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Edinburgh Business School MBA AUC Academic Partner Strategic Planning Module 6 - Part 1 Internal Analysis of the Company Instructor: Moataz Darwish, MBA
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Contents 6.1 Opportunity Cost 6/3 6.2 Fixed Costs, Variable Costs and Sunk Costs 6/4 6.3 Marginal Analysis 6/5 6.4 Diminishing Marginal Product 6/8 6.5 Profit Maximisation 6/10 6.6 Estimating Production Costs 6/10 6.7 Accounting Techniques: Break Even, Payback and Sensitivity 6/13 6.8 Accounting Ratios 6/17 6.9 Benchmarking 6/22 6.10 Research and Development 6/23 6.11 Human Resource Management 6/29 6.12 The Scope of the Company 6/31 6.13 The Value Chain 6/40 6.14 Competence 6/43 6.15 Strategic Architecture 6/49 6.16 Strategic Advantage Profile 6/54 EBS MBA / AUC 2
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The Scope of the CompanyThe Scope of the Company Economies of scaleEconomies of scale Fixed Costs, Variable CostsFixed Costs, Variable Costs Economies of scopeEconomies of scope and Sunk Costsand Sunk Costs DiversificationDiversification Estimating Production CostsEstimating Production Costs SynergySynergy Accounting RatiosAccounting Ratios Vertical IntegrationVertical Integration Opportunity CostOpportunity Cost Marginal AnalysisMarginal Analysis Diminishing MarginalDiminishing Marginal ProductProduct Profit MaximizationProfit Maximization Module 6 Value ChainValue Chain Accounting Techniques:Accounting Techniques: CompetenceCompetence Sensitivity AnalysisSensitivity Analysis Strategic ArchitectureStrategic Architecture Break-Even AnalysisBreak-Even Analysis Payback PeriodPayback Period Research and Development:Research and Development: Research and InnovationResearch and Innovation DevelopmentDevelopment Human Resource ManagementHuman Resource Management Types of culturesTypes of cultures Benchmarking EBS MBA / AUC 3
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Introduction • Using analytical tools from different disciplines to: – to assess the effectiveness with which resources have been allocated in the past, – identify the sources of competitive advantage – estimate the strengths and weaknesses of the company EBS MBA / AUC 5
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Opportunity Cost • Constraints on the resources requires choice amongst alternatives. The best alternative forgone is the opportunity cost of the action chosen. EX. • The opportunity cost, in purely financial terms, of spending $1 million on marketing is to reduce prices because this is the next best alternative; since these two options have a similar level of risk they can be compared directly. • Help identify relevant tradeoffs and establish priorities. • The idea can be used to evaluate resource allocation options at all levels in the company; • From the strategy viewpoint it helps to focus on the following questions: – ‘Have we identified all relevant options?’ – and ‘How do the options compare with each other?’ EBS MBA / AUC 6
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Fixed Costs, Variable Costs and Sunk Costs • Many accounting systems ignore the fact that some costs are fixed and some are variable with respect to changes in output. • Many accountants are firmly convinced that each product must bear its share of overheads. Application of this principle can lead to misallocation of resources. • Factory rent is an example of a fixed cost; no point to reallocating factory rent over the new range of output and changing the calculation of unit cost. • Materials are a variable input, hence the cost of materials must be taken into account in deciding the level of output. • Sunk costs are the costs which were incurred in the past, and as a result cannot vary with respect to output. • Expenditure on development incurred last quarter is a sunk cost, and therefore has no bearing on whether to continue developing a product. EBS MBA / AUC 7
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Fixed Costs, Variable Costs and Sunk Costs • When making strategy decisions it is obviously important to make sure that the appropriate costs are taken into account; • Sunk costs are a particularly important strategic consideration for barriers to entry; if the costs of entry are recoverable then they are not sunk as far as the strategic move is concerned. • The fact that a cost was incurred in the past does not necessarily make it sunk. EBS MBA / AUC 8
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Marginal Analysis Marginal cost principle: Being the change in costs as output varies • Outcome of failing to distinguish between fixed and variable cost is focusing on average costs - major error. • Marginal cost - only relevant costs should be taken into account in making pricing and output decisions. – excludes fixed cost – hence significantly lower than average cost. – used as a guide to the minimum acceptable price. • The benefit of thinking in marginal terms is that it focuses on the costs and benefits associated with specific actions. • The additional amount gained from the sale of each additional unit is known as marginal revenue • Marginal cost pricing – one off prices (ex. Hotel night) EBS MBA / AUC 9
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Diminishing Marginal Product • Marginal cost vary because productivity of resources varies at the margin. – Ex. Hectare of land • This has important implications for: – determining the scale of company operations, ex hiring additional workers. – allocation of resources among company activities (optimum allocation), ex. government employees. – at the corporate level, where SBUs are competing for scarce funds - allocate resources based on it. EBS MBA / AUC 10
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Profit Maximisation • Profit maximising output is that where marginal cost equals price. • The two questions that are really about profit maximisation: – ‘What are the additional expected costs?’ and – ‘What are the additional expected revenues?’ • Notion of profit maximisation is concerned with efficient resource allocation given the tastes and preferences of consumers; • The great economist Adam Smith pointed out that everyone can be made better off through the pursuit of profit maximisation, since this leads to the most efficient use of resources in an economy. EBS MBA / AUC 11
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Estimating Production costs • Disagreement between economists and accountants. • Many accounting systems are simply incapable of providing an answer to the question of how much it costs to produce a particular product, and how costs vary as the level of output changes. • The debate has centered on the concept of marginal (economists) versus average (accountants) costs, and on expected future costs versus historical costs. • Economists argue that sunk costs should be excluded from decision making information, and that the only use for historical costs is to provide guidance on what costs are likely to be in the future; • The general principle to apply is that if the company accounting system does not provide information which is consistent with economic concepts there is a good chance that mistaken decisions will be made. EBS MBA / AUC 12
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Joint Production • The classic case of joint production is that of a sheep, which produces both wool and mutton; • The key problem is cost allocation - An example is activity based costing, if the resources devoted to a particular output cannot be identified, neither can the costs. • the manager should be aware that allocated costs may be irrelevant for decision making purposes. • it may not be possible to identify variable costs separately. • Strategic Implications: – it may not be possible to produce certain products on their own – And/or compete effectively with those produced under conditions of joint production. EBS MBA / AUC 13
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Break-Even Analysis • Breakeven Analysis: ‘How many units would have to be sold before the product starts making a net contribution?’ • A simple version: – Cost side: Total cost = Sales × Variable unit cost + Fixed cost – Revenue side: Total Revenue = Sales × Price – Solve for sales: • Is total sales requirement attainable before the product makes a positive cash contribution? based on the marketing information. • Sensitivity analysis can be used to identify conditions under which the product will not even cover its production costs. • Breakeven analysis is obviously limited in that it concentrates only on the volume of output and sales, and does not take into account the passage of time; EBS MBA / AUC 15
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Payback Period • ‘How long will it be before the project pays back its start up costs?’ • The payback period is the length of time until the running total becomes positive. • There is some dispute as to whether the payback period adds to the information produced by a properly executed net present value analysis. • What is important is to generate information on different aspects of investments so that corporate decision makers can arrive at a well balanced view of the implications of different courses of action. EBS MBA / AUC 16
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Sensitivity Analyses • When making predictions about the future it is not possible to be precise, but it is possible to have some idea of the range of values likely to be associated with important variables. • At the very least, the best possible and worst possible scenario for each important variable can be projected. • Sensitivity analysis is related to the investigation of scenarios, but is conducted at a more detailed level. • Sensitivity analysis can be carried out in relation to different dimensions of performance. • powerful technique for generating a perspective on the potential returns from a course of action. • It identifies which are the crucial variables, and where unexpected threats may exist. • A somewhat less obvious aspect of sensitivity analysis is to identify the combination of circumstances which are necessary to ensure success. EBS MBA / AUC 17
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Accounting Ratios AccountingAccounting FinanceFinance efficiency with which resource allocation in the future resource allocation to- date • Ratios: – provide information on different dimensions of company performance. – assess the effectiveness with which resources have been allocated in the past. – can identify potential weaknesses in company management. – no definitive set of ratios. EBS MBA / AUC 19
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Accounting Ratios • Ratios produce performance measures which relate to the efficiency with which resources are allocated, appropriate measures must be used for: – Revenues / Costs / Assets – Assets appear in the bottom line of most of the measures, • The following ratios are typically encountered in company accounts: – ROI Return on Investment – RONA Return on Net Assets – ROCE Return on Capital Employed – ROTA Return on Total Assets – Value Added – Earnings per Share – Gearing ratio EBS MBA / AUC 20
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