UNIT – 4

COSTING OF SERVICE SECTOR AND BUDGETERY CONTROL

1. Just-in-time approach

Just-in-time (JIT) is a management philosophy and inventory management method that aims to reduce
inventory costs and increase inventory turnover by receiving goods only when they are needed. The goal
is to have little to no excess inventory at any given time.

JIT can have several advantages, including:

 Reduced warehousing

Companies don't need large warehouses when they have less inventory to store.

 Improved efficiency

Less material overhead leads to less waste.

 Local sourcing

Reduces transportation time and cost, which can improve employment rates in the local area.

 Right first time

Carrying out activities right the first time can reduce inspection and rework costs.

Some requirements for an effective JIT strategy include: Small lots, Excellent supplier relationships,
Good communication with internal stakeholders, Standardized operations, and Continuous improvement.

However, JIT also has some limitations, including: Reliance on precise forecasting, Risks of process
manufacturing being affected by delays or disruptions, Small room for error or unexpected demand,
Quality control issues, and High-pressure environment.

Toyota Motor Corporation is one well-known example of a company that uses the JIT method. When a
client places an order, Toyota only receives raw materials in the factory when it is ready to start building
the automobile.

2. Material Requirement Planning

What Is Material Requirements Planning (MRP)?

Material requirements planning (MRP) is a software-based integrated inventory and supply management
system designed for businesses.

Companies use MRP to estimate quantities of raw materials, maintain inventory levels, and schedule
production and deliveries.

KEY TAKEAWAYS

 Material requirements planning (MRP) is the earliest computer-based inventory management

system.

 MRP helps develop a production plan for finished goods by defining inventory requirements for
components and raw materials.
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  MRP assures that materials and components will be available when needed, minimizes inventory
levels, reduces customer lead times, and improves customer satisfaction.

 MRP relies on data accuracy, has a high cost to implement, and maintains a strict production
schedule.

How Material Requirements Planning (MRP) Works

MRP helps businesses and manufacturers define what is needed, how much is needed, and when
materials are needed and works backward from a production plan for finished goods.

MRP converts a plan into a list of requirements for the subassemblies, parts, and raw materials needed to
produce a final product within the established schedule. MRP helps manufacturers get a grasp
of inventory requirements while balancing both supply and demand.

Using MRP, managers can determine their need for labor and supplies and improve their production
efficiency by inputting data into the MRP scheme such as:

 Item Name or Nomenclature: The finished good title, sometimes called Level "0" on BOM.

 Master Production Schedule (MPS): How much is required to meet demand? When is it
needed?

 Shelf life of stored materials.

 Inventory Status File (ISF): Materials available that are in stock and materials on order from
suppliers.

 Bills of materials (BOM): Details of materials and components required to make each product.

 Planning data: Restraints and directions like routing, labor and machine standards, quality and
testing standards, and lot sizing techniques.

MRP and Manufacturing

Manufacturers manage the types and quantities of materials they purchase strategically and cost-
effectively to ensure that they can meet current and future customer demand. MRP helps
companies maintain appropriate levels of inventory so that manufacturers can better align their
production with rising and falling demand.

BOM

A bill of materials (BOM) is an extensive list of raw materials, components, and assemblies required to
construct, manufacture or repair a product or service.

The MRP process:

• Estimates demand and required materials. After determining customer demand and utilizing the bill
of materials, MRP breaks down demand into specific raw materials and components.

• Allocates Inventory of materials. MRP allocates inventory into the exact areas as needed.

• Schedules Production. Time and labor requirements are calculated to complete manufacturing and a
timeline is created.

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• Monitors the process. MRP automatically alerts managers of any delays and even suggests
contingency plans to meet build deadlines.

History of MRP

Material requirements planning was the earliest of the integrated information technology (IT) systems
that aimed to improve productivity for businesses by using computers and software technology.

The first MRP systems of inventory management evolved in the 1940s and 1950s, using mainframe
computers to extrapolate information from a bill of materials for a specific finished product into a
production and purchasing plan. MRP systems expanded to include information feedback loops so that
production managers could change and update the system inputs as needed.

The next generation of MRP, manufacturing resources planning (MRP II), also incorporated marketing,
finance, accounting, engineering, and human resources aspects into the planning process. A concept that
expands on MRP is enterprise resources planning (ERP), developed in the 1990s, which uses computer
technology to link various functional areas across an entire business enterprise.

Advantages and Disadvantages of MRP

Pros

 Materials and components are available when needed

 Minimized inventory levels and associated costs

 Reduced customer lead times

 Increased manufacturing efficiency

 Increased labor productivity

Cons

 Heavy reliance on input data accuracy

 Expensive to implement

 Lack of flexibility in the production schedule

 Tendency to hold more inventory than needed

 Less capable than an overall ERP system

MRP vs. ERP

Enterprise resource planning (ERP) is an extension of MRP systems. While MRP is a planning and
control system for the resources in a company, ERP is a solution for the enterprise as a whole and an ERP
system includes advanced functionality in the areas of financial, customer relationships, and sales order
management.

MRP can be a stand-alone application or a piece of an ERP, a single solution that addresses all business
needs, not just the scheduling of resources. It decreases any information redundancies and adds elements,
like user-level security.

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Benefits of an ERP system include increased efficiency, integrated information, customized reports, and
higher-quality customer service,

What Are the 3 Main Inputs for MRP?

The three basic inputs of an MRP system include the Master Production Schedule (MPS), Inventory
Status File (ISF), and Bill of Materials (BOM).

How Does MRP Benefit a Business?

MRP ensures that materials and components are available when they're needed, inventory levels are
optimized, manufacturing efficiency is improved, and customer satisfaction increases.

What Are the Outputs of an MRP System?

Using required inputs, the MRP calculates what materials are needed, how much is needed to complete a
build, and exactly when materials are needed in the build process.

This allows businesses to use just-in-time (JIT) production, scheduling production based on material
availability. This minimizes inventory levels and businesses can move materials through the
manufacturing process efficiently.

The Bottom Line

Material requirements planning (MRP) is a software-based integrated inventory and supply management
system that companies use to estimate quantities of raw materials and schedule production. By inputting
information like the Master Production Schedule, Inventory Status File, and the Bill of Materials (BOM),
MRP calculates the materials needed, how much are needed, and when they are needed in the
manufacturing process.

3. Enterprise Resource Planning

What Is Enterprise Resource Planning (ERP)?

Enterprise resource planning (ERP) is a platform companies use to manage and integrate the essential
parts of their businesses. Many ERP software applications are critical to companies because they help
them implement resource planning by integrating all the processes needed to run their companies with a
single system.

An ERP software system can also integrate planning, purchasing inventory, sales, marketing, finance,
human resources, and more.

KEY TAKEAWAYS

 ERP software can integrate all of the processes needed to run a company.

 ERP solutions have evolved over the years, and many are now typically web-based applications
that users can access remotely.

 Some benefits of ERP include the free flow of communication between business areas, a single
source of information, and accurate, real-time data reporting.

 There are hundreds of ERP applications a company can choose from, and most can be customized.

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  An ERP system can be ineffective if a company doesn't implement it carefully.

Understanding Enterprise Resource Planning (ERP)

You can think of an enterprise resource planning system as the glue that binds together the different
computer systems for a large organization. Without an ERP application, each department would have its
system optimized for its specific tasks. With ERP software, each department still has its system, but all of
the systems can be accessed through one application with one interface.

ERP applications also allow the different departments to communicate and share information more easily
with the rest of the company. It collects information about the activity and state of different divisions,
making this information available to other parts, where it can be used productively.

ERP applications can help a corporation become more self-aware by linking information about
production, finance, distribution, and human resources together. Because it connects different
technologies used by each part of a business, an ERP application can eliminate costly duplicates and
incompatible technology. The process often integrates accounts payable, stock control systems, order-
monitoring systems, and customer databases into one system.

How Enterprise Resource Planning Platforms Work

ERP has evolved over the years from traditional software models that made use of physical client servers
and manual entry systems to cloud-based software with remote, web-based access. The platform is
generally maintained by the company that created it, with client companies renting services provided by
the platform.

Businesses select the applications they want to use. Then, the hosting company loads the applications
onto the server the client is renting, and both parties begin working to integrate the client's processes and
data into the platform.

Once all departments are tied into the system, all data is collected on the server and becomes instantly
available to those with permission to use it. Reports can be generated with metrics, graphs, or other
visuals and aids a client might need to determine how the business and its departments are performing.

A company could experience cost overruns if its ERP system is not implemented carefully.

Types of ERP Systems

There's a number of different ERP solutions that can meet a variety of business needs. This list is not
meant to list every single type of ERP, though the list is pretty comprehensive. Any business considering
implementing an ERP system should be able to find value in some of these types of systems, and multiple
systems may be relevant in any given situation.

On-Premise ERP

On-premises ERP systems involve purchasing the software licenses and installing the ERP system
directly onto a company's own servers. Companies have full control over the system and data, as it resides
within their premises. Customization and integration with existing systems can be more extensive, and
this type of ERP usually requires dedicated IT resources for maintenance, updates, and security.

Cloud ERP

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Cloud ERP systems are hosted on remote servers and accessed through the internet. Cloud ERPs
like SaaS products offer better scalability, allowing businesses to easily adjust resources and features as
needed without significant upfront investment in hardware. Cloud ERP systems typically have a
subscription-based pricing model, and updates/maintenance are managed by the ERP provider (not the
company itself).

Industry-Specific ERP

Industry-specific ERP systems are tailored to meet the unique needs and requirements of particular
industries. These systems often include industry-specific modules, functionalities, and best practices to
address the complexities of the industry. For example, consider a manufacturing firm that is heavily
reliant on inventory, supply chain management, and distribution of goods. That type of ERP will be vastly
different than a client-based ERP such as a financial institution's ERP.

Open-Source ERP

An open-source ERP system (or any open-source software, for that matter) provides users with access to
the source code. This means a company can customize, modify, or redistribute the ERP to better meet the
company's needs. Implementing and maintaining open-source ERP systems may require more technical
expertise and resources compared to commercial ERP solutions.

Small Business ERP

On the other hand, small business ERP systems are designed specifically for the needs of small and
medium-sized businesses (SMBs). These types of ERP systems try to offer balance between being
slightly niche while offering essential functionalities at a more affordable price point. Because they are
less robust, small business ERP solutions are often easier to implement and require less customization
compared to enterprise-level ERP systems.

Tiered ERP

Tiered ERP systems offer different levels of functionality and scalability to cater to businesses of varying
sizes and complexity. Companies can choose the tier that best matches their current needs and budget,
with the option to upgrade or customize as their requirements evolve. This would entail adding on
modules as they become relevant (i.e. a company that is scaling to international operations may wait to
implement foreign current modules).

Benefits of ERP

Businesses employ enterprise resource planning (ERP) for various reasons, such as expanding, reducing
costs, and improving operations. The benefits sought and realized between companies may differ;
however, some are worth noting.

Improves Accuracy and Productivity

Integrating and automating business processes eliminates redundancies and improves accuracy and
productivity. In addition, departments with interconnected processes can synchronize work to achieve
faster and better outcomes.

Improves Reporting

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Some businesses benefit from enhanced real-time data reporting from a single source system. Accurate
and complete reporting help companies adequately plan, budget, forecast, and communicate the state of
operations to the organization and interested parties, such as shareholders.

Increases Efficiency

ERPs allow businesses to quickly access needed information for clients, vendors, and business partners.
This contributes to improved customer and employee satisfaction, quicker response rates, and increased
accuracy rates. In addition, associated costs often decrease as the company operates more efficiently.

ERP software also provides total visibility, allowing management to access real-time data for decision-
making.

Increases Collaboration

Departments are better able to collaborate and share knowledge; a newly synergized workforce can
improve productivity and employee satisfaction as employees are better able to see how each functional
group contributes to the mission and vision of the company. Also, menial and manual tasks are
eliminated, allowing employees to allocate their time to more meaningful work.

ERP Weaknesses

An ERP system doesn't always eliminate inefficiencies within a business or improve everything. The
company might need to rethink how it's organized or risk ending up with incompatible technology.

ERP systems usually fail to achieve the objectives that influenced their installation because of a
company's reluctance to abandon old working processes. Some companies may also be reluctant to let go
of old software that worked well in the past. The key is to prevent ERP projects from being split into
smaller projects, which can result in cost overruns.

4. Activity- Based Cost Management

What Is Activity-Based Costing (ABC)?

Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related
products and services. This accounting method of costing recognizes the relationship between costs,
overhead activities, and manufactured products, assigning indirect costs to products less arbitrarily than
traditional costing methods. However, some indirect costs, such as management and office staff salaries,
are difficult to assign to a product.

KEY TAKEAWAYS

 Activity-based costing (ABC) is a method of assigning overhead and indirect costs—such as

salaries and utilities—to products and services.

 The ABC system of cost accounting is based on activities, which are considered any event, unit of
work, or task with a specific goal.

 An activity is a cost driver, such as purchase orders or machine setups.

 The cost driver rate, which is the cost pool total divided by cost driver, is used to calculate the
amount of overhead and indirect costs related to a particular activity.

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ABC is used to get a better grasp on costs, allowing companies to form a more appropriate pricing
strategy.

How Activity-Based Costing (ABC) Works

Activity-based costing (ABC) is mostly used in the manufacturing industry since it enhances the
reliability of cost data, hence producing nearly true costs and better classifying the costs incurred by the
company during its production process.

This costing system is used in target costing, product costing, product line profitability analysis, customer
profitability analysis, and service pricing. Activity-based costing is used to get a better grasp on costs,
allowing companies to form a more appropriate pricing strategy.

The formula for activity-based costing is the cost pool total divided by cost driver, which yields the cost
driver rate. The cost driver rate is used in activity-based costing to calculate the amount of overhead and
indirect costs related to a particular activity.

The ABC calculation is as follows:

1. Identify all the activities required to create the product.

2. Divide the activities into cost pools, which includes all the individual costs related to an activity—
such as manufacturing. Calculate the total overhead of each cost pool.

3. Assign each cost pool activity cost drivers, such as hours or units.

4. Calculate the cost driver rate by dividing the total overhead in each cost pool by the total cost
drivers.

5. Divide the total overhead of each cost pool by the total cost drivers to get the cost driver rate.

6. Multiply the cost driver rate by the number of cost drivers.

As an activity-based costing example, consider Company ABC that has a $50,000 per year electricity bill.
The number of labor hours has a direct impact on the electric bill. For the year, there were 2,500 labor
hours worked, which in this example is the cost driver. Calculating the cost driver rate is done by dividing
the $50,000 a year electric bill by the 2,500 hours, yielding a cost driver rate of $20. For Product XYZ,
the company uses electricity for 10 hours. The overhead costs for the product are $200, or $20 times 10.

Activity-based costing benefits the costing process by expanding the number of cost pools that can be
used to analyze overhead costs and by making indirect costs traceable to certain activities.

Requirements for Activity-Based Costing (ABC)

The ABC system of cost accounting is based on activities, which are any events, units of work, or tasks
with a specific goal, such as setting up machines for production, designing products, distributing finished
goods, or operating machines. Activities consume overhead resources and are considered cost objects.

Under the ABC system, an activity can also be considered as any transaction or event that is a cost driver.
A cost driver, also known as an activity driver, is used to refer to an allocation base. Examples of cost
drivers include machine setups, maintenance requests, consumed power, purchase orders, quality
inspections, or production orders.

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There are two categories of activity measures: transaction drivers, which involve counting how many
times an activity occurs, and duration drivers, which measure how long an activity takes to complete.

Unlike traditional cost measurement systems that depend on volume count, such as machine hours and/or
direct labor hours, to allocate indirect or overhead costs to products, the ABC system classifies five broad
levels of activity that are, to a certain extent, unrelated to how many units are produced. These levels
include batch-level activity, unit-level activity, customer-level activity, organization-sustaining activity,
and product-level activity.

Benefits of Activity-Based Costing (ABC)

Activity-based costing (ABC) enhances the costing process in three ways. First, it expands the number of
cost pools that can be used to assemble overhead costs. Instead of accumulating all costs in one company-
wide pool, it pools costs by activity.

Second, it creates new bases for assigning overhead costs to items such that costs are allocated based on
the activities that generate costs instead of on volume measures, such as machine hours or direct labor
costs.

Finally, ABC alters the nature of several indirect costs, making costs previously considered indirect—
such as depreciation, utilities, or salaries—traceable to certain activities. Alternatively, ABC transfers
overhead costs from high-volume products to low-volume products, raising the unit cost of low-volume
products.

5. Bench Marking

What is benchmarking?

Benchmarking is when a business uses data to compare its activities to other companies.

Most often, a business will create benchmarks to measure its performance against competitors or other
companies engaged in similar activities. However, benchmarking can be performed against any
organization with practices that you want to emulate.

You can establish benchmarks for different parts of your business, including teams, products and
services, or overall metrics like sales volume and revenue.

Benchmarking produces standards and identifies opportunities for change. As a result of benchmarking, a
business might adopt new working practices, engage in restructuring, or alter its sales strategy to improve
performance.

Why start benchmarking?

The main reason to create benchmarks for your business is to find areas where your performance falls
below the standards other organizations set. Identifying these areas for improvement will help focus your
time and resources.

Depending on the data you gather from companies you choose to benchmark against, the process may
reveal strategies for closing performance gaps. If you’re benchmarking against direct competitors where
data gathering is limited, a strategic planning step is likely required to determine how to respond to
benchmarking results.

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Benchmarking can help you tweak your product’s features to stay competitive, introduce a new service to
capture market share, or switch to a different customer relationship management (CRM) system that’s
working well for other businesses.

On the other hand, benchmarking can be used to find places where your business is outperforming the
competition. Used in this way, benchmarks can validate your unique value proposition.

For example, benchmarking helps Shopify deliver the world's best-converting online checkout by
confirming it outperforms competitors by up to 36%.

5 benefits of the benchmarking process

1. Set data-based goals for departments and individuals

2. Discover and improve inefficient processes

3. Discover and reduce costly overheads

4. Identify small changes to your business that result in big improvements

5. Find and quantify industry-leading aspects of your business

5 types of benchmarking

Benchmarking projects can be categorized depending on their aims and the data you gather. Here are five
popular forms of benchmarking:

1. Technical benchmarking

Design teams use technical benchmarking to assess product capabilities and make continual
improvements. Let’s say you’re a smartphone manufacturer. Your engineers might compare the battery
specifications of your device with those of competitors to create a phone with an industry-leading battery
life.

2. Performance benchmarking

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Performance benchmarking tells you the health status of your business. It looks at key performance
indicators (KPIs), such as email sign-ups or ecommerce conversion rates, to compare current activities to
historical business performance and industry standards.

You can also use performance benchmarking to audit your internal reporting. By comparing how KPIs
are used across your teams, you may discover which measures of success are most aligned with broader
business goals.

3. Competitive benchmarking

Competitive benchmarking compares your business with direct competitors. For instance, if you run a
coffee shop, you might compare your sales, menu pricing, or customer satisfaction ratings with another
popular coffee shop in your area. The goal is to understand if and why a business is outcompeting you in
a specific area—or if you are outperforming competitors.

Difficulties of competitive benchmarking include sourcing sensitive data from direct competitors. In these
cases, it may be challenging to understand precisely what competitors are doing to achieve their
performance.

4. Strategic benchmarking

Strategic benchmarking is another type of external benchmarking, this time involving non-competitor
businesses. In strategic benchmarking, a business seeks to emulate the performance and practices
observed in other companies.

For example, you could measure the high-performing marketing campaigns of a clothing brand to gain
insights for your SaaS company. Or adopt helpful technology used in other industries, such as when
retailers began using Universal Product Codes after noticing their success in the grocery industry.

5. Internal benchmarking

Internal benchmarking is a form of self-evaluation within your business. It involves comparing a team,
specific process, or metric from one area of your company to an equivalent team, process, or metric in
another area.

Imagine you run a chain of boutique hotels. The front desk of your Miami location receives consistently
high customer service scores. In contrast, guests at your New York location don’t rate the front desk team
as favorably. Internal benchmarking of metrics such as customer query response times or complaint
resolution methods may reveal the cause of the disparity.

At the same time, care should be taken during internal process benchmarking to acknowledge potential
variables between comparable processes and teams.

6. Balanced Score Card

What Is a Balanced Scorecard (BSC)?

The term balanced scorecard (BSC) refers to a strategic management performance metric used to identify
and improve various internal business functions and their resulting external outcomes.1 Used to measure
and provide feedback to organizations, balanced scorecards are common among companies in the United
States, the United Kingdom, Japan, and Europe. Data collection is crucial to providing quantitative results
as managers and executives gather and interpret the information. Company personnel can use this
information to make better decisions for the future of their organizations.
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KEY TAKEAWAYS

 A balanced scorecard is a performance metric used to identify, improve, and control a business's
various functions and resulting outcomes.

 The concept of BSCs was first introduced in 1992 by David Norton and Robert Kaplan, who took
previous metric performance measures and adapted them to include nonfinancial information.

 BSCs were originally developed for for-profit companies but were later adapted for use by
nonprofits and government agencies.

 The balanced scorecard involves measuring four main aspects of a business: Learning and growth,
business processes, customers, and finance.

 BSCs allow companies to pool information in a single report, to provide information into service
and quality in addition to financial performance, and to help improve efficiencies.

Understanding Balanced Scorecards (BSCs)

Accounting academic Dr. Robert Kaplan and business executive and theorist Dr. David Norton first
introduced the balanced scorecard. The Harvard Business Review first published it in the 1992 article
"The Balanced Scorecard—Measures That Drive Performance." Both Kaplan and Norton worked on a
year-long project involving 12 top-performing companies. Their study took previous performance
measures and adapted them to include nonfinancial information.

Companies can easily identify factors hindering business performance and outline strategic changes
tracked by future scorecards.

BSCs were originally meant for for-profit companies but were later adapted for nonprofit organizations
and government agencies. It is meant to measure the intellectual capital of a company, such as training,
skills, knowledge, and any other proprietary information that gives it a competitive advantage in the
market. The balanced scorecard model reinforces good behavior in an organization by isolating four
separate areas that need to be analyzed. These four areas, also called legs, involve:

 Learning and growth

 Business processes
 Customers
 Finance

The BSC is used to gather important information, such as objectives, measurements, initiatives, and
goals, that result from these four primary functions of a business. Companies can easily identify factors
that hinder business performance and outline strategic changes tracked by future scorecards.

The scorecard can provide information about the firm as a whole when viewing company objectives. An
organization may use the balanced scorecard model to implement strategy mapping to see where value is
added within an organization. A company may also use a BSC to develop strategic initiatives and
strategic objectives.

Characteristics of the Balanced Scorecard Model (BSC)

Information is collected and analyzed from four aspects of a business:1

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 1. Learning and growth are analyzed through the investigation of training and knowledge
resources. This first leg handles how well information is captured and how effectively employees
use that information to convert it to a competitive advantage within the industry.

2. Business processes are evaluated by investigating how well products are manufactured.
Operational management is analyzed to track any gaps, delays, bottlenecks, shortages, or waste.

3. Customer perspectives are collected to gauge customer satisfaction with the quality, price, and
availability of products or services. Customers provide feedback about their satisfaction with
current products.

4. Financial data, such as sales, expenditures, and income are used to understand financial
performance. These financial metrics may include dollar amounts, financial ratios, budget
variances, or income targets.

These four legs encompass the vision and strategy of an organization and require active management to
analyze the data collected.

The balanced scorecard analyzes is often referred to as a management tool rather than a measurement
tool because of its application by a company's key personnel.

Benefits of a Balanced Scorecard (BSC)

There are many benefits to using a balanced scorecard. For instance, the BSC allows businesses to pool
together information and data into a single report rather than having to deal with multiple tools. This
allows management to save time, money, and resources when they need to execute reviews to improve
procedures and operations.

Scorecards provide management with valuable insight into their firm's service and quality in addition to
its financial track record. By measuring all of these metrics, executives are able to train employees and
other stakeholders and provide them with guidance and support. This allows them to communicate their
goals and priorities in order to meet their future goals.

Another key benefit of BSCs is how it helps companies reduce their reliance on inefficiencies in their
processes. This is referred to as suboptimization. This often results in reduced productivity or output,
which can lead to higher costs, lower revenue, and a breakdown in company brand names and their
reputations.2

Examples of a Balanced Scorecard (BSC)

Corporations can use their own, internal versions of BSCs, For example, banks often contact customers
and conduct surveys to gauge how well they do in their customer service. These surveys include rating
recent banking visits, with questions ranging from wait times, interactions with bank staff, and overall
satisfaction. They may also ask customers to make suggestions for improvement. Bank managers can use
this information to help retrain staff if there are problems with service or to identify any issues customers
have with products, procedures, and services.

In other cases, companies may use external firms to develop reports for them. For instance, the J.D.
Power survey is one of the most common examples of a balanced scorecard.2 This firm provides data,
insights, and advisory services to help companies identify problems in their operations and make
improvements for the future. J.D. Power does this through surveys in various industries, including the
financial services and automotive industries. Results are compiled and reported back to the hiring firm.

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 7. Value-Chain Analysis

What is value chain analysis?

Value chain analysis is a strategic process that can increase profit margins and provide a competitive
advantage for companies of all sizes. Within this analysis, businesses identify areas where the value of
specific production and sales activities can be increased. By discovering opportunities for cost reduction
and/or improved customer value, businesses can decrease production costs and increase revenue.

Strong value chain strategy is your path to outperforming the competition and becoming the leading
company in your particular field. Just as sales metrics and analysis indicate trouble spots in your sales
process, value chain analysis indicates the trouble spots in your production process. You can’t fix what
you can’t see.

Purpose of value chain analysis

The purpose of value chain analysis is to give your company a clear path to greater profits. By
understanding the value that your company brings to your audience, you can craft a more strategic sales
plan and alter your chain activities to produce additional revenue.

Value chain analysis also helps your company determine the best strategies within the current market—
not just with your audience. For instance, if you’re looking to offer new financial management software,
your value chain analysis might help you decide how specific you want your targets to be and how much
to charge for your product. By finding the gaps in the market, you can use price and quality to pinpoint
the perfect niche.

Essentially, value chain analysis gives you a starting point for your entire sales and marketing approach.
From initial ads to sales funnel analysis and lead qualification, all improvements stem from the value
chain.

Components of a value chain

Our current model of the value chain comes from Michael Porter’s 1985 book, Competitive Advantage.
Considering how quickly trends move in sales, the fact that we still use this model speaks to how well it
works and how much it’s benefitted companies over the years. Porter breaks VCA into five primary
activities and four secondary activities that together create value greater than the cost of performing those
activities.

That premise makes sense: Profit is created when the overall cost of producing your product is less than
the amount you sell that product for. However, it’s common to see companies that don’t track all aspects
of product creation and therefore miss opportunities to increase profit margins.

That’s why we use Porter’s value chain analysis chart.

Value chain analysis chart

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The VCA chart is broken into two sections: primary activities and supportive (or secondary) activities.
Primary activities focus on the manufacturing of goods and services, while secondary activities back up
primary activities.

Primary activities include:

 Inbound logistics: availability of raw materials, warehousing, and distribution

 Operations: creating products from raw materials

 Outbound logistics: delivery of products to customers, including warehouse, transportation, and

distribution

 Marketing and sales: all advertising and sales interactions and activities (also a great place to use
your sales forecasting data)

 Service: all forms of customer support interaction and brand credibility

Secondary activities include:

 Infrastructure: any administrative, finance, management, planning, or legal operations needed to

support primary activities

 Technology development: any technological improvements made to existing machinery,

hardware, or software in the name of supporting primary activities

 Human resource management: hiring and then placing workers in the correct and most efficient
positions

 Procurement: all purchases related to buying raw materials or any fixed assets (for example,
vendor fees and selection)

The key to a successful value chain analysis is figuring out which processes are having issues and then
implementing fixes in a timely fashion.

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What are the benefits of a value chain analysis?

It’s clear that value chain analysis increases profit margin, but the importance of VCA goes far beyond
revenue alone. The VCA process is all about streamlining and alignment. When done right, it not only
boosts profits, it also:

 Establishes better vendor management

 Reduces cost and delivery times

 Optimizes inventory

 Improves customer relationships

 Standardizes and optimizes processes

 Helps you gain a competitive edge

That last benefit is arguably the most essential. No two businesses can survive by creating the exact same
products and customer experiences, which means it’s never enough to simply match your competitors. To
truly succeed, every business needs to find an edge. Whether in pricing, style, or quality, your company’s
unique competitive edge makes you stand out from the crowd.

You can always examine your company’s value through alternative methods like customer surveys, but
those methods don’t always provide consistent feedback or useful information.

Despite being time consuming, value chain analysis is the most reliable sales analytics tool when it comes
to understanding the full scope of your company’s activities. As a result, it remains one of the best ways
to pinpoint improvement opportunities across your various departments.

How to conduct a value chain analysis

There are two primary ways to look at value chain analysis depending on how you’re trying to edge out
the competition:

1. Cost advantage analysis: pulling customers in with low prices

2. Differentiation advantage analysis: pulling customers in with unique benefits

Let’s take a closer look at both types of analysis.

Cost advantage

Cost advantage is all about lowering—everything except expectations, that is. With cost advantage
analysis, you want to lower both the cost of production and the cost of products. If your company is
aiming to do a cost advantage VCA, then you have a product that can be easily mass-produced and holds
higher value as a low-cost item rather than a high-quality item.

Great examples of companies that use cost advantage VCA are McDonald’s and Walmart. They use low-
cost production to sell massive amounts of products to customers on a daily basis with an emphasis on
quantity over quality.

There are five steps to the cost advantage analysis VCA:

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 1. Identify primary and support activities. You need to list out all activities used in product
creation, especially in supply chain management.

2. Identify the cost of each activity in regards to the overall product cost. If the overall product
cost of a blender is $24, what percentage of that cost comes from each activity? If you discover
that one or two activities are accounting for a huge percentage of the cost, scale those down.

3. Identify cost drivers for each activity. Cost drivers are quantifiable aspects of an activity. For
example, the activities of human labor cost drivers include work hours, work speed (KPIs), and
wage rate. These drivers are measurable using specific activity metrics.

4. Identify any links between activities. Some activities are related and decreased costs in one may
lead to increased profit in another.

5. Identify opportunities for reduction. You can’t cut all production costs, but you can
substantially lower them. Look at where your biggest costs are coming from and make
adjustments. Some simple tweaks could include decreasing inventory variety, sourcing lower-cost
materials, switching vendors, or automating parts of your labor force.

Differentiation advantage

In contrast to cost advantage analysis, differentiation analysis seeks to set a company apart for its product
quality and brand value. Sometimes, this process can actually increase production costs, but as long as
your overall profit margin increases, that’s fine.

Prominent examples of companies based on differentiation advantage VCA include Apple and Starbucks.
Both of these companies sell relatively high-cost, high-quality products with high customization. They
win over their customers with branding, features, and other non-financial aspects of their products. For
example, you don’t buy a pumpkin spice latte because your wallet says it’s a good idea; you buy it
because society now associates it with fun, status, and the essential fall Instagram picture.

There are three steps to differentiation advantage analysis:

1. Identify value-creating activities. Once you’ve listed all activities, pull the ones that contribute
most to customer value. These could include marketing and branding, extra feature production and
tech, etc.

2. Look at strategies for improving those activities to increase customer value. If your product
value is coming from brand credibility, look at ways to increase that activity. Perhaps you want to
look at social value-based selling and donate part of each purchase to a charity.

3. Identify a sustainable differentiation. Not all customer-value improvements are sustainable.

Look for activity improvements that will keep generating profit over time.

8. Budgetary Control: Flexible Budgets; Performance budgets; Zero-based budgets.

Budgetary control

What is Budgetary Control?

Budgetary control refers to the process of planning, controlling, and monitoring the organization’s
revenue and expenses to ensure that they align with the budget. It involves creating budgets for various

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business activities, monitoring actual performance against the budget, identifying variations, and taking
corrective actions to bring the budget back on track.

According to Brown and Howard, “Budgetary control is a system of controlling costs which includes the
preparation of budgets, coordinating the departments and establishing responsibilities, comparing actual
performance with the budgeted and acting upon results to achieve maximum profitability.”

Flexible Budgets:

What is a flexible budget?

A flexible budget is a budget that adjusts for changes in the level of activity or output. Unlike a static
budget, which is based on a fixed level of activity or output, a flexible budget is designed to be adaptable
to changes in sales volume, production volume, or other measures of business activity.

A flexible budget is typically created by identifying the various costs and expenses that vary with changes
in activity levels and calculating the expected cost or expense for each level of activity. For example, if a
business sells widgets and the cost of producing each widget decreases as more are produced due
to economies of scale, the flexible budget would reflect this by showing a lower cost per widget as
production increases.

The benefit of a flexible budget is that it provides a more accurate picture of a business’s performance by
adjusting for changes in activity levels. This can help businesses make better decisions about their
operations, identify areas where they can improve efficiency or reduce costs, and better plan for future
growth.

Steps in Creating a Flexible Budget

1. Identify the key drivers of your business- Determine what factors are driving your business,
such as sales volume, production volume, or number of customers.

2. Determine the activity levels- Decide on the range of activity levels that your business is likely
to experience during the budget period, such as low, medium, and high levels of sales or
production.

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 3. Estimate costs for each activity level- Calculate the expected costs for each activity level by
breaking down your costs into fixed costs and variable costs. Fixed costs, such as rent or salaries,
will remain the same regardless of activity level, while variable costs, such as raw materials or
labor costs, will change with activity level.

4. Create a flexible budget spreadsheet- Organize the costs by activity level in a spreadsheet
or budgeting software. Use formulas or functions to automatically calculate the expected costs for
each activity level.

5. Compare the flexible budget to actual results- Once the budget period begins, track your actual
results and compare them to the flexible budget. This will allow you to see where your actual
results differ from your expectations and identify any areas where you need to adjust your
operations.

6. Revise the flexible budget as needed- If you find that your actual results are significantly
different from your flexible budget, revise the budget to reflect the new information. This will
allow you to make more accurate forecasts for future periods.

The 3 Levels of Flexible Budget

1) Basic Flexible Budget

This is the simplest form of a flexible budget, and it alters those expenses that vary directly with
revenues. For example, finance can build a percentage into the basic flexible model, which they multiply
by actual revenues to determine the expenses at a specified revenue level. It doesn’t provide the full level
detail that a flexible budget would, but it does provide flexibility and a more accurate, up-to-date budget
than a static budget.

2) Intermediate flexible budget

A flexible intermediate budget takes into account expenses that go beyond a company’s revenue.
Revenue is constantly changing and is the most important factor in business decisions, but the
intermediate flexible budget includes costs that vary based on other activity measures such as salaries
and benefits based on the number of employees in the company.

3) Advanced Flexible Budget

A flexible budget adjusts for changes in activity levels for all costs, including both fixed and variable
costs. This type of flexible budget takes into account how changes in activity levels affect all costs and
provides the most accurate picture of expected costs at different levels of activity.

Example of a Flexible Budget

Let’s say a restaurant has a fixed budget of $10,000 for food expenses for the month, which is based on
an expected number of customers served. However, the restaurant experiences a significant increase in
customer traffic during a particular week, resulting in higher food costs.

To account for this increase, the restaurant creates a flexible budget based on the actual number of
customers served. Here’s how the flexible budget might look:

 Food Expenses: $1.50 per customer x 3,000 customers = $4,500

 Labor Expenses: $3,000

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  Rent and Utilities: $2,000

 Marketing and Advertising: $1,000

 Other Expenses: $1,000

Total Flexible Budget: $11,500

As you can see, the flexible budget adjusts the expected food expenses based on a higher cost per
customer, resulting in an extra $1,500 in the overall budget. This allows the restaurant to better manage
its expenses and make informed decisions about future pricing and menu offerings, potentially leading to
a better allocation of resources and seizing the opportunity of the increase in customers to make a higher
profit.

Advantages of a Flexible Budget:

 Accuracy- A flexible budget can provide a more accurate picture of a company’s expenses since
it adjusts for changes in activity levels.

 Flexibility- A flexible budget can adapt to changes in the business environment, such as changes
in sales volumes or unexpected expenses, making it easier to manage operations and make
informed decisions.

 Motivation- A flexible budget can motivate employees since it allows for adjustments in
spending to achieve their goals.

 Better Decision-making- A flexible budget allows for more informed decision-making,

especially in situations where there are significant changes in the business environment.

Disadvantages of a Flexible Budget:

 Complexity- A flexible budget can be more complex to create than a fixed budget, requiring more
time and resources to prepare.

 Difficulty in Comparison- A flexible budget can be more difficult to compare with actual results
since it involves a range of activity levels and expected expenses.

 Higher Costs- A flexible budget can be more costly to implement, especially if it requires
additional resources or software to track expenses accurately.

 Time-consuming- A flexible budget can be more time-consuming to manage, requiring ongoing

updates and adjustments as activity levels change.

Performance budgets:

What Is a Performance Budget?

A performance budget is one that reflects both the input of resources and the output of services for each
unit of an organization. The goal is to identify and score relative performance based on goal attainment
for specified outcomes. This type of budget is commonly used by government bodies and agencies to
show the link between taxpayer funds and the outcome of services provided by federal, state, or local
governments.

KEY TAKEAWAYS

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  Performance budgets reflect the input of resources and the output of services for each department
or unit of an organization.

 They are designed to motivate employees' commitment to produce positive results.

 Disadvantages include the potential for disagreement over spending priorities and a lack of unified
cost standards.

Understanding a Performance Budget

The decision process for performance budgets focuses on outputs—or outcomes—of services. In other
words, the allocation of funds and resources is based on specific goals agreed upon by budget committees
and agency heads of services. For instance, in schools, teachers may earn bonuses or promotions based on
aggregate test scores among their students, which is supposed to show a high degree of skill and
effectiveness (although this may not always be the case.)

Performance budgets, as the theory goes, are designed to motivate employees, enhancing their
commitment to producing positive results.

A few examples of outcomes that a performance budget could address include:

 Improvement in average test scores of a school district

 Decreases in mortality or morbidity rates of a health program

 Improvement of water quality of a county's drinking supply

 Non-violent crime reduction in a city

 Reduction in road pothole complaints

All of these would have numerical targets attached to them. A performance budget would be developed
accordingly to identify those target numbers and a method of evaluating performance. Performance
budgets often rely on quantifying otherwise qualitative or subjective factors so that they can be measured
and accounted for.

Advantages and Disadvantages of a Performance Budget

The advantages in the public sector are an increase in accountability of the local authorities to
the taxpayers, communication to the public about priorities, and quantifying particular goals. Taxpayers
want to know where and how their money is being spent and to what end.

Similarly, nonprofit organizations draw up performance budgets to link inputs and outputs for their
missions. Donors to these organizations also want to know what kind of "return" society is getting from
their donations.

Some disadvantages of a performance budget include:

 The potential for disagreement on where spending priorities should lie, in the case of a
government with multiple agencies

 Lack of unified cost standards across multiple agencies

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  The potential for a department to manipulate data in order to reach a target, which could lead to a
need to spend funds on an independent party to verify results

 A lack of flexibility once the inputs/outputs have been set

One prominent disadvantage of performance budgets is that by assigning target scores or numbers that an
organization uses as its benchmark for achievement, the numbers can be gamed or become the sole focus
of one's task. For instance, teachers looking to earn a certain score may only focus on the factors that
comprise that score and overlook or ignore other factors that may be important to teaching but not for the
performance budget.

Zero-based budgets:

What Is Zero-Based Budgeting (ZBB)?

Zero-based budgeting (ZBB) is a method of budgeting in which all expenses must be justified for each
new period.

The process of zero-based budgeting starts from a “zero base,” and every function within an organization
is analyzed for its needs and costs. The budgets are then built around what is needed for the upcoming
period, regardless of whether each budget is higher or lower than the previous one.

KEY TAKEAWAYS

 Zero-based budgeting is a technique used by companies, but this type of budgeting can be used by
individuals and families.

 Budgets are created around the monetary needs for each upcoming period, like a month or a year.

 Traditional budgeting and zero-based budgeting are two methods used to track expenditures.

 Zero-based budgeting helps managers lower costs for a company.

How Zero-Based Budgeting (ZBB) Works

In business, ZBB allows top-level strategic goals to be implemented into the budgeting process by tying
them to specific functional areas of the organization, where costs can be first grouped and then measured
against previous results and current expectations.

Because of its detail-oriented nature, zero-based budgeting may be a rolling process done over several
years, with a few functional areas reviewed at a time by managers or group leaders. Zero-based budgeting
can help lower costs by avoiding blanket increases or decreases to a prior period’s budget. It is, however,
a time-consuming process that takes much longer than traditional, cost-based budgeting.

Zero-Based Budgeting vs. Traditional Budgeting

Traditional budgeting calls for incremental increases over previous budgets, such as a 2% increase in
spending, as opposed to a justification of both old and new expenses, as called for with zero-based
budgeting.

Traditional budgeting also only analyzes new expenditures, while ZBB starts from zero and calls for a
justification of old, recurring expenses in addition to new expenditures. Zero-based budgeting aims to put
the onus on managers to justify expenses and aims to drive value for an organization by optimizing costs
and not just revenue.
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Example of Zero-Based Budgeting

Suppose a construction equipment company implements a zero-based budgeting process calling for closer
scrutiny of manufacturing department expenses. The company notices that the cost of certain parts used
in its final products and outsourced to another manufacturer increases by 5% every year. The company
can make those parts in-house using its workers. After weighing the positives and negatives of in-house
manufacturing, the company finds it can make the parts cheaper than the outside supplier.

Instead of blindly increasing the budget by a certain percentage and masking the cost increase, the
company can identify a situation in which it can decide to make the part itself or buy the part from the
external supplier for its end products.

Traditional budgeting may not allow cost drivers within departments to be identified. Zero-based
budgeting is a more granular process that aims to identify and justify expenditures. However, zero-based
budgeting is also more involved, so the costs of the process itself must be weighed against the savings it
may identify.

What Are the Advantages of Zero-Based Budgeting?

As an accounting practice, zero-based budgeting offers a number of advantages, including focused

operations, lower costs, budget flexibility, and strategic execution. When managers think about how each
dollar is spent, the highest revenue-generating operations come into greater focus. Meanwhile, lowered
costs may result as zero-based budgeting may prevent the misallocation of resources that may happen
over time when a budget grows incrementally.

What Are the Disadvantages of Zero-Based Budgeting?

Zero-based budgeting has a number of disadvantages.

First, it is timely and resource-intensive. Because a new budget is developed each period, the time cost
involved may not be worthwhile. Instead, using a modified budget template may prove more beneficial.

Second, it may reward short-term perspectives in the company by allocating more resources to operations
with the highest revenues. In turn, areas such as research and development, or those that have a long-term
horizon, may get overlooked.

The Bottom Line

Zero-based budgeting (ZBB) is a budgeting method that justifies all expenses for each new period. The
process begins from a “zero base,” analyzing every function within an organization for its needs and
costs. Then budgets are built around what is needed for the upcoming period, regardless of whether each
budget is higher or lower than its predecessor.

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