End of Chapter: Strategy, Balanced Scorecard, and Strategic Profitability Analysis

Problem for Self-Study

Following a strategy of product differentiation, Westwood Corporation makes a high-end kitchen range hood, KE8. Westwood’s data for 2019 and 2020 are shown below:

	2019	2020
1. Units of KE8 produced and sold	40,000	42,000
2. Selling price	$100	$110
3. Direct materials (square feet)	120,000	123,000
4. Direct material cost per square foot	$10	$11
5. Manufacturing capacity for KE8	50,000 units	50,000 units
6. Conversion costs	$1,000,000	$1,100,000
7. Conversion cost per unit of capacity $(row 6 \div row 5)$	$20	$22
8. Selling and customer-service capacity	30 customers	29 customers
9. Selling and customer-service costs	$720,000	$725,000
10. Cost per customer of selling and customer-service capacity $(row 9 \div row 8)$	$24,000	$25,000

In 2020, Westwood reduced direct material usage per unit of KE8. Conversion costs in each year are tied to manufacturing capacity. Selling and customer-service costs are related to the number of customers that the selling and customer-service functions are designed to support. Westwood had 23 customers (wholesalers) in 2019 and 25 customers in 2020.

Required

Describe briefly the key elements you would include in Westwood’s balanced scorecard.
Calculate the growth, price-recovery, and productivity components that explain the change in operating income from 2019 to 2020.
Suppose during 2020, the market size for high-end kitchen range hoods grew 3% in terms of number of units and all increases in market share (that is, increases in the number of units sold greater than 3%) are due to Westwood’s product-differentiation strategy. Calculate how much of the change in operating income from 2019 to 2020 is due to the industry-market-size factor, cost leadership, and product differentiation.
How successful has Westwood been in implementing its strategy? Explain.

Solution

1. The balanced scorecard should describe Westwood’s product-differentiation strategy. Key elements that should be included in its balanced scorecard are as follows:
1. • FINANCIAL PERSPECTIVE. Increase in operating income from higher margins on KE8 and from growth
2. • CUSTOMER PERSPECTIVE. Customer satisfaction ratings and market share in the high-end market
3. • INTERNAL-BUSINESS-PROCESS PERSPECTIVE. Number of major new product features, development time for new products, number of advanced controls in manufacturing processes, number of reworked products, order-delivery time, and on-time delivery
4. • LEARNING-AND-GROWTH PERSPECTIVE. Number of employees in product development, percentage of employees trained in process and quality management, and employee satisfaction ratings
2. Operating income for each year is as follows:

Details of operating income are as follows:

2019:

Revenues (product of $100 per unit and 40,000 units): $4,000,000

Costs

Direct material costs (product of $10 per square feet and 120,000 square feet): 1,200,000
Conversion costs (product of $20 per unit and 50,000 units): 1,000,000
Selling and customer-service cost (product of $24,000 per customer and 30 customers): 720,000
Total costs: 2,920,000

Operating income: $1,080,000

2020:

Revenues (product of $110 per unit and 42,000 units): $4,620,000

Costs

Direct material costs (product of $11 per square feet and 123,000 square feet): 1,353,000
Conversion costs (product of $22 per unit and 50,000 units): 1,100,000
Selling and customer-service cost (product of $25,000 per customer and 29 customers): 725,000
Total costs: 3,178,000

Operating income: $1,442,000

Change in operating income (Difference of $1,442,000 and $1,080,000): $362,000 F.

Growth Component of Change in Operating Income

$\begin{array}{lll} \begin{matrix} Revenue effect \\ of growth \end{matrix} & = & (\begin{matrix} Actual units of \\ output sold \\ in 2020 \end{matrix} - \begin{matrix} Actual units of \\ output sold \\ in 2019 \end{matrix}) \times \begin{matrix} Selling \\ price \\ in 2019 \end{matrix} \\ = & (42,000 units - 40,000 units) \times $ 100 per unit = $ 200,000 F \\ \begin{matrix} Cost effect of \\ growth for \\ variable costs \end{matrix} & = & (\begin{matrix} Units of input \\ required to \\ produce 2020 \\ output in 2019 \end{matrix} - \begin{matrix} Actual units of \\ input used \\ to produce \\ 2019 output \end{matrix}) \times \begin{matrix} Input \\ price \\ in 2019 \end{matrix} \\ \begin{matrix} Cost effect \\ of growth for \\ direct materials \end{matrix} & = & (120,000 sq . ft . \times \frac{42,000 units}{40,000 units} - 120,000 sq . ft .) \times $ 10 per sq . ft . \\ = & (126,000 sq . ft . - 120,000 sq . ft .) \times $10 per sq . ft . = $60,000 U \\ \begin{matrix} Cost effect \\ of growth for \\ fixed costs \end{matrix} & = & (\begin{matrix} Actual units of capacity in \\ 2019 because adequate capacity \\ exists to produce 2020 output in 2019 \end{matrix} - \begin{matrix} Actual units \\ of capacity \\ in 2019 \end{matrix}) \times \begin{matrix} Price per \\ unit of \\ capacity \\ in 2019 \end{matrix} \\ \begin{matrix} Cost effect of \\ growth for \\ fixed conversion costs \end{matrix} & = & (50,000 units - 50,000 units) \times $20 per unit = $ 0 \end{array}$

$\begin{matrix} Cost effect of growth for \\ fixed selling and \\ customer-service costs \end{matrix} = (30 customers - 30 customers) \times $ 24,000 per customer = $ 0$

In summary, the net increase in operating income attributable to growth equals

The table depicts net increase in operating income attributable to growth. The details of the table are as follows:

1. Revenue effect of growth: 200,000 dollars F

2. Cost effect of growth, direct material costs: 60,000 dollars U

3. Cost effect of growth, conversion costs: 0 dollars

4. Cost effect of growth, selling and customer-service costs: 0 dollars

5. Cost effect of growth, total costs: 60,000 dollars U

6. Change in operating income due to growth: 140,000 dollars F

Price-Recovery Component of Change in Operating Income

$\begin{array}{l} \begin{matrix} Revenue effect of \\ price recovery \end{matrix} & = & (\begin{matrix} Selling price \\ in 2020 \end{matrix} - \begin{matrix} Selling price \\ in 2019 \end{matrix}) \times \begin{matrix} Actual units \\ of output \\ sold in 2020 \end{matrix} \\ = & ($ 110 per unit - $100 per unit) \times 42,000 units = $ 420,000 F \\ \begin{matrix} Cost effect of \\ price recovery \\ for variable costs \end{matrix} & = & (\begin{matrix} Input \\ price \\ in 2020 \end{matrix} - \begin{matrix} Input \\ price \\ in 2019 \end{matrix}) \times \begin{matrix} Units of input \\ required to produce \\ 2020 output in 2019 \end{matrix} \end{array}$

$Direct material costs : ($ 11 per sq . ft . - $ 10 per sq . ft .) \times 126,000 sq . ft . = $ 126,000 U$

$\begin{matrix} Cost effect of \\ price recovery for \\ fixed costs \end{matrix} = (\begin{matrix} Price per \\ unit of \\ capacity \\ in 2020 \end{matrix} - \begin{matrix} Price per \\ unit of \\ capacity \\ in 2019 \end{matrix}) \times \begin{matrix} Actual units of capacity in \\ 2019 because adequate capacity \\ exists to produce 2020 output in 2019 \end{matrix}$

Cost effects of price recovery for fixed costs are

$\begin{matrix} Conversion costs: ($22 per unit - 20 per unit) \times 50,000 units = $ 100,000 U \\ Selling and cust . ‐ service costs: ($ 25,000 per cust. - $ 24,000 per cust .) \times 30 customers = $ 30,000 U \end{matrix}$

In summary, the net increase in operating income attributable to price recovery equals

The table depicts the net increase in operating income attributable to price recovery. The details of the table are as follows:

1. Revenue effect of price recovery: 420,000 dollars F

2. Cost effect of price recovery, direct material costs: 126,000 dollars U

3. Cost effect of price recovery, conversion costs: 100,000 dollars U

4. Cost effect of price recovery, selling and customer-service costs: 30,000 dollars U

5. Cost effect of price recovery, total costs: 256,000 dollars U

6. Change in operating income due to price recovery: 164,000 dollars F

Productivity Component of Change in Operating Income

$\begin{array}{l} \begin{matrix} Cost effect of \\ productivity for \\ variable costs \end{matrix} & = & (\begin{matrix} Actual units of \\ input used to produce \\ 2020 output \end{matrix} - \begin{matrix} Units of input \\ required to produce \\ 2020 output in 2019 \end{matrix}) \times \begin{matrix} Input \\ price in \\ 2020 \end{matrix} \\ \begin{matrix} Cost effect of \\ productivity for \\ direct materials \end{matrix} & = & (123,000 sq . ft . - 126,000 sq . ft .) \times $11 per sq . ft . = $ 33,000 F \\ \begin{matrix} Cost effect of \\ productivity for \\ fixed costs \end{matrix} & = & (\begin{matrix} Actual units \\ of capacity \\ in 2020 \end{matrix} - \begin{matrix} Actual units of capacity in \\ 2019 because adequate \\ capacity exists to produce \\ 2020 output in 2019 \end{matrix}) \times \begin{matrix} Price per \\ unit of \\ capacity \\ in 2020 \end{matrix} \end{array}$

Cost effects of productivity for fixed costs are

$\begin{matrix} Conversion costs : (50,000 units - 50,000 units) \times $22 per unit = $ 0 \\ Selling and customer ‐ service costs : (29 customers - 30 customers) \times $ 25,000 / customer = $25,000 F \end{matrix}$

In summary, the net increase in operating income attributable to productivity equals

The table depicts the net increase in operating income attributable to productivity. The details of the table are as follows:

1. Cost effect of productivity, direct material costs: 33,000 dollars F

2. Cost effect of productivity, conversion costs: 0 dollars

3. Cost effect of productivity, selling and customer-service costs: 25,000 dollars F

4. Change in operating income due to productivity: 58,000 dollars F

A summary of the change in operating income between 2019 and 2020 follows.

Details of the change in operating income between 2019 and 2020 are as follows:

Revenue

Income statement amounts in 2019: $4,000,000
Revenue and cost effects of growth component in 2020: $200,000 F
Revenue and cost effects of price-recovery component in 2020: $420,000 F
Cost effect of productivity component in 2020: none
Income statement amounts in 2020 (sum of 1, 2, 3, and 4): $4,620,000

Costs

Income statement amounts in 2019: $2,920,000
Revenue and cost effects of growth component in 2020: $60,000 U
Revenue and cost effects of price-recovery component in 2020: $256,000 U
Cost effect of productivity component in 2020: $58,000 F
Income statement amounts in 2020 (sum of 1, 2, 3, and 4): $3,178,000

Operating income

Income statement amounts in 2019: $1,080,000
Revenue and cost effects of growth component in 2020: $140,000 F
Revenue and cost effects of price-recovery component in 2020: $164,000 F
Cost effect of productivity component in 2020: $58,000 F
Income statement amounts in 2020 (sum of 1, 2, 3, and 4): $1,442,000

Change in operating income (Difference of $1,442,000 and $1,080,000): $362,000 F.

3. Effect of the Industry-Market-Size Factor on Operating Income Of the increase in sales from 40,000 to 42,000 units, 3%, or 1,200 units $begin inline style left parenthesis 0.03 cross times text 40,000 end text right parenthesis end style$ , are due to growth in market size, and 800 units $begin inline style left parenthesis text 2,000 end text minus text 1,200 end text right parenthesis end style$ are due to an increase in market share. The change in Westwood’s operating income from the industry-market-size factor rather than specific strategic actions is:

The table depicts the effect of the industry-market-size factor on operating income. The details of the table are as follows:

140,000 dollars (column 2 of preceding table) times the quantity 1,200 units divided by 2,000 units equals 84,000 dollars F

Effect of Product Differentiation on Operating Income

The table depicts the effect of product differentiation on operating income. The details of the table are as follows:

1. Increase in the selling price of KE8 (revenue effect of the price-recovery component): 420,000 dollars F

2. Increase in prices of inputs (cost effect of the price-recovery component): 256,000 dollars U

3. Growth in market share due to product differentiation: 140,000 dollars (column 2 of preceding table) times the quantity 800 units divided by 2,000 units equals 56,000 dollars F

4. Change in operating income due to product differentiation: 220,000 dollars F

Effect of Cost Leadership on Operating Income

The table depicts the effect of cost leadership on operating income. The details of the table are as follows:

Productivity component: 58,000 dollars F

A summary of the net increase in operating income from 2019 to 2020 follows:

The table depicts a summary of the net increase in operating income from 2019 to 2020. The details of the table are as follows:

1. Change due to the industry-market-size factor: 84,000 dollars F

2. Change due to product differentiation: 220,000 dollars F

3. Change due to cost leadership: 58,000 dollars F

4. Change in operating income: 362,000 dollars F

4. The analysis of operating income indicates that a significant amount of the increase in operating income resulted from Westwood’s successful implementation of its product-differentiation strategy (operating income attributable to product differentiation, $220,000 F). The company was able to continue to charge a premium price for KE8 while increasing market share. Westwood was also able to earn additional operating income from improving its cost leadership through productivity improvement (operating income attributable to cost leadership, $58,000 F).