Nature of Strategic Planning
This chapter describes the nature of strategic planning. The second part discusses techniques for analyzing and deciding on proposed new programs. The third part describes techniques that are useful in analyzing ongoing programs. The conducting part describes the sevÂeral steps in the strategic, planning process.
The discussion implicitly assumes a moderately large organization, typiÂcally consisting of a headquarters and several decentralized business units. In such an organization, strategic planning takes place both at headquarters and in the business units. If the organization is small and especially if it does not have business units, the process involves only senior executives and planning staff. In a small organization, the process may involve only the Chief Executive Officer.
Most competent managers spend considerable time thinking about the future. The result may be an informal understanding of the future direction the enÂtity is going to take or it may be a formal statement of specific plans about how to get there. Such a formal statement of plans is here called a strategic plan and the process of preparing and revising this statement is called strategic planning (elsewhere called long-range planning and programming). Strategic planning is the process of deciding on the programs that the organiÂzation will undertake and the approximate amount of resources that will be allocated to each program over the next several years.
Relation to Strategy Formulation
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We draw a distinction between two management processes-strategy formations and strategic planning. Because "strategy" or "strategic" is used in both terms, there is a possibility of confusion. The distinction is that strategy formulation is the process of deciding on new strategies, whereas strategic planning is the process of deciding how to implement the strategies. In the strategy formulations process, management arrives at the goals of the organizations and creates the main strategies for achieving those goals. The strategic planning process then takes the goals and strategies as given and develops programs that will carry out the strategies and achieve the goals efficiently and effectively. The decision by an industrial goods manufacturer to-diversify into conÂsumer goods is a strategy formulation, a strategic decision after which a number of implementation issues have to be resolved: whether to diversify through acquisition or through organic growth, what product lines to emphaÂsize, whether to make or to buy, which marketing channels to use. The document that describes how the strategic decision is to be implemented is the strategic plan.
In practice, there is considerable amount of overlap between strategy formulation and strategic planning. Studies made during the strategic planÂning process may indicate the desirability of changing goals or strategies. Conversely, strategy formulation usually includes a preliminary consideration of the programs that will be adopted as a means of achieving the goals. Nevertheless, it is important to keep a conceptual distinction between strategy formulation and strategic planning, one reason being that the planning process tends to become institutionalized, putting a damper on purely creÂative activities. Segregating strategy formulation as a separate activity, at least in the thinking of top management, can offset this tendency. Strategy formulation should be an activity in which creative, innovative thinking is strongly encouraged.
Strategic planning is systematic; there is an annual strategic planning process, with prescribed procedures and timetables. Strategy formulation is unsystematic. Strategies are reexamined in response to perceived opportuniÂties or threats. Thus, ideally, a possible strategic initiative may surface at any time from anyone in the organization. If judged to be worth pursuing, it should be analyzed immediately, without waiting upon a prescribed timetable. Once a strategy is accepted, the planning for it follows in a systemÂatic way.
In many companies, unfortunately, goals and strategies are not stated exÂplicitly enough or communicated clearly to the managers who need to use them as a framework for their program decision. Thus, in a formal strategic planning process an important first step often has to be to write descriptions of the organization's goals and strategies. This may be a daunting task, for alÂthough top management presumably has an intuitive feel for what the goals and strategies are, they may not be able to verbalize them with the specificity necessary for making good program decisions. Planners may have to interpret or elicit management thinking as a first step.
Evolution of Strategic Planning
Always on Time
Marked to Standard
Fifty years ago the strategic planning process in most organizations was unÂsystematic. If management gave thought to long-range planning, it was not in a coordinated way. A few companies started formal strategic planning sysÂtems in the late 1950s, but most early efforts were failures; they were minor adaptations of existing budget preparation systems. The required data were much more detailed than was appropriate; staff people rather than line manÂagement did most of the work; participants spent more time filling in forms than thinking deeply about alternatives and selecting the best ones. As time went on, management learned their lessons- the objective should be to make difficult choices among alternative programs, not to extrapolate numbers in budgetary detail; time and effort should go into analysis and informal discusÂsion, relatively less on paperwork; the focus should be on the program itself rather than on the responsibility centers that carried it out.
Currently, many organizations appreciate the advantages of making a plan for the next three to five years. The practice of stating this plan in a forÂmal document, or model, is widely, but by no means universally, accepted. The amount of detail is usually much less than in the strategic plans of the 1950s.
Benefits and Limitations of Strategic Planning
A formal strategic planning process can give to the organization: (1) a frameÂwork for developing the annual budget; (2) a management development tool; (3) a mechanism to force managers to think long term; and (4) a means of aligning managers with the long-term strategies of the company.
Framework for Developing the Budget: An operating budget calls for resource commitments over the coming year; it is essential that management make such resource commitments with a clear idea of where the organization is heading over the next several years. A strategic plan provides that broader framework. Thus, an important benefit of preparing a strategic plan is that it facilitates the formulation of an effective operating budget.
As Exhibit given below suggests, a company without a strategic planning process considers too many strategic issues in the budgeting stage, potentially leadÂing to information overload, inadequate consideration of some strategic alterÂnatives, or neglect of some choices altogether- a dysfunctional environment that can seriously affect the quality of resource allocation decisions. An imÂportant benefit of strategic planning is to facilitate optimal resource allocation decisions in support of key strategic options. Exhibit given below shows how the strategic planning process narrows the range of options such that planners can make intelligent resource allocation decisions during the budgeting process. Thus, the strategic plan helps the organization understand the imÂplications of strategic decisions for action plans in the short term.
Strategic option A
Strategic option B
Strategic option C
Strategic option D
(Exhibit 1. A company without strategic planning)
Strategic option A
Strategic option C
Strategic option A
Strategic option B
Strategic option C
Strategic option D
(Exhibit 1. A company with strategic planning)
Management Development Tool: Formal strategic planning is an excelÂlent management education and training tool that provides managers with a process for thinking about strategies and their implementation. It is not an overstatement to say that in formal strategic planning, the process itself is more important than the output of the process, which is the plan document.
Mechanism for Forcing Management to Think Long Term: Managers tend to worry more about tactical issues and managing the present, day-to-Âday affairs of the business than about creating the future. Formal strategic planning forces managers to make time for thinking through important long-term issues.
Means of Aligning Managers with Corporate Strategies: The debates, discussions, and negotiations that take place during the planning process clarÂify corporate strategies, unify and align managers with such strategies, and reveal the implications of corporate strategies for individual managers.
As we will show, program decisions are made one at a time and the strategic plan brings them all together. Preparing the strategic plan may reÂveal that individual decisions do not add up to a satisfactory whole. Planned new investments may require more funds in certain years than the company can obtain in those years; planned changes in direct programs may require changes in the size of support programs (e.g., research and development, adÂministrative) that were not taken into account when these changes were conÂsidered separately. The profit anticipated from individual programs may not add up to satisfactory profit for the whole organization.
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Example: In 1996, Texaco, a large, complex oil and gas producer, had a capital spending and exploration budget of $3.6 billion. Some of its 1996 projects included "... Developing offshore projects in the North Sea, Nigeria, Angola, Australia, and Southeast Asia. Continuing to increase production in the neutral zone beÂtween Saudi Arabia and Kuwait." With the level of risk associated with the differÂent projects and the amount of resources available, strategic planning was a neÂcessity for Texaco in choosing among projects.
Limitations: There are several potential pitfalls or limitations to formal strategic planning. First, there is always a danger that planning can end up becoming a "form-filling," bureaucratic exercise, devoid of strategic thinking. In order to minimize this risk of bureaucratization, organizations should periÂodically ask, "Are we getting fresh ideas as a result of the strategic planning process?"
A second danger is that an organization may create a large strategic planÂning department and delegate the preparation of the strategic plan to that staff department, thus forfeiting the input of line management as well the edÂucational benefits of the process. Strategic planning is a line management function. The staff in strategic planning departments should be kept to a minimum and their role should be as a catalyst, an educator, and a facilitator of the planning process.
Finally, strategic planning is time consuming and expensive. The most significant expense is the time devoted to it by senior management and manÂagers at other levels in the organization. A formal strategic plan is desirable in organizations that have the following characteristics:
Top management is convinced that strategic planning is important. Otherwise, strategic planning is likely to be a staff exercise that has little imÂpact on actual decision-making.
The organization is relatively large and complex. In small, simple orÂganizations, an informal understanding of the organization's future direcÂtions is adequate for making decisions about resource allocations, the princiÂpal purpose of preparing a strategic plan.
Considerable uncertainty about the future exists, but the organization has the flexibility to adjust to changed circumstances. In a relatively stable organization, a strategic plan is unnecessary; the future is sufficiently like the past, so the strategic plan would be only an exercise in extrapolation. (If a staÂble organization foresees the need for a change in direction, such as a decline in its markets or drastic changes in the cost of materials, it prepares a continÂgency plan showing the actions to be taken to meet these new conditions.) On the other hand, if the future is so uncertain that reasonably reliable estimates cannot be made, preparation of a formal strategic plan is a waste of time.
In summary, a formal strategic planning process is not needed in small, relatively stable organizations, and it is not worthwhile in organizations that cannot make reliable estimates about the future or in organizations whose senior management prefers not to manage in this fashion.
Program Structure and Content
In most industrial organizations, programs are products or product families, plus research and development, general and administrative activities, planned acquisitions or other important activities that do not fit into existing product lines. At Procter & Gamble, for example, each product line is a proÂgram. By contrast, General Electric structures its programs by profit centers- that is, business units; each business unit is responsible for a speciÂfied number of product lines.
In service organizations, programs tend to correspond to the types of serÂvices rendered by the entity. In a multi-unit service organization, such as a hotel chain, each unit or each geographical region may constitute a program.
The typical strategic plan covers a period of five future years. Five years is a long enough period to estimate the consequences of program decisions made currently. The consequences of a decision to develop and market a new product or to acquire a major new capital asset may not be fully felt within a shorter period. The horizon beyond five years may be so murky that attempts to make a program for a longer period are not worthwhile. Many organizaÂtions prepare very rough plans that extend beyond five years. In some organiÂzations the strategic plan covers only the next three years.
The dollar/rupee amounts for each program show the approximate magnitude of its revenues, expenses and capital expenditures. Because of the relatively long time horizon, only rough estimates are feasible. Such estimates are satisfactory as a basis for indicating the organization's general direction. If business units structure the strategic plan, the "charter," which specifies the boundÂaries within which the business unit is expected to operate, is also stated.
The strategic planning process involves senior management and the manÂagers of business units or other principal responsibility centers, assisted by their staffs. A primary purpose is to improve the communication between corporate and business unit executives by providing a sequence of scheduled activities through which they can arrive at a mutually agreeable set of objecÂtives and plans. Managers of individual departments usually do not particiÂpate in the strategic planning process.
In some organizations, the controller organization prepares the strategic plan; in others, there is a separate planning staff. Strategic planning requires analytical skills and a broad outlook that may not exist in the controller orgaÂnization; the controller organization may be skilled primarily in the detailed analytical techniques that are required in fine-tuning the annual budget and analyzing variances between actual and budgeted amounts.
Even if there is a separate planning staff, the controller organization usuÂally does the work of disseminating guidelines and assembling the proposed numbers, as we describe in a later section. The numbers in the strategic plan,' in the annual budget and in the accounting system must be consistent with one another, and the best way of assuring this consistency is to assign reÂsponsibility for all three to the same staff. Moreover, some companies include the numbers for all three systems in a single computer model.
Headquarters staff members facilitate the strategic planning process, but they should not intervene too strongly. The best role of staff members is as a catalyst; they ensure that the process is properly carried out, but they do not make the program decisions. In particular, if business unit managers perÂceive that the headquarters staff is overly influential in the decision-making process, these managers will be reluctant to have the frank discussions with staff that are essential in developing sound plans. (Business unit managers, of course, have their own staffs who presumably are loyal to them.)
Top Management Style: Strategic planning is a management process, and the way in which it is conducted in a given company is heavily dependent on the style of the chief executive officer. Some chief executives prefer to make decisions without the benefit of a formal planning apparatus. If the controller of such a company attempts to introduce a formal system, he or she is likely to be unsuccessful. No system will function effectively unless the Chief ExecuÂtive actually uses it; if other managers perceive that the system is not a vital part of the management process, they will give only lip service to it.
In some companies, the Chief Executive wants overall plan for the reasons given earlier but by temperament has an aversion to paperwork. In such companies, the system can contain all the elements we describe in a later section, but with minimum detail in the written documents and relaÂtively greater emphasis on informal discussion. In other companies, senior management prefers extensive analysis and documentation of plans, and in these companies the formal part of the system is relatively elaborate.
Designers of the system must correctly diagnose the style of senior manÂagement and see to it that the system is appropriate for that style. This is a difficult task because formal strategic planning has become something of a fad and managers think they may be viewed as old-fashioned if they do not embrace all its trappings. Thus, they may instruct the staff to install an elaborate system, or permit staff to install one, that they later feel uncomfortÂable using.
Analyzing Proposed New Programs
Ideas for new programs can originate anywhere in the organization: with the Chief Executive, with a headquarters planning staff, or in various parts of the operating organization. For example, in 3M Corporation, the idea for "Post-It" notepads originated down in the organization, not at the initiative of the CEO. Some units are a more likely source of new ideas than others, for obviÂous reasons. The R&D organization is expected to generate ideas for novel products or processes, the marketing organization for marketing innovations, and the production engineering organization for better equipment and manuÂfacturing methods.
Proposals for programs are essentially either reactive or proactive- they arise either as a reaction to a perceived threat such as rumors of the introÂduction of a new product by a competitor, or as an initiative to capitalize on an opportunity. The a company's success depends in part on its ability to find and implement new programs and as ideas for these can come from a wide variety of sources, the atmosphere needs to be such that ideas come to light and receive appropriate management attention. A highly structured, formal system may create the wrong atmosphere for this purpose. The system should be flexible enough and receptive enough so that good new ideas do not get killed off before they come to the attention of the proper decision-maker.
Planners should view the adoption of a new program not as a single all-or-nothing decision but rather as a series of decisions, each one a relatively small step in testing and developing the proposed program. They should deÂcide to carry through full implementation and its consequent significant inÂvestment only if the tests indicate that the proposal has a good chance of sucÂcess. Most new programs are not like the Edsel automobile, which committed several hundred million dollars in a single decision; rather, they involve many successive decisions: agreement that the initial idea for a product is worth pursuing, examining its technical feasibility in a laboratory, examining production problems and cost characteristics in a pilot plant, testing consumer acceptance in test markets, and only then making a major commitÂment to full production and marketing. The system must provide for these successive steps and for a thorough evaluation of the results of each step as a basis for making the decision on the next step.
Capital Investment Analysis
Most proposals require significant new capital. Techniques for analyzing capÂital investment proposals attempt to find either (a) the net present value of the project- the excess of the present value of the estimated cash inflows over the amount of investment required; or (b) the internal rate of return implicit in the relationship between inflows and outflows. An important point is that these techniques are used in only about half the situations in which concepÂtually, they are applicable. There are at least four reasons for not using present value techniques in analyzing all proposals
The proposal may be so obviously attractive that a calculation of its net present value is unnecessary. A newly developed machine that reduces costs so substantially that it will pay for itself in a year is an example.
The estimates involved in the proposal and so uncertain that making present value calculations are not worth the effort- one can't draw a reliable conclusion from unreliable data. This situation is common when the results are heavily dependent on estimates of sales volume of new products for which no good market data exist. In these situations, the "pay-back period" criterion is used frequently.
The rationale for the proposal is something other than increased profitability. The present value approach assumes that the "objective function" to increase profits, but many proposed investments win approval on grounds that they improve employee morale, the company's image, or safety.
There is no feasible alternative to adoption. Environmental laws require investment in a new program, as an example.
The management control system should provide an orderly way of deciding on proposals that cannot be analyzed by quantitative techniques. Systems that attempt to rank number of quantifiable projects in order of profitability won't work; many projects do not fit into a mechanical ranking scheme.
We describe briefly considerations that are useful in implementing capital expenditure evaluation systems.
Rules: Companies usually publish rules and procedures for the approval capital expenditure proposals of various magnitudes. Proposed the plant manager, subject to a total specified amount in one year, may approve small expenditures and larger proposals go successively to business managers, to the Chief Executive Officer, and, in the case of very important proposals, to the Board of Directors.
The rules also contain guidelines for preparing proposals and the gene criteria for approving proposals. For example, small cost-saving proposals require a maximum payback period of two (sometimes three) years. For larger proposals, there is usually a minimum required earnings rate, to be used either in net present value or internal rate of return analysis. The required earnings rate may be the same for all proposals, or there may be different rates for projects with different risk characteristics; also, proposals for additional working capital may use a lower rate than proposals for fixed assets.
Avoiding Manipulation: Sponsors who know that their project with a negative net present value is not likely to be approved may nevertheless have a "gut feeling" that the project should be undertaken. In some cases, they may make a proposal attractive by adjusting the original estimates so that the project meets the numerical criteria- perhaps by making optimistic estiÂmates of sales revenues or by reducing allowances for contingencies in some of the cost elements. One of the most difficult tasks of the project analyst is to detect such manipulations. The reputation of project sponsors can provide a safeguard; the analyst may place more reliance on numbers from a sponsor who has an excellent track record. In any event, although all proposals that come up for approval are likely to satisfy the formal criteria for this reason, not all of them are truly attractive.
Models: In addition to the basic capital budgeting model, there are specialÂized techniques, such as risk analysis, sensitivity analysis, simulation, sceÂnario planning, game theory, option pricing models, contingent claims analyÂsis, and decision tree analysis. Some of them have been oversold, but others are of practical value. The planning staff should be acquainted with them and require their use in situations in which the necessary data are available.
Organization for Analysis
A team may evaluate extremely large and important proposals, and the process may require a year or more. Even for small proposals, considerable discussion usually occurs between the sponsor of the proposal and the headÂquarters staff. As many as a dozen functional and line executives may sign off on an important proposal before it is submitted to the chief executive officer. The CEO may return the proposals for further analysis several times before making the final decision to go ahead with or reject the project. As noted earlier, the decision to proceed may require a succession of development and testing hurdles be crossed before full implementation.
Recent work in the rapidly developing field of expert systems uses comÂputer software in the analysis of proposed programs. The new software perÂmits each participant in the team that is considering a proposal to vote on, and to explicitly rank, each of the criteria used to judge the project. The comÂputer tabulates the results and uncovers inconsistencies or misunderstandÂings and raises questions about them. A succession of votes on criteria can lead to a conclusion that expresses the consensus of the group.
There is no set timetable for analyzing investment proposals. As soon as people are available, they may start analysis. Planners collect approved projÂects during the year for inclusion in the capital budget. There is a deadline in the sense that the capital budget for next year has a deadline (usually just prior to the beginning of the budget year). If a proposal doesn't make that deadline, its formal approval may wait until the following year, unless there are unusual circumstances. The capital budget contains the authorized capital expenditures for the budget year, and, if additional amounts are approved, cash plans must be revised; there may be problems in financing the addiÂtional amount.
Analyzing Ongoing Programs
In addition to developing new programs, many companies have systematic ways of analyzing ongoing programs. Several analytical techniques can aid in this process. This section describes value chain analysis and activity based costing.
Value Chain Analysis
The value chain for any firm is the linked set of value-creating activities of which it is a part, from acquiring the basic raw materials for component supÂpliers to making the ultimate end-use product and delivering it to the final consumers. Each firm must be understood in this context of its place in some overall chain of value-creating activities.
From the strategic planning perspective, the value chain concept highÂlights three potentially useful areas:
1. Linkages with suppliers.
2. Linkages with customers.
3. Process linkages within the value chain of the firm.
Linkages with Suppliers: As Exhibit given below on this page indicates, the linkage with suppliers should be managed so that both the firm and its supÂpliers can benefit. Taking advantage of such opportunities can dramatically lower costs, increase value, or both.
Example: When delivery of bulk chocolate began in liquid form in tank cars inÂstead of in 10-pound molded bars, an industrial chocolate firm (i.e., the supplier) eliminated the cost of molding and packing bars, and a confectionery producer (i.e., the firm) saved the cost of unpacking and melting.
Linkages with Customers: As Exhibit given on the next page indicates, customer linkages can be just as important as supplier linkages. There are many examples of mutually beneficial linkages between a firm and its customers.
Example: Some container producers (i.e., the firms) have constructed manufacturÂing facilities next to beer breweries (i.e., the customers) and deliver the containers through overhead conveyors directly onto the customers' assembly lines. This results in significant cost reductions for both the container producers and their customers by expediting the transport of empty containers, which are bulky and heavy.
Exhibit: Profit improvement opportunities through linkages with suppliers
Exhibit: Profit improvement opportunities through linkages with customers
Process Linkages with the Value Chain of the Firm: Value chain analysis explicitly recognizes the fact that the individual value activities within a firm are not independent but rather are interdependent.
Example: At McDonald's, the timing of promotional campaigns (one value acÂtivity) significantly influences capacity utilization in production (another value activity). These linked activities must be coordinated if the full effect of the proÂmotion is to be realized.
A company might want to analyze the process linkages within the value chain, seeking to improve their efficiency. The overall objective of this analyÂsis is to move materials from vendors, through production, and to the cusÂtomer at the lowest cost, in the shortest time, and of acceptable quality. Efficiency of the design portion of the value chain might be increased by reÂducing the number of separate parts and increasing their ease of manufacture.
Example: Japanese VCR producers were able to reduce prices from $1,300 in 1977 to $295 in 1984 by emphasizing the impact of an early step in the chain (product design) on a later step (production) by drastically reducing the number of parts in VCRs.
A firm should also work toward improving the efficiency of every activity within the chain through a better understanding of the drivers that regulate costs and value for each activity.
Efficiency of the inward portion (i.e., the portion that precedes producÂtion) might be improved by reducing the number of vendors; by having a comÂputer system place orders automatically; by limiting deliveries to "just-in-time" amounts (which reduces inventories); and by holding vendors reÂsponsible for quality, which reduces or eliminates inspection costs.
Efficiency of the production portion might be improved by increased auÂtomation, perhaps by using robots; by rearranging machines into "cells," each of which performs a series of related production steps; and by better producÂtion control systems.
Efficiency of the outward portion (i.e., from the factory door to the cusÂtomer) might be improved by having customers place orders electronically (which is now common in hospital supply companies and in certain types of retailing); by changing the locations of warehouses; by changing channels of distribution and placing more or less emphasis on distributors and wholeÂsalers; by improving the efficiency of warehouse operations; and by changing the mix between company-operated trucks and transportation furnished by outside agencies.
Examples: Procter & Gamble places order-entry computers in Wal-Mart stores, eliminating errors that used to occur when Wal-Mart buyers transmitted orders to P&G order-entry clerks, reducing the cost of operation in both firms, and reducÂing the time between initiation of an order and shipment of the goods. Levi Strauss has a similar system with its own retail stores.
These efficiency-oriented initiatives usually involve trade-offs. Direct orders from customer computers may speed delivery and reduce paperwork but lead to an increase in order-filling costs because of the smaller quantities ordered. Thus, it is important that all related parts of the value chain be analyzed together; otherwise, improvements in one link may be offÂset by additional costs in another.
Increased computerization and automation in factories have led to important changes in systems for collecting and using cost information. Sixty years ago, most companies allocated overhead costs to products by means of a plant-wide overhead rate based on direct labor hours or dollars. Today, an increasing number of companies collect costs for material-related costs (e.g., transportation, storage) separately from other manufacturing costs; and they collect manufacturing costs for individual departments, individual machines, or individual "cells," which consist of groups of machines that perform a series of related operations on a product. In these cost centers, direct labor costs be combined with other costs, giving conversion cost- that is, the labor and factory overhead cost of converting raw materials and parts into finished products. In addition to conversion costs, the new systems also assign R&D, general and administrative, and marketing costs to products. The new sysÂtems also use multiple allocation bases. In these new systems, the word acÂtivity is often used instead of cost center and cost driver used instead of basis of allocation; and the cost system is called an activity-based cost system (ABC).
The basis of allocation, or cost driver, for each of the cost centers reflects the cause of occurrence- that is, the element that explains why the amount of cost incurred in the cost center, or activity, varies. For example, in procurement, the cost driver may be the number of orders placed; for internal transportation, the number of parts moved; for product design, the number of different parts in the product; and for production control, the number of setÂups. Note that "cause" here refers to the factor causing the costs in the indiÂvidual cost center.
Examples: General Motors used ABC analysis to formulate a component make-or-buy strategy in a single plant, its ABC system had over 5,000 activity cost pools and over 100 different cost drivers (i.e., drivers that traced activity cost pools to products).
Schrader Bellows, a division of Scovill, Inc., used ABC analysis to reevaluate marketing and product line strategies. Its ABC analysis had 28 activity cost pools and 16 cost drivers. Its previous system had one cost pool for each of the five proÂduction departments and used one cost driver (direct labor) to allocate the cost pools to products.
The ABC concept is not particularly subtle or counterintuitive. In fact, it is very much, in line with common sense. In earlier days factories tended to produce fewer different products, cost was labor dominated (high labor cost relative to overhead), and products tended to differ less in the amount of supÂport services they consumed. Thus, the activity basis for overhead allocation was not likely to result in product costs much different from a simple volume-driven basis tied to labor cost.
Today, labor cost in many companies is not only dramatically less imporÂtant, it is also viewed less and less as a cost to be varied when production volume varies. Indirect cost is now the dominant part of cost in many compaÂnies. In the prototypical "flexible factory," raw material is the only producÂtion volume-dependent cost and the only cost directly relatable to individual products. Advocates of ABC maintain that a meaningful assessment of full cost today must involve assigning overhead in proportion to the activities that generate it in the long run.
Use of ABC Information
ABC, when used as part of the strategic planning process, may provide useful insights. For example, it may show that complex products with many separate parts have higher design and production costs than simpler products; that products with low volume have higher unit costs than high-volume products; that products with many setups or many engineering change orders have higher unit costs than other products; and that products with a short life cycle have higher unit costs than other products. Information on the magnitude of these differences may lead to changes in policies relating to full line versus foÂcused product line, product pricing, make-or-buy decisions, product mix deciÂsions, adding or deleting products, elimination of non value added activities, and to an emphasis on better factory layouts and simplicity in product design.
Examples: In 1992, Chrysler benefited from ABC analysis in a pilot project that examined the designs for wiring harnesses for the company's popular mini-vans. The harnesses yoke together bundles of wires. Nine departments, from deÂsign to assembly to finance, set out to reckon the optimum number of wiring harÂnesses. The assembly people favored using just one kind of harness; the design group wanted nine, and so on. When ABC was used to cost out activities across the entire production of the vehicles, everyone saw the optimum number was two. Hewlett-Packard's successful products, new models of HP 3000 and HP 9000 midrange computers, benefited from better cost information. When ABC showed that testing new designs and parts was extremely expensive, engineers changed their plans to favor components that required less testing, thus lowering costs. Other companies have realized significant cost savings as a result of reÂducing complexity.
Examples: Procter & Gamble had standardized product formulas and packages. P&G used just two basic packages for shampoo in the United States, saving $25 million a year.
General Motors had reduced the number of US car models from 53 to 44 and combined its Pontiac and GMC division to simplify marketing.
Strategic Planning Process
In a company that operates on a calendar-year basis, the strategic planning process starts in the spring and is completed in the fall, just prior to the preparation of the annual budget. The process involves the following steps:
Reviewing and updating the strategic plan from last year.
Deciding on assumptions and guidelines.
First iteration of the new strategic plan.
Second iteration of the new strategic plan.
Review and approval.
Reviewing and Updating the Strategic Plan
During the course of a year, decisions are made that change the strategic plan; management makes decisions whenever there is a need to do so, not in response to a set timetable. Conceptually, the implications of each decision for the next five years should be incorporated in the strategic plan as soon as the decision is made. Otherwise, the formal plan no longer represents the path that the company plans to follow. In particular, the plan may not repreÂsent a valid base for testing proposed strategies and programs, which is one of the plan's principal values. As a practical matter, however, very few organÂizations continuously update their strategic plans. Updating involves more paperwork and computer time than management believes is worthwhile.
The first step in the annual strategic planning process, therefore, is to reÂview and update the strategic plan that was agreed to last year. Actual expeÂrience for the first few months of the current year is already reflected in the accounting reports, and these are extrapolated for the current best estimate of the year as a whole. If the computer program is sufficiently flexible, it can extend the impact of current forces to the "out years"- that is, the years beÂyond the current year; if not, rough estimates are made manually. The impliÂcations of new program decisions on revenues, expenses, capital expendiÂtures, and cash flow are incorporated. The planning staff usually makes this update. Management may be involved if there are uncertainties or ambiguiÂties in the program decisions that must be resolved.
Deciding on Assumptions and Guidelines
The updated strategic plan incorporates such broad assumptions as the growth in Gross Domestic Product, cyclical movements, labor rates, prices of important raw materials, interest rates, selling prices, market conditions such as the actions of competitors and the impact of government legislation in each of the countries in which the company operates. These assumptions are reexamined and, if necessary, are changed to incorporate the latest information.
The updated strategic plan contains the implications on revenues, exÂpenses, and cash flows of the existing operating facilities and changes in these facilities from opening new plants, expanding existing plants, closing plants, and relocating facilities. It shows the amount of new capital likely to be available from retained earnings and new financing. These conditions are examined to ensure that they are currently valid, and the amounts are exÂtended for another year.
The resulting update is not done in great detail. A rough approximation is adequate as a basis for senior management decisions about objectives that are to be attained in the plan years and about the key guidelines that are to be observed in planning how to attain these objectives. The objectives usually are stated separately for each product line and are expressed as sales revÂenue, as a profit percentage, or a return on capital employed. The principal guidelines are assumptions about wage and salary increases (including new benefits programs that may affect compensation), new or discontinued prodÂuct lines, and selling prices. For overhead units, personnel ceilings may be specified. At this stage, they represent senior management's tentative views. In the next stage, business unit managers have an opportunity to present their views.
Management Meetings: Many companies hold an annual meeting of corÂporate and business unit managers (often called a "summit conference") to discuss the proposed objectives and guidelines. Such a meeting typically lasts several days and is held away from company facilities to minimize distracÂtions. In addition to the formal agenda, such a meeting provides an opportuÂnity for managers throughout the corporation to get to know one another.
First Iteration of the Strategic Plan
Using the assumptions, objectives, and guidelines, the business units and other operating units prepare their "first cut" of the strategic plan, which may include different operating plans than those included in the current plan, such as a change in marketing tactics; these are supported by reasons. Business unit staffs do much of the analytical work, but business unit managers make the final judgments. Depending on the personal relationships, business unit personnel may seek the advice of the headquarters staff in the development of these plans. Members of the headquarters staff often visit the business units during this process for the purpose of clarifying the guidelines, assumptions, and instructions and, in general, to assist in the planning process.
The completed strategic plan consists of income statements; of inventory, accounts receivable, and other key balance sheet items; of number of employÂees; of quantitative information about sales and production; of expenditures for plant and other capital acquisitions; of any other unusual cash flows; and of a narrative explanation and justification. The numbers are in considerable detail (although in much less detail than in the annual budget) for the next year and the following year, with only summary information for the later years.
When headquarters receives the business unit plans, they aggregate them into an overall corporate strategic plan. Planning staff and the marketing, production, and other functional executives at headquarters analyze this plan in depth. Business Unit X plans a new marketing tactic; is it likely that the resulting sales will be as large as the plan indicates? Business Unit Y plans an increase in general and administrative personnel; are the additional peoÂple really needed? Business Unit Z assumes a large increase in productivity; is the supporting justification realistic? Research and development promises important new products; are the business units prepared to manufacture and sell these products? Some business unit managers tend to build slack into their estimates, so their objectives are more easily accomplished; can some of this slack be detected and eliminated?
The headquarters people examine the business unit plans for consistency also. If one business unit manufactures for another unit, are the planned shipments from the manufacturing unit equal to the planned sales of the sales unit? In particular, are planned shipments to overseas subsidiaries conÂsistent with the planned sales volume of these subsidiaries?
Headquarters staff and their counterparts in the business units resolve some of these questions by discussion and report others to corporate manageÂment, at which point they are the basis for discussions between corporate managers and business unit managers. These discussions are the heart of the formal planning process, usually requiring several hours and often going on for a day or more in each business unit.
In many cases, the sum of the business unit plans reveals a planning gap- that is, the sum of the individual plans does not add up to attainment of the corporate objectives. There are only three ways to close a planning gap: (1) find opportunities for improvements in the business unit plans, (2) make acquisitions, or (3) review the corporate objectives. Senior management usuÂally focuses on the first.
From the planning numbers, the headquarters staff can develop planned cash requirements for the whole organization. These may indicate the need for additional financing or, alternatively, the possibility of increasing dividends.
Second Iteration of the Strategic Plan
Analysis of the first submission may require a revision of the plans of only certain business units, but it may lead to a change in the assumptions and guidelines that affect all business units. For example, the aggregation of all plans may indicate that the cash drain from increasing inventories and capiÂtal expenditures is more than the company can safely tolerate; if so, there may be a requirement for postponing expenditures throughout the organizaÂtion. These decisions lead to a revision of the plan. Technically, the revision is much simpler to prepare than the original submission, because it requires changes in only a few numbers; but organizationally, it is the most painful part of the process because it calls for difficult decisions. Some companies do not require a formal revision from the business units. They negotiate the changes informally and enter the results into the plan at headquarters.
Final Review and Approval
A meeting of senior corporate officials usually discusses the revised plan at length. The plan also may be presented at a meeting of the board of directors. The chief executive officer gives final approval. The approval should come prior to the beginning of the budget preparation process, because the strateÂgic plan is an important input to that process.
A strategic plan shows the implications, over the next several years, of impleÂmenting the company's strategies. In the period since the current strategic plan was prepared, the organizaÂtion has made capital investment decisions. The process of approving proÂposed capital investments does not follow a set timetable; senior managers make the decisions as soon as the need for them is identified. Planners incorÂporate in the strategic plan the implications of these decisions, as well as asÂsumptions and guidelines about external forces such as inflation, internal policies, and product pricing.
Using on this information, the business units and support units propose new strategic plans, and these are discussed in depth with senior manageÂment. If the resulting corporate plan does not indicate that profitability will be adequate, there is a planning gap, which is dealt with by a second iteraÂtion of the strategic plan, sometimes entailing painful curtailments of busiÂness unit plans. Several analytical techniques, such as value chain analysis and activity-based costing, can aid in the strategic planning process.