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Chapter 16 - Operational Performance Measurement: Further Analysis of Productivity and Sales

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that variance analysis becomes most meaningful
By Vijay Govindarajan and John K. Shank
when it is tied exp licitly to strategic analysis.

Profit variance analysis is the process of

summarizing what happened to profits during the
period to highlight the salient managerial issues.
Variance analysis is the formal step leading to
determining what correct ive actions are called fo r by
management. Thus it is a key link in the management
control process. We believe this element is
underutilized in many co mpanies because of the lack
of a meaningful analytical framework. It is handled
by accountants in a way that is too technical. This
paper proposes a different profit variance framework
as a “new idea” in management control.
Historically, variance analysis involved a simple
methodology where actual results were compared
with the budget on a line-by-line basis. We call this
Phase I thinking. Phase II thinking was provided by
Shank and Churchill [1977] who proposed a
management-oriented approach to variance analysis.
Their approach was based on the dual ideas of profit
impact as a unifying theme and a mult ilevel analysis
in which co mplexity was added gradually, one level
at a time. We believe that the Shank and Churchill
approach needs to be modified in important ways to
take explicit account of strategic issues. Our
framework, which we call Phase III thinking, argues

Budget (1,000s)
Sales $16,872
Cost of goods sold 9,668
Gross margin $ 7,204
Less: Other operating expenses
Marketing $1,856 $1,440
R&D 1,480 932
Administration 1,340 4,676 1,674
Profit before taxes $ 2,528

Chapter 16 - Operational Performance Measurement: Further Analysis of Productivity and Sales


This paper presents a short disguised case, APPROACH” TO VARIANCE ANALYS IS
United Instruments, Inc., to illustrate the three phases
A straightforward, simple -minded explanation of the
or generations of thinking about profit variance
difference between actual profit ($3,150) and the
analysis. We believe it also demonstrates the
budgeted profit ($2,528) might proceed according to
superiority of integrating strategic planning and
T-3. Incidently, this type of variance analysis is what
overall financial performance evaluation, wh ich is the
one usually sees in published annual reports (where
essence of Phase III thinking. The purpose of this
the comparison is typically between last year and this
paper is to emphasize how variance analysis can be,
year). If we limit ourselves to this type of analysis,
and should be, redirected to consider the strategic
we will draw the following conclusions about
issues that have, during the past 15 years, become so
United’s performance:
widely accepted as a conceptual framewo rk for
decision making. 1. Good sales performance (slightly above plan).
2. Good manufacturing cost control (marg ins as per
3. Good control over marketing and R&D costs
Steve Park, president and principal stockholder (costs down as percentage of sales).
of Un ited Instruments, Inc., sat at his desk reflecting
4. Admin istration overspent a bit (slightly up as
on the 1987 results (Table 1). For the second year in
succession, the company had exceeded the profit percentage of sales).
budget. Steve Park was obviously very happy with 5. Overall Evaluation: Nothing of major
the 1987 results. All the same, he wanted to get a significance; profit performance above plan.
better feel for the relat ive contributions of the R&D,
manufacturing, and market ing departments in this How accurately does this summary reflect the
overall success. With this in mind, he called his actual performance of United? One objective of this
assistant, a recent graduate of a well-known business paper is to demonstrate that the analysis is
school, into his office. misleading. The plan for 1987 has embedded in it
“Amy,” he began, “as you can see from our certain expectations about the state of the total
recent financial results, we have exceeded our profit industry and about United’s market share, its selling
targets by $622,000. Can y ou prepare an prices, and its cost structure. Results from variance
analysis showing how much R&D, computations are more “actionable” if changes in
manufacturing, and marketing contributed to t his actual results for 1987 are analyzed against each of
overall favorable profit variance?” these expectations. The Phase I analysis simp ly does
Amy Shult z, with all the fervor of a recent not break down the overall favorable variance of
convert to professional management, set to her task $622,000 according to the key underlying causal
immed iately. She collected the data in Table 2 and factors.
was wondering what her next step should be.
United Instruments’ products can be grouped PHAS E II THINKING: A MANAGEMENT-
into two main lines of business: electric meters (EM) ORIENT ED APPROACH TO VARIANCE
and electronic instruments (EI). Both EM and EI are ANALYS IS
industrial measuring instruments and perform similar The analytical framework proposed by Shank and
functions. However, these products differ in their Churchill [1977] to conduct variance analysis
manufacturing technology and their end-use incorporates the following key ideas:
characteristics. EM is based on mechanical and 1. Identify the key causal factors that affects profit.
electrical technology, whereas EI is based on 2. Break down the overall profit variance by these
microchip technology. EM and EI are substitute
key causal factors.
products in the same sense that a mechanical watch
and a digital watch are substitutes. 3. Focus always on the profit impact of variat ion in
United Instruments uses a variable costing each causal factor.
system for internal reporting purposes.

Chapter 16 - Operational Performance Measurement: Further Analysis of Productivity and Sales

Electric Electronic
Meters Instruments
(EM) (EI)
Selling prices per unit
A verage standard price $40.00 $180.00
A verage actual prices, 1987 30.00 206.00
Variable product costs per unit
A verage standard manufacturing cost $20.00 $50.00
A verage actual manufacturing cost 21.00 54.00
Volume information
Units produced and sold–actual 141,770 62,172
Units produced and sold–planned 124,800 66,000
Total industry sales, 1987–actual $44 million $76 million
Total industry variable product costs, 1987–actual $16 million $32 million
United’s share of the market (percent of physical units)
Planned 10% 15%
Actual 16% 9%
Planned Actual
Firm-wide fixed expens es (1,000s)
Fixed manufacturing expenses $3,872 $3,530
Fixed marketing expenses 1,856 1,440
Fixed administrative expenses 1,340 1,674
Fixed R&D expenses
(exclusively for electronic instruments) 1,480 932

4. Try to calculate the specific, separable impact of Marketing

each causal factor by varying only that factor Co mments:
while hold ing all other factors constant Market Share (SOM) increase benefited
(“spinning only one dial at a time”). the firm $1,443 F
But, unfortunately, sales mix was managed
5. Add complexity sequentially, one layer at a time,
toward the lower marg in product 921 U
beginning at a very basic “common sense” level
(“peel the onion”). Control over marketing expenditure
benefited the firm (especially in the face of
6. Stop the process when the added complexity at a an increase in SOM) 416 F
newly created level is not justified by added
useful insights into the causal factors underlying Net effect $938 F
the overall profit variance. Uncontrollables: Unfortunately, the overall
market declined and cost the firm $680 U
T-4 and 5 contain the explanation for the overall Overall evaluation: Very good performance
favorable profit variance of $622,000 using the above Manufacturing
approach. In the interest of brevity, most of the Co mments:
calculation details are suppressed (detailed Manufacturing cost control cost the $ 48 U
calculations are available fro m the authors). firm
What can we say about the performance of Overall evaluation: Sat isfactory performance
United if we now consider the variance analysis R&D
summarized in T-5? The following insights can be Co mments:
offered organized by functional area: Savings in R& D budget $ 548 F
Overall evaluation: Good perfo rmance
Co mments:
Admin istration budget overspent $ 334 U
Overall evaluation: Poor performance

Chapter 16 - Operational Performance Measurement: Further Analysis of Productivity and Sales

Budget (1,000s) Actual (1,000s)
Sales $16,872 (100%) $17,061 (100%)
Cost of goods sold 9,668 (58% ) 9,865 (58% )
Gross margin $ 7,204 (42% ) $ 7,196 (42% )
Less: Other expenses
Marketing $1,856 (11% ) $1,440 (8%)
R&D 1,480 (9%) 932 (6%)
Administration 1,340 (8%) 4,676 (28% ) 1,674 (10% ) 4,046 (24% )
Profit before tax $ 2,528 (14% ) $ 3,150 (18% )

variance across jet engines, steam turbines, and light

Thus, the overall evaluation of the general bulbs really makes any sense. This is more nearly the
manager under Phase II thinking would probably be case for United because one unit of EM (which sells
“good,” though specific areas (such as manufacturing for $30) is not really fully substitutable for one unit
cost control or admin istrative cost control) need of EI (wh ich sells for $206).
attention. The above summary is quite different— An important issue in the history of many
and clearly superior —to the one presented under industries is to determine when product
Phase I thinking. But, can we do better? We believe differentiation has progressed sufficiently that what
that Shank and Churchill’s framework needs to be was a single business with two varieties is now two
modified in important ways to accommodate the businesses. Some examp les include the growth of the
following ideas. electronic cash register for NCR, the growth of the
Sales volume, share of market, and sales mix digital watch for Bu lova, or the growth of the
variances are calculated on the presumption that industrial robot for General Electric.
United is essentially co mpeting in one industry (i.e., Following Phase II thinking, performance
it is a single product firm with two different varieties evaluation did not relate the variances to the differing
of the product). That is to say, the target customers strategic contexts facing EM and EI.
for EM and EI are the same and that they view the
two products as substitutable. Is United a single
product firm with two product offerings, or does the PHAS E III THINKING: VARIANCE ANALYS IS
firm co mpete in two different markets? In other US ING A STRATEGIC FRAMEWORK
words, does United have a single strategy for EM and We argue that performance evaluation, which is a
EI or does the firm have two different strategies for critical co mponent of the management control
the two businesses? As we argue later, EM and EI process, needs to be tailored to the strategy being
have very different industry characteristics and followed by a firm o r its business units. We offer the
compete in very different markets, thereby, requiring following set of arguments in support of our position:
quite different strategies. It is, therefore, more useful (1) different strategies imply different tasks and
to calculate market size and market share variances require different behaviors for effective performance
separately for EM and EI. Just introducing the [Andrews, 1971; Gupta and Govindarajan, 1984a;
concept of a sales mix variance implies that the and Govindarajan, 1986a]; (2) different control
average standard profit contribution across EM and systems induce different behaviors [Govindarajan,
EI together is meaningful. 1986b; Gupta and Govindarajan, 1984b]; (3) thus,
For an ice cream manufacturer, for examp le, it is superior performance can best be achieved by
probably reasonable to assume that the firm operates tailoring control systems to the requirements of
in a single industry with multip le product offerings, particular strategies [Govindarajan, 1988; Gupta and
all targeted at the same customer group. It would, Gov indarajan, 1986].
therefore, be meaningful to calculate a sales mix
variance because vanilla ice cream and strawberry ice
cream, for instance, are substitutable and more sales
of one imp lies less sales of the other for the firm (for
an elaboration on these ideas, refer to the Midwest
Ice Cream Co mpany case [Shank, 1982, pp. 157–
173]). On the other hand, for a firm such as General
Electric, it is much less clear whether a sales mix

Chapter 16 - Operational Performance Measurement: Further Analysis of Productivity and Sales


Key Causal Factors:

Total Market Expected Actual Actual Actual Actual Actual
Market share Expected Expected Actual Actual Actual Actual
Sales mix Expected Expected Expected Actual Actual Actual
Selling price Expected Expected Expected Expected Actual Actual
Costs Expected Expected Expected Expected Expected Actual

Profit Calcu lation:

Sales $16,872 $15,836 $18,034 $16,862 $17,060 $17,060
Variable costs 5,769 5,440 6,195 5,944 5,944 6,334
Contribution $11,076 $10,396 $11,839 $10,918 $11,116 $10,726
Fixed costs 8,548 8,548 8,548 8,548 8,548 7,576
Profit $ 2,528 $ 1,848 $ 3,291 $ 2,370 $ 2,568 $ 3,150
Variance Analysis:
Level 1
Overall variance=$622 F

Level 2
Sales volu me and mix=$158 U Sales prices and costs=$780 F

Level 3 Sales mix Sales prices Costs

Sales volu me=$763 F =$921 U =$198 F =$582 F
Level 4
Market EM EI Variable costs of Fixed costs
Size Market Share $1,418 U $1,616 manufacturing  Manufacturing $342 F
=$680 U =$1,443F EM $142 U  Marketing $416 F
EI $248 U  Admin istration $334 U
 R&D $548 F

Note: F indicates a favorable variance and U indicates an unfavorable variance.

Chapter 16 - Operational Performance Measurement: Further Analysis of Productivity and Sales

Overall market decline $ 680 U
Share of market increase 1,443 F
Sales mix change 921 U
Sales prices improved 198 F
EM $1,418 U
EI $1,616 F
Manufacturing cost control 48 U
Variable costs $390 U
Fixed costs $342 F
R&D 548 F
Administration 334 U
Marketing 416 F
Total $ 622 F

We will first define and briefly elaborate the its capital investment needs. Business units with
concept of strategy before illustrating how to link “low market share” in “high growth industries”
strategic considerations with variances for typically pursue a “build” mission (e.g., Apple
management control and evaluation. Strategy has Co mputer’s MacIntosh business, Monsanto’s
been conceptualized by Andrews [1971], Ansoff Biotechnology business).
[1965], Chandler [1962], Gov indarajan [1989], Hofer
and Schendel [1978], M iles and Snow [1978], and HOLD:
others as the process by which managers, using a This strategic mission is geared to the protection
three- to five-year t ime horizon, evaluate external of the business unit’s market share and
environmental opportunities as well as internal competitive position. The cash outflows for a
strengths and resources in order to decide on goals business unit follo wing this mission would
as well as a set of action plans to accomplish these usually be more or less equal to cash inflows.
goals. Thus, a business unit’s (or a firm’s) strategy Businesses with “high market share” in “high
depends upon two interrelated aspects: (1) its growth industries” typically pursue a “hold”
strategic mission or goals, and (2) the way the mission (e.g., IBM in main frame co mputers).
business unit chooses to compete in its industry to
accomplish its goals—the business unit’s competitive HARVEST:
This mission imp lies a goal of maximizing short-
Turning first to strategic mission, consulting
term earn ings and cash flow, even at the expense
firms such as Boston Consulting Group [Henderson,
1979], Arthur D. Little[Wright, 1975], and A. T. of market share. A business unit following such
a mission would be a net supplier of cash.
Kearney [Hofer and Davoust, 1977], as well as
Businesses with “high market share” in “low
academic researchers such as Hofer and Schendel
[1978], Bu zzell and Wiersema [1981], and growth industries” typically pursue a “harvest”
mission (e.g., American Brands in tobacco
Gov indarajan and Shank [1986], have proposed the
following three strategic missions that a business unit
can adopt: In terms of co mpetitive strategy, Porter [1980]
has proposed the following two generic ways in
B UILD: which businesses can develop sustainable
This mission implies a goal of increased market competitive advantage:
share, even at the expense of short-term earn ings
and cash flow. A business unit following this
mission is expected to be a net user of cash in
that the cash throw-off fro m its current
operations would usually be insufficient to meet

Blocher,Stout,Cokins: Cost Management 5e 16-9 ©The M cGraw-Hill Companies, Inc 2010

Chapter 16 - Operational Performance Measurement: Further Analysis of Productivity and Sales


Electric Meters (EM) Electronic Instruments (EI)
Overall market (units):
Plan 1,248,000 440,000
Actual 886,080 690,800
Declining Market Growth Market
(29% Decrease) (57% Increase)
United’s share:
Plan 10% 15%
Actual 16% 9%
United’s prices:
Plan $40 $180
Actual 30 206
We apparntly cut price to build We apparently raised price to ration
United’s margin : share the high demand.
Plan $20 $130
Actual 9 152
Industry prices:
Actual $50 $110
We are well below “market.” We are well above “market.”
Industry costs:
Actual $18 $46
Procuct/market characteristics: Mature Evolv ing
Lower technology Higher technology
Declining market Growth market
Lower margins Higher margins
Low unit price High unit price
Industry prices holding up Industry prices falling rapidly
United’s apparent strategic mission “Build” “Skim” or “Harvest”
United’s apparent competitive strategy The low p rice imp lies we are trying The high price imp lies we are try ing
for low cost position for a d ifferentiation position.
A more plausible strategy “Harvest” “Build”
Key success factors (arising fro m the Hold sales prices vis-à-vis Co mpetitively price to gain SOM.
plausible strategy) competition.
Do not focus on maintaining and Product R&D top create differentiat ion
improving SOM.
Aggressive cost control Lower cost through
Process R&D to reduce unit costs. experience curve effects

The primary focus of this strategy is to achieve DIFFER ENTIATION:

low cost relat ive to co mpetitors. Cost leadership The primary focus of this strategy is to
can be achieved through approaches such as differentiate the product offering of the business
economies of scale in production, learning curve unit, creating something that is perceived by
effects, tight cost control, and cost minimizat ion customers as being unique. Approaches to a
in areas such as R&D, service, sales force, or product differentiation include brand loyalty
advertising. Examp les of firms following this (Coca-Co la in soft drinks), superior customer
strategy include: Texas Instruments in consumer service (IBM in co mputers), dealer network
electronics, Emerson Electric in electric motors, (Caterp illar Tractors in construction equipment),
Chevrolet in automobiles, Briggs and Stratton in product design and product features (Hewlett-
gasoline engines, Black and Decker in mach ine Packard in electronics), and/or product
tools, and Commodore in business machines. technology (Coleman in camp ing equip ment).

Blocher,Stout,Cokins: Cost Management 5e 16-10 ©The M cGraw-Hill Companies, Inc 2010

Chapter 16 - Operational Performance Measurement: Further Analysis of Productivity and Sales


Key Casual Factors:
Total market Expected Actual Actual Actual Actual
Market share Expected Expected Actual Actual Actual
Selling price Expected Expected Expected Actual Actual
Variable costs Expected Expected Expected Expected Actual
Electric Meters (EM)
Sales $ 4,992 $ 3,544 $ 5,671 $ 4,253 $ 4,253
Variable costs 2,496 h are als 2,835 2,835 2,835 2,977
Contribution $ 2,496 $ 1,772 $ 2,836 $ 1,418 $ 1,276

Market sizee Market share Sales price Cost
=$724 U =$1,064 F =$1,418 U =$142 U

Electronic Instruments (EI)

Sales $11,880 $18,652 $11,191 $12,807 $12,807
Variable costs 3,300 5,181 3,109 3,109 3,357
Contribution $ 8,580 $13,471 $ 8,082 $ 9,698 $ 9,450

Market size Market share Sales price Manufacturing

=$4,891 F =$5,389 U =$1,616 F =$248 U

Firmwide Fixed Costs (by responsibility centers)

Budget Actual Vari ance
Manufacturing $3,872 $3,530 $342 F
Marketing 1,856 1,440 416 F
Admin istration 1,340 1,674 334 U
R&D 1,480 932 548 F

The above framework allows us to consider strategies. Therefore, no attempt is made to calcu late
explicit ly the strategic positioning of the two a sales mix variance. The basic idea is that even
product groups: electric meters and electronic though a sales mix variance can always be calcu lated,
instruments. Though they both are industrial the concept is meaningful only when a single
measuring instruments, they face very different business framework is applicable. For the same
competitive conditions that very probably call reason, Tables 7 and 8 report the market size and
for different strategies. T-6 summarizes the market share variances for EM and EI separately, and
differing environments and the resulting strategic T-4 reported these two variances for the instruments
issues. business as a whole. Obviously, a high degree of
subjectivity is involved in deciding whether United is
How well did electric meters and electronics
in one business or two. The fact that the judgment is
instruments perform, given their strategic contexts?
to a large extent subjective does not negate its
The relevant variance calculations are given in Tables
importance. T-9 summarizes the managerial
7 and 8. These calculations differ fro m Phase II
performance evaluation that would result if we were
analysis (given in T-4) in one important respect. T-4
to evaluate EM and EI against their plausible
treated EM and EI as two varieties of one product,
strategies, using the variances reported in T-7 and 8.
competing as substitutes, with a single strategy. Thus,
a sales mix variance was computed. Tables 7 and 8
treat EM and EI as different products with dissimilar
Blocher,Stout,Cokins: Cost Management 5e 16-11 ©The M cGraw-Hill Companies, Inc 2010
Chapter 16 - Operational Performance Measurement: Further Analysis of Productivity and Sales


Electric Meters
Market size $ 724 U
Market share 1,064 F
Sales price 1,418 U
Variable manufacturing cost 142 U
Electronic Instruments
Market size 4,891 F
Market share 5,389 U
Sales price 1,616 F
Variable manufacturing cost 248 U
R&D 548 F
Firm wide Fixed Costs
Manufacturing 342 F
Marketing 416 F
Admin istration 334 U
TOTA L $ 622 F

The overall performance of United would Phase I, Phase II, and Phase III thinking yield
probably be judged as “unsatisfactory.” The firm has different imp licat ions for this first step. That is, the
not taken appropriate decisions in its functional areas detailed variance calculations do differ across the
(marketing, manufacturing, R&D, and three approaches. Their implications differ even more
administration) either for its harvest business (EM ) or for the second step. The computational aspects
for its build business (EI). The summary in T-9 identify the variance as either favorable or
indicates a dramatically different picture of United’s unfavorable. However, a favorable variance does not
performance than the one presented under Phase II necessarily imp ly favorable performance; similarly,
thinking. This is to be expected because Phase II an unfavorable variance does not necessarily imply
thinking did not tie variance analysis to strategic unfavorable performance. We argue that the link
objectives. Neither Phase I nor Phase II analysis between a favorable or unfavorable variance, on the
explicit ly focused on ways to improve performance one hand, and favorable or unfavorable performance,
en route to accomplishing strategic goals. This would on the other, depends upon the strategic context of
then imply that management compensation and the business under evaluation.
rewards ought not to be tied to performance No doubt, judgments about managerial
assessment undertaken using Phase I or Phase II performance can be dramatically different under
frameworks. Phase I, Phase II, and Phase III thin king (as the
United Instruments case illustrates). In our view,
CONCLUS IONS moving toward Phase III thinking (i.e., analyzing
Variance analysis represents a key link in the profit variances in terms of the strategic issues
management control process. It involves two steps. involved) represents progress in adapting cost
First, one needs to break down the overall profit analysis to the rise of strategic analysis as a major
variance by key causal factors. Second, one needs to element in business thinking [Shank and
put the pieces back together most meaningfully with Gov indarajan, 1988a, 1988b, and 1988c].
a view to evaluating managerial performance. Putting
the bits and pieces together most meaningfully is just
as crucial as computing the pieces. This is a
managerial function, not a computational one.

Blocher,Stout,Cokins: Cost Management 5e 16-12 ©The M cGraw-Hill Companies, Inc 2010

Chapter 16 - Operational Performance Measurement: Further Analysis of Productivity and Sales


Electric Meters Electronic Instruments

“Harvest” vs. “Build” “Build” vs. “Skim”

Comments If we held prices and share, decline in We raised prices to maintain margins
this mature business would have cost and to ration our scarce capacity (our
us $ 724 U price was $206 vs. The industry price
of $110). In the process, we lost
But, we were further hurt by price cuts
significant SOM whic h cost us (netted
made in order to build our SOM (our
against $1,616 F from sales prices).
prices was $30 vs. the industry price
$3,773 U
of $50). $1,418 U
1,064 F This is a booming market that grew
57 percent during this period. Then
Net effect $1,078 U
why did we decide to improve
This is a market that declined 29 margins at the expense of SOM in
percent. Why are we sacrificing this fast growing, higher margin
margins to build market position in business?
this mature, declining lower margin
Fortunately, growt h in the total market
improved our profit picture.
We unders pent t he marketing budget. $4,891 F
$ 416 F
We unders pent t he marketing budget.
But why are we cutting back here in $416 F
the face of our major marketing
But why are we cutting back here in
the face of our major marketing
Overall evaluation Poor performance Poor performance
Comments Manufacturing cost cont rol was lousy Variable Manufacturing costs showed
and cost the firm $142 U an unfavorable variance of $248 U
(industry costs of $46 vs. our costs of
If we are trying to be a cost leader,
where are t he benefits of our
cumulative experience or our scale Does the higher manufacturing cost
economies? (industry unit costs of result in a product perceived as
$18 vs. our costs of $21) better? Apparently not based on
market share dat a.
Overall evaluation Poor performance Poor performance

R&D Not applicable Why are we not s pending sufficient

Comments dollars in product R& D? Could this
explain our decline in SOM?
Overall evaluation Poor performance

Administration Inadequate control over overhead Administration budget overspent.

Comments costs, given the need to become the $334 U How does this relate to cost
low cost producer ($334 U). control?
Overall evaluation Poor performance Not satisfactory

Blocher,Stout,Cokins: Cost Management 5e 16-13 ©The M cGraw-Hill Companies, Inc 2010

Chapter 16 - Operational Performance Measurement: Further Analysis of Productivity and Sales

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