An Introduction to Strategic Cost Management PDF

mcq CHAPTER 12 AN INTRODUCTION TO STRATEGIC COST MANAGEMENT LEARNING OUTCOMES After studying this chapter, you will be able to: ❑ UNDERSTAND the need of strategic cost management and...

mcq CHAPTER 12 AN INTRODUCTION TO STRATEGIC COST MANAGEMENT LEARNING OUTCOMES After studying this chapter, you will be able to: ❑ UNDERSTAND the need of strategic cost management and ANALYSE its distinction from traditional cost management. ❑ UNDERSTAND the source of Gaining Competitive Advantage, apart from APPLYING Value Proposition Canvas and Osterwalder's Business Model Canvas. ❑ ANALYSE the external environment to EVALUATE the Industry Profitability & UNDERSTANDING Customers and Markets, Basis of Competition, and Key Success Factors. ❑ EVALUATE the role of Information Technology in strategy making with specific application in case of the Porter’s Five Forces and the Value Chain. ❑ EVALUATE the role of Management Accountant as a Leader and UNDERSTANDING the Communication, Decision Making, and Business Ethics aspect of Management Accountant role. © The Institute of Chartered Accountants of India  1.2 STRATEGIC COST & PERFORMANCE MANAGEMENT Chapter Overview This chapter will start by highlighting the limitations of traditional cost management and showcasing how Strategic Cost Management aligns costs with the business strategy while measuring and managing costs. This chapter will provide an overview of the organizational and ex ternal environment context of Strategic Cost Management, followed by a discussion of the role of information technology and information systems in the strategic context, as well as shed light on the role of the management accountant as a leader. A. MANAGING COST STRATEGICALLY Let’s start by acknowledging the fact that ‘anything which can be measure, can also be controlled and managed1’. Therefore, earlier cost control and now cost management are applied realities for optimisation as an extension of cost accounting. 1 V. F. Ridgway published a paper in 1956 criticizing the measurement mantra. Simon Caulkin, a columnist, neatly summarized Ridgway’s argument as: “What gets measured gets managed — even when it’s pointless to measure and manage it, and even if it harms the purpose of the organisation to do so”. © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.3 Here students are advised to take note that cost accounting deals with only the ascertaining and recording of costs, not the control or management thereof; it is management accounting that empowers the management of organisations with an information and support system to make efforts and attempts to control and manage the costs. The emphasis was only on cost containment under cost control (maintaining the status quo), but with the changing business environment wherein every organization is witnessing cut -through competition, the emphasis has been shifted (better to say widening) from cost containment to cost reduction. Cost reduction is an emotive term; hence, it shall be better represented through the term ‘cost management’. Traditionally, cost management focused only on cutting or reducing cost, whereas the focus is now widening and aiming for either reducing cost while maintaining the same quality level (value) or increasing value at the same or reduced cost level. In a contemporary set-up, Cost Management is much more than just cost reduction; it has gained strategic importance in aligning the cost to business strategies. Strategic Cost Cost Cost Control - Traditional Cost Management - Ascertainemnt - Containment of Management - Alligning costs to Recoding of Cost Cost Cost Reduction strategies Figure A.1 – Evolution of cost concepts over time horizon When techniques of cost management are practiced as strategic driver in context of organisational objectives and vision, this is termed as Strategic Cost Management. In other words, strategic cost management deals with measuring and managing costs and aligning them to the business strategy. Prior to discussing the underpinning aspects of Strategic Cost Management and highlighting its differences from traditional cost management, let us consider the limitations of traditional cost management, which warrant the evolution of Strategic Cost Management. 1. Traditional Cost Management & Its Limitations Traditional Cost Management aims at cost reduction. It revolved around the central theme ‘that cost cutting always results in enhanced profits’. But a question arises here: Does the theme of traditional cost management always hold truth? The simplest answer to this question is no, not in every case. © The Institute of Chartered Accountants of India  1.4 STRATEGIC COST & PERFORMANCE MANAGEMENT Let’s consolidate the above answer by considering the following illustrations – ▪ Reducing cost by not performing preventive maintenance as and when it bec omes due as per the maintenance schedule may lead to major breakdown and therefore results in high corrective maintenance cost and lower profitability. ▪ In order to reduce cost, if any automobile business decides to close some of the service stations, it may end up losing customers due to poor after-sale services, which in turn leads to a reduction in the top line (i.e., revenue) as well as the bottom line (i.e., profit). Practical Insight (In continuation to above illustration) In the automotive sector, service stations or dealers’ network act as a touch point to engage the customer and hence carry strategic importance. Vehicle owners in India place a great level of importance on proactive service advisor-led interaction during their service experience, according to the J.D. Power 2022 India Customer Service Index (CSI) Study released on Nov ember 24th, 2022. Do You Know? According to industry leaders, service (after-sale services) is key in the automotive industry and effectively makes a difference in the car buying decision too. Therefore, most automobile companies in India are striving for expanding their dealers’ network which helps them showcase their presence in the market and act as positive decision stimuli for buyers of the class. The above illustration in the context of stated industry insight highlights the limitations of traditional cost management in considering customer value proposition, aspects of the market, the basis of competition, quality, and many more. The major limitations of traditional cost management are listed below – ▪ Traditional cost management ignores competition, market growth, and customer requirements, because it is largely concerned with the quantitative factors inside the organisation. ▪ Traditional cost management places excessive focus on cost reduction. It ignores the strategic importance of individual cases. Broad cost reduction leads to inferior quality. ▪ Traditional cost management ignores the dynamics of marketing and economics because it relies on financial accounting data that is static and historical in nature. ▪ Traditional cost management has a limited focus on review and investigation, only of those variances and deviations that are quantitative in nature. ▪ Traditional cost management is a reactive approach. It can be seen as a corrective function rather than a preventive one. ▪ Traditional cost management has a short-term outlook and may focus on the upcoming year, quarter, or even month. © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.5 The above specified limitations of traditional cost management, in themselves emphasise on the need for Strategic Cost Management. The need for strategic cost management also observed due to– ▪ The requirement for detailed cost analysis is essential to gain an in-depth understanding of cost structure. ▪ Strategic use of cost data to gain and sustain a competitive advantage. ▪ To assimilate cost management into strategy and vice versa. ▪ To comprehend the big picture (a canvas that can showcase the business model), to have a holistic analysis of cost relations among the different activities and empower the management in managing those relations. Cooper and Slagmulder2 rightly suggested ‘it is not sufficient to simply reduce costs; instead, costs must be managed strategically’.  Note: Students are advised to read the need for strategic cost management in reference to the second chapter, i.e., Modern Business Environment. 2. Strategic Cost Management (SCM) Strategic cost management is the implementation of cost management techniques to sustain and improve the organisation’s strategic position as well as reduce costs. It also deals with the collection, processing, analysis and dissemination of cost data with a view to feed information to the system for decision-making to support the organizational strategy as a whole. Hence, Strategic Cost Management is the use of cost information in developing and deploying the strategy to practice superior performance that leads to sustainable competitive advantage. Strategic Cost Management can be applied in service and manufacturing settings , as well as in not- for-profit environments. Strategic Cost Management deals with the assimilation of both quantitative and qualitative information in decision making. Strategic Cost Management is the application of cost management techniques so that they simultaneously improve the strategic position of a firm and reduce costs. 2.1 Underneath Pillars of Strategic Cost Management Strategic cost management has three important pillars: strategic positioning, cost driver analysis, and value chain analysis. 2Cooper, R., & Slagmulder, R. R. A. (1998). Strategic cost management - What is strategic cost management? Management Accounting, January, 14-16. © The Institute of Chartered Accountants of India  1.6 STRATEGIC COST & PERFORMANCE MANAGEMENT Value Strategic Chain Positioning Analysis Analysis Cost Driver Analysis Strategic Cost Management Figure A.2 - Pillars of Strategic Cost Management Strategic Cost Management is the managerial use of cost information explicitly directed at one or more of the four stages (strategy formulation, communicating the strategy, implementing the strategy, and controlling) of strategic management. Overall recognition of the cost relationships among the activities in the value chain and the process of managing those cost relationships to attain the firm's strategic objectives are the main focal points of Strategic Cost Management. The relationship among pillars can be viewed as ‘understanding the value chain will help in defining the optimal strategic position (positioning strategy), and eventually both will help in identifying relevant cost drivers’. 2.1.1 Value Chain Analysis Michael E. Porter3 in 1985 advocated using value chain analysis to gain a competitive advantage. The Value Chain is the sequential chain of activities that leads to the delivery of the final product to the customer; it also depicts how value (utility) accumulates for the customer.  Note – The use cases of the Value Chain as a model, discussed in detail under heading 2 in the chapter, An Introduction to Strategic Performance Management. 3 Michael E Porter in year 1985 in his book Competitive Advantage: Creating and Sustaining Superior Performance , introduced generic value chain. This book answered the questions he posed; things remain undone in his earlier book, ‘Competitive Strategy - Techniques for Analysing Industries and Competitors’, written in 1980. © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.7 Figure A.3 – The Generic Value Chain 4 The Value chain comprises the activities in two sets, the first being primary activities (vertical), which are directly involved in the transformation of a product or provisioning of a service, whereas the second set is support activities (horizontal), which ensure support to perform primary activities. Margin is the excess of the value that a customer is willing to pay over the cost incurred by the firm for the product. Primary Activities comprising of: I. Inbound logistics cover receiving, storing, and handling raw material inputs. Mind it, inbound logistics don’t cover the purchase or procurement. Inbound logistics are deeply impacted by the location of business operations. Illustration – Most Indian sugar mills are operating in the states of UP, Maharasthra, and Karnataka to generate value through low cost on inbound logistics because these states collectively account for nearly 80% of sugarcane production in India, UP leading the chart with more than 46% of total production 5. II. Operations include the transformation of raw materials into finished goods and services; operations must be seen in depth; it may or may not be possible for an organisation to be master of all the activities that are required to render the service or to convert raw material into finished goods; the organisation may take the decision to outsource those activities which are not its core competences. Illustration – Apple only designs and sells the iPhone; it doesn't manufacture its components. Outsourcing manufacturing to locations with lower resource costs is the main source of value for Apple operations 6. 4 Figure 2-2 at p.37 of Competitive Advantage: Creating and Sustaining Superior Performance (1985) by Michael E Porter 5 Para 2.8 on page 21 of the NITI Aayog report titled “Report of the Task Force on Sugarcane and Sugar Industry”, https://niti.gov.in/sites/default/files/2020-08/SugarReport.pdf) 6 https://www.cnbc.com/2018/12/13/inside-apple-iphone-where-parts-and-materials-come-from.html © The Institute of Chartered Accountants of India  1.8 STRATEGIC COST & PERFORMANCE MANAGEMENT III. Outbound logistics covers storing, distributing, and delivering finished goods to customers. This includes how, when, and where for customer reference. Where to deliver, how to deliver, and when to deliver. Illustration – Many e-retail platforms, such as Amazon, Flipkart, etc., offer delivery at a shipping address that may be different than the billing address; they also offer contactless delivery, and the buyer is free to select the time frame within which delivery shall be attempted. Practical Insight The selection of place of business operation is critical to generate value from both inbound and outbound logistics apart from core operation activities as well. Tata Steels, a Tata Sons group company that is headquartered in Mumbai, had its early operations in Jamshedpur and is still working there. Have you ever thought why J. Tata, in 1908 selected Jamshedpur for Tata Steel? It was close to the iron ore, coal, and manganese deposits as well as to Kolkata, which provided a large market. Therefore, location became the source of value for Tata Steels in both inbound and outbound logistics apart from making operations easy7. IV. Marketing and sales activities comprise conducting market research to determine the marketing mix8 that comprises product, price, place, and promotion. McCarthy’s concept was further developed by Booms and Bitner9 into the 7Ps of the marketing mix by adding three more Ps, i.e. People, Process, and Physical evidence (sometime referred to positioning). The newly added 3Ps have a relatively grater bearing on the provisioning and supply of services than goods. The marketing and selling activities broadly comprise the aspects pertaining to these 7Ps. It is worth noting that if we keep the customer at the focal point then 4Ps can be replaced by the 4Cs, which are consumer wants and needs (for products); Cost to satisfy (for price); convenience to buy (for place); and communication (for people). Illustration – A fast-food restaurant chain (with presence in the western part of the globe), decided to enter the Indian market; for that, it had to drastically modify its marketing mix for Indian operations (to be the best fit in the Indian context). Considering this, rather than chicken patties, aloo tikkis were used, prices were kept low, intensive promotional activities and campaigns were lunched, and most of their franchises in India offer sitting arrangements as well. Practical Insight Marketing and sales effort are truly of significant importance to let the customer, perceive value of the product. Brands often use taglines that create impact. A Noodles brand may choose any of the following taglines or keep changing its tagline from time to time – - 2 mins noodles … to focus on convenience. - Taste Bhi Health Bhi … to emphasis at health. - 2-minute mein Khushiyan (Happiness in 2 minutes) … to collaborate on fun and happiness. 7 https://www.tatasteel.com/corporate/our-organisation/heritage/ 8 By E. Jerome McCarthy in 1960 in his book Basic Marketing 9 Booms, B. & Bitner, M. J. (1981). Marketing Strategies and Organizational Structures for Service Firms. Marketing of Services, James H. Donnelly and William R. George, eds. Chicago: American Marketing Association, 47 -51 © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.9 V. After sales service includes all those activities that occur after the point of sale, such as installation, training, and repair. It is important to note that the importance of after sale services is higher in the case of durable products in comparison to products falling into the FMCG category. In the service industry after sale service depends on the nature of the service. Illustration – Service station network, time taken to service the vehicle, and quality of service (coverage of what is asked for to check or repair and manner to do so) are key aspects for creating value for its customers in the automobile industry. Even service costs become part of cost ownership and shall be a deciding factor for making purchases in the automobile sector. Support activities also referred as to secondary activities; it comprises of: I. Firm infrastructure deals with how the firm is organised. It basically describes the activities pertaining to legal, general management, administrative, accounting, finance, public relations , and quality assurance in the organisation apart from who will perform these and how. II. Technology development describes how the firm uses technology. Activities such as research and development, IT management, and cybersecurity that build and maintain an organization's use of technology. III. Human resource management describes how people contribute to competitive advantage. Basically, it deals with the management of human capital. Human resource functions such as hiring, training, building and maintaining an organizational culture, and maintaining positive employee relationships. IV. Procurement signifies purchasing, but not just limited to materials. Finding new external vendors, maintaining vendor relationships, negotiating prices, and other activities related to bringing in the necessary materials and resources used to build a product or service. Typically, increasing the performance of one of the four secondary activities can benefit at least one of the primary activities. Value Chain Analysis is a process of identifying Key Value Drivers (can be referred to as equivalent to CSFs) that add substantial value and contribute most towards a firm’s competitive advantage by categorising the activities into value-added and non-value-added activities, with the objective of eliminating non-value-added activities to obtain cost leadership and focusing (by further resource deployment) on value-added activities to improve product differentiation. Hence, Value Chain Analysis is a means of evaluating each of the activities in a firm’s value chain to understand where opportunities for improvement lie. Conducting a value chain analysis prompts you to consider how each step adds or subtracts value from your final product or service. Value chain analysis can help you realise some form of competitive advantage, such as cost reduction (becoming cost leader) and product differentiation. © The Institute of Chartered Accountants of India  1.10 STRATEGIC COST & PERFORMANCE MANAGEMENT Value Chain Analysis requires a framework (strategic framework), which can collect a variety of information strategically. Three essential analyses to collect such strategic information are– ❑ Industry Structure Analysis – to determine industry profitability and the basis of competition. ❑ Core Competencies Analysis – to determine whether organisation possess the desired key success factors. ❑ Segmentation Analysis – to understand customers and markets.  Note - How to conduct a value chain analysis, the strategic framework thereof and strategies of cost leadership and differentiation, as well as how to attain them, are discussed in detail in upcoming sections of this chapter. Figure A.4 – The Value Shop Model 10 10 https://www.researchgate.net/figure/Diagram-of-a-Value-Shop-Stabel-Fjeldstad-1998_fig2_44709027) © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.11 Concept Insight Value Shop Model (or Service Value Chain) can resolve the customer’s hardship for service providers (Figure A.4). Value Shop Model (VSM) conceptualised by Mr. James D. Thompson in 1967. It was named and defined by Mr. Charles B. Stabell & Mr. Oystein D. Fjeldstad in 1998. Value Shop Model is oriented to mobilises resources (man, machine, money, and knowledge) to solve the problem by service sector firms. This is similar to the value chain, but with differences in two aspects– ▪ Rather than focusing on creating value, value shop model focuses on solving problems. ▪ Primary activities are described as Problem Finding and Acquisition, Problem Solving, Choice, Execution, Control, and Evaluation. Note- There is no fixed sequence for these activities or resources. Each problem is treated uniquely, and activities and resources are allocated specifically to cater to the problem. These activities are cyclic in nature, and the cycle will run until a solution reached. Some of the classical examples of value shops include management consultancies such as Boston Consulting Group, Deloitte, and McKinsey. The model can be applied to the BFSI sector, apart from applications in the case of value-based consumption services such as telecom services, services by internet service providers, subscriptions to some software or data processing solutions, etc. Value is created in the shop by several mechanisms that allow the organization to solve problems better or faster than the client. These are variables such as: ▪ The organization is in possession of more information about the problem than the client. ▪ The organization is specialized to deal with the problem at hand with specific methods of analysis. ▪ Strong expertise from expert professionals is available. To cut a long story short, for a professional services firm, an alternate representative of a value chain is the value shop, which is essentially a problem resolution model. The primary activities are problem finding and acquisition, problem solving, choosing among solutions, execution, control, and evaluation. Hence, the value shop principle is not concerned with value addition; instead, it deals with the resolution of customer’s hardships. 2.1.2 Strategic Position and Strategic Positioning Analysis Understanding the strategic position is concerned with the impact of the external environment, internal resources and competences, and the expectations and influence of stakeholders on strategy.11 Together, a consideration of the environment, strategic capability, expectations , and purposes within the cultural and political framework of the organisation provides a basis for understanding the strategic position of an organisation. 11Johnson, G., Scholes, K., Whittington, G. (2008), Exploring Corporate Strategy, 8th Edition: Financial Times Prentice Hall (p. 13) © The Institute of Chartered Accountants of India  1.12 STRATEGIC COST & PERFORMANCE MANAGEMENT Strategic Positioning Analysis is the analysis of the company's relative position within that strategic segment of industry that matters for the purpose of establishing performance targets (while attaining competitive advantage) in addition to determining the means (strategies and plans) of attaining the same and then the measurement of performance as well as the evaluation thereof. Basically, the intent seen in where the firm is positioned in context to its true peer group (which can be referred to competitor) or how it is performing in comparison to others who are operating in the same segment. To illustrate, Tata Motors’ performance or standing shall be analysed in the context of Maruti, Toyota, Honda, and Hyundai, which offer the same products in the same price range with similar features. Strategic positioning reflects choices a company makes about the kind of value it will create and how that value will be created differently than rivals. Strategic positioning should translate into either one of two things: a premium price (i.e., differentiation) or a lower cost (i.e., cost leadership) Note- Driving up prices is one way to increase profitability. To command a premium price, a company must deliver distinctive value to customers…. differentiation. Driving down costs is another way to increase profitability. To compete on cost, companies must balance price with acceptable quality…. cost leadership. Strategic positioning analysis includes the study of III. Task IV. Environment in Environemnt in context of I. Culture, beliefs, II. Stakeholders’ context of competitors, and assumptions influence and capability i.e., markets, of the organisation expectations resources, core regulations, etc. competences Mission and Strengths and Opportunities and Vision and Values Weaknesses Threats Objectives Figure A.5 – Scope of Strategic Positioning analysis I. Culture, beliefs, and assumptions of the organisation help in appraising the vision and values. Vision is aspiration statement, while values are the guiding principle that will be observed to attain such an aspiration (vision). Culture is the beliefs, values, mindsets, and practices of a specific group of people. It includes behaviour patterns and norms. © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.13 Illustration - Google's vision statement is “to provide access to the world's information in one click12”. The nature of company's business is a direct manifestation of this vision statement. For instance, Google's most popular product is its search engine service. Further, as part of their value system, Google is committed to significantly improving the lives of as many people as possible. Concept Insight Denison Organizational Culture Survey (DOCS) 13- Culture has a strong bearing on Shareholders ROI, Customer Satisfaction, and Business Growth Denison Organizational Culture Survey (DOCS; a 50-question employee survey) used the Denison Organizational Culture Model, to measure the specific aspects of an organization's culture based on four core critical cultural trait areas: Adaptability, Mission, Involvement, and Consistency. The survey breaks these four areas down into 3 further sub-categories each, giving a total of 12 areas of cultural assessment. Denison has found an important link between four critical cultural traits and how they can have a significant impact on organizational performance. Culture and Shareholders’ Return on Equity A Study of 161 publicly traded companies from a broad range of industries was conducted to compare the performance of the 10% of organizations with the best culture scores with the 10% of organization with the worst culture scores. The average ROE for the organizations with the lowest culture scores is 6%, and the average ROE for organizations with high culture scores is 21%. Highly similar results for return on total investment. Culture and Customer Satisfaction Correlations with customer satisfaction were significant for all twelve indices. Average 24 percentile point difference between the top and bottom five performers of a large Fortune 500 construction company in all 12 indices. Culture and Business Growth A Study of retail supermarkets in the USA was conducted, comprising 12,000 individuals and 2,500 stores to compare culture profiles with growth rates. 1,305 stores with weak culture records over 5% of sales declined, whereas 424 stores with strong culture records above 5% of sales increased. II. Stakeholders’ influences and expectations shall be considered in order to determine what the shareholders want and how much they will cooperate. So that the same can be reflected in the mission statement and objectives of the organisation. It also needs to be seen whether we are able to meet their expectations or not while appraising strategic position. Different stakeholder groups have their own set of forces and tactics that have a strong bearing on organisations mission and objectives and, in turn, on its strategic position. Illustration – Google’s key stakeholders are its users, and they will continue using google more and more if it is convenient to use, freely accessible, and user friendly. This is reflected in Google’s mission statement. Google's mission is to organize the world's information and make it universally accessible and useful 14. That's why search makes it easy to discover a broad range of information from a wide variety of sources. 12 https://www.comparably.com/companies/google/mission 13 https://www.denisonconsulting.com/culture-surveys/ 14 https://about.google/intl/ALL_in/ © The Institute of Chartered Accountants of India  1.14 STRATEGIC COST & PERFORMANCE MANAGEMENT Do You Know? Do we need to consider all the stakeholders or only those who are significant enough? If only those limited chunk of stakeholders exist, then how do we identify them? Mendelow’s Matrix helps in considering the attitude of stakeholders while setting out strategic objectives. Mendelow’s Matrix consists of four boxes representing stakeholders with: High Interest and High Power – These will be considered key stakeholders, and a business will need to actively engage this group. This group is likely to have a significant influence; they may be the driver behind the change or strategy. They will likely have the power to stop the change or strategy from going ahead if they are unhappy. This is the group that requires most focus. Keep them both updated on any strategic changes and empowered to steer the direction of change (or at least feel that they have the opportunity to input into the direction of the project). High Interest and Low Power – This group has an interest in what is happening; however, they are unlikely to have the power to influence change. This group should be kept informed. While, they have little power themselves, they could attempt to join forces with a group with power. Low Interest and High Power – This group of stakeholders has the potential to move into the ‘High Interest and High Power’ group, so it is essential that they are kept satisfied. By keeping them satisfied, they are less likely to gain interest and exercise their power of influence. Low Interest and Low Power – This group is unlikely to have an interest in the organization and its strategic direction. This is often due to their lack of power to influence a situation. They are likely to accept the position and show little, if any, resistance. Figure A.6 – Mendelow’s Matrix and Response to each class of stakeholders 15 15Mendelow, A. L. (1991), ‘Environmental Scanning: The Impact of the Stakeholder Concept’. Proceedings from the Second International Conference on Information Systems, 407-418, Cambridge, MA © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.15 III. Strategic capabilities in terms of resources and core competences shall be analysed in the context of the task environment (which may be referred to as the microenvironment) in which organisation is operating to assess the strengths and weaknesses to appraise the strategic position. Strengths shall be used aggressively to exploit opportunities to capture competitive advantage , whereas weaknesses need to be analysed at the root-cause level, and those causes shall either be removed or reduced (if they can’t be reduced). Practical Insight If we have to appraise the position of any automobile company in the context of the automobile industry by identifying its strengths and weaknesses, then we have to consider factors (which may be positive or negative; if positive, then it becomes a strength, and if negative, then it becomes a weakness) like – ▪ Brand image and STP (segmentation, targeting, and positioning). ▪ Market value. ▪ Distribution system. ▪ Market penetration, product and market development, and diversification. ▪ Research and development. ▪ International presence. ▪ Pattern of production and operational costs and the rate of profits. Note – Above factors are only illustrative, and the importance of these factors depends upon the influence that it may create. IV. The macro environment (beyond the control of organisation), especially the basis of competition, industry profitability, industry key success factors, customers’ behaviour, markets and regulations, etc., shall be analysed to assess Opportunities and Threats to appraise the strategic position. Opportunities need to be exploited, whereas a defence mechanism shall be created against threats that can be mitigated. Risk management is of key importance to protect the organisation from threats to sustain its strategic position and make the most of opportunities. This will improve its strategic position, apart from ensuring it realizes the benefits of competitive advantages. © The Institute of Chartered Accountants of India  1.16 STRATEGIC COST & PERFORMANCE MANAGEMENT Practical Insight In line with previous practical insight to identify opportunities and threats to exploit the earlier and residual the later for any automobile company, the relevant facts may include − ▪ Capabilities in direct and digital marketing. ▪ Relationship with channel partners. ▪ Supply chain integrations and after sale services (cost and availability). ▪ Demand for low cost or innovative products. ▪ Acquisition, merger, or joint venturing to register un-organic growth. ▪ Competitors who are aggressive and striking hard to capture market share. ▪ Stagnation in the economy or industry. ▪ Price war and innovation war among the players. Note – Above points are illustrative only. Mind it, tapped opportunities turned into strengths over time, while unattended or mishandled threats led to weakness. Do You Know? What tools are handy for conducting strategic position analysis? SWOT analysis is the focal tool for Strategic Position Analysis supported by PESTEL Analysis (specifically relied on for the analysis of remote environmental factors), Porter’s Five Forces (for industry analysis), Porter’s Diamond Studies, etc. for external environment analysis. Porter's Value Chain, Critical Success Factors and Core Competencies, Product Lifecycle, McKinsey 7S, etc. for internal environment analysis. Note - Lists of tools/ models stated above are illustrative only, not exhaustive. 2.1.3 Cost Driver Analysis Cost driver is the unit of that activity that causes costs to be incurred. Hence, cost driver is trigger of change in cost, meaning thereby more frequency/ runs of cost driver led to more cost. © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.17 Cost Driver Analysis includes the examination, quantification, and explanation of the monetary effects of cost drivers associated with an activity. It is an in-depth review of the cost drivers to make sure that your firm correctly allocates the supporting production and service costs to all goods and services. There are different cost driver analysis methods, including a cost accounting system review, industry analysis, and internal activity analysis. In traditional costing, the cost driver used to allocate overhead costs (supporting cost) to cost objects only relates to the quantity/ volume of output. But under Strategic Cost Management cost driver for short-term overhead costs (that occur once in a while) may be the volume of output or activity. But for long-term overhead costs, a variety of cost drivers are used. Based upon the nature of supporting cost (overhead cost), appropriate drivers can be identified and categorised into the following classes– Supporting Cost Resource Drivers Activities Drivers Organisational Activities & Drivers Operational Activities & Drivers Structural Activities & Drivers Executional Activities & Drivers Figure A.7 – Classification of cost drivers Structural cost drivers relate to business strategic choices about an organization’s underlying economic structure, such as scale and scope of operations, use of technology , and complexity of products (it is not necessary that more is better). Executional cost drivers relate to the execution of the business activities, such as the utilization of employees in terms of involvement, the provision of quality service, product design and manufacturing, and links with suppliers and clients (higher is the better).  Note - Students are advised to refer Annexure 1 at the end of the chapter for a detailed overview of the types of cost drivers. 2.2 Key tools of Strategic Cost Management and their nature Following are the key tools of strategic cost management; their nature is briefly described here to highlight how they help in aligning costs with business strategies – © The Institute of Chartered Accountants of India  1.18 STRATEGIC COST & PERFORMANCE MANAGEMENT Tool Description Activity Based Costing To provide accuracy in allocating indirect costs. Benchmarking Process performed to determine critical success factors and study the ideal procedures of other organizations in order to improve operations and dominate the market. Competitive Advantage Defining strategies that an organization could adopt to excel over Analysis rivals. Just-in-Time A comprehensive system to buy materials (JIT Purchase) or produce commodities (JIT Production) when needed at the appropriate time. Kaizen - Continuous Conducting continuous improvements in quality and other critical Improvement success factors. Target Costing Cost that an organization is willing to incur according to a competitive price that could be used to achieve the desired profit. Theory of Constraints A tool to improve the rate of transferring material into finished goods. Total Quality Adapt the necessary policies and procedures to meet customers’ Management expectations. Value Chain Analysis Add value to customers, reducing costs and understanding relationship between business organization and customers.  Note - List of tools specified above is only illustrative, not exhaustive. 3. Traditional vs. Strategic Cost Management Based upon discussion conducted in the previous headings, Traditional Cost Management & its Limitations and Strategic Cost Management, the following key differences between Traditional and Strategic Cost Management can be considered– Basis of Difference Traditional Cost Management Strategic Cost Management Allocation of cost Volume (per unit produced). Allocation will be w.r.t. relevant cost driver – Activity Based Costing. Nature Reactive (risk averse) approach. Proactive and dynamic approach. Objective Cost control and reduction. Product differentiation (apart from cost containment). Risk Appetite Risk-averse approach. Risk taking approach and ability to adapt itself to changing environment. Scope Internal business environment. Both internal and external. Term Short term focus. Long span or perpetual focus. © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.19 B. ORGANISATIONAL CONTEXT Strategic Cost Management is the analysis of cost in a broader context (Organisational as well as External Environment Context), where the strategic elements become more conscious, explicit, and formal. The cost data is used to develop superior strategies in route to gaining a sustainable competitive advantage. Strategic Cost Management gives a clear understanding of the firm's cost structure in search of sustainable competitive advantage through cost reduction or differentiation. 1. Gaining Competitive Advantage A Competitive advantage is the ability of an organisation to outperform its competitors and make more profits than its competitors do from an equivalent set of activities through superior performance. Gaining and maintaining a competitive advantage over a period of time is challenging for organisations in the global economy with the speed of competition and information exchange possible today. The role of the strategist (including the management accountant as a cost engineer) is to engineer superior performance within a given industry in which organisation is operating. A genuine question arises here – 1.1 How can a strategist increase profitability? The answer lies in having a competitive advantage. Companies must search out “white space” in the industry, which usually means competing on either one of two fronts– Differentiation Cost Leadership Figure B.1 – Generic strategies to attain competitive advantage (to enhance profitability) Do You Know? It’s possible to compete at a low cost and be differentiated at the same time, but companies that try to be all things to all customers can wind up getting stuck in the middle, a strategic mistake that Michael Porter calls “the kiss of death”. © The Institute of Chartered Accountants of India  1.20 STRATEGIC COST & PERFORMANCE MANAGEMENT 1.1.1 Differentiation Driving up prices is one way to increase profitability. To command a premium price, a company must deliver distinctive value to customers. A customer may perceive the high value of any product and be ready to pay a premium due to the differentiation it offers. E.g., Apple. Product differentiation is achieved by investing more time and resources into activities like research and development, design, or marketing that can help the organisation’s product stand out. ▪ Source - Differentiation can be sourced from quality (design, knowhow or performance), innovation, customer relations/ response (including after sale services), a wide-product range etc. ▪ Benefits - Differentiation helps either earn a huge margin by charging the top price or build market share by charging lesser than premium price. 1.1.2 Cost Leadership Driving down costs is another way to increase profitability. To compete on cost, firm must balance price with acceptable quality and become the lowest cost producer in an industry. A firm can create a cost advantage in two different ways, by reducing the cost of individual value chain activities and by reconfiguring the value chain as shown below in figure B.2 ▪ Source - Cost Leadership can be sourced from cost effective inputs, process innovation or re- engineering, low-cost distribution channel, superior operation management, learning curve, and the economics of scale. ▪ Benefits - By producing at the lowest possible cost, the manufacturer can compete on price with every other producer in the industry and earn the highest unit profits, or by charging a lower price than others, it can capture market share. Reconfiguring the value chain Reducing the cost of individual value chain activities Cost Leadership Figure B.2 – Drivers of Cost Leadership © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.21 1.2 Relation between strategies and cost management Emphasis Strategic emphasis 16 on different aspects under Product Differentiation and Cost Leadership is enumerated below – Strategic Emphasis Aspects Product Cost Leadership Differentiation Role of standard costs in assessing Not very important Very important performance Importance of concepts such as flexible Moderate to low High to very high budgeting for manufacturing cost control Perceived importance of meeting budgets Moderate to low High to very high Importance of marketing cost analysis Critical to success Relatively less important Importance of product cost as an input to Low High pricing decisions Importance of competitor cost analysis Low High The competitive advantage can be sourced from product differentiation or cost leadership, either by reconfiguring the value chain or by reducing the cost of each individual value chain activity; hence, conducting a value chain analysis is essential in both scenarios. So, another question arises here: 1.3 How to conduct a Value Chain Analysis? There are three steps involved in conducting value chain analysis – Identify Value Chain Activities Determine the Cost and Value of Activities Identify Opportunities for Competitive Advantage Figure B.3 - Steps involved in value chain analysis 16Shank (1989), Strategic Cost Management: New Wine or Just New Bottle? Journal of Management Accounting Research (1): 47-65 © The Institute of Chartered Accountants of India  1.22 STRATEGIC COST & PERFORMANCE MANAGEMENT 1.3.1 Identify Value Chain Activities The first step in conducting a value chain analysis is to understand all of the primary and secondary activities that go into your product or service creation. If your company sells multiple products or services, it’s important to perform this process for each one. 1.3.2 Determine the Cost and Value of Activities Once the primary and secondary activities have been identified, the next step is to determine the value that each activity adds to the process, along with the costs involved. When thinking about the value created by activities, an organisation needs to ask itself following questions – ▪ How does each activity increase the end user’s satisfaction? ▪ How does it create value for the firm? To be more specific, the organisations need to answer – ▪ Does constructing the product out of certain materials make it more durable or luxurious for the user? ▪ Does including a certain feature make it more likely your firm will benefit from network effects and increased business? Similarly, it’s important to understand the costs associated with each step in the process. Depending on the situation, lowering expenses may be an easy way to improve the value each transaction provides. 1.3.3 Assessing and Identify Opportunities for Competitive Advantage Value Chain analysis can help in identifying points where differentiation can be created or cost leadership can be gained, meaning thereby value chain approach can be used to assess the competitive advantage (because it is better to focus on the process and activities involved in the creation of the product rather than the product alone). Hence, once you’ve compiled your value chain and understood the cost and value associated with each step, you can analyse it through the lens of whatever competitive advantage you’re trying to achieve. Assessing Competitive Advantage Internal Differentiation Vertical Linkage Internal Cost Analysis Analysis Analysis Figure B.4 – Analysis for Assessing Competitive Advantage © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.23 Internal Cost Analysis helps in understanding the cost of processes/ activities and identifying the sources of profitability. The steps are as follows – ▪ Identify the firm’s value creating processes. ▪ Determine the portion of the total cost of the product attributed to each value creating process. ▪ Identify the cost driver for each process. ▪ Identify the link between processes. ▪ Evaluate the opportunities for achieving a relative cost advantage. To illustrate If your primary goal is to reduce your firm’s costs, you should evaluate each piece of your value chain through the lens of reducing expenses. ▪ Which steps could be more efficient? ▪ Are there any that don’t create significant value and could be outsourced or eliminated to substantially reduce costs? Internal Differentiation Analysis helps in creating and offering superior differentiation to customers. In order to increase the value perceived by customer, the following steps are to be performed − ▪ Identify the customer’s value creating process. ▪ Evaluate differentiation strategies for enhancing customer value. ▪ Determine the best sustainable differentiation strategies. To illustrate If primary goal is to achieve product differentiation, you should evaluate each piece of your value chain through the lens of– ▪ Which parts of your value chain offer the best opportunity to realize that goal? ▪ Would the value created justify the investment of additional resources? Vertical Linkage Analysis – Creating an extendable organisation by extending the value chain across the firms of suppliers and users. Using value chain analysis, you can uncover several opportunities for your firm, which can prove difficult to prioritize. It’s typically best to begin with improvements that take the least effort but offer the greatest return on investment. © The Institute of Chartered Accountants of India  1.24 STRATEGIC COST & PERFORMANCE MANAGEMENT We already discussed in the previous section of this chapter that Value Chain Analysis (three steps explained above) requires a strategic framework that can collect a variety of strategic information that will be used while performing the above three steps (especially the third one). Three essential analyses to collect such strategic information are – ❑ Industry Structure Analysis – to determine industry profitability and the basis of competition. ❑ Core Competencies Analysis – to determine whether organisation possess the desired key success factors. ❑ Segmentation Analysis – to understand customers and markets.  Note - These three analyses are discussed in detail in an upcoming section of this chapter.  Note - Value Chain as a Model, along with how an organisation uses value chain to gain and sustain competitive advantage (desired performance), is discussed in detail under heading 2 in the Chapter, An Introduction to Strategic Performance Management. For creating a sustainable competitive advantage, in depth analysis of Value Propositions is essential, for which Osterwalder's Business Model Canvas can be helpful. But prior to move on to Osterwalder's Business Model Canvas, it is important to consider what a business model is or what consists of. 2. Business Model A business model explains how a business works and the economic logic behind it. It is a way of representing and communicating how an organisation creates values for itself while delivering products or services to customers. Margretta proposed that a business model should include all the activities associated with two key components – a. Producing or making something. b. Selling something. But in 2008, Johnson along with Christensen & Kaggerman 17 extended the scope and proposed that a business model also needs a value proposition; a business model should contain three components – a. Customer value proposition. b. Profit formula. c. Key resources and processes. Around 5 years later, in May 2013, Alexander Osterwalder further extended the scope and coverage of business model by suggesting the Business Model Canvas, discussed in detail ahead. 17Johnson M, Christensen C, & Kaggerman H, 2008, ‘Reinventing your business model’, Harvard Business Review, December, www.innosight.com/insight/reinventing-your-business-model-form. © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.25 3. Osterwalder’s Business Model Canvas Alexander Osterwalder18 proposed a nine-element business model canvas wherein four elements pertaining to cost (key partners, key activities, key resources, and cost structure; on the left side of the canvas) are connected to another four elements pertaining to revenue (customer relationships, channels, customer segments, and revenue streams; on the right side of the canvas) through the ninth element, which is value proposition, as shown in figure B.5. Key Partners Key Activities Value Customer Customer Proposition Relationship Segments Key Resources Channels Cost Structure Revenue Streams Figure B.5 – Generic Template of Business Model Canvas Business Model Canvas helps the firm to map, discuss, design, and develop robust business models. Business Model Canvas helps users visualize what is important and forces them to address key areas that are relevant from the point of view of strategy as well as performance. a. Customer Segments describe who the customers of a business are and why they buy from it. Segmentation is discussed in detail in the next section of this chapter. b. Value Proposition deals with products or services that business offers to target customer segment in order to solve their problems or satisfy their needs. 18 Osterwalder, (May 2013), ‘A better way to think about your business model’, Harvard Business Review, May, https://hbr.org/2013/05/a-better-way-to-think-about-yo. © The Institute of Chartered Accountants of India  1.26 STRATEGIC COST & PERFORMANCE MANAGEMENT To illustrate– A camera, printer, photocopier, and scanner manufacturer is selling camera by emphasising on the point that it helps the users to capture beautiful moments, while the range of printers, scanners, and photocopiers that it offers help users experience ease in dematerialisation/ materialisation (conversion of physical content/ data into digital forms and reconversion thereof), digitation, and duplication (replica). Hence, value propositions include creating/ capturing memories, keeping and retrieving records. Business’s value proposition shall be oriented to customers’ needs and problems, not its capabilities. In 11th grade your school and teacher taught you bookkeeping, despite the fact that they are capable of teaching analysis of financial statements or even accounting for virtual digital assets, or any other advanced topic on said day. Certain automobile or e-vehicle manufacturers can manufacture cars that have auto-pilot mode; are there enough customers who really want such a car? Cars from certain premium brands have top speed ranging from 340-325 kmph; do drivers/ passengers actually require this, especially in the context of road infrastructure? c. Channels deal with distribution channels using which businesses will deliver the product or render services to their customers. Earlier, there were only physical channels, but now virtual or digital channels such as the web, cellular (mobile), and cloud, etc. have come into existence. To illustrate– Digital products such as anti-virus software and subscriptions to some websites are delivered digitally rather than through physical mode. d. Customer Relationship deal with interactions. It basically answers how we get the customers, keep them, and grow them. Customer Relationship Management came into the play here. To illustrate– some businesses send promotional content (a push mode of communication with customers), other do not (a pull mode of communication with customer). Mobile App based business model using notification as a mean to keep engaging their customer, because engaging customers is important in order to retain them. e. Revenue Streams describe how business actually make money. It depends on what value the customer is paying for. Here, the strategy to capture the value becomes significant; it may be a direct sale, transaction based price (use and pay, i.e., post-paid telephone bill, electricity), freemium, license, or subscription model. To illustrate– Online video sharing and social media platforms earn through advertisement and premium services as they follow a freemium as revenue model. Revenue Models will be discussed in detail in the upcoming chapters of this course. E-newspapers use a subscription model. f. Key Resources describe the most important assets in the business that are nearly indispensable; they can be man, material, machine, method, money, etc. The need is to dig down and identify what is actually driving the business. Key resources are critical in planning, budgeting, and determining the activity level. In the same case, these may be Key factor (or limiting factor). © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.27 g. Key partners include suppliers and channel partners who make the business model work. Here, it is important to consider What resources we acquire from them - are those resources key resources? and What activities they are performing for us as business - are these activities key activities or not? This element also defines the need for strategic alliances and partnerships that a company needs to enter. h. Key activities describe the most important things to do in a business or to keep it running or working. Here, the need is to define whether the business is a manufacturing solution (production), supply chain partner (trader or only a logistic partner) , or a problem solving (service entity). Key activities become the basis for the determination of cost drivers for absorbing the cost of supporting activities. i. Cost includes the expenses to operate the business and perform activities, hosting partners, and owning the resources. Here the active role of the management accountant comes into play in determining the cost structure and evaluating the scope as well as scale of economics. What are the most important costs that require management? What are the most expensive resources that require control? 3.1 How to draw Business Model Canvas By answering the questions written next to each element in figure B.6, a business can draw its business model on a single piece of paper, irrespective of whether it is a mere start-up or a grand old company. 8. Key Partners 6. Key Activities 4. Customer Who are our What uniquely Relationship partners and strategic things How do you interact key suppliers? does the business 2. Value with the customer 1. Customer Which key do to deliver its Proposition throughout their Segment resources are proposition? What’s compelling journey? Who are the we acquiring about the customers? 7. Key 3. Channels from our proposition? Why What do they Resources How are these partners? do customers buy, think? See? What unique use? propositions Feel? Do? Which key strategic assets promoted, sold, and activities do must the business delivered? Why? Is it partners have to compete? working? perform? 9. Cost Structure 5. Revenue Streams What are the business’s major cost drivers? How How does the business earn revenue from the are they linked to revenue? value propositions? Figure B.6 – Questions to answer while drawing a Business Model © The Institute of Chartered Accountants of India  1.28 STRATEGIC COST & PERFORMANCE MANAGEMENT Do You Know? How to use Business Model Canvas? ▪ Element 1, 2, 3, and 4 in figure B.6 are attributed to customers focus (which can be correlated with the value proposition canvas, i.e., heading 4 of the upcoming topic). ▪ Element 6, 7, and 8 in figure B.6 are attributed to infrastructure. ▪ Element 5 and 9 in figure B.6 signify financial viability. 3.2 Industry Insight Figures B.7 and B.8 shows the generic business model of any entity operating as an Online Meeting Platform or a manufacturer & trader of Razor and Blades, respectively. Customer Key Partners Key Activities Relationship Payment Software and app Value Proposition Customer Mass customer base, partners development Free video calling Segment hence casual Telco partners cheaper than a Web users Key Resources globally Distribution phone (cellular) Channels partners Software and Skype.com developers Cost Structure Revenue Streams Software development; Resolving complaints and Prepaid or subscription debugging the technical snags Figure B.7 - Generic Business Model of any Online Meeting Platform Key Activities Value Proposition Customer Marketing and Razor handle and Relationship selling apart from stainless blades Key Partners Lock in (retain) Customer R&D Manufacturer Adjustable, twin Segment Key Resources blade shaving Channels Retailer Mass user base Brand Value razors with Retails store (through Patents and lubricating Aloe stockist and trademark Vera strip wholesaler) Cost Structure R&D Revenue Streams Manufacturing cost Blade replacement for the razor Marketing and selling cost Multiple piece value saver pack Logistics cost Figure B.8 - Generic Business Model of any entity operating as a manufacturer & trader of Razor and Blades © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.29 4. Value Proposition Canvas Value Proposition describes the benefits that customers can expect from a product and the bundle of products and services that business offer to specific customer segment to create value. The value proposition canvas 19 is the tool that will help the organisation to design, test, build, and manage the great customer value propositions. It’s like a plugin for the business model canvas. Figure B.9 – Value Proposition Canvas The tool is based upon two elements of the business model, i.e., the customer segment for whom the business firm intends to create the value and the value proposition (value proposition map) that will attract customers to the business. With a value proposition canvas, a business firm can map out both of these (customer segment and value proposition) with more granularity and show the fit between what it offers and what customers want. 4.1 Customer Segment Profile The customer segment profile describes the characteristics of the business’s customers in more detail. The profile is composed of three elements: first, the jobs (termed as ‘Customer Jobs’) that customers are trying to get done in their service or product; second, the related pains, i.e., aspects outlining the negative aspects that customers hate or like to avoid; and third, the gains, i.e., aspects describing the positive outcomes or benefits that your customers desire to have. 4.1.1 Customer Jobs describes the important issues that business’ customers are trying to solve/ resolve in their work; it could be their needs that they wish to satisfy or a task that they try to perform and complete in their lives (professional and personal) or at work. To illustrate, Matrimonial services, legal advice, a specially designed shoe for an internationally recognised player, construction of the house (safety, look, and comfort can be major concerns), ordering food with specifications, face mask/ PPE Kit to protect from specific viruses etc. 19By Alexander Osterwalder, Yves Pigneur, Gregory Bernarda, Alan Smith in Value Proposition Design - How to Create Products and Services Customers Want (2014) © The Institute of Chartered Accountants of India  1.30 STRATEGIC COST & PERFORMANCE MANAGEMENT Mind it, customers include industrial customers, and jobs can have functional, social, or emotional/ personal intent. Some jobs may be crucial to customers, while others may be trivial. To illustrate, an e-vehicle manufacturer seeking specially designed assembly from its vendor for electronic vehicle, message over the birthday cake ordered, and the seasoning and toppings of pizza you just ordered are crucial aspects. 4.1.2 Pains describes anything that annoys the customer before, during, or after getting a job done. This could be unwanted cost, situation, negative emotion, or even risks. Obviously, some of the customer’s pains will be severe, while others are mild. 4.1.3 Gains describe the outcome or benefits that the customer requires, expects, or desires, as well as a complementary benefit that he doesn’t expect, but will be excited about or surprised by if he gets it. This includes things like functional utilities, social gains, positive emotion , and cost savings. Obviously, some of the benefits will be more relevant to customers than others. These three elements of the profile describe the customer characteristics that you can observe in the market. Concept Insight A clear and concrete description of pains and gains is essential key to offer a better value proposition. To clearly differentiate jobs, pains, and gains, describe them as concretely as possible. For example, when a customer says, “Waiting in line was a waste of time,” ask after how many minutes exactly it began to feel like wasted time. That way, you can note “wasting more than x minutes standing in line.” When you understand how exactly customers measure pain severity, you can design better pain relievers in your value proposition. Ranking jobs, pains, and gains is essential. Although individual customer preferences vary, you need to get a sense of customer priorities. Investigate which jobs the majority consider important or insignificant. Find out which pains they find extreme versus merely moderate. Learn which gains they find essential, and which are simply nice to have. Ranking jobs, pains, and gains is essential in order to design value propositions that address things customers really care about. Of course, it’s difficult to unearth what really matters to customers, but your understanding will improve with every customer interaction and experiment. It doesn’t matter if you start out with a ranking that is based on what you think is important to your potential customers, as long as you strive to test that ranking until it truly reflects priorities from the customer’s perspective. 4.2 Value Proposition Map A value proposition map describes the features of a business’s value proposition that it has designed to address its customers’ jobs (through products and services), pains (through pain relievers); and gains (through gain creators). Hence, a value proposition map is composed of the three elements: firstly, the product and services around which your value proposition is built; secondly, the pain relievers that outlines how the business’s products and services alleviate the customers’ pains; © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.31 thirdly, the gain creators describe the positive outcomes and benefits that business’s products and services create for your customers. 4.2.1 Products and Services outlines the bundle of products and services that the business is offering to its customers to help them get a functional, social, or emotional / personal job done and to address their pains and gains in the process. 4.2.2 Pain Relievers explicates how your products and services will alleviate specific customer pains before, while, and after the customer tries to get the job done. Pain relievers show or highlight which of all the customers’ pains are addressed by the value proposition by either eliminating or reducing them. 4.2.3 Gain Creators describes how products and services offered by business create customer gains. Gain creators show which of all the customers’ gains are addressed by the value proposition by creating benefits and outcomes. Do You Know? Can you list the elements that can contribute to customer value creation (act as either pain reliever or gain creator)? ▪ Newness - Some Value Propositions satisfy an entirely new set of needs that customers previously didn’t perceive because there was no similar offering. Cell phones, for instance, created a whole new industry around mobile telecommunication. ▪ Performance - Improving product or service performance has traditionally been a common way to create value. ▪ Customization - Tailoring products and services to the specific needs of individual customers or customer segments creates value. ▪ Design - A product may stand out because of superior design. Design is a major element in determining the cost. Design not only of the product but also of the process and service through which that product is manufactured and sold. ▪ Brand/status - Customers may find value in the simple act of using and displaying a specific brand. ▪ Price - Offering similar value at a lower price is a common way to satisfy the needs of price - sensitive customer segments. ▪ Cost reduction - Helping customers reduce costs is an important way to create value. ▪ Risk reduction - Customers value reducing the risks they incur when purchasing products or services. ▪ Accessibility - Making products and services available to customers who previously lacked access to them is another way to create value. ▪ Convenience/ usability - Making things more convenient or easier to use can create substantial value. Mind it, the above list is non-exhaustive in nature. © The Institute of Chartered Accountants of India  1.32 STRATEGIC COST & PERFORMANCE MANAGEMENT Business is said to achieve a problem-solution fit when the features of its value proposition map perfectly match the characteristics of customer segment profile. When the market validates this match and the business value proposition gets traction with real customers, the business has achieved the product-market fit. It is worth noting that successful and sustainable businesses have more than just great value propositions; they also have a great business model that makes a great customer value proposition possible. Do You Know? What are the key questions that businesses are supposed to ask while defining its value proposition or working on its value proposition canvas? ▪ What value do we deliver to the customer? ▪ Which one of our customers’ problems are we helping to solve? ▪ Which job are we helping the customer get done? ▪ Which customer needs are we satisfying? ▪ What bundles of products and services are we offering to each customer segment? To conclude, the Value Proposition Canvas has two sides. With the customer profile, business can have a clear understanding of customer character. With the value map, business describes how it intends to create value for that customer. Business achieve Fit between the two when one meets the other. C. EXTERNAL ENVIRONMENT CONTEXT Survival and sustainability are precondition for any business to be successful. The survival of the fittest (fittest to the business environment in which the business operates) is a universal principle; hence, the need for crafting and deploying agile strategies (capable of responding and adapting to the changes that are taking place in and around it) becomes inevitable; therefore, it becomes essential to understand the business environment. Earlier in this chapter, we recognised the need to analyse the business environment for the purpose of developing and implementing the strategy. Here we will consider the requirement in a specific context of the external environment, which has a subset of remote and industry operative environment. External environment, comprising the factors that are beyond the control of organisation (outside organisation boundary) but have influences on the organisation, its performance, and its strategic positions. Prior to starting with external environment analysis, it is essential for business firms to define the industry in which they are operating and set out the dimensions of the remote and industry operative environment. © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.33 An industry is a group of companies that are relatively comparable based on their primary business activities, or it can be seen as a group of organisations or business units participating in similar economic or commercial activities and producing similar products or services. Here, it is important to note that there is no single universally acceptable definition of industry. Further, what industry will consist of depends upon the width and depth of the business firm. To illustrate, when a fast-food retail chain started its operations in the USA, its industry analysis was reserved only up till the customers and fast-food chains (competitors and rivals) operating in the USA. The moment it decides to go beyond borders (continents Asia, Europe, Australia, etc.), the scope of industry has been changed, and now the factors of those continents or countries also become relevant while making decisions or crafting strategies. Hence, any single economic definition of industry can’t be relied on here; business organisations, in light of the competitive market in which they operate need to come up with their own concept of industry. To illustrate, A two-wheeler riding app-based transport company may not consider a four wheeler riding app-based transport company as its competitors; hence, scope of the industry may be restricted to the other two wheeler ride provider only (where power to substitute (perfect substitute) exists), but reciprocally, it may be possible that a four wheeler riding app based transport company also consider a two-wheeler riding app based transport company as its competitor while performing industry analysis. Therefore, the scope of industry (definition with narrow or wide inclusions) is a subjective issue. Narrow scope may make analysis more manageable, but exclusion of relevant substitutes or disruptive influences may make it meaningless, whereas a wide scope of industry can ensure more relevance and utility but will be more resource consuming and complex. Cost benefit analysis came into play here. For further analysis, the external environment is usually broken down into two sub-sets: called the remote environment and the industry operating environment, including the competitive environment. The element of remote environment, such as social, technological, economic, environmental, political, legal, and ethical factors (STEEPLE), comprises factors that originate beyond (and usually irrespective of) any single firm's operating situation. Remote environment presents firms with opportunities, threats, and constraints, but rarely does a single firm exert any meaningful reciprocal influence. By working systematically through each of the elements of the remote environment, business should have a comprehensive list of factors that have shaped the historical growth of the industry and are likely to affect the future growth of the industry. © The Institute of Chartered Accountants of India  1.34 STRATEGIC COST & PERFORMANCE MANAGEMENT Illustration – Due to technological advancement, the cellular phone changed dramatically from a QWERTY keypad-based handset to a smart phone (touch screen phones with better battery backup and function like internet connectively, a camera etc.). A cellular phone manufacturer that was once the market leader and held a substantial percentage of market share failed to respond to the changing technology, hence being replaced by an emerging brand that later occupied the position of market leader. Hence, remote environment is beyond the control of single firm operating in the industry. The same factor (technology in this case) brings threat to one and opportunity to the other. Concept Insight Industry analysis was conventionally performed using the PEST Framework, i.e., Political, Economic, Social, and Technology, but this approach has evolved to reflect the dynamics of the business environment, to PESTEL with the addition of environmental and legal issues, and now to STEEPLE with the addition of ethical aspects. Further, as part of the analysis of the industry’s operating environment (including the competitive environment), it is important to consider all the factors (within the particular industry) that affect industry profitability as well as the competitive position of business organisations within it. These factors can be grouped into elements such as customers, competitors (as well as potential entrants), suppliers, advocacy groups, regulations, regulatory groups, and many other elements such as the industry life cycle, supplier’s suppliers, and buyer’s buyers, etc. Basically, it considers the wider picture through factors that are capable of determining the growth trajectory in addition to future profitability. Hence, further in this section, we will consider the forces that determine the profitability of industry, the basis of competition and key success factors that can help business organisations gain a competitive advantage, apart from understanding how customers and markets behave and related aspects thereto in the context of the external environment. 1. Industry Profitability Michael E. Porter20 suggests five force model to assess the intensity of industry competition. Industry structure (or environment) analysis highlights the profitability potential of any industry using Porter’ five forces model. A higher intensity of competition results in lower potential profitability, and vice versa. The five forces that are enumerated by this model are pictured below – 20 In 1980, in his book Competitive Strategy - Techniques’ for analysing industries and competitors © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.35 Figure C.1 - Forces Driving Industry Competition 21 Competition in an industry continually works to drive down the rate of return on invested capital toward the competitive floor rate of return, or the return that would be earned by the economist's "perfectly competitive" industry. This competitive floor, or "free market" return, is approximated by the yield on long-term government securities adjusted upward by the risk of capital loss. 1.1 Bargaining Power of Buyers Bargaining power of buyers determines their ability to dictate terms, including price. Bargaining power will be high if the cost of switching supplier is low, buyers are few and buyers buy in high volume from small suppliers. High bargaining power may lead to low prices or high costs, hence resulting in a low margin. A buyer group is powerful if the following circumstances hold true: ▪ It is concentrated or purchases large volumes relative to seller sales. ▪ The products it purchases from the industry represent a significant fraction of the buyer's costs or purchases. ▪ The products it purchases from the industry are standard or undifferentiated. Moreover , the industry's product is unimportant to the quality of the buyers' products or services. ▪ The buyer has full information. It faces few switching costs. To illustrate - Bargaining power of buyers in the ‘airline’ industry is high. Customers are able to check the prices of different airline companies quickly through the many online price comparison websites. In addition, there aren’t any switching costs involved in the process. 21 Figure 1-1 at p.4 of Competitive Strategy - Techniques for analysing industries and competitors (1980) by Michael E Porter © The Institute of Chartered Accountants of India  1.36 STRATEGIC COST & PERFORMANCE MANAGEMENT 1.2 Bargaining Power of Suppliers Bargaining power of suppliers determines the cost and quality of input. Bargaining power is higher if a replacement or alternate is not available. A supplier group is powerful if the following apply: ▪ It is dominated by a few companies and is more concentrated than the industry it sells to. ▪ It is not obliged to contend with other substitute products for sale to the industry. ▪ The industry is not an important customer of the supplier group. ▪ The suppliers' product is an important input to the buyer's business. ▪ The supplier group's products are differentiated, or it has built up switching costs. To illustrate - The bargaining power of suppliers in the ‘airline’ industry can be considered very high. When looking at the major inputs that airline companies need, we see that they are especially dependent on fuel and aircrafts. 1.3 Threat of Substitute Products or Services Threat of substitute may cause a loss of revenue (top-line) or an increased cost of retention. Threat will be high if the substitute is perfect in nature and cheaper. Substitute can be from different segment and different industry. Switching cost and the perceived level of product differentiation are also relevant here. To illustrate - In terms of the ‘airline’ industry, it can be said that the general need of its customers is traveling. It may be clear that there are many alternatives to traveling besides going by airplane. Depending on the urgency and distance, customers could take the train or go by car. People in East Asia (also in Southeast Asia) prefer to use high speed trains, even for long distance. 1.4 Threat of New Entrants New entrants to an industry bring new capacity, the desire to gain market share, and often substantial resources. Hence, the threat of new entrants may damage market share if materialise. The degree of threat depends on the barrier to entry coupled with the reaction from existing competitors that the entrant can expect, apart from perceived profitability. The major sources of barriers to entry are economies of scale, product differentiation, capital requirements, switching costs, access to distribution channels, government policy, etc. To illustrate - The threat of new entrants in the ‘airline’ industry can be considered low to medium. It takes quite some upfront investment to start an airline company, especially in purchasing aircraft. New entrants also need licenses, insurance, and access to distribution channels, which are not easy to have or get when you are new to the industry. 1.5 Rivalry among Existing Firms Rivalry occurs because one or more competitors either feel the pressure or see the opportunity to improve their position. Competitive moves by one firm generally have effects on its competitors and thus may incite retaliation or efforts to counter the move; that shows firms are mutually dependent. This pattern of action and reaction may or may not leave the initiating firm and the industry as a whole better off. If moves and countermoves escalate, then all firms in the industry may suffer and be worse off than before. Intensity of competition/ rivalry will determine the effect on profitability or market share. Competition will be stiffer if the number of firms increases, extra capacity exists, products are homogenous, fixed costs are high and exit barriers are also high. © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.37 To illustrate – As far as the Indian ‘Airline’ business is concerned, the industry is extremely competitive because of a number of reasons, which include the entry of low-cost carriers, tight regulation leading to high fixed costs, and high barriers to exit. As the same time, the switching cost is low or nil for passenger; hence, rivalry becomes more intensive and stiffer. The passenger market share in the Indian aviation industry in Jan 2015 and Oct 2022 is given below for reference– January 2015 October 2022 Airline Total 6.2 million passengers Total 11.4 million passengers carried during Jan 2015 carried during Oct 2022 Air India 18.7% 9.1% Vistara 0.2% 9.2% Air Asia India 1.3% 7.6% IndiGo 36.4% 56.7% Spice jet 9.4% 7.3% Jet Air 19.6% - Go Air 8.9% - Jet Lite 4.5% - Go First - 7% Alliance Air - 1.3% Source: Indian Express Dated 4 th December 2023 p.13 Economy Concept Insight Interconnectedness of Barriers (Exit Barriers and Entry Barriers) and Profitability - Although exit barriers and entry barriers are conceptually different, their joint level is an important aspect of the analysis of an industry. Often, exit and entry barriers are related. Substantial economies of scale in production, for example, are usually associated with specialized assets, as is the presence of proprietary technology. Taking the simplified case in which exit and entry barriers can be either high or low, refer to Figure C.2. Figure C.2 – Barriers and Profitability © The Institute of Chartered Accountants of India  1.38 STRATEGIC COST & PERFORMANCE MANAGEMENT All five competitive forces jointly determine the intensity of industry competition and profitability, and the strongest force or forces govern and become crucial from the point of view of strategy formulation. To illustrate, even a company with a very strong market position in an industry where potential entrants pose no threat will earn low returns if it faces a superior, lower-cost substitute. Even with no substitutes and blocked entry, intense rivalry among existing competitors will limit potential returns. The five forces enumerated by Porter’s five force model are constantly changing, which makes the model a dynamic analytical tool. Porter’s Five Forces is a good starting point to evaluate an industry but should not be used in isolation. You could, for example, combine it with a Value Chain Analysis or through the VRIO framework in order to get a better sense of where your company’s competitive advantage is coming from and to better position your company among rivals. Moreover, Porter’s Five Forces is often combined with the STEEPLE analysis to give a good overview of the organization’s environment.  Note – Students are advised to refer to the Annexure which contains a list of Porter’s Five Forces factors. 2. Understanding Customers and Markets After assessing the profitability and growth potential of an industry, the industry analysis extends to developing an understanding of customers and markets. The need and importance of understanding customers and markets as well as segments thereof is inevitable because, for a business firm, it is not always beneficial to be operative in all segments of the market. A strategic choice can be made to decide in which segment the firm will operate. Hence, segmentation analysis is relied upon to identify the primary area of operations. 2.1 Market, Market Segment and Market Segmentation Analysis 2.1.1 Market Market consists of the business firm that is selling the product or rendering the services in addition to the buyer who is buying/ hiring them. Market can be physical (where brick and mortar stores exist) or virtual (based on an e-platform). There may be many sellers and buyers, or only a handful. Market also includes potential buyers. 2.1.2 Segment or Market Segment A market segment is a category of customers who have similar likes and dislikes in an otherwise homogeneous market. In order to be recognised as a segment, the following criteria must be satisfied– © The Institute of Chartered Accountants of India  AN INTRODUCTION TO STRATEGIC COST MANAGEMENT 1.39 ▪ The segment should be homogeneous internally in terms of constituents (which may be their demographic character, behaviour, trait, or any other basis of segmentation). To illustrate, Fabric or readymade clothing firms have kid/ children’s ranges in addition to male and female collections. These segments are homogeneous internally; for the first segmentation, age is the basis, whereas for the later two, gender is the basis; all three segments are demographic in nature. ▪ The segments should be heterogeneous externally in terms of other segments. Each segment must be different from the others. To illustrate, Passenger vehicles and commercial vehicles for automobile companies. Now electronic vehicles are also seen as entirely separate segment. In the given example, all the segments are heterogeneous externally based upon the user (or purpose of use) and source of energy/ power (fuel vs. electricity). ▪ Segment shall be clearly identifiable. A business firm must be able to distinguish between group members and non-group members. The characteristics of group members due to which they fall under a particular segment shall be consistent. The basis of segmentation should be strong enough to make identification easy. ▪ Segment size shall be reasonable, if not substantial, at least of sufficient size so that specific marketing efforts can be made considering potential profitability. Mind it, any size can be considered reasonable, if it can be operated profitably. To illustrate, most of the companies that adopt the focus strategy or offer limited edition products are still able to operate profitably despite having a small number of target customers. ▪ A segment must be responsive in the sense that it must respond / react to marketing offerings. Do You Know? What benefits Market Segmentation provides? Benefits of market segments includes create stronger marketing messages, identify the most effective marketing tactics, design hyper-targeted ads, attract (and convert) quality leads, differentiate your br