Further Analysis of Growth, Price-Recovery, and Productivity Components

As in all variance and profit analysis, Chipset’s managers may want to further analyze the change in operating income. For example, Chipset’s growth might have been helped by an increase in industry market size. Therefore, at least part of the increase in operating income may be attributable to favorable economic conditions in the industry rather than to any successful implementation of strategy. Some of the growth might relate to the management decision to decrease selling price, made possible by the productivity gains. In this case, the increase in operating income from cost leadership must include operating income from productivity-related growth in market share in addition to the productivity gain.

Try It! 13-2

Strategic Analysis of Operating Income

Costa Associates is a construction engineering firm that prepares detailed construction drawings for single-family homes. The market for this service is very competitive. To compete successfully Costa must deliver quality service at low cost. Costa presents the following data for 2019 and 2020.

The table depicts number of jobs billed, selling price per job, engineering labor-hours, cost per engineering labor-hour, engineering support capacity (number of jobs the firm can do), total cost of engineering support (space rent, equipment, etc.), and engineering support-capacity cost per job for 2019 and 2020.. The details of the table are as follows:

1. Number of jobs billed

2019: 450
2020: 650

2. Selling price per job

2019: 3,500 dollars
2020: 3,300 dollars

3. Engineering labor-hours

2019: 27,000
2020: 32,000

4. Cost per engineering labor-hour

2019: 39 dollars
2020: 40 dollars

5. Engineering support capacity (number of jobs the firm can do)

2019: 850
2020: 850

6. Total cost of engineering support (space rent, equipment, etc.)

2019: 263,500 dollars
2020: 306,000 dollars

7. Engineering support-capacity cost per job

2019: 310 dollars
2020: 360 dollars

Engineering labor-hour costs are variable costs. Engineering support costs for each year depend on the engineering support capacity that Costa chooses to maintain each year (that is, the number of jobs it can do each year). Engineering support costs do not vary with the actual number of jobs done in a year.

Calculate the operating income of Costa Associates in 2019 and 2020.
Calculate the growth, price-recovery, and productivity components that explain the change in operating income from 2019 to 2020.
Comment on your answer in requirement 2. What do these components indicate?

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We illustrate these ideas, using the Chipset example and the following additional information. Instructors who do not wish to cover these detailed calculations can go to the next section without any loss of continuity.

The market growth rate in the industry is 8% in 2020. Of the 150,000 $left parenthesis 1 comma back space 150 comma back space 000 minus 1 comma back space 000 comma back space 000 right parenthesis$ units of increased sales of CX1 between 2019 and 2020, 80,000 $left parenthesis text 0.08 end text cross times 1 comma back space 000 comma back space 000 right parenthesis$ units are due to an increase in industry market size (which Chipset should have benefited from regardless of its productivity gains), and the remaining 70,000 units are due to an increase in market share.
During 2020, Chipset could have maintained the price of CX1 at the 2019 price of $23 per unit. But management decided to take advantage of the productivity gains to reduce the price of CX1 by $1 to grow market share leading to the 70,000-unit increase in sales.

The effect of the industry-market-size factor on operating income (not any specific strategic action) is as follows:

A table shows effect of the industry-market-size factor on operating income

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

Change in operating income due to growth in industry market size

2,820,000 dollars (Exhibit 13-6, column 2) times the quantity 80,000 units divided by 150,000 units equals 1,504,000 dollars F

Even while lacking a differentiated product, Chipset could have maintained the price of CX1 at $23 per unit. Under this assumption the revenue effect of price recovery of $1,150,000 (Exhibit 13-6, column 3) cannot be attributed to a lack of product differentiation. The lack of product differentiation affects operating income only as a result of higher input prices.

The effect of product differentiation on operating income is as follows:

A table shows the 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. Change in prices of inputs (cost effect of price recovery): 607,500 dollars U

2. Change in operating income due to product differentiation: 607,500 dollars U

To exercise cost and price leadership and to achieve faster growth, Chipset made the strategic decision to cut the selling price of CX1 by $1. This decision resulted in an increase in market share and 70,000 units of additional sales.

The effect of cost leadership on operating income is as follows:

A table shows the 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:

1. Productivity component: 1,912,500 dollars F

2. Effect of strategic decision to reduce price, 1 dollar per unit times 1,150,000 units: 1,150,000 dollars U

3. Growth in market share due to productivity improvement and strategic decision to reduce prices, 2,820,000 (Exhibit 13-6, column 2) times the quantity 70,000 units divided by 150,000 units: 1,316,000 dollars F

4. Change in operating income due to cost leadership: 2,078,500 dollars F

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

A table shows a summary of the change in operating income between 2019 and 2020

The table depicts a summary of the change in operating income between 2019 and 2020. The details of the table are as follows:

1. Change due to industry market size: 1,504,000 dollars F

2. Change due to product differentiation: 607,500 dollars U

3. Change due to cost leadership: 2,078,500 dollars F

4. Change in operating income: 2,975,000 dollars F

Consistent with its cost-leadership strategy, the productivity gains of $1,912,500 in 2020 were a big part of the increase in operating income from 2019 to 2020. Chipset took advantage of these productivity gains to decrease price by $1 per unit at a cost of $1,150,000 to gain $1,316,000 in operating income by selling 70,000 additional units. Under different assumptions about the change in selling price of CX1, the analysis will attribute different amounts of the change in operating income to the different strategies.

The Problem for Self-Study in the End of Chapter section describes the analysis of the growth, price-recovery, and productivity components for a company following a product-differentiation strategy. The Concepts in Action: Operating Income Analysis and the Decline of Casual Dining Restaurants describes how analysis of operating income revealed strategic challenges at chain restaurants like Buffalo Wild Wings.

Concepts in Action

Operating Income Analysis and the Decline of Casual Dining Restaurants^*

For decades, chain restaurants like Olive Garden and TGI Fridays dominated the dining landscape. With thousands of locations to grab a booth and order off the menu in shopping and strip malls across America, the casual dining industry was very robust and profitable.

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By the mid-2010s, however, analyzing the operating income of these chains revealed strategic challenges. At Buffalo Wild Wings, for example, though revenue increased 31% from 2014 to 2016, operating income fell 23% over the same period. Meanwhile, same store sales were declining and the costs of sales, labor, and operating expenses were rising. The reason: Younger diners were fleeing Buffalo Wild Wings and other restaurant chains in favor of trendier, tech-savvy, and more health-conscious options. According to former Buffalo Wild Wings CEO Sally Smith, “Millennial consumers are more attracted than their elders to cooking at home, ordering delivery from restaurants, and eating quickly, in fast-casual or quick-serve restaurants.”

To turn things around, chains from Chili’s to Outback Steakhouse are moving quickly to reshape their menus and renovate their restaurants to attract younger consumers—including creating Instagrammable atmospheres with picturesque, healthier menu items and introducing new to-go and mobile ordering services. It may be too late for some chains, however. In 2018, Applebee’s announced plans to close 80 locations and IHOP shuttered 40 locations as well. As for Buffalo Wild Wings, unable to quickly attract a younger clientele, it was acquired by Roark Capital Group, the parent company of Arby’s, for $2.9 billion in 2018.