COLLEGE OF ACCOUNTANCY

LEARNING MATERIALS IN CAS 11 (STRATEGIC COST MANAGEMENT)

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THE BALANCED SCORECARD

The balanced scorecard translates an organization's mission and strategy into a set of performance measures
that provides the framework for implementing the strategy. The balanced scorecard does not focus solely on
achieving financial objectives. It also highlights the nonfinancial objectives that an organization achieve to
meet its financial objectives. The scorecard measures an organization’s performance from four perspectives:
(1) financial, (2) customer, (3) internal measures, and (4) learning and growth. A company's strategy
influences the measures it uses to track performance in each of these perspectives.

Strategic information using critical success factors such as growth in sales and earnings, cash flow, stock price,
market share, product quality, customer satisfaction, and growth opportunities provides a road map for a firm
to chart its competitive course and serves as a benchmark for competitive success. To emphasize the
importance of using strategic information, both financial and nonfinancial, accounting reports of a firm's
performance are now often based on critical success factors in different dimensions.

Financial performance measures summarize the results of past actions and are important to a firm's owners,
creditors, employees and so forth. Nonfinancial performance measures concentrate on current activities which
will be the drivers of future financial performance. Thus, effective management requires a balanced
prospective on performance measurement, a viewpoint that some call the "balanced scorecard" perspective.
The balance scorecard integrates performance measures in four key areas:

(1) financial perspective,

(2) customer satisfaction,

(3) internal business processes, and

(4) innovation and learning.

A balanced scorecard consists of an integrated system of performance measures that are derived from and
support the company's strategy. Different companies will have different balanced scorecards because they
have different strategies. A well-constructed balanced scorecard provides a means for guiding the company
and also provides feedback concerning the effectiveness of the company's strategy.

It is called the balances scorecard because it balances the use of financial and nonfinancial performance
measures to evaluate short-run and long-run performance in a single report. The balanced scorecard reduces
managers; emphasis on short-run financial performance, such as quarterly earnings. That's because the
nonfinancial and operational indicators, such as product quality and customer satisfaction, measure changes
that a company is making for the long run. The financial benefits of these long-run changes may not appear
immediately in short-run earnings, but strong improvement in nonfinancial measures is an indicator of
economic value creation in the future.

The balanced scorecard is depicted in Figure 7-1.

Figure 7-1: The Balanced Scorecard

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FOUR PERSPECTIVES OF THE BALANCED SCORECARD

(1) Financial Perspective. Measures of profitability and market value among others, as indicators of how well
the firm satisfies its owners and shareholders. These financial measures show the impact of the firm's policies
and procedures on the firm's current financial position and therefore its current return to the shareholders.
Answers the question: “How do we look to the firm’s owner’s?”

(2) Customer Satisfaction. Measures of quality service and low cost, among others, as indicators of how well
the firm satisfies its customers. Answers the question: “How do the customers see us?”

(3) Internal Business Processes. Measures of the efficiency and effectiveness with which the firm produces the
product or service. Answers the question: “In what business process must the firm excel in order to achieve its
long-term financial goals?”

(4) Learning an Growth. Measures of the firm's ability to develop and utilize resources to meet the strategic
goals now and into the future. Answers the question: “How can we continually improve an create value?”

Features of a Good Balanced Scorecard

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1. The balanced scorecard should tell the story of a company's strategy by articulating a sequence of cause-
and-effect relationships. For example, if the objective of XYZ Manufacturing Co. is to be a low-cost producer
with emphasis on growth, the balanced scorecard describes the specific objectives and measures in the
learning and growth perspective that lead to improvements in internal business processes. These would lead
to increased customer satisfaction and market share as well as higher operating income and shareholder
wealth. Each measure in the scorecard is part of a cause-and-effect chain, a linkage from strategy formulation
to financial results.

2. It helps to communicate the strategy to all members of the organization by translating the strategy into a
coherent and linked set to understandable and measurable operational targets. Managers and employees are
guided by the scorecard and take actions and make decisions that aim to achieve the company's strategy.

3. In for-profit companies, the balanced scorecard places strong emphasis on financial objectives and
measures. When financial and nonfinancial performance measures are linked, many of the nonfinancial
measures serve as leading indicators of future financial performance.

4. The balanced scorecard should focus only on key measures to be used by identifying only the most critical
ones.

5. The scorecard should highlight suboptimal tradeoffs that managers may make when they fail to consider
operational and financial measure together.

Pitfalls in Implementing a Balanced Scorecard

Pitfalls to avoid in implementing a balanced scorecard include the following:

1. Don't assume the cause-and-effect linkages are precise. They are merely hypotheses. Over time, a company
must gather evidence of the strength and speed of the linkages among the nonfinancial and financial
measures.

2. Don't seek improvements across all of the measures all of the time. Trade-off may need to be made across
various strategic goals. For example, strive for quality and on-time performance but not beyond a point at
which further improvement in these objectives may be inconsistent with long-run profit maximization.

3. Don't use only objective measures in the balanced scorecard. The balanced scorecard should include both
objective measures (such as operating income from cost leadership, market share and manufacturing yield)
and subjective measures (such as customer and employee satisfaction ratings). When using subjective
measures, though, management must be careful to trade off the benefits of the richer information these
measures provide against the imprecision and potential for manipulation.

4. Don't fail to consider both costs and benefits of initiatives such as spending on information technology and
R&D before including these objectives in the balanced scorecard. Otherwise, management may focus the
organization on measures that will not result in overall long-run financial benefits.

5. Don't ignore nonfinancial measures when evaluating managers and employees. Managers tend to focus on
what their performance is measured by. Excluding nonfinancial measures when evaluating performance will
reduce the significance and importance that managers give nonfinancial measures.

6. Don't use too many measures. It clutters the balanced scorecard and takes attention away from the
measures that are critical for implementing strategy.

Evaluating the Success of a Strategy

To evaluate the success of a company's strategy, we analyze changes in operating income into components
that can be identified with growth, product differentiation, and cost leadership. Subdividing the change in
operating income to evaluate the success of a company's strategy is similar to variance analysis. The focus
here, however, is on comparing actual operating performance over two
different time periods and explicitly linking it to strategic choices. A company is considered to be successful in
implementing its strategy when the amounts of the product differentiation, cost leadership, and growth
components align closely with its strategy.
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The following analytical relationships may be used:

1. Growth component
The calculation for the growth component are similar to Sales-Volume or Quantity Factor.

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Illustrative Problem 7-1: Strategy; Balanced Scorecard; Strategic Analysis of Operating Income;
Identifying and Managing Unused Capacity

Metro Corporation makes a special-purpose machine OM used in the textile industry. Metro has designed the
OM machine for 20X3 to be distinct from its competitors. It has been generally regarded as a superior
machine. Metro presents the following data for the years 20X2 and 20X3.

20X2 20X3
1. Units of OM produced and sold 200 210
2. Selling price P40,000 P42,000
3. Direct materials (kilograms) 300,000 310,000
4. Direct materials cost per kilogram P8 P8.50
5. Manufacturing capacity in units of OM 250 250
6. Total conversion costs P2,000,000 P2,025,000
7. Conversion costs per unit of capacity P8,000 P8,100
8. Selling and customer-service capacity 100 customers 95 customers
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 9. Total selling and customer-service costs P1,000,000 P940,500
10. Selling and customer-service capacity cost per customer P10,000 P9,900
11. Design staff 12 12
12. Total design costs P1,200,000 P1,212,000
13. Design costs per employee P100,000 P101,000

Metro produces no defective machines, but it wants to reduce direct materials usage per OM machine in 20X2.
Conversion costs in each year depend on production capacity defined in terms of OM units that can be
produced, not the actual units of OM produced. Selling and customer-service costs depend on the number of
customers that Metro can support, not the actual number of customers Metro serves. Metro has 75 customers
in 20X2 and 80 customers in 20X3. At the start of each year, management uses its discretion to determine the
number of design staff for the year. The design staff and costs have no direct relationship with the quantity of
OM produced or the number of customers to whom OM is sold.

Required:

1. Is Metro’s strategy one of the product differentiation or cost leadership? Explain briefly.
2. Describe briefly key elements that you would include in Metro's balanced scorecard and the reasons for
doing so.
3. Calculate the operating income of Metro Corporation in 20X2 and 20X3.
4. Calculate the growth, price-recovery; and productivity components that explain the change in operating
income from 20X2 to 20X3.
5. Comment on your answer in requirement 4. What do these components indicate?
6. Where possible, calculate the amount and cost of unused capacity for (a) manufacturing, (b) selling and
customer service, and (c) design at the beginning of the year 20X3 based on year 20X3 production. If you
could not calculate the amount and cost of unused capacity, indicate why not.
7. Suppose Metro can add or reduce its manufacturing capacity in increments of 30 units. What is the
maximum amount of costs that Metro could save in 20X3 by downsizing manufacturing capacity?
8. Metro, in fact, does not eliminate any of its unused manufacturing capacity. Why might Metro not
downsize?

Answer:

1. Metro Corporation follows a product differentiation strategy in 20X3. Metro's OM machine is distinct from
its competitors and generally regarded as superior to competitors' products. To succeed, Metro must
continue to differentiate its product and charge a premium price.
2. Balanced Scorecard measures for 20X3 follow:
Financial Perspective
(1) Increase in operating income from charging higher margins
(2) Price premium earned on products
These measures indicate whether Metro has been able to charge premium prices and achieve operating
income increases through product differentiation.
Customer Perspective
(1) Market share in high-end special-purpose textile machines
(2) Customer satisfaction
(3) New customers
Improvements in these customer measures are leading indicators of superior financial performance.
Internal Business Process Perspective
(1) Manufacturing quality
(2) New product features added
(3) Order delivery time
Improvements in these measures are expected to result in more satisfied customers and in turn superior
financial performance.
Learning and Growth Perspective
(1) Development time for designing new machines
(2) Improvements in manufacturing processes
(3) Employee education and skill levels
(4) Employee satisfaction
Improvements in these measures have a cause-and-effect relationship with improvements in internal
business processes, which in turn lead to customer satisfaction and financial performance.
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3. Operating income for each year is as follows:

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5. The analysis of operating income indicates that a significant that a significant amount of the increase in
operating income resulted from Metro’s product differentiation strategy. The company was able to continue to
charge a premium price while growing sales. Metro was also able to earn additional operating income by
improving its productivity.

*The absence of a cause-and-effect relationship makes identifying unused capacity for discretionary costs
difficult. Management cannot determine the R &D resources used for the actual output produced to compare R
& D capacity against.

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7. Metro can reduce manufacturing capacity from 250 units to 220 (250-30) units. Metro will save 30 x P8,100
= P243,000. This is the maximum amount of costs Metro can save in 2013. It cannot reduce capacity further
(by another 30 units to 190 units) because it would then not have enough capacity to manufacture 210 units
in 20X3 (units that contribute significantly to operating income).

8. Metro may choose not to downsize because it projects sales increases that would lead to a greater demand
for and utilization of capacity. Metro may have also decided not to downsize because downsizing requires a
significant reduction in capacity. For example, Metro may have chosen to downsize some more manufacturing
capacity if it could do so in increments, of say, 10, rather than 30 units. Also, Metro may be focused on
product differentiation, which is key to its strategy, rather than on cost reduction. Not reducing significant
capacity also
helps to boost and maintain employee morale.

Internal Business Process Performance

Most of the performance measures are self-explanatory. However, three are not delivery cycle time,
throughput time, and manufacturing cycle efficiency (MCE). These three important performance measures are
discussed below.

Figure 7-3: Delivery Cycle Time and Throughput (Manufacturing Cycle) Time

Delivery Cycle Time. The amount of time from when an order is received from a customer to when the
completed order is shipped is called delivery time cycle. This time is clearly a key concern to many customers,
who would like the delivery cycle time to be as short as possible. Cutting the delivery cycle time may give a
company a key competitive advantage – and may be necessary for survival. Consequently, many companies
would include this performance measure on their balanced scorecard.

Throughput (Manufacturing Cycle) Time. The amount of time required to turn raw materials into
completed products is called throughput time, or manufacturing cycle time. The relation between the delivery
cycle time and the throughput (manufacturing cycle) time is illustrated in the diagram above.

As shown in the diagram, the throughput time, or manufacturing cycle time, is made up of process time,
inspection time, move time, and queue time. Process time is the amount of time work is actually done on the
product. Inspection time is the amount of time spent ensuring that the product is not defective. Move time is
the time required to move materials or partially completed products from workstation to workstation. Queue

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time is the amount of time a product spends waiting to be worked on, to be moved, to be inspected, or to be
shipped.

As shown at the bottom of the diagram, only one of these four activities add value to the product- process
time. The other three activities- inspecting, moving, and queuing- add no value and should be eliminated as
much as possible.

Manufacturing Cycle Efficiency (MCE). Through concerted efforts to eliminate the non-value-added
activities of inspecting, moving and queuing, some companies have reduced their throughput time to only a
fraction of previous levels. In turn, this has helped to reduce the delivery cycle time form months to only
weeks or hours. Throughput time, which is considered to be a key measure in delivery performance, can be
put into better perspective by computing the manufacturing cycle efficiency (MCE). The MCE is computed by
relating the value-added time to the throughput time. The formula is:

Value-added time
MCE =
Throughput (manufacturing cycle) time

If the MCE is less than 1, then non-value-added time is present in the production process. An MCE of 0.5 for
example, would mean that half of the total production time consisted of inspection, moving, and similar non-
value-added activities. In many manufacturing companies, the MCE is less than 0.1 (10%), which means that
90% of the time a unit is in process is spent on activities and thus get products into the hands of customers
more quickly and at a lower cost.

Illustrative Problem 7-2: Measures of Internal Business Process Performance

Southwest Company keeps careful track of the time relating to orders and their production. During the most
recent quarter, the following average times were recorded for each unit or order:

Days
Wait time 17.0
Inspection time 0.4
Process time 2.0
Move time 0.6
Queue time 5.0

Goods are shipped as soon as production is completed.

REQUIRED:

1. Compute the throughput time, or velocity of production.

Solution:
1. Throughput time = Process time + Inspection time + Move time + Queue time
= 2.0 days + 0.4 days + 0.6 days + 5.0 days
= 8.0 days
2. Only process time is value-added time; therefore, the computation of the MCE would be as follows:
MCE = Value-added time = 2.0 days = 0.25
Throughput time 8.0 days

Thus, once put into production, a typical unit is actually being worked on only 25% of the time.

3. Since the MCE is 25%, the complement of this figure, or 75% of the total production time, is spent in non-
value-added activities.

4. Delivery cycle time =Wait time + Throughput time

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=17.0 days + 8.0 days
= 25.0 days

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