Absorption Costing, Activity-based Costing and Marginal Costing

In Absorption Costing, Activity-based Costing and Marginal Costing, we we learn to:

Discuss the possible conflicts between cost accounting for profit reporting and inventory valuation and the information for decision-making.

This is still part of "Pricing and Product Decision"!

1) Allocation and Apportionment

*Note: the first stage of analysis of Overheads is to determine the overhead cost for each cost centres.

Cost Allocation -  this is possible only if we can identify a cost as specifically attributable to a particular cost centre (i.e., the salary of the manager of the packing department)

Cost Apportionment - is necessary when it is not possible to allocate a cost to a specific cost centre (i.e., the salary of the manager who is managing packing and operation department or the cost of rent and rates might be apportioned according to the floor space occupied by each cost centre).

2) Overhead Absorption

Overhead Absorption is the amount of indirect costs assigned to cost objects. Indirect costs are costs that are not directly traceable to an activity or product. Cost objects are items for which costs are compiled, such as products, product lines, customers, retail stores, and distribution channels.

Selecting the most appropriate absorption rate
It is generally accepted that a time-based method should be used wherever possible, i.e. the machine hour rate or the labour hour rate. This is because many overhead costs increase with time, for example, indirect wages, rent and rates.

However, each absorption method has its own advantages and disadvantages:

(a) Rate per unit. This is the easiest method to apply but it is only suitable when all cost units produced in the period are identical. Since this does not often happen in practice this method is rarely used.

(b) Direct labour hour rate. This is a favoured method because it is time-based. It is most appropriate in labour-intensive cost centres, which are becoming rarer nowadays and so the method is less widely used than it has been in the past.

(c) Machine hour rate. This is also a favoured method because it is time-based. It is most appropriate in cost centres where machine activity predominates and is therefore more widely used than the direct labour hour rate. As well as absorbing the time-based overheads mentioned earlier, it is more appropriate for absorbing the overheads related to machine activity, such as power, maintenance, repairs and depreciation.

(d) Direct wages cost percentage. This method may be acceptable because it is to some extent time-based. A higher direct wages cost may indicate a longer time taken and therefore a greater incidence of overheads during this time. However, the method will not produce equitable overhead charges if different wage rates are paid to individual employees in the cost centre. If this is the case then there may not be a direct relationship between the wages paid and the time taken to complete a cost unit.

(e) Direct materials cost percentage. This is not a very logical method because there is no reason why a higher material cost should lead to a cost unit apparently incurring more production overhead cost. The method can be used if it would be too costly and inconvenient to use a more suitable method.

(f ) Prime cost percentage. This method is not recommended because it combines methods (d) and (e) and therefore suffers from the combined disadvantages of both.



Absorption Costing

• Something to do in establishing COST PER UNIT (i.e., how much does it cost to produce something)
• AIM: Establish the Full (Production) Cost/unit
• Reasons:
• Pricing (i.e., Cost Plus)
• Product Profitability
• Statutory Reporting (i.e., Inventory valuation)
• Budgeting/Control/Decision-making
• Helping out the financial accountant to value the finished-goods stock at full production cost

Overhead Absorption Rate (OAR) = Budgeted Overhead cost/Budgeted Level of Activity

Level of Activity:

• Time Basis (Hours) - (i.e., labour hours or machine hours)
• Units (Output)
• Measure of Cost (%) - Direct Materials/Direct Labour/Total Prime Cost

Reciprocal Servicing - the service cost center not only provides the service to the production cost centers but also provides the service to the OTHER SERVICE COST CENTER.

This is critical - as we apportion and reapportion the costs until all the monies are out of the service cost centers.

Pricing 

Cost Plus - simplest form of pricing. If we know already the cost, we simply add a margin on the cost to reflect our price.

Note: Cost Plus pricing doesn't consider volume. It doesn't take into account the market price.

Cost Base:

• Full Production Cost
• Full Cost (includes expenses) --> absorb the expenses to the product
• Marginal Cost

Understanding the difference between cost and price:

3) Predetermined overhead absorption rate

Predetermined overhead rates mean that the rates are calculated in advance of the period over which they will be used.

MAIN REASON: Overhead costs are not incurred evenly throughout the period - as it fluctuates every month.

Under-or -over absorption of overheads

Under- or Over- absorption of overhead exists when the actual spending is less or more as compared to predetermined overhead.

The reasons for under- or over- absorption of overheads

4) Activity based costing

Activity based costing - because production became more mechanised, thus the traditional absorption costing will not give an accurate rate as this is more applicable to labour-intensive production.

ABC is a refined absorption costing methodology, which uses cost pool and cost driver as compared to cost center and overhead absorption rate.

Two categories of cost driver:

Resource cost driver - measure of the quantity of resources consumed by an activity. This is used to assign the cost of a resource to an activity or cost pool.

Activity cost driver - measure of the frequency and intensity of demand placed on activities by cost objects. This is used to assign activity costs to cost objects.

The different stages in ABC calculation:

• Identify the different activities within the organisation. Compared to a traditional overhead system, ABC has more number of activities, which depends on how the management subdivides the organisation's activities
• Relate the overheads to the activities. This is the creation of 'cost pools.'
• Support activities are then spread across the primary activities. The base is the cost driver that is the measure of how the support activities are used.
• Determine the activity cost drivers. This is based on the factor that drives the consumption of the activity. The question is - what causes the activity to incur cost?
• Calculate activity cost driver rates = Total cost of activity/Activity driver

4 Categories of Activities

• Unit level activities - costs that are related to the number of units produced (i.e., indirect materials or consumables)
• Batch level activities - costs that are related to the number of batches produced (i.e., material ordering, where an order is placed for every batch production)
• Product level activities - costs that are driven by the creation of a new product line and its maintenance (i.e., designing the product)
• Facility level activities - costs that are related to maintaining the buildings and facilities (i.e., maintenance of buildings, plan security)

• In ABC, all costs are variable
• Environment - where ABC can apply:
• Production - repetitive nature
• Complex - multi-product or many processes
• High Overhead costs
• Problems of ABC
• Cost/Benefit
• Implementation risk
• Focus on Cost Allocation (Internal)

5) Marginal costing and Absorption costing

Marginal Costing

• The focus is on cost behaviour and the changes in the level of activity.
• Used for specific application like making decisions. The changes in the level of activity are vitally important
• Not used in statutory reporting purposes

Variable Cost

• Varies proportionately with the activity
• Variable Cost per unit is constant
• Product Cost
• Treatment: Charged to the cost unit and to the income statement as part of the cost of sales

Fixed Cost

• One that remains constant
• Fixed Cost in total is constant
• Period Cost
• Treatment: Charged to the Income Statement in the period in which they are incurred

Uses of Marginal Costing:

• Decision Making
• Budgeting (both marginal and absorption costing can be used in budgeting)

Terminologies:

• Marginal Cost = sum of variable costs (Variable cost and marginal cost are used interchangeably)
• Contribution = Sales - Variable Cost (Fixed cost + Profit)

Profit - is calculated for a period of time, thus marginal cost and absorption cost will differ because of the fixed cost. The change in stock will dictate the differences.

Overall the profit will be the same over time but in individual accounting periods, profits may differ.

Reconciling Item = Fixed Cost/unit X Change in Stock

Impact on Profit

Stock is constant - Marginal Costing profit (MCP) = Absorption Costing Profit (ACP)

Increase in Stock - Marginal Costing profit (MCP) < Absorption Costing Profit (ACP)

Decrease in Stock - Marginal Costing profit (MCP) > Absorption Costing Profit (ACP)

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P2 Performance Management Syllabus

Paper P2 continues the analytic theme of Paper P1 Performance Operations (for example in terms of identifying relevant costs). However, its main focus is on the application of information in the management processes of decision-making and control, from a performance optimising perspective. The first section covers the key contributors to operational performance – revenue; decisions of what to produce, at what price. The second section covers costs; how to manage them to maximise profitability. The role of control in monitoring and improving performance then comes to the fore in the final two sections, dealing with principles and practices in the use of responsibility centres and budgeting.


Syllabus structure
The syllabus comprises the following topics and study weightings:
30% - Pricing and Product Decision

• Relevant Costing and Short-Term Decisions
• Marginal and Absorption Costing
• Pricing
• Linear Programming
• Cost-Volume-Profit

30% - Cost Planning and Analysis for Competitive Advantage
20% - Budgeting and Management Control
20% - Control and Performance Measurement of Responsibility Centres

Assessment strategy
There will be a written examination paper of three hours, plus 20 minutes of pre-examination question paper reading time.

The examination paper will have the following sections:

Section A – 50 marks
Five compulsory medium answer questions, each worth ten marks. Short scenarios may be given, to which some or all questions relate.

Section B – 50 marks
One or two compulsory questions. Short scenarios may be given, to which questions relate.

Full syllabus here

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How To Pass P2 Performance Management?

CIMA P2 Performance Management is a continuation of the analytic theme of P1 (Performance Operations). However, P2 will focus more on the application of information in the management processes of decision-making and control.

The first section of P2 covers mainly the key contributors to operation performance (i.e., revenue; decisions of what to produce, at what price). The second section covers costs (i.e., how to manage them to maximise profitability).

So, what should be our strategy to pass this exam? Perhaps, we should start on how we're going to prepare for this exam paper - by studying of course!

I've listed down my personal strategy on how I will nail this exam once I enter the exam room! I don't have plans to topnotch this paper - I just want to pass.

1) Familiarise and understand the syllabus

There is no point of studying the entire textbook from cover to cover if some parts of it won't be included in the exam. Unless you have plenty of time, you can really devote most of it in getting used to the questions that will mostly appear.

The syllabus structure for P2 has been communicated to the students. As you can see, Pricing and Product Decisions and Cost Planning and Analysis for Competitive Advantage has 30% each weight. If you can get all the questions related to these two topics correctly, you've already passed at 60% mark!

2) Read the study text and answer the example questions

There is no way you'll be able to pass P2 if you immediately jump into answering the questions from Past Papers. You should at least know the basic theories - like what is relevant cost or ABC costing or Cost-Volume Profit, etc.

3) Practice, practice, practice

The key really in passing P2 is by constant practicing in answering the questions. The exam is actually more or less 90% computation - so, it means you need to compute!

In practicing, don't simply copy the model answers. At least, try to come up with your own solution. Once you have your own proforma answers, live everyday with those answers!

4) Read the Post Exam Guides

The Post Exam Guides are comments from the examiners about the common mistakes of the students who took the past exams. These aim to guide you on how marks are allocated on the questions, expected outline of the answers and the usual mistakes committed.

5) On the Exam itself, Write Legibly!

Put yourself on the examiners' shoes, would you be encouraged to understand and put marks on a very chaotic and disorganised answers? Most likely you want to mark all of them wrong. 

Answer the questions! Plan your Answers! Write Clearly!

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Relevant Cost and Short Term Decisions

In Relevant Cost and Short Term Decisions, there are three learning outcomes we can get from this discussion:

• Discuss the principles of decision making including the identification of relevant cash flows and their use alongside non-quantifiable factors in making rounded judgement.
• Explain why joint costs must be allocated to final products for financial reporting purposes, but why this is unhelpful when decisions concerning process and product viability have to be taken.
• Explain the usefulness of dividing costs into variable and fixed components in the context of short-term decision-making. 

1) Relevant Cost and Non Relevant Cost

Relevant Cost - affected by decisions being taken
Non-relevant cost - cost is the SAME regardless of the decisions being taken

• Sunk/Past cost - spent and cannot be recovered (i.e., NPI Cost)
• Fixed Overhead - do not increase/decrease as a result of decision being taken (i.e., Space, Building)
• Committed cost - expenditure that will be incurred in the future, but as a result of decisions taken in the past that cannot be changed (i.e., Special packaging for new product)
• Historical cost depreciation - do not result in any future cash flows/ book entries only
• Notional cost - only relevant if they represent an identified cost opportunity to use the premise (i.e., notional rent/notional interest)

2) Opportunity Cost

Opportunity cost - value of the benefit sacrificed when one course of action is CHOSEN, in preference to an alternative. This is the forgone potential benefit from the best rejected course of action.




3) Avoidable and Differential/Incremental Cost

Avoidable Cost - specific cost of an activity or sector of a business which would be avoided if the activity or sector did not exist (i.e., shutting down a department - cost of labour/rental cost)

Differential/Incremental Cost - difference in total cost between alternative; calculated to assist in decision making. This is Incremental revenue less incremental cost equals Incremental gain/loss. Ultimately, we'll choose an activity that will give us incremental gain.

 

4) Limiting Factor Decision-Making

Limiting Factor - any factor that is in SCARCE supply and that stops the organisation from expanding its activities further, that is, it limits the organisation's activities.

Examples: (All the factors of production)
1) Materials
2) Labour Hours (Supply of Skilled Labour)
3) Machine Hours (Machine capacity)

Aim: Maximise Contribution

Steps in Making Decision when there is a limiting factor:

1. Check if limiting factor exist (i.e., materials required to produce the maximum demand vs available materials.
2. Calculate the contribution per unit of limiting factor (Note: Do not take the contribution per unit alone. It should relate to the limiting factor)
3. Rank the products from highest to lowest contribution per unit of limiting factor
4. Allocate the available materials according to the rank 

           - Product at Maximum production
           - Product at balancing/residual for production



5) Further Decision Making

Make or Buy

Discontinue a product

Deciding when to close a department

Further processing

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Free P2 Performance Management Resources

If you are really into studying CIMA, of course, you are much willing to buy all the study materials available that will aid in passing the exam. But, it is no joke to purchase those big textbooks and carry them whenever you want to read them. Just imagine - one Kaplan textbook costs around £35, excluding delivery.

So what I did -- I did a widely search online of any free study materials that I can use in preparation for the P2 Performance Management Exam. And I'm so much willing to share them to you!

The good thing about these free study materials - you can sync this to your iPad, iPhone or any Tablet or Smartphone that will be accessible to you anytime. Also, it ranges from the full-length study materials to summarised versions from expert tutors online.

CIMA P2 Performance Management Study Text by Jo Avis

CIMA P2 Notes by LSBF

CIMA P2 Revision Summaries by Acorn

CIMA P2 Express Notes by ExpGroup

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5 Reason Why I Study CIMA

The good thing about being an accountant - we have choices on what we want to specialize in. We can choose to be an external/internal auditor, an investment professional, an insurance agent, an accounting professor, or simply as a simple accountant. In my case, I never thought I will be specializing in Management Accountant.

Before I decided to take CIMA, I already had CPA under my belt but my experience comprises mainly of 5 solid years of being a Management Accountant. I was contemplating if I will take CIMA or other Chartered Accountants. But then, I found five good reasons why I should choose CIMA among all others.

1) Global Recognition

By becoming a CIMA member you will join the world’s largest professional body of management accountants. You will be able to use the Chartered Global Management Accountant (CGMA) designation and be part of a truly global network.

2) Combine finance and business
CIMA focuses on business, giving you more than just accounting knowledge. You will not only be financially qualified but also professionally trained in business management, capable of advising on business strategy and risk management.

3) Employability
As a CIMA student or member, you show employers that you have a commitment to uphold the highest ethical and professional standards. The ongoing professional development also keeps your qualification relevant.

The updated syllabus, which will take effect in January 2015, is built around addressing the ‘employability’ needs of businesses and people by helping them develop the skills and knowledge needed to create and execute successful strategies.

4) Post-graduate study
It is like taking an MBA - but a lot more convenient, cheaper and easier!

5) Boost Earning potential
A CIMA qualification can increase your earning potential, even while you are still studying. The global salary surveys show what you can expect to earn as a fully qualified or part-qualified professional.

See 2013 salary surveys

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CIMA Certificate | The CIMA Examiner’s Guides to the Certificate Exams

The following guides will help you gain an understanding of what is required to succeed in the certificate level exams. Each paper assesses a different fundamental area of management accounting and as such requires a slightly different approach. Check them out below…

C01 fundamentals of management accounting

C02 fundamentals of financial accounting

C03 fundamentals of business mathematics

C04 fundamentals of business economics

C05 fundamentals of ethics, corporate governance and business law

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E2: Chapter 2 - The Nature of the Competitive Environment

2.1 Introduction
2.2 Environmental impact assessment
2.3 Different stages in environmental analysis

• 2.3.1 Analysing the macro-environment
• 2.3.2 Analysing the micro-environment/industry environment
• 2.3.3 Industry life cycle analysis
• 2.3.4 Illustration of external environmental analysis – Example of a car manufacturer
• 2.3.5 Evaluation of environmental models
• 2.3.6 Survival and success factors

2.4 Causes of environmental uncertainty

• 2.4.1 Impact of uncertainty
• 2.4.2 Has uncertainty really increased?

2.5 Competitor analysis

• 2.5.1 The importance of competitor analysis
• 2.5.2 Competitor analysis – key concepts
• 2.5.3 Levels of competitors
• 2.5.4 Gathering competitor intelligence
• 2.5.5 Forecasting competitors’ response profiles

2.6 Competitor accounting

• 2.6.1 Evaluation of barriers to entry
• 2.6.2 Estimate competitors’ costs

2.7 The global economic environment

• 2.7.1 The new global economy

2.8 National competitive advantages

• 2.8.1 Porter’s Diamond
• 2.8.2 Demand conditions
• 2.8.3 Related and supporting industries
• 2.8.4 Factor conditions
• 2.8.5 Firm structure, strategy and rivalry
• 2.8.6 Other events
• 2.8.7 National competitive advantage
• 2.8.8 Losing competitive advantage
• 2.8.9 Porter’s strategic prescriptions
• 2.8.10 Comment on Porter’s Diamond 95

2.9 Country analysis and political risk 96

• 2.9.1 Political risk 96

2.10 Sources of information for environmental analysis 97

• 2.10.1 Environmental scanning 97
• 2.10.2 Accessing environmental information 98
• 2.10.3 Detailed environmental analysis 98
• 2.10.4 Categorisation of information sources 99

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E2: Chapter 1 - The Nature of Strategic Management

Objectives:

• Compare and contrast the approaches in STRATEGY FORMULATION
• Discuss concepts in an emergent thinking in STRATEGIC MANAGEMENT
• Explain and discuss the relationships between DIFFERENT LEVELS OF STRATEGY
• Discuss the nature of COMPETITIVE ENVIRONMENTS

Contents:

1.1 Introduction to the nature of strategic management
1.2 The concept of strategy

• 1.2.1 Common themes in strategy
1.3 Levels of strategy

1.4 A model of the rational strategy process

• 1.4.1 Mission, objectives and goals
• 1.4.2 The link between mission, goals and objectives
• 1.4.3 The goal structure
• 1.4.4 External environmental and competitive analysis
• 1.4.5 Internal analysis/position audit
• 1.4.6 Corporate appraisal (SWOT)
• 1.4.7 Strategic options and choice
• 1.4.8 Strategy implementation
• 1.4.9 Review and control

1.5 Criticisms of the rational model of strategy formulation
1.6 A formal top-down strategy process

• 1.6.1 Benefits of the formal top-down approach to strategy
• 1.6.2 Drawbacks of the formal top-down approach to strategy

1.7 Strategy and small businesses
1.8 Achieving competitive advantage – alternative perspectives: resource-based view versus the positioning view

• 1.8.1 Competitive advantage and economic theory
• 1.8.2 The positioning approach
• 1.8.3 Resource-based view
• 1.8.4 Principles of resource-based theory
• 1.8.5 The implications of the resource-based view for strategy development

1.9 Alternative approaches to formulating strategy

• 1.9.1 Emergent strategies
• 1.9.2 Logical incrementalism

1.1 Introduction to the nature of strategic management

Strategic Management

• Decisions that organizations make about their future direction and the development and implementation of strategies which will enhance COMPETITIVENESS of the organizations
• Aim is to establish the purpose of the organization and guide the managers on how to implement those strategies to achieve the goals

1.2 The Concept of Strategy

Strategy

• A course of action, including specification of resources required, to achieve a specific objective. Strategy refers to how to be unique, how to have an advantage or how to sustain that advantage over time. 

• Let's use Apple as an example. Apple strategy is how they can make iPhone the no. 1 smartphone in the world, or how iPad the no. 1 tablet over time

• Strategic plan is statement of long-term goals along with a definition of the strategies and policies which will ensure achievement of these goals.
• Strategic plan is a roadmap to grow your business. Included in a strategic plan are:
• Executive Summary
• Brief description of the business
• Company mission statement
• SWOT
• Goals
• KPIs
• Target customers
• Industry analysis
• Competitive analysis and advantage
• Marketing plan
• Team
• Operations Plan
• Financial Projections
• Corporate strategy is the pattern of major objectives, purposes and goals and essential policies or plans for achieving those goals, stated in such a way as to define what business the company is in or is to be in and the kind of company it is or is to be.

 1.2.1 Common themes in strategy

V-alue to the stakeholders
O-rganization's resources are used to meet the environmental challenges
C-hallenges are faced (competitors and customer requirements)
A-ctivities and actions required to meet the objectives
L-ong term direction of the business

1.3 Levels of strategy

Typically, strategies occur at different levels of the organization. This is where the levels of strategy appeared and built the hierarchical levels of strategy.

Corporate Strategy - the strategy focused on the overall purpose and scope of the organization. In simple terms, this is about knowing what type of business should the organization should be in.

What are the good examples of events or issues encountered at this level of strategy?

• decisions on acquisitions, mergers and sell-offs or closure of business units (i.e., Hewlett-Packard bought Autonomy and EDS)
• relations with key external stakeholders such as investors, the government and regulatory bodies (i.e., Apple CEO Tim Cook meets the Chinese officials)
• decisions to enter new markets or embrace new technologies (i.e., Microsoft bought Nokia)
• development of corporate policies on issues such as public image, employment practices or information systems (i.e., Pannone, a Manchester-based law firm, pays for its employees divorces)

Business Strategy - the strategy that is concerned with how an operating or strategic business unit

approaches a particular market.

A SBU or strategic business unit is a division within a larger organization, that has a degree of autonomy, typically being responsible for developing and marketing its own products or services. 

A good example of business unit is the PPS or Printing and Personal Systems Group of Hewlett-Packard. This is a merged business units of IPG and PSG.

Management of the SBU will be responsible for winning customers and beating rivals in its particular market. Consequently, it is at this level that competitive strategy is usually formulated. 

The considerations at this level will include:

• marketing issues such as product development, pricing, promotion and distribution;
• how should it segment the market – should it specialize in particular profitable segments.

The fundamental measure of winning customers:

• Am I creating a customer?
• Am I creating more customers?
• Are my customers becoming more loyal?
• Am I creating value to the customers?

Functional Strategy - The functional (sometimes called operational) level of the organisation refers to main

business functions such as sales, production, purchasing, human resources and finance.

Functional strategies are the long-term management policies of these functional areas. They are intended to ensure that the functional area plays its part in helping the SBU achieve the goals of its corporate strategy.

Example of Functional Strategies are:

• Marketing strategy that deals with pricing, promotion, selling and distribution
• R&D strategy that deals on product innovation and process improvement
• HRM strategy that deals on the people in the organization
• Financial strategy that involves financial planning
• Information Management strategy is about the alignment of information management within an organization with its business and corporate strategies to gain strategic advantage

1.4 A model of the rational strategy process

Formal or Rational Strategy approach - the traditional approach to strategic management.

Rational strategy process seeks to answer questions concerning where the organisation is now, where it should go in the future, and how it should get there.

First step: What are the mission and objectives of the organization? This is where the strategy will start, with its existing strategy. The mission will is the ultimate purpose of the organization's existence, like what business it is in.

Second step: Gather information from external and internal analysis.

External analysis assesses if the strategy of the organization fits on its environment. These represent the threats and opportunities and the competition that the organization faces. PEST framework helps in the analysis of the macro or general environment and the 5 forces model in analyzing the competitive environment.



Internal analysis is about the organization's internal resources and capabilities. What the company is good at as compared to the competitors? This will involve resource audit - financial resources, human skills, physical assets, technologies and so on.

For an organization to survive and prosper, it depends on the adequacy and sustainability of 'resources' and 'competences.' Resources are what the organization has while Competences are the activities and processes
through which the organisation deploys its resources effectively. Michael Porter's Value Chain helps to identify the internal position of an organisation.



After gathering the information from external and internal analysis, it's time to do the SWOT analysis or Corporate Appraisal. SWOT stands for Strengths, Weaknesses, Opportunities and Threats.

At this stage, management will assess the ability of the business, following its present
strategy, to reach the objectives they have set.

They will draw on two sets of information:
(a) Information on the current performance and resource position of the business. This
will have been gathered in a separate internal position audit exercise.
(b) Information on the present business environment and how this is likely to change
over the period of the strategy. This will have been collected by a process of external
environmental analysis and competitor analysis.



Third step: What are the Strategic Options and Choices?

After doing the SWOT analysis, management needs put all the options that will lead to having a choice. Strategic Choice is basically a process of choosing alternative strategic options generated by the SWOT analysis. Management needs to seek to identify and evaluate alternative courses of action to ensure that the business reaches the objectives they have set.

The strategic choice process involves making decisions on:

• What basis should the organisation compete and on what basis can it achieve competitive advantage (How does Apple managing the competition with Samsung?)
• What are the alternative directions available and which products/markets should the organisation enter or leave? (By launching an iPad, this became the alternative directions of Apple that took the market by surprise)
• What alternative methods are available to achieve the chosen direction? (Apple's alternative methods will probably include making a thinner or smaller iPad for those consumers who are particular with the sizes.)

After evaluation and coming up with alternative strategic options, the management will decide how they are going to execute - by taking advantage and leveraging on the strengths and opportunities, at the same time minimizing and preventing the weaknesses and threats. This is called the Strategic Direction.

Strategic Direction will include options to penetrate the market, develop a new product, develop a new market and diversify.

These directions entail to come up with methods how to do either options. These are the Strategic Methods, which will bring different ideas on how to perform the Strategic direction. It can be through internal development, acquire a new company or merge to another company that will help to penetrate the market or diversify, or strategic alliance.

After choosing the strategic direction and method of achieving that, the next step is to evaluate. The evaluation stage considers each options available and assesses if these fit the mission or objectives of the organization.

Fourth step: Implementation stage of strategy

This stage is actually the most tedious part of the rational strategy process. This is where the detailed plans, policies and programs are formulated. This will also involve the acquisition of required resources that will make the strategy happen. There are two (2) decisions that management will focus on:

(1) Tactical programmes and decisions - these are essentially about implementing some of the key elements of the strategy like developing new products, recruitment or downsizing of staff or investing in new production capacity.

(2) Operational programmes and decisions - these cover the day-to-day matters such as meeting
particular production, cost and revenue targets.

Fifth step: Review and Control

After the implementation, it doesn't stop there. This will be an on-going process that will require reviewing both the implementation and the overall continuing suitability of the strategy.

It will consider two aspects:
1. Does performance of the strategy still put the business on course for reaching its strategic
objectives?
2. Are the forecasts of the environment on which the strategy was based still accurate, or have unforeseen threats or opportunities arisen subsequently that might necessitate a reconsideration of the strategy?

1.5 Criticisms of the rational model of strategy formulation

I - nvolvement in the strategy. Senior management should not be the only people involved in setting strategy. Senior management are too detached and lack understanding of the details. Also, they will most likely not to consider the the social processes, values and cultures of the staff in the division.

S - tep-by-step. Strategy formulation is not a simple step-by-step process. In reality, it is much more of a jumbled-up process and can include considerable backtracking and revisiting of earlier stages in the model.

N - ot something decided in advance by managers. Apply Mintzberg's model of Managing. Strategy is often recounted by managers long after the event. Strategy emerges as a pattern from the piecemeal decisions of management. Another name for this view is adaptive because it sees the organisation as

adapting to the circumstances around it.

O - rganizations are incapable of having objectives. Organization is a collection of people, with people has a variety of goals. These objectives may be in conflict with the other and change from time to time. It is also inevitable that the objective of the organization will please the stakeholders group.

R - ational process of strategy shouldn't apply. The excessive rationality in decision-making will rob a manager of the motivation and commitment necessary to implement the strategy successfully.

E - ventually, organizations follow the strategies that aren't set. Management suffered from bounded rationality during the strategy formulation. This means that they cannot have perfect knowledge of the future and so any strategies developed will fail to take into account all eventualities.

1.6 A formal top-down strategy process

Features:

A-ssigned Team.  A designated team responsible for strategy development. This will include strategic planning unit reporting to top management, groups of managers and business consultants
F-ormal collection of information for strategy purposes. This includes environmental scanning reports, specially commissioned reports, management accounting information and research reports.
T-eam working together for the decision-taking. Collective decision-taking by the senior management team.
E-ngage a process for the communication and implementation. A process of communicating and implementing the business strategy.
R-egular review and control of the strategy. Management will monitor the success of the strategy by receiving regular reports on performance and on environmental changes.

Benefits:

A-voids Short-Termist Behavior. Management will focus on long-term development of the business 

I - ssues are Identified. Management is proactive and keeps ahead of the change when the business environment in the plans and decisions are considered.

G-oal Congruence. This is basically about the coordination of each team player that will make the strategy successful.

I-mproves stakeholder perceptions of the business. This gives a clear idea on where the business is going, which gives confidence to the stakeholders that the organization is progressing and will become successful.

C-ontrol has basis. Provides a basis for strategic control. This includes essentially the implementation and completion stage of the strategy. It ensures that there is someone looking after the development of the strategy, has clear programmes and policies, and targets and reports enabling review of success of the strategy.

E-nsures continuity and develops future management potential. This relates to the fact that formal strategy formulation is a collective process.

Drawbacks:

D-ynamic. It is too infrequent to allow the business to be dynamic.(for example by continuing to make a product no one wants)

E-ntrepreneurial spirit. There is loss of entrepreneurial spirit. 

D-ifficulties of implementation. 

U-ncertain business environments. Successful implementation requires the participation of middle and junior management, together with operative staff. There is a danger that the formal process will not build the support of these people and hence will be misunderstood or resisted.

C-omplicated and expensive for small businesses. The opportunity cost in terms of the time away from direct management of the operational parts of the business are likely to be too great.

E-xcludes the development of radical or innovative strategies. The need to retain consensus among the management team means that radical ideas are too often rejected.

1.7 Strategy and small businesses

The top-down process is not suitable for small businesses due to following reasons:

G-oals are different as compared to big companies. Small businesses often do not exhibit the economic rationality and single-minded pursuit of dividends and growth often associated with businesses governed by external shareholders.

R-esources are limited. Smaller firms lack the resources to invest in new strategic ventures

and rapid growth.

O-rganizational structure. Strategic implementation demands the setting up of an appropriate structure and selection of an appropriate team to carry it out.

S-cope of product/market choices are limited. Small-business managers typically consider a much narrower range of strategic options than do their large-business counterparts.

1.8 Achieving competitive advantage – alternative perspectives: resource-based view versus the positioning view

Positioning view sees competitive advantage stemming from the firm’s position in relation to its competitors, customers or stakeholders. It is sometimes called an outside-in view because it is concerned with adapting the organisation to fit its environment.

Criticisms of Positioning View, from resource based theorists perspective:

• The competitive advantages are not sustainable.
• Environments are too dynamic to enable positioning to be effective.
• It is easier to change the environment than it is to change the firm.

Resource-based view is based on competitive advantage stemming from some unique asset or competence possessed by the firm. This is an inside-out view of strategy because the firm must go in search of environments that enable it to harness its internal competences.

Resource-based theory raises a number of issues:

• Conflict with conventional product/market-based views of strategy
• Challenges the rational model of strategy
• RBT can lead to different conclusions.

1.9 Alternative approaches to formulating strategy

Emergent strategies

• According to Henry Mintzberg, real strategies are combination of planned strategy and unanticipated emergent strategies
• Defined as patterns or consistencies realized despite, or in the absence of, intentions’

Logical incrementalism

• Logical incrementalism is the term developed by Lindblom to describe how 
• government administrators ‘muddle through’ from year to year rather than carry out bold 
• strategic initiatives
• Accept that they cannot foresee the future and survive by muddling through, taking small steps based on what has been done and has worked in the past
• For Quinn, a manager must map where he or she wants the organisation to go and then proceed towards it in small steps, being prepared to adapt if the environment changes or if support is not forthcoming.

1.10 Stakeholders

Stakeholders - Those persons and organisations that have an interest in the strategy of an organisation

They include:
● shareholders and owners
● management
● employees
● customers/clients
● suppliers
● local community
● local and national governments
● trade unions
● media
● regulatory bodies
● pressure groups

The influence of stakeholders
Strategic decision-making requires managers to consider stakeholders when setting the mission and objectives of the firm. This is for two broad groups of reasons:

• Issues of stakeholder power. This view observes that, like it or not, management must recognise that stakeholders can affect the success of a strategy, depending on whether they support or oppose it.
• For example, customers refusing to buy products, shareholders selling their shares or staff striking would disrupt any strategy. The view concludes that management should consider stakeholders before setting strategic objectives.

• Issues of organisational legitimacy. This more radical view suggests that firms are required to be good citizens because they are only permitted to exist by society on sufferance of not abusing their power. Consequently, although working primarily for the shareholders, management must ensure that its decisions do not ignore the interests of other stakeholders.

Mendelow Matrix

Mendelow (1991) developed a framework to help analyse stakeholders power and interest

• To keep track of changes in the potential influence of different stakeholder groups. By plotting the matrix periodically, management can be alerted when a strategy may need to be changed to accommodate (or avoid a threat from) particular stakeholders.
• To assess the impact of a particular strategic development on stakeholders. For example, managers proposing a factory closure could use mapping to identify where opposition to closure may come from and how it might be managed.

Assessing interest of stakeholders

• Where their interests rest
• Powerful stakeholders will pursue their self-interest. Example of these are managers, whose interests are their career and pay, or employees who require higher pay and good working condition.
• How interested they are
• Not all stakeholders have the time or interest to follow management's decisions.
  Example of these are the high personal financial or career investment in what the business does or the absence of alternative.

1.11 Meeting the objectives of shareholders

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