Cola War continue: Coke and Pepsi in the Twenty First Century

1. Why is the soft drink industry so profitable?
An industry analysis through Porter’s Five Forces reveals that market forces are favorable for profitability.

Defining the industry: Both concentrate producers (CP) and bottlers are profitable. These two parts of the industry are extremely interdependent, sharing costs in procurement, production, marketing and distribution.Many of their functions overlap; for instance, CPs do some bottling, and bottlers conduct many promotional activities. The industry is already vertically integrated to some extent. They also deal with similar suppliers and buyers. Entry into the industry would involve developing operations in either or both disciplines. Beverage substitutes would threaten both CPs and their associated bottlers. Because of operational overlap and similarities in their market environment, we can include both CPs and bottlers in our definition of the soft drink industry. In 1993, CPs earned 29% pretax profits on their sales, while bottlers earned 9% profits on their sales, for a total industry profitability of 14% (Exhibit 1). This industry as a whole generates positive economic profits.

Rivalry: Revenues areextremely concentrated in this industry, with Coke and Pepsi, together with their associated bottlers, commanding 73% of the case market in 1994. Adding in the next tier of soft drink companies, the top six controlled 89% of the market. In fact, one could characterize the soft drink market as an oligopoly, or even a duopoly between Coke and Pepsi, resulting in positive economic profits. To be sure, there was tough competition between Coke and Pepsi for market share, and this occasionally hampered profitability.For example, price wars resulted in weak brand loyalty and eroded margins for both companies in the 1980s. The Pepsi Challenge, meanwhile, affected market share without hampering per case profitability, as Pepsi was able to compete on attributes other than price.

Substitutes: Through the early 1960s, soft drinks were synonymous with “colas” in the mind of consumers. Over time, however, other beverages, from bottled water to teas, became more popular, especially in the 1980s and 1990s. Coke and Pepsi responded by expanding their offerings, through alliances (e.g. Coke and Nestea),acquisitions (e.g. Coke and Minute Maid), and internal product innovation (e.g. Pepsi creating Orange Slice),capturing the value of increasingly popular substitutes internally. Proliferation in the number of brands did threaten the profitability of bottlers through 1986, as they more frequent line set-ups, increased capital investment, and development of special management skills for more complex manufacturing operations and distribution. Bottlers were able to overcome these operational challenges through consolidation to achieve economies of scale. Overall, because of the CPs efforts in diversification, however, substitutes became less of a threat.

Power of Suppliers: The inputs for Coke and Pepsi’s products were primarily sugar and packaging. Sugar could be purchased from many sources on the open market, and if sugar became too expensive, the firms could easily switch to corn syrup, as they did in the early 1980s. So suppliers of nutritive sweeteners did not have much bargaining power against Coke, Pepsi, or their bottlers. NutraSweet, meanwhile, had recently come off patent in 1992, and the soft drink industry gained another supplier, Holland Sweetener, which reduced Searle’s bargaining power and lowering the price of aspartame.
With an abundant supply of inexpensive aluminum in the early 1990s and several can companies competing for contracts with bottlers, can suppliers had very little supplier power. Furthermore, Coke and Pepsi effectively further reduced the supplier of can makers by negotiating on behalf of their bottlers, thereby reducing the number of major contracts available to two. With more than two companies vying for these contracts, Coke and Pepsi were able to negotiate extremely favorable agreements. In the plastic bottle business, again there were more suppliers than major contracts, so direct negotiation by the CPs was again effective at reducing supplier power.

Power of buyers: The soft drink industry sold to consumers through five principal channels: food stores, convenience and gas, fountain, vending, and mass merchandisers (primary part of “Other” in “Cola Wars…” case).Supermarkets, the principal customer for soft drink makers, were a highly fragmented industry. The stores counted on soft drinks to generate consumer traffic, so they needed Coke and Pepsi products. But due to their tremendous degree of fragmentation (the biggest chain made up 6% of food retail sales, and the largest chains controlled up to 25% of a region), these stores did not have much bargaining power. Their only power was control over premium shelf space, which could be allocated to Coke or Pepsi products. This power did give them some control over soft drink profitability. Furthermore, consumers expected to pay less through this channel, so prices were lower, resulting in somewhat lower profitability. National mass merchandising chains such as Wal-Mart, on the other hand, had much more bargaining power. While these stores did carry both Coke and Pepsi products, they could negotiate more effectively due to their scale and the magnitude of their contracts. For this reason, the mass merchandiser channel was relatively less profitable for soft drink makers. The least profitable channel for soft drinks, however, was fountain sales. Profitability at these locations was so abysmal for Coke and Pepsi that they considered this channel “paid sampling.” This was because buyers at major fast food chains only needed to stock the products of one manufacturer, so they could negotiate for optimal pricing. Coke and Pepsi found these channels important, however, as an avenue to build brand recognition and loyalty, so they invested in the fountain equipment and cups that were used to serve their
products at these outlets. As a result, while Coke and Pepsi gained only 5% margins, fast food chains made 75% gross margin on fountain drinks.
Vending, meanwhile, was the most profitable channel for the soft drink industry. Essentially there were no buyers to bargain with at these locations, where Coke and Pepsi bottlers could sell directly to consumers through machines owned by bottlers. Property owners were paid a sales commission on Coke and Pepsi products sold through machines on their property, so their incentives were properly aligned with those of the soft drink makers, and prices remained high. The customer in this case was the consumer, who was
generally limited on thirst quenching alternatives.
The final channel to consider is convenience stores and gas stations. If Mobil or Seven-Eleven were to negotiate on behalf of its stations, it would be able to exert significant buyer power in transactions with Coke and Pepsi. Apparently, though, this was not the nature of the relationship between soft drink producers and this channel, where bottlers’ profits were relatively high, at $0.40 per case, in 1993. With this high profitability, it seems likely that Coke and Pepsi bottlers negotiated directly with convenience store and gas station owners.
So the only buyers with dominant power were fast food outlets. Although these outlets captured most of the soft drink profitability in their channel, they accounted for less than 20% of total soft drink sales. Through other markets, however, the industry enjoyed substantial profitability because of limited buyer power.

Barriers to Entry: It would be nearly impossible for either a new CP or a new bottler to enter the industry. New CPs would need to overcome the tremendous marketing muscle and market presence of Coke, Pepsi, and a few others, who had established brand names that were as much as a century old. Through their DSD practices, these companies had intimate relationships with their retail channels and would be able to defend their positions effectively through discounting or other tactics. So, although the CP industry is not very capital
intensive, other barriers would prevent entry. Entering bottling, meanwhile, would require substantial capital investment, which would deter entry. Further complicating entry into this market, existing bottlers had exclusive territories in which to distribute their products. Regulatory approval of intrabrand exclusive territories, via the Soft Drink Interbrand Competition Act of 1980, ratified this strategy, making it impossible for new bottlers to get started in any region where an existing bottler operated, which included every significant market in the US.
In conclusion, an industry analysis by Porter’s Five Forces reveals that the soft drink industry in 1994 was favorable for positive economic profitability, as evidenced in companies’ financial outcomes.

2. Compare the economics of the concentrate business to the bottling business. Why is the profitability so different?

In some ways, the economics of the concentrate business and the bottling business should be 

inextricably linked. The CPs negotiate on behalf of their suppliers, and they are ultimately dependent on the same customers. Even in the case of materials, such as aspartame, that are incorporated directly into concentrates, CPs pass along any negotiated savings directly to their bottlers. Yet the industries are quite different in terms of profitability. In some ways, the economics of the concentrate business and the bottling business should be inextricably linked. The CPs negotiate on behalf of their suppliers, and they are ultimately dependent on the same customers. Even in the case of materials, such as aspartame, that are incorporated directly into concentrates, CPs pass along any negotiated savings directly to their bottlers. Yet the industries are quite different in terms of profitability. 

The fundamental difference between CPs and bottlers is added value. The biggest source of added value for CPs is their proprietary, branded products. Coke has protected its recipe for over a hundred years as a trade secret, and has gone to great lengths to prevent others from learning its cola formula. The company even left a billion-person market (India) to avoid revealing this information. As a result of extended histories and successful advertising efforts, Coke and Pepsi are respected household names, giving their products an aura of value that cannot be easily replicated. Also hard to replicate are Coke and Pepsi’s sophisticated strategic and operational management practices, another source of added value. 

Bottlers have significantly less added value. Unlike their CP counterparts, they do not have branded products or unique formulas. Their added value stems from their relationships with CPs and with their 



customers. They have repeatedly negotiated contracts with their customers, with whom they work on an ongoing basis, and whose idiosyncratic needs are familiar to them. Through long-term, in depth relationships with their customers, they are able to serve customers effectively. Through DSD programs, they lower their customers’ costs, making it possible for their customers to purchase and sell more product. In this way, bottlers are able to grow the pie of the soft drink market. Their other source of profitability is their contract relationships with CPs, which grant them exclusive territories and share some cost savings. Exclusive territories prevent intrabrand competition, creating oligopolies at the bottler level, which reduce rivalry and allow profits. To further build “glass houses,” as described by Nalebuff and Brandenberger (Co-opetition, p. 88), for their bottlers, CPs pass along some of their negotiated supply savings to their bottlers. Coke gives 2/3 of negotiated aspartame savings to its bottlers by contract, and Pepsi does this in practice. This practice keeps bottlers comfortable enough, so that they are unlikely to challenge their contracts. Bottlers’ principal ability is to use their capital resources effectively. Such operational effectiveness is not a driver of added value, however, as operational effectiveness is easily replicated. 

Between 1986 and 1993, the differences in added value between CPs and bottlers resulted in a major shift in profitability within the industry. Exhibit 1 demonstrates these dramatic changes. While industry profitability increased by 11%, CP profits rose by 130% on a per case basis, from $0.10 to $0.23. During this period, bottler profits actually dropped on a per case basis by 23%, from $0.35 to 0.27. 

One possibility is that product line expansion in defense against new age beverages helped CPs but hurt bottlers. This would be expected if bottler’s per case costs increased due to the operational challenges and capital costs of producing and distributing broader product lines. This, however, was not the case; cost of sales per case decreased for both CPs and bottlers by 27% during this period, mostly due to economies of scale developed through consolidation. The real difference between the fortunes of CPs and bottlers through this period, then, is in top line revenues. While CPs were able to charge more for their products, bottlers faced price pressure, resulting in lower revenues per case. 

These per case revenue changes occurred during a period of slowing growth in the industry, as shown in Exhibit 2. Growth in per capita consumption of soft drinks slowed to a 1.2% CAGR in the period 1989 to 1993, while case volume growth tapered to 2.3%. In an struggle to secure limited shelf space with more products and slower overall growth, bottlers were probably forced to give up more margin on their products. CPs, meanwhile, could continue increasing the prices for their concentrates with the consumer price index.Coke had negotiated this flexibility into its Master Bottling Contact in 1986, and Pepsi had worked price increases based on the CPI into its bottling contracts. So, while the bottlers faced increasing price pressure in a slowing market, CPs could continue raising their prices. Despite improvements in per case costs, bottlers could not improve their profitability as a percent of total sales. As a result, through the period of 1986 to 1993, bottlers did not gain any of the profitability gains enjoyed by CPs. 

3. Why have contracts between CPs and bottlers taken the form they have in the soft drink industry?

Contracts between CPs and bottlers were strategically constructed by the CPs. Although beneficial to bottlers on the surface, the contracts favored the CPs’ long-term strategies in important ways. 

First, territorial exclusivity is beneficial to bottlers, as it prevents intrabrand competition, ensures bargaining power over buyers and establishes barriers to entry. But it is also beneficial to CPs, who are also not subject to price wars within their own brand. The contracts also excluded bottlers from producing the flagship products of competitors. This created monopoly status for the CPs, from the bottler perspective. Each bottler could only negotiate with one supplier for its premium product. Violation of this stipulation would result in termination of the contract, which would leave the bottler in a difficult position. 

Historically, contracts were designed hold syrup prices constant into perpetuity, only influenced by rising prices of sugar. This changed in 1978 and 1986, as contracts were renegotiated, first to accommodate for rises in the CPI, and then to give general flexibility to the CP (Coke) in setting prices. Coke could negotiate this more flexible pricing because its bottlers were dependent on it for business. It further ensured that its bottlers would be captive to its monopoly status by buying major bottlers and then selling them into the CCE holding company, which would only produce Coke products. Coke would capture 49% of the dividends from CCE, without the complications of vertical integration. 

Bicycle Case

Case setup (facts offered by interviewer):
q Your client is a manufacturer of bicycles
q They have been in business for 25 years
q They manufacturer and sell three categories of bicycles:
Ø Racing bikes: High end, high performance bikes for sophisticated cyclists
Ø Mainstream bikes: Durable, but not overly complicated bikes for everyday riders
Ø Children’s bikes: Smaller, simpler versions of their mainstream bikes for children
q Profits at your client have decreased over the past five years

Question:
q What is driving the decline in overall profits?
q What recommendations might correct the situation?

Suggested solutions:
The first question is to determine what has caused overall profits to decrease. To accomplish this the candidate must first understand what has transpired in each of the three product categories over the past five years during which profitability has slipped. The following are questions and answers that would be provided in an interview scenario.

q What are the client’s margins for a bicycle in each of the three segments?
Racing: Cost = $600/unit, Profit=$300/unit
Mainstream: Cost = $250/unit, Profit = $75/unit
Children’s: Cost = $ 200/unit, Profit = $50/unit

q What has happened to the market size of each of the three segments over the past five years?
Racing: Has remained constant at its present size of $300MM
Mainstream: Has increased at 2% growth rate per year to its present size of $1.0B
Children’s: Has increased at 3% growth rate per year to its present size of $400MM

q What has happened to our client’s market share in each of these segments?
Racing: Market share has decreased from 60% to 30%
Mainstream: Market share has increased from 0% to 5%
Children’s: Market share has increased from 0% to 3%

q Who are the client’s major competitor’s in each market segment? What has happened to their market share in each segment over the past five years?

Racing: There is one main competitor and a host of small firms. Your main competitor has increased market share from 30% to 50%

Mainstream: There exist many, large competitors, none of which holds more than 10% of the market

Children’s: As in the mainstream segment, there are many competitors, none with more than 10% of the market

The above information provides enough information to put together a picture of why profits have decreased over the past five years : Your client, with a commanding position in a flat market segment (racing), expanded into new segments (mainstream and children’s). As this occurred, market share decreased dramatically in the most lucrative segment (racing), creating an unfavorable mix.

The extent to which profits have decreased can be deduced from some quick math : profits have slipped from $60MM five years ago (=60% x $300MM x 33% racing margin) to $44MM today ( = (30% x $300MM x 33% racing margin) + (5% x $1B x 23% mainstream margin) + (3% x $400MM x 20% children’s margin)).

The dramatic decrease in market share in the racing segment is at this point still unexplained. Questions that would help formulate an explanation include:

q Have there been any major changes in product quality in your client’s racing product? Or in its main competitor’s racing product?
No

q Have there been any major price changes in your client’s racing product? Or in its main competitor’s racing product?
No

q Have there been any major changes in distribution outlets for your client’s racing product? Or for its main competitor’s racing product?
Yes. Previously your client and its main competitor in the racing segment sold exclusively through small, specialty dealers. This remains unchanged for the competition. Your client, however, began to sell its racing bikes through mass distributors and discount stores (the distribution outlets for mainstream and children’s bikes) as it entered the mainstream and children’s segment.

q How do the mass distributors and discount stores price the racing bikes relative to the specialty stores?
Prices at these stores tend to be 15 to 20% less.

q What percent of your client’s racing sales occur in mass distributors and discount stores?
Effectively none. This attempt to sell through these distributors has failed

q How has the decision to sell through mass distributor’s and discount stores affected the image of the client’s racing product?
No studies have been done.

q How has the decision to sell through mass distributor’s and discount stores affected your client’s relationship with the specialty outlets?
Again, no formal analysis has been performed.

Although some analysis and/or survey should be performed to answer more conclusively the last two questions, a possible story can be put together. There has been no appreciable change in either quality or price (or any other tangible factor) of your client’s racing product relative to its competition. It is not the product that is the problem, but rather its image. As your client came out with lower end, mainstream and children’s products and began to push their racing segment through mass distributors and discount outlets, their reputation was compromised. Additionally, the presence of the racing products in the discount outlets has put your historic racing distributor (the specialty shops) in a precarious position. The specialty shops must now lower price to compete, thereby cutting their own profits. Instead, they are likely to push the competition’s product. Remember, your client has no direct salesforce at the retail outlets. The specialty shops essentially serve as your client’s sales force.

The above analysis offers an explanation of what has affected the top side of the profitability problem. Still to be examined is the cost, or bottom side, of the profitability issue. Questions to uncover cost issues would include:

q How does the client account for its costs?
The client has a single manufacturing and assembly plant. They have separate lines in this facility to produce racing, mainstream and children’s products. They divide their costs into the following categories: labor, material and overhead. Overall costs have been increasing at a fairly hefty rate of 10% per year.

q What is the current breakdown of costs along these categories for each product segment?
Racing: Labor = 30%, Material = 40%, Overhead = 30%
Mainstream: Labor = 25%, Material = 40%, Overhead = 35%
Children’s: Labor = 25%, Material = 40%, Overhead = 35%

q How has this mix of expenses changed over the past five years?
In all segments, labor is an increasing percentage of the costs.

q Does the basic approach to manufacturing (i.e. the mix of labor and technology) reflect that of its competition?
Your client tells you that there is a continuing movement to automate and utilize technology to improve efficiency throughout the industry, but it is his/her opinion that their approach, maintaining the “human touch”, is what differentiates them from the competition. (Unfortunately, he’s right!!)

q Is the workforce unionized?
Yes

q What is the average age of the workforce?
52 and climbing. There is very little turnover in the workforce.

q What is the present throughput rating? How has it changed over the past five years?
Presently the plant is producing at about 80% of capacity. This has been decreasing steadily over the last several years.

q What is the typical reason for equipment shutdown?
Emergency repair

q Describe the preventive maintenance program in effect at the client’s facility?
Preventive maintenance is performed informally based on the knowledge of senior technicians.

q How often has equipment been replaced? Is this consistent with the original equipment manufacturer’s recommendations?
The client feels that most OEM recommendations are very conservative. They have followed a philosophy of maximizing the life of their equipment and have generally doubled OEM recommendations.

The above information is sufficient to add some understanding to the cost side of the equation. Your client has an aging workforce and plant that is behind the times in terms of technology and innovation. This has contributed to excessive breakdowns, decreased throughput, increased labor rates (wages increase with seniority) and greater labor hours (overtime to fix broken machines).

In proposing recommendations to improve the client’s situation, there is no single correct approach. There are a number of approaches that might be explored and recommended. The following are some possibilities:

q Abandon the mainstream and children’s segment to recover leadership in the racing segment
Issues to consider in this approach:
Ø How much of the racing segment is “recoverable”?
Ø What are the expected growth rates of each segment?
Ø How badly damaged is the relationship with the specialty outlets?
Ø Are there alternative outlets to the specialty shops such as internet sales?
Ø How will this move affect overall utilization of the operating facilities?

q Maintain the mainstream and children’s segment, but sell under a different name
Issues to consider in this approach:
Ø Is there demand among the mass and discount distributors for bicycles under their name?
Ø What additional advertising and promotions costs might be incurred?
Ø What are the expected growth rates of each segment?
Ø What is driving the buying habits of the mainstream and children’s market?

q Reduce costs through automation and innovation
Issues to be considered:
Ø What technological improvements are to be made?
Ø What are the required investments?
Ø What are the expected returns on those investments?
Ø How will these investments affect throughput?
Ø To which lines are these investments appropriate?
Ø Are the mainstream and children’s segments potentially “over-engineered”?
Ø What impact will this have on the required workforce levels?
Ø If layoffs are required to achieve the benefits, what impact will this have on labor relations?

q Reduce costs through establishing a formal preventive maintenance program
Issues to be considered:
Ø What organizational changes will be required?
Ø What analysis will be performed to determine the appropriate amount of PM?
Ø What training is required of the workforce?
Ø What technical or system changes are required?
Ø How will the unionized workforce respond?

Key takeaways:
This case can prove to be lengthy and very involved. It is not expected that a candidate would cover all of the above topics, but rather work through selected topics in a logical fashion. It is important that the candidate pursue a solution that considers both revenue and cost issues to impact profit. Additionally, a conadidate’s ability to work comfortably with the quantitative side of this case is important. The above recommendations for improving profitability are just a few among many. The candidate may come with their own ideas.

Beauty Asia: Cosmetics Case

Cosmetics Case

Situation:

BeautyAsia (BA) is a health and beauty consumer products company headquartered in Malaysia. It manufactures and sells a line of cosmetic products ideally suited for the Malaysian marketplace. Although it has been a successful company for over twenty years, it has been losing money for the past two years and its market share has declined. The CEO has asked you to assist in diagnosing the problem and generating a few possible solutions.


Question:

What should BeautyAsia do to restore its profitability?


Suggested Frameworks:

Given the client’s decline in market share, the 3Cs model (i.e., Competition, Competencies, Customers) is an effective framework.


Key Facts (to be shared as the case progresses):

Company
· Market share declined from 90% to 60% in the past two years.
· Manufacturing is excellent
· Inventory management systems are unsophisticated and ineffective, resulting in excess inventory and order fulfillment problems
· Brands are widely recognized throughout Malaysia
· No new products have been launched in the past eight years
· BA sells its health and beauty products primarily through local mom and pop shops (i.e., convenience stores)
· Management considered selling its current products outside Malaysia, but has been distracted by problems in its home country


Competitors
· Several large multinational manufacturers have entered the market
· Competitors have flooded the market with new products
· Multinational competitors sell their products through supermarkets

Consumers
· As a result of multinational competitors entering the market, consumers have been exposed to new types of products and their health and beauty product tastes have become broadened and become more sophisticated

Products
· BA has multiple product lines ranging from lipstick to skin creams
· BA’s products appeal to price-conscious consumers
· The health and beauty products industry is growing approximately 15% per year

Channels
· BA products are currently sold through small proprietary shops
· Supermarkets are becoming increasingly popular in Malaysia
· Supermarkets have high order fulfillment and stocking requirements


Good Conclusions:

· Multinational competitors are creating a new distribution channel for health and beauty products. The channel shift is causing BA to lose market share. BA needs to update its inventory systems to compete in the new channel and reduce its costs.
· Competitors are driving changes in consumer tastes toward greater product variety and quality. BA has not kept pace with new product introductions. BA needs to improve its marketing/market research.


Excellent Conclusions:

· BA’s manufacturing expertise gives it an opportunity to sell high quality private label products at a discount to current prices in the supermarkets.
· There is danger in challenging multinational competitors by offering a wider assortment of products in the supermarket channel. Alternatives for BA include: strengthening its position in the local shop channel; focusing on profitable customer niches (premium, low price, etc.); targeting only certain product categories like lipstick and blush for distribution through supermarkets.
The cost to BA of regaining its lost market share is extremely high. BA may be better off preventing further loss in market share and focusing on improving its current profitability instead

Supplies Mate, Office Supplies Distributor Case

Situation:

Supplies Mate (SM), a distributor of office supplies in Central London, has experienced declining profitability over the past five years.
Question:

How can the distributor address this profitability trend?
Suggested Frameworks:

Profitability model with emphasis on understanding fixed vs. variable operating costs.


Key Facts (to be shared as the case progresses):
Company
· Profitability has slipped from 12% to 8% over the past five years
· Revenues have grown by 15% over the past five years
· SM distributes from one central warehouse in downtown London that it has owned for 20 years
· SM has built a reputation for customer service, “Personal on-time delivery and support every time.”

Customers
· Large businesses (60%), medium-sized business (20%), small businesses (20%)
· Many of the medium-sized and most of the small business accounts were acquired recently and are located on the perimeter of the city (not to be given unless asked for specifically).

Competitors
· Fragmented industry
· Client is one of the largest and most successful distributors
· Category killer OfficeMax has just entered the market, but the client’s revenues have grown due to its focus on customer service

Products
· Sells a full-line of office supplies (e.g., paper, pens, toner), “All your office supply needs. “

Order Fulfillment
· Most orders take over the phone and processed by data entry specialists, some large customers transmit order electronically
· Orders appear on terminals as individual line items, several line items may comprise an order
· Stock pickers take an order, pick all the items and send the completed order to packaging, staging and distribution
· Trucks are stocked each morning with deliveries for that day
· Company-employed drivers deliver to clients

Costs
· Industry standard costs as office supplies are commodities
· Typical fix costs are property, plant and equipment, technology infrastructure and some portion of labor are utilities
· Typical variable costs are supplies, labor, fuel, etc.
· Cost are comparable to competitors using the same data entry and order picking methods
· Sixty percent of order fulfillment costs are fixed
Good Conclusions:

Conclusions will address cost problems. The order picking system and delivery systems can be rationalized to lower costs. Orders can be grouped and picked simultaneously by one picker or some kind of “assembly line” picking system can be proposed. Alternative delivery systems (i.e., Federal Express or the like) can be proposed, but likely at the expense of personal customer service. All these options are possible, but would likely lead to minimal cost reductions.

Excellent Conclusions:

Conclusion will recognize this as a revenue problem. The company has been growing revenue by adding unprofitable accounts. Many of the newly acquired small and medium-sized accounts have the same order fulfillment and customer service costs as larger accounts, but do not generate an adequate volume and are therefore, unprofitable to service under the existing business model. Additionally, smaller businesses often make a large number of smaller orders. Rationalizing the client list or offering a reduced level of service to small and medium-sized clients can yield immediate gains in profitability. Candidates should offer creative solutions to servicing smaller clients profitably.

Case Summary: Proctor & Gamble: Organization 2005 (A)

Harvard Business School Case Summary of Proctor & Gamble: Organization 2005 (A) by MikolajPiskorski and Alessandro L. Spadini

Problem : Durk Jager , had introduced a restructuring program named “Organization 2005” – designed to accelerate sales and innovations. In past P&G chain of formal command put geography first, followed by product and function. In new design, P&G was structured as 3 interdependent global organizations, one organized by product category, one by geography and one by business process.

Lack of immediate results, job reductions, reduced employee morale led to reduced profits and stock price reduced to half in last six months.

Organizational Structure: Two different models for US and Europe were adopted, as US market was more homogenous, a nationwide brand and product division management was adopted. Western Europe is a heterogeneous market with different languages, culture and laws therefore a decentralized model was adopted.

United States

The organizational model was developed on two key dimensions: functions and brand. Brand manager has responsibility for profitability and matching company strategy with product category. Brand manager has access to strong divisional functions. It was more product centric and costlier. There was competition within brand managers and this was the era when max product innovation took place.

In 1987 structure was changed and functional units were centralized. Brands would be managed as components of category portfolios by category general manager, to whom both brand and functional managers would report. Each business unit has it’s own sales, product development, manufacturing and finance functions. To retain the functional strength a matrix reporting structure was set up whereby functional leaders report directly to their business leader and also have reporting relationship to their functional leadership. Again product managers were more powerful and responsible for profit and loss, matrix structure create ambiguity as man can’t serve two masters. Interdivision communication improved.

Western Europe

P&G organizational model developed along three key dimensions: Geography , function , brand. The result was a portfolio of self- sufficient subsidiaries led by country GM with local market expertise. New technologies were sourced from US , tested in local R&D and manufactured in each country. there was high product launch time and sometimes it was as high as 14 years !

In 1963 , the European Technical Center (ETC) in Brussels was establish to act as centralized R&D and process-engineering unit. ETC develop products and manufacturing process that country managers could choose to adapt and launch in their own countries.

Problems in Europe: Corporate R&D were completely disconnected from US operations. European functional organizations were also in isolation from US counterparts. Un standardized , sub-scale production was expensive and unreliable. Country R&D were expensive to maintain.

By early 1980s , An attempted was made to promote cross-border cooperation and focus was shifted from country management to product-category management. Headquarters at Brussels encouraged formation of regional committees and eliminate needless product variations. The strategy was successful and Entire Europe was divided into three sub regions, whose leaders were given secondary responsibility for coordinating particular product category across the entire continent. Country GMs were replaced with multiple country product-category GMs who report to the division VPs.

Global Matrix

In late 1980s, expansion opportunities in Japan and other parts of world led P&G to develop globalization model. Corporate functions in Brussels still lacked direct control of country functional activities. P&G started migrating to a global matrix structure, country functions were consolidated into continental functions reporting through functional leadership and direct reporting through the regional business manager. All country category GMs had reporting to their global category president. The global category presidents and R&D VPs developed product category platform technologies that could be applied to global branding strategies. In 1995 this structure was extended to rest of the world through creation of four regions – North America , Latin America , Europe /Middle East/Africa and Asia.

Regionally managed product supply groups could extract massive savings by consolidating country manufacturing plants and distribution centers into high scale regional facilities.

Global Matrix Problem

Strong regional functions produced extraordinary advantages,but in mid 1990s created grid lock. Most functions nominally had straight line reporting through regional management and also reporting through functional management, the function retained a high degree of de-facto control. They develop their own strategic agenda, maximize power, do not coordinate with other functions and business units. Regional managers were responsible for profit and loss statement, they often hesitate to launch a particular product even if it made sense for the company strategically because it could weaken their upcoming profit and loss statement. As regional managers were responsible for profit and loss they were hesitate to launch new product.

Organization 2005

In 1998 , P&G started a 6 years restructuring program – organization 2005.

• Voluntary separations of 15000 employees by 2001
• 45% job separations from global product-supply consolidation.
• 25% from exploitation of scale benefits arising from standardized business process.
• Eliminate 6 management layers , reducing the total from 13 to 7
• Dismentaling matrix organization and replacing with interdependent organizations: Global Business Units, Market Development , and a Global Business Services managing internal business process.

Analysis of Organization 2005

• Focus was more on rolling out new products at faster rate. Implementation of 3M concept i.e product launched in last 3 year should make up certain percentage of total turnover.
• Previously organization was more decentralized and centralization coupled with separations and negative growth rate has weaken moral of employees
• Jager decided that P&G would sell its products under the same name all around the world. So in Germany, the name of its dishwashing liquid suddenly changed from Fairy to Dawn
• Large level of transfers (2000 from Europe to Geneva ) and relocation led to moral and behavioral changes.

Paradoxical Twins: Acme and Omega Electronics

Case Symmary for "Paradoxical Twins: Acme and Omega Electronics" by John F. Veiga as discussed and presented in class

After Technological Product was sold out it’s two plants under electronic division become two firms Acme and Omega Electronics. Both of the firms are competitor if each other , Acme had annual sales of $10 million and 550 employees and Omega had annual sale of $8 million and 480 employees. Acme is consistently more effective and achieve greater net profits.

Organizational differences between Acme and Omega

Acme

• Retained original management and promoted GM to president.(Mr John)
• Well defined organizational structure
• Decisions taken by top management without consulting manufacturing dept.
• Well defined job responsibilities

Omega

• Hired new president and upgraded several existing personnel within plant.(Mr. Jim)
• Organizational chart seems like artificial barrier.
• Filling people who could not contribute to solution (participative management)
• No well defined job specification

Both of these firm competed for a major photocopier manufacturer’s project. Photocopier firm gave 2 weeks time to manufacture 100 prototypes each. Based on the prototype photocopier manufacture will award the final order.

Prototype Development at Acme

Mr John president of Acme , issued a memo to purchase department , drafting department, Industrial Engineering dept. and all heads and executives indicating time constrains.

Purchase dept. notice that a component could not be purchased for next 2 weeks. Acme decided to built the prototype except for the one component and add component later.

In haste to make things going production foreman ignored the normal procedure of contacting the methods engineers and set up assembly line and started assembly.

Method engineers complained to head industrial engineer, who immediately complaint to plant manager. Plant manager ignored the complaint.

Later , a design error was identified and photocopier manufacture instructed Acme to rectify the problem. The alteration in design , lead to disassembly and unsoldering of several connections.

After design error was rectified missing components were installed by again disassembly. This increased the time of production and final prototype was sent without inspection.

Prototype Development at Omega

A meeting was called with all head of the departments , criticality of issue was explained and department heads agreed to start process at their end.

Purchase dept. notice that a component could not be purchased for next 2 weeks. Head of the engineer suggested for substitution. Head of mechanical department stated that in absence of the component assembly time and cost will increase.

Electrical department inspected the design and came up with substitute.

While building the unit they discover the error in design, Error was corrected and changes were approved from photocopier manufacturing firm.

They developed the prototype before the deadline and final prototype was sent after inspection.

Result

Acme had delivery delays. Acme’s 10 /100 units were found defective. Omega’s all prototype were passed. The final contract was split between the two firms. Acme reduced its unit cost by 20 percent and was ultimately awarded the total contract.

Case Analysis

Acme had a well defined organizational structure but was information flow was unidirectional. Direct contact between management and technical experts was lacking. As one of the employee has mentioned that, “ I wish I had a little more information about what is going on”. Interdepartmental communication was only possible at management level.

In case of Omega , It’s president was from a research laboratory and thus respect input of every one. Organizational structure and work allocation was not clear. Departmental communication was strong, when purchase department raise concern for delay in a particular component there was prompt response from electrical department for substitution and mechanical department told that without this particular component cost and assembly time will increase. Information was flowing in both directions without routing it from president. This enabled Omega to manufacture at time.

In long run, as we know that Acme was more successful than Omega. This could be attributed to the fact that job allocation was not clear. Moreover information flow was better in Omega but sometimes such information flow also create hindrance by creating interference in each other’s domain.

HBS: Executive Decision Making at General Motors

In 1908, entrepreneur and visionary Billy Durant had created the first automotive conglomerate and the industry’s first vertically integrated company through a series of mergers and acquisitions. There were 25 automobile manufactures , suppliers and others who operated independently and report directly to Durant. There were duplication , internal competition and high cost of production. By 1920 due to poor management and economic recession , Durant lost control of the company to the Dupont family. The Doponts appointed Alfred P. Sloan to reorganize GM’s structure and management processes to be line with Dupont strategy

Sloan Strategy
Three major strategies
Ingenious Marketing policy : Pricing of various different cars from economic class to deluxe. Within the company there would be no duplication in the price fields. GM had car for every purse and purpose which gave competitive advantage from its competitors.
Commitment to innovation: Innovation includes annual vehicle change, high compression , over head valves , V-8 engines, automatic transmissions they also include financial innovations like credit financing facilities.
International Diversification: GM began exporting of cars in 1925 and the purchased British vehicle firm Vauxhall in 1925, German operation Opel in 1929 and Australian Holden in 1931.

Structure
Sloan devised a multidivisional structure to replace Durant’s loose management system. The system was known as “decentralization with coordinate control”. A General Manager run each car division, which contain assembly, production, engineering and sales. General Motor’s subsidiary and many assembly plants in 15 counties operated independently. Divisions were aggregated in group and each group was headed by group executive. This role reduced number of direct reports to CEO. Assisting CEO in his role was a Management Committee. Members of this committee included president , chairman , CEO, CFO, any vice – chairs and executive vice presidents. Group executives did not serve on Management Committee. There was a policy group which had responsibility for supporting Management Committee. The Heads of each staff area such as finance, purchase, personnel , engineering chaired the policy group.

Policy group met monthly to set standards and policies and to make recommendation to the Management Committee. Policy group had no funding authority. Executive would review proposals with General Manager and would then take proposal to the monthly meeting of policy group. That policy group would then decide on the matter or make a recommendation to the management Committee.

GM sales were large to cover costs of plants dedicated to single model of car, and to absorb the duplication of functions , processes and competitive inside the organization.

Problems Started 1960s to 1990s
Competition increased from inside and outside, divisions were competing with each other for market share, there was brand confusion in market, new car manufacturers have entered market with low cost cars, and govt. tightened regulation and standards for environment and safety. Unlike its foreign competitors GM was not able to respond quickly to market changes and duplication, confusion and resistance continued in GM.

In 1960s and 1970s, cost and product proliferation consideration led to a limited consolidation of some of the assembly/manufacturing operations into a more centralized assembly division. More focus was given towards costs than on revenue. North American operations were restructured into a new organization with two car groups. The Buick, Oldsmobile, Cadillac (BOC) group making large cars and Chevrolet, Pontiac , and Canada (CPC) group focused on making small cars.

Despite change in organizational and external environment, the management committee and Policy Group stayed roughly the same. The reorganization of 1980s slows down decision making. It added one more layer of required reviews on top of divisional management review. Senior management becomes more internally focused. Policy Group staff shifted their focus from recommendation to gathering of data to support particular position. There were pre-meeting to avoid surprises at regular meetings and lining up of votes before meeting.

By 1990s there was fear for its survival, amid rumors of bankruptcy.

Restructure 1992
In 1992 , board of directors acted and then chairman was replaced with Jack Smith. Jack Smith reduced overlapping of product lines by eliminating similar competing models, developed common systems for product development, and eliminated two vehicle group structure and policy group.

Established North American Operation Board to manage North America and globally combine remaining regions into a General Motors International Operations organization at Zurich. Subsidiaries outside US like Opel and Holden continue to operate as independent organization.

In 1998, Single Automotive Strategy Board (ASB) was established, chaired by COO. Smith eliminated GM International Operation organization and strategy Board. Leaders of critical global processes in now report directly to CEO.

Matrix organization was introduced. Four regional presidents formed the vertical columns. The horizontal rows were made up of Global Process Leaders, representing the critical functions. Staff in each region reported directly to both the global process leader of their function and to the region president.

Policy and decision making
The four regional Presidents and their strategic board was responsible for developing , reviewing and approving regional operating budget and business plans. Decisions were taken at regional level and “Notice of Decision” were sent to the ASB to keep it informed.

Global process Leaders were responsible for their functions across the entire company. They had their own council which met monthly or quarterly.

Regions were initially given dominating role in the matrix. Salaries and other expanses for functions were included in or allocated to the regional budget. The CEO and CFO set profit targets and allocated capital and engineering budgets to the four regions. Functions with only a few exceptions, did not have capital budget.

Automotive Strategy Board
The regional strategy board and the global process councils came together at ASB, which along with GM’s board of directors made the major decisions for the company.

was responsible for the company’s over all strategic direction.
made decisions about financial commitments and resource allocation.
ASB review and approve corporate budget
Global process Leaders propose new policies to ASB and policy was formulated

ASB staff was required to make pre-meeting preparation. ASB staff open their secure website where all planned presentation were posted. ASB member was expected to review and comment on material and vote on them. Voting helped to eliminate topics where there might already be agreement and to focus the discussion on remaining topics.
They were required to funnel questions to appropriate presenter who were expected to focus their time in the meeting on those questions.

Supporting Matrix
The regional presidents had to take responsibility of geographic activities and global process leader. This gives better sense of balance. Each ASB member was given individual objective with one week to respond. To make ASB meeting run smoothly and ensure good interaction ground rules and guidelines were established. ASB director was responsible for managing agenda and maintaining action –items and approval list.

Demand

Demand for a commodity : It is number of units of that particular commodity goods or services that consumer is willing and able to purchase during a specified period of time at each conceivable price.

Qty demand for a commodity : It is the no. of units that consumer is willing to buy per unit of time at given price.

Demand and it's dependency : Demand for a commodity is function of following variables :

• Price of commodity (Pn)
• Price of relative product (Pr)
• Consumer's income (Y)
• Taste (T)
• Other environmental factors. (S)

Dn = f(Pn,Pr,Y,T,S)

We now discuss each one of these factors effecting demand.

1. Price of commodity (Pn) : As the price of commodity increases it's demand reduces. This is because price goes beyond the range of some consumer. These two are inversely related.

2. Price of relative product : There could be two types of relative products

(a). Complementary goods : These are goods which is either input to the commodity or commodity is input to complementary goods. For function or for it's complete use both of these are required. For example ink and pen , Tooth paste and tooth brush, wheel and automobile. As the price of complementary good increases demand is reduced .This is because of the fact that the two are jointly required for functioning of that commodity . An increase in total price will reduce the demand and decrease in total price will increase the demand. These two are inversely related.

(b). Competitive Goods : Competitive goods are those goods which can completely replace the commodity as it has same functionality and use as the commodity. An decrease in competitive goods price will decrease the demand as now consumer can have same type of product at lower price. A shift in customer base will reduce the demand. These two are directly related to each other. Example : Coco Cola and pepsi

3. Consumer's income (Y) : Consumer's income is measure of purchase power. More is the income of consumer he will invest more. These are three types of products available in market for consumer.

(a). Necessary Goods : These are the essential commodities required for living. Even if the income of consumer increases he is less likely to invest in these type of products after their requirement is fulfilled for example food grains and salt. For such type of goods demand increases up to certain level according to consumer's requirement and then it ceases.

(b). Goods for luxuries and comfort : As the income of consumer increases it starts investing more into goods which provide comfort. Demand for such products increases with increase in consumer's income . Example of such products are air conditioner , television etc.

(c). Inferior quality goods : Inferior quality of goods are goods which consumer buy to fulfill their requirement and to save money. Consumer compromise with quality to buy required no. of quantity. As the income of consumer increases consumer starts buying good quality product. With increase in consumer's income demand for such goods reduces.

4. Taste of consumer : Taste of consumer depends on number of factors like age , occupation , community size , family composition etc.

5. Other factors : other factors include size of population , Composition of population more children or adults, Distribution of income , Festival seasons like Diwali, Christmas , New year etc.

Law of demand : Law of demand expresses functional relationship between price of commodity and it's quantity demand .Price and demand are inversely related. A fall in price either induces new consumers to purchase that commodity or tempts the previous consumers to buy more of that commodity. An increase in price may make it out of reach for many consumers and this reduces demand.

There are exception in law of demand at many situations law of demand fails to explain nature of demand

1. Giffen goods : these are the goods for which demand increases as price of commodity increases.
2. Inferior goods : As the price of inferior goods decrease demand also decreases. This is due to the fact that consumer saves more money and it adds to it's income.
3. Conspicuous necessities : Goods which through constant use become necessity , and have attached prestige value to it. For example cooking gas and refrigerator. This type of goods can be termed as U-sector goods (goods used by upper strata of the society).
4. Conspicuous consumption : A few things like diamond , gold jewellery are beyond the reach of common man because of their high prices. Wealthy people or rich section of society buy such products when prices of such products are increasing.
5. Future change in price : In anticipation of prices to change in future consumer purchases large quantity of that commodity and make a stock.
6. Emergencies : In case of state emergencies like war , flood and famine house hold behave in abnormal manner and buy more at higher prices so as to make sure that there is no scarcity.
7. Change in fashion : As fashion changes , irrespective of prices consumer is not willing to buy a out of date fashion. Or if the commodity is in fashion consumer is willing to buy at higher prices to keep up with fashion.
8. Ignorance : Ignorance of customer is another factor , which induces customer to buy at higher prices. this is especially which customer is haunted by the phobia of higher - priced commodity is better in quality than at lower - price commodity.

What is difference between macro and micro economics ?

Macro economics is study of consumption and production activities with averages and aggregates of the system. It study the forces that effect economy as whole while assuming that all economics units are homogenous. Macro economy is top-down view of economy while micro economics is bottom-up view of economics. It studies problems and policies given at particular time and place. It fails to explain how overall economy works.

Economic Model : Highly simplified representation of real world. Un-necessary irrelevant information is removed from model to make is simple and sometimes approximation and assumption are done. the process of removing un-necessary information is known as "Ockham's Razor".

Limitation of the Heuristic Method for resource allocation

The inherent limitation of the heuristic models is their being heuristic in nature. These models base the analysis on a certain set of simplified rules and assumptions, and are put to use only to avoid the complexity associated with the real detailed models.

Hence we have to compromise on the precision of the solution in terms of its optimality and settle for a near-optimal solution, which might even be the optimal solution in certain cases.

There has been a revival of interest in integer linear programming formulations of the multi-resource constrained project scheduling problem as more efficient computer codes for solving such problems are being developed. Still, relatively small (generally upto 15 activities and 3 resource types) can be handled by this approach.

Resource Allocation – Weist’s Procedure

Suppose, however, that only 10 men are available for the project on any one day. To obtain a heuristic solution, the following heuristics can be applied.
1. Allocate resources serially in time. That is, start on the first day and schedule all jobs possible, then do the same on the second day, and so on.
2. When several jobs compete for the same resources, give preference to the jobs with the least slack.
3. Reschedule non-critical jobs, if possible, to free resources for scheduling critical or non-slack jobs.

Hence, the project duration has been extended to 14 days but it keeps the manpower requirement under the tab of 10. This obtained solution might not be the optimal solution to the problem, but is a decent approximation for practical use.

Weist’s Trigger Level Setting Heuristic Algorithm

Designed originally to smoothen manpower requirements in naval shipyards, since shop crew sizes generally must be sufficient to meet maximum manpower requirements, a schedule which reduces peak loads by increasing usage during slack periods would allow smaller shop sizes and hence reduce labour expense.

This model [1] tries to do this by scheduling all jobs at their earliest start times and then shifting some of them that occur at peak periods to later slack periods.

First, an early start schedule, along with the total slack values for all the jobs, is calculated by regular network procedures. A manpower loading chart is then generated. The program then sets the ‘trigger levels’, or resource limits, one unit below the peak requirement in each of the shops, and it attempts to reschedule the jobs so that peak requirements do not exceed trigger levels.

Jobs are then reloaded, or rescheduled, one at a time, until the trigger level is exceeded in some shop. All jobs active in that shop on the peak day are examined, and those which lack sufficient slack to be shifted beyond the peak period are discarded from consideration. Of those which remain, one is chosen at random and rescheduled to start at some point beyond the peak day.

Such a move may effect the early start dates and total slack of jobs following the one moved. These are recalculated and the loading is continued until all jobs are loaded or until the trigger level is again exceeded and another job is shifted. If the trigger levels of each shop are met, then all of them are reduced one unit again, and the process of loading and shifting repeated.

The trigger-level can be looked upon as a ceiling pressing down on the manpower requirements. Peaks are reduced by pushing them to the right. The ideal schedule would result in a rectangle as shown in the figure, but because of fixed sequencing of jobs, variations in crew sizes on different jobs, and the interactions of trigger levels in various shops, the ideal is improbable. It is possible that reducing a peak on one day by shifting a job to the right may result in a second, and perhaps worse, peak later, in the same shop or a different one.

Resource Scheduling

After the objective of a project has been explicitly specified, one of the important constraints to be considered is the means or resource by which it is to be attained. A resource is a physical variable, such as labour, finance, equipment and space, which will impose a limitation on time for the project. When the resources are limited and conflicting demands are made for the same type of resource, a systematic method for the allocation of resources becomes essential. Resource scheduling usually incurs a compromise and the choice of this compromise depends on the judgment of managers.
There are basically two approaches in solving such a problem, resource leveling and resource allocation. In resource leveling, the total project duration is maintained to the minimum level, but the activities having floats are shifted so that a uniform demand on the resources is achieved. In other words, the constraint in the case of resource leveling operation would be the project duration time. In resource allocation, the main constraint would be on the resources. If the maximum demand on any resource is not to exceed a certain limit, the activities will then have to be rescheduled so that the total demand on the resource at any time will be within the limit. The project duration time consequently is exceeded.

Complexity of Network Scheduling with Limited Resources

Problems of resource scheduling vary in kind and severity, depending upon the project and the organizational setting. The problem of scheduling activities so that none of the resource availabilities are exceeded and none of the precedence relationships are violated is an exceedingly difficult task. Scheduling projects with limited resources is a large combinatorial problem. That is, there are a very large number of combinations of activity start times – each combination representing a different schedule - too large to enumerate even with a computer.

Heuristic Programs
In recent years a good deal of work has been done in the development of heuristic programs for solving large combinatorial problems. Heuristic programs for resource scheduling may take one of the following two forms:
i. Resource Leveling Programs. These attempt to reduce peak resource requirements and smooth out period-to-period assignments, within a constraint on project duration.
ii. Resource Allocation Programs: These allocate available resources to project activities in an attempt to find the shortest project schedule consistent with fixed resource limits.

Cost Calculation for Project management

Time-Cost Trade-off Relationship for a Typical Job

The Cost Consideration

The CPM was developed to solve the scheduling problems in an industrial setting. It was more concerned with the costs of scheduling and how to minimize them. Most jobs can be reduced in duration if extra resources are assigned to them. If the other advantages outweigh the additional cost, then the job should be expedited or crashed. But it is not necessary to crash all jobs to get a project done faster; only the critical jobs need be expedited. The CPM attempts to solve the problems of finding such jobs and how to crash them.





Schedule-Related Project Costs


The cost of a project is due to the direct costs associated with individual activities and the indirect expenses such as managerial services, indirect supplies, equipment rentals etc. Normally the direct costs related to an activity will increase if we crash that activity. On the other hand, the indirect costs decrease if the activity is shortened.

The relationship can be expressed by a straight line on a graph plotting job duration versus cost. The steeper the slope of this line, the higher the cost of expediting the activity. A horizontal line, then, indicates that crashing the job would result in no decreased efficiency shortening is possible (either because the job duration cannot be reduced further or because some other job has become critical on a parallel path). If there are parallel critical paths, then one job in each of them must be chosen for crashing. The improvements are made in a stepwise fashion and the new schedules are continued as long as the jobs can be crashed with a net reduction in total costs.





Basic Concepts of Network Cost Systems


The basic concept of PERT and CPM cost systems is different from that of most cost accounting systems. In essence it is: Costs are to be measured and controlled primarily on a project basis rather than according to the functional organization of a firm. The rationale of the system is the entirely logical notion that responsibility for expenditures should coincide with responsibility for managing that which gives rise to the expenditures. Under a PERT or CPM management system, project managers and submanagers are ordinarily chosen for supervising individual activities and they should be responsible for controllable costs associated with the activities.

A project-oriented cost accounting system does not necessarily replace existing systems based on organizational structure. If the costs are identified with the proper degree of detail, cost summaries can readily be generated on either basis.





Cost Accounting by Work Packages


If a project has been broken down into activities small enough to be used for purposes of detailed planning and scheduling, many such activities would be too small to be used and, therefore no added cost. If a job cannot be shortened regardless of extra resources applied to it, the line would be vertical. All the three possibilities are represented in figure 3.2.
There is probably a minimum duration which cannot be reduced no matter what the expenditure of resources (vertical portion of line). Similarly, slowing the job will decrease the costs only upto a certain point; beyond this no additional savings are obtained (horizontal portion of line).

The Lowest-Cost schedule
The CPM model specifies a method for finding the optimum point representing the lowest-cost schedule. A preliminary schedule is generated in which all jobs are assigned at their early start times and with normal resources. The length of this maximum duration schedule can be reduced only by expediting one or more of the critical path activities at an extra cost.

At each step of the process, the cost-time slope of each critical job is examined, and the job with least slope is determined. This job is expedited upto the point where no further conveniently for cost-control purposes. If so, several related activities may be grouped together into larger "work packages". These represent particular units of work for which responsibility can be clearly defined and which are still small enough to be manageable for planning and control purposes. The work packages formed at the lowest level of breakdown, then, constitute the basic unit in the PERT cost system by which actual costs are (1) collected and (2) compared with estimates for purposes of cost control.

Forecast of Project Costs
For planning and budgeting purposes, it is useful for a manager to know the time pattern of the expenditures. If costs are estimated for each work package then a projection of costs can easily be made. To do this, the assumption is usually made that expenditures for an activity are incurred at a constant rate over the duration of the activity. If this assumption is not valid for certain activities, they should be divided into a sequence of two or more activities, each having a constant expenditure rate.
A schedule graph, in which the network is plotted on a time scale and in which the horizontal length and placement of activity arrows indicate activity duration and schedule, facilitates cost calculation. When cumulative costs are plotted versus time, the graph illustrates the budget implications of early start and early finish times. The area between these two curves represents a range of budgets which are feasible from a technological viewpoint.

Analysis and Control of Project Costs

The first step in the control procedure is the measurement and recording of costs which are incurred as the project progresses. At the same time that costs are reported, an estimate should be made of the percentage of work accomplished. With the cost and time data collected from period to period as the project progresses, some very useful graphic reports are produced that help the managers to answer such questions as :

• 
  Is the project on schedule?
• 
  How far over budget are the present costs?
• 
  What are the sources of delay and overruns?

Accounting Problems with PERT/Cost

The managerial benefits from the PERT/Cost system derive largely from the increased detail with which the costs are categorized and reported. Although this detail permits closer control of project performance and costs, it is also the cause of some accounting problems. More specific of them include the following:
· Indirect Costs: Some project costs are not easily identifiable with end items or specific work packages. Conventionally, such items are considered to be a part of the overhead.
· Overhead Control: Since overhead is a sizable expense, and since overruns may result from indirect as well as direct costs, it seems desirable to provide some means of exerting better control over overhead.
· Material Costs: Because of long lead time between release of material requirements and their eventual use, actual costs of materials are often incurred long before the work packages are scheduled to begin.

Time Calculation for Project Activities

Expected Times for Activities
For each activity in the project network, not only is an estimate made of the most probable time required to complete the activity, but some measure of uncertainty is also noted in the estimate. The pessimistic estimate and optimistic estimate is also made to have an idea of the approximate maximum and minimum completion times respectively for the activity.

PERT calculates the expected value of activity duration (te) as a weighted average of the three time estimates. The expected time is the best estimate that we can make of the time required for a single occurrence of an activity.

Variability of Activity Times
One measure of variability of possible activity times is given by the standard deviation of their probability distribution. Standard deviation and variance are commonly used as measures of variability among numbers. The variance (Vt) is simply the average squared difference of all the numbers from the mean value. The standard deviation (St) is the square root of the variance.

The Expected Length of a Critical Path
The expected length of a sequence of independent activities is simply the sum of their separate expected lengths. We calculate a te for every activity in the project network and use these te s to identify the critical path. We obtain an expected length of the project (Te) by summing the expected activity durations along the critical path.
Similarly, the variance (VT) of a sum of independent activities is equal to the sum of their individual variances and the standard deviation of the project length (ST) is the square root of VT.

Effects of Near-Critical Path
We calculate Te by adding the te s of the critical path activities. But it might not always be the best estimate of project length because under some combination of activity times and variances, a near-critical path may exist with a higher variance than the "main" critical path. Thus, where the possibility of uncertain activity times is admitted, the possibility of alternate critical paths is implied and the simple estimating procedures tend to yield overly optimistic results.

Gantt charts

A Gantt chart is a matrix which lists on the vertical axis all the tasks to be performed. Each row contains a single task identification which usually consists of a number and name. The horizontal axis is headed by columns indicating estimated task duration, skill level needed to perform the task, and the name of the person assigned to the task, followed by one column for each period in the project's duration. Each period may be expressed in hours, days, weeks, months, and other time units. In some cases it may be necessary to label the period columns as period 1, period 2, and so on.

The graphics portion of the Gantt chart consists of a horizontal bar for each task connecting the period start and period ending columns. A set of markers is usually used to indicate estimated and actual start and end. Each bar on a separate line, and the name of each person assigned to the task is on a separate line. In many cases when this type of project plan is used, a blank row is left between tasks. When the project is under way, this row is used to indicate progress, indicated by a second bar which starts in the period column when the task is actually started and continues until the task is actually completed. Comparison between estimated start and end and actual start and end should indicate project status on a task-by-task basis.

Variants of this method include a lower chart which shows personnel allocations on a person-by-person basis. For this section the vertical axis contains the number of people assigned to the project, and the columns indicating task duration are left blank, as is the column indicating person assigned. The graphics consists of the same bar notation as in the upper chart indicates that the person is working on a task. The value of this lower chart is evident when it shows slack time for the project personnel, that is, times when they are not actually working on any project.

PERT and CPM

PERT chart

A PERT chart is a project management tool used to schedule, organize, and coordinate tasks within a project. PERT stands for Program Evaluation Review Technique, a methodology developed by the U.S. Navy in the 1950s to manage the Polaris submarine missile program. A similar methodology, the Critical Path Method (CPM), which was developed for project management in the private sector at about the same time, has become synonymous with PERT, so that the technique is known by any variation on the names: PERT, CPM, or PERT/CPM.

A PERT chart presents a graphic illustration of a project as a network diagram consisting of numbered nodes (either circles or rectangles) representing events, or milestones in the project linked by labeled vectors (directional lines) representing tasks in the project. The direction of the arrows on the lines indicates the sequence of tasks. In Figure 3.1 the tasks between nodes 1, 2, 4, 8, and 10 must be completed in sequence. These are called dependent or serial tasks. The tasks between nodes 1 and 2 and nodes 1 and 3 are not dependent on the completion of one to start the other and can be undertaken simultaneously. These tasks are called parallel or concurrent tasks. Tasks that must be completed in sequence but that don't require resources or completion time are considered to have event dependency. These are represented by dotted lines with arrows and are called dummy activities. For example, the dashed arrow linking nodes 6 and 9 indicates that the system files must be converted before the user test can take place, but that the resources and time required to prepare for the user test (writing the user manual and user training) are on another path. Numbers on the opposite sides of the vectors indicate the time allotted for the task.

The PERT chart is sometimes preferred over the Gantt chart, another popular project management charting method, because it clearly illustrates task dependencies. On the other hand, the PERT chart can be much more difficult to interpret, especially on complex projects. Frequently, project managers use both techniques.

Critical Path Method (CPM)

Critical Path Method (CPM) charts are similar to PERT charts and are sometimes known as PERT/CPM. In a CPM chart, the critical path is indicated. A critical path consists of that set of dependent tasks (each dependent on the preceding one) which together take the longest time to complete. Although it is not normally done, a CPM chart can define multiple, equally critical paths. Tasks which fall on the critical path should be noted in some way, so that they may be given special attention. One way is to draw critical path tasks with a double line instead of a single line.

Tasks which fall on the critical path should receive special attention by both the project manager and the personnel assigned to them. The critical path for any given method may shift as the project progresses; this can happen when tasks are completed either behind or ahead of schedule, causing other tasks which may still be on schedule to fall on the new critical path.

Simulation of a Network

The normal PERT procedure which bases the estimates of Te and ST on a single critical path can grossly overstate the probabilities of completing a project by a given date, especially if there are one or more parallel paths through the network which are nearly critical, and/or which have relatively large variances. By use of Monte Carlo sampling technique, activity times are randomly selected for each activity from some appropriate frequency distribution. The project length and critical path data are then calculated in the normal way, based on these times. This procedure is repeated several thousand times and finally an average project length and standard deviation are calculated on the basis of simulated data. In the simulation procedure no single path is identified as the critical, but the probability of each activity's being on a critical path is estimated. Thus, this procedure helps the planner in identifying the critical activities which may not lie on the same path.

Scheduling Computation , Critical Path Method. (CPM)

The basic scheduling computation consists of three distinct sequences:
i. The forward pass through the network,
ii. The backward pass through the network,
iii. Calculation of slack or float and determination of critical path.

Forward Pass Computation
The forward pass through the network is made by computing the earliest expected occurrence dates for every other event and the earliest completion dates for the activities. In case there is more than one activity merging at a point, the maximum of the completion times is taken as the earliest completion time. Starts should be chosen as it fulfills the condition that no activity can begin until all its constraining activities are complete. The forward pass procedure proceeds event to event along each node of the network until the end event has been reached. The expected duration time will be longest sequence of activities through the network i.e. the earliest completion time of the last event.

Backward Pass Computation
The planner establishes the latest allowable occurrence date for each event (TL) and latest allowable start at completion date for the event. In the backward pass the planner employs the path tracing procedure characteristic of the forward path in reverse starting with the last event and proceeding backwards along each path to the baseline or the beginning event.

In the backward pass a latest allowable occurrence time is set for the end event corresponding to the scheduled or expected completion date for the project. In the absence of a scheduled end later the earliest expected completion date is automatically set as the latest allowable date.

Slack Computation
Slack is defined as the difference between an earliest possible occurrence time for an event and its latest allowable occurrence time. This difference expressed in time units indicates how the occurrence of the event can be delayed without delaying the end event in the network.

Identification of Critical Path
Once we have determined the slack values attached to various events and activities in the network, the critical path is identified. Critical path can be defined as the longest sequence of activities leading to the end objective. It is the path with the lowest slack value. When a network contains negative slack, the path with the most negative slack is identified as the critical path.

There are many types of slack defined in literature but the two most important ones are Total Slack and Free Slack.
Total Slack: It is the amount of time an activity could be delayed without affecting the overall project duration.
Free Slack: It is the amount of time an activity could be delayed without delaying subsequent activities. It is equal to the difference between the earliest start time of the successor activity and the early finish time of the activity in question.

The Problem of Uncertainty
The project network is the basis of both the PERT and the CPM technique. The notions of the critical path and activity slack are common to each. But these models were developed independently and in somewhat distinct problem settings.

PERT was developed for and has been used most frequently research and development types of programmes. The technologies are rapidly changing and their products are nonstandard. CPM on the other hand, has most frequently been applied to construction projects. The activities in these projects use standard materials whose properties are well known. They employ long-developed and well-seasoned components, and they are based on a more or less stable technology. The PERT technique assumes that the activities and their network relationships have been well defined, but it allows for uncertainties in the activity times.