Strategic Analysis of Operating Income

Learning Objective 3 Analyze changes in operating income to evaluate strategy

• growth, price recovery, and productivity

As we have discussed, Chipset performed well on its various nonfinancial measures, and operating income also increased. As a result, Chipset’s managers might be tempted to declare the cost-leadership strategy a success. However, more analysis is needed before managers can conclude that Chipset successfully formulated and implemented its intended strategy. Operating income could have increased simply because prices of inputs decreased or the entire market expanded. Alternatively, a company that has chosen a cost-leadership strategy, like Chipset, may find that its operating-income increase actually resulted from some degree of product differentiation. To evaluate the success of a strategy, managers and management accountants need to link strategy to the sources of operating-income increases. These are the kinds of analyses that top management and boards of directors routinely discuss in their meetings when evaluating performance. Managers who have mastered the strategic analysis of operating income changes gain an understanding of the levers of strategy and strategy implementation that help them deliver sustained operating performance.

Can Chipset’s managers conclude they were successful in implementing their strategy? They can only do so if improvements in the company’s financial performance and operating income over time can be attributed to achieving targeted cost savings and growth in market share. The top two rows of Chipset’s balanced scorecard in Exhibit 13-3 show that operating-income gains from productivity ($1,912,500) and growth ($2,820,000) exceeded targets. (The next section of this chapter describes how these numbers were calculated.) This means that Chipset’s strategy formulation and implementation, not other factors, led to increases in operating income. The success of its strategy means that Chipset’s management can be more confident that the gains will be sustained in subsequent years.

We next discuss how Chipset’s management accountants subdivide changes in operating income into components that can be identified with product differentiation, cost leadership, and growth. Subdividing the change in operating income to evaluate the success of a strategy is conceptually similar to the variance analysis discussed in Chapters 7 and 8. One difference, however, is that in strategic analysis of operating income, management accountants compare actual operating performance over two different periods, not actual to budgeted numbers in the same time period as in variance analysis.^* A second difference is that the analysis in this section breaks down changes in operating income rather than focus on differences in individual cost categories (direct materials, direct manufacturing labor, and overhead) as we did in Chapters 7 and 8.

We next explain how the change in operating income between any two periods can be subdivided into product differentiation, cost leadership, and growth components.^* We illustrate the analysis using data from 2019 and 2020 because Chipset implemented key elements of its strategy in late 2019 and early 2020 and expects the financial consequences of these strategies to occur in 2020. Suppose the financial consequences of these strategies had been expected to affect operating income in only 2021. Then we could just as easily have compared 2019 to 2021. If necessary, we could also have compared 2019 to 2020 and 2021 taken together.

Chipset’s data for 2019 and 2020 follow:

Chipset managers obtain the following additional information:

1. Conversion costs (labor and overhead costs) for each year depend on the production processing capacity defined in terms of the quantity of square centimeters of silicon wafers that Chipset can process. These costs do not vary with the actual quantity of silicon wafers processed.
2. Chipset incurs no R&D costs. Its marketing, sales, and customer-service costs are small relative to the other costs. Chipset has eight customers in 2020, each purchasing roughly the same quantities of CX1. Because of the highly technical nature of the product, Chipset uses a cross-functional team for its marketing, sales, and customer-service activities. This cross-functional approach ensures that, although marketing, sales, and customer-service costs are small, the entire Chipset organization, including manufacturing engineers, remains focused on increasing customer satisfaction and market share. (The Problem for Self-Study at the end of this chapter describes a situation in which marketing, sales, and customer-service costs are significant.)
3. Chipset’s asset structure is very similar in 2019 and 2020.
4. Operating income for each year is as follows:

The goal of Chipset’s managers is to evaluate how much of the $2,975,000 increase in operating income was caused by the successful implementation of the company’s cost-leadership strategy. To do this evaluation, management accountants start by analyzing three main factors: (1) growth, (2) price recovery, and (3) productivity.

The growth component measures the change in operating income attributable solely to the change in the quantity of output sold between 2019 and 2020. It evaluates how revenues and costs change as a company sells more products and services. The price-recovery component measures the change in operating income attributable solely to changes in Chipset’s prices of inputs and outputs between 2019 and 2020. The price-recovery component measures the change in revenues as a result of a change in output price compared with the change in costs as a result of changes in input prices. A company that has successfully implemented a strategy of product differentiation will be able to increase its output price faster than its input prices increase, boosting profit margins and operating income; these companies will show a large positive price-recovery component.

The productivity component measures the change in costs attributable to a change in the quantity of inputs used in 2020 relative to the quantity of inputs that would have been used in 2019 to produce the 2020 output. The productivity component measures the amount by which operating income increased as a result of using inputs efficiently and thereby lowering costs. In the case of fixed costs, productivity improvement takes the form of reducing the costs of unused capacity. A company that has successfully pursued a strategy of cost leadership will be able to produce a given quantity of output with a lower cost of inputs and will show a large positive productivity component. Given Chipset’s strategy of cost leadership, managers expect the increase in operating income to be attributable to the productivity and growth components, not to price recovery. We now examine these three components in detail.

Growth Component of Change in Operating Income

The growth component of the change in operating income measures the increase in revenues minus the increase in costs from selling more units of CX1 in 2020 (1,150,000 units) than in 2019 (1,000,000 units), assuming nothing else has changed.

Revenue Effect of Growth

This growth component is favorable (F) because the increase in output sold in 2020 compared to 2019 increases operating income, assuming nothing else has changed. Components that decrease operating income are unfavorable (U).

Note that Chipset uses the 2019 price of CX1 and focuses only on the increase in units sold between 2019 and 2020 because the revenue effect of the growth component measures how much revenues would have changed in 2019 if Chipset had sold 1,150,000 units instead of 1,000,000 units.

Cost Effect of Growth

If Chipset had produced more units in 2019, it would also have incurred more costs to produce those units. These additional costs would have to be offset against the higher revenues from producing and selling the additional units to determine how much operating income would change as a result of growth. The cost effect of growth measures how much costs would have changed in 2019 if Chipset had produced 1,150,000 units of CX1 instead of 1,000,000 units. To measure the cost effect of growth, Chipset’s management accountants distinguish variable costs (only direct material costs) and fixed costs (conversion costs) because as units produced (and sold) increase, variable costs increase proportionately but fixed costs, generally, do not change.

The units of input required to produce 2020 output in 2019 can also be calculated as follows:

Units of input required to produce 2020 output of $\text{1,150,000}\hspace{0.17em}\text{units\hspace{0.17em}in}\hspace{0.17em}2019=3\hspace{0.17em}\mathrm{sq}.\mathrm{cm}.$ $\text{per\ unit}\times \text{1,150,000}\hspace{0.17em}\text{units}=\text{3,450,000}\hspace{0.17em}\mathrm{sq}.\mathrm{cm}.$ 

Conversion costs are fixed costs at a given level of capacity. Chipset has manufacturing capacity to process 3,750,000 square centimeters of silicon wafers in 2019 at a cost of $4.28 per square centimeter (rows 5 and 7 of data in section Strategic Analysis of Operating Income). To produce 1,150,000 units of output in 2019, Chipset needs to process 3,450,000 square centimeters of direct materials, which is less than the available capacity of 3,750,000 sq. cm. Throughout this chapter, we assume adequate capacity exists in 2019 to produce 2020 output. Under this assumption, the cost effect of growth for capacity-related fixed costs is, by definition, $0. Had 2019 capacity been inadequate to produce 2020 output in 2019, we would need to calculate the costs of the additional capacity required to produce 2020 output in 2019. These calculations are beyond the scope of this text.

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