MIKE'S BIKES
INTEGRATED BUSINESS LEARNING ONLINE
(2nd Edition)
MIKE'S BIKES
INTEGRATED BUSINESS LEARNING ONLINE
(2nd Edition)
Copyright  1997, 2000 SmartSims.com Ltd.
All rights reserved. No part of this book may be used or reproduced in any manner without written permission of
the authors, except in the case of brief quotations embodied in critical articles and reviews.
Published by:
Irwin/McGraw-Hill, SmartSims.com, 2000
First Printing:
January, 2000
Cover design by:
Robert Chan.
Edited by:
The SmartSims.com Team.
Library of Congress Cataloguing-in-Publication Data
Mazany, Pete, 1957with Sharpe, Andrew, 1967 -.
Mike's Bikes: Integrated Business Learning Online (2nd Edition)
ISBN 0-473-04894-9
1. Management. 2. Simulation. 3. Teamwork. 4. Cross-functional I. Title.
Page ii
Table of Contents
1
2
3
4
INTRODUCTION AND OVERVIEW
6
1.
WHAT IS MIKE'S BIKES?
6
2.
AN OVERVIEW OF THE INDUSTRY
9
3.
USING SOLOMIKE
13
4.
USING NETMIKE
18
DEVELOPING BUSINESS STRATEGY
19
1.
LEARNING OUTCOMES
19
2.
THE OBJECTIVE FOR STRATEGY
19
3.
A FRAMEWORK FOR DEVELOPING STRATEGY
20
4.
APPLYING THE FRAMEWORK
22
5.
QUESTIONS TO ASSIST LEARNING
35
6.
MODIFICATIONS FOR NETMIKE
35
7.
REFERENCES
35
TEAM DYNAMICS – BY DARL KOLB AND JOLINE FRANCOEUR
36
1.
LEARNING OUTCOMES
36
2.
WHY USE SIMULATIONS?
36
3.
ISSUES FOR INDIVIDUALS TO CONSIDER
37
4.
MANAGING GROUPS AND TEAMS IN SIMULATIONS
39
5.
GROUP AND TEAM PERFORMANCE
45
6.
MAKING IT HAPPEN IN MIKE’S BIKES
50
7.
QUESTIONS TO ASSIST LEARNING
51
MARKETING AND DEMAND
52
1.
LEARNING OUTCOMES
53
2.
A FRAMEWORK FOR THE MARKETING PROCESS
53
3.
DETERMINING STRATEGIC OBJECTIVES
53
4.
ANALYZING THE MARKET
54
5.
SELECTING TARGET SEGMENTS
57
6.
DEVELOPING THE MARKETING MIX
58
7.
QUESTIONS TO ASSIST LEARNING
65
8.
REFERENCES
70
9.
MODIFICATIONS FOR NETMIKE
70
Page iii
5
6
7
OPERATIONS AND SUPPLY
73
1.
LEARNING OUTCOMES
73
2.
A FRAMEWORK FOR OPERATIONS
74
3.
DETERMINING STRATEGIC OBJECTIVES
74
4.
ORDER QUALIFIERS AND ORDER WINNERS
76
5.
ACHIEVING STRATEGIC OBJECTIVES
76
6.
ONGOING STRATEGIC CONTROL
87
7.
QUESTIONS TO ASSIST LEARNING
88
8.
MODIFICATIONS FOR NETMIKE
92
9.
REFERENCES
92
ACCOUNTING
93
1.
LEARNING OUTCOMES
94
2.
A FRAMEWORK FOR ACCOUNTING
94
3.
ELEMENTS OF COST
94
4.
COST BEHAVIOUR
95
5.
CONTRIBUTION ANALYSIS
95
6.
THE BASIC REPORTS FOR FINANCIAL MEASUREMENT
96
7.
ECONOMIC VALUE ADDED (EVA )
103
8.
PRODUCT COST
105
9.
ACTIVITY BASED COSTING
107
10.
DEPRECIATION OF PLANT
108
11.
OTHER ASPECTS OF PERFORMANCE MEASUREMENT
108
12.
IN MIKE’S BIKES
109
13.
QUESTIONS TO ASSIST LEARNING
109
14.
MODIFICATIONS FOR NETMIKE
112
FINANCE AND PERFORMANCE MEASUREMENT
113
1.
LEARNING OBJECTIVES
113
2.
A FRAMEWORK FOR FINANCE
114
3.
INVESTMENT EVALUATION
114
4.
FINANCING DECISIONS
118
5.
MEASUREMENT AND THE BALANCED SCORECARD
120
6.
QUESTIONS TO ASSIST LEARNING
122
7.
MODIFICATIONS FOR NETMIKE
125
8.
REFERENCES
125
Page iv
8
9
10
PRODUCT DEVELOPMENT
126
1.
LEARNING OBJECTIVES
126
2.
A FRAMEWORK FOR PRODUCT DEVELOPMENT
126
3.
TYPES OF PRODUCT DEVELOPMENT PROJECTS
128
4.
DECISIONS REQUIRED FOR PRODUCT DEVELOPMENT
129
5.
AN EXAMPLE
129
6.
APPLICATION IN MIKE'S BIKES
132
7.
QUESTIONS TO ASSIST LEARNING
134
8.
MODIFICATIONS FOR NETMIKE
136
MICROECONOMICS
137
1.
LEARNING OUTCOMES
137
2.
A FRAMEWORK FOR THE ROLE OF ECONOMICS
137
3.
DETERMINING STRATEGIC OBJECTIVES
138
4.
ECONOMIC MODELING OF CONSUMERS
138
5.
PREFERENCE THEORY
138
6.
UTILITY FUNCTIONS
139
7.
HOW IS UTILITY INCORPORATED IN THE MIKE’S BIKES MODEL?
140
8.
HOW MIKE’S BIKES CALCULATES DEMAND FOR A PRODUCT
143
9.
THE MIKE'S BIKES AGGREGATE SEGMENT DEMAND FUNCTION
144
10.
USING ECONOMETRIC TECHNIQUES TO SUPPORT MARKETING DECISION MAKING
146
11.
THE PRODUCTION FUNCTION
148
12.
PRODUCTION COSTS
151
13.
QUESTIONS TO ASSIST LEARNING
152
CONCLUSION
154
1.
LEARNING OBJECTIVES
154
2.
A FRAMEWORK FOR DEVELOPING STRATEGY
154
3.
CROSS-FUNCTIONAL STRATEGY AND BUSINESS MODELING
156
4.
THE IMPORTANCE OF PROCESS
161
5.
FINAL COMMENT
161
Page v
1 INTRODUCTION AND OVERVIEW
1. What is Mike's Bikes?
1
Mike's Bikes is a computer-based business simulation system that can be used as a tool to enhance the
integration and learning of a variety of business-oriented subjects, interactively and in a realistic context.
It provides a challenging and enjoyable business learning environment where in a simulated bike industry the
user manages a company to maximize shareholder value. In this way, Mike's Bikes combines hands-on
practical decision making with real world modeling, to provide participants with a broad understanding of
contemporary business issues.
1.1 LEARNING OBJECTIVES
By interacting in this simulated environment the user learns
• the standard terms of strategy, marketing, new product development, operations, finance,
economics and accounting;
• to think of business as an interacting system of these components;
• to analyze company data using highly visual graphics;
• quantitative skills using advanced Excel spreadsheets;
• to use the Balanced Scorecard and Economic Value Add (EVA) in context;
• many key quantitative skills for management;
• the importance of team dynamics for good decision-making.
Such skills are vital for the new millennium, and the quote below, first made in the late 1980's, sums up the
key issues.
“We understand that the only competitive advantage the company of the future will have is its
managers' ability to learn faster than their competitors.”
Eric de Geus, Head of Planning for the Royal Dutch Shell Group
At that time, this quote was interesting due to its
emphasis on the human capital of an organization as
being a key source of competitive advantage. Today,
when terms like innovation, learning organizations,
knowledge-worker and information-economics are
commonplace, it is accepted as a truth. Systems such
as Mike's Bikes can help to accelerate business
learning and understanding and in this way add
significantly to the competitiveness of the organization.
The system is designed for use in many different ways
and at different levels, and there are two versions for
students: SoloMike and NetMike. And as an instructor
you get access to the Administrator and Assessor. All
these are described below.
1.2 SOLOMIKE
In SoloMike - shown to the right - the player pits his or
her skills against an intelligent robot competitor called
“Mike”. This is a standalone application designed to
1
Mike's Bikes has been used successfully in undergraduate, MBA, Executive Programs and Distance Learning programs.
Page 6
Introduction and Overview
introduce the new user to the interface and basic concepts of the environment as well as business. It may be
used in a standalone mode and has all the resources for a complete course to be based on it.
The user's perception of the realism of the environment used in a simulation is very important. It must be
sufficiently realistic so that the user can draw parallels between the simulation and reality, but it must not be
so complex that unnecessary detail clouds the key issues. The SoloMike microworld is rich in diversity, but is
simplified by restricting it to 2 competitors, 2 market segments, and 2 distribution channels.
1.3 NETMIKE
When a richer environment allowing more competition is called for, NetMike fulfills this requirement. NetMike
allows teams of students or business people to compete against one another in an industry consisting of 5
firms, 5 market segments and 3 distribution channels. This improves participants' business skills, while also
improving their use of information technology and their team skills. It all happens over the internet, allowing
considerable flexibility and rollover times are of the order of a minute. Because of the competitive element and
the richer environment, the learning can be considerably accelerated, especially when complemented by
SoloMike.
This manual applies to both products since the
underlying theory is the same. Where relevant, any
differences are noted in a section at the end of the
chapter.
1.4 THE ADMINISTRATOR
The Administrator program - shown to the right allows instructors to setup and run their own
simulations quickly and easily. It includes functions
such as:
• Assigning individuals;
• Setting up the teams;
• Adding shocks to the environment;
• Determining the rollover schedule;
• The ability to assist teams;
• The ability to view company and
industry data.
1.5 THE ASSESSOR
The Assessor - shown to the right - is designed to facilitate the development of good team dynamics. It allows
the Administrator (or team leader) to send questionnaires to the team members, and to solicit feedback on a
variety of team–related issues. This data may be processed in real time and then returned to the team
members so that any team performance issues may be dealt
with. Good uses include team improvement and 360 degree
feedback. Specifically the Assessor allows the Instructor to:
• Set up individuals;
• Assign them to teams;
• Author questions;
• Form these into questionnaires;
• Send these to teams;
• Generate reports;
• Send these to the teams who can see the see
the results immediately.
1.6 INSTALLING AND USING THE SOFTWARE
Mike's Bikes runs under Windows 95/98, and Windows NT
3.51/4.0. Its minimum requirements are a 486 processor with 8
MB of RAM and 20 MB free disk space.
Page 7
MIKE’S BIKES – Integrated Business Learning Online
To install, download the appropriate file from the web, double click on it and follow the short list of instructions.
SoloMike runs immediately on your PC, while NetMike, the Administrator and Assessor attempt to connect to
our remote server. If you have internet access on your computer and your instructor has set up a simulation
for you, these will appear immediately and you can start playing. All this can take less than 5 minutes.
1.7 GETTING HELP
We realize that Mike's Bikes is ambitious in its objectives and is a very rich learning environment. For this
reason we have designed many additional features to get you going quickly with the system and the software
has numerous sources of Help. These include:
• Frequently Asked Questions (FAQ's) on the Web page,
• The Advisor,
• Four Levels of Online Help,
• and pop-up Hints.
However, should you require additional help with installation or other issues, we provide email help at
[email protected].
1.8 HOW TO USE THIS MANUAL
This manual has been written to help you achieve the objective of maximizing your shareholder value over
a 10-year horizon. It may be used to get a general overview of the theory of the functional areas that have
been included in Mikes Bikes, and also to provide background scenario information.
To achieve this, each chapter has been organized into 6 main sections:
• Learning objectives;
• A framework (or theory) for the functional area;
• The application in Mike's Bikes;
• Relevant assignment questions;
• Modifications for NetMike;
• References for further reading.
1.9 THE MANAGEMENT GOAL
Welcome to the wonderful world of business simulation! - business virtual reality.
You are faced with the task of managing one of two companies, both of whom are competing for dominance
of the bicycle industry in Erehwon. Your goal is to maximize your shareholder value over a 10-year
horizon. As part of your management brief, you must make many business decisions in a variety of functional
areas. Your decisions apply for a whole year, so it is critical that you develop a coherent strategy, and prepare
plans for the future. You are taking the reins of a going concern, and it is your job to ensure that the company
continues to grow and prosper.
The business scenario encompasses a variety of decisions that will require you to analyze information, identify
alternative courses of action, evaluate these alternatives and consider the final decisions for your firm.
Ultimately your success will be determined by how well you promote your company as a stable, efficient, and
enterprising bicycle manufacturer.
1.10 THE UNDERLYING MODEL
Business is typically highly cross-functional. Marketing, product development, operations, finance, human
resource and information technology all interact and are all required to work towards a common goal. Many of
these functions are described in Mike's Bikes and this section provides a brief overview of the model that is
used to determine the interactions of all the different decisions on the outcome.
Page 8
Introduction and Overview
A high-level diagram indicating the main
relationships is shown to the right. While a
complete explanation of these relationships is
beyond the scope of this manual, this is the
underlying model in Mike's Bikes and more
detail is provided in subsequent chapters, and
also the spreadsheet models.
SHAREHOLDER VALUE
12
Overall Logic
ECONOMIC
CONDITIONS
COMPETITORS’
ACTIONS
Shareholder Value
Current Profit
Demand
Future Profit
Supply
Accounting
operating
decisions
investment
decisions
Maximizing shareholder value is assumed to be
Business Strategy
the ultimate goal. This may be controlled to
some degree by the firm's decisions as these
affect current and future profits. However,
Product
Marketing
shareholder value is also affected by some
Operations
Finance
Development
Strategy
Strategy
Strategy
variables outside of a firm's control such as
Strategy
competitor actions and general economic
Motivation and Overview
conditions. These also affect a firm's strategy,
as it seeks to improve its performance in the broader context of its competitive business environment.
STRATEGY
The most directly controllable determinant of a firm's long term profitability is its strategy. This results in two
types of decisions - operating decisions that are concerned with achieving the best short-term performance
from existing markets; and investment decisions which relate to maximizing future profits by investing in new
opportunities.
FUNCTIONAL STRATEGIES
Traditionally, an organization has been broken into a number of functions. While the names in a specific
organization may vary, the generic functions are usually marketing, product development, operations, finance,
2
human resources and information technology . A number of organizational techniques (such as Just-In-Time
and Total Quality Management) have been developed to encourage all these to work together, and a good
test is to see if their individual decisions support the overall strategy of the business. In Mike's Bikes it is
assumed that the collective actions of these functions IS THE STRATEGY.
Let the learning and fun begin!
2. An Overview of the Industry
In this section we give an overview of the business situation for Mike's Bikes at the end of 1998. More detail
on each of these areas is given in subsequent chapters.
2.1 HISTORY
This is a special report on the bicycle market prepared by Woolly Woolly McNully & Woolly. This report covers
the history of the industry, the market segments, the distributors, and the competitors.
Mike's Bikes models a bicycle industry in a country called Erehwon and has around 15 million people and a
western capitalist economy. Several years ago the government set up two bicycle manufacturing firms in an
attempt to stimulate economic growth, investment and create employment. This initiative was consistent with
their policy of developing clusters of firms that could build up competence in high-margin niche markets. The
bicycle industry was selected because of its close ties to the growing outdoors and health-conscious
consumer market prevalent in Erehwon. Consumers in these markets have high discretionary income, and will
freely buy any bicycle that suits their individual needs. In order to protect their investment, the government
banned the importing of bicycles and bicycle components from other countries in all segments except for the
2
While human resources and information technology are not modeled explicitly as functions, they are included in the other functional
areas as decisions.
Page 9
MIKE’S BIKES – Integrated Business Learning Online
low cost leisure segment (where a number of bicycles and components were being produced very cost
effectively by some third world countries).
Both firms were built from nothing and attempted to maximize economic benefits to the community by
producing one identical bike - the "RockHopper". The factories used by each company were set up identically,
and produced an even quota of the RockHopper. Anyone wanting a new bike had to buy a RockHopper or a
cheap import and therefore there was virtually no competition since these products appealed to quite distinct
market segments. Although there was an effective monopoly for the Adventurer segment, firms were
regulated to ensure that the companies did not make excess profits at the consumers' expense.
As the government's policy started to work and the financial strength and competence of these manufacturers
increased, the government initiated stage two of its master plan. A prohibitive import duty was imposed on all
imports, effectively killing demand for cheap third world imports and leaving both segments available to the
two local manufacturers - Real Cool Cycles and MountainTop Cycles. With this change to the Erehwon
bicycle market, the government also decided to privatize the manufacturing companies. The firms were
snapped up by investors who were able to spot a good opportunity and cheap resources.
The new owners of MountainTop Cycles decided to promote "Steady" Mike to be their chief executive officer.
Although not known for his entrepreneurial skills, his experience in the industry and conservative approach
was favored by the investors. (The option exists of replacing him with another candidate, "Sharp" Mike, should
more brainpower be required.)
You have been recruited as the CEO of Real Cool Cycles. Your general knowledge of bicycles will prove
useful, but you should remember that you are dealing with new bicycles only in the domestic market and are
selling them through retail shops.
Your goal is to maximize your company's shareholder value over a 10-year horizon.
2.2 INDUSTRY DYNAMICS AND MARKETING
There are two market segments - Adventurer and
Leisure. These two segments are supplied by two
distribution channels that in turn are supplied by two
firms - Real Cool Cycles run by you and MountainTop
Cycles run by Mike.
100
Tech Specs
The two segments are differentiated by their
preferences for the products’ attributes as indicated in
the perceptual map shown. The Leisure segment
prefers reasonable style and low technical specs
whereas the Adventurer segment requires more in
terms of the technical specifications to handle the
rougher conditions. These are illustrated in the
perceptual map at right. Other factors differentiate
segments also and these are summarized in the tables
below.
13
The Perceptual Map
80
60
Adventurers
40
20
Leisure
0
0
20
40
60
80
100
Style/Design
Motivation and Overview
Note that the Leisure segment was completely
unserved in 1998. It is also more sensitive to price advertising and delivery and less to quality than the
Adventurers.
Segment
Adventurers
Leisure
Segment
Sensitivity
Adventurer
Leisure
Est. Pot. Market Retail Price Range
Size (Units)
70,000
$500-$4000
50,000
$100-$600
Price
Advertising
PR
Low
Med
Med
High
Med
Low
Page 10
Average Score for Average Score for
Style/Design
Technical Specs.
50
50
50
10
Quality
Distribution Delivery Time
High
Low
Med
Med
Low
High
Introduction and Overview
PRODUCT AND BRAND ADVERTISING
Estimates of the media viewing habits of the different
segments are provided in the table to the right for use
in deciding on an advertising strategy. Depending on
your strategy you may choose different media to
advertise your product.
Adventurers
Leisure
TV
Reach
50%
60%
Brand advertising is more general and improves the
effectiveness of any product advertising that is carried out.
Adventurers
Leisure
DISTRIBUTION
There are two types of distribution channels that you can
choose. These have differing costs of support and
maximum numbers. Depending on your strategy you may
choose different channels to distribute your product. The
one you choose will be determined by the market
segments that you target.
Number of
Dealers
Annual Cost to
Support
Newspaper
Reach
10%
60%
Magazines
Reach
60%
20%
Bike
Shops
70%
25%
Department
Stores
30%
75%
Bike
Shops
120
Department
Stores
300
$450
$200
QUALITY
Quality can either be built into the products through
training, maintenance and raw material quality or it can be
inspected in. Relevant costs are given in the table to the
right.
Warranty as a % of selling
cost
Unit SCU inspection costs
100%
$400/unitSCU
DELIVERY TIME
Delivery time is determined by a number of factors. Most directly, these include effective demand and
available capacity. Available capacity in turn is determined by plant capacity, worker capacity, batch size, and
setup time.
2.3 CURRENT OPERATIONAL POSITION
You currently make one type
of bike for the Adventurer
market. You have about 80
people and the capacity to
manufacture about 15,500
units of these annually.
Other relevant summary
information is given in the
table to the right.
Flexibility of production
Benchmark average annual wage
Hire cost
Fire cost
Cost of new plant
Maximum potential capacity per person
Current Theoretical Factory Capacity
Current Effective Capacity
Unit SCU inspection costs
Annual warehouse cost per unit raw materials
Annual warehouse cost per unit finished goods
Warranty cost as a percent of selling cost
Training materials & instructors cost
Annual Wear out rate on plant
Page 11
+/- 50% of decision
$25,000
$4,000
$4,000
$16,000 per 100 SCU
625 SCU per worker
25,000 SCU
15,500 SCU
(15,500 RockHopper bikes)
$400/unitSCU
$47/unitSCU
$100/unitSCU
100%
$30/worker/hour
approx. 15%
MIKE’S BIKES – Integrated Business Learning Online
2.4 CURRENT FINANCIAL POSITION
Your company has been operating for one year at a profit. A summary of your current position shows that you
have revenues of around $13 million, and costs of around $10 million. Your net worth (equity) is $5.4 million.
IDENTICAL PROFIT AND LOSS STATEMENTS AND BALANCE SHEETS
21
Simplified Income Statement - 1998
REVENUE
$12.8m
GROSS MARGIN
$5.5m
$2.0m
Other Income
$0.1m
NET INCOME BEFORE TAX
NET INCOME AFTER TAX
TOTAL EQUITY
(share issues + retained profits)
$5.4m
These funds are represented by:
Less: Selling, Admin and
Finance Expenses
Taxation
22
Simplified Balance Sheet - 1998
Assets
$8.3m
(cash, inventory/stock, (debtors), plant)
$3.5m
Liabilities
$2.9m
(overdraft, (creditors), long-term debt)
$1.1m
$2.4m
Equity = Assets - Liabilities = $5.4m
Motivation and Overview
Motivation and Overview
2.5 PRODUCT DEVELOPMENT
Developing products is one way of getting
ahead of competition. In Mike's Bikes, a firm
can use new product development in 3 ways:
• to improve its cost position;
• to reposition existing
products;
• or to introduce new products.
Relevant information is given to the right.
Time to get a new project completed
Cost per unit of change in Technical Specs
Cost per unit of change in Style/Design
Product (Prime) Cost for each unit of
Technical Specs
Product (Prime) Cost for each unit of
Style/Design
Minimum Realistic Project Expenditure
1 period
$20,000
$1,000
$4.75
12c
$100,000
2.6 FINANCIAL AND ECONOMIC CONDITIONS
The political, financial and economic situation
is stable with no growth expected in the
markets. Key financial data is given to the
right. Your performance will be determined
solely by how well you compete against
MountainTop Cycles.
Mike is in the same situation as you in
every way at the start of 1999.
Weeks/year
Days/week
Hours/day
Issue Discount for shares
Issue Premium for shares
Depreciation rate
Inflation rate
Market rate of return
Interest on dividends
Overdraft interest penalty (above LT interest
rate)
Interest on long-term (LT) debt
Tax Rate
Risk free rate of return per annum
Ratio of equity expansion to current equity
Ratio of equity reduction to current equity
Page 12
50
5
8
5%
5%
20%
0%
10%
10%
3%
8%-80%
33%
1%
50%
25%
Introduction and Overview
3. Using SoloMike
This section gives a summary of the steps involved in playing and learning from Mike's Bikes, and in particular
SoloMike.
It has six main sections:
• an overview of the steps in each round:
• viewing the results;
• a summary of the decision screens:
• how to process decisions:
• getting feedback and help;
• and a description of other features.
3.1 OVERVIEW
In Mike's Bikes you are managing a bicycle
manufacturer. The emphasis is on your
strategy, so, rather than make decisions on a
day by day basis, you are required to make
strategic decisions which apply for a whole
year. To do this, you will have to review your
firm's performance in the previous year and
analyze what your competitors are doing.
Based on this analysis, you will make decisions
for the coming year. When you are happy with
your decisions, you may process your
decisions and determine “what happened”.
Then you are ready to make decisions for the
next year. This process is shown in the Kolb
3
Learning Cycle diagram shown to the right.
12
The Kolb Learning Cycle
Stage 1:
Concrete
Experience
Stage 2:
Reflective
Observation
Stage 4:
Active
Experimentation
To get the most out of the experience,
consider each of the steps shown and consider
how you might implement them. They are
described more fully in the Team Dynamics chapter.
Stage 3:
Abstract
Conceptualization
Team Dynamics
3.2 GETTING GOING
There are three main ways of getting help in
the Mike's Bikes microworld: the Advisor,
Help, and pop-up Hints.
WHAT NEXT? - THE ADVISOR
Pressing the Advisor button will bring
up the Advisor screen (shown to the right). In
the first period, it provides you with a basic
description of the variables and with step-bystep instructions on what decisions to make.
In subsequent periods, the Advisor is able to
give you some very useful hints on how to
improve your performance.
3
Click on the arrow to see the comments and
hints that the advisor has to offer.
Kolb, D. (1976). Management and the learning process. California Management Review, Spring.
Page 13
MIKE’S BIKES – Integrated Business Learning Online
3.3 ONLINE HELP
There is detailed online Help available in the standard way whenever you click on a Help button. The table of
contents is shown below to give you some idea of the scope.
HINTS
To find out what a particular button does,
simply leave the mouse cursor stationary
over the item. A short description will popup which disappears when you move the
mouse.
These are in the order that
most people would need to
see them.
3.4 VIEWING THE RESULTS
There is a substantial number of reports available for you in the
microworld to let you know the results of your decisions and to
help you analyze and learn from your performance. These reports
can be accessed from the report menu as shown in the picture to
the right. You are encouraged to flick through these to get a better
feel for what each provides.
There are more in
these sections
Page 14
Introduction and Overview
3.5 A SUMMARY OF THE DECISION SCREENS
These screens are described in more detail in the chapter that deals with the particular topic. The summary
below is for convenience only.
THE MAIN DECISION SCREEN
The main decision screen is displayed to the right.
You will see:
• the name of your company (which
you can change in the first period),
• the period for which you are making
decisions,
• results from the previous period
(presented in the format of the
Balanced Scorecard),
• and the four main types of functional
decisions are on the tabs marketing, operations, finance, and
product development.
Each button leads to a decision dialog and these are
described next.
MARKET
The Market decisions tab is where you enter your decisions about marketing each of your firm's products for
the coming year. Here you set marketing and production levels, and can launch, modify or abandon products.
MAKE AND SELL
The Product decision screen is where you set the levels of selling price, advertising, product PR, target
production volume and target finished goods stock levels for a particular product.
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MIKE’S BIKES – Integrated Business Learning Online
DISTRIBUTION CHANNELS
The Distribution Decision Screen is where you enter your decisions
about distributing your products for the coming year. The Distribution
Allocation screen is where you make decisions regarding your
relationships with stores in a particular distribution channel. You
must specify what margin and what extra support (in terms of
special promotions and discounts) you are going to offer the
retailers in this channel. You will want to consider the shopping
habits of the market segments you are targeting.
The number of stores in this channel who decide
to stock your products will depend on the retail
price, retailers’ margin, unit sales volume history,
and extra support offered. Each store will stock all
of your firm's products.
OPERATIONS
The Operations Decisions tab allows you to focus
on products and manufacturing process. Two
aspects
of
manufacturing
process
are
emphasized:
responsiveness
and
quality.
Changes made to either of these areas apply for
all the firm's products.
RESPONSIVENESS
Responsiveness refers to the ability of the firm to
produce its product to serve customer demand in a
timely manner. Capacity (Workforce and Plant)
decisions will affect the quantity you are able to
produce, while process decisions will affect
production lead-time.
QUALITY
Quality decisions will impact on the internal and
external failure rates - the number of defective
products produced, and the number of defective
products that reach the final customer.
Average Salary and Training hours will have a
significant impact on the average skill level of your
production staff, while Preventative Maintenance,
Quality Systems Technology and Supplier Relations
affect the amount of defects resulting from
machinery. These factors together determine the total
amount of defective products that will be produced.
The Inspection decision sets the proportion of
finished bikes that will be inspected for defects before
leaving the factory to be sold, hence avoiding a
dissatisfied customer.
Page 16
Introduction and Overview
PRODUCT DEVELOPMENT
The Product Development decisions tab is where you enter your
decisions about product design and development for your firm for the
upcoming year.
NEW PRODUCT DESIGN PROJECT
On this screen you enter or modify the
specifications
for
a
Product
Development project for the coming
year.
Attributes are the desired characteristics
of the bike in terms of Style/Design and
Technical Specs. You will be trying to
produce a bike whose attributes match
as closely as possible those desired by
your target market.
Target Prime Cost is the amount you
would prefer your desired bike to cost to
produce. It costs money to develop new
ways of manufacturing in order to
produce a new bike in a cost-effective manner, and this decision sets a target to aim towards.
Expenditure Next Period is the amount you plan to spend on this project in the coming period. If you spend too
little you may end up with a bike that is far from what you asked for!
FINANCE
The Finance Decision tab allows you manage the cash
your firm has available to it by paying dividends to your
shareholders, raising or repaying long-term debt, and
issuing or repurchasing equity (i.e. shares in your firm).
You can also decide how much to spend on Investor
Relations. (You can make these decisions for any
companies that your firm owns using the Capital
Transfer screen.)
COMPANY INVESTMENT
The
Investment
Decision
Screen (right) is where you
launch takeover bids for other
firms, transfer capital to and
from firms you own, and sell
your investment in a firm back
to the sharemarket at large.
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3.6 PROCESSING DECISIONS
Once you are ready to try your decisions, press the rollover
button found near the top right of your
screen. Your decisions (and those of your competitor) will then be processed and results calculated.
If you are unhappy with the results you have two choices:
1. First, you may rollback to make modifications to your decisions by pressing the rollback
button.
2. The second alternative is to choose Restore
from the Game menu. This will clear all your
decisions and take you back to the starting
position making decisions for 1999.
3.7 OTHER FEATURES
This section outlines some of the other features of the
Mike's Bikes environment. Many of these are found in the Preferences section of the File menu displayed
below. To change one of these simply select the option you wish to change.
DIFFICULTY LEVEL
There are two difficulty levels when playing Mike's Bikes. These correspond to the intelligence of your
competitor. Steady Mike is the easiest level. If you are successful against Steady Mike over several periods,
then consider switching to Sharp Mike.
TUTORIAL HELP, POP-UP HINTS AND ADVISOR
Switching these on and off will control what happens automatically for you. As you become more advanced,
you may wish to switch these off and access them only when needed.
COMPETITOR INFORMATION MODE
This mode allows you to see Mike's results and decisions alongside your own. It is provided to help you learn
by comparing with what Mike is doing.
FONTS
This is provided to allow you to alter the size and font used when displaying and printing reports. Depending
on your screen size and resolution, you may wish to fit more information onto each report screen or increase
the size of the text to make it more legible.
4. Using NetMike
Intentionally we have made SoloMike and NetMike very similar, and the only difference is that NetMike is
richer with 5 segments, 3 distribution channels and 5 firms. The firms in NetMike are initially very similar to the
SoloMike firms. All relevant information is in the NetMike Help and More Info buttons.
Page 18
2 DEVELOPING BUSINESS STRATEGY
We separate strategy into two issues - the content of the strategy and the process of developing the
strategy. The content describes how an organization will achieve its vision or strategic intent. i.e. it is a
blueprint for winning. As such there is no one best strategy. It ties together the different functional areas of the
organization so that there is a consistency in action over time, and it drives the implementation and measures
results so that there is strategic control.
The process refers to how the strategy is developed. It starts with a definition of strategy, and then describes
each of the following areas: external analysis, internal analysis, evaluation, implementation and control. All of
these areas except for implementation can be well illustrated with the Mike's Bikes environment, and this
chapter goes through these different steps in the context of Mike's Bikes in order to illustrate the concepts.
1. Learning Outcomes
In this chapter we explore some theory related to strategy. The main learning objective for this chapter is the
understanding of the following issues:
a) Developing a strategy
• Porter's Generic Strategies - cost, differentiation, focus.
b) External Analysis
• Environmental analysis - PESTE.
• SWOT analysis.
• Competitor Analysis.
c) Internal Analysis
• Understanding of vision, mission, strategic intent
• Understanding of Core Competencies
d) The importance of measurement and use of the Balanced Scorecard
e) Relationship of strategy to marketing plan, operations plan and financial plan.
2. The Objective for Strategy
A strategy describes how an organization will win. In most business contexts, winning is defined in terms of a
good shareholder return, subject to operating ethically within the laws of the land. As such it consists of a
number of decisions made in various functional
3
areas of the organization that should lead to an
Shareholder Value
increase in shareholder value. These decisions
Overall Logic
are then implemented at lower levels of the
organization by a broader set of more detailed
Future Profit
Current Profit
ECONOMIC
decisions. Consistency among the different
CONDITIONS
decisions is a key to success and the diagram
shown to the right gives a good structure for
COMPETITORS’
Demand
Supply
ACTIONS
understanding this.
Accounting
There are usually 6 areas to consider at the
functional
level:
marketing,
product
development, operations, finance, human
resources and information technology. In
Mike's Bikes the first four of these are
represented directly and the other two
indirectly within the other functions. In addition,
accounting is covered integratively as a
support function.
operating
decisions
investment
decisions
Business Strategy
Marketing
Strategy
Operations
Strategy
Finance
Strategy
Product
Development
Strategy
Developing Strategy
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MIKE’S BIKES – Integrated Business Learning Online
In Mike's Bikes, we assume that strategy is set according to where the business wishes to go and where the
functional areas wish to take it. So, rather than just a top-down approach, we envisage a dynamic process,
where each of the functions (in particular, marketing, operations and finance) is aware of its own position and
where the organization wishes to go, and wants to influence overall strategy so that its particular strength is
utilized. These functions inform the business strategy, which in turn is set and implemented in a consistent
way by the functions.
3. A Framework for Developing Strategy
To do well in Mike's Bikes you must develop a long-term strategy. Making consistent decisions in all aspects
of a firm's operations is difficult without a well-defined and clearly integrated strategy. As in real life, if you
bounce around with your decisions you will incur unnecessary costs. In this section we outline the process of
developing and implementing a consistent strategy, and the diagram below summarizes a framework which is
often helpful in developing this.
Roughly speaking, there is a reasonably
good overlap between the functional areas
and the first four of these steps: external
analysis is often linked with marketing;
internal analysis is often linked with
operations; and options, choices and
evaluation are often linked with finance. We
shall adopt these groupings in the discussion
that follows.
4
Framework for Developing Business
Strategy
External Analysis
Internal Capabilities
Options and Choices
Motivation
Evaluation
Leadership
=
3.1 ANALYSIS
+
Rewards
Implementation
The first stage in developing a strategy is
analysis
of
the
environment.
The
Control/Feedback
management team should consider both the
internal and external environment. Firstly,
they should look at the opportunities and
Developing Business Strategy
threats in the external environment. This
should include a sound analysis of latent and perceived needs of customers, and also the actions, intentions
and capabilities of its competitors. Internally, the management team should consider the firm's own
competencies and resources. This may include looking at where the firm is currently positioned, its strengths
in terms of quality and delivery and its financial resources.
3.2 SYNTHESIS AND EVALUATION
Synthesis relates to pulling together all the data from the analysis phase and formulating a number of
alternatives. The desired strategy is chosen by evaluating these against a number of criteria - some of which
are financial and some more qualitative. The chosen strategy can then be broken up into sub-strategies for
distinct functional areas, but in reality there is considerable overlap among these and much iteration occurs.
3.3 DEVELOPING FUNCTIONAL STRATEGIES
Developing functional strategies refers to the translation of the overall strategy into strategies for the functions.
These will often involve shorter term goals and the time frame for these is sometimes called tactical. In Mike's
Bikes we focus on marketing, product development, operations, and finance and these are discussed briefly
below.
CREATING MARKETING STRATEGY:
Having completed external and internal analysis, a management team should be able to develop a marketing
strategy. This should consider the 3 C's - customers, competitors and company - and then segment the
market as a result. An important step in this involves the decision about whether to compete in one narrow
segment or broadly in several segments. The selection of a specific segment or segments allows customer
Page 20
Developing Business Strategy
needs to be defined, and once these are defined the 4 P's for each segment - product, price, promotion and
place (distribution) - may be determined.
CREATING PRODUCT DEVELOPMENT STRATEGY:
This is closely related to both the marketing and the manufacturing strategies. Depending on the choices of
which segments will be served, it is necessary to develop the products and processes for these. Decisions
must be made about the positioning of the new products, the ideal cost so that they can be sold with the
required profit margin, how much investment will be required, and whether it is a good investment.
CREATING OPERATIONS STRATEGY:
A production strategy should be defined in conjunction with marketing strategy. Strategic decisions may
include setting objectives in capacity, responsiveness, quality and cost. As a result it should be possible to
decide whether to produce a low cost product, or to try to differentiate it with features and to charge a
premium for this.
CREATING FINANCING STRATEGY:
After both the marketing and production strategies have been defined, the financing strategy can be
developed to provide the necessary finance to support investments required by the marketing and production
strategies. In addition to financing, investment decisions relating to future profits may also be made.
3.4 ITERATING STRATEGIES
While the process outlined above follows clear sequential steps, in reality these are interrelated. So it is
important to reconsider each of the strategies to ensure that the marketing strategy does not make demands
beyond the capabilities of manufacturing and that neither the manufacturing nor marketing strategies require
investments beyond the firm's ability to finance them.
3.5 IMPLEMENTATION
Planning is necessary, but some would say that 10% of the effort is in the planning and 90% is in the
implementation. In Mike's Bikes, it is assumed that the outcome of your firm's decisions depends on the
amount of money you commit and on the decisions of the competitors. In reality many other things also come
into play, such as the quality of the feedback and control systems, the nature of leadership, and the motivation
of the people in the organization.
3.6 FEEDBACK AND CONTROL
In Mike's Bikes, you have feedback on a variety of quantitative measures at the end of each year of operation,
and this is the information that allows you to learn and to improve performance in the following year. You may
need to alter your strategy in response to this information.
3.7 LEADERSHIP
Leadership can make a huge difference to the performance of an organization, but what sort of leadership, by
whom, and when, is often difficult to specify. This factor is not modeled in SoloMike, (but does come into
NetMike), and a brief discussion is provided in the next chapter.
3.8 MOTIVATION AND REWARDS
Motivation comes from rewards. These rewards can be financial (such as salary, bonuses, cars, etc.), or nonfinancial (such as the satisfaction that comes from the work and being part of a team, the development of
personal skills, etc.). A good environment balances these two types for each individual to get the most
rewarding environment. This is modeled to some extent in Mike's Bikes in the salary and training decisions,
and when playing in NetMike the rewards of good team dynamics can be significant.
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MIKE’S BIKES – Integrated Business Learning Online
4. Applying the Framework
The previous section provided a quick overview of the steps in a strategy development process. This section
now revisits each of these to describe some analytical tools that may be used to provide more detail.
4.1 EXTERNAL ANALYSIS
External Analysis may be broken into three main areas – environment, competitor, and customer. It consists
of understanding how competitors and the company interact in the environment to provide products to
customers. In this chapter we consider environment and competitor and in the chapter on marketing and
demand, we consider the customer. There are a number of tools that can help in external analysis, and the
ones that will be covered here are PESTE, Porter's Five Forces, SWOT and Stakeholder Analysis, which all
relate to environmental analysis. Then we cover competitor analysis and stress the importance of good
competitive intelligence. Finally, customer analysis overlaps and flows through into the marketing function.
ENVIRONMENTAL ANALYSIS
PESTE ANALYSIS
4
PESTE analysis considers the
business environment in which an
organization operates and identifies
the elements that could have some
impact on the products that an
organization produces or intends to
produce. Typically a lot of data will be
required for this, so structuring and
summarizing is important. The other
important consideration is the quality
of the information and most people
would argue that the better the
quality the better the decision.
However, the more current the
information the more valuable it is,
but it is usually also the most illdefined. The art of analysis is to sort
the nuggets of gold from the deserts
of data and to convert this to
knowledge useful for decisions.
6
PESTE Analysis
(political, economic, societal, technological, environmental)
Economic Factors /
Restructuring
Capital
Markets
Labor
Market
Competition
Economic Financial
Labor &
Marketing
Forecasting
Policy Industrial Relations Policy
Demographics Demographic
Forecasting
THE ENTERPRISE
Environmental Sensing
Socio-Cultural
Factors
Ecology
R&D
Policy
Technology
Lobbying
Government
Purchasing
Policy
Supplies
Developing Business Strategy
The PESTE analysis is useful to this
end, and considers the political, economic, societal, technological and environmental conditions in which a
firm operates. It provides a good overview of the overall environment and can be completed at a number of
different levels anywhere from trivial to an exhaustive level taking months and even years to complete. The
objective is to put on one page all the main issues that relate to the enterprise and the industry in which it is
competing. It is best to start simple and with time more information can be gathered about each of the areas.
4
Johnson, G., Scholes, K,. Exploring Corporate Strategy (4th ed), Prentice-Hall Europe, 1997.
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Developing Business Strategy
PORTER'S FIVE FORCES ANALYSIS
Porter's Five Forces Analysis is a tool
for analyzing the attractiveness of an
industry. It has 5 components customer,
competitor,
suppliers,
barriers to entry, threat of substitutes.
The tool allows you to consider each of
these areas and to determine whether
this is going to be profitable or not for
companies in that industry.
Porter’s 5 Forces - Industry Attractiveness
New Entrants
Threat of New Entrants
Industry
Competitors
Bargaining
Power of Buyers
Buyers
Suppliers
5
Porter identifies many elements that
can be considered in each of these
areas. These factors can be scored,
the higher the score the better the
industry. A simple way to do this is to
score each factor out of four: 1: weak;
4: strong.
8
Bargaining Power
of Suppliers
Intensity of
Rivalry
Threat of Substitutes
Substitutes
Developing Business Strategy
Any experience with this tool will
indicate that while it can be very effective, it can also quickly introduce a Pandora's Box of issues. Our
suggestion is that the 80/20 rule needs to be applied to make it work effectively. Do it quickly at first on one
sitting, and then come back and increase the level of analysis. Porter's book on the subject has about 30
different areas that can be considered
12
to get a more complete picture and
Sources for Competitor Analysis
NOT all of these will be equally
relevant and important. However it has
•Central Government
•Standard Setting Bodies
three main purposes.
Industry Observers •Local Government
•Unions
• It serves as a way of
•International Organizations
•The Press / Media
•Watchdog Groups
sharing information in
•Local Organizations
•Financial Community
a management team.
• It serves to structure
Suppliers
Distributors
Customers
Industry
the information.
• The
scores
will
indicate
the
attractiveness of the
Interview Sources
Service Companies
industry. i.e. if the
scores are high in
•Market Research Staff
•Trade Associations •Auditors
•Sales Force
each dimension, then
•Investment Banks •Commercial Banks
•Former Competitors’ •Purchasing Dept.
•Consultants
•Advertising Agencies
it suggests that most
•R & D Dept
Employees
firms will be able to get
•Engineering Staff
a good return.
Developing Business Strategy
SWOT ANALYSIS
The SWOT (Strengths, Weaknesses, Opportunities, Threats) analysis is a very basic, but very useful way to
get an idea of where the organization stands at present. It is
simply a list of key issues for the organization. The
Internal
External
strengths/weaknesses relate to the internal aspects of the
organization, and the opportunities/threats to the external
Strengths
Opportunities
aspects. This can be modified to include the estimated current
and anticipated future positions. Because of its simplicity, it
helps prioritize the issues and as with the PESTE, it can be
Weaknesses
Threats
repeated over time to give more insight, and also allows more
in-depth analysis to occur if required.
5
Porter M., Competitive Advantage, The Free Press, 1985 and Porter M., “How Competitive Forces Shape Strategy,” HBR, March-April
1979.
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MIKE’S BIKES – Integrated Business Learning Online
STAKEHOLDER ANALYSIS
Stakeholder analysis is a way of identifying the important groups of people affecting the
will include groups within the organization and outside. The list
shown is typical of who these people might be and these nine
Internal
groups should be ranked in terms of importance, and also in
• different plants
terms of their level of interest and predictability. They can then
• different
be managed accordingly with the key ones receiving the
functions
attention that they require.
• employees
• management
COMPETITIVE ANALYSIS
SOURCES FOR COMPETITIVE ANALYSIS
organization. These
External
•
•
•
•
customers
suppliers
shareholders
local
community
government
•
6
Competitive analysis is important when
identifying which segments to compete in
and how. Information about the competition
is often challenging to obtain, but usually
less difficult than most people think. The
wide variety of sources that may be useful
for an organization are given in the slide on
7
the previous page.
What Drives
the Competitor
What the Competitor
is Doing and Can Do
FUTURE GOALS
CURRENT STRATEGY
At all levels of management
and in multiple dimensions
How the business is
currently competing
THE COMPETITOR RESPONSE PROFILE
Competitive activity is a key determinant of
ultimate success in any industry and so with
this information it is important to put
together a competitor response profile
indicating the likely way that the competitor
will behave.
Competitors consist of soft resources
(people, their knowledge and skills) and
hard (physical, non-human) resources. The
interaction of these will determine the likely
actions of the firm in the future and a key
outcome of competitive analysis is to make
meaningful assessments of these.
COMPETITOR’S RESPONSE PROFILE
Is competitor satisfied with current position?
What strategy shifts is competitor likely to make?
Where is competitor vulnerable?
What will provoke greatest & most effective retaliation?
ASSUMPTIONS
CAPABILITIES
Held about itself
and the industry
Both strengths
and weaknesses
Developing Business Strategy
11
Map out your competitive responses
Planning Strategic Moves
COMPETITIVE RESPONSES
My Move
Enter Leisure
It is also useful to use this information to
map out your competitive moves for at least
a couple of periods in advance. This forces
a management team to think in a “what-if”
mode and to look at the strategic
alternatives.
A decision tree format is useful for this, but
considerable skill is required to keep the
options at a level that they can be relatively
easily understood and represented. If this is
9
Components of a Competitor Analysis
Competitor move
Enters Leisure
Goes for Adventurer
Competitive
Irrational
Try to keep price up
Focus on advertising
Do not enter price war
Look at destroying competition
Developing Business Strategy
6
7
Porter M., Competitive Advantage, The Free Press, 1985, Appendix B.
Although competitor intelligence is vital in business, ethical actions are an important issue. This is often a personal call on the part of
the company and of the person collecting the information. However, in the long run, good ethical foundations can almost always be
shown to have positive effects on the people and company.
Page 24
Developing Business Strategy
not done then even the simple example shown can get very complicated very quickly.
Experience suggests that competitive analysis is usually done quite informally by organizations on a
continuous basis and often only for a couple of the main competitors. It is usually only a few groups who are
involved (and not necessarily those that should be). Also it is often not updated as frequently as it should.
The lesson is to make sure that this is done at least roughly, regularly and by the right people. As with the
other tools in this section, the 80/20 rule should be applied constantly and iteration is the key.
4.2 EXTERNAL ANALYSIS IN MIKE'S BIKES
ENVIRONMENTAL ANALYSIS
BACKGROUND INFORMATION FOR SOLOMIKE (REPEATED FROM CHAPTER ONE).
This is a special report on the bicycle market prepared by Woolly Woolly McNully & Woolly. This report covers
the history of the industry, the market segments, the distributors, and the competitors.
Mike's Bikes models a bicycle industry in a country called Erehwon and has around 15 million people and a
western capitalist economy. Several years ago the government set up two bicycle manufacturing firms in an
attempt to stimulate economic growth, investment and create employment. This initiative was consistent with
their policy of developing clusters of firms that could build up competence in high-margin niche markets. The
bicycle industry was selected because of its close ties to the growing outdoors and health-conscious
consumer market prevalent in Erehwon. Consumers in these markets have high discretionary income, and will
freely buy any bicycle which suits their individual needs. In order to protect their investment, the government
banned the importing of bicycles and bicycle components from other countries in all segments except for the
low cost leisure segment (where a number of bicycles and components were being produced very cost
effectively by some third world countries).
Both firms were built from nothing and attempted to maximize economic benefits to the community by
producing one identical bike - the "RockHopper". The factories used by each company were set up identically,
and produced an even quota of the RockHopper. Anyone wanting a new bike had to buy a RockHopper or a
cheap import and therefore there was virtually no competition since these products appealed to quite distinct
market segments. Although there was an effective monopoly for the Adventurer segment, firms were
regulated to ensure that the companies did not make excess profits at the consumers' expense.
As the government's policy started to work and the financial strength and competence of these manufacturers
increased, the government initiated stage two of its master plan. A prohibitive import duty was imposed on all
imports, effectively killing demand for cheap third world imports and leaving both segments available to the
two local manufacturers - Real Cool Cycles and MountainTop Cycles. With this change to the Erehwon
bicycle market, the government also decided to privatize the manufacturing companies. The firms were
snapped up by investors who were able to spot a good opportunity and cheap resources.
The new owners of MountainTop Cycles decided to promote "Steady" Mike to be their chief executive officer.
Although not known for his entrepreneurial skills, his experience in the industry and conservative approach
was favored by the investors. (The option exists of replacing him with another candidate, "Sharp" Mike, should
more brainpower be required.)
You have been recruited as the CEO of Real Cool Cycles. Your general knowledge of bicycles will prove
useful, but should remember that you are dealing with new bicycles only in the domestic market and are
selling them to retail shops. Retail prices are assumed when calculating demand.
Your goal is to maximize your company's shareholder value over a 10 year horizon.
This can all be summarized in a PESTE analysis and you are asked to complete this in Question 1a).
PESTE ANALYSIS
A PESTE analysis for Mike's Bike would show a stable political environment, with some economic growth,
some societal trends towards more environmentally friendly activities, technological breakthroughs continuing
in the areas of information technology and bio-technology, and continuing and worsening pressure on the
environment.
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MIKE’S BIKES – Integrated Business Learning Online
PORTER'S FIVE FORCES ANALYSIS
Consider a Porter's Five forces analysis that you are asked to complete in the questions at the end of this
chapter. A Five-Forces analysis would suggest this is currently a 2-star industry with high barriers to entry and
low risk of substitutes.
SWOT ANALYSIS
Complete a SWOT analysis for Mike's Bikes as requested in Question 1c).
STAKEHOLDER ANALYSIS
The main stakeholders in Mike's Bikes are the current management team and the shareholders. While other
groups are represented these are the only ones who have decision-making power.
COMPETITIVE ANALYSIS
Real Cool Cycles has only one competitor - MountainTop Cycles. At the beginning of 1998 both firms are
identical in every respect, but that will surely change!
MountainTop Cycles is managed by Mike - either "Steady" Mike or "Sharp" Mike. Depending on your choice,
you may choose Steady Mike (who is a steady sort of person with reasonable but limited intelligence) or Sharp
8
Mike (who is more proactive and much more intelligent). By default, Steady Mike has the reins.
Extensive competitor information on MountainTop Cycles (in the form of duplicate reports) is available to you
9
if you wish.
4.3 INTERNAL ANALYSIS
Internal Analysis considers the internal capability of the organization. This has a heavy overlap with
operations. Perhaps the most important tool in this regard is the concept of core competency. Although this
10
term has recently been repackaged and resold to business by Hamel and Prahalad , it has been around for a
long time. After all is simply asks the question: What profitable activity does an organization do better than
anyone else in a defensible way? Such a deceptively simply question can take a long time to answer, and is in
fact quite crucial for the organization's long term success. We elaborate in the section below.
CORE COMPETENCIES
A core competency is something that an organization does really well. As defined by Hamel and Prahalad,
there are three tests for a core competency:
• Does it provide potential access to a wide variety of markets?
• Does it significantly add to the customer value derived from the end product?
• Is it difficult to imitate?
Examples include the “stickiness” of 3M, the miniaturization of Sony and the engine technology of Honda.
The reason for agonizing over what this is for an organization is that these core competencies give it
competitive advantage. They are what allow it to be more profitable than others in the industry. They are what
allow it to move into other industries and be profitable.
Typically, an important part of the strategy will relate to how to grow these; the idea of stretch is to use the
core competencies as a source of competitive advantage in other industries, thus supporting innovation in
new areas.
8
9
10
If you want the extra challenge of Sharp Mike running MountainTop Cycles, choose the appropriate option from /Preferences on the
File menu. From then on, Sharp Mike will make all the decisions!
To switch on “Competitor Information” mode, choose the appropriate option from /Preferences on the File menu and then check out
the extra reports which appear on the Reports menu.
Hamel, G., Prahalad, C.K “The Core Competence of the Corporation”, HBR, May-June, 1990
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Developing Business Strategy
4.4 INTERNAL ANALYSIS IN MIKE'S BIKES
CORE COMPETENCY
A core competency frequently combines the abilities of people with the capabilities of the technology. Mike's
Bikes does not allow a good understanding of core competencies since these are often described more
qualitatively than the system can allow. However, on a more limited basis, companies can talk about building
competency in quality, distribution, or branding for example by investing more heavily in these areas.
For example, if quality has been found to be a key issue in the Adventurer segment, then a core competency
might be the ability to guarantee 99.9%
quality.
30
Core Competencies and Core Products
4.5 SPECIFIYING,
EVALUATING AND
SELECTING A STRATEGY
Based on the External and Internal
analyses, an organization is well equipped
to determine some strategies for
evaluation. There are two steps to this
1. Developing
alternative
strategies.
2. Selecting one from these.
Core
Competency
Core
Competency
Core Product
End
Product
DEVELOPING VISION AND SPECIFYING
STRATEGIES
End
Product
Core
Competency
Core Product
End
Product
End
Product
Developing Business Strategy
This can be a very creative activity, and
depends upon the synthesis of all the data that has been amassed from the internal and external analysis. It
also involves reconsidering the mission, vision and strategic intent of the organization (if the organization has
been in existence for some time), or developing these for the first time. This needs to be in conjunction with
the core competencies. A quick definition of these concepts follows.
VISION AND STRATEGY
One of the first things that a company needs to do is to understand why it exists, what it is trying to achieve
and how it is trying to achieve this. While this may be clear at the beginning of a new organization, it will
change over time both due to the changing environment and due to a better understanding of the environment
by the organization.
A vision statement is a good start for describing the “what” and “why” of an organization. Technically a
mission statement gives the reason that a company exists, a vision what it wants to achieve and a strategic
intent makes this emotionally compelling. A strategy then describes how this will be achieved and
communicates this i.e. it is a blueprint for winning. In most cases, there is no one best strategy.
TYPES OF STRATEGIES: PORTER'S FIT STRATEGIES
11
In the 1980's, Michael Porter did considerable work in defining three types of strategies that "fit" a business
unit into its environment. One way of describing these is by considering two dimensions: Strategic Target and
Strategic Advantage. The quadrants then lead to 3 strategies: differentiated, cost and focus. A quick
description of each follows
11
See for example, Porter M., Competitive Advantage, The Free Press, 1985 and Porter M., “How Competitive Forces Shape
Strategy,” HBR, March-April 1979
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DIFFERENTIATED
A differentiated strategy is one that has a broad target and has a scope that is concerned with creating
products and services that are different to the competition. A higher margin can then be charged.
COST
A cost strategy is one that has a broad target
and has a scope that is concerned with
creating products and services that are priced
less than the competition. For this to work, the
company must have lower production costs
than competition, since the margins will
otherwise be too small for profit.
FOCUS
A focused strategy is one that has a narrow
strategic target, and is either differentiated or
cost. The essence of this strategy is to make
sure that the product is targeted carefully at the
needs of the segment.
35
Porter’s Generic Company Strategies
Broad
Differentiation
Strategic
Target
Cost
Manage
Carefully
Focus
Narrow
Differentiated
Cost
Strategic Advantage
Porter's original ideas strongly argued that
while an organization could focus on any one
of these, it should not be “stuck in the middle”
Developing Business Strategy
of the strategic grid. Subsequent debate would
suggest that the original conditions have to be carefully considered. In fact, most business must be in both
camps – they must be cost-orientated in mature markets that have many competitors, and differentiated in
newer markets where there is less competition.
Another issue of debate is with the issue of the sustainability of a cost strategy. Is this sustainable and can it
be a source of competitive advantage in its own right? We believe that the answer to both of these is yes and
that organizations can indeed compete successfully on this dimension alone. In this case all their efforts are
expended on improving and innovating processes to reduce their costs.
EVALUATION
It has been suggested that there are three dimensions that should be used as the basis of selecting a
strategy. These are:
• Suitability: Is it appropriate?
42
• Feasibility: Can it be done?
What should you do?
• Acceptability: How good is the
Rank the alternatives
result?
Suitability asks whether the chosen strategy
is appropriate for the organization. No matter
how attractive some strategies may be for
certain organizations, they may not be able to
implement them for some reason. An example
would be a health insurance company with
spare cash not able to invest in a tobacco
company due to a conflict with its mission
statement.
1 is low
Strategy 1
Strategy 2
Strategy 3
5 is high
Suitable Feasible Acceptable
2
3
4
1
3
4
4
2
4
Which do you choose?
Feasibility asks whether it is possible to carry
out the strategy. Are there enough resources
or can they be acquired from somewhere? Is
Developing Business Strategy
the way in which the organization intends to
develop itself, its markets and its products supported by theory (both managerial and technical)?
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Developing Business Strategy
Acceptability asks whether the expected return is high enough. This is usually calculated using Net Present
Value techniques.
SCORING OF STRATEGIES
A problem with the selection process is that it can get very complicated. A good way to start the analysis is to
consider the three dimensions above and to score the strategies on them using a crude scoring system to
focus the issues. This approach is shown in the table above and can be refined as appropriate.
It may be appropriate to simply add the scores or some weighting may be applied. Of course, any such
approach must support common sense and is more a technique for filtering and focusing the information than
for actually making decisions. This process will have to be repeated as more information unfolds.
HOW IS STRATEGY REALLY DEVELOPED?
A rather pure process has been described above but there are probably nearly as many ways of developing
strategies as there are organizations. Constant feedback is vital, as is constant adjustment to the new
conditions, and this is where much traditional strategy often falls down.
4.6 SPECIFIYING, EVALUATING AND SELECTING STRATEGY IN MIKE'S BIKES
DEVELOPING VISION AND SPECIFYING STRATEGIES
A vision for an organization that wants to own the Adventurer segment might be “Our bike's climb any
mountain.” and a strategic intent: “No one will catch our quality.” Such statements can be an important way of
focusing on the organization on its reason for being. Then it is necessary to develop a strategy that supports
this vision. Specifically, it will need to answer the following questions.
a) What is going on in the external environment - current and future?
b) What is the current state of the internal environment?
c) What you will do to win?
• What core competencies are required?
• What businesses do you want to get into?
• What is the competition doing?
• What resources are required?
d) Why will this work?
• feasibility
• acceptability
• suitability
e) How will it work? This may be broken down into measurable projects that are cross-functional
or functional such as
• marketing
• operations
• finance
• information technology
• human resources
• new product development
EVALUATION
OF A STRATEGY
Suitability:
All companies are in the same business and so can do whatever
they wish as long as it is to do with bikes.
Feasibility:
Everything is determined by mathematical relationships and dollars
expended. If the relationships are understood and the dollars are
available then it is possible - provided that competitive activity does
not intervene.
Acceptability:
The outcome of a strategy is measured in terms of Shareholder
Value Added. EVA is also calculated to give people a comparison.
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SELECTION OF STRATEGY
Based on these three criteria it should be possible to choose a strategy that most satisfies the requirements of
the organization.
4.7 IMPLEMENTATION AND FUNCTIONAL DECISIONS
It is one thing to have a strategy, and quite another to have one that is understood, accepted and “do-able”.
This is often the hardest thing to do in a strategy. A good strategy needs the input, buy-in and understanding
of many people to be successfully implemented. One step in this direction is to break down the strategy into
functional areas.
4.8 IMPLEMENTATION AND FUNCTIONAL DECISIONS IN MIKE'S BIKES
The functions represented in Mike's Bikes are marketing, product development, operations, and finance and
subsequent chapters describe the decisions required by these functions in more detail.
In Mike's Bikes it is simply a matter of spending money on decisions and they will get done, but in real life the
implementation of the functional strategies is a key part of achieving success. Issues of leadership, rewards,
motivation and measurement arise. These issues are not addressed directly in Mike's Bikes, although a
considerable amount of insight into group dynamics can occur in the networked version.
4.9 MEASUREMENT AND STRATEGIC CONTROL
What you cannot measure you cannot manage - Lord Kelvin
Measurement is key to the long-term success of a project or organization, and what you measure will
determine what you get. So it is vital to get the measures right. Many of the important measures are difficult to
make - but since an imprecise measure of something important is far more valuable than a precise measure
of something irrelevant, such measures should receive most of the emphasis.
Working hand-in-hand with measurement is the concept of strategic control. This refers to the regular review
of the key measures and learning from these. There is a significant link between this and the learning
organization and some of these linkages are discussed below.
MEASUREMENT AND THE BALANCED SCORECARD
Historically, many people have measured a company's
performance only by looking at immediate profit or
earnings per share. However, focusing on this has
been compared to driving a car by looking out the back
window. If performance has deteriorated, it is usually
too late to take corrective action, and so it is important
to look at some indicators which are correlated to
future financial performance.
45
Balanced Scorecard
Vision/Strategic Intent
Critical Success Factors
Goals/Measures
Rewards
Customer Financial
These are described in the concept of the Balanced
Scorecard. This measurement tool introduced by
12
Kaplan and Norton extends the idea of financial
measurement to three other areas as listed below.
• financial: measures of the profitability.
• internal: measures of productivity and
internal efficiency.
• customer: measures of customer satisfaction.
• innovation and learning: measures of new products and improvements.
12
Internal Innovation
Sub-unit
Personal
Developing Business Strategy
See for example: Kaplan, R.S., Norton, D.P., “The Balanced Scorecard - Measures that Drive Performance”, HBR, Jan-Feb, 1992;
Kaplan, R.S., Norton, D.P., “Putting the Balanced Scorecard to Work”, HBR, Sept-Oct, 1993; Kaplan, R.S., Norton, D.P., “Using the
Balanced Scorecard as a Strategic Management System”, HBR, Jan-Feb, 1996
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Developing Business Strategy
Their well-supported argument is that if these measures start to deteriorate then financial results will
eventually follow.
However, The Balanced Scorecard is more than just a set of measures financial, innovation and learning,
customer satisfaction and internal performance measures. It may be viewed as a total system that links these
upwards to the strategic intent and vision of the company, through critical success factors (i.e. those few
aspects of a business that must succeed for the business to succeed). And it links them downwards to sub
units and to individuals. These measures can (and should) be linked to rewards also.
This relationships are indicated in the diagram on the previous page.
4.10 MEASUREMENT AND STRATEGIC CONTROL IN MIKE'S BIKES
The main decision screen of Mike's Bikes summarizes
the Balanced Scorecard measures and is shown to the
right.
While these are just a selection of the sorts of measures
that could be of use, the principle is to start with a few
simple measures and add other measures on later. In
this case, they are already indicating potential problems
in a few key areas such as no new product designs and
little investment in training.
There are a substantial number of reports available for
you in the simulation to let you know the results of your
decisions and to help you analyze and learn from your
performance. These reports can be accessed from the
report menu as shown in the figure to the right, and it is
up to the user to look at what they think is relevant. They
provide a wide variety of graphical as well as textual
information relating to the previous period.
In the sections below, the four categories of the
Balanced Scorecard are considered and examples of
these reports fitting into these different sections are described.
FINANCIAL RELATED MEASURES
INCREASE IN SHAREHOLDER VALUE
The essence of shareholder value added is to create
wealth for shareholders, and so you will be evaluated on
the cumulative change in shareholder value that your firm
generates. Being evaluated on shareholder wealth is
significantly different from evaluation based on net profit.
You should aim to:
13
• Maximize net profit
There are more in
• Minimize shareholder investment
these sections
• Minimize risk
Because of these multiple objectives a small niche
marketer with significant but stable earnings may
outperform a risky firm with earnings several times larger.
This means firms will need to carefully consider these objectives when developing their overall strategy, and
their marketing, operational and financial plans. Most importantly, a firm should only invest money (for
13
There has been considerable recent interest in another concept for measuring annual profit called Economic Value Add (EVA – this is
a registered trademark of Stern, Stewart & Co). In its simplest form this modifies profit by considering the cost of capital employed.
Alternative reports for EVA are included in addition to the basic profitability figures.
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example in a new plant, product development, or on factory improvements) if the management team believes
that the return on these investments will be greater than shareholders could achieve elsewhere (and currently
shareholders can earn returns of 10% by investing in the share market). If companies cannot pay this level of
return, they should instead consider paying a dividend (so that its shareholders can undertake other
investments themselves), or repay debt.
Share Price is based on Earnings per Share smoothed over several years. It includes investments which will
reduce current net profit but may well produce returns in the future.
1
2
3
4
The Shareholder Value represents the Period
increase in wealth obtained by a shareholder Share Price
$13.00 $14.00 $15.75 $16.00
in the firm. This table shows how shareholder Current Dividend
$0.20 $5.00
$0.40
$0.35
value is calculated and a summary is
Total Previous Dividends $0.00 $0.20
$5.22
$6.14
available in the financial results report.
and Interest @ 10%
The figure which is most important is in the Interest on Dividends
$0.00 $0.02
$0.52
$0.61
final row - the Cumulative Change. This (PV)
represents the return which an investor with
one share purchased at the end of the first
Shareholder Value
$13.20 $19.22 $21.89 $23.10
period would have received to date. This
Value
Created
$6.02
$2.67
$1.31
number is made up of:
• the share price increase;
Change in Year
45.6% 13.9%
5.9%
• the
dividend
payments
received;
Cumulative Change
45.6% 65.8% 75.7%
• any return that would have
been earned on dividends received in the past.
The Change in Year represents the percent increase (or decrease) in shareholder wealth for that period, and
the Cumulative Change represents the percent increase (or decrease) in shareholder wealth since the first
period. For the purposes of this simulation, the base value for calculating Cumulative Change is the share
price at the time you take over the management of the firm.
CUSTOMER-SATISFACTION RELATED MEASURES
Sales Revenue and Warranty Rate are the two
measures shown on the Mike’s Bikes sample
Balanced Scorecard, but a variety of others exist,
including Market Share and more detailed product
comparisons.
THE MARKET SHARE REPORT
The Sales Revenue and Warranty Rate measures
focus on your own performance. The Market Share
chart shows how your products are performing
compared to your competitors'.
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Developing Business Strategy
THE PRODUCT DETAILS REPORT
It's one thing knowing what your market share is. It's another to work out why one product is selling better than
another. The Product Details report found in the Marketing Reports sub-menu gives details on all products
competing in the market including their sales, awareness and quality levels.
Often the differences in market share will be explained by perusing this report, especially when combined with
considering the sensitivities of the market segments
to the price, quality, advertising, etc.
THE PERCEPTUAL MAP OF MARKET SEGMENTS
This report shows what levels of Style/Design and
Technical Specs are desired by the market segments
(i.e. Adventurers and Leisure.) The circles indicate
the acceptable ranges of Style/Design and Technical
Specs. It also shows how well your products (and
unused product designs) match these requirements,
and by selecting a different firm, you can see its
products too. Note that demand for a product is also
determined by many other factors (such as pricing,
quality, advertising, distribution etc.). In most cases
these other factors are more significant than how
close a product is to the center of the circle.
INTERNAL MEASURES
THE CAPACITY USAGE REPORT
This report shows how much of your factory capacity
was wasted on rework etc., and how much was used
productively. In this case only about 60% of the
factory's potential capacity is being used to produce
products. Any idle time will be due either to planned
product production volumes that are too low, or
insufficient demand for the products.
INNOVATION AND LEARNING MEASURES
There are only a couple of these measures and they
relate to training time and new products developed.
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4.11 MISCELLANEOUS REPORTS
THE PRODUCTS REPORT
The Products report is an example of a textual report. It shows the sales, accounting margins and production
figures for each product. It is a useful source of information on the performance of your products.
COMPETITOR INFORMATION MODE
In addition to all the information normally found
under the reports menu, switching on the
Competitor Information mode will allow you to
see additional reports giving you inside
information on what your competitor is doing.
This will help you to get more understanding of
Mike's performance. To switch on this mode
choose /Preferences /”Benchmark against
competitor's reports” from the File menu.
4.12 STRATEGIC CONTROL
In an organization this occurs on different time
scales for different levels of the organization. At
the operational level, feedback on processes
may be almost instantaneous and highly
detailed. At the strategic level, feedback may
be less frequent and more aggregated.
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Developing Business Strategy
5. Questions to Assist Learning
1.
Start a strategic business analysis for the Mike's Bikes environment for the next 2 years. This
should include a consideration of the following issues and can be in bullet form. (Make sure that
you think about consistency and these may have to be revisited as the situation develops.)
a)
b)
c)
d)
2.
Carry out an environmental analysis. Use the PESTE as a basis for this.
Use Porter's Five Forces framework to carry out an industry analysis.
Complete a SWOT analysis for your company, identifying core competencies
Carry out a competitor analysis.
Based on this, start to formulate a draft strategy (2-3 pages) by:
a) defining a mission and a strategic intent/vision, showing clearly the difference.
b) describing your intended strategy in terms of Porter's Generic Strategies i.e. cost, differentiation, and
focus.
c) Evaluate this against an alternative.
d) Roughly describe the marketing, operations and finance implications of this.
e) Consider the main reports that you use to monitor and control progress. Categorize these into the
Balanced Scorecard format and indicate any categories that need more measures.
3.
The Balanced Scorecard
The management team of your company has decided that they need to investigate more formal procedures
for disaggregating and controlling the company's strategic direction. Kaplan & Norton's (1992) Balanced
14
Scorecard approach has been suggested as one possible method of doing this .
a) Prepare a balanced scorecard for your bike company based on your own company's strategy. You
should present the scorecard on a single page, separating out each of the four perspective's
(internal, external, financial, innovation & learning) and providing suggested performance measures
for each perspective. Be creative in your selection of performance measures. You should think of 13 measures for each perspective and make graphs of them (make up the data if you have to).
b) In a table, justify your choice of performance measure for each perspective.
6. Modifications for NetMike
Intentionally we have made NetMike very similar SoloMike, and in fact the only difference is that it is richer
with 5 segments, 3 distribution channels and 5 firms. This makes the decisions and dynamics more
interesting.
7. References
rd
1. Grant, Robert, M., Contemporary Strategy Analysis (3 Ed), Blackwell Publishers Inc, 1998
2. Porter M., Competitive Strategy, The Free Press, 1980.
3. Hamel, G., Prahalad, C.K., Competing for the Future, 1994
14
Kaplan, R. S., & Norton, D. P. (1992). “The Balanced Scorecard - Measures that Drive Performance.” Harvard Business Review.
January - February, pp. 71 - 79.
Page 35
3 TEAM DYNAMICS – BY DARL KOLB AND JOLINE FRANCOEUR
The content and techniques around the development of strategy are very important and have historically
received considerable attention. However, the process of strategy formation is often equally or more
important than the strategy itself. It has been generally shown to be difficult to get a good strategy with a bad
process. A good process will allow all members of the team to understand the key issues, to contribute their
perspectives, and to be committed to the final strategic choices.
Mike’s Bikes is an excellent environment in which to understand and develop the team dynamics for good
management decision making. Teams must make good business decisions. This requires both analytical
skills and intuition. The experience also requires a reasonable amount of work and so motivation and
commitment of team members become important issues.
This chapter addresses some of the issues affecting group behavior and performance in simulated
environments, particularly business simulations like Mike’s Bikes. The main intent is to offer brief
explanations and practical advice. The following sections are based on sound academic principles and
theories, but is not intended to replace or cover basic ‘groups and teams’ content found in most organizational
behavior and/or management text books. If a term or concept used here is unclear, or if you’d like to find out
more about it, check out any OB or introductory management textbook for more detail. We will cover topics
including motivation, group formation, decision-making, performance and communication. We also describe
a fundamental feedback loop that is vital for learning and continuous improvement at individual, team and
organizational levels. Finally, we present some ways of controlling and measuring team dynamics using the
Assessor feature of Mike’s Bikes.
1. Learning Outcomes
In this chapter we explore some theory related to team dynamics. The main learning objectives are the
understanding of the following issues:
a) How simulations may be used to develop good team dynamics.
b) Understanding of team formation issues and team maintenance issues. - forming, storming,
norming, conforming, performing, and adjourning.
c) Developing team process skills – listening, feedback, time management.
d) Getting consensus and commitment of team members.
e) Appreciating the value of different perspectives.
f) Effective use of data including the collection, processing and feedback of team data.
2. Why use simulations?
Nearly one hundred years ago, feeling that day-to-day life had lost some of the intensity and power of more
primal environments, psychiatrist William James observed that what society needed was a 'moral equivalent
th
to war'. Later, in the early 20 century, Kurt Hahn founded the Outward Bound schools, partly as a means to
offer survival challenges to youth as a means of strengthening their resolve to overcome adversity and to
value life itself. You may have thought of Outward Bound as an adventure program, which it is, but Outward
Bound programs are also educational simulations. They are simulations in the sense that, while they are very
real encounters with nature, oneself and others, the adventures undertaken are nonetheless artificially created
for the program’s purposes. Outward Bound participants join a world of Spartan conditions, including rugged
terrain, minimal sleeping shelters, basic food and so on. That world, albeit wondrously beautiful and
adventurous, is running in parallel with a day-to-day world of McDonalds restaurants, cars, soft beds, etc.
Like participants on an Outward Bound adventure, you, as a participant in a business simulation, are also
joining a world designed to provide challenges and to test your thinking and reasoning skills. Like any good
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Team Dynamics
adventure, during the course of the simulation, you are likely to feel challenged and frustrated at times. You
are likely also to feel exhilaration and to have fun.
Simulated business environments are powerful teaching tools for several reasons. First, like James’ 'moral
equivalent to war,' simulated environments allow us to learn by making mistakes, without endangering our
careers or the lives of others. In a word, simulations are ‘safe’! Second, they allow us to compress time and
make a lot happen in a relatively short amount of time. Indeed, it may be years between joining a company
and making the kinds of high-level decisions involved in a simulation. Third, simulations can be controlled to
make certain things happen in order that particular lessons become available. In ‘real life’ such manipulation
of circumstances in real companies would be unethical and, quite possibly, illegal. Fourth, simulations are
engaging, suit different learning styles and are usually enjoyable, which makes them a powerful learning tool,
since the more engaged and motivated we are, the more we tend to learn. Finally, business simulations help
15
us think creatively about business in order to discover new ways of doing things.
3. Issues for Individuals to Consider
As an individual member of a group or team involved in a simulation, you may be asking yourself if you really
want to be here and/or your group may be asking you for a commitment to the simulation. Since group
behavior begins with input from individuals, each individual should consider the following issues.
3.1 MOTIVATION
Your personal motivation to participate in the simulation will greatly affect the outcomes. Before you begin,
consider the following questions.
WHY AM I HERE?
What brought you to be involved in the simulation? Was it a free choice? If it was not a directly free choice of
your own, what other choice(s) have you made to get you here? For instance, is the simulation part of a
university degree program or an executive development course? Can you transfer your commitment to that
program of study or development to this activity? If you are not sure why you are involved, that's OK. It's
actually quite natural to be only curious at first. Later, you may find many reasons to stay involved in the
simulation.
NEEDS
You may not have thought about it in these terms before, but we all have ‘needs’ that contribute to why and
16
how we act in our day-to-day lives. McClelland has identified three types of human needs, which show up in
group and organizational settings. They are need for power, need for achievement and need for affiliation.
How might these personal needs affect groups and teams in simulations?
NEED FOR POWER
Those with a high need for power in groups like to get their own way. And, generally, they like to win at all
costs! Those with a moderate need for power usually don't like to get 'trampled' by others in the group, or by
other competing groups. Not surprisingly, many individuals who have a high need for power are not aware of
this need. Therefore, they may express it as being super-competitive and believing that everything must be
tightly controlled (usually by them) at all times. A healthy need for power is correlated with some forms of
leadership and can be useful in getting things done in groups. Members with high power needs usually make
sure that their group gets its fair share of points, resources, etc.
15
Schrage, M. (1999). Serious play: How the world’s best companies simulate to innovate. Cambridge, MA: Harvard Business School
Press.
16
McClelland, D. C. (1985). Human motivation. Chicago: Scott-Foresman.
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NEED FOR ACHIEVEMENT
Our need for achievement is essentially what underpins any simulated learning environment. What 'drives' us
to become engaged within an artificial scenario is the challenge to see if we can succeed at the objective,
whether that objective is survival, 'winning' in terms of pretend dollars earned or having a great team
experience. While most managers and students of management have a relatively high need to achieve, the
level of need for achievement does vary from person to person and group to group. Therefore, you may want
to consider, personally and as a group, how important it is to win in the simulated exercise. This may lead to
the question of 'what is winning' and 'what do you and your group wish to achieve from the activity'?
NEED FOR AFFILIATION
The need for affiliation is part of the glue which holds a group or team together. We human beings are social
animals. Most of us enjoy the company of others, in some form or other. You can rely on this need to draw
your group together, but you must also be aware of how this need may vary from individual to individual. First,
how people wish to socialize and interact varies. Dominant and subordinate sub-groups can develop in
teams, whereby the group norms are determined by a few members, with other members going along
because they don't want to 'rock the boat' or face rejection. In groups with high work output demands, some
members may, in addition to the stress of producing outputs, experience social 'pressure' from too high an
expectation of loyalty to the group.
As we've tried to illustrate, each of these needs can have, potentially, both positive and/or negative effects on
a group. Since no person is driven by only one need, to the exclusion of others, it is important for each of us
to consider the relative importance of each need for us at any given time and place. You may also find that all
three needs interact simultaneously in motivating you.
FEAR OF FAILURE AND OVERACHIEVEMENT
The under side of our need for achievement is a commonly occurring fear of failure. Too much fear and we
become immobilized. But fear of failure can also be a powerful motivational force toward action. Indeed,
underlying many rags-to-riches and 'corporate hero' stories is often a mighty fear of failure, which gets
translated into repeated patterns of over-achievement. If you're an overachiever, you want to do well in the
simulation, just as you strive to do well in every other aspect of your life. Working with overachievers can be
difficult at times, as they may demand as much of others as they demand of themselves and/or they may
'burn-out', leaving the rest of the team to pick up the pieces.
FUN!
Remember that fun is an important motivator. We all have choices in life and, generally speaking, if
something appears to be more entertaining and engaging, we are more likely to devote our attention to it and
learn from it. Simulations are designed to be stimulating and enjoyable. If you find yourself 'playing' around
with the software, then you may be responding to one of our most natural motivational forces--enjoyment,
relaxation or pleasure! Having fun not only serves to motivate, but it also tends to heighten creativity and
reduce or counteract stress.
3.2 PAST EXPERIENCES WITH GROUPS
No doubt, your past experience(s) with groups will factor into how you perceive your group or team in this
context. If you've had positive experiences with sports teams, church or social groups, or other study/learning
teams, you are more likely to be open to the simulation becoming another positive and productive group
experience. If, on the other hand, you have had negative or counter-productive group experiences, then you
are more likely to be suspicious of group work or study teams. You may consider suspending judgement on
this group experience, until you have more data, i.e., some time spent establishing good team practices or
writing up a team agreement. Team agreements can help your team overcome past negative group
experiences by agreeing in advance how you, as a team, would like to deal with groups issues, rather than
wait for them to arise when stress is high and the pressure of performance is heavy.
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Team Dynamics
3.3 CYNICISM—WHAT CAN I POSSIBLY LEARN FROM THIS?
If you find yourself really cynical about collective effort and collaborative learning, you are not alone. Scott
Adams has made a full-time career (and, presumably a fortune) sketching Dilbert™ cartoons, which highlight
the cynical view of organizational life. And, we all deserve to be somewhat skeptical and careful about what
we commit to these days. However, if we sit back and judge too harshly, we may also be passed by in these
fast-paced times. If your group experience has been painted as a perfect panacea of wisdom and light, it
probably won't live up to your expectations. If it has been offered as an opportunity to try out some business
skills and/or take on some reasonable personal and group challenges, then it may be worth giving it a shot.
It's up to you to decide.
4. Managing Groups and Teams in Simulations
4.1 WHAT'S THE DIFFERENCE BETWEEN A "GROUP" AND A "TEAM"?
While any configuration of two or more individuals could be described as a 'group,' they are not necessarily a
17
'team.' As Katzenbach and Smith note: "Teams differ from work groups. They require both individual and
mutual accountability. Teams rely on more than group discussion, debate, and decision; on more than
sharing information and best practice perspectives; on more than a mutual reinforcing of performance
standards. Without discrete team work-products produced through the joint, real contributions of team
members, the promise of incremental or magnified performance impact goes untapped." (pp. 89-90) By
"team work-products" they mean that only if a group produces something more than the sum of what its
individual members could have produced through shared responsibility is it a real "team." Using this
definition, a group which approaches a learning simulation by simply dividing up tasks among members, who
then work individually and supply their results back to the group, is not producing a team work-product, but
merely pooled individual effort.
Making distinctions between "group" and "team" efforts is not easy, and may be debated. But, it is
nonetheless important to realize that creating a team from a group requires a substantial commitment from
each member to contribute to the group's objectives and to accept help from others in doing so. Both points of
this distinction are important. In order for a group to perform like a team, individuals must commit and
contribute to the group and they must encourage and accept the help of others. Groups often complain of
'free-riders,' individuals who fail to
contribute to the group's objectives,
4
but for every free-rider, there is often
Factors Important for Teams
a group member who cannot accept
help from others and who insists that
'to get a job done right, do it yourself.'
While most of us would like to be
part of a 'team,' we must realize that
ACCOUNTABILTY
Mutual
ProbleSKILLS
while teams offer the promise of
solving
Small
improved performance, they also
number of
Interpersonal
involve more risk and therefore more
people
Individual
commitment
from
individual
Technical
function
members than do work groups. This
Specific goals
is portrayed in the diagram to the
Common approach
Meaningful purpose
right showing necessary elements of
18
teams.
For the purposes of your simulation,
you may not necessarily want or
need a 'team' performance. Your
group may decide to aim at being a
COLLECTIVE
WORK
PRODUCTS
Katzenbach & Smith
17
COMMITMENT
PERSONAL
GROWTH
Team Dynamics
Katzenbach, J.R. and Smith, D.K. (1993). The wisdom of teams: Creating the high-performance organization. New York:
HarperCollins.
18
Ibid, p. 90.
Page 39
MIKE’S BIKES – Integrated Business Learning Online
'team' or may focus on being an effective work or study 'group' to achieve your objectives. Work groups
sometimes develop into 'teams' and teams sometimes revert to being 'work groups' or simply a collection of
individuals, each trying to 'survive'. The latter development is not necessarily a bad thing, provided group
members learn from the experience.
4.2 SIMULATED ENVIRONMENTS
A simulated environment, like any other group environment, does play a part in shaping group processes and
behaviors. Groups which interact face-to-face can rely on hand gestures, eye movements and other body
language to relay subtle messages of support, frustration, agreement or fatigue. Virtual groups and teams
can not rely on these communication enhancers. Because your group is operating in a simulated
environment, however, doesn't mean that you can not form a 'real' team. Indeed, virtual environments offer
some advantages over face-to-face environments. For example, using the web and/or other electronic media,
team members do not have to be in the same place. In fact, they can be anywhere in the world! And, unlike
face-to-face teams, groups in virtual environments do not have to all participate at the same time, thus
allowing for further flexibility. Consider the possible configurations of time and place, illustrated below.
Media
Time
Place
Decision Laboratory
Same time
Same place
Electronic Bulletin Board
Different time
Same place
Chat Rooms
Same time
Different place
E Mail
Different time
Different place
19
Virtual Environments Time and Place Matrix
The flexibility of time and place offered by virtual environments and new communication technologies,
however, does require coordination and cooperation from participants. Indeed, just as face-to-face teams
need to agree when and where to meet (physically), virtual teams must decide some or all of the following:
• Which medium or media should we use?
• If we meet for same time chat sessions, when should they be?
• If we don't meet physically, will members shirk their responsibilities to the group?
• How will we know how members are doing if we can't see them?
• How often should we be expected to check our email?
• Should everyone receive a copy of all email?
• When, if ever, should we meet face-to-face, rather than electronically?
Research has shown that some study groups who had the option of face-to-face and electronic virtual
meetings preferred face-to-face meetings during the early, creative, idea-generating phase of a project. At
later stages in their projects, the same groups preferred electronic communication to work on revisions and
20
refinements to the team's outputs.
4.3 WHO MAKES UP THE GROUP?
Group composition obviously affects performance, but what is the best combination of characteristics to form
a team? Most research suggests that complementary skills and attributes are desirable in teams. Therefore,
in Mike's Bikes and other simulations which draw upon business functional knowledge, having, for instance,
an Accounting or Finance major working with a Marketing major and an Operations Management major
provides the team with complementary skill sets.
In addition, balancing or off-setting personality
characteristics traits can be useful in team development. Generally, diversity is a good attribute for groups
who need to do creative problem-solving. However, putting individuals who are polar opposites into the same
group can spell disaster, unless each individual is committed to making the team work. Some criteria for
selecting members of groups working in simulations (and other learning team environments) include, but are
not limited to, the following:
• functional area or discipline, i.e., strategy, marketing, etc.
19
Fan, C. (1995). Toward a Model of Groupware Implementation and Usage Among Executives: An Analysis of The University of
Auckland Executive MBA Remote Access Project. Master's Thesis, The University of Auckland, New Zealand.
20
Ibid.
Page 40
Team Dynamics
•
•
•
•
•
•
•
•
•
work experience
personality traits (introvert/extrovert, creative/analytical, high/low energy, etc.)
role preferences, i.e., big picture/detail, promotion/"back office", leader/follower, etc.
gender
ethnic background
geographical location (ease of commute for team meetings, if required)
experience with simulations, virtual environments
information technology skills
grade point average (may not be predictive in simulated, virtual environments)
4.4 GETTING INTO TEAMS
Getting people into groups or teams for a simulation is one of the most challenging and critically important
aspects of a simulation exercise. There are several ways to approach group selection, including, but not
limited to, random assignment, facilitator assignment (usually against some criteria and generally with an
intent to create 'balanced' teams or to distribute functional expertise and/or experience), participant selfselection or participant recruitment exercises. Each approach has advantages and disadvantages.
Random assignment into groups is probably the 'easiest' approach to getting people into groups. Despite, or
rather due to, statistically even probability, pure random assignment provides little assurance that groups will
have complementary skills and/or personality types. Stratified random assignment, i.e., randomly assigning
Strategy, Marketing, Accounting, HR, etc. majors across all groups yields an even distribution of skill sets.
Alternatively, randomly assigning extroverts and introverts across groups provides some balance of these
traits. Whether or not personalities mesh in randomly assigned groups is, of course, random!
Facilitators may assign individuals to groups using the stratified random distribution noted above in
combination with their understanding of other member attributes. These include things such as work
experience, physical location (where they live may be relevant to team meetings), gender, race and so on,
and will ensure group composition that is diverse and, at the same time, as compatible as possible.
Random or facilitator assignment allows participants in the simulation to escape a fundamental decision,
which will affect their experience greatly. It subsequently becomes easy for participants whose team is
experiencing problems, to blame either 'bad luck' (in the case of random assignment) or the facilitator for the
team's problems, rather than shoulder ownership and responsibility for the team's performance.
Participant self-selection into teams takes time, but has added benefits, including participants' input and
control over the process, participant ownership of the outcomes (i.e., the resulting teams), and better
understanding of criteria which might be useful when forming a team. These benefits are lost if the selection
process gets reduced to 'picking one's friends' or choosing only those who are most similar to ourselves. A
friend of the authors tells of her mother's code term for identifying others. Her mother once asked her, "Are
they PLU's?" In reply, our friend asked, "What are PLU's?" Her mother replied, “PLU’s are 'People Like
Us'?" We all feel a natural tendency to want to be with "people like us", but similarity and familiarity has
generally been proven to not be the best way to form high-performing teams.
So how might a whole class or executive group self-select into teams, with the aim of distributing expertise,
skills and other characteristics? There are many approaches and no doubt your group may come up with
creative alternatives or blends of these approaches. Each individual may be asked to prepare a one-page
résumé, which can be circulated to other participants, either in advance or during a group selection session.
The résumés allow participants to identify their background and to highlight their strengths in relation to the
simulation. They may also hold accurate and necessary information such as contact phone numbers, email
addresses and so on. Participants may be asked to bring several copies of their personal résumé to distribute
to the facilitator and, ultimately, to each member of their newly-formed group. One way to semi-structure the
selection process is to ask for volunteer "leaders", who introduce themselves and any ideas they have for a
simulated company. Participants then circulate and interview with the leaders until all members have joined
companies. "Leaders" may recruit certain functions or types of members. Group membership is jointly
agreed by each member and the volunteering leader of the group. Variations to this recruitment model
include starting with a function, such as Human Resource Management (HRM), Marketing, etc. represented
as "starter" members (like "founders") for each company and allowing these members to recruit others in the
same manner described above. It is recommended that potential members circulate among leaders or
"starter" members and, to the extent possible, select themselves into their preferred group. This is in contrast
to "starter" members or leaders choosing from an assembled body of members. Like picking a sports team
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MIKE’S BIKES – Integrated Business Learning Online
on a playground, this form of "choosing sides" can be demoralizing for those who are chosen last, regardless
of their qualifications, skills or abilities.
4.5 EARLY ISSUES
Individual and group behavior varies, in part, due to the stage of group development. Most of you would have
21
heard of Tuckman's stages of group development, i.e., "forming," "storming," "norming," "performing" and
"adjourning." These may apply to your simulation group. For instance, when "forming," you will seek to get to
know one another better, find out the skills each person brings to the group and so on. Groups often, but not
always, encounter a "storming" phase as conflict arises. The conflict may be based on deep, fundamental
issues or on relatively minor events or differences between members. In any case, while storming may be
uncomfortable for some members, it is often a very necessary and useful stage, which allows the group to get
on with "norming." Norms are patterns of behavior that develop in groups. They are the way your group does
things. For example, where you meet, who usually is late, who usually leads the conversation, what you eat,
drink, etc. while meeting are all "norms." "Performing" is, of course, a very important stage of group behavior.
It is essential for most organizational groups to do something. In a simulation environment, making decisions
and navigating through challenges are forms of group performance. Finally, groups "adjourn" when they are
no longer necessary. While some work groups may exist for long periods of time, a group in a simulation is
very likely to adjourn after the simulation (although sometimes friendships develop which last longer). A group
in the adjourning phase must accept the ending and move on to other activities. Adjourning can be difficult
because group members may enjoy one another's company and/or the group may serve individual needs for
acceptance, affiliation or enhanced learning and performance. As the old song goes, sometimes, "Breaking
up is hard to do."
IMPRESSION MANAGEMENT
One of the first, and indeed ongoing, aspects of group behavior is known as 'impression management.' As
the term suggests, impression management is managing or attempting to influence the way others perceive
you. Most of us make some attempt to 'make an impression' on others, especially when we don't know the
other person or persons well. In face-to-face organizational situations, people use dress, body language and
verbal communication to send messages about who they are. In virtual environments, however, dress and
body language are not perceptible. Other factors may be used to manage impressions or be used to form an
impression of other members of a virtual team. In email exchanges, for example, how fast, fluid and errorfree our typing is may suggest to others how comfortable and/or proficient we are with electronic media. Just
as visual impressions may be misleading, so too can something like typing speed be mis-interpreted for
something it is not, namely good ideas or expertise in computing. A fast typist might be synonymous with the
person in a group who always speaks first, but may not always have the best ideas.
Other ways we can impress others in virtual environments is by issuing speedy replies to email messages,
letting others in the group know that we are never far from our computer or an email facility. Logging on and
sending messages late at night and early in the morning send a signal that we are hard working and
committed to our virtual team. In developing virtual teams, just like other teams, it is important to develop
trust among members. Therefore, too much impression management may lead to an overly competitive,
superficial forms of 'one-upsmanship,' which can potentially destroy trust and cooperation.
STATUS ISSUES
An issue related to impression management is status. Groups may be highly hierarchical, with formally
recognized levels of status, such as 'team leader' or 'coordinator.' Individuals with these roles, of course,
generally have a certain degree of status within the group. Some groups and teams, however, have no formal
positions of power or official status. Many teams fit this latter description. This is not to say that members of
simulated environments can not or do not carry or develop status within their team. Much like we do in other
team situations, in virtual or simulation teams, we tend to give status to those members who have expertise or
experience relevant to the context or problem(s) facing the group. In virtual environments, however, higher
status may be shared between those who understand the task at hand, i.e., developing a strategic plan,
21
Tuckman, B.W. and Jensen, M.A.C. (1977). 'Stages of small-group development revisited', Group and Organizational Studies, 2, 3,
pp. 419-27.
Page 42
Team Dynamics
creating a marketing plan or budget, with those who are particularly competent with the medium of personal
computers, i.e., the so-called 'nerds' of the group.
Besides expertise and familiarity with their environment, individuals may also gain status from personal power
and charisma. Even though email may seem a less personable medium, personalities do nonetheless
emerge in virtual environments and status within a group may be attributed to a convincing, passionate and/or
compassionate individual, who may or may not also possess experience or expertise in the task confronting
the group. Groups and teams are usually unaware of status issues, especially if they have avoided formal
22
hierarchical roles and have acting as a 'boss-less team.' But even 'boss-less teams' need leadership.
ASSUMPTIONS, STEREOTYPES AND MENTAL MODELS
What else can 'get in the way' during group formation in virtual environments? As with any other environment,
our assumptions, stereotypes and mental models tend to interfere with finding the best way for our team to
work together. Going back to impression management, it is easy to see how one member's desire to be seen
as competent can lead to other members' overly relying upon that member and assuming that he or she can
handle anything, because they 'look' or appear to be competent. Expertise in one area may easily be
assumed (rightly or wrongly) to mean expertise in other areas. For example, if Mary is confident with financial
models, we might assume that she will be equally comfortable with marketing models. Mary may or may not
be comfortable in both areas, but we won't know unless we check our assumptions and ask Mary or Mary
anticipates the confusion and tells us her limits of understanding.
Assumptions are often underpinned by stereotypes of others. If, for instance, members of your simulation or
virtual team are from certain ethnic groups, do you perceive them to be hard working and industrious? On
what are you basing that judgement  evidence from those individuals' performance or a stereotype about
their performance capabilities? Is this a fair way to judge your peers? If you never meet your peers face-toface in a virtual environment, do you pre-judge their performance and gauge your expectations based on their
surname, their university or organizational affiliation?
Finally, our collective beliefs, stereotypes and past experiences lead us to create mental models of what is
right for a given situation. The concept of mental models has been around for some time, but it was
23
popularized in Peter Senge's book, The Fifth Discipline. Mental models are pictures of how the world works.
Our mental models are useful in understanding and reconstructing a new experience based on what we have
learned from previous experiences. The trap, however, is that the new experience may be different from our
past experiences. Our 'old' mental models may blind us to new possibilities and therefore limit our
effectiveness in the new situation.
Individuals who have experience working in teams build mental models of what teams are about. When a
new team situation arises, they may not challenge their mental models about what a team is or what it could
be. When members of a new team meet face-to-face or in cyberspace, they may find themselves disagreeing
over how the new team should work. This is due, in part, to individuals having different mental models about
teams. There may also be a tendency to bring our experience from working in face-to-face environments to
virtual environments without checking or refining our mental models about teams and what is necessary for
effective team performance. Perhaps the first challenge for a virtual team is to consider each member's
mental model of what an effective team is and how that might be achieved in a virtual or simulated
environment.
4.6 LATER ISSUES
MANAGING AGREEMENT
As mentioned above under 'Mental Models' there are dangers of groups and teams having different ideas or
models about what to do in a given situation. Indeed, many of us think of intra-group conflict or tension as the
major challenge in managing a group or team. While conflict certainly is not an uncommon aspect of group
behavior, it is possibly not as troublesome as a lack of conflict within groups. In a classic article, entitled "The
22
Barry, D. (1991). "Managing the bossless team: Lessons in distributed leadership." Organizational Dynamics, Summer, pp. 31-47.
23
Senge, P. M. (1991). The fifth discipline. Sydney: Random House.
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MIKE’S BIKES – Integrated Business Learning Online
24
Abilene Paradox," a family finds itself driving across the Texas plains to Abilene, Kansas for a Sunday's
outing. The long drive in hot weather causes irritation among family members, who one-by-one on the porch
that evening declare that he or she actually did not want to go to Abilene in the first place! So, how did they
get there?
The answer lies in the common problem of managing, or rather not managing, 'agreement' in a group setting.
Group members sometimes take actions based on the belief that those actions are what others in the group
want. And, when the other members do not question the behavior, it is assumed that that is what everyone
wants. Groupthink is a similar phenomenon, wherein group members seek to anticipate (guess) what others
25
Group members often hesitate to question what
in the group think, without asking the other members.
appears to be group consensus. When questioned, consensus often turns out to be less than full agreement,
but we never know unless we check it out with others. Groups in simulations which require problem solving
and/or commitment to a course of action often report metaphorically 'going to Abilene,' that is not questioning
one another's true intent, desire or preferred course of action before it’s too late.
CONFLICT AVOIDANCE
That which is not acknowledged can not be managed. There are many reasons why conscious and
unconscious agreement occurs in groups. A major factor is our individual need for acceptance or affiliation,
as described in the section on Motivation. Another major reason is our desire to avoid conflict. As selfpreserving Homo Sapiens, we have a natural fight or flight reaction, which prompts us to equally want to flee
frightening situations as it does to stay and 'fight' or confront others. Building on from innate tendencies,
society teaches us to be cautious about confrontation. Admittedly, some cultures are more confrontational
than others, but most cultures teach their members that too much conflict is a bad thing. Consequently, most
individuals assembled into real or virtual teams will be hesitant to confront others in the group. Of course, if
group performance is threatened and/or some individuals' behavior becomes a concern to others, conflict
becomes necessary and therefore more acceptable within the group. The main point is that while conflict
avoidance is a natural reaction of individuals within group situations, it is not necessarily a sustainable, nor
productive behavior pattern for groups to follow. Generally speaking, groups with a lot at stake will reach a
point where conflict is inevitable and they will have to manage it or have it flair up within the group in
'unmanageable' forms.
MANAGING CONFLICT
As discussed above, conflict in groups can be a natural part of the group formation process. Furthermore
agreement can actually be worse than conflict for a group's overall performance. Managing conflict can,
nonetheless, be one of a group's most onerous challenges and, if left unmanaged, conflict can destroy group
cohesion and team effectiveness.
There is no one particular way to manage group conflict, but there are skills and tools which can be developed
and applied by team members to help detect, negotiate and generally manage their way through group
conflict. Some attitudes, skills, tools and techniques include the following:
Attitude: A positive attitude can be helpful, as it helps you see a way through conflict toward agreement or
acceptable compromise. Openness to the conflict being 'resolvable' usually means it can, indeed, be
resolved. You have to be motivated to deal with conflict. It helps to accept conflict as a normal aspect of
group behavior and not a 'bad' thing or a sign of weakness within the group. As will be discussed below, high
performing teams tend to tolerate, if not invite, a certain level of conflict as a healthy attribute of creativity.
Skills: Good communication skills, including listening, and speaking clearly and honestly, are extremely useful
in managing conflict. In particular, the importance of listening--really LISTENING to others' viewpoints and
concerns--cannot be over-emphasized! Communicating and getting your messages heard and understood by
others may be somewhat different and more challenging if your simulated environment is totally or even
partially virtual, i.e., relying on email or other media, which preclude face-to-face interaction. It will be
interesting to see how new technologies, such as teleconferencing, video-conferencing and "CU-See Me"
(personal internet video links between PCs) will affect teamwork in the future. These media forms may
24
Harvey, J. (1988). The Abilene paradox: The management of agreement. Organizational Dynamics, Summer, pp. 63-80.
25
Janis, I. (1986). Groupthink. Boston: Houghton Muffin.
Page 44
Team Dynamics
require new skills of communicating. The good news is that most communication skills can be learned and
developed by anyone willing to work at it.
Tools and Techniques: Standard tools and techniques for group interaction can be very helpful to assist virtual
and simulated teams in avoiding and/or dealing with conflict. One useful technique is a routine "check-in" with
each member before the main meeting or email exchange begins. A check-in is just a brief report on how the
individual is doing, overall, and 'where they are at' in relation to the group's mission or task.
For example, a team member might check-in with something like this: "Hi. I'm ready to discuss our next
decision, but must say I'm feeling a bit discouraged with our group's last quarter results."
...or this: "I've just returned from a great conference and my head is buzzing with some great ideas. I'd like to
share these with the group, but don't know when we'll have time to discuss them."
Decision-making may be aided by getting input from all group members before a decision is made.
Fortunately, classic group idea generation techniques such as brainstorming and nominal group technique
have been shown to be more productive using email than with more conventional face-to-face meetings.
Once conflict has arisen in a group setting, the converse seems to be true, namely that email exchange tends
to aggravate rather than sooth existing tensions. Where possible, face-to-face meetings, preferably with a
facilitator (a teacher or other objective and skilled party), are still the best means of negotiating or resolving
conflict among group members. If you must resolve conflict remotely, it must be done with special attention to
the clarity of each written message and, if possible, with a facilitator.
5. Group and Team Performance
As challenging as it can be to form and maintain groups and teams, they are usually assembled not just to
bond together and understand one another. Most groups and teams are expected to perform some task or
function and/or produce a product or products. Since groups and teams perform on several dimensions at the
same time and since performance depends on many factors, there is no one single model of group or team
performance. Some ways to think about your group's performance are provided below.
5.1 COMPETING GOALS IN SIMULATIONS
Performance is always relative to a goal or
objective. Performance problems can arise
when goals are not clear and/or when there
are competing goals. Simulations provide
more than one level of learning and
simultaneously
offer
different,
possibly
competing, goals for individual group members
and for the group or team as a whole. Three
common goals of
simulated learning
environments include: game goals, personal
learning goals and team learning goals, as
shown to the right.
Competing Goals in Simulations
Simulation Goals
6
Team Learning Goals
'Game goals' include 'winning' or just 'surviving'
Personal Learning Goals
the simulation's demands for decision-making
and competitive success in relation to other
groups and teams. 'Personal learning goals'
are goals set by the individual learner and will
Team Dynamics
vary depending on her or his level of
education, experience, particular challenges (quantitative skills, for example), personal and/or professional
development needs, etc. Personal learning goals may also include passing a course, getting a degree and so
on. 'Team learning goals' should be determined collectively by members of the group or team, but may also
be set by instructors in the form of structured assignments which focus on learning the key elements of
working as a team. (For this reason, we use the term 'team' learning, as a higher aspiration level, but we
acknowledge that 'group' goals may be more appropriate in your situation and can be equally or more
satisfying than 'team' goals, which go unfulfilled.) Some examples of team learning goals include: effective
communication, managing diversity, learning from those from other disciplines, etc. While all three goals can
be met within the context of a simulation, there is the potential for one goal to take precedence over others. If
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MIKE’S BIKES – Integrated Business Learning Online
5.2 THE TEAM PERFORMANCE
CURVE
26
Katzenbach and Smith offer a typology of
groups and teams, including their
distinguishing features and the type of
performance one might expect from each.
Their "Team Performance Curve" is
represented in the graph to the right and
27
table below .
8
The Team Performance Curve
High-performing team
Performance Impact
one goal is to take top priority, then it is
important for members of the group or team
to explicitly recognize their personal and
collective priority ranking of goals for the
simulation. Clarifying and prioritizing group
or team goals can be an important element
of a learning team agreement, discussed
below.
Real Team
Working
Group
Potential Team
Pseudo-team
Katzenbach & Smith
Team Effectiveness
Team Dynamics
The team performance curve highlights the
fact that, while it is tempting to call any collection of individuals a 'team,' there are important distinctions in
performance between 'work groups,' 'pseudo-teams,' 'potential teams,' 'real teams,' and 'high-performance
teams.'
Type of Group
or Team
Working Group
Pseudo-Team
Potential Team
Real Team
High-Performance
Team
Shared Performance Needs
Performance Results
No significant need to work together; may
share information and some other
resources.
Need for collective performance, and may
refer to itself as a 'team,' but no desire to
define common purpose or goals.
Need for collective performance, and really
trying to improve performance. May need
more clearly defined goals, processes and
collective accountability.
Vary according to individuals' capability
and level of individual commitment and
effort.
Weakest of all groups in terms of
performance.
Often perform worse
than the sum of individuals' capabilities.
The most common form of team, with
marginal success overall, but also with
the most to gain from team
development toward becoming a real
team.
Real
teams
usually
yield
real
performance.
When they fail, they
know why, and share responsibility,
rather than blaming one another.
Significantly outperforms other teams
and usually surpasses the expectations
of team members. When they fail, they
learn and support one another.
Usually small number of members with
equal commitment to shared goals and
work processes, to which they hold
themselves mutually accountable.
All the shared performance needs met as
a real team, but additionally, members are
committed to one anothers' personal
growth and success.
Adapted from Katzenbach, J.R. and Smith, D.K. (1993). The wisdom of teams: Creating the high-performance organization.
New York: HarperCollins, pp. 90-92.
26
Katzenbach, J.R. and Smith, D.K. (1993). The wisdom of teams: Creating the high-performance organization. New York:
HarperCollins.
27
Katzenbach, J.R. and Smith, D.K. (1993). The wisdom of teams: Creating the high-performance organization. New York:
HarperCollins, p. 84.
Page 46
Team Dynamics
28
High-performing teams may also share other characteristics, including shared vision and values, ongoing
29
30
learning and enhancement of the group's capabilities and satisfaction of members' needs . Specific
practices of high-performing teams vary, but some common habits include frequent 'debriefing' or discussions
31
What seem
that review and analyze previous performance with an eye toward improving future practice.
less important in these teams are strictly defined roles, which can be replaced with 'responsible membership,'
32
meaning simply that members contribute whenever and however is appropriate at any given time.
5.3 TASK VS PROCESS
9
Blake & Mouton Managerial Grid
Some group members may show a high
'concern for task completion', i.e., getting
things done, and others may demonstrate a
high 'concern for people' and group process
issues. It is also possible to have a high
concern for both task and people, according
33
to Blake and Mouton's model.
In simulated and virtual environments--much
like other environments--group members who
feel less comfortable with people issues
and/or feel a high need to achieve (win or
succeed) may tend to avoid or hurry through
group 'process' discussions, including
consideration of others’ feelings.
Group
process requires reflection on 'why'
something is being done, rather than 'what' to
do next.
Both task and process aspects of group
performance are important. Groups who only
concentrate on their internal well-being may
not perform very well in their assigned or
chosen tasks. And, groups who excel in task
completion, but who ignore group processes,
often thinly mask shallow, disaffected and/or
highly individualistic, rather than cohesive
and cooperative high-performing teams.
Effective group communication requires
attention to both task (including goals,
resources, data, statistics, achievements,
9,9
1,9
Concern for People’s Feelings
A simple way to think about group
performance is to consider two fundamental
dimensions of group behavior: 1) task
achievement and 2) processes that support
and facilitate task achievement. These two
dimensions are illustrated in the Blake and
Mouton's classic 'managerial grid' model.
1,1
5,5
Concern for Production
9,1
Team Dynamics
Task versus Process
10
COMMUNICATION
TASK
PEOPLE
goals
feelings
resources
views
data
thoughts
statistics
ideas
achievements
support
targets
encouragement
deadlines
RESULTS
(Chaudhry-Lawton et al, 1992)
personal
feedback
Team Dynamics
28
Mazany, P. (1995). Teamthink: Team New Zealand. Auckland: VisionPlus Developments.
29
Hackman, J.R. (Ed.) (1990). Groups that work (and those that don't). San Francisco: Jossey-Bass. and Mohrman, S.A., Cohen, S.G.
and Mohrman, A.M. (1995). Designing team-based organizations: New forms for knowledge work. San Francisco: Jossey-Bass.
30
Hackman, J.R. (Ed.) (1990). Groups that work (and those that don't). San Francisco: Jossey-Bass.
31
Vaill, P.B. (1978). Towards a description of high-performing systems. In McCall, M.W. and Lombardo, M.M. (Eds.) Leadership: Where
else can we go? Durham, NC: Duke University Press, pp. 103-125.
32
Donnellon, A. (1996). Team talk. Boston, MA: Harvard Business School Press.
33
Blake, R.A. and Mouton, J.S. (1985). The managerial grid®III. Houston: Gulf Publishing.
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MIKE’S BIKES – Integrated Business Learning Online
targets and deadlines) as well as people issues (including feelings, views, thoughts, ideas, support,
encouragement and personal feedback). The connection between task and people is illustrated by Chaudhry34
Lawton and others in the figure to the right.
5.4 MANAGING TEAM PERFORMANCE:
THE TEAM AGREEMENT (OR PSYCHOLOGICAL CONTRACT)
One of the best mechanisms we've found for groups and teams to manage personal needs, implicit
assumptions, professional biases and performance expectations is the 'team agreement.' Based on the
concept of a 'psychological contract,' a team agreement clarifies the expectations of the parties involved and
makes explicit some of the operating assumptions, practices and behaviors expected of group members. A
sample form for developing a team agreement is found below. However, you may choose to create your own
format and include other meaningful elements to your group or team's agreement. In fact, the critical aspect
of a team agreement is not what's in it, but how well it represents the group's expectations, desires,
standards, etc. and whether or not the document represents a consensus agreement among group members.
A team agreement has two major benefits for a group or team. First, the process of identifying goals and
setting out processes that the group will use to achieve those goals can be helpful in the early stages of group
development. Second, if the group has difficulty in meeting its goals, the agreement provides a safe starting
place for the group to review its own behavior without members blaming one another or blaming others
outside the group. Taking into consideration the accountability and responsibility described above under
'high-performing teams,' it is important to remember that a team agreement is only as good as the honesty,
commitment and integrity put in to it. It is worth adding, however, that no matter how good a team agreement
is to begin with, it may require change as the group evolves. Therefore, the best team agreement is revisited
and revised as needed, making it a living document which can serve the group development process and help
ensure that the team performs to the satisfaction of all its members.
SAMPLE TEAM AGREEMENT OR CONTRACT
This is a sample Team Agreement or Contract, which you may find helpful as you begin to work together.
OBJECTIVES:
• To build a foundation for effective team work
• To help clarify expectations and agreements among team members
PART 1. THE TEAM AGREEMENT
The team agreement is a single document that should be arrived at jointly with all the members of the team. It
must outline the expectations that team members have of each other, and how those expectations are going
to be realized. In general, the kinds of things a team might want to articulate in their agreement include, but
are not limited to, the following:
1. Your team’s mission statement
2. When, where and how your team will meet.
3. Who will facilitate/chair meetings? Will this role rotate?
4. How will your team manage time expectations, i.e., length of meetings, time allowed for
assignments, etc.
5. What decision-making process will your team strive for?
6. How will your team manage conflict?
7. What will you do to ensure members are meeting their personal objectives?
8. What will you do to ensure that the team agreement is met?
34
Chaudhry-Lawton et al (1992).
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Team Dynamics
PART 2. TEAM AGREEMENT REFLECTION
Team agreements reflect (hopefully) the integration of different perspectives held by individual members of
the team. After your team has arrived at its team agreement, Part 2 requires you to reflect on (think about,
consider) the following aspects of your needs and expectations in relation to your group.
1. What were your personal expectations of how your team might approach the simulation? Were your
expectations met? If so, how? If not, how is your group’s Team Agreement different from your
expectations?
2. How did your group arrive at its Team Agreement, i.e., how would you describe the process(es)
used?
3. What academic links can you make (e.g., terminology, concepts and theories) between your group’s
behavior so far and the literature on groups and teams, decision-making, etc.?
5.5 A PROCESS FOR LEARNING
The ideas above prescribe many of the
requirements for a high-performing team, but do not
indicate how to check if it is being achieved and to
constantly keep improving performance. The Kolb
35
Learning Cycle does this. While it focuses on the
individual level, it is equally relevant for teams and
organizations, and is a powerful way to ensure
continuous improvement.
12
The Kolb Learning Cycle
Stage 1:
Concrete
Experience
Stage 2:
Stage 4:
The model starts off with the recognition that work
Reflective
Active
experience itself has great value in developing the
Observation
Experimentation
person, particularly if the experience is stimulating
or novel, or involves a higher level of responsibility
Stage 3:
(Stage 1: experience). The individual capitalizes on
Abstract
that experience by considering it carefully and by
Conceptualization
listening to feedback from others (Stage 2:
Team Dynamics
reflection). Further development comes from the
tying together of experience and observation with
more theoretical principles, so that the person combines his or her own work with external information (for
example, from a training course) to develop new principles for use on the job (Stage 3: new approach). There
follows a period of experimentation and trial as the new principles are tried out and used in the job (Stage 4:
experimentation). The experimental phase provides fresh experience, and the cycle repeats.
5.6 MEASURING OUTCOMES
If we know “what” the outcomes are and “how” team
dynamics achieve this, then it is possible to measure both
the outcome and process variables.
Outcomes can be described in terms of outputs, in a
certain time and with given resources – the traditional 3
constraints of project management. A fourth – personal
satisfaction – is included, because unless this is also
satisfied, the team will not endure over time.
Outcomes
Measures
Output
Design specifications
Time
Schedule
resources
budget
Personal
Satisfaction
Surveys, turnover, smiles
Outputs are measured by various quality controls including
customer feedback and design specifications. Time is measured in terms of adherence to a schedule - often
represented as a Gantt chart. Resources are frequently measured in terms of budgets. And personal
satisfaction may be measured in terms of questionnaires, staff turnover, and even smiles!!!
These are illustrated concisely in the table shown to the right.
35
Kolb, D. (1976). Management and the learning process. California Management Review, Spring.
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MIKE’S BIKES – Integrated Business Learning Online
6. Making it Happen in Mike’s Bikes
Mike’s Bikes allows teams to focus on both the content of strategy and the team dynamics process, by
providing two types of feedback - one is the direct feedback from the relevant scores in the simulation, and
the other is on team process provided through the use of the Assessor. These are described in more detail
below.
6.1 FEEDBACK FROM THE BUSINESS SIMULATION
The overall score at the end of each period is often a good indicator of both the understanding of the content
and the success of the team dynamics, since both of these (and sometimes a little bit of luck) are required to
achieve good performance. Of course, as in real life, some teams will perform badly in a given period for
reasons outside of their direct control. You may use the Assessor to assess group performance. This
feedback tool allows the team to develop a Team Profile by asking each team member to complete a Team
Profile questionnaire. But while The Assessor can help to collect and process the information, it is up to the
team to discuss and understand this and then to develop actions that must be monitored on a ongoing basis
to ensure improvement.
6.2 FEEDBACK ON TEAM PROCESS USING THE ASSESSOR
Another valuable source of data is the evaluation by each team member of the overall team performance and
the performance of the individuals within the team. You may request that the instructor create a questionnaire
that is sent to your team and may be completed confidentially. There is a standard selection of questions such
as those shown to the right. These are at both the team and individual levels and may be edited or sent
directly to the team and
upon completion may be
returned to the instructor
who will process them.
A Team Profile will give
some indication of the likely
strengths and weaknesses
of the team.
On an
ongoing
basis,
teams
should complete a Team
Performance questionnaire
that allows them to monitor
their performance and
agree
on
required
improvements. Using these
can provide an excellent
introduction to 360 degree
feedback.
6.3 THE TEAM PROFILE
Here are some useful questions to start to examine the team profile and competency. These are included in
the Assessor under Team Profile and may be edited and extended as required.
Sample questions for a team profile
1. To what extent do I understand the vision?
2. To what extent do I relate to it?
3. Do I focus more on the big picture or detail?
4. How good is my knowledge of marketing?
5. How good is my knowledge of operations?
6. How good is my knowledge of finance?
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Team Dynamics
7. How good is my knowledge of accounting?
8. Do I tend to be more quantitative or qualitative?
9. How good are my quantitative skills?
10. How well do I work with other people?
11. How well do I understand my role in this team?
12. How much time am I willing to put in to do well in this team?
13. How motivated am I overall to do well in this team?
6.4 TEAM PERFORMANCE
Here are some useful questions to start to examine team performance issues at both the team and individual
levels. These are included in the Assessor under Team Performance and may be edited and extended as
required.
Sample Individual Performance Questions
1. To what extent did this person show active
listening skills?
2. How good were this person’s communication
skills?
3. How good were this person’s analytical skills
4. How much did leadership did this person
exhibit?
Sample Team Performance Questions
1. How well did we focus on the task?
2. How well did we use time?
3. How motivated were we as a team?
4. How good were our decisions?
5. How good were our marketing skills?
6. How good were our operations skills?
5. How focused was this individual?
7. How good were our finance skills?
6. How supportive of others in the team was
this person?
8. How good were our accounting skills?
7. To what extent did this person use humor?
9. How well did we allocate and work?
10. Did we have clear standards and objectives for our
work?
11. How much did we involve all team members?
12. How well did we use our skills as a team?
13. How much fun did we have?
7. Questions to Assist Learning
1.
What is your team’s profile i.e. what are the strengths and weaknesses when considering the task of
managing your Mike’s Bike’s firm?
2.
How can you take advantage of the strengths and minimize the weaknesses?
3.
What were the main areas of team dynamics requiring improvement in your last decision?
4.
What might you and/or your team do to improve your team’s decision-making process for the next
decision?
Page 51
4 MARKETING AND DEMAND
Traditionally, the marketing function is often defined as “a process through which people create, offer and
exchange products of value with others”. This implies that the primary role of the marketing function is to
maximize sales. This is achieved by determining what product attributes the customers desire, and by
branding and positioning existing and new
4
products. Tactical decisions are then taken:
Shareholder Value
pricing decisions, communication to customers Marketing Logic
via advertising and other means, and
determining distribution channels (the so-called
Current Profit
Future Profit
ECONOMIC
‘4P’s’ of product, price, promotion and place).
CONDITIONS
The figure shown to the right represents the
fundamental framework that is used for
marketing in Mike’s Bikes. It shows the role of
marketing relative to the other functions and
with respect to shareholder value. Specifically,
marketing
complements
decisions
in
operations, finance and product development,
in order to achieve the best match between
demand and supply, in so doing generating
profits and shareholder value.
COMPETITORS’
ACTIONS
Demand
Supply
Accounting
operating
decisions
investment
decisions
Business Strategy
Marketing
Strategy
Operations
Strategy
Finance
Strategy
Product
Development
Strategy
In response to a changing market place and
Marketing and Demand
the growth of information and service-oriented
businesses, a more sophisticated view of marketing is now evolving. The trend towards a more teamorientated and process driven firm requires a broader role for marketing. Rather than being solely functional
specialists, marketers are increasingly seen as both full and part-time marketers. Arguably, in the marketing
(or customer) oriented firm, everyone is a marketer. Part-time marketers are found throughout the firm (for
example, at senior management and board level, and customer service personnel and technical advisers at
lower levels) while full-time marketers are located in the marketing function – should this exist (and
increasingly it may not). All work in concert with the rest of the organization to maximize long-term profits
associated with sales.
The distinction between the traditional and emerging role for marketing is subtle. In the first case marketers
would research the market, determine customer needs and wants, and work with production to arrive at a
product offer that matched the market’s requirements with the firm’s capabilities. Price and distribution
strategy would be set, and the market would be informed and persuaded of the offer’s competitive superiority.
The end result was a transaction – or customer purchase. In the second case, emphasis is on building long
term customer relationships, or paying attention to streams of transactions. The focus is directed at identifying
and keeping the ‘right’ customers, rather than ‘getting’ customers indiscriminately on a one-off transactional
basis. To achieve this, consistently superior customer value must be delivered over time, requiring attention to
all aspects of the firm’s performance – including achieving lowest delivered cost. This in turn requires a crossfunctional process-oriented approach, and a great deal of interaction with both internal and external parties.
Excellent relationships must be built and maintained with (for example):
• accounting and finance (to ensure monitoring and controlling of lowest delivered cost, among
other things);
• production (to ensure performance in a number of areas, including delivery and fitness for
function via core product attributes); and
• externally with suppliers (e.g. advertising agencies and packaging suppliers).
While the trend towards service and relationship marketing is very important, it is excluded specifically from
this model. In Mike’s Bikes the environment has been set up so that marketing tries to maximize shareholder
wealth by allowing people to purchase goods of value. It is assumed that consumers buy according to a
demand curve. Total demand is determined by a range of factors – and marketing decisions are just one of
Page 52
Marketing and Demand
these. There are two other areas affecting the demand for a product - its quality and delivery time or
availability. For our purposes they are covered in the operations function.
1. Learning Outcomes
In this chapter we explore some theory related to these issues, and work simple numerical examples and
more complex spreadsheet examples (if appropriate). The main learning objectives for this chapter are the
understanding of the following:
a) A framework for marketing;
b) Market analysis and segmentation;
c) Selection of target markets;
d) The effect of branding;
e) Product positioning using attributes and perceptual map;
f) The perceptual map;
g) The Marketing Mix (4 P’s):
• Pricing strategy;
• Promotion - Advertising strategy and media selection, product PR;
• Distribution strategy and channel selection;
• NB: product quality and availability are covered in the operations function
h) Determination of margin for channels;
i) Determination of demand for products;
j) Substitution of products;
k) Linkages to other functions;
• marketing/operations interface
• marketing/finance interface
• marketing/product development interface
l) Strategic marketing control and developing a marketing plan.
While these issues may be considered in isolation, Mike's Bikes encourages users to view them as a part of
the overall strategy and so to think of the firm and industry as an interactive system.
2. A Framework for the Marketing Process
The figure shown to the right represents the
fundamental framework that is used for
marketing in Mike’s Bikes to generate
profits and shareholder value.
12
Market Mix - Detail
The strategic marketing process may be
viewed as a number of steps:
1. Analyze
and
segment
markets;
2. select target market(s);
3. determine branding and
positioning strategy;
4. determine
the
best
marketing mix to generate
optimum demand.
Marketing
Strategy
Product
Attributes
• Analysis of Markets
• Selection of Target Markets
• Market Mix
• Ongoing Management
Price
Promotion
Distribution
Marketing management implements the
outcomes of that process.
These steps will now be illustrated using
the Mike’s Bikes microworld.
Marketing and Demand
3. Determining Strategic Objectives
From a strategic perspective, marketing has 3 main goals:
1. to determine which segments to target;
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MIKE’S BIKES – Integrated Business Learning Online
2. to achieve a certain number of sales in each segment;
3. to achieve a given contribution margin (profit) from each segment.
Sales performance will then determine the required market share and competitive position of the company in
each of these segments. Before these objectives can be set it is necessary to do some market analysis.
4. Analyzing the Market
Market Analysis considers the business environment in which an organization operates, including the
customer segments that could be matched with the products that an organization produces or intends to
produce. Typically a lot of data informs a sound market analysis – and this data does not become a good
basis for decision-making until it has been processed, structured and summarized. Information quality is vital.
The most valuable information is current information - but this is also the most ill-defined and informal. It is
better to be roughly right than precisely wrong, and the art of analysis is to sort the nuggets of gold from the
deserts of data.
In the case of Mike’s Bikes, this information is provided to you in the form of some summary reports. In a real
context, there is a lot of work entailed in arriving at good summary information for effective decision-making.
The information provided in Mike’s Bikes can be considered as the outcome of prodigious marketing research
efforts.
A good way of covering key aspects of market analysis is by way of the three C’s - Customer, Competitor and
Company - and these are covered briefly below.
4.1 CUSTOMERS - IDENTIFYING SEGMENTS
A good analysis should provide a map of the market. Management can then use this map to decide how to
segment the market, ensuring each segment has separate and distinct customer requirements. Then
management can target a particular segment or segments, aiming for the best match with the organization’s
capabilities and resources.
Segmenting a market appropriately is as much as an art as it is a science. There are many ways to go about
it - the ‘right’ way is the one that results in the best insight into product sales! There are many factors, or
criteria for segmentation, that one could consider; loosely categorizable as geographic, demographic,
psychographic, and behavioral factors. For example, the toothpaste market could be segmented by:
• country or state or rural vs. city users (geographic); and/or
• family life cycle stage, whether empty nest, young single etc. (demographic); and/or
• attitude or lifestyle of users, whether educated greens or urban sophisticates; and/or
• by how many times per week the product is used (behavioral).
By looking at what the different segments require, at competitive activity, and at the organization’s potential
resources, a choice may be made about which segments to serve, and what position to adopt in those
segments. There is a strong need for consistency in these choices.
The perceptual map is a useful tool for building understanding of differing consumer needs in various
segments or markets. This identifies the most important product or service attributes valued by consumers,
and positions a number of segments in relation to these attributes. Several attributes may be important to a
market (e.g. in the case of toothpaste these may include taste, sex appeal or whiteness, appeal to children,
ease of use). A perceptual map can only show 2 (or 3 if using a 3-D approach) of these at any one time.
Several different maps may be constructed to get the overall picture, however use of more than 3 attributes
makes identification of segments difficult.
THE PERCEPTUAL MAP IN MIKE’S BIKES
Following extensive international research into the types of people who purchase bikes, we have concluded
that the potential bike market can be broken into two key segments. The segments have been given the
names ‘Adventurer’ and ‘Leisure’.
Note that only the ‘Adventurer’ segment is currently being served by RockHopper Bikes. Adventurers are
those desiring trendy, high-specification, high quality mountain bikes for reasonably demanding usage. They
are prepared to pay retail prices ranging from $500-$4000.
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Marketing and Demand
On the other hand, the ‘Leisure’ segment purchases bikes for relaxed Sunday afternoon bike rides. They want
a lower spec, stylish bike with a realistic retail price range from $100-$600. As of 1998, no bikes suitable for
the Leisure segment are being sold.
ADVENTURERS
The Adventurer segment is broadly typified by the young suburban bicycle purchaser who wishes to buy a
mountain bike. An Adventurer is typically a young, fit person, focused on fitness and the outdoors. Thus he or
she wants a bike that will go anywhere and everywhere, and then come back. Often the Adventurer will forego
luxury features in favor of a sturdy, high performance bike. The evidence is that the use of bikes for fun
adventures and blood pumping action is very popular and in fact this segment is experiencing strong growth.
The people who buy these bikes tend to be prepared to pay more for the right bike because they have a
specific purpose for it and do not want to be held back with slow equipment or to have to stop for repairs.
Given the many and varied exciting opportunities for off-road biking in Erehwon, we are confident this
segment has good potential if appropriate bikes are released into the market.
LEISURE
The Leisure segment is typified by those who own a bike, but only use it once or twice a month. Their bike is
seen primarily as a means of relaxation, or leisure, and they go for a Sunday ride every now and then, usually
with others (often in family groups). The Leisure segment therefore requires less in terms of high tech
components and accessories, with “leisurites” preferring more comfort and style. Purchasers who buy bikes
for leisure purposes are not very fussy, but they like to be able to buy a bike when they go out shopping, so
long as they’ve seen the bike on TV before. Consumers in the leisure segment abhor having to wait to buy,
even if it is the best value for money. Because this segment is quite broad, it is also typically very large accounting for 50% of new bike sales units overseas.
THE PERCEPTUAL MAP OF MARKET SEGMENTS
In order to produce some data that would be
useful in differentiating the market segments, a
market research house was commissioned to
undertake a survey. 1000 potential bicycle
purchasers were asked :
a) Thinking about bicycles, what two
factors are most important to you
were you to purchase one
tomorrow?; and
b) How important is each factor to
you?
The two factors identified were:
a) the aesthetic style and design of a
bike;
b) the
technical
features
and
components (including construction
materials and strength).
This research is on-going. From year to year
there may be slight variations in the positioning of
the segment points, as customer needs change.
In general, it is safe to assume that people’s expectations will increase with time.
The Perceptual Map Report shows what levels of Style/Design and Technical Specs are desired by the
market segments (i.e. Adventurers and Leisure.) The circles indicate the acceptable ranges of Style/Design
and Technical Specs. It also shows how well your products (and unused product designs) match these
requirements, and by selecting a different firm, you can see its products too.
The segment centers are the best points on the map to aim for - these are ‘ideal’ positions satisfying all of the
segment. You could of course move away from this point, and produce a product exceeding the style and
technical specifications of the segment. You could sell it at the same price as one that met exactly the needs
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MIKE’S BIKES – Integrated Business Learning Online
of that segment. However, the “better” product would not sell as well as one exactly meeting the segment
needs, because it is not what the customer wants. Unnecessary features can be annoying for someone who
wants a simple bike. Extra style and design attributes can reduce a bike’s performance and functionality for
someone who uses the bike for a specific purpose.
It is important to note that demand for a product is also determined by many other factors (such as pricing,
quality, advertising, distribution etc.). In most cases these other factors are more significant than how close a
product is to the center of the circle.
SEGMENT SUMMARY
Key information regarding each of the segments is given in the tables below.
Segment
Adventurers
Leisure
Segment
Sensitivity
Adventurer
Leisure
Est. Pot. Market Retail Price Range
Size (Units)
70,000
$500-$4000
50,000
$100-$600
Average Score for
Style/Design
50
50
Average Score for
Technical Specs.
50
10
Price
Advertising
PR
Quality
Distribution
Delivery Time
Low
Med
Med
High
Med
Low
High
Low
Med
Med
Low
High
4.2 COMPETITORS
This is covered in the previous chapter on strategy and requires analyses such as: environmental analysis,
PESTE, competitor profiles, SWOT analysis, understanding of their vision, mission, strategic intent, and core
competencies.
4.3 COMPANY
This is also covered in the previous chapter and deals with issues such as the mission, strategic intent and
core competencies of the company.
4.4 CONJOINT ANALYSIS
OVERVIEW OF CONJOINT ANALYSIS36
Conjoint Analysis is a technique used specifically to understand how respondents develop preferences for
products or services. It is based on the simple premise that consumers evaluate the value of a
product/service/idea by combining the separate amounts of utility provided by each attribute. It is unique in
that the researcher first constructs a set of hypothetical products or services by combining the possible
attributes at different levels. These hypothetical products are then presented to respondents who provide only
their overall evaluations of the hypothetical products/services. Thus the researcher is asking the respondent
only to perform a very realistic task - choosing among a set of products. Because the researcher constructed
the hypothetical products/services in a specific manner, the importance of each attribute and each value of
each attribute can be determined even while having only the respondents’ overall ratings.
36
Hair, J., Anderson, R., Tatham, R., Black, W., “Multivariate Data Analysis with Readings (3rd Ed)”, Macmillan, 1992
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Marketing and Demand
A typical card examining the business traveler might look like the following:
"On your next business flight overseas how likely would you be to choose a flight that
has all the following characteristics? Please circle the appropriate number from 1 to 10
to indicate your feelings."
• one stop en route
• extra-wide seats
• Departure time: before 8:00 am
• "double" mileage points
• $200 fee to change ticket
Would never
choose this flight
1 2 3 4 5 6 7 8 9 10
would definitely choose this
flight
Data collection involves showing respondents a series of cards that contain a written description of the
product or service. If a consumer product is being tested then a picture of the product can be included along
with a written description. Analysts are able to use statistical manipulations to avoid having to make
consumers rate every possible combination. In a typical conjoint study, respondents only need to rate between
10-20 cards. This data becomes the input for the conjoint analysis. Utilities can then be calculated and
simulations can be performed to identify which products will be successful and which should be changed.
Price simulations can also be conducted to determine sensitivity of the consumer to changes in prices.
QUESTIONS CONJOINT ANALYSIS CAN ANSWER
•
•
•
•
•
•
•
Which new products will be successful?
Which features or attributes of a product or service drive the purchase decision?
Do specific market segments exist for a product?
What advertising appeals will be most successful with these segments?
Will changes in product design increase consumer preference and sales?
What is the optimal price to charge consumers for a product or service?
Can price be increased without a significant loss in sales?
CONJOINT ANALYSIS IN MIKE’S BIKES
The results of a conjoint analysis survey conducted on members of each of the segments identified in the
Erewhon bike market is available to firms. The attributes tested were price, quality, delivery time,
availability/distribution, style, and technical specifications.
A summary is shown in the table below.
Segment
Price
Advertising
Sensitivity
Low
Med
Adventurer
Med
High
Leisure
PR
Quality
Distribution
Delivery Time
Med
Low
High
Low
Med
Med
Low
High
Conjoint analysis results for the extended NetMike segments are shown in the appendix to this chapter after
the questions.
5. Selecting Target Segments
Market analysis completes the basic groundwork for selecting target segments. Selecting a target segment is
an important decision. The basis for this is long-term segment profitability. In real life, strategic criteria (such
as fit with parent company aspirations, or a desire to build competency in a particular market) may also need
to be considered.
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5.1 SELECTING TARGET SEGMENTS IN MIKE’S BIKES
The table shows the process that one could go through to determine the profitability of a segment in Mike’s
Bikes. First is an assessment of what the segment requires and its total sales potential. Total sales potential
must be assessed in view of likely competitor activity and the ability of the firm to compete. This assessment
will
lead
to
an
Segment Required
Segment
Expected
Company
Profitability
estimate of the most
Name
Attributes
Potential
Competitor
Competence
profitable segment for
Activity
the
firm
in
that
Racers
25,000 units
Medium
$2,000,000
•= Style not
•= Medium
competitive
per year
compared to
based on 10%
important
2 competitors
environment. It may
others - need
market share
= (20)
willing to
be wise to start with a
maintain profit to invest in
•= Excellent
table using textual
machinery
technical
descriptions
and
and hire
specs (80)
include the numerical
skilled staff
measures later, as
this data is often
difficult and/or expensive to obtain.
6. Developing the Marketing Mix
The next step is to determine the details or tactics of how to achieve the desired position in each of the
segments. This requires consideration of the marketing mix - loosely called the ‘four Ps’ (product, price, place,
and promotion).
‘Product’ is the bundle of physical product and intangible service benefits provided to the consumer
(expressed in terms of the attribute scores i.e. ‘stylishness’ and ‘technical specifications’). ‘Price’ is the retail
price charged by the store to the consumer. ‘Place’ relates to the type of distribution channel or store that will
be used to distribute the product. ‘Promotion’ will entail communicating the total product bundle to the target
segments, resulting in brand and product awareness, and (ideally) sales.
These tactics will all influence segment demand. Demand will also be influenced by delivery and quality assumed to be operations decisions in Mike’s Bikes.
14
6.1 PRODUCT37
Positioning Logic
Consumers base their purchase decisions on
the attributes of the products that are available
to them. The closer these attributes are to what
they require, the more likely they are to buy.
Marketing
Strategy
Management of these attributes can be achieved
by measuring actual product attributes and
relating these to the ideal attributes desired by
each market segment. The product may then be
modified (if necessary) to suit the market. The
Perceptual Map is used in business modeling to
quantify this.
Product
Attributes
Position of
Segment
• Analysis of Markets
• Selection of Target Markets
• Market Mix
• Ongoing Management
Price
Promotion
Distribution
Attributes
of Product
Marketing and Demand
37
Price, quality, distribution, delivery, and product awareness are excluded from the perceptual map. In general the more appropriate
each of these is, the more likely all segments are to buy the bike. In contrast, there are often other attributes where “better” is different
for different market segments. Consider seat height for example. Kids bikes’ requirements are quite different from other market
segments. A higher (or lower) bike seat is not better for everyone!
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Marketing and Demand
In Mike’s Bikes, we have assumed that the most important physical attributes of a bike are Style/Design and
level of Technical Specification (including components, construction
materials and strength). The product’s performance on these
attributes can be assessed (through market research), and then
compared to the segment’s ideal requirements. The distance
between product actual and market segment ideal points may then
be calculated. The closer the distance, the more suited the product
is to the segment’s requirements.
THE PRODUCT DECISION IN MIKE’S BIKES
In Mike’s Bikes, you are restricted to selling bikes only. Decisions
are required to determine when and how new bike products will be
launched, and existing products modified and deleted. This is done
on the ‘Products’ screen shown to the right.
NEW PRODUCTS
New products can be launched at any time. These products are
based on the physical characteristics of a completed Product Development project (sometimes called a New
Product Development project). New products can be used to enter new segments or to attempt to dominate a
current segment. In general, firms should be wary of product proliferation (i.e. a many different products).
This increases complexity and costs. It may also increase factory lead times, resulting in poor delivery
performance. A direct effect of product proliferation is that more head office marketing staff are required,
depending on your workforce effectiveness, you may need one head office marketing staff member for each
product you launch.
PRODUCT MODIFICATION
Current products can be modified using a completed Product Development project. Modifications can be
made for a number of reasons:
• adapting the product to the changing needs of a segment;
• re-engineering – retaining the same physical characteristics but simplifying production
requirements and lowering costs;
• enhancing an existing well known product so that it appeals to new market segments.
NB: consumers may not always react positively to such modifications.
In situations where finished goods exist for a product that is modified, the obsolete stocks are automatically
dumped at prime cost (Materials + Labor).
See the section on Product Development for information on how to develop new products.
PRODUCT DELETION
Products can be abandoned at any time if they prove no longer consistent with a firm’s strategy. If finished
goods inventories exist for deleted products they will be dumped at prime cost.
6.2 PRICE
Price is usually a key determinant of demand. Several pricing strategies are listed below. Price to suit your
strategy.
• Mark-up: A fixed margin is applied over and above costs.
• Target Return: A specific return/margin required by the company.
• Perceived-Value: Price at what the consumer is willing to pay.
• Going Rate: Price which is being charged in the market.
THE PRICE DECISION IN MIKE’S BIKES
Pricing can be determined in any way that is considered appropriate.
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This decision can be made on the products screen for
each individual product as shown to the right. A price
decision must be made for each product, and these prices
should be set having regard for the price sensitivity of
consumers in your target segments and the price of
competing products.
6.3 PROMOTION
Marketing communications (or promotion) is important in
generating product demand. Marketing communications
can include advertising, public relations, personal selling,
direct marketing, Internet activities, outdoor signage and
many other tactics and techniques. The aim of marketing
communications is to create consumer awareness,
product and brand recognition, and intention to purchase.
Brand advertising and product advertising work together.
For example, Toyota’s brand advertising creates an image and communicates brand values for the Toyota
brand (incorporating all product variants or models); while specific model or product advertising (e.g. Corolla
and Corona) informs the consumer about particular model features and benefits. Brand advertising, in effect,
leverages the effectiveness of product advertising.
In Mike’s Bikes, brand awareness, product
awareness and product public relations influence
depend on current budget and the carryover effect
from previous periods.
The effectiveness of
product advertising and PR depends on choosing
media that matches the target market’s media
consumption habits. Brand advertising increases
the effectiveness of product advertising and results
in increased product awareness.
20
Promotion Logic
Marketing
Strategy
Product
Attributes
AN EXAMPLE
• Analysis of Markets
• Selection of Target Markets
• Market Mix
• Ongoing Management
Price
Promotion
Advertising
Distribution
Public
Relations
Given the S-curve shown, what increase in TV
viewers’ awareness will an expenditure of $2m on
TV advertising achieve?
How much product awareness will there be if we
Marketing and Demand
assume that product awareness last period was
10% but half of this is lost each period, all our target consumers watch TV, and if brand advertising is
ignored?
SOLUTION
Advertising Awareness Curve for TV
Page 60
$2,500,0
00
$2,000,0
00
There are three forms of promotion (or marketing
communications) in Mike’s Bikes:
1. Brand advertising
2. Product advertising.
3. Product PR
$1,500,0
00
PROMOTION IN MIKE’S BIKES
$1,000,0
00
Total product awareness for this period = 10% -5%
+35% = 40%.
$500,000
Loss for this period = 5%.
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
$0
Last period awareness = 10%.
Awareness Increase in TV
Watchers
$2m will achieve an increase of 35% amongst TV
viewers.
TV Advertising Expenditure
Marketing and Demand
BRAND ADVERTISING
Only one brand is permitted (the name of the manufacturer
i.e. Real Cool Cycles) and this contributes to the effect of
any other product advertising that is carried out.
A budget can be allocated to brand advertising (as shown).
This determines the effectiveness of the advertising. In the
next period, some forgetting occurs, but any new brand
advertising adds cumulatively to what is left.
PRODUCT ADVERTISING
Analyzing the Erehwon bike market has revealed that there are three media choices for bike advertising – TV,
newspapers and magazines. In general, the Adventurer segment are heavier readers of magazines, while the
Leisure segment tend to be heavier readers of newspapers. Both segments watch television. Newspaper
advertising is about half as expensive as TV and magazine advertising per person reached.
As of 1998, Real Cool Cycles and MountainTop Cycles have concentrated advertising for RockHopper bikes
on television. Newspapers would be utilized more if and when Leisure bikes are released onto the market. A
brief description of each medium is given below.
Television: Erehwon has only one national TV
network. Television is a good way of reaching most
market segments.
Adventurers
Leisure
TV
Reach
50%
60%
Newspaper
Reach
10%
60%
Magazines
Reach
60%
20%
Newspaper: There is one main newspaper in
Erehwon - a monthly called the Erehwon Herald. An awareness curve like the one shown above for TV is
available for Newspaper and Magazine advertising in the Mike’s Bikes help.
Magazines: There are a variety of monthly magazines in Erewhon. Magazines related to the bike market
range from a specialist racing bike magazine through general outdoor adventure magazines to very general
leisure magazines.
PRODUCT PUBLIC RELATIONS
Product public relations (PR) related to the bike market includes product reviews and press releases. The
idea is that consumers will give more weight to news and independent reviews than advertisements. The
Adventurers are more sensitive to this kind of product promotion (see the Media Reach table above).
MAKING THE PROMOTION DECISION
The brand advertising expenditure decision can be
found on the Marketing decisions tab of the main
decision screen. The resulting brand awareness
applies to all the firm’s products.
Specific product-related media advertising and
public relations is budgeted for each product from
the ‘Product’ decision screen.
Advertising activity affects the awareness levels of
the product.
It should be remembered that
awareness takes time to build and will decline over
time as consumers ‘forget’. Advertising experts
estimate that an investment of around $2m is
required to achieve initial awareness levels of 25%50%. Less is required to maintain these levels. In
deciding the level of investment in advertising, it is
important to remember that certain segments are
more responsive to advertising than others. The
investment includes money spent on advertising
research to develop advertising messages.
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Product PR works in a similar way to product media advertising. However each market segment’s sensitivity
to advertising may be different from its sensitivity to PR.
6.4 PLACE (DISTRIBUTION)
Distribution (place) relates to the ability of the firm to make products accessible to its target segments. This is
achieved through distribution channels – in this case retail outlets. The effectiveness of distribution (and
hence its impact on demand) is determined by the shopping habits of the target market and the number of
stores in the required channels that carry the product.
For example, if Adventurers are being targeted, then it is more effective to have a greater number of sports
stores and bike shops.
The number of stores persuaded to stock a firm’s products is determined by margin offered, expected product
sales, and extra support provided.
DISTRIBUTION CHANNELS IN MIKE’S BIKES
Distributors carry a complete line of products. You
will need to decide on broad or narrow coverage
(i.e. many or few different channels), and the
intensity of distribution (i.e. number of stores in
each channel). This will be influenced by the
shopping habits of the market segments you are
targeting. Another small influence on your decision
is that the greater the number of distributors the
higher the number of head office marketing staff
that you will need (a head office marketing staff
person will be required for approximately every
hundred stores stocking your products).
Distribution
Logic
37
Marketing
Strategy
Product
Attributes
• Analysis of Markets
• Selection of Target Markets
• Market Mix
• Ongoing Management
Price
Promotion
Distribution
Number
of Stores
Shopping
Habits
The number of stores in the channel who decide to
Expected
Retailer
Extra
stock your products will depend on the retail price,
Sales
Margin
Support
margin, unit sales history, and extra support offered.
You must specify what margin and what extra
Marketing and Demand
support (in terms of special promotions and
discounts etc.) you are going to offer the retailers in each channel. (Note that the retailer margin decision
refers to the percentage of the retail price that the retailer keeps. So a percentage of 60% means that they
keep 60% of the sales revenue and give you the remaining 40%.)
Maintaining existing distributors and acquiring new ones requires considerable resources. Costs associated
with distribution include: hiring and training retailers, field sales representatives and head office sales staff;
providing promotional literature; organizing delivery and ordering of products; following up complaints;
collecting accounts. Distribution costs vary with the number and types of distributors/retailers used.
Analyzing the Erehwon bike market has revealed that the vendors of bikes may be broken into two categories:
Bike Shops and Department Stores. In general, the Adventurer segment favors the specialty bike shops while
the Leisure segment simply shops in the familiar department stores. An analysis of the costs of supporting
retail stores in the two channels has revealed that the Bike Shops are more expensive to support per store,
but this is balanced by the fact that there are so many more Department Stores.
As at 1998, the majority of bikes sold are sold through Bike Stores. Department Stores would be expected to
be deliver more sales when/if Leisure bikes are released onto the market. A brief description of each channel
is given below.
BIKE SHOPS
The Bike Shop (often called ‘the bike boutique’) is a specialty store dedicated to bikes and bike related
products. Store assistants are trained bike specialists, able to tailor specific bikes to specific customers.
Thus, people unsure of which bike to buy will usually go to a bike shop, especially if the bike is required for a
specific purpose. Bike shops stock an extensive range of different models, catering to all types of purchasers.
Bike shops generally stock bikes in the mid to high price range and bikes they stock in common with the
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Marketing and Demand
Department Stores are often priced slightly higher than in the Department Stores. They are thus perceived as
the quality bike vendor (at the cost of being perceived as the most expensive bike vendor). Bike shops rely on
their higher margin to gain a profit, so are less likely to discount their stock. Their customers tend to be less
price sensitive than those of Department Stores.
DEPARTMENT STORES
Department stores (e.g. chain retailers such as Wal-Mart) stock a wide range of goods - from consumer
durables (such as refrigerators and televisions) to apparel and kitchenware. They often specialize in budget
or exclusive items. Department stores appeal to people wanting to complete their weekly shopping in one
store. They are increasingly being built in mall sites surrounded by smaller satellite stores providing other
shopping requirements. The typical shopper at a department store is a family out on Saturday or Sunday
afternoon. Often they do not have a definite purchase in mind, but in walking around may see something that
appeals. The busiest time of year for department stores is prior to Christmas, when gifts are in everyone’s
thoughts.
In terms of support, department stores seem to offer little support to
salespeople who are bike experts to give the
customers information, nor do they take part
Number of Dealers
in many of the promotions that the
Annual Cost to
manufacturers propose. They typically stock
Support
a wide range of mid-priced bikes, stocking
competing brands side by side.
bike manufacturers. They do not have
Bike Shops
120
$450
Department Stores
300
$200
The costs of distributing through each
Bike Shops
distribution channel are shown in the table to
Adventurers
70%
the right. The other distribution costs are the
Leisure
25%
salaries of head office marketing staff, and
any extra support that you allocate to any of the distribution channels.
Department Stores
30%
75%
SUMMARY
Estimates of the shopping habits of the different segments in the different distribution channels are also given
for use in deciding on a distribution strategy.
AN EXAMPLE
Assume you are targeting the Adventurer segment. Assume that 20% of consumers prefer to purchase in
department stores and 40% prefer bike shops. Your margin means that 50% of department stores stock your
product and 80% of bike shops. Roughly what coverage of the adventurer segment do you have?
SOLUTION
Approximate coverage of the Adventurer segment = 0.2 x 0.5 + 0.4 x 0.8 = 0.42%
MAKING THE DISTRIBUTION DECISION
The Distribution Channels screen is where you enter your decisions
about distributing your products for the coming year. Here you
decide the importance of the different channels.
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To allocate the number of stores for a particular channel,
first select it by clicking on it in the list. A summary of
decisions for the selected distribution channel appears
towards the bottom of the screen.
Then click the Allocate button and enter your decision in
the dialogue box that appears.
You must specify what margin and what extra support (in
terms of special promotions and discounts etc.) you are
going to offer the retailers in each channel. This is the
margin the retailers keep - so don’t increase it too much!
The number of stores in each channel who decide to stock
your products will depend on the retail price, margin, unit
sales history, and extra support offered.
6.5 GENERATING DEMAND
Arguably, the objective of marketing activity is to
generate demand. This idea overlaps heavily
with economic theory. The ‘Traditional
Economics’ model diagram shows market
demand, based on average price. The higher
the average price, the lower the demand (i.e. an
elastic demand curve, or one that is sensitive to
price). It is assumed that the relationship is
linear for a realistic range of prices.
Demand for Adventurer Segment
Product Specs
Price
Awareness
PR Influence
Distribution
33
Delivery
Quality
Product Segment Share
The formula for demand is given. Obviously this
is simplistic - in reality price is not the only
determinant of demand. To enrich our model to
include other factors (e.g. relative product
quality, consumer awareness), we have defined
a variable labeled ‘ValueForMoney’ (VFM) and
have adjusted the market demand model to
include these factors.
Segment Demand
Total Product Demand
Marketing and Demand
The logic we follow in modeling demand for the bike scenario is shown in the diagram entitled ‘Demand for
Adventurer Segment’.
46
The calculation steps are as follows:
Traditional economics
1. A VFM or segment attractiveness
score for each product, based on
n “Demand = Alpha - Beta * Price”
attributes of price, advertising, PR
influence, quality, distribution and
Demand vs Avg Price for Adventurer Segment 1996-1999
product delivery;
2. Segment share for each product,
200,000
y = -82.144x + 195182
achieved by comparing VFM
150,000
scores for different products.
100,000
(Note that products from the
50,000
same firm selling to the same
0
segment cannibalize each other);
$0
$500
$1,000
$1,500
$2,000
3. Segment share-weighted average
price, quality, distribution etc
indices;
4. Segment demand (based on the
Marketing and Demand
weighted average indices). The
higher the index, the greater the segment demand generated;
5. Product demand – share of segment demand, determined by the ratios of the VFM indices;
6. Total product demand - the sum of all segment demands for the product.
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Marketing and Demand
GENERATING DEMAND IN MIKE’S BIKES
An Example
Assume that segment demand for Leisure is given by:
Segment Demand = alpha + beta * avg_priceindex + beta * avg_awarenessindex .
The numbers for this are:
Segment Demand = 20,000 + 10,000 x avg_priceindex + 5,000 x avg_awarenessindex.
If avg_priceindex = 0.6 and avg_awarenessindex = 0.2, what is the demand from the segment?
Which factor (price or awareness) has more effect on demand and by how much?
Solution
Segment Demand = 20,000 + (10,000 x 0.6) + (5,000 x 0.2) = 27,000. Because the beta for price is twice that
for awareness, price is twice as much effect on demand as awareness per unit change in index.
An Example
Assume that the total potential demand from the Leisure segment is 24,000 units.
Assume that there are two products that sell to the segment - Cruiser 1 and Cruiser 2.
If the Value for Money of Cruiser 1 is 10 and for Cruiser 2 is 20, how much potential demand will each get?
Solution
Potential demand for Cruiser 1 = 10/(10+20) x 24,000 = 8,000 units.
Potential demand for Cruiser 2 = 20/(10+20) x 24,000 = 16,000 units.
6.6 ONGOING MANAGEMENT
None of this is a ‘set and forget’ one-off exercise. The market changes over time. There is a constant
requirement for feedback, updating of market data, and plan modification in response. Planning and strategy
needs to take into account the actions of competitors, and the improved understanding of the environment
that comes from feedback. Internal consistency between marketing, production/operations and finance is
also critical to success.
Some key reports that could be used to assess market changes are sales, market share, margins, and
customer satisfaction surveys.
Important organizational decisions relate to a desired position or strategic posture – whether innovators,
followers, best-price or differentiators. These decisions cannot be made in isolation by the marketing
department but must be consistent with other organizational functions, recognizing both organizational and
competitor capabilities.
7. Questions to Assist Learning
7.1 QUANTITATIVE QUESTIONS BASED ON SOLOMIKE
All of the following questions deal with information contained in the workbook MARKET.XLS found in the
directory where you installed SoloMike (usually C:\MikeBike\SoloMike). Copy MARKET.XLS to another
directory to use for this assignment. Before starting each question, remove the protection from the relevant
worksheet by choosing Protection\ Unprotect Sheet from the Tools menu. This allows you to use data tables
and add graphs to the sheet.
For the purposes of this assignment assume that your firm has decided to “consistently produce a bike that is
considered the best value for the Adventurer segment” (ie a best price marketing strategy targeted at the
adventurer segment) and the management team is assessing possible ways of implementing this from the
marketing mix. The long-term overall plan is to double sales and production volumes to 30,000 units, reducing
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MIKE’S BIKES – Integrated Business Learning Online
unit costs and being able to lower prices, while still earning a good profit. Assume also that someone in the
firm has put together this spreadsheet model of the SoloMike bike industry.
1.
Product Attributes
Consider the product positioning model presented in the worksheet PERCEPTUAL MAP.
a) [Basic] The team considers modifying the existing product’s attributes to Style 55 and Technical
Specifications 55. Assume the Adventurer segment’s current ideal levels are 52 and 53.5 for Style
and Tech Specs respectively. What is the perceptual distance of the current (unmodified) product
from the Adventurer segment? (cell B33). Without using the worksheet, calculate the perceptual
distance for this modified product from the Adventurer segment. Now check your answer by entering
the product’s new attributes (cells B26 and C26) and reading off the calculated figure (cell B34).
b) [Integrating] (Unprotect the worksheet before doing this question.) To estimate the demand for the
new product, change both cells B11 and C11 to 55. Now move to worksheet DEMAND and find the
demand for RC_RockHopper (B88). If the demand for the product with the old specs was 15,751,
by how much has demand increased? If the costs of modifying the product are $200,000 and the
unit cost for each extra unit sold is about $400, and assuming a retailer margin of 50%, does the
increased demand over 3 years justify the change?
c) Finally, restore PERCPETUAL MAP cells B11 and C11 to 50 and 60 respectively.
2.
Price
Consider the pricing model presented in the worksheet PRICING, and the figures in the table below.
a) [Basic] Consider the maximum and minimum realistic retail prices for the adventurer segment (row
10), and the price index (cell B28) when the retail price (cell B17) is $1700. By trial and error (or
using Goal Seek), find the approximate retail prices corresponding to a price indexes of 0.8 and 0.4
respectively. What retail price would correspond to a price index of 1.0? Finally, restore the retail
price (cell B17) to $1700.
b) [Advanced] Calculate the wholesale price and break-even sales volume for RC-RockHopper using
markup pricing based on a markup of 20% over
RC_RockHopper
the estimated unit cost; and then repeat using
VariableCostPerUnit
$375
target-return pricing based on a target return on
FixedCosts
$4m
invested capital of 20%. (The PRICING sheet has
InvestedCapital
$5m
space for these calculations in rows 38 to 56.)
Est. Unit Sales
13,000
c) [Basic] Based on the figures in the table above,
and using the current effective wholesale price of $850, calculate the revenue, total costs and profit
for a range of sales volumes from 5,000 units to 30,000. Create a graph of these results and identify
the break-even point on the graph. (Remember to Unprotect the sheet so that you can add the
graph.)
d) [Advanced, Integrating] The management team estimates that in order to produce 30,000 bikes,
capital invested would be $20m, fixed costs increase to $5m, but the variable cost per bike would
drop to around $300. Calculate the wholesale price and break-even sales volume for this situation
using firstly a markup of 20% and then a target return on invested capital of 20%. Compare these
wholesale prices with the overall strategy to reduce retail price to around $1400
3.
Promotion - Brand Advertising
Consider the advertising model in worksheet BRANDING.
a) [Basic] One option the team considers is changing expenditure on promoting the firm’s brand.
Looking at the curve presented, you decide to try increasing the branding expenditure to $200,000
per annum. Firstly look at the brand awareness (cell B35) that would be achieved by the current
level of expenditure ($100,000). Now try entering $200,000 into the decision cell (B20) and see what
brand awareness results.
b) [Basic] In order to clearly place your brand ahead of your competition, it is decided to double your
brand awareness. Because the Adventurer market segment is quite responsive to advertising this
should increase the demand and allow some economies of scale in the production area. Either by
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Marketing and Demand
38
trial and error, or by using the Excel Goal Seek function from the Tools menu, find the advertising
expenditure which would increase the brand awareness to 11%.
c) [Integrating] Consider the graph in the top right hand corner of the sheet showing the increase in
brand awareness resulting from a range of brand advertising expenditures. In a real situation, where
does this sort of awareness information come from?
d) For the purposes of the remainder of the assignment assume that the team has decided to keep the
original expenditure of $100,000 while it explores other options, so make sure that cell B20 is
$100,000.
4.
Promotion - Media Selection
Consider the advertising model in worksheet ADVERTISING. Before starting this question, remove the
protection from the sheet by choosing Protection\ Unprotect Sheet from the Tools menu. This allows you to
add the data and graph required in parts (b) and (c).
a) [Basic] Based on the audience habits of the adventurer segment (see rows 15-17 of the
spreadsheet), the company has been allocating 75% of its product media advertising to TV and only
25% to newspaper (cells B34 and C34). The result of continuing this allocation for the next year
would be a product awareness of 12.8% (cell B77) among the adventurer segment. Change the
allocation so that 50% of the product media expenditure goes to goes to each of TV and Newspaper
(cells B34 and C34), and see what the resulting product awareness (cell B77) would be. Why does it
decrease?
b) [Basic] For a more complete picture of the possible results of changing the advertising media
allocation, generate a curve showing the product awareness resulting from a range of allocations to
TV from 0% to 100% (the remainder is allocated to newspaper advertising). Either do this manually,
39
or use a data table (the beginnings of one can be found in rows 84 and 85). Once you have the
data, select it and use the chart wizard to create the graph. Based on this information, what
proportion of the advertising media budget would you allocate to TV?
c) [Advanced] Now try increasing the advertising media budget (cell B32) from $800,000 to
$4,000,000. How does the shape of the curve you found in (b) change? Approximately what
proportion of the advertising media budget would you allocate to TV now? Why has it become better
to allocate more money to newspaper advertising? (Hint: in addition to the adventurer audience
habits, look at the TV and newspaper awareness curves at the top right of the sheet.)
d) Finally, restore the total budget (cell B32) to $800,000 and the proportions allocated to TV and
newspaper to 75% and 25% respectively.
5.
Place - Distribution Coverage
Consider the distribution model presented in the worksheet DISTRIBUTORS. Assume the maximum number
of dealers as below. Before starting this question, remove the protection from the sheet by choosing
Protection\ Unprotect Sheet from the Tools menu. This allows you to add the data and graph required in parts
(b) and (c).
a) [Basic] Before now, no-one has considered
Shopping
Bike
Department
increasing the distribution coverage of your
Habits
Shops
Stores
bikes by offering a different retail margin to
70%
30%
Adventurers
the retailers, so a 50% margin has remained
25%
75%
Leisure
for several years. Continuing this would
result in 80 Bike stores (cell B51) stocking your bikes and 58% coverage (cell B61) to the adventurer
segment. Based on the shopping habits of the adventurer segment (see rows 16-18 of the
spreadsheet), try encouraging more Bike stores to stock your products by increasing the retailer
margin you offer them to 55% (cell B28). How many more Bike stores stock your products? What is
the new adventurer segment coverage? Restore the retailer margin to 50%. Now try increasing the
38
39
Using the Excel Goal Seek function, set ‘B35’ as the target cell, specify the doubled awareness (i.e. 11% or 0.11) as the value
required, and set ‘B20’ as the cell to change.
MEDIA SELECTION: To create a Data Table: Select cells B84 to H85, choose Table from the Data menu, enter B34 into the Row
Input Cell field, then click OK.
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MIKE’S BIKES – Integrated Business Learning Online
b)
c)
d)
e)
6.
extra support (retail sales assistant training, etc) offered to Bikes stores from $100,000 to $200,000
(cell B29). How many more Bike stores stock your products? What is the new adventurer segment
coverage? Then restore cell B29 to $100,000.
[Basic] Estimate loss in revenues to your firm from increasing retailer margin for Bike Stores from
50% to 55%. Assume that retail sales total $25m and that the vast majority of these are through
Bike Stores.
[Basic] For a more complete picture of the possible results of changing the retailer margin offered to
Bike Stores, generate a curve showing the number of Bike Stores stocking your bikes and the
adventurer segment distribution coverage resulting from a range of Bike Store retailer margins from
40
30% to 70%. Either do this manually, or use a data table (the beginnings of one can be found in
rows 72 to 75). Once you have the data, select it and use the chart wizard to create the graph. Why
might the distribution coverage curve be flattening out as the number of Bike Stores approaches the
total number available?
[Integrating] Try increasing the sales volume (cell B37) from 15,908 to 30,000 in anticipation of the
increased volumes you expect in future years, and look at the curve you drew for (c) (it should have
changed shape). Why does the curve change? What retailer margin would you offer Bikes stores in
this situation? How does this tie into the overall strategy of producing the best value adventurer
bike?
Before continuing, restore original values: Bike Store retailer margin (cell B27) to 50% and sales
units (cell B37) to 15,098.
Total Effect on Demand
The demand model is presented in the worksheet DEMAND. For the purposes of this question however, we
will be using the part of the worksheet PRICING labeled “Demand Analysis” (rows 64 and below). Before
starting this question, remove the protection from the sheet by choosing Protection\ Unprotect Sheet from the
Tools menu. This allows you to add the data and graphs required.
A critical part of your firm’s overall plan is the increased sales volumes achieved by reducing retail price from
the current $1700 to around $1400. This question investigates how much extra demand will result as prices
are reduced.
a) [Basic] Assume that your competitor doesn’t reduce prices. Find the part of the PRICING sheet
labeled “Demand Analysis” (rows 64 and below). Using the Data table template provided (i.e use
B17 as the row input cell), find the demand and segment share achieved for different levels of price.
Create a graph of demand for RC_RockHopper and its segment share for different prices. Estimate
the price reduction required to achieve a demand of 30,000.
b) [Basic] Repeat the previous question assuming that your competitor matches your price. (Change
the PRICING sheet cell C17 so that contains the formula =B17).
c) [Advanced] Consider the share of segment demand achieved in parts (a) and (b). Explain why this
occurs. What other actions could be taken to increase segment share apart from lowering price?
d) Finally restore PRICING cell C17 to contain $1700 (not = B17).
7.
Bringing it all together:
A crucial part of your firm’s overall plan is doubling sales
RC_RockHopper
volumes (to around 30,000 units). So far we have
(Sales = 30,000 units)
considered how each of the elements of the marketing mix
$375
VariableCostPerUnit
in isolation could contribute to this. In this question we will
$3.2m
FixedCosts
(excl.
advtg)
investigate the optimal combination of reducing price and
increasing product media advertising budget in achieving this target. For the purposes of this question
assume the fixed and variable cost information in the table at the right and that your competitor maintains
prices and advertising at their current levels. We will be using the worksheet DEMAND, but creating links to
the worksheets ADVERTISING and PRICING.
40
DISTRIBUTION COVERAGE: To create a Data Table: Select cells B70 to G72, choose Table from the Data menu, enter B27 into the
Row Input Cell field, then click OK.
Page 68
Marketing and Demand
a) [Integrating]. We will create a two-dimensional data table of demand achieved for different levels of
price & advertising using the template provided in rows 92 to 104 of worksheet DEMAND. To do this
we need to create links between what we set as advertising and price on the DEMAND sheet and
what is used in the ADVERTISING and PRICING sheets. Firstly, move to worksheet ADVERTISING
and link Advertising Expenditure (cell B32) to cell A95 on the DEMAND worksheet by typing
=Demand!A95 <Enter>. Now move to the PRICING worksheet and link Retail Price (cell B17) to cell
D92 on the DEMAND sheet by typing =Demand!D92 <Enter>. Now move to the DEMAND sheet,
select cells B93 to H104 and create the 2-D data table with RowInput cell D92 and ColumnInput cell
A95. You should see a table of demand figures for the different levels of price and advertising.
Approximately what level of advertising is required to achieve a demand of 30,000 units when retail
price each of $1000, $1100, $1200, $1300, $1400? If you wish, create a 3-D graph of this table of
information.
b) [Advanced, Integrating] Now we consider which of the combinations of price and advertising
identified in the previous question yield the highest profit. Use the Variable and Fixed cost
information in the table above to change cell B93 to estimate profit based on demand. (For price and
advertising use cells D92 and A95. Assume that the retailer margin is 50%). The data table should
now re-calculate to show profit. Which combination identified in the previous question yields the
highest profit, and what is that profit? If you wish, create a 3-D graph of this table of information.
Before staring the following question, copy cells B92 to H104 and paste the values of these cells
using Paste Special.
c) [Advanced, Integrating] We now use Excel’s non-linear solver (Solver Add-In) as an alternative
method to finding the profit-maximizing combinations of price and advertising to achieve sales
volume of 30,000 units. We will use the template in rows 107 to 109. To do this we need to create
links between what we set as advertising and price on the DEMAND sheet and what is used in the
ADVERTISING and PRICING sheets. Firstly, move to worksheet ADVERTISING and link
Advertising Expenditure (cell B32) to cell B109 on the DEMAND worksheet by typing
=Demand!B109 <Enter>. Now move to the PRICING worksheet and link Retail Price (cell B17) to
cell A109 on the DEMAND sheet by typing =Demand!A109 <Enter>. Now use choose Solver from
the Tools menu. The solver problem definition has already been set up for you. Note the constraint
which ensures that demand is 30,000. Press Solve. What is the optimal price and advertising level
found ? Compare it with the answer you found in the previous question.
7.2 QUALITATIVE QUESTIONS (EITHER SOLOMIKE OR NETMIKE)
1.
Write a draft marketing plan for the Mike’s Bikes environment for the next 2 years. (2-3 pages).
This should include a consideration of the following issues and can be in bullet form. (Make sure that you think
about consistency - among themselves, with the overall strategy, and with the operations and finance
strategies.)
a) What are your target segments? Why?
b) Considering competition, what is their sales potential?
c) For each of these, what are your objectives for the products, price, advertising, and distribution, and
where appropriate indicate how these will be achieved.
2.
Construct an advertising and promotion strategy for the Mike’s Bikes environment for the next 2
years. This should consider things such as the following.
a)
b)
c)
d)
e)
f)
What segments are you aiming at?
What do they watch/read and what types of promotion is appropriate?
How much do these cost?
How much awareness do they generate per dollar of cost?
What is your plan, how much will it cost and how much extra demand will it generate?
Is this consistent with the distribution, operations/production and finance strategies?
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MIKE’S BIKES – Integrated Business Learning Online
3.
Write a draft distribution strategy for the Mike’s Bikes environment for the next 2 years. This
should consider things such as the following.
a)
b)
c)
d)
e)
f)
4.
What segments are you aiming at?
Where do they go to purchase?
How much do these cost?
How much coverage do they provide per dollar of cost?
What is your plan, how much will it cost and how much extra demand will it generate?
Is this consistent with the advertising, operations/production and finance strategies?
Write a draft pricing strategy for the Mike’s Bikes environment for the next 2 years. This should
consider things such as the following.
a)
b)
c)
d)
e)
f)
What segments are you aiming at?
With what products?
How sensitive are the segments to price?
What type of pricing strategy are you going to adopt?
How will you react to competition?
Is this consistent with the advertising, promotion, operations/production and finance strategies?
5.
When positioning products, what are three key issues?
6.
What is the difference between branding and the product advertising and how would you decide the
correct mix between the two?
7.
What is the purpose of distribution channels and how do you decide on the appropriate mix?
8.
Why is it vital to coordinate marketing and production and how is this achieved?
8. References
rd
1. Hair, J., Anderson, R., Tatham, R., Black, W., Multivariate Data Analysis with Readings (3 Ed),
Macmillan, 1992
9. Modifications for NetMike
NetMike differs from Solo Mike in only 3 areas: the number of segments, the number of distribution channels
and the number of firms. A summary of the main differences is given below.
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Marketing and Demand
9.1 SEGMENT DESCRIPTIONS
Segment
Adventurers
Commuters
Kids
Leisure
Racers
Est. Pot. Market
Size(Units)
130,000
40,000
125,000
90,000
20,000
Retail Price
Range
$500-4000
$100-400
$100-500
$100-600
$800-6,000
Average
Score for
Style/Design
50
25
75
50
20
Average Score
for Technical
Specs.
50
10
10
10
85
9.2 CONJOINT ANALYSIS RESULTS
Segment
Sensitivity
Adventurers
Commuters
Kids
Leisure
Racers
Price
Advertising
PR
Quality
Distribution
Delivery Time
Low
High
High
Med
Low
Med
Med
High
High
Low
Med
Low
Low
Low
High
High
Med
Low
Low
High
Med-High
Low
Med
Med
Med
Low
High
High
High
Low
COMMUTERS
The Commuter Segment has appeared in the past decade in several overseas economies. The growth of
environmental concern worldwide has meant that more and more people are viewing their bike primarily as a
means of transport. Bike users include the University Student who battles early morning rush-hour traffic to
get to a 7:30am lecture, the Factory Worker who rides his bike to work each day because he feels better
getting some exercise before work, and the Business Woman who rides into the CBD each morning because
she can’t get a car park and sees her bike as an environmentally responsible option. All these people see
their bikes essentially as a packhorse. It doesn’t need to look fashionable, or do anything too exciting - it just
has to get them from A to B. Thus Commuters place a great deal of emphasis on reliability and comfort. Price
is of more concern than performance or of buying a well-known brand.
KIDS
The potential Kids segment for bikes is understandably large. Children see bikes as a means of freedom many teenagers require a certain amount of mobility, but are unable to get a driver’s license. The advantage
of the Kids Segment is that an average youth will go through 2.1 bikes between the ages of 4 and 15 years.
The primary requirements of such purchasers are seen usually through their parents eyes - the bike has to be
simple and durable (so that it can take the knocks), but also relatively inexpensive, while having the best
image on the block. Overseas, the Kids market segment is typically the biggest with a strong growth rate. In
Erehwon however, the segment is currently unserved because the Adventurer is too big and unfashionable.
RACERS
Those who view cycling primarily as a competitive activity (as its name suggests) dominate the Racer
Segment. The typical Racer owns at least two bikes and trains at least three times a week. The range of
racers is great, from the Saturday morning school team to the Olympic Squad. However, we can generalize
that the Racer wants a bike that performs - both on the track and on the road. It must be light, fast, and
technically at the leading edge. Racers are not as sensitive to price as the other segments - some paying up
to $7,000 retail for the “right” bike. Racers also know what they want, seldom taking the advice of a sales
assistant or being influenced by advertising when making their purchase. They know the bike that they need,
are prepared to pay more for it and are also prepared to wait longer than most. The segment has good
growth in overseas markets although it always tends to be small, around 5% of the market.
The other definitions are in the main text.
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MIKE’S BIKES – Integrated Business Learning Online
9.3 MARKET SEGMENT AUDIENCE HABITS
Segment
Adventurers
Commuters
Kids
Leisure
Racers
TV
50%
50%
80%
60%
10%
Newspaper
10%
20%
0%
60%
10%
Magazines
60%
10%
30%
20%
80%
9.4 DISTRIBUTION CHANNELS
Dealer Information
Number of Dealers
Annual Margin Required
Annual Cost to Support
Customer Shopping Habits
Adventurers
Commuters
Kids
Leisure
Racers
Bike Shops
400
$200,000
$450
Sports Stores
800
$150,000
$400
Department Stores
1000
$50,000
$200
50%
10%
20%
20%
85%
40%
30%
20%
40%
15%
10%
60%
60%
40%
0%
SPORTS AND OUTDOOR STORES
Sports and Outdoor stores stock a wide range of sporting equipment, including bikes that have been designed
for active outgoing people. The staff at these stores do not know much about technical aspects of the bikes,
but they are knowledgeable about the purpose for which the bikes will be used. They tend to sell bikes at a
higher price than department stores because they have lower turnover and are able to offer extra advice that
their customers are prepared to pay for.
Consumers who buy from these stores generally know what they are looking for in a bike, or at least the
purpose for which they will use the bike. However they are less particular than racers, and may still buy bikes
close to what they want if the bike best suited to their needs is unavailable, especially if it is a well-known highprofile brand.
Because they buy for a purpose they will also tend to be prepared to pay more than those segments which are
less specific.
The other definitions are in the main body of the text.
Page 72
5 OPERATIONS AND SUPPLY
The traditional view of the operations function is to maximize the quantity of product produced for the target
markets in the most effective and efficient way. However significant changes are occurring in operations. An
important one is a trend towards a more team-orientated firm, where the operations role is modified to work
with the rest of the organization to maximize the long-term stream of profits associated with operations. The
distinction is not as subtle as it may seem. In the first case operations would take marketing as a given and
would work to maximize production. In a team-orientated firm, operations work with marketing to decide
production, quality, responsiveness, price and advertising in order to maximize overall profits. The same must
be done with the other functional areas, i.e. a cross-functional approach.
The figure to the right shows the fundamental
framework that is used in Mike's Bikes for
operations, and the role of operations relative
to the other functions and with respect to
shareholder value. Specifically operations
complements decisions in marketing, finance
and product development, to achieve the best
match between demand and supply to
generate profit and shareholder value.
Operations typically defines its objectives in
terms of:
• responsiveness (e.g. delivery
time)
• quality
• flexibility (e.g. product range)
• and cost.
4
Operations Logic
Shareholder Value
Current Profit
ECONOMIC
CONDITIONS
COMPETITORS’
ACTIONS
Demand
Future Profit
Supply
Accounting
operating
decisions
investment
decisions
Business Strategy
Marketing
Strategy
Operations
Strategy
Finance
Strategy
Product
Development
Strategy
Operations and Supply
These objectives then form the basis of a
strategic plan which is implemented through
more basic tactical decisions such as the number of people to employ, training levels, salary levels, machine
capacity, maintenance levels, setup times, batch sizes, inspection rates, investment into quality systems and
the like.
Mike's Bikes supports such a view by integrating the decisions of operations with all the other functions, and
while it is possible to focus on maximizing the performance of operations, this will not necessarily lead to good
overall performance unless considered in conjunction with the other areas.
1. Learning Outcomes
In this chapter we explore some theory related to these issues, and work simple numerical examples and
more complex spreadsheet examples (if appropriate). The main learning objectives for this chapter are an
understanding of the following:
a)
b)
c)
Developing an operations plan.
Order winners and order qualifiers.
Understanding operations objectives:
• responsiveness/flexibility
• quality
• cost
d)
Understanding operations tactics
• Machine requirements including capacity and maintenance.
• Personnel requirements including numbers of people and training.
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MIKE’S BIKES – Integrated Business Learning Online
•
•
•
•
•
e)
The impacts of setups and batch size on responsiveness and available capacity.
Inventory decisions
Supplier relations and their effect on quality and responsiveness.
The importance of quality systems.
The role of inspection.
The marketing and production interface
2. A Framework for Operations
This figure shows the fundamental framework that is used in Mike's Bikes for operations, and the role of
operations relative to the other functions and with respect to shareholder value. Specifically operations
complements decisions in marketing, finance and product development, to achieve the best match between
demand and supply to generate profit and shareholder value.
3. Determining Strategic Objectives
From a strategic perspective, operations has
objectives in four main areas:
• responsiveness e.g. (delivery
time)
• quality
• flexibility (e.g. size of product
range)
• and cost.
The detail of the operations management
process then consists of creating a strategic
plan that sets the objectives in these four areas
while being consistent with the firm’s overall
business strategy. The operations plan is then
achieved through a combination of tactical
decisions.
5
Operations - Detail
Operations
Strategy
Capacity and
Production
• Determine Capacity and Production,
Cost, Quality, and
Responsiveness Objectives
• Select Tactics
Responsiveness
Quality
Cost
Capacity and cost have traditionally been key
Operations and Supply
drivers of operations decisions in the following
ways. Cost has been an objective for many
years as it is a fundamental determinant of the price and therefore the value that the customer receives.
Capacity has been directly related to the ability to produce enough product to meet demand.
Over the last three decades there has been an increasing emphasis on quality, and more recently on
responsiveness. These objectives can sometimes be pursued simultaneously (such as by Total Quality
Management TQM) and sometimes require trade-offs, and the appropriate levels will be determined by the
preferences of the target markets chosen and by benchmarking against the competition.
3.1 TACTICS (TOOLS)
To achieve the overall objectives requires a number of tactical decisions (or tools), and the framework below
suggests that a manufacturing strategy consists of a set of structural, infrastructural, and integration choices.
The structural choices are the traditional, hard, "brick and mortar" choices regarding technology, capacity,
facilities, and vertical integration. The infrastructural, or soft choices relate to management policies, systems
and processes that are linked to the structural components. Finally, the integration choices describe how
manufacturing will strategically interface with external functions such as suppliers and customers, and internal
ones such as marketing and product development.
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Operations and Supply
STRUCTURAL STRATEGY 41
Facilities
• Where should facilities be located?
• What are the number and sizes of the plants?
• How should they be focused?
Capacity
• How much capacity should be available?
• How should the capacity be utilized?
• What is the correct mix of permanent vs.
temporary capacity?
Process Technology/Equipment
• What technology should be employed?
• How much of our process technology should
be developed internally?
• How should we service and maintain it?
Degree of Vertical Integration and Control
• Should we make or buy our materials?
• How many suppliers should we have?
• How should we manage and control our
supplier network?
Materials Systems
• How should we store & transport the
materials?
• How should we control & secure the
materials?
INFRASTRUCTURAL STRATEGY
Human Resource Policies
• What skills are required?
• How should we train our employees?
• What should we train our employees on?
Quality
• What is our quality policy?
• What approach will we use to achieve our
quality objectives?
• What is the optimal quality position for our
company?
Production Planning and Control
• How should we plan our materials needs?
• What system of production control will we
employ?
Performance Measurement and Rewards
• How will we measure performance?
• How will we define superior performance?
• How will we reward desired performance?
Organizational Structure and Design
• How will we organize?
• How many layers in management do we need?
• Should we focus on product or process?
INTEGRATION STRATEGY
External Integration
• What types of relationships will be developed
with suppliers?
• What types of relationships will be developed
with customers?
• What will be the nature of customer contacts?
• What types of strategic alliances and
partnerships will be employed?
• How will the global networks be established and
communication maintained?
Internal Integration
• How will interfaces with other functional units R&D, marketing, finance - be bridged?
• How will strategic fit with the business unit be
linked with manufacturing?
• What mechanisms will be employed to integrate
product/process choices?
• How will technologies be shared between the
business unit and corporation?
Adaptive Mechanisms
• How will organizational learning be hastened?
• How can manufacturing work smarter?
• Where can system synergies occur?
• How will technology be transferred?
3.2 APPLICATION IN MIKE'S BIKES
There are many different industries in which an organization may operate, each leading to different operating
42
environments , and where each of these tactics may have a different meaning. In the case of Mike's Bikes,
firms are operating in a batch mode environment, and Mike's Bikes allows you to work with a selection of
tactics to make decisions that affect the strategic objectives. In particular it allows you to make decisions on
the following issues:
• Capacity (size of plant);
• Process Technology (setup times, batch size, maintenance);
• Human resources (workforce size, wage/salary levels, training);
41
42
Giffi, C., Roth, A.V., Seal, G.M., Competing in World Class Manufacturing: America's 21st Century Challenge, Richard D. Irwin, Inc.,
1990.
Manufacturing environments include: A job shop (e.g. metal-working machine shop), a batch flow process (e.g. clothing
manufacturer), a machine paced line flow process (e.g. auto manufacturer), a hybrid (batch/continuous flow) process (e.g. brewery), a
continuous flow process (e.g. paper mill). Service environments include: a worker-paced line flow process/service factory (e.g. fastfood restaurant), a service shop (e.g. auto service, goods service), mass service (e.g. department store), professional service (e.g.
law, health, accounting)
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MIKE’S BIKES – Integrated Business Learning Online
•
•
•
•
Material systems (inventory);
External Integration (supplier relations);
Quality;
Internal integration (interfaces with other functional units)
4. Order Qualifiers and Order Winners43
In any industry, certain criteria must be satisfied in order for the product or service to be even considered by
the purchaser - these are called order qualifiers. Then there are other criteria which determine which product
is chosen to be purchased - these are called order winners. In purchasing a mountain bike, for example, a
base level of at least 10 gears might be required to be even considered (ie an order qualifier). Advanced
shock absorbers, on the other hand, may be the reason why a particular bike is chosen to purchase (ie an
order winner). Non-product features may also fall into these categories such as being in an industry where
cheap servicing may be an order qualifier and a money-back guarantee may be an order winner. It is
important to realize that these will be different for different market segments, and will change over time.
5. Achieving Strategic Objectives
11
5.1 CAPACITY AND PRODUCTION
Capacity and Production Logic
Capacity is the maximum output that can be
produced in a time period and is determined by:
• human resource capacity
• machine capacity
• supplier relations
This capacity is allocated to production. However
some is wasted due to factors such as setup times
and breakdowns so the actual amount of product
produced is always less than the total theoretical
capacity. The actual amount of product produced
also depends on the expected demand and the
planned finished goods inventory level.
CAPACITY
AND
Capacity and
Production
Workforce
Capacity
Quality
Cost
Supplier
Relations
Combinations of Plant and Workforce Capacity Required to
Achieve Overall Capacity of 25000 SCU
CAPACITY
70,000
In Mike's Bikes the theoretical capacity is
determined by the Cobb Douglas production
function, which combines workforce capacity and
machine capacity as shown and leads to a
diminishing return for each, if the other is held
constant. i.e. maximum output is when both inputs
are the same. (Both the workforce and machine
capacity are affected by other decisions such as
training, maintenance, numbers of people and the
like but that will be covered later in this section).
60,000
Theoretical capacity is modified by factors such as
the suppliers' ability to deliver raw materials on time
and with acceptable quality levels, and this
43
Machine
Capacity
Responsiveness
Operations and Supply
Plant (Machine) Capacity (SCU)
THEORETICAL
ALLOCATION
• Determine Capacity and Production,
Cost, Quality, and
Responsiveness Objectives
• Select Tactics
Operations
Strategy
Hill, T.J. Manufacturing Strategy: Text and Case,
Irwin, Homewood, IL, 1994.
Page 76
50,000
40,000
30,000
20,000
10,000
0
0
10,000
20,000
30,000
40,000
50,000
Workforce Capacity (SCU)
60,000
70,000
Operations and Supply
theoretical capacity is then divided amongst a
number of productive and non-productive activities
as shown in the slide below to the right. The
resulting production efficiency profile is what is used
later to determine the actual maximum amount of
product able to be produced by the firm.
12
Capacity Allocation
Training
Workforce
Capacity
For any period, a capacity usage chart may be
generated from this that reflects how the capacity
was actually used. It is of considerable interest
when looking at the productive capability of the firm.
The various decisions about setups, batch size,
quality, training, salary, workforce size, machine
capacity, maintenance, supplier relations, and
production of the different products may be used to
improve this profile if necessary.
RM Stockout
Breakdown
Machine
Capacity
Theoretical
Capacity
Rework
Setup
Supplier
Relations
Idle
Productive
Capacity
Operations and Supply
WORKFORCE CAPACITY44
Now we go into more detail on how the factory workforce capacity is determined. First of all the overall
workforce size is set. Then the number of administration staff (general, marketing & sales and production
administration) is determined. The remainder is the factory workforce. The number of general administration
staff required is dependent on your sales volume and batch size; the production administration staff levels
depend on the batch size and production volume; and the marketing and sales staff levels depend on the
number of different products you sell and the
number of distributors selling your products.
15
For both factory and office staff there are 3 main
inputs: number of workers, worker effectiveness,
and the potential capacity of the workforce. Number
of workers is simply the number of people working
and for factory workers potential capacity is the
amount of product that a fully trained workforce
could produce, while for office staff it is the amount
of office work that a fully trained specialist could
process.
Worker effectiveness, in turn, is determined by
motivation and skills and is key to the performance
of the organization. It reflects the view that each
worker's effectiveness is determined by the
equation:
Capacity and Production
- Workforce Capacity
Operations
Strategy
Capacity and
Production
• Determine Capacity and Production,
Cost, Quality, and
Responsiveness Objectives
• Select Tactics
Responsiveness
Workforce
Capacity
Machine
Capacity
# Workers
Worker
Effectiveness
Quality
Cost
Supplier
Relations
Potential
Capacity
Operations and Supply
Effectiveness = Motivation x Skill.
Motivation is determined by salary, job security & training, and skill is determined by starting ability and
training.
The salary of your factory staff and office staff are linked as well as their training. So the salary you set in the
game is the base rate for factory workers while office staff are paid on average twice that amount. The training
level you can set for your workforce also applies to all workers. So the worker effectiveness is always the
same for all of your workforce as you can not pay or train the office staff more than the factory staff or vice
versa.
MACHINE CAPACITY
Now we go into more detail on the how machine capacity is determined.
44
These relationships cover most of the fundamental relationships that lead to worker effectiveness. The main one omitted relates to
the intrinsic motivation that comes from people working on things that interest them and that they feel develops them.
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There are obvious differences between people and machines. However, in modeling these issues there are
also certain strong similarities. There are 3 main inputs - quantity of machines, maintenance (which leads to
machine effectiveness), and the potential capacity of the machines.
Quantity of machines is measured in Standard Capacity Units (SCU). Maintenance is the amount of money
that is spent to maintain machines and will be reflected in both the product quality and the frequency of
breakdowns. Potential capacity is the amount of
18
product that a fully maintained plant can
Capacity and Production
produce.
- Machine Capacity
SUPPLIER RELATIONS
Since the early 1980's, the ideas of Just-in-Time
(JIT) and Total Quality Management (TQM)
have emphasized the importance of developing
strong relationships with suppliers and linking
them into the firm's value chain. This has grown
into the area of supply chain management and a
large industry supports the range of software
products and computerized technology that
enable this increased level of operational
integration. SAP and Oracle are examples of
companies that provide ERP (enterprise
resource planning) software.
• Determine Capacity and Production,
Cost, Quality, and
Responsiveness Objectives
• Select Tactics
Operations
Strategy
Capacity and
Production
Workforce
Capacity
Machine
Capacity
Standard
Capacity Units
Responsiveness
Quality
Cost
Supplier
Relations
Maintenance
Potential
Capacity
Operations and Supply
AN EXAMPLE OF CAPACITY AND PRODUCTION
Assume that you have a theoretical capacity of 10,000 adventurer bikes, and with your current batch size,
setups, training, maintenance and supplier relations you have 60% of total capacity available for production.
Assume that you want 2000 units left in finished goods inventory and that you currently have 3000. You
believe that demand will be 6000 units. How much should you try to produce? Do you have sufficient
capacity?
If forecast demand increases to 10,000 units, what are your alternatives?
SOLUTION
Demand estimate of 6,000 units + Ending inventory of
2,000 units = Requirement of 8,000 units.
Requirement of 8,000 units - starting inventory of 3,000
units = production required is 5,000 bikes.
Your effective capacity is 60% of 10,000 = 6,000 bikes,
so you have sufficient capacity.
If forecast demand increases to 10,000 units then
9,000 bikes are required to be produced.
Your 6,000 effective capacity will not be sufficient, so
plant must be increased or temporary capacity brought
in.
CAPACITY IN MIKE'S BIKES
The manufacturing screen is where you enter your
decisions about how you are going to spend your
money on manufacturing process-related costs. There
are two components of operations that are modeled
explicitly in Mike's Bikes - quality and responsiveness,
and these relate naturally to the operations objectives
outlined earlier in this chapter. Changes made to these
areas apply for all the firm's products.
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Operations and Supply
The Responsiveness screen is broken into two parts: capacity and process. The first relates to the amount of
plant that you will use; the second to the processes that you will use.
CAPACITY
On this decision screen you can change the size of the work force and the amount of plant used by your firm.
The shaded boxes labeled "Current" tell you the current level of your Workforce and Plant. Determining
capacity and utilizing it efficiently is an important part of managing production as it affects the potential
production and has a large effect on total cost.
Overall factory capacity is determined by the plant (machine) capacity and the number and effectiveness of
the workers. However, effective capacity will prove to be less than this because of various wastage factors.
Decisions regarding manufacturing process will determine the level of the various wastage factors. A factory
efficiency of about 70%-80% is very good.
Your factory is potentially operational for 8 hours x 5 days x 50 weeks per year. There is no shift work nor
overtime. Besides working on your factory efficiency, the only way to alter your factory capacity is by changing
the size and effectiveness of your workforce, and the amount of plant you have. Workforce size can be
changed very quickly, but a change in plant size takes a year before it is completed. Funding a large
investment in plant will require additional capital to be found. A share issue and/or an increase in long-term
debt may be required.
Capacity may be lost to:
Wastage:
• Rework - time spent reworking units
instead of producing units.
• Breakdowns
line
stoppages
because of plant breakdowns.
• Raw Material Stock outs - line
stoppages due to unavailability or
poor quality of raw materials
• Setups - stoppages due to having to
perform machine setups.
Training:
• Training - time lost because of
worker involvement in training or
improvement groups.
The Manufacturing Capacity Usage report above shows the way capacity was used in the previous period.
The Responsiveness report under the Operations section of the Reports menu gives further detail.
STANDARD CAPACITY UNITS
The factory capacity required to
Product 1
Product 2
Total
produce the target volumes of
20,000
10,000
Desired Production in Units
products can be determined using
1
3
SCU per Unit
standard capacity units (SCU)
20,000
30,000
______
Required Capacity in SCU
which is a standard term in
50,000
Required
Capacity
for
2
products (SCU)
production to represent a unit of
30,000
Plus Wastage Estimate (SCU)
work on a product. Each product
80,000
Overall Required Factory
requires a certain number of SCU
Capacity (SCU)
to produce, and typical products
are in the range of 0.1 - 2 SCU per bike depending upon the product specifications and the degree of cost
reduction incorporated in the design. The rule is that for each $300 of product prime cost, a product requires 1
SCU to produce. For example RockHopper has a product prime cost of $300 so it requires exactly 1 SCU for
every unit produced in a given period. The example in the table demonstrates how overall capacity
requirements can be determined with this information.
Worker and plant capacity can be used in a variety of combinations to produce the same amount of factory
capacity, and the optimum level of capital and labor intensity will depend upon a number of factors.
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WORKFORCE
You can increase or decrease the size of your workforce each period. A portion of your workforce is
automatically assigned to the office staff roles of administration, production administration and sales while the
rest of your workforce is available as factory workers. This means that if your sales volume increases, or your
batch size reduces then it is likely that you will require more office staff which will reduce your available factory
workforce. So you need to monitor your factory workforce capacity, because even though you have a constant
sized workforce more and more of your workers may be being assigned to office work. Factory workers (if an
equal level of plant capacity is available) can contribute a maximum of 625 SCU of capacity each per period
depending upon their skill levels and motivation levels, and this affects the overall factory capacity of the firm.
However at the start of the first period all of factory and office staff will be able to produce roughly half (370
SCU) of their potential maximum capacity. The average annual factory worker wage cost is $25,000 while
administration, production administration and sales staff get on average twice this amount. It also estimated
that it costs $4,000 to hire a new person, and $4,000 to make one redundant.
PLANT
Plant can be purchased or sold each period in multiples of 100 SCU. Each 100 SCU of plant costs $16,000 to
buy, and any new plant takes one period to be commissioned and to become productive. Plant is depreciated
in the annual accounts using the diminishing value method, at a rate of 20% per annum.
Plant can be sold at the end of any period. However the selling price will depend upon the age of the plant and
how well it has been maintained, as is described below under the Preventative Maintenance decision. If
there is any difference between the actual selling price of plant and its book value then that will be reported in
the accounts as either a loss or gain on sale.
PRODUCTION VOLUME IN MIKE'S BIKES
This screen allows product-specific decisions to be made. The
Modify, Launch and Abandon features are explained in the
Marketing chapter. However, the Marketing and Production screen
requires more explanation.
MARKETING AND PRODUCTION
Clicking on this button allows you to determine
the quantities of product to produce and to plan
the desired safety stock (inventory level). The
Make/Sell screen is where you set the levels of
selling price, advertising, target production
volume and target finished goods stock levels
for a particular product.
PRICING
A price decision must be made for each
product. This is the retail price paid by the final
consumer. The distribution channel keeps a
certain percentage of this and passes the
remainder on to you. This is described more
fully in the chapter describing the marketing
issues.
ADVERTISING
The expenditure on advertising for each product must be decided. This is also described more fully in the
chapter on marketing.
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Operations and Supply
PRODUCTION VOLUME
For each product a target level of production for the year must be set. The following formula provides one
means of considering this:
Target Annual Production
= Sales Forecast - Beginning Finished Goods + Desired Ending Finished Goods
The target level of production is only a desired level of production. Actual production levels during the year
may vary slightly from this depending upon:
•
Capacity Constraints - If insufficient capacity is available due to lack of workers/plant or wastage
such as breakdowns or reworks then actual production may be less than target production.
•
Variations in Demand - If demand is substantially greater than forecasted then the factory may
increase production slightly to take advantage of this. Similarly if demand proves to be extremely low
it may be able to reduce production to prevent production of excessive finished goods stocks. The
maximum production flexibility is a variation of 50% up or down on the planned figure.
TARGET FINISHED GOODS INVENTORY
As well as a target production level for each product a target finished goods inventory level should be set. This
inventory level is set in weeks of demand and thus the actual holding in units will vary depending upon the
levels of demand. This is similar to the production decision, in that it indicates only a desired level of finished
goods. Actual finished goods inventories may vary depending upon the demand for the product and actual
production levels. For example if demand outstrips production then a firm may be left with no stock in its
finished goods warehouses despite desiring to hold a month's worth of inventory.
The target finished goods inventory decision is important as these goods are held in warehouses throughout
the country and hence can be used to significantly reduce the delivery time to distributors. However, there is a
warehousing cost of around $100/unit of finished goods inventory. If there is no finished goods inventory then
delivery time depends upon the factory lead time, so firms with long lead times may choose to hold large
finished goods inventories to improve their delivery responsiveness.
Delivery time advantages must also be traded off against the cost of warehousing goods and the implicit cost
of financing them.
Notes:
• Production will adjust up or down somewhat depending on demand and overall production capacity.
• The planned safety stock level indicates how much stock you would like to keep to cope with
fluctuations in demand.
5.2 RESPONSIVENESS - DELIVERY AND FLEXIBILITY
Some customers will wait for their product and
some will not. Depending on the requirements of
the customer, an organization must plan to be
responsive enough or lose the business.
Responsiveness (sometimes called delivery
time) depends on a variety of things, and most
importantly by the balance of demand and
supply. Supply from a firm will be determined by
its productive capacity and those issues
described in the section above.
Responsiveness
Logic
25
• Determine Capacity and Production,
Cost, Quality, and
Responsiveness Objectives
• Select Tactics
Operations
Strategy
Capacity and
Production
If demand is drastically higher than the
maximum possible capacity, the only way that
responsiveness can be made reasonable is by
obtaining
extra
capacity
(either
by
subcontracting or by direct investment in
capacity expansion), or by holding extra stock.
Capacity
Responsiveness
FG Stock
Level
Product
complexity
Quality
Cost
Mfg
Leadtime
Number
of products
Batchsize
Setup time
Operations and Supply
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MIKE’S BIKES – Integrated Business Learning Online
Other demand management strategies can also be employed such as raising the product price.
If, however, demand and theoretical capacity
are closer, then a number of the techniques of
Just-in-Time
(JIT)
and
Total
Quality
Management (TQM) may be employed to
increase available capacity closer to the
theoretical
maximum
to
improve
responsiveness.
27
Production Leadtime Equation
Leadtime =
The responsiveness of the organization
depends upon Finished Goods Stock level and
manufacturing lead times. Techniques to
increase responsiveness include:
• product redesign to reduce the
complexity of the product,
• reducing the product line so
that only the higher margin
products are produced,
• reducing the batch size used in
production,
• and reducing the setup time so that the
available capacity.
(SetupTime + BatchSize × UnitRunTime) × ScalingFactor
Products
Runtime is based on the runtime for a product with 1 SCU
Setup time is expressed as a ratio of setup time to runtime
Investment in setup reduction reduces that ratio
Operations and Supply
benefits of smaller batches are not offset by less
These relationships are shown in the slide to the right.
AN EXAMPLE OF A LEADTIME CALCULATION
Assume that you are producing one product. Assume that the total setup time for all the machines required to
produce one batch = 25 hours; batch size = 500; total runtime/unit (over all machines)= 1 hour; you have 1000
hours available/week. Assume a scaling factor of 2 to account for scheduling inefficiencies. What is the
leadtime for this batch? How many units are produced in one week?
SOLUTION
Leadtime = (25 + (500 x 1)) x 2 =1050 hours are required. Available capacity is 1000 hours. Total lead time =
1 week approximately. The capacity with this batch size is approximately 475/week (1000/1050x500).
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
400
0.00
300
Leadtime refers to the time taken for an order to
get through production and so can be a major
determinant of delivery time. This graph shows
the relationship between leadtime and batch
size. The smaller the batches the more quickly a
typical order will get through the plant.
1.80
200
LEADTIME,
LeadTime
2.00
100
RELATIONSHIP
AMONG
BATCHSIZE AND SETUP TIME
Production Leadtime vs Batch Size
Production Leadtime (weeks)
The issue of flexibility is fundamentally
associated with the product design and the
ability of the plant to manufacture the required
product mix. Often there is a trade-off between
delivery and flexibility i.e. the more flexible the
organization is in terms of what it can provide,
the longer it takes to deliver. Similarly, the
shorter the delivery time, the less an order can
typically be customized.
Batch Size (units)
On the other hand, reducing set up time does
not have much bearing on lead time. For many organizations reducing setup times significantly will involve
investment in computerized machinery and so is not taken on lightly. If it can be so expensive why is it
considered at all? The key to this is to consider the capacity implications of making lots of small batches. Lots
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Operations and Supply
of capacity is “wasted” on setups, reducing the capacity available for production. If this capacity is not
sufficient to meet demand, then delivery times will increase markedly.
RESPONSIVENESS IN MIKE'S BIKES
Decisions on the operations process are also made on the Responsiveness screen.
BATCH SIZE
Batch size reflects the average batch size used within the factory. Larger batch sizes will proportionately
reduce the number of setups and hence increase available capacity. However this comes at the cost of
increasing factory lead time and potentially delivery times. The other main effect of batch sizes is on the
number of administration and production administration staff. Large batch sizes make production scheduling
relatively simple but small batch sizes increases complexity and requires more production administration staff.
Batch sizes also affect the number of administration staff required, once again large batches require little
accounting type processing time while lots of smaller batches need more staff to process. So from a human
resources viewpoint, smaller batch sizes require more administration staff which will reduce your factory
workforce unless you hire more staff.
SETUP TIME REDUCTION
Expenditure can also be made on setup time reduction. This includes expenditure on analyzing setup
procedures and developing and documenting new operating procedures. It also includes expenditure on plant
modifications to facilitate quick changeovers.
Investment in setup time reduction will reduce the amount of time spent setting plant up and hence increase
effective capacity (provided batch size remains constant).
We assume that there is a baseline standard time it takes to complete the setup of all the machines required
to make a batch of bikes. By investing in setup time reduction you can reduce this time. Over the last 5 years
setup times have been reduced by 5%, and with the present batch sizes and number of products, each firm is
losing about 10% of capacity on setups.
SUPPLIER RELATIONS
Firms can also choose to direct resources into improving supplier relations. This includes expenditures
directed at negotiating single source contracts,
providing suppliers with demand forecasts and
educating suppliers in JIT and TQM techniques. It
may also extend to paying incentives for supplying
quality products, consulting suppliers when designing
new products and paying increased transportation
costs for more frequent deliveries.
The benefits of investing in supplier relations include
reducing line stoppages due to reduced unavailability
and/or inadequate quality of materials. Current
relationships with suppliers are only about half as
good as they could be. It requires around $30,000 to
maintain supplier relations at this level, otherwise it
will decay with time.
RAW MATERIALS INVENTORY
You must decide upon the average level of raw
material inventories in weeks. As this is based upon
weeks of production, the actual amount will vary with
the level of production. Raw materials inventories
provide a buffer to protect against unreliable
suppliers and to ensure there are sufficient materials
to cover late deliveries. It is estimated that an
average of four weeks raw material inventory will be
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MIKE’S BIKES – Integrated Business Learning Online
enough to ensure that the factory loses only 10% of its time due to unavailability of key raw materials.
However, firms incur a warehousing and implicit financing cost when they hold raw material inventories. There
is an annual holding cost of $47/unit of raw materials inventory. (One unit of raw materials is required for each
$300 of prime cost in a product - ie one unit of materials for each SCU. For example, to produce one unit of a
RockHopper bike requires one unit of raw materials to produce since it has prime cost of $300 and so
requires 1 SCU to produce.)
5.3 QUALITY
Overall product quality is a broad
concept including
many different
dimensions. Conformance quality
refers to how well a product meets its
specifications. In this section we will
consider conformance quality only.
Take a mountain bike as an example.
Overall quality could include the level of
customer
service,
delivery
time,
aesthetics etc. Conformance quality
would only be related to things such as
whether or not the wheels were properly
attached, the frame welded correctly etc.
Quality
Logic
34
Capacity and
Production
Responsiveness
Cost
Internal
quality
Quality
Systems
Supplier
relations
Maintenance
Worker
Effectiveness
Operations and Supply
35
Quality Index
INTERNAL QUALITY
Quality Index vs External Defect Rate
1.00
0.90
0.80
Quality Index
Internal quality refers to the conformance
quality of the products produced by the
manufacturing process. A high level of
internal quality can be attained through
staff training, preventative maintenance of
machines and good supplier relations.
These investments will be enhanced by
applying the techniques of Total Quality
Management (TQM) to produce “quality at
the source”. Examples of TQM techniques
are: quality circles, Poke Yoke (foolproofing),
fishbone
analysis,
and
statistical quality control charts.
Quality
Inspection
Conformance quality is an important
determinant of demand. It is often
measured in terms of the warranty rate
and/or customer surveys, and is related
to
• inspection,
• internal processes,
• training,
• maintenance,
• raw material quality.
We separate quality into 2 components internal and external quality.
• Determine Capacity and Production,
Cost, Quality, and
Responsiveness Objectives
• Select Tactics
Operations
Strategy
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
0%
5%
10%
15%
20%
External Defect Rate
The customers’ perception of the external defect rate
focuses on the range between 0-10%defects
Operations and Supply
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Operations and Supply
EXTERNAL QUALITY
External quality is the quality that the customer
sees and could be a result of a high level of
internal quality or simply a thorough QA
inspection of the finished products at the end of
the process. While the customer does not care
how they get quality, external quality is usually
much more expensive due to the rework
involved.
36
Improving External Quality by QA Inspection
External Defect Rate and Quality Index a s Inspection Increases
1.00
External Defect Rate / Warranty Rate
3.5%
A certain proportion of products will have defects
which will be found by the customers after they
purchase the product. These will result in a
warranty claims rate (or external defect rate). In
Mike's Bikes the quality index curve shown
represents the customer satisfaction with
different levels of external quality (as determined
by the external defect rate).
0.90
3.0%
0.80
2.5%
0.70
0.60
2.0%
0.50
1.5%
ExternalDefectRate
QualityIndex
0.40
0.30
1.0%
0.20
0.5%
0.10
50%
45%
40%
35%
30%
25%
20%
15%
5%
10%
0.00
0%
0.0%
Proportion Inspected
Increasing inspection improves external quality
up to a point
Operations and Supply
AN EXAMPLE OF QUALITY CALCULATIONS
Assume the current quality level is: internal quality problem rate is 3.5%; QA inspection level is 15%; external
quality index is 0.67 (warranty rate is 1.3%). To match a competitor you desire a quality index rating of 0.8
(which corresponds to a warranty rate of 0.7%). What level of inspection is required to achieve this? What
other options could you consider?
SOLUTION
Reading from the graph on the right, an inspection level of about 25%-30% would be required to increase
quality to this level. Another option to consider would be improving the level of internal quality by, for example,
investment in a TQM program.
QUALITY IN MIKE'S BIKES
Decisions in this area determine the quality of the
products produced. The gray Previous Period
boxes show the values that were used in the
previous decision making period, and they will be
the default options for this period.
AVERAGE SALARY
The average salary level you set will impact not
only the bottom line but also worker motivation
and effectiveness. Factory workers are paid (on
average) the rate you type in, and administration
staff are paid (on average) twice this rate. For
comparison purposes, the industry average is
$25,000 per year.
TRAINING
You must decide how much time each worker
spends on training. For factory workers this
training includes specific on-the-job skills training,
cross training so that different plant can be
operated, and external training in areas such as
quality methods, teamwork and supervisor skills.
For administration staff this training includes
computer skills, stress management and team
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MIKE’S BIKES – Integrated Business Learning Online
development.
Training has a number of significant impacts. It will decrease capacity directly as workers do this instead of
production. However, training increases the skill level of workers and through the increased effectiveness of
improvement groups can actually increase the level of overall capacity. For office staff it makes them more
efficient so that for a given level of sales or batch size you need less staff. Also, application of quality methods
can reduce the number of defects produced.
However for every worker-hour of training specified in the decision, $30 will be spent on outside trainers and
training materials.
Having employees spend about 40 hours in the year on training says that they spend 2% of their time on
training (since the total working time is 40hrs/week x 50weeks/yr). A cost of $1,200/year/employee would be
incurred for external trainers and training materials in this case. In this industry this is sufficient training for
them to slightly improve their skills, knowledge and effectiveness from what is currently around half of their
potential.
The effect of staff turnover should also be considered when making training decisions as new workers usually
have lower skill levels than existing employees.
PREVENTATIVE MAINTENANCE
You should decide on the total amount to spend on preventative maintenance. This is an aggregate amount
and so should be varied when a firm changes its plant capacity.
Expenditure on preventative maintenance may also have a number of effects. Preventative maintenance
reduces the likelihood of plant breakdown and hence capacity losses and lead time delays. Adequate
maintenance may also serve to maintain the resale value of plant. Finally ensuring the plant is producing
within tolerances contributes towards the reduction of defects.
Currently your firm has 25,000 SCU of plant. If it were new it would be worth $4m, however it is a few years
old and already its book value is only $1.6m. It has been reasonably well-maintained though, and only 5% of
its potential is lost due to breakdowns. Investment of about $600,000/year in preventative maintenance will
keep its operational level (and hence resale value) constant at its current level.
QUALITY SYSTEMS TECHNOLOGY
Quality Systems refers to processes and equipment which ensure quality at the source. It will involve installing
equipment to monitor the manufacturing processes and to pin-point problems before they occur.
INSPECTION
Firms need to decide what proportion of their final production they wish to inspect. Sampling techniques
eliminate the need for 100% inspection so about half of defective finished products can be identified by
sampling only around 10% of products. However, note that the Adventurer segment is quite sensitive to
product quality, so before reducing inspection,
42
make sure that the underlying product quality is
Cost Logic
sufficient.
The cost of inspection is $400 per SCU for
every unit inspected. This is small in
comparison to the cost of servicing warranty
claims. It is estimated that the average
warranty claim costs at least the wholesale
price of the bike concerned.
5.4 COST
Operations
Strategy
Capacity and
Production
There are 4 main determinants of cost as
defined below. The first three are actual costs
and the last is a technique for cost reduction
and general improvement.
• Determine Capacity and Production,
Cost, Quality, and
Responsiveness Objectives
• Select Tactics
Responsiveness
Development
Cost
Quality
Prime
Cost
Cost
Overheads
Process
Improvement
Operations and Supply
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Operations and Supply
DEVELOPMENT COST:
This is the amount spent on the product development project and is basically a research and development
cost. It is usually amortized across the expected life of the product.
PRIME COST OF THE COMPONENTS:
This is determined by the costs of direct labor and materials for the product and is the ongoing direct per unit
cost of making the product.
OVERHEADS:
The overheads are the costs associated with the factory that cannot be directly traced to each unit of product
that you produce (e.g. machine maintenance and production scheduling costs). The techniques of Activity
Based Costing (ABC) relate to better ways of allocating these. Often overhead cost reduction is viewed as a
trade-off against improved quality or responsiveness. However this view has been increasingly challenged
over the last decade. Which leads on to...
PROCESS IMPROVEMENT (VALUE ENGINEERING):
Process improvement is not a cost. It is a way of reducing costs by ongoing investment in the improvement of
the production process - as is supported by TQM and JIT initiatives. In Mike’s Bikes this can be either
product-specific (through a product development project), or factory-wide (through quality systems investment
, reorganizing batch sizes, increased training and many others). The result of such initiatives may be
increased overheads in one area but reductions in
Expenditure Required for Prime Cost
another. For example, increased quality systems
Reduction
investment, but reduced rework and warranty costs.
$3,000,000
AN EXAMPLE OF CALCULATING COST
Assume that the original prime cost of your product
is $200 and that the cost reduction curve is as
shown. You invest $500,000 in a process
improvement project for this product. What will the
new cost be?
Expenditure Required
$2,500,000
$2,000,000
$1,500,000
$1,000,000
$500,000
$0
SOLUTION
Reading from the graph indicates that a $500,000
investment will lead to a 25% decrease in cost.
Hence the new prime cost will be $150 (i.e. 75% of
the original prime cost).
COST IN MIKE’S BIKES
In Mike’s Bikes the product development cost, prime
cost, and product-specific process improvements occur
in the product development screen. Most other
overheads are a result of decisions made in the
Operations area and covered earlier in this chapter.
6. Ongoing Strategic Control
For any period, the capacity usage chart presented
above, reflects how theoretical capacity was actually
used. It is of considerable interest when looking at the
productive capability of the firm.
By looking at the various measures on this chart, an
organization is able to monitor its operations.
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($500,000)
50%
70%
90%
% of Full Prime Cost
110%
130%
MIKE’S BIKES – Integrated Business Learning Online
The various decisions on setups, batch size, quality, training, salary, workforce size, machine capacity,
maintenance and supplier relations, production of the different products may all be used to improve its
capacity profile.
7. Questions to Assist Learning
7.1 QUANTITATIVE QUESTIONS BASED ON SOLOMIKE
The following questions deal with information contained in the workbooks OPERATE.XLS and
ACCOUNT.XLS found in the directory where you installed SoloMike (usually C:\MikeBike\SoloMike). Copy
these spreadsheets to another directory to use for this assignment. Before starting each question, remove the
protection from the relevant worksheet(s) by choosing Protection\ Unprotect Sheet from the Tools menu. This
allows you to use data tables and add graphs to the sheet.
For the purposes of this assignment assume that your firm has decided to “consistently produce a bike that is
considered the best value for the Adventurer segment” and the management team is assessing ways of
implementing this in the operations area. The long-term overall plan is to double sales and production
volumes to 30,000 units, reducing unit costs and being able to lower prices, while still earning a good profit.
Assume also that someone in the firm has put together this spreadsheet model of the SoloMike bike industry.
1.
Capacity
The most obvious requirement of the firm’s strategy is to increase the factory capacity to produce 30,000
units. It is important, however, that cost reductions from economies of scale are found wherever possible.
Consider the production capacity model included in the worksheet PRODUCTION VOLUME.
a) [Basic] It is planned to reduce the capacity required to produce your firm’s bike from 1 SCU
(currently) to 0.75 SCU per bike. How many SCU will be required to produce of these 30,000 bikes
(ignoring rework, setups etc) ?
b) [Basic] List the current workforce capacity, plant capacity, theoretical capacity (cells B63, B64 and
B65 respectively). Assuming the efficiency level of 63% is maintained, what overall factory capacity
would be required? By how much does the workforce capacity and plant capacities need to be
increased? (assuming you keep balanced capacities of plant and workforce). How many extra
factory workers will be required (assume that worker efficiency remains constant, and that the
maximum potential per worker is 625 SCU) ?
c) [Basic] The cost of new plant is $160,000 per 1000 SCU, and the annual average wage cost is
currently $25,000 per worker. Roughly how much will be required to purchase new plant? By roughly
how much will the annual wage bill increase?
d) [Integrating] Aware that different combinations of workforce and plant sizes can be used to achieve
the same level of factory capacity (i.e. 35,714 SCU), the team decides to investigate the costs of
different combinations. Use the table of workforce capacities and plant capacities provided and
calculate the total costs if the annual cost of plant is roughly $30 per SCU ($24 depreciation + $6
maintenance). Graph the cost of curves and state the combination of plant and workforce you would
choose to achieve a factory capacity of 35,714 SCU. (Remember to Unprotect the sheet so that you
can add the graph.) What other factors might you take into account?
2.
Responsiveness - Production Leadtime & Setup Time
Since the Adventurer segment is not that sensitive to slow delivery, it is tempting to ignore this area. However,
it is worth investigating the influence of batch size on setup time and production lead time. Consider the lead
time model presented in spreadsheet LEADTIME.
a) [Basic] Use data tables (templates provided) to create charts showing how sensitive production lead
time (in weeks) is to changes in the following factors:
•
Setup time reduction (cell B25)
•
Batch size (cell B26)
•
Product complexity (cell B45)
•
Number of products produced (cell B44)
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Operations and Supply
b)
c)
d)
e)
3.
To make the graphs comparable, ensure that the same scale is used for the vertical axis (lead
time).
[Basic] You should have found that production lead time doesn’t change much as setup time is
reduced. The 'SetupTime:RunTime Ratio' (cell B58) is a measure of the proportion of time spent on
setups and hence the capacity lost to setups. To investigate how this varies with batch size, create a
new chart which shows how sensitive SetupTime:RunTime Ratio is to changes in batch size. What
conclusions can you draw from this chart about the relationship between batch size and capacity lost
to setups?
[Integrating] What observations can you make from these graphs regarding the relationships
between batch size, product complexity, setup time, & lead time? Are these consistent with what you
have learned about JIT?
[Integrating] With setup time currently taking about 10% of factory capacity (see PRODUCTION
VOLUME cell B122) it is decided to investigate reducing increasing batch size from 200 to 600.
What does the setup time proportion reduce to? Switch to the DELIVERY sheet and investigate the
effects of the longer manufacturing cycle/lead time. What say demand outstripped supply so that
stocks run out? Try increasing demand (PRODUCTION VOLUME cell B58 & DELIVERY cell B35) to
22,500. What would the delivery lead time and delivery index be? Is the adventurer segment highly
sensitive to delivery time? Do you think that the given delivery would be acceptable?
Finally, restore the batch size to 200 (LEADTIME cell 26) to 200, and demand (PRODUCTION
VOLUME cell B36) to 15,751.
Quality
Since the adventurer segment is highly sensitive to quality, the quality level is important. It has been decided
not to attempt to have the best quality in the industry, but to maintain the level of quality required for an order
qualifier. This has been estimated at a 1% external failure/ warranty rate. To help clarify the best course of
action in the long run, the team decides to compare increasing inspection with increasing investment in quality
systems.
a) [Basic] Explain the following terms: rework rate/internal defect rate, warranty rate/external defect
rate, quality index. What is the current level of each of these?
b) [Basic] Use Goal Seek to find the level of inspection (cell B29) required to achieve the target 1%
external failure rate (cell B59) (assume the existing level of investment in quality systems). If
inspection costs $400 per SCU inspected, and your future production is about 22,500 SCU, how
much would this level of inspection cost? The factory manager points out that any new plant
purchased has no quality systems. Calculate the additional investment required to add the level of
quality systems found in cell B39 to 10,000 SCU of new plant.
c) [Basic] As an alternative to raising the level of inspection, the management team considers reducing
inspection to 5%, and instead raising the level of investment in quality systems. As an indication, use
Goal seek to find the level of investment in quality systems (cell B28) that would be required in the
next year (with your existing plant size) so as to achieve a 1% external failure rate (cell B59)
(assuming 5% inspection (cell B29)). What is the accumulated level of investment in quality systems
per SCU (cell B39) ? Also find the cost of inspection in this situation (assuming 22,500 unit sales).
d) [Advanced] In part (c) you found the accumulated level of investment (cell B39) required to achieve
1% warranty rate when inspection is 5%. Calculate the additional investment required to add the
level of quality systems found in part (c) to 10,000 SCU of new plant. Add this to the amount found in
(c) to find the total investment required to achieve the required level of quality systems in the factory
(both new and existing plant). If maintaining that level requires 5% (of cell B39) investment per year,
calculate the required on-going investment for a plant of 35,000 SCU
e) [Advanced, Integrating] Assume that maintaining the level of quality systems found in (b) costs
$180K per year. Assuming that you are expanding plant capacity to 35,000 as in (c) but maintaining
production at 22,500 as in (b) would you recommend increasing inspection or increasing investment
in quality systems? Why?
f) Finally, restore the level of inspection to 15% and investment in quality systems to $150,000 while
you complete the remainder of the assignment.
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MIKE’S BIKES – Integrated Business Learning Online
4.
Cost
Key to the success of the firm’s strategy will be the your ability to find economies of scale and keep costs
under control as the factory capacity is expanded. Labor Overhead in particular is very high. The factory
manager explains that all the following are counted as labor overhead: having too many workers, worker
effectiveness below 100% (currently only about 56% of potential); and non-value-added activities in the factory
such as breakdowns, setups, rework, etc. A full breakdown of the Labor Overhead is given on the Factory
Overhead Allocation Rates report. It is worth considering if most of the increase in workforce capacity can be
achieved by internal productivity gains rather than by hiring more staff.
To complete this question you will need to refer to the workbook ACCOUNT.XLS in addition to
OPERATE.XLS.
a) [Basic] Direct Costs. Currently the direct prime (labor and material) cost of RC_RockHopper is $300
per unit. Calculate the current cost of manufacturing 15,588 units (compare to the Cost of Goods
Manufactured on the COGM sheet of the ACCOUNT workbook). It is planned to reduce the unit
prime cost to around $225. Calculate the cost of manufacturing 30,000 units @ $225. How much
would this prime cost reduction save per year?
b) [Basic] Overheads. Look at the Overhead Allocation Rates sheet of the ACCOUNT workbook and
identify current overhead costs above $150,000. Which of these could/will grow significantly as the
factory is expanded?
c) [Integrating] Overhead growth: Consider the PROFIT & LOSS sheet of the ACCOUNT workbook.
We want to identify how much the factory operations overheads could grow. Assume that sales
revenue and direct costs will grow by 50% and that the following overheads will increase by the
same proportion: All of the Selling and Distribution expense except for Advertising, Branding and
Product Development, and the total Administration expense. What is the current total of these
overheads and how much would they increase to? Using the OVERHEAD ALLOCATION RATES
sheet of the ACCOUNT workbook, assume that the plant will increase in size by 40% and that the
following overheads will increase by the same proportion: maintenance, setup reduction, quality
systems, depreciation. What is the current total of these overheads and how much would they
increase to? Using the OVERHEAD ALLOCATION RATES sheet of the ACCOUNT workbook,
assume that the workforce will increase in size by 17% and that all of the labor overheads except
inspection will increase by the same proportion. What is the current total labor overhead excluding
inspection costs and how much would it increase to?
d) [Integrating] The largest single overhead - Labor Overhead: Consider the worksheet TRAINING of
the OPERATE workbook. As an alternative to hiring more staff, the team considers substantially
increasing training (currently costing $102,000) for one year so as to lift the skill rating (cell B54) and
worker effectiveness (cell B57) to a higher level. (Training could then return to previous levels).
What level of worker effectiveness is required to achieve a workforce capacity of 30,000 given your
67 factory workers and that each has a maximum potential of 625 SCU? Use goal seek to find the
level of training required to achieve this level of worker effectiveness. How much extra would this
training cost (cell B60) over the original level of training? How much would be saved on salaries for
the extra people who would otherwise have to be hired assuming that they worked at the current
worker effectiveness of 0.564 ?
5.
Bringing all this together
Having looked at each of the areas of Capacity, Responsiveness, Quality, Cost in relative isolation, we now
bring them together to see the effects. To avoid leftovers from previous questions, open a clean copy of
OPERATE.XLS.
a) Select the PRODUCTION VOLUME worksheet. Copy existing production capacity allocations (cells
B119-B125) and use Paste Special to paste the Values to cells D119-D125 for future reference.
b) [Integrating] Here we are going to move forward 2 years to when the new plant has been purchased
and is coming on-line. Move to the worksheets indicated and enter the following values into the cells
indicated: MAINTENANCE: Maintenance (cell B20) $700K, PlantSCU(t-1) (cell B31) 35,000, Value
of Plant Purchased (cell B32) $1.6m; TRAINING AccumTraining(t-1) (cell B38) 570; PRODUCTION
QUALITY Quality Systems Inspection (cell B29) 18.9% and Quality Systems Investment to (cell B28)
$1m; LEADTIME BatchSize (cell B26) 600, SCU (cell B48) 0.75; PRODUCTION VOLUME Planned
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Operations and Supply
production units (cell B26) 30,000, Demand (cell B58) 30,000, DELIVERY Demand (cell B35)
30,000.
c) [Integrating] Select the PRODUCTION VOLUME worksheet. Have we achieved the capacity to
produce 30,000 bikes? Select the QUALITY worksheet. Have we achieved the 1% external defect
rate? Select the DELIVERY worksheet. Have we maintained a reasonable delivery time and delivery
index? (Yes, SCU required = 22500, SCU available after wastage is 22827; Yes, external defect rate
is 0.93%, lower than 1.0% due to the effect of increased training; Yes, 100% delivery.
d) [Integrating] Cost: Open the ACCOUNT workbook and look at the PROFIT & LOSS and
OVERHEAD ALLOCATION RATE sheets to see how the overheads have increased. How do they
compare with the estimates in part (c) of the Cost question in the section above?
e) [Integrating] Which aspect (capacity, responsiveness, quality, or cost) would you want to revisit the
most? Why?
7.2 QUALITATIVE QUESTIONS (APPLICABLE TO SOLOMIKE OR NETMIKE)
1.
Write a draft operations plan for the Mike’s Bikes environment for the next 2 years. (2-3 pages).
This should include a consideration of the following issues and can be in bullet form. (Make sure
that you think about consistency - among themselves, with the overall strategy, and with the
marketing and finance strategies.) Give your objectives, reasons, and tactics in the following
areas
a) For production? Why? What decisions will you make in the areas of capacity, training, maintenance
to support this objective?
b) For quality? Why? What decisions would you make in the areas of inspection, training,
maintenance, to achieve the quality objective?
c) For cost? Why? What decisions would you make in the areas of design to achieve the cost
objective?
d) For responsiveness? Why? What decisions would you make in the areas capacity, production, batch
size and setup time to achieve the responsiveness objective?
2.
Write a draft training and development plan for the Mike’s Bikes environment for the next 2
years.This should relate to an organization of around 80 people (unless another size is more
appropriate) and can assume that there are three levels: senior management, first line supervisor
and front-line staff. There are also the functional areas to consider. Your plan should consider
things such as the following.
a)
b)
c)
d)
e)
f)
3.
What levels of employee would you expect in the organization? Would these vary by function?
What would be the training and development activities that they should do.
How much would these cost? (Direct cost and opportunity cost?)
How much profit will they generate per dollar of cost?
What is your plan, how much will it cost and how much extra profit do you think that it will generate?
Is this consistent with the other plans that are in place?
Write a draft maintenance plan for the Mike’s Bikes environment for the next 2 years. This should
relate to an organization of around 80 people (unless another size is more appropriate) and can
assume that the main machines and layout are as indicated. Your plan should consider things
such as the following.
a) Which machines would you focus on.
b) What would be the types of maintenance activities that would be required and how would you
schedule these?
c) How much would these cost? (Direct cost and opportunity cost?)
d) How much profit will they generate per dollar of cost?
e) What is your plan, how much will it cost and how much extra profit do you think that it will generate?
f) Is this consistent with the other plans that are in place?
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MIKE’S BIKES – Integrated Business Learning Online
4.
Write a draft quality plan for the Mike’s Bikes environment for the next 2 years. This should relate
to an organization of around 80 people (unless another size is more appropriate). Your plan
should integrate the training and development, and maintenance plans and consider things such
as the following.
a)
b)
c)
d)
e)
f)
Which operations would you focus on?
What would be the main measures that you would use?
How much would these cost and so what is the cost of quality?
How much profit will they generate per dollar of cost?
What is your plan, how much will it cost and how much extra profit do you think that it will generate?
Is this consistent with the other plans that are in place?
8. Modifications for NetMike
There is only one area where operations varies significantly between NetMike and SoloMike - the number of
firms is 5, not 2.
9. References
1. Hill, T.J., Manufacturing Strategy: Text and Case, Irwin, Homewood, IL, 1994
2. Schmenner, R.W., Productions/Operations Management - From the Inside Out, MacMillan
Publishing Company, 1993.
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6 ACCOUNTING
While there is reasonable consensus that the major objective of a profit-seeking entity is the maximisation of the
net present value of cash flows (or a similarly-stated goal), there are other important goals such as the welfare of
employees. Furthermore, there is a wide range of goals in any business, relating to its various facets and
activities such as sales, inventory levels, departmental goals and the like. In the ordinary course of events, some
of these goals are bound to conflict.
A well-known example is the potential
conflict between sales and manufacturing.
The factory manager probably prefers long
production runs to promote efficiency and
contain costs. On the other hand, the sales
manager wishes to maximise sales. To keep
his/her customers happy, he/she would like
to be able to interrupt production runs to
meet their needs. Achieving an acceptable
balance among often conflicting goals is the
hallmark of a successful manager. You will
see that the Balanced Scorecard provides a
means of reflecting these separate goals and
facilitating their management. While an
acceptable level of financial performance is
necessary, it is not always sufficient.
3
Shareholder Value
Accounting
Current Profit
ECONOMIC
CONDITIONS
COMPETITORS’
ACTIONS
Demand
Future Profit
Supply
Accounting
operating
decisions
investment
decisions
Business Strategy
Marketing
Strategy
Operations
Strategy
Finance
Strategy
Product
Development
Strategy
Accounting is a systematic means of
Accounting
reporting and interpreting the financial
Copyright 1998
performance of organizations. Its main
purpose is to communicate financial information to interested parties to facilitate business decisions.
Whatever type of organization is considered, financial information will be required on the results of its activities
for a given period of time. The diagram above illustrates the pervasiveness of the function within the Mike’s
Bikes cross-functional framework.
The accounting function is often broken up into management and financial accounting. The former is
concerned with providing all the information required by management to make decisions relating to the
profitability of the firm, while the latter is concerned with satisfying the legal and professional requirements of
the countries in which the firm is operating.
While management accounting can have considerable flexibility in how it deals with the numbers, financial
accounting must follow very specific rules, most of which are required by law. As far as possible, we use the
reports and incorporate the generally accepted accounting principles and reports that you would expect to find
in any firm in a western economy.
Accounting for transactions, that is, the detailed procedures that determine debits and credits and how they
are processed, is not covered because they are increasingly automated and follow standardized procedures
that are not strategic. However, remember that, if they are not working correctly the situation could quickly
become critical.
This chapter covers three major areas. The first sets out the basic elements of cost and some of the more
common terms in product costing, and introduces the notion of cost behavior and contribution analysis. The
second area describes the most commonly used reports for financial measurement and identifies the
interrelationships among these statements. The third area introduces activity-based costing and explains
some of the technical aspects of depreciation. Since the detail is presented in the simulated environment, only
an overview is provided. In addition the spreadsheets in workbook ACCOUNT.XLS provide good interactive
support to the understanding of the accounting dynamics.
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MIKE’S BIKES – Integrated Business Learning Online
1. Learning Outcomes
The presentation of financial data and inter-relationships among the main reports or statements:
• Cost Elements
• Cost Behavior
• Contribution Analysis
• Basic reports:
Gross Margin, Cost of Goods Manufactured, Income Statement, Cashflow, Balance Sheet,
Movements in Equity.
• Economic Value Added
• Product Costing
• Activity-Based Costing
2. A Framework for Accounting
Managerial accounting pervades the organization. Its role is to provide both monetary and non-monetary
information on all aspects of a firm’s operations. As such it links in to all levels of the diagram above.
While financial accounting tends to use historical information, managerial accounting is proactive and forwardlooking, including such roles as forecasting and budgeting.
3. Elements of Cost
There are three basic elements of cost: (1) raw materials, (2) labour, and (3) overhead. Each of these may be
further categorised as direct or indirect. A direct cost may be traced to the product or service. For example, the
amount of metal used in making a bike can be traced to the bike itself and it would therefore be described as
direct materials.
Some costs, while they are conceptually direct costs, may nevertheless be treated as indirect costs. The oil used
to lubricate the bikes once they have been assembled can physically be traced to each bike, but the amount per
bike, and the dollar value thereof is so small that it is not worth tracing the dollar amount of oil to each bike. It is
even more difficult to trace the oil used to lubricate the equipment in the bike assembly area , which is used to
build all Mike’s Bikes. Indirect costs are those that are not traced to the product or service either because it is too
difficult to do so or because it is not worthwhile. For example, the factory manager's salary would be treated as
indirect as it cannot usually be traced to any particular job. However, the line worker's time is usually traceable to
the job and is therefore treated as direct. Overhead items are indirect expenses.
It may be possible to change a particular indirect cost to a direct cost. Consider the cost of electricity for a bike
factory which has only one meter to record the usage. In that situation, the electricity cost must be allocated to
the jobs or products using some appropriate allocation basis e.g. machine time, direct labour hours etc. because
it cannot be traced to the jobs or products. If the firm introduced meters for each machine or process they would
be able to measure how much electricity was used for each job or product, and therefore electricity would be a
direct cost. There are in fact many overhead items that have previously been regarded as indirect which could be
changed to direct costs.
Full cost includes all costs including manufacturing, selling, distribution and administration. Full production cost
includes direct materials, direct labour and factory overhead and excludes the other costs as product costs are
said to "stop at the factory door". Often full cost is used to mean the same as full production cost. Note that for
financial reporting purposes, full cost must only be full production cost; in other words, selling, general and
administrative costs must not be included in the valuation of inventory. For all other internal management
purposes inventory may be valued any way management choose
In addition to the distinction between direct and indirect, costs may
be classified by their nature (e.g. materials) or by the function to
which they relate (e.g. administration). A classification list is
suggested to the right.
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Direct Materials
Direct Labour
Direct Expenses
Indirect Production Overhead
Selling and Distribution Costs
Administration Costs
Finance Costs
DM
DL
DE
IPO
SD
A
F
Accounting
For illustrative purposes, the
above classification has been
applied to sample items from a
bike industry like Mike’s Bikes.
While this classification is
useful for organisational control
purposes, it may not be very
useful to management for
many of the decisions they
have to make. Such decisions
often require consideration of
how costs will change as a
consequence.
Lubricant for assembly equipment
Forms for office computer printer
Interest on bank overdraft
Factory security guard wages
Freight on raw materials
Product advertising
Wages of line staff in assembly
department
Storekeeper wages
Chief accountant's salary
Royalty payment on BikeX
$500
$150
$1,900
$18,000
$5,000
$800,000
$150,000
IPO
A
F
IPO
DM
SD
DL
$22,350
$75,000
$5,000
IPO
A
DE
4. Cost Behaviour
Within a specified time period, some costs vary with respect to changes in activity whereas others are not
affected by the change. For example, an increase in sales volume will give rise to increases in cost of sales,
sales commissions, freight, packaging etc. but there is unlikely to be any change in rent, office salaries,
depreciation on office equipment, cleaning etc. Management accounting attempts to identify cost behaviour using
a classification based on variable costs, fixed costs, semi-variable and semi-fixed costs.
Variable costs are costs that vary in direct proportion to the level of activity (e.g. sales). In contrast, fixed costs
remain unchanged over wide ranges of activity for a given time period. Compare total cost of sales with rent.
A 10% increase in sales volume should lead to a 10% increase in cost of sales but rent will normally remain
unchanged.
Semi-variable costs are those that contain both a fixed and a variable element. An example would be a
salesperson who was paid a base salary plus 5% commission on sales. There is the fixed element (the base
salary) and the variable element (the commission).
Semi-fixed costs (sometimes called step-costs) are fixed for a given level of activity but eventually increase by a
constant amount at some critical point. For example, only one supervisor might be required for up to eight
employees. If a ninth employee is hired, another supervisor is required leading to a jump in the cost of
supervisory salaries.
5. Contribution Analysis
The difference between sales and variable costs is known as contribution. If the selling price of a unit is $10
and the variable cost per unit is $6, then the contribution per unit is $4. If the volume sold is 6,000 then total
sales will be $60,000, total variable costs will be $36,000 and total contribution will be $24,000.
Contribution may be expressed as a percentage of either selling price or sales. In this example, contribution is $4
and selling price is $10. The contribution margin % is 40% being $4 divided by $10 expressed as a
percentage. Alternatively, the total contribution of $24,000 divided by sales of $60,000 is also 40%. Both methods
yield the same answer.
We can assume that the contribution per unit and contribution margin % will remain the same provided that the
selling price and variable cost per unit do not change over a specific range of activity.
Contribution is different from Gross Margin because it is calculated after deducting all variable costs whereas
Gross Margin may still have variable costs to be deducted from it such as sales commissions, wages etc. You
will also see in the statements of gross margin and cost of goods manufactured, that the cost of sales includes
some fixed overhead expenses when calculating Gross Margin. In this case Gross Margin includes some fixed
costs.
Although contribution is a useful concept, caution is needed in its application. The analysis depends on the
accuracy of the classification of costs into their variable and fixed categories. For example, it may be that some
fixed costs may increase with higher production levels as extra administration costs are incurred to handle the
extra purchasing effort required.
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Careful attention to cost behaviour and the identification of all costs and benefits are the major principle in
special decisions. There have been several criticisms of the marginal costing or contribution analysis
approaches. The main thrust of the criticisms is that there are hidden costs that these approaches ignore. Thus,
a firm might be offered $100 for a product that normally sells for $150. Assume that direct material and direct
labour cost $60 per unit, variable overheads cost $20 per unit and fixed costs of $30 are allocated per unit.
Normally the firm would not accept the offer, but this might be a "one-off" offer and the firm might have spare
capacity for the next period. The only costs that change are taken to be the variable costs as the fixed costs are
assumed not to change with the increase in volume. Therefore, the marginal or extra cost to make the product is
$80 ($60 + $20) which will provide a contribution of $20 per unit if the order is accepted. On the surface the order
looks attractive. However, what the analysis overlooks is the fact that acceptance of the order may increase the
administrative burden. Extra materials may need to ordered which will increase the work of the purchasing,
warehouse and accounts payable departments; an extra customer has to be looked after by the accounts
receivable department which adds to their workload; production schedules may need to be revised which adds to
the work of the production manager etc. All of these additional tasks may lead to an increase in the
administrative overhead costs. So why can't these costs be identified at the time the decision is to be made?
After all, the analysis should include all costs.
The reason why all costs are not identified at the start, according to the critics, is because most accounting
systems do not provide sufficient information to enable the hidden costs to be identified; some critics go so far as
to say that the accounting system conceals these costs from decision makers! The problem is caused by
concentrating on cost changes in relation to changes in volume only and ignoring other causes of cost
behaviour. Thus, warehouse costs may be relatively fixed in relation to production volume but they may well have
a strong relationship to the number of deliveries. The costs of the accounts payable department may be fixed in
relation to volume but there may be a strong relationship between the number of suppliers or the number of
components used. It is therefore necessary to consider cost behaviour with regard to other levels of activity
besides volume. This is the basis of activity-based costing which is discussed in the latter part of this chapter.
Activity based costing does provide a means of identifying all the costs involved in a special decision.
Before that however, we describe some of the higher-level reports used by managers.
6. The Basic Reports for Financial Measurement
Five main reports are presented in this
section. Each is given a quick description in
the section that follows. These are:
• Gross Margin (incl. Cost of
Goods Manufactured)
• Income Statement (Profit and
Loss)
• Cashflow
• Balance Sheet
• Movements in Equity
All these accounts link to one another.
Because of these linkages it is useful to look
at them as an integrated set. While the above
statements are useful for reporting the firm’s
financial performance, management need
more detailed information about products and
processes to maintain or improve on these
results.
29
How the main reports link together
COGM,
Gross Margin
Cash Flow
Income Statement
Movements
in Equity
Balance
Sheet
Accounting
6.1 GROSS MARGIN AND COSTS OF GOODS MANUFACTURED
The Cost of Goods Manufactured (COGM) measures the manufacturing cost of each product. It gives a
measure of the manufacturing cost of units that we make. The Cost of Goods Sold (COGS) measures the
cost of manufacturing the goods which we sold. (NB This may not be the same as the COGM because we
may not sell all we make, or we may have a large stock carried over from the previous period which we sell
this period.) Sales revenue less the Cost of Goods Sold gives the Gross Margin.
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Accounting
The three basic elements of cost can be seen in the COGM statement: raw materials used, direct labor and
factory overhead or indirect expenses. Note that the cost of goods manufactured is the same as full
production cost.
AN EXCEL EXAMPLE
Gross Margin & Contribution Margin Report
ProductName
Sales Dollars
RC_Rockhopper
$13,388,350
Opening Finished Goods
Plus: Cost of Goods Manufactured
$606,589
$7,682,286
$8,288,875
$514,518
$7,774,357
Less: Closing Finished Goods
Cost of Goods Sold
GROSS MARGIN
$5,613,993
Total
$13,388,350
$606,589
$7,682,286
$8,288,875
$514,518
$7,774,357
$5,613,993
AN EXCEL EXAMPLE
Statement of Cost of Goods Manufactured
Note: See the Overhead Rates Report for Overhead Allocation Rate calculations.
ProductName
RC_Rockhopper
Total
Materials Costs
Opening Raw Materials Inventory
Plus: Purchases
$0
$3,642,828
$3,642,828
$71,428
$3,571,400
$0
$3,642,828
$3,642,828
$71,428
$3,571,400
$117,266
$117,266
Standard Direct Labor
Direct Labor Efficiency Variance
(due to effectiveness & wage levels)
Direct Labor Cost
$1,020,400
$34,921
$1,020,400
$34,921
$1,055,321
$1,055,321
Standard Direct Labor Hours
Labor Overhead Applied
81,632
$1,871,843
81,632
$1,871,843
61,224
$1,070,000
61,224
$1,070,000
$7,685,830
$7,685,830
Less: Closing Raw Materials
Total Raw Materials Used
Materials Overhead Applied
Labor Costs
Machine Costs
Standard Machine Hours
Machine Overhead Applied
TOTAL COST OF GOODS MANUFACTURED
Unallocated Overhead
$0
6.2 INCOME STATEMENT
The Income Statement is often called the Profit and Loss Report (United Kingdom).
In order for the company to survive long-term it must earn a margin on its sales (ie its sales revenues must be
greater than its expenses). The Income Statement brings together the expenses and revenues for a given
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MIKE’S BIKES – Integrated Business Learning Online
period and gives you the "bottom line" - the
net profit or loss after deducting all the
expenses incurred in earning sales.
Simplified Income Statement
13
Are we making money?
It is important to understand the distinction
REVENUE
$12.8m
between the Income Statement and the
Cashflow Statement (see section below). The
GROSS MARGIN
$5.5m
Income Statement brings together revenues
Less: Selling, Admin and
and costs (strictly, "expenses") for a given
Finance Expenses
$2.0m
period. It does not consider whether the
Other Income
$0.1m
money has changed hands yet for these
items. The Cashflow on the other hand,
NET INCOME BEFORE TAX
$3.5m
measures the flows of cash in and out of the
firm. Consider a sale made on credit to a
Taxation
$1.1m
particular customer. The Income Statement
NET INCOME AFTER TAX
$2.4m
records the revenue even though the cash
may not have been received yet, but the
cashflow ignores the transaction until the
Accounting
money comes in. Consider also a firm that
overestimates demand and produces far more of a product than it is able to sell. The Income Statement will
consider only the cost of the products actually sold, while the Cashflow will record all the money spent to
produce all the units of the product (whether sold or not).
Another important point is that the Income Statement brings together costs and revenues for a particular
period. If it is better to spread the cost over several periods (because the item has a benefit over these
periods), then a portion of the cost will affect each period’s Income Statement. The best example of this in
Mike’s Bikes is the cost of new plant. Obviously the benefit of new plant will be spread over the many years of
useful life of the machines. Spreading this cost over many periods, rather than lumping it all in a single period,
results in an annual expense which is called depreciation. Because this is a factory expense item, it has been
included in the cost of goods manufactured statement. Depreciation on non-factory fixed assets such as office
buildings, delivery vehicles, sales personnel vehicles would appear in the income statement. (Depreciation is
explained more fully later in this chapter).
The income statement below provides more information than the simplified version above, by (1) extending
the Gross Margin report, including all the non-manufacturing expenses such as selling and distribution,
administration and finance, and (2) reflecting net profit after taxation has been deducted. An often confusing
aspect of accounting (and many other disciplines) is the use of different terms or expressions that mean the
same thing. For example, net profit, net income, operating surplus are different terms but in effect are the
same. Other examples are sales, turnover, revenue although the latter may include what we call nonoperating revenue such as interest income. Generally, organizations will choose the format and expressions
that suit them best for management accounting purposes. It is up to the reader to study the terms used by the
particular company to extract their meaning.
The report below groups non-factory items under headings pertaining to selling and distribution, administration
and finance. It is not always clear where particular expenses should be classified. For example, expenditure
on design and development projects has been included under selling and distribution. It could be argued that
a substantial part of this expenditure should be capitalized and included as a long-term asset in the balance
sheet. This type of asset would be amortized over time in the same way as depreciation of plant, buildings etc.
Another item is warranty claims, which the sales manager might argue are the responsibility of the factory
manager. If this view is accepted, they should therefore appear in the cost of goods manufactured statement.
Note the impact of views and judgment on how something is treated.
We reiterate that decisions such as this depend on the individual organization and will vary from one situation
to another.
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Accounting
AN EXCEL EXAMPLE
Income Statement (Profit & Loss)
Revenue
$12,833,300
Less: Cost of Goods Sold
($7,379,239)
GROSS MARGIN
$5,454,061
Selling & Distribution Expenses
Salaries
$200,000
Brand Advertising
$100,000
Product Advertising
$800,000
Distribution Channel Support
$191,727
Warranty Claims
$166,689
Product Development Projects
$0
Sales Of Obsolete Stock
$0
Cost Of Obsolete Goods Sold
$0
$1,458,416
Administration Expenses
Salaries
$300,000
Finished Goods Warehousing
$110,400
Legal Fees
Miscellaneous Expense
Unallocated Factory Overhead
$0
$0
$0
$410,400
Financial Expenses
Interest on Overdraft
$0
Interest on Debt to Owning Company
$0
Interest on Long Term Debt
$144,000
Loan to Owned Company Written Off
$0
Takeover bids premiums and expenses
$0
$144,000
TOTAL OTHER EXPENSES
$2,012,816
Other Income
Interest on Cash in Bank
$94,632
Interest on Loans to Owned Companies
$0
Debt to Owning Company Written Off
$0
Miscellaneous Cash Windfall
$0
TOTAL OTHER INCOME
$94,632
3,535,877
Profit Before Taxation
Less: Income Tax
Plus: Tax Credit
Profit After Taxation
($1,166,839)
-
2,369,038
Dividends Received From Owned Companies
NET INCOME
-
$2,369,038
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6.3 CASH FLOW
In order for the company to survive in the
short-term it must maintain enough cash to
be able to pay its obligations when they fall
due (employees, creditors and shareholders).
The Cashflow Report measures the flows of
cash in and out of the firm.
21
Cash Flow
Operating Cashflows
$2.6m
–Cash flows from your operations
Investment Cashflows
–Cash flows from big operating
It states the cash position of the firm at the
asset sales/purchases
end of the period and how it came about. The
Financing Cashflows
cashflows fall under three major headings:
–Cashflows related to how the firm
(1) operating cash flows, which represent the
is financed by debt & equity
cash portion of income and expenses shown
Net Change in Cash
in the income statement, (2) investment cash
flows, such as the purchase physical assets,
Starting Cash
other companies, disposals thereof and
Ending Cash
related transactions, and (3) financing
cashflows, relating to financing the firm, such
as share issues and repayment of debt For
more on the difference between the Cashflow
and Income Statement see the section on the Income Statement.
$0m
$0m
$2.6m
$3.5m
$6.1m
Accounting
The report follows the following format. First it calculates Operating Cashflows, then Investment Cashflows,
and finally Financing Cashflows. The net sum of these is added to the initial cash balance and this yields the
final cash balance. Its links to the Balance Sheet items representing bank and cash balances of the firm.
Page 100
Accounting
AN EXCEL EXAMPLE
Cashflows From Operating Activities
Cash was provided from:
Sales
Sale of Obsolete Stock
Miscellaneous Cash Windfall
Cash was disbursed to:
Labour Costs
Raw Materials Purchase Costs
CompanyTax previous period
Supplier Relations
Maintenance
Setup Time Reduction
QualitySystems
Training Expenses
Inspection Cost
Workforce Change Cost
Distribution Cost
Advertising
BrandAdvertising
Warranty Claims
Rework Material Cost
Product Development Projects
Legal Fees
Raw Materials Holding Cost
Finished Goods Holding Cost
Miscellaneous Expense
$12,833,300
$0
$0
$2,325,000
$3,642,828
$1,000,000
$30,000
$500,000
$20,000
$150,000
$103,200
$938,964
$60,000
$191,727
$800,000
$100,000
$166,689
$80,126
$0
$0
$7,140
$110,400
$0
OPERATING CASHFLOWS
$2,607,226
Cashflows From Investing Activities
Cash was provided from:
Sale of Plant
$0
Sale of Owned Companies
$0
Sellback of Shares in Owned Companies
$0
Dividends Received from Owned Companies
$0
Loans to Owned Companies Repaid
Interest on Loans to Owned Companies
Cash was disbursed to:
$0
$0
Plant Purchase
$0
Takeover bids (incl. premiums and expenses)
$0
Purchase Share Issues in Owned Companies
$0
Increase Loans to Owned Companies
$0
INVESTMENT CASHFLOWS
$0
Cashflows From Financing Activities
Cash was provided from:
Long Term Debt Raised
Shares Issued
$0
$0
Emergency Equity Injection
$0
Debt Raised from Owning Company
$0
Interest on Cash in Bank
Cash was disbursed to:
$94,632
Long Term Debt Repaid
$0
Shares Repurchased
$0
Withdrawal of Emergency Equity
$0
Debt Repaid to Owning Company
$0
Interest on Long Term Debt
Interest on Loan From Owning Company
Interest on Overdraft
$144,000
$0
$0
Distributions
$0
Share Issue/Repurchase Costs
$0
FINANCING CASHFLOWS
($49,368)
Net Cash Change
Beginning Cash Balance
$2,557,858
$3,500,000
ENDING CASH BALANCE
$6,057,858
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MIKE’S BIKES – Integrated Business Learning Online
6.4 BALANCE SHEET
While the Income Statement and the Cashflow
reports show performance related information
on what happened in the period, the "position"
of the company at the end of the period is
shown by the Balance Sheet.
In very simplistic terms, it lists what the
company owns (assets), and what it owes
(liabilities). Some (non-current) assets are
shown at their original cost less depreciation
while others (current assets) may be shown at
the lower of cost or market value. Assets less
liabilities represent the interest of the
shareholders in the company. It is important to
understand that the balance sheet does not
necessarily reflect up-to-date or current market
values.
TOTAL EQUITY
(share issues + retained profits)
Assets
$8.3m
(cash, inventory/stock, (debtors), plant)
Liabilities
$2.9m
(overdraft, (creditors), long-term debt)
Equity = Assets - Liabilities = $5.4m
Accounting
Balance Sheet
Equity
IssuedCapital
Retained Earnings
$2,000,000
$3,369,038
TOTAL EQUITY
$5,369,038
These funds are represented by:
Current Assets
$71,428
$606,591
$6,057,858
$6,735,877
Non Current Assets
Shares in Owned Companies
Loans to Owned Companies
Plant
Less: Accumulated Depreciation
$0
$0
$4,000,000
($2,400,000)
$1,600,000
TOTAL ASSETS
$8,335,877
Current Liabilities
Overdraft
Tax to be paid
$0
$1,166,839
$1,166,839
Non Current Liabilities
Debt To Owning Company
Long Term Debt
$5.4m
These funds are represented by:
AN EXCEL EXAMPLE
Raw Materials Inventory
Finished Goods Inventory
Cash
25
Simplified Balance Sheet - 1998
$0
$1,800,000
$1,800,000
TOTAL LIABILITIES
$2,966,839
TOTAL NET ASSETS
$5,369,038
Page 102
Accounting
6.5 MOVEMENTS IN EQUITY
27
The Income Statement and the Cashflow reports
summarize the company’s performance in the
period. This (hopefully) results in a profit/surplus
which increases the equity (assets less liabilities)
of the company. But there are other factors that
affect the equity of the company too. Issuing or
repurchasing the company’s shares will
obviously change the equity of the company.
Movements in Equity
The statement of movements in equity
summarizes the changes in equity over the
period - including share transactions and
dividend distributions. It is especially informative
where company share issues and repurchases
are frequent.
Starting equity
+ changes in shares
+ starting retained earnings
+ surplus
- dividends
= Ending equity
$2.0m
$0m
$1.0m
$2.4m
$0m
$5.4m
AN EXCEL EXAMPLE
Accounting
Statement of Movements in Equity
Issued Capital
Issued Capital at beginning of period
Plus: Shares Issued
Less: Share Repurchases
Less: Share Issue/Repurchase Costs
$2,000,000
$0
$0
$0
$2,000,000
Retained Earnings
Retained Earnings at beginning of period
Plus: Net Surplus for Year
Plus: RevaluationOfOwnedCompanies
Less: Dividends To Shareholders
Plus: Emergency Equity Injection
Less: W ithdrawal of Emergency Equity
$1,000,000
$2,369,038
$0
$0
$0
$0
$3,369,038
TOTAL NET EQUITY
$5,369,038
7. Economic Value ADDED (EVA
)
45
Increasing attention has been paid to value creation in recent years, and one of the most widely used
measures of this is EVA. EVA views the business as an investment that must produce a certain return on the
capital invested in it. This view provides valuable information to managers of a single business, and can be
even more valuable in a business that has a number of divisions. To create value for shareholders, capital,
should be managed as effectively as any other resource. Yet many performance measures do not reflect the
full cost of capital, and it does not appear in conventional income or cash flow statements. Before arriving at
EVA, adjustments must be made to the net profit shown in a conventional income statement because only
historical interest is deducted from income to calculate net profit, whereas the full capital charge is deducted
to calculate EVA. A more direct way of doing this is shown in the next section.
45
EVA is a registered trademark of Stern Stewart & Co.
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MIKE’S BIKES – Integrated Business Learning Online
1.
The capital charge is the product of the cost of capital and the dollar amount of all assets that are
financed by equity and interest-bearing debt. There are a few reasons why this charge differs from the
interest charge in the income statement:
2.
The capital charge includes the cost of servicing capital raised by issuing shares or similar instruments
(equity) as well as that of servicing capital raised issuing by debentures, loans or similar instruments
(debt).
3.
The cost ascribed to debt is the opportunity cost, not the actual, historical cost. For example, if the firm
has a ten-year loan that it negotiated at 8% pa, and the ruling rate (representing the return that investors
require today for this instrument) is 10%, the debt portion of the capital charge is 10% before tax, not 8%.
Further, the normal interest paid on operations is allowable for tax, so the cost to the firm is 10% (1-t)
where t is the current tax rate.
4.
The cost ascribed to equity is also an opportunity cost, based on the return expected by equity investors.
It is not difficult to find this out in a small company – ask the equity investors. The return they seek will be
determined by the premium that they require as compensation for the risks investing in this business. For
a large company this may be estimated using the required rate of return on equity as calculated using the
CAPM model (see the Finance module).
5.
Accountants using conventional accounting usually report assets at their historical cost, which most often
does not represent what they are worth. If the company bought a piece of land many years ago for
$50,000, is it worth that today? Perhaps the company could sell it for $105,000 today and receive
$100,000 for it after paying commission and other disposal costs. In calculating the capital tied up by the
company, which is the relevant number - $50,000, $100,000 or $105,000. The best measure of its worth
is $100,000, as that represents the number of dollars tied up in land.
6.
Accountants also frequently exclude items from the balance sheet altogether when there are
measurement difficulties associated with them. The specifics differ from country to country, but may
include items such as research and development (including software development), project promotion or
brand value. While the value of these assets may be contentious, a common sense view would suggest
that they can be extremely valuable. Observation will show that in practice, the shares of a software
company may trade at substantial prices while the balance sheet reflects a low dollar-value for assets.
7.
Finally, a weighted-average of the cost of debt and the cost of equity is calculated to arrive at the capital
charge. For example, if the total equity is $60,000 and total debt is $40,000, (ie total capital is $100,000)
and the cost of each is 20% pa and 10% pa respectively, then the weighted average cost of capital is
16% [(0.6*20%) + (0.4*10%)].
8.
Please bear in mind that the adjustments in general and valuation issues in particular can become
complex – Stern Stewart have identified 160 potential adjustments that may be required to calculate the
capital charge when one is working with conventional financial statements.
AN EXCEL EXAMPLE
Statement of Economic Value Created
Net Surplus
Interest Charge (adjusted for tax)
Net Operating Profit After Tax (excluding interest costs)
Interest Charge (adjusted for tax)
Equity Charge
Capital Charge
$2,369,038
$33,076
$2,402,114
$33,076
$754,350
$787,426
Economic Value Created/Added
$1,614,688
Page 104
Accounting
8. Product Cost
Managers typically want to know the cost of something. In management accounting, anything for which
management requires a separate measurement is called a cost object. The most common example of a cost
object is product cost which may be full production cost or full cost (recall the discussion of elements of cost
earlier). Direct costs can be recorded and accumulated for the product as they are incurred but overhead or
indirect costs need to be allocated to products using some systematic basis that will reflect the way in which
these resources are used by the product.
The simplest way to calculate an overhead recovery rate is to divide the total overhead cost by the volume of
products to be produced in a period and allocate this amount to each unit of product as it is produced. For a very
simple system, the total overhead cost is divided by an allocation base to arrive at an overhead recovery rate. For
example, if for the next 12 months total overheads are expected to be $200,000 and planned production is
100,000 units, then the overhead recovery rate is $2 per unit. As each unit is produced, it is assigned $2 for its
share of overhead.
An example of the Mikes Bikes Overhead Allocation Rate report is shown below.
AN EXCEL EXAMPLE
Factory Overhead Allocation Rates
This report lists the factory overhead costs and calculates the overhead application rates.
Note that the direct costs are based on the product standards (not actuals).
Material Overheads
Raw Materials Warehousing Cost
Relationships with Suppliers
Rework Materials Cost
Total Material Overheads
Total Direct Material Costs
Material Overhead Application Rate
$7,140
$30,000
$80,126
$117,266
$3,571,400
$0.03
($ per DMat$)
$1,871,843
81,632
$22.93
($ per DLHr)
Labor Overheads
Setup Labor
Training Labor
Rework Labor
Other Labor
Inspection
Training Expenses
Workforce Change Cost
Production Scheduling & Administration
Total Labor Overheads
Total Direct Labor Hours
Labor Overhead Application Rate
$179,065
$36,013
$23,677
$380,925
$938,964
$103,200
$60,000
$150,000
Machine Overheads
Preventative Maintenance
Depreciation Expense
Reduction of Setup Times
Quality Systems
Gain On Sale Of Plant
Loss On Sale Plant
Total Machine Overheads
Total Direct Machine Hours
Machine Overhead Application Rate
$500,000
$400,000
$20,000
$150,000
$0
$0
$1,070,000
61,224
$17.48 ($ per DMachHr)
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MIKE’S BIKES – Integrated Business Learning Online
Often unit volume is not a satisfactory allocation base when there are multiple products with different production
scales (e.g. units, kilograms, litres) or when the resources required differ from one unit to another. Consider for
example, a firm producing paint. A litre of one type of paint may only involve filling a one-litre can from a vat.
Another type of paint may require blending and mixing to produce one litre. Obviously the second paint uses
more resources than the first but if volume is used to allocate overhead, the same amount per litre will be
allocated to both products.
Other commonly used bases are direct labour hours, direct labour cost, machine hours, direct materials used;
these are all volume-based or unit-level measures. Although they may reflect some of the overhead cost
behaviour, it is extremely unlikely that they will reflect all overhead cost behaviour. Activity based costing
attempts to reflect the consumption of resources by identifying what drives particular costs. For example,
warehouse costs might be driven by the number of deliveries received per period or by the bulkiness of the
materials. The number of deliveries would be called an activity cost driver.
Regardless of the base or activity cost driver selected, the formula for calculating the overhead rate is the same.
It is:
Overhead to be Recovered
Allocation Base
In the example above, overhead is $200,000 and planned production is 100,000 units.
$200,000
= $2.00 per unit
100,000 units
Alternatively, if direct labour hours is used and the estimated total direct labour hours for the coming period is
400,000
$200,000
= $0.50 per DL hour
400,000 DL hours
Provided the actual production units or labour hours turns out as estimated, $200,000 will be charged to products
for overhead recovery regardless of the driver selected. It must be emphasised that simply allocating overheads
to products does not in itself recover cost – only receiving cash from sales does that! However, the use of
simplistic methods of overhead allocation has become a major object of criticism by managers of management
accounting systems.
Production cost of RC_RockHopper (traditional cost system)
$
233.33
Materials
Materials overhead
$0.03 per DMat$
7.66
Total materials cost
5.33 DLHr * $12.93
68.95
Direct labor
Labor overhead
$22.93 per DLHr
122.29
Total labor cost
Machine overhead
Machine overhead
4 DMachHr * $17.48
69.92
Machine overhead costs
Total product cost
Page 106
$
240.99
191.24
69.92
502.15
Accounting
9. Activity Based Costing
Activity Based Costing (ABC) has arisen because of growing criticism of traditional costing methods and in
particular with the ways in which overheads were allocated to products and services. The dramatic changes in
production methods and services provided over the latter half of the twentieth century resulted in enormous
increases in overhead costs. At the same time, traditional allocation bases such as direct labour have been
declining in significance. For many firms the result has been serious distortions in product costings, leading to
incorrect strategic decisions. (Examples of these include: proliferation of product components as engineers
attempt to reduce the direct labour content in the production process; expansion of product lines as the cost
accounting system fails to reveal the extra cost of added lines; and movement away from a firm's mainstream
products to more complex short run products encouraged by an accounting system that conceals crosssubsidisation amongst products.)
Activity-based costing focuses on activities and how these activities are consumed by products during the
production process. It does this by measuring the cost of the activities, identifying what drives these costs, and
tracing the costs through to individual products according to their consumption of the cost drivers. It therefore
uses multiple cost drivers as a means of attributing overhead costs to activities and to products. Most activities
can be classed as unit-level, batch-level, product-sustaining, or customer-sustaining depending on whether they
are primarily performed on each unit (eg machining), batch (eg setup), etc. Remaining activities might be
regarded as company-sustaining, ie required to keep the company going no matter how many products are sold.
Conceptually, we would identify activities and appropriate resource drivers in order to trace or allocate
expenses to activities. In the next stage, appropriate activity drivers would be identified and selected to
allocate activity cost pools to products.
Mike’s Bikes provides a report listing potential cost drivers and their levels for many of the production activities.
This allows you to construct your own ABC system. Later versions of Mike’s Bike will include a simple ABC
system using some of these drivers. This system may classify the activities something like the following example:
Activity Based Costing - Cost Driver Rate Calculation
Unit level
Batch-level
Product-sustaining
Activity
Possible Cost Driver
Raw materials warehousing
Average RM stock units
Finished goods warehousing
Average FG inventory units
Relationships with Suppliers
Raw materials used
Training
Direct labor hours
Idle (incl Raw Material Stockout and Breakdowns Direct labor hours
$381,090
81,621
$4.67
Rework
Units reworked
$103,789
343
$302.59
Inspection
Units inspected
$938,841
2,347
$400.00
Warranty claims
Number of claims
$166,667
196
$850.00
Workforce change cost
Direct labor hours
$60,000
81,621
$0.74
Preventative maintenance
Direct machine hours
$500,000
61,216
$8.17
Depreciation on plant
Direct machine hours
$400,000
61,216
$6.53
Quality systems
Direct machine hours
$150,000
61,216
$2.45
Setup
Number of batches
$179,042
78
$2,288.46
Production scheduling
Number of batches
$150,000
78
$1,917.26
Reduction of setup times
Number of batches
$20,000
78
$255.63
Product advertising
Product advertising expense
$800,000
$800,000
$1.00
Marketing administration
Number of products
$200,000
1
$200,000.00
Product development
Cost Driver Value
Cost Driver Rate
$7,140
153
$46.67
$110,350
1,104
$100.00
$30,000
$3,570,933
$0.01
$139,213
81,621
$1.71
$0
1
$0.00
Customer-sustaining Distribution channel support
Number of orders received
$191,727
1,034
$185.39
Company-sustaining Brand advertising
Brand advertising expense
$100,000
Admin salaries expense
$300,000
Administration
etc
Number of products
Activity Resource Cost
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MIKE’S BIKES – Integrated Business Learning Online
The cost driver rates can then be used to assign activity costs to products. The following report gives an
example of this.
Activity Based Costing - Sample Product Cost Report
This sample report assigns the cost of product-specific activities to two products according to the consumption of cost drivers.
Product
RC_RockHopper
Cost Driver Value
Assigned Cost
$2,156,121
$714,428
Cost Driver
Direct Material
Direct Labor
Unit-level
Average RM stock units @ $46.67
Raw materials warehousing
Average FG inventory units @ $100
Finished goods warehousing
Relationships with Suppliers
Raw materials used @ $0.01
Training
Direct labor hours @ $1.71
Idle (incl Raw Material Stockout and Breakdowns)Direct labor hours @ $4.67
Rework
Units reworked @ $302.59
Inspection
Units inspected @ $400
Warranty claims
Number of claims @ $850
Workforce change cost
Direct labor hours @ $0.74
Preventative maintenance
Direct machine hours @ $8.17
Depreciation on plant
Direct machine hours @ $6.53
Quality systems
Direct machine hours @ $2.45
Batch-level
Setup
Production scheduling
Reduction of setup times
Number of batches @ $2288.46
Number of batches @ $1917.26
Number of batches @ $255.63
Product-sustaining
Product advertising
Product advertising expense @ $1
Total Cost
51
496
$2,156,121
55,263
55,263
256
735
85
55,263
34,261
34,261
34,261
$2,380
$49,600
$21,561
$94,500
$258,078
$77,463
$294,000
$72,250
$40,895
$279,912
$227,150
$83,939
RC_Breeze
Cost Driver Value
Assigned Cost
$1,414,812
$340,755
102
608
$1,414,812
26,358
26,358
87
1,612
111
26,358
26,955
26,955
26,955
$4,760
$60,750
$14,148
$45,073
$123,093
$26,325
$644,841
$94,417
$19,505
$220,222
$178,712
$66,040
36
36
36
$82,385
$69,021
$9,203
42
42
42
$96,657
$80,979
$10,797
$350,000
$350,000
$450,000
$450,000
$4,882,887
$3,891,887
10. Depreciation of Plant
Depreciation is the term used to describe the spreading of the cost of major investments (such as plant) over
their useful lifetime. As such it is a non-cash expense (the cashflow having occurred when the plant was
purchased) but still with a cash effect in that it allows an organization to reduce its tax burden each year.
There are several depreciation rules that are accepted for tax purposes. The "book value" of the plant is its
purchase cost less the accumulated depreciation recognized so far. Note that the market value can be much
higher than the book value, particularly if the equipment has been well maintained.
The most common methods of depreciation are straight-line depreciation, and diminishing balance (or
diminishing value). Straight-line depreciation is where the asset costing say $1m is depreciated by the same
amount (say $100,000) each year so that after 10 years it will have been fully depreciated. The diminishing
balance method recognizes a certain percentage of the opening book value as the depreciation expense.
Diminishing balance is the method used to depreciate plant in Mike's Bikes.
Year
Year1
Book Value
Year2
Book Value
Year3
Book Value
Straight Line
$100K
$900K
$100K
$800K
$100K
$700K
Dim Balance @ 20%
$200K
$800K
20%x$800K = $160K
$740K
$148K
$592K
11. Other Aspects of Performance Measurement
Traditional management accounting has emphasized the historical and financial aspects of a firm’s
performance. Over the past two decades, other measures that correlate more closely to future performance
have been suggested. Recently these other measures have been put into a framework and labeled as the
Page 108
Accounting
46
Balanced Scorecard by Kaplan and Norton . The Balanced Scorecard includes financial performance,
customer measures, innovation and learning, internal measures. More detail on the Balanced Scorecard is
given in the chapter on Strategy as well as Finance and Performance Measurement.
12. In Mike’s Bikes
This chapter provides a quick overview of the types of accounts that result from the first period of Mike’s
Bikes. All these may be found under /Reports/Financial Reports. While the spreadsheets presented here are
virtually identical in what they cover and how they treat things, there are variations in the numbers that are
used. Copies of these may also be found in ACCOUNTS.XLS.
13. Questions to Assist Learning
13.1 QUANTITATIVE QUESTIONS BASED ON SOLOMIKE
All of the following questions deal with information contained in the workbook ACCOUNT.XLS found in the
directory where you installed SoloMike (usually C:\MikeBike\SoloMike). We recommend copying this
workbook to another directory to use for this assignment. Before starting each question, remove the protection
from the relevant worksheet(s) by choosing Protection\ Unprotect Sheet from the Tools menu. This allows you
to use data tables and add graphs to the sheet.
For the purposes of this assignment assume that your firm has decided to “consistently produce a bike that is
considered the best value for the Adventurer segment” and the management team is assessing the effect on
the accounts of the decisions made in the marketing, operations and product development areas. The longterm overall plan is to double sales and production volumes to 30,000 units, reducing unit costs and being
able to lower prices, while still earning a good profit.
1.
Financial Performance - Depreciation
Depreciation is a non-cash expense that allows you to amortize the cost of your capital equipment over its
useful life. A major part of the operating strategy is to purchase new plant worth $1.6m (10,000 SCU) at the
start of 1999. The management team wants to investigate the effects of different depreciation methods on this
new plant. Consider the depreciation model presented in worksheet DEPRECIATION.
a) [Basic] The existing plant is depreciated using the diminishing value method, using a depreciation
rate of 20% per annum. The accountant suggests using a new method, and depreciating the new
plant linearly over 10 years. Consider the new plant only. What would be the depreciation expense in
the first year if the new plant is depreciated at 20%? And using linear depreciation over 10 years?
b) [Basic] Consider the new plant only. Calculate the opening book value, depreciation expense, and
accompanying tax saving for both methods of depreciation. Draw a single graph comparing the tax
savings generated by the two methods over the first five years.
c) [Basic] How does the depreciated (book) value of an asset relate to the net current value (the value
that it could be sold for)?
d) [Integrating] Cash reserves will be stretched by product development costs and plant purchase in
1999 and 2000. Which depreciation method would you prefer and why? (Be sure to provide
supporting calculations)
e) [Advanced] Assume that the company continues to use the diminishing value method at 20%. For
the whole plant (existing and new) calculate the opening book value and depreciation expense for
the five years 1999-2003.
46
See for example: Kaplan, R.S., Norton, D.P., "The Balanced Scorecard - Measures that Drive Performance", HBR, Jan-Feb, 1992;
Kaplan, R.S., Norton, D.P., "Putting the Balanced Scorecard to Work", HBR, Sept-Oct, 1993; Kaplan, R.S., Norton, D.P., "Using the
Balanced Scorecard as a Strategic Management System", HBR, Jan-Feb, 1996
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2.
Financial Performance - Forecasting.
The team is (understandably!) interested to forecast the profit resulting from the strategy before they commit
to product development and purchasing plant. Consider the worksheet PlanningAhead.
a) [Basic] The planned sales volume is 30,000 units, enter this value in cell D22. Based on decisions
made for the operations area (and including $1m product development in 1999) the accountant has
calculated the level of Total Expenses in 2000 as being approximately constant at about $3m,
change cell D48 to $3m. Change cell D27 to =D22*400. What are the profit figures for 1999 and
2000?
b) [Integrating] Now look at how sensitive profit is to changes in demand. Assume that the factory
cannot scale down production if demand is less than 30,000, and ignore changes in stock holding
costs. Calculate the break-even point in demand assuming that the variable COGS is constant at
$400 (i.e. assume the only "fixed costs" are the Total expenses). Try entering this, then restore
sales to 30,000.
c) [Basic] Add Dividend payments of $1m per year to cells C19-D19. Does the forecast profit change?
Why not?
3.
Financial Survival - Forecasting
Even if the proposed strategy is profitable, it may not be feasible if it requires more cash than is available. The
management team now attempts to forecast the cash position both at the end of the first month (when major
investment cashflows often occur) and at the end of each year. Assume that the firm has an overdraft (limit of
around $1.5m) to cover short term cashflow issues. (This question builds on the previous one, so make sure
that you have made the spreadsheet changes mentioned there.)
a) [Basic] Look at cashflows for demand of 30,000. Start by setting Cost of Goods Manufactured =
Cost of Goods Sold, i.e. set cell C76 = cell C27 and D76 = D27. Set depreciation to $640K, i.e. set
cell C78 = $640K. Set cell D79 = cell D48. What is predicted cash position at end of first month and
end of year for 1999 and 2000?
b) [Advanced] One of the big differences between the income statement and the cashflow statement is
how the costs of producing each unit is handled. Imagine that 30,000 bikes are produced in the year
2000, but only 15,000 sell. Calculate the cost of goods sold and the cost of goods manufactured for
this case. Alter the number of bikes sold in cell D22, and the cost of goods manufactured in cell D76
on the PLANNINGAHEAD sheet to show this difference (assume manufacturing costs of $400/unit).
What is the forecast cash position at the end of the year 2000 in this situation?
4.
Activity Based Costing
Inspection is a major overhead cost. In order to help estimate the costs associated with introducing a second
bike to the range in the long-term future, the team decides
to investigate how inspection cost could be allocated to
BikeA
BikeB
particular products. Consider a situation where you inspect
20,000
5,000
Production
10% of bikes and have $1.5m of inspection cost to
1
2
Complexity (SCU)
allocate to two bikes as in the table.
a) [Basic] The accountant suggests that the time and resources taken to inspect each bike are pretty
much the same. Calculate the number of bikes inspected, the cost per bike inspected and hence the
inspection costs to allocate to BikeA and BikeB.
b) [Advanced] After talking to the inspection staff it is discovered that BikeB is twice as complex as
BikeA and takes about twice as long to inspect (as reflected in the SCU rating). Calculate the
number of each bike inspected, total SCU of bikes inspected, the cost per bike inspected and hence
the inspection costs to allocate to BikeA and BikeB
c) [Advanced] Imagine the number of BikeB being produced doubled while the number of BikeA being
produced halved. Estimate the new inspection costs based on the answers found in (a) and (b).
5.
Integration of Accounting Support with Marketing and Operations
Start with the original unaltered ACCOUNT, OPERATE and MARKET spreadsheets. The purpose of this
question is to show you how management accounting supports marketing and operational decisions.
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Accounting
a) [Basic] A young engineering intern with your firm doing some machine set up efficiency analysis
suggests that increasing the batch size from 200 units to 600 units would save a significant amount
of money. Check the original EVA of your firm on the EVA sheet and then check the Set Up Labor
cost and Total Labor Overhead on the OVERHEAD ALLOCATION RATES sheet, then change the
batch size to 600 on the LEAD TIME sheet. How much does the EVA change? How much do the
Set Up labor costs change? How much does Total Labor Overheads change? Which other labor
overhead has changed significantly and why? What another possible significant impact of changing
the batch size besides the impact on set up costs?
b) [Advanced] After presenting the batch size proposal to a manufacturing meeting the manufacturing
team come up with a proposal to optimize manufacturing costs. Their plan is: to increase batch
size to 1000 units (on the LEAD TIME sheet); to increase raw material inventories from 1 week to 4
(on the SUPPLIER RELATIONS sheet); and to fire 19 staff (on the MOTIVATION sheet). Find the
change in Total Materials Overhead, Total Labor Overhead, and Total Machine Overhead. What is
the total estimated cost saving based on these results? However the marketing team after hearing
the proposal say that they doubt the current level of sales could be maintained, check the DEMAND
sheet before and after the changes, are they right? Why? Finally it comes down to the accountancy
team to do a draft forecast on the changes effects on profitability, what is the change in EVA on the
EVA sheet? Approximately what percentage of the manufacturing team's planned cost reduction
has eventuated as increased profit?
c) [Advanced] Your marketing team suggests that instead of firing staff perhaps you should try
reducing your price to increase sales to use up the excess capacity generated from setting the batch
size to 1000 and increasing raw material inventory levels to 4 weeks. They suggest a price of
$1500, however this results in an EVA of $989K which is less than the $1148K EVA of the
manufacturing plan. However your team decides that these are the two best strategies to choose
between and you are confident that these must be the two best strategies that Mike is choosing
between since you are starting in identical positions. To try to predict what to do you draw the game
decision tree given below.
The decisions are actually made simultaneously
by both firms, not sequentially
Your EVA = $1148K
Mike EVA = $1148K
Price = $1700
Fire 19
Price = $1700
Fire 19
Mike’s
Decision
Price = $1500
Keep All Staff
Your EVA = $504K
Mike EVA = $989K
Your
Decision
Price = $1700
Fire 19
Your EVA = $989K
Mike EVA = $504K
Price = $1500
Keep All Staff
Mike’s
Decision
Price = $1500
Keep All Staff
Your EVA = $403K
Mike EVA = $403K
d) Given this diagram, your team is just about to make a decision, when someone remembers that
Steady Mike has a history of price steadiness, so is most likely to charge $1700. What strategy
would you decide to implement? What criteria did you use for deciding on your optimal choice?
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MIKE’S BIKES – Integrated Business Learning Online
13.2 QUALITATIVE QUESTIONS (APPLICABLE TO SOLOMIKE OR NETMIKE)
1.
In the Marketing assignment, the
Financial Statement
management team decided to
Two
increase advertising for the
Item B Increases by
Adventurer bike to around
$xxx,xxx
$550,000. Draw a flow chart
which shows the impact of this
expenditure on the financial
Financial Statement
Financial Statement
Four
statements, holding all other
One
Item E Increases by
things constant. (NB Consider
Item A Increases by
$xxx,xxx
only the simple effects on
$xxx,xxx
Item F Decreases by
Contribution Margin, Operating
$xxx,xxx
Surplus Before Tax, Income Tax,
Financial Statement
Net Surplus, Ending
Cash
Three
Item C Increases by
Balance, Total Equity, Total
$xxx,xxx
Assets, and Total Liabilities.) Use
Item D Decreases by
the following diagram to help
$xxx,xxx
structure your chart: You do not
need to trace changes through to
all affected totals, although you must provide information on useful summary totals such as Operating
Surplus Before Tax, or Total Equity.
2.
In addition to 1 above, the board has also decided to pay a dividend of 10c per share. Draw a second
flow diagram.
14. Modifications for NetMike
There are some relatively minor changes in the starting dollars for the Income statement and the Balance
Sheet. Just check out these reports for the differences. They do not make much difference to the
environment.
Page 112
7 FINANCE AND PERFORMANCE
MEASUREMENT
At the most general level the financial manager
deals with two decision making areas: what
investments should a company make; and how
should it finance these. The main role of the finance
function is to manage the process of funding the
firm in the best possible way. The first of these
involves the financial evaluation of strategies
associated with existing products and new capital
expenditure. The second includes decisions on
capital structure and dividends.
To reflect these two areas, the chapter is broken up
into two main parts: evaluating strategies and
investments; and financing of the firm. In each case
these are concerned with finding ways of adding
value to the existing business.
Shareholder Value
Current Profit
ECONOMIC
CONDITIONS
COMPETITORS’
ACTIONS
Demand
Future Profit
Supply
Accounting
operating
decisions
investment
decisions
Business Strategy
Marketing
Strategy
Operations
Strategy
Finance
Strategy
Product
Development
Strategy
Finance and Performance Measurement
1. Learning Objectives
a) A Framework for Finance
b) Investment Evaluation
• NPV
• Evaluation of projects
• Weighted Average Cost of Capital (WACC)
• Evaluation of shares
• Risk, Return and CAPM
• Evaluation of strategies
• Assessing corporate takeovers
c) Financing Decisions
• Dividend policy
• Financing by debt
• Financing by equity
d) Financial Measures
• Increase in Shareholder Wealth
®47
• Economic Value Added (EVA )
e) The Balanced Scorecard
47
3
Finance Logic
EVA is a registered trademark of Stern, Stewart & Co
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MIKE’S BIKES – Integrated Business Learning Online
2. A Framework for Finance
The diagram shown assumes that the overall
corporate objective is to create shareholder value.
This is not to say that social objectives are not
important. It is simply meant to emphasize that
without a return to shareholders a capitalist system
cannot operate.
4
Finance Logic - Detail
Achieving such a return occurs through a number of
levels. It is dependent on economic conditions,
competitor activity and management decisions in
three areas - operating, investment and financing.
Which of these is most important is contingent on the
circumstances, and varies over time.
Finance
Strategy
• Investment
- Projects, Corporate Takeovers
• Financing
- Dividends, Debt, Equity,
Investment
Product NPV
Corporate
Financing
Dividends
Debt
Equity
Takeovers
Operating decisions are those that result in operating
profits and relate directly to the product or service
Finance and Performance Measurement
being produced. These decisions are usually made
by marketing and operations, and the finance function has little involvement except in assessing the funding
implications of these decisions. They are not shown on the diagram above.
Investment decisions refer to the types of new projects and products that a firm should invest in and many
people would argue that this is the area where most effort should be expended. This type of decision will
focus on identifying the projects which give the "best" possible financial return. It is usually these projects that
constitute the strategy of an organization.
Financing decisions determine the "best" way in which to fund the requirements of the organization and its
strategy. While there are many unique financial instruments, these primarily fall under two generic headings debt and equity. One must determine how much funding is required and what is the best mix of debt and
equity. Related to this is the issue of determining an appropriate level of distributions/dividends.
2.1 THE RELATIONSHIP OF FINANCE TO STRATEGY
Good strategy has been defined as the
formulation and implementation of any
Investment
set of decisions that will lead to the long
term success of the organization. It is
difficult to define a good strategy ex ante,
Financing
since only time will tell whether the
strategy has been a success, and many
things outside of the control of the
organization can affect success - including luck.
Evaluating Projects ($)
Valuing corporate takeovers - buy or sell ($)
Assisting with evaluating strategies ($)
Determining dividend policy (Cents/ Share)
Debt decisions - raise or repay ($)
Equity decisions - raise or repurchase ($)
However, many strategies involve the decision to invest or divest of product, plant, or entire organizations.
Finance helps to evaluate the financial attractiveness of these. We will consider six main financial functions
listed in the table above.
3. Investment Evaluation
Evaluating investments relates to the future profitability of an organization. The finance function has two roles
to play here. The first is to help other functions within the organization to evaluate their strategic investment
48
decisions . The second is in the direct valuation of corporate takeovers and divestments.
48
Barwise, P., Marsh, P., Wensley, R., "Must Finance and Strategy Clash”, HBR, Sept-Oct, 1989.
Page 114
Finance and Performance Measurement
3.1 NET PRESENT VALUE (NPV)
One of the main tasks of finance is evaluation of
different investment alternatives. The method of choice
is Net Present Value (NPV). NPV is a measure of the
value added by the future income stream associated
with a project, strategy or firm. Apart from these
forecast cashflows, NPV also requires a discount rate
reflecting the cost of capital for the project (which in
turn depends on the risk of the project).
Most projects have a high capital outlay at the
beginning, and then small positive net cash flows in the
following periods. For these projects, the higher the
49
required discount rate, the lower the NPV.
3.2 EVALUATING PROJECTS
7
Example Calculation of NPV
h
FreeCashFlow t
(1
+ DiscountRate) t
t =1
(and assuming h is 2)
NPV = FCF0 +
= −$4000 +
$2000
$2000
+
1 + 0.1 (1 + 0.1) 2
= −$529
Finance and Performance Measurement
The most basic way of evaluating projects is to use
the measure of Net Present Value. This requires that
the expected cash flows associated with a project be
adjusted by a discount factor that reflects the risk of
the project relative to those normally undertaken by
the firm. If the project has the about the normal level
of risk then the appropriate discount rate would
usually be the weighted average cost of capital for the
firm (see relevant section below).
The risk of the project refers to whether an investor
would regard this project as more risky than ones
typically undertaken by the company. Projects
associated with higher risk often include those more
dependent on the business cycle and those with
higher ratios of fixed costs to project value.
The risk of the project does not refer to the likelihood
of the project failing to meet the projected cash flows.
The cashflows resulting from best, worst and average
cases should be forecast, along with the estimated
probability of each outcome. Using these probabilities
one can arrive at an expected outcome. The best and
worst case scenarios will also help ascertain how sensitive the NPV is to the uncertainty of the forecasts, and
might highlight areas for more research.
In Mike's Bikes it is possible to make an estimate of the NPV of a product development project by entering the
costs of the project and the expected revenues and costs in the following years (up to a maximum of 10). The
current Weighted Average Cost of Capital (WACC) is applied to calculate NPV. This can be modified to reflect
differences in the risks of the project.
49
NPV=0 where the Discount Rate equals the Internal Rate of Return (IRR) - another way of selecting projects
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MIKE’S BIKES – Integrated Business Learning Online
3.3 EVALUATION OF SHARES
10
Theoretically, the value of a share is the
present value of all dividends that will be
received from the share over its life. The
required rate of return (sometimes called the
market capitalization rate) is the return that
investors expect on similar shares.
Use NPV to Value a Share
… “the present value of all future dividends.”
∞
Share Value =
If we simplify so that dividends are assumed to
grow at a constant rate and the required rate of
return remains constant, then the second
formula can be applied. Note that high current
dividend growth rates (eg above 10%) are very
unlikely to be sustained in the long-term. A
commonly used average for the long-term
growth rate is 2%.
DIVt
(1+
r) t
t =1
n
The issue is how to estimate future dividends and the
required rate of return on this company’s shares
n
If you assume constant dividend growth (g):
Share Value 0 =
DIV1
(r - g)
How is Share Price calculated in Mike’s Bikes?
A key difference is that it uses smoothed EPS
Finance and Performance Measurement
in place of dividends. This is to cover for
situations where low dividends are paid by high-growth companies. While not entirely accurate, this makes the
computation simpler and relative share prices will stay the same.
Mike’s Bikes also assumes that future earnings are reflected in a weighted average of the past earnings.
Again this is not particularly realistic, but does give a consistent way of estimating future earnings that is
representative of how some shareholders tend to view their investments. To make the share price less volatile
(and more realistic) the earnings per share figure is adjusted for expenditures that may have a long term
benefit (such as product development, advertising, branding, maintenance, supplier relations).
The risk of the firm is determined
by the risk of the industry and the
extra risks associated with the firm
(measured by the D/E ratio). This is
used to calculate the Required
Rate of Return.
Share Price:=
Smoothed EPS
(Required Return on Equity - Growth Rate in Perpetuity)
The long-term dividend growth rate is assumed to be 2% for all
firms.
Share Price :=
$2.60
= $20
(15% - 2%)
AN EXAMPLE
A simple example will help to solidify these ideas. Assume the smoothed earnings per share of a firm are
$2.60 and this is all returned as dividends. Assume that this is expected to grow at 2% and the required return
on equity is 15%. Then what is the present value of this income stream?
SOLUTION
But how do we calculate the required return on
equity? This is determined by the risk involved
and this is where the Capital Asset Pricing Model
(CAPM) comes in.
3.4 RISK, RETURN AND CAPM
It is an accepted principle of finance that the
higher the risk associated with an investment,
the higher the return expected and required from
it by investors.
The Capital Asset Pricing Model (CAPM) says
that the required rate of return is directly
Use the CAPM to Estimate the
Required Rate of Return
11
Required Rate of
Return
r - rf = beta (rm - rf)
Market
Rate (rm)
RiskFree
Rate (rf)
Risk
beta =1.0
The Capital Asset Pricing Model says:
In a competitive market, the expected risk premium varies in
direct proportion to the risk (measure by beta)
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Finance and Performance Measurement
Finance and Performance Measurement
proportional to the risk as measured by “beta”.
But how is Beta calculated? Beta measures the monthly price movements of the individual stock relative to
price movements in the overall stock market. If the stock price on average moves at exactly the same rate as
the stock market it has beta=1. If it moves on average less than the market then its beta is less than 1; if more
then its beta is greater than 1. If the beta of a stock is 1.5 then for every 1% movement in the overall market,
this stock will move 1.5%. In essence, beta measures the risk of an asset, relative to the variablity of the "the
market".
If the share is not listed (or has not been listed for long enough) then you will want to look at the betas for
comparable companies in the same industry. Sometimes an unlevered industry beta is available, which you
can adjust for your firm by using the debt/equity ratio. This is what Mike’s Bikes does.
3.5 INVESTOR RELATIONS
The value of a share is determined by more than a mathematical analysis of risks and returns. It is also
affected by how much the investment community knows and understands about the company concerned, and
their perceptions of the quality of the firm’s management.
Hence to ensure that their shares are fairly valued, firms need to make every effort to ensure that investors
and their advisors have recent frequent clear information about the firm’s situation and plans. The larger and
more complex the firm, the more effort is required.
15
NPV of a Strategy
3.6 EVALUATING STRATEGIES
Any strategy will have a financial outcome on the
organization. When comparing strategies one
needs to consider the true profit expected to be
generated by the different strategies. There are at
least two problems here already. One relates to
the time frame of the analysis since different
strategies may be expected to have different
periods over which they are effective. The second
relates to the fundamental uncertainty of the
estimates - and this is captured in the concept of
risk.
This includes
any projects which will generate future profits
any operational decisions generating current profit
any acquisitions
– The return on assets for the combined assets is greater than
the sum of the returns on the individual assets.
– Thus, the buying firm can add-value to its return.
any divestments
Same as the NPV for a project but harder to calculate.
h
NPV = FCF0 +
t =1
FreeCashFlow t
(1 + DiscountRate) t
In Mike's Bikes there are many strategies that can
be played out. It is the role of the finance function
Finance and Performance Measurement
to evaluate the impacts of these on shareholder
value. These may be as simple as maintaining a steady path with little modification to existing decisions, to
introducing or deleting products in the market place, adding capacity, buying or issuing stock, or the purchase
or sale of other firms in the industry. All these strategy options must be evaluated.
Mike's Bikes offers two ways of evaluating strategies. If the strategy is simple and essentially revolves around
a product development project then there is the NPV function which
requires that the player enter the likely revenue and expenses of the
project for the specified time frame and the cost of capital. The NPV
is then calculated. For more complex strategies, the players can
make all the decisions that they want and then roll over to the next
period to see what the effect would be in shareholder value and
other measures, given a certain set of assumptions for the
environment and competitive actions.
3.7 VALUING CORPORATE TAKEOVERS
An important part of a strategy may be to purchase another
company (or to sell a subsidiary). This could be because it will
strengthen the market position of the buying company or provide it
with some other advantages that would be valued higher than the
purchase price. Sometimes the new owner is able to inject enough
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MIKE’S BIKES – Integrated Business Learning Online
capital or know-how to enable the purchased company to reach new levels of performance. This would again
require a valuation of the true profit that would be created by the purchase and a comparison of this against
the purchase price.
Mike's Bikes allows these dynamics to be played out. The decision screen shown allows a team to takeover
and sell other companies and to transfer capital back and forward between itself and the companies it owns.
4. Financing decisions
These decisions relate directly to achieving the optimal cost of capital for the organization. The dividend policy
may be used to stabilize the price of the firm's shares even in the context of variable earnings. Raising and
repayment of debt and raising and repurchase of equity may be used as levers to make sure that the best
cost of capital is achieved.
The Finance Decision Screen allows you to
manage the cash your firm has available to it
by paying dividends to your shareholders,
raising or repaying long-term debt, and
issuing or repurchasing equity (i.e. shares in
your firm).
4.1 DETERMINING DIVIDEND
POLICY
How do Managers decide on Dividends?
(Lintner’s model)
n
n
n
n
18
Reference: Brealey and Myers, Principles of Corporate Finance, McGraw-Hill, 1996
Firm’s have long-run target dividend payout ratios.
Managers focus more on dividend changes than on
absolute levels.
Dividend changes follow shifts on long-run
sustainable earnings.
Managers are reluctant to make dividend changes
that might have to be reversed.
Formula
Each year the management team must set
n
the dividend level in cents per share.
Dividends have a direct effect on shareholder
value as shareholders receive a cash return
from their investment. However dividends
DIV 1 - DIV 0 = adjustmen t rate x ( target rat io x EPS 1 - DIV 0 )
reduce a firm's cash reserves and may
prevent it from undertaking potentially
Copyright 1998
Finance and Performance Measurement
profitable new projects. Thus a firm should
consider increasing its dividends when it does not believe that it can use the money to achieve a return
greater than that required by shareholders. (In such cases it could even consider returning capital to
shareholders by repurchasing shares.)
50
In a pure economy (i.e. one without taxes), Miller and Modigliani showed that the amount of dividend paid
has no effect on the value of the firm, all else being equal. However the fact that dividends are taxed but
capital gains often not coupled with other issues muddies the waters to the extent that there are three widelyheld positions on dividend policy: those advocating high dividend levels, those advocating medium levels, and
those advocating minimum dividends.
51
The slide shown indicates some empirical research as to what managers really do. The Lintner model
suggests that a firm will have a target ratio of dividends to earnings per share. As earnings per share changes
the dividend will begin to increase towards the target ratio, but not too quickly because the management does
not want to have to reduce dividends in the case that the current high earnings turn out to be short-lived. The
more volatile the earnings the lower the adjustment rate will be. In this model a large dividend increase can be
used to signal management's view that future earnings will increase.
In Mike's Bikes the dividend decision is given in cents you wish to pay per share. Dividends are paid on the
number of shares outstanding at the end of the previous period (as listed on your balance sheet report). The
real market return shareholders can receive elsewhere is 10% per annum. Government bonds' real return is
1%.
50
51
Miller, M.H, Modigliani, F., “Dividend Policy, Growth and the Valuation of Shares,” Journal of Business, 34:411-433 (Oct 1961).
As summarized in Brealey, R. A., Myers, S. C., Principles of Corporate Finance, McGraw Hill, 1996
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Finance and Performance Measurement
4.2 RAISING/REPAYING DEBT
Except (perhaps) for retaining profits, raising debt is
often the easiest way to get additional funds. However,
there is an effective limit as to how much can be raised
due to the burden of high fixed interest charges, which
will increase with increasing debt levels.
In Mike's Bikes, the firm may choose to raise finance
using debt instruments (for example, debentures, notes,
or mortgages). Interest will be charged on these long
term debts based upon the level of risk of the firm, which
is determined by the debt/equity ratio. The higher the
ratio and therefore risk, the more interest you pay. The
lowest rate is at 8% which increases to 20% or more
when the debt/equity ratio is more than 2. The financial
market will not allow you to raise debt beyond a
debt/equity ratio of 3. If your firm spends more money
than it receives and goes into overdraft then the interest
rate applied is 3% higher than what you pay on long-term
debt. The maximum overdraft facility available is set at
25% of the book value of equity. Firms which exceed this
overdraft limit are placed under statutory management
and must pay additional legal fees. An alternative
available to companies which are owned by another firm is to request debt financing from their parent. The
interest payable is negotiable (within certain limits!).
4.3 RAISING/REPURCHASE OF EQUITY
As an alternative to debt a firm may choose to issue
shares to raise finance. If an organization needs more
money for implementing its strategy then it can raise this
by a share issue. This can (depending on the
regulations) dilute the ownership which makes the
company more vulnerable to takeovers if results are not
forthcoming. On the other hand, if the firm has excess
cash and no profitable uses for it, it may consider
repurchasing some shares, thereby reducing the number
of shares among which the firm's future profits must be
distributed.
Fundamental to this decision and to much of financial
theory is the share price. This has been described above
and is influenced by earnings per share, the required
rate of return and the expected growth rate of earnings
and the economy over time. The required rate of return
is dependent on the risk of the firm and industry.
In Mike's Bikes, issues and repurchases will occur at
current market prices with underwriting and merchant
banking fees also being incurred. There is a 5% issue
premium on equity repurchased, and a 5% issue discount on equity raised. This effectively means that the
cost of repurchasing or issuing equity is 5% of the value. These costs are automatically added/deducted from
the dollar figure you specify in your decision.
To prevent speculative trading, a firm can, in a given year, only issue up to 50% of the current book equity
value. For example, if a firm currently has book equity of $4m, then the largest equity issue it can make is
$2m. If its book equity is very low, then this will severely limit its ability to raise cash through equity issues.
Similarly, in a given year a firm can only repurchase shares worth up to 25% of the current book equity.
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In Mike’s Bikes firms pay company tax of 33% on profits and there is dividend imputation so there is no
effective tax on dividends. Tax credits on losses are carried forward until the next year of profit.
4.4 DEBT OR EQUITY? IS THERE AN OPTIMAL D/E RATIO?
It has been traditionally been thought that there is an optimal capital structure (i.e. proportion of debt and
equity) which minimizes the overall cost of capital. Modegliani and Miller (MM) argue that it does not matter, at
least in the absence of taxes.
The diagram shows the differing curves
predicted by these two schools of thought.
5. Measurement and
the Balanced
Scorecard
Is there an optimal Debt/Equity ratio?
22
Reference: Brealey and Myers, Principles of Corporate Finance, McGraw Hill, 1996
Traditional view
Modigliani and Miller (MM)
– there is an optimal
debt/equity ratio that
minimizes the return on
assets required by investors
– there is no optimal
debt/equity ratio
rE (MM)
Rates of Return
rE (Traditional)
In this section we look at the issue of
rA (Traditional)
measurement,
and
introduce
the
rA (MM)
Balanced Scorecard to reflect the
movement
to
more
complete
rD
measurement systems
than
those
provided by financial measures only. To
start with we consider three financial
D/E
measures. First we describe the
Optimal D/E ratio
calculation of Shareholder Value in Mike's
Copyright 1998
Finance and Performance Measurement
Bikes. Then we introduce the idea of the
weighted cost of capital (WACC), which leads on to Economic Value Added (EVA).
These measures which have come into fashion since the 1980's, are natural extensions of shareholder value
but take explicit account of the cost of money that is used to generate income.
5.1 SHAREHOLDER VALUE
In Mike's Bikes, shareholder value is measured quite naturally as
• Share price (determined by profit and required return)
• Plus any dividends/distributions (including interest on these)
This table shows the calculations in more detail. Total shareholder value is the shareprice change, plus any
dividends paid and the interest on these.
Period
1
2
3
4
Share Price
$13.00
$14.00
$15.75
$16.00
Current Div
$0.20
$5.00
$0.40
$0.35
Total Previous Divs and Interest @ 10%
$0.00
$0.20
$5.22
$6.14
Interest on Divs (PV)
$0.00
$0.02
$0.52
$0.61
$13.20
$19.22
$21.89
$23.10
Value Created
$6.02
$2.67
$1.31
Change in Year
45.6%
13.9%
5.9%
Cumulative Change
45.6%
65.8%
75.7%
Shareholder Value
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Finance and Performance Measurement
5.2 WEIGHTED AVERAGE COST OF CAPITAL (WACC)
The weighted average cost of capital for a project or firm depends on
whether it is financed by debt or equity or both. Each of these will
have a different cost associated with it and the WACC forms a
weighted average of these to get the true cost of capital, as shown
(assuming no taxes).
WACC = rA = ç
D
æE
ö
× rD ÷ + ç × rE ÷
èV
V
Note that it is reasonably straight forward to estimate the cost of debt, since interest rates are usually explicit.
The cost of equity (rE) is not so easily observed, and the weights (D/V and E/V) should be based on maket
values of D and E. Clearly WAAC is an average, and may not be the appropriate rate to use for evaluating a
project proposal if the risk of the project differs from the average risk of the firm. The CAPM makes it clear
that projects of above average risk should have above average required rates of return applied to them.
®52
5.3 ECONOMIC VALUE ADDED (EVA
Economic Value Add (EVA) improves on
conventional profit measures by deducting
the cost of capital. The cost of capital is
made up of the cost of debt (eg interest
adjusted for tax) and cost of equity (required
return on equity).
)
29
Economic Value Add
EVA is a registered trademark of Stern, Stewart & Co
Improves on profit measures by deducting the
implicit cost of the equity used to generate the
profits.
Roughly speaking, it is calculated from
1. Operating Profit excluding interest costs.
“operating profit less the cost of all the
capital employed to produce the earnings”
2. Cost of debt
The interest cost of debt (adjusted for tax) is
usually a reasonable approximation for this.
3. Cost of equity
The return on equity expected by
shareholders (covered in an earlier section).
(EVA®)
G. Bennett Stewart, III
n
Roughly speaking:
Operating Profit
- Cost of Debt (eg interest costs adjusted for tax)
- Cost of Equity (implicit required rate of return on equity)
Economic Value Add
Finance and Performance Measurement
AN EXAMPLE
Consider the sample EVA report to the right.
The Net Operating Profit After Tax would
have been about $2.37m. Of this about
$50,000 would have been interest cost (eg
10% on $500,000) which would have had an
associated tax saving of about $17,000. So
the net effective interest cost to the company
is about $33,000. Assuming that this interest
cost is a fair reflection of what the company
could expect to pay in interest the $33,000
can be taken as the cost of debt capital. The
book equity during the period may have been
$2.8m with a required rate of return of 15%.
This would lead to cost of equity capital of
about $420,000. To summarize, we have
$2.4m in “profit” being earned by the
company on $3.3m capital ($0.5m debt and
$2.8m equity), where the required return on
the capital is about $0.45m ($30,000 net
effective interest and $420,000 return on
52
EVA is a registered trademark of Stern, Stewart & Co
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MIKE’S BIKES – Integrated Business Learning Online
equity). So the value earned by the company above that which would be expected is $1.95m ($2.4m less
$0.45m). Note that this level of earned value is very high compared to most real-life examples.
5.4 THE BALANCED SCORECARD
Financial measures are just one part of the
picture and tend to look more at the past than
the future. They must be supplemented by
other measures for a better indication of future
profits. A popular methodology for bringing
together such measures is the Balanced
Scorecard methodology developed by Kaplan
53
and Norton . The Balanced Scorecard
supplements
financial
measures
with
measures of innovation and learning, customer
satisfaction and internal performance. It links
these upwards to the strategic intent and vision
of the company, through critical success
factors (i.e. those few aspects of a business
that must succeed for the business to
succeed) as well as downwards to sub units
and to individuals. These measures can also
be linked to rewards.
32
Balanced Scorecard
Vision/Strategic Intent
Critical Success Factors
Goals/Measures
Rewards
Customer Financial
Internal Innovation
Sub-unit
Personal
Finance and Performance Measurement
Examples of some typical Balanced Scorecard measures would be:
• Customer – Satisfaction, Reorders
• Innovation - Product innovations
• Internal - Delivery time, Efficiency
• Financial – Revenue, Profit, Value add
6. Questions to Assist Learning
6.1 QUANTITATIVE QUESTIONS BASED ON SOLOMIKE
The following questions deal with information contained in the workbooks DEVELOP.XLS, ACCOUNT.XLS
and FINANCE.XLS found in the directory where you installed SoloMike (usually C:\MikeBike\SoloMike). Copy
these workbooks to another directory to use for this assignment.
Before starting each question, remove the protection from the relevant worksheet(s) by choosing Protection\
Unprotect Sheet from the Tools menu. This allows you to use data tables and add graphs to the sheet.
For the purposes of this assignment assume that your firm has decided to “consistently produce a bike that is
considered the best value for the Adventurer segment” and the management team is assessing ways of
implementing financial areas of this strategy. The long-term overall plan is to double sales and production
volumes to 30,000 units, reducing unit costs and being able to lower prices, while still earning a good profit.
Assume also that someone in the firm has put together this spreadsheet model of the SoloMike bike industry.
Unless otherwise advised assume a cost of capital of 11% for all the following questions.
53
See for example: Kaplan, R.S., Norton, D.P., “The Balanced Scorecard - Measures that Drive Performance”, HBR, Jan-Feb, 1992;
Kaplan, R.S., Norton, D.P., “Putting the Balanced Scorecard to Work”, HBR, Sept-Oct, 1993; Kaplan, R.S., Norton, D.P., “Using the
Balanced Scorecard as a Strategic Management System”, HBR, Jan-Feb, 1996
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Finance and Performance Measurement
1.
Investment Evaluation - NPV, Share Valuation and Company takeover
Your management team is considering taking over MountainTop Cycles. The question is whether the current
minimum realistic bid of about $24m represents a good purchase or not. This question uses the COMPANY
SHAREHOLDINGS sheet in the FINANCE workbook.
a) [Basic] As a first cut on determining the value of MountainTop the team considers the classic
dividend-based method of valuation where the value of an investment is the present value of the
sum of the future dividends. (Use the table presented at the bottom of the COMPANY
SHAREHOLDINGS sheet.) Assume that Real Cool purchases all shares for MountainTop Cycles for
a final cost of $24m at the beginning of 1999 and that MountainTop pays a dividend at the beginning
of each of 1999-2003: $1m in 1999 and growing by 2% for each year following. Finally, at the
beginning of 2004 Real Cool sells all its shares receiving $30m. Calculate the Net Present Value of
this investment.
b) [Basic] An alternative valuation method is to assume that Real Cool holds the investment in
perpetuity. Assume that that MountainTop pays a dividend of $1m at the start of 1999 and each year
thereafter growing by 2% per annum. If the required return on equity for MountainTop is 11%, find
the value of MountainTop Cycles.
c) [Basic] Based on these analyses, would you recommend taking over MountainTop Cycles
(assuming that you had sufficient cash)?
2.
Investment Evaluation - NPV and Product Development
Given the importance of the prime cost reduction product development project to the overall strategy (see the
Product Development section of the manual), the team decides to investigate the benefits of this investment
further. Consider the Net Present Value table found at the base of the worksheet in workbook DEVELOP.
a) [Basic] Assume that the existing margin is (15,000*($850-$300)) $8.25m per year. Calculate the
additional gross margin for 2000-2003 if the sales of the cheaper product are 30,000 at $700 and
unit prime cost is $225. Assume that additional costs for 1999 are $1.5m (product development,
extra depreciation and training); 2000 are $2.7m (incl quality systems, extra depreciation); 20012003 are $1.5m. Calculate the net present value of this investment between 1999 and 2003.
b) [Advanced] Sensitivity Analysis on NPV. The Net Present Value found in the previous question is
very impressive (about $11m!). However, there is some uncertainty in the demand forecast. Imagine
the sales volumes are 20% less than predicted. Find the NPV in this case (assume all costs
constant). Then use Goal Seek to find the level of extra margin at which the NPV falls to zero. Work
out what level of sales volume this corresponds to.
c) [Integrating] Given that in a perfect market, the NPV of any investment should always be zero, what
is the source of the large NPV figure found in (a)? What would you expect to happen over time?
3.
Investment Evaluation - Share Valuation
The team is considering the likely effect of the long-term strategy on share price.
a) [Basic] Many people base their share price estimates solely on the current profit and earnings per
share figures. How would these people value the shares after Real Cool Cycles posted a lower profit
in 1999?
b) [Basic] Others realize that short-term blips will occur - especially when the firm is investing for future
profits. They look at the performance of the company in the past and adjust for investments made.
How would these people value the shares after Real Cool Cycles posted a lower profit in 1999?
(This is essentially how the Mike’s Bikes logic works).
c) [Basic] Still others analyze the company’s strategy and decide whether they think that the strategy
will produce good returns in the long-run. How would these people value the shares after Real Cool
Cycles posted a lower profit in 1999?
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MIKE’S BIKES – Integrated Business Learning Online
4.
Investment valuation - EVA
The accountant mentions that EVA has become a fashionable measure of company performance. It
essentially attempts to compare the firm’s earnings with the cost of the capital invested in the firm, both the
cost of debt and the implied cost of equity being the rate of return required by shareholders.
a) Open the PLANNING AHEAD sheet of the ACCOUNT.XLS workbook, and enter the following
figures. General expenses (cells C55-G55) as $3m, $3.5m, $3.1m, $2.8m, $2.7m. To maintain
consistency with the remainder of the sheet go to Depreciation (row 78) in the cashflow section and
enter the following approximate depreciation figures (into cells C50-G50) $650,000, $500,000,
$400,000, $350,000, $250,000. Next change cells D27 to =D22*400, copy this formula across cells
E27 to G27. Change cell C79 to =C48-C78, copy this formula across cells D79 to G79. Enter sales
of 30,000 units in cells D22 to G22.
b) [Advanced] Why does the EVA fall in 2002 and 2003 even though the profit is rising? What finance
decisions could be taken to increase the EVA?
5.
Finance - Dividend policy
It would be good to find a consistent dividend policy which will work for the proposed strategy. Set up the
PLANNING AHEAD sheet as described in the question e).
a) [Basic] The marketing manager suggests that a certain proportion of the previous period’s earnings
be paid out as a dividend each period. He suggests that 40% might be a good proportion. Find the
dividend paid out in 1999 if the Profit After Tax was $2m in 1998. What is the dividend per share if
there are 2,000,000 shares? Enter a dividend pay out of 40% of $2m in cell C19, set cells D19 to
G19 to be 40% of the previous year's after tax profit. What is the dividend in 2003? What is the
Retained Earnings at the close of 2003? (Ans: $1.66m, $27.4m)
b) [Advanced] The accountant suggests a slightly more conservative approach of adjusting the
previous period’s dividend up or down trending towards a long-term target pay out ratio of 40%.
Assume a dividend paid out in 1999 of $800,000, and an adjustment factor of 0.25. Implement this
dividend policy on the Planning Ahead sheet. What is the dividend in 2003? What would the target
dividend for 2003 be? What is the Retained Earnings at the close of 2003?
6.
Integrating Finance - Optimal Capital Structure (Debt/Equity Position), WACC
The accountant mentions that it might be worth investigating different capital structures to see if the cost of
capital can be reduced. Consider the capital structure table outlined on the INTEREST sheet of the FINANCE
workbook.
a) [Basic] Use the table provided to calculate the interest charge, capital charge and total cost of
capital for a range of debt/equity ratios from 0.2 to 2.0. Create a graph of these figures. Roughly
what debt/equity ratio corresponds to the minimal cost of capital? Now add the effective cost of debt,
equity, and weighted cost of capital as percentages. Graph these also. What is the rough minimum
weighted average cost of capital?
b) [Integrating] Based on the analysis in the previous question, the management team decides to aim
for a debt/equity ratio of about 1. They also want to minimize unused cash by maintaining only about
$1m in cash above what it is required to pay tax in the following period. See if you can implement
this policy using the raise (repay) LT debt and dividend decisions on the Planning Ahead sheet.
6.2 QUALITATIVE QUESTIONS (APPLICABLE TO SOLOMIKE OR NETMIKE)
1.
Construct a draft finance plan for the Mike’s Bikes environment for the next 2 years. (2-3pages).
This should include pro-formas (forecasted) for the following. (Make sure that you think about consistency among themselves, with the overall strategy, and with operations and finance strategies.)
a) Statement of Financial Performance (Profit and Loss)
b) Statement of Financial Position (Balance Sheet)
c) Statement of Cash Flows - including sources and uses of funds The statement of cash flows should
include a description of major investments and critical areas of funding.
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Finance and Performance Measurement
2.
Construct a draft plan for a share float for the Mike’s Bikes environment (2-3pages).
This should describe the process that would be followed including:
a) Evaluating the number and price of the shares.
b) The advertising that would be carried out.
c) Choosing the underwriters.
3.
Project Evaluation
a) What are the key issues that determine the attractiveness of a new project for a company.
b) How will WACC vary with project, company and industry?
4.
Takeovers
If you are attempting to purchase other organizations, how will you determine which one to purchase (or sell)?
5.
Evaluating Strategies
a) Describe a way for evaluating a strategy?
b) What are the most difficult parts of doing this in practice?
6.
Dividend Policy
a) What are the key determinants of a dividend policy
b) How should this be reflected in the main characteristics of a firm’s dividend policy?
c) Does it appear as though there is an optimal capital structure for our firm? What are the major
determinants of this? Why is this an important issue (i.e. what is the relationship between WAAC
and the overall firm value?
d) Will you have a dividend policy in Mike’s Bikes? What is this?
7.
Debt Policy
a) How does the cost of debt alter as the level of debt in the capital structure increase?
b) What practically determines the amount of debt that a firm such as Real Cool Cycles should hold?
c) How does the desired debt/equity ratio come into this decision?
8.
Equity Issues
a) How does the cost of equity alter as the level of debt in the capital structure increase?
b) When would a company such as Real Cool Cycles decide to issue equity?
c) When should it decide to repurchase equity?
7. Modifications for NetMike
The main difference is that the firm takeovers become more complex when there are 5 firms instead of 2.
8. References
1. Brealey, R.A., and Myers, S. C., Principles of Corporate Finance, McGraw-Hill, 1996.
Page 125
8 PRODUCT DEVELOPMENT
A key to the long-term survival of an
organization is a steady stream of new
products that satisfy the requirements of
the
target
markets.
Many
top
organizations are spending an increasing
proportion of their revenues on the
development of new products.
This is a complex area since it has more
uncertainty associated with it than any
other function within an organization.
There are uncertainties associated with
specification of what the customer wants,
forecasting likely demand, whether the
technical specifications of the desired
product can then be achieved, at what
budget, and in what time frame. All the
qualitative and quantitative techniques of
Project Management are typically brought
to bear on these issues.
Product
Development
Logic
3
Shareholder Value
Current Profit
Future Profit
ECONOMIC
CONDITIONS
COMPETITORS’
ACTIONS
Demand
Supply
Accounting
operating
decisions
investment
decisions
Business Strategy
Marketing
Strategy
Operations
Strategy
Finance
Strategy
Product
Development
Strategy
Product Development
The traditional role of the product development function is to develop new products, and this was often done
in virtual isolation. However, more recently the emphasis has been on their ability to work with the rest of the
organization to identify the market as well as technological possibilities and then to develop the products and
the processes of production to maximize organizational performance.
1. Learning Objectives
a)
Types of Product Development
• Developing new products
• Enhancement of products.
• Process improvement (Value engineering).
b)
Decisions on Product Development
• Product attributes.
• Differing costs of product attributes.
• Target prime cost.
• Product development cost.
• NPV of the investment in product development .
2. A Framework for Product Development
The overall logic of Mike's Bikes is captured in the diagram shown below. This shows how many internal and
external aspects of a firm interact to generate profits and shareholder value.
When considering our fundamental model of creating value, Product Development is essentially an
investment decision into plant and/or products. It impacts future profits since these will be a direct result of the
success of new products. However, it also has a significant impact on current profits, since these are used to
fund the development.
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Product Development
More detail on product development shows
that it can be translated into four types of
decisions:
• Positioning of the new
product on the perceptual
map;
• Prime cost of the product;
• Development cost of the
product and manufacturing
process.
• A go/no go decision based
on the Net Present Value of
the project.
4
Product Development Logic
Product
Development
Strategy
Product
Attributes
Target
Prime Cost
• Positioning
• Target Cost
• Development Cost
• Product NPV
Development
Cost
Product
NPV
This is summarized in the diagram shown,
and is described in more detail below.
Fundamentally, the Product Development
decision is about answering the questions:
Product Development
1. What is required by the marketplace? (Marketing)
This could be based on both perceived as well as latent needs. The basic marketing question is what
does the consumer want? The answer to this comes from a variety of sources including detailed market
knowledge, interviews, surveys, and various more structured methods. The product also often needs to
be test marketed and the appropriate modifications made.
2.
What is the organization capable of producing from a technical standpoint? (Operations)
The basic question to be answered here is what can the organization do technically. If the product is
beyond the ability of the organization to produce, it does not matter what the market potential of it is.
3. How much financing is required and how is this best done? (Finance)
The question to be asked here is how much can the organization afford, how is the money best raised,
and what will be the return over the product life cycle?
4. How long will this new product give us a competitive advantage? (Strategy)
The strategic question is how this product fits into the strategy and how it will give it a long term strategic
advantage.
It can be seen that the Product Development decision is highly cross-functional, involving interaction with most
parts of the organization. In reality most larger organizations separate out the function into a separate
department. While this has the advantages of simplicity, it also suffers from the danger that the function will
develop products that are not sufficiently related to market needs. This introduces the issue of what is the
development philosophy of the organization - customer-pull or technology-push.
2.1 CUSTOMER-PULL
In this case the organization assumes that customers know what they want, what is possible and will ask for
the right things. All efforts are related to working with the customer to define these needs more fully and to set
up communication and feedback mechanisms with them. Products tend to be evolutionary. Examples would
be the sort of systems that IBM developed and that Microsoft are now developing.
2.2 TECHNOLOGY-PUSH.
In this case the organization looks at the most basic unsatisfied needs of consumers and assumes that there
are some fundamental creative or technological breakthroughs that will allow them to provide products that
the customer cannot even imagine. All efforts are put into the basic research efforts and getting the most upto-date equipment and knowledge. Products tend to be revolutionary and examples would be some drugs,
CD's, photocopying, video and the like.
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Often the appropriate form depends on the life-cycle of the industry and while technology-push can start whole
new industries such as the chip spawning the personal computer industry, customer-pull extends and grows it
through maturity. This is one of the difficulties of a company that is good at one approach and not the other,
and one reason why some companies that develop entire industries then proceed to lose that leadership to
others who are good imitators.
3. Types of Product Development Projects
These decisions can translate into one of
three types of development as shown in
the diagram.
3.1 ENHANCE AN EXISTING
DESIGN
When the product is satisfying the market
requirements reasonably well, but some
minor modifications are required because
of changing preferences, a new project is
developed that changes the specifications
slightly to take account of this.
5
Types of Product Development
A New
Model
Value
Engineering
A New
Product
• =Based on an
• =Same model - no
•=Completely
existing
model/project
• =Based on the
same process
3.2 PROCESS
REENGINEERING
new product
•=Usually
targeted at a
new segment
•=New process
required
Product Development
Expenditure to reduce Prime Cost
14
(Process Reengineering)
Expenditure Required for Prime Cost
Reduction
$3,000,000
$2,500,000
Expenditure Required
This is the way in which cost reductions
are achieved. Money is spent on a new
product development project with the
same perceptual map specifications, but
with a requirement for a lower prime cost.
The result will be a product which costs
less to make and takes less factory
capacity to make it. The curve shown to
the right indicates the expenditure
required to get cost reductions. Such a
curve could be drawn for the projects of
most companies and shows that while
small cost reductions are relatively easy to
make, the required expenditure increases
sharply as more reduction is required.
This reflects the new processes and
materials that will have to be adopted as
the cost reduction increases.
changes to attributes
• =M odifications to the
process that will
make it
• =cheaper - cost
•=better - quality
•=faster responsiveness
$2,000,000
$1,500,000
$1,000,000
$500,000
$0
($500,000)
50%
70%
90%
110%
130%
% of Full Prime Cost
3.3 COMPLETELY NEW
DESIGN
Product Development
This is the most difficult type of new
product development, since it requires a fundamental redesign of the product. This means deciding on a
different target market, a different set of product requirements, changes to the distribution channels, and a
new production process.
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Product Development
4. Decisions required for product development
The following decisions are required for product development:
• Project name
• Determining the target attribute values
• Determining the target product prime cost ($)
• Determining the project development cost ($)
• Evaluating the project NPV.
4.1 PROJECT NAME
This is a small but important detail. Often a good name will indicate clearly the nature of the product and the
segment that is being targeted. It will help to name projects with a different extension to products since this
will help to differentiate them.
4.2 DETERMINING THE TARGET ATTRIBUTE VALUES
One of the first decisions that has to be made for
any new project relates to its attributes. This will
be determined by the market segment that is
being targeted, and is defined in terms of the axes
of the perceptual map as shown to the right. The
marketing chapter describes this in more detail.
4.3 TARGET PRIME COST
Another important consideration is the final cost of
the product. If this is too high, then the final retail
price could be too high for the target market. On
the other hand, to make it lower may require an
investment that is too high and may never be
recouped within the life-time of the product.
4.4 TOTAL DEVELOPMENT COST
This is the total amount that is spent to achieve
the attributes and the prime cost. If not enough
money is allocated then the final design will have
product attributes and the prime cost which have been scaled back accordingly.
4.5 EVALUATING THE PROJECT NET PRESENT VALUE
The NPV of a project calculates the current value of the net
h
FreeCashFlow t
income stream associated with it. To do this we ultimately
NPV = FCF0 +
t
need to consider the revenues and the costs. Costs are
t =1 (1 + DiscountRate)
determined by the target specifications which will impact the
prime costs and the development cost as described above.
Revenues will be determined by the potential of the target market as described in the marketing module. And
then NPV is calculated according to the formula shown (and described more fully in the finance module).
5. An Example
To illustrate the theory let's work an example. Assume that we wish to introduce a new product for the Leisure
segment. How do we calculate what this should be and whether or not this should be done?
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5.1 PROJECT NAME
Let's call the project The Cruiser.
5.2 DETERMINING THE TARGET ATTRIBUTE VALUES
The first question is what attribute values the
new product should have. Again the best way to
describe this is to consider the perceptual map
described in the marketing module. Assume
there is currently an Adventurers segment and
there is a product called AdvX selling to it.
Assume that there is an unserviced Leisure
segment. If we wish to develop a new project
that will target this, it must have attribute values
that will be within the area that is attractive for
the Leisure segment. i.e within its radius of
influence. For our example, marketing research
has determined that the Leisure segment
requires
• Style/Design = 55,
• Technical Specs = 10
• At a retail price of $400.
9
New Product Attributes
Technical specs
AdvX
Adventurers
The Cruiser
Leisure
Style/design
Product Development
5.3 TARGET PRIME COST
It is important to specify a target prime cost that will allow the product to be sold profitably. This is the basic
cost of labor and materials for ongoing production and an example of its calculation follows.
Market research has identified that the Leisure segment will pay a retail price $400. By deducting retailer
margin and overhead costs lets say that we estimate we need the unit prime cost to be $48.
5.4 TOTAL PROJECT DEVELOPMENT COST
The next issue that must be dealt with is the development cost. This may be viewed as the one-time cost of
developing the first product and the manufacturing process.
AN EXAMPLE
What is the total development cost for
achieving the target attribute values?
13
Expenditure to Change Attribute Values
SOLUTION
The closest available existing project is taken
as the base, and the change in attributes to get
to the new project is calculated. In this case
the required change for Style/Design is 5 and
for Technical Specs is 50.
Example
Tech
Specs
(50, 60) to (55, 10)
Style/Design: Change = 5
Technical Specs: Change = 50
(50,60)
Again, it is assumed that the product
development department has been able to give
particularly precise estimates of the per unit
development costs as $1,000 for Style/Design
and $20,000 Technical Specs. So the total
development cost for this specification is
calculated to be $1,005,000.
(55,10)
Style/Design
Cost = 5 x $1,000
+ 50 x $20,000
= $1,005,000
Product Development
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Product Development
AN EXAMPLE
We wish to produce a Leisure product with
attribute values of 55 for Style/Design, and 10
for Technical Specifications. The product
development people have given us precise
estimates and said that each unit of Style/Design
will cost $0.12 and each unit of Technical Specs
will be $4.75. (In reality, while these people will
be able to give estimates of how much the
manufacturing costs of a product of this
specification will be, they will seldom be this
precise.) This would lead to a prime cost of
$54.10.
Based on the retail price the Leisure segment
will pay and the distribution and other overhead
costs, however, we determined above that we
need to be able to produce the new bike for $48.
So a 10% cost reduction is required. How much
do we have to invest to achieve this cost
reduction?
11
Expenditure Required for product with
Desired Specification and Prime Cost.
Example
At (55,10):
Full Prime Cost = (55 x $0.12) + (10 x $4.75)
= $54.10
n
(55, 10) Full Prime Cost = $54.10
●
●
n
n
Technical Specs Prime Cost = $4.75 / unit
Style Design Prime Cost = $0.12 / unit
Desired Prime Cost = $48
So desired Prime Cost Reduction = 10%
Product Development
14
Expenditure to reduce Prime Cost
(Process Reengineering)
SOLUTION
Expenditure Required for Prime Cost
Reduction
For typical project in the Mike's Bikes world, the
curve to the right is used to determine how much
money is required to reduce target prime cost.
So to reduce costs by 40% requires an
additional $1,500,000. In the case of Mike's
Bikes, the cost of a 10% cost reduction is
$100,000.
$3,000,000
Expenditure Required
$2,500,000
How much you achieve is determined by the
ratio of actual expenditure to the required
expenditure. If not enough money is spent, then
the required target prime cost and the attribute
values are scaled back proportionately. If too
much money is spent, then the extra is invested
in reduction of target prime cost.
$2,000,000
$1,500,000
$1,000,000
$500,000
$0
($500,000)
50%
70%
90%
110%
130%
% of Full Prime Cost
Product Development
16
$ Actual Expenditure
% Achieved =
$ Required Expenditure
Expenditure Required
So the total cost for this project is calculated as
$1,105,000 which includes the cost reduction
component.
5.5 EVALUATING THE PROJECT
NET PRESENT VALUE (NPV)
n
Attribute Change Cost
= $1,005,000
n
Prime Cost Reduction Cost =
n
Required Expenditure
$100,000
= $1,105,000
The final issue is whether or not this project
should be completed and NPV is the method of
choice.
Product Development
AN EXAMPLE
How do we calculate the NPV for this project?
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SOLUTION
For example, assume that the marketing forecasts are that the leisure bike will sell 10,000 units with
advertising of $1m at a wholesale price of $250 for the next five years, (i.e. $2.5m revenue). The best cost
forecasts (including advertising, direct costs and overheads) are $2m per year. The investment in the first
year would be about $1.1m. The net present value of this investment given a Weighted Average Cost of
Capital (WACC) of 11% is $750,000.
Year
Revenue
Cost
0
$1.1m
1
$2.5m
$2.0m
2
$2.5m
$2.0m
3
$2.5m
$2.0m
4
$2.5m
$2.0m
5
$2.5m
$2.0m
6. Application In Mike's Bikes
6.1 DESIGN DECISION
You may choose to undertake product development projects in the
coming year to develop designs for new products or modifications for
existing ones. The results of these product development projects are
available in the following year (with varying levels of success).
Projects can be any combination of the three types described below:
• New Products - Used to develop a new product often
for a new market segment.
• Product Modification - Used to enhance an existing
product so that it satisfies the market more.
• Value Engineering Projects - Used to reduce the
product prime cost (and required SCU) while
maintaining the current physical characteristics.
When completed, projects can be used to:
• Launch new products.
• Modify existing products.
• Save for later use.
The Product Development Screen is where you enter your decisions about product design and development
for your firm for the upcoming year. Product Development is organized into separate design projects. Each
design project has a set of target product attributes and prime cost, as well as a project budget (which is
always spent constructively e.g. reducing unit prime
costs further if the other specifications have been
achieved!). The design project takes a year to
complete - even if the targets are not completely met.
At that stage the design may be used to launch or
modify a product, used as the starting point for further
development (this will require a new project), or
simply kept until needed. To enter or modify the
specifications for a product design project, press the
appropriate button. Summary information for the
selected project is shown towards the bottom of the
screen. The project will take one period to complete,
so the product launch/modification must be planned
for in advance!
6.2 EVALUATING THE PROJECT NET
PRESENT VALUE (NPV)
This screen to the right allows you to evaluate the
NPV of projects that you have specified.
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Product Development
A Note on Time Lags in Design and Production
The process of producing a new bike takes at least a year to prepare. Before a new product can be launched
there must be a Product Development project completed in a previous period to base the product on. Plant
capacity will probably have to be altered as well, and, because of lead times in purchasing and installing new
capacity, a decision to alter capacity must be made the period before it is required. To modify products that
you already have also requires a completed Product Development project and similar capacity considerations,
but the advantage is that the modified product keeps most of the awareness that the existing product had
within the market.
6.3 INITIATING A PRODUCT DEVELOPMENT PROJECT
On this screen you enter or modify the specifications
for a Product Development project for the coming
year.
You define the project name, the desired levels for
the attributes for the project, decide on the target
prime cost and how much budget to give the Product
Development team to spend on achieving this goal.
(See Notes below for further comments.) The Product
Development team will do the best they can (given
your budgetary constraints) to achieve your goals,
and will deliver the result to you at the end of the
period. You can then view the results of the project in
the Product Development Report.
Projects may not always meet the initially specified
attributes but a design adequate to use for product
modification or launch will always be provided.
The degree of success of the project in terms of
whether it meets its specified attributes and target
cost will depend upon other factors such as the
similarity to other products, the feasibility of the
design in terms of the attributes and the product prime cost, and the total amount spent on the project. Note
that an estimated expenditure of $500,000-$1,000,000 is required to develop a bike design for another market
segment. This may be broken down into a one-time cost for making the desired changes in the technical
specs and the design/style. It may be financially prudent to spread development costs over a couple of years.
The minimum realistic expenditure for any project is $100,000, and the exact cost may be calculated from the
theory and examples in the previous section of this chapter.
Each project will take one period to achieve a result. You may have more than one New Product Development
project per year (if you can afford it!). The result of a New Product Development project can be used to launch
or modify a product in the next period or at any time after that.
PROJECT NAME
Each new project requires a new name. We suggest that you use similar names for successive projects (eg
Cruiser1, Cruiser2 etc.
DETERMINING THE TARGET ATTRIBUTE VALUES
To help you decide on the desired levels for the attributes, you may wish to consult the Market Research
reports, available from the Reports menu. These reports list the ideal values desired by the different market
segments and information about all products. You should enter the target attribute values as shown in the
screen shot above.
TARGET PRIME COST
"Prime cost" refers to the direct labor and raw material cost of making one unit of the product (i.e. each bike).
It does NOT include the very significant overhead costs required to run the factory and market the products.
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As a rule of thumb, to cover these overheads and allow for a profit margin, the wholesale price for a product
will be two to three times higher than the prime cost! So the retail price will have to be four to six times higher
than the prime cost!! In the "Target prime cost" field you enter the prime cost you would like to achieve for a
product based on this new design. Note also that product prime cost is highly dependent upon the level of
technical specifications (since this takes a lot of work), but depends very little on the style/design attribute. For
example the RockHopper has a product prime cost of $300, as compared to around only $60 for a leisure
bike.
TOTAL PROJECT DEVELOPMENT COST
The "Expenditure next period" field is where you specify the budget to be used for the total development cost
of trying to design the required product. The minimum expenditure is $100,000. Depending on how different
the attribute values are from existing designs and how tight the prime cost restriction is, project expenditures
might range as high as $5m.
If the New Product Development
Time to get a new D&D project completed
project team are unable to achieve
Cost per unit of change in Technical Specs
your specifications they will return you
Cost per unit of change in Style/Design
a design part way between their
Product (Prime) Cost for each unit of Technical
starting point (one of your existing
Specs
designs)
and
your
requested
Product (Prime) Cost for each unit of Style/Design
specifications. If your specifications
Minimum Realistic Project Expenditure
are easily achieved, then any extra
money will be used to reduce the prime cost further (ie below your specification).Estimates of
summarized in the table above.
1 period
$20,000
$1,000
$4.50-$5.00
10-15c
$100,000
these costs are
7. Questions to Assist Learning
7.1 QUANTITATIVE QUESTIONS BASED ON SOLOMIKE
The following questions deal with information contained in the workbook DEVELOP.XLS found in the directory
where you installed SoloMike (usually C:\MikeBike\SoloMike). Copy this workbook to another directory to use
for this assignment. Before starting each question, remove the protection from the relevant worksheet(s) by
choosing Protection\ Unprotect Sheet from the Tools menu. This allows you to use data tables and add
graphs to the sheet.
For the purposes of this assignment assume that your firm has decided to “consistently produce a bike that is
considered the best value for the Adventurer segment” and the management team is assessing ways of
implementing the product development. The long-term overall plan is to double sales and production volumes
to 30,000 units, reducing unit costs and being able to lower prices, while still earning a good profit. Assume
also that someone in the firm has put together this spreadsheet model of the SoloMike bike industry.
1.
[Basic] Product Enhancement.
The team considers modifying the
Cost per unit of change in Technical Specs
$20,000
existing product’s attributes to Style 55
Cost per unit of change in Style/Design
$1,000
and Technical Specifications 55.
Product Prime Cost for each unit of Technical
$4.75
Without using the worksheet, calculate
Specs
the unit prime cost of this modified
$0.12
product. Now check your answer by Product Prime Cost for each unit of Style/Design
Minimum
Realistic
Project
Expenditure
$100,000
entering the product’s new attributes
(cells B24 and C24) and reading off the calculated figure (cell B46). Given that your existing product has
attributes Style 50 and Tech Specs 60, calculate the amount of change required in each dimension and hence
the investment required to achieve a design with Style 55 and Tech Specs 55. Check your answer by reading
off the calculated figure (cell B43).
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Product Development
2.
[Basic] Value Engineering.
Reducing the cost, complexity and capacity of producing the bike is critical to the firm’s strategy of increasing
sales volumes by reducing retail prices. The team decides to forego any change in attributes in favor of
concentrating resources on value engineering the unit prime cost down to $225. Restore the desired product
attributes (cells B24 and C24) to Style 50 and Tech Specs 60, and set the desired prime cost to (cell B25) to
$225. Use the table found in rows 98 to 101 to calculate the prime cost achieved for a range of expenditures
from $200,000 to $1m. Create a graph showing the achieved prime cost for the range of expenditures. From
your graph estimate the investment in value engineering required to reduce the unit prime cost to $225?
Check your answer by reading cell B63
3.
[Integrating] Net Present Value.
A “do-nothing” option worth considering would be to simply take the lower prime costs but leave existing
operations and marketing exactly as they are. In this case the return on the investment would be the
increased margin achieved from the lower unit prime costs. (Assume that all other costs would remain
constant.) Calculate this return if sales volumes are 15,000 with wholesale price $850, previous unit prime
cost $300, and new prime cost $225. If the cost of capital for this project is 11%, calculate the net present
value of this investment between 1999 and 2003 (remember that the increased margin does not start until
2000 when the modified product is introduced).
4.
[Advanced] Net Present Value.
Now the team considers what the NPV would be if they follow through with the strategy as planned. Assume
that the existing gross margin is (15,000*($850-$300)) $8.25m per year. Calculate the additional gross margin
for 2000-2003 if the sales of the cheaper product are 30,000 at $700 and unit prime cost is $225. Assume that
additional costs for 1999 are $1.5m (product development, extra depreciation and training); 2000 are $2.7m
(incl quality systems, extra depreciation); 2001-2003 are $1.5m. Calculate the net present value of this
investment between 1999 and 2003.
5.
[Advanced, Integrating] New Product Development.
Just for the sake of argument, the team decides to also consider the rough NPV for launching a new bike for
the leisure segment in addition to your existing adventurer bike. Market research indicates that the ideal
attributes would be Style 50, Tech 10. Estimate the cost of developing a leisure bike with Style 50 and Tech
10 (assume no prime cost reduction). What major costs would you need to consider when calculating the
NPV? Assume demand for the new bike is 20,000 at retail price $250, annual advertising costs are $700,000
and the annual cost of new capacity (plant and workforce) is roughly $100 per SCU. If factory efficiency is
65% estimate the capacity required and hence the overhead costs. Estimate the NPV between 1999 and
2003. What do you conclude?
6.
[Advanced, Integrating] Optimization.
Because of the great potential of reducing the cost of the existing bike to $225, the management team
assigns you to investigate prime cost reduction further. Assume that you are creating a bike with Style 50 and
Tech 60, and that the target selling price is $700 and sales 30,000 units. Further, assume that additional
overhead costs for 1999 are $0.5m (excl. product development), for 2000 are $2.7m, for 2001-2003 are
$1.5m. Find the investment in cost reduction which yields the greatest NPV between 1999 and 2003.
7.2 QUALITATIVE QUESTIONS (APPLICABLE TO EITHER SOLOMIKE OR NETMIKE)
1.
Write a draft product development plan for the Mike’s Bikes environment for the next 2 years. (2-3
pages). This should include a consideration of the following issues and can be in bullet form. (Make
sure that you think about consistency - among themselves, with the overall strategy, and with the
marketing, operations and finance strategies.)
a) What products will you develop over the next 2 years? (Describe the targeted segments and
attribute values, target prime cost, expected development cost, and NPV.)
b) Which are the key groups involved in product development?
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2.
What are some techniques for determining the ideal positioning of a new product?
3.
What is a way of estimating the total development cost of a new product?
4.
How would you determine the target prime cost?
5.
What is the role of NPV in the Product Development decision? What is the difference between using
NPV and EVA?
6.
Which are the main groups involved in product development? Describe some of the main techniques
that are used to encourage the effective integration of these groups.
8. Modifications for NetMike
The only differences between SoloMike and NetMike is that NetMike has more market segments to consider
developing products for.
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9 MICROECONOMICS
The aim of this section is to go over some of the basic microeconomic models and show how they have been
used to develop the models that drive Mike’s Bikes. The purpose of this will be to show you that many of the
intuitions learned from microeconomic theory can be applied in the Mike’s Bikes environment to improve your
decision-making skills.
1. Learning Outcomes
In this chapter we explore some theory related to these issues, and work simple numerical examples. The
main learning objectives for this chapter are the understanding of the following:
a) A framework for Economics
b) Understanding the concept of preferences and utility
c) Understanding a Mike’s Bikes consumer's preferences
d) The concept of Market segmentation and different representative consumer utility
functions;
e) The Mike’s Bikes demand model
f) The effect on Demand of manipulating Mike’s Bikes demand drivers
g) Price Elasticity of Demand and its effect on Pricing Decisions
h) A simple traditional Cobb Douglas production function
i) The enhanced Mike’s Bikes production function
j) Production decisions in the short run vs. long run
While these issues may be considered in isolation, Mike's Bikes encourages users to view them as a part of
the overall strategy and so to think of the firm and industry as an interactive system.
2. A Framework for the Role of Economics
The figure shown to the right represents the
fundamental framework that is used in Mike’s
Bikes. It shows a common view of economics
relative to real business functions and with respect
to shareholder value. Specifically, economics is
seen as something that is just there. However
economics tries to capture the fundamental
factors of the market and to simplify them into
models to try to learn the intuition to achieve the
most profitable match between demand and
supply. The lesson from economics is that all the
real world functional units must work as a team to
ensure maximum profitability of the firm.
4
Shareholder Value
Economics
Current Profit
ECONOMIC
CONDITIONS
COMPETITORS’
ACTIONS
Demand
Future Profit
Supply
Accounting
operating
decisions
investment
decisions
Business Strategy
Marketing
Strategy
Operations
Strategy
Finance
Strategy
Product
Development
Strategy
Economics
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3. Determining Strategic Objectives
5
From a strategic perspective, economics has 3
main goals:
1. To understand the determinants
of market demand and production
cost.
2. To manipulate these factors to
maximize profit.
3. To try to predict competitors'
actions to further increase profit
and to protect future profitability.
Economic performance is measured by both the
rate of economic value being created and by the
probability of further success given the state of
competitors.
Economics - Market Logic
“THE MARKET MECHANISM”
Equilibrium
- Perfect Competition
- Imperfect Competition
Supply
Product
Attributes
Profit
Maximization
Labor
Cost
Price
Demand
Consumer
Utility
Promotion
Cost of
Capital
Consumer
Preferences
Distribution
Consumer
Income
Economics
4. Economic Modeling of Consumers
Every individual consumer in the world has his or her own unique personal preferences about everything.
Given a group of consumers they will always only partially agree on what they like and dislike. However
Marketing uses the technique of breaking up groups into sub-groups or segments of people with more highly
correlated agreement on what they like and dislike. Economics attempts to fit functions to these segments to
allow mathematical evaluation of their reaction to different stimuli.
5. Preference Theory
Economists concentrate on modeling rational consumers. To be considered "rational" a consumer has to
obey three preference axioms (rules). Using bikes as examples these rules are:
1. COMPLETENESS: Given two bikes A & B a consumer can always decide that either, A is preferred
to B, B is preferred to A, or A and B are “equally attractive”, i.e. a rational consumer is not allowed to
say "don't know".
2. TRANSITIVITY: If a consumer says that bike A is preferred to bike B and that B is preferred to bike
C, then for a rational consumer bike A must also be preferred to bike C.
3. CONTINUITY: If a consumer says that bike A is preferred B then a bike almost exactly the same as
A must also be preferred to B.
The purpose of these rules is to enable mathematical models called utility functions to model these
preferences.
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5.1 MIKE’S BIKES CONSUMER PREFERENCES
Mike’s Bikes consumers are split into segments
preferences are shown below.
Segment
Sensitivity
Adventurer
Leisure
Segment
54
that have similar preferences. The SoloMike consumer
Price
Advertising
PR
Quality
Distribution
Delivery Time
Low
Med
Med
High
Med
Low
High
Low
Med
Med
Low
High
Average Score for Style/Design
Average Score for Technical
Specs.
Adventurers
50
50
Leisure
50
10
Mike’s Bikes consumers are rational and obey the three axioms of preference. However the preferences
above indicate the "average consumer" in the segment but not everybody in the segment. Consider the
following example. Assume that there are two bikes A and B with exactly the same attributes except for price.
If A is cheaper than B then the majority of people in the segment will choose A. However others with slightly
different preferences will still be indifferent to A and B. Some of these people would buy B. As the price gap
between Bike A and Bike B increases, fewer people will still be indifferent, so fewer will buy Bike B.
6. Utility Functions
A utility function is a mathematical function that obeys the three preference rules of completeness, transitivity,
and continuity. It achieves this is by taking a consumer's preferences and allocating a utility value to them that
can be used for ranking different possibilities. For example in Mike’s Bikes a consumer's utility function
evaluation of two bikes might give the result:
Ubike A(advertising, distribution, quality, delivery time, physical attributes) = 5
Ubike B (advertising, quality, distribution, delivery time, physical attributes) = 10
The rule of utility functions is that consumers are always trying to maximize utility so in this case that means
that Bike B is preferred to Bike A. However the utility values are just a ranking system and do not mean that
bike B is twice as good as bike A. Notice that price was not included as a variable of the utility functions. The
reason for this is that most consumers are constrained by income and tend to try to maximize their utility with
respect to what they can afford. So although some consumers may gain some utility from "getting a bargain",
generally they get no utility from price, it is just a measure of what they can or cannot afford.
54
For further discussion of the segmentation process see the Marketing Chapter
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6.1 A STANDARD INTRODUCTORY UTILITY FUNCTION
A simple way of introducing utility theory is to
model the utility of a single consumer given
the choice between varying amounts of two
goods X and Y, where X and Y are both
normal goods and neither complements or
close substitutes for each other.
a
b
U = X *Y
Where U = utility
X = good X
25.0
20.0
Quantity of Good Y (units)
A common utility function for this situation is
the Cobb Douglas function where:
0.5 0.5
Indifference Curves for U = X Y
15.0
U=9
U' = 10
U" = 11
10.0
Y = good Y
5.0
a, b, = constants and
both are <= 1
0.0
0
5
10
15
20
25
Quantity of Good X (units)
7. How is Utility Incorporated in the Mike’s Bikes Model?
Understanding how utility theory relates to the Mike’s Bikes model can seem very complex. However the key
is to try to grasp the intuition and rules of the simpler models and check their results versus the Mike’s Bikes
Model.
Introductory utility theory models are based around one or two consumers choosing between different
amounts of two goods. It is currently technologically impossible for Mike’s Bikes to individually model every
consumer in the Mike’s Bikes economy so aggregate utility functions were developed to model the general
utility concepts.
7.1 VALUE FOR MONEY
Value for money is the name of the "multiplicative regression" function that Mike’s Bikes uses for measuring a
type of "utility" value of a product. Value for money is calculated on a by segment basis and each product in
the segment is assigned a “value for money” value.
If we let U stand for "Value for Money", then U is a function of type:
U (price, advertising, distribution, quality, delivery time, physical attributes)
Given
P = Price
A= Advertising
R= Public Relations
D = Distribution
Q = Quality
T = Delivery Time
S = Physical Attributes (Style/Design and Technical)
Also given that all of these values are indexes with values between 0 and 1, therefore Umax = 1
Then
p
a
r
d
q
t
s
U=P *A *R *D *Q *T *S
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Microeconomics
Where the indices indicate the relative importance of each attribute to the average consumer of that segment
as shown below.
Segment
Sensitivity
Adventurer
Leisure
Segment
Price
Advertising
PR
Quality
Distribution
Delivery Time
Low
Med
Med
High
Med
Low
High
Low
Med
Med
Low
High
Average Score for Style/Design
Average Score for Technical
Specs.
Adventurers
50
50
Leisure
50
10
All of the sensitivity categories are measured in the model as an index between 0 and 1, where 1 is the best
result possible. For example with the price index, a value close to 1 indicates a low price and a value close to
0 a high price. For physical product attributes like style and technical specs then they are given a "perceptual
55
distance " which is:
No of Attributes
(ImptceAttrib i) x (Segment1Attrib i - Prod1Attrib i) 2
PerceptDistanceProd1 =
i =1
This distance measures how far away from the ideal physical specifications the product is.
7.2 EXAMPLE OF VALUE FOR MONEY
The best way of explaining the value for money function is to calculate an example.
In SoloMike the indices for the adventurer segment are:
p=
PowerPrice
=
4.061
a=
PowerAwarenessIndex
=
0.810
r=
PowerPublicRelationsIndex
=
0.400
d=
PowerDistribution
=
0.585
q=
PowerQuality
=
1.050
t=
PowerDelivery
=
0.062
s=
PowerDistance
=
0.058
So for our example lets set all the index values for Bike W to 0.5, i.e. P = A = R = D = Q = T = S = 0.5
4.061
So UW = 0.5
.0.810
*0.5
.0.400
*0.5
0.585
*0.5
1.050
*0.5
0.062
*0.5
0.058
*0.5
UW = 0.00767
Now say there is a competitor's product Bike X with a lower price so that P = 0.6
UX = 0.01609
Next say there is a third competitor with a Bike Y with the same features as Bike W but A = 0.6
55
For a more detailed description of perceptual mapping see the Marketing Chapter
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UY = 0.00889
Finally say there is a fourth competitor with a Bike Z with the same features as Bike W except S = 0.6
UZ = 0.00775
Using the ">" to show preferred to then the average consumer in the adventurer segment prefers
X>Y>Z>W
So in a simple economic model given these results all the consumers in the adventurer segment would buy
Bike X, and settle for Y if X sold out and so on.
However the Mike’s Bikes model wants to simulate that not every consumer in the segment is the average
consumer. There will be some consumers in the segment that are still indifferent between bikes X, Y, Z, W
given this small level of variation between the bikes. Of course as the variation increases more and more
consumers in the segment would definitely prefer the bike with the highest value for money value.
The other issue that needs to be addressed is the highlighted by the "utility" components of advertising and
distribution coverage. In a standard simple theoretical model, every consumer knows all products that exist
and has access to buy any of them. In the Mike’s Bikes model some products do not have full distribution
coverage so some consumers in the segment do not have the opportunity to buy every product being sold,
and depending on the level of advertising some consumers do not know that every product exists.
To create these effects while still maintaining the core concepts of preference theory, Mike’s Bikes uses the
"ordinal" "value for money" amounts, e.g. U = 0.02 is approximately twice as good as U = 0.01.
To achieve this, the Mike’s Bikes model uses a "sum of value for money" term.
Sum of Value for Money = Value for MoneyProd1 + Value for MoneyProd2 + ....Value for MoneyProdn
The market shares for a product (SegmentShareProd1) is then determined by:
SegmentShareProd1 =
Value for MoneyProd1
Sum of Value for Money
So in the case above,
Sum of Value for Money = 0.04040
So
SegmentShareProdW =
19.0%
SegmentShareProdX = 39.8%
SegmentShareProdY =
22.0%
SegmentShareProdZ = 19.2%
These results show that the value for money formula maintains the spirit of preference theory. Completeness
can be seen by the fact that no consumers can not choose between the bikes. Transitivity is shown most by
the ranking of market share. The possibility of continuity can be seen by how close the market shares are for
the slightly different bikes W and Z. If a Bike Z" with substantially lower indexes was available, then knowing
that Bike W was preferred to Z' would automatically tell you that Bike Z was preferred to Bike Z".
The "realistic feel" quality is also met. Although Bike X was clearly the most preferred bike on the market it
was not significantly different enough in its attributes to completely dominate sales. Bike X needs to increase
its distribution and advertising indexes or to further reduce its price to increase its market share above 40%.
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Microeconomics
7.3 EXAMINING THE VALUE FOR MONEY FUNCTION
The components for the Value for
Money function for the SoloMike
adventurer segment are shown on the
graph to the right as well as the function
when all the indexes are equal as in the
example above.
Quality (Q), Distribution Coverage (D)
and Awareness/Advertising (A) results in
approximately
constant
marginal
increases in value for money while Price
(P) results in exponential increases.
Price is obviously a major determinant of
value for money for the Adventurer
segment.
1.0
0.8
Value for Money
Delivery Time (T), and Physical
Attributes (S) show diminishing marginal
increases in value for money, having the
least effect on total value for money.
Sensitivity of Value For Money to changes in each
component of demand
All indexes
P
A
0.6
R
D
Q
0.4
T
S
0.2
0.0
0.0
0.2
0.4
0.6
0.8
1.0
Index value
The purpose of the power indices is to mimic the effect of elasticities. So a bigger power indicates that the
average consumer of that segment has a high elasticity with respect to that attribute while a lower power
shows that they are relatively inelastic with respect to that attribute. For example in the adventurer segment
above, the price index (P) has a high power and consumer demand is elastic with respect to price, while in
regards to delivery time (T) consumers have relatively inelastic demand.
8. How Mike’s Bikes Calculates Demand for a Product
Mike’s Bikes calculates demand backwards. In simple models each firm faces their own demand curves and
the aggregate demand for the industry is found by summing the individual demand curves. However in Mike’s
Bikes the aggregate segment demand is calculated first, with product demand being derived from its share of
the aggregate segment demand.
1. Determine the product’s market share
of the total demand for the segment
•
through the value for money
calculation of the product for that
segment
Product Specs
Price
2. Determine the aggregate demand for
each segment
•
PR Influence
Distribution
Quality
Product Segment Share
based on a market share weighted
average of product attribute
indexes of all products currently
selling to a segment
Segment Demand
Total Product Demand
3. Total demand for the product is the
sum of its individual segment demands
•
Awareness
However most products will only
sell in one segment.
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9. The Mike's Bikes Aggregate Segment Demand Function
Each market segment has its own aggregate demand function. These aggregate market demand curves are
of the form:
Q = t*(a + bB + pP + cC + dD + eE + fF + gG)
Where
t = an exogenous market growth/decline trend factor
Q = Quantity
a = a constant
B = Weighted average perceptual distance of products from the ideal attributes
P = Weighted average Price Index of products sold to that segment
C = Weighted average Product Awareness Index
D = Weighted average Distribution Index
E = Weighted average Quality Index
F = Weighted average Delivery Index
G = Weighted average Public Relations Index
b, p, c, d, e, f, g = constants
NOTE: That all Index values range from 0 to 1.
Weighted averages for each factor are calculated using segment shares as the weights. This means that the
more important products influence the average to a greater degree. The weighted averages are calculated
using the type of formula shown below:
AveragePriceIndex =
(SegmentShare Product i × PriceIndex Product i )
9.1 AN EXAMPLE OF AN AGGREGATE SEGMENT DEMAND FUNCTION
The Mike’s Bikes demand philosophy is that the representative consumer for the segment is sensitive to the
representative level of the demand drivers.
Segment
Sensitivity
Adventurer
Leisure
Price
Advertising
PR
Quality
Distribution
Delivery Time
Low
Med
Med
High
Med
Low
High
Low
Med
Med
Low
High
For each segment of representative consumers their elasticity to the demand drivers is kept constant. A
maximum total demand for each segment is then defined. Portions of the total demand are then allocated to
each demand driver.
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Microeconomics
For example in the Adventurer segment in SoloMike the aggregate demand curve is:
Q = t*(a + bB + pP + cC + dD + eE + fF + gG)
Where
t = 1.07
a = -18,206.00
b = -100.00
p = 39,615.70
c = 50,000.00
d = 6,666.67
e = 14,639.88
f = 2,222.22
g = 20,000
Now
B = 0 to 15
P,C,D,E,F,G = 0 to 1
So Qmax occurs when B = 0 and all the others = 1. So Qmax = t*94938 scu, so substituting the segment size
factor of 1.07 for adventurers to generate the final total maximum segment size gives Qmax = 101584 scu.
9.2 ELASTICITIES AND THE AGGREGATE SEGMENT DEMAND FUNCTION
The aggregate demand function is a multiple linear regression function as shown in the example above.
The graph in the next section shows demand as a function of quantity versus weighted-average price. Each
period the entire function moves up or down dependent on the segment's growth factor, for example in
SoloMike in the adventurer segment the segment demand grows by 7% from 1998 to 1999. Notice that you
can also plot quantity versus any of the other attributes (for example, quantity versus weighted-average brand
awareness).
Therefore you need to realize that the following elasticities are incorporated in the function:
•
Design Attributes elasticity of demand (b)
•
Price elasticity of demand (p)
•
Advertising elasticity of demand (c)
•
Distribution elasticity of demand (d)
•
Quality elasticity of demand (e)
•
Delivery Time elasticity of demand (f)
•
Public Relations elasticity of demand (g)
For example if the segment has matured and all of the other attributes apart from price stayed relatively stable
then arc price elasticity of demand for the segment could be calculated using the formula:
arc price elasticity of demand = -(∆Q/Qavg)/( ∆P/Pavg)
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10. Using Econometric Techniques to Support Marketing
Decision Making
From a marketing perspective the two areas that you can analyze are either the performance of the entire
segment or the performance of your individual products.
10.1 ANALYZING AGGREGATE SEGMENT DEMAND
The first step of analyzing the aggregate
performance of a segment is to sum the
demands of the bikes being sold to that
segment so you know what the total
demand of that segment was. Next you
can determine whether total demand
has increased or decreased and at what
rate.
$2,500
$2,000
$1,500
Price ($)
Since you know that the aggregate
demand curve for any segment is of the
form Q = t*(a + bB + pP + cC + dD + eE
+ fF + gG), then the second step is to
estimate what the weighted average
index values are.
For product
awareness, quality and delivery index
values for each product are available in
the "All Product Details" Marketing
Report. You can also calculate the
weighted-average price of the segment.
One way of estimating the distribution
coverage is to look at the distribution
reports to see how many distributors are
stocking each product.
Example of an Aggregate Segment Demand Function
$1,000
$500
$60000
65000
70000
75000
80000
85000
Quantity (bikes)
The
purpose
of
calculating these values
is to compare them to the
previous period to try to
estimate which factors
are having the greatest
effect on total aggregate
demand.
Generally the
Mike’s
Bikes simulations are not
run over enough periods
for you to get enough
data points to accurately
estimate each segment's
aggregate
market
demand
function.
However you should be
able to learn which
factors have the greatest
impact on aggregate
demand for each segment.
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Microeconomics
10.2 ANALYZING INDIVIDUAL PRODUCT PERFORMANCE
The methods available to you depend
on how volatile the segment that your
product is competing in is. In every
segment each of your products is facing
a demand curve of the type:
Individual Product Demand Functions
100000
90000
Qi = (value for money producti)/(sum of
value for money all products in this
segment)
80000
Quantity (bikes)
70000
Your aim is to determine the most
profitable combination of price, product
awareness,
quality,
delivery
performance, distribution coverage and
product attributes that you can achieve.
Anything that you do that increases your
product's value for money will increase
your market share and anything that
your competitors do that increases their
value for money will negatively affect
your market share.
Product1
60000
Product2
50000
Product3
40000
Total
30000
20000
10000
0
$500
$1,000
$1,500
$2,000
$2,500
Weighted Average Price ($)
The first point you need to understand is
the relationship between individual product's demand curves and the aggregate demand curve for the
segment as shown in the graph above.
The graph above shows an example of a market segment with three products being sold. If you sum the
individual demand curves you will get the total aggregate demand curve. For example given a weightedaverage market price of about $1400 (as shown by the dotted black line) then Product2 would sell about
38,000 units, Product1 about 30,000 and Product3 about 17,000.
You will not be able to construct this graph yourself since the data available to you each period will only be the
weighted average price, the total aggregate demand, and quantity sold of each bike in the segment.
One of the most useful econometric tools available to you is elasticity calculation. However its usefulness
depends on how volatile the segment's market is. When competitors first enter a market they tend to compete
across all of the product dimensions and the segment is quite volatile. But after a couple of periods the quality,
delivery performance, and distribution coverage reach the firm's equilibrium values. At that point advertising
and price are the main bases of
competition, allowing the use of price
Quantity vs Price for the Adventurer Segment 2003
elasticity of demand and advertising
elasticity of demand calculations. In a
2000
mature segment product awareness
often stabilizes too, leaving price as
1900
the main form of competition and low
production costs the main profit driver.
1800
During the initial volatile phase as new
products enter a segment then
graphical analysis is one of the best
econometric tools available to you.
The first graph that you should draw
should be a simple quantity versus
price graph as to the right.
From the graph above, one of the first
things that you should see is that a
bike with a price of $1700 and another
Price ($)
VOLATILE MARKET ASSESSMENT
1700
1600
1500
1400
0
2000
4000
6000
8000
Quantity (bikes)
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12000
14000
MIKE’S BIKES – Integrated Business Learning Online
with a price of $1750 both sold 10,000 units. So from the quantity versus price graph you are trying to find a
linear approximation of the demand curve facing your firm, and to identify "outliers" and anomalies that you
could investigate further. Therefore in this case you might check the other attributes of the $1700 and $1750
bike to see why the more expensive bike was able to achieve the same sales volume.
MATURING MARKET ASSESSMENT
The graphical evaluation method above is good for getting a "rough" estimate. However once a market
segment starts to stabilize then elasticity calculations will help you to fine-tune your marketing decisions.
From the graph above you also need to realize that each product is on its own individual demand curve.
However if products have similar attributes except for price then you will have multiple points on a single
demand curve. You can cause this deliberately by launching multiple products in one segment with identical
attributes except for price. Once you have three or more points on a single demand curve then you can get a
reasonable estimate of its shape.
The two main elasticity calculations that you can use are:
•
The arc price elasticity of demand is defined as elasticity = -(∆Q/Qavg)/( ∆P/Pavg)
The price elasticity of demand estimates what percentage your demand would change given a 1% change in
price.
•
The arc advertising elasticity of demand is defined as elasticity = (∆Q/Qavg)/( ∆A/Aavg)
The advertising elasticity of demand estimates what percentage your demand would change given a 1%
change in advertising expenditure.
For example if you discover that there are two almost identical bikes, one with a price of $1700 selling 12,000
bikes and another with a price of $1800 selling 10,000 bikes then you can calculate the arc elasticity of
increasing price from $1700 to $1800:
arc price elasticity = -(10,000-12,000)/((10,000+12,000)/2) / (1800-1700)/((1800+1700)/2) = 3.18, so you know
a 1% increase in price for that bike causes a 3.18% decrease in demand, and can estimate that a 1%
decrease in price would cause a 3.18% increase in demand. So you can estimate that if you reduced the
price of the $1700 bike to $1600 (a reduction of about 6%) then the increase in demand should be about 19%,
or 12,000 bikes increasing to about 14,000 bikes.
The other main use of the price elasticity of demand is for estimating the optimal price to charge for a product.
The optimal price formula is:
P = MC*(1/(1-1/price elasticity))
Where P = price and MC = marginal cost.
The marginal cost can be estimated from the "average manufacturing cost per unit" value available on the
"COGM and Gross Margin Report".
For example given an adventurer "average manufacturing cost per unit" of $502.14 and a price elasticity of
demand of 3.18 then an estimate of the optimal wholesale price would be P = $502.14*(1/(1-1/3.18)) =
$732.48 which with a 50% retailer margin corresponds to a price of about $1465.
11. The Production Function
Economics is based on the study of how to use limited resources as efficiently as possible. In complex
situations most of the debate focuses on how you define “efficient”. However in the case of a simple factory
most managers would agree that the aim is to get maximum output at least cost.
The classic theoretical trade-off is that between capital (plant and equipment) and labor. The basic idea is
that for each level of output there are a number of possible combinations of capital and labor that you could
use to produce them.
A typical function used to model this is a Cobb Douglas production function of the form:
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Microeconomics
a
b
q=K *L
Where
q = output
Isoquant for Q = K0.5 * L0.5
K = capital
30.0
L = labor
25.0
The indices "a" and "b" indicate the relative
productivity of each sort of production factor input
and are both always less than one.
20.0
9 units
15.0
K (units)
10.0
Mike’s Bikes uses the following production function:
q = K0.5 * L0.5
5.0
This is shown in the graph to the right.
0.0
0
5
10
15
20
25
L (units)
Basic Cobb Douglas Isoquant
11.1 FEATURES OF THE COBB DOUGLAS PRODUCTION FUNCTION
Setting "a" and "b" both less than one models
the "diminishing marginal returns" result. For
example, consider the Mike’s Bikes equation
0.5
*L
14.0
If "K" is kept constant and "L" is increased then
each additional unit of labor increase "q" by a
steadily decreasing amount. This reducing
increase in "q" with each additional unit of labor
is called diminishing marginal returns. This is
shown on the graph to the right. This is an
intuitive result for a Bike factory since there are
only so many tools and machines to go around.
As you hire more employees they have less
machine time available to them to make more
bikes.
12.0
10.0
Q (units)
0.5
q=K
Short Run Output PossiblitiesWith K= 9 units
8.0
9 units of K
6.0
4.0
2.0
Another feature of Cobb Douglas equations is
that you can differentiate them. The point of
differentiating is to find the slope of the
production curve. This slope is called the
Marginal Rate of Technical Substitution
(MRTS) and shows the rate at which Labor (L)
can be substituted for Capital (K).
0.0
0
5
10
15
20
L (units)
For the Mike’s Bikes function the slope at any point is:
MRTS = (dq/dL)/(dq/dK) = K/L
So in the graph above the MRTS at (12, 6.8) = 6.8/12 = 0.567, so at that point 1 unit of labor can be swapped
for 0.567 units of capital while still remaining the same output of "q" units.
11.2 THE ENHANCED MIKE’S BIKES PRODUCTION FUNCTION
The core of the Mike’s Bikes production function is the Cobb Douglas equation of the form:
0.5
q=K
0.5
*L
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Where "q" is the number of units produced, "K" is the units of capital and "L" is the number of workers.
However Mike’s Bikes is not set in a simplified economics model so it needs to show the impact of real world
factors on this production function. This is done by changing the definition of L and by using two efficiency
indexes, the "worker effectiveness index" and the "production efficiency adjustment factor".
In Mike’s Bikes, "K" is plant capacity in (scu) and "L" is defined as Worker Capacity (scu) where:
Worker Capacity = No. of Factory Workers * Potential Capacity per Worker * Worker effectiveness index
The "worker effectiveness index" is an efficiency factor that determines how much of their potential output
workers are willing or able to produce. It is based on the workers' motivation and skill levels. The motivation
level is determined by the staff turnover rate and the pay rate relative to the industry average while the skill
level is based on the staff turnover rate and amount of time devoted to training.
The second efficiency index is the production efficiency adjustment factor. So letting
production efficiency adjustment factor = e
Then the true Mike’s Bikes production function is:
Qactual = Qtheoretical*e
where
0.5
Qtheoretical = K
0.5
*L
THE IMPACT OF EFFICIENCY IN
MIKE’S BIKES
The effect of a change in the
production efficiency adjustment
figure can be seen on the graph
to the left. Both isoquants are for
producing 31597 scu, but the one
to the right with 50% efficiency
requires significantly more plant
and workers compared to the left
isoquant with 64% efficiency.
Plant Size (scu)
The "production efficiency adjustment factor" tries to take into account inefficiencies in the production process.
It includes delays due to raw
material stock-out, breakdown,
Isoquant Map for Mikes Bikes Production Function in Period 1 for 31597 (scu)
and set up time. These three
70000
factors are calculated in the
model as a result of decisions
60000
such as how many weeks of raw
material inventory are stored, how
much to spend on maintenance,
50000
what size batches to make etc.
40000
Production Efficiency
Adjustment Figure = 50%
Production Efficiency
Adjustment Figure = 64%
30000
20000
10000
0
0
20
40
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60
80
100
120
Number of Workers
140
160
180
200
Microeconomics
The effect of an decrease in the worker
effectiveness from 0.61 to 0.50 causes
the production isoquant to move to the
right parallel to the x-axis. What this
means is that the same amount of
capital is required as before but now
more labor is also needed.
Isoquant Map for MikesBikesProduction Function in Period 1 for 31597 (scu)
70000
60000
Plant Size (scu)
50000
Worker Effective
Index = 0.50
40000
Worker Effective
Index = 0.61
30000
20000
10000
0
0
20
40
60
80
100
120
Number of Workers
140
160
180
200
12. Production Costs
Given a Cobb Douglas production function the total cost (TC) of producing "q" items is:
TC(q) = vK + wL
Where
TC = Total Cost in $
v = The cost of using the capital (K)
w = The cost of using the labor (L)
12.1 LONG-RUN COST MINIMIZATION
With a Cobb Douglas production function, the minimum cost point of production is where the Marginal Rate of
Technical Substitution (MRTS) is equal to the ratio of the cost of labor to capital, i.e.
TCmin occurs when:
MRTS = w/v
For the Mike’s Bikes production function this point is when:
MRTS = K/L = w/v
which is equivalent to
wL = vK
So in the long run to produce a quantity "q" scu you should try to set the total cost of labor (wL) equal to the
total cost of capital (wK). The difficulty is measuring "w" and "v", especially since "L" is dependent on the
worker effectiveness level of your factory staff. However you can approximate "w" by your employee wages
bill and approximate "v" by the depreciation expense plus the maintenance expense plus the value of your
plant multiplied by your required return on equity. In the long run you should be trying to keep “wL” and “vK”
equal if you want to minimize your production costs.
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13. Questions to Assist Learning
13.1 QUANTITATIVE QUESTIONS BASED ON SOLOMIKE
1.
Economic Modeling of Consumers
The purpose of this question is to clarify your understanding of the theoretical constraints of modeling
consumer behavior.
a) One of the assumptions underlying much of economic analysis is that of rational consumers. Using
examples from Mike’s Bikes, describe and define the three axioms that must hold in order for a
consumer to be considered “rational”.
b) What is the relationship between these three axioms and the marketing technique of segmentation?
2.
Utility in Mike’s Bikes
In Mike’s Bikes consumer utility is modeled using a “Value for Money” function. This question explores your
understanding of what this function is simulating and how it works.
a) Briefly describe how the six components that contribute to the Value for Money function increase a
consumer’s utility.
b) Assume an adventurer segment with a total demand of 60,000 bikes. Assume there are only three
bikes being sold (called A1, B1 and C1), and they have value for money values of 0.2, 0.6, and 0.7
respectively. What will the approximate demand for each bike would be?
c) Open the DEMAND sheet and look at rows 21 through 26. Rank the six components in order of
importance for an Adventurer bike. Given this ranking, which is likely to increase your market share
most, a small increase in the retailer margin or a slightly improved adventure bike design? Name
one other reason that you might choose to invest in a slightly improved adventure bike design?
3.
Price Elasticity of Demand
The demand model is presented in the worksheet DEMAND. For the purposes of this question however, we
will be using the part of the worksheet PRICING labeled “Demand Analysis” (rows 64 and below). Before
starting this question, remove the protection from the sheet by choosing Protection \ Unprotect Sheet from the
Tools menu. This allows you to add the data and graphs required.
This question investigates the price elasticity of demand for your adventurer bike as prices are increased or
reduced.
a) [Basic] Assume that your competitor doesn’t reduce prices. Find the part of the PRICING sheet
labeled “Demand Analysis” (rows 64 and below). Using the Data table template provided (i.e use
B17 as the row-input cell), find the demand and segment share achieved for different levels of price.
Create a graph of demand for RC_RockHopper and its segment share for different prices. Estimate
the price reduction required to achieve a demand of 19,000.
b) Plot a graph of quantity demanded (x-axis) versus price (y-axis). Notice that this is approximately a
straight-line demand curve. Notice that in Mike’s Bikes $500 is the minimum allowable price for an
Adventurer bike. This means that $500 is the price inelastic point: prices below $500 would sell the
same number of bikes.
c) In the row under your data table, calculate the arc price elasticity between $500 and $1000, $1000
and $1500 etc. Notice that this straight-line demand curve follows the traditional model of inelastic
at the lowest price, unit elastic in the middle and elastic towards the top prices. At what approximate
price is the demand curve unit elastic? What does unit elastic mean?
d) Now assume that your competitor decides to employ a price-following strategy. Set your
competitor’s price so that it matches your price (Change the PRICING sheet cell C17 so that
contains the formula =B17). Is your demand curve still approximately a straight line? At what
approximate price is the demand curve unit elastic now? Why has this price moved?
e) Finally restore PRICING cell C17 to contain $1700 (not = B17).
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4.
Advertising Elasticity of Demand
The demand model is presented in the worksheet DEMAND. For the purposes of this question we will also be
using the worksheet BRANDING. Before starting this question, remove the protection from the sheets by
choosing Protection\ Unprotect Sheet from the Tools menu. This allows you to add the data and graphs
required.
This question investigates the price elasticity of demand for your adventurer bike as advertising expenditure is
increased or reduced.
a) Try changing the Branding value on the BRANDING Sheet to $0, $100K, $200K, $300K, $400K,
$500K, $600K. Each time you change it, go to the DEMAND Sheet and record the total adventurer
demand (B79), RC_RockHopper Demand (B88), and the MT_RockHopper Demand (B99) on to a
new spreadsheet.
b) Plot a graph of RC RockHopper Demand vs Branding (x-axis). Calculate the arc advertising
elasticity of demand between each increase in branding expenditure. Notice that diminishing returns
set in between 400K and 500K.
5.
Production in Mike’s Bikes
Mike’s Bikes uses a modified Cobb Douglas production function to calculate production capacities. This
question tests your understanding of these modifications.
0.5
0.5
a) The underlying Cobb Douglas equation used by Mike’s Bikes is q = K * L , where q = production
capacity, K is scu of plant, and L is scu of labor. Given a plant size of 25,000 scu and a labor force
equivalent to 30,000 scu, what is the production capacity?
b) One adjustment that Mike’s Bikes makes to this equation is the way that “L” is calculated. Given a
factory workforce of 67, a maximum effectiveness of 625 scu each and a worker effectiveness of
0.60, what is the theoretical capacity of this workforce?
c) Another change is that Mike’s Bikes allows time for training for the workers. If the workers are
allocated 2% of their time to training, what is the actual production capacity of these 67 workers?
d) Another important aspect of production is cost. If your factory workers are paid a salary of $25,000
and have an annual maximum effectiveness of 625 scu and an actual worker effectiveness of 0.62
and have no time allocated to training, then what is the cost of a labor scu?
e) Given a plant cost of $160 per scu, a depreciation rate of 20%, a maintenance cost of $20 per scu,,
and a opportunity cost of capital invested in plant of 10%, what is the approximate cost of a plant
scu per year?
f) Your long run plan is to have a plant capacity of 40,000 scu, given your cost of labor (w) calculated
in Part (d) and your cost of capital (v) calculated in Part (e) then what would be your long run split of
labor and capital in scu?
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10 CONCLUSION
Mike's Bikes presents a range of business disciplines in an integrated and experiential way. In particular it
emphasizes the
• importance of the strategy development process;
• role of the different functions and the importance of analytic business modeling.
• importance of team dynamics.
This chapter summarizes some of the main issues in each of these areas as presented in earlier chapters.
1. Learning Objectives
By interacting in this simulated environment the user learns
• the standard terms of strategy, marketing, new product development, operations, finance, and
accounting;
• to think of business as an interacting system of these components;
• to analyze company data using highly visual graphics;
• quantitative skills using advanced Excel spreadsheets;
• to use the Balanced Scorecard and Economic Value Add (EVA) in context;
• many key quantitative skills for management;
• the importance of team dynamics for good decision-making.
2. A Framework for Developing Strategy
To do well in Mike's Bikes you must develop a
long-term
strategy.
Making
consistent
decisions in all aspects of a firm's operations is
difficult without a well-defined and clearly
integrated strategy. As in real life, if you
bounce around with your decisions you will
incur unnecessary extra costs. In this section
we outline the process of developing and
implementing a consistent strategy, and the
diagram shown to the right summarizes a
framework which is often helpful in developing
this.
3
Framework for Developing Business Strategy
External Analysis
Internal Capabilities
Options and Choices
Motivation
Evaluation
Leadership
=
+
Implementation
Roughly speaking, there is a reasonably good
overlap with the functional areas and the first
four of these steps i.e. the functions of external
analysis are often linked with marketing,
internal analysis linked with operations, and
options, choices and evaluation linked with
finance. We shall adopt these groupings in the discussion that follows.
Rewards
Control/Feedback
Module 2: Developing Strategy
2.1 ANALYSIS
The first stage in developing a strategy is an analysis of its environment. A management team should
consider both its internal and external environment. Externally, a firm should look at the opportunities and
threats in its external environment. This should include a good understanding of broader trends in the
environment, including political, economic, societal, technological, environmental (PESTE), sound analysis of
latent and perceived needs of customers, and also the actions, intentions and capabilities of its competitors.
Internally, a management team should also consider the firm's own competencies and resources. This may
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Conclusion
include looking at where the firm is currently positioned, its strengths in terms of quality and delivery and its
financial resources.
2.2 SYNTHESIS AND EVALUATION
Synthesis relates to pulling together all the data from the analysis phase and formulating a number of
alternatives. The desired strategy is chosen by evaluating these against a number of criteria - some of which
are financial and some more qualitative. The chosen strategy can then be broken up into sub-strategies for
distinct functional areas, but in reality there is considerable overlap among these and much iteration occurs.
2.3 DEVELOPING FUNCTIONAL STRATEGIES
Developing functional strategies refers to the translation of the overall strategy into strategies for the functions.
These will often involve shorter term goals and the time frame for these is sometimes called tactical. In Mike's
Bikes we focus on marketing, product development, operations, and finance and these are discussed briefly
below.
CREATING MARKETING STRATEGY:
Having completed external and internal analysis, a management team should be able to develop a marketing
strategy. This should consider the 3 C's - customers, competitors and company - and segmenting the market
as a result. An important step in this involves the decision about whether to compete in one narrow segment
or broadly in several segments. The selection of a specific segment or segments allows customer needs to be
defined, and once these are defined the 4 P's for each segment - product, price, promotion and place
(distribution) - may be determined.
CREATING PRODUCT DEVELOPMENT STRATEGY:
This is closely related to both the marketing and the manufacturing strategies. Depending on the choices of
which segments will be served, it is necessary to develop the products and processes for these. Decisions
must be made about the positioning of the new products, the ideal cost so that they can be sold with the
required profit margin, how much investment will be required, and whether it is a good investment.
CREATING OPERATIONS STRATEGY:
A production strategy should be defined in conjunction with marketing strategy. Strategic decisions may
include setting objectives in capacity, responsiveness, quality and cost. As a result it should be possible to
decide whether to produce a low cost product, or to attempt to differentiate it with features and to charge a
premium for this.
CREATING FINANCING STRATEGY:
After both the marketing and production strategies have been defined, the financing strategy can be
developed to provide the necessary finance to support investments required by the marketing and production
strategies. In addition to financing, investment decisions relating to future profits may also be made.
2.4 ITERATING STRATEGIES
While the process outlined above follows clear sequential steps, in reality these are interrelated. So it is
important to reconsider each of the strategies to ensure that the marketing strategy does not make demands
beyond the capabilities of manufacturing and that neither the manufacturing nor marketing strategies require
investments beyond the firm's ability to finance them.
2.5 IMPLEMENTATION
Planning is necessary, but some would say that 10% of the effort is in the planning and 90% is in the
implementation. In Mike's Bikes, it is assumed that the outcome of your firm's decisions depends on the
amount of money you commit and on the decisions of the competitors. In reality many other things also come
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into play, such as the quality of the feedback and control systems, the nature of leadership, and the motivation
of the people in the organization.
2.6 FEEDBACK AND CONTROL
In Mike's Bikes, you have feedback on a variety of quantitative measures at the end of each year of operation,
and this is the information that allows you to learn and to improve performance in the following year. You may
need to alter your strategy in response to this information.
2.7 LEADERSHIP
Leadership can make a huge difference to the performance of an organization, but what sort of leadership, by
whom, and when, is often difficult to specify. This factor is not modeled in SoloMike, but is important in
NetMike.
2.8 MOTIVATION AND REWARDS
Motivation comes from rewards. These rewards can be financial (such as salary, bonuses, etc.), or nonfinancial (such as the satisfaction that comes from the work and being part of a team, the development of
personal skills, etc.). A good environment balances these two types so that each individual gets the most
rewarding environment. This is modeled to some extent in Mike's Bikes in the salary decision, and when
playing in NetMike the rewards of good team dynamics can be significant.
3. Cross-Functional Strategy and Business Modeling
8
3.1 STRATEGY
A strategy describes how an organization will
win. In most business contexts, winning is
defined in terms of a good shareholder
return, subject to operating within the laws of
the land. As such it consists of a number of
decisions made in various functional areas of
the organization that should lead to an
increase in shareholder value. These
decisions are then implemented at lower
levels of the organization by a broader set of
more detailed decisions. Consistency among
the different decisions is a key to success
and the diagram to the right shows a good
structure for understanding this.
Shareholder Value
Overall Logic
Current Profit
ECONOMIC
CONDITIONS
COMPETITORS’
ACTIONS
Demand
Future Profit
Supply
Accounting
operating
decisions
investment
decisions
Business Strategy
Marketing
Strategy
Operations
Strategy
Finance
Strategy
Product
Development
Strategy
Debrief of Mike’s Bikes
There are usually 6 areas to consider at the
functional level: marketing, product development, operations, finance, human resources and information
technology. In Mike's Bikes the first four of these are represented directly and the other two indirectly within
the other functions. In addition, accounting is covered integratively as a support function.
We assume that strategy is set based on where the business wishes to go and where the functional areas
wish to take it. So, rather than just a top-down approach, we envisage a dynamic process, where each of the
functions (in particular, marketing, operations and finance) is aware of its own position and where the
organization wishes to go, and wants to influence overall strategy so that its particular strength is utilized.
They inform the business strategy which is set and is implemented in a consistent way by the functions.
3.2 MARKETING
The traditional view of the marketing function may be defined as “a social and managerial process by which
people obtain what they need and want through creating, offering and exchanging products of value with
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Conclusion
56
others ”. Such a perspective implies that the main function of the marketing in a manufacturing firm is to
maximize the sales of its products. It does this by determining the desired attributes of products, by
positioning existing as well as new products, by making pricing decisions, advertising, and determining the
distribution channels. It seems that this is changing in a number of ways.
First, there is a trend towards a more team-orientated firm, where the marketing role is modified to work with
the rest of the organization to maximize the long-term stream of profits associated with sales. The distinction
is not as subtle as it may seem. In the first case marketing would take production as a given and work with
price and advertising so that all product is sold, and in the second they would work with production to decide
price, advertising and production to maximize overall profits. The interaction must occur with finance, product
development and all the functions i.e. a cross-functional approach.
Another significant trend is towards service and relationship marketing, and while this is very important, is
excluded specifically from this model. It makes marketing more concerned with delivering value to the
customer.
In Mike's Bikes the environment has been set up so that marketing tries to maximize shareholder wealth by
allowing people to purchase goods of value. It is assumed that consumers buy according to a demand curve
so that the amount is determined by a range of factors of which the marketing decisions make up just one
part. There are two other areas affecting the demand for a product - its quality and delivery time or availability,
and for our purposes they are covered in the operations function.
The Overall Logic shown earlier represents the fundamental framework that is used in Mike's Bikes, and
shows the role of marketing relative to the other functions and with respect to shareholder value. Specifically it
complements decisions in operations, finance and product development, to achieve the best match between
demand and supply to generate profit and shareholder value.
The detail of marketing management process may then be viewed as shown in the diagram below. This
consists of a number of steps that represent the strategic marketing process:
• analyze markets,
• select target markets,
• determine the best marketing
11
mix to generate the required
Marketing Logic - Detail
demand,
• and manage the process.
Then from a strategic perspective, marketing
has 3 main objectives:
• to determine which segments
to target;
• to achieve a certain number of
sales in each segment;
• a given contribution margin
from each segment.
Marketing
Strategy
Product
Attributes
• Analysis of Markets
• Selection of Target Markets
• Market Mix
• Ongoing Management
Price
Promotion
Distribution
Objectives on these will then determine the
required market share and competitive position
of the company in each of these segments.
Debrief of Mike’s Bikes
3.3 OPERATIONS
The traditional view of the operations function is to maximize the quantity of product produced for the target
markets in the most effective and efficient way. However significant changes are occurring in operations. An
important one is a trend towards a more team-orientated firm, where the operations role is modified to work
with the rest of the organization to maximize the long-term stream of profits associated with operations. The
distinction is not as subtle as it may seem. In the first case operations would take marketing as a given and
would work to maximize production. In a team-orientated firm, operations work with marketing to decide
production, quality, responsiveness, price and advertising in order to maximize overall profits. The same must
be done with the other functional areas i.e. a cross-functional approach.
56
Kotler, P., “Marketing Management: Analysis, Planning, Implementation, and Control (9th ed)”, Prentice-Hall, 1997
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Specifically, Operations must now work together with marketing, finance and product development to
formulate and achieve its objectives, which are typically defined in terms of:
• responsiveness e.g. (delivery time)
• quality
• flexibility (e.g. size of product range)
• and cost.
These objectives then form the basis of a strategic plan which is implemented through more basic tactical
decisions such as the number of people to employ, training levels, salary levels, machine capacity,
maintenance levels, setup times, batch sizes, inspection rates, investment into quality systems and the like.
Mike's Bikes supports such a view by integrating the decisions of operations with all the other functions, and
while it is possible to focus on maximizing the performance of operations, this will not necessarily lead to good
overall performance unless considered in conjunction with the other areas.
The Overall Logic shown earlier indicates the fundamental framework that is used here, and specifically the
role of operations relative to the other functions and with respect to shareholder value. Here operations
complements decisions in marketing, finance and product development, to achieve the best match between
demand and supply to generate profit and shareholder value.
Then from a strategic perspective, operations has objectives in four main areas as shown:
• responsiveness e.g. (delivery time)
• quality
• flexibility (e.g. size of product range)
• and cost.
The detail of the operations management
process consists of creating a strategic plan
that sets the objectives in these four areas
that are consistent with the firm’s overall
business strategy. The operations plan is
then achieved through a combination of
tactical decisions.
Capacity and cost have traditionally been key
drivers of operations decisions in the
following ways. Cost has been an objective
for many years as it is a fundamental
determinant of the price and therefore the
value that the customer receives. Capacity
has been directly related to the ability to
produce enough product to meet demand.
12
Operations - Detail
Operations
Strategy
Capacity and
Production
• Determine Capacity and Production,
Cost, Quality, and
Responsiveness Objectives
• Select Tactics
Responsiveness
Quality
Cost
Debrief of Mike’s Bikes
Over the last three decades there has been
an increasing emphasis on quality, and more recently on responsiveness. These objectives can sometimes
be pursued simultaneously (such as by Total Quality Management TQM) and sometimes require trade-offs,
and the appropriate levels will be determined by the preferences of the target markets chosen and by
benchmarking against the competition.
3.4 FINANCE
At the most general level the financial manager deals with two decision making areas: what investments
should a company make; and how should it finance these. The main role of the finance function is to manage
the process of funding the firm in the best possible way. The first of these involves the evaluation of strategies
involving the development of new products and corporate takeovers; the second includes decisions on
dividend policy, debt and equity.
To reflect these two areas, the discussion is broken up into two main parts: evaluating strategies and
investments; and financing of the firm. In each case these are concerned with finding the most profitable way
of financing the business.
The Overall Logic diagram shown earlier assumes that the overall corporate objective is to create shareholder
value which can then be distributed to shareholders as capital or dividends. This is not to say that social
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Conclusion
objectives are not important. It is simply meant to emphasize that without a return to shareholders a capitalist
system cannot operate.
But achieving such a return depends on a number of issues. It is dependent on economic conditions,
competitor activity and management decisions in three areas - operating, investment and financing. Which of
these is most important is contingent on the circumstances, and varies over time.
Operating decisions are those that result in
operating profits and relate directly to the
product or service being produced. These
decisions are usually made by marketing and
operations, and the finance function has little
involvement except in assessing the funding
implications of these decisions.
13
Finance Logic - Detail
Finance
Strategy
Investment and financing decisions are of
most concern to finance as shown in the
diagram to the right.
Investment decisions refer to the types of
new projects and products that a firm should
invest in and many managers would argue
that this is the area where most of the
finance effort should be expended. This type
of decision will focus on identifying the
projects which give the best possible financial
return. It is usually these projects that
constitute the strategy of an organization.
• Investment
- Projects, Corporate Takeovers
• Financing
- Dividends,Debt, Equity,
Investment
Product NPV
Corporate
Takeovers
Financing
Dividends
Debt
Equity
Debrief of Mike’s Bikes
Financing decisions determine the best way in which to fund the requirements of the organization and its
strategy. While many financial instruments exist, there are still two primary ways to fund an organization - debt
and equity. This type of decision determines how much funding is required and what is the best mix of debt
and equity. Related to this is the issue of determining an appropriate level of distributions/dividends.
3.5 ACCOUNTING
Ultimately it is the profits of a firm that determine its long-term survival. It will only have profits if it develops
good products and sells these at a good margin over a period of time. The financial statements convert all the
other activities in marketing, production, product development and finance into costs and revenues, and a
profit figure for the period.
We assume that the main role of the accounting function is the recording and presentation of all the financial
transactions that occur in a business and the planning of future inflows and outflows of money. This role is
often broken up into management and financial accounting- the first concerned with providing all the
information required by management to make decisions for the profitability of the firm; the second with
satisfying the legal requirements of the countries in which the firm is operating to ensure the rights of the
shareholders and society at large.
While management accounting can have considerable flexibility in how it deals with the numbers, financial
accounting must follow very specific rules, most of which are required by law. Since there is considerable
overlap between these two, Mike's Bikes has a mix between the two approaches and presents a set of
accounts that covers both, and the objective is to give the user hands-on understanding of how the accounts
interact from quite a high level.
The role of managerial accounting is pervasive throughout the organization, and is to provide monetary
information on all aspects of a firm's operations. As such it links in to all levels of the Overall Logic diagram
earlier.
While traditionally its role has emphasized historical information, it is important to consider its role in forwardlooking roles such as forecasting and budgeting.
There are five main accounts that are presented here. They are:
• Cost of Goods Manufactured
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•
•
•
•
Profit and Loss
Cash flow
Balance Sheet
Movements in Equity
Economic Value Added is an extension of the Statement of Financial Performance and is also described.
All these accounts link to one another as
shown. Because of these linkages it is useful
to look at them as an integrated set.
3.6 PRODUCT DEVELOPMENT
A key to the long-term survival of an
organization is a steady stream of new
products that satisfy the requirements of the
target markets and top organizations are
spending an increasingly large proportion of
revenues on the development of new products.
29
How the main reports link together
COGM,
Gross Margin
Cash Flow
Income Statement
Movements
in Equity
Balance
Sheet
It is a complex area since it has more
uncertainty associated with it than any other
function within an organization. There are
uncertainties associated with specification of
Accounting
what the customer wants, forecasting likely
demand, whether the technical specifications of the desired product can then be achieved, at what budget,
and in what time frame. All the qualitative and quantitative techniques of Project Management are typically
brought to bear on these issues.
The traditional role of the product development function is to develop new products, and this was often done
in virtual isolation from the other functions. However, more recently the emphasis has been on its ability to
work with the rest of the organization to identify the market as well as technological possibilities and then to
develop the products and the processes of
14
production
to
maximize
organizational
performance.
Product Development Logic - Detail
The basic model of Mike's Bikes is captured in
the Overall Logic diagram shown earlier. This
shows how many internal and external aspects
of a firm interact to generate profits and
shareholder value. When considering this
model, Product Development is essentially an
investment decision into plant and/or products.
It impacts future profits since these will be a
direct result of the success of new products.
However, it also has a significant impact on
current profits, since these are used to fund
the development.
Product
Development
Strategy
Positioning
Target
Prime Cost
More detail on product development shows
that it can be translated into four types of
decisions as shown in this diagram.
• Positioning
• Target Cost
• Development Cost
• Product NPV
Development
Cost
Product
NPV
Debrief of Mike’s Bikes
These are:
• Positioning of the new product on the perceptual map;
• Prime cost of the product;
• Development cost of the product and manufacturing process.
• A go/no go decision based on the Net Present Value of the project.
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Conclusion
3.7 BUSINESS MODELING
We argue that business modeling is a very important complement to traditional approaches to strategy, many
of which are largely qualitative. Qualitative assertions must be complemented by scenario planning and
quantitative analysis, and this is where a business modeling approach becomes important. As a result, a
number of approaches and tools to help with this, have emerged over the last decade.
LIMITATIONS
It is clear that even for the relatively simple case of 2 segments, 2 channels, 2 products and 2 firms, it
becomes quite complex to model competitive behavior adequately. Better techniques are required to handle
the complexities.
EXTENSIONS
While we have used a manufacturing Strategic Business Unit as the Mike’s Bikes example, it is evident that
many parts of this model are identical in a wide variety of different environments. For example, we think that a
distinction between manufacturing and services is largely artificial, and the difference lies in which aspects of
the model are emphasized.
Used in this way, the Mike’s Bikes model may be easily extended to many different environments and the
spreadsheets changed appropriately. In some cases the components may need to be simplified and in others
enhanced, but it is important to remember that a model is an abstraction of reality, the intent of which is to
focus attention on the important issues. If it gets too simple it becomes unrealistic, and if too complicated then
it becomes unusable. Only you will be able to determine the appropriate level of detail for your needs.
In addition, many extensions can be made to channels, segments, products and competitors. When these are
made the flexibility of the spreadsheet environment quickly becomes outweighed by the complexity of the all
the sheets that are required, and of the difficulty of running multi-period simulations. This is where more
advanced business modeling systems including a model builder become necessary.
4. The Importance of Process
The content and techniques around the development of strategy are very important and have historically
received considerable attention. However, the process is often equally as important, and it is generally difficult
to get a good strategy with a bad process. A good process will allow all members of the team to understand
the key issues, to contribute their perspectives, and to be committed to the final decisions.
Mike's Bikes is an excellent environment in which to understand and develop the team dynamics for good
management decision making. Teams must make good business decisions that require analytical inputs,
intuition and team process. The experience also requires a reasonable amount of work and so motivation and
commitment of team members become important issues.
Other aspects of team dynamics are highlighted naturally as a part of the process, such as choosing teams,
developing a process, managing conflict, conflicting goals, and the measurement of performance.
5. Final Comment
The primary objective of Mike's Bikes is to present the learning of business as highly eclectic, consisting of
cross-functional issues, analysis, synthesis, people and process issues. In a real work environment, all this is
best learned by doing, and Mike's Bikes has attempted to mirror this process to the extent that information
technology currently allows. However, while information technology has been the vehicle, the individual and
team learning i.e. the human element, has been our first and foremost priority.
As technology improves, instructors will be able to include a raft of other experiences in a natural way that
accelerates the business learning of the participants, but the fundamental emphasis on people must always
be maintained.
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