CHAPTER 4
DEVELOPING A COMPETITIVE STRATEGY AND
CONTEMPORARY COST MANAGEMENT TECHNIQUES
EXPECTED LEARNING OVERCOMES
After studying this chapter, you should be able to:
1. Understand the basic approach of how a firm’s competitive strategy is developed
2. Explain the strategic measures of success, financial and nonfinancial factors
3. Describe the critical success factors in a business firm and how they can be
measured
4. Explain the consequences of lack of strategic information
5. Describe the two basic competitive strategies, namely,
a. Cost Leadership
b. Product Differentiation
6. Understand and describe the contemporary cost management techniques such
as
a. Total Quality Management
b. Just-in-Time Production System
c. Process Reengineering
d. Benchmarking
e. Mass Customization
f. Balanced Scorecard
g. Activity-based Costing and Management
h. Theory of Constraints
i. Life Cycle Costing
j. Target Costing
k. Computer-Aided Design and Manufacturing
l. Automation
m. E-Commerce
n. The Value Chain
CHAPTER 4
DEVELOPING A COMPETITIVE STRATEGY AND
CONTEMPORARY COST MANAGEMENT TECHNIQUES
DEVELOPING A COMPETITIVE STRATEGY
A strategy is a set of policies, procedures and approaches to business that produce
long-term success.
Finding a strategy begins with determining the purpose and long-range direction or in
other words, the mission of the company. The mission is developed into specific
performance objectives which are then implemented by specific corporate or company’s
strategies, that is, specific actions to achieve the objectives that will fulfill the mission. A
firm succeeds by implementing a strategy.
Strategy specifies how an organization matches its own capabilities with the
opportunities in the market place to accomplish its objectives. In other words, strategy
describes how a compete will compete and the opportunities its employee should seek
and pursue. Companies follow one of two broad strategies. Some companies such as
Jollibee, Pure Gold and Cebu Pacific Airline compete on the basis of providing a quality
product or service at low prices. This is also known as “Cost Leadership” strategy. Other
companies such as Rustan’s Department Store and BGC Shangri-La Hotel compete on
their ability to offer unique products or services that are often priced higher than the
products or services of competitors. This is known as “Product Differentiation” strategy.
Deciding between these strategies is a big part of what managers do. Management
accountants work closely with managers in formulating strategy by providing information
about the sources of competitive advantage – for example, the cost, productivity, or
efficiency advantage of their company relative to competitors or the premium prices a
company can charge relative to the costs of adding features that make its products or
services distinctive. The management accountant also helps formulate a strategy by
answering questions such as:
Who are our most important customers?
How sensitive are their purchases to price, quality, and service?
Who are our most important suppliers?
What substitute products exists in the marketplace, and how do they differ from
our product in terms of price and quality?
Is the industry demand growing or shrinking?
Is there overcapacity?
Strategic cost management is often used to describe Cost Management that specifically
focuses on strategic issues such as these.
STRATEGIC MEASURES OF SUCCESS
Firms use cost management to support their strategic goal. The strategic cost
management system develops strategic information, including both financial and non-
financial information.
Financial performance measures include among others
a. Growth in sales and earnings
b. Cash flows
c. Stock price
They show the impact of the firm’s policies and procedures in the firm’s current financial
position and therefore, its current return to the shareholders.
Non-financial measures of operation include among others
a. Market share
b. Product quality
c. Customer satisfaction
d. Growth opportunities
The nonfinancial factors show the firm’s current and potential competitive position as
measured from three additional perspective, namely:
1. The customer
2. Internal business process and
3. Innovation and learning
Strategic financial and nonfinancial measures of success are also commonly called:
Critical Success Factors (CSFs)
Figure 4-1 shows the Financial and Nonfinancial Measures of Success (Critical Success
Factors)
Figure 4-1: Financial and Nonfinancial Measures of Success or Critical Success Factors
and How to Measure CSF
Critical Success Factors How to Measure CSF
Financial Measures of Success
Sales Level of sales in critical product groups, sales trend,
percent of sales from new products, sales forecast
accuracy.
Profitability Earnings from operations, earnings trend, dividend
growth
Liquidity Cash flow, trend in cash flow, interest coverage asset
turnover, inventory turnover, receivables turnover,
credit ratings
Market value Share price
Non-Financial Measures of Success Customer Factors
Customer satisfaction Customer returns and complaints, customer survey
Dealer and distributor Coverage and strength of dealer and distributor
channel relationships; e.g., number of dealers per state
or region
Marketing and selling Trends in sales performance, training, market research
activities; measured in hours or peso
Timeliness of delivery On-time delivery performance, time from order to
customer receipt
Quality Customer complaints, warranty expense
Internal Business Process
Quality Number of defects, number of returns, customer
survey, amount of scrap, amount of rework, field
service reports, warranty claims, vendor quality defects
Productivity Cycle time (from raw materials to finished product);
labor efficiency; machine efficiency; amount of waste,
rework and scrap
Flexibility Setup time, cycle time
Equipment readiness Downtime, operator experience, machine capacity,
maintenance activities
Safety Number of accidents, effects and accidents
Learning and Innovation
Product Innovation Number of design changes number of new patents or
copyrights, skills of research and development staff
Timeliness of new product Number of days over or under the announced ship
date
Skill development Number of training hours, amount of skill performance
improvement
Employee morale Employee turnover, number of complaints, employee
survey
Competence Rate of turnover, training, experience, adaptability,
financial and operating performance measures
Other factors
Government relations Number of violations, community service activities
Without strategic information, the firm is likely to stray from its competitive course, to
make strategically wrong manufacturing and marketing decisions, to choose the wrong
products or the wrong customers. Some of the consequences of a lack of strategic
information are shown in Figure 4-2.
Figure 4-2: Consequences of Lack of Strategic Information
Decision making based on intuition
Lack of clarity about direction and goals
Lack of clear and favorable perception of the firm by customers and suppliers
Incorrect investment decisions; choosing products, markets or manufacturing
processes inconsistent with strategic goals
Inability to effectively benchmark competitors, resulting in lack of knowledge about
more effective competitive strategies
Failure to identify most profitable products, customer and markets
COMPETITIVE STRATEGIES
For a firm to sustain a competitive position, it must purposefully or as result of market
forces, arrive at one of the two competitive strategies, namely
Cost Leadership and Product Differentiation
Cost Leadership
This is a competitive strategy in which a firm succeeds in producing products or
services at the lowest cost in the industry. A firm that is a cost leader makes sustainable
profits at lower prices, thereby limiting the growth of competitions in the industry through
its success in price wars and undermining the profitability of competitors which must
meet the firm’s low price.
Product Differentiation
The differentiation strategy is implemented by creating a perception among consumers
that the product or service is unique in some important way, usually by being of higher
quality, features or innovation. This perception allows the firm to charge higher prices
and outperform the competition in profits without reducing cost significantly. Most
industries, including automobile, consumer electronics, and industrial equipment, have
differentiated firms. The appeal of differentiation is especially strong for product lines
which the perception of quality and image is important, as in cosmetics, jewelry and
automobiles. Tiffany, Rolex, Ferrari and BMW are good examples of firms that
emphasize differentiation.
Distinctive Aspects of the Two Competitive Strategies
Aspect Cost Leadership Differentiation
Strategic target Broad cross section of the Focused section of the
market market
Basis of competitive Lowest cost in the industry Unique product or service
advantage
Product line Limited selection Wide variety, differentiating
features
Production emphasis Lowest possible cost with Innovation in differentiating
high quality and essential products
product features
Markets emphasis Low price Premium price and
innovative, differentiating
features
Looking more closely at differentiated firms, the keys CSFs and execution issues are in
marketing and product development – developing customer loyalty and brand
recognition, emphasizing superior and unique products, and developing and using
detailed and timely information about customer needs and behavior. This is where the
marketing and product development within the firm provide leadership and the
management accountants support these efforts by gathering, analyzing, and reporting
the relevant information.
Other Strategic Issues
A firm succeeds by adopting and effectively implementing one of the strategies
explained earlier. Recognize that although one strategy is generally dominant, a firm is
most likely to work hard at process improvement throughout the firm, whether cost
leader or differentiator, and on occasion to employ both of the strPategies at the same
time. However, a firm following both strategies is likely to succeed only if it achieves one
of them significantly. A firm that does not achieve at least one strategy is not likely to be
successful. This situation is what Michael calls “getting stuck in the middle”. A firm that
is stuck in the middle is not able to sustain a competitive advantage, For example, giant
retailer Makati Supermarket been stuck in the middle between trying to compete with
Pure Gold on cost and price, and with style conscious target on differentiation.
P
CONTEMPORARY COST MANAGEMENT TECHNIQUES
Managers commonly use the following tools to implement the firm’s broad strategy and
to facilitate the achievement of success on critical success factors: just-in-time (JIT),
total quality management, process reengineering, benchmarking, mass customization,
balance scorecard, activity-based costing and management, theory of constraints
(TOC), life cycle costing, target costing, computer-aided design and manufacturing,
automation, e-commerce and the value chain and supply-chain analysis.
The basic concepts of these cost management techniques are discussed in the
succeeding section:
a. Total Quality Management
To survive in an increasingly competitive environment, firms realize that they must
produce high-quality products. As a result, an increasing number of companies have
instituted total quality management programs to ensure that their products are of the
highest quality and that production processes are efficient.
Total Quality Management (TQM) is a technique in which management develops
policies and practices to ensure that the firm’s products and services exceed customers’
expectations.
Currently, there is no generally agreed upon “perfect” way to institute a TQM program.
But most companies with TQM develop a company that stresses listening to the needs
of customers, making products right the first time, reducing defective products that must
be reworked, and encouraging workers to continuously improve their production
process. That is why some TQM programs are referred to as continuous quality
improvement programs.
TQM affects product costing by reducing the need to track the cost of crap and rework
related to each job. If TQM is able to reduce these costs to a very low level, the benefit
of tracking the costs is unlikely to exceed the cost to the accounting system.
Total Quality Management (TQM) is a formal effort to improve quality throughout an
organization’s value chain. The two major characteristics of TQM are:
1. A focus on serving customers, and
2. Systematic problem-solving using teams made up of front-line workers.
b. Just in Time (JIT)
Just-in-Time (JIT) is the philosophy that activities are undertaken only as needed or
demanded. JIT is a production system also known as pull-it-through approach, in which
materials are purchased and units are produced only as needed to meet actual
customer demand. In a JIT system, inventories are reduced to a minimum and in some
cases, zero.
Just-in-Time (JIT) production is a system in which each component on a production line
is produced immediately as needed by the next step in the production line. In a JIT
production line, manufacturing activity at any particular workstation is prompted by the
need for that station’s output at the following station. Demand triggers each step of the
production process, starting with customer demand for a finished product at one end of
the process and working all the way back to the demand for direct materials at the other
end of the process in this way, demand pulls a product through the production line. The
demand-pull feature of JIT production systems achieves close coordination among work
centers. It smoothes the flow of goods, despite low quantities of inventory.
Financial Benefits of JIT
JIT tends to focus broadly on the control of total manufacturing costs instead of
individual costs such as direct manufacturing labor. For example, idle time may rise
because production lines are starved for materials more frequently than before.
Nevertheless, many manufacturing costs will decline. JIT can provide many financial
benefits, including
1. Lower investment in inventories.
2. Reductions in carrying and handling costs of inventories.
3. Reductions in risk of obsolescence of inventories.
4. Lower investment in plant space for inventories and production.
5. Reductions in setup costs and total manufacturing costs.
6. Reduction in costs of waste and spoilage as a result improves quality.
7. Higher revenues as a result of responding faster to customer.
8. Reductions in paperwork.
Major Features of JIT Production System
There are five main features in a JIT production system:
1. Production is organized in manufacturing cells, a grouping of all the different
types of equipment used to manufacture a given product.
2. Workers are trained to be multiskilled so that they are capable of performing a
variety of operations and tasks.
3. Total quality management is aggressively pursued to eliminate defects.
4. Emphasis is placed on reducing setup time, which is the time required to get
equipment, tools and materials ready to start the production of a component or
product, and manufacturing lead time, which is the time from when an order is
ready to start on the production line to when it becomes a finished good.
5. Suppliers are carefully selected to obtain delivery of quality-tested parts in a
timely manner.
c. Process Reengineering
Reengineering is a process of creating competitive advantage in which a firm
reorganizes its operating and management functions, often with the result that jobs are
modified, combined, or eliminated. It has been defined as the “fundamental rethinking
and radical design of business processes to achieve dramatic improvements in critical,
contemporary measures of performance, such as cost, quality, service and speed.
Process reengineering, a more radical approach to improvement than TQM, is an
approach where a business process is diagrammed in detail, questioned and then
completely redesigned in order to eliminate unnecessary steps, to reduce opportunities
for errors and to reduce costs. A business process is any series of steps that are
followed in order to carry out some task in a business.
The main objective of this approach is the simplification and elimination of wasted effort
and the central idea is that all activities that do not add value to product or service
should be eliminated. In its most simplified version, the steps used in process
reengineering are
1. A business process is diagrammed in detail.
2. Every step in the business process must be analyzed and justified.
3. The process is redesigned to include only those steps that make the product or
service more valuable.
This process can yield the following anticipated results:
1. Process is simplified
2. Process is completed in less time
3. Costs are reduced, and
4. Opportunities for errors are reduced
Process reengineering has one basic recurrent problem, that is – employee resistance.
As with other improvement projects, employees fear loss of jobs which may lead to lost
morale and failure to improve the bottom line (i.e., profits). For the process to prosper
and succeed, employees must be convinced that the end result of the improvement will
be more secure rather than less secure jobs. They can be made to understand that
improving the processes, the company can generate more business, produce a better
product at lower cost and will have the competitive strength to prosper.
d. Benchmarking
Benchmarking is a process by which a firm
Determines its critical success factors
Studies the best practices of other firms (or other units within a firm) for achieving
these critical success factors, and
Then implements improvements in the firm’s processes to match or beat the
performance of those competitors.
Today benchmarking efforts are facilitated by cooperative networks of noncompeting
firms that exchange benchmarking information.
e. Mass Customization
Many manufacturing and service firms increasingly fin that customers expect products
and services to be developed for each customer’s unique needs. And many firms have
been successful with a strategy that targets customer’s unique needs.
Mass Customization is a management technique in which marketing and production
processes are design to handle the increased variety that results from delivering
customized products and services to customers.
The growth of mass customization is in effect another indication of the increased
attention given to satisfying the customer.
f. Balanced Scorecard
The balanced scorecard is an accounting report that includes the firm’s critical success
factors in four areas
a. Financial performance,
b. Customer satisfaction,
c. Internal business process, and
d. Innovation and learning.
The concept of balance captions the intent of broad coverage, financial and nonfinancial
of all factors that contribute to the success of the firm in achieving its strategic goals.
The use of the balance scorecard is thus a critical ingredient of the overall approach
that firms take to become and remain competitive.
g. Activity-based Costing and Management
Activity analysis is used to develop a detailed description of the specific activities
performed in the operation of the firm. Many firms have found that they can improve
planning, product costing, operational control, and management control by using activity
analysis to develop a detailed description of the specific activities performed in the firm’s
operations. The activity analysis provides the basis for activity-based costing and
activity-based management. Activity-based costing (ABC) is used to improve the
accuracy of cost analysis by improving the tracing of costs to products or to individual
customers. Activity-based management (ABM) uses activity analysis to improve the
operational control and management control. ABC and ABM are key strategic tools for
many firms, especially those with complex operations, or great diversity of products.
h. Theory of Constraints (TOC)
The Theory of Constraints is a sequential process of identifying and removing
constraints in a system.
The Theory of Constraints emphasizes the importance of managing the organization’s
constraints or barriers that hinder or impede progress toward an objective. Since the
constraint is whatever is holding back the organization, improvement efforts usually
must be focused on the constraint to be really effective.
The basic sequential steps followed in applying TOC are
1. Analyze all factors of production (materials, labor, facilities, methods, etc.)
required in the production chain.
2. Identify the weakest link, which is the constraint.
3. Focus improvement efforts on strengthening the weakest link.
4. If improvement efforts are successful, eventually the weakest link will improve to
the point where it is no longer the weakest link.
5. At this point, a new weakest link (new constraint) must be identified and
improvement efforts must be shifted over that link.
The Theory of Constraints approach is a perfect complement to Total Quality
Management and Process Reengineering – it focuses improvement efforts where they
are likely to be most effective.
i. Life Cycle Costing
Life-cycle costing is a management technique to identify and monitor the costs of a
product throughout its lifecycle. It consists of all steps from product design and
purchase of raw material to delivery of and service of the finished product. The steps
include
1. Research and development
2. Product design, including prototyping, target costing and testing
3. Manufacturing, inspecting, packaging and warehousing
4. Marketing, promotion and distribution
5. Sales and service
Cost management traditionally has focused only on costs incurred up to the third
manufacturing. Management accountants now strategically manage the product’s full
life cycle of costs, including upstream and downstream costs as well as manufacturing
costs.
j. Target Costing
Target costing involves the determination of the desired cost for a product or the basis
of a given competitive price so that the product will earn a desired profit. The basic
relationship that is observed in this approach is
Target cost = Market determined price – Desired Profit
The entity using target costing must often adopt strict cost-reduction measures to meet
the market price and remain profitable. This is a common strategic approach used by
intensively competitive industries where even small price differences attract consumers
to the lower-priced product.
k. Computer-Aided Design and Manufacturing
More companies are using computer-aided design (CAD) and computer-aided
manufacturing (CAM) to respond to changing consumer tastes more quickly. These
innovations allow companies to significantly reduce the time necessary to bring their
products from the design process to the distribution stage.
Computer-aided design (CAD) is the use of computers in product development,
analysis, and design modification to improve the quality and performance of the product.
Computer-aided manufacturing (CAM) is the use of computers to plan, implement, and
control production.
l. Automation
Automation involves and requires a relatively large investment in computers, computer
programming, machines, and equipment. Many firms add automation gradually, one
process at a time. To improve efficiency and effectiveness continuously, firms must
integrate people and equipment into the smoothly operating teams that have become a
vital part of manufacturing strategy. Flexible manufacturing systems (FMS) and
computer-integrated manufacturing (CIM) are two integration approaches. A flexible
manufacturing system (FMS) is computerized network of automated equipment that
produces one or more groups of parts or variations of a product in a flexible manne r. It
uses robots and computer-controlled materials-handling systems to link several stand-
alone, computer-controlled machines in switching from one production run to another.
Computer-integrated manufacturing (CIM) is a manufacturing system that totally
integrates all office and factory functions within a company via a computer-based
information network to allow hour-by-hour manufacturing management.
The major characteristics of modern manufacturing companies that are adopting FMS
and CIM are production of high-quality products and services, low inventories, high
degrees of automation, quick cycle time, increased flexibility, and advanced information
technology. These innovations shift the focus from large production volumes necessary
to absorb fixed overhead to a new emphasis on marketing efforts, engineering and
product design.
m. E-Commerce
A number of internet-based companies have emerged and had been proven successful
in last decade. This E-Commerce business model adopted by Amazon.com and eBay
has also attracted many investors to pursue the use of Internet in conducting business.
Established companies will undoubtedly continue to expand into cyberspace – both for
business-to-business transactions and for retailing. The Internet has important
advantages over more conventional marketplaces for some kinds of transaction such as
mortgage banking. It is also very likely that a blockbuster business may be built around
the concept of selling low-value, low-margin and bulky items like groceries over the
Internet.
n. The Value Chain
Value chain refers to the sequence of business functions in which usefulness is added
to the products or services of a company. The term value refers to the increase in the
usefulness of the product or service and a result its value to the customer.
The value chain is an analysis tool that firms use to identify the specific steps required
to provide a product or service to the customer. They key idea of this concept is that the
firm studies each step in its operation to determine how each activity contributes to the
firm’s competitiveness and profits.
Analyzing the firm’s value chain help management discover
Which steps or activities are not competitive
Where costs can be reduced, or
Which activity should be outsourced, and
How to increase value for the customer at one or more of the steps of the value
chain
When properly implemented, these approaches can (a) enhance quality, (b) reduce
cost, (c) increase output, and (d) eliminate delays in responding to customers.
Internal value chain is the set of activities required to design, develop, produce, market
and deliver products or services to customers. If customer values are emphasized,
managers are forced to determine which activities in the value chain are important to
customers. A management accounting system should track information about a wide
variety of activities than span the internal value chain.
Illustrative Case 4-1: Value Chain Analysis
Jack Reyes, a consultant for the Red Archer basketball team, has been asked to
complete a value-chain analysis of the franchise with a particular focus on comparison
with a nearby competing team, the Roaring Lions. Jack has been able to collect
selected cost data, as shown below, for each of the six steps in the value chain. Single-
ticket prices range from P45.00 to P80 and average paying attendance is approximately
2,200 for Red Archers and 5,000 Roaring Lions.
Average Cost per Person and Scheduled Games
Red Archer Steps in the Value Chain Roaring Lions
P.45 Advertising and general promotion expenses P.50
.28 Ticket sales: local sporting goods stores and at .25
the ballpark
.65 Ballpark operations .80
.23 Management compensation .18
.95 Players’ salaries 1.05
.20 Game-day operations, special entertainment, .65
and game-day promotions
P2.76 Total cost P3.43
Required:
Develop and analysis of the value chain to help Jack better understand the nature of the
competition between the Archers and the Lions, and to identify opportunities for adding
value and/or cost reduction of each step.
Illustrative Case 4-1 Analysis of the Value Chain
The cost figures Jack has assembled suggest that the two team’s operations are
generally quite similar, as one would expect in basketball. However, an important
difference is the amount that the Lions team spends on game-day operations – more
than three times than that of the Red Archers. That difference has, in part, built a loyal
set of fans in Lions, where gate receipts average more than twice that of the Archers
(P285,000 versus P123,500). It happens that the Lions have found an effective way to
compete – by drawing attendance to special game-day events and promotions.
To begin to compete more effectively and profitability, Archers might consider additional
value-added services, such as game-day activities similar to those offered in Lions.
Whole Archers costs per person are somewhat lower than Lion’s the cost savings are
not enough to offset the loss in revenues.
On the cost side, the comparison with Lions shows little immediate promise for cost
reduction; Archer spends on the average less that Lions in every category except
management compensation. Perhaps this is a further indication that instead of reducing
costs, Archer should spend more on fan development. The next step in Jack’s analysis
might be survey of Archer fans to determine the level of satisfaction and to identify
desired services that are not currently provided.
