acquiring established businesses or products.
(b) Potentially more expensive than acquisition if there is risk of failure or lack of transferable
experience.
(c) May be too slow in a fast-developing market.

Firms need to have some track record of internal development, even if their preferred route is
acquisition, for the following reasons.
(a) Suitable acquisition targets may not be available at all times and hence growth can only be
delivered by internal growth.
(b) The City will find it hard to value a company which is unable to demonstrate internal growth. This
could lead to a low share price and hence difficulties in raising finance for future bids.
(c) Internal growth will be necessary to retain the dynamism and motivation of already acquired
businesses.
(d) Since it is likely that an acquisition price exceeds the present value of the targets earnings it follows
that unless the new management can raise the earnings of the target it will never be worth what they
paid for it.
Acquisitions and mergers :These are external growth and can be theoretically distinguished as follows:
(a) Acquisitions involve one legal entity subsuming another within it. It may be contested or
uncontested.
(b) Mergers are where the two original legal entities cease to exist and a third new one is created.
Usually takes place by mutual agreement.

Advantages of both methods include:


(a) Swifter access to new product/markets.
(b) Acquires knowledge, expertise and goodwill.
(c) Possibility of realizing the cost advantages, and selling unwanted assets
(d) Instant removal of competitor.

Considerations in planning a merger or acquisition

Suitability of the target The Acceptability of the The Feasibility of the


company being acquired: acquisition to the proposal:
common cultural values shareholders of the acquiring the cost of acquiring
strategic fit of activities, company: attitude of regulator
markets, and products risk profile of target
projected cash flows, and
NPV projections

some guidelines on acquisitions:


(a) The acquiring business needs to consider what value it can add to the acquired business, as well as
valuing the acquisition.
(b) There must be some common core of unity between the two businesses.
(c) Management in the acquiring company must fully understand the business being acquired.

29 | P a g e
(d) The acquiring business must be able to put in place an effective management team at the acquired
business.
(e) The acquiring business must be able to hold onto the best management and staff in
both businesses
Joint development : There are several types of joint development:

(a) A Consortium has a number of partners and is usually set up for large-scale projects.
(b) Joint ventures involve the creation of a legally separate company with its own personnel and
strategic aims distinct from its parent company's.
(c) Strategic alliance is a long-term agreement to work together on a common project.
Often this involves alliances between firms at different points in the value chain and is cemented by
long-term contracts or share exchanges.
(d) Franchising involves an established product/service owner (franchisor) utilizing the marketing and
sometimes the production capacity of another firm in order to expand. In recent years franchising has
become a popular method of growth and many different types of agreement have developed.
However:
(i) The franchisor typically supplies the product, advertising and accounting systems.
(ii) The franchisee typically provides the capital investment, enthusiasm and commitment.
(e) Licensing is more common in science-based industries where a firm lacks the resources to fully
develop products or patents it has developed. Instead they give production rights to other firms in
return for a license fee.
(f) Agents are particularly useful in overseas marketing. The agent is appointed as a distribution
channel where local knowledge and contacts are important or where the sales volumes are not
sufficient to justify the attention of a full-time representative.
Firms may also like to harness the entrepreneurial qualities of commission earning agents.

3. Corporate Strategy

Coporate Parent
Managing
diversity to create value
1. products & markets
2. internatinal diversity

SBU SBU SBU

A small company will consist of a single business. As the company grows (through product development
/ diversification etc.) it becomes harder for a single business to do everything. At this point it is common
to split the company into a number of Strategic Business Units (SBUs) with a corporate parent.

Each SBU sells its own products in a particular market using its own knowledge and experience. There
will also need to be a Head Office that oversees the operations of the entire company. There may be

30 | P a g e
various functions that are performed by Head Office on behalf of the entire company to gain economies
of scale (for example, HR or IT). The corporate parent controls the extent of diversification of products
and markets by the organization as a whole. Parent can add/destroy value for SBUs.

How does Head office (Corporate) add value for business: there are 3 ways;

1. Portfolio Managers These businesses find 3. Parental developers These companies look
undervalued companies, acquire them and to use the competencies based at Head Office,
then aim to improve profitability. This might such as tight financial control, to improve the
be done by using the functions that already performance of all the SBUs. Other possible
exist, such as a marketing department, to competences could include marketing ability
lower costs. These organizations tend to or Research and Development. The role of the
follow a path of unrelated diversification. The parent in this situation is that the managers at
role of the parent is to keep Head Office costs Head Office should be very clear about what
low and will typically provide few centralized they cannot do cheaply and outsource this.
services to the SBUs. Whichever approach head office adopts it
2. Synergy managers These businesses look for must be careful to add value to the business.
synergies between existing and future SBUs. The main ways to do this are through:
For example, a company might start providing
ACCA courses and then use much of that a) Providing access to resources the individual
knowledge to start an SBU delivering CIMA, SBUs could not access on their own (e.g.
then another doing other courses. This will financing).
typically mean attempting to find resources b) Achieving economies of scale and synergies
and competences that can be shared between that an SBU would not be able to achieve on
SBUs. The role of the parent is to know the their own (e.g. a coordinated IT system).
operations of the SBUs in great detail, so that Giving a strategic direction the SBUs and to co-
they can identify potential synergies. ordinate their activities.

Head office can also destroy value through:

a) High costs outweighing synergies achieved elsewhere.


b) Slower response times to changes in the external environment.

Corporate Portfolio: can be applied to products/markets/SBUs:A corporate parent has to acquire,


nurture and dispose of its SBUs. The options are therefore:
(a) Build investing for the future
(b) Hold maintain current position
(c) Harvest short term profits
(d) Divest releasing resources for other areas

The following models are used for this:

31 | P a g e
BCG matrix: tell about contribution of different SBUs Ashridge Model: two variables are considered:
to business and assess the potential future of a - Feel: The degree of fit between the parent's
company in a group. skills, resources and other characteristics and
Consider 2 variables- Market growth & Market Share the SBUs' CSFs
- Benefit: the degree of fit between the
Market share opportunities the SBUs present for parenting
High low and the parent's skills resources and other
characteristics
Question
High Star
Market mark
growth
low Cash Cow Dog

Strategy to use:
Question mark- should be build
Star- should be Hold
Cash cow- should be Harvest/Hold
Dog- should be Hold/divest
Public sector portfolio: The principal way of judging
success in the private sector is by reference to
customers. In the public sector, activities must have
political support. This does not depend exclusively on
the options of the customers of the services provided.

Ability to serve effectively


Public or High low (a) Heartland businesses benefit from the
political attention of the parent without risk of harm from
Public Political
need (and High unsuitable developments.
sector star hot box
therefore (b) Ballast businesses well-understood by the
support for Back parent, but need little assistance.
Golden
expense) low drawer (c) Value trap businesses good opportunities, but
fleece
issue they do not relate to the SBU's CSFs; only retained if
A public sector star is something that the system is they can be moved into the heartland.
doing well and should not change. They are essential (d) Alien businesses have no place in the portfolio.
to the viability of the system.
Political hot boxes are services that the public want, This analysis reverses the usual approach to
or which are mandated, but for which there are not portfolio management: it does not ask what the
adequate resources or competences. value of the SBUs is to the centre, but what value
Golden fleeces are services that are done well but for the centre can add to the SBUs.
which there Is low demand. They are potential targets
for cost cutting.
Back drawer issues are unappreciated and have low
priority or funding. They are obvious candidates for
cuts, but if managers perceive them as essential, they
should attempt to increase support for them and
move them into the political hot box category.

32 | P a g e
Product lifecycle

Success Criteria/SFA (very important for exam questions):

The exam question of P3 on strategic choices (where examiner asks to evaluate a strategy); the answer
can be structured around the following 3 headings to score maximum marks:

1. Suitability: Determining the suitability of an option can consider that an option being evaluated
can?

(a) Exploits the companys strengths and distinctive competencies


(b) Grasps opportunities
(c) Addresses weaknesses
(d) Combats threats
(e) Fits the organisations mission and goals
(f) Suits internal politics and corporate culture

2. Feasibility : is concerned with whether or not the organisation has:

(a) Adequate resources (cash, people, information,etc.)


(b) Ability to accommodate the required level of performance
(c) Ability to withstand competitive retaliation
(d) Ability to acquire the required technology, materials and other resources
(e) Legal capacity
(f) Ethical considerations
(g) Sufficient time.

- Hint: Ms Model can be used from chapter 4

33 | P a g e
3. Acceptability: Acceptability is concerned with the expected performance of outcomes if a strategy is
implemented to. Acceptability to shareholders and other relevant stakeholders is considered

It can be assessed in three broad ways (Financial considerations):


(a) Returns
(b) Risk
(c) Stakeholder's attitude

The organisation requires to objectively assess the likely returns from accepting a particular option.
There are a number of techniques available including:
(a) the return on capital employed
(b) payback period
(c) discounted cash flow
(d) cost benefit analysis

The organisation must be able to determine the level of risk associated with a particular option. Risk can
be high if the strategic option involves dramatic changes in activity in areas of uncertainty over the long
term. Risk assessment techniques include Key financial ratios, such as gearing which considers changes
to the capital structure and so determines the level financial risk or liquidity ratios determine the
impact on cash flows and the potential risk of insolvency or Break-even analysis which considers the risk
of making a loss from pursuing an option.

Other topics:

Diversification: Diversification is the deployment of a companys resources into new products and new
markets. The company thus becomes involved in activities that differ from those in which it is currently
involved. Diversification strategy means the company selectively changes the product lines, customer
targets and perhaps its manufacturing and distribution arrangements. The term diversification actually
covers a range of different techniques.it can be;

a) Related
b) Unrelated

a) Related Diversification: is the development beyond current products and markets but within the
capabilities or value network of the organization. It can further take two forms ; horizontal & vertical
diversification

Horizontal diversification:

Synergy is highest in the case of horizontal diversification, especially if the technology is related, but the
disadvantage is that little additional flexibility is provided. This type of strategy affects all parts of the
value chain since fixed costs can be spread over an increased number of units. Most diversification
strategies are of this type. The strategy is undertaken when a company extends its activities into
products and markets in which it already possesses necessary expertise. For example, a manufacturer of
television branching into the manufacture of DVD recorders, camcorders and hi-fi equipment.

34 | P a g e
Horizontal diversification refers to development into activities that are competitive with, or directly
complementary to, a companys present activities. There are three cases.

a) Competitive products: taking over a competitor can have obvious benefits, leading eventually
towards achieving monopoly. Apart from active competition, a competitor may offer advantages
such as completing geographical coverage
b) Complementary products: for example, a manufacturer of household vacuum cleaners could make
commercial cleaners. A full product range can be presented to the market and there may well be
benefits to reaped from having many of the components common between the different ranges.
c) By products: for example, a butter manufacturer discovering increased demand for skimmed milk.
Generally, income from byproducts is a windfall; any you get is counted, at least initially, as a bonus.

Advantages Disadvantages
Likely to be more synergies. For example, when Selling to different customers against different
Coca Cola moved into the production of other rivals will require an understanding of the market
types of drinks such as bottled water and bottled
tea, they could share bottling plants, staff and
distribution networks
This can offer a defense against substitutes Some new strategies capabilities will be needed
This can widen the companys product portfolio Synergies are not automatic and will need to be
and reduce reliance on one product or on worked on
powerful customers
There is likely to be less risk than with vertical It can be more difficult to manage a
integration or conglomeratisation as some diversification business.
existing strategies capabilities can still be used Many of these problems can be overcome by the
use of strategic alliance and good corporate
parenting.

Vertical integration:

This can take the form of forward or backward integration,

Forward integration: moving towards the consumer, control of distribution, e.g. drinks manufacturers
buying public houses.

Backward integration: moving away from the consumer, control of suppliers, e.g. Ford company created
subsidiaries that provide key inputs to vehicle such as glass, rubber and metal.

Advantages Disadvantages
COST
Economies of combined operations It may not be cheaper to do it oneself especially if
suppliers have economies of scale
Economies of internal control Increased operating gearing
Economies of avoiding the market Dulled incentives
Capita investment

35 | P a g e
Reduced flexibility to switch to cheaper suppliers
QUALITY
Tap into technology, enhanced ability to Cut off from suppliers/customers
differentiate
Reduced flexibility to switch to better suppliers
Differing managerial requirements
BARRIERS
Assured supply/demand Much more difficult to exit the industry
Defense against lock out
Create barriers by controlling
supplies/distribution/retail outlets.

b) Unrelated/ Conglomerate diversification:

A firm move into markets that are unrelated to its existing technologies and products to build up a
portfolio of businesses. Sometimes this is because the company has developed skills in turnaround or
brand management, and can buy an ailing company very cheaply and quickly create value. A company
might use conglomerate diversification if it believes it has no real future in its existing product market
domain. Finally, many entrepreneurial leaders move in and out of markets simply because of
opportunities.

Advantages Disadvantages
Increased flexibility No synergies
Increased profitability No additional benefit for shareholders
Ability to grow quickly No advantage over small firms
Better access to capital markets No advantage over small firms
Avoidance of anti-monopoly legislation
Diversification of risk

Globalization (International Diversification): Globalisation at a macroeconomic level comes from the


closer integration of national economies and the elimination of impediments to the transfer of
materials, components, products and staff between them.

Factors which have brought about the shrinking and borderless world of globalization include:

(a) Technological developments permitting co-ordination of international business (e.g. faster


transport, satellite communications, the Internet)
(b) Location of factories or outsourcing of production and service activities to countries with lower costs
or better infrastructure (e.g. service centres to lower wage countries)
(c) Changing customers values and behaviour towards preference for global brands and technologies
(d) International labour market resulting from mobility of staff between countries.Spreads expertise and
tastes.
(e) International capital markets resulting in firms being owned by residents of many nations.
(f) Cross-border mergers, acquisitions and strategic alliances have provided the scale economies and

36 | P a g e
coverage necessary for global activity
(g) De-regulation and political realignment
(h) International trade agreements to reduce barriers (e.g. World Trade Organisation)

Globalization of business is the response of businesses to the opportunities and threats this globalisation
phenomenon presents.

Effects of globalization

Basic consequence is that firms will no longer survive if they confine their attentions to their domestic
(i.e. national) markets and domestic competitors.

Main effects are:


(a) Domestic firms now have access to much larger markets for their products.
(b) Domestic firms will face new global competitors both in newly available markets and, more
importantly, in domestic market.
(c) Domestic firm will face competitors, domestic and foreign, that utilise the radically lower cost
structures and improved skills available globally.
(d) Firms will need to devise organisational structures that enable them to operate globally.
(f) Need to cope with much wider cultural diversity amongst customers and employees.

Important: Management Orientation (international business-way to market):


1. Ethnocentrism (International): It ignores any inter country differences. Marketing mix is centralised
and standardized with no local adaptations .e.g. paper industry
2. Polycentrism (Multinational): Each country is unique, therefore, marketing must be decentralised.
This may increase business volume in the target country at the expense of economies of scale.
Openness towards other cultures .e.g. food chains
3. Geocentrism (global environment): It is based on the assumption that there are both similarities
and differences between countries .e.g. construction companies.
4. Regiocentrism: Recognizes regional differences. Close to geocentrism.

Modes of entry to foreign markets


Exporting Overseas production
Meaning: Goods are made at home but sold Entry to the market other than domestic
abroad. It is the easiest, cheapest and market or home market.
most commonly used route into a new
foreign market.
Advantages: 1. Concentrate production, 1. Better understanding of customers
economies of scale and consistency 2. Economies of scale
of product quality 3. Production costs are lower
2. International marketing on small 4. Lower storage and transportation cost
scale 5. Overcome the effects of traffic and non-
3. Minimizes exporting cost tariff barriers
Methods: Indirect export & direct export Contract manufacture, joint venture &
wholly owned overseas production
Where: Indirect exporting: Where a firms Contract manufacture: a firm makes a

37 | P a g e
goods are sold abroad by other contract with other another firm abroad
organizations who can offer greater whereby the contractee manufactures or
market knowledge assembles a product on behalf of the
contractor.
Direct exporting: occurs where the Joint Venture: when governments
producing organization itself performs discourage setting independent foreign
the export tasks rather than using operations, joint venture is the only option
intermediary. Sales are made directly where local knowledge flows quickly to
to customers overseas who may be the indigenous firm
wholesalers, or agents or final users Wholly owned overseas production:
Production capacity can be built from
scratch or alternatively an existing firm can
be acquired.

End of chapter

38 | P a g e
Chapter 6

Organizing for success

Overview:

Organizing for success

Organizational Structures
Important Terms

Introduction: To implement the selected strategy the organization needs to get ready in the following
areas:

(a) Structure
(b) Processes; and
(c) Relationships

These three elements are highly inter-related and should be consistent with the strategy being followed
by the organization.

Organization Structures: No single model of organization is suitable for all purposes. Managers must
choose a structure in the light of which challenges they must regard as most pressing.

Different types are;

1. Simple Structures: A highly centralized structure where there is one owner and all other are
workers. All decisions are made by the boss (owner). It is highly informal, roles and responsibilities
not documented.

2. Functional Structure: One of the common structures found in medium-sized organisations is the
functional structure. That simply means that people within the organisation are organized by a
function. So there is a finance function, a manufacturing function, research and development
function, sales function, and so on. Specialist managers are inducted.

39 | P a g e
Advantages Disadvantages
- The organisation gains great economies of scale. - As the organization grows, each of the functional
For example, all financial recording goes through departments can become very powerful and can
the finance department, all manufacturing goes begin to concentrate on their own interests
through the manufacturing department and so on. rather than the interest of the organisation as a
whole. For example, the manufacturing
- Each of these departments is likely to be large department could become obstructive if asked by
enough to be headed by a well-qualified manager. the sales department to respond to a special
order from an important customer.
- There is also great comfort and satisfaction for the
people within these departments. They are - It might not be appropriate to push all similar-
dealing with like-minded individuals with a similar sounding activities through one department if the
background, similar motivation, and similar skills. activities are, in fact, somewhat diverse

3. Divisional structure: As organizations grow they will often develop a divisional structure. This is because
growth usually involves an element of diversification in terms of product, or geographical area, or even
customer.
For example, a very large chemical manufacturer could typically be manufacturing paints and agriculture
chemicals. There is very little in common between these two activities: the suppliers of raw material will
be dierent as will be the competition, customers and the manufacturing processes. It makes little sense
to try and jam these together in one structure, and almost certainly its going to be better to have a
divisional structure based on products where there are separate departments for finance, manufacturing,
sales, research and developments, and so on. This allows a degree of specialization so that each division
concentrates very specifically on what it does best.

40 | P a g e
Advantages of decentralization:

- Avoids overburdening top managers


- Improves motivation of more junior managers
- Greater awareness of local problems.
- Greater speed of decision-making.
- Helps junior managers to develop.
- Control systems set up for junior management.

4. Matrix Structure: where there are two bosses to report to

Advantages Disadvantages
- Greater flexibility - Dual authority - conflicts between managers.
(i) Employees more accepting to - Stress.
change - More costly management posts, meetings,
(ii) Encourages problem solving. and so on.
(iii) Tasks focused - Slower decision-making.

- Inter-disciplinary co-operation.
- Motivation through greater participation.
- Quality of decision making.
-More awareness of the market.
- Managers can see the whole picture.

5. Henry Mintzbergs structure:The five components of an organisation need to be in the appropriate


balance for the strategy and environment and culture that they face.

The five components are:

a) Strategic apex is the source of direction for the organisation (eg board of directors); they seek to
control
b) Middle line are the middle managers that convert t direction into tasks and procedures; they seek
autonomy

41 | P a g e
c) Operating core are those that provide the outputs of the organisation; they seek autonomy and
mutual working
d) Technostructure exist to standardise through procedures and checking (e.g. quality control,
compliance);
e) Support staff support the operating core; they seek their expertise to be recognised as vital (e.g.
finance, administration)

- Mintzberg identified five configurations depending on the relative importance of the elements of
the organization as follows:

42 | P a g e
Other Important Terms:

- Centralization: refers to the level in the organisations structure at which decisions are taken.
It is Easier to co-ordinate.,Senior managers can take a wider view,Keep a proper balance between
different departments, Cheaper and Crisis decisions are best taken at the center.

- Boundary less organization: A boundary-less organization can be virtual, hollow or modular:

Virtual: is a geographically distributed network with little formal structure, probably held
together by IT applications, partnerships and collaboration.

Hollow: all non-core operations are outsourced eg accounting, human resources, legal services
and manufacturing could be outsourced, leaving the company to concentrate on its core
competence eg design of new products.

Modular: order parts from dierent internal and external providers and assemble into a
product.

Because market and technical conditions are changing rapidly and unpredictably, there has been growth
in the boundary less organization as they tend to allow flexibility and fast reaction to changes.

Virtual organization have become particularly common and there is a current trend to outsource as
much as possible. A small core company of management and key employees is kept and company buys
in specialist services (outsources) as and when needed from suppliers who are experts in what they do.

By keeping the permanent organization relatively small, fixed costs are minimized and the organization
is supposed to be faster at changing and adapting to match its environment.

- Outsourcing & offshoring: both involves external providers taking on activities previously carried
out in-house. Offshoring involves using external providers in different countries.

- Shamrock organization: or flexible firm, has a core of permanent managers and specialist staff
supplied by a contingent workforce of contractors and part time and temporary workers. This is
popular during recession

End of chapter

43 | P a g e
Chapter 7

Strategic Change Management

Overview:

change management

Types of changes(scope & nature Model)


contexual features
forcefeild analysis
styles of change management
Turnaround Strategy

Is it possible to avoid change?


No, because of:
- Size/Structure
- Management
- Ownership
- Technology
- Economic conditions
- Government policies
- Any other internal or external factor

Types of changes: The matrix considers two variable--Nature of change and Scope of change
Scope of change
Realignment Transformational
(minor change) (fundamental change)
Adaptation Evolution
Nature Incremental (most common type
of (gradual)
of change)
change
Reconstruction Revolution
Big bang (rapid & expensive
(sudden) action)

- Examples of fundamental change may be is change in competitive strategy or change in


organizational culture.

44 | P a g e
The context of change-the contextual feature Model(Assessing the acceptance level of change):
The following factors increases/decreases the acceptance of change in any situation:
- Time-is sufficient time available to implement change?
- Scope-wider or narrow?
- Preservation-will current competences and knowledge and skills of people be required after change?
- Diversity-Difference of opinion about the change-normally depends of past experience
- Capability-change management skills available in the organization?
- Capacity-resources to bring change available?
- Readiness- with regards to acceptance of stakeholders (mendelows stakeholder matrix can help)
- Power-with regards to key stakeholders.
** Conclusion should be written in exam questions.
Force Field Analysis (Lewins): helps to Roles of management/Style of introducing change:
identify the factors of change - Participation/collaboration: bring those effected by
The normal assumption is that change will be change in decision making
resisted by employees, and even if its not - Negotiation: with employees or those resisting change
resisted very strongly there is likely to be a - Education/Communication: explaining/persuasion
period where employees are nervous and - Intervention: by change agent
there will be a certain amount of disruption. - Manipulation: focus on the positive aspects of change
Its important for companies to try and - Coercion: implementing a change by force/use of power
manage change so that disruption and
resistance are both minimized. Turnaround Strategy: when the business faces terminal
decline and there is a need for rapid and extensive change.
1. Crisis stabilization: serious cost cut/increase revenue
2. Changes to management: old management is replaced
3. Communicating with stakeholders: taking stakeholders
into confidence
4. Financial restructuring: further finance is arranged either
by gearing or equity
5. Concentration of effort: focusing on core business activity-
outsource rest of them
6. Attention to target markets: focus on appropriate target
Driving forces for change: e.g. new
markets
legislation, professional commitment,
7. Prioritization: of the above strategies-very important for
reporting requirement etc.
success of turnaround strategy.
Restraining forces for change: e.g. belief that
existing system is sufficient, cost, complexity, Change Agents: Change Agents are the people who bring
employees resistance etc. change. For example, business consultancy firm.
-driving forces should be built on and Process of change(Lewins): is as follows
restraining forces should be reduced. Unfreeze(Prepare people for change)
Change(Tell them change)
Refreeze(Make it difficult to go back)

End of chapter

45 | P a g e
Chapter 8:

Business process Change:

Overview:

Outsoucing Process Improvement Software Solutions

Harmon's Process strategy Harmon's pattern of Re- Generic Software Vs


Matrix Design bespoke softwares
POPIT Model (Advantages &
Disadvantages)
Assesing a software Package
Process of purchase &
implementation of software

What is a business process?


Arrangement of resources and competences to convert input into output to satisfy customer needs. For
a process, more than one departments are involved.

Outsourcing: Outsourcing is when any operation or process that could be or would usually be
performed in-house by an organisations employees is sub-contracted to another organisation for a
substantial period. The outsourced tasks can be performed on-site or off-site.Outsourcing is currently
relatively popular with both profit-seeking and not-for-profit organisations
It is important to appreciate that outsourcing will almost certainly continue to be examined as part of a
scenario in the Paper P3 exam, so you could be required to, for example, describe the specific
advantages that outsourcing could bring to the organisation described in the scenario.
Advantages:
1. It allows the organisation to focus on its core, value-adding activities without the distraction of
having to run support services. Support services can soak up both management time and financial
resources and these would usually be better spent concentrating on where the business can use its
resources and competences to gain competitive advantages.
2. Cost savings. Usually the organisations to which activities are outsourced specialise in those
activities and, therefore, are likely to enjoy economies of scale, whether from the use of machinery
or the employment of expertise. There can be additional cost savings if a process is outsourced to a
foreign company operating in a cheaper labour area (off-shoring).
3. Cost certainty. An outsourcing contract at a fixed, or closely defined price, shifts much of the
financial risk on to the provider. Costs become more predictable.
4. Cost restructuring. For some types of outsourcing such as component manufacturing, there will be
lower fixed costs and higher variable costs. If all components are bought in, then these costs are all
variable. Had the components been made in-house, there would inevitably have been associated
substantial fixed overheads.

46 | P a g e
5. Access to cutting edge expertise and talent. In technically advanced, fast moving industries, it can
be difficult for small companies to develop or make use of new processes. Outsourcing to a
specialist company can give access to the latest technologies.
6. Better quality. There can be an immediate improvement in quality if a process is outsourced to a
world-class company where the quality is carefully defined in a service level agreement.
7. Risk transference. If a company perceives that one of its processes has high risks, then this can be
transferred by outsourcing to another company.
8. Capacity management. For example, it can be difficult for businesses to deal with variable demand:
either they run out of capacity (unhappy customers), or have (expensive) unused capacity.
Outsourcing to a large company can mitigate this problem.

Disadvantages:
1. Unexpected costs. Although many costs become more predictable, the supplier will be very careful
to define exactly what these costs cover. There are likely to be substantial additional charges for
anything extra. Additionally, remember that almost certainly the supplier knows that part of the
business better than the outsourcer and will ensure that the contract is carefully (and
advantageously) worded.
2. Difficult to reverse. Once an activity is outsourced and internal knowhow gone, it can be very
difficult to bring a process in-house again. This is particularly relevant when a contract comes up for
renewal: the price increase might be higher than expected but it can be difficult t o abandon the
supplier.
3. Damage to reputation. If the outsource company does not perform properly for example, not
manufacturing to the required quality standards and not supplying goods on time great damage
can be done to the organisations reputation.
4. Non-congruent objectives and loss of managerial control. The supplier company makes money
doing things efficiently. The buying company might make money by innovation. To some extent,
despite the contract, there can therefore be a difference in the objectives and core values between
the two parties.
5. Success depends on another companys performance. Though there is always a dependency
between buyers and sellers, outsourcing shifts more responsibility for success to other companies
performance. If an important outsource company goes bankrupt, there can be serious
consequences.
6. Confidentiality/security. Outsourcing some processes can give the supplier information that could
be valuable or sensitive. Keeping a process in-house should increase security.

Harmons process strategy matrix:

What should be outsourced?


Harmons Process Strategy Matrix provides very useful guidance about which processes can be safely
outsourced and which should be kept in-house, but subject to automation or other improvement.
It uses two axes:
Complexity/dynamism of the process. Dynamism is a measure of how much the process changes.
Strategic importance of the process

47 | P a g e
Notice that in the right-hand pair of quadrants, where strategic importance of the process is high,
outsourcing is not recommended. If a process is strategically important it is likely to be a source of
competitive advantage. If that were to be outsourced, then the company would be telling the supplier
about its most valuable secrets and competences. What would then be left for the outsourcer to do? If a
process is relatively stable and non-complex, then automation would be feasible and worthwhile. If,
however, the process were very complex and subject to many changes, then automation will be difficult
to achieve and even more difficult to keep up to date.

Important terms:
- Process re-engineering this is used at the strategic level, when major threats or opportunities in the
businesss external environment prompt a fundamental re-think of the large-scale core processes critical to
the operation of the value chain.
This pattern relates to a fundamental rethinking starting from a zero base and building up the process from
scratch. The object is to obtain major fundamental improvements in the process.

- Process redesign this is an intermediate scale of change operation, appropriate for medium-sized
processes that require extensive improvement or change. Redesign efforts often result in changed job
descriptions and the introduction of some automation.

- Process improvement this is a tactical level, incremental technique that is appropriate for developing
smaller, stable, existing processes. It can often be undertaken using a Six Sigma approach.

Harmon's pattern of Re- Design:


Having identified the context for looking at processes, and the levels of change which may be required to
manage them, we will now look at how process change can be approached. One of the most prominent authors
on business process change, Paul Harmon, describes four basic process redesign patterns: re-engineering,
simplification, value-added analysis, and gaps and disconnects.

1. Simplification: The simplification pattern assumes that most established processes (or sub-processes) are

48 | P a g e
likely to have developed elements of duplication or redundancy. Process efficiency can be improved by
removing these.

2. Gaps & Disconnects: Many of the problems affecting process performance (and businesses more generally)
result from a failure in communication between functions or business departments. The focus of this
redesign pattern is to ensure that the appropriate checks and controls are in place so that efforts are
coordinated between functions and departments.

For example, if the production department builds a product and ships it to the customer, then the finance
department needs to be aware of this so that they can raise an invoice to the customer.

These process redesign patterns could well form the basis of a question in a P3 exam. The examiner could
present the process map of a current business process, and ask students to identify any problems and how
they could be overcome. The patterns should help students answer such questions

3. Value-Added Analysis: This pattern looks at the process (or sub-process) from a customers perspective. A
process or activity is said to add value if it meets three criteria:
1. the customer is willing to pay for the output
2. it physically changes the output in some way
3. it is performed correctly at the first attempt.

Against value-adding activities, Harmon contrasts non-value-adding activities, which he classifies as:
preparation and set-up
control and inspection
simply moving a product from one place to another without physically changing it
Activities that result from delays or failures of any kind.

Harmon suggests that non-value-adding activities should be eliminated as far as possible. Obviously, some of
them (for example set-up activities) may be essential for the value-added activity to take place. These essential
support activities are known as value-enabling activities, and cannot be eliminated altogether. However, they
should be done simply and cost-effectively to allow resources to be focused as much as possible on the value-
added activities.

4. Re-engineering: As one would expect, given the levels of change we looked at earlier, the re-engineering
pattern relates to a fundamental rethinking of existing processes to achieve major efficiency improvements.
However, the other three can all be applied on a more modest scale, and could therefore be more relevant
to the type of practical situation presented in a P3 exam question.

- The exam questions are based on a swim lane diagram

Example of an exam like question:

Diskus is a company which sells CDs and DVDs by mail order. Customer orders are received by the sales team,
which checks that customer details are completed properly on the order form (for example, delivery address
and method of payment). If they are not, a member of the sales team contacts the customer to get the correct
details. Once the correct details are confirmed, the sales team passes a copy of the order through to the

49 | P a g e
warehouse team to pick and pack, and a copy to the finance team to raise an invoice. Finance raises an invoice
and sends it to the customer within 48 hours of the order being received.

When a member of the warehouse team receives the order, they check the real-time inventory system to make
sure the discs ordered are in stock. If they are, they are collected from the shelves, packed and sent to the
customer within 48 hours of the order being received, so that the customer receives the goods at the same time
as the invoice.

If the goods are not in stock, the order is held in a pending file in the warehouse until the stock is replenished,
whereupon the order is fulfilled.

The diagram is normally given in the question like this:

Required: Suggest improvements to the process.

Solution:
The process diagram highlights two major problems in the order fulfillment process:
1. There is no communication between finance and the warehouse to confirm discs are in stock so that the
order can be shipped. Therefore finance could be raising invoices when the order has not been sent. This is
an example of a gap or disconnect.
2. The discs and the invoices are sent independently of each other, meaning that Diskus will be duplicating its
postage costs. Sending the invoice is not a value-added activity. The customer will not be willing to pay the
invoice without the discs.

In response, to solve the first problem, finance could set up pending invoices when they are notified of an
order by the sales team, but the invoices would only be generated as live when the warehouse confirms
that the discs are in stock and the order can be fulfilled. And to solve the second problem, a member of the
warehouse team could be assigned to collate all outgoing orders. Finance could then send the invoice to
that person, who could match the invoice to the order, and then send them both out to the customer
together.
Admittedly, this is a very simple example, and real-life processes are often far more complex, but it still
illustrates the way a process diagram helps managers analyse business processes and thereby remove
duplication, non-value-added activities, and gaps and disconnects. This not only makes the process more
efficient internally, but also, more importantly, means the customer is prepared to pay for the output. And
this is critical because, as we noted in the definition of processes at the start of this article, the underlying
point of a process is to satisfy customer needs.

50 | P a g e
POPIT Model: people, organization, processes, information technology
This approach to business change suggests that four elements need to be considered to achieve
successful business change:

Organisation: consider the organisational capabilities and structure and ensure that these are suitable.

Processes: How are the core business processes carried out? Also, Analyse the value chain and
understand the processes (activities) and their linkages.

People: Roles, job descriptions, competences, motivation, rewards, culture.

Information technology: IT architecture, IT capabilities, controls, software and information provision.

Software & Process improvement: There are a number of software packages available to assist with
redesign in processes. The most basic of them are known as Enterprise Resource Planning systems.
These packages tend to provide standard solutions, for example, to carry out the work of the sales
ledger (this may not be ideal for a particular company). These might then be adapted to meet the
particular needs of the company. The advantage of using these generic packages is that they:
are relatively cheap
are readily available.
should not contain errors
be easy to train staff on.

Software Standardized Software Vs. Bespoke Software: Also the advantages & disadvantages;

51 | P a g e
Standardized software Customized
/off the shelf software software/bespoke
software
Time Immediately available Long process
Cost Low High
Possibility of initial error Nil Strong possibility
Level of user friendliness High Relatively low
Possibility to provide competitive No possibility Very high possibility
advantage
Ability to meet specific need of the No yes
organization

Assessing a software Package(Skidmore & Eva):At the time of acquisition of software;

1. Functional requirements-Basic requirement e.g. to support business operations


2. Non- functional requirements-e.g. user friendliness, integrity
3. Technical requirements-is it compatible with your current operation system or harware
4. Design requirements-colours, fonts etc.
5. Suppliers stability requirement-suppliers going concern?
6. Suppliers citizenship requirements-reputation and image of supplier
7. Initial implementation requirements-who will install/training procedures/data migration etc.
8. Operational requirements-user manual/helpline
9. Time requirements-how much time will it take
10. Cost requirements-what cost will it incur

Software Selection- 4 or 5 stage Process(Skidmore & Eva):The company may decide to have a software
package written especially (known as a bespoke package). There are five stages the company goes
through:
1. Define need/requirements of the software and Obtain tenders
2. First pass selection
3. Second pass selection
4. Implementation
5. Managing long-term relationship.

End of chapter

52 | P a g e
Chapter 9

Information Technology

Overview:

IT
E business-Benefits and Barriers,influence on strategy
emarketing(6I Model)
Stages in the use of IT(Nolan's Model)
Customer relationship Management(CRM)
Big Data
Hardware,software infrastructure and Controls

E Business- transformation of Benefits of adopting E-Commerce/E- Barriers in adopting E-


key business processes through Business? Commerce/E-Business?
the use of internet
technologies 1. Cost reduction- e.g. using 1. Setup cost
teleconferencing saves travelling and 2. Maintenance cost
In simple words, It is the use of accommodation cost for important 3. Lack of knowledge/skills
internet for business activities meetings. 4. Security concerns
E.g. if a manager scans a 2. Capability-e.g. online store-unlimited 5. Culture
purchase invoice and emails it items can be displayed
to relevant person. 3. Communication-online chat windows
4. Competitive advantage
E commerce-Buying and selling 5. Controls-e.g. in online banking
over the internet (financial
transaction)

Influence of Internet on Strategy

Disintermediation-some intermediaries going out of business e.g. business now sell online directly to end
user, so need of distributors

Re-intermediation-new intermediaries are coming in e.g. a website for online booking of an air ticket

Power moving to customers- because they have a lot of information, reviews and analysis available on
internet about products and service. They can do comparisons of prices, quality etc.

Growing international competition-more and more companies are going international via internet

Increasing international customers

53 | P a g e
Stages in the use of technology in a business E commerce-Buying and selling over the internet
(Nolans Model) (financial transaction)

1. Initiation-start of IT- main reason to use IT is Forms of E-Commerce: there are four different form;
the accuracy, speed, efficiency of work.
2. Contagion- the use of IT spread in the 1. Business to Business (B2B)-involves companies doing
organization-everyone want to use it (spread in business with each other
whole organization). 2. Business to Customer (B2C)-involves businesses
3. Control-Senior management now starts to plan selling to general public, typically through catalogues
the budget. Start making cost benefit analysis- with shopping cart software
decisions about how much to incest in IT- 3. Consumer to Business (C2B)-a consumer post their
maintenance etc. project with a set budget online and within hours,
4. Integration-Different departments start to companies review the consumers requirement and
integrated through computer systems and bid on the project. The consumer review the bids and
networks. selects the company that will complete the project
5. Data Administration-After few years the data 4. Consumer to Consumer (C2C)-consumer sell their
become more important than the devices itself goods to other consumers directly e.g. eBay, OLX etc.
6. Maturity-Data becomes information and
becomes the asset for the organization.

E-Marketing- Application of internet technology to achieve marketing objectives (the 7 Ps)

Different Characteristics of E-Marketing (6 Is Model)-a very important model for exam questions. The six
features are:

1. Integration-advertisement and sales are integrated in online marketing. Customers can buy the products
right on the spot if they like it.in traditional marketing however if a customer watch an ad on television or
on a broucher. They have to make an effort to go to the shop and buy it-so sales and marketing are not
integrated(websites recognizes the computer systems and record data)

2. Interactivity-recording of information -of customers computer system-also through registrations on


websites the customers applies

3. Intelligence-understanding customers, identification of preferences, patterns and trends analyzed from the
data recorded in interactivity. Intelligence and interactivity are linked.

4. Individualization-promotions according to individuals interest e.g. on Facebook

5. Industry Structure- Intermediation plus disintermediation(as discussed above)

6. Independence of Location-marketing can be done from anywhere even from home. No specific need of an
office etc.

From Technical Article:


This model is particularly useful when analyzing the downstream side of businesses (the marketing, distribution

54 | P a g e
and sales functions) but can also be relevant elsewhere. The 6Is are:

Customer Relationship Management (CRM)


Establishing, developing and maintaining long-term relationship with customer

Building relationship with customer

1. Develop a customer database


2. Have more direct contact with customer-via Surveys,e-mail etc.
3. Develop customer oriented products/services to cater for the changing needs of customers

Customer relationship goes through following stages:

Customer selection(understanding who your customers are/segments)


Customer acquisition(promotions/discounts)
Customer Retention(understanding customers preferences and developing products according to that)
Customer Extension(Try and find/attract more customers)

Big Data

Extremely large collections of data (data sets) that may be analysed to reveal patterns, trends, and
associations, especially relating to human behaviour and interactions.'
In addition, many definitions also state that the data sets are so large that conventional methods of storing
and processing the data will not work

Characteristics of Big Data, known as the 3Vs:

55 | P a g e
1. Volume 2. Variety 3. Velocity

this data can be both structured and unstructured:

Structured data: this data is stored within defined fields (numerical, text, date etc) often with defined lengths,
within a defined record, in a file of similar records. Structured data requires a model of the types and format of
business data that will be recorded and how the data will be stored, processed and accessed. This is called a
data model. Designing the model defines and limits the data which can be collected and stored, and the
processing that can be performed on it.

Unstructured data: refers to information that does not have a pre-defined data-model. It comes in all shapes
and sizes and it is this variety and irregularity which makes it difficult to store in a way that will allow it to be
analysed, searched or otherwise used. An often quoted statistic is that 80% of business data is unstructured,
residing it in word processor documents, spreadsheets, PowerPoint files, audio, video, social media interactions
and map data.

The processing of big data is generally known as big data analytics and includes:

Data mining: analysing data to identify patterns and establish relationships such as associations (where
several events are connected), sequences (where one event leads to another) and correlations.
Predictive analytics: a type of data mining which aims to predict future events. For example, the chance
of someone being persuaded to upgrade a flight.
Text analytics: scanning text such as emails and word processing documents to extract useful
information. It could simply be looking for key-words that indicate an interest in a product or place.
Voice analytics: as above but with audio.
Statistical analytics: used to identify trends, correlations and changes in behaviour.

The analytical findings can lead to:

Better marketing
Better customer service and relationship management
Increased customer loyalty
Increased competitive strength
Increased operational efficiency
The discovery of new sources of revenue.

Dangers of big data


Despite the examples of the use of big data in commerce, particularly for marketing and customer relationship
management, there are some potential dangers and drawbacks.

1. Cost:
2. Regulation:
3. Loss and theft of data:
4. Incorrect data (veracity)
5. Employee monitoring

56 | P a g e
Hardware and Software Infrastructure & Controls: From Technical Article:

INFRASTRUCTURES TO SUPPORT BUSINESS INFORMATION SYSTEMS


Very large companies began to use of computers in the 1960s. The first applications were for wages and salaries
processing, the production of sales invoices and receivables ledger accounting. These applications automated existing
operations allowing greater accuracy, more speed and cheaper processing. At this time the IT operations would have
been called data processing.
Once transactions are processed by computer it is easy to analyse those transactions to produce information that could
be useful for management. For example, once the sales ledger is computerised it is easy to produce aged receivables
listings. These additional management reports became common in the 1970s (and are still important) and IT
operations became known as management information systems (MIS). The systems could also be programmed to
make simple decisions such as comparing inventory levels to production plans to enable automatic stock ordering. The
simple decisions are known as programmable or structured decisions, meaning that there is a well-defined way of
getting to the correct answer. MIS primarily allows companies to keep their costs down, helping them to move towards
cost leadership, through a combination of automation and rationalisation.
At the beginning of the 1980s, spreadsheets were invented and this allowed computers to be used to help managers
make unstructured (non-programmable) decisions. For these decisions there is no definitively right answer. For
example, what should next years budget look like? At what price should a new product be launched? Financial models
on spreadsheets allow managers to try out 'what if?' experiments where they try out different combinations of
assumptions and try to home in on a credible answer. These systems are known decision support systems (DSS): they
do not make the decision but help managers make decisions.
More sophisticated DSS systems can combine, for example, computer aided design and computer aided manufacturing
systems to enable new products to be brought to market more quickly: data warehousing (recording historical
transaction data) and data mining (trawling through that data to learn more about customers preferences and buying
patterns). Both of these techniques can help with differentiation and focus strategies.
Somewhat later, around the 1990s, executive information systems were developed. These were of particular use to
senior managers and they have a particular emphasis on giving access to external information that is needed for
operational and strategic planning. It was, of course, in the 1990s that the Internet began to expand rapidly and much
more external information became available. Executive information systems also emphasise flexibility so that
executives can see company data in a wide variety of ways. Typically, such systems would initially present sales for the
group, but upon double-clicking on that figure, it would split into sales by division. Double-clicking on one of those
figures might show the sales to the divisions 10 key customers, compared to the comparable period last year. This
process is known as drilling down.
Databases are by far the preferred way to hold data. Databases allow a wide range of users and applications to use the
data flexibly and to update it. Each user can be given a unique, personalised and relevant view of the data which they
can easily search and manipulate.
The increasing reliance on computers by all levels within a company requires careful design of the information
technology (IT) infrastructure. IT usually refers to the hardware: computers, connections, disk storage.
NETWORKS
Only the very smallest of businesses will have stand-alone computers, computers not connected to other computers.
Even in small businesses employees need to share data and very soon after personal computers were invented
networks of computers were introduced. There are two main types:
Local area network (LAN): Here the network extends over only a relatively small area, such as an office, a

57 | P a g e
university campus or a hospital. The small area means that these networks use specially installed wiring to
connect the machines.
Wide area networks (WAN): Here the network can extend between several cities and countries. Each office
would have its LAN, but that connects to LANs in other offices and countries using commercial, public
communications systems. At one time this would have been done by the organisation leasing telephone lines for
their private use to transmit data from office to office. However, this is expensive and inflexible and the common
system now used is known as a virtual private network (VPN)
VPNs allow data to be transmitted securely over the internet between any two locations. For example, an employee
working from home or a hotel can access the company system as though being in the office. Information will pass over
many different circuits and connections but the system gives the impression that you are operating over a dedicated,
private communications link. Hence, the name: virtual private network. Because data is being transmitted over public
systems it is particularly vulnerable to interception and it is very important that adequate security measures are in
place to safeguard the data. There are three essential steps in the security measures:
1. Access control and authentication this ensures that unauthorised users do not access the system. Typically this
will be accomplished through a log-in procedure. Many organisations, such as banks, may require a password,
answers to security questions (such as What is the fourth letter of your secret word?), and also a code number
generated by a security device that has been issued to the user. Use of the latter technique means that anyone
logging on has both to know a password and to be in possession of the security device.
2. Confidentiality this ensures that data cannot be intercepted and read by a third party whilst being transmitted.
This is achieved using encryption.
3. Data integrity this ensures that the data has not been altered or distorted whilst in transit. To ensure this, the
message could have special check digits added to ensure that the data complies with a mathematical rule.
CENTRALISED AND DECENTRALISED (DISTRIBUTED) ARCHITECTURES
Consider an office local area network. There are three main ways in which the data and processing can be arranged:
centralised, decentralised (distributed) and hybrid.
Centralised systems
In these systems there is a powerful central computer which holds the data and which carries out the processing. The
main advantages of such systems are:
Security: all data can be stored in a secure data centre so that, for example, access to the data and back-up
routines are easier to control.
One copy of the data: all users see the same version of the data.
Lower capital and operational costs: minimal hardware is needed at each site. There is also less administrative
overhead.
The central computer can be very powerful: this will suit in processing-intensive applications.
They allow a centralised approach to management. For example, a chain of shops needs to keep track of
inventory in each shop and to transfer it as needed. There is little point in a shop that is running low ordering
more of a product if another branch already has a surplus of that product.
The main disadvantages of such systems are:
Highly dependent on links to the centralised processing facility. If that machine fails or communication is
disrupted then all users are affected.
Processing speed: will decrease as more users log-on
Lack of flexibility: local offices are dependent on suitable software and data being loaded centrally.

Decentralised (distributed) systems In these systems, each user has local processing power and will hold data locally.

58 | P a g e
The main advantages of such systems are:
Resilience: if one machine breaks down, others are unaffected.
Easy expansion: simply add another computer.
Flexibility: local users can decide which programs and software should be installed to meet local needs.
They are more useful where each location can operate more or less separately from others.

The main disadvantages are:


More difficult to control: data storage and processing are in many locations and correct access, processing and
back-up of data are more difficult to enforce.
Multiple versions of data: users might have their own version of data that should be uniform.
Potentially higher costs: each local computer has to have sufficient processing power and each location might
require an IT expert.

Hybrid systems
In these systems some data and processing are local and some are centralised. For example, web-browsing and word-
processing might be local but critical business applications might be centralised.
CLIENT-SERVER AND PEER-TO-PEER SYSTEMS
These concepts are similar to centralised and decentralised, but are not quite identical.
In a client-server arrangement, a powerful computer (the server) is dedicated to providing a service to other
computers in the network (the clients). Typical services provided are:
File storage (file servers)
Handling printing (print server)
Handling the sending and receiving of emails (mail servers).
There is an element of centralisation here, but although files might be held centrally on the server they will often be
processed locally. For example, a report will be held on the server, but when it is being edited it is downloaded to the
users local machine (client). The edited version will be saved back to the server where other users can then access it.
Obviously there will be great disruption if the server fails. Access rights to files are set centrally and typically enforced
by users log-on information.
Traditionally, in client server networks each client would have had a copy of, say, Word for Windows. Documents
would have been downloaded from the server for local editing then saved back to the server. The disadvantage of this
is that each machine in the network needs a copy of Word and if the company was upgrading its software all copies of
the program would have to be changed. Providing the software initially for all machines and its subsequent
management is very expensive. With cloud computing, this approach has changed. There is only one copy of the
software on the server within a web-based interface. Users log into the web system and their processing is then carried
out on the server or a cloud of servers. It appears to each user that they have a local version of the software, but what
they are really seeing is the program operating in the server. Client machines can be thin-clients which are not very
powerful as they do not have to store much data and software nor do they have to carry out much processing.
Hardware, software and maintenance costs are greatly reduced, though the system is vulnerable to service disruption.
Hotmail and Gmail provide examples of this approach. Whenever you want to write an email you log into the web
email account and the processing is carried by the systems computer cloud not your computer. All it has to do is to
handle the interface.
In peer-to-peer networks, two or more computers are connected directly without the need for a server. Access rights
to files are given by individual users to specified other users. This is a simpler system to set-up, requiring no specialist
operating system or specialist staff and many home systems are like this. It is a much more distributed system than
client server systems and therefore has back-up and security issues.

59 | P a g e
CONTROLS IN IT SYSTEMS

IT poses particular risks to organisations internal control and information systems. This can lead to their operations
being severely disrupted and subsequently to lost sales, increased costs, incorrect decisions and reputational damage.
Risks include:
Reliance on systems or programs that are inaccurately processing data, processing inaccurate data, reporting
inaccurate, misleading results - or all three.
Unauthorised access to data leading to destruction of data, improper changes to data, or inaccurate recording of
transactions.
Particular risks may arise where multiple users access a common database on which everyone in the organisation
relies.
The possibility of IT personnel gaining access privileges beyond those necessary to perform their assigned duties.
Unauthorised changes to data in master files. For example, changing a selling price or credit limit.
Unauthorised changes to systems or programs so that they no longer operate correctly and reliably.
Failure to make necessary changes to systems or programs to keep them up-to-date and in line with legal and
business requirements.
Potential loss of data or inability to access data as required. This could prevent, for example, the processing of
internet sales.
Controls in computer systems can be categorised as general controls and application controls.
GENERAL CONTROLS
These are policies and procedures that relate to the computer environment and which are therefore relevant to all
applications. They support the effective functioning of application controls by helping to ensure the continued proper
operation of information systems. General IT controls that maintain the integrity of information and security of data
commonly include controls over the following:
Data centre and network operations. A data centre is a central repository of data and it is important that controls
there include back-up procedures, anti-virus software and firewalls to prevent hackers gaining access.
Organisations should also have disaster recovery plans in place to minimise damage caused by events such as
floods, fire and terrorist activities. Where IT is critical to an operations business these plans might include having
a parallel system operating at a remote location that can be switched to immediately.
System software acquisition, change and maintenance. System software refers to operating systems, such as
Windows or Apples OS. These systems often undergo updates as problems and vulnerabilities are identified and
it is important for updates to be implemented promptly.
Access security. Physical access to file servers should be carefully controlled. This is where the company keeps it
data and it is essential that this is safeguarded: data will usually endow companies with competitive advantage.
Access to processing should also be restricted, typically through the use of log-on procedures and passwords.
Application system acquisition, development, and maintenance. Applications systems are programs that carry
out specific operations needed by the company such as calculating wages and invoices and forecasting inventory
usage. Just as much damage can be done by the incorrect operation of software as by inputting incorrect data. For
example, think of the damage that could be done if sales analyses were incorrectly calculated and presented.
Management could be led to withdraw products that are in fact very popular. All software amendments must be
carefully specified and tested before implementation.

60 | P a g e
Example: Royal Bank of Scotland
A software update was applied on 19 June 2012 to RBS's system which controls its payment processing. The update
had been corrupted by RBS technical staff so that customers' wages, payments and other transactions were disrupted.
Many customers were unable to withdraw cash using automatic teller machines and were not able to see their bank
account details. Others faced fines and surcharges for late payment of bills because the system could not process
direct debits. For many customers the disruption lasted for around a week.
APPLICATION CONTROLS
Application controls are manual or automated procedures that typically operate at a business process level, such as the
processing of sales orders, wages and payments to suppliers.
These controls help ensure that transactions are authorised, and are completely and accurately recorded, processed
and reported. Examples include:
Edit checks of input data
Checks on input data are very important because once data has been input it is often automatically processed
thereafter without the further chance of human scrutiny. Methods include:
Range tests can be applied to reject data outside an allowed range. For example, when accepting orders through a
website, the system could be programmed to prevent, or at least query, unusually large quantities being ordered.
Format checks ensure that data is input in the correct format (credit card numbers should be 12 digits long).
Dependency checks, where one piece of data implies something about another (you have probably had a travel
booking rejected because you inadvertently had a return date earlier than the outward date).
Check digits, where a number, such as an account number, is specially constructed to comply with mathematical
rules. For example, UK and European VAT numbers use this method:
VAT number = GB 2457193 48 (the last two digits, here 48, are the check digits)
The first seven numbers are multiplied by the weighting factors 8, 7, 6, 5, 4, 3, 2:
So 2 x 8 + 4 x 7 + 5 x 6 + 7 x 5 + 1 x 4 + 9 x 3 + 3 x 2 = 146
Subtract 97 until the result is zero or negative:
146 97 97 = -48
The resulting number is the check digit. The chances of someone incorrectly typing in a VAT number which
accidentally followed these rules are very small.
Numerical sequence checks to ensure that all accountable documents, such as cheques, have been processed.
Drop down menus which constrain choices and ensure only allowable entries can be made. For example,
constraining delivery choices to ordinary post or express delivery, or presenting a list of allowable account codes.
Batch total checks. Here, the data is first added up to create a control total, which is subsequently compared to
the total of the data actually submitted.

Online, real time systems can pose particular risks because any number of employees could be authorised to process
certain transactions. Anonymity raises the prospect of both carelessness and fraud so it is important to be able to trace
all transactions to their originator. This can be done by requiring users to log-on and then tagging each transaction with
the identity of the person responsible. Logging on should require passwords and it is important that members of staff
keep these confidential. Many business systems enforce a rule that requires passwords to be changed every few
months. This is fine in theory, but to remember their changing passwords many users start to write them down a
potential breach in security. Increasingly, biometric measurement, such as fingerprint or retina recognition, can be

61 | P a g e
used to control access.
Log-in security, whether through passwords or biometrics, also helps to control both processing and access to data.
Each user is provided with tailored rights that allow them to see only certain data, change only certain data and to
carry out only specified processing.

End of chapter

62 | P a g e
Chapter 10

Leadership & Human Resource Management

Overview:

HRM

Leadership therioes and styles


Job Design-4 types
Competency framework
Appriasal
important terms

Leadership theories Types & Styles of leadership:

1. Trait theories Transactional leaders


Good leaders share similar characteristics Use systems and processes to control the behavior of
It is possible to develop leaders by team members
learning these characteristics
More suitable for relatively static environment
2. Style theories:
Workers respond better to certain styles of Transformational leaders
leadership Change from within
Empower others
3. Situational theories/Contingency theories Be visionary
Good leaders have this ability to adopt their Passionate for their beliefs
leadership style depending upon Clarity of direction about how to achieve their
i. Task targets
ii. Team they are interacting with
Kurt Lewins 3 styles of leadership:

Autocratic
Leaders take decision without consulting the team members

Democratic
Team members are allowed to participate in decision making but leaders take the final decision
Positive impact on the team members
Learning opportunities foe team members
Not suitable where a range of options are available

Laissez fiare
Allow team members to take decisions and be responsible for the effects
Suitable where team members are capable and motivate

63 | P a g e
Job Design: is essentially about organizing work and that has always been a major role of management.
Four approaches are;

1. The scientific approach:

This approach is associated with Frederick Taylor (18561915). Taylor believed that many workers went
about their jobs inefficiently and without management direction as to the best way to accomplish tasks. He
believed that it was managements duty to investigate tasks and to arrange them in a scientific way that
minimised wasted effort and maximised efficiency. The results of his studies in search of efficiency were
that:
Jobs were fragmented into simple tasks
Manual workers simply had to get on with their simple, repetitive task and leave decision making to
managers
The skill in each job should be minimised
The arrangement of machines should be such so as to minimise material and people movement.

2. job rotation, job enlargement and job enrichment :

The scientific approach to management resulted in high productivity and also allowed workers wages to
increase. However, it was criticised because it often turned employees into automatons, condemning them
to mindless tasks and driven by the speed of the production line. Job satisfaction, motivation and pride in
their work decreased. Often labour relations and quality were bad and commitment to employers was low.
These problems gave rise to recognition that job design should also pay attention to the employees social
and psychological needs. This is the human relations school of management. Employees get bored, so
more variety in work could be useful; employees like being challenged; employees like feeling they are
contributing something worthwhile. This realisation gave rise to attempts at job redesign where managers
aimed to produce better jobs. Methods available are:
Job rotation. This is a horizontal change in the job, meaning that a worker is regularly moved from one
simplified, de-skilled job to another. This should reduce worker boredom (at least for a while).
Job enlargement. Another horizontal change, but each job now consists of several unskilled tasks.
Job enrichment. This is a vertical change in which some of the tasks previously carried out by
managers and supervisors are added to the job. For example, in addition to repetitive construction
tasks the employee could now also be required to assess and report on the quality of the item.
Of the three, job enrichment holds the most promise of long-term increases in job-satisfaction. It must be
pointed out, however, that managers often do not find it easy to relinquish managerial control to their
subordinates, so that frequently the apparent delegation of power is accompanied by increased
monitoring of performance. In many organisations job enrichment might therefore be an illusion
perpetrated by managers to try to keep employees happy, but without giving them any worthwhile
discretion

64 | P a g e
3. Japanese management

In the 1970s and 1980s Japanese manufacturing companies were world-leading. Companies such as Sony,
Mitsubishi, Panasonic, Canon, Nikon, Toyota and Nissan usually beat their western competitors. Because of
that success, much attention has been paid to Japanese management approaches. Much of the pioneering
work was done in Toyota and resulted in their Toyota Production System. This approach is also known as
lean manufacturing and it concentrates on eliminating any activity and expenditure that does not add
value to the finished product or service.
There are three elements:
Elimination of waste: First the products and their manufacture have to be properly planned (for
example by eliminating unnecessary parts or processes). Second, that planning has to be put into
action (for example by scheduling production efficiently). Third, performance has to be monitored to
identify where, despite the first two steps, things could still be improved. Just in time manufacturing
is an example of an approach aimed at reducing waste.
Flexibility: In a traditional factory workers service a single production line running from receiving of
raw materials to delivering the finished products. A breakdown in any part of the line nearly always
resulted in the entire process halting until the problem was overcome. Cellular manufacturing
systems separate the production line into cells or modules, each with a group of workers and
machines. Each cell is dedicated to a particular component of the manufactured product. Ideally,
workers and equipment comprising a particular cell are trained and configured to be able to take over
the processes of another cell when necessary. Thus, the breakdown of one cell, due to equipment
breakdown or staffing problems, does not radically affect the rest of the production process.
Quality: Quality of design and quality of conformance are essential if waste is to be eliminated and
value added consistently. Japanese companies were the first to embrace the concept of total quality
management. This addresses every activity an organisation carries out and encourages a culture of
never being satisfied that further improvements are not possible.

4. Business process re-engineering:


This approach says that the structure of work has to be radically changed. Part of this means perceiving
core employees not as an expense but as valuable assets, who are able to serve customers needs well
without instruction from above. Following managers instructions is no guarantee that an organisation will
be successful as those instructions might be wrong. Organisations should be market driven.
The approach has had many critics, mainly pointing out that managers still want to manage (to justify their
higher salaries), that there will still be a hierarchical structure, and that many employees will, inevitably,
end up carrying out repetitive, specialist tasks.

65 | P a g e
Knowledge work : is work that is mainly concerned with skills and experience (asopposed to manual labour).
The implications for HRM will be:

Selection needs to be based on general competencies rather than directed at a particular task.
Staff will need to be able to access data from remote locations.
Team and project based work becomes more common.

The transfer of knowledge inside an organisation can be a competence that gives an organisation a
competitive advantage.

The idea of knowledge management is becoming increasingly important. The main tasks of the organisation
will be:
To establish a culture where sharing of ideas is encouraged.
A programme to move individuals to different parts of the organisation to share knowledge and to
make contacts.
A flat structure so that decisions can be made by those with the appropriate knowledge.
Development of intranets (perhaps with remote access).
Development of data warehousing.

Competency framework(HRM): the required outcome Appraisal (HRM)


expected from the performance of a task in a work role,
expressed as performance standards with criteria Expected performance vs actual
performance
Uses/Advantages of competency framework Appropriate timing
Should be based on controllable factors
Hiring Performance measures must be pre-
Training decided and communicated
Appraisal Appraisal has to be future oriented
Promotions
Dismissals Appraisal Methods
Tell
Succession planning: facilitates management development Tell and sell
at all levels. It refers to developing a system to ensure Listen, tell and sell
important staff is replaced. Key features will include:

Early identification of potential candidates for senior


management.
Training linked to career development.
Development of contingency plans in case a post
becomes vacant sooner than expected.

End of chapter

66 | P a g e
Chapter 11

Project management

Overview:

Project Management

Stages in Project Lifecycle


Important Terms

Project: A project is an undertaking that has a beginning and an end and is carried out to meet
established goals within cost, schedule and quality objectives.

Project management
Project management is the combination of systems, techniques and people used to control and monitor
activities undertaken within the project. A project will be deemed successful if it is completed
At the specified level of quality
On time
Within budget
Within the specified scope

Stages in the project life cycle


Every project is different but each will include at least the following stages:
1. Initiation
2. Planning
3. Execution
4. Control
5. Completion

Step 1. Project initiation:


At this stage, a business case document is formed. This document assesses what benefits might be
derived from a project and how these benefits should be managed, it assesses potential project costs.
A business case document has the following elements:
An assessment of current strategic position
The constraints that are likely to exist for any project
The risks that might arise for the project and how these will be managed
An assessment of benefits and costs of performing the project

Strategic position analysis


It includes:

67 | P a g e
SWOT
What is wrong with the current system?
How the project will assist in achieving objectives

Project constraints
There are three key project constraints:

Costs:

Initial budget for


project
Need to prove the
benefits of pro project
exceed costs

DIMENSIONS OF
Time: PROJECT Scope:
MANAGEMENT
Overall time Series of tasks
constraints on to be
completion of performed
project
Quality level
Time budget
expected of
amount of
each task
man-hours,
etc. available
for project

Risk assessment
Risk can result in four types of consequences:
1. Benefits are delayed or reduced scope
2. Timeframes are extended time
3. Cost over-run budget
4. Output quality is reduced quality

In order to avoid these consequences, a project manager should add two elements to his/her business
case:

a risk assessment explaining type of scale of risks that might occur

68 | P a g e
a risk management plan explaining how these risks will be managed in order to ensure project
success

Risk can be analysed and evaluated according to:

The likelihood that they will occur


The impact that they could have on the project

This in turn can lead to plans on how each risk should be managed:

Likelihood
Low High

Low Accept Reduce

Impact

Transfer Avoid
High

Level of risk is low if

Project is well defined


Small
Low complexity

Cost benefit analysis


At this stage, all benefits to be achieved from the project are identified, responsibility is clear and the
likely value o the benefits is quantified. It also includes analysis of financial and non-financial costs and
benefits using techniques such as
NPV
Payback
IRR

Assumption of business case must be written and signed by benefit owner and senior management.
A benefit owner is an individual or group who will gain advantage from a business benefit and who will
work with the project team to ensure that benefit is realized.

69 | P a g e
Step 2.Project planning:
A project plan is needed to ensure that the project objectives are achieved within the constraints of
quality, cost and time. The plan is recorded as an element of project initiation document (PID). The
project initiation document contains all the information necessary for the execution of the project.
It includes:
Scope
Quality
Time
Budget
List of deadlines
Ways and time of communication
Team structure
Roles and responsibilities
Any other relevant clause agreed by project sponsor and deliverer.
Must be signed by both parties.
A project sponsor provides and is accountable for the resources invested into the project and is
responsible for the achievement of projects business objectives.
A deliverer is the person or group who is responsible to perform the project normally project team.

Step 3. Project execution:


Executing a project consists of the processes used to complete the work defined in PID to accomplish
the projects requirements. Execution process involves coordinating people and resources, as well as
integrating activities of the project in accordance with the project plan.

A project team is formulated to execute a specific project.

A project team is formed on the basis of Ideally a project team should be:

What skills/ competences are required Small


Who has the required skills Cohesive
inside/outside the organization Right mix of personalities
Availability
Affordability
Level of supervision required

Some of the roles taken on by team members in organizations include:


Co-ordinator
Shaper
Plant
Monitor/Evaluator
Resource invigilator
Implementer
Team worker
Finisher

A project manager is the person appointed by the organization to lead the team and manage it on a

70 | P a g e
day-today basis.

Responsibilities of project manager include: Skills required of a project manager:

Efficient use of resources Leadership and team building


Outline planning Communication and negotiation
Detailed planning Technical
Obtain necessary resources Decision making
Teambuilding Change management skills
Communication
Coordinating project activities
Monitoring and helping team members
Problem resolution
Quality control

Stage 4. Project monitoring and control


A project is monitored throughout for the purpose of review and control to track all major project
variables and to ensure the team is making satisfactory progress to the project goals.

Stage 5. Project completion

A project is completed with a post project review (PPR). It is normally

Done by the deliverer


Done at the last stage before the formal dissolution of the project team
Focus on the conduct of the project
What went well and what went wrong
To improve the project management skills to conduct future projects in more efficient way

A post implementation review (PIR) is also at a specified time after the project is delivered. It is:

Done by the sponsor


Allow actual user to experience the product delivered by the deliverers
Product delivered must be exactly according to the PID
Focus on the product delivered rather than the conduct of the project

A benefit realization review is done to assure that all the benefits promised at the evaluation stage have
been subsequently realized. It is:

Done by the sponsor


Allow actual user to experience the product delivered by the deliverers
Product delivered must be exactly according to the PID
Focus on the product delivered rather than the conduct of the project

71 | P a g e
Important terms
Project creep: Project creep relates to changes in the scope of project
Project slippage: When a project has slipped behind schedule
Milestone: A milestone is a significant event in the life of the project, usually completion of a major
deliverable.
Project management software: Project management software can be used to produce detailed
project planning documentation, to update plans and to produce reports.

End of chapter

72 | P a g e
Chapter 12

Forecasting & Finance

Overview;

Ratio analysis + Forecasting Decision making Other areas

Ratio Analysis Short term decisions (limiting pricing


linear regression factor,make or buy, standard costing & Budgeting
Time Series Analysis outsourcing, shut down Full costing & Activty based
decisions, accepting or costing(ABC)
probability,expected values,
rejecting special contracts,
decision trees (risk & Finanace & Strategy
determining the most efficient
uncertainity) (managing decisions)
use of resources etc)

Ratio analysis :
In P3 Ration analysis can be used in identifying
Strength and weakness
SWOT analysis
Analyzing strategic option specially merger and acquisition
Straight performance analysis question

Profitability ratios
Gross profit margin = Gross profit x100
sales

Net profit margin = Net profit x100
sales

(Gross profit is the main-spring of profit generation. If gross profit stays high, but net profit falls, this can
imply that expenses are poorly controlled.)

Return on capital employed =Profit before interest and tax 100


capital employed

(capital employed = long term liabilities + share capital)

Asset turnover = Revenue x 100


Capital employed

73 | P a g e
Asset turnover measures how hard the assets are worked: $ of revenue from each $ of capital.
Note ROCE = asset turnover net profit margin

Liquidity ratios
Inventory days = Inventory x 100
Cost of sales

Debtors days = Trade recievable x 100


Credit sales

Payable days = Trade payables x 100


Credir purchases

Long collection periods might indicate inecient receivable management or agreeing longer
credit to compete or win contracts.

Current ration = Current asset


Current lialbilities

Quick ratio = current asset inventory


Current liabilities
If too low, the organisation will have trouble paying its suppliers and employees on time.
Investment ratios
P/E ratios = price per share
Earning per share

P/E ratio indicate investors expectation about companies future growth.


Earning per share = profit after tax
No of ordinary shares
Shareholders like to see this increase. It can decrease when new issues are made and the capital
raised hasnt yet produced profits.
Paying too much for an acquisition (for example by a share exchange) can depress the EPS

Risk measurement ratios


Interest cover = profit before interest & tax
Interest charge per year

Interest cover is use to asses the compnays ability to pay its interest.

Gearing ratio = long term liablity


Long term liablity + capital
Gearing ration is use to asses the risk compnay is facing because of long term debt.

74 | P a g e
Forecasting In P3

1. High low method: used to 2. Linear Regression Analysis: finds the equation of the straight line
segregate variable and (line of best fit) and used to forecast.
fixed costs. Y=a + b x
It is also known as least square method.
Problems:
1. Based on historical costs, Attempts to find the relationship between two variables. A scattered
conditions may have graph would show this relationship.
changed.
Conditions required for the method/problems/assumptions:
2. It ignores some cost
information at the 1. A linear cost function is assumed
extremes and can result in 2. Historical cost data is accurately recorded
inaccurate cost estimates 3. There are 10+ pairs of data
(considers only highest 4. The activity levels in historical data cover the full normal range of
and lowest activities) activity
5. Past conditions are indicative of future conditions
6. The value of y can be predicted from the value of x

3. Time Series Analysis: Using moving averages:

Problems:
1. PESTEL changes make forecasting difficult
2. The further into the future the forecast is made, the more unreliable it is.
3. The less data available for forecast the less reliable it is
4. The pattern of trend and seasonal variation may not continue

Correlation: relationship between two variable.


1. Positive
2. Negative
3. No correlation

Correlation coefficient(r)
it tells the strength of relationship between two variables
Range= -1 to +1
Perfect negative-inversely proportional
Perfect positive-directly proportional

Coefficient of determination(r )
It tells us the % dependency of dependent variable on independent variable

Forecasting-Technical Articles:

An outline of the key forecasting techniques: The examiners article explaining the syllabus changes stated
that the key techniques include linear regression, the coefficient of determination, time series analysis and
exponential smoothing. All but the last item should have been studied in Paper F5. In the exam,
interpretation and an awareness of limitations rather than calculations will be required.

75 | P a g e
1. Linear regression
Least squares linear regression is a method of fitting a straight line to a set of points on a graph. Typical
pairs of graph axes could include:
total cost v volume produced
quantity sold v selling price
Quantity sold v advertising spends.
The general formula for a straight line is y = ax +b. So, y could be total cost and x could be volume. a
gives the slope or gradient of the line (eg how much the cost increases for each additional unit), and b is
the intersection of the line on the y axis (the cost that would be incurred even if production were zero).

You must be aware of the following when using linear regression:


The technique guarantees to give the best straight line possible for any set of points. You could supply
a set of peoples ages and their telephone numbers and it would purport to a straight-line relationship
between these. It is, therefore, essential to investigate how good the relationship is before relying on
it. See later when the coefficients of correlation and determination are discussed.
The more points used, the more reliable the results. It is easy to draw a straight line through two
points, but if you can draw a straight line through 10 points you might be on to something.
A good association between two variables does not prove cause and effect. The association could be
accidental or could depend on a third variable. For example, if we saw a share price rise as a
companys profits increase we cannot, on that evidence alone, conclude that an increase in profits
causes an increase in share price. For example, both might increase together in periods of economic
optimism.
Extrapolation is much less reliable than interpolation. Interpolation is filling the gaps within the area
we have investigated. So, if we know the cost when we make 10,000 units and the cost when we
make 12,000 units, we can probably make a reasonable estimate of the costs when we make 11,000
units. Extrapolation, on the other hand, is where you use data to predict what will occur in areas
outside the region you have investigated. We have no experimental data for those areas and
therefore run the risk that things might change there. For example, if we have never had production
of more than 12,000 units, how reliable will estimates of costs be when output is 15,000 units?
Overtime might have to be paid, machines might break down, more production errors might be made.
Remove other known effects, such as inflation, before performing the analysis, or the results are likely
to be distorted.

76 | P a g e
2. The coefficients of correlation and determination
The coefficients of correlation (r) and determination (r 2 ) measure how good a fit the linear regression line
is. If r = 1, there is perfect positive correlation, meaning that all the points will fit on a straight line, and as
one variable increases so does the other. If r = -1, there is perfect negative correlation meaning that all the
points will fit on a straight line, and as one variable increases the other decreases. If r = 0 there is no
correlation and the two variables show no association (age and telephone numbers).

The coefficient of determination, r 2 , is similar but is, perhaps, easier to understand. If r 2 is 80% (or 0.8)
this implies that 80% of the changes in one variable can be explained by changes in the other. Note
carefully: this does not mean that 80% of the changes in one is caused by 80% of changes in the other.
Even good correlation does not prove cause and effect.

3. Time series analysis


A time series shows how an amount changes over time. For example, sales for each month, profits for a
number of years, market share over each quarter. Because strategic management inevitably implies trying
to look into the future, time series analysis is extremely important. Very often the starting point for
predictions will be based on historical patterns of growth or decline, or a recognition that, in the past,
amounts seem to have varied randomly.

Time series are often analysed by using moving averages, and the Paper P3 specimen paper contains an
excellent example of how this is likely to be examined: not by performing the calculations (no one in their
right mind would do this manually nowadays) but by interpreting the results. In the following table, column
3 shows the readings (sales units) for each quarter for three years.

77 | P a g e
Time series analysis usually recognises four effects:
A trend. This is the underlying growth or decline in an amount. For example, sales of a product could
show increases year-on-year.
To find a trend first decide on a likely periodicity or seasonality. For example, 6 for the trading days of
the week, 4 for seasons of the year. Then ensure that the average is centred on a season. Above it
has been assumed there are four seasons, so 4-part averages are first calculated : 1,250 = (2,000 + 900
+ 1,000 + 1,100)/4. That average is between seasons 2 and 3. To obtain a centred average, average
with the next one: 1,144 = (1,250 + 1,038)/2. Here, the 8-point moving averages move up and down
implying no strong trend.
Seasonal variations. These are variations which repeat fairly consistently within a period of no more
than a year. For example, although the trend could be increasing, sales in summer could always be
higher than sales in winter. Variations are identified by the differences between the actual results and
the trend figures. Again, this table has been designed to show no stable seasonable variations and all
seasons show both positive and negative effects.
Cyclical variations. These are variations which repeat over longer than a year. For example, economic
boom and depression.
Random variations. Unexpected changes in what might be expected. For example, a very cold winter
could provoke much larger than normal sales of certain products.
Time series analysis usually concentrates on the first two effects. Once again, if must be emphasised that
even if a strong trend has been identified there is no guarantee that this will continue in the future. For
example, a product life cycle curve might show a strong growth trend early in a products life, but then at
some point, growth will fall off, and probably even further in the future the trend will show decline. Any
prediction, even if based on a large amount of historical data and using recognised and sophisticated
techniques, can still be prove to be very different to the actual results that occur. Judgment has always to
be applied when assessing how much to believe the results.

Let us say that we want to predict the sales for Quarter 1 of Year 4. Remember, in this table, we have
detected no well-defined trend and no well-defined seasonal variations. There are three methods:
The random walk model: next periods prediction is based on the latest actual and would, therefore,
be predicted to be 800. However, because the data obviously moves up and down frequently this
method might place too much emphasis on the latest actual result.
The simple moving average method: next periods prediction is based on the latest moving average
and would therefore be predicted to be 1,021. This averages out the ups and downs in the data, but
suffers from two potential problems:
(i) The predicted value lags the actual results because so much historical data is included in the
prediction. One could easily argue that 1,021 looks much too high given recent actual results.
(ii) Every time a new moving average is calculated, the oldest component of the calculation is
removed from the calculation, and a new one taken in. It can be considered as unrealistic and erratic
to drop a reading so abruptly.
Exponential smoothing. Whereas time series analysis was a topic in Paper F5, exponential smoothing
was not, but it can be regarded as a refinement of the moving average technique. Here, a weighted
average of the last actual result and the last predicted result is used as the next prediction. The
weighting factors used are arbitrary, and alter how much importance is given to the last actual result
and how much to the last estimated result; this varies how stable or volatile the predictions are. So, if
we began the process from Year 3 Season 2 and used weighting factors of 0.5 and 0.5, the prediction

78 | P a g e
for Season 3 would be:

0.5 x 1,180 + 0.5 x 1,021 = 1,101

The prediction for Season 4 would be:

0.5 x 900 + 0.5 x 1,101 = 1,001

And for Year 4 season 1 would be:

0.5 x 800 + 0.5 x 1,001 = 901

In general, the new prediction will usually not lag behind latest results as much with simple moving
averages, and historical results are not abruptly dropped. Instead, their importance to the prediction
gradually decreases.

Dealing with risk and uncertainty in predictions


In the discussions above it has been emphasised that past performance is no guarantee of future
performance. It would, therefore, be unconscionable to plough ahead with plans based on estimates that
you know must be unreliable without examining what might go wrong.
You need to know two technical terms:
Uncertainty occurs when you know that there might be alternative outcomes, but cannot attach a
probability to each of those occurring. There, decisions rely greatly on personal attitude to risk and, in
particular, should examine the bad or worst case scenarios as these can lead to trouble.
Risk is where we feel we can assign probabilities to the various outcomes. The normal method of
attack is to calculate the expected value of the outcome.
Expected values: can be fine if a project is repeated many times because the expected value will equate to
the long-term average result. However, most strategic plans, and any projects making them up, are once-
off. That introduces two problems:
usually the expected value is not an expected outcome
the expected value gives no hint about the spread of results that might occur.

Here, both scenarios have the same expected values, but Scenario 1 has very little risk. With Scenario 2,
however, outcome 2 could be very serious indeed for the organisation.

Risk can be handled by:


Toleration: the risk is thought to be so small that it can be borne. For example, Scenario 1 above might
be tolerable.

79 | P a g e
Treat: do something to reduce the risk. Perhaps we could carry out a plan in phases and see how each
stage does rather than being committed to the whole plan from the start. Alternatively, escape routes
might be available.
Transfer: perhaps by means of insurance, by sub-contracting some of the tasks and by entering into a
joint venture.
Terminate: the risk is so great and so impervious to treatment or transfer that we choose to avoid the
opportunity altogether.
Sensitivity analysis: can play an important role in deciding how risk should best be handled: assumptions
are varied and the outcomes monitored. Often sensitivity is measured by the percentage that an
assumption can be varied before a project breaks even, though there is no need always to measure to the
break-even point.

Decision Trees:
Look at the following example: a development project is budgeted to cost $150 million and it is estimated
that after two years income will be $200 million if the project is successful (probability 0.8), or only $30
million if the project is unsuccessful (probability 0.2). On a decision tree, this can be represented as:

The expected monetary value at point B is: 0.8 x 200 + 0.2 x 30 = 166 (circles represent where expected
values have to be calculated)

The decision to be made at point A (decision points are represented by squares) is either to abandon the
project (zero financial effect) or to go for it with an expected profit of 166 150 = 16.

It looks as though the company should proceed with the project, but that decision depends on its forecasts
and those could be wrong. You will see that if the expenditure rose by just over 10%, or if the successful
income fell from 200 by 10% to about 180, or the probabilities changed to about 0.7/0.3, then the project
would be breaking even or worse.

Let us say that actual expenditure rose to 200 and that, although the project was successful, its income
there fell to 180 only. We would wish that we had not embarked on the venture as it has made a loss of 20
(= -200 + 180).

Now imagine that we could have the project in phases:

At the outset, A, our decision would be to go ahead if we were happy about the risks (expected monetary
value as before = 16)

80 | P a g e
Say that A is now one year later. We will have better knowledge about how the project is turning out (70
was spent in year 1 instead of 50) and perhaps altered probabilities and estimates. The decision tree could
be displayed as:

Note that the 70 already spent is now a sunk cost and not relevant to any decision about continuation of
the project. We are now at A on the diagram. The second phase has an increased cost, income has fallen
and success is less likely, perhaps because we have now identified additional technical difficulties. As it
stands the expected value of continuing is:

-130 + 0.75 x 180 + 0.25 x 30 = 12.5

This implies that it is worth carrying on, but the reliability of the estimates and the sensitivities would need
to be looked at carefully.

However, say that after the first year, the project showed the following:

Now the expected value of continuing at A is:

-148 + 0.75 x 180 + 0.25 x 30 = -5.5

Now, we would be more likely to abandon the project in the light of the new information that has become
available.

As time passes and projects progress, estimates inevitably change. This example illustrates how our
decision-making might be affected by those changes and emphasises how important it is continually to
keep matters under review and to build in as much flexibility as possible, such as break clauses in leases or
options to extend operations.

Summary

Paper P3 candidates will be required to Evaluate methods of business forecasting used when
quantitatively assessing the likely outcome of different business strategies. Emphasis will be on
evaluating methods and results.
Linear regression allows an objectively obtained straight line to be fitted to any set of points, but of
itself says nothing about how good or reliable the fit is, nor whether there is a cause/effect
relationship.
The coefficients of regression and determination allow assessment of fit.

81 | P a g e
Time series analysis allows both trends and seasonal variations to be estimated. It can be criticised
because historical readings are abruptly dropped as the calculation progresses. The calculated trends
can lag substantially behind what the actual data is currently doing.
Exponential smoothing is an approach which weights the latest actual results and the latest predicted
results to give the next predicted result. Past data fades from the calculation and the time lags are
usually not so great.
No prediction method, no matter how scientific gives guaranteed answers and sensitivity analyses can
give some information about the risks involved.
Decision trees allow a series of decisions and outcomes to be mapped out and investigated.
Where possible, because the future is always uncertain, organizations should always try to build
flexibility into their planning and investment. For example, break clauses in leases and options to
extend or expand operations.

Short term decisions-Technical Articles

Marginal costing assigns only variable costs to the product or service being produced. It is sometimes
referred to as a variable or direct costing system. The marginal cost represents the additional cost of one
extra unit of output.
Relevant costing assigns future costs and revenues to the decision being made. It includes only those cash
flows which will be affected by the decision.
There is commonly an overlap between the two methods, as variable costs will commonly be future costs
affected by the decision, and hence also be considered relevant.
The remainder of this article will focus on the use of relevant costing for short-term or one-off decisions.
Relevant costs must be future (incremental) cash flows affected by the decision and therefore ignore the
following:
Sunk costs those which have already been incurred before the decision is made, for example if a
company has already purchased material then the cost of the material at that time is irrelevant.
Instead, the current replacement value (if material is still regularly used) or the scrap value (if material
is no longer used) would be considered the relevant cost to the decision.
Unavoidable (committed) costs those costs which will be incurred/cannot be avoided regardless of
the decision. The difference between these and sunk costs is the time at which the costs are incurred.
These are future costs, whereas sunk costs are in the past.
Apportioned costs those costs which have been split between units of production or service based
on some arbitrary allocation method, for example fixed machine service costs apportioned based on
the number of machine hours used.

However, relevant costs do include opportunity costs; the costs of the benefit foregone when the decision
being made means that an alternative opportunity must be rejected. For example, if a company owns an
asset which can be leased out to other companies, but is used on a short-term internal contract instead,
then the relevant cost would include the external rental income foregone.
Let us consider the use of relevant costing in the following scenarios:

82 | P a g e
MAKE OR BUY DECISIONS

A company may choose to make its own products or component parts (insource), or may choose to buy
them in from an external supplier (outsource). There are a number of factors which will influence this
decision, both qualitative as well as quantitative. However, there needs to be some basis on which to
compare the financial impact of the alternative choices. The basic rule, if considering this from a purely
financial perspective, is to choose the cheaper of the two options. For example, the decision would be to
outsource if:
Cost of outsource option < relevant costs (of insource option) + opportunity costs
The following shows a simple example of a make or buy decision using relevant costing.
A manufacturer of music and sound systems, Audio Tech, has decided to use a new speaker technology in
its systems. The technology was developed overseas and its patent does not apply in the country in which
Audio Tech operates. Audio Tech believes it is capable of producing this technology itself, but it is
considering whether it should do this or outsource to the company (STT) holding the overseas patent. STT
has offered to supply the speakers using this technology, for a cost of $8 per speaker. Each speaker would
also incur a shipping fee of $2 and would have a lead time of five working days from order to arrival.
Estimated demand is 12,000 speakers per month.
Audio Tech could manufacture these speakers internally, and have estimated the following unit costs:

Labour (note 1) 1

Materials (note 2) 7

Variable overheads 1

Fixed Overheads (note 3) 2

11

Notes:
1. There is currently spare capacity of 1,000 hrs of labour per month. Labour is paid at $10 per hour,
increasing to $12 an hour for any overtime incurred. Overtime is limited to 4,000 hrs per month.
2. Materials will need to be bought in new for this speaker.
3. Fixed overheads are absorbed at the rate of $20.00 per labour hour

Required
Using relevant costing as the basis of the decision, should Audio Tech produce the speakers in-house or
outsource to STT?
Solution
Outsourcing option
The costs of outsourcing are $8 (buy in) + $2 (shipping) = $10 per speaker

83 | P a g e
Insourcing option
It is necessary to determine which costs are relevant. This is not always a clear cut decision. Taking each of
the notes in turn:
Note 1. There is spare capacity which suggests that labour is being paid to be idle. Spare capacity of 1,000
hrs would allow for production of 10,000 speakers, given that the labour cost per speaker is $1, which is
one tenth of the hourly rate (1,000/0.1 = 10,000). Existing capacity of labour would not normally be
considered a relevant cost, given that the salaries are likely to be committed costs.
However, the demand is estimated to be 12,000 speakers, which would require 200 (2,000 * 0.1) hours of
overtime at $12 an hour. This would cost $2,400 ($12 * 200) which would be considered relevant, as it
would be a future cash flow, incurred directly as a result of this decision. If this cost were to be split evenly
between the total production, it would equate to a labour cost of $0.20 per speaker ($2,400/12,000).
Note 2. This is clearly a relevant cost as the materials will be bought in for the new speaker.
Note 3. Fixed overheads are not considered relevant, given that they are costs which will not be changed
by the decision being made.
Therefore, the relevant costs of producing in house are $0.20 (labour) + $7 (material) + $1 (variable
overheads) = $8.20 per speaker
$10 (cost of outsourcing) > $8.20 (relevant costs of insourcing)
Therefore, Audio Tech should choose to produce in-house from a financial perspective.
It is easy to see decision from a purely financial perspective, but decisions of this type also require some
consideration of qualitative measures. For example, the decision above would require the use of 200 hours
of overtime per month. It is unclear whether this is sustainable, or whether there would be capacity to
employ more staff in the long term. The effect on staff morale and productivity is also unclear. Similar
consideration would need to be given to any make or buy decision for example, a buy in decision may
lead to redundancies and a reduction of morale in remaining staff.
Consideration needs to be given to the quality of the alternative sources. With outsourcing, the company
cannot always control the quality or delivery schedule of the external supplier. In this scenario, however, it
could be the quality of the in-house option that is uncertain. It is mentioned that 'Audio Tech believes it is
capable...', but if it failed to produce a speaker of sufficient quality, this may damage its reputation, and
subsequent sales. From an alternative perspective, however, in-house production may allow Audio Tech to
acquire this knowledge, and with it a competitive advantage in its home country.
It is also important to consider that in the long-term, the labour capacity would be addressed and therefore
it may be worthwhile including the full cost of labour in this calculation. In the example described above,
this would not change the decision being made.

ACCEPTING OR DECLINING SPECIAL CONTRACTS

A special contract is a one-off, usually short-term contract, which will make use of specified company
resources. Using relevant costing, the costs and revenues of accepting a special contract would be
calculated using the same principles as the make or buy decision previously mentioned. However, instead
of comparing to an alternative approach, the entire contract would be evaluated to determine whether the
contract price would be greater than the relevant costs in addition to the opportunity cost of choosing to
use the resources for an alternative action. The basic rule for accepting a special contract is, therefore, that

84 | P a g e
the contract is worthwhile if:
Contract price relevant costs + opportunity costs
The following shows a simple example of a special contract decision:
A food production company, Dragon Foods, has been approached by a local charity, Coakers, with a
request to produce a special order of soup, which it wishes to distribute in its homeless shelters for 3
months over the winter period. Dragon Foods currently produce this type of soup and has a capacity of
3,500 soups per month. Current production is 2,500 soups a month. Coakers has said it would like 1,000
portions per month and can pay up to $1,750 for the entire contract. Dragon Foods had considered using
the spare capacity for an alternative contract that would earn a total contribution of $200 over the 3
month period.
Total costs, of $1.20 per portion of soup, are currently as follows:

Cost per portion


$

Manufacturing costs
Direct materials* 0.30
Direct labour 0.20
Variable overhead 0.20

Total cost to manufacture 0.70

Fixed overhead 0.35

Sales commission 0.15

Total cost 1.20

* at current replacement cost

Given that Dragon Foods currently has the spare capacity, it can be assumed that the labour is available
and the salary costs are committed costs, therefore these costs can be ignored. The fixed overhead will not
change as a result of the contract and can also be ignored. As Coakers approached the company, there
should be no sales commission required and this can also be ignored. Therefore, the total relevant cost is
$0.50 per portion of soup.
Relevant costs = $0.50 * 3,000 portions (1,000 * 3 months) = $1,500
Opportunity costs = $200
$1,750 (Contract price) > $1,700 (relevant costs + opportunity cost) therefore the contract can be
accepted from a financial perspective
As with make or buy decisions, there are qualitative factors to take into account with special contracts. For
example, a special contract may provide some experience not previously gained within the company, or
could potentially lead to further future orders. However, if the latter is the case, the company must be

85 | P a g e
careful to ensure they cover fixed costs in the long-term. All contracts could not be priced using relevant
costing techniques as the company would fail to break-even.
In the scenario above, another qualitative consideration may be the positive reputation gained from
assisting a local charity in this way. This could lead to further sales as a result. Therefore companies should
also consider any specific potential benefits or otherwise, of each contract individually.

CLOSURE OR CONTINUATION DECISIONS

Companies usually account separately for different businesses or production lines, in order to determine
the profitability of each. This can lead to the consideration of closure of one or more areas of the business.
When considering this, a company should determine whether the closure of that part of the business will
lead to the entire company being more or less well off than they would be if they retained it. The basic rule
for a closure or continuation decision is, therefore, that the area of the business should be closed if:
Contribution < relevant fixed costs + opportunity costs
To identify whether a fixed cost is relevant, we need to determine whether the cost would be avoidable if
the product or department were to be dropped. If it is, then the fixed cost is relevant, if not, then we
ignore it as an irrelevant cost.
The following shows a simple example of a closure or continuation decision:
ShortBowl, a sportswear and trophy retail outlet has several product lines and is carrying out profitability
analysis on each line. The following are the monthly costs and revenues associated with the product lines:

Sportswear Equipment Trophies


$ $ $

Revenue 15,000 7,500 5,000

Variable costs 8,500 1,500 500

Contribution 6,500 6,000 4,500

Fixed costs 10,000 3,000 2,500

Profit (3,500) 3,000 2,000

As a result of the above analysis the company is considering dropping the sportswear product line. It has
further analysed the fixed costs for the sportswear line as follows:

Company fixed costs absorbed on the basis of labour hours $2,000

Rental of storage warehouse used for sportswear only $6,000

86 | P a g e
Depreciation on ironing and printing equipment used for
sportswear $2,000

$10,000

Clearly, the first is unavoidable as it relates to company fixed costs, which would still exist if the company
continued to operate in any way. The depreciation would also not be relevant as it is a notional cost, not an
actual cash flow. Therefore these should not be taken into consideration. However, the storage warehouse
could presumably be discarded should this area of the business close. Therefore this would be considered a
relevant fixed cost.
Contribution = $6,500 (given)
Relevant fixed costs = $6,000 (from above)
No opportunity costs are mentioned.
$6,500 (contribution) > $6,000 (relevant fixed costs) and so the product line should be continued from a
financial perspective
As with the other decision types discussed in this article, there are qualitative factors to be considered. The
decision to discontinue a product line or business unit could have a negative effect on the company as a
whole, as it may be seen as a signal that the company is in difficulty. If the products are complimentary, as
they are in the above example, then the discontinuation of one product line may lead to fewer customers
for the remaining products, if they prefer to use a one-stop shop.
Discontinuation may also have a negative effect on the employees, and possibly the local area if it leads to
mass redundancies within the organisation. For example, when Tata Steel was considering closing its UK
business, it was suggested that up to 40,000 jobs could be at risk (over half of which were indirect) and the
UK Government may have to cover a 4,6bn bill. Tata Steel has now scrapped these discontinuation plans,
but still finds itself at odds with unions and employees, over the continued confusion of the future of the
business. It also needs to find large savings to make the division viable, an alternative option available to a
discontinuation decision.

SUMMARY

As with all management accounting techniques, there isnt necessarily a 'one rule fits all' approach to the
decisions discussed in this article. Some companies may prefer to consider fixed costs in all their decisions
and therefore choose not to use methods of relevant costing at all. Even within the method itself, there
might be slightly different approaches taken. For example, some companies may prefer to include the full
costs of direct labour, even if the spare capacity exists, thus treating it as an entirely variable cost, rather
than one which is fixed in the short-term. Academics do not necessarily agree on this with Drury (2012)
suggesting that if direct labour is to remain unchanged for the period under consideration then direct
labour costs 'are irrelevant for this decision'. However, Eldenburg and Wolcott (2011) include direct labour
when performing quantitative analysis for all of the above decisions. It is important, therefore, to always
state reasons regarding the inclusion or exclusion of costs within your analysis.

Marginal costing assigns only variable costs to the product or service being produced. It is sometimes
referred to as a variable or direct costing system. The marginal cost represents the additional cost of one

87 | P a g e
extra unit of output.
Relevant costing assigns future costs and revenues to the decision being made. It includes only those cash
flows which will be affected by the decision.
There is commonly an overlap between the two methods, as variable costs will commonly be future costs
affected by the decision, and hence also be considered relevant.
The remainder of this article will focus on the use of relevant costing for short-term or one-off decisions.
Relevant costs must be future (incremental) cash flows affected by the decision and therefore ignore the
following:
Sunk costs those which have already been incurred before the decision is made, for example if a
company has already purchased material then the cost of the material at that time is irrelevant.
Instead, the current replacement value (if material is still regularly used) or the scrap value (if material
is no longer used) would be considered the relevant cost to the decision.
Unavoidable (committed) costs those costs which will be incurred/cannot be avoided regardless of
the decision. The difference between these and sunk costs is the time at which the costs are incurred.
These are future costs, whereas sunk costs are in the past.
Apportioned costs those costs which have been split between units of production or service based
on some arbitrary allocation method, for example fixed machine service costs apportioned based on
the number of machine hours used.

However, relevant costs do include opportunity costs; the costs of the benefit foregone when the decision
being made means that an alternative opportunity must be rejected. For example, if a company owns an
asset which can be leased out to other companies, but is used on a short-term internal contract instead,
then the relevant cost would include the external rental income foregone.
Let us consider the use of relevant costing in the following scenarios:

MAKE OR BUY DECISIONS

A company may choose to make its own products or component parts (insource), or may choose to buy
them in from an external supplier (outsource). There are a number of factors which will influence this
decision, both qualitative as well as quantitative. However, there needs to be some basis on which to
compare the financial impact of the alternative choices. The basic rule, if considering this from a purely
financial perspective, is to choose the cheaper of the two options. For example, the decision would be to
outsource if:
Cost of outsource option < relevant costs (of insource option) + opportunity costs
The following shows a simple example of a make or buy decision using relevant costing.
A manufacturer of music and sound systems, Audio Tech, has decided to use a new speaker technology in
its systems. The technology was developed overseas and its patent does not apply in the country in which
Audio Tech operates. Audio Tech believes it is capable of producing this technology itself, but it is
considering whether it should do this or outsource to the company (STT) holding the overseas patent. STT
has offered to supply the speakers using this technology, for a cost of $8 per speaker. Each speaker would
also incur a shipping fee of $2 and would have a lead time of five working days from order to arrival.
Estimated demand is 12,000 speakers per month.
Audio Tech could manufacture these speakers internally, and have estimated the following unit costs:

88 | P a g e
$

Labour (note 1) 1

Materials (note 2) 7

Variable overheads 1

Fixed Overheads (note 3) 2

11

Notes:
1. There is currently spare capacity of 1,000 hrs of labour per month. Labour is paid at $10 per hour,
increasing to $12 an hour for any overtime incurred. Overtime is limited to 4,000 hrs per month.
2. Materials will need to be bought in new for this speaker.
3. Fixed overheads are absorbed at the rate of $20.00 per labour hour

Required
Using relevant costing as the basis of the decision, should Audio Tech produce the speakers in-house or
outsource to STT?
Solution
Outsourcing option
The costs of outsourcing are $8 (buy in) + $2 (shipping) = $10 per speaker
Insourcing option
It is necessary to determine which costs are relevant. This is not always a clear cut decision. Taking each of
the notes in turn:
Note 1. There is spare capacity which suggests that labour is being paid to be idle. Spare capacity of 1,000
hrs would allow for production of 10,000 speakers, given that the labour cost per speaker is $1, which is
one tenth of the hourly rate (1,000/0.1 = 10,000). Existing capacity of labour would not normally be
considered a relevant cost, given that the salaries are likely to be committed costs.
However, the demand is estimated to be 12,000 speakers, which would require 200 (2,000 * 0.1) hours of
overtime at $12 an hour. This would cost $2,400 ($12 * 200) which would be considered relevant, as it
would be a future cash flow, incurred directly as a result of this decision. If this cost were to be split evenly
between the total production, it would equate to a labour cost of $0.20 per speaker ($2,400/12,000).
Note 2. This is clearly a relevant cost as the materials will be bought in for the new speaker.
Note 3. Fixed overheads are not considered relevant, given that they are costs which will not be changed
by the decision being made.
Therefore, the relevant costs of producing in house are $0.20 (labour) + $7 (material) + $1 (variable
overheads) = $8.20 per speaker
$10 (cost of outsourcing) > $8.20 (relevant costs of insourcing)
Therefore, Audio Tech should choose to produce in-house from a financial perspective.

89 | P a g e
It is easy to see decision from a purely financial perspective, but decisions of this type also require some
consideration of qualitative measures. For example, the decision above would require the use of 200 hours
of overtime per month. It is unclear whether this is sustainable, or whether there would be capacity to
employ more staff in the long term. The effect on staff morale and productivity is also unclear. Similar
consideration would need to be given to any make or buy decision for example, a buy in decision may
lead to redundancies and a reduction of morale in remaining staff.
Consideration needs to be given to the quality of the alternative sources. With outsourcing, the company
cannot always control the quality or delivery schedule of the external supplier. In this scenario, however, it
could be the quality of the in-house option that is uncertain. It is mentioned that 'Audio Tech believes it is
capable...', but if it failed to produce a speaker of sufficient quality, this may damage its reputation, and
subsequent sales. From an alternative perspective, however, in-house production may allow Audio Tech to
acquire this knowledge, and with it a competitive advantage in its home country.
It is also important to consider that in the long-term, the labour capacity would be addressed and therefore
it may be worthwhile including the full cost of labour in this calculation. In the example described above,
this would not change the decision being made.

ACCEPTING OR DECLINING SPECIAL CONTRACTS

A special contract is a one-off, usually short-term contract, which will make use of specified company
resources. Using relevant costing, the costs and revenues of accepting a special contract would be
calculated using the same principles as the make or buy decision previously mentioned. However, instead
of comparing to an alternative approach, the entire contract would be evaluated to determine whether the
contract price would be greater than the relevant costs in addition to the opportunity cost of choosing to
use the resources for an alternative action. The basic rule for accepting a special contract is, therefore, that
the contract is worthwhile if:
Contract price relevant costs + opportunity costs
The following shows a simple example of a special contract decision:
A food production company, Dragon Foods, has been approached by a local charity, Coakers, with a
request to produce a special order of soup, which it wishes to distribute in its homeless shelters for 3
months over the winter period. Dragon Foods currently produce this type of soup and has a capacity of
3,500 soups per month. Current production is 2,500 soups a month. Coakers has said it would like 1,000
portions per month and can pay up to $1,750 for the entire contract. Dragon Foods had considered using
the spare capacity for an alternative contract that would earn a total contribution of $200 over the 3
month period.
Total costs, of $1.20 per portion of soup, are currently as follows:

Cost per portion


$

Manufacturing costs
Direct materials* 0.30
Direct labour 0.20
Variable overhead 0.20

90 | P a g e
Total cost to manufacture 0.70

Fixed overhead 0.35

Sales commission 0.15

Total cost 1.20

* at current replacement cost

Given that Dragon Foods currently has the spare capacity, it can be assumed that the labour is available
and the salary costs are committed costs, therefore these costs can be ignored. The fixed overhead will not
change as a result of the contract and can also be ignored. As Coakers approached the company, there
should be no sales commission required and this can also be ignored. Therefore, the total relevant cost is
$0.50 per portion of soup.
Relevant costs = $0.50 * 3,000 portions (1,000 * 3 months) = $1,500
Opportunity costs = $200
$1,750 (Contract price) > $1,700 (relevant costs + opportunity cost) therefore the contract can be
accepted from a financial perspective
As with make or buy decisions, there are qualitative factors to take into account with special contracts. For
example, a special contract may provide some experience not previously gained within the company, or
could potentially lead to further future orders. However, if the latter is the case, the company must be
careful to ensure they cover fixed costs in the long-term. All contracts could not be priced using relevant
costing techniques as the company would fail to break-even.
In the scenario above, another qualitative consideration may be the positive reputation gained from
assisting a local charity in this way. This could lead to further sales as a result. Therefore companies should
also consider any specific potential benefits or otherwise, of each contract individually.

CLOSURE OR CONTINUATION DECISIONS

Companies usually account separately for different businesses or production lines, in order to determine
the profitability of each. This can lead to the consideration of closure of one or more areas of the business.
When considering this, a company should determine whether the closure of that part of the business will
lead to the entire company being more or less well off than they would be if they retained it. The basic rule
for a closure or continuation decision is, therefore, that the area of the business should be closed if:
Contribution < relevant fixed costs + opportunity costs
To identify whether a fixed cost is relevant, we need to determine whether the cost would be avoidable if
the product or department were to be dropped. If it is, then the fixed cost is relevant, if not, then we
ignore it as an irrelevant cost.
The following shows a simple example of a closure or continuation decision:
ShortBowl, a sportswear and trophy retail outlet has several product lines and is carrying out profitability

91 | P a g e
analysis on each line. The following are the monthly costs and revenues associated with the product lines:

Sportswear Equipment Trophies


$ $ $

Revenue 15,000 7,500 5,000

Variable costs 8,500 1,500 500

Contribution 6,500 6,000 4,500

Fixed costs 10,000 3,000 2,500

Profit (3,500) 3,000 2,000

As a result of the above analysis the company is considering dropping the sportswear product line. It has
further analysed the fixed costs for the sportswear line as follows:

Company fixed costs absorbed on the basis of labour hours $2,000

Rental of storage warehouse used for sportswear only $6,000

Depreciation on ironing and printing equipment used for


sportswear $2,000

$10,000

Clearly, the first is unavoidable as it relates to company fixed costs, which would still exist if the company
continued to operate in any way. The depreciation would also not be relevant as it is a notional cost, not an
actual cash flow. Therefore these should not be taken into consideration. However, the storage warehouse
could presumably be discarded should this area of the business close. Therefore this would be considered a
relevant fixed cost.
Contribution = $6,500 (given)
Relevant fixed costs = $6,000 (from above)
No opportunity costs are mentioned.
$6,500 (contribution) > $6,000 (relevant fixed costs) and so the product line should be continued from a
financial perspective
As with the other decision types discussed in this article, there are qualitative factors to be considered. The
decision to discontinue a product line or business unit could have a negative effect on the company as a
whole, as it may be seen as a signal that the company is in difficulty. If the products are complimentary, as
they are in the above example, then the discontinuation of one product line may lead to fewer customers
for the remaining products, if they prefer to use a one-stop shop.

92 | P a g e
Discontinuation may also have a negative effect on the employees, and possibly the local area if it leads to
mass redundancies within the organisation. For example, when Tata Steel was considering closing its UK
business, it was suggested that up to 40,000 jobs could be at risk (over half of which were indirect) and the
UK Government may have to cover a 4,6bn bill. Tata Steel has now scrapped these discontinuation plans,
but still finds itself at odds with unions and employees, over the continued confusion of the future of the
business. It also needs to find large savings to make the division viable, an alternative option available to a
discontinuation decision.

SUMMARY

As with all management accounting techniques, there isnt necessarily a 'one rule fits all' approach to the
decisions discussed in this article. Some companies may prefer to consider fixed costs in all their decisions
and therefore choose not to use methods of relevant costing at all. Even within the method itself, there
might be slightly different approaches taken. For example, some companies may prefer to include the full
costs of direct labour, even if the spare capacity exists, thus treating it as an entirely variable cost, rather
than one which is fixed in the short-term. Academics do not necessarily agree on this with Drury (2012)
suggesting that if direct labour is to remain unchanged for the period under consideration then direct
labour costs 'are irrelevant for this decision'. However, Eldenburg and Wolcott (2011) include direct labour
when performing quantitative analysis for all of the above decisions. It is important, therefore, to always
state reasons regarding the inclusion or exclusion of costs within your analysis.

Other Areas:

Pricing-Technical Article:

The influences on prices


The influences on prices can be summarised by the following diagram:

Mission and marketing objectives


Pricing is ultimately part of an organisations strategy and we should, therefore, go back to where strategic
planning should begin: the organisations mission. There we will find the organisations purpose, its self-
perception, its feeling about its position in the market, and material relating to the organisations culture and
ethics. Pricing cannot be separated from mission.

For example:
An organisation might have a charitable or not-for-profit purpose, in which case prices for its products and
services might be zero or heavily subsidised.

93 | P a g e
An organisation might perceive itself to be up-market, in which case it might have to charge high prices to
project quality and exclusivity.
Pharmaceutical companies face ethical issues when pricing their life-saving products for both rich markets
where they hope to make profits, and for poor markets where there are ethical and social responsibility
dimensions.

Economic and Non-Economic Factors effecting Pricing Decisions:

Costs
In profit-seeking organisations, revenues have to exceed costs; in not-for profit organisations revenue has to
match income. By this stage of your studies you should be well aware that any positive contribution (that is when
marginal revenues exceed marginal costs) helps to cover fixed costs. To make a profit, revenue has to exceed all
costs. What might become more relevant in strategic management is the importance of opportunity costs and of
exit costs.

An opportunity cost is the revenue foregone as a result of a decision. If you build on a piece of land you cannot
then sell the land for cultivation, for example, and the sale price foregone is an opportunity cost of the decision to
build. Exit costs can arise when trying to abandon a strategy. For example, in some countries large liabilities can
be incurred if employees are made redundant. Sometimes clean-up or reparation costs can be triggered if
undertakings are closed down. In such circumstances, it might be cheaper to carry on provided marginal revenues
just exceed marginal costs. If competitors are in this position then we are likely to suffer great price pressure from
them.

Competition
There are four main types of market, each giving rise to a particular type of competition:
Perfect competition. This form of market consists of many small suppliers and customers none of which can
influence the market. There is free entry and exit from the market and all supply identical products. Here,
suppliers must charge the market price. They cannot charge more because, as the products are identical,
every customer would move to cheaper suppliers; there is no point in reducing their prices because all
output can be sold at the market price. It is worth noting that the internet has tended to make price and
competition much more transparent and that there are sites which specialise in comparing suppliers prices.
Oligopoly. This special type of market consists of a small number of suppliers supplying identical products. An
example is found in petrol companies. If a supplier increases prices, the others simply have to maintain theirs
to gain market share. If a supplier reduces prices, the others must follow suit to maintain their market share.
There is therefore little incentive to reduce prices as competitors will follow.
Monopoly. In a monopoly market there is only one supplier of a product. The supplier can charge whatever is
wished, though demand is likely to vary as a result. This is the great freedom a monopolist has: choose the
price to charge so that profits can be maximised. Note that despite that statement, being a monopolist does
not guarantee that a profit is made. You might be the sole supplier of something no one wants.
Monopolistic competition. This is a very unhelpful, almost self-contradictory term for the type of market this
represents. This form of competition means that there are a number of suppliers supplying similar but not
identical goods. Essentially, the products are being differentiated in some way and, therefore, can command
different prices. Suppliers are competing, but with different offerings.

Price competition means that consumers are motivated primarily by price and usually suppliers will have to offer
low prices to succeed. Very often organisations which use a cost leadership strategy adopt price competition.
Their products are ordinary, but because their costs are very low (if not actually the lowest) prices can also be

94 | P a g e
kept down.

Many laptop producers use price competition because, for most, their products have been commoditised: they all
do the same things, with the same operating systems, run the same application software and have similar
reliabilities.

Non-price competition means that consumers pay attention not only to the price of the goods but are also
influenced by other marketing mix variables such as the:
quality, brand and features of the goods
promotion activities
place (where the goods or services are obtained).

Essentially, organisations which follow a differentiation or focus strategy will be making use of non-price
competition. They seek to make their products different so that they are particularly attractive to consumers, who
in turn are willing to pay premium prices. Considering again the laptop producers mentioned above, we could
probably argue that Apple uses non-price competition. Its laptops look different and unique, they have a different
operating systems and run different (but often compatible) software. This can make it difficult to directly compare
prices, but many people have the impression that, insofar as it is possible to compare like with like, Apple
machines are more expensive than others. Nevertheless, they sell well and profitably.

Consumers/Customers
Suppliers have to keep in mind both what the end consumers are willing to pay and also the profits that will be
expected by intermediaries in the supply chain. Many industries have rules of thumb about the mark-ups they
expect to be able to apply. It is common to segment markets according to wealth so that a company will have a
value range of goods for poorer or thriftier customers who might respond to price competition, and a more
exclusive range for better-off customers, who might respond to non-price competition.

Even if there are not different lines of goods for different customer groups, it can still be possible to charge
different prices for the same product to different groups. This is known as price discrimination. For example, it is
often cheaper to buy electronic goods in the US than in Europe. Leakage of goods from the cheaper to the more
expensive market must be prevented in some way, so the groups have to be sufficiently separate (or un-
informed). The pharmaceutical company example given above is another instance of price discrimination where
drugs are sold at high prices within rich economies and often at much lower prices elsewhere. Leakage from one
market to the other is reduced by giving the products different names (even though they are pharmacologically
identical) and by controlling distribution carefully through hospitals and government agencies.

The perceived value of goods is a concept which is also related to non-price competition and, indeed, to price. We
have all, no doubt, been influenced by the thought that a higher price implies goods of a higher value even though
we are often essentially ignorant about the merit of those goods. For example, when buying a T-shirt there is a
very wide range of prices for a range of garments which are very similar looking. We assume that the expensive T-
shirt with the fashionable label is better than the cheaper, more basic lines. However, often we really do not
know, and might even be paying for the kudos we feel an exclusive label gives us.

Whether goods are necessities or luxuries also influences consumers reactions to prices and price changes. This
affects the elasticity of demand of the product, which is a measure of how a change in sales volume is caused by a
change in price. Goods that have a high elasticity of demand are very price sensitive and are likely to be luxury
products that consumers are prepared to do without if the price rises too much. Goods with a low elasticity of

95 | P a g e
demand are relatively unaffected by price changes and are likely to be necessities. As prices rise, demand will stay
high because customers need the goods. Note that not all goods are regarded the same way by customers. Some
consumers might regard a foreign holiday as the highlight of their year and sacrifice other consumption so that
they can afford higher air fares. Other consumers have little interest in going abroad so would immediately react
to price increases.

Controls
Some industries are closely regulated by statute and regulation, and they have little power to choose their own
prices. Other industries are able to, or try to, dictate final prices charged to consumers. For example, exclusive
perfume and cosmetic producers resist price competition by insisting in their supply contracts that their retailers
do not discount their products. Note that not all contractual arrangements are legal. Pricing cartels (competitors
fixing prices) are frowned upon by most governments.

Setting prices

Setting prices to maximize profits


In theory, and as you might recall from earlier studies, profits are maximised when:

Marginal cost = Marginal revenue

In practice, this is almost useless advice to most organisations. Although we might expect a well-controlled
organisation to have reasonable information about how its costs move, very few will have sufficiently detailed or
stable information about how revenues move, as they are affected by fickle consumers, competitor action and
economic confidence.

Setting prices to break even


The break-even volume is given by:

Fixed costs/(Selling price per unit Variable cost per unit)


or
Fixed costs/Contribution per unit

Setting a high selling price per unit will generate a high contribution per unit and this would require a smaller
volume to be sold before breakeven point is reached. The company could, therefore, evaluate various options of
prices and volume and compare these to what it feels customers might find attractive and what competitors
might be charging.

Cost-based pricing
Here the cost per unit is determined (either total absorption cost, marginal cost or relevant costs) and a set
amount, or a set percentage, is added to that to give the selling price. If the forecast volume is sold at the price
set, then the forecast profit would be made. However, although useful as a guideline, the method is not sufficient
because it is entirely inward looking and pays no heed to competitors or customers. The resulting prices must
always be looked at with some scepticism, and the organisation must assess how those fit in with the market. An
inability to make a reasonable margin on sales must indicate that either costs are too high or demand for the
product is too weak. Strategically speaking the organisation would be stuck in the middle.

Competition-based pricing
By contrast, this approach is entirely outward-looking. It strives to match what competitors are charging and is the

96 | P a g e
only option when in perfect competition. Goods should sell at that price, but there is no guarantee that sufficient
profit will be made. This approach, therefore, places high importance on being able to achieve low costs, ideally
cost leadership.

Marketing-orientated pricing
In this approach, the organisation attempts to escape from the constraints of perfect competition and sells a
product differentiated by features, quality, design, promotion, place and so on. Generally, higher prices are
sought and are justified by products better matching a market segments needs. For example, consider a company
which makes agricultural chemicals. In general, farmers will need to buy these in spring, but will get no income
from their crops until harvest in the autumn, so farmers have a very adverse cash flow for around six months.
Think how attractive it might be if the manufacturer gave farmers payment terms of six months to match their
cash flow needs. The prices of the chemicals might be higher than those of competitors, but the convenience to
farmers plus the apparent empathy shown with their problems could well outweigh the price differences.

Strategic approaches
It is important to note several ways in which price can be used with more strategic intent, here using the term
strategy to mean a ploy.
Price skimming. This approach is often seen when new technology is introduced. There are some consumers
who will pay a very high price for new products, perhaps because they need them or perhaps because they
have more money than sense. After the most desperate, the richest or the most profligate consumers have
been satisfied, the price is reduced to skim off another layer. At some stage a longer-term stable price is
reached.
Penetration pricing. Here, the ambition it to use a very low price to capture a very high market share. Note
that this very high market share could well give economies of scale that will allow low costs and hence low
prices to be maintained in the long term. In fact, a large market share can be a barrier to entry as smaller
new suppliers will have to match, what are to them, uneconomic low prices.
Product-line pricing. Car manufacturers, for example, offer ranges of the same model of car. This enables
them to attract customers by advertising Prices from $10,000..., and then often to persuade the customer
to move up the range. You can be sure that the additional price on upmarket models will be much greater
than the additional costs incurred making them.
Related product pricing. We have probably all experienced this with inkjet printers. Many of these sell for
about $100, and when you come to renew the ink cartridges you have to pay about $80. Here the
organisation makes most of its profits on after sales services that consumers feel committed to after the
initial purchase.
Demand manipulation. This is frequently seen in train ticket and airline prices. Not only are the companies
using price discrimination (charging business travellers more for peak-time travel) but they are also
encouraging others to make use of the services at other, less crowded times. Another example can be seen
in heating engineering businesses which can have a problem meeting demand in winter but have idle staff
over summer. They could even-out demand (and lower their costs) by offering routine servicing over summer
at a discount, or for which payment did not have to be made until much later.

97 | P a g e
Budgeting: a plan not a forecast. Its a short term plan expressed in financial terms .It converts strategic
plans into specific targets.

Objectives of budgetary Styles of budgeting:


planning and control systems Imposed ( top-down )
Ensure the organizations Participation (bottom-up)
objectives are achieved negotiated
Compel planning
Communicate ideas and Advantages of participative approach
plans More realistic budgets
Co-ordinate activities Co-ordination, morale motivation improved
Provide a framework for Increased management commitment to objectives
responsibility accounting
Establish a system of control Disadvantages of participative approach
Motivate employees to More time-consuming
improve their performance Budgetary slack may be introduced
Does not suit some employees
Flexible budgets
These are budgets which, by recognizing different cost behavior patterns, change as activity levels change.
At the planning stage, flexible budgets can be drawn up to show the effect of the actual volumes of the
output and sales differing from budgeted volumes
At the end of a period, actual results can be compared to a flexed budget as a control procedure.

- In an exam question examiner might expect you to make a flexed budget and comment on the results

Standard Costing:

Uses: Types of standards:


To act as a control device Ideal
To value inventories and cost of production Perfect operating conditions
To assist in setting budgets and evaluating Unfavorable motivational impact
managerial performance Attainable
To enable the principle of management by Allowances made for inefficiencies and wastages
exception to be practiced Incentives to work harder ( realistic but
To provide a prediction of future costs for challenging)
use in decision-making situations Current
To motivate staff and management by Based on current working conditions
providing challenging targets No motivational impact
To provide guidance on possible ways of Basic
improving efficiency Unaltered over a long period of time
Unfavorable impact on performance

Variance Analysis-Reasons For variances:

Variance Favourable Adverse


Material price Unforeseen discounts received Price increase
Greater care in purchasing Careless purchasing

98 | P a g e
Change in material standard Change in material standard
Material usage Material used of higher quality than Defective material
standard Excessive waste or theft
More efficient use of material Stricter quality control
Errors in allocating material to jobs Errors in allocating material to
jobs
Labour rate Use of workers at a rate of pay lower Wage rate increase
than standard
Idle time The idle time variance is always adverse Machine breakdown Illness or injury
to worker
Labour Output produced more quickly than Lost time in excess of standard
efficiency expected because of worker Output lower than standard set
motivation, better quality materials because of lack of training,
Errors in allocating time to jobs substandard materials etc
Errors in allocating time to jobs
Fixed overhead Savings in costs incurred Increase in cost of services used
expenditure

Overhead expenditure variances ought to be traced to the individual cost centres where the variances
occurred.
Fixed overhead Production or level of activity greater Production or level of activity less
volume than budgeted than budgeted

Efficiency Reasons for this tie in exactly to Reasons for this tie in exactly to
labour efficiency labour efficiency

Capacity Labour worked for more hours than Maybe a result of lower
budgeted. Maybe due to more production volumes or higher
production than expected absenteeism eg holidays / sickness
Sales price Unplanned price increase Anticipated increase in selling
Fewer discounts given than expected price did not happen
More discounts allowed than
expected
Sales volume Additional demand experienced Fall in demand Lower output

Traditional Costing/Absorption Costing: Calculation of cost of one unit based on full cost (variable+ fixed
production cost)

Advantages:
1. Pricing decisions
2. Exercising control
3. assessing efficiency
4. Assessing performance

99 | P a g e
Activity Based Costing

steps of activity based costing


1. Identify organizations major activities creating overheads.
2. Collect cost related to each activity in a separate cost pool.
3. Identify factor causing change in the cost of these activities. (cost drivers)
4. Calculate absorption rate per cost driver for each activity.
5. Charge cost to products on the basis of usage of these activities.

suitability of activity based costing (ABC)

Number of products
Cost structure
Cost benefit analysis
Resistance by employees
Change in information system

Advantages of activity based costing ABC


1. Accurate cost calculation
2. Accurate selling price
3. Better cost control
4. Better decision making
5. Better planning/ activity based budgeting
6. Better performance measurement

Disadvantages of activity based costing ABC


1. ABC is time consuming and expensive.
2. Many judgmental decisions still required in the construction of an ABC system.
3. Selection of cost driver may not be easy.
4. Implementing ABC is often problematic.
5. The cost of implementing and maintaining an ABC system can exceed the benefits of improved accuracy in
product costs.
6. ABC will be of limited benefit if overhead costs are primarily volume related
7. Reduced benefit if the company is producing only one product or a range of products with similar costs
8. There must be a reason for using a system of ABC. ABC must provide meaningful product costs or extra
information that management will use. If management is not going to use ABC information for any practical
purpose, a traditional absorption costing system would be simpler to operate and just as good.

Finance & Strategy: Strategic decisions in business have a number of financial components

Investment decisions
Assessing levels of risk and return,
Establishing suitable discount rates,
Calculating project NPVs

100 | P a g e
Funding decisions whether to raise equity, debt or convertible finance

(a) Sources of equity (b) Sources of debt


Retained earnings, Bank loans,
Rights issues, Issue bonds
Institutional placements, duration
Public floatation. currency
coupon rate
convertible to equity

Dividend decisions when and how to return funds to investors?


Constant $ dividend
Constant % of profits dividend
Zero dividend
Occasional share buyback schemes

End of chapter

101 | P a g e