9

ProfitabilityAnalysis-Product
Wise/Segment Wise/ Customer Wise

LEARNING OBJECTIVES
After studying this chapter you will be able to understand:
• The various components of operating income and its impact on the profitability,
• Effect of growth component, price recovery component and productivity components in
the change of operating income,
• Reasons for the difference in the operatingprofit of two periods and its reconciliation,
• Product wise profitability analysis- Direct Product Profitability (DPP)
• Segment wise profitability analysis and Customer profitability analysis.
• Four perspectives of the Balanced scorecard.

9.1 Profitability Analysis

An organisation which operates in a competitive environment has to adopt various strategies
to survive profitably into the market where it operates. Porter in its generic strategy theory has
suggested that a firm can survive profitably in the long term if it chooses its generic strategy
according to the environment in which it operates and which conformsto the overall corporate
objectives. A firm would be profitable if it is either a cost leader i.e. it can produce its product
at a lower cost than its competitor and enjoy maximum market share or if it produces its
products with some peculiar features which make it different from others. Whichever,
approacha firm may choose it has to be very careful on the part of actual performance and any
deviation from the set performance [Link] achieve its objectives it has to put some
performance measurement mechanism into place so that any deviation can be measured and
corrective action can be taken.
ProfitabilityAnalysis can be useful to measure the performance of a firm against the
acceptable standards. In this chapter we will learn toanalyseoperating profit of an organization
from various angles. Profitability can be analysedas per the requirement of the management,
to assist them to identify the critical success factors and to take appropriate decisions.
9.1.1 Operating profit analysis: Operating profit of a firm is affected by various components
which are responsible for changes in the revenue and costs. A change in the profit may be
due to revenue or costs orboththe factors. For the purpose of analysing operating income, we

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 9.2 Advanced Management Accounting

spread our analysis into three main areas or components which are (a) Growth component (b)
Price recovery component and (c) Productivity [Link] will cover both revenue
and cost effect,wherever applicable,on these components separately.
(a) Growth component measures the change in the quantity of output sold. The growth
component of the change in the operating income measures the increase/ decrease in
revenue and in costs due to selling more/ less quantity units from the previous period.
Revenue effect of growth component:
Revenue effect of growth can be measured with the help of the following formula:

⎛ Actualunit of output Actualunits of output ⎞

Revenue effect of growth = ⎜ − ⎟ × Sellingprice inlast year
⎝ soldincurrent year soldinlast year ⎠

The revenue effect of growth measures the increase/ decrease in revenue solely due to
change in number of units sold.
Cost effect of growth component:
Cost effect of growth measures the effect of variable cost and fixed cost separately.
For variable cost components:

⎛ Unit of input required to Actualunits of input ⎞

⎜ ⎟
Cost effect of growth = ⎜ produce current year output − used to produce last year ' s ⎟ ×Input price inlast year
⎜ inlast year output ⎟
⎝ ⎠

For fixed cost components:

⎛ Actualunits of capacity in ⎞
⎜ ⎟
last year if adequate to Actualunits of Capacity ⎟
Cost effect of growth = ⎜ − × Rate inlast year
⎜ produce current year ' s inlast year ⎟
⎜ ⎟
⎝ productioninlast year ⎠

(b) Price recovery component of change in operating income measures the changes in
the revenue and costs solely due to changes in prices.
Revenue effect of price recovery component:
Revenue effect of price recovery can be measured with the help of the following formula:

⎛ Sellingprice in Sellingprice in ⎞ Actualunits of output

Revenue effect of Price recovery = ⎜ − ⎟⎠ × soldincurrent year
⎝ current year last year

The revenue effect of price recovery measures the increase/ decrease in revenue solely due
to change in selling prices.

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 Profitability Analysis- Product wise/ Segment wise/ Customer wise 9.3

Cost effect of price recovery component:

Cost effect of price recovery measures the effect of variable cost and fixed cost separately.
For variable cost components:

⎛ Input price in Input price in ⎞ Units of input required to produce

Cost effect of Price recovery = ⎜ − ⎟⎠ × current year ' s output inlastyear
⎝ current year last year

For fixed cost components:

Actualunits of capacity inlast year,
Cost effect of ⎛ Rate per unit Rate per unit ⎞
= − × if adequate to produce current
Price recovery ⎜⎝ incurrent year inlast year ⎟⎠
year ' s output inlastyear

(c) Productivity componentmeasures the change in the operating income due to changes in
the product mix and/ or yieldof inputs as compared with the last year. This component uses
current year’sprices of input to measure the changes in costs only.
For variable cost components:

⎛ Actualunits of input Units of input required ⎞

Cost effect of ⎜ ⎟
= used to produce current − to produce current year ' s × Input price incurrent year
productivity ⎜⎜ ⎟
⎟
⎝ year ' s output output inlast year ⎠
For fixed cost components:
⎛ Actualunits of capacity in ⎞
Cost effect of
⎜ Actualunits of capacity last year if adequate to
⎟
=⎜ − ⎟ × Rate incurrent year
productivity ⎜ incurrent year produce current year ' s ⎟
⎜ ⎟
⎝ productioninlast year ⎠

Reconciliation of Operating Profit

Costs Revenue
Operating profit in last year xxx
(+) F (+) F
Add/(Less): Revenue and Cost effect of Growth component
(-) A (-) A
Add/(Less):Revenue and Cost effect of Price recovery (+) F (+) F
component (-) A (-) A
(+) F
Add/ (Less):Cost effect of Productivity component
(-) A -
xxx xxx
Operating Income in current year (Revenue – Costs) xxx
F= Favourable, A= Adverse

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 9.4 Advanced Management Accounting

Illustration 1
Y Limited is a manufacturer of Cardboard boxes. An analysis of its operating income between
2012and 2013 shows the following:
Income Revenue & Revenue & Cost Cost effect of Income
Statement Cost effect effect of Price productivity Statement
(amount in of Growth recovery component in (amount in
2012) component component in 2013 2013)
in 2013 2013
Revenue (`) 40,00,000 2,00,000(F) 4,20,000(F) - 46,20,000
Cost (`) 29,20,000 60,000 (A) 2,56,000(A) 58,000(F) 31,78,000
Operating Income 10,80,000 1,40,000(F) 1,64,000(F) 58,000(F) 14,42,000
(`)
Y limited sold 4,00,000 boxes and 4,20,000 boxes in 2012 and 2013 respectively. During 2013 the
market for cardboard boxes grew 3% in terms of number of units and all other changes are due to
company's differentiation strategy and productivity. Compute how much of the change in operating
income from 2012 to 2013 is due to the industry market size factor, productivity and product
differentiation and also reconcile the profit of both years due to these factors.
Solution:
Reconciliation of Operating Income
Particulars Amount (`)
Operating Income in 2012 10,80,000
Add: Change Due to Industry Market Size Factor (W.N.-1) 84,000
Changes Due to Productivity (W.N.-2) 58,000
Changes Due to Product Differentiation (W.N.-3) 2,20,000
Operating Income in 2013 14,42,000
Workings:
Total Increase in Sale of Cardboard Boxes 20,000 Boxes (4,20,000 Boxes – 4,00,000 Boxes). Out
of this increase in Sales of 20,000 Boxes,12,000 Boxes (3% of 4,00,000) is due to growth in
market size, and the remaining 8,000 Boxes (20,000 Boxes – 12,000 Boxes) are due to an
increase in market share .

W.N.1 Effect of the Industry Market Size Factor on operating income:

=Revenue and Cost Effect of Growth Component in 2013 ×
Increase in Sales Unit Due to Market Growth
Total Growth in Sales Unit (from2012 to 2013)
12,000Boxes
= `1,40,000 ×
20,000Boxes
= `84,000 (F)

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 Profitability Analysis- Product wise/ Segment wise/ Customer wise 9.5

W.N.2. Effect of Productivity on operating income:

= Cost Effect of Productivity Component in 2013
= `58,000 (F)
W.N.3 Effect of Product Differentiation on operating income:
Particulars Amount (`)
Increase in the Selling Price 4,20,000 (F)
(Revenue Effect of the Price Recovery Component)
Increase in Prices of Inputs 2,56,000 (A)
(Cost Effect of the Price Recovery Component)
Growth in Market Share Due to Product Differentiation*
⎛ 8,000 Boxes ⎞ 56,000 (F)
⎜ ` 1,40,000 x ⎟
⎝ 20,000 Boxes ⎠
Total 2,20,000 (F)
* Revenue and Cost Effect of Growth Component in 2013 ×
Increase in Sales Unit Due to Product Differentiation
Total Growth in Sales Unit (from 2012 to 2013)

9.2 Profitability Analysis-Product wise

For a profit making organisation, profit earned from an operation is a key performance
indicator which assures and controls the direction towards the organisation’s objectives. In
today’s competitive business era most of the firms are having a portfolio of various ranges of
products either for the same consumer market or for different consumer markets. A firm which
has a portfolio ofprofitable products enjoys high profitability. However, it is very important to
know the relative profitability of an individual product so that management can concentrate on
the profitable products and weed out the loss making products from the products’ portfolio.
Direct product profitability is one among the various analytical methods which analyse the
profitability for each product or segment of products separately.
9.2.1 Direct Product Profitability (DPP):DPP is used to measure the profitability of an
individual product and assist management to know the true profitability to make appropriate
[Link] opposed to the traditional absorption costing, where normally labour hours or
machine hours are used as a basis for absorption of indirect costs, DPP uses variety of
measures like space used for transportation and storing of goods, refrigeration time etc. DPP
is generally used in the retail tradeto determine profitability from an individual product.
CIMA describe DPP“used primarily within the retail sector, DPP involves the attribution of both
the purchase price and other indirect costs (for example distribution, warehousing and
retailing) to each product line. Thus a net profit, as opposed to a gross profit, can be identified
for each product. The cost attribution process utilizes a variety of measures (for example
warehousing space and transport time) to reflect the resource consumption of individual
products.”

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 9.6 Advanced Management Accounting

In recent years DPP has developed considerably in parallel with activity-based costing. DPP
hasbecome much more sophisticated and is now very similar to activity-based costing. Infact it
may be regarded as the application or extension of activity based costing.
Benefits of DPP
• Better cost analysis
• Better pricing decisions
• Better management of stores and warehouse space
• The rationalisation of product ranges.
Direct product profitability statement: Retail organisations traditionally deducted the
boughtincost of goods from the selling price to give a gross margin. The gross margin is
uselessmeasure for controlling the costs of the organisation itself or making decisions about
the profitabilityof the different products. This is because none of the costs generated by the
retailorganisation itself are included in its calculation. For example, it does not include the
storagecosts of the different goods and these costs vary considerably from one goods to
another. Amethod was needed which relates the indirect costs to the goods according to the
way the goodsuses or creates these costs.
Indirect costs, for DPP may be analysed into basic cost categories as follows:
(i) Overhead cost: This is incurred through an activity that is not directly linked to a
particularproduct.
(ii) Volume related cost: The cost is incurred in relation to the space occupied by
[Link] includes storage and transport costs.
(iii) Product batch cost: This cost is often a time based cost. If product items (that is a
numberof identical products which are handled together as a batch) are stocked on
shelves alabour time cost is incurred.
(iv) Inventory financing costs: This is the cost of tying up money in stock and is the cost
ofthe product multiplied by interest rate per day or per week.
Direct product profit can be derived as shown below:
Direct Product Profit
Sales xx
Less:Cost of Goods Sold xx
Gross Margin xx
േ Adjustments xx
Adjusted Gross Margin xx
Less:Direct Product Costs xx
(Warehouse, Transportation, Store etc.)
Direct Product Profit xx

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 Profitability Analysis- Product wise/ Segment wise/ Customer wise 9.7

Table 1, given below shows the DPP for product A. Directly attributable costs have been
groupedinto three categories and are deducted from the gross margin to determine the good’s
DPP.
Table- 1
Direct product profit for product A
(`) (`)
Selling price p.u. 150.00
Less : Bought-in price 80.00
Gross margin 70.00
Less : Direct product costs :
Warehouse costs 16.00
Transport costs 18.00
Store costs 22.00 56.00
Direct product profit p.u. 14.00
Warehouse and store costs will include items such as labour, space and insurance costs,
while,transport costs will include labour, fuel and vehicle maintenance costs. The usual way to
spreadthese costs across the different goods sold is in relation to volume or area occupied, as
mostcosts increase in direct proportion to the volume of the good or the space it occupies.
However,there are some exceptions to this; for example, insurance costs may be better
spread on value oron a risk index. Risk is greater with refrigerated or perishable goods.
Refrigeration costs mustonly be related to those products that need to be stored in the
refrigerator.
The result of this type of DPP cost analysis may give information such as that given in
thefollowing table:
Table-2
Profit Gross margin (%) DPP (%)
Ice-cream 20.40 4.60
Baby food 11.00 5.50
Tooth paste 31.20 18.80
Wine 45.30 17.20
Paper tissues 15.70 0.00
Above table-2 shows that for ice-cream there is a considerable gap between the gross
marginand the DPP because its refrigerated storage is expensive. It also shows that paper
tissues,which had quite a healthy gross margin, are just breaking even with DPP; this is
because theyare very bulky relative to their price.
While the supermarket or other retailer does not have theluxury of stopping selling paper
tissues, because obviously it would lose considerable trade if itdid not stock a complete range

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 9.8 Advanced Management Accounting

of goods, it does have other choices. The choices are merchandisingones, such as where to
display the stock and in what position on the shelves. Stocks at eyelevelsells more quickly
than the above or below eye level. The brand with the greatest marginshould be placed at eye
level. Goods at the front of the store tend to sell faster than goods at theback. This explains
why tissues are rarely found close to the entrance or the cash till.
With manufactured products cost per unit for the different products is often calculated and
theproducts ranked. For a retail organisation DPP per unit may not be the best measure to
use.
DPPper unit of time adds another dimension to the measurement and DPP per unit of time
permeasure of space adds a third. This is automatically built in when overheads are spread if
a costeach product uses this rate multiplied by the volume and the number of days or weeks in
thesystem. In the example in Table 1, the store costs would be based on a rate per cubic
centimeter or metre per day and the product cost can be calculated according to its size and
the time it takes to flowthrough the system. For example, if the store cost per cubic cm is `
0.0073 per day and goodA is 10 cubic cms and the average stay in the store is three days, the
store cost per item is `0.0073 × 10 cms. × 3 days = ` 0.22.
According to Doherty et al (1993) the single most valuable aspect of DPP lies in its
diagnosticcapabilities, allowing managers to ask questions, such as why did a product group
over or underperform. Table-3 shows that product group A-2 accounts for 3.07 per cent of
sales but for 3.31per cent of DPP. Upon investigation it emerged that stock-turn was managed
particularly well inthis group. Product B-2 has 3.05 per cent of sales but accounts for only 2.85
per cent of DPP. Aninvestigation of the warehouse costs might explain this or the opportunity
of offering multipacksmight reduce costs.
Table–3
DPP values by Product Group. From Doherty et al 1993.
Product Group Sales as a % of total sales DPP as a % of total DPP
A-1 3.20 3.40
A-2 3.07 3.31
B-1 2.84 2.89
B-2 3.05 2.85
C-1 2.75 2.66
A-3 2.26 2.48
Illustration 2
Jigyasa India Ltd. (JIL) has 30 retail stores of uniform sizes ‘Fruity &Sweety Retails’ across
the country. Mainly three products namely ‘Butter Jelly’, ‘Fruits & Nuts’ and ‘Icy Cool’ are sold
through these retail stores. JIL maintains stocks for all retail stores in a centralised
warehouse. Goods are released from the warehouse to the retail stores as per requisition
raised by the stores. Goods are transported to the stores through two types of vans i.e. normal
and refrigerated. These vans are to be hired by the JIL.

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 Profitability Analysis- Product wise/ Segment wise/ Customer wise 9.9

Costs per month of JIL are as follows:

(`)
Warehouse Costs:
Labour& Staff Costs 27,000
Refrigeration Costs 1,52,000
Material Handling Costs 28,000
Total 2,07,000
Head Office Cost:
Salary & Wages to Head Office Staff 50,000
Office Administration Costs 1,27,000
Total 1,77,000
Retail Stores Costs:
Labour Related Costs 33,000
Refrigeration Costs 1,09,000
Other Costs 47,000
Total 1,89,000
Average transportation cost of JIL per trip to any retail stores are as follows:
Normal Van `3,200
Refrigerated Van `4,900
The Chief Financial Manager asked his Finance managers to calculate profitability based on
three products sold through Fruity &Sweety retail stores rather than traditional method of
calculating profitability.
The following information regarding retail stores are gathered:
Butter Jelly Fruits & Nuts Icy Cool
No. of Cartons per cubic metre (m3) 42 28 40
No. of Items per cartons (units) 300 144 72
Sales per month (units) 18,000 4,608 1,152
Time in Warehouse (in months) 1 1.5 0.5
Time in Retail Stores (in months) 1 2 1
Selling Price per unit (`) 84 42 26
Purchase Price per unit (`) 76 34 22
Butter Jelly and Icy-Cool are required to be kept under refrigerated conditions.
Additional information:
Total Volume of All Goods Sold per month 40,000 m3
Total Volume of Refrigerated Goods Sold per month 25,000 m3
Carrying Volume of each van 64 m3

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 9.10 Advanced Management Accounting

Required:
Calculate the Profit per unit using Direct Product Profitability (DPP) method.
Solution:
Direct Product Profitability (DPP) Statement
(Amount in `)
Butter Jelly Fruits & Nuts Icy Cool
Selling Price per unit 84.00 42.00 26.00
Less: Purchase Price per unit 76.00 34.00 22.00
Gross Profit …(A) 8.00 8.00 4.00
Direct Product Costs:
Warehouse Costs per m3 [W.N.-1] 7.46 2.07 3.73
Retail Stores Costs per m3 [W.N.-2] 6.36 4.00 6.36
Transportation Costs [W.N.-3] 76.56 50.00 76.56
Total DPP costs per m3 90.38 56.07 86.65
Items per m3[W.N.-4] 12,600 4,032 2,880
Cost per item …(B) 0.007 0.014 0.030
Direct Product Profit …(A) - (B) 7.993 7.986 3.97
Working Notes
(1) Warehouse Related Costs
General Costs (`) Cost Related with
Refrigerated Goods (`)
Labour& Staff Costs 27,000 ---
Refrigeration Costs --- 1,52,000
Material Handling Costs 28,000 ---
Total 55,000 1,52,000
Volume of Goods Sold 40,000 m3 25,000 m3
Cost per m3 per month 1.38 6.08

Products Time in Warehouse Cost per m3 per month Total Cost

(`) (`)
Butter Jelly 1 Month 7.46 7.46
(1.38 + 6.08)
Fruits & Nuts 1.5 Months 1.38 2.07
Icy-cool 0.5 Months 7.46 3.73
(1.38 + 6.08)

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 Profitability Analysis- Product wise/ Segment wise/ Customer wise 9.11

(2) Retail Stores Related Costs

General Costs Cost Related with
(`) Refrigerated Goods (`)
LabourRelated Costs 33,000 ---
Refrigeration Costs --- 1,09,000
Other Costs 47,000 ---
Total 80,000 1,09,000
Volume of Goods Sold 40,000 m3 25,000 m3
Cost per m3 per month 2.00 4.36

Products Time in Retail Stores Cost per m3 per month Total Cost
Butter Jelly 1 Month `6.36 `6.36
(`2.00 + `4.36)
Fruits & Nuts 2 Months `2.00 `4.00
Icy-Cool 1 Month `6.36 `6.36
(`2.00 + `4.36)
(3) Transportation Costs
Normal Van Refrigerated Van
Costs Costs
Cost per trip `3,200 `4,900
Volume of Van 64 m3 64 m3
Cost per m3 per trip `50.00 `76.56
(4) No. of Items per m3
Products No. of No. of Items per No. of Items per m3
Cartons (m3) Cartons (units)
Butter Jelly 42 300 12,600
(42 × 300)
Fruits & Nuts 28 144 4,032
(28 × 144)
Icy- Cool 40 72 2,880
(40 × 72)

9.3 Profitability Analysis- Segment wise

As a part of performance evaluation, a firm can segment its operations in many different ways.
The basis of segmentation can be product, price, geographical boundaries, demographics,
consumers or production processes [Link] financial reporting, there is no need to follow
any prescribed criteria as set by any [Link] management accounting the purpose of
segment wise profitability analysis is to assist management to make better decisions, hence, it
is customisable.

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 9.12 Advanced Management Accounting

Costs, in segment analysis can be classified into direct costs and indirect costs. All expenses
which are directly related with the existence of a segment are called direct costs. Direct costs
can be variable or fixed in nature. On the other hand indirect costs are common costs which
cannot be attributed totally to a particular segment. Generally, there are two approaches
followed to calculate segmental profit which are (i) Full cost approach and (ii) Contribution
approach.
(i) Full cost approach:Under this approach profit for a segment is calculated taking all
direct andindirect costs into account. The indirect costs are allocated to the segment based on
appropriate allocation base. Under this approach, since full costs are taken into account while
calculating segmental profit so sum total of profits of each segment equals to total
organisational profit. Mathematically it can be written as:
Segmental profit = Segmental revenue – Direct costs – Allocated indirect costs.
And
Organisational profit = ∑Segmental profits
(ii) Contribution approach:Under this approach instead of calculating segment wise net
income contribution is calculated. To calculate segmental contribution only direct costs are
deducted from the segmental revenue. All indirect expenses are deducted from the overall
organisational contribution. While following this approach one may find that the segment which
was seemed to be unprofitable is contributing towards the indirect expenses. Segmental
contribution can be simply calculated as:
Segmental contribution = Segmental revenue – Direct costs
And
Organisational profit = ∑Segmental contribution – Total indirect costs

9.4 Profitability Analysis- Customer wise

9.4.1Customer Profitability Analysis: In many organisations it is just as important to
costcustomers as it is to cost products. Different customers or groups of customers differ in
theirprofitability. This is a relatively new technique that ABC makes possible because it
creates costpools for activities. Customers use some activities but not all, and different groups
of customershave different ‘activity profiles’.
Service organisations, such as a bank or a hotel, in particular need to cost customers. A
bank’sactivities for a customer will include the following types of activities:
• Withdrawal of cash
• Unauthorised overdraft
• Request for a statement
• Stopping a cheque
• Returning a cheque because of insufficient funds.

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 Profitability Analysis- Product wise/ Segment wise/ Customer wise 9.13

Different customers or categories of customers will each use different amounts of these
activitiesand so customer profitability profiles can be built up, and customers can be charged
accordingto the cost to serve them. A hotel may have activities that are provided for specific
types ofcustomers, such as well laid-out gardens, a swimming pool and a bar. Older guests
may appreciateand use the garden, families use the swimming pool and business guests use
the bar. If theactivities are charged to the relevant guests a correct cost per bed occupied can
be calculated forthis type of category. This will show the relative profitability and lead to
strategies for encouragingthe more profitable guests.
Even a manufacturing organisation can benefit from costing its customers. Not all customerscost
the same to serve even if they require the same products. Some customers may be locateda
long way from the factory and transport may cost more. Other customers may be disruptiveand
place rush orders that interrupt production scheduling and require immediatespecial
[Link] customers need after sales service and help with technical matters, etc.
Illustration3
A manufacturing organisation has four different customers A, B, C and D. A single product
issold to them at different prices because of trade discount offered. Data is given for cost per
unit of business activity. You are required to prepare customer profitability statement.
Information on four customers
Customers A B C D
No. of units sold 60,000 80,000 1,00,000 70,000
Selling price net of discount 25p 23p 21p 22p
No. of sales visits 2 4 6 3
No. of purchase orders 30 20 40 20
No. of deliveries 10 15 25 14
Kilometres per journey 20 30 10 50
No. of rush deliveries — — 1 2
Cost of each activity
Sales visit ` 210 per visit
Order placing ` 60 per order
Product handling ` 0.10 per item
Normal delivery cost ` 2 per kilometer
Rushed delivery cost ` 200 per delivery

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 9.14 Advanced Management Accounting

Solution:
Customer profitability Statement
Customers A B C D
(`) (`) (`) (`)
Revenue net of discount 15,000 18,400 21,000 15,400
(60,000 × ` 0.25) (80,000 × `0.23) (1,00,000 × `0.21) (70,000× `0.22)
Costs :
Sales visits 420 840 1,260 630
Ordering processing 1,800 1,200 2,400 1,200
Product handling 6,000 8,000 10,000 7,000
Normal Delivery 400 900 500 1,400
Rush deliveries — — 200 400
8,620 10,940 14,360 10,630
Operating profit 6,380 7,460 6,640 4,770
Percentage profitability 43% 41% 32% 31%
It is apparent from above solution that all four customers are profitable, but customers C and
Dnot particularly so when compared with customers A and B. There are several reasons for
thisrange in profitability one reason is the negotiation of favourable terms such as higher
tradediscount as compared to other customers.
Benefits of Customer Profitability Analysis:
1. It helps the supplier to identify which customers are eroding overall profitability andwhich
customers are contributing to it.
2. It can help to provide a basis for constructive dialogue between buyer and seller to
improve margins.

9.5 The Balanced Scorecard

In today’s business environment information becomes a vital element and to gain competitive
advantage over the peers, it cannot be denied. In this era of information age competition, a
company cannot survive just by injecting huge capital investment in new technology for
physical assets only or by excellent management of financial assets and liabilities. In this
information age both manufacturing and service organisation needs new capabilities for
competitive success. Merely investing in and managing physical, tangible assets is not enough
but an organisation must be able to mobilise and exploit its intangible or invisible assets which
in turn becomes a decisive factor.
Intangible assets enable an organisation to:
• Maintain and further development in customer relationships to retain loyalty of existing
customers and to serve new market/ customer segments effectively and efficiently.

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 Profitability Analysis- Product wise/ Segment wise/ Customer wise 9.15

• Introduce products and services as per the desire of targeted customer and market
segments.
• Produce customised high-quality products and services economically with short
gestation periods.
• Mobilise employee skills and motivation for better and consistent deliberation in process
capabilities, quality, and response times.
• Deploy information technology, data bases and effective management information
systems.
The balanced scorecard is a method which displays organisation’s performance into four
dimensions namely financial, customer, internal and innovation. The four dimensions
acknowledge the interest of shareholders, customers and employees taking into account of
both long-term and short-term goals.
Kaplan and Norton classified performance measures into four business ‘perspectives’:
(i) The financial perspective
(ii) The customer perspective
(iii) The internal business perspective
(iv) The learning and growth perspective
(i) Financial Perspective: “How Do We Look To Shareholders?” In this step manager of a
division or a unit, links its business objectives to the corporate strategy of the company as a
[Link] performance measures indicate whether the company’s strategy
implementation and execution are contributing to its revenue and earnings. To identify key
performance measures in this perspective, managers, during strategic planning ask “How do
we look to shareholders?”
Corporate strategy and strategic initiatives are examined from the financial perspective to see
feasibility of these initiatives of being met. The financial objectives chosen at the onset of the
balanced scorecard implementation should serve two purposes:
1. To provide definite performance that was expected at the time of strategies selection.
2. To provide a focus for objectives and appropriate measures in each of the other three
perspectives.
(ii) Customer Perspective: “How Do Customer View Us?” In this stage, companies identify
customers and market segments in which they compete and also the means by which they
provide value to these customers and markets. Managers identify the lead indicators which
make a particular business unit or product different from that of others. Lead indicator may
vary from customer to customer or market segment. If for example, a customer values on-time
delivery then on-time delivery becomes a lead indicator. Examples of lead indicators may
include any number of customer considerations, including:
• On-time delivery
• On-site service

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 9.16 Advanced Management Accounting

• After sales support

• Defects per order
• Cost of the product
• Free shipments etc.
By delivering quality as per the customer demand and need, business units can improve
outcome measures such as customer satisfaction, retention, acquisition and loyalty.
(iii) Internal Business Perspective: “At What Must We Excel?” In this stage companies
identify processes and activities which are necessary to achieve the objectives as identified at
financial perspectives and customer perspective stage. These objectives may be achieved by
reassessing the value chain and making necessary changes to the existing operating
activities. If maintaining net earnings is the financial objective of a company and after sales
service can increase customer retention, then internal business perspective needs to improve
after sales services to satisfy customer requirements to maintainnet earnings. This objective
may be achieved by providing for example toll free customer help lines, setting up service
centresin all major cities.
(iv) Learning and Growth Perspective: “How Do We Continue To Improve And Create
Value?” In the learning and growth perspective, Companies determine the activities and
infrastructure that the company must build to create long term growth, which are necessary to
achieve the objectives set in the previous three perspectives. Organisational learning and
growth comes from three principle sources:
• People i.e. employee capabilities
• Systems i.e. information system capabilities and
• Organisational procedures i.e. motivation, empowerment and alignment.
Since, the balanced scorecard is intended to improve long-term performance, managers may
invest in resources needed in the short-run but this should not affect business unit’s
performance.
The ultimate result of using the Balanced Scorecard approach should be an improved
longtermfinancial performance. Since the scorecard gives equal importance to the relevant
non –financial measures, it should discourage the short termism that leads to cuts in spending
on newproduct development, human resource development etc which are ultimately
detrimental forthe future prospects of the company.
The responsibility to devise and implement a Balanced Scorecard should be that of
themanagersworking with the business. Since every company is different, it shall need to work
out for itselfthe various financial and non – financial measures, which need to be focused upon
for its owndevelopment. Since the Balanced Scorecard is recommended as a management
tool usedboth for internal and external reporting purposes, it is again the
The following figure summarises the ideas of a Balanced Scorecard:

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 Profitability Analysis- Product wise/ Segment wise/ Customer wise 9.17

manager’s responsibility todecide as to what information needs to be disclosed and how any
problems of confidentialitycan best be overcome.

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 9.18 Advanced Management Accounting

The following are some reasons why Balanced Scorecards sometimes fail to provide for
thedesired results;
• Managers mistakenly think that since they already use non – financial measures,
theyalready have a Balanced Scorecard.
• Senior executives misguidedly delegate the responsibility of the Scorecard
implementationto middle level managers.
• Company’s try to copy measures and strategies used by the best companies rather
thandeveloping their own measures suited for the environment under which they function.
• There are times when Balanced Scorecards are thought to be meant for reporting
purposesonly. This notion does not allow a Business to use the Scorecard to manage
Business ina new and more effective way.
It may be noted that the above-mentioned difficulties refer to the internal use of the
Scorecard,unless it is used internally successfully, it should not be used as a basis for
external reporting.

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