Developing Corporate Strategy Through Planning, and Budgeting

Developing Corporate Strategy Through Planning1 Prograntnting1 and Budgeting L. A. Dougharty Cost Analysis Department, Rand Corporation, Santa Monica, California.

The Corporation needs a planning framework that aids in clarifying objectives, identifying the alternatives open to the firm, and measuring the effectiveness of those alternatives towards the attainment of the objectives of the corporation. To cope with this problem of integrating objectives (i.e. sales) with resources (in plant, capacity, personnel) the Government of the United States-the biggest conglomerate of them all-is employing what is termed "Planning, Programming and Budgeting" (P.P.B.). This article examines how P.P.B. may be of use to the Corporation. The author reviews the features of the system, constructs a P.P.B. planning framework for the corporation, then shows how the system may be applied to a specific strategic problem.

Any views expressed in this paper are those of the author. They should not be interpreted as reflecting the views of the Rand Corporation or the official opinion or policy of any of its governmental or private research sponsors.

24

A producing and selling selected goods

CORPORATE STRATEGY IS A PLAN FOR

and services to a particular segment ofthe market. The longrun health of the firm depends upon the implementation of a strategy that selects the proper mix of products that it can both produce and market successfully. Much has been written about market research that selects the type of product and product characteristics that can be successfully marketed. However, the problem of integrating the results of this market research with the resource capabilities of the firm has been given less attention.* This ommission may have been partly based on the premise that if a product can be sold, then it can and should be produced. However, with the increase in conglomeration and integration within the corporate structure, product profitability cannot be examined and decided upon in isolation from the rest of the firm. The number of product-mix decisions and the *General Motors' strategy for penetrating the automobile market was based on producing automobiles in all price ranges that were economically feasible. This strategy has been generally credited for General Motors' success in the automobile industry. The acceptance of the General Motors' cars showed that the public preferred the product and price differentiation offered by General Motors over the black, low-cost vehicle produced by Ford. Just as important, however, was that General Motors also had the resources to implement this strategy, since it was a conglomeration of automobile manufacturers that already produced cars in most of the price ranges. (See A. P. Sloan, My Years with General Motors, Chapter 4, "Product Policy and its Origins", McFadden-Bartell Corporation, 1965.)

interdependence among decisions has led to a resultant complexity in the development of corporate strategy. In brief, the corporation needs a planning framework that aids in clarifying objectives, identifying the alternatives open to the firm, and measuring the effectiveness of those alternatives toward the attainment of the objectives of the corporation. To cope with this problem of intrgrating objectives (i.e. sales) with resources (i.e. plant capacity, personnel), the Government of the United States-the biggest conglomerate of them all-is employing what is termed "Planning, Programming and Budgeting" PPB). To examine how PPB can be of use in the development of corporate strategy, it is necessary to review its most important features. This review is presented in the next section. The concepts of PPB are then applied in the construction of a planning framework for a corporation. This construction illustrates the difference between PPB and the more conventional type of corporate planning, and the implications of those differences on corporate strategy development. To further clarify the PPB process, an example is presented in the last section that employs PPB in strategy development. PLANNING, PROGRAMMING AND BUDGETING (PPB) PPB has two important aspects for developing strategy for the firm.* The first aspect is programme structure development. In the structural part of PPB,

LONG RANGE PLANNING

TABLE 1. PROGRAMME STRUCTURE OF THE UNITED STATES GOVERNMENT Planned budget allocation Programme area

I. II. Ill. IV.

v.

VI. VII. VIII. IX. X.

National defense International affairs and finance Space research and technology Agriculture and agricultural resources Natural resources Commerce and transportation Housing and community development Health, Labor and welfare Education General support Total

1969

1970

1971

1972

1973

1974

1975

XX XX XX XX XX XX XX XX XX XX

XX XX XX XX XX XX XX XX XX XX

XX XX XX XX XX XX XX XX XX XX

XX XX XX XX XX XX XX XX XX XX

XX XX XX XX XX XX XX XX XX XX

XX XX XX XX XX XX XX XX XX XX

XX XX XX XX XX XX XX XX XX XX

XX

XX

XX

XX

XX

XX

XX

Source: "The Federal Program by Function", The Budget of the United Slates Government, 1969, U.S. Government Printing Office, Washington, D.C., 1968, p. 79.

the activities of the organization and the resource consumption of those activities are classified by functional area. Table I presents a programme structure for the U.S. Government. It illustrates how the resources of the government (measured in dollars) are allocated to the various broad programme areas such as National Defense, Education, etc. Under each broad programme area, the programmes of the government agencies that contribute toward the attainment of the broad programme area objective would be arrayed. Education programmes, for example, would be arrayed under the Education category, rather than under the sponsoring agency. Selecting from among the competing programmes in each broad programme area involves the second aspect of PPB-the analytical part. Analysis is shorthand for a variety of quantitative techniques for exploring the cost and effectiveness of programme proposals over an extended time period.t The most prominent example of the use of PPB is in the United States Department of Defense, where the new planning structure clarified objectives in defense and pinpointed weaknesses in the then current strategy for defense. Prior to the introduction of PPB in the Department of Defense in 1961, planning and budgeting were essentially done independently by the three services-the

Army, the Navy, and the Air Force. In previous times when the objectives of the U.S. could be stated as supremacy of the land, sea and air, planning by organization was essentially the same as planning by objectives. However, with the advent of the nuclear weapon, intercontinental missile, and the emergence of the guerrilla, the objectives of the U.S. and the role of the services have changed. Objectives are now stated in terms of strategic offense, strategic defense, tactical, etc. Each service is no longer solely responsible for the attainment of its own objectives. The Navy with its Polaris submarines, and the Air Force with its land-based intercontinental missiles and bombers, offer alternative ways of gaining strategic superiority. Moreover, the effectiveness of one strategic missile will depend upon not only its own characteristics, but the quality and quantity of the other strategic missiles in the force. The Army and Navy missile systems must be treated as complements,* as well as alternatives in the planning process. The decision on a missile force posture should be made by comparing various mixes of these alternatives, and not by letting each service contribute to this force in isolation from the others. The complexity of war has also required the close co-operation of the services in the support of each other. Those pro-

*PPB also includes a third part that is an information system that reports on the cost and effectiveness of the implemented plans. While this is an important aspect for strategy implemention, it is not necessary in the strategy development phase. For a fuller exposition of the concept of PPB, see D. Novick, Program Budgeting: Program Analysis and the Federal Budget (2nd ed.), Harvard University Press, Cambridge, Massachusetts, 1967. tSee E. S. Quade and W. I. Boucher, Systems Analysis and Policy Planning: Applications in Defense, American Elsevier Publishing Co., Inc., New York, 1968.

*Complementary systems are those that contribute to the same objective and where the total output of the two programms is net a linear combination of the separate outputs of each programme. For example, if the output of two complementary programms where Ot and 02 the output of the combined programms might be expressed as equal to OT.=Ot+02+KOt02, K>O Since the resource allocation process is designed to maximize output for a given level of inputs, failure to recognize complementary systems will mean a degradation in the performance of the resource allocation process.

MARCH, 1970

grammes that are designed to support another service may be unjustly cut back if the services were to plan and budge.t separately. The pr0ble:n in t\e D~part­ ment of Defense was that the organizational structure did not reflect the objective of the Department. The planning and budgeting th:tt was done within the organizational structur~. therefore, did not reflect the objectives of the Department. PPB corrects this deficiency of the organizational structure in recognizing the objectives of the entity. The objectives of the entity prescribe a programme structure (planning and budget format) and the lower levels of organization compete for resources within that structure. In the case of the Department of Defense, the programme categories that reflect the military objectives of the United States are set by the Department and not by the services.* The services then compete for funds within these categories on the basis of cost-effectiveness for the limited budget of the Department. Moreover, by making alternative and complementary system trade-off decisions explicit in the analytical phase of PPB, the decisionmaker has a greater realization of what he can attain and how it can be attained. The transition of the PPB concept used in government planning to corporate planning is not difficult to make. The parallel between business and war is remark::tbly close, so it is not surprising that planning techniques of the two can be quite similar. To be more precise about how PPB can be applied in the development of corporate strategy, the next section discusses the PPB process in the context of the corporation and its implications for corporate planning. *These military objectives are set within the guidelines of the national security policy established by the President and Congress.

25

FIGURE 1. THE ORGANIZATION OF GENERAL PRODUCTS CORPORATION

APPLYING PPB TO THE DEVELOPMENT OF CORPORATE STRATEGY

The two important parts of PPB in the development of corporate strategy were outlined in the previous section. In the first part, structuring of the activities of the corporation along the line of its objectives, several principles must be observed. First, and most obvious, is that the programme structure should reflect the objectives of the firm. Second, the programme categories should be independent so that alternatives can be analyzed within one programme category without regard to major effects on the other programme categories; and, third, programme categories should be selected that can reflect complementaries within the system trade-off decisions. To illustrate how these principles are applied in the structuring process, we have represented a typical corporation that has the facets of both conglomeration and vertical integration. Figure 1 presents the organization of the firm which we will call the General Products Corporation (GPC). GPC consists of three subsidiaries: Subsidiary 1 produces two brands, X and Y, of essentially the same product for the same general market segment-toothpaste could be the example. Subsidiary 2 produces product Z which is used in the manufacture of both X and Y, but also has other industrial uses. Subsidiary 3 26

manufactures a product, W, that does not compete with any of the other products. Each subsidiary is organized into the four functional divisions-marketing, sales, manufacturing, and finance. Subsidiary 1 is further broken down below the functional level by type of product and then by sales district. Budgeting under this type of organization is likely to start with the sales estimates that are made at the district level. Estimates are then further refined in the finance department to correspond with its view of what can be sold and what can be produced. These sales and production estimates are then the basis for the more detailed budget for the marketing division (what type of promotion will be needed), the sales division (how much selling expense will be involved at this sales level?), manufacturing division (what will the production schedule and cost be?), and the finance division (what will be the cash flow requirements?).* Under this type of planning system, three important features of a planning process are omitted. First, alternatives that contribute to the same objective are *See Moore and Jaedike, Managerial Accounting, Chapter 16, "Budgets-Sales and Production", South-Western Publishing Co., Cincinnati, Ohio,1963. In their chapter the authors explicitly separate the type of budgeting process described above from the broader aspects of business planning. However, the annual budget is the financial translation of the first year of the plan. Therefore, it is difficult to separate the budgeting and the planning process.

not explicitly analyzed together. For example, sales estimates for product X and Y in each of the districts are made independently. Certainly the sales of X have an impact on the sales of Y, since they are direct competitors. The interdependence of the sales of these two products mean that profit rates for the products cannot be estimated independently. A resource allocation method using independent estimates of profit rates would not necessarily tend to maximize actual profits. Secondly, the sales estimates are made without regard to the complementary systems such as marketing and pricing policy that are made independently in the marketing and finance divisions. A planning system that does not provide for the thorough examination of various combinations of sales, marketing, and pricing policy narrows the perspective of top management and eliminates what could be highly profitable alternatives from consideration. Third, no attention is given to alternatives that are not already part of the firm. The systematic evaluation of the possibilities for replacing or adding new products is not an integral feature of this type of planning system. One programme structure for the GPC could look something like that presented in Table 2 *. The programme areas correspond to the product areas. Each product area is nearly independent from the other. That is, decisions in one area should not have a large impact upon programmes in the other product areas. This LONG RANGE PLANNING

satisfactory mix of the two products is not assured because attaining such a mix is not an integral feature of that type of planning process. The structure also reveals how complementary systems fit within the programme structure. A programme for Product X, for example, is not a sales projection but consists of elements from sales, marketing, and manufacturing. In this programme formulation alternative types of sales and marketing strategies can be compared, for resource requirements and relative effectiveness. This is contrasted to the previous case where marketing services were designed after sales quotas were made. There is increasing evidence that the necessity of central planning for organizationally independent parts but operationally dependent parts is being recognized. Several of the major U.S. airlines have recently reorganized their marketing efforts to have the previously independent sales,

format arrays all of those programmes that compete with each other in the same category. Various mixes of products X and Y, for example, would be evaluated for their effectiveness in penetrating the market in each sales district. Regional differences in income, sales history, and distribution facilities would be considered in the evaluation of the alternative product mixes. The allocation of the scarce resource, in this case money, can be portrayed in this framework for as many alternatives as management wants to evaluate. Using rate of return as a criterion for programme selection, adequate analysis within the framework of the programme structure should provide for a production mix tailored to the desires of the market and the capabilities of the corporation. In the planning by organization presented previously, each product pushes for large production, independent of the plans for the other product. A

TABLE 2. PROGRAMME STRUCTURE FOR GPC Net funds year

1

2

3

4

5

6

7

8

9 10

Ill. Product area 1 (product X & Y) District 1 Prdouct X Costs Sales Marketing Manufacturing Revenue Net Funds Product Y (Same as Product X) District 2 (Same as District 1)

11. Product area 2 (product Z) District 1 (Same as District 1, product area 1) District 2 (Same as district 1, product area 1) Sales to subsidiary 1 Ill. Product area 3 (product W) District 1 (Same as district 1, product area 1) District 2 (Same as district 1, product area 1) IV. General Support Net Funds required *There are many possible program structures-one for each set of corporate objectives. For el\ample, the programming structure for the corporation interested in "public service projects" will certainly look different from that of the corporation that believes that the conduct of such projects is not a proper function of private business.

MARCH, 1970

passenger service, scheduling, and advertising departments in one department and under one man.* Whether this change will make actual passenger service more like advertised passenger service, one can only hope for. In any event, planning will not be done separately by the advertising and passenger service groups. The new head of the marketing department will now have the explicit trade-off decisions concerning the relative effectiveness of advertising and passenger service in increasing passenger revenue. To reiterate, in strategy development and programme selection, the components of the business system must be evaluated together to achieve a proper mix of the complementary systems. The implication of vertical integration for corporate policy is also made explicit within this framework. Under Programme Area II, the corporation analyzed the effects of selling Product Z to Subsidiary 1 or selling the product to other industrial users. The alternatives are analyzed in the usual type of "make or buy" analysis New programmes can be introduced within the existing programme categories or by creating new programme categories. Where they compete within the product areas already established as programme categories, they are included as a new alternative. If new product areas are proposed, new categories are established, and alternatives are selected from within those new categories. The longer term implications of current budget decisions are reflected in the programme structure. Table 2 reflects the net demand for funds (expendituresrevenue) for the next ten years for this set of programmes. The net change in scarce resources shown in the programme structure need not be money. Forecasts of the needs for personnel, raw materials, and manufacturing capacity could just as easily be shown if there were some indication that these resources could not be purchased at the prices reflected in the net funds forecast. Though the most effective mix may have been selected within each category, it is likely that there are not enough resources to fund all of the selected alternatives. The final decision on the corporate strategy must be made centrally. The amount of funds committed to each product area would depend upon the amount of funds available and the rate of return of the individual programmes within each category. Alternatives with low rate-of-return would be eliminated until the resources required by the remain*Carol J. Loomis, "As the World Turns on Madison Avenue", Fortune Magazine, December 1968, p. 193.

27

ing alternatives match the resources available to the firm. The marginal contribution of acquiring more capital can be seen by examining the different programmes that could be adopted if the capital constraint were relaxed. In summary, PPB is a process for systematically arraying and selecting programmes. It presents choices to the decision-maker by making the alternatives explicit. It puts the decision in proper context by ensuring that alternatives that contribute to the same objective are analyzed together; and, finally, PPB illuminates the decision in its analytical part by examining the relative effectiveness of the alternative and its total system cost. The next section presents an example that integrates the two components of PPB, programme structure and programme analysis, in strategy development. Since PPB has only been formally applied in government,* the selection of a comprehensive example is somewhat restricted. The example presented concerns the development of a strategy for a state government in the field cf health. The processes of decision-making in the public and private sector should be similar enough to make the example a relevant illustration for corporate planning. t EXAMPLE OF STRATEGY DEVELOPMENT One of the more rural states in the United States is concerned that its citizens are not getting adequate health care. Indicators of the health of the community such as infant mortality, reported syphilis cases, and mortality rate justify this concern. It is felt that the main reason for this lack of adequate health care is the shortage of doctors. The doctors per capita in the State is only 25 per cent of the national average. The government, therefore, adopts as an objective the increase in the stock of doctors in the State. To achieve this increase, programmes are proposed by the University, the Health Department, the Welfare Department, and the Administration Department. Without PPB, each department would make a decision on these programmes without regard to the relative effectiveness of each of the competing programmes. With PPB, each of the alternative programmes are arrayed and analyzed together to develop *The concepts of PPB have been used in industry without being documented. For a fuller discussion, see Novick, op. cit., "Introduction: Origins and History of Program Budgeting". tFor a discussion of the differences in the corporate and government planning environment, see Hitch, Charles and Roland McKean, Economics of Defense in the Nuclear Age, The RAND Corporation, 1960, Chapter 7.

28

the most viable strategy for the State. Table 3 presents the abbreviated Health Programme Category that reflects only the programme for· increasing medical personnel. Programme 1 would have the State increase its training of doctors at the University Medical School. Programme 2 is a method of raising the compensation to the doctor, sponsored by the Administration Department. Programme 3 would lower the requirements for obtaining a license to practice medicine in the State. Programme 4 would increase the demand for health services by providing health insurance, and subsequently increase the supply of doctors within the State. Programme 5 would build facilities for the practice of medicine. The State would then lease these facilities to doctors at a moderate price. Facilities are used as an indirect subsidy to attract and retain doctors. The structure exemplifies what is meant by arraying all alternative programmes together. While medical education is often considered in the budget deliberations of the University (where the trade-off is with other types of education), the real impact of this education is in the health area. Therefore, the medical school competes for resources with alternatives for increasing the health care fur the community and not agaimt programmes fur raising the quality and quantity of education within the State. Before the analysis proceeds, it is decided that Programme 3 and 5 are untenable solutions. Programme 3 is eliminated because the State has delegated its responsibility in setting standards to the medical profession itself. The State does not feel that it wants to incur the political costs of reassuming this responsibility. Programme 5 is eliminated because there is no way of insuring that it will increase the number ot doctors in the State. It is more likely that current residents will apply for the better facilities, so that there may be no net change in the number of doctors in the State. Alternative 4 is set aside for the moment since the Federal Health Insurance programme has not been finalized and thenJore the possible course for State action in this field is unclear. Alternatives 1 and 2 are analyzed to test their feasibility. The first step in the analysis is the construction of a model that will estimate the number of doctors in the State as a function of the number trained at the medical school and the average income of a doctor in the State expressed as a percent of the national average income of this group. These are considered the policy variables in this

TABLE 3. ABBREVIATED HEALTH PROGRAMME CATEGORY I. Increasing the medical personnel programme A. Doctors 1. Training facilities (u niversity) 2. Pecuniary reward for medical service in State (administration) 3. Lower entrance requirements (health) 4. Health insurance (welfare) 5. Construction of health facilities (health) II.

analysis. (Policy variables are ones that the State can change through a change in policy.)* One alternative for increasing the stock of doctors is to double the capacity of the medical school. It will be three years before facilities can be built, and doctors recruited, and larger classes can be admitted. Therefore, it will be ten years (three years for start-up, four years of medical school, and three years of residency) altogether before this increase in production has any effect on the health of the community. The estimated increase in the stock of doctors in the State using this alternative is shown in Table 4. t The incremental system cost to the State for this alternative is also shown in Table 4. Table 4 shows that the State will be spending $80 million to procure this increase in doctors over the next 16 years. If this money were spent to increase the average income of the doctor, what would be the increase in the doctor stock ? To *The Model is of the form: D(t)= D(t-1 )-D(t-1) E(P) + d(t-1 )I(P)+ G(t-3(S(P) -R(t) where D(t)=stock of doctors in the state in year t, P=ratio of average doctor's income to national average, E(P)= percent of doctors in the state that immigrate as a function of P, d(t-1)=stock of doctors in the country in year t-1' I(P)=percent of national doctor stock that immigrates to the state as a function of P, G(t-3)=number of graduates from the medical school in year t-3, S(P)= percent of graduates that immigrate from the state before three years after graduation (i.e., before they complete residency and can be licensed), R(t)=number of doctors that retire from active practice in year t.

tThe increase is the number of doctors in the State using the alternative minus the number of doctors in the State with no change in policy. The projection of the number of doctors if there is no change In policy is shown in Table 4.

LONG RANGE PLANNING

TABLE 4. STOCK OF DOCTORS

Year

No change in policy No. Doctors

No. Doctors

Increase

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

1500 1452 1411 1378 1351 1330 1314 1303 1295 1290 1288 1288 1290 1294 1298 1303

1500 1452 1411 1378 1351 1330 1314 1303 1295 1290 1344 1386 1420 1448 1471 1491

0 0 0 0 0 0 0 0 0 0 56 98 130 156 173 187

Increase Income Ratio

Increase No. of Graduates Cost (M. $)

No. Doctors

Increase

1500 1481 1467 1457 1450 1447 1446 1446 1449 1453 1458 1464 1471 1478 1486 1495

0 29 56 79 99 117 132 143 154 163 170 176 181 184 188 192

10 10 10

9 2 3 4 4 4 4 4 4 4 4 4 4

MARCH, 1970

5 5 5

-80

2063

80

sidizing all doctors in the State was not a practical way to increase the doctor stock. Since the graduates of the medical school are the most mobile in the first three years, and this mobility is the most sensitive to income, it seems reasonable to subsidize this group alone. Using this approach, a third alternative is generated. It is suggested that tuition to the medical school be raised to more closely approximate the cost of that education, while at the same time offering student loans to those who qualify for entry into the school. The loans can then be forgiven for years of service in the State (e.g., 25 per cent is forgiven for each year of service in the State). If the medical school graduate perceives a 10 per cent increase in his salary through this mechanism, the model predicts the doctor stock as shown in Table 5. Since the incremental cost to implement this alternative is low--tuition is almost free currently-the alternative is adopted. Moreover, if the programme succeeds, increasing the size of the medical school should be reviewed since indigenous production of doctors would be more efficient in increasing the stock of doctors than previously. It has been noticed that increasing the doctors per capita is not the objective of the State. The real objective of the State is to ensure that reasonable health standards are maintained for all its citizens. The analysis presented was too narrow in its focus when it accepted the stock of doctors as a proxy measure of the attainment of the real objective. Further analysis in this area must include the

5 5 5 5 5 5 5 5 5 5 5 5 5

--

-

make this estimate, it is assumed that the annual sum of $5 million is distributed among the doctor stock, D(t), over and above keeping pace with an income that is 80 per cent of the national average. This alternative produces the doctor stock shown in Table 4. Both alternatives cost the same but have different expenditure time patterns, as shown in the table. The figure shows that the alternative, to increase the income ratio is the dominant solution. That is, for every year under consideration, more doctors are practicing in the State under this alternative than if the alternative to increase enrollment at the medical school were adopted. However, there are several arguments against such a proposal. Even if the model is correct, there is no assurance that the doctors will be distributed within the State to service those in the rural areas where the medical personnel shortage is greatest. Secondly, if the State starts giving tax concessions to one profession, it may be forced through political pressure to give it to other groups-teachers and engineers, for example. Thirdly, it may prompt other states (i.e. competitors) to grant equal subsidies so that the end result would be higher cost for doctors and no change in the stock of doctors. Lastly, the high cost of $38,800 per doctor-year seems high. The State is subsidizing all the doctors but only influer.cing migration on the margin. For these reasons, this alternative is not considered feasible. The analysis has been enlightening to the decision-maker, even though its results were not adopted. It showed that sub-

Cost (M. $)

other alternative of broadening health insurance coverage so that the disadvantaged can have access to medical resources that the state may create. This example IS not similar to those found in many textbooks. No easy solution is presented. The goal and objective formulation is not clear cut. It represents the type of thinking that PPB should force upon the analyst and the decision-maker. What are my objectives? Am I measuring the right thing? It is an iterative process by which many alternatives can be generated and evaluated in the framework of the objectives of the firm. It does not ensure success, but if performed properly, it does ensure illumination. • TABLE 5. FORECAST STOCK OF DOCTORS Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Cost Number of Net doctors increase (M $) 1500 1459 1424 1396 1373 1356 1342 1333 1327 1323 1322 1322 1324 1328 1332 1337

0 7 13 18 22 26 28 30 32 33 34 34 34 36 36 34

·1 ·1 ·1 ·1 ·1 ·1 ·1 ·1 ·1 ·1 ·1 ·1 ·1 ·1 ·1 ·1

29