SFM Notes

Module- I: Mergers, Acquisitions and restructuring.

Course Outline:

 Nature and objectives.

 Forms of corporate restructuring.
 Types of Merger.
 Reasons for Merger,takeover and Acquisitions.
 Business Alliances.
 Divestitures.
 Legal and Procedural aspects.
 Tax Implication.
 Cross Border acquisition and International acquisition.

Mergers- Introduction.

Merger is a financial tool that is used for enhancing long-term profitability by expanding
their operations. Mergers occur when the merging companies have their mutual consent
as different from acquisitions, which can take the form of a hostile takeover.

The business laws in US vary across states and hence the companies have limited options
to protect themselves from hostile takeovers. One way a company can protect itself from
hostile takeovers is by planning shareholders rights, which is alternatively known as “
poison pill. If we trace back to history, it is observed that very few mergers have actually
added to the share value of the acquiring company. Corporate mergers may promote
monopolistic practices by reducing costs, taxes etc.

Such activities may go against public welfare. Hence mergers are regulated d supervised
by the government, for instance, in US any Merger required\s the prior approval of the
Federal Trade Commission and the Department of Justice. In US regulation son mergers
began with the Sherman Act in 1890.

Mergers may be horizontal, vertical, conglomerate or congeneric, depending or the nature

of the merging companies.

In the pure sense of the term, a merger happens when two firms, often of about the same
size, agree to go forward as a single new company rather than remain separately owned
and operated. This kind of action is more precisely referred to as a "merger of equals."
Both companies' stocks are surrendered and new company stock is issued in its place. For
example, both Daimler-Benz and Chrysler ceased to exist when the two firms merged,
and a new company, DaimlerChrysler, was created.

The combining of two or more companies, generally by offering the stockholders of one
company securities in the acquiring company in exchange for the surrender of their stock.

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“A merger is a combination of two or more corporations in which only one corporation
survives and the merged corporations go out of business”.

Benefits of Mergers:-

• Staff reductions-As every employee knows, mergers tend to mean job losses.
Consider all the money saved from reducing the number of staff members from
accounting, marketing and other departments.

• Economies of Scale-Whether it's purchasing stationery or a new corporate IT

system, a bigger company placing the orders can save more on costs. Mergers
also translate into improved purchasing power to buy equipment or office supplies
- when placing larger orders, companies have a greater ability to negotiate prices
with their suppliers.

• Acquiring new technology-To stay competitive, companies need to stay on top

of technological developments and their business applications. By buying a
smaller company with unique technologies, a large company can maintain or
develop a competitive edge.

• Improved market reach and industry visibility-Companies buy companies to

reach new markets and grow revenues and earnings. A merge may expand two
companies' marketing and distribution, giving them new sales opportunities. A
merger can also improve a company's standing in the investment community:
bigger firms often have an easier time raising capital than smaller ones.

Acquisitions

Acquisitions or takeovers occur between the bidding and the target company. There may
be either hostile or friendly takeovers. Reverse takeover occurs when the target firm is
larger than the bidding firm. In the course of acquisitions the bidder may purchase the
share or the assets of the target company.

Merger Acquisition Laws

Business firms opt for mergers and acquisitions mostly for consolidating a fragmented
market and also for increasing their operational efficiency, which give them a
competitive edge. Nations across the globe have promulgated Mergers and Acquisitions
Laws to monitor the functioning of the business units therein. An estimate made in 2007
put the number of global competition laws at 106. They possess merger control
provisions.

While most mergers and acquisitions increase the operational efficiency of business firms
some can also lead to a building up of monopoly power. The anti-competitive effects are
achieved either through coordinated effects or unilateral effects. Sometimes mergers and
acquisitions tend to create a collusive market structure.

However, free and fair competition is seen to maximize the consumers' interests both in
terms of quantity and price.

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Objectives of Mergers and Acquisitions

Merger refers to the process of combination of two companies, whereby a new company
is formed. An acquisition refers to the process whereby a company simply purchases
another company. In this case there is no new company being formed. Benefits of
mergers and acquisitions are quite a handful.

Mergers and acquisitions generally succeed in generating cost efficiency through the
implementation of economies of scale. It may also lead to tax gains and can even lead to
a revenue enhancement through market share gain.

Birds Eye View of the Benefits Accruing from Mergers and Acquisitions

The principal benefits from mergers and acquisitions can be listed as increased value
generation, increase in cost efficiency and increase in market share.

Mergers and acquisitions often lead to an increased value generation for the company. It
is expected that the shareholder value of a firm after mergers or acquisitions would be
greater than the sum of the shareholder values of the parent companies.

An increase in cost efficiency is affected through the procedure of mergers and

acquisitions. This is because mergers and acquisitions lead to economies of scale. This in
turn promotes cost efficiency. As the parent firms amalgamate to form a bigger new firm
the scale of operations of the new firm increases. As output production rises there are
chances that the cost per unit of production will come down.

An increase in market share is one of the plausible benefits of mergers and acquisitions.
In case a financially strong company acquires a relatively distressed one, the resultant
organization can experience a substantial increase in market share. The new firm is
usually more cost-efficient and competitive as compared to its financially weak parent
organization.

It can be noted that mergers and acquisitions prove to be useful in the following
situations:

Firstly, when a business firm wishes to make its presence felt in a new market. Secondly,
when a business organization wants to avail some administrative benefits. Thirdly, when
a business firm is in the process of introduction of new products. New products are
developed by the R&D wing of a company.

Forms of Corporate Restructuring:-

A) Expansion:-
i) Merger and acquisitions
ii) Tender offers
iii) Joint Venture

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 B) Contraction:-
i) Spin-offs
ii) Split-offs
iii) Divestitures
iv) Equity carve-out
C) Corporate Control:-
I) Premium Buyback
ii) Standstill Agreements
iii) Anti takeover Amendments
IV) Proxy contests
D) Changes in Ownership Structures:-
i) Exchange offers
ii) Share repurchases
iii) Going private
iv) Leveraged buyout

A-Tender offer

The acquirer pursues takeover (with out consent of the acquiree) by making a tender offer
directly to shareholders of the target company to sell their shares. This offer is made for
cash.

Joint Venture

This is an agreement between two or more companies where there will be an agreed
contribution and participation of the respective companies.

B-Spin Off

It is a kind of a demerger where an existing parent company distributes on a pro-rata

basis all the shares it owns in a controlled subsidiary to its own shareholders by which it
gains effect to make two of the one company or corporation. There is no money
transaction, subsidiary’s assets are not valued, and transaction is not treated as stock
dividend and tax free exchange. Both the companies exist and carry on business. It does
not alter ownership proportion in any company.

This takes place when part of a company’s undertaking is transferred to a newly formed
or an existing company. Some or that part of the shares of the first company are also
transferred to the new company. The reminder of the first company’s undertaking
continues to be vested in it and the share holders of the main company gets reduced by
that extent.

Split Off

This occurs when equity shares of a subsidiary company are distributed to some of the
parent company’s shareholders in exchange for their holdings in parent company.

Split Up

It is s diversion of a company into two or more parts through transfer of stock and parent
company ceases to exist.

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Divestiture

They are sale, for cash or for securities, of a segment of a company to a third party which
is an outsider.

Equity Carved Out

It is a type of divestiture and different to spin off. It resembles the IPO of some portion of
equity stock of a wholly owned subsidiary by the parent company. Some of the
subsidiary’s shares are offered for sale to general public for increasing cash inflow
without losing control.

This is also called split off IPO.

C-Corporate Control:

Corporate control involves obtaining control over the management of the firm. The
various techniques of obtaining corporate control are as-

Premium Buyback-

Standstill Agreement-

Anti Takeover Amendment-

Proxy Contest: A proxy contest is an attempt by a single shareholder or a group of share

holders to take control or bring about other changes in a company through the use of the
proxy mechanism of the corporate voting.

D-Change in Ownership Structure:

It is one type of restructuring the ownership of a firm. The various techniques of

changing the ownership structure are explained below---

Exchange Offers: It provides one or more classes of securities, the right or option to
exchange part or all of their holdings for a different class of securities of the firm.

Share Buyback/repurchases: section 77(A) allows companies buy back their own
shares as well as other specified securities. (So the acquirer will not get chance to buy
shares….)

Going Private: it refers to the transformation of a public corporation into a privately hold
firm. It involves purchase of the entire equity interest in a previously public corporation
by a small group of investors.

Leveraged Buy outs: This is the acquisition of a company by its management personnel.
It is also known as management buyout. Management may raise capital from the market
or institutions to acquire the company on the strength of its assets.

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Types of Mergers:-

 Horizontal Mergers
 Vertical Mergers
 Conglomerate Mergers
Horizontal Mergers:-
In a horizontal merger, one firm acquires another firm that produces and sells an identical
or similar product in the same geographic area and thereby eliminates competition
between the two firms.
Horizontal mergers are those mergers where the companies manufacturing similar kinds
of commodities or running similar type of businesses merge with each other. The
principal objective behind this type of mergers is to-

o Achieve economies of scale in the production procedure through carrying off

duplication of installations.
o Services and functions.
o Widening the line of products.
o Decrease in working capital and fixed assets investment.
o Getting rid of competition.
o Minimizing the advertising expenses.
o Enhancing the market capability and to get more dominance on the market.

Nevertheless, the horizontal mergers do not have the capacity to ensure the market
about the product and steady or uninterrupted raw material supply. Horizontal
mergers can sometimes result in monopoly and absorption of economic power in the
hands of a small number of commercial entities.

Vertical Mergers:-
Vertical mergers refer to a situation where a product manufacturer merges with the
supplier of inputs or raw materials. In can also be a merger between a product
manufacturer and the product's distributor.

Vertical mergers may violate the competitive spirit of markets. It can be used to block
competitors from accessing the raw material source or the distribution channel. Hence, it
is also known as "vertical foreclosure". It may create a sort of bottleneck problem.

This type merger is made to avail the following type benefits. They are as-

o Technological economies
o Elimination of transaction costs
o Improved planning for inventory and production.
o Avoidance of transportation cost
o Working capital investment
o Reduction of inventory/stock

Conglomerate Mergers:-

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As per definition, a conglomerate merger is a type of merger whereby the two companies
that merge with each other are involved in different sorts of businesses. The importance
of the conglomerate mergers lies in the fact that they help the merging companies to be
better than before.

Types of Conglomerate Mergers:-

There are three types of conglomerate mergers –

• Product Extension Merger
• Geographic Market Extension Merger
• Pure Conglomerate Merger

Product Extension Merger:-

According to definition, product extension merger takes place between two business
organizations that deal in products that are related to each other and operate in the same
market. The product extension merger allows the merging companies to group together
their products and get access to a bigger set of consumers. This ensures that they earn
higher profits.

Geographic Market Extension Merger:-

As per definition, market extension merger takes place between two companies that deal
in the same products but in separate markets. The main purpose of the market extension
merger is to make sure that the merging companies can get access to a bigger market and
that ensures a bigger client base.

Pure conglomerate merger:-

It is one where the merging companies are doing businesses that are totally unrelated to
each other.

Pure conglomerate mergers are of two types. They are as follows---

i) Financial Conglomerates:-

Financial conglomerate mergers provide a flow of funds to each segment of their

operations, exercise control and are the financial risk takers. They under take strategic
planning but do not participate in operational decisions.

ii) Managerial Conglomerates: -

It plays a role in operating decisions and provides staff expertise and staff services to the
operating entities.
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Difference between Market & Product Extension:-

• The difference between market extension merger and product extension merger
lies in the fact that the later is meant to add to the existing variety of products and
services offered by the respective merging companies; while, in case of the
former the two merging companies are dealing in similar products.
• In case of the market extension merger the two merging companies are operating
in the same market and as far as product extension merger is concerned the two
merging companies are operating in different markets.

Reasons of Conglomerate Mergers:-

There are several reasons as to why a company may go for a conglomerate merger.
Among the more common reasons are adding to the share of the market that is owned by
the company and indulging in cross selling. The companies also look to add to their
overall synergy and productivity by adopting the method of conglomerate mergers.

Benefits of Conglomerate Mergers:-

There are several advantages of the conglomerate mergers. One of the major benefits is
that conglomerate mergers assist the companies to diversify. As a result of conglomerate
mergers the merging companies can also bring down the levels of their exposure to risks.

Reasons for Mergers:-

• Technologically dynamic industries to seize opportunities in industries with
developing technologies.

• To develop a new strategic vision.

• To apply a broad range of capabilities and managerial skills in new areas.

• International competition- to establish presence in foreign markets and strengthen

position in domestic market.

• Deregulation- relaxation of government barriers.

• Industry excess capacity and need to cut costs.

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 • Industry roll ups- consolidation of fragmented industries.

• Change in strategic scientific segment of the industry.

• Shift from over capacity area to area with more favorable sale-to-capacity ratios.

• Exit a product area that has become commoditized to area of specialty.

• Combined company can better meet customers’ demands for a wide range of
services; strengthens distribution systems.

Business Alliances.

Divestitures

Legal and Procedural aspect of Merger

Indian competition law grants a maximum time period of 210 days for the determination
of the combination, which comprises acquisitions, mergers, amalgamations and the like.
One needs to take note of the fact that this stated time frame is clearly distinct from the
minimum compulsory wait period for applicants.

As per the law, the compulsory period of waiting for applicants can either be 210 days
starting from the day of notice filing or receipt of the Commission's order, whichever
occurs earlier.

The threshold limits for firms entering business combinations are substantially high under
the Indian law. The threshold limits are set either in terms of the asset value or or in terms
the firm's turnover. Indian threshold limits are greater than those for the EU. They are
twice as high when compared with UK.

The Indian law also provides for the modern day phenomenon of merger and
acquisitions, which are cross border in nature. As per the law domestic nexus is a pre-
requisite for notification on this type of combinations.

It can be noted that Competition Act, 2002 has undergone a recent amendment. This has
replaced the the voluntary notification regime with a mandatory regime. Of the total
number of 106 countries, which possess competition laws only 9 are thought to be
credited with a voluntary notification regime. Voluntary notification regimes are
generally associated with business uncertainties.

Post-combination, if firms are seen to be involved in anti-competitive practices de-merger

shows the way out.

Tax Implication of Merger and Acquisition

Indian Income Tax Act has provision for tax concessions for mergers/demergers between
two Indian companies. These mergers/demergers need to satisfy the conditions pertaining
to section 2(19AA) and section 2(1B) of the Indian Income Tax Act as per the applicable
situation.

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In case of an Indian merger when transfer of shares occur for a company they are entitled
to a specific exemption from the capital gains tax under the “Indian I-T tax Act”. These
companies can either be of Indian origin or foreign ones.

A different set of rules is however applicable for the 'foreign company mergers'. It is a
situation where an Indian company owns the new company formed out of the merger of
two foreign companies.

It can be noted that for foreign company mergers the share allotment in the merged
foreign company in place of shares surrendered by the amalgamating foreign company
would be termed as a transfer, which would be taxable under the Indian tax law.

Also as per conditions set under section 5(1), the 'Indian I-T Act' states that, global
income accruing to an Indian company would also be included under the head of 'scope
of income' for the Indian company.

International Mergers and Acquisitions

International mergers and acquisitions are growing day by day. These mergers and
acquisitions refer to those mergers and acquisitions that are taking place beyond the
boundaries of a particular country. International mergers and acquisitions are also termed
as global mergers and acquisitions or cross-border mergers and acquisitions.

Globalization and worldwide financial reforms have collectively contributed towards the
development of international mergers and acquisitions to a substantial extent.
International mergers and acquisitions are taking place in different forms, for example
horizontal mergers, vertical mergers, conglomerate mergers, congeneric mergers, reverse
mergers, dilutive mergers, accretive mergers and others.

International mergers and acquisitions are performed for the purpose of obtaining some
strategic benefits in the markets of a particular country. With the help of international
mergers and acquisitions, multinational corporations can enjoy a number of advantages,
which include economies of scale and market dominance.

International mergers and acquisitions play an important role behind the growth of a
company. These deals or transactions help a large number of companies penetrate into
new markets fast and attain economies of scale. They also stimulate foreign direct
investment or FDI.

The reputed international mergers and acquisitions agencies also provide educational
programs and training in order to grow the expertise of the merger and acquisition
professionals working in the global merger and acquisitions sector.

The rules and regulations regarding international mergers and acquisitions keep on
changing constantly and it is mandatory that the parties to international mergers and
acquisitions get themselves updated with the various amendments. Numerous investment
bank professionals, consultants and attorneys are there to offer valuable and
knowledgeable recommendations to the merger and acquisition clients.

Methods of Financing International Mergers and Acquisitions

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Usually, the following methods are implemented for funding international mergers and
acquisitions:

• Financing (or taking loans)

• Cash
• Factoring
• Hybrid Financing

Significant International Mergers and Acquisitions

Following are the instances of the major international mergers and acquisitions:

• The merger of British Petroleum (BP) with Amoco (erstwhile Standard Oil of
Indiana)
• The acquisition of Mannesmann AG by Vodafone Airtouch PLC
• The merger of Exxon with Mobil (The name of the company formed as a result
of the merger is ExxonMobil)
• The acquisition of AirTouch Communications by the Vodafone Group
• The acquisition of Compaq by Hewlett-Packard
• The acquisition of Shell Transport & Trading Company by Royal Dutch
Petroleum Company
• The merger of Bank One Corporation with JPMorgan Chase & Company

Factors Affecting International Mergers and Acquisitions

The following elements influence the international mergers and acquisitions from
many aspects:

• Corporate governance
• Company acts
• The capacity of average workers
• Expectation of the consumers
• Political features of a country
• Tradition and culture of a country

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Module II :Strategic Financial Management
* Strategic cost management,
* Activity based costing,
* Financial management in knowledge
* Intensive companies,
* Financial Innovations and Financial Engineering: Management
* Leverage,
* Leverage buys out-operations, norms for financing leverage buyouts,
* Share Repurchase,
* Corporate Control Mechanisms.

Strategic Cost Management

Introduction:

Many of the terms are not new: cost reduction, target costing, total cost management, or
cost avoidance. These efforts have been targeted in several organizations. But how many
purchasing and supply organizations have adopted these tactics for the short-term gain
and how many have taken a strategic approach that spans several links in the supply
chain? More and more will be taking the strategic approach, focusing on strategic cost
management. It has now a days become abuzz word in the street of corporate houses.
Corporate houses are now searching out for ways to manage their huge conglomerates.

The downsizing and reengineering initiatives so prevalent in the early '90s have largely
proved financially short-sighted. With hindsight, we now know that almost half of
downsizing companies reported lower profits the year following their cutbacks. Cost-
cutters' stock prices grew more slowly than those of companies which successfully grew
both their top and bottom lines. Less than one in five cost-cutters were subsequently able
to put their companies back on a profitable growth track. Pressures on costs come from
many external quarters, including shifting customer priorities, the emergence of new
competitors and channels, and increasingly inquisitive financial mark.

Concept of Strategic Cost Management:

Trying to define strategic cost management requires looking at today's leading

organizations who are venturing in this area. Some of the processes are new and
uncharted territory, so there's no textbook to spell it out.

Cost Management Defined:

The Purchasing Handbook defines cost management as, "the establishment of

programs that regularly analyze purchase requirements and suppliers to identify
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lowest total cost and maximize total value to the company. The development of a
savings forecast by commodity is necessary to define budget parameters for building
cost-of-goods structures."

Strategic Cost Management:

Strategic cost management can be defined as" scrutinizing every process within your
organization, knocking down departmental barriers, understanding your suppliers'
business, and helping improve their processes"

Applications of Strategic Cost Management:

There are three basic business areas where strategic cost management can be applied.

Strategy:

A strategy in general terms refers to a plan of action that will shape the direction of
organization's success. Companies of late have realized the importance of clear
articulation of strategy and its effective implementation. Before formulating any strategy,
the management should think about the business model whether it is still relevant or need
to be changed? Or whether the objectives of the business are going to be accomplished
through laid out strategy.

Operations:

By setting the priorities according to its significance we can operate the tasks effectively
and efficiently.

Organization:

Company should time and again check whether it is allocating its limited resources in the
businesses which generate more value for the entire organization. Resources as such are
the liming factors for any organization and that's why the company should be focus on
the structure of the business and it should decide well in advance whether it should own
all resources or not?

Strategic Cost management framework:

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The Strategic cost management framework provides a clear plan of attack for addressing
costs and decisions that affect them. Following are the three core components of this
framework.

Core Functions:

Core functions elaborate on the nature of the business. It answers the very obvious
question what type of business are we in? At this stage the company has to clearly
identify its courses of actions with respect to strategy planning, research and
development, and product development.

Customer Delivery Function:

This step emphasizes more on value addition with various activities such as marketing,
sales, manufacturing, quality assurance and control, sourcing, procurement and logistics,
engineering and maintenance, customer service and technical support etc. Excellence in
those activities can create a sort of competitive advantage for the company if it could
harness its resources intelligently than its competitors.

Support Functions:

As the name suggests, to support the core activities of business some secondary activities
are to be carried out which includes IT, Finance and Accounting, HR management
General administration. These activities will facilitate the performance of the core
activities in a way that goals of the business can be accomplished successfully without
wasting limited resources. They will also help in synchronizing the different tasks which
are to be carried out simultaneously.

Strategic Management Programme Steps:

SCM Programme includes following five steps. These steps can be detailed out as
follows:

1. Focus:

Focus state starts with reviewing the different strategies of the company. Reviewing the
strategies will lead to clear identification of performance gaps and this will help to bridge

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the gap by improving targets already set beforehand. Modifying the targets will lead to
developed plan of attack which will foster better internal communication within the
organization.

2. Planning and Training:

Planning plays a crucial role in implementing strategic cost management programme. To

implement the planning, a manager should gather very efficient team members and train
them accordingly. Setting up of project management structure will facilitate the
implementation of strategic cost management by clearly identifying the day to day
activities, steering guidance and offering ad hoc assistance.

3. Fact Finding:

This stage includes the tasks such as data gathering, conducting interview, developing
benchmarks, conducting and customer surveys.

4. Analysis and Recommendations for changes:

Analysis of activities plays a crucial role in ascertaining the cost of the company. It can
be done by various strategic cost management analytical tools viz. cost driver analysis,
activity-based costing, selective business process reengineering etc. An action plan for
proposed change should address the following questions what, who, when how aspects of
the activities.

5. Implementation:

In implementation stage the first task to be done is to define responsibilities and

accountability of each individual and controlling i.e. monitoring and corrective action
should be the taken at each stage of programme. And this is how the continuous
improvement can be achieved. The third, fourth and fifth sate in the above process
indicates continuous improvement.

Key Enablers That Facilitate Strategic Cost Management.

Each individual organization needs to review their various supply needs and supply
chains and determine what enablers are of prime importance to their situations. We will
discuss an approach to that problem later in the paper. In this section we will discuss a
number of generally applicable enablers, some of which are likely to be present in many
supply situations. The enablers are grouped by the three phases present in most cost
management approaches: analysis and planning, implementation, and ongoing
management and control. Some apply to more than one phase and are so listed but
discussed only at the first listing.

Analysis and Planning Enablers:

• Top management support and sponsorship - Without this forget the whole idea
of cost management. However, to get this support, top management must
understand the value of supply chain management to the bottom line. If
management seems reluctant to recognize this from internal efforts alone,
cooperative efforts with suppliers and/or customers may help to convince them.

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• Information systems - To capture spending by commodity or service, supplier,
and geographical area. Information can be used to: identify opportunities for
synergy with other supply chain members in areas such as leveraging spend,
pooling knowledge, acquiring/providing/sharing technology, identify areas where
transfer of best practices will reduce costs, optimize location and use of resources,
such as inventories, in the supply chain, and help to identify total cost drivers.
• Identity of total cost drivers - What are all of the elements that make up the total
cost in a given supply chain? Total cost drivers may vary by geographical areas
and may include items such as logistics, transportation, inventory, lead time, lack
of infrastructure, lack of qualified or trained personnel, lack of qualified suppliers,
and production impact of particular products or services. Additional drivers that
may be present in a global analysis could include tariffs and duties, currency
exchange rates, hostile political or geographical environments.
• Cost models - If models of major costs in the supply chain are not available, they
may need to be developed. Cost models may have to be adjusted by country or
region in global supply chain situations. Some techniques for modeling costs
include learning curve analysis, experience effect analysis, price productivity
analysis, implied set-up cost analysis, should-cost analysis, comparative process
analysis, and cost breakdown analysis. Some approaches to cost and price
modeling and analysis are presented in Chapter 19 of the current edition of The
Purchasing Handbook.
• A strategic cost management plan - There must be known cost management
objectives and a plan as to how you are going to achieve them. One approach to
prepare such a plan is to use a three-step approach that includes: classifying
purchases, matching cost analysis tools with the purchase classifications, and
focusing on strategic cost management techniques to achieve cost management
results.
• Effective cross-functional teams - Vital to the success of any cost management
effort because of the varied departments and functions that are affected and need
to be involved to implement cost management initiatives. All parties either
affected by the costs in question or involved in generating those costs need to be
involved in the applicable cost management teams.
• Known Business strategies - To develop purchasing cost management strategies,
overall business strategies must be known. The maximum effect of strategic cost
management in the supply chain can only be achieved when supply chain
strategies are aligned with overall business strategies. Obviously, to achieve
alignment, overall business strategies must be known to the supply chain team.
• Alignment of supply strategies with business strategies - To be most effective,
purchasing cost management strategies must be aligned with overall business
strategies. This enabler is key to successful strategic cost management and also to
obtaining full support of top management. Do not make the mistake of
concentrating cost management efforts in an area that management considers
unimportant, or in an area of the business that is not strategically important to the
company and/or may be up for divestiture.
• Total cost approach to procurement - Frequently the most significant cost
reductions in a supply chain do not result from lower prices. Price is important but
it is not the only cost. Costs other than price may have more reduction potential or
may be easier to reduce than price itself. Do not overlook any cost element.
Sometimes costs that are indirectly linked to the use of products or services may
contain large reduction potential as a result of changes in the purchased products
or services.

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 • Balanced approach to sourcing - It is inefficient to either purchase everything
through alliances or purchase everything on a transactional basis. All purchases
must be analyzed and categorized according to criteria such as total spend, long-
term vs. short-term need, strategic importance, and supply base capabilities. From
such an analysis individual purchase categories can be identified as candidates for
strategic alliances, small-value purchase techniques, and transactional approaches.
• Performance measurements - Without measurements you don't know where you
are, where you came from, or where you are going. Performance measurements
should be established for all aspects of a strategic cost management plan that are
critical to its success. Therefore the first step in establishing measurements is to
identify critical success factors and then develop indicators to measure how well
they are being achieved. The results of measurement can be used to report
success, to identify problem areas, and as the basis for taking corrective action.
• Redefinition of procurement business processes - Necessary to accommodate
balanced sourcing and efficient methods for handling transactional purchasing
activities. Adoption of a continuous process improvement approach to supply
chain operations will cause continual redefinition of business processes in the
supply chain.
• Maximize the leverage effect of purchasing - Use the information available
from data systems to determine global spend by product, supplier, and
geographical area to identify leverage opportunities. Leverage benefits can
include price, quality, service, availability, knowledge, and other factors

Sharing of Risks and Rewards - Necessary to the successful integration of activities in a

supply chain to achieve strategic cost management in the chain. Provides all chain
members with incentives to cooperate and participate in cost management initiatives

Implementation Enablers:

• Supply chain visioning - Brainstorm cost improvement possibilities with affected

business units and others in your organization and supply chain
members/partners. Do this through working sessions with the active leadership of
business units or internal customer groups to develop a common understanding of
internal customer requirements and to develop a value proposition, i.e. a
distinctive competence that can be used to better serve internal customer needs
and how operations must be changed to implement the envisioned improvements.
• Diffusion of best practices in the organization - Without organization-wide
application of best practices, cost management objectives cannot be fully
achieved. Frequently a best practice in one part of the supply chain is a good
model for application elsewhere in the chain to achieve the most effective cost
management.
• Strategic alliances - Necessary in key supply chains to achieve the close
cooperation required for effective cost management. The set-up and maintenance
costs of strategic alliances rule them out in many purchase situations but they are
necessary in high-spend, critically important areas.
• Planned change management - Changes in processes and procedures must be
well-planned and executed. Use techniques such as pilot implementation of
changes (make mistakes on a small scale). Also, adequate training in new or
changed processes must be provided for all affected groups and individuals.
• Supply base rationalization - To effectively manage costs, the number of
suppliers must be reduced to a minimum. Qualification and maintenance of large
supplier bases is expensive. Leverage potential for price, quality, service,
17
 delivery, and technology cannot be maximized without reducing the number of
suppliers.
• Existence of shared supplier-customer strategies - Shared strategies are best
and most easily obtained by use of cross-functional teams. Such teams must
include supplier, critical third party, and customer representation in addition to
key functions of the buying organization.
• Minimization of transactional activities of purchasing - Eliminate, automate,
or shift non-value-added activities, e.g. processing of low-value purchase
transactions out of purchasing.
• Shifting of supply chain costs - Find the member of the chain that can perform
the activity most efficiently and move the activity there. Be sure that actual cost
reduction (and not merely cost shifting) is achieved in the total cost of the supply
chain.
• Outsourcing - If an activity can be performed more efficiently by someone who
is not a member of the supply chain, shift the activity outside the supply chain,
effectively enlarging the chain but making it more efficient. Guard against
potential loss of technological advantage when outsourcing state of the art
processes.

Activity-based costing

Activity-based costing (ABC) is a costing model that identifies activities in an

organization and assigns the cost of each activity resource to all products and services
according to the actual consumption by each: it assigns more indirect costs (overhead)
into direct costs.

In this way an organization can precisely estimate the cost of its individual products and
services for the purposes of identifying and eliminating those which are unprofitable and
lowering the prices of those which are overpriced.

In a business organization, the ABC methodology assigns an organization's resource

costs through activities to the products and services provided to its customers. It is
generally used as a tool for understanding product and customer cost and profitability. As
such, ABC has predominantly been used to support strategic decisions such as pricing,
outsourcing and identification and measurement of process improvement initiatives.

Historical development

Traditionally cost accountants had arbitrarily added a broad percentage of expenses into
the indirect cost

However as the percentages of indirect or overhead costs had risen, this technique
became increasingly inaccurate because the indirect costs were not caused equally by all
the products. For example, one product might take more time in one expensive machine
than another product, but since the amount of direct labor and materials might be the
same, the additional cost for the use of the machine would not be recognized when the
same broad 'on-cost' percentage is added to all products. Consequently, when multiple
products share common costs, there is a danger of one product subsidizing another.

1. The concepts of ABC were developed in the manufacturing sector of the United
States during the 1970s and 1980s. During this time, the Consortium for
18
 Advanced Management-International, now known simply as CAM-I, provided a
formative role for studying and formalizing the principles that have become more
formally known as Activity-Based Costing.

Robin Cooper and Robert S. Kaplan, proponents of the Balanced Scorecard, brought
notice to these concepts in a number of articles published in Harvard Business Review
beginning in 1988. Cooper and Kaplan described ABC as an approach to solve the
problems of traditional cost management systems. These traditional costing systems are
often unable to determine accurately the actual costs of production and of the costs of
related services. Consequently managers were making decisions based on inaccurate data
especially where there are multiple products.

Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify
cause and effect relationships to objectively assign costs. Once costs of the activities have
been identified, the cost of each activity is attributed to each product to the extent that the
product uses the activity. In this way ABC often identifies areas of high overhead costs
per unit and so directs attention to finding ways to reduce the costs or to charge more for
costly products.

Activity-based costing was first clearly defined in 1987 by Robert S. Kaplan and W.
Bruns as a chapter in their book Accounting and Management: A Field Study Perspective.

They initially focused on manufacturing industry where increasing technology and

productivity improvements have reduced the relative proportion of the direct costs of
labor and materials, but have increased relative proportion of indirect costs. For example,
increased automation has reduced labor, which is a direct cost, but has increased
depreciation, which is an indirect cost.

Like manufacturing industries, financial institutions also have diverse products and
customers which can cause cross-product cross-customer subsidies. Since personnel
expenses represent the largest single component of non-interest expense in financial
institutions, these costs must also be attributed more accurately to products and
customers. Activity based costing, even though originally developed for manufacturing,
may even be a more useful tool for doing this.

Uses

• It helps to identify inefficient products, departments and activities

• It helps to allocate more resources on profitable products, departments and
activities
• It helps to control the costs at an individual level and on a departmental level
• It helps to find unnecessary costs
• It helps fixing price of product or service scientifically

Limitations

Even in activity-based costing, some overhead costs are difficult to assign to products and
customers, such as the chief executive's salary. These costs are termed 'business
sustaining' and are not assigned to products and customers because there is no meaningful
method. This lump of unallocated overhead costs must nevertheless be met by
contributions from each of the products, but it is not as large as the overhead costs before
ABC is employed.
19
Although some may argue that costs untraceable to activities should be "arbitrarily
allocated" to products, it is important to realize that the only purpose of ABC is to
provide information to management. Therefore, there is no reason to assign any cost in an
arbitrary manner.

Financial engineering

What is financial engineering

Financial engineering is a process that utilizes existing financial instruments to create a

new and enhanced product of some type. Just about any combination of financial
instruments and products can be used in financial engineering. The process may involve a
simple union between two products, or make use of several different products to create a
new product that provides benefits that none of the other instruments could manage on
their own.

Financial engineering is a multidisciplinary field involving financial theory, the

methods of financing, using tools of mathematics, computation and the practice of
programming to achieve the desired end results.

The financial engineering methodologies usually apply social theories, engineering

methodologies and quantitative methods to finance. It is normally used in the securities,
banking, and financial management and consulting industries, or as quantitative analysts
in corporate treasury and finance departments of general manufacturing and service
firms.

Leveraged buyout

A leveraged buyout (or LBO, or highly-leveraged transaction (HLT), or "bootstrap"

transaction) occurs when a financial sponsor acquires a controlling interest in a
company's equity and where a significant percentage of the purchase price is financed
through leverage (borrowing). The assets of the acquired company are used as collateral
for the borrowed capital, sometimes with assets of the acquiring company. The bonds or
other paper issued for leveraged buyouts are commonly considered not to be investment
grade because of the significant risks involved.

Companies of all sizes and industries have been the target of leveraged buyout
transactions, although because of the importance of debt and the ability of the acquired
firm to make regular loan payments after the completion of a leveraged buyout, some
features of potential target firms make for more attractive leverage buyout candidates,
including:

• Low existing debt loads;

• A multi-year history of stable and recurring cash flows;
• Hard assets (property, plant and equipment, inventory, receivables) that may be
used as collateral for lower cost secured debt;
• The potential for new management to make operational or other improvements to
the firm to boost cash flows;
• Market conditions and perceptions that depress the valuation or stock price.

20
Rationale

The purposes of debt financing for leveraged buyouts are two-fold:

1. The use of debt increases (leverages) the financial return to the private equity
sponsor. Under the Modigliani-Miller theorem the total return of an asset to its
owners, all else being equal and within strict restrictive assumptions, is unaffected
by the structure of its financing. As the debt in an LBO has a relatively fixed,
albeit high, cost of capital, any returns in excess of this cost of capital flow
through to the equity.
2. The tax shield of the acquisition debt, according to the Modigliani-Miller theorem
with taxes, increases the value of the firm. This enables the private equity sponsor
to pay a higher price than would otherwise be possible. Because income flowing
through to equity is taxed, while interest payments to debt are not, the capitalized
value of cash flowing to debt is greater than the same cash stream flowing to
equity.

Germany currently introduces new tax laws, taxing parts of the cash flow before debt
interest deduction. The motivation for the change is to discourage leveraged buyouts by
reducing the tax shield effectiveness.

Historically, many LBOs in the 1980s and 1990s focused on reducing wasteful
expenditures by corporate managers whose interests were not aligned with shareholders.
After a major corporate restructuring, which may involve selling off portions of the
company and severe staff reductions, the entity would likely be producing a higher
income stream. Because this type of management arbitrage and easy restructuring has
largely been accomplished, LBOs today focus more on growth and complicated financial
engineering to achieve their returns. Most leveraged buyout firms look to achieve an
internal rate of return in excess of 20%.

Management buyouts

A special case of such acquisition is a management buyout (MBO), which occurs when a
company's managers buy or acquire a large part of the company. The goal of an MBO
may be to strengthen the managers' interest in the success of the company. In most cases,
the management will then make the company private. MBOs have assumed an important
role in corporate restructurings beside mergers and acquisitions. Key considerations in an
MBO are fairness to shareholders, price, the future business plan, and legal and tax
issues. One recent criticism of MBOs is that they create a conflict of interest—an
incentive is created for managers to mismanage (or not manage as efficiently) a company,
thereby depressing its stock price, and profiting handsomely by implementing effective
management after the successful MBO, as Paul Newman's character attempted in the
Coen brothers' film The Hudsucker Proxy.

Of course, the incentive to artificially reduce share price extends beyond

management buyouts.

It is fairly easy for a top executive to reduce the price of his/her company's stock - due to
information asymmetry. The executive can accelerate accounting of expected expenses,
delay accounting of expected revenue, engage in off balance sheet transactions to make
the company's profitability appear temporarily poorer, or simply promote and report
severely conservative (eg. pessimistic) estimates of future earnings. Such seemingly
21
adverse earnings news will be likely to (at least temporarily) reduce share price. (This is
again due to information asymmetries since it is more common for top executives to do
everything they can to window dress their company's earnings forecasts).

A reduced share price makes a company an easier takeover target. When the company
gets bought out (or taken private) - at a dramatically lower price - the takeover artist gains
a windfall from the former top executive's actions to surreptitiously reduce share price.
This can represent 10s of billions of dollars (questionably) transferred from previous
shareholders to the takeover artist. The former top executive is then rewarded with a
golden parachute for presiding over the firesale that can sometimes be in the 100s of
millions of dollars for one or two years of work. (This is nevertheless an excellent
bargain for the takeover artist, who will tend to benefit from developing a reputation of
being very generous to parting top executives).

Similar issues occur when a publicly held asset or non-profit organization undergoes
privatization. Top executives often reap tremendous monetary benefits when a
government owned or non-profit entity is sold to private hands. Just as in the example
above, they can facilitate this process by making the entity appear to be in financial
crisis - this reduces the sale price (to the profit of the purchaser), and makes non-profits
and governments more likely to sell. Ironically, it can also contribute to a public
perception that private entities are more efficiently run reinforcing the political will to
sell of public assets.

Again, due to asymmetric information, policy makers and the general public see a
government owned firm that was a financial 'disaster' - miraculously turned around by the
private sector (and typically resold) within a few years.

Nevertheless, the incentive to artificially reduce the share price of a firm is higher for
management buyouts, than for other forms of takeovers or LBOs.

Share repurchase

In some countries, including the United States and the United Kingdom, corporations can
buy back their own stock in a share repurchase, also known as a stock repurchase or
share buyback. There has been a meteoric rise in the use of share repurchases in the U.S.
in the past twenty years, from $5 billion in 1980 to $349 billion in 2005.A share
repurchase distributes cash to existing shareholders in exchange for a fraction of the
firm's outstanding equity. That is, cash is exchanged for a reduction in the number of
shares outstanding. The firm either retires the shares or keeps them as treasury stock,
available for re-issuance. Under U.S. corporate law there are five primary methods of
stock repurchase: open market, private negotiations, repurchase put rights, and two
variants of self-tender repurchase, a fixed price tender offer and a Dutch auction.

Motivations for share repurchases

Companies making profits typically have two uses for those profits. Firstly, some part of
profits are usually repaid to shareholders in the form of dividends. The remainder, termed
stockholder's equity, are kept inside the company and used for investing in the future of
the company. If companies can reinvest most of their retained earnings profitably, then
they may do so. However, sometimes companies may find that some or all of their
retained earnings cannot be reinvested to produce acceptable returns.

22
Share repurchases are one possible use of leftover retained profits. When a company
repurchases its own shares, it reduces the number of shares held by the public. The
reduction of the float, or publicly traded shares, means that even if profits remain the
same, the earnings per share increase. So, repurchasing shares, particularly when a
company's share price is perceived as undervalued or depressed, may result in a strong
return on investment.

One reason why companies may prefer to keep a substantial portion of earnings rather
than distribute them to shareholders, even if they aren't able to reinvest them all
profitably, is that it is considered very embarrassing for companies to be forced to cut
dividends. Normally, investors have more adverse reaction in dividend cut than
postponing or even abandoning the share buyback program. So, rather than pay out larger
dividends during periods of excess profitability then have to reduce them during leaner
times, companies prefer to pay out a conservative portion of their earnings, perhaps half,
with the aim of maintaining an acceptable level of dividend cover.

Another reason why executives, in particular, may prefer share buybacks is that
Executive compensation is often tied to executives' ability to meet earnings per share
targets. In companies where there are few opportunities for organic growth, share
repurchases may represent one of the few ways of improving earnings per share in order
to meet targets. Therefore, safeguards should be in place to ensure that increasing
earnings per share in this way will not affect executive or managerial rewards, even
though this does not always occur. Furthermore, increasing earnings per share does not
equate to increase in shareholders value. This investment ratio is influenced by
accounting policy choices and fails to take into account the cost of capital and future cash
flows, which are the determinants of shareholder value.

Share repurchases avoid the accumulation of excessive amounts of cash in the

corporation. Companies with strong cash generation and limited needs for capital
spending will accumulate cash on the balance sheet, which makes the company a more
attractive target for takeover, since the cash can be used to pay down the debt incurred to
carry out the acquisition. Anti-takeover strategies therefore often include maintaining a
lean cash position, and at the same time the share repurchases bolster the stock price,
making a takeover more expensive.

Share repurchases also allow companies to covertly distribute their earnings to investors
without inflicting them with double taxation. This only holds true in jurisdictions which
do not operate imputation tax credit systems. For example, if a company were to pay
$100,000 in dividends on one million shares or as 10¢ dividend per share, investors may
incur tax upon this disbursement. This means that instead of receiving 10¢ of already
taxed earnings per share, they receive 8.5¢ (.10×(1 − .15)) at a 15% tax rate with 1.5¢
going to the government. An investor with 10 shares will receive 85¢. As the company
has to pay out this money the share price drops according, from $10 to $9.90, so the
investor with 10 shares now has; $99 + 85¢ dividend, or $99.85.

Compare this with spending $100,000 buying back shares. This will remove 10,000
shares from the market, leaving 990,000 shares at $10 each (10,000,000 − 100,000 =
9900000/990000), meaning our investor with 10 shares still has $100, and the
government receives no tax revenue. Ultimately there is no net change in investor wealth
assuming a fully equity financed business.

They also minimise transaction costs.

23
Open market share repurchases

The most common share repurchase method in the United States is the open-market stock
repurchase, representing almost 95% of all repurchases. A firm may or may not announce
that it will repurchase some shares in the open market from time to time as market
conditions dictate and maintains the option of deciding whether, when, and how much to
repurchase. Open market repurchases can span months or even years. There are, however,
daily buy-back limits which restrict the amount of stock that can be bought over a
particular time interval.

Fixed price tender offer repurchases

Prior to 1981, all tender offer repurchases were executed using a fixed price tender offer.
This offer specifies in advance a single purchase price, the number of shares sought, and
the duration of the offer, with public disclosure required. The offer may be made
conditional upon receiving tenders of a minimum number of shares, and it may permit
withdrawal of tendered shares prior to the offer's expiration date. Shareholders decide
whether or not to participate, and if so, the number of shares to tender to the firm at the
specified price. Frequently, officers and directors are precluded from participating in the
tender offer. If the number of shares tendered exceeds the number sought, then the
company purchases less than all shares tendered at the purchase price on a pro rata basis
to all who tendered at the purchase price. If the number of shares tendered is below the
number sought, the company may choose to extend the offer’s expiration date.

Types of buy-backs

Selective buy-backs

In broad terms, a selective buy-back is one in which identical offers are not made to
every shareholder, for example, if offers are made to only some of the shareholders in the
company. The scheme must first be approved by all shareholders, or by a special
resolution (requiring a 75% majority) of the members in which no vote is cast by selling
shareholders or their associates. Selling shareholders may not vote in favour of a special
resolution to approve a selective buy-back. The notice to shareholders convening the
meeting to vote on a selective buy-back must include a statement setting out all material
information that is relevant to the proposal, although it is not necessary for the company
to provide information already disclosed to the shareholders, if that would be
unreasonable.

Other types of buy-backs

A company may also buy back shares held by or for employees or salaried directors of
the company or a related company. This type of buy-back, referred to as an employee
share scheme buy-back, requires an ordinary resolution.

A listed company may also buy back its shares in on-market trading on the stock
exchange, following the passing of an ordinary resolution if over the 10/12 limit . The
stock exchange’s rules apply to on-market buy-backs.

A listed company may also buy unmarketable parcels of shares from shareholders (called
a minimum holding buy-back). This does not require a resolution but the purchased
shares must still be cancelled.
24
Module III :Value Based Management

• Value analysis and Value Engineering,

• Target Costing,
• Balanced Scorecard,
• TQM
• JIT,
• Mckinsey approach,
• EVA approach.

Value Analysis/Value Engineering

When to use it

Use Value Analysis to analyze and understand the detail of specific situations.

Use it to find a focus on key areas for innovation.

Use it in reverse (called Value Engineering) to identify specific solutions to detail

problems.

It is particularly suited to physical and mechanical problems, but can also be used in other
areas.

Quick X Long

Logical X Psychological

Individual X Group

How to use it

Identify and prioritize functions

Identify the item to be analyzed and the customers for whom it is produced.

List the basic functions (the things for which the customer is paying). Note that there are
usually very few basic functions.

Identify the secondary functions by asking ‘How is this achieved?’ or ‘What other
functions support the basic functions?’.

Determine the relative importance of each function, preferably by asking a representative

sample of customers (who will always surprise you with what they prefer).
25
Analyze contributing functions

Find the components of the item being analyzed that are used to provide the key
functions. Again, the question ‘How’ can come in very useful here.

Measure the cost of each component as accurately as possible, including all material and
production costs.

Seek improvements

Eliminate or reduce the cost of components that add little value, especially high-cost
components.

Enhance the value added by components that contribute significantly to functions that are
particularly important to customers.

Example

In analyzing a pen, the following table is used to connect components with the functions
to which they contribute and hence identify areas of focus.

How it works

Value Analysis (and its design partner, Value Engineering) is used to increase the value
of products or services to all concerned by considering the function of individual items
and the benefit of this function and balancing this against the costs incurred in delivering
it. The task then becomes to increase the value or decrease the cost.
26
THE CONCEPT OF VALUE

The value of a product will be interpreted in different ways by different customers. Its
common characteristic is a high level of performance, capability, emotional appeal, style,
etc. relative to its cost. This can also be expressed as maximizing the function of a
product relative to its cost:

Value = (Performance + Capability)/Cost = Function/Cost

Value is not a matter of minimizing cost. In some cases the value of a product can be
increased by increasing its function (performance or capability) and cost as long as the
added function increases more than its added cost. The concept of functional worth can
be important. Functional worth is the lowest cost to provide a given function. However,
there are less tangible "selling" functions involved in a product to make it of value to a
customer.

INTRODUCTION TO VALUE ANALYSIS

Lawrence Miles conceived of Value Analysis (VA) in the 1945 based on the application
of function analysis to the component parts of a product. Component cost reduction was
an effective and popular way to improve "value" when direct labor and material cost
determined the success of a product. The value analysis technique supported cost
reduction activities by relating the cost of components to their function contributions.

Value analysis defines a "basic function" as anything that makes the product work or sell.
A function that is defined as "basic" cannot change. Secondary functions, also called
"supporting functions", described the manner in which the basic function(s) were
implemented. Secondary functions could be modified or eliminated to reduce product
cost.

As VA progressed to larger and more complex products and systems, emphasis shifted to
"upstream" product development activities where VA can be more effectively applied to
a product before it reaches the production phase. However, as products have become
more complex and sophisticated, the technique needed to be adapted to the "systems"
approach that is involved in many products today. As a result, value analysis evolved into
the "Function Analysis System Technique" (FAST) which is discussed later.

THE VALUE ANALYSIS METHOD

In all problem solving techniques, we are trying to change a condition by means of a

solution that is unique and relevant. If we describe in detail what we are trying to
27
accomplish, we tend to describe a solution and miss the opportunity to engage in
divergent thinking about other alternatives. When trying to describe problems that affect
us, we become locked in to a course of action without realizing it, because of our own
bias. Conversely, the more abstractly we can define the function of what we are trying to
accomplish, the more opportunities we will have for divergent thinking.

This high level of abstraction can be achieved by describing what is to be accomplished

with a verb and a noun. In this discipline, the verb answers the question, "What is to be
done?" or, "What is it to do?" The verb defines the required action. The noun answers the
question, "What is it being done to?" The noun tells what is acted upon. Identifying the
function by a verb-noun is not as simple a matter as it appears.

Identifying the function in the broadest possible terms provides the greatest potential for
divergent thinking because it gives the greatest freedom for creatively developing
alternatives. A function should be identified as to what is to be accomplished by a
solution and not how it is to be accomplished. How the function is identified determines
the scope, or range of solutions that can be considered.

That functions designated as "basic" represent the operative function of the item or
product and must be maintained and protected. Determining the basic function of single
components can be relatively simple. By definition then, functions designated as "basic"
will not change, but the way those functions are implemented is open to innovative
speculation.

As important as the basic function is to the success of any product, the cost to perform
that function is inversely proportional to its importance. This is not an absolute rule, but
rather an observation of the consumer products market. Few people purchase consumer
products based on performance or the lowest cost of basic functions alone. When
purchasing a product it is assumed that the basic function is operative. The customer's
attention is then directed to those visible secondary support functions, or product features,
which determine the worth of the product. From a product design point of view, products
that are perceived to have high value first address the basic function's performance and
stress the achievement of all of the performance attributes. Once the basic functions are
satisfied, the designer's then address the secondary functions necessary to attract
customers. Secondary functions are incorporated in the product as features to support and
enhance the basic function and help sell the product. The elimination of secondary
functions that are not very important to the customer will reduce product cost and
increase value without detracting from the worth of the product.

The cost contribution of the basic function does not, by itself, establish the value of the
product. Few products are sold on the basis of their basic function alone. If this were so,
the market for "no name" brands would be more popular than it is today. Although the
cost contribution of the basic function is relatively small, its loss will cause the loss of the
market value of the product.

One objective of value analysis or function analysis, to improve value by reducing the
cost-function relationship of a product, is achieved by eliminating or combining as many
secondary functions as possible.

28
VALUE ANALYSIS PROCESS

The first step in the value analysis process is to define the problem and its scope. Once
this is done, the functions of the product and its items are derived. These functions are
classified into "basic" and "secondary" functions. A Cost Function Matrix or Value
Analysis Matrix is prepared to identify the cost of providing each function by associating
the function with a mechanism or component part of a product. Product functions with a
high cost-function ratio are identified as opportunities for further investigation and
improvement. Improvement opportunities are then brainstormed, analyzed, and selected.

The objective of the Function Cost Matrix approach is to draw the attention of the
analysts away from the cost of components and focus their attention on the cost
contribution of the functions. The Function Cost Matrix displays the components of the
product, and the cost of those components, along the left vertical side of the graph. The
top horizontal legend contains the functions performed by those components. Each
component is then examined to determine how many functions that component performs,
and the cost contributions of those functions.

Detailed cost estimates become more important following function analysis, when
evaluating value improvement proposals. The total cost and percent contribution of the
functions of the item under study will guide the team, or analyst, in selecting which
functions to select for value improvement analysis.

A variation of the Function-Cost Matrix is the Value Analysis Matrix. This matrix was
derived from the Quality Function Deployment (QFD) methodology. It is more powerful
in two ways. First, it associates functions back to customer needs or requirements. In
doing this, it carries forward an importance rating to associate with these functions based
on the original customer needs or requirements. Functions are then related to
mechanisms, the same as with the Function-Cost Matrix. Mechanisms are related to
functions as either strongly, moderately or weakly supporting the given function. This
relationship is noted with the standard QFD relationship symbols. The associated
weighting factor is multiplied by customer or function importance and each columns
value is added.

These totals are normalized to calculate each mechanism's relative weight in satisfying
the designated functions. This is where the second difference with the Function-Cost
Matrix arises. This mechanism weight can then be used as the basis to allocate the overall
item or product cost. The mechanism target costs can be compared with the actual or
estimated costs to see where costs are out of line with the value of that mechanism as
derived from customer requirements and function analysis.

FUNCTION ANALYSIS SYSTEM TECHNIQUE

Function Analysis System Technique is an evolution of the value analysis process created
by Charles Bytheway. FAST permits people with different technical backgrounds to
effectively communicate and resolve issues that require multi-disciplined considerations.
FAST builds upon VA by linking the simply expressed, verb-noun functions to describe
complex systems.

FAST is not an end product or result, but rather a beginning. It describes the item or
system under study and causes the team to think through the functions that the item or
system performs, forming the basis for a wide variety of subsequent approaches and
29
analysis techniques. FAST contributes significantly to perhaps the most important phase
of value engineering: function analysis. FAST is a creative stimulus to explore innovative
avenues for performing functions.

The FAST diagram or model is an excellent communications vehicle. Using the verb-
noun rules in function analysis creates a common language, crossing all disciplines and
technologies. It allows multi-disciplined team members to contribute equally and
communicate with one another while addressing the problem objectively without bias or
preconceived conclusions. With FAST, there are no right or wrong model or result. The
problem should be structured until the product development team members are satisfied
that the real problem is identified. After agreeing on the problem statement, the single
most important output of the multi-disciplined team engaged in developing a FAST
model is consensus. Since the team has been charged with the responsibility of resolving
the assigned problem, it is their interpretation of the FAST model that reflects the
problem statement that's important. The team members must discuss and reconfigure the
FAST model until consensus is reached and all participating team members are satisfied
that their concerns are expressed in the model. Once consensus has been achieved, the
FAST model is complete and the team can move on to the next creative phase.

FAST differs from value analysis in the use of intuitive logic to determine and test
function dependencies and the graphical display of the system in a function dependency
diagram or model. Another major difference is in analyzing a system as a complete unit,
rather than analyzing the components of a system. When studying systems it becomes
apparent that functions do not operate in a random or independent fashion. A system
exists because functions form dependency links with other functions, just as components
form a dependency link with other components to make the system work. The importance
of the FAST approach is that it graphically displays function dependencies and creates a
process to study function links while exploring options to develop improved systems.

There are normally two types of FAST diagrams, the technical FAST diagram and the
customer FAST diagram. A technical FAST diagram is used to understand the technical
aspects of a specific portion of a total product. A customer FAST diagram focuses on the
aspects of a product that the customer cares about and does not delve into the
technicalities, mechanics or physics of the product. A customer FAST diagram is usually
applied to a total product.

CREATING A FAST MODEL

The FAST model has a horizontal directional orientation described as the HOW-WHY
dimension. This dimension is described in this manner because HOW and WHY
questions are asked to structure the logic of the system's functions. Starting with a
function, we ask HOW that function is performed to develop a more specific approach.
This line of questioning and thinking is read from left to right. To abstract the problem to
a higher level, we ask WHY is that function performed. This line of logic is read from
right to left.

There is essential logic associated with the FAST HOW-WHY directional orientation.
First, when undertaking any task it is best to start with the goals of the task, then explore
methods to achieve the goals. When addressing any function on the FAST model with the
question WHY, the function to its left expresses the goal of that function. The question
HOW, is answered by the function on the right, and is a method to perform that function
being addressed. A systems diagram starts at the beginning of the system and ends with
30
its goal. A FAST model, reading from left to right, starts with the goal, and ends at the
beginning of the "system" that will achieve that goal.

Second, changing a function on the HOW-WHY path affects all of the functions to the
right of that function. This is a domino effect that only goes one way, from left to right.
Starting with any place on the FAST model, if a function is changed the goals are still
valid (functions to the left), but the method to accomplish that function, and all other
functions on the right, are affected.

Finally, building the model in the HOW direction, or function justification, will focus the
team's attention on each function element of the model. Whereas, reversing the FAST
model and building it in its system orientation will cause the team to leap over individual
functions and focus on the system, leaving function "gaps" in the system. A good rule to
remember in constructing a FAST Model is to build in the HOW direction and test the
logic in the WHY direction.

The vertical orientation of the FAST model is described as the WHEN direction. This is
not part of the intuitive logic process, but it supplements intuitive thinking. WHEN is not
a time orientation, but indicates cause and effect.

Scope lines represent the boundaries of the study and are shown as two vertical lines on
the FAST model. The scope lines bound the "scope of the study", or that aspect of the
problem with which the study team is concerned. The left scope line determines the basic
function(s) of the study. The basic functions will always be the first function(s) to the
immediate right of the left scope line. The right scope line identifies the beginning of the
study and separates the input function(s) from the scope of the study.

The objective or goal of the study is called the "Highest Order Function", located to the
left of the basic function(s) and outside of the left scope line. Any function to the left of
another function is a "higher order function". Functions to the right and outside of the
right scope line represent the input side that "turn on" or initiate the subject under study
and are known as lowest order functions. Any function to the right of another function is
a "lower order" function and represents a method selected to carry out the function being
addressed.

Those function(s) to the immediate right of the left scope line represent the purpose or
mission of the product or process under study and are called Basic Function(s). Once
determined, the basic function will not change. If the basic function fails, the product or
process will lose its market value.

All functions to the right of the basic function(s) portray the conceptual approach selected
to satisfy the basic function. The concept describes the method being considered, or
elected, to achieve the basic function(s). The concept can represent either the current
conditions (as is) or proposed approach (to be). As a general rule, it is best to create a "to
be" rather than an "as is" FAST Model, even if the assignment is to improve an existing
product. This approach will give the product development team members an opportunity
to compare the "ideal" to the "current" and help resolve how to implement the
differences. Working from an "as is" model will restrict the team's attention to
incremental improvement opportunities. An "as is" model is useful for tracing the
symptoms of a problem to its root cause, and exploring ways to resolve the problem,
because of the dependent relationship of functions that form the FAST model.

31
Any function on the HOW-WHY logic path is a logic path function. If the functions
along the WHY direction lead into the basic function(s), than they are located on the
major logic path. If the WHY path does not lead directly to the basic function, it is a
minor logic path. Changing a function on the major logic path will alter or destroy the
way the basic function is performed. Changing a function on a minor logic path will
disturb an independent (supporting) function that enhances the basic function. Supporting
functions are usually secondary and exist to achieve the performance levels specified in
the objectives or specifications of the basic functions or because a particular approach
was chosen to implement the basic function(s).

Independent functions describe an enhancement or control of a function located on the

logic path. They do not depend on another function or method selected to perform that
function. Independent functions are located above the logic path function(s), and are
considered secondary, with respect to the scope, nature, level of the problem, and its logic
path. An example of a FAST Diagram for a pencil is shown below.

Adapted from an example developed by J. Jerry Kaufman

The next step in the process is to dimension the FAST model or to associate information
to its functions. FAST dimensions include, but are not limited to: responsibility, budgets,
allocated target costs, estimated costs, actual costs, subsystem groupings, placing
inspection and test points, manufacturing processes, positioning design reviews, and
others. There are many ways to dimension a FAST model. The two popular ways are
called Clustering Functions and the Sensitivity Matrix.

Clustering functions involves drawing boundaries with dotted lines around groups of
functions to configure sub-systems. Clustering functions is a good way to illustrate cost
reduction targets and assign design-to-cost targets to new design concepts. For cost
reduction, a team would develop an "as is" product FAST model, cluster the functions
into subsystems, allocate product cost by clustered functions, and assign target costs.
32
During the process of creating the model, customer sensitivity functions can be identified
as well as opportunities for significant cost improvements in design and production.

Following the completion of the model, the subsystems can be divided among product
development teams assigned to achieve the target cost reductions. The teams can then
select cost sensitive sub-systems and expand them by moving that segment of the model
to a lower level of abstraction. This exposes the detail components of that assembly and
their function/cost contributions.

VALUE IMPROVEMENT PROCESS

Performing value analysis or producing the FAST model and analyzing functions with
the value analysis matrix are only the first steps in the process. The real work begins with
brainstorming, developing and analyzing potential improvements in the product. These
subsequent steps are supported by:

• The QFD Concept Selection Matrix is a powerful tool to evaluate various concept
and design alternatives based on a set of weighted criteria that ultimately tie back
to customer needs.
• Benchmarking competitors and other similar products helps to see new ways
functions can be performed and breaks down some of the not-invented-here
paradigms.
• Product cost and life cycle cost models support the estimating of cost for the
Function-Cost and Value Analysis Matrices and aid in the evaluation of various
product concepts.
• Technology evaluation is leads us to new ways that basic functions can be
performed in a better or less costly way. Concept development should involve
people with knowledge of new technology development and an open mind to
identify how this technology might relate to product functions that need to be
performed. Methods such as the theory of inventive problem solving or TRIZ are
useful in this regard.
• Design for Manufacturability/Assembly principles provide guidance on how to
better design components and assemblies that are more manufacturability and, as
a result, are lower in cost.

Value Analysis or Function Analysis provide the methods to identify the problem and to
begin to define the functions that need to be performed. As we proceed in developing a
FAST model, implicit in this process is developing a concept of operation for the product
which is represented by all of the lower order functions in a FAST diagram.

Concept alternatives will be developed through brainstorming, benchmarking other

products performing similar functions, and surveying and applying new technology.
Since multiple concepts need to be evaluated, we want to use a higher level of abstraction
for the FAST model to provide us with the greatest flexibility and a minimum level of
effort. Trade studies and technical analysis will be performed to evaluate various product
concepts. A concept selection matrix is a good tool to summarize a variety of different
data and support making a decision about the preferred concept.

All of these steps may be iterative as a preferred concept evolves and gets more fully
developed. In addition, there should be a thorough evaluation of whether all functions are
needed or if there is a different way of accomplishing a function as the concept is
developed to a lower level of abstraction. When a Function Cost or Value Analysis
33
Matrix is prepared, functions that are out of balance with their worth are identified,
further challenging the team to explore different approaches.

Target costing

Target costing is a pricing method used by firms. It is defined as "a cost management
tool for reducing the overall cost of a product over its entire life-cycle with the help of
production, engineering, research and design". A target cost is the maximum amount of
cost that can be incurred on a product and with it the firm can still earn the required profit
margin from that product at a particular selling price.

In the traditional cost-plus pricing method materials, labor and overhead costs are
measured and a desired profit is added to determine the selling price.

What is target costing?

Target costing involves setting a target cost by subtracting a desired profit margin from a
competitive market price

To compete effectively, organizations must continually redesign their products ( or

services) in order to shorten product life cycles. The planning, development and design
stage of a product is therefore critical to an organization's cost management process.
Considering possible cost reduction at this stage of a product's life cycle (rather than
during the production process) is now one of the most important issues facing
management accountants in industry.

Here are some examples of decisions made at the design stage which impact on the cost
of a product.

1. The number of different components

2. Whether the components are standard or not
3. The ease of changing over stoo

Target Costing Approach to Pricing:

34
In traditional costing system it is presumed that a product has already been developed,
has been costed, and is ready to be marketed as soon as a price is set. In many cases, the
sequence of events is just the reverse. That is, the company already knows what price
should be charged, and the problem is to develop a product that can be marketed
profitably at the desired price. Even in this situation, where the normal sequence of
events is reversed, cost is still a crucial factor. The company can use an approach called
target costing.

1. Definition and Explanation of Target Costing

2. Reasons for Using Target Costing Technique
3. Example of Target Costing Process
4. Advantages and Disadvantages of Target Costing

Definition, Explanation and Formula of Target Costing:

Target costing is the process of determining the maximum allowable cost for a new
product and then developing a prototype that can be profitably made for that maximum
target cost figure. A number of companies--primarily in Japan--use target costing,
including Compaq, Culp, Cummins Engine, Daihatsu Motors, DaimlerChrysler, Ford,
Isuzu Motors, ITT, NEC, and Toyota etc.

The target costing for a product is calculated by starting with the product's anticipated
selling price and then deducting the desired profit. Following formula or equation
further explains this concept:

[Target Cost = Anticipated selling price – Desired profit]

The product development team is then given the responsibility of designing the product
so that it can be made for no more than the target cost.

Following set of activities further explains the concept of target costing technique:

TARGET COSTING PROCESS DIAGRAM

Determine Customer Wants and Price Sensitivity

↓
Planned Selling Price is Set
↓
Target Cost is Determined As: Selling Price Less Desired
Profit
↓
Teams of Employees from Various Areas and Trusted
Vendors Simultaneously
↓
Determine Determine
Design Product Manufacturing Necessary Raw
Process Materials
35
 ↓
Costs are Considered Throughout this Process. The Process
Requires Trade-offs to Meet Target Costs
↓
Once Target Cost is Achieved the Manufacturing Begins and
Product is Sold

Reasons for Using Target Costing Technique:

The target costing approach was developed in recognition of two important

characteristics of markets and costs. The first is that many companies have less control
over price than they would like to think. The market (i.e., supply and demand) really
determines prices, and a company that attempts to ignore this does so at its peril.
Therefore, the anticipated market price is taken as a given in target costing. The second
observation is that most of the cost of a product is determined in the design stage. Once a
product has been designed and has gone into production, not much can be done to
significantly reduce its cost. Most of the opportunities to reduce cost come from
designing the product so that it is simple to make, uses inexpensive parts, and is robust
and reliable. If the company has little control over market price and little control over
cost once the product has gone into production, then it follows that the major
opportunities for affecting profit come in the design stage where valuable features that
customers are willing to pay for can be added and where most of the costs are really
determined. So that it is where the effort is concentrated--in designing and developing the
product. The difference between target costing and other approaches to product
development is profound. Instead of designing the product and then finding out how
much it costs, the target cost is set first and then the product is designed so that the target
cost is attained.

Example of Target Costing:

To provide a simple numerical example of target costing, assume the following

situations:

Handy Appliance Company feels that there is a market niche for a hand mixer with
certain new features. Surveying the features and prices of hand mixers already in the
market, the marketing department believes that a price of $30 would be about right for
the new mixer. At that price, marketing estimates that 40,000 of new mixers could be
sold annually. To design, develop, and produce these new mixers, an investment of
$2,000,000 would be required. The company desires a 15% return on investment (ROI).
Given these data, the target cost to manufacture, sell, distribute, and service one mixer is
$22.50 as calculated below:

Projected sales (40,000 mixers $30 per mixer ) $1,200,000

Less desired profit (15% $2,000,000) 300,000
------------
Target cost for 40,000 mixers $9,00,000
=======
Target cost per mixer ($9,00,000 / 40,000$22.50

36
 mixer)

This $22.5 target cost would be broken into target cost for the various functions:
manufacturing, marketing, distribution, after-sales service, and so on. Each functional
area would be responsible for keeping its actual costs within target.

Advantages and Disadvantages of Target Costing Approach:

Target costing has the following main advantages or benefits:

1. Proactive approach to cost management.

2. Orients organizations towards customers.
3. Breaks down barriers between departments.
4. Implementation enhances employee awareness and empowerment.
5. Foster partnerships with suppliers.
6. Minimize non value-added activities.
7. Encourages selection of lowest cost value added activities.
8. Reduced time to market.

Target costing approach has the following main disadvantages or limitations:

1. Effective implementation and use requires the development of detailed cost data.
2. its implementation requires willingness to cooperate
3. Requires many meetings for coordination
4. May reduce the quality of products due to the use of cheep components which
may be of inferior quality.

Balanced scorecard

The balanced scorecard (BSC) is a strategic performance management tool - a semi-

standard structured report supported by proven design methods and automation tools that
can be used by managers to keep track of the execution of activities by staff within their
control and monitor the consequences arising from these actions. It is perhaps the best
known of several such frameworks, and was widely adopted in English speaking western
countries and Scandinavia in the early 1990s. Since 2000, use of Balanced Scorecard, its
derivatives (e.g. performance prism), and other similar tools (e.g. Results Based
Management) have become common in the Middle East, Asia and Spanish-speaking
countries also.

Characteristics

The core characteristic of the Balanced Scorecard and its derivatives is the presentation
of a mixture of financial and non-financial measures each compared to a 'target' value
within a single concise report. The report is not meant to be a replacement for traditional
financial or operational reports but a succinct summary that captures the information
most relevant to those reading it. It is the methods by which this 'most relevant'
information is determined (i.e. the design processes used to select the content) that most
differentiates the various versions of the tool in circulation.

The first versions of Balanced Scorecard asserted that relevance should derive from the
corporate strategy, and proposed design methods that focused on choosing measures and

37
targets associated with the main activities required to implement the strategy. As the
initial audience for this were the readers of the Harvard Business Review, the proposal
was translated into a form that made sense to a typical reader of that journal - one
relevant to a mid-sized US business. Accordingly, initial designs were encouraged to
measure three categories of non-financial measure in addition to financial outputs - those
of "Customer," "Internal Business Processes" and "Learning and Growth." Clearly these
categories were not so relevant to non-profits or units within complex organizations
(which might have high degrees of internal specialization), and much of the early
literature on Balanced Scorecard focused on suggestions of alternative 'perspectives' that
might have more relevance to these groups.

Modern Balanced Scorecard thinking has evolved considerably since the initial ideas
proposed in the late 1980s and early 1990s, and the modern performance management
tools including Balanced Scorecard are significantly improved - being more flexible (to
suit a wider range of organisational types) and more effective (as design methods have
evolved to make them easier to design, and use).

History

The first balanced scorecard was created by Art Schneiderman (an independent
consultant on the management of processes) in 1987 at Analog Devices, a mid-sized
semi-conductor company. Art Schniederman participated in an unrelated research study
in 1990 led by Dr. Robert S. Kaplan in conjunction with US management consultancy
Nolan-Norton, and during this study described his work on Balanced Scorecard.
Subsequently, Kaplan and David P. Norton included anonymous details of this use of
balanced scorecard in their 1992 article on Balanced Scorecard. Kaplan & Norton's
article wasn't the only paper on the topic published in early 1992. But the 1992 Kaplan &
Norton paper was a popular success, and was quickly followed by a second in 1993. In
1996, they published the book The Balanced Scorecard. These articles and the first book
spread knowledge of the concept of Balanced Scorecard widely, but perhaps wrongly
have lead to Kaplan & Norton being seen as the creators of the Balanced Scorecard
concept.

While the "balanced scorecard" concept and terminology was coined by Art
Schneiderman, the roots of performance management as an activity run deep in
management literature and practice. Management historians such as Alfred Chandler
suggest the origins of performance management can be seen in the emergence of the
complex organisation - most notably during the 19th Century in the USA More recent
influences may include the pioneering work of General Electric on performance
measurement reporting in the 1950’s and the work of French process engineers (who
created the tableau de bord – literally, a "dashboard" of performance measures) in the
early part of the 20th century. The tool also draws strongly on the ideas of the 'resource
based view of the firm' proposed by Edith Penrose. However it should be noted that none
of these influences is explicitly linked to original descriptions of Balanced Scorecard by
Schniederman, Maisel, or Kaplan & Norton.

Although Kaplan & Norton's first book, The Balanced Scorecard, remains the most
popular. The book reflects the earliest incarnations of Balanced Scorecard - effectively
restating the concept as described in the 2nd Harvard Business Review article. Their
second book, The Strategy Focused Organization, echoed work by others (particularly in
Scandinavia) on the value of visually documenting the links between measures by
proposing the "Strategic Linkage Model" or strategy map. Since then Balanced Scorecard
38
books have become more common - in early 2010 Amazon was listing several hundred
titles in English which had Balanced Scorecard in the title.

Design

Design of a Balanced Scorecard ultimately is about the identification of a small number

of financial and non-financial measures and attaching targets to them, so that when they
are reviewed it is possible to determine whether current performance 'meets expectations'.
The idea behind this is that by alerting managers to areas where performance deviates
from expectations, they can be encouraged to focus their attention on these areas, and
hopefully as a result trigger improved performance within the part of the organization
they lead.

The original thinking behind Balanced Scorecard was for it to be focused on information
relating to the implementation of a strategy, and perhaps unsurprisingly over time there
has been a blurring of the boundaries between conventional strategic planning and control
activities and those required to design a Balanced Scorecard. This is illustrated well by
the four steps required to design a Balanced Scorecard included in Kaplan & Norton's
writing on the subject in the late 1990s, where they assert four steps as being part of the
Balanced Scorecard design process:

1. Translating the vision into operational goals;

2. Communicating the vision and link it to individual performance;
3. Business planning; index setting
4. Feedback and learning, and adjusting the strategy accordingly.

These steps go way beyond the simple task of identifying a small number of financial and
non-financial measures, but illustrate the requirement for whatever design process is used
to fit within broader thinking about how the resulting Balanced Scorecard will integrate
with the wider business management process. This is also illustrated by books and
articles referring to balanced scorecards confusing the design process elements and the
balanced scorecard itself. In particular, it is common for people to refer to a “strategic
linkage model” or “strategy map” as being a balanced scorecard.

Although it helps focus managers' attention on strategic issues and the management of the
implementation of strategy, it is important to remember that the balanced scorecard itself
has no role in the formation of strategy. In fact, balanced scorecards can comfortably co-
exist with strategic planning systems and other tools.

Criticism of Balanced Scorecard Methodology

The Balanced Scorecard has always attracted criticism from a variety of sources. Most
has come from the academic community, who dislike the empirical nature of the
framework: Kaplan & Norton notoriously failed to include any citation of prior art in
their initial papers on the topic. Some of this criticism focuses on technical flaws in the
methods and design of the original Balanced Scorecard proposed by Kaplan & Norton,
and has over time driven the evolution of the device through its various Generations.
Other academics have simply focused on the lack of citation support. But a general
weakness of this type of criticism is that it typically uses the 1st Generation Balanced
Scorecard as its object: many of the flaws identified are addressed in other works
published since the original Kaplan & Norton works in the early 1990s.

39
Another criticism, usually from pundits and consultants, is that the balanced scorecard
does not provide a bottom line score or a unified view with clear recommendations: it is
simply a list of metrics. These critics usually include in their criticism suggestions about
how the 'unanswered' question postulated could be answered. Typically however, the
unanswered question relates to things outside the scope of Balanced Scorecard itself
(such as developing strategies).

There are few empirical studies linking the use of Balanced Scorecards to better decision
making or improved financial performance of companies, but some work has been done
in these areas. However broadcast surveys of usage have difficulties in this respect, due
to the wide variations in definition of 'what a Balanced Scorecard is' noted above (making
it hard to work out in a survey if you are comparing like with like). Single organization
case studies suffer from the 'lack of a control' issue common to any study of
organizational change - you don't know what the organization would have achieved if the
change had not been made, so it is difficult to attribute changes observed over time to a
single intervention (such as introducing a Balanced Scorecard). However, such studies as
have been done have typically found Balanced Scorecard to be useful

The four perspectives

The 1st Generation design method proposed by Kaplan & Norton was based on the use of
three non-financial topic areas as prompts to aid the identification of non-financial
measures in addition to one looking at Financial. The four "perspectives" proposed were.

• Financial;
• Customer;
• Internal Processes;
• Innovation and Learning.

Adapted from The Balanced Scorecard by Kaplan & Norton

40
The "financial perspective" encourages the identification of a few relevant high-level
financial measures. In particular, designers were encouraged to choose measures that
helped inform the answer to the question "How do we look to shareholders?"

The "customer perspective" encourages the identification of measures that answer the
question "How do customers see us?"

The "internal business perspective" encourages the identification of measures that answer
the question "What must we excel at?"

The "innovation and learning perspective" encourages the identification of measures that
answer the question "Can we continue to improve and create value?".

As noted above, these 'prompt questions' highlight, Kaplan & Norton were thinking about
a medium sized commercial organisation in the USA when choosing these topic areas.
They are not very helpful to other kinds of organisations, and much of the literature on
Balanced Scorecard since has focused on alternative headings and questions to link to]

Total quality management

Total Quality Management (or TQM) is a management concept coined by W. Edwards

Deming. The basis of TQM is to reduce the errors produced during the manufacturing or
service process, increase customer satisfaction, streamline supply chain management, aim
for modernization of equipment and ensure workers have the highest level of training.
One of the principal aims of TQM is to limit errors to 1 per 1 million units produced.
Total Quality Management is often associated with the development, deployment, and
maintenance of organizational systems that are required for various business processes.

TQM and Six Sigma

The main difference between TQM and Six Sigma (a newer concept) is the approach.
TQM tries to improve quality by ensuring conformance to internal requirements, while
Six Sigma focuses on improving quality by reducing the number of defects.

Just-in-time

Return on investment by reducing in-process inventory and associated carrying costs. To

meet JIT objectives, the process relies on signals or Kanban between different points in
the process, which tell production when to make the next part. Kanban are usually
'tickets' but can be simple visual signals, such as the presence or absence of a part on a
shelf. Implemented correctly, JIT can improve a manufacturing organization's return on
investment, quality, and efficiency.

Quick notice that stock depletion requires personnel to order new stock is critical to the
inventory reduction at the center of JIT. This saves warehouse space and costs. However,
the complete mechanism for making this work is often misunderstood.

For instance, its effective application cannot be independent of other key components of a
lean manufacturing system or it can "...end up with the opposite of the desired result.". In
recent years manufacturers have continued to try to hone forecasting methods (such as

41
applying a trailing 13 week average as a better predictor for JIT planning), however some
research demonstrates that basing JIT on the presumption of stability is inherently flawed

Philosophy

The philosophy of JIT is simple: inventory is waste. JIT inventory systems expose hidden
causes of inventory keeping, and are therefore not a simple solution for a company to
adopt. The company must follow an array of new methods to manage the consequences
of the change. The ideas in this way of working come from many different disciplines
including statistics, industrial engineering, production management, and behavioral
science. The JIT inventory philosophy defines how inventory is viewed and how it relates
to management.

Inventory is seen as incurring costs, or waste, instead of adding and storing value,
contrary to traditional accounting. This does not mean to say JIT is implemented without
awareness that removing inventory exposes pre-existing manufacturing issues. This way
of working encourages businesses to eliminate inventory that does not compensate for
manufacturing process issues, and to constantly improve those processes to require less
inventory. Secondly, allowing any stock habituates management to stock keeping.
Management may be tempted to keep stock to hide production problems. These problems
include backups at work centers, machine reliability, process variability, lack of
flexibility of employees and equipment, and inadequate capacity.

In short, the just-in-time inventory system focus is having “the right material, at the right
time, at the right place, and in the exact amount”, without the safety net of inventory. The
JIT system has broad implications for implementers.

Transaction cost approach

JIT reduces inventory in a firm. However, a firm may simply be outsourcing their input
inventory to suppliers, even if those suppliers don't use JIT (Naj 1993). Newman (1993)
investigated this effect and found that suppliers in Japan charged JIT customers, on
average, a 5% price premium.

Environmental concerns

During the birth of JIT, multiple daily deliveries were often made by bicycle. Increased
scale has required a move to vans and lorries (trucks). Cusumano (1994) highlighted the
potential and actual problems this causes with regard to gridlock and burning of fossil
fuels. This violates three JIT waste guidelines:

1. Time—wasted in traffic jams

2. Inventory—specifically pipeline (in transport) inventory
3. Scrap—fuel burned while not physically moving

JIT Implementation Design

Based on a diagram modeled after the one used by Hewlett-Packard’s Boise plant to
accomplish its JIT program.

1) F Design Flow Process

- F Redesign/relayout for flow
42
 - L Reduce lot sizes
- O Link operations
- W Balance workstation capacity
- M Preventive maintenance
- S Reduce Setup Times
2) Q Total quality control
- C worker compliance
- I Automatic inspection
- M quality measures
- M fail-safe methods
- W Worker participation

3) S Stabilize Schedule
- S Level Schedule
- W establish freeze windows
- UC Underutilize Capacity
4) K Kanban Pull System
- D Demand pull
- B Backflush
- L Reduce lot sizes
5) V Work with vendors
- L Reduce lead time
- D Frequent deliveries
- U Project usage requirements
- Q Quality Expectations
6) I Further reduce inventory in other areas
S Stores
- T Transit
- C Implement Carroussel to reduce motion waste
- C Implement Conveyor belts to reduce motion waste

7) P Improve Product Design

- P Standard Production Configuration
- P Standardize and reduce the number of parts
- P Process design with product design
- Q Quality Expectations

Benefits

Main benefits of JIT include:

• Reduced setup time. Cutting setup time allows the company to reduce or eliminate
inventory for "changeover" time. The tool used here is SMED (single-minute
exchange of dies).
• The flow of goods from warehouse to shelves improves. Small or individual piece
lot sizes reduce lot delay inventories, which simplifies inventory flow and its
management.
• Employees with multiple skills are used more efficiently. Having employees
trained to work on different parts of the process allows companies to move
workers where they are needed.
• Production scheduling and work hour consistency synchronized with demand. If
there is no demand for a product at the time, it is not made. This saves the
43
 company money, either by not having to pay workers overtime or by having them
focus on other work or participate in training.
• Increased emphasis on supplier relationships. A company without inventory does
not want a supply system problem that creates a part shortage. This makes
supplier relationships extremely important.
• Supplies come in at regular intervals throughout the production day. Supply is
synchronized with production demand and the optimal amount of inventory is on
hand at any time. When parts move directly from the truck to the point of
assembly, the need for storage facilities is reduced.

Economic Value Added (EVA)

• The Economic Value Added (EVA) is a measure of surplus value created on an

investment.
• Define the return on capital (ROC) to be the ìtrueî cash flow return on capital
earned on an investment.
• Define the cost of capital as the weighted average of the costs of the different
financing instruments used to finance the investment.

EVA = (Return on Capital - Cost of Capital) (Capital Invested in Project)

Things to Note about EVA

• EVA is a measure of dollar surplus value, not the percentage difference in

returns.
• It is closest in both theory and construct to the net present value of a project in
capital budgeting, as opposed to the IRR.
• The value of a firm, in DCF terms, can be written in terms of the EVA of
projects in place and the present value of the EVA of future projects.

DCF Value and NPV

Value of Firm = Value of Assets in Place + Value of Future Growth

= ( Investment in Existing Assets + NPVAssets in Place) + NPV of all future projects

= ( I + NPVAssets in Place ) +

where there are expected to be N projects yielding surplus value (or excess returns) in the
future and I is the capital invested in assets in place (which might or might not be equal to
the book value of these assets).

The Basics of NPV

NPVj = : Life of the project is n years

Initial Investment = : Alternative Investment

44
NPVj =

NPV to EVA (Continued)

• Define ROC = EBIT (1-t) / Initial Investment: The earnings before interest and
taxes are assumed to measure true earnings on the project and should not be
contaminated by capital charges (such as leases) or expenditures whose benefits
accrue to future projects (such as R & D).

• Assume that : The present value of depreciation

covers the present value of capital invested, i.e, it is a return of capital.

DCF Valuation, NPV and EVA

Value of Firm = ( I + NPVAssets in Place ) +

In other words,

Firm Value = Capital Invested in Assets in Place + PV of EVA from Assets in Place +
Sum of PV of EVA from new projects

Advantages of EVA

1. EVA is closely related to NPV. It is closest in spirit to corporate finance theory that
argues that the value of the firm will increase if you take positive NPV projects.

2. It avoids the problems associates with approaches that focus on percentage spreads -
between ROE and Cost of Equity and ROC and Cost of Capital. These approaches may
45
lead firms with high ROE and ROC to turn away good projects to avoid lowering their
percentage spreads.

3. It makes top managers responsible for a measure that they have more control over - the
return on capital and the cost of capital are affected by their decisions - rather than one
that they feel they cannot control as well - the market price per share.

4. It is influenced by all of the decisions that managers have to make within a firm - the
investment decisions and dividend decisions affect the return on capital (the dividend
decisions affect it indirectly through the cash balance) and the financing decision affects
the cost of capital.

46
Module IV: Advanced Cost and Management Techniques

• Cost control and cost reduction,

• Product/project life cycle costing,
• Kaizen technique,
• Benchmarking,
• Business process reengineering,
• Management Control Systems.

Introduction of Cost Reduction and Cost Control

Some people don't differentiate between cost control and cost reduction but I tend to
consider cost control to be a reactive measure to stem cost growth to stay within
budget (e.g. overspending in an account) rather than a proactive effort to actually reduce
costs from baseline.

In reality some people do not differentiate between cost reduction and cost control. I
think that is why you are having a problem with finding examples. But, that said, I think
the best approach is to look at the definitions of the two words - reduction and control.
Those words have different meanings.

I can't guarantee that every business professor will accept my definitions but, as a cost
reduction consultant with over 30 years in business, the opinion is based on hands-on
experience. Please read "Instant Profits: Making Your Business Pay" for the practical
aspects of cost reduction and cost control in real business.

Cost reduction:

An organized and intentional one-time (cost reduction project) or continuous (cost

reduction process) initiative taken with the goal to reduce business costs from a current
level to a desired lower level. Cost reduction may be targeted to one specific cost
(account), a selection of costs (accounts) or organization-wide.

Cost control:

A organized and intentional effort to limit the growth of costs within specific accounts.
The management practice of putting lock limits on accounts is, in my opinion, an
example of cost control. Mandating the reduction of consumption of a supply or utility is
an example of cost control.

Cost Reduction Strategies

It’s time to stop thinking of cost cutting in a vacuum. In the new world, the same
initiatives can both reduce costs AND raise revenues. The most successful airlines will
learn how to work across departments to not just control costs but achieve the ultimate
goal: maximizing profitability.

How You Will Benefit

• Improve your understanding of key drivers of airline profitability and shareholder

value
47
• Recognize the key ways in which global economic fundamentals impact an airline’s
cost base
• Become familiar with the latest and most important technologies airlines are using to
lower their costs while simultaneously raising revenue, often with the same initiatives
• Answer questions such as: If bag check fees reduce bags handled while generating
revenues from those that are still checked, is this a revenue generation strategy or a
cost management strategy? What about onboard food sales, which reduce
consumption while driving revenues? Are there other opportunities for such dual-
purpose strategies?
• Identify crucial areas where costs can be prevented or reduced
• Review and study real-life examples of cost management techniques and
technological adoption at world-class airlines
• Evaluate the long-term prospect for cost management

Designed For

• Chief Financial Officers and Financial Controllers.

• Cost and Management Accountants.
• Costs Analysis Managers.
• Operation Cost Control Managers.
• Divisional Managers.

Procedure

• Identifying areas for cost prevention and reduction

• Understanding the factors driving costs in areas such as fuel, labor, distribution,
inventory management, corporate purchasing, fleet planning, airport and flight
operations and foreign exchange
• Implementing initiatives across departments that reduce costs while raising revenues
with a view to maximizing profitability
• Identifying and analysing dual-purpose strategies. Is it a a revenue generation strategy
or a cost management strategy?
• Distinguishing good costs from bad costs
• Analyzing questions like outsourcing versus insourcing, buying versus leasing, self
versus third party distribution, etc.
• IATA’s Simplifying the Business (StB) Program
• Developing and implementing effective cost-containment programs
• Sustaining the impact of your cost-reduction program
• Ensuring participation at all levels

Kaizen Technique
Kaizen (Japanese for "improvement" or "change for the better") refers to a philosophy or
practices that focus upon continuous improvement of processes in manufacturing,
engineering, supporting business processes, and management. It has been applied in
healthcare, government, banking, and many other industries. When used in the business
sense and applied to the workplace, kaizen refers to activities that continually improve all
functions, and involves all employees from the CEO to the assembly line workers. It also
applies to processes, such as purchasing and logistics, that cross organizational
boundaries into the supply chain. By improving standardized activities and processes,
kaizen aims to eliminate waste (see lean manufacturing). Kaizen was first implemented in
48
 several Japanese businesses after the Second World War, influenced in part by American
business and quality management teachers who visited the country. It has since spread
throughout the world.

Introduction

Kaizen is a daily activity, the purpose of which goes beyond simple productivity
improvement. It is also a process that, when done correctly, humanizes the workplace,
eliminates overly hard work ("muri"), and teaches people how to perform experiments on
their work using the scientific method and how to learn to spot and eliminate waste in
business processes. In all, the process suggests a humanized approach to workers and to
increasing productivity: "The idea is to nurture the company's human resources as much
as it is to praise and encourage participation in kaizen activities." Successful
implementation requires "the participation of workers in the improvement."

People at all levels of an organization can participate in kaizen, from the CEO down, as
well as external stakeholders when applicable. The format for kaizen can be individual,
suggestion system, small group, or large group. At Toyota, it is usually a local
improvement within a workstation or local area and involves a small group in improving
their own work environment and productivity. This group is often guided through the
kaizen process by a line supervisor; sometimes this is the line supervisor's key role.
Kaizen on a broad, cross-departmental scale in companies, generates total quality
management, and frees human efforts through improving productivity using machines
and computing power.

While kaizen (at Toyota) usually delivers small improvements, the culture of continual
aligned small improvements and standardization yields large results in the form of
compound productivity improvement. This philosophy differs from the "command and
control" improvement programs of the mid-twentieth century. Kaizen methodology
includes making changes and monitoring results, then adjusting. Large-scale pre-planning
and extensive project scheduling are replaced by smaller experiments, which can be
rapidly adapted as new improvements are suggested.

In modern usage, a focused kaizen that is designed to address a particular issue over the
course of a week is referred to as a "kaizen blitz" or "kaizen event". These are limited in
scope, and issues that arise from them are typically used in later blitzes

History

After World War II, to help restore Japan, American occupation forces brought in
American experts to help with the rebuilding of Japanese industry. The Civil
Communications Section (CCS) developed a Management Training Program that taught
statistical control methods as part of the overall material. This course was developed and
taught by Homer Sarasohn and Charles Protzman in 1949 and 1950. Sarasohn
recommended William Deming for further training in Statistical Methods. The Economic
and Scientific Section (ESS) group was also tasked with improving Japanese
management skills and Edgar McVoy is instrumental in bringing Lowell Mellen to Japan
to properly install the TWI programs in 1951. Prior to the arrival of Mellen in 1951, the
ESS group had a training film done to introduce the three TWI "J" programs (Job
Instruction, Job Methods and Job Relations)- the film was titled "Improvement in 4
49
Steps" (Kaizen eno Yon Dankai). This is the original introduction of "Kaizen" to Japan.
For the pioneering, introducing, and implementing Kaizen in Japan, the Emperor of Japan
awarded the Second Order Medal of the Sacred Treasure to Dr. Deming in 1960.
Consequently, the Union of Japanese Science and Engineering (JUSE) instituted the
annual Deming Prizes for achievements in quality and dependability of products in Japan.
Reference: US National Archives - SCAP collection

Implementation

The Toyota Production System is known for kaizen, where all line personnel are expected
to stop their moving production line in case of any abnormality and, along with their
supervisor, suggest an improvement to resolve the abnormality which may initiate a
kaizen.

The cycle of kaizen activity can be defined as:

• Standardize an operation
• Measure the standardized operation (find cycle time and amount of in-process
inventory)
• Gauge measurements against requirements
• Innovate to meet requirements and increase productivity
• Standardize the new, improved operations
• Continue cycle ad infinitum

The five main elements of kaizen

• Teamwork
• Personal discipline
• Improved morale
• Quality circles
• Suggestions for improvement

Benchmarking
Benchmarking is the process of comparing one's business processes and performance
metrics to industry bests and/or best practices from other industries. Dimensions typically
measured are quality, time, and cost. Improvements from learning mean doing things
better, faster, and cheaper.

Benchmarking involves management identifying the best firms in their industry, or any
other industry where similar processes exist, and comparing the results and processes of
those studied (the "targets") to one's own results and processes to learn how well the
targets perform and, more importantly, how they do it.

The term benchmarking was first used by cobblers to measure people's feet for shoes.
They would place someone's foot on a "bench" and mark it out to make the pattern for the
shoes. Benchmarking is most used to measure performance using a specific indicator
(cost per unit of measure, productivity per unit of measure, cycle time of x per unit of
measure or defects per unit of measure) resulting in a metric of performance that is then
compared to others.

50
Also referred to as "best practice benchmarking" or "process benchmarking", it is a
process used in management and particularly strategic management, in which
organizations evaluate various aspects of their processes in relation to best practice
companies' processes, usually within a peer group defined for the purposes of
comparison. This then allows organizations to develop plans on how to make
improvements or adapt specific best practices, usually with the aim of increasing some
aspect of performance. Benchmarking may be a one-off event, but is often treated as a
continuous process in which organizations continually seek to improve their practices.

Collaborative benchmarking

Benchmarking, originally invented as a formal process by Rank Xerox, is usually carried

out by individual companies. Sometimes it may be carried out collaboratively by groups
of companies (e.g. subsidiaries of a multinational in different countries). One example is
that of the Dutch municipally-owned water supply companies, which have carried out a
voluntary collaborative benchmarking process since 1997 through their industry
association. Another example is the UK construction industry which has carried out
benchmarking since the late 1990s again through its industry association and with
financial support from the UK Government.

Procedure

There is no single benchmarking process that has been universally adopted. The wide
appeal and acceptance of benchmarking has led to various benchmarking methodologies
emerging. The seminal book on benchmarking is Boxwell's Benchmarking for
Competitive Advantage published by McGraw-Hill in 1994. It has withstood the test of
time and is still a relevant read. The first book on benchmarking, written and published
by Kaiser Associates, is a practical guide and offers a 7-step approach. Robert Camp
(who wrote one of the earliest books on benchmarking in 1989) developed a 12-stage
approach to benchmarking.

The 12 stage methodology consisted of

1. Select subject ahead

2. Define the process

3. Identify potential partners

4. Identify data sources

5. Collect data and select partners

6. Determine the gap

7. Establish process differences

8. Target future performance

9. Communicate

10. Adjust goal

51
11. Implement

12. Review/recalibrate.

The following is an example of a typical benchmarking methodology:

1. Identify your problem areas - Because benchmarking can be applied to any

business process or function, a range of research techniques may be required.
They include: informal conversations with customers, employees, or suppliers;
exploratory research techniques such as focus groups; or in-depth marketing
research, quantitative research, surveys, questionnaires, re-engineering analysis,
process mapping, quality control variance reports, or financial ratio analysis.
Before embarking on comparison with other organizations it is essential that you
know your own organization's function, processes; base lining performance
provides a point against which improvement effort can be measured.
2. Identify other industries that have similar processes - For instance if one were
interested in improving hand offs in addiction treatment he/she would try to
identify other fields that also have hand off challenges. These could include air
traffic control, cell phone switching between towers, transfer of patients from
surgery to recovery rooms.
3. Identify organizations that are leaders in these areas - Look for the very best
in any industry and in any country. Consult customers, suppliers, financial
analysts, trade associations, and magazines to determine which companies are
worthy of study.
4. Survey companies for measures and practices - Companies target specific
business processes using detailed surveys of measures and practices used to
identify business process alternatives and leading companies. Surveys are
typically masked to protect confidential data by neutral associations and
consultants.
5. Visit the "best practice" companies to identify leading edge practices -
Companies typically agree to mutually exchange information beneficial to all
parties in a benchmarking group and share the results within the group.
6. Implement new and improved business practices - Take the leading edge
practices and develop implementation plans which include identification of
specific opportunities, funding the project and selling the ideas to the organization
for the purpose of gaining demonstrated value from the process.

Cost of benchmarking

The three main types of costs in benchmarking are:

• Visit Costs - This includes hotel rooms, travel costs, meals, a token gift, and lost
labor time.
• Time Costs - Members of the benchmarking team will be investing time in
researching problems, finding exceptional companies to study, visits, and
implementation. This will take them away from their regular tasks for part of each
day so additional staff might be required.
• Benchmarking Database Costs - Organizations that institutionalize
benchmarking into their daily procedures find it is useful to create and maintain a
database of best practices and the companies associated with each best practice
now.

52
 The cost of benchmarking can substantially be reduced through utilizing the many
internet resources that have sprung up over the last few years. These aim to capture
benchmarks and best practices from organizations, business sectors and countries to make
the benchmarking process much quicker and cheaper.

Technical Benchmarking/Product Benchmarking

The technique initially used to compare existing corporate strategies with a view to
achieving the best possible performance in new situations (see above), has recently been
extended to the comparison of technical products. This process is usually referred to as
"Technical Benchmarking" or "Product Benchmarking". Its use is particularly well
developed within the automotive industry ("Automotive Benchmarking"), where it is
vital to design products that match precise user expectations, at minimum possible cost,
by applying the best technologies available worldwide. Many data are obtained by fully
disassembling existing cars and their systems. Such analyses were initially carried out in-
house by car makers and their suppliers. However, as they are expensive, they are
increasingly outsourced to companies specialized in this area. Indeed, outsourcing has
enabled a drastic decrease in costs for each company (by cost sharing) and the
development of very efficient tools (standards, software).

Types of benchmarking

• Process benchmarking - the initiating firm focuses its observation and

investigation of business processes with a goal of identifying and observing the
best practices from one or more benchmark firms. Activity analysis will be
required where the objective is to benchmark cost and efficiency; increasingly
applied to back-office processes where outsourcing may be a consideration.
• Financial benchmarking - performing a financial analysis and comparing the
results in an effort to assess your overall competitiveness and productivity.
• Benchmarking from an investor perspective- extending the benchmarking
universe to also compare to peer companies that can be considered alternative
investment opportunities from the perspective of an investor.
• Performance benchmarking - allows the initiator firm to assess their
competitive position by comparing products and services with those of target
firms.
• Product benchmarking - the process of designing new products or upgrades to
current ones. This process can sometimes involve reverse engineering which is
taking apart competitors products to find strengths and weaknesses.
• Strategic benchmarking - involves observing how others compete. This type is
usually not industry specific, meaning it is best to look at other industries.
• Functional benchmarking - a company will focus its benchmarking on a single
function to improve the operation of that particular function. Complex functions
such as Human Resources, Finance and Accounting and Information and
Communication Technology are unlikely to be directly comparable in cost and
efficiency terms and may need to be disaggregated into processes to make valid
comparison.
• Best-in-class benchmarking - involves studying the leading competitor or the
company that best carries out a specific function.

Operational benchmarking - embraces everything from staffing and productivity to office

flow and analysis of procedures performed

53
 Business process reengineering

Overview

Business process reengineering (BPR) began as a private sector technique to help

organizations fundamentally rethink how they do their work in order to dramatically improve
customer service, cut operational costs, and become world-class competitors. A key stimulus
for reengineering has been the continuing development and deployment of sophisticated
information systems and networks. Leading organizations are becoming bolder in using this
technology to support innovative business processes, rather than refining current ways of
doing work

Reengineering guidance and relationship of Mission and Work Processes to Information

Technology.

Business process reengineering is one approach for redesigning the way work is done to
better support the organization's mission and reduce costs. Reengineering starts with a high-
level assessment of the organization's mission, strategic goals, and customer needs. Basic
questions are asked, such as "Does our mission need to be redefined? Are our strategic goals
aligned with our mission? Who are our customers?" An organization may find that it is
operating on questionable assumptions, particularly in terms of the wants and needs of its
customers. Only after the organization rethinks what it should be doing, does it go on to
decide how best to do it

Within the framework of this basic assessment of mission and goals, reengineering
focuses on the organization's business processes—the steps and procedures that govern
how resources are used to create products and services that meet the needs of particular
customers or markets. As a structured ordering of work steps across time and place, a
business process can be decomposed into specific activities, measured, modeled, and
improved. It can also be completely redesigned or eliminated altogether. Reengineering
identifies, analyzes, and redesigns an organization's core business processes with the aim
of achieving dramatic improvements in critical performance measures, such as cost,
quality, service, and speed.

54
Reengineering recognizes that an organization's business processes are usually fragmented
into subprocesses and tasks that are carried out by several specialized functional areas within
the organization. Often, no one is responsible for the overall performance of the entire
process. Reengineering maintains that optimizing the performance of subprocesses can result
in some benefits, but cannot yield dramatic improvements if the process itself is
fundamentally inefficient and outmoded. For that reason, reengineering focuses on
redesigning the process as a whole in order to achieve the greatest possible benefits to the
organization and their customers. This drive for realizing dramatic improvements by
fundamentally rethinking how the organization's work should be done distinguishes
reengineering from process improvement efforts that focus on functional or incremental
improvement.

Definition

Different definitions can be found. This section contains the definition provided in
notable publications in the field:

• "... the fundamental rethinking and radical redesign of business processes to

achieve dramatic improvements in critical contemporary measures of
performance, such as cost, quality, service, and speed."
• "encompasses the envisioning of new work strategies, the actual process design
activity, and the implementation of the change in all its complex technological,
human, and organizational dimensions."

Additionally, Davenport (ibid.) points out the major difference between BPR and other
approaches to organization development (OD), especially the continuous improvement or
TQM movement, when he states: "Today firms must seek not fractional, but
multiplicative levels of improvement – 10x rather than 10%." Finally, Johansson provide
a description of BPR relative to other process-oriented views, such as Total Quality
Management (TQM) and Just-in-time (JIT), and state:

• "Business Process Reengineering, although a close relative, seeks radical rather

than merely continuous improvement. It escalates the efforts of JIT and TQM to
make process orientation a strategic tool and a core competence of the
organization. BPR concentrates on core business processes, and uses the specific
techniques within the JIT and TQM ”toolboxes” as enablers, while broadening the
process vision."

The role of information technology

Information technology (IT) has historically played an important role in the reengineering
concept. It is considered by some as a major enabler for new forms of working and
collaborating within an organization and across organizational borders.

Early BPR literature identified several so called disruptive technologies that were
supposed to challenge traditional wisdom about how work should be performed.

• Shared databases, making information available at many places

• Expert systems, allowing generalists to perform specialist tasks
• Telecommunication networks, allowing organizations to be centralized and
decentralized at the same time
• Decision-support tools, allowing decision-making to be a part of everybody's job
55
 • Wireless data communication and portable computers, allowing field personnel to
work office independent
• Interactive videodisk, to get in immediate contact with potential buyers
• Automatic identification and tracking, allowing things to tell where they are,
instead of requiring to be found
• High performance computing, allowing on-the-fly planning and revisioning

Research & Methodology

Although the labels and steps differ slightly, the early methodologies that were rooted in
IT-centric BPR solutions share many of the same basic principles and elements. The
following outline is one such model, based on the PRLC (Process Reengineering Life
Cycle) approach developed by Guha.

Simplified schematic outline of using a business process approach, examplified for

pharmceutical R&D:
1. Structural organization with functional units
2. Introduction of New Product Development as cross-functional process
3. Re-structuring and streamlining activities, removal of non-value adding tasks

Critique

Reengineering has earned a bad reputation because such projects have often resulted in
massive layoffs. This reputation is not altogether unwarranted, since companies have
often downsized under the banner of reengineering. Further, reengineering has not always
lived up to its expectations. The main reasons seem to be that:

• Reengineering assumes that the factor that limits an organization's performance is

the ineffectiveness of its processes (which may or may not be true) and offers no
means of validating that assumption.
• Reengineering assumes the need to start the process of performance improvement
with a "clean slate," i.e. totally disregard the status quo.
• According to Eliyahu M. Goldratt (and his Theory of Constraints) reengineering
does not provide an effective way to focus improvement efforts on the
organization's constraint.

Other criticism brought forward against the BPR concept include

• It never changed management thinking, actually the largest causes of failure in an

organization
• lack of management support for the initiative and thus poor acceptance in the
organization.
• exaggerated expectations regarding the potential benefits from a BPR initiative
and consequently failure to achieve the expected results.
• underestimation of the resistance to change within the organization.
• implementation of generic so-called best-practice processes that do not fit specific
company needs.
• overtrust in technology solutions.
• performing BPR as a one-off project with limited strategy alignment and long-
term perspective.
• poor project management.
56
Management control system

A management control systems (MCS) is a system which gathers and uses information
to evaluate the performance of different organizational resources like human, physical,
financial and also the organization as a whole considering the organizational strategies.
Finally, MCS influences the behavior of organizational resources to implement
organizational strategies. MCS might be formal or informal. The term ‘management
control’ was given of its current connotations by Robert N. Anthony (Otley, 1994).

Robert N. Anthony (2007) defined Management Control is the process by which

managers influence other members of the organization to implement the organization’s
strategies. Management control systems are tools to aid management for steering an
organization toward its strategic objectives. Management controls are only one of the
tools which managers use in implementing desired strategies. However strategies get
implemented through management controls, organizational structure, human resources
management and culture. Anthony & Young (1999) showed management control system
as a black box. The term black box is used to describe an operation whose exact nature
cannot be observed. MCS involves the behavior of managers and these behaviors cannot
be expressed by equations. Anthony & Young (1999) showed that management
accounting has three major subdivisions: full cost accounting, differential accounting and
management control or responsibility accounting.

According to Horngren et al. (2005), management control system is an integrated

technique for collecting and using information to motivate employee behavior and to
evaluate performance. According to Simons (1995), Management Control Systems are
the formal, information-based routines and procedures managers use to maintain or alter
patterns in organizational activities.

Chenhall (2003) mentioned that the terms management accounting (MA), management
accounting systems (MAS), management control systems (MCS), and organizational
controls (OC) are sometimes used interchangeably. In this case, MA refers to a collection
of practices such as budgeting or product costing. But MAS refers to the systematic use
of MA to achieve some goal and MCS is a broader term that encompasses MAS and also
includes other controls such as personal or clan controls. Finally OC is sometimes used to
refer to controls built into activities and processes such as statistical quality control, just-
in-time management.

According to Maciariello et al. (1994), management control is concerned with

coordination, resource allocation, motivation, and performance measurement. The
practice of management control and the design of management control systems draws
upon a number of academic disciplines. Management control involves extensive
measurement and it is therefore related to and requires contributions from accounting
especially management accounting. Second, it involves resource allocation decisions and
is therefore related to and requires contribution from economics especially managerial
economics. Third, it involves communication, and motivation which means it is related to
and must draw contributions from social psychology especially organizational behavior
(see Exhibit#1).

57
Management control as an interdisciplinary subject

58