Strategic Planning

Professorial Fellow of Edinburgh Business School, The Graduate School of Business, Heriot-Watt University, Alex Scott (MA, MSc, PhD) is an economist and has published over thirty research papers into efficiency in education, efficient use of energy, energy and the environment and the cost to the taxpayer of government industrial aid programmes. He is a pioneer in developing and carrying out research into new educational techniques, particularly in the field of business simulations. Professor Scott’s executive teaching includes running strategic planning sessions for groups of senior managers, widening the perspectives of functional managers, and teaching financial specialists the principles of how economies function in today’s highly complex and interdependent world. Among the companies for which he has run management programmes are American Express, British Rail, British Telecom, Cathay Pacific, Fiskars, Hewlett-Packard, National Health Service, ScottishPower, Scottish Widows, Swiss Bank Corporation.

Release SP-A1.3

ISBN 0 273 60924 6

HERIOT-WATT UNIVERSITY

Strategic Planning
Professor Alex Scott MA, MSc, Phd

Edinburgh Gate, Harlow, Essex CM20 2JE, United Kingdom Tel: +44 (0) 1279 623112 Fax: +44 (0) 1279 623223 Pearson Education website: A Pearson company www.pearsoned-ema.com

Release SP-A1.3 First published in Great Britain in 2003 c 2003 Alex Scott The right of Professor Alex Scott to be identified as Author of this Work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988. ISBN 0 273 60924 6 British Library Cataloguing in Publication Data A CIP catalogue record for this book can be obtained from the British Library. All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior written permission of the Publishers. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers. Typesetting and SGML/XML source management by CAPDM Ltd. Printed and bound in Great Britain. (www.capdm.com)

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Contents
Using the Course Package 9 1/1 1/2 1/4 1/23 1/40 1/47 2/1 2/1 2/8 3/1 3/2 3/3 3/7 3/10 3/11 3/13 3/14 3/15 3/17 3/18 3/18 3/21 3/29 3/31 3/38 4/1 4/2 4/3 4/4 4/21 4/25 4/26 4/27 4/27 4/31 5/1 5/3 5/3

Module 1

Introduction to Strategy, Planning and Structure
1.1 1.2 1.3 1.4 1.5 Strategic Planning: The Context What Is Strategic Planning? The Process of Strategy and Decision Making Business Unit and Corporate Strategy Is Strategic Planning Only for Top Management?

Module 2

Modelling the Strategic Planning Process
2.1 2.2 The Modelling Approach Strategy Making

Module 3

Company Objectives
3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12 3.13 3.14 3.15 Setting Objectives From Vision to Mission to Objectives The Gap Concept Credible Objectives Quantifiable and Non-Quantifiable Objectives Aggregate Objectives Disaggregated Objectives The Principal/Agent Problem Means and Ends Behavioural versus Economic and Financial Objectives Economic Objectives Financial Objectives Social Objectives Stakeholders Ethical Considerations

Module 4

The Company and the Economy
4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 The Company in the Economic Environment Revenue and Costs: The Basic Model The Workings of the Economy Forecasting: What Will Happen Next? PEST Analysis Environmental Scanning Scenarios The Economy and Profitability Environmental Threat and Opportunity Profile: Part 1

Module 5

The Company and The Market
5.1 5.2 The Market The Demand Curve

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5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10 5.11 5.12 5.13 5.14 5.15

Competitive Reaction Segmentation Product Quality Product Life Cycles Portfolio Models Supply Markets and Prices Market Structures The Role of Government The Structural Analysis of Industries Strategic Groups An Overview of Macro and Micro Models Environmental Threat and Opportunity Profile: Part 2

5/13 5/18 5/24 5/31 5/34 5/43 5/45 5/47 5/54 5/57 5/60 5/61 5/62 6/1 6/2 6/4 6/5 6/8 6/10 6/11 6/13 6/14 6/15 6/16 6/17 6/18 6/21 6/23 6/24 6/26 6/31 6/33 6/35 6/38 6/40 6/41 6/44 6/49 6/50 6/53 7/1 7/2 7/3 7/5 7/17 7/26

Module 6

Internal Analysis of the Company
6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10 6.11 6.12 6.13 6.14 6.15 6.16 6.17 6.18 6.19 6.20 6.21 6.22 6.23 6.24 6.25 6.26 Opportunity Cost Fixed Costs, Variable Costs and Sunk Costs Marginal Analysis Diminishing Marginal Product Profit Maximisation Economies of Scale and the Experience Curve Economies of Scope Production Costs Joint Production Break-Even Analysis Payback Period Accounting Ratios Benchmarking Sensitivity Analysis Research and Innovation Development Resource Management Human Resource Management Vertical Integration The Value Chain Diversification Synergy Competence Strategic Architecture The Definition of Competitive Advantage Strategic Advantage Profile

Module 7

Making Choices among Strategies
7.1 7.2 7.3 7.4 7.5 A Structure for Rational Choice Strengths, Weaknesses, Opportunities and Threats Generic Strategies Identifying Strategic Variations Strategy Choice

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Module 8

Implementing and Evaluating Strategy
8.1 8.2 8.3 8.4 8.5 8.6 8.7 Implementing Plans Organisational Structure Resource Allocation Evaluation and Control Feedback The Augmented Process Model Postscript: Strategic Planning Works

8/1 8/2 8/3 8/6 8/12 8/18 8/19 8/23 A1/1 A2/1 A3/1 A4/1 I/1

Appendix 1 Appendix 2 Appendix 3 Appendix 4 Index

Strategy Report Answers to Review Questions and Case Analyses Practice Final Examinations Guide to Strategic Planning Practice Final Examinations

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Using the Course Package
It is widely accepted that strategic planning is extremely difficult to teach effectively. This is because, at the MBA level, it is not sufficient to know about the subject – it is necessary to be able to apply ideas in order to carry out strategic analysis of real problems. While there are many strategy models on which analyses can be based, the strategic approach also requires the application of a great many ideas and models drawn from the core business disciplines; this is what gives substance to strategic analysis and this integrative element is why strategic planning is typically regarded as the capstone course in MBA programmes. A further problem is that strategy solutions are to a large extent a matter of personal judgement. A strategic planning analysis is judged on the structure and approach of the analysis and the justification for the policy proposals recommended rather than the proposals themselves. While it may be possible to recognise that recommendations are unlikely to be successful because of misunderstandings about the basic business tools which are applied, it is usually difficult to judge how good or bad the results of a particular set of recommendations are likely to be because no one really knows what is going to happen in the future. In real life strategy is undertaken in a constantly changing environment which is full of uncertainty, and it is difficult to replicate these conditions in the classroom. But it is obvious when students are using analytical ideas rather than adopting a subjective and unstructured approach. The approach adopted in this course is based on cases. There are some review exercises which are intended to reinforce your comprehension of specific topics, but the overall objective of the course is to enable you to apply strategic analysis to real life issues.

Cases
The case method is the most widely used technique for teaching strategic planning, and was pioneered at Harvard Business School. The case is a powerful teaching tool in class because it enables students to tackle real life examples, which have been abstracted and structured by teachers, and to present, discuss and defend their analysis. The case method as used in class teaching cannot be implemented for distance learning because it is based on interaction among students and between students and teacher. In this course each case has been analysed fully by the professor, and many of the cases have been used in a similar form in examinations and the analysis has benefited from the wisdom of large numbers of students. Each case has been analysed using a variety of business models, and as you work through the course you will learn by analysing the cases and comparing your solutions with those of the professor. It may often be the case that you consider your analysis to be superior to the professor’s; this is all to the good, particularly if you can justify your position. The case method is a static approach, in that the you analyse a given situation, but cannot then experience how a plan might work out in practice, and how
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it might need to be adjusted as time proceeds. Strategic planning is a dynamic process in real life, and no case can capture this fully. A drawback of the case method is therefore that you will not have to live with the consequences of your strategy recommendations. Feedback on student performance presents difficulties when using cases in the distance learning mode. The professor’s analysis provides a benchmark against which you can evaluate your own answer, but it cannot be regarded as a ‘perfect answer’ to the case. This is because there can be legitimate disagreement on the weights to ascribe to different aspects of the issue, such as the relative importance of different types of risk. Therefore the professor’s analysis can be regarded as an analytical framework within which you can judge the quality of your own thinking. One of the difficulties in using real life cases is that they typically touch on many issues. Several of the cases in the course attempt to focus on particular topic areas, but the cases in the earlier Modules will be difficult to analyse fully because you do not have many of the analytical tools available with which to tackle them. However, it is a salutory lesson to attempt cases without having the benefit of a full framework because there are still many lessons to be learned from applying what you do know. Because strategic planning is about applying ideas to the real world it is important that you tackle the exercises, in the form of cases and review questions, and assess your analysis in relation to the model answers provided. You will find that many issues are elaborated on and reinforced in the model answers and these are an essential complement to the ideas developed in the text. In fact, the text and the exercises must be regarded as a single learning tool. The cases, by their nature, are a snapshot at a particular time and, while they contain important lessons, time does march on and it is quite possible that actual events will turn out differently to what might have been expected in the cases. Accordingly, each case is dated with the time the ‘snapshot’ was taken. An important feature of these cases is that they are not based on privileged information nor in depth analysis of the organisations concerned; they have been constructed from the information available to everyone which is freely available in the public domain, i.e. newspaper reports, magazine articles, television programmes and company reports. You will find that the cases are much shorter than those typically used in business school courses, and those of you who are familiar with Harvard Business School cases, for example, may at first feel that they are ‘too short’. However, it is not the sheer amount of information in a case which is important rather than what you can make of the information which is available. In fact you will find it instructive to keep track of developments relating to the examples in the text and the cases; naturally you will expect to keep track of developments in periodicals such as the Economist and newspapers such as the Financial Times, but you will also come upon relevant information in the most surprising places – magazines, gossip columns, or whatever. Keep your eyes open.

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Your Learning Style
It is entirely up to you how you decide to learn about strategy. Two totally different learning models reported by students appear to have been equally successful for them. One student worked through each Module and spent a lot of time on each case or review question both analysing the problem and comparing the outcome with the analysis provided in Appendix 2 before proceeding. Her intention was to build up comprehension in an incremental fashion. Another student started by reading Modules 1 to 8 without attempting the cases or review exercises with the intention of gaining a general perspective; he then went back to the beginning and worked through the cases and exercises. Each felt that this approach was right for them. Whichever approach you adopt bear in mind that strategic planning is not an individual discipline which is unrelated to the core courses; when ideas from the core courses are used you may often find it worthwhile to revisit the relevant text to refresh your mind on ideas which are discussed and applied in the strategic context. But there is one important piece of advice which you should keep in mind whatever your learning style: do not get obsessed with detail. For example, some of the cases contain numerical information relating to company accounts and market position; you might make a computational mistake when using these numbers but that is not important. What is important is that the conclusions you arrive at are consistent with whatever numerical answers you have produced. Strategic planning is about the big picture and the quality of your thinking; if you lose sight of that you will find yourself in the classic position of not being able to see the wood for the trees.

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Module 1

Introduction to Strategy, Planning and Structure
Contents
1.1 1.2 1.2.1 1.2.2 1.2.3 1.2.4 1.2.5 1.2.6 1.2.7 1.3 1.3.1 1.3.2 1.3.3 1.3.4 1.3.5 1.3.6 1.3.7 1.4 1.4.1 1.4.2 1.5 1.5.1 1.5.2 1.5.3 Strategic Planning: The Context What Is Strategic Planning? Managers’ Definitions of Strategy Strategy in the Business Context Three Approaches to Strategic Planning Rittell’s Tame And Wicked Problems The Origins of Strategy and Tactics Strategy and the Scientific Approach Strategic Planning and Strategic Thinking The Process of Strategy and Decision Making Strategy Dynamics The Mythical Company How Well Are We Performing? What Should We Be Doing in the Future? How Can We Achieve Successful Change? Strategy and Crises Elements of Strategic Planning Business Unit and Corporate Strategy Allocating Corporate Resources Development of Corporate Strategies Is Strategic Planning Only for Top Management? Company Benefits of Strategic Planning Individual Benefits of Understanding Strategic Planning Understanding Strategic Planning: Who Should Pay? 1/2 1/4 1/5 1/6 1/8 1/13 1/15 1/17 1/21 1/23 1/23 1/25 1/25 1/28 1/31 1/31 1/33 1/40 1/41 1/42 1/47 1/47 1/48 1/48 1/49 1/49 1/49 1/49 1/49

Review Question 1 Review Question 2 Review Question 3 Review Question 4 Review Question 5

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Learning Objectives
• • • • The meaning of strategic planning as it is used in business. To visualise strategy as a structure of thought which can be applied to the complex strategy process. The different strategy concerns at the corporate and business levels. How the major approaches to corporate strategy have developed.

1.1

Strategic Planning: The Context
It has been mentioned that strategic planning is usually the capstone course in MBA courses; it is therefore useful to look at what the core courses are concerned with and how strategic planning fits with them. Because the core courses are taught individually it is easy to get the impression that they are independent of each other, but this is far from the case. The following story tries to capture the rationale for studying the core courses. • Organisational behaviour: this subject should come at the top of the list of requirements for any management course because if you cannot handle people then you are not a manager. It is as simple as that. The fact is that organisations are run by people, and if you have no understanding of what motivates people and how they interact in the organisational setting then you are unlikely to get an efficient response from the people you are managing. One of the most successful companies in history, IBM, appeared to lose its way in the early 1990s and reported the biggest loss in corporate history in 1993: it was unable to convert its inventions, such as the new RISC chips, into marketable products as fast as competitors, and it was unable to respond quickly to changing circumstances; this was largely attributable to the huge bureaucratic structure which had evolved and IBM was forced to take steps to reorganise itself so that it could once again react in a competitive manner. The people problem lay at the root of IBM’s difficulties and this had to be sorted before real progress could be made. Economics: everything that happens in business is related to economic influences and these operate at three levels. At the highest level it is important to have some understanding of how the economy operates. Every business is affected by the business cycle, the rate of interest, the exchange rate and government economic policies; a manager’s view on what is happening in the economy can greatly affect decisions on what to do next; for example, should a major investment be taken now, when all the signs are that the economy is heading for recession, or should it be delayed until there is an improvement? The next level concerns how markets operate and how prices are determined. What type of competitive forces prevail in your industry? How does market structure affect profitability? What is signalled by a change in prices? An understanding of basic economic ideas enables you to discuss and interpret such questions; without that understanding you have no idea what is going on. The third level concerns ideas about efficiency, primarily based on marginal analysis. Rational decision making
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is based on an understanding of relevant costs and benefits, and serious mistakes are often made because efficiency ideas are not understood. Marketing: there is little point to being able to manage people, interpret surveys and make rational economic decisions if you cannot sell effectively in markets. Marketing is often mistakenly thought of as advertising, but advertising is simply one of many marketing tools. Marketing is the complex process of relating product characteristics to market demand and attempting to win competitive advantage in a dynamic competitive setting. Why is it that some brands of whisky are much more successful than others, despite the fact that the majority of people cannot tell one brand from another? Without an understanding of marketing principles and ideas it is impossible to answer such a difficult question. Finance: you may be running your company well and selling effectively, but managers always have to bear in mind that perhaps they should have been doing something different which is more profitable. How is the choice among competing courses of action made in a world of uncertainty? Finance takes all available information on projected future cash flows and subjects them to rigorous evaluation; a company might have the choice of revamping an existing product or launching a new product which is a close substitute, and the projected cash flows both in and out are totally different while the risks associated with each are also different. The tools of financial theory provide you with a quantitative solution to such problems, and this takes you a long way towards deciding on the most appropriate course of action. Accounting: you may have decided on the best course of action using financial techniques, but it is then necessary to ensure that over time resources are allocated efficiently; in a company which produces more than one product it is difficult to isolate relevant costs, but knowing the costs of what you produce is central to running a business. While finance is concerned with deciding what should be done, accounting concentrates on how efficiently resources are subsequently allocated. In many ways a knowledge of accounting helps in the same way as an understanding of quantitative methods: you should be able to ask the correct questions and be able to interpret the answers. Otherwise you are at the mercy of accountants, and obviously no one wants to be in that position. Project management: while it may appear to be a good idea to embark on a new course of action, such as launching a new product, unless you understand how to implement projects effectively there is a good chance that the launch will fail. The success of the launch will depend on meeting criteria centred on time, cost and quality because the product will have to be on the market by a certain date, the development and production costs will have to be maintained within budget and the quality has to be as good as competitors’. In addition, the launch of any new product generates risk. Project management tools and techniques allow the risk profile to be mapped, assessed and monitored over time and any changes in risk impact, such as those due to the actions of competitors, can be tracked. As the launch progresses tools such as earned value analysis and trade-off analysis enable the project manager to consider different combinations of time, cost and
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performance both at present and at the projected end condition. Clearly, the lack of the project management approach can result in a haphazard product launch. Project management tools and techniques enable the project manager to plan and implement change effectively, hence increasing the likelihood of success. A major problem confronting organisations is that they do not realise that their approach to managing change is haphazard because they are not aware that most change activities are in fact projects in their own right and should be managed as such. Strategic planning: the areas covered by the six core disciplines can be defined reasonably easily, and it is clear that they all have an important role to play in running a company. Strategic planning is less easy to define, and the content and role of strategic planning is what the rest of this course is about. But one thing is certain: strategic planning is not independent of the other core disciplines.

1.2

What Is Strategic Planning?
Strategic planning is a complex activity and before attempting a definition it is useful to compare its degree of complexity with another complex activity: economic policy making, which has a general similarity with strategic planning in that strategic planning is concerned with running a company and economic policy is concerned with running the economy of a country. The study of macroeconomics reveals the complexity of fiscal and monetary policy and the many ideas and theories which are involved; furthermore, there are no completely right or wrong economic policy decisions because information has to be interpreted and conflicting theories reconciled. Although the scale of a company is very much less than that of an industrialised country such as the UK or Japan the job of business policy making is probably just as complex. That is one reason why effective CEOs are as rare as effective Presidents, Prime Ministers and Central Bank Governors; in fact, effective CEOs are typically paid much more than government ministers. The complexity of economic policy becomes apparent when a list of the issues involved is compiled: • • • • • • • • • • • • growth of GNP unemployment inflation the budget balance the role of markets the trade balance the rate of interest the exchange rate income redistribution pollution government expenditure business investment
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This list is by no means complete; in fact, the list could be extended to fill this page. When we turn to strategic planning it is not difficult to generate a list of equal length: • • • • • • • • • • • • profitability growth in sales market share relative costs competitive position pricing environmental scanning human resource management accounting ratios investment appraisal shareholder value dividend policy

The theories of microeconomics and macroeconomics are used to make sense of the relationships among the many variables involved in the economy and to provide an understanding of how economies operate; this provides the basis for interpreting government economic policy making. The approach in strategic planning is to bring together business concepts and ideas in order to understand how companies (and other organisations) operate in a competitive environment, develop an understanding of the inter-relationships involved, and hence provide the basis for arriving at explanations of why companies have succeeded or failed in the past and how they might operate successfully in the future. There is an added dimension to the scope and complexity of strategic planning which does not occur in economic policy making. Looking at the list of strategic planning issues there is an item called ‘environmental scanning’. This activity is concerned with monitoring the environment within which the company operates and assessing the extent to which current and potential changes in that environment are likely to impact on the company. But the macroeconomic environment is largely determined by the state of the economy, which in turn is greatly influenced by economic policy making. Thus to make sense of the macroeconomic environment it is necessary to have some understanding of economic policy making and its implications. The need to understand economic policy making is not confined to government policy makers and it is subsumed into strategic analysis. 1.2.1

Managers’ Definitions of Strategy
Over many years I have posed the question ‘What do you understand by strategy?’ to experienced executives attending management programmes, and each time the groups have responded with a wide range of answers including the following.

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1 2 3 4 5

Knowing where you are going and how you are going to get there. Setting a clear set of objectives and mobilising resources to achieve them. Thinking in the long rather than the short term. Working out how to do better in the market place than your competitors. Deriving and selecting a course of action.

There are some common threads running through these definitions, but individually they could lead to different courses of action. For example, definition 2 focuses on objectives, but does not differentiate between short term and long term as in definition 3; definition 4 is the only one explicitly concerned with markets. Definition 5 is the only one which explicitly considers choice. It is not unusual to obtain ten different definitions from a single group. These managers are typically involved in formulating and implementing strategy so it might appear strange that there is such apparent confusion in their minds about what is meant by the term. 1.2.2

Strategy in the Business Context
If you were to visit a large or medium sized company, chosen at random, and attempt to identify and track the formulation and implementation of a ‘strategic plan’, you may well find the task to be elusive and perplexing. In pursuing the strategic planning process some questions which you might ask, in no particular order, include: ‘Was the strategy ever written down?’ ‘ Where did it originate?’ ‘Why was it selected rather than alternatives?’ ‘Who was responsible for it?’ ‘Who knew if it was working or not?’ In some cases you would find it difficult to elicit answers to these seemingly straightforward questions. Despite this, individual companies may consider that they have a well-developed strategic planning process, although it is informal and subject to constant revision in the light of circumstances. On the other hand, in some companies you would find a formal planning system complete with clearly specified objectives, responsibilities and control procedures. You would therefore encounter a wide diversity of activity which individual companies would consider to be strategic planning. Some additional questions might include: ‘Is there a payoff to the company from the resources devoted to strategic planning?’ ‘Which is more appropriate, the informal approach or the structured formal plan?’ You would probably find that managers offered a variety of views on both the effectiveness of planning in general and the most appropriate approach to planning. One reason that questions relating to strategy are difficult to answer unambiguously is that strategic planning takes place in a complex and ever-changing business environment. One description of strategy is
A pattern in a stream of decisions; the pattern may not be comprehensive, unified or integrated1

This raises the question as to whether strategic planning is a conceptually valid concept in business; the study of strategic planning may merely be an attempt to impose a structure on events after they have occurred. The central question is whether strategy is a rational process, in the sense that it was carefully thought
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out by senior management and then put into practice, or whether it is emergent, in the sense that it develops over a period as the result of many influences from all levels in the organisation. The following are some academic definitions of strategy, each with its own particular focus.
The decisions taken over time by top managers, which, when understood as a whole, reveal the goals they are seeking and the means used to reach these goals. Such a definition of strategy is different from common business use of the term in that it does not refer to an explicit plan. In fact, by my definition strategy may be implicit as well as explicit.2 the determination of the basic long term goals and objectives of an enterprise, and the adoption of courses of action and the allocation of resources necessary for carrying out these goals.3 the pattern of objectives, purposes or goals, and the major policies and plans for achieving these goals, stated in such a way as to define what business the company is in or should be in and the kind of company it is or should be.4 what determines the framework of a firm’s business activities and provides guidelines for coordinating activities so that the firm can cope with and influence the changing environment. Strategy articulates the firm’s preferred environment and the type of organisation it is striving to become.5

Each of these quotes can be interpreted as saying different things. The first definition seems to suggest that strategy can only be understood after the event, and is revealed by studying what management actually did. The second claims that strategy is a proactive process where long term goals are determined before the event and resources deployed accordingly. The third portrays strategy as a pattern of objectives which define what the company is and intends to be in a broad sense. The fourth presents strategy as a set of guidelines which will help it operate in a changing environment. The fact that there are such different perspectives on the issue suggests that some observers will see strategic behaviour where others will not. A different approach to strategy can be derived from economics: the forces of competition ensure that, on average, successful companies are those which, by chance or otherwise, choose the most effective strategies. As a result it might be expected that such companies would tend to exhibit various characteristics of strategic planning contained in the definitions, such as identification of objectives, plans and guidelines for dealing with the unexpected, and effective allocation of resources. Since many companies have a record of success stretching over decades, it is reasonable to conclude that there is scope for distilling lessons from their experience and formalising these into a set of generally applicable principles. However, any attempt to identify characteristics which lead to success or failure is dependent on relating actions to outcomes, i.e. attributing cause and effect. This is difficult in the field of business. There are numerous instances of companies which have a record of success because they happened to be in the right market position at the right time to take advantage of favourable
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economic circumstances; investigation of such companies may reveal that they had little understanding of their markets and generally haphazard management controls, and from this there would be little to learn about successful behaviour. However, the subsequent performance of such companies may have the potential to generate lessons for strategic planning: do they capitalise on their good fortune, consolidate their market position, ensure that resources are deployed efficiently and start looking forward with the objective of identifying and seizing similar opportunities in the future? If not, they may be caught out by the next adverse event. But the major problem in trying to relate cause and effect is that strategy is also concerned with the behaviour of competitors. Decisions are not only taken in the context of unpredictable outcomes such as market growth and the business cycle, but have to take into account confrontation with other companies, each of which is trying to achieve a competitive advantage. If one company is capable of carrying out an analysis of market conditions, it stands to reason that other companies can do so also, and may well have exactly the same information at their disposal. Strategy decisions may then become something of a guessing game, where managers attempt to predict what competitors will do rather than analyse options derived from financial and economic appraisal. As a result an elaborate and sophisticated strategy based upon the latest thinking in the business disciplines may be associated with failure because a major competitor did something totally unexpected. Another way of looking at this is that strategy is about the unknowable as well as the unpredictable. This means that it is necessary to go beyond the application of concepts from the individual business disciplines on their own to derive effective courses of action. Everyone should be aware that there are no simple answers to strategy issues; you only have to read the continual newspaper reports on the varying fortunes of prominent business personalities and famous companies. In international publishing and communications the careers of Rupert Murdoch and the late Robert Maxwell provide a strong contrast. The huge Bond empire based in Australia fell apart in 1991. Richard Branson capitalised on the success of music publishing and is now an important player in the airline business and is moving into the financial sector. Lord Hanson was one of the most successful take-over specialists in the world and by 1996 had started to dismember his corporate empire. The list of successes and failures is endless, and it is a useful exercise to write down a list of companies from your own experience, and label them success or failure at the moment; then put yourself back five years and see if you could have predicted what has happened to them. It is obviously important to determine whether general principles exist whose application would have prevented the failures, and whether such principles are the underlying reason for the successes. 1.2.3

Three Approaches to Strategic Planning
Since strategy is such a troublesome concept to define it is to be expected that there are several ways of approaching the idea. Strategy can be regarded as a purely planning exercise, or a course of action which emerges over time, or as the outcome of the resources which are available to the company.

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The Planning Approach
This approach is based on the notion that once a set of objectives have been determined, the business environment analysed and forecasts made, a plan can be worked out by senior management which is then passed down for implementation; this plan is then adhered to over the planning time scale. This is usually thought of as the strategic planning approach, and it has been claimed by its supporters that this prescriptive form of strategy is rational and objective; but as Mintzberg6 and many others have pointed out, it makes a number of assumptions about the world which are highly questionable. • The future can be predicted accurately enough to make rational choices. It is in fact a widespread fallacy that the future can be predicted with any realistic degree of accuracy. At the macro level economists disagree quite markedly on the economic prospects for any given country during the course of the next year; such forecasts can never take into account unforeseeable events such as the Asian economic crisis in 1997 or the collapse of the Russian financial system in 1998. At the micro level market innovations and the actions of competitors can have fundamental effects which are also impossible to predict, such as the introduction of direct telephone insurance selling in the UK in the early 1990s. One reason that many market changes are impossible to predict is that that they are dependent on the unique vision of individuals; if such unique vision did not exist there would be virtually no scope for competitive action in the first place. It is possible to detach strategy formulation from everyday management. In arriving at a strategy it is necessary to have a full set of data which can be subjected to analysis and from which conclusions can be drawn. But this assumes that there is some technique whereby the relevant information is extracted from the organisation, and from individual managers, and presented to strategy makers in a tidy bundle. This dodges the question of who is to decide on which information is relevant, and indeed whether the information is readily available. Furthermore, as events unfold information is continually evolving and can go out of date very quickly. As a consequence everyday management is closely tied in with strategy formulation because it is in everyday events that information is generated. It is possible to forego short-term benefit in order to gain long-term advantage. In a situation of uncertainty, and lack of knowledge about the future because of the difficulties of forecasting mentioned above, it may often appear preferable to reap short-term benefits which can be achieved with a high degree of certainty rather than waiting for highly uncertain returns. It can also be extremely difficult to convince those who lose in the short term that the trade-off is worthwhile. Many companies may find it virtually impossible to undertake action which relates to the long term when there are viable short term alternatives. The strategies proposed are capable of being managed in the way proposed. Any strategic initiative which involves change is dependent on company personnel adapting and working in alignment with company objectives. Change management is one of the most problematical areas of strategy implementation, and it can not be taken for granted. Time and again it is found in
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practice that prescriptive actions simply do not take the human dimension adequately into account. The Chief Executive has the knowledge and power to choose among options. He does not need to persuade anyone, nor compromise his decisions. This takes a naive view of leadership and how it is exercised. In reality, very few business leaders can behave like dictators, and certainly not for very long. It is necessary to achieve consensus and agreement at all levels of the organisation, otherwise a prescriptive plan simply cannot be made to work. The fact of selecting one option implies that some individuals will be made better off and some worse off (or perceive that this is the case) than they otherwise would have been. Compromises are inevitable during the implementation process. After careful analysis, strategy decisions can be clearly specified, summarised and presented; they do not need to be altered because circumstances outside the company have changed. This is perhaps one of the greatest and most potent fallacies: it is never possible to avoid ambiguity completely, and it is potentially lethal to ignore changing competitive circumstances. One of the most important reasons for company failure is the lack of a feedback mechanism and the channels of communication that make it possible for decision makers to adapt to changing circumstances. Implementation is a separate and distinctive phase that only comes after a strategy has been agreed. This assumption is possibly a reflection of the fact that the implementation stage of strategy has always received much less attention than the more glamorous and exciting areas of objective setting and strategy choice. In reality nothing ‘just happens’, and an essential part of strategy making is to evaluate the feasibility of different courses of action. It may well be desirable, on financial grounds, to close a factory, but the actual process of achieving this may have widespread and damaging effects on the company as a whole.

During the early 1960s the notion of prescriptive planning was quite popular and many corporations set up corporate strategic planning departments. However, experience has revealed that the attempt to drive corporate strategy in this restrictive fashion is unproductive. A major problem arises when individuals become committed to the strategic plan itself, and not to the success of the company; this can occur when performance measures have been expressed in financial terms and the pursuit of favourable financial reports takes precedence over longer term issues.

Emergent Strategy
This approach starts from a different premise: that people are not totally rational and logical. The extent of this irrationality has been the subject of some research and the general findings accord with common sense. • • Managers can only handle a relatively small number of options. Managers are biased in their interpretation of data – in fact any data set can be interpreted in a number of legitimate ways, and it is not surprising that
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• •

managers often select the interpretation which backs up their previously determined views. Managers are likely to seek a satisfactory solution rather than maximise profits. Organisations consist of coalitions of interest groups. The implementation of decisions depends on negotiation and compromise between those groups, leading to unpredictable outcomes. When making decisions, managers pay as much attention to a company’s culture and politics as to factors such as resource availability and external factors.

According to this approach strategy is not planned before the event but emerges over time in an unpredictable manner and hence may appear to have little structure; it is therefore argued that the claim of a cause and effect relationship between analysis and strategy choice and implementation is fundamentally flawed. There is another very good reason why there is a limited use of information in decision making: the world is actually too complex to be understood by the human brain. Rationality has to be seen in the context of what is possible in the real world, rather than what might be done in an ideal world. The term used to describe rationality when it is impossible to take into account the complexity of real life is ‘bounded rationality’; the decision maker is rational given the information available, but is quite aware that more information could be obtained at a cost. In economics it is argued that broadly speaking decision makers act in accordance with profit maximisation, but it is impossible to reconcile profit maximisation with bounded rationality. This means that a different view of decision making has to be taken and the term ‘satisficing’7 was invented to reflect the fact that decision makers collect information and defer selecting a course of action until the costs of further delay and information collection are considered to be greater than the potential benefits of searching out a better option. Thus rather than simply attempting to maximise profit, the decision maker satisfies himself that there is nothing more to be gained from further delay. This helps to explain why decision makers are so eager to find out what management gurus have said and are continually searching for ways of making sense of the real world. To decision makers any information is better than no information, and it does not matter very much to them that the information they are acting on does not accord with accepted views of what is proper scientific enquiry. Another way of looking at this is to make up a list of things which the company does not know with any certainty when about to launch a new product; for example • • • • •
Strategic Planning

How customers will perceive quality How far it will be possible to meet production cost targets How competitors will react When a substitute will appear on the market The impact on sales of a one year delay in launch
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It is certainly possible to collect some information on such issues, but it will not be complete and is likely to be unreliable. In fact, it turns out that you can not actually get hold of the really important information and it is always necessary to make assumptions and to take many things on trust. However, it can be argued that just because the world is a complex and changing place does not mean that decision makers should simply sit back and let things happen and that there is still a role for the proactive approach. • While there are bound to be adjustments to corporate objectives as time goes on, the company can still be directed along the general lines of a broad mission. The Board need to do more than simply react to changing circumstances. There is a need for efficient resource allocation; if this is not tackled resources might as well be allocated randomly. While compromises need to be made with interest groups within the organisation, this is more of a constraint than a barrier to action. Decisions still have to be taken, and it is nonsense to avoid this simply because people are difficult to manage. In many cases investments take a considerable time to reach fruition, therefore a degree of long term planning is inevitable. Satisficing is in itself a rational basis for choice, since it is better to make an informed judgement on the basis of some information than no information at all, or to ignore information altogether. The act of attempting to plan at least makes the basis for management action clear.

• •

• •

Therefore there is some middle ground between trying to plan for all eventualities and simply reacting to events as they occur.

Resource Based Strategy
This approach lays emphasis on the internal resources available to the company. While it does not overlook the importance of the competitive environment, it starts from the basic premise that strategy is primarily concerned with the search for competitive advantage, and to a large extent the source of competitive advantage rests within the organisation’s resources. The resource based view does not focus so much on the actual labour and capital deployed by the company, but rather on the way in which these resources are utilised. It starts from the premise that a successful company is not a passive collection of resources which reacts to changes in the competitive environment, but is one that develops the ability not only to take advantage of opportunities as they arise, but to create the opportunities themselves by innovative behaviour. Ways in which this might be put into practice include the idea of total quality management, which attempts to orientate all resources in the company to delivering high quality output to customers and establishing a reputation which is a significant competitive asset. Another is the development of distinctive competencies which other companies do not have and cannot imitate and which provide the basis for lasting competitive advantage. None of the resource based
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approaches provides a full prescription for success, and research into their effectiveness is still at a relatively early stage; this being the case, it is not surprising that there is a great deal of controversy surrounding the pay off from the resource based approach. 1.2.4

Rittell’s Tame And Wicked Problems
It should be clear from the preceding discussions that strategic planning, or strategy, is a complicated subject. If you think of strategy as being a problem to solve, say for a particular company, it does not take long to realise that it is incredibly complex; the trouble is that there is a lot of confusion about what the terms ‘difficult’ and ‘complex’ actually mean. At one time, for example, it was thought that the problem of running an economy efficiently was solvable in the sense that a sufficiently powerful computer program could work out all input requirements for feasible outputs and allocate resources accordingly. The planners in the old Soviet economies fell into this trap, and were of the opinion that it if you worked at it long enough it would be possible to plan the economy. But what if the basic premise were totally wrong, i.e. it is not possible even in principle to plan an economy or a company with any degree of precision? The implications of this are quite profound because if the notion that a ‘perfect’ plan is mistaken in principle we move into different conceptual territory. Here is a warning before you tackle the rest of this section. Some students find this argument somewhat academic and feel that it merely defines the difference between ‘scientific’ and ‘non-scientific’ problems. However, this is not the case because the distinction is between different types of problem, whether they are defined as scientific or not. It is usually felt that strategy problems are difficult because they are complex, but the shortcoming of focusing on complexity becomes clear when problems are classified as ‘tame’ or ‘wicked’ in the sense used by Rittel8 . In this scheme, wicked means much more than incredibly complex. For example, consider Fermat’s Last Theorem; in about 1637 the mathematician Fermat noted that he had a proof for the proposition that there were no three numbers which would fit the expression
xn + yn = zn , where n > 2

The trouble was that he claimed not to have sufficient room in the margin to elaborate the proof. The search for the proof occupied many mathematicians for the next three hundred years, and it was not until 1993 that Andrew Wiles, after many years of effort, found the solution using highly refined and abstract mathematical concepts. There is no doubt that Fermat’s Last Theorem is an incredibly complex problem, but consider it in the light of Rittell’s distinction between tame and wicked characterised in Table 1.1. Is Fermat’s Last Theorem a tame or wicked problem? The following classification suggests that it is overwhelmingly a tame problem, despite its great difficulty and complexity. You may disagree with some of the individual classifications, but it is unlikely that more than two categories can be unambiguously classified as wicked.

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Table 1.1
Property 1 2 3 4 5 6 7 8

Tame and Wicked problems
Tame Can be written down Can be formulated independently of solution Either true or false Clear solution Identifiable list of operations can be used Can identify root cause Can be tested over again as in a laboratory May occur often Wicked No definitive formulation Understanding problem is same as solving it Solutions good or bad relative to each other No clear end and no obvious test No exhaustive identifiable list of operations Never sure whether a problem or a symptom Only one try: no room for trial and error Unique

Ability to formulate the problem Relationship between problem and solution Testability Finality Tractability Level of analysis Reproducibility Replicability

Classifying Fermat’s last Theorem as Tame (T) or Wicked (W) 1 2 Fermat’s Last Theorem can be written down unambiguously, and in fact it is quite simple to understand. The fact that it took over 350 years to find a solution is indicative of the fact that the problem can be formulated independently of the solution. There is no such thing as partly solving the Theorem: it is either true or false. While Wiles’ solution is not clear to anyone but a highly sophisticated mathematician, it is clear in the sense that the proof is accepted as the final word. The Theorem was solved using a battery of mathematical tools. It is possible that it could be solved in a different way, just as many mathematical problems have more than one solution. The root cause of the problem is the difficulty of finding a general proof which will fit all cases. No matter how many times an attempt is made to find a solution using arithmetic the general finding will always emerge: no power greater than two can provide a solution. The problem is unique, but the issue arises in many circumstances. T T

3 4

T T

5

T

6 7

T T

8

T

When an attempt is made to classify strategic planning the differences between the two types of problem start to emerge. 1 2 It is difficult to formulate the problem not only because it is complex, but because the same information can be interpreted in many ways. The process of formulating and understanding the problem goes a long way towards solving it. This is partly because there are so many dimensions to strategy issues. The scientific approach cannot be used to test solutions (see later).
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W W

3
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4

5 6

7 8

It is not clear where the problem ends because of real world dynamics. It is impossible even to visualise the time frame over which a proposed solution will prevail. There are many techniques which can be applied, and no agreement on which is most effective in which circumstances. This is characterised by management ‘fads’ which come and go regularly. The cause is usually not clear, and symptoms are often confused with problems; for example, a falling market share may be a symptom of diminishing competitive advantage. Opportunities typically only present themselves once, and it is impossible to go back in time and try again. Each business problem is unique, although it may share common features with other situations.

W

W W

W W

While there is room for discussion on the extent to which each issue can be classified as tame or wicked, there is no doubt that strategic planning emerges overwhelmingly as a wicked problem. Managers may feel that they understand strategy problems better than Fermat’s Last Theorem, and that they could never remotely understand the solution to the Theorem; but in fact it is meaningless to compare the two types of problem because they are intrinsically different. 1.2.5

The Origins of Strategy and Tactics
The roots of the word ‘strategy’ lie in the Greek strategio, meaning a general, stratos meaning an army, and agein meaning to lead. Some dictionaries define strategy as the planning and implementation of military campaigns; its meaning has widened in common use to include activities such as gaming and business, in which planning and the implementation of plans are undertaken. In the expression ‘strategic planning’ the term ‘planning’ is therefore tautologous, since it is already included in the concept of strategy. Despite the tautology, the term has now been accepted in general use, particularly in business schools and in the literature relating to strategic activities in business. Given the origins of strategy, it is not surprising to find that many of the ideas of military strategy have been carried over to business strategy; these include setting objectives, identifying strengths and weaknesses, organising resources accordingly and evaluating outcomes. Tactics is a notion which is closely related to strategy. Again, the meaning can be clarified by the Greek roots: taktikos meaning fit for arranging, and taktos meaning ordered. The military definition relates to the science or art of manoeuvring in the presence of the enemy. Thus, in the military context, strategy is deciding what is to be done, and tactics is deciding how individual objectives are to be achieved. The attempt to transplant these military ideas into business has led to some degree of confusion. The basic reason for this is that running a business is not truly analogous to fighting a war, although there are many similarities in a competitive environment. Figure 1.1 is by no means definitive, but it gives an impression of the difference between military and business strategy.

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Armed forces Military Resources Enemy

Competitors Business Market Customers

Figure 1.1

Business and military strategy

The primary objective in military strategy is to defeat the enemy, and this is done by direct attack on the enemy’s forces and/or by destroying the enemy’s resources. However, in business the objective is to get people to buy the company’s products and make a profit in so doing. The company does not attack competitors directly in the sense of killing their sales forces and burning their factories. The path to success lies in activities such as capturing market share and controlling costs. This may lead to the weakening of competitors, but their destruction is not a precondition of success; competition never really goes away, and the manager who thinks that the removal of a major competitor will permit profits to be made without interference does not really understand the market place. There is always the possibility of new competitors appearing. Because the military analogy does not fit exactly with the business environment, rather than attempting to adjust military definitions to business, we can visualise business strategy as a set of decision rules which guide the company’s resource allocation process, taking into account both the short and the long run, with the emphasis on allocating resources in uncertain conditions to achieve future objectives. The company which uses a form of strategic planning does not simply react to events in the present, but considers what should be done now in order to achieve future objectives. In practice the difference between strategy and tactics is not clear cut in the business context, and the term strategy tends to be used in relation to any action with long term implications. Decision makers usually tend to think in terms of formulating strategies to achieve objectives decided at the level above them. Thus in business strategic planning is a combination of strategic and tactical decisions, and it is probably pointless to attempt to distinguish between them. Given the imprecision of the terminology, and the activity itself, it is not surprising to find that various terms are used to describe the process: they include strategic management, business strategy, business policy, corporate planning and long range planning.

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1.2.6

Strategy and the Scientific Approach
The social sciences are concerned with analysing and explaining human behaviour in the areas of economics, behavioural relationships, social interaction, and so on. The business disciplines are largely concerned with applying the methods of the social sciences to the running of companies. For example, the idea of economies of scale originates from economic theories relating to the combination of the factors of production, and has been subjected to a great deal of empirical testing. It is well known that economies of scale can lead to lower average costs, possibly up to some point beyond which costs no longer fall; however, the theory underlying economies of scale is quite subtle and does not lead to the expectation that decreasing average cost with size will actually be observed even in those industries where economies of scale exist. This is because of the concepts of short run and long run adjustment to different levels of output; economies of scale will only be observed where firms have made ‘long run’ adjustments to their factor inputs. As a result, it is necessary to take a sample of firms in order to carry out statistical analysis because, for any given size of firm, there is likely to be a range of unit cost; the statistical analysis takes account of the random variations from the underlying relationship between size and unit cost. Those who have been trained in science will recognise elements of what is known as the scientific method in the description of how economies of scale might be estimated: a theory is developed based on ideas relating to costs, a hypothesis is derived from the theory (i.e. something which can be tested), data are collected, subjected to appropriate analysis, and the hypothesis is accepted or rejected. This rigorous approach appeals to the ordered mind, and is usually used as a benchmark as to whether a subject ought to be deemed scientific. Disciplines are often (explicitly or implicitly) ranked according to where they lie on the scientific spectrum on the basis of whether the scientific method is applied. Physics lies at the top end of the scientific spectrum and the social sciences lie near the bottom and above the arts; among the social sciences economics is typically regarded as the most scientific. But it is important to be aware that philosophers of science do not agree on what the scientific method actually is. It is not necessary to go into the subject in detail, but a brief outline of the main strands of thought gives an impression of how scientific thinking itself has developed. The best known view, advanced by the philosopher Karl Popper, is that hypotheses or theories can only ever be falsified; it is impossible to verify a theory because the possibility that it might be falsified always exists. The trouble is that, by the same token, it is not possible to falsify a theory either, because the reverse is also true. In other words, it is never possible to arrive at a definite answer on the basis of the evidence available. A wider view, associated with Kalakos, is that it is not the testing of individual theories that is important, but the overall research programme; individual projects only have relevance in the context of the programme and there is no such thing as falsification. Finally, a contrary view expressed by Feyerabend is that the scientific method is unduly constrictive, and the major discoveries have not been made as a result of following it. In fact, this view holds that discoveries are much more the

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result of lateral thinking and chance events, and that subsequently they are made respectable by framing the discoveries in the scientific manner. Thomas Kuhn pointed out that the prevailing mode of thought, or scientific paradigm, determines what is thought of as science, and the paradigm itself is subject to change over time. The scientific paradigm that the earth is flat and is orbited by the sun was only overturned after a great deal of controversy; similarly, the scientific approach outlined above is just a paradigm of thought, and is not even rigorously applied in physics, a discipline in which there is a great deal of speculative thinking. It is intuitively attractive to apply the scientific method to strategy making and, by following the approach used to estimate economies of scale, identify criteria for effectiveness which can be applied in a variety of circumstances. But when attempting to apply the scientific method to the question of what course of action is likely to lead to success for a company, we are faced with several intractable problems. • As indicated above, there are different views on what strategic planning actually is; for example, many studies have attempted to measure the impact of planning systems on company performance, but planning systems and strategic planning are not necessarily closely related. The types of company, the environments in which they operate, and the problems facing them, are so different that it is difficult to do more than draw general similarities among companies and situations. In other words, the range of variables which would have to be controlled for is enormous. There may be significant interactions among variables; for example, economies of scale may only occur in certain circumstances, and the use of company size on its own as an indicator of potential economies of scale may be misleading. Another way of expressing this is that the company as a whole is more than the sum of its individual parts, and undue emphasis on disaggregating the functions and characteristics of a company can obscure the overall picture. Companies and their markets change with the passage of time, and combined with the inevitable lags between actions and outcomes, it becomes impossible to disentangle cause and effect. In other words, it cannot be inferred with certainty that a company succeeded either because it made the right decisions or because circumstances turned out to be favourable in relation to what it did. It is easy to fall into the trap of post hoc, ergo propter hoc, i.e. the fallacious reasoning of being after this, therefore being because of this.

So there are two levels of problem in trying to find out anything about the real world. First, the scientific method cannot provide definite answers; at best it is a rigorous approach which identifies the necessary steps in an investigation. Second, the data available in real life do not make it possible to test hypotheses about strategy. The problem of dealing with large numbers of interacting variables subject to lags is not unique to the analysis of strategic planning; research into education is another example where student, teacher and social characteristics are
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notoriously difficult to measure, and interaction effects between teachers and students are likely to be important. Researchers have to make a choice between two approaches to educational studies: concentrate on relatively few institutions in depth, or carry out a large scale survey on many institutions. The large scale study cannot take into account as many variables as the in-depth study, and may omit many potentially important variables; furthermore, those variables included in the study may not be the most important but merely those most susceptible to measurement. However, the results obtained in the large scale study are likely to be of general applicability; while the small scale study can take into account many more variables the results cannot be generalised because they may be particular to the cases studied. There are therefore costs and benefits associated with both large scale and in-depth methodologies. Research into strategy is dominated by the in-depth approach, which means that any prescription for ‘best practice’ strategy can only be corroborated by reference to relatively few cases. A feature of the strategy literature is that it is heavily spiced with anecdotes, and evidence in favour of hypotheses comes in the form of what is sometimes known as casual empiricism. But if there is no scientific proof in favour of different courses of action, how is it that experts in strategy command very high fees for telling companies what they should be doing? To some extent there is a degree of fashion in strategy advice. There is no doubt that experts have offered different prescriptions for strategy approaches: that consistency of delivery is the key issue; that striving for higher quality is a major success factor in its own right; that diversification is an essential aspect of company growth; that company success depends on the identification and exploitation of core competencies; that internationalisation is the engine of growth; that a strong home base is a prerequisite for international success. The scientifically trained may find it puzzling that so much credibility is attached to prescriptions which have no empirical foundation. On the other hand, managers point out that they have to operate in an environment in which the scientific approach cannot be applied, that the anecdotal approach is better than nothing, and it is necessary to use what we do know in order to introduce rationality into decision making. The question of whether a company strategy will work in practice is as uncertain as an economic strategy for a country as a whole. In 1990 the UK adopted the strategy of entering the European Exchange Rate Mechanism (ERM) with the objective of curing both inflation and a chronic imbalance of trade; despite the enthusiasm for this move in many quarters, by early 1991 it was obvious that membership of the ERM was not an immediate cure for the underlying problems of relatively low productivity and overheated labour markets. This led to a loss of confidence in the UK economy on the part of international speculators, and in September 1992 the UK had no option but to leave the ERM and the currency immediately depreciated by about 15% against the German mark. Some prominent economists gloated that they had predicted this outcome from the beginning; others were dumbfounded. The point to ponder is that if this strategy, which was subject to so much informed analysis, could end in utter disaster, then the same fate can well lie in store for company strategies. One of the best known attempts to identify the company characteristics which
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lead to strategic success is contained in the book In Search of Excellence.9 Their quest for the characteristics of excellent companies was based on a non-random sample of 43 US companies which fulfilled stringent market conditions for success; these included three measures of growth and long term wealth creation over a 20 year period, three measures of return on capital and sales, and the view of industry experts on the company’s innovative track record. With the resources at their disposal it was possible to interview 21 of the companies in depth, and conduct less intensive studies on the remainder. The research identified eight attributes which characterised the excellent, innovative companies as defined. Without going into the details of these attributes, the authors acknowledge that ‘Most of these eight attributes are not startling.’ They also acknowledge that the eight attributes were not present to the same degree in all of the companies studied; however, the authors claimed that there was a preponderance of the eight in each company, and that the general traits of the companies were obvious. This is something which we have to take on trust. The point here is not to criticise the research, but to use it as an example of how difficult it is to find out anything from the experience of actual companies. The authors also acknowledge that they cannot guarantee that the companies will remain in the excellent category, but they do maintain that these companies will cope with adversity better than companies which do not have their attributes. This brings us to the logical problem in interpreting the research findings: the companies were defined as being excellent on the basis of being good market performers and having a good innovative track record; another way of looking at this conclusion is to say that successful companies stand a better chance of being successful in the future, and the attributes identified in the research may have little to do with future success. It does seem rather odd that all of the excellent companies exhibited the identified attributes; there is clearly a danger here of having identified companies as being excellent on the basis of the attributes in the first place, because that was what the researchers were looking for. Because business conditions are continually changing, it is difficult to falsify or verify the authors’ claim of continuing success; there is no doubt that the 43 companies listed on pages 20–21 of their book have gone in different directions: Wang Laboratories failed as did Digital Equipment, and General Motors’ market share in the US dropped from 55 per cent to 33 per cent, the company losing $4 billion in 1991; on the other hand companies such as Disney Productions have continued to be highly successful. But this is not the whole story, since Disney found it extremely difficult to transplant its successful US operations into France – the troubled history of Euro Disney is discussed in Practice Final Examination 2. An important issue is whether they have performed, and will continue to perform, as a group better than companies which did not exhibit the excellent attributes; this would be the subject of another research project. On balance it seems that the research did not identify all the attributes of successful companies, nor can we be confident that those which it did identify were relatively important. For example, it may be that the history of these companies since 1982 can be explained by changes in competitive conditions, and the degree of competitive edge conferred on them by the identified attributes had only a minor impact on their performance.
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An attempt to determine whether strategy making processes rather than other company characteristics make a difference to company performance was carried out by Hall and Banbury.10 This was a large scale study which obtained responses from over 300 companies, and it is interesting for the light which it sheds on the problems of carrying out research in the area rather than in the statistical findings themselves (which are hedged with qualifications because of the limitations of the study). The objective of the study was to concentrate on whether a strategy process was followed rather than what it was; for example, the split between the rational and the incremental approaches was considered too simple to be useful. What the authors considered important was the accumulation of strategy skills over time, or the development of a strategy making process capability; this is clearly a subjective variable and is open to interpretation based on the information provided by the respondents. They pointed out that the one variable which cannot be used as a performance measure is current profitability, because of lagged effects; this means it is necessary to use measures such as new product development, innovation, social responsiveness and growth, all of which are also subject to subjectivity and may be irrelevant in certain cases. By and large, it was found that strategic process capability counts: that the more firms in the study were able to develop competence in multiple modes of strategy making processes then the higher their performance. But the authors make a telling point which makes it impossible to draw specific lessons from the study: the direction of causation may be the other way round, and it may be that successful firms adopt processes which accord with the definitions of strategic process capability. This is a particular problem when looking at a cross section of companies at one time, where it is not possible to pursue the dynamics of strategy making and performance. So even a well specified and conducted study which produces statistically significant findings may contain little more than a description of the way the world is. 1.2.7

Strategic Planning and Strategic Thinking
So far we have seen that strategic planning is a complex activity, that it has many definitions, that there are at least three different approaches to strategy, that strategy has the characteristics of a wicked problem, and that the scientific method cannot easily be applied to strategy. By this time you might well feel that we have not been able to pin down exactly what strategic planning is, but all is not lost. We can in fact arrive at a useful definition of what strategic thinking is about. It emerges from the discussion in 1.2.2 that functional specialists tend to regard business issues from their own perspective. Take the case of a new product launch. To the organisational behaviour manager a new product launch means internal change and its management; to the marketer it means market research and consumer behaviour; the economist is concerned with whether it is the right time to be investing in expansion; to the accountant it means break even analysis; to the financer it means discounted cash flow and the rate of return; to the quantifier it means understanding market research surveys and interpreting often conflicting numerical arguments. Therefore to visualise the

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implications of a new product launch for a company it is necessary to synthesise the business disciplines. To complicate matters the fact that business problems are wicked means that they tend to be loosely defined and it is not always clear what the problem is and it is never quite clear whether a satisfactory solution has been arrived at. A company may embark on change for a variety of reasons; at one level it may be because it seems like a good idea to launch a new product, while at another level the company is at a stage when it needs to diversify its portfolio because its existing products are nearing the end of their product life cycles. Furthermore, the competitive environment is dynamic and constantly changing, with the result that yesterday’s answers may be overtaken by today’s competitor reactions. This means that it is necessary to bring very high-level evaluation skills to bear in selecting among competing courses of action. So at this stage we have identified two skills which are fundamental to strategic thinking: synthesis and evaluation. These two skills can be plotted as in Figure 1.2.

High Identify relevant models

Strategic Thinking

Synthesis

Core MBA subjects: Organisational Behaviour Quantitative Methods Economics Marketing Finance Accounting Use prescribed models

Low Evaluation

High

Figure 1.2

Strategic thinking

Subject specialists are able to synthesise and evaluate in the bottom left hand corner within the context of their own disciplines. The trouble is that a strategic problem cannot be resolved by the application of only one business discipline. The strategist’s job is to bring these together (moving up the vertical axis) and identify the relevant models to apply to a particular issue. That is why it is
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necessary to have a sound knowledge of the core business disciplines before undertaking the study of strategic planning. The strategist then has to weigh up the pros and cons of potential courses of action and arrive at a reasoned conclusion (moving along the horizontal axis) Thus the strategist has to think more widely and deeply than the individual functional specialists. This is an extremely difficult game to play and it goes without saying that unless you practice you will never get into the top right hand box. This course provides the structure within which the disciplines can be synthesised and evaluation skills developed.

1.3

The Process of Strategy and Decision Making
Strategy decisions are by their nature complex, and involve many imponderables. The selection of a course of action depends on the availability and interpretation of information, analysis, intuition, emotion, political awareness and many other factors. Different individuals and groups emphasise different aspects and, in the sense that a strategy decision is an advance into the unknown, there is no correct course of action; all that can be done is to interpret the current situation, form expectations about the future, and act according to personal views on risk and the likely course of events. It is usually possible to identify courses of action which are unlikely to be successful, and in that sense the strategy process can have real benefits in helping to avoid disastrous courses of action. It must be stressed at the outset that it is naive to suggest that strategy decision making can be expressed in a mechanistic fashion, where the optimum course of action is identified solely on the basis of an analytical investigation. However, it would be defeatist to conclude that strategic planning is not susceptible to structured analysis; many complex areas of human endeavour can be systematised with a view to providing managers with insights into events.

1.3.1

Strategy Dynamics
It is important to stress from the outset that strategy problems cannot be analysed and resolved and then more or less forgotten about. In real life the day never comes when strategy decisions are made and all problems are solved. This is because the environment within which the company competes is constantly changing: products move through the life cycle; new companies enter the market; consumer preferences change; government regulations change; major political events alter markets both domestically and internationally. Thus the functional view of management, i.e. the view that there is a set number of objectives to be tackled by individual managers which, taken together, determine the effectiveness of the company, is a limited interpretation of the strategy problems which companies face. Strategy can only be properly understood in a dynamic rather than a static setting. It is only relatively recently that scientists have discovered the peculiar properties of complex interdependent non-linear dynamical systems. The best known examples are in weather forecasting, where the models are so complex that changes in the inputs have unpredictable effects; in fact, the patterns over time

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produced by such systems are highly sensitive to initial conditions. It was discovered that a great deal of what was thought to be random was in fact deterministic but chaotic, in the sense that it could be described mathematically but exhibited what appeared to be random behaviour. This led to renewed interest in modelling the behaviour of the stock market, the behaviour of which has always defeated attempts at prediction. Needless to say, this has not been at all successful (or if it has been no one is saying). A company can be regarded as a complex dynamical system interacting with its environment; this can be modelled in such a way that relatively small changes in the environment will at times cause significant changes in company performance. If the performance of companies is chaotic it is impossible to model them or to predict their behaviour; the firm itself can be regarded as a complex adaptive system which attempts to develop rules which will enable it to function in the complex environment. At first, this might seem to be a bit theoretical, but it is as well to bear in mind the possibility that the business system itself is possibly not capable of being explained or predicted because of dynamical effects. To illustrate the importance of a dynamic approach to strategy, consider one of the numerous examples of how companies have been ‘turned round’ by the application of strategy ideas. Without going into details, by the early 1980s the Bank of Ireland was losing market share and was hampered in its ability to adapt to changing market conditions by the management structure and internal relations of a traditional bank. A number of strategic changes were made: the Bank was reorientated as a retailer of financial services, and many internal changes were made, for example communications were improved as part of the change process. As a result the Bank of Ireland regained its market position, increased its product portfolio, and prepared itself to operate on the forefront of changes in the banking market during the 1990s. But this did not mean that the senior executives of the Bank could regard their strategy job as completed. Factors such as the development of the free trade area in Europe, the increasing strength of international financial entities, the changing pattern of personal expenditure, rapid technological advances in payment methods, and the reaction of competitors still have to be monitored. Therefore, while it is possible to pin-point specific strategy successes in a particular company, it is necessary to ensure that these are not simply temporary, and that when the next major change occurs the company does not lose its competitive advantage again. Another example is British Airways, which in the early 1980s was an inefficient state owned airline with a poor record on service and profitability. After British Airways was privatised, the dynamic Lord King was largely credited with turning the company into ‘the world’s favourite airline’, and by the mid 1990s it was recognised as one of the most effective airlines in the world. Both profits and passengers carried increased steadily during the 1990s. But in 1996 the company announced the need for further rationalisation and the prospect of several thousand job losses; subsequently it changed focus towards attracting high fare paying business passengers at the expense of the low fare high volume holiday market. A complicating factor is that the only real assets that British Airways (or any other airline, for that matter) needs is the route structure and brand. Everything else can be purchased or contracted in. This set British Airways on line to be the world’s first ‘virtual airline’. In the face of its earlier success why
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was such a radical restructure required? Looking ahead, the company could see that as regulation was relaxed and competition from low price carriers increased the current cost structure of British Airways would plunge it into the red. In other words, it no longer had a sustainable competitive advantage. To pursue the dynamic dimension of strategy further, the following example examines the process by which a mythical company arrives at a strategy decision. It is not derived from a specific ‘real life’ company example because it is designed to bring out many facets of strategy without relating it to a specific case; it is partly based on discussions monitored in management groups when running simulations of companies. The CEO of this mythical company is cast in the role of strategic planner, and every day he comes into work he asks himself questions like the following: • • • 1.3.2 How well are we performing? What should we be doing in the future? How can we achieve successful change?

The Mythical Company
The company is engaged in the production of electrical components for both consumers and companies. It has been in existence for five years, and currently produces three products which are related to each other both in their productive and market characteristics (Plugs, Switches and Fuses). Current sales amount to about $35 million per annum, and the company employs about 300 people. Of these, 250 are employed in manufacturing, and the remaining 50 in research, development, administration and marketing. The company is organised into three product divisions. From now on we follow the CEO as he pursues his role in strategic management by tackling his three questions.

1.3.3

How Well Are We Performing?
CEO’S STATEMENT TO THE BOARD The company has been making a profit for the past three years, but there are signs of increasing competitive pressures in existing markets; the research department has some products under development which at this stage seem to have the potential to generate profits, but might entail some change of direction. The first step is to get reports on current activities from each functional area in the company; these reports should be expressed in nonnumerical terms because we are concerned with the overall view at this stage rather than the precise details. ACCOUNTING REPORT The company is currently making 14 per cent return on assets. But the Plug, which was launched last year, is currently making a negative contribution to overall performance, and profitability would be increased by abandoning it. While our overall operating surpluses generate a good return on assets, our

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cash flow position is not good because of current expenditure on research and development. Are we convinced that there is a long term payoff from continued expenditure on research and development at the current level? RESEARCH AND DEVELOPMENT REPORT We currently have four products under development which will be ready for launch in the next year. These will complement our existing product lines, and one of them represents a major technological breakthrough. Furthermore, we have a highly productive team engaged in the search for new ideas, and we are confident that we shall continue to produce a stream of potentially profitable prototypes in the future; these are, after all, the life blood of our company, since without new products we shall not last very long. The company should not adopt a short-sighted and restrictive approach to our budget. MARKETING REPORT We are in a highly competitive market, and the product life cycles are quite short, and may become shorter in the future. At the moment we have two cash generating products in the Switch and the Fuse, and a potentially profitable product in the form of the Plug. At the moment the Switch and the Fuse are subsidising the Plug, but the prospects for the Plug are very good in the longer term; we cannot make decisions on abandoning the Plug on the basis of its historical contribution. It is essential that we not only keep the Plug on the market, but that we continue to search for new products. We need to increase our product portfolio if we are to accommodate the combination of life cycle effects and increased competition. However, we should be wary of diversifying into areas where we have no experience of selling, and where production skills may be different. While market shares are reasonably secure for the Switch and the Fuse, our technological advantage in both has been undermined by imitators from abroad; it looks as though we can expect the selling price of both to fall by about 20 per cent over the next couple of years as competition increases. FINANCE REPORT The marketing department has provided projections of demand for the four products which are in the development stage, and the accounting department has provided details of likely cost. A detailed financial appraisal suggests that only two of the four projects currently being developed seem capable of generating an adequate rate of return. Development of the two poorest products should be abandoned, and we should devote more resources to basic research, i.e. to identifying new market opportunities. The marketing department have pointed out the problems of moving into new markets; however, there may be some advantage to diversifying our portfolio of risks. ECONOMIC REPORT The economy has been in a depression for the last couple of years, but the government’s more liberal monetary policy seems likely to cause a substantial stimulus to economic activity. In fact, if the economy had been
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in better shape we would have been more profitable than we have been. We should be looking forward to buoyant demand in most sectors during the next year. However, the international sector has become increasingly uncertain. The government has recently announced that monetary policy will be relaxed, and this is likely to be associated with a reduction in interest rates, which may cause the currency to depreciate; this would be to our advantage in export markets. However, there is a move towards protectionism which could have serious consequences for our sales in some countries. PRODUCTION REPORT We have not coordinated production and orders very well, and we have built up substantial inventories of Switches and Plugs, while we have backlog orders for Fuses. We should be diverting resources to the production of Fuses at the expense of Switches and Plugs. However, if we switch manpower about we may adversely affect productivity. It may be more cost effective to sacrifice sales of the Fuse because of the increase in unit cost which would result from reducing, even temporarily, output of the Switch and Plug. Furthermore, I have some reservations about the accounting department’s conclusion that the Plug is a liability; we have been producing a substantial proportion of output for inventory; the problem is not that we are incurring high production costs, but that we are not actually selling what we are making. We currently have a poor system for communicating production requirements. MANPOWER REPORT We have now developed a skilled and motivated labour force, and this is reflected in the fact that unit labour costs are now ten per cent lower than they were three years ago. We have been able to provide stable employment for the labour force and a general feeling of confidence in job security with the result that the attrition rate is minimal. CEO’S SUMMARY We now have information on which to base an analysis of our strengths and weaknesses. Our strength is that we have carved out profitable markets for two products, and there are some signs that our third will make a contribution to profits in the future. We have a company which has a structure and workforce which provides us with a potential cost advantage; we also have a productive research department. We have some internal weaknesses, such as the fact that we are not always coordinating production and sales, with consequent inventories and backlogs. Our main weakness is external; there are ominous signs that competition is increasing in our established markets and if we wish to grow it may have to be in a different direction. We may not be equipped to do this.

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1.3.4

What Should We Be Doing in the Future?
CEO’S STATEMENT There are three broad strategies which we could follow. First, we could carry on doing the same things as in the past, and accept that our markets are likely to come under increasing competitive pressure. We can rely on the invention of new products to carry us into new markets as the old ones disappear. Second, we could attack our existing markets more aggressively, attempt to maintain or increase market share, and accept that this will lead to short term reductions in profitability. However, over the longer period this has the potential to pay off. Third, we could combine the second option with expansion into new markets to diversify our activities. I have had some informal discussions with Easy Turbines, who would welcome a friendly take-over because of their cash flow problems. This would give us a relatively painless entry into the turbine market, but carries the risk that we do not know much about making turbines or the turbine market. However, this will provide us with a basis from which to grow in the longer term. We now require a report from each functional area on potential future courses of action. RESEARCH AND DEVELOPMENT REPORT Given the four products we are currently developing, and the number of ideas which we have for prototypes, we see the possibility for significant diversified expansion in the medium term. All we need is an additional $5 million over the next year to speed up the launch of our development projects. FINANCE REPORT Our colleagues in research are being a bit optimistic, because only two of the products they are working on seem capable of generating a positive NPV at the current cost of capital, even on the most optimistic marketing estimates. Furthermore, we have not been explicit enough in the past in relation to the measurement of risk, and our attitude to risk taking. The risk adjusted rates of return suggest that we should stay in the markets we have already developed, and only venture into new ones as a last resort. However, the fact that Easy Turbines has cash flow problems at the moment means that we might be able to acquire it at a bargain basement price. ECONOMIC REPORT The prospects for the economy are good, and profitability will increase next year even if we do not change our current marketing strategy. However, it is likely to be difficult to increase market shares because the price elasticity of demand for our products is quite low. The new products should be highly successful on launch, because they are mainly aimed at export markets and there are signs that the currency is going to depreciate significantly in the next few months. Longer term prospects will be partly dependent on diplomatic solutions to increased protectionism.

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MARKETING REPORT There is a limit to how long we can stay in our established markets. Our cash cows could come under competitive attack at any time. We need to diversify to stay alive in the long run, and the four products which the research department have on the stocks would fit the bill perfectly. Some of them may not seem financially attractive, but the financial analysis takes a very narrow approach to the benefits of developing a new range of products. I am not sure about the proposal to enter the turbine market through acquisition because at this stage I do not know much about that market. I would like to know if Easy Turbines’s cash flow problems have been due to sales problems. ACCOUNTING REPORT If we try to follow a strategy of diversification we shall quickly run out of cash, because the payback period of the new products on the stocks is quite long, even assuming that the marketing department is not being overly optimistic in relation to expected sales. Furthermore, the measures of return on investment and capital employed will be adversely affected, and this is likely to affect our share price, perhaps making us susceptible to take-over, never mind us taking over Easy Turbines. I think the idea of taking over another company is far too speculative and is not a realistic option. OPERATIONS REPORT At the moment we have spare factory capacity, and there is no problem in recruiting more labour, given the current state of employment in the local area. However, if we do embark on expansion into new products we shall have to undertake a major training programme. MANPOWER REPORT Any attempt to diversify must take into account that an infusion of labour, and a change in what people are doing, may have substantial implications for morale. The attempt to exploit new markets will require a change in what people do, and we shall have to ensure that we have the backing of the complete workforce to achieve success. There is little doubt that we shall be faced with many problems in implementing a growth and diversification strategy, and we may be faced with much higher attrition rates and lower productivity growth than in the past. In this situation there is a real productivity payoff from better communications, incentives geared to performance, and the development of a company culture. CEO’S SUMMARY The immediate threat facing us is that we are in danger of isolating ourselves in declining markets where competition is becoming increasingly fierce. The potential threat facing us is that if we decide on expansion we are moving into unknown markets which have a high degree of risk; this move may make us open to take-over. While we could pre-empt this by taking over Easy Turbines, I do not think the idea of diversifying through take-over is appropriate at this stage: as far as I know, the chances of such a venture being successful in the long run are not high – in any case it would take
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a long time to set up the financial infrastructure necessary even to think about making a hostile bid for a company. However, there are clearly many opportunities. We have the resources to exploit our existing markets, and we have products which can be used to broaden our portfolio. The price of the company’s shares on the stock market has been reasonably stable for some time. However, the Board feels that our shares are undervalued, and that the market has not taken into account the recent relatively large expenditures on research and development. One of the Board members recently received this confidential report on us from his stockbroker. MARKET ANALYST’S REPORT This company displayed strong growth for the first three years of its existence. Since then it has tended to rest on its laurels, despite the fact that it is in a highly competitive and changing market. Recent expenditures on research and development have tended to depress profitability, and to some extent this has been reflected in the share price. But there is no guarantee as yet that the company management has the vision to maintain its current market position, or to diversify into related markets which will lead to continued growth. It is therefore time that we shed the image of conservatism and proved to the market that we have the ability to grow and generate profits in the long run. There are clearly different views on what course the company should pursue. For example, the finance department is opposed to expansion because of reservations about the new products, but do think that an acquisition might be the way forward. The marketing department is in favour of expansion because of optimism concerning future prospects for a diversified company, and the economics department is in favour of expansion but has reservations about the marketing strategy. The CEO’s job is then to arrive at a decision which will be supported by the functional managers, since without them nothing can be made to work; he must acknowledge the fact that while each of the functional managers is able to offer a reasoned exposition of how things are and what the company should do, each is preoccupied with his own viewpoint. You will notice that each functional manager tends to talk his own ‘language’. If the CEO is not educated in management he might find some of the discussion baffling; for example, the marketing manager referred to product life cycles, the accountant to return on assets, the finance manager to a positive NPV, the economist to monetary policy and so on. In the course of a discussion like this each manager cannot keep asking the others to define terms. So in order to develop a strategy from the range of views it is essential that the full implications of what might appear to be innocuous statements are appreciated by everyone concerned, and in particular by the CEO who is charged with the responsibility of deciding what to do next. The process by which the decision is arrived at would be a story in its own right, but suffice it to say that the management team is persuaded by the CEO’s vision of shedding the company’s conservative image, and agrees to pursue an expansionary, diversified strategy but without attempting to acquire Easy Turbines.
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1.3.5

How Can We Achieve Successful Change?
The CEO set the functional managers to work to prepare a programme for change. Based on their understanding of what needs to be achieved in their individual areas the team arrives at a five point plan. 1 2 3 4 5 Attempt to attain a higher degree of competitive advantage in existing products and step up research and development efforts. Improve resource planning by introducing ‘just in time’ techniques and co-ordinating more closely with marketing. Improve market intelligence and improve economic analysis. Introduce more rigorous control systems to monitor company performance. Communicate company goals to everyone; develop a company culture so that individuals can identify with the company’s objectives.

The exact details of how the new company objective is attained will depend on how events unfold. 1.3.6

Strategy and Crises
Why do managers find it so difficult to get together to devise and implement company strategy? Part of the answer is that there are many pressing problems which must be dealt with on a day to day basis which divert attention from strategy, and which do not apparently bear on the immediate problems facing managers. Imagine that the outcome of the strategy discussions is circulated on Wednesday. By Friday the following incidents have occurred. CASH FLOW A major customer has run into problems and will not be able to settle current accounts for six months. This means that cash flow for the next six months will be negative. MEMO from Accounting Department to CEO. In view of the additional cash flow strains which the proposed strategy changes will involve, the strategy changes should be shelved. JAPANESE INVASION In a surprise announcement, the Japanese have revealed the development of an electrical device which will reduce market share of the Fuse by about 5 per cent, unless a strong marketing offensive is launched. MEMO from Marketing Department to CEO. All marketing resources will have to be diverted to meet the Japanese challenge for the next few months; the strategy changes should be shelved. HEAD-HUNTED The finance director has been head-hunted MEMO from Finance Department to CEO. In view of the many complex financial issues which will be raised by the proposed strategy, we must have a finance director of experience and vision; until we can recruit a replacement the strategy changes should be shelved.

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DEVELOPMENT COST OVERRUNS Some unexpected problems have been encountered and the development department will not be able to bring the new products to the market within the original projected budget. MEMO from Development Department to CEO. We need to re-evaluate our options but, given the turmoil in the Finance Department, this will not be possible for some time; the strategy changes should be shelved. LABOUR RELATIONS The first attempt at communicating the new strategy was disastrous. After a preliminary discussion labour representatives interpreted the proposed changes as an attempt to increase productivity at the expense of a deterioration in working conditions; the notion of a new incentive system was criticised severely. MEMO from Personnel Department to CEO. It looks like it will take more time than we thought to sell the proposed strategy to the workforce; the strategy changes should be shelved until such time as we can achieve progress on this front. No doubt more issues will crop up the following Monday, and will continue to emerge. The salient point is that even though the individual managers have agreed with the overall interpretation of the current state of the company and what it should be doing in the future, their own immediate concerns naturally appear to be more urgent than the implementation of a course of action which has no obvious short term payoff. The CEO now has several options. • • He can agree with his managers, and shelve the changes until times are more favourable; he will be aware that this is likely to be a fond hope. He can attempt to amend the proposed changes to take account of what has happened; in this case he will find himself attempting to hit a target which never stops moving. He can point out that the strategy is based on an agreed vision of the company as it exists and the necessity to adjust to the changing market place; the crises are evidence that the company does need a strong sense of direction so that management is not merely a series of reactions to everyday events. The job of the managers is to achieve the general objectives given that these crises are always going to occur.

But there is another way of looking at the problems which have arisen and the individual managers’ reaction to them. The CEO decided on a course of action and set his managers the task of determining what should be done. But it seems that no one was given the job of determining how the five point plan would actually be implemented. Thus the CEO’s approach was strong on identifying objectives and courses of action, but weak on implementation; as a result the overall plan was vulnerable to the types of crisis which occurred. It must be accepted that no plan can be inflexible, and that it should be modified as additional information becomes available; the crisis events can be regarded as new information to take into account in refining the overall strategy.
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For example, the Japanese invasion is indicative of the fact that competitive pressures are changing more quickly than anticipated, and that some resources should be diverted to protecting the Fuse; where these resources should come from is a problem for the management team. 1.3.7

Elements of Strategic Planning
Apart from recognising that some degree of forward thinking is important, is it possible to extract any lessons of general applicability from what happened? The CEO asked specialist managers various questions, and they generated a lot of information and opinions, and finally a course of action was decided on. In fact there are five aspects of what happened which are important to recognise. First, individual managers used a structure of thought to tackle problems within their area. Second, managers applied this structure to the analysis of data. Third, the CEO integrated the different types of analysis presented by the managers in order to arrive at a decision. Fourth, a system of evaluation was devised to monitor the allocation of resources. Finally, the door was left open to modify the strategy as events unfolded. These components of strategic planning are worth considering in some detail.

Structure
The first thing the CEO did was to ask his functional managers to provide information on the current state of the company. He expected to get different information from each because the functional managers bring different types of expertise to the issue. For example, the finance manager used the theory of finance to evaluate alternatives; the marketing manager used the theory of competitive advantage to work out marketing strategies; the economist used macroeconomic theories to explain and predict the impact of government policies on product markets; the manpower manager used theories of group behaviour and motivation in drawing up work schemes. These theories provide functional managers with a structure within which to tackle problems. This structure is comprised of a body of theory which introduces order into the complexities of the real world; without a structure the answers which any of the functional managers produced could have been based on completely irrelevant factors, and this would not have been apparent. That is why it was noted earlier that each manager appeared to be speaking a particular language. In order to make sense out of the complexity of life it is necessary to impose an intellectual structure on events and processes. A theoretical structure makes it possible to tackle new problems in a systematic manner; the lack of general principles which can be applied to seemingly different issues leads to inconsistency, and to an impartial observer decisions may appear to be taken at random. When there is no structure, managers will not appreciate that apparently different situations share common themes and are susceptible to similar types of analysis and solution. It is something of a paradox that while most companies would like to have a system for allocating resources in the long run, i.e. a means of seeing how things fit together, which potential opportunities should be pursued, and how resources should be mobilised to take advantage of them,
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it is not necessarily appreciated that this presupposes structured thinking. For example, everyone is aware that prices vary over time. But what is not always obvious is that relative prices often change significantly, because changes in relative prices are often masked by general price changes, i.e. inflation. A manager needs to be aware of the difference between nominal and real price changes, be able to identify where there have been significant changes in relative prices, and then be able to analyse the factors which have caused relative prices to change. To put this in perspective, the real price of television sets has declined during the past fifteen years. However, the decline in real price has generally been offset by inflationary price increases, with the result that the nominal price of television sets has risen in most countries. But what has happened to the relative price of colour and monochrome television sets? Demand and supply influences in these markets have led to changes in the ratio between the prices of monochrome and colour television sets, i.e. to changes in the relative prices. In order to understand why the relative prices of the two types of television set have changed it is necessary to have a theory of supply, demand and price determination. An aspect of business which makes the application of structured approaches difficult is that the manager’s average day is characterised by a continuous sequence of seemingly unrelated activities; many researchers have attempted to record and classify managers’ daily routines with the objective of identifying what comprises efficient managerial behaviour. A general finding is that the effective manager needs to do more than provide fast, efficient reaction to events as they occur; it is also necessary for managers to have a structure within which priorities can be established and objectives identified. Such a structure can be based on the core business disciplines which contain a body of theory which can be brought to bear on general problems in the areas of finance, marketing, human relations, and so on. The notion of a conceptual structure can be generalised from the individual specialities to the company as a whole. The lack of a structured approach to planning activities can lead to a reactive management style and arbitrary decision making criteria. It is a common observation in business that individual managers become frustrated by apparently arbitrary decisions which do not relate to any overall purpose; decisions which may be unpleasant for the individual can be made acceptable if they are seen to occur within a recognisable framework. When it comes to making choices between competing alternatives, the absence of a structure within which to allocate resources can lead to the company developing a random portfolio of products; it is possible for the company to exist and grow indefinitely in such a manner, but it is continually faced with the prospect of being confronted by problems which might have been avoidable or predictable within an understood structure. In the Mythical Company, the CEO imposed a general structure on the information presented to him by thinking in terms of the company’s strengths and weaknesses: the threats posed by changes in market conditions and the opportunities existing in related markets. By balancing up these categories he arrived at his vision, or the strategic thrust which the company would follow. A word of caution is necessary about structured approaches. The decision
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structure which has been developed for the company may be inappropriate or out of date; the classic instance is the control system which no one really understands but which gives the illusion of control. To operate in the belief that because a structure has been developed it is the right one is possibly more damaging than to have no control system at all. Even when the right choice has been made initially, to be effective the structure must be continually adapted to cope with changing circumstances, and be known and understood by the right people in the company.

Analysis
The information the functional managers provided was in the form of analyses based on their individual areas of expertise. A structure is of little use in business unless it can be applied to real world problems. Many advanced economic theories comprise a powerful structure of thought, but they have no relevance to business because they cannot be used to analyse issues which arise in companies. In this case each functional manager analysed the information relevant to his part of the company’s operation and came up with a variety of conclusions. The structure of thought requires to be supplemented with tools and techniques of analysis in order to make sense of relationships and data. Information available in real life often appears to be conflicting, and at times downright useless: this can lead to the ‘don’t confuse me with the facts’ syndrome. The ability to make sense of data and interpret statistics requires an understanding of basic concepts – in finance, accounting, economics and marketing – together with the tools of quantitative methods which enable data to be manipulated and events better understood; for example, why is it that when the price of gin rises the quantity of tonic sold falls and the quantity of whisky sold increases? The reason is that gin and tonic are complements, while gin and whisky are substitutes; when the price of gin increases relative to the price of whisky, some drinkers will substitute whisky for gin. Since gin and tonic are complements, the quantity of tonic purchased will fall with the quantity of gin purchased. The extent to which the quantities of gin, tonic and whisky purchased will change depends on the responsiveness of demand to price changes, otherwise known as elasticity. Analytical techniques also help to identify what information is important and what is irrelevant; in modern life the problem is typically not the lack of information, but the lack of relevant information. For example, there is plenty of information available on the sales of gin, tonic and whisky over time, by geographical area, across different social groups, by brand and so on. But the really important information is difficult to obtain: what is the price elasticity of gin, and what is the degree of substitution between gin and whisky. Many managers take the view that management is an art rather than a science, and that concentration on data is counter-productive. It is, of course, naive to suggest that management problems can always be solved by recourse to numbers, and by statistical and financial calculations. However, rigour and analysis should not be confused with manipulation of numbers. Sometimes all that is available is qualitative rather than quantitative information, but this does
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not imply that analysis is irrelevant. For example, at the very least it is useful to know whether we are dealing with positive or negative quantities, such as whether cash flow is likely to be positive or negative; the rough order of magnitude may be all that can be concluded from available information, but even this can be useful in determining whether a project is likely to be within a company’s resources. The non-quantitative analytical approach can help identify whether the balance of influences is favourable or not to a potential course of action. Always bear in mind that your competitors will also be trying to make as much sense as possible from available data; adopting a non-analytical approach could put the company at a serious disadvantage. To summarise, the following issues have an important bearing on the analytical approach. 1 2 3 Do not confuse rigour with numbers. Precision is not essential. Data can be expressed as: • relative orders of magnitude. • positive or negative. • quantitative or qualitative.

A rigorous approach to issues does not necessarily mean that numbers are involved; the use of theories and concepts to clarify problems and evaluate potential solutions can be independent of the precise numerical quantities. Conversely, the fact that numbers are presented as part of an argument is no guarantee of the rigour with which the argument itself has been developed. All information about markets, finance and the economy is subject to a degree of error. This means that there is nothing to be gained by attempting to be highly accurate; while the appearance of several figures after the decimal point may impress the unwary, such precision is spurious. Rather than concentrating on the accuracy of calculations, there are some general issues to which attention should be paid when dealing with numbers. First, whether the orders of magnitude suggested by the numbers are large or small in relation to the operations involved. If the relative magnitude of the numbers is small, the issue is of minor importance; for example, a marketing analyst may predict that the cost of introducing a new brand to maintain market share is around $5 million, but if the total value of sales is $385 million there is not much to be gained by attempting to be more exact about the figure of $5 million. It is sensible to avoid spending time refining relatively unimportant items of information. Second, whether the numbers are positive or negative; examples are whether it is expected that a market will increase or decrease in the future, or whether cash flows are likely to be positive or negative. Third, impressionistic or qualitative information has a role as opposed to numerical information. For example, a feeling that fashions were likely to change in the late 1980s as a result of the change in attitudes towards wearing animal fur could not be quantified, but it had important strategic implications for manufacturers of fur coats. A fur company which realised early on what was happening could have investigated the likely effect of, say, a 10 per cent reduction in demand for
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fur coats and decide whether production should be reduced immediately and inventories run down to a new level; it could also attempt to predict the effect on prices using its knowledge of demand and supply conditions in the fur market, and produce a forecast of the implications for cash flows. The company could also investigate the implications of a continuing fall in demand, or stabilisation of demand at the new low level, or an eventual return to original levels as manufacturers took action to counter the ‘endangered species’ argument. Compare the likely competitive position of such a company with one which made no preparation for the change in market conditions and suddenly found itself in a situation of unsold stocks, falling prices and cash flow difficulties. This perspective on the effective use of information can help to throw light on the seeming contradiction between what theory says managers should do, and what they are actually observed to do. The theory suggests that managers should make careful use of information in analysing situations and arriving at conclusions. But the research reveals that managers have a tendency to rely on abbreviated and verbal accounts. The argument above suggests that in the first instance it is important for managers to determine the direction of change and the rough order of magnitude; in many instances the course of action which these suggest may be virtually unaltered by more detailed information which, because of the errors associated with information, may itself be suspect. As a result, there are likely to be significantly diminishing returns at the margin to the effort devoted to analytical detail. This leads to the paradoxical situation that the educated manager is able to identify what information is really required to deal with a particular issue, and the level of detail to arrive at an informed conclusion in an economical manner, but that this behaviour may appear to be shallow and impressionistic when observed by a researcher who concentrates only on identifying the use of detail.

Integration
In the example discussed above, the CEO was faced with a variety of analyses based on different structures. His task was then to integrate them; no single functional manager provided the perspective to decide which of the strategy options to pursue. The CEO added a vision of where the company was going and an overview of the information provided by the functional managers in arriving at a strategic thrust. Each of the business disciplines has a part to play in developing the overall strategy; an important management skill is to recognise when specific disciplines can be applied, and to identify the tools and concepts relevant to different situations. It is not necessary for the manager himself to be able to carry out a financial appraisal or a marketing study, but it is necessary to be able to see when such studies are required, to understand them well enough to make constructive criticism, to visualise the relative importance of the various results, and to be able to fit the results into the formulation of strategy. Consider the process of deciding whether to develop and market a brand new product. Market research techniques are used to identify the potential sales and the marketing strategy to adopt to manage the product once it has been launched. Financial appraisal shows the likely rate of return on investment
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in the product, and provides information to compare it with other potentially competing investments. Economic analysis provides information on optimum pricing and potential threats which may arise at industry, national or international levels. Organisational behaviour theories will suggest policies designed to get the best out of the workforce. Accounting techniques will monitor the costs of production in relation to the revenues from sales. It is the manager’s job to ensure that the appropriate techniques are applied at the right time, and the manager needs to be able to grasp the meaning of the diverse types of information which different techniques generate. Integration is an essential component of strategy because the implications of specific recommendations in one area can have implications for other aspects of company operations. For example, a proposal to abandon a product may be based on a financial appraisal which suggests that the value of the company would be decreased as a result of a reduction in cash flows; the financial argument needs to be weighed up against potential negative effects. The personnel department might argue that the effect on employee motivation and commitment could be serious because everyone feels that it is a ‘worthwhile’ product to make; the production department might claim that while the product has a poor accounting contribution it has helped to eliminate excess capacity in the past, and this is not reflected in the accounts; the marketing department might argue that the product is still at an early stage in the evolution of its life cycle and has a substantial longer term potential. The strategy problem is to incorporate and reconcile the implications of the specialist disciplines, which in this case suggest different courses of action. Integration goes beyond simply adding up the pros and cons as presented by the individual disciplines. The decision on abandoning the product will ultimately depend on the extent to which it fits with the strategic thrust of the company. For example, broad economic and social trends might indicate that there is no future in current and related markets beyond the medium term, and the company should be thinking in terms of a change in direction. In this case the real strategy question may be when, rather than whether, to abandon the product.

Evaluation
It was recognised by several functional managers that it was necessary to evaluate performance. In the light of the many crises which the company would be facing, it was clear that it would be essential to attempt to determine how well resources were being allocated in the pursuit of the strategy goals. In order to monitor the performance of the company it is necessary to devise measures which generate information on how well objectives are being attained. A variety of measurements can be used to evaluate company performance such as Return on Investment and Profit Margin, and the efficiency with which resources have been allocated can be judged by measures such as Asset Turnover, Contribution on Assets and Sales per Employee. While difficulties are often encountered in interpreting and reconciling aggregate measures of performance and efficiency, such measures serve the functions of providing an early warning of potential problems, and of identifying areas of potential concern. A further
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problem is that it is not possible to express all targets in quantitative terms; for example standards of service, corporate image and degree of product differentiation cannot be measured in ways which provide a clear indication of performance. In a competitive environment absolute measures of performance are less important than measures relative to the competition. Studies have found that companies rarely set even their financial goals relative to competitors. A very good reason for the lack of competitively set benchmarks is the difficulty of obtaining information about competitors; but even if it is difficult to obtain relevant information, it is well worth the trouble. This is because industry-wide changes affect all firms, and by focusing on performance relative to competitors this distorting influence is minimised. For example, the absolute target of increasing return on assets by 2 per cent may be rendered impossible by an unexpected 10 per cent increase in raw material costs; if the target had been defined as achieving a return on assets 2 per cent higher than a major competitor the firm would be able to judge its reaction against the indication of best practice as achieved by the competitor. Aggregate measurements of company performance cannot be used to provide guidelines at all levels in the organisation, and it is necessary to devise measures which relate properly to the objectives which have been set for individuals and groups. This is difficult to achieve in practice, and it is possible to end up with a set of performance measures which do not adequately reflect the efficiency with which resources are allocated at different levels in the company. There can be few more pointless activities than to censure departmental managers for not performing well on the basis of performance measures which are almost totally meaningless. In fact, the use of irrelevant performance measures can be counter-productive and have serious long term consequences for the company as a whole. In the short term, it is only to be expected that employees will become dispirited and lose their motivation if their efforts and successes are not reflected in measured outcomes; this has implications for productivity and innovative behaviour. In the longer term, the company is liable to misallocate its resources in striving to maximise misleading measurements of objectives. For example, evaluation of the sales force on the basis of growth in sales value may lead to a level of sales where the full cost of additional sales is greater than the additional revenue generated: capacity may be overstretched to meet the demand, service teams may be unable to support sales outside large cities, and resources may be diverted from product development. Thus while the sales manager is performing well in terms of his measure, managers in other areas such as production and support will find their performance measures declining.

Feedback
If a company does not monitor, react to and learn from feedback its strategies will quickly cease to be aligned with actual events. In the case of the Mythical Company, the CEO was immediately confronted with feedback on both internal and external factors, all of which had implications for carrying out the agreed strategy; he now has to make decisions on how to adapt to these changes. In the longer term the CEO would require feedback on the implementation of the strategy and measures of company performance.
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1.4

Business Unit and Corporate Strategy
The firm upon which much economic theory is based is a single product entity operating in a well defined market. But it is obvious that a large proportion of economic activity takes place in firms of varying forms: some produce a range of outputs (horizontal integration), some produce not only the final output but several or all of the intermediate products (vertical integration), some market a given product in different ways in separate markets (Pepsi Cola), some market the product in much the same way in separate markets (McDonald’s). The diversity of forms can be simplified by looking at a firm as a ‘corporation’ of different activities, and focusing on the running of the corporation as opposed to the individual firms which comprise it. There is a clear distinction between corporate and business strategy; the firm can be visualised as a group of strategic business units (SBUs) which are coordinated and directed by a corporate headquarters. An SBU is an operating division of a company which serves a distinct product-market segment or a welldefined set of customers or a geographic area. The SBU is given the authority to make its own decisions within corporate guidelines. The corporate objectives and guidelines comprise the strategy for the company as a whole, and the SBUs are tactical units charged with achieving their part of the overall strategy; whether the activities of the SBU are tactics or strategy is largely a matter of semantics since the term ‘strategic’ tends to be applied to any activity in the company which entails looking to the future; for example, the marketing manager within an SBU pursues a marketing strategy within the objectives of the SBU. Everyone is then in some sense both a strategist and a tactician. The strategic questions addressed by SBUs are related to products, and include • • • • What is the market? Which segments are products aimed at? What is the competition? Can a sustainable competitive advantage be achieved?

The strategic goals pursued by an SBU may be independent of other SBUs within the corporation. Indeed, those working in an SBU may be unaware that a particular company is part of their own corporation. Corporate strategy is therefore concerned with the portfolio of SBUs, ensuring that they do not behave in a way which is detrimental to each other, and allocating resources among them. If the current portfolio of SBUs cannot achieve corporate objectives, corporate strategy may be redirected to developing new business ventures. It is obvious that a successful company is based on successful SBU strategies. However, from the corporate viewpoint, an apparently efficient SBU may not necessarily be a desirable component of the company. Although an SBU may be generating a profit, it is possible that the resources it ties up could be more profitably employed in a different SBU, or the SBU may be generating a return which is lower than the company’s cost of capital. It is the job of corporate strategy to ensure that SBU resources are allocated to the most productive ends for the company as a whole.
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1.4.1

Allocating Corporate Resources
A relatively simple example involves the corporate policy on rationing capital among SBUs. Take the case where a company has two business groups each comprised of three SBUs. When an SBU requests capital, it states the amount required and the value which it would create by using the capital. For the moment, the precise method of deriving this value does not matter. Corporate headquarters has received bids from the two business groups and the details of the value created by the SBUs are shown in Table 1.2.
Table 1.2
SBU 1 2 3 Total

Capital requested and value created
Group A Capital Requested ($000) 100 100 100 300 Value Created ($000) 80 40 30 150 Group B Capital Requested ($000) 100 100 100 300 Value Created ($000) 50 50 50 150

The corporate role is to ensure that a set of rules exist which lead to efficient resource allocation, since every resource allocation decision cannot be subjected to detailed analysis. This example will show that the corporate decision rule chosen can itself have important implications for company success. There are at least two approaches to corporate resource allocation: 1 Use competitive bidding; the component parts of the company compete with each other for scarce funds, on the assumption that this competitive element will go a long way towards ensuring efficient resource allocation. In this case the criterion is to allocate capital to groups on the basis of the total capital cost to each group of identified value creating investments. The method used is to allocate capital between the groups according to the ratio of the total requested by each, and the group manager then allocates capital to the SBUs using the criterion of value created. On the face of it, this might appear to be an efficient procedure because it combines the notion of the demand for capital by groups with efficient allocation within groups. It also serves the function of being clear to everyone concerned and provides group managers with financial accountability for their SBUs. Allocate capital directly to the individual SBUs using the ratio of value added. This would by-pass the group structure and reduce the responsibility of group executives.

2

The two policies can result in different allocations of resources. Take the case where the company has only $400 000 available rather than the $600 000 requested. The group allocation approach dictates that $200 000 be allocated to each group because they requested the same amount originally, i.e. the ratio of the value of requests was 1:1. The group managers would then allocate $100 000 each to their two top value creating SBUs. The outcome of allocating capital to groups compared to SBUs directly can be compared as shown in Table 1.3.
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Table 1.3

Allocation to groups and SBUs
Value created ($000) To group To SBU 80

Group A SBU1 SBU2 SBU3 Group B SBU1 SBU2 SBU3 Total 220 50 50 50 50 50 230 80 40

The allocation to groups results in value creation of $220 000 compared to $230 000 by allocation directly to SBUs. In the first case corporate policy, which is based on a strategy of competitive bidding between groups, leads to a misallocation of resources which is not apparent to managers in charge of the individual SBUs. However, there may be arguments in favour of retaining the group allocation policy which cannot be measured in immediate financial terms; for example, Group A might be seriously weakened by being starved of investment capital during a period when Group B’s SBUs were producing relatively attractive investment opportunities. There is typically a long term dimension to corporate policy. While the concerns of corporate and SBU strategy might differ, it is clear that there are many common themes, such as interpreting diverse information, allocating resources effectively, and reconciling the short and long term. Corporate policies, such as that above relating to capital rationing, have the additional problem of becoming ‘cast in stone’ over time, and may end up being inappropriate to changed business conditions. 1.4.2

Development of Corporate Strategies
The example above, which deals with how corporate headquarters may deal with the problem of allocating financial resources among business units, does not identify how the corporate structure itself adds value to the SBUs. Clearly, the major preoccupation of corporate strategy is to add value to the component SBUs which would not otherwise have been possible. The rationale for having a corporate structure in the first place is that the costs of the corporate structure are less than the benefits which it bestows on the individual businesses, otherwise the break-up value of the corporation would be greater than its current value. It is therefore necessary to clarify how the corporate structure can add value to the individual businesses; for the meantime we can avoid defining precisely what is meant by ‘adding value’ (this will be developed at length in Module 3) and use the term in its intuitive sense. The history of the corporation in Table 1.4 shows how the pursuit of value creation has led to changes in corporate strategies over time, and how ideas relating to corporate strategy have been greatly influenced by the outcome of previous strategic approaches. (This outline owes a great deal

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to Goold, Campbell and Alexander.11 ) The division of history into decades is an approximation to the time periods involved, recognisable to most people who lived through them.
Table 1.4
Decade 1950s 1960s 1970s 1980s

Corporate history and strategic ideas
Strategic issues Centralised control Maintain growth Manage diversity Poor performance of diversification Value destruction Hostile takeovers Strategic concepts Devolve responsibility General management skills plus Synergy Portfolio planning Shareholder value Stick to the knitting Core competencies Dominant logic Parenting advantage Economies of scale Global reach Linked portfolios Downsizing Mega mergers Corporate strategies Divisionalisation Diversification Balanced portfolio Restructuring

Early 1990s Late 1990s

Core business

Globalisation

Divisionalisation
After about the mid 1930s companies such as GM, Du Pont and Standard Oil had grown too large and complex to be managed with their previous functional organisation. The decentralisation of activities into divisions which characterised the 1950s heralded the start of the distinction between business and corporate strategy. This was the beginning of the process of disaggregating companies into SBUs.

Diversification
It was during the 1960s that the notion of general management skills which could be used effectively in any business setting began to be developed, and was associated with the growth and development of the first business schools whose objective was to identify and teach the common core of business skills. By the 1960s the established markets of many large companies had entered the mature stage, and opportunities for growth were now perceived to lie in diversification of activities. This built on the established divisionalisation, and new companies were brought under the corporate umbrella as additional divisions, as opposed to creating divisions by decentralising the existing company. A compelling argument during this period was that the assimilation of different, but related, businesses under the corporate umbrella would lead to synergy. The quest for synergy provided a powerful rationale for diversification through acquisition, because it offered the promise of creating value beyond that which the business would have were it left on its own. Synergy in fact turned out to be elusive; this ought not to have been surprising, because the benefits were based more on hope than on evidence (this is dealt with in detail in 6.22). The quest for synergy often led to value destruction rather than value creation, and this sowed the seeds
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for later corporate strategies. Another reason advanced for diversification was risk spreading (dealt with in 6.21); this was a questionable basis for corporate strategy because it spread management risk rather than shareholder risk. As the number of take-overs increased, the forces of competition led to increased prices for acquisitions, and this reduced the scope for value creation. In fact, as take-over prices began to reflect not only the current but the potential value of companies, diversification often led to the destruction of value because companies were caught up in take-over battles, and ended up literally paying too much for their acquisitions. At the same time the notion of the generalist manager started to come under criticism: it started to become clear that ‘management’ could not be viewed as independent of the particular business, and the emphasis turned to the importance of focused skills.

Portfolio Planning
Economic conditions changed in the 1970s: slower national growth rates, recession, and historically high inflation: at the same time it was generally felt that competitive pressures had increased with advances in technology, reduction of trade barriers and the growth of the Pacific rim economies. It was generally felt that the market environment was much more complex and unpredictable than in the 1960s. The management of diversity was increasingly recognised to be a problem, and the search for a balanced portfolio of products led to the development of the portfolio approach to product management (dealt with in detail in 5.7). It was now widely recognised that unless the parent company could identify value creating potential that had not already been realised and which had not been recognised by another bidder, the company would pay the full price of a take-over, including potential value increases. At the same time capital markets had developed to a level of sophistication far greater than in the 1960s, and the argument that a portfolio must include high profit products (cash cows) to pay for products which had still to generate profits (stars and question marks) no longer applied with the same force; this is because in many ways internal financing is not more efficient than external financing. It is questionable whether an investment project which cannot satisfy external financiers should be funded by retained earnings; it is reasonable to ask whether shareholders would be willing to invest their funds in an internal project rather than in some other company which offers a potentially higher return.

Restructuring
The inability of many companies to manage and add value to diverse portfolios led to take-overs by corporate raiders who saw opportunities for releasing value from failed corporate strategies. This development was largely confined to the US and the UK partly because of their more developed capital markets and the independence of corporations from banks. The scale of the take-over strategy was staggering: in the US in 1988 over 2000 companies were acquired with a total market value of over $850 billion. The take-over battles made the specialists into household names: Goldsmith, Milken, Kravis and Boesky (who went to jail) in the US, Hanson and White in the UK (both of whom were rewarded with the
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title of Lord), and Robert Maxwell. The excitement of these times was captured in the film Wall Street in 1987 starring Michael Douglas as Gordon Gekko, to whom ‘greed is good’. The search for value creation focused on cash flows and led to the development of techniques known as value based planning, which include discounted cash flows and net present values. These financial ideas are central to understanding company valuations and value creation, and had largely been ignored in the preceding decades. The approaches adopted to release value in diversified companies included delayering, which involved reducing management structures, and divestment, which involved selling off parts of the corporation. The Peters and Waterman study mentioned above concluded that successful firms had a focus (they called it ‘stick to the knitting’); they concluded that diversified companies had performed less well than those which concentrated on a core activity. There was now a great deal of concern about pseudo-professional managers who knew nothing about the businesses they were running. The inevitable conclusion was that many parents were destroying value by the 1980s; it was no wonder their break-up value was often found to be greater than their corporate value.

Core Businesses
Available evidence suggests that the performance of conglomerates has not been improved by take-overs. The Financial Times Stock Exchange Index for the 100 leading UK companies grew from 100 in the base year 1986 to 240 in 1996; during the same period the Financial Times Index of 350 diversified industrial companies increased from 100 to 130. Clearly some radical thinking was required if conglomerates were to remain viable in the long run. The process of restructuring implies the selection of appropriate core businesses which remain once the process of breaking up is complete. The trouble is that it is not necessarily obvious where a company’s core advantages lie. One possible answer was to focus on related diversifications; but this would not necessarily solve the problem of value destruction because related activities do not necessarily reduce complexity, and there are no guarantees that the simple fact of running two apparently related businesses under the same corporate umbrella will lead to overall cost reductions. An alternative approach was to utilise the company’s dominant general management logic by selecting companies in strategically similar industries.
A dominant general management logic is defined as the way in which managers conceptualise the business and make critical resource allocation decisions – be it in technologies, product development, distribution, advertising or in human resource management.12

A rather different view is that the only valid justification for a diversified company is sharing resources and particular competitive advantages– which came to be called core competences13 – across businesses; otherwise diversification is nothing more than mutual fund portfolio management. One view is that businesses comprising the diversified company should be viewed as a collection of competences. Even a poorly performing business, in terms of financial indicators, may make a significant contribution to overall company performance in terms
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of competence. But it is difficult to transform this idea into practice, because it means suspending the normal investment criteria which had been so useful in the era of value based planning. While the research suggests in retrospect that there are instances of companies which have benefited from concentrating on core competences, it is difficult in practice to predict how companies will achieve benefits from corporate strategies based on linkages, core competences and synergy.
Benefits of synergy are now truly legendary. Diversification and synergy have become virtually inseparable in texts and business language. Yet. . . those particular benefits show an almost unshakeable resolve not to appear when it becomes time for their release.14

While there is no doubt that the concept is important, it is not unreasonable to conclude that linking businesses by core competences is neither a necessary nor sufficient condition for success. The story of corporate strategy and the potential for value creation is by no means fully worked out.

Parenting Advantage
While it is uncertain how the future will unfold, Goold et al. make a persuasive case for the development of parenting advantage as the basis for corporate value creation. They identify four potential ways by which the parent might add value. 1 Stand-alone influence: the parenting activities include agreeing and monitoring performance targets, approving major capital expenditures and selecting business unit managing directors; the parenting influence may extend to product-market strategies, pricing and human resource management. But it can be argued that the more the parent extends its influence into the affairs of the individual businesses, the more likely it is that it will destroy value; this is the 10 per cent versus 100 per cent paradox: why should a parent manager working part time do better than a business manager working full time? Linkage influence: the parent can encourage relationships to capitalise on synergy. But in the absence of a parent, business managers are free to establish linkages without parental involvement; so why should the parent do any better? This is the ‘enlightened self-interest’ paradox. Functional and services influence: the parent can provide functional leadership and cost effective services. But this creates a supplier insulated from outside competition, and it is difficult to guarantee that internal suppliers will be as efficient as the market. This is the ‘beating the specialists’ paradox. Corporate development activities: the main role of the parent is usually seen as buying and selling businesses, creating new businesses, and redefining businesses. This amounts to changing the businesses in the corporate portfolio. But since the weight of research indicates that the majority of corporately sponsored acquisitions, new ventures and business redefinitions fail to create value, the odds against success are long; this is the ‘beating the odds’ paradox.
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While there is a real potential role for the parent in the areas outlined above, it has to be recognised that success is not guaranteed and that there are formidable obstacles in the path of value creation. Given these obstacles, it is not surprising to find that value has often been destroyed rather than created, and when the parent organisation is responsible for poor executive appointments, invalid objectives, inappropriate strategies, and unsuitable review processes the potential for value destruction is multiplied.

Globalisation
As trade barriers have continued to fall, through the work of the World Trade Organisation and the formation of trading blocks such as the European Union, and capital markets have transcended national frontiers, companies have increasingly found themselves competing in an international market place. Companies in many industries began to fear that nationally based operations would stand little chance against powerful multi nationals. Thus the late 1990s witnessed huge international mergers in industries such as financial institutions, telecommunications, energy supply, car production and pharmaceuticals. While the arguments in favour of mega mergers are clearly persuasive enough to provide companies with the incentive to embark on these ventures, it is an open question whether the outcome in the longer term will be viable, value generating operations. There is no guarantee that scale economies will be realised, nor is there any guarantee that size will confer a real competitive advantage in servicing distinctive local markets for goods and services.

1.5

Is Strategic Planning Only for Top Management?
Since strategic planning is typically visualised as the grand strategy of a company, it could be argued that this is the domain of top management, and that middle and lower management need not be concerned with such issues. However, there are potential returns to both the company and the individual from comprehension of strategic planning at all levels of management.

1.5.1

Company Benefits of Strategic Planning
Some organisational behaviour experts maintain that it is not so much the existence of a plan which benefits the company, but the process by which a plan is developed; this process leads to relationships among employees, and approaches to the job, which would otherwise be missing. Apart from this general potential benefit, the company stands to benefit in several ways from managers’ comprehension of strategic planning. • The individual manager is enabled to see where his sub-unit fits into the overall system of objectives, and is able to interpret corporate objectives in that light. The manager competing for scarce resources has a better understanding of the true opportunity cost of his demands. Similarly, the manager is in a better position to understand instances where cooperation is required; the reason for such cooperation might not be obvious in the context of a limited set of objectives. In many circumstances, managers
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can be excused for feeling that decisions are simply made at the whim of their superiors since they do not appreciate the overall resource allocation picture and have no understanding of the direction in which the company is headed. This reasoning applies to all aspects of management education, i.e. that a better appreciation of company functions provides individuals with a more balanced view of the actions of others; comprehension of strategic planning has a particularly powerful role to play in the elimination of unnecessary conflicts, and the associated effects on morale and productivity. The manager will better understand which of his potential proposals are likely to contribute to the overall plan; he will also be in a position to produce arguments for a proposal which will be consistent with the objectives of higher level managers. Because strategies are developed in a dynamic fashion, managers who are actually involved in the process of making the company’s strategy work may not be aware of the strategy within which they are operating; for example, economic circumstances may lead to a change in general objectives and the criteria used to judge company performance. It cannot be taken for granted that managers will have an up-to-date appreciation of the company’s current strategy.

Thus, company-wide knowledge of the approach to strategic planning, and the process by which it is arrived at, can have a positive impact on resource allocation within the company by helping to minimise unnecessary conflict and to provide an overall sense of direction. It is difficult for managers to feel part of a team working towards a common goal when that goal is not clear to them and they do not see how their individual actions contribute to achieving it. 1.5.2

Individual Benefits of Understanding Strategic Planning
If comprehension of strategic planning generates returns to the company, it is clearly worthwhile for the company to persuade managers to spend time learning about it. However, individual managers must have incentives to spend time on this activity. The payoff to the individual manager comes in two ways. First, the manager will achieve a better understanding of where the company is going, and what it is attempting to achieve. The manager should be able to take advantage of this to predict changes likely to occur in the organisation which will be personally advantageous, or disadvantageous. Second, proposals and arguments submitted to higher level managers will be consistent with and relevant to the aspirations of the manager’s superiors, and this can enhance prestige and career prospects.

1.5.3

Understanding Strategic Planning: Who Should Pay?
The fact that there are benefits both to the company and to the individual raises an interesting issue concerning who should pay for the education. Since individuals benefit from understanding strategic planning they have an incentive to pay something towards their education; the same goes for the company. However, since both parties will obtain some benefit the issue of who should

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pay is a negotiating point. There is a maximum amount which the company is willing to pay for any individual’s strategic planning education, and there is a maximum amount which any individual is willing to pay for his own education. In principle, the compromise will fall in between these two extremes. In practice, it is usually not possible for such a negotiation to take place, and this accounts for the fact that some individuals are willing to pay for their own education, and some companies are willing to pay for some employees’ education.

Review Question 1
The following is a hypothetical statement by the Chief Executive Officer of a medium sized company producing packaged breakfast cereals.
‘The people who sell strategic planning are certainly on to a good thing. They don’t define their product, they have no measure of success or failure when applying their methods, many of them seem to provide contradictory solutions, and they can provide no proof whatsoever that they have done any good. As an ex-army man I know a lot about strategy, and in my business I simply keep an eye on who is doing what in the market, try to make sure my costs are under control and keep my customers and my employees as happy as I reasonably can. I have given up trying to look more than a year ahead, because every time I have done so in the past, events have turned out to be completely unpredictable. In the past 10 years we have managed a 12 per cent return on capital and have kept our market share. I don’t think I have much to learn from studying strategic planning.’

This CEO gives the impression of being complacent, and perhaps he has good reason for feeling this way. Think up a series of questions which might unsettle him.

Review Question 2
Analyse the strategic planning experiences of the Mythical company in terms of the three approaches to strategy: planning, emergent and resource based.

Review Question 3
Assess the Mythical company’s five point plan in terms of business unit and corporate strategy.

Review Question 4
Assess the experience of the Mythical company’s CEO in terms of Rittell’s properties.

Review Question 5
Some time in the future the Mythical company ran into another problem. About half way through the financial year the company finance director informed the CEO that half year profits were much reduced and that there was little prospect of maintaining the performance of the past three years. The CEO gathered his

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senior management team to discuss the reasons for this setback and hired a strategy consultant to contribute. This is an extract from the discussion. CEO: I don’t think our profit problem is simply due to external events such as the recent problems with the economy. It seems to me that it is more to do with the way we do things – I am not certain that we are acting as efficiently as we could be. Operations manager : we have actually invested heavily in more productive assets and in training programmes in the last two years. I am not sure there is much more we can do in that respect. Marketing manager : I don’t think we exploited the market opportunities for our new range of products as well as we could have done. We invested a great deal in attempting to capture an increased share of the market early on last year; when that didn’t work we should have channelled a lot more resources into the marketing effort. We should have allowed for changing market conditions. Finance director : but we had no spare resources. CEO: we put a lot of effort into the plan and it was a great disappointment when it didn’t work out. Maybe we need to spend even more time planning in the future. Marketing manager : what is the point of planning in ever more detail when we can’t seem to react to the unexpected? Operations manager : that is a defeatist attitude. We just don’t spend enough time collecting and analysing information. Strategy consultant : you are approaching the strategy problem from two different perspectives; once you have recognised this you might be able to work out where to go from here. What did the strategy consultant mean?

References
1 2 3 4 5 6 7 8 9 10 11 Mintzberg, H. (1978) ‘Patterns in strategy formation’, Management Science, pp. 934–48. Lorsch, J. (1986) ‘Managing culture: the invisible barrier to strategic change’, California Management Review, 28, pp. 95–109. Chandler, A.D. (1974) Strategy and Structure, Cambridge, MA.: MIT Press. Andrews, K. (1971) The Concept of Corporate Strategy, Homewood, IL: Irwin. Itami, H. (1987) Mobilising Invisible Assets, Cambridge, MA: Harvard University Press. Mintzberg, H. (1994) The Rise and Fall of Strategic Planning, New York: Free Press. Simon, H. (1957) Models of Man, New York: Wiley, p.198. Rittel, H. (1972) ‘On the planning crisis: systems analysis of the first and second generations’, Bedriftsokonomen No 8, pp. 390-6. Peters, T. J. and Waterman, R. H. (1982) In Search of Excellence, Harper & Row. Hall, S. and Banbury, C. (1994) ‘How strategy-making processes can make a difference’, Strategic Management Journal, Vol. 15, pp. 251–63. Goold, M., Campbell, A. and Alexander, M. (1994) Corporate-Level Strategy: Creating Value in the Multi-Business Company, New York: John Wiley.

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12 13 14

Prahalad, C.K. and Bettis, R.A. (1986) ‘The dominant logic: a new linkage between diversity and performance’, Strategic Management Journal, 7, pp. 485–501. Prahalad, C.K. and Hamel, G. (1990) ‘The core competence of the corporation’, Harvard Business Review, May–June, pp. 79–91. Reed, R. and Juffman, G.A. (1986) ‘Diversification: the growing confusion’, Strategic Management Journal, Vol. 7, pp.29–35.

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Module 2

Modelling the Strategic Planning Process
Contents
2.1 2.1.1 2.1.2 2.1.3 2.2 2.2.1 2.2.2 The Modelling Approach The Components of a Model Benefits and Costs of the Modelling Approach A Functional Model Strategy Making Strategy and the Evolution of the Company Strategists 2/1 2/2 2/4 2/5 2/8 2/9 2/10 2/13 2/13 2/16

Review Question Case 1: Rover Accelerates into the Fast Lane (1994) Case 2: The Millennium Dome: How to Lose Money in the 21st Century (2001)

Learning Objectives
• • • To represent the complex strategy process in terms of a model. To show how strategic planning depends on the evolution of the company. To identify who makes strategy.

2.1

The Modelling Approach
A model of the strategic planning process provides a structure within which strategy problems can be analysed. A model is a structured method of thinking which enables the component parts of complex processes to be identified and related to each other; this does not imply that the process of strategic planning occurs in individual companies exactly as described by a model. No model can describe a process exactly; for example, in economics the objective of most models is to summarise important causal economic relationships so that a view can be developed of how the economy operates; an economic model does not aspire to represent the world with total accuracy, but it is intended to capture some of the main elements which determine how the economy functions. The economic model can then be used as the basis for explaining what is currently happening, and predicting what is likely to happen in the future. A strategic planning model is not based on cause and effect relationships in the same way as an economic or financial model. A strategic planning model is an

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attempt to rationalise the complex processes of company decision making where the connection between cause and effect is obscure. When trying to make sense of complicated human interactions it is inevitable that an observer will have to use subjective impressions of what is actually happening. Since subjective impressions are used to interpret how strategy processes work, a strategic planning model can take various forms. The fact that such variety exists is not a weakness of the modelling approach, as the power of the modelling approach lies in simplifying and making understandable what at first sight appears to be impenetrable; different models can throw light on different aspects of the strategy process. It is essential to think explicitly in terms of models from the beginning. Whenever you attempt to explain what is happening in the world, or express a view as to how things should be done, you are implicitly using a model within which your ideas are structured. For example, the issue of how to eliminate the US budget deficit was an important concern in the early 1990s. Many people thought that this could be achieved simply by increasing the tax rate; to hold such a view this group must have had an implicit model of the economy in which an increase in taxes would lead to higher tax revenues. However, an alternative model, in which increased taxes could lead to lower incomes and hence to reduced tax revenues, is also feasible. The problem is that neither model could be proved nor disproved at the time, and people often lost sight of the fact that they were really disagreeing about an implicit model of the economy rather than the objective of eliminating the budget deficit. In companies, different views on the process of how to plan are based on different models of how strategic planning works, whether this is recognised explicitly or not. It was discussed previously how managers often have completely different definitions of strategic planning; this is usually associated with differences in their views of how planning should work in practice. For example, some managers believe that planning should take the form of a series of specified targets, together with a monitoring and control system; other managers feel that this approach is unnecessarily rigid and that an informal, flexible approach is more effective. These views are based on two different models of the planning process. 2.1.1

The Components of a Model
The simple strategic planning model shown in Table 2.1 represents planning as a flow process. The model identifies seven activities which occur in a logical progression: Step 1 is concerned with identifying company goals, which may be in the form of market shares or rates of return; Steps 2 and 3 are concerned with forecasts which identify the potential payoffs and problems associated with different courses of action; from these potential alternatives the strategy option is chosen in Steps 4 and 5; having decided what to achieve, Step 6 is concerned with how to achieve it by identifying critical success factors and allocating resources; finally, in Step 7, procedures are set up to monitor how effectively the objectives are being achieved, together with an ongoing system of reappraisal to ensure

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Table 2.1
Sequence 1 2 3 4 5 6 7 8

A simple strategic model
Activity Setting goals Forecasting payoffs Forecasting shortfalls Identifying potential strategies Selecting the best strategy mix Organization and implementation Control and reappraisal Feedback to previous activities

that the company can react to changing circumstances. This finally leads back to Step 1 as new goals and alternative strategies are identified. The model attempts to extract ‘a pattern in a stream of decisions’. A cynic might argue that this model is logically invalid and as such offers no insight into real life processes. A telling criticism is that it is impossible to set goals without some sort of prediction, and therefore forecasting must precede the setting of goals. It can be argued that goals which are set without attempting to look into the future are little better than random and may turn out to be unrealistic. Taking the argument further, if goals can be redefined at any time, the whole process must fold up since the model suggests that Steps 2 to 7 depend on the goals. If they do not depend on the goals, then why is the model set up like this in the first place? The cynic’s argument is persuasive, but it is usually easy to pick holes in someone else’s conceptual framework. The real response to the cynic is to say ‘I agree. Now you do better.’ The strength of this simple model is that it identifies the main components of the strategic planning process, suggests that attention should be paid to the order in which different tasks are tackled, takes into account that the process is dynamic and feeds back on itself, and perhaps most important of all, provides a structure for discussing strategy issues. The feedback process is crucial to understanding the role of the model. It is naive to suggest that a company works through the seven steps and ends up with a ‘strategy’. The experience of the Mythical Company in Module 1 demonstrated the importance of the dynamic element in the process. Feedback will continually cause managers to re-evaluate predictions, re-assess the chosen strategy mix, and so on. In fact, one view is that feedback is the most important element in the strategic planning process, and is the means by which the organisation learns by experience. There is little point in adhering to a strategic plan which no longer relates to the environment within which the company is operating, hence the importance of the ‘learning organisation’ which is able to adapt to change instead of ignoring it. The notion of ‘logical incrementalism’1 is based on the contention that a company can only start with certain strategic thrusts in mind, which are general notions of what should be done in the future, and that these are refined as time progresses in an iterative fashion. Given the many imponderables facing managers, it is clearly impossible to predict the future of a particular market, and the resources available to the company, with any degree of precision; therefore pursuing a set of objectives without taking
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into account the ongoing course of events hardly makes sense. It is possible that the incrementalist process itself is subject to management, and that techniques can be developed which will help ensure that the iteration is effective. The debate on the validity of models is not unique to strategic planning. The famous economist Milton Friedman advanced the argument that the real test of a model is how well it predicts events. If it is able to predict accurately and consistently then it does not matter if economists disagree on the validity of the underlying economic relationships. Opponents of this view claim that a model must be based on sound theories before its predictions can have credibility; without these it is impossible to explain why predictions turn out to be wrong. This argument has led to heated exchanges in academic journals, and the philosophical issue has yet to be resolved. So far as the modelling of strategic planning is concerned, there is a limited amount of theory which can be applied, and the models are intended to be explanatory rather than predictive; in principle, their usefulness can be judged on the contribution which they make to understanding and improving the process of strategic planning. In the model illustrated above, it is certainly true that the ordering of the steps is based on a logical framework which may not exist in real life, and there is scope for debate about which part of the process ought to come first in practice; while most managers will agree from their experience that the seven steps do occur, they are not necessarily consecutive. This is because additional information and perspectives generated during the later stages can cause reversion to an earlier step. The model is in fact an attempt to represent a dynamic process in a static setting; thus while the conceptual structure may be valid, it may be impossible to observe in practice. An important attribute of a model lies in providing the basis for a check that the necessary steps have been carried out prior to committing the company to a course of action. For example, Step 3, which is concerned with identifying potential weaknesses, may have been virtually ignored in the process of developing the strategic plan; the mere fact of focusing attention on this aspect could change the emphasis of the strategy, once it has been discovered that there are potential weaknesses which have not hitherto been taken into account. A subsequent revision of Step 4, which is concerned with identifying alternative strategies, might reveal that the original goals were much too ambitious because no feasible strategy seems likely to achieve them. 2.1.2

Benefits and Costs of the Modelling Approach
All approaches to problems have benefits and costs, and if a particular approach is adopted it must be because the perceived benefits outweigh the perceived costs. The idea of using a modelling approach to strategic planning can give rise to heated argument: those in favour consider that actions undertaken without a structured or theoretical base are little more than random; those against consider that it is naive to approach issues in this way and that the modelling approach constrains rather than enriches understanding of decision making. There is no clear cut answer to this argument, and typically both sides can provide instances where both structured and unstructured approaches to decision making have

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been effective; disagreements in this area cannot be resolved by recourse to data, and the difficulties of applying the scientific approach in this area were discussed at 1.2.2. However, it is impossible to identify general principles from unstructured and one-off examples, and the anecdotal approach to strategic planning, while usually entertaining, gives no real indication of why the particular circumstances led to success rather than to failure. Furthermore, there is a natural tendency to concentrate attention on strategic approaches associated with success rather than failure, which biases the conclusions generated by the anecdotal approach. If there is no carry over from one case to another then the very attempt to teach strategic planning is open to question. Therefore, to the extent that there are general principles involved, the modelling approach is valid; it could be argued that to dismiss the possibility of modelling the process is to deny the existence of general strategic principles. The following are some of the benefits and costs which might be associated with modelling the strategic planning process. Costs and benefits of modelling planning • Benefits – Provides a structure – Simplifies complex processes – Acts as a check list – Identifies areas of disagreement • Costs – Imparts a mechanistic impression to the process – Introduces rigidity to a dynamic process – Gives impression that strategy can be derived from a model It is important to realise that a strategy model is not a prescription for how strategic planning should be carried out. It is intended to help in understanding strategy making, and does not imply that a company should adopt a particular planning system which itself might constrain the inventiveness and innovation on which much of strategic planning depends. 2.1.3

A Functional Model
A more detailed model, shown in Figure 2.1, indicates the tasks involved at the various stages of the process. This model conveys more information than the previous one about the activities related to the process of strategic planning, and uses different explanatory headings. For example, four areas have been identified in which analysis and diagnosis should be carried out; these include the general environment, which is concerned with the state of the economy and social trends, competition within the industry, the internal strengths and weaknesses of the company, and its current and potential competitive position. Steps 6 and 7 in the previous model are included under Implementation, which is concerned with the organisational structure of the company, techniques for efficient resource allocation, and the measurement of outcomes.

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Strategists

Objectives

Who decides to do what

The macro environment

The industry environment

Internal factors

Competitive position

Analysis and diagnosis

Feedback

Generic strategy alternatives

Strategy variations

Strategy choice

Choice

Resources and structure

Resource allocation

Evaluation and control

Implementation

Figure 2.1

A functional model

Despite the differences in detail, both models follow the general pattern of deciding what to do, finding out different ways of doing it, selecting one of them, and finally tracking the outcomes while keeping options open as far as possible at all stages. The use of these two or other models is largely a matter of subjective preference. At the end of the day, it could be argued that even the most unstructured, adventurous entrepreneur implicitly follows a grand design along these lines. The process model can be thought of as a paradigm, along the lines discussed in 1.2.2. In 1994 a group of prominent academics in the field of strategy attended a conference on the topic ‘Strategy: search for new paradigms’ and the complete issue of the Summer 1994 issue of the Strategic Management Journal was devoted to their deliberations. In the Introduction the Editor-in-Chief of the Journal, Dan Schendel,2 noted that he had organised a similar conference in 1977 with broadly the same objective of identifying what the field of strategy was about. At the time the conclusion was that strategy was really a flow process which involved the six steps of goal formulation, environmental analysis, strategy formulation, strategy evaluation, strategy implementation and strategy control. This was the first time that these ideas had been brought together to form a cohesive structure. Schendel felt that seventeen years after the first attempt to articulate the paradigm it still remained the basic way of thinking about strategy; this does not suggest there had been no development in strategic concepts and ideas, but that these new ideas fit within the framework of thought which describes the
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strategic process. The functional process model shown in Figure 2.1 follows Schendel’s notion of a paradigm quite closely; instead of six steps there are four, but the boxes contain the same ideas. An appreciation of the strategy process model is fundamental to understanding strategy issues because the model provides a framework within which concepts and ideas can be located. The model provides a basis for formulating questions when addressing strategy problems, and these tend to be common among different situations. The general questions which arise from the model include Do the strategists have the appropriate characteristics for the type of company? Have they formulated clear objectives? Has adequate analysis of the environment and the company been carried out? Was an appropriate choice of strategy made in the light of the potential alternatives? Were company resources used effectively to achieve the strategic objectives? Was the company able to learn from subsequent feedback and adapt accordingly? One of the most important outcomes of the process model approach is to recognise that there is typically no single reason for company failure or success. When attempting to explain why a particular company got into difficulties there is a tendency to answer in terms of a single factor, for example that the market turned down, that technology moved on, or whatever. But it is unlikely that any one factor can really account for failure, since companies are run by people who are able to adapt to changing circumstances. The root causes of failure lie in the strength or weakness of the company’s strategic process; it then becomes a question of how many areas of weakness can a strategic process bear. The approach adopted in the remainder of this course follows this process model; it starts by looking at strategy makers and company objectives, then goes on to discuss the company in the economic environment – both at the economywide and market levels; this is followed by an analysis of the internal factors affecting competitive advantage which leads on to an analysis of strategic choice; implementation, control and feedback are the final parts of the story. Strategic planning is thus not a plan or a blueprint for company success but a framework for understanding strategy making. The first step in analysing the various aspects of the strategic planning process is to consider who makes strategy in the first place.

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2.2

Strategy Making

Strategists

Objectives

Who decides to do what

The macro environment

The industry environment

Internal factors

Competitive Analysis and diagnosis position
Feedback

Generic strategy alternatives

Strategy variations

Strategy choice

Choice

Resources and structure

Resource allocation

Evaluation and control

Implementation

Individuals, not companies, make decisions, but the decisions taken are constrained by the organisation and its traditions. The relative importance of individuals versus organisations has always been a topic of debate; the emphasis varies among companies depending on their age, the personalities of individual managers, and many other factors. An important outcome of the Peters and Waterman research into company excellence was that a strong leader, who made the company excellent in the first place, was a recurring factor in almost every case. In fact, you will observe in everyday life that one of the first things which companies do when they encounter severe problems is to change the leader. There is no doubt that the leader can set the style for the whole organisation. Perhaps the most extreme cases occur in sports management, where unsuccessful teams typically react by firing the manager. The success of the Asda chain of superstores in the UK between 1992 and 1996, when the Asda share price grew at twice the rate of the stock exchange index, was largely attributed to Archie Norman; during his five years he not only changed the company culture and rescued it from collapse under £1 billion of debt, but also fought a wider battle against price fixing and had a significant effect on competition in the retail industry. When Norman decided to become chairman in 1996, with the avowed intention of ultimately going into politics, the market took fright and many articles appeared in the financial press suggesting that most commentators felt that the future success of the company was dependent on Norman and very little else. The value which companies place on leadership can be very high: for example, in 1996 GEC, the giant electrical conglomerate, offered George Simpson (who had been chief executive of Rover Group and Lucas Industries) a remuneration package worth £10 million; but in this case the major shareholders felt that he could not possibly be worth this and forced the board to renegotiate. The best known tycoon in Britain is Richard Branson, who initially made his fortune from building up the Virgin record company and is now known for his airline company Virgin Atlantic; he is also well known for piloting a speedboat across the Atlantic in record time and undertaking highly dangerous ballooning
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expeditions. A champion of competition with a clear dislike of monopolies, he challenged British Airways by obtaining slots at Heathrow and providing standards of service which rapidly gained a significant share of the market in the face of intense competition. But it is not widely known that Branson’s business empire spans retailing, media, design and modelling, and financial services besides his airline, which accounts for only about half of the £1.8 billion value of his companies. In a Sunday Times interview in October 1996 Branson stated that his next priority would be to develop a structure for his group so that its existence will not be threatened by his disappearance. We know from everyday experience that different individuals have different objectives, view the same information in different ways, and often act differently depending on the decision making environment. Those who sit on boards or committees often feel that decisions arrived at would have been different had the decisions been taken by any individual member of the group. Thus the setting of the company’s objectives may appear to be arbitrary to the extent that it is dependent on who is involved at the time. This raises the question: If the setting of objectives is not systematic, is there any point in attempting to be systematic about meeting these objectives? The answer is that objectives are set by people, with their particular insights into the world, together with all their defects, but they are the only ones we have. 2.2.1

Strategy and the Evolution of the Company
The typical company is continuously evolving, and the roles undertaken by decision makers are to some extent dependent on the stage of the company’s evolution, which can be classified in three stages: the small single-product company, the integrated company, and the large diversified company. Only a very small minority of companies actually ‘evolve’ in the sense that they end up as large diversified companies. However, the classification makes it possible to characterise the role of the strategy maker as follows: Small or Entrepreneurial Integrated Single-product company with little formal structure controlled by the owner-manager. Single product-line company with vertically integrated manufacturing and specialised functional organisation. The owner-manager still retains control over strategic decisions, but most operating decisions are delegated through policy. Multi-product company with formalised managerial systems which are evaluated by objective criteria, such as return on investment. Product and market decisions are delegated to the heads of SBUs.

Diversified

In smaller companies the individual owner plays a dominant role in determining strategy, but in the larger, diversified company it may be difficult to identify strategists. The latter is the type of company in which ownership and control tend to be differentiated, with managers answerable to shareholders rather than to individual owners. In fact, many aspects of the company’s operations depend on the stage of evolution of the company. For example, the ability of a company
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to undertake radical innovation depends on its stage in evolution, with large diversified companies facing the problem of how to stimulate innovative activity within the company’s structure. When a company reaches a certain size there is a tendency for bureaucratic procedures to become dominant, with the result that a significant proportion of resources is devoted to maintaining the status quo, and innovation is seen as a costly and disruptive form of behaviour. This was one of the factors which led to the problems encountered by IBM discussed at 1.1. 2.2.2

Strategists

Strategists

Objectives

Who decides to do what

The macro environment

The industry environment

Internal factors

Competitive Analysis and diagnosis position
Feedback

Generic strategy alternatives

Strategy variations

Strategy choice

Choice

Resources and structure

Resource allocation

Evaluation and control

Implementation

It is often difficult to identify the ‘ultimate’ strategic planner in companies which have developed beyond the stage of owner/manager control. The functions carried out by managers are complex, and are continuously changing. While managers tend to feel that they understand their own function, there is relatively little systematic information available on how managers actually spend their time. Some research has been carried out into managerial styles and approaches; but it is extremely difficult to carry out research in this area because it is necessary to observe what managers actually do on the job. Because of the labour intensive nature of the research, it is virtually impossible to generate information on a large sample, and the information produced has to be interpreted by the observer as events occur, resulting in a high degree of subjectivity. While the research has produced some information about what managers actually do, it has been unable to identify causal relationships between behaviour and outcomes. In general terms, it has not been possible to identify which characteristics contribute in what degree to being a good manager in real life; in particular, very little has been found out about what comprises an effective strategic planner. Examples of the difficulty involved in identifying the characteristics of an effective strategic planner can be seen in the books written by successful managers. The accounts are typically idiosyncratic, and it is virtually impossible to identify the key characteristics which contributed to success rather than to failure. This is partly because few professional managers are trained in the scientific
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approach, and this is compounded by the fact that their accounts are at least partially concerned with portraying themselves in a favourable light. One of the best known research findings is that there is a significant difference between what general managers actually do and what theory suggests that they ought to do. For example, when seeking out information, theorists suggest that the general manager should think in terms of obtaining data which will enable thorough organisational and environmental analysis to be carried out, which in turn will assist the manager in arriving at effective strategies. However, research suggests that general managers prefer verbal sources and that they avoid documented information; their approach is impressionistic rather than detailed. Added to this is the widely known fact, which does not require research to verify it, that there are significant differences in management style: some general managers are naturally reflective while others tend to be doers. There is therefore no particular reason to expect that observed management behaviour will be identical for different individuals; what is not known is whether such variation has an impact on effectiveness. The observer based research has not uncovered significant connections between management style and effectiveness. Since the activities of managers cannot be readily classified and fitted into a model of behaviour, the precise role of different managers in the strategic planning process is not subject to hard and fast rules. The roles which managers play depend on many factors unique to the individual company; for example, in companies with a rigid hierarchical structure the process may be concentrated on one person, such as the managing director. For many managers the identity of the strategic planner in their own company is obscure, and many may not be able to identify any one person with responsibility for the function. Strategic planning can be regarded as a multidimensional role which is undertaken by many individuals working at different levels. For example, there are corporate level strategists, typically the Board of Directors and the CEO; below these are the SBU strategists, who comprise executives, planning departments and consultants. In some cases the pinnacle of the strategic planning process is occupied by the General Manager who sits at the top of the decision making process. It is thus the case that control of the strategic planning process can rest in the hands of different people. This does not mean that the process itself cannot be identified and analysed, but it does suggest that companies should give some thought to how the function is undertaken in their organisations. If no one is very sure about who is carrying out the strategic planning function, it could well be that the process itself could be greatly improved. Our attempt to categorise the experiences of the Mythical Company helps to explain why the attempts to identify what managers do, and the functions of strategic planners, have produced little in the way of results. A glance at the functional model of Figure 2.1 suggests one good reason for this: the whole process is very complex. There are 12 separate boxes in the functional model, each of which may relate to a number of functional specialists. In any one day a manager may be involved in evaluation and control problems, discussions on strategy variations, investigating changes in the competitive environment, and resource allocation problems. Sometimes the activities in these boxes may
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overlap, and the manager may give very little thought to why particular actions are being undertaken in terms of the general strategy picture, being only aware that specific problems need to be solved quickly. The trouble is that immediate solutions may be mistaken when viewed against the backdrop of the functional model; for example, decisions on resource allocation may be made solely with reference to accounting rather than taking relevant marketing information into account. The functional process model also provides insights into the complexity of the management function in terms of the roles which managers are required to adopt at different times, and because of the fluid nature of everyday events the manager is likely to flit from one role to another without giving the matter conscious thought. The four ‘eggs’ on the right hand side of the process model serve to identify several roles. • Strategist, entrepreneur and goal setter. Even in large companies these functions are not the sole domain of the chief executive, and some aspects are typically devolved to managers. While managers are to some extent constrained by existing plans and commitments, they have a role to play in making decisions about potential investments, reacting to changing circumstances, identifying new courses of action and so on. Analyser and competitor. The manager needs to be constantly aware of changes in the economic environment, the efficiency of the firm, and its competitive position. The process of information collection and analysis is time consuming, and it is necessary for managers to filter out what is unimportant and focus on factors which are likely to impact significantly on the firm. Managers are typically keenly aware that time spent on analysing is at the expense of more immediate concerns and this role tends to be given a low priority because of its lack of immediate payoff. Strategy decision maker. It is rare that major strategy decisions are taken without wide managerial consultation. Options must be identified and different points of view brought to bear in order to assess the costs and benefits associated with each. At times the manager will be involved in higher level strategy assessment, and at others he will be making devolved strategy type decisions at his own level. Implementer and controller. Once decisions have been taken the manager has a major role to play in making them happen. This involves allocating resources in the first instance. Organising resources is typically thought of as being the major role a manager has to perform, but in fact it is only one of several, and it may not consume most time. As well as allocating resources, the manager has to monitor how effectively resources are being utilised, and this means that systems must be set up which adequately measure performance. Communicator. As new information becomes available and competitive conditions change the manager has to ensure that everyone is kept aware of changes in direction as far as possible.

There is more to the problem of management than complexity and competing demands on the manager’s time and intellectual resources. There is also a degree
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of conflict inherent in the different roles. For example, the manager needs to set up systems which ensure that resources are used efficiently; but these very systems may introduce inflexibility and resistance to the very changes which the manager sees are necessary in his role as competitor. The objectives and mission of the firm may be expressed in general and non-measurable terms, while the control systems tend to be based on financial measurements; the two approaches may be difficult to reconcile. Thus as well as being charged with the task of resolving conflicts of interest in the firm, the manager must also deal with the internal conflicts caused by the roles which he is required to adopt.

Review Question
Apply the functional model of Figure 2.1 to the Mythical Company’s strategy making in Module 1. Allocate the various reports and actions to the boxes and evaluate each stage of the process represented by the eggs; use the model to evaluate the overall effectiveness of the strategy making process in the Mythical Company.

Case 1: Rover Accelerates into the Fast Lane (1994)
The British car industry has a history from the early 1970s of poor productivity, bad labour relations, out of date models and falling market share. But by the early 1990s the prestige name of Rover was making a comeback, and the company was steadily moving back into profitability. Rover is in fact the remnants of the giant British Leyland which produced (amongst other cars) the well known Austin and Morris marques, and which competed directly with Ford and GM as a volume car maker. In 1980 British Leyland had 33 per cent of the UK market, but this had fallen to 14 per cent by the beginning of 1993.

100 50 0 –50 –100 –150 –200 –250 –300 –350 84 85 –350 86 87 88 –5 –50 60 25

100 60 60 50

–50

–50

89

90

91

92

93

94

Figure 2.2

Rover profit/loss (£million)

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The approximate trading profitability record of Rover since 1984 is shown in Figure 2.2. The productivity record can be judged from the fact that in 1988 the company produced 10 cars per worker (one of the worst productivity records in the world industry), and by 1993 it produced 14 cars per worker. This was still short of the company objective of 20 cars per worker, already achieved by the Japanese. The workforce had been reduced to 32 000 by 1993 from 44 000 three years earlier. By 1993 the company still faced the problem that its car production made losses, while all trading profits were due to the 4-wheel drive Range Rover and Discovery models; by 1994 profits on this division were about £200 million – so the other 80 per cent of the company was making a loss of about £100 million. The market performance of Rover by 1993 was outstanding in many respects. During 1993 continental Europe was in recession, while the UK was emerging from recession. The sales picture is shown in Table 2.2.
Table 2.2
Area UK Europe

Rover’s relative sales growth in 1993
Total Market Growth Rover Sales Growth

+5% −20%

+9% +5%

How Rover got there
The recovery was not an overnight affair, but dated back 15 years or more. Rover was fortunate to have had two outstanding leaders who paved the way for future success. During the late 1970s Sir Michael Edwardes effectively ended the long term labour unrest in British Leyland by much improved labour relations policies, and forged the link with Honda which gave Rover access to modern car technology. His successor, Sir Graham Day, provoked a cultural revolution by convincing his managers that Rover was no longer a volume producer which could compete with Ford and GM; this was not easy, because he had to convince long serving managers that the company did not have the volumes to be a low cost producer. He changed the name to Rover and disposed of the Austin and Morris marques. Rover established partnerships with a few key suppliers and as a result restrained cost increases and improved systems reliability. In 1985 Rover’s break-even output was 500 000 cars per year; by 1993 this was down to 400 000, and the objective was to reduce this further in line with being a niche producer. The CEO in 1993, George Simpson, felt that there was plenty of scope for a ‘medium sized, slightly upmarket, semi-autonomous’ car maker. However, he felt that the future for European car makers was unclear because there will be significant levels of over-capacity for up to 10 years, and this may lead to price wars. Rover would also need to raise a significant level of long term debt if it was to develop a new small car to replace the Metro.

Enter BMW

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Table 2.3
Sales Assets Debt

Structure of Rover in 1993
£billion 4.0 1.4 0.4

The structure of Rover in 1993 was as shown in Table 2.3. At the beginning of 1994 Rover was purchased, in a surprise move, by BMW for £529 million; this caused a little trouble with the Japanese car maker Honda, which had technology agreements with Rover and owned 20 per cent of the company. BMW’s chairman, Bernd Pischetsreider, declared his intention to revolutionise Rover in two ways: by turning it into a brand as strong as BMW, and doubling or trebling its sales world-wide. For example, in 1994 Rover expected to sell only 13 000 cars in Germany, while Pischetsreider wanted to increase this to between 80 000 and 120 000 cars per year. One major change designed to achieve this would be to install in the UK BMW’s logistics technology for building cars in response to individual customer specification; the problem confronting BMW was that Rover was locked into the Honda method of producing identical cars in batches of 30. While Rover had increased productivity, the UK motor industry as a whole was still relatively uncompetitive, and the indices of unit labour costs for a selection of countries in 1993 are shown in Figure 2.3.

120 100 80 60 40 20 0 Germany UK US Japan

Figure 2.3

Motor industry unit labour costs (Germany = 100)

Questions
1 2 In what ways had the Rover management failed to maximise value by 1994? Do you think that Rover was a good buy for £529 million in 1994, bearing in mind that not all potential strategic gains can be expressed in financial terms?
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3

Discuss the strategies of Edwardes, Day and Pischetsreider using the process model.

Case 2: The Millennium Dome: How to Lose Money in the 21st Century (2001)
The Millennium Dome was designed to mark Britain’s triumphant entry into the new millennium and, as the Prime Minister Mr Tony Blair said, it was going to be ‘the greatest show on earth’. But after six months of operation both the Chairman and the CEO had been sacked and it was eating up public money at the rate of about £20 million per month while little more than half the expected number of visitors had turned up. What could have caused this drastic outcome for such a high profile national investment? The Millennium Dome was conceived by the Conservative government in the mid 1990s and was taken on by the Labour government which was elected in 1997; however, newspaper reports at the time suggested that a significant minority of Cabinet Ministers were opposed to the idea. The original notion was that the Dome would open for the Millennium celebrations and its attractions would subsequently stay open for a year; after that the Dome would be sold to the highest bidder, most probably for scrap. It was to be funded by a combination of Lottery grants through the Millennium Commission and company sponsorship; these companies would figure prominently in the various zones within the Dome.

Mission and Objectives
The following is taken from the Millennium Dome website. Mission • To create, build, and operate a national Millennium Experience which attracts, inspires, entertains, educates and involves visitors and participants. • To seek, through the Experience, to influence positively each individual’s view of themselves and the world’s view of this nation. • The Millennium Experience incorporates the Dome at Greenwich and a linked programme of events and activities throughout the UK which will be branded as The Challenge. Objectives • To deliver a once in a lifetime, high quality Experience at Greenwich and a country-wide Challenge programme to time and to budget. • To achieve at least 12 million visits to the Dome at Greenwich. • To deliver value for money to the Millennium Commission, sponsors and paying visitors. • To develop and implement the Experience in a way which: – Optimises access, in the widest sense, by people of all ages, backgrounds and interests achieving a nationally and socially inclusive event.
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Involves, engages, entertains, educates and transforms the visitor and participant. – Makes best use of British and international creative talent and state of the art technology. To create a world profile for the celebration of the millennium in the UK. To assist, and where possible contribute to, the Government’s policy that there will be a lasting legacy for the nation from the Experience.

Forecasts of Visitor Numbers
The New Millennium Experience Company (NMEC) was responsible for running the Dome and projected in 1997 that the Dome would attract 11 million paying customers during the Millennium year, and that 1 million free visits would also be provided. Despite the fact that advance ticket sales were very poor the NMEC still adhered to this forecast by January 2000. Later that month the figure was revised down to 10 million and the NMEC still claimed that the Dome would break even over the course of the year. By May 2000 the dome had attracted only 2 million paying customers and the prospect of meeting the target looked remote. In June the target was reduced to 6 million. By the end of the year 5 million visitors actually turned up. The grand opening was a farce, with many VIPs being stranded at the railway station for hours. Subsequently there were many complaints of the length of time spent in queues. In August 2000 a government report concluded that an important reason for the poor attendance figures was the lack of a ‘wow’ factor: the exhibits were all interesting but none of them really captured the imagination.

What Was Spent on the Dome
The Dome costs as estimated in 1997 were as follows. Construction & infrastructure Exhibition & central attraction Operations & running costs in year of operation: The Challenge Marketing Support services Central contingency Total £ million 198 95 54 29 34 88 498

The Dome Revenue
The original projections were Sponsorship
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£ million 150
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Commercial activities Final sale value (probably for scrap) Total

194 15 359

It is assumed that the ‘commercial activities’ refer to the sales of tickets. If this were the case it would appear that from the outset the Dome was expected to have a financial shortfall of £139 million. The tickets were priced at a basic £20 per adult and £16.50 per child; special rates were set for families and parties so it is likely that the average price paid was in the region of £17. Using this figure the following revenues would have been generated with the three estimates of attendance. 11 million (up to January 200) 10 million (from end January 2000) 6 million (from June 2000) £ million 187 170 102

The figure of £187 million is not far away from the original estimate of £194 million. However, using the 6 million figure for visitors the shortfall increases from £139 million to £231 million. This amounts to a subsidy of about £40 for every ticket sold.

Pouring the Cash In
It should come as no surprise that, when the number of paying visitors fell far below expectations, significant cash flow problems arose and it became necessary to inject more public money. The original Millennium Commission lottery grant was for £399 million; an additional grant of £50 million was paid in November 1999, another £60 million in February 2000 and a further £29 million in May 2000. This meant that a total of £538 million of public money had been injected into the Dome. This, of course, was only half way through 2000 by which time only about half of the running and operating costs of the Dome would have been incurred. But ignoring this, given the cost and revenue estimates, it should only have been necessary to inject about £231 million into the Dome. So where had the additional £307 million gone? It was later discovered that accounting procedures were very poor and it was almost impossible to construct a balance sheet.

Who Were the Managers?
The Board of the NMEC was comprised of some well known and highly successful British business personalities. The Chairman was Mr Robert Ayling whose main employment was CEO of British Airways. The Dome CEO was Miss Jenny Page who had overseen the construction and launch of the whole project; Miss Page had previously been CEO of the Millennium Commission and English Heritage and was a forceful and dynamic character. Her top priority was to complete the Dome on time and to achieve this was a remarkable accomplishment.
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When the Dome’s financial problems started to become apparent in February Mr Ayling sacked Miss Page. Soon afterwards Mr Ayling was fired by British Airways which was experiencing heavy losses. In May, at the time of the £29 million handout, Mr Ayling was fired from his position as Chairman of NMEC. The new CEO was Mr Pierre-Yves Gerbeau who took over in a blaze of publicity but was unable to revive the Dome’s failing fortunes.

What Next for the Dome?
In July 2000 it was announced that a consortium backed by Nomura International was to invest more than £800 million in the Dome to turn it into a huge entertainment resort with hotels, restaurants, shops and offices; some £200 million would be spent on refurbishing the Dome and its exhibits in order to attract tenants. The investment included a payment of £53 million to MNEC. However, agreement could not be reached on the details and Nomura withdrew; no credible bid was subsequently received and the contents of the Dome were auctioned off for a few million pounds at the beginning of 2001.

Questions
1 2 Assess the Dome as a financially viable concept if its life had not been restricted to one year. Discuss the fortunes of the Dome using the process model.

References
1 2 Quinn, J. B. (1980) Strategies for Change: Logical Incrementalism, Richard D. Irwin. Schendel, D. (1994) ‘Introduction to the Summer 1994 Special Issue – Strategy: search for new paradigms’, Strategic Management Journal, Vol. 15 (Special Issue), pp. 1–5.

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Company Objectives
Contents
3.1 3.2 3.2.1 3.2.2 3.2.3 3.2.4 3.3 3.3.1 3.3.2 3.3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12 3.12.1 3.12.2 3.12.3 3.12.4 3.12.5 3.12.6 3.13 3.14 3.14.1 3.14.2 3.14.3 3.14.4 3.15 Setting Objectives From Vision to Mission to Objectives Defining the Business of the Organisation Deriving the Mission Statement Disaggregating the Mission Setting Objectives The Gap Concept External versus Internal Gap Factors Gaps and Resources Gaps and Incentives Credible Objectives Quantifiable and Non-Quantifiable Objectives Aggregate Objectives Disaggregated Objectives The Principal/Agent Problem Means and Ends Behavioural versus Economic and Financial Objectives Economic Objectives Financial Objectives Discounting and Present Value Net Present Value Capitalised Value Choice of Interest Rate: The Cost of Capital Return on Investment Shareholder Wealth Social Objectives Stakeholders Stakeholder Interest Stakeholder Interests: The Priorities Stakeholder Influence Mapping Stakeholders Ethical Considerations 3/2 3/3 3/4 3/5 3/6 3/7 3/7 3/9 3/9 3/10 3/10 3/11 3/13 3/14 3/15 3/17 3/18 3/18 3/21 3/21 3/22 3/22 3/23 3/25 3/26 3/29 3/31 3/31 3/32 3/34 3/37 3/38 3/40 3/40

Review Question 1 Review Question 2

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Case: Porsche: Glamour at a Price (1993)

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Learning Objectives
• • • • To investigate the many dimensions of company objectives. To demonstrate the connection between business definition, mission and objectives. To show how company objectives determine strategy formulation. To demonstrate the link between capital markets, company valuation and company objectives.

Strategists

Objectives

Who decides to do what

The macro environment

The industry environment

Internal factors

Competitive Analysis and diagnosis position
Feedback

Generic strategy alternatives

Strategy variations

Strategy choice

Choice

Resources and structure

Resource allocation

Evaluation and control

Implementation

3.1

Setting Objectives
It is often difficult for managers to answer the fundamental question ‘What are we trying to achieve?’ In the rough and tumble of a competitive environment many managers are apt to reply ‘Keeping the company in business, and surviving another day in the job.’ Managers tend to be concerned with reacting to changing circumstances, seizing opportunities as they arise, and trying to ensure effective performance from both themselves and their subordinates. Managers may well ask whether it really does help matters to have some overall objective for the company, given that it is difficult enough to survive from day to day and to meet short term targets. However, whatever the relevance of company objectives to individual managers might be, one issue needs to be clarified from the outset: any strategic plan is based on the achievement of specified objectives; devising a plan without objectives is a meaningless exercise. This point may be considered banal and obvious, but in fact the confusion between plans and objectives pervades many areas of activity. For example, when the government is deciding on its budgetary policy, i.e. setting government expenditure, tax rates and money supply, it must have some objective in mind

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in terms of real income per head, inflation and unemployment; if not, it would not matter which policies were undertaken. But try to get any member of the government to be explicit about the objectives which the government is attempting to achieve, and see how far you get. At the level of the company, some managers become so involved in the planning process that they overlook what it is meant to achieve; there is a danger that managers confuse the means by which ends are to be achieved with the ends themselves. Since strategy is at least partly concerned with confrontation with competitors, it may not always be advisable for a company to be explicit about its objectives. For example, a company may identify an increased market share in a particular market segment as a major policy objective. However, if competitors became aware of this they could pre-empt the company’s moves by reducing prices, with the result that the company becomes worse off than before. There is clearly a balance to be struck between informing managers about objectives and ensuring that competitors cannot pre-empt strategic moves. Reluctance on the part of senior managers to be specific about company objectives may help account for the fact that many companies express their objectives in terms of bland ‘mission statements’ which are devoid of operational implications. It is also likely that in the early stages of strategy formulation it is not possible to identify more than the general thrust of strategy, and at this stage it is not possible to be specific. The mission statement can be an important dimension of the company objective because it captures the attitudes and expectations of employees and provides a general focus for its activities with which people can identify. Although the mission may not be an operational idea, it can provide the general framework over time within which strategies are worked out. However, it needs to be borne in mind that a company is a collection of many individuals, each with their own set of goals, and it may not be possible to find a general statement of intent which is consistent with these sub-goals and which will galvanise everyone in a common purpose. Whether the mission statement is a powerful, visionary focus for company activity, or whether it is no more than a meaningless compromise depends on the individual circumstances.

3.2

From Vision to Mission to Objectives
One of the primary roles of the CEO is to develop a long term view of what the company is about and the markets within which it should be operating. This is sometimes referred to as the vision because it is not expressed in detailed terms and is perhaps no more than a broad thrust within which the company will be directed. But it is necessary to translate this vision into a tangible set of directions which can be used by employees to direct their efforts in a manner which is consistent throughout the organisation. There are a number of steps which are necessary to achieve this: 1 2 3 develop the mission statement; disaggregate the mission; derive objectives.
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There is no absolutely right or wrong way to proceed in developing objectives which serve as the basis for directing resources, but it needs to be recognised that if objectives are to serve a useful function they need to be logically thought out. The mission statement needs to have several characteristics including the following. • • • Serve as a definition of the business the organisation is in. Be clearly understood by employees. Provide a focus for activities.

The characteristic which raises most difficulty is defining the business of the organisation. Because this issue is of central importance it is worth spending some time considering how this definition might be arrived at. 3.2.1

Defining the Business of the Organisation
In a world of constant change it is worth stepping back on a regular basis and confronting the issue of what business the company is actually in; this is because markets can change without managers being aware of the fact because they are too closely involved in the day to day running of the company to appreciate wider events. For example, the managers of a football club may run the club under the impression that they are in the sport business; but if they realised that the club was really in the entertainment business they would approach their management job in a different way. It is not always obvious what the business definition is even when a well defined product is involved. Take the case of a soft drinks company, where a few questions reveal potentially significant differences in business definition. 1 2 3 4 • Does the company control all stages of production or does it purchase all ingredients and merely mix and bottle? Does the company control distribution and marketing channels? Does the company compete in the soft drinks or beverage market? Is the drink a stand alone or is it also intended as a mixer? Question 1 relates to the productive scope of the company, i.e. the extent to which it buys in its inputs and hence how it perceives its own supply chain. For example, a soft drinks company which makes its own bottles has a whole series of concerns which are absent from a company which buys its bottles from a bottle making company. In particular, it has to be concerned with the efficiency of its own bottle making plant, rather than relying on the forces of the market to enable it to purchase bottles at the lowest cost. The scope of the company also impacts on the skill set which the company needs to develop, and has an effect on how the company focuses its resources. For example, the company which buys in bottles needs a negotiator who can work out deals with bottle manufacturers which generate a competitive price and a guarantee of supplies; the company which makes its own bottles
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needs to recruit individuals with productive expertise in this function. These are clearly quite different skill sets. Question 2 relates to the market positioning of the product; for example, the company may produce soft drinks for ‘own brand’ supermarket products, and have little need for marketing the product in its own right. This is of fundamental importance for company expansion, because the own brand producer can only expand if its customer base grows or by finding more large customers to supply, while the company which markets directly to consumers can increase its sales by marketing more aggressively. Question 3 relates to the breadth and focus of the business definition; for example, soft drinks are sold alongside alcoholic drinks in restaurants and public houses, and could be promoted as an alternative to alcoholic drinks. Or it might be possible to present the soft drink as an alternative to coffee, which contains caffeine and is a mild stimulant. Question 4 relates to the target markets; for example, tonic water is relatively rarely consumed on its own and is usually mixed with gin. It is unlikely that tonic water could be aimed at both this market and the health market.

The first step, then, in arriving at a vision for the company and its future is to understand properly what business the company is in. Unless this is clearly defined the company vision is likely to be meaningless at best, and misleading at worst. 3.2.2

Deriving the Mission Statement
Once the business definition has been arrived at it is possible to derive a statement of how the company intends to operate within that business area. The statement may be related to factors such as the following. • • • • the the the the quality of the company’s products; degree of differentiation; geographical area which it intends to serve; segment of consumers which it targets.

Reverting to the hypothetical soft drinks company discussed above, the mission statement could take the following forms depending on how the business is visualised. • • • To deliver high energy drinks to energetic individuals who care about their health. To service the soft drink needs of supermarket chains who need a high quality dependable product to market under their umbrella brand. To target teenage consumers who want a brightly coloured effervescent drink in an unusually shaped container.

Each of these mission statements provides employees with a different focus, and implies a different allocation of resources and marketing approaches. But the operational usefulness of the mission statement can be exaggerated, and it can
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often be argued that the mission statement is merely a description of what the company is rather than providing any new direction to employees. For example, the company may have been producing own brand drinks to supermarkets since it began business, so the introduction of a mission statement has virtually no impact on employees. Sometimes the mission is a statement of where senior management wish the organisation to be at some point in the future. For example, a company might aspire to be the market leader in terms of market share, and therefore the mission statement is based not only on what business the company is in, but where it would like to be positioned within the relevant market. But in these cases it is important not to produce a mission which employees see as being unattainable and to which they cannot relate. The consequences could be quite far reaching, as middle managers and employees may develop a cynical view of senior management and their aspirations.

3.2.3

Disaggregating the Mission
The mission statement for the company as a whole can be quite general, but it can be modified and applied to individual parts of the organisation to ensure, as far as possible, that the focus of functional departments is aligned with the vision of the senior managers. The missions of functional departments could be expressed as follows. • • Corporate security’s mission is to protect corporate personnel in an unobtrusive fashion by preventative measures whenever possible. Human resources’ mission is to identify and develop effective leaders, create high performance teams and enable individuals to maximise their potential.

While such mission statements might appear to be obvious, in their turn they can have a major influence on the focus of the functional departments. For example, compare the following mission statements with those above. • • Corporate security’s mission is to provide a feeling of corporate security by a high profile stance of uniformed patrols and fast response. Human resources’ mission is to focus on the development of the individual rather than that of groups and foster the benevolent culture created by its founder.

The type of security personnel required for the first mission statement would, of course, be totally different to those required for the second. The focus of human resources on developing leaders and effective teams rather than actively pursuing the development of individuals as a top priority implies different criteria for recruitment and promotion.

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3.2.4

Setting Objectives
Once the general vision of the company has been established, and the mission identified, it is necessary to determine what has to be achieved for the mission to be successful. While the mission can be expressed in general terms, it is necessary to state the objectives in terms of measurable performance targets; in the absence of such identifiable targets the mission can have little operational significance and will probably be acknowledged but largely ignored by managers at all levels. Objective setting introduces accountability into the business of pursuing the company vision, so it is not productive to use vague terms such as ‘increase market share’ or ‘increase the return on assets employed’.

3.3

The Gap Concept
The notion of performance gaps is closely connected with the setting of objectives in the sense that it shows what has to be accomplished in order to achieve specified objectives. The gap concept is concerned with the difference between expected and desired future states. There are two steps in identifying a performance gap. The first is to decide what the desired future state is at a specified time in the future; this can be expressed in terms of new products, market shares, profitability and so on. The second is to analyse the state the company is likely to be in at that time if no changes to strategy are made. The difference between the expected and the desired state is the performance gap. The salient issue here is comparison of expected future states, and not comparison of the current state with the desired future state. It may be that the current state is far removed from the desired state, but this may not result in a change in strategy simply because of the impact of the passage of time.

Present

New strategy

Future Desired outcome

Current position

Performance gaps

Existing strategy

Expected outcome

Figure 3.1

Performance gaps

An illustration of the gap concept is shown in Figure 3.1. The gap can be determined once objectives have been set in terms of desired future states. Since the gap has to be closed in order to achieve the objective, or the future desired
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state of the company, the closing of the gap could be defined as the company objective. This is not quite consistent with the definition of an objective, since the closing of the gap is a means to an end, not the end itself. It may turn out that identification of the gap results in a modification of the company objective, because it transpires that the gap cannot be closed; there is continual feedback between objective setting and gap analysis. The problem facing planners is to make projections of total company performance; this can be complicated, and is typically carried out by using the scenario approach. A scenario comprises a series of ‘what if’ projections, and should not be confused with a forecast. For example, if the desired future state involved achieving a 3 per cent higher market share in two years, a scenario could be investigated whereby marketing expenditure would be increased by 30 per cent during the next two years. The resulting scenario would include the impact on cash flow, the likely effect on market share, the reaction of competitors, and the identification of what additional measures might be required, such as a price reduction and increased productive capacity. This is clearly a difficult process, but it is of considerable value in focusing attention on the potentially most important factors determining the ability to achieve objectives. There is more to scenario planning than meets the eye, because it is based on a premise that makes many people uncomfortable, namely, that it is impossible to foretell the future and possibly dangerous to attempt to do so. A scenario is actually a carefully argued narrative about a particular way in which the future might take shape. It is therefore a story about what could happen if particular assumptions hold true. It is not an attempt to say what will happen. Instead, the idea is to compare the scenario’s implications with the implications of rival scenarios and then examine the costs of being prepared to cope with these possible futures. The approach is usually associated with Shell International Petroleum Company. The Shell senior planners had been disturbed by the quality of their own predictions round about the time of the 1973 oil price rises, and developed the method as a means of coping with a great deal of uncertainty over oil supplies, prices and related issues. However, they encountered resistance to this approach from colleagues; this is because to most people, planning is an activity that should reduce uncertainty rather than increase awareness of it – and there is a widespread predisposition to converting alternative scenarios to single point or line estimates. This is what the Shell planners encountered, and they reckoned that it took about eight years for management to accept that scenario planning was an appropriate tool for developing strategy. Once the gap has been identified, three questions can be tackled: • • • Does the gap arise because of external or internal factors? Does the company have potential resources to close the gap? Can a strategy be developed which will close the gap?

A revealing outcome of gap analysis is that while it may appear that the difference between the current and the desired state is not large, there may well be a substantial difference between expected and desired states. Gap analysis can reveal that the company is not actually moving in the direction desired,
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and closing such a gap may imply substantial redeployment of resources and changes in marketing strategy. 3.3.1

External versus Internal Gap Factors
Broadly speaking, there are two reasons for the emergence of gaps: those factors outside and those within the control of the company. If the gap is due to factors outside the control of the company, such as a predicted reduction in market size and product prices, the original company objectives may be revealed as unfeasible because the changes in the market are too great to counter. There is clearly no point in pursuing a target level of sales and revenues if market conditions will make it impossible to achieve; this would lead to a waste of resources, and could have far reaching implications for employee incentives and commitment. Other external factors might be aggressive competitor actions or government intervention, both of which it might be possible to counter by appropriate marketing policies. The fact that gaps are due to external causes does not necessarily mean that the company can do nothing about them, but those instances where they cannot be fully counteracted need to be recognised. Internal gap constraints arise when the current allocation of resources is not consistent with achieving the future desired state. The process of resource reallocation may not be easy, and some managers may be unwilling to cut back on resources in some areas and increase them in others when there is no immediate and obvious benefit. Another internal gap factor arises when the resources available to the company are insufficient in quantity or quality to achieve the desired objective. Capital equipment may be obsolete, managers may not be sufficiently enterprising or labour might not have the necessary skills. Internal gap factors are related to the mobilisation of resources, and as such are more likely to lie within the control of the company. However, it may well be that the restructuring of the company implied by some internal gap factors is too great to be accomplished with the skills and finance at its disposal. It may be possible to overcome this by initiating a programme of change management, but this may not be an immediate solution.

3.3.2

Gaps and Resources
It is not just the company’s ability to acquire and deploy resources which is important, but the timing involved. By combining gap analysis with the dynamic scenario approach it is possible to estimate the timing of resource acquisition and reallocation required to achieve a desired future state. By taking a view on the future course of events it is possible to identify those actions which are essential for implementation; these are known as critical success factors. Once these have been identified steps can be taken to arrange finance, recruit personnel, increase productive capacity and ensure that the various service functions are in place in advance of requirements. This helps to avoid the emergence of production bottlenecks, skill shortages and financial headaches which typically beset companies during the process of change. Often managers point to the cause of failure as ‘We could have done it, but we started too late. All that we needed was a little bit of foresight’.

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Another potential advantage of scenario projection is somewhat less obvious. For example, it may be found that significant redeployment of resources is required only towards the end of the scenario period, despite the fact that a substantial gap has been identified. This can make it possible to identify when commitment to a course of action can be delayed; the chance to hedge positions can have significant implications for success and failure. 3.3.3

Gaps and Incentives
One reason for the existence of a gap is that the current incentive system is consistent with what is expected to happen as opposed to what is desired. Given the issues of timing discussed above, it is necessary to ensure that the workforce is given the appropriate motivation to change objectives and behaviour at the required times. It is necessary to initiate a system of incentives which converts the gap closing objective, which is conceptual in nature, into a series of attainable objectives. This can be difficult to achieve, and it may be somewhat difficult for a strategist to convince managers that they need to alter their behaviour at a time when the company is performing well, and when there may not appear to be a great deal of difference between current and desired positions.

3.4

Credible Objectives
Setting objectives, including the determination of future desired states, is not an activity which can be carried out in isolation from the particular circumstances of the company. There is no point to setting objectives, even where these are derived from the company mission, which employees think cannot be achieved and hence do not serve as a guide for resource allocation. Thus the setting of objectives is partly dependent on past decisions and on the state of the company at the moment, as well as on perceived market opportunities. The setting of realistic objectives is a dynamic process which is constantly under review. It would be naive to characterise objectives as immutable goals set by isolated policy makers, and the process models discussed in Module 2 emphasised the feedback which makes it possible to adjust objectives in the light of experience. It might be deduced from the fact that objectives need to be constantly revised that it is easier to frame them in loose terms which can cover a variety of situations; this has the added advantage that objectives will not impose too much constraint on the company’s operations. The danger inherent in this approach is that loose objectives may be interpreted merely as wishful thinking by those charged with implementing them. Objectives must be relevant to the managers involved and seen to be achievable if they are to have credibility and operational validity. This is where gap analysis can play an important role. For example, an objective may not appear to be feasible at the present, but in terms of gap analysis it can be demonstrated that it is achievable in relation to where the company is expected to be in the future.

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3.5

Quantifiable and Non-Quantifiable Objectives
Company objectives can be expressed in terms of a single variable, such as a target rate of return on investment. However, few companies claim to focus on only one objective, and companies typically express objectives in terms of a number of components or characteristics. For example, a company objective might be defined as • • • • being associated with high-quality products having a happy and stable workforce having a dominant market share generating a specified rate of return on investment.

Some of these components are not readily measurable, and hence their relative importance is difficult to identify. For example, what is meant by ‘high-quality’ needs to be made explicit, because it may not be possible to have both a ‘highquality’ product, as defined by the development engineers, and a dominant market share. To a large extent factors such as ‘happiness’ and ‘quality’ can only be measured subjectively, and it is inevitable that different managers will attach different weights to these components of the company objective. It is reasonable to ask whether there are any guidelines which managers can use in attempting to determine the relative importance of such intangible factors. Some light can be shed on this issue by considering how managers make decisions in enterprises where the value of outputs cannot be measured because the output is not sold on the market, for example in deciding where to build a new road, or whether to set up a national park. This problem is addressed by using the tools of cost benefit analysis, which attempts to determine the values which society assigns to such factors as the value of a human life saved, or a stretch of scenic water made available for leisure use. The handling of intangibles in cost benefit analysis has lessons for managers who wish to incorporate non-measurable components into company objectives. Take the case of a new by-pass which is expected to cut journey times round a town by 20 per cent on average, but which involves the destruction of a local beauty spot. Calculations can be made of the impact of the road on national income, taking into account the initial investment, time savings, relative accident rates and so on; while the answer cannot be exact, the outcome will be an approximate figure which is likely to lie within an upper and a lower bound. Assume that the analysis suggests that there is a 95 per cent chance that the impact on national income will be between $20 million and $25 million. The decision can then be framed as: Is the local beauty spot worth $20 million to $25 million? It is then up to society, usually through its elected representatives in government, to decide on the trade-off in the light of this information. It would be nonsense for a cost benefit analyst to assign a value of, say $14 million to the beauty spot and therefore conclude that the investment was worthwhile because the net gain to society was likely to be between $6 million and $11 million (i.e. between $20 million minus $14 million and $25 million minus $14 million). A complicating factor is that the issue may not be decided on the basis of relative
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values because there are distributional problems involved; those who pay, i.e. the locals who stand to lose their beauty spot, will not necessarily receive full compensation. But the equity problem should not obscure the conceptual point that a rational view on the relative value of the beauty spot can be obtained from the facts available about the cost in terms of alternatives; this is an important component of the final decision. In the case of a company, an indirect approach can be taken to derive the relative value of unquantifiable objectives. The first step is to decide on a unit of account which is both measurable and important to managers. An obvious contender is return on investment (ROI), since at the end of the day the company must have a positive ROI to stay in business. Second, attempts can be made to determine how change in the non-quantifiable objective is related to changes in ROI. For example, resources devoted to the creation of a happy and stable labour force may at first be accompanied by increases in ROI, but after a certain level of expenditure additional resources allocated to this end may result in a net reduction in ROI; or a company may estimate that expenditure on a new social club, while seen as highly desirable by most employees, is unlikely to have significant positive effects on productivity, and consequently will reduce ROI by 1 per cent. This provides the company with an objective measure of the cost of the social club in terms of ROI; the company may still think that the effect of the social club on welfare is worthwhile, but it will undertake the expenditure in the full knowledge of what it is really costing. A more complex allocation problem arises when there is a constraint on resources and it is estimated that the allocation of resources to either of two non-quantifiable objectives, such as welfare and product quality, will result in an increased ROI. In principle, it is possible to determine the allocation of available resources between the two objectives which results in the highest impact on ROI. For example, the available budget may be $500 thousand, and spending an additional $100 thousand on each results in the impact on ROI shown in Table 3.1.
Table 3.1
Additional

Expenditure and ROI
Expenditure ($000) Total 100 200 300 400 500 Welfare 0.2 0.1* 0.04 0.02 0.01 Increase in ROI Quality 0.25 0.2 0.1* 0.02 0.0

+100 +100 +100 +100 +100
* optimum allocation

There is a relatively high payoff from the first $100 000 spent on each, but this rapidly decreases. The highest joint impact on ROI is obtained by spending $200 000 on welfare and $300 000 on quality, giving an increase of:
0.85% = 0.2 + 0.1 + 0.25 + 0.2 + 0.1

Any reallocation between them would result in a lower increase in ROI; for
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example switching $100 thousand from quality to welfare would result in an increase of:
0.79% = 0.2 + 0.1 + 0.04 + 0.25 + 0.2

The fundamental issue here is to visualise the issue in terms of trade-offs. The final decision may well be based on other factors, but the expression of the alternatives in terms of a common unit of account such as ROI is a powerful technique for focusing what otherwise is likely to be a highly subjective discussion.

3.6

Aggregate Objectives
The corporate objective as derived from the mission statement is an aggregate concept in the sense that it applies to overall company performance, size, target markets, financial structure and so on. The specification of corporate aggregate objectives has profound implications for the structure of the company and the operations of SBUs. Aggregate objectives are sometimes indistinguishable from mission statements and may be expressed in vague terms such as ‘being in the transport business’ or ‘being innovative and quality orientated’; this is possibly because it is difficult to visualise a single objective which applies to a range of products and SBUs. One way of combining these is to use the notion of maximising shareholder wealth (or shareholder value1 ); this idea is discussed in detail at 3.12.6. The notion of maximising shareholder wealth is central to corporate strategy, and the rationale for framing the company objective in this form can be expressed as follows:
Those who criticise the goal of share value maximisation are forgetting that stockholders are not merely the beneficiaries of the corporation’s financial success, but also the referees who determine the management’s financial power. Any management – no matter how powerful and independent – that flouts the financial objective of maximising share value does so at its own peril.2

One important reason for adopting a quantitative view of aggregate objectives is that it can be used as a measure of the effectiveness of corporate executives. The separation between ownership and control is a well known problem (known in economics as the principal agent problem and dealt with in 3.8), and can result in a wide divergence between the objectives of managers and shareholders. An obvious example is where the remuneration of corporate executives is related to the size of the corporation, which may not be consistent with maximising shareholder wealth. An alternative to measuring shareholder wealth is to estimate the value of the company to its stakeholders.The relationship between stakeholders and company management is discussed at 3.14. These stakeholders are the various groups without whom the company could not exist and include shareholders, government, customers, community, employees, suppliers, and any other groups which share in the value produced by the company. There is a minimum value which must accrue to each group to sustain its involvement with the enterprise;
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for example, shareholders must receive the appropriate market return on their investments; employees must feel that the combination of working conditions, career prospects and remuneration give them an adequate incentive to continue working productively rather than seek to work somewhere else; suppliers must feel that the price and quantity of orders received is worthwhile in relation to the resources allocated to dealing with the company. A possible measure of value creation is the surplus over these minimum requirements. This is a much wider concept than shareholder wealth, and is obviously impossible to measure with any accuracy. In fact, it is more of an intuitive than a quantitative idea. A major problem with the notion of creating wealth for stakeholders is that they have conflicting interests, and this brings us back to the principal agent problem: if sacrifices are made on the part of one group, such as employees, in order to ensure an adequate stakeholder return to another, such as suppliers, then who is to judge whether this makes all stakeholders better off? Any attempt to interfere with the market forces which set stakeholder returns in the first place may have a disastrous effect on the profitability, and hence survival, of the company.

3.7

Disaggregated Objectives
The process of converting corporate or aggregate objectives to a series of objectives for managers at lower levels raises many difficulties. This is because it is necessary to interpret the aggregate objective in terms which are realistic and achievable, and make sense to managers at each level in the company. A prerequisite is to identify the individual objectives which must be achieved in pursuit of the aggregate objectives. For example, there is little point in telling a sales force manager that the corporate objective is to achieve 15 per cent rate of return on investment. Instead, the manager needs to be told what level of sales is consistent with the objective of a 15 per cent rate of return. If he is not given explicit guidance, the sales force manager may attempt to maximise the sales of all products in response to being given the general objective, while the optimum corporate strategy may be to maintain market share at the current level and take-over a key competitor. An example of how objectives might be set at different levels, partly determined by the constraints faced by the company at the corporate level, is as follows: • • CORPORATE OBJECTIVE Achieve target ROI MEANS Maintain market share Take-over competitors CONSTRAINTS Existing productive capacity Sharply increasing marginal cost Current high debt ratio SBU OBJECTIVES Maintain existing market shares
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• •

Control costs CONSTRAINTS No investment capital SALES OBJECTIVES Maintain market shares Cut marketing expenditure PRODUCTION OBJECTIVES Increase productivity Reduce inventories

The objectives set by corporate headquarters may not be consistent with the objectives of individual managers. For example, a sales manager may see his career prospects being dependent on maximising sales rather than restricting sales to some predetermined level; the manager may fight against a cut in marketing expenditures because from his viewpoint this will lead to missed opportunities. It may be very difficult to convince the marketing manager that it is not in the corporate interest to pursue what he perceives as being potentially profitable opportunities. This is an example of the principal agent problem which is discussed in the next section. Ensuring consistency with corporate objectives is not the only problem; some managers may perceive their objectives as being in conflict with those of other managers. For example, consider the following objectives: • • SALES OBJECTIVES Increase market share PRODUCTION OBJECTIVES Reduce inventories

The marketing manager will want to have access to sufficient inventories so that new customers can be supplied immediately, otherwise some marketing resources will be wasted. The production manager will have an incentive to tailor production and inventories in relation to historic and immediate demand requirements, and will have no incentive to respond to the marketing manager’s case that supplies must be available to satisfy unpredictable new orders as they arise.

3.8

The Principal/Agent Problem
The problem which permeates management at all levels is the need to strike a bargain with subordinates which ensures that the manager’s objectives are met without the need for constant monitoring of activity. The personal objectives of an individual manager may include maximisation of wealth, ambition, desire for a quiet life, desire to avoid confrontation, and so on. There is no guarantee that the manager will place the company’s objectives high in this personal set of priorities. For example, a CEO may have a remuneration package which includes a bonus for growth in current profits; to ensure that current profits

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continue to grow the CEO may reduce expenditure on R&D, which has the effect of increasing current profit at the expense of long term competitiveness. The problem is to generate a series of objectives which ensure that corporate and SBU objectives are achieved. This involves drawing up a contract between the manager (principal) and the subordinate (agent) which ensures that the agent attempts to achieve the objectives laid down in the contract. By and large, the manager is contracted by superiors to carry out certain functions, and then is left free to determine how they are to be achieved. In the absence of close monitoring, the fact that the terms of the contract are not being adhered to may not become evident for some time, and during that time a misallocation of resources can occur. To exacerbate the problem, the individual manager has an incentive to conceal the fact that objectives have not been achieved, and will possibly attempt to ascribe an unsuccessful outcome to other factors, such as supply problems lying outside the manager’s control. The misallocation of resources can be compounded by invoking the efforts of accountants and other specialists in attempting to find out what has gone wrong, while the problem really lies with the contract and incentive system. This is an area of economics which has provided valuable insights into the relationship between principal and agent, and the types of contract which might be drawn up to ensure that the principal’s objectives are met by the agent, given differing degrees of uncertainty regarding outcomes, risk aversion, and budget constraints. A central issue for managers at all levels is that the setting of objectives cannot be isolated from the design of incentive systems. The difficulty of ensuring that the agent acts in the interests of the principal can become apparent when one company mounts a take-over bid for another. This always has the effect of initially increasing the share price of the target company. If the managers running the company had acted in the best interests of the shareholders then this could not happen, because they would have run the company efficiently and exploited opportunities, all of which would have been reflected in the current share price. In these circumstances it would appear that the outsider actually knows more about the company than the incumbent management, and has spotted opportunities for increasing shareholder wealth which these managers have not. The trouble is that there is no effective mechanism by which shareholders can ensure that their managers act efficiently; this is because the ownership of the company is spread among many shareholders while the running of the company is concentrated in the hands of relatively few senior managers and board members. An example of the lack of control on the part of shareholders occurred in the UK in the years following the privatisation of huge nationalised industries including gas and water utilities. In all cases the existing management received enormous increases in remuneration, and the argument that it was necessary to pay such large salaries in order to attract the best talent appeared spurious to most shareholders because they had been in the job prior to privatisation. In the case of British Gas this coincided with a high degree of dissatisfaction with the provision of gas as measured by the number of official complaints received by the gas regulator, and in 1995 the British Gas Annual General Meeting was attended by a pig by the name of Cedric (the unfortunate CEO of British Gas was called
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Cedric Brown) brought by a group of dissatisfied small shareholders. In the event it proved impossible for the small shareholders to censure the management board because the large institutional investors supported the existing management. The privatised Water Companies caused similar dissatisfaction; for example, the people of Yorkshire (one of the rainiest areas in Europe) had to suffer restricted supplies because of water shortages at a time when management freely admitted that about one third of all water was being lost through leaks in the pipes. Once more it proved impossible for the small shareholders to oust what they perceived as incompetent and greedy top management. No position is taken here on whether the top management of these organisations were in fact greedy and incompetent; the point is that a significant minority of shareholders felt that they were but were unable to do anything about it.

3.9

Means and Ends
An issue which is closely related to the process of disaggregating objectives is the difference between means and ends, i.e. what is to be achieved ought to be differentiated from how it is to be achieved; the distinction between means and ends is not always clear cut when applied to many real life situations, and this can lead to confusion as to the nature of objectives. For example, the objective of a company may be to achieve a 15 per cent rate of return on investment. The extent to which this is best achieved by a happy and stable workforce, or by being associated with high-quality products, depends on subjective judgements concerning the contribution of each to the profit objective; because of the importance a company lays on a happy and stable workforce, many managers, and their subordinates, may gain the impression that this is an objective of the company. Strictly speaking, it is a means to an end. It may in time become embedded in the culture of the company, and trade-offs may be made between profits and the perceived well-being of the workforce. As an alternative to specifying aggregate and disaggregated objectives, the process of achieving a corporate objective could be set out as a series of means to achieve the desired end as follows: • • END Achieve 15 per cent ROI MARKETING MEANS Achieve 23 per cent market share Improve quality Achieve more effective quality control PRODUCTION MEANS Reduce unit cost by 4 per cent Stabilise labour force Improve sports facilities

Some managers might argue that the distinction between means and ends is merely a semantic issue, and has no operational significance. However, the notion can be applied in many real life situations. For example, the issue of
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providing amenable working conditions can generate heated discussions; it is important to discover if the parties are disagreeing about the level of expenditure because of differing views on the contribution of working conditions to productivity (the connection between working conditions and job performance using the two-factor theory of motivation was discussed at 1.3, where the necessary but not sufficient condition relating working conditions to job performance was identified), or because one party to the argument feels that good working conditions are desirable in their own right. In the former case a judgement can be reached based on differing estimates of productivity, but in the latter there can be no recourse to facts because the matter hinges on a question of individual value systems. Some managers see good working conditions as an end in itself, others as a means to an end.

3.10 Behavioural versus Economic and Financial Objectives
There are two approaches to this issue. The approach which stems from economics, marketing and finance stresses that objectives must be primarily expressed in economic or financial terms, otherwise they are not related to market conditions, do not indicate the efficiency of the resource conversion process, and hence cannot be used as a basis for rational resource allocation. The behaviourist approach argues that effective interpersonal processes greatly improve the probability of success for the company as a whole; a company which has efficient communication systems, good labour relations and a contented workforce is in a strong position to succeed in the competitive market place. Even imprecise behavioural notions, such as maintaining a socially conscious public profile, are real enough to employees and can be interpreted as a reflection of their performance. Behaviourists point out that in many cases financial and economic objectives are no more than wishful thinking, and are based on assumptions and projections which are even less precise than behavioural characteristics. There is no right or wrong approach to setting objectives, given the speculative base on which they are founded. While it may be true that behavioural objectives contribute significantly to a company’s success, no company can afford to ignore economic and financial objectives which, by their very nature, are susceptible to measurement and evaluation. A company which does not meet minimum economic and financial objectives may not stay in business long enough to be rescued by behavioural attributes. The two approaches are complementary, but it is impossible to say which comes first. The achievement of financial objectives makes it possible to create the behavioural environment which makes it possible to aspire to higher financial objectives which, etc.

3.11 Economic Objectives
Those who have not been instructed in economics often assume that economic and financial objectives are the same, but this is not necessarily the case. Economists have always taken into account motives which cannot be expressed in financial or monetary terms. In fact, the first question asked by an economist
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when analysing behaviour is ‘What is being maximised?’ The reason for expressing the issue in this way is that, unless an objective is specified, decisions and actions could be random because the consequences do not matter. The idea of maximisation takes the notion of objectives a stage further, in that it takes into account the fact that additional resources devoted to the achievement of any particular objective are likely to yield diminishing returns after some point. For example, a company may have the objective of maximising the contribution from the sales of a certain product; this does not imply that a limitless amount of resources should be devoted to the product because, after a certain level, it becomes virtually impossible to increase market share without disproportionate increases in marketing expenditure, causing contribution to decline. Thus the notion of maximisation combines an objective with a resource allocation implication, i.e. additional resources should be devoted to the achievement of an objective up to the point where additional resources have no positive impact. The confusion between economic and financial objectives is partly accounted for by the fact that, when constructing theories of behaviour, economists assume that individuals attempt to maximise their welfare or happiness, and companies attempt to maximise profits. While it is accepted that this is a simplified version of what motivates individuals and companies, these assumptions are normally regarded as being strong enough to capture a large element of motivation. Naturally, there has always been debate about the extent to which individuals and companies attempt to maximise anything. The best known objection is that altruism, both on the part of individuals and companies, is an example of non-maximising behaviour. However, this is not necessarily the case, because it may be that the altruistic individual derives more satisfaction from giving some money away to the poor than by spending it, and is therefore maximising satisfaction by giving money away. Companies which donate cash to causes such as charities, orchestras and sports may be pursuing similar objectives: their shareholders are jointly willing to forgo some income for altruistic purposes, and/or the management considers that there is a market payoff from at least some of these activities. A strong position on maximisation is that actions which are inconsistent with maximising welfare are illogical for the individual, because a preferred position is by definition one which makes the individual happier. Similarly, it is illogical for a company to act in a manner which is inconsistent with profit maximisation, because in a competitive market it will eventually be driven out of business. In fact, despite the arguments surrounding it, the welfare and profit maximisation concept is consistent with a wide variety of behaviour and provides the theoretical basis for analysing and explaining many economic phenomena. The central role which profit maximisation plays as a company objective can be illustrated by considering the impact of any other objective on profits. For example, a company which pursues what it considers to be enlightened labour relations policies may cause labour productivity to be lower than it otherwise would have been, putting the company at a potential competitive disadvantage. Similarly, if the company has a policy of high quality output, the rationale must be that policy makers believe the consequences for segmentation, market share
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and hence profits are worthwhile; otherwise, insistence on quality may place the company under threat. Thus when setting objectives, policy makers need to pay attention to the potential contribution of each option to long run profits. This approach may appear at first to be somewhat ruthless; managers may consider that there is little point in running a company which is not a pleasant place to work. However, in a competitive labour market, companies which are not pleasant to work in are likely to have more difficulty in recruitment and turnover rates than those which are pleasant, with implications for productivity and costs. Indeed, economists argue that the operation of the market is the vehicle by which many improvements in working conditions are introduced into companies: those which do not improve conditions in line with the general desires of the working population are likely to end up at a competitive disadvantage. A practical objection which is often levelled at the notion of profit maximisation is that it is an unattainable ideal because of the vast number of options which would have to be evaluated to find the one which maximises profit. There is no doubt that there are significant costs associated with search, and that these should be taken into account in the process of evaluating alternative courses of action. The problem of bounded rationality, and its solution known as ‘satisficing’, which involves choosing the first alternative which meets a predetermined criterion of acceptability, was discussed in 1.3. An example of a satisficing criterion is the ‘hurdle’ rate used in financial appraisal, where the most profitable among a set of identified alternatives is accepted only if it generates a return higher than the ‘hurdle’ rate. A further objection is that companies exist in a continuously changing dynamic environment, and there is no such thing as a single profit maximising decision. Decisions are of varying importance to the company, and many decisions have to be taken at relatively short notice leaving little opportunity for detailed analysis. This is a valid criticism of the idea of profit maximisation, as it may well be impossible to ascertain the connection between profit maximisation and decision making, given the number of issues which bear on individual decisions in a dynamic setting. For example, it may be decided not to undertake a potentially profitable investment because the company is marshalling its resources for a strategic assault in a different market; taken in isolation the decision may not appear to be consistent with profit maximisation, but in the wider strategic sense it is. This is illustrative of the fact that the simple textbook objective of profit maximisation is difficult to translate into real life actions; the issue then becomes whether companies act in a manner which is generally consistent with the concept of profit maximisation. Empirical research reveals that few companies actually express their objectives in terms that an economist would recognise as approximating to long run profit maximisation. A possible explanation for this finding is that the profit maximisation objective is a self fulfilling prophecy, in that the competitive process weeds out those companies which do not follow policies broadly consistent with it. If this is true, then the company which is explicit in defining its profit maximisation objective in a strategic planning context is likely to be taking account of one of the major forces determining company survival.
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3.12 Financial Objectives
The application of financial concepts makes it possible to quantify the profit maximisation objective. In economics, the profit maximisation objective is expressed in terms of comparative statics, i.e. it is assumed that all future cash flows can be collapsed to a present value so that projects which are undertaken at the present with different cash flows in the future can be compared. The application of rigorous financial appraisal to the quantification of objectives is of basic importance in understanding shareholder wealth creation, and it is necessary at this stage to outline the main financial concepts which underlie the approach. The intention is not to present a full exposition of financial concepts and theory, but simply to indicate those areas of finance which are of particular relevance in the derivation of measures of company objectives. 3.12.1

Discounting and Present Value
The notion of discounting is fundamental to understanding financial appraisal. It is the technique for converting streams of future positive and negative net cash flows into current terms. It takes account of the fact that a dollar in the future, say in five years’ time, is worth less than a dollar now because a dollar now can be invested to produce a stream of income over the next five years. The value of a dollar in one year’s time is the original dollar plus the interest for the year, i.e.
Dollar in one year = 1 × (1 + r )

where r is the rate of interest. Looking at a dollar which is received in a year’s time, the value today of one dollar is:
Dollar today = 1 (1 + r )

The value today of a dollar in two years’ time is:
Dollar today = = 1 (1 + r ) × (1 + r ) 1 (1 + r )2

This can be generalised to give the value today of a dollar at any time in the future:
Dollar today = 1 (1 + r )n

where n is the number of years in the future. Thus by using the rate of interest and the time period, it is possible to express a dollar in what is known as ‘present value’ terms. This makes it possible to compare the value of cash received at different times.
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X dollars today =

X (1 + r )n

3.12.2

Net Present Value
When an investment is undertaken, the cash flow pattern is usually negative at the beginning, when the expenditures are made, and positive thereafter when the investment generates income. A typical cash flow stream associated with an investment is: −A1 , A2 , A3 , . . . , An where A1 = expenditure in Year 1, and A2 , . . . , An = income in Years 2 to n. The net present value (NPV) is found by summing the discounted streams of future expenditure and income over the life of a project: A2 A3 An + + ... + 2 3 (1 + r )n (1 + r ) (1 + r ) where r = cost of capital to the company
NPV = (1 + r ) +

− A1

If the NPV is positive, it means that the investment yields a value over its life, and is worth considering. Typically the choice between potential projects is made on the basis of which generates the higher NPV. If a project has a negative NPV the company would be better off putting the money in the bank. One way of assessing strategy options is to think in terms of cash flows: what are the initial costs of the strategy and what are the expected cash flows? As will be seen, it is typically not possible to reduce strategic choice to such a straightforward calculation, but the approach is valuable in focusing on a very important aspect of the strategy process, namely the potential for generating cash flows. 3.12.3

Capitalised Value
Imagine you were left a bond which provided an annual income of $100; how much would you be willing to sell this bond for? You would be willing to consider any offer of at least the amount which, when invested at the current rate of interest, gave an income of $100 per year. If the current interest rate were 5 per cent you would work out the following:
Income stream = Capital sum × Interest rate 100 = Capital sum × 0.05

therefore
Capital sum = Income stream Interest rate 100 Capital sum = = 2000 0.05
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Thus the capitalised value of a stream of income is found by dividing the annual income by the interest rate. The same reasoning applies to a constant stream of costs. Any future stream of income or cost can be converted to a capitalised value. Another way of looking at this is that a guaranteed income and a capital sum come to the same thing. Take the case of holding a share in a company: divide the expected income by the going interest rate and you obtain an approximation to the share price. You would, in fact, add a premium to the interest rate to reflect your estimate of risk associated with that company. One method of evaluating the return on a share is to use the price earnings ratio. For example, a ratio of 20 suggests that the interest rate (plus risk premium) is 5 per cent. Why do some shares have very high price earnings ratios, i.e. low rates of return? It is because earnings are expected to grow in the future; for example, if the growth rate in earnings was expected to be 1 per cent for ever, the capitalised value of the income stream shown above would be approximately:
Capital sum = 100 0.05 − 0.01 = 2500

This gives a current price earnings ratio of 25. Thus the value of a share, or the value of any asset, is determined by the expected future income stream accruing from that asset. In fact, the calculation demonstrates that the share value is quite sensitive to relatively marginal changes in expectations of future growth rates. This is why companies go to great lengths to maintain confidence in their prospects and why they are averse to releasing information which might affect the financial market’s perception. Thus the Annual Report is usually an optimistic document and rarely contains unexpected bad news such as a major loss; if a loss is in prospect the information will typically be leaked to the press over a period so that when the information does become public the impact on the share price is not catastrophic. In July 1996 the shares in Great Universal Stores, a UK home shopping to finance conglomerate, fell by 35p to 637p after reporting a rise of 3.25 per cent in profits over the previous year. This was in fact GUS’s 48th consecutive year of profit increases. How could the share price fall when reported profits had increased? The answer is that market analysts had expected a much larger increase in profits, and this expectation had been included in the share price. When the ‘disappointing’ news became public the price immediately adjusted to a revised profit expectation. 3.12.4

Choice of Interest Rate: The Cost of Capital
When carrying out NPV calculations it is necessary to select a rate of interest to use for discounting. The obvious choice of interest rate is the cost to the company of raising money on the open market, and this is usually termed the cost of capital. There are two methods of raising finance: debt and equity. The cost of finance from the two sources can be significantly different, and thus the proportion of finance raised by the two methods can affect the composite cost of capital.

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So far as debt is concerned, the relevant rate of interest is the cost to the company of the capital over the planning period, i.e. the rate of interest payable on debt which matures at the end of the planning period. The cost of debt cannot be determined on a historical basis; it is the cost of new debt which determines the true present value of future cash flow streams. It may not be possible to predict the cost of debt precisely because a company may operate on the basis of short term debts, with continuous loan restructuring. However, the best estimate of the cost of debt is the interest rate on a loan of the appropriate duration, not the cost of debt in the past. Equity finance raises a number of problems, the most obvious of which is that the rate of return on equity is not known, and therefore must be estimated. In conceptual terms, the rate of return which should be estimated is the implicit rate of return, which is the rate that just induces shareholders to purchase equity in the company. The implicit rate has two components: the risk free rate and an allowance for risk, known as the equity risk premium. The risk free rate comprises the market rate plus the expected inflation rate; the risk free rate is partly a function of the current interest rate, and partly determined by expectations. It can be approximated to by the rate of return offered on long term government debt, which is the nearest thing to a risk free investment available on the market. The equity risk premium is based on the market assessment of the risk associated with the company. This is affected by the track record of the company’s managers, past dividend payments and profitability. The theory known as capital asset pricing provides a perspective on the appropriate method of calculating and allowing for risk. The objective of this theory is to explain what determines the value of a company’s shares by taking into account different forms of risk, and it is an important part of modern finance theory. The value of the common stock of a company can be interpreted as the capitalised value of the future expected stream of income from the stock, i.e. the expected future stream of dividends. The capitalised value of the future expected stream depends on the current interest rate plus an adjustment for risk. It is the approach to risk which differentiates the capital asset pricing model. In simplified terms, the appropriate risk is that which cannot be eliminated by holding the shares of the company in a portfolio. This is known as nondiversifiable risk. It is estimated by taking into account not only the variability of a company’s dividends in the past, but the correlation between company dividends and those paid by the rest of the market. (The Beta coefficient is a well known method of calculating risk of this type.) An important implication of the capital asset pricing model is that the discount rate applied to individual investments by the company should include the measure of non-diversifiable risk; this is because the company is in competition for funds, and suppliers of funds require information on risk when structuring their portfolios. While there are many problems associated with measuring the appropriate cost of capital for the company, it is important that the issues of the cost of debt, the risk free rate and the equity risk premium are taken into account. If a discount rate is used which does not properly represent the cost of capital the calculation will generate misleading information on value creation. The connection between market performance and the discount factor which
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should be applied to investments is one of the important links between capital markets and what managers actually do. The external perception of the company has a double edged effect. If the financial market takes a pessimistic view of future expected cash flows then the share price will suffer, as was the case for GUS; at the same time, if the company is seen as a risky proposition the cost of raising equity finance will be significantly increased. It is not surprising that companies try to project an image of stability with secure growth prospects. In the turbulent business environment of today this is extremely difficult to maintain for any length of time. 3.12.5

Return on Investment
The profit maximisation objective can be expressed as maximising the rate of return on investment; in practical terms this involves taking into account a stream of investments over time, changes in interest rates, liquidity and cash flow requirements, tax incidence, the portfolio of assets, dividend payments, and many other considerations. Because of the difficulty of reducing these complex calculations to a single figure managers tend to use alternative measures which can be calculated relatively easily. Perhaps the most widely used is return on investment (ROI), which is usually expressed as net income divided by value of assets in a particular year. While ROI can be used as an alternative to a more sophisticated rate of return calculation, the fact that it is based on a simple concept raises reservations about its use. The main drawback associated with using ROI as a company objective is that the figures for both asset values and income are historical. It therefore may not capture the income earning potential of the company produced by recent investment. Furthermore, the figure used for the value of assets is typically arbitrary, being the result of accounting depreciation procedures. On the other hand, it is often contended that despite the deficiencies of ROI, it still contains sufficient useful information for determining company objectives. Critics contend that this is not necessarily the case, and ROI may actually produce misleading information, which may be worse than having no information at all, since adherence to a mistaken objective could result in misallocating resources. Table 3.2 is designed to illustrate the main pitfalls associated with using ROI; it shows the cash flows resulting from an initial investment of $1 million which is depreciated over five years using the straight line method.
Table 3.2
Year Cash flows

Return on investment over time
1 175 200 2 250 200 50 800 200 600 700 7.1% 3 350 200 150 600 200 400 500 30.0% 4 400 200 200 400 200 200 300 66.7% 5 400 200 200 200 200 0 100 200%

− Depreciation
Net income Book value start year

−25
1000 200 800 900

− Depreciation
Book value end year Average book value Return on investment

−2.8%

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The ROI varies between −2.8 per cent and 200 per cent during the five years; different depreciation conventions would lead to different series of ROIs. It is difficult to relate the ROIs for different years to relative cash flows. For example, the increase in ROI from 7.1 per cent in Year 2 to 30 per cent in Year 3 is partly due to the increase in cash flow and partly due to the lower book value which appears in the denominator; the 200 per cent ROI in Year 5 is based on the same cash flow as the 66.7 per cent in Year 4. It is therefore virtually impossible to use the ROI calculations as the basis for choosing among competing investment possibilities. One method of generating a single ROI is to calculate the average ROI using the average book value and the average cash flow; this gives an ROI of 29 per cent. The drawback of this calculation is that it takes no account of the distribution of cash flows over time; the discounting approach gives an Internal Rate of Return of 15 per cent (the interest rate which just gives an NPV of zero); thus not only does the ROI calculation provide results which are difficult to interpret, but the ROI calculation may result in an overestimate of the rate of return on the investment. Despite the difficulties associated with ROI it should not be dismissed as irrelevant to decision making. While it may provide a misleading view of the rate of return on a single investment, the average ROI for a company as a whole, which is comprised of returns derived from many assets of various vintages, may be sufficiently accurate to monitor a company’s performance. For example, if the ROI were to fall from 18 per cent to 8 per cent from one year to the next, this is a clear signal that something is amiss and that resources are not being utilised as efficiently in the second year. This may be a ‘red herring’ at times, but it is unlikely that major changes in the company’s ROI are due merely to accounting conventions. The fact is that accounting information is extremely difficult to use in an unambiguous fashion, but it is the only information available and it is essential that as much use of it is made as possible. 3.12.6

Shareholder Wealth
This definition of company objectives originates from the proposition that the primary objective of a company is to maximise the wealth of those who own it, namely the shareholders. It ignores value which may accrue to other stakeholders because they do not have a direct impact on the allocation of financial resources among companies. The approach is similar to that of working out a capitalised value:
Shareholder wealth = Expected income stream Interest rate

The market forms its view on the expected income stream on the basis of published company accounts, the track record of the company, and announcements about company plans. The interest rate which is used to derive the capitalised value will contain an allowance for the risk associated with the company. This measure of shareholder wealth differs from the total capitalisation of the company on the stock market; it is more useful than market capitalisation because while there is a connection between share value and effective management in
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the long run, share value on its own cannot be used as a day to day company objective because it also varies with many factors, such as the state of the stock market as a whole, which are unrelated to company operations. Shareholder wealth analysis is based on a detailed analysis of the revenue generating potential of the various parts of the business, and hence may often bear little relation to the market valuation. There are several stages in estimating shareholder wealth. • Stage 1: Decide on the Planning Period The planning period is defined in various ways, for example as that period beyond which the company can expect to earn exactly its cost of capital on new investments. It is the period during which meaningful projections can be made, and is typically around five years in real life. Stage 2: Determine the Cost of Capital The process of determining the cost of capital is described above under ‘Choice of Interest Rate’. Stage 3: Decide on the Residual Cash Flow This is the constant net cash flow predicted after the end of the planning period. Stage 4: Determine the Cash Flows during the Planning Period This depends on investment and marketing strategies. Stage 5: Calculate Net Present Value of Cash Flows during the Planning Period The process is explained under ‘Net Present Value’. Stage 6: Calculate the Present Capitalised Value of the Residual Cash Flow The process for calculating the capitalised value is explained under ‘Capitalised Value’. This value is discounted back to the present, since it does not occur until after the end of the planning period. Stage 7: Add the Net Present Value, Capitalised Residual Value, Marketable Securities minus Debt The current debts of the company must be set against expected future income, and any assets which are not involved in wealth production must be added to the total. There is a distinction between the value to shareholders of wealth producing assets (which could be sold on the market), and non wealth producing assets. The former cannot be sold without reducing the expected stream of income, therefore to add them in would be double counting. The latter are the result of past wealth generation which have not been distributed to shareholders.
Estimating shareholder wealth ($million)
Cash flows Year Shareholder wealth 857 PV flows 393 PV residual 464 1 100 2 110 3 120 4 130 5 140 6+ 140

• •

Table 3.3

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Table 3.3 is an example of a shareholder wealth calculation using a 5 year planning period and a cost of capital of 15 per cent. The cash flows start at $100 million and increase to $140 million by Year 5; from Year 6 on it is assumed that cash flows will be constant at $140 million. The Present Value of the cash flows from Year 1 to Year 5 is $393 million, and the Present Value of the residual is $464 million. In this case the present value of the residual cash flow is greater than the present value of cash flows during the planning period. It should be clear from the above that the calculations made by the company, using all the information available on future prospects, is unlikely to accord with the market valuation of shares. However, it is a fair indication of the underlying value creation potential of the company. This is a more sophisticated approach than simply using a constant growth factor in perpetuity, because it takes into account that the company cannot be expected to grow indefinitely. This approach to value creation has important implications for the perspective taken on potential strategies because the ultimate test of a strategy is whether it is likely to add to shareholder wealth. It concentrates attention on the impact of strategies on future cash flows, and forces managers to be explicit about how potential cash flows will be generated. Because it is a company-wide idea, the impact of strategies on the cash flows of the company as a whole is taken into account, enabling a wider perspective on investment appraisal, which typically focuses on directly relevant cash flows. An additional use of the shareholder wealth approach is to break down the company into its value generating components. It is a revealing exercise to estimate which activities generate value and compare these to the activities on which managers spend their time. The notion of using shareholder value as a company objective might at first appear to be somewhat unrealistic, being based on projections of cash flows and the residual value which may have little operational meaning to individual managers. However, the underlying idea is simple, and should be borne in mind by managers at all levels in an organisation; posing the question ‘in what sense is this activity adding value to the company?’ is a powerful method for focusing the mind on the relevance of alternative courses of action. Shareholder wealth is in fact used by sophisticated stock exchange analysts to assess the underlying effectiveness of companies. During 1991 Lord Hanson, a noted take-over expert, bought a very small percentage of the huge British company Imperial Chemical Industries (ICI). Immediately there was public concern that this previously successful company, with its distinguished record of R&D, would fall prey to asset stripping. Fears were expressed that the huge ICI R& D programme would be abandoned if Hanson was successful, and ICI mounted a vigorous defence. But a different viewpoint was expressed by New York analyst Mark Gressle (employed by Stern Stewart), who uses a model of shareholder value creation (which he calls Market Value Added, or MVA); the MVA technique is similar to the shareholder wealth approach described above. Gressle argued that in the period 1984 to 1988 Hanson had generated £2.7 billion in wealth for investors compared to the £0.5 billion generated by ICI. In fact, some quite famous companies have been wealth destroyers, according to the MVA model, which identified some famous British wealth destroyers as shown
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in Table 3.4.
Table 3.4 Wealth destruction
Wealth destroyed 1984–1988 (£million) British Aerospace General Electrics Co. Allied-Lyons British Telecom
Source: Stern Stewart, Extel

Capital invested (£million) 1 787 4 240 6 345 13 024

1 240 1 064 533 413

The Gressle argument is quite simple: could Hanson generate more wealth for shareholders than the existing management? The market seemed to think so, because the value of ICI increased significantly when Hanson made his initial share purchase. However, mainly as a result of poor publicity, Hanson did not proceed with the take-over, but he did sell his shares for a substantial profit! He thus achieved some of the wealth gain which he might have generated if the take-over had gone ahead. Three months after Hanson sold his shares in ICI, it was announced that the company would split into two parts: ICI and ICI Biosciences (later named Zeneca), the latter specialising largely in pharmaceuticals, which was a distinctive part of the company. This ‘demerger’ was a clear recognition of the fact that size and diversity are not necessarily efficient; it also corroborated the Gressle argument about ICI’s ability to create wealth compared to Hanson’s.

3.13 Social Objectives
There is plenty of scope for disagreement among those managers whose objectives can be characterised as profit maximisation; these disagreements revolve around the appropriate measure of profit making. However, there is another body of thought which takes the view that companies should have objectives which are much broader in scope than simply maximising profits. These objectives might include the minimisation of pollution and creating employment opportunities for the disadvantaged and for those who live in depressed areas. This view was strongly criticised by Friedman,3 who argued that not only is any other goal than profit maximisation bad for the company, but it can result in a misallocation of resources so that everyone ends up worse off. This, of course, is consistent with the view of Adam Smith, that the interests of society as a whole are served by the self-seeking actions of individuals, while the undesirable side effects of the market can be tackled through collective action using elected governments; attempts by individual companies to shoulder the role of government are misguided. The arguments against incorporating social objectives into company objectives are, first, the lack of efficiency criteria. The most obvious difficulty which a company faces when attempting to incorporate objectives relating to civil rights or ecology is the determination of how much of its scarce resources to devote to any particular end. The next problem is to determine whether this allocation
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of resources is efficient. Given the difficulty managers have in determining the efficiency of resource allocation within the company itself, such a venture is bound to be frustrating. It may be that there is a real return on being associated with a ‘green’ approach to production, and in this case ecological concern is really a form of marketing expenditure; furthermore, these returns may only be achieved in the long term. In the extreme, the attempt to achieve social objectives may generate a paternalistic attitude in large companies which is contrary to the concepts of freedom of action upon which the notion of the market system is based. It may also lead to an allocation of resources which an elected government would not agree with; if the government’s view is an expression of the will of the majority, it could be argued that society is less well off than if the government had been allowed to make the choice. The second argument relates to the self-interest of the shareholders. Any company pursuing social objectives which incur costs which the company would not otherwise bear has to compete against rivals who are pursuing a purely profit maximising set of objectives; this means that the company will have higher relative costs. If the end result is that the company goes out of business and shareholders lose their wealth, the attempt to achieve social objectives becomes rather pointless and self-defeating. However, it may be the case that the pursuit of some social objectives incurs trivial costs. In that case the issue of whether to use social objectives is a matter for the owners of the company. The problem is that managers are likely to be unaware of the costs involved, and this is an area where shareholder wealth analysis could be put to use. Attention could be focused on the likely impact of pursuing social objectives on expected cash flows, with the consequent implications for shareholder wealth. The underlying issue here is what is referred to by economists as ‘efficiency versus equity’. The efficiency issue is concerned with maximising the output of goods and services. The equity issue is how the output should be distributed among members of society, bearing in mind that different distribution systems themselves have implications for incentives and hence for efficiency. A generally accepted view now is that managers should not attempt to achieve social objectives directly. Once profits have been made, attempts can be made to discharge social responsibilities which are consistent with the interests of those whom managers represent, i.e. the shareholders in the business. Managers who feel that they should follow their social conscience in the general process of resource allocation may well be doing net harm both to their own company and to society as a whole. This is an example of what the Austrian economist Hayek referred to as the ‘unintended consequences of human action’. While there is no absolute right or wrong concerning which course of action should be taken, managers should be aware of the practical dangers which a non profit maximising approach can generate.

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3.14 Stakeholders
3.14.1

Stakeholder Interest
A variety of individuals and groups have an interest in the organisation and the way in which it is managed, and those individuals and groups are categorised as the stakeholders. The notion of stakeholder extends well beyond the shareholders, or owners of the company, to include managers, employees, customers, suppliers, creditors, the local community and the government. Each stakeholder has a different type of interest in the company, for example the shareholders are concerned with the return on their investment, and the safety of their capital, while customers are concerned with the quality of the product they purchase and after sales service. Thus each stakeholder has an expectation of some return from the company which is not necessarily expressed in financial terms. An outline of the various stakeholders and their interest is shown in Table 3.5.
Table 3.5
Stakeholder Shareholders Managers Employees

Stakeholders and their interests
Interest Return on investment Risk Salary Advancement Salary Advancement Security Fair treatment

Suppliers Customers

Prompt payment Repeat orders Relative value for money Quality Availability

Creditors Local community Government

Cash flow Financial stability Lack of negative externalities Employment prospects Payment of taxes Lawful operation

The main characteristic of this classification is that the interests of the different stakeholders are completely different. This raises the possibility of conflicts of interest, therefore the issue of stakeholder influence needs to be pursued in some detail. There are in fact two distinct issues to be addressed when analysing stakeholder interests and expectations: • •
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which interests are most important; the influence which stakeholders have on the operation of the company.
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The first of these largely relates to how stakeholders feel the company should be run, while the second relates to how the company is actually run. 3.14.2

Stakeholder Interests: The Priorities
It could be argued that this is really a discussion about how society should be run, for example, in a general sense should employees or shareholders be regarded as more important? An individual’s judgement on this is likely to be affected by which group he or she is in, for example it is quite natural for an employee to consider that his day to day involvement with the company is more important than that of the shareholder who may never have been inside the door. It is important to be explicit about the issue of shareholder priorities because it has implications for the efficiency with which the company can be operated. The following are the type of arguments you will encounter on stakeholder priorities, but it is important that you keep an open mind on the issue. Furthermore, this discussion is conducted in terms of a commercial organisation; the not-for-profit sector, which includes education, health provision and charities, will differ in many respects.

Shareholders
The shareholders can be regarded as the most important because they provide the capital for the company and if it does not operate efficiently shareholders can withdraw their funds and invest it in something more profitable. In this respect the shareholders provide a service to the rest of the economy in that they direct resources to those operations which provide the highest financial returns; in that sense everyone benefits from the freedom of choice to pursue the best return on their money. On the other hand it can be argued that shareholders tend to take a short term view of company prospects and it is not safe to leave the destiny of companies to their discretion. This in turn becomes an argument about how efficiently capital markets work, and the fact is that no method has yet been discovered which is as effective as capital markets in directing the allocation of resources in the economy as a whole. Central planning was exposed as a failure with the fall of communism; variations on free market operations have been tried, but these amount to attempts at influencing the way the market works rather than replacing it. So far as the company is concerned, it needs to be recognised that shareholders control the supply of capital, and if their interests are not met in the form of a rate of return which is comparable to other investment opportunities then the company will most likely cease to exist. It is because of this that it is often concluded that shareholder interest is the highest priority stakeholder and companies ignore this at their peril.

Managers
Managers comprise the group which is charged with determining the direction, scope and effectiveness of the business. They are responsible for the allocation of resources, and it is largely upon them that the stakeholders depend for their
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returns. In addition, if managers make the wrong decisions the employees lose their jobs and customers are deprived of the company’s products. It can thus be argued that managers are the most important stakeholders and therefore should be rewarded accordingly. While this is true, there is also a market in managers, and so long as the company treats them at least as well as companies which might compete for their services then they do not need to be singled out for special treatment. Their stakeholder priority is high, but it need not be at the expense of shareholder or employee returns.

Employees
It is on the productive effort of employees that the success of the company depends. But exactly the same argument applies in the case of managers: there is a market in employees which determines the conditions under which they are employed, and again it is unnecessary to single them out for special stakeholder treatment above and beyond that dictated by the market.

Suppliers
The stakeholder priority depends on the number of suppliers which the company uses. The five forces model discussed at 5.12 highlights the bargaining power of suppliers, and when the company is greatly dependent on one supplier it follows that its stakeholder priority is relatively high. But before assigning too high a priority to suppliers it is necessary to determine whether the company can substitute for other suppliers, or increase the number of suppliers. If there is a high degree of dependence with a supplier then this may be a case for vertical integration, but typically recourse to the market will reveal that there are plenty of other suppliers. It may be that a long term relationship has been developed with certain suppliers which provides security of supplies, flexibility and so on. But it has to be recognised that there are costs as well as benefits in such a relationship, and if dependence on particular suppliers is found to have an unjustified influence on the management and direction of the company then the stakeholder priority must be reconsidered.

Customers
It is clearly important to provide customers with what they want, but this is because they can take their custom elsewhere in competitive markets. Other than the obvious fact that the company sells to customers, it is difficult to see what priority should be accorded to customers as stakeholders.

Creditors
As capital markets have become increasingly competitive the interests of individual creditors has diminished. If the creditor has made a realistic estimate of the client then it will be reasonably confident that its debts will be serviced and need have no other interest in the company.
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Local community
Companies depend on their local community for employees, services, land, planning permission and so on; the local community depends on the company for employment and the creation of wealth. Both sides benefit from the arrangement and in this respect it is important for the company to live in harmony with the local community. There is no doubt that the local community has a valid stakeholder interest, and these need to be taken into account in company decision making.

Government
So long as the company pays its taxes and acts according to the law there is no need for the government to figure in its decision making. In a market economy the role of the government is to set the rules of the game and monitor that they are being adhered to. The government really has no stakeholder interest beyond this for market companies. In government run organisations such as the civil service this is not the case, but here the government acts as a shareholder and it is in that sense that it has a high stakeholder priority. 3.14.3

Stakeholder Influence
While it can be argued that in principle some stakeholders should have little interest in the company, the existence of legislative, institutional and historical factors can imbue stakeholders with a significant degree of influence; for example, a strong trade union can result in employees having a significant impact on major company decisions. In the not-for-profit sector there are typically many interest groups who have to be consulted. It is not only the degree of influence which is important, but the fact that the interests of stakeholders are often in conflict; this leads to the principal agent problem discussed in section 3.8. While the profile of stakeholder influence varies among different companies, the following indicates the factors which determine how important that influence is likely to be.

Shareholders
Despite their importance, shareholders usually exert little influence on major company decisions or how the company is run from day to day. Large companies typically have many shareholders and they are geographically isolated, coming together, if at all, only for the annual general meeting. Power rests with the executives, and it is only in exceptional circumstances that CEOs are censured or dismissed at the AGM; this is an aspect of the principal agent problem discussed at 3.8. In some cases large financial institutions, which manage portfolios for pension funds and investment trusts, may have a significant shareholding in a particular company; if the institutional shareholders together take a similar view on a particular issue they may wield some power over company executives at the AGM. However, it must be recognised that these financial institutions are really the representatives of the individuals whose money they manage, and there is
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no guarantee that they will act in accordance with these individuals’ wishes. In smaller companies, which are family owned or have a few partners, the shareholders wield a direct influence on company operations. But in this case they typically play the dual role of shareholders and managers, and this negates the principal agent problem.

Managers
By and large the influence of managers increases with the size of the company, as the influence of the shareholders diminishes. The independence of managers also depends on the type of remuneration package – whether it is related to absolute profits, growth in sales, successful acquisitions, or whatever. Ideally, the management incentive structure would be aligned with shareholder interests, which are largely profit maximisation, but this is notoriously difficult to achieve. There are many examples of CEOs receiving huge salary increases at the same time as company fortunes are falling – this is usually because remuneration is lagged and is related not to current but to past performance. One method of attempting to align the two is to make the CEO a shareholder by giving stock options instead of direct remuneration. While the outcome of this should be the maximisation of shareholder wealth, the CEO has an incentive to cash in the options at the most opportune time, and this may not be consistent with long term profit maximisation. In principle, the role of the non executive board members, and an independent chairman, is to provide the countervailing power which will balance up the interests of managers and stakeholders, but given the limited time which the non-executives spend in the company, and the fact that directorships are often interlocking, the non-executives often wield little real power.

Employees
There was a time in the UK when trade unions had sufficient numerical strength, and the backing of legislation, to ensure that employees had a significant impact on company decision making. The changes in the legislation in the 1980s, coupled with an absolute decline in trade union membership led to a significant reduction in this form of employee influence. In some countries, such as Germany, employee influence is much higher because of labour legislation which is more favourable to employees than is the case in the UK. Thus much depends on the individual country and its legislation. However, employees wield influence in a different way. At the simplest level, it is not feasible for a company to replace its entire workforce at a stroke. Even if it were, the new employees would start off far down the experience curve and productivity and competitiveness would be severely undermined. Thus the company is to a great extent dependent on the skills and attributes of the current employees. In this case it is not so much the direct influence of employees on company decision making which is important, but the extent to which they are able and willing to collaborate in the changes which strategic decision making involves. This in turn depends on the company culture, organisational structure, incentives and so on. The more specific the employee skill sets are to the individual company the more important this factor is likely to be.
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Suppliers
As discussed above, the important considerations are the number of suppliers and the availability of substitutes.

Customers
Again, the five forces model reveals that the number of customers or customer groups largely determines customer influence. On the other hand, if there are few substitutes for the company’s products this power will be greatly diminished.

Creditors
Companies tend to build relationships with sources of credit, such as banks, so that they can rely on a fast and fairly sympathetic reaction to credit requirements. Some companies have representatives of creditors on the board; this is usually the outcome of venture capital being provided by banks for high risk start ups who wish to monitor their investments. But typically this involvement diminishes as the management establishes a track record. Companies have the option of financing investments from retained earnings, obtaining loans, or a combination of both. It could be argued that a company which has become so dependent on a particular bank that it exerts influence on company operations only has itself to blame. In principle, the influence wielded by the bank is to decide whether to provide a loan, and it does this in competition with other banks. Where a relationship has been established it can be costly to change creditor, but this is an issue of costs and benefits rather than creditor influence. The fact that the company is highly geared (as discussed at 6.12) may constrain its activities, but it is difficult to see how the creditor can exert direct influence on the company unless it has put the creditors’ funds at risk.

Local community
The influence of the local community is in the form of a series of constraints. For example, if the company develops a reputation as a good employer, it will typically have little difficulty in recruiting at the going wage rate; however the opposite is likely to apply if its reputation is suspect. If the company pollutes the locality it will probably have difficulty obtaining permission for expansion.

Government
Apart from regulation, the government can influence companies by its own role as a purchaser and its policies on subsidies and trade. The purchasing influence affects companies in the defence industry, subsidies affect companies in the sectors which the government is attempting to encourage, and trade policy affects importers and exporters. Again the extent of shareholder influence depends on the individual case.

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3.14.4

Mapping Stakeholders
In order to understand why a company operates in the way it does, or to assess its potential for change, the influence of the individual stakeholders needs to be identified and prioritised. The general principles of stakeholder influence discussed above will not necessarily apply to every case. In most instances it is pointed out that there are likely to be significantly different levels of influence in individual cases. The results of the stakeholder analysis can be mapped in the following way. Consider a company which is family owned and the family maintains a close control on the business, uses mostly unionised labour and supplies a single customer; one of the owners is currently considering moving into new markets. The stakeholder map relating to this potential course of action might look like: Stakeholder Shareholders (family) Managers Employees Existing customers Suppliers Influence High Low High Low Low Priority High High Low High High

The potential move into new markets can then be considered in the light of the priorities attributed to and the influence wielded by stakeholders; this form of mapping makes it possible to focus on those stakeholders who are likely to have a major influence on successful change. For example, in this case while employees have a low priority they have a potentially high influence on the outcome. Closer investigation may reveal that the change would be constrained by • • the attitudes of the other shareholders; the willingness of the employees to accept change.

An organisational change which is not accompanied with some form of stakeholder mapping may well run into constraints which could have been identified well in advance. The stakeholder map can usefully be presented diagrammatically as shown in Figure 3.2. Clearly the precise location of each stakeholder is a matter of subjective judgement, but the diagram immediately identifies clusters of stakeholders, who may therefore require a similar degree of consideration, and outliers such as the shareholders who in this case occupy a unique position. Any movement in the relative positions of stakeholders can be tracked over time as a means of identifying the changing power structure confronting the company. A final point must be made in response to those who consider that the whole notion of stakeholders is irrelevant to a profit maximising company for many of the reasons outlined under the discussion of stakeholder priorities. The fact is that stakeholders do wield varying degrees of influence in any organisation and often decisions taken reflect an implicit mapping of stakeholders on the part of
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senior management. If this implicit mapping turns out to be seriously in error then it is quite likely that outcomes will not turn out as intended.

High Employees Shareholders Influence

Customers Managers Suppliers Low Priority High

Figure 3.2

A stakeholder map

3.15 Ethical Considerations
The extreme characterisation of a manager as a Dickensian capitalist with no moral feeling other than the desire to make money is rarely encountered in real life; managers are just the same as anyone else, and have a set of moral values based on parents, education, religion and so on. Managers strive as hard as anyone else to act in a way which is consistent with their moral outlook. In the complex world of business it is usually very difficult to define appropriate moral codes of conduct. At 3.9 it was pointed out that managers should attempt to be clear about the distinction between means and ends. A related issue is whether a particular means justifies a particular end. By the nature of production, costs are incurred in the creation of output; sometimes these costs can be very high to some of the individuals involved. However, moral issues are never simple to resolve; for example, at 3.13 it was argued that companies which attempt to meet social rather than profit related objectives may do more harm than good, and in that sense their well meaning attempts could be regarded as immoral. Many management issues are related to moral dilemmas, but these are often to do with society generally rather than the individual company. For example, in Britain during the eighteenth century children were employed to work in factories and mines in very poor conditions; if society in general was morally satisfied with this arrangement, in what sense was the individual employer acting in an immoral fashion? A striking example of a change in moral values was witnessed in the late 1980s in relation to the wearing of fur coats. Large sections of the population adopted the view that it was morally wrong to make and wear animal fur coats because it directly or indirectly led to the
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endangerment of species. The moral arguments related to this issue cannot be addressed here but some relevant questions are: • • Does it matter if tigers disappear? Species are eliminated all the time, so what is so special about big cats? There can be genuine disagreement on the contribution of wearing fur coats to the endangerment of species; what are the real facts relating to wearing animal furs? What proportion of the population does it take to decide whether something is immoral or not? It is bad luck for a manager to wake up one morning and find that he is no longer acting in a moral fashion.

Some companies impose a code of ethics on their employees, such as never accepting bribes. This is somewhat difficult to enforce in countries where bribery is socially acceptable, and is not seen as immoral behaviour. To some observers, such ethical attitudes are reminiscent of the zeal with which missionaries attempt to transplant their concepts of morality into other societies. On the other hand, it may simply be the case that such companies are using moral values as a means towards the end of promoting an image of honesty, integrity and dependability which will enhance their competitive potential. To summarise, moral behaviour is difficult to define for companies and for managers. The manager may find it counter-productive to take a stand ‘for the sake of principle’ when that principle is based on a series of dubious premises. The impact which ethical considerations can have on a company became evident when Shell attempted to dispose of the obsolete Brent Spar oil rig by sinking it in the North Sea. The company had carried out exhaustive scientific analyses of the various options, and sinking had emerged as the clear favourite in terms of environmental pollution and cost. However, Greenpeace took the view that the oil rig would be the cause of major pollution on the sea bed, and would lead to many more such disposals. A campaign to boycott Shell petrol stations was instigated, and a group of protestors occupied the oil rig at sea. Eventually, Shell backed down and moved the Brent Spar to a location where it could be dismantled on land. Soon afterwards, Shell announced its intention to invest $2.6 billion in a Nigerian gas plant. Environmentalists claimed that Shell had been responsible for most of the pollution in the Niger Delta during the past 40 years, and that this investment would make things even worse. Shell came under intense pressure not to proceed with this investment. The rights and wrongs of the Brent Spar and Nigerian issues are not the issue: the fact is that these ethical issues had a significant effect on the company. Not only is it virtually impossible to incorporate ethical issues into company objectives, but one survey4 reports that practicing managers have little idea of what ethical behaviour should be. Many felt that performing well and being loyal to the company constituted behaving ethically, while less than one third of employees believed that their firms respected employees who blew the whistle on unethical practices.

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Review Question 1
The CEO of the Mythical Company in Module 1 did not deal with objective setting in the explicit manner set out in this module. 1 2 Apply the gap concept to objective setting in the Mythical Company. Interpret objective setting in the Mythical Company in terms of the main headings in this Module.

Review Question 2
An industrial cleaning company has three divisions under the CEO and provides corporate services of Human Resources and Accounting to the three divisions. Each division has one SBU; these are a factory producing high powered water cleaners, a small chemical plant producing abrasive cleaning fluid and fleet of mobile cleaning teams which tackle difficult industrial cleaning jobs. The sales turnover of SBU1:SBU2:SBU3 is 3:2:1. The SBU1 manager has suggested that the salaries of the three SBU managers should also be in the ratio 3:2:1. It turns out that the only two in favour of the idea are the the SBU1 manager and the Accounting manager from Corporate Services. Set out a discussion between the CEO, the two corporate services officers and the three SBU managers showing why each agrees or disagrees with the proposal.

Case: Porsche: Glamour at a Price (1993)
Everyone knows what a Porsche car is, and its brand image is unique: it is an expensive, luxurious high performance sports status symbol which any major manufacturer would be happy to have in its stable. The company itself is rather unique, in that Porsche is a privately owned company and is run by a very wealthy family whose personal life is little affected by the fortunes of the company, at least in the short term. The family has recently embarked on a programme of rationalisation, and is unwilling to sell Porsche to one of the major manufacturers, several of whom have expressed interest. Porsche car sales reached a record high in the mid 1980s, peaking at about 50 000 cars per year. But by 1991 sales were down to half these levels and the company started making losses. Figure 3.3 shows recent world sales, where the general downward trend from 1986 is clearly visible. At its peak Porsche made profits of about DM120 million on a turnover of about DM5 billion; in 1990 profit was DM17 million on a turnover of DM3.1 billion; in 1991 the loss was DM66 million on a turnover of DM2.7 billion. However, the company has no debt and holds net cash assets of about DM600 million. Figure 3.4 shows sales to Western Europe and the US from 1982 to 1992. The pattern of total sales was dominated by the very large changes in the US market. To some extent this was due to a fluctuating exchange rate, and the movements of the mark against the dollar are shown in Figure 3.5.

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60 50 (in thousands) 40 30 20 10 0 82 83 84 85 86 87 88 89 90 91 92

Figure 3.3

Porsche world sales

(in thousands)

30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 82 83 84 85 86 87 88

Western Europe US

89 90

91 92

Figure 3.4

Porsche sales in Western Europe and US

Analysts take the view that the company is too small to carry on competing now that the market is dominated by very large manufacturers. Critics claim that the cars are old fashioned and relatively expensive, and that the company has not attempted to meet the type of competition appearing from Japan at the luxury end of the sports car market. The company claims that it will introduce a new range of sports cars in 1995.

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25 20 15 10 Percentage 5 0 –5 –10 –15 -20 82 83 84

Annual changes

85 86

87

88

89 90 91

92

Figure 3.5

The mark against the dollar

Questions
1 2 Analyse Porsche’s competitive position over the ten years. Discuss Porsche’s prospects, paying attention to the principal/agent problem and how this might affect the setting of objectives.

References
1 2 3 4 Rappaport, A. (1986) Creating Shareholder Value, The Free Press. Treynor, J. L. (1981) ‘The financial objective in the widely held corporation’, Financial Analysts Journal, March–April. Friedman, M. (1962) Capitalism and Freedom, University of Chicago Press. Badaracco, J. and Webb, A. (1995) ‘Business ethics: the view from the trenches’, California Management Review, Vol. 37, No. 2.

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Module 4

The Company and the Economy
Contents
4.1 4.2 4.3 4.3.1 4.3.2 4.3.3 4.3.4 4.4 4.5 4.6 4.7 4.8 4.8.1 4.8.2 4.8.3 4.9 The Company in the Economic Environment Revenue and Costs: The Basic Model The Workings of the Economy Understanding and Using Economic Information Supply and Demand in the Economy Unemployment and Inflation The International Economy Forecasting: What Will Happen Next? PEST Analysis Environmental Scanning Scenarios The Economy and Profitability Implications for Company Sales and Revenues Competitive Reaction and the Economic Environment Implications for Inputs and Company Costs Environmental Threat and Opportunity Profile: Part 1 4/2 4/3 4/4 4/7 4/10 4/13 4/16 4/21 4/25 4/26 4/27 4/27 4/28 4/29 4/30 4/31 4/34 4/34

Review Questions Case: Revisit Porsche: Glamour at a Price

Learning Objectives
• • • • • To demonstrate why an understanding of the economy is important for managers. To show how different aspects of the economy affect the company. To develop a framework for analysing the state of the economy and understanding economic forecasts. To show how competitive forces are influenced by economic events. To use economic data in deriving an environmental threat and opportunity profile.

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Strategists

Objectives

Who decides to do what

The macro environment

The industry environment

Internal factors

Competitive Analysis and diagnosis position
Feedback

Generic strategy alternatives

Strategy variations

Strategy choice

Choice

Resources and structure

Resource allocation

Evaluation and control

Implementation

4.1

The Company in the Economic Environment
It probably seems like a statement of the obvious that before a company can identify its strategic possibilities it must form a systematic view of the environment and its likely impact on the company, taking into account economic, political and social factors. To many managers this means no more than a general awareness of what is going on in the world at large. However, the development of a systematic view involves much more than general awareness. The process is known as environmental scanning, and provides information which can be used to constuct a political, economic, social and technological (PEST) review of the environment and an environmental threat and opportunity profile (ETOP). The quantity of information to which managers are exposed is vast: from external sources it includes newspaper reports, statistical publications, trade journals and reports; from internal sources it includes management accounts, balance sheets, performance measures, market surveys, and consultancy reports. In the face of this quantity of information, the basic point to bear in mind is that no matter what issue is under investigation the rules of quantitative methods apply: identify important variables, simplify them as far as possible, and subject them to appropriate analyses. At the level of the economy, as opposed to the individual markets within which companies operate, political, economic and social changes occur which can have significant effects on the company. For example, a change in government policy towards pollution can result in companies incurring costs to deal with

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higher emission standards; the change in social attitudes towards smoking had a significant effect on the big tobacco companies.

4.2

Revenue and Costs: The Basic Model
The profitability of a company ultimately depends on the difference between revenue generated and costs incurred; this somewhat obvious fact can be lost sight of in the day to day complexity of running a company. Continual reference to a basic model of revenue and cost generation can help to ensure that the central issues of costs and revenues are maintained as the focus of attention. This is necessary because economy-wide changes can have significant effects on revenues and costs and the likely relative impact of such changes needs to be continually assessed. The model is constructed by identifying the variables which determine revenue and costs and determining the factors which affect these variables. Starting with the case of an individual product, the company generates revenue from sales:
Revenue = Total market × Market share × Price

On the cost side, the company makes expenditures on the acquisition and deployment of productive factors:
Outlay = Number of workers × Wage rate + Units of capital × Price + Units of material × Price

In real life these revenues and costs are often difficult to allocate to specific time periods and products. However, the conceptual model focuses attention on the importance of factors such as market share and prices. The factors which affect the variables in the model include those shown in Table 4.1.
Table 4.1
Variable Total market Market share Price Workforce Wage rate Capital Capital price Materials Materials price

Some determining factors
Determining factors National income; Foreign national income; Population; Preferences; Competing products; Product life cycle. Price; Marketing expenditure; Marketing strategies; Competitor marketing expenditure; Competitor strategies. Demand conditions; Competitive reaction; Competitive advantage; Market segmentation. Labour market conditions; Regional supply variations; Wage rate offered; Working conditions. Labour market conditions; Unemployment rate. Capacity of the capital goods sector. Capital market conditions. Capacity of suppliers. Materials market conditions.

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While the list of determining factors is by no means complete, this display illustrates that it is necessary to have an understanding of a wide range of influences in order to develop a comprehensive picture of company performance. For example, it is not sufficient to recognise that revenue has fallen because of a reduction in market share. In developing potential courses of action to remedy the fall in market share the underlying causes must be identified and addressed. The reduction in market share may have been caused by a decrease in the price charged by competitors which the company has not matched, or by a strategic allocation of marketing resources by competitors which has resulted in the loss of important customers. The model is useful not only for providing a structure for investigating those products which the company is currently producing, but it can also be applied to those which it might produce in the future. The answer to the question ‘What market should we be in?’ requires the analysis of many influences common to current products, although quantification is bound to be less precise and the answers more speculative. The relative importance of the factors in the table will depend on the individual circumstances of the company. These factors themselves are in turn all dependent to some extent on the general state of economic activity. For example, the state of the business cycle has implications for the emergence of competing products, competitor reactions, demand conditions, labour market conditions and the unemployment rate. It follows that since company strategies are conditioned by the overall economic environment, it is important to have an understanding of what determines the behaviour of the economy as a whole.

4.3

The Workings of the Economy
There are several reasons for analysing and attempting to understand the economy. • It is necessary to distinguish between events and influences which are outside the control of the company and those which are the results of its own decisions. For example, if sales revenue unexpectedly declines, it is essential to determine whether this has been caused by general economic conditions, such as a downturn in business activity, rather than by an inadequate marketing response to strategic moves by competitors. It is important to be aware of changes in the economy which may present opportunities or pose threats. For example, economic conditions likely to lead to a rise in interest rates could pose a threat to companies whose sales are largely funded through hire purchase, such as TVs and videos. An understanding of how the economy operates makes it possible to understand and interpret predictions. It is impossible to switch on a current affairs programme on TV without being confronted by an ‘expert’ giving an opinion on the prospects for the economy, and these can often be contradictory. Politicians often make statements about the economy which shows their political opponents in a bad light; you might find yourself agreeing with both sides of an argument about the economy, or tending to accept the last argument you have heard. This is not unusual, and arises partly because of the complexity of the topic and partly because you are likely to be almost
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Strategists

Objectives

Who decides to do what

The macro environment

The industry environment

Internal factors

Competitive Analysis and diagnosis position
Feedback

Generic strategy alternatives

Strategy variations

Strategy choice

Choice

Resources and structure

Resource allocation

Evaluation and control

Implementation

totally ignorant of the underlying model of the economy on which the arguments are based. Some writers on strategy take the position that there is no point to analysing the economy because the behaviour of the economy is unpredictable and, in any case, economists continually disagree about the causes of changes in important variables such as the level of economic activity, interest rates and exchange rates. While it is true that many things are unpredictable (and forecasting will be dealt with at 4.4), this is not a valid argument for ignoring them. If a general understanding of macroeconomics was irrelevant to strategy the subject would certainly not be included in the MBA syllabus. It will emerge in this Module that macroeconomic analysis is an important element of environmental scanning, and can provide the basis for strategic action. Although managers may not be aware of it, their attitudes and management styles can be greatly affected by general economic conditions. A brief outline of UK economic history during the past five decades illustrates this; the lessons of this story have implications for all countries. During the 1950s and 1960s the UK experienced relatively stable prices, growth rates, unemployment rates and inflation rates. To some extent this was a world-wide phenomenon, and rapid change was something which companies were not exposed to; this set of conditions contributed to the development of a complacent generation of UK management which seemed incapable of dealing with the increasing pace of change which started about the beginning of the 1970s; in fact, management was regarded as an activity for which training was irrelevant, and the idea that management ideas could be formalised was an alien concept. By the mid 1970s the stable scenario had been destroyed; global depression in the mid 1970s
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was partly caused by the trebling of oil prices, which in turn caused substantial economic upheavals. This period also saw the end of stable international exchange rates with the collapse of the Bretton Woods agreement in 1973, and the emergence of powerful competition from the Far East economies. It is no secret that UK managers were ill equipped to deal with these changes, and the economic traumas of the 1970s, which included 25 per cent inflation rates, poor productivity growth, the loss of important markets and endless labour disputes, were at least partly caused by lack of foresight and adaptability on the part of managers. The period up to 1979 also saw a significant increase in the extent to which governments attempted to regulate the level of economic activity. The share of government in the economy (measured by the sum of government expenditures on goods and services and transfer payments) increased to well over 40 per cent of national income by 1979, and the notorious ‘stop-go’ policies which were utilised in response to economic fluctuations seemed at times to make the situation worse rather than better. The incomes policy introduced in the mid 1970s, which was a misguided attempt to reduce the inflation rate, coupled with very high marginal tax rates, led to a significant reduction in incentives for managers generally. By the end of the 1970s the prevailing view was that government would continue to increase its involvement in the economy, and managers should learn to function in a government dominated economy. A prolonged period of intervention had undermined the ethos of self-reliance and personal initiative; the result was a marked reluctance to take risks and undertake new ventures. The pace of change and the volatility of economic activity and related factors increased in the 1980s. In the UK there were substantial changes in unemployment rates, industrial output, inflation rates, interest rates, productivity, exports, imports, capital flows, and exchange rates. But a major change in the political climate had led to the election of a right wing free market orientated government under the leadership of Margaret Thatcher in 1979. There was a conscious effort on the part of government to disengage from the economy and allow market forces to operate more freely; this in turn led to deregulation, selling state owned companies, and lower marginal tax rates. These economic changes affected individual company performances in many ways. For example, by the late 1980s the UK was experiencing a boom, with record growth rates and the lowest unemployment rate for ten years; in particular, asset prices spiralled, and many successful large companies started to diversify into property, while those already in the property business began to extend themselves. To many observers it seemed that the pinnacle of credit and unfettered expectations on which this boom depended was unstable, but developers pressed on regardless. After the economic downturn in 1990 the bubble burst and there were many disasters, the best known being the Canary Wharf development – the largest building in London – which went bankrupt before it was even occupied. Economic circumstances had led yet again to a ‘gold rush’ outlook on the part of otherwise sensible managers, who did not seem to appreciate that they were gambling entirely on the continuation of boom time conditions. A rudimentary understanding of economics might have given cause for concern about the inflationary pressures being generated during the boom and the possibility that the
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government might be forced to take deflationary measures. The major recession which the UK experienced from 1991 to 1993 was relatively short lived, but recovery from the recession was very slow, and by the late 1990s the unemployment rate was still well above the 1990 level. By the mid 1990s the economy had improved dramatically in real terms: productivity had soared, the inflation rate was low compared with other major economies, the interest rate was historically low, and the economy was the fastest growing in Europe. But despite this managers were greatly affected by the experience of the early 1990s recession, and the absence of a ‘feel good’ factor was a generally accepted fact; confidence on the part of both consumers and producers was low, leading to an unwillingness to spend on the part of consumers and to invest on the part of companies. In the mid 1990s it was as if companies felt that the prosperity was fragile and that recession could return at any time. Managers who have not been educated in general economic principles can be excused for finding it difficult, or impossible, to explain the various changes observed in the economy, which is subject to a seemingly perplexing variety of influences of the type described above. It has already been pointed out that managers are bombarded with information of all kinds; information on economic conditions arrives in the form of news reports, national and international statistics, news commentaries by experts, and reports prepared by specialists who may be independent economic consultants, stockbrokers, or employed by the company. The problem facing the manager is to decide which information is relevant, and interpret it in order to form a view on what is happening in the economy as a whole; this is a prerequisite to deriving implications for the industry and the company itself. Managers therefore often ask if it is possible to make sense of the multitude of factors which they have to take into account, and whether anything can be done to accommodate them. This is in fact the area of study known as macroeconomics. A sample of what macroeconomic theories cover is: • the determination of GNP through the interaction of demand and supply in the economy as a whole, and the effect of changes in both demand and supply factors; full employment output, actual output, the unemployment rate and the inflation rate; the role of expectations; money supply and the rate of interest; the rate of interest and investment expenditure; factors affecting the demand for and supply of imports and exports; the determination of the exchange rate and international financial flows.

• • • • • 4.3.1

Understanding and Using Economic Information
At the very least, a manager needs to be able to use economic information to form a view of the current state of the economy. An overall impression of the level of economic activity can be obtained from general economic indicators such as unemployment rates, industrial output and consumer spending. A typical set of data published each week in The Economist is shown in Table 4.2.

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Table 4.2

UK economic indicators
Last year This year (early) Recent changes 0.5% Change over year 3.2% 1.1% 4.3%

Economic indicator Gross National Product Industrial output Retail sales (volume) Investment expenditure Unemployment rate Inflation rate Wage inflation rate

−1.1%
Current value 5.8% 9.3% 12.2%

−1.5% −1.1% −3.2%
6.2% 9.7% 10.0%

The general impression of the state of economic activity from the viewpoint of last year is that the economy was growing both in terms of total output and consumer expenditure, and that there was very little unemployment. However, there were two ominous signs: investment expenditure was declining and both prices and wages were increasing at a relatively high rate. Typically, there is consensus among commentators when the economy is in a boom or a slump; for example, it was generally agreed that by 1990 the UK economy was ‘overheating’, in the sense that there were bottle-necks in the economy, shortages of labour, the inflation rate was increasing and wage rate increases were running well ahead of increases in productivity; the government took steps to remedy this by increasing the rate of interest. However, there is scope for disagreement about how ‘bad’ or ‘good’ things actually are; for example, what is a high compared to a low rate of unemployment? In the early 1970s the UK unemployment rate was about 3 per cent, and in the early 1980s, it reached 12 per cent; by that time there seemed little chance that the unemployment rate would ever fall again to the level of the 1970s. By 1990 the rate was down to under 6 per cent which would have been considered high in the 1970s, but was by that time associated with excess demand for labour. Economic information must be interpreted in the context of current conditions. From Table 4.2 it can be deduced that by early in the current year there had been a significant slow-down in economic activity. The growth in output had virtually ceased, both industrial output and consumer expenditure were declining, and the inflation rate had stabilised. The unemployment rate had increased and this had contributed to the reduction in wage rate inflation. It is quite clear from these few statistics that the ‘boom’ economy of the previous year had ground to a halt, and this had strategic implications for companies in the current year, depending on which markets they were operating in. It is not necessary for managers to have a detailed understanding of how the statistics in the table were arrived at in order to derive strategy implications. Take the case of a manufacturer of machine tools which was working close to full capacity at the beginning of the current year: should it increase or decrease capacity now? This company produces for the investment sector, i.e. it does not produce for final consumers, therefore the CEO had to make deductions about the likely future for the investment sector. Assume he has the previous year’s data available; the following deductions can be made:
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The increase in Gross National Product (GNP) during the previous year was largely due to an increase in consumer expenditure (see the increase in Retail Sales); in other words, the economy was experiencing a consumer boom. The consumer boom had not led to an increase in capital equipment, as can be seen from the fact that Investment Expenditure had fallen. In fact, Industrial Output had not grown as much as Retail Sales. Companies must have been selling from inventories and/or imports must have increased. Wage costs were rising faster than the inflation rate.

The CEO could start by assessing what would happen to net cash flow if the conditions for the previous year carried on through the rest of the current year using the basic model of revenues and costs: Revenue = Revenue = = Total market 0.99 1.08 × × Market share 1 × × Price 1.093

This simple calculation makes a number of assumptions: the price of output is assumed to move in line with the inflation rate (i.e. multiplied by 1.093), market share is assumed to remain unchanged (i.e. multiplied by 1), and the change in market size is assumed to be equal to the change in investment expenditure (i.e. multiplied by 0.99). The net effect is that cash flows would increase by about 8 per cent. Table 4.1 provides less information on which to judge the likely change in outlays: Outlay = Number of workers Units of capital Units of material × × × Wage rate Price Price + +

The one figure which is known with certainty is the wage inflation rate which is currently 12.2 per cent. If other costs move in line with wages then outlays will increase by more than revenues, resulting in a reduction in net cash flow of about 4 per cent. However, this calculation assumes that trends will remain unaltered during the rest of the year, and this may not be the case. First, it is likely that the consumer expenditure boom will cause an increase in investment spending in the relatively near future because of lagged effects as companies adjust their capacity to new levels of demand. This suggests that the appropriate strategy is to increase capacity now to be ready for the increase in investment demand. Second, it follows that in order to increase capacity it would be necessary to increase recruitment, and the historically low unemployment rate suggests that there is likely to be a shortage of labour, particularly of workers with skills. Third, political commentators take the view that the government intends to bring down the inflation rate by maintaining high interest rates, and this is likely to have an effect on economic activity in the short term. The dilemma facing the company is that the markets for its products are likely to get worse
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before any improvement can be expected; therefore it might be worthwhile waiting until the pressure on labour markets eases. The data which became available three months later for the early part of the year shows that this is precisely what happened. Investment expenditure had declined further, while the unemployment rate had increased and the wage inflation rate had fallen, suggesting an easing of labour markets. Thus a sensible interpretation of macroeconomic factors could not only identify a potential strategic thrust, but prevent the company from undertaking strategic moves too early. So by early in the year the company was ready to install new capacity and hire and train additional manpower. But whether this was yet the time to make a move depends on how the CEO interpreted the rather gloomy figures for Gross National Product and Industrial Output. Given the importance of these economic variables for company performance, an understanding of the influences which determine them would help managers make informed predictions of at least short term changes in important variables such as labour costs, and make a rational assessment of the likely effects of changes in economic conditions arising from influences such as changes in government expenditure and tax rates.

4.3.2

Supply and Demand in the Economy
This section revisits the major ideas of macroeconomics in a brief fashion, and while it is not easy you are advised to stick with it because it will provide you with an overall perspective on the issues involved and an appreciation of the implications of macroeconomic analysis for strategic thinking. A major cause of confusion to non-economists is simply the terms used to describe economic activity. The terms National Income, National Output, Domestic Output, National Expenditure and Domestic Expenditure tend to be used without any clear distinction drawn between them. It will be seen later that there is no real need to worry about these distinctions, but in order to develop some basic ideas about how the economy operates the first step is to think in terms of the goods and services which the economy produces rather than the income which accrues to individuals. The total value of goods and services produced in one year is known as Gross National Product (GNP). At any one time the maximum output which the economy could produce is constrained by the resources available. The total output which the economy could produce if the labour force were fully employed and there were no excess capacity is known as potential or full employment GNP. Given the substantial variations in the unemployment rate it is immediately clear that the actual output of the economy is not necessarily equal to potential output. A useful perspective on the connection between potential and actual output is to define potential output as the output which the economy could produce with the labour force working the standard work week on average, and the unemployment rate at a level which accommodates structural changes in the economy. Over time the pattern of potential and actual output might be as shown in Figure 4.1.

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300 280

Potential GNP GNP 1980 Prices

260 £bn 240 220 200 74 76 78 80 82 84 Year 86 88 90 92 94 96

Figure 4.1

Potential and actual GNP

This pattern is based on UK experience from 1974. In the early 1970s there was a very low unemployment rate associated with actual output being equal to or above potential output. But how could actual output exceed potential output? This occurs when there are shortages of labour and a great deal of overtime is being worked. In the mid 1970s there was a reduction in actual output partly caused by the first round of oil price rises, and actual output was marginally lower than potential output until the early 1980s, when there was a further slump and the gap between actual and potential increased substantially. In the later 1980s the unemployment rate began to fall, and by 1989 it was generally agreed that the economy was operating at full employment once more. The very large trade deficit which emerged in 1989 and continued through 1990 was indicative of an economy operating above potential output, in the sense that individuals were attempting to consume more than the economy was capable of producing. In 1991 the economy took a ‘nose-dive’, actual output fell below potential and the unemployment rate increased dramatically. By 1993 the economy was growing again, but because of the continuing increase in potential output the unemployment rate did not fall until the growth in actual output exceeded the growth in potential output. Other economic indicators confirm this scenario. For example, during the early 1970s there was a substantial increase in the inflation rate, primarily caused by excess demand; the inflation rate fell to its lowest rate for many years in the mid 1980s when the unemployment rate was very high, and in 1989 the inflation rate began to increase to previous high levels as actual output exceeded potential output. It did not begin to fall again until the effects of the higher unemployment rates of 1991 and 1992 started to become apparent. The inflation rate did not increase after 1993 despite the growth in GNP because actual output was still well below potential output. Given the importance of the concepts of potential and actual output, the first
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question the manager should ask is: what is the difference between potential and actual output? By framing the issue in this way, it is possible to explain how the unemployment rate can increase despite the fact that actual output is increasing; the effect on the unemployment rate depends on the relative rates of growth of potential and actual output. The important factor is the gap between potential and actual output, and this will be reflected in the current rate of unemployment. The relationship between the unemployment rate and the gap between potential and actual output is not exact because of changes in the definition of unemployment and changing labour market conditions, and the connection between the two tends to change over long periods of time. To put this in context, it is useful to think of unemployment as being comprised of three elements: 1 Structural unemployment: this is typically associated with large scale disruptions in the economy when whole industries close down, for example the mining industry in the UK in the 1980s, or changes towards service based economies which have occurred in all mature economies during the past twenty years. The impact of structural changes on the long term unemployment rate depends on how quickly the working population adapts to new conditions. Structural unemployment has grown in relative importance in mature economies in the past few decades. Frictional unemployment: the pool of unemployed can be regarded as the outcome of a flow process, which is continually being added to as people decide to change jobs, and reduced as people find jobs. If the cost of unemployment is reduced, perhaps because of an increase in unemployment compensation, then individuals may spend longer in job search, thus increasing the number of people in the unemployment pool. There are many factors which affect how long individuals choose to remain unemployed, and there is little which can be done about it in the short term. Demand related unemployment: this is the element caused by the difference between actual and potential output. It can be seen from Figure 4.1 that the difference between actual and potential output varies dramatically over relatively short periods, therefore it is to be expected that demand related unemployment will also vary in the short run.

2

3

By thinking of the issue in these terms it is possible to interpret statistics such as ‘the rate of unemployment was 2.8 per cent in 1972, 11.8 per cent in 1984 and 5.8 per cent in 1989’. There was an increase over the period in structural and frictional unemployment, but between 1984 and 1989 the reduction in demand related unemployment greatly exceeded the increase in the other forms of unemployment. This simplified approach to the behaviour of the economy using actual and potential output coupled with the different types of unemployment gives managers a common-sense basis on which to assess the likely impact of government policy measures.

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4.3.3

Unemployment and Inflation
One reason why managers are sceptical of economics is that the debates on the causes of inflation often seem to be contradictory, and mostly baffling to the non-economist. In fact, the ideas which underlie the determinants of inflation are quite simple, but they are rarely explained properly in the contexts of political debate or newspaper analysis. It is a well known feature of market economies that when the economy approaches full employment there is a pronounced tendency for supply bottlenecks to emerge, and as a result wage rates, capital costs and material prices tend to increase. Improvements in expectations fuelled by a reduction in the unemployment rate leads companies to bid up the price of resources in local markets, particularly where labour is concerned. For example, in the South East of England there was virtually no unemployment by 1990, and wage rates were significantly higher than in the rest of the country. On the other hand, when there is significant unemployment the wage rate is rarely observed to decline; it might be expected that when there is an excess supply of labour the price of labour (i.e. the wage rate) might be expected to fall, leading to the eventual elimination of unemployment. However, the labour market does not operate like that; wage rates are ‘sticky’ when labour market conditions suggest that there ‘should be’ a reduction. At the same time, there is excess demand for final goods and services, which tends to push prices up. Taken together, these influences are known as ‘demand pull’ inflation; generally, people think of it in terms of ‘too much money chasing too few goods’. It is a reasonable proposition that the lower the unemployment rate, the higher will be the wage inflation rate, and this relationship was investigated in the 1950s by Phillips, who estimated the trade-off between the unemployment rate and the wage inflation rate. Nowadays the relationship is usually expressed in terms of the inflation rate and the unemployment rate, and looks something like that shown in Figure 4.2. However, during the 1970s there was an onset of historically high unemployment and inflation rates at the same time, which the ideas underlying the Phillips curve suggested should not happen because as the unemployment rate increased the inflation rate should fall. This became known as ‘stagflation’. One way of explaining what had happened was that the Phillips curve had shifted, and at the new position the trade-off between unemployment and inflation was different. This is shown in Figure 4.3. But what might have caused the curve to move? And if the curve could move all over the place, did it have any operational use? The answer to the first question was that a new variable had entered the arena: expectations; once inflation existed in the economy everyone expected that it would continue and made their forward contracts accordingly, causing the inflation rate to carry on unchanged although the unemployment rate was greatly increased. The answer to the second question was that the Phillips curve was still important if something could be done about expectations. The policy objective therefore became to shift the Phillips curve back to the left so that the trade-off between unemployment and inflation would occur at a lower level. Since this shift could only be accomplished by eliminating the

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Inflation rate (%)

Phillips curve

Unemployment rate (%)

Figure 4.2

The Phillips curve

Inflation rate (%)

Phillips curve

Unemployment rate (%)

Figure 4.3

The shifting Phillips curve

expectation that inflation would continue in the future, the debate then shifted to how this change in expectations might be brought about. This led to one of the ‘monetarist’ policy ideas, which was to keep the growth in the money supply constant and hence remove the expectation that the government would
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accommodate inflation in the future. This policy has been greatly misrepresented, and in most people’s minds monetarists are probably associated with the idea of reducing the money supply. This is incorrect, since the monetarist policy was directed towards removing the expectation that future inflation would be accommodated by increases in the money supply, therefore the solution was to make it clear that money supply would only be allowed to grow by a predetermined percentage each year. Another approach was simply to increase the unemployment rate and wait until the inflation rate itself fell, and this would certainly eliminate expectations of future inflation. A potential advantage of the monetarist approach was that it raised the possibility of eliminating expectations without incurring the high cost of unemployment. The fact that general price increases are apt to set in quickly when the economy is at full employment output, combined with ‘sticky’ prices when there is unemployment, suggests that once inflation has been generated it will be difficult to get rid of; this is made worse by the effect of expectations. In order to demonstrate the problems of reducing inflation, the following model shows how prices and wages might be determined by the unemployment rate and inflationary expectations.
Wage inf ratet = a × (Inflation ratet−1 ) − b × (Unemployment ratet ) Inflation ratet = c × (Inflation ratet−1 ) − d × (Unemployment ratet ) + e × (Wage inflation ratet−1 )

where a, b, c, d, e are parameters The rationale for the two equations is as follows. The Wage Inflation Rate depends on the current unemployment rate plus an allowance for last period’s Inflation Rate; this is because recent inflation rates affect current wage negotiations. The values of a and b depend on many factors, and many attempts have been made to estimate them. As an example, assume that it was generally expected that the current inflation rate would be 80 per cent of the previous year’s rate, and wage negotiators on average scaled down their wage demands by 0.5 per cent for every 1 per cent increase in the unemployment rate. If the inflation rate in the previous year was 12 per cent and the current unemployment rate was 8 per cent, the current wage inflation rate would be:
Wage inf ratet = (0.8 × 12) − (0.5 × 8) = 5.6

This helps to explain why wage rates can continue to increase even during a period of relatively high unemployment. In this example the unemployment rate required to achieve a zero wage rate inflation rate would be 19.2 per cent. The Inflation Rate depends on the current unemployment rate (demand pull), plus the amount of last period’s Wage Inflation Rate which has found its way into final prices through increased production costs (cost push), plus last period’s Inflation Rate (expectations). It is immediately obvious that an increase in the current unemployment rate will not eliminate a high inflation rate immediately, because the expectations and cost effects of previous inflation rates still have to be worked out of the system. Assume that last year’s wage inflation rate was 10
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per cent, and that 60 per cent of this will emerge in prices due to cost increases in the current year; last year’s inflation rate was 12 per cent, the unemployment rate was 8 per cent, and expectations are as above. This results in the following inflation rate:
Inflation ratet = (0.8 × 12) − (0.5 × 8) + (0.6 × 10) = 11.6

Clearly it will take some time before the unemployment rate of 8 per cent eliminates inflation. In this model the only way to reduce expectations of future inflation is to get rid of inflation now; if this is roughly what happens in real life the implication is that inflation can only be countered by a period of high unemployment rates. In fact, this model, which is based on simple but not unrealistic assumptions, does capture the connection between unemployment, inflation and wage inflation rates in developed economies. It would be possible to include the effect of a constant increase of the money supply in the model, but it is generally accepted that this is not a short term solution because it would take some time to convince people that the central bank meant what it said. From the strategic viewpoint managers should therefore be aware that once factor prices have increased because of inflation caused by excess demand, it will be some time before the wage inflation rate is likely to fall. Managers with an understanding of the determinants of inflation would have recognised that the inflation which built up in the UK in the late 1980s was likely to remain for some time, and would probably lead to government actions designed to eliminate excess demand. A likely consequence would be restrictive monetary and fiscal policies leading to a significant reduction in the growth rate of GNP. This view of economic prospects could have important implications for the timing of a company’s strategy. By the mid 1990s the UK inflation rate had fallen to its lowest level for 30 years, and a great deal of debate centred on whether inflationary expectations had finally been purged from the economy. Bear in mind that expectations do not operate only at the economy-wide level; it is a salutory lesson to sit back and imagine that you are about to make a forward contract of some sort in your own business; this could be renting a photocopier for five years, agreeing with a supplier a fixed price for four years, or deciding whether to go for a fixed interest or variable interest loan. What allowance for inflation over the period would you build into your negotiating stance? And why? 4.3.4

The International Economy
Few companies are immune from international factors. Those which sell directly in foreign markets are continuously exposed to changes in trading conditions; under conditions of relatively free trade even those companies which sell only in domestic markets are open to competition from imports. Consequently, many companies are concerned with factors such as differences in local and foreign inflation rates, variable exchange rates, and the impact of economic conditions on competitive advantage.

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Relative Inflation Rates
There can be substantial differences in the inflation rates in different countries which are not compensated for by changes in the exchange rate. Thus it may not be adequate simply to convert selling prices at the going exchange rate; for example, if the domestic inflation rate has been higher than the foreign rate this may result in entering foreign markets at too high a price. There are potential implications for costs also. For example, if the domestic inflation rate appears likely to continue at a higher level than the foreign rate, domestic costs can be expected to increase relative to foreign costs. Thus what might appear to be an attractive foreign market at the moment may contain the seeds of disaster as relative costs increase.

Exchange Rate Fluctuations
The standard textbook analysis of the determinants of the exchange rate lays stress on the value of exports and imports, which determines the demand and supply of the currency. For example, when U.S. exports exceed imports there will be a balance of trade surplus, the demand for dollars will exceed the supply of that currency, and the value of the dollar will appreciate. This in turn will cause exports to be more expensive to sell abroad, and imports to be relatively cheaper. The end result is that the value of exports will decline, the value of imports will increase, and the balance of trade will deteriorate. However, in today’s world the textbook explanation is obsolete. This is because the demand for and supply of currencies is dominated by international capital flows, which are currently about 80 times the value of payments for real trade flows. It is therefore possible for exchange rate changes to be independent of the balance of trade. The factors which affect capital flows are relative interest rates and expectations, and since neither of these can be predicted with any accuracy it stands to reason that exchange rates themselves cannot be predicted. There is therefore no guarantee that differences in relative inflation rates will be compensated for by changes in the exchange rate, and that the exchange rate will take care of cost disadvantages caused by a higher domestic price level. Indeed, it has long been argued that exchange rates will consistently ‘overshoot’ and ‘undershoot’ because of capital flows. For example, imagine a currency has been in equilibrium and the country suddenly experiences a surge in exports. The demand for the currency will increase, and there will be a revaluation. Observing this revaluation, owners of ‘hot money’ will purchase the currency in the expectation of making a capital gain from the expected continuing increase in price. The effect is that the currency will increase in value by more than the amount necessary to balance the additional demand caused by the original increase in exports. Taking the effect further, the currency is now ‘over-valued’, and there could be a significant reduction in exports as a result, causing a devaluation because the demand for the currency has fallen. The effect on owners of ‘hot money’ is now reversed: they sell their holdings in order to avoid a capital loss, with the result that the currency is devalued by more than would be required by the reduction in exports, i.e. it ‘undershoots’. The international exchange system therefore has a built-in bias towards cyclical
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variations, and given the relatively large flows of cash described above, it is to be expected that these cycles will be extremely large from time to time.
Table 4.3
Year 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991

The pound/dollar exchange rate approximate year on year change (%)
Exchange rate 0.52 0.62 0.69 0.86 0.69 0.68 0.53 0.55 0.62 0.53 0.57 12 4 13 15 Devaluation 24 19 11 25 20 1 22 Revaluation

Table 4.3 gives an indication of the extent to which the exchange rate of the UK pound against the US dollar varied during the 1980s. These fluctuations have significant implications for predicting the cash flows from foreign markets. For example, a company making plans two years ahead in 1989 in the UK would not have known that the pound would be revalued by 15 per cent the following year. Imagine that the company expected to sell 5000 units per year at $1000, giving revenue of $5 million; what would this be worth in pounds in 1990? And could the company really expect to sell that amount with a 15 per cent price increase? It is clearly difficult to plan ahead in such an unstable economic environment. However, a company which incorporated potential exchange rate movements in its scenario planning would have had some idea whether this type of fluctuation was potentially disastrous, and could have developed a contingency plan to activate in the event of a revaluation of the magnitude which occurred in 1990. In fact, little did managers expect that in 1992 Britain would drop out of the European Exchange Rate Mechanism due to international speculative pressure, and that the pound would depreciate against all European currencies by about 15 per cent. In the light of these factors, the company stands to benefit by taking a view on what is expected to happen to the exchange rate when trading internationally. For example, if the company is convinced that a particular currency is undervalued in relation to the domestic currency, a potential strategy is to break into the market now and establish market share in the knowledge that losses will be incurred until a revaluation takes place. Or if a company is evaluating a potential investment in a country, the prospect of a revaluation of that country’s currency could have major implications for the timing of the cash flows necessary to carry out the investment. Many companies argue that they are in the business of making and selling their products, and are not in the business of foreign exchange dealing. Others
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justify ignoring possible future changes on the grounds that they do not see what they can do about them. However, a decision to ignore the problem of uncertain exchange rates is equivalent to adopting the view that there will be no changes in the future; this is as much a response as a forecast that changes will occur. There are various methods of hedging bets in relation to exchange rates, for example buying currency forward; this makes it possible to predict some future cash flows, but it means that the company will not gain from any favourable movements in the exchange rate. It is not possible for a company to cover future exchange rates entirely, because cash flows will extend for years in the future, and these cash flows are difficult to predict with any degree of certainty. There is no reason to view exchange rate risks as being different from the other uncertainties facing the company, and in the current volatile state of the international economy it makes sense to attempt to identify risks and incorporate them into decision making. As the risks inherent in an unstable international monetary system have increased, a great deal of ingenuity has been applied to finding ways of hedging these risks. The whole world knows about the activities of Nick Leeson, the ‘rogue’ Barings bank trader who lost £800 million on the foreign exchange market and destroyed one of Britain’s oldest and most respected banks in the process; Leeson was able to do what he did because his superiors had no understanding of how the market in options worked. The risks generated by the foreign exchange markets affect everyone, for example the Barings bondholders lost everything and had no idea that their cash was at risk to such an extent.

The Competitive Advantage of Nations
The role which national location can play in influencing the competitive position of companies was developed by Michael Porter1 who pointed out that competitive advantage is often strongly concentrated in a few locations; for example, the clustering of electrical distribution equipment in Sweden, tunnelling equipment in Switzerland, large diesel trucks in the USA and microwaves in Japan. Porter identified several ways in which a nation can affect the competitive advantage of individual companies. • A firm’s home nation plays a critical role in shaping managers’ perceptions about the opportunities that can be exploited by supporting the accumulation of valuable resources and capabilities and creating pressures on the firm to innovate, invest and improve over time. The impact of the history and environment of a country is often obvious. Scotland has had a long history of industrial decline and the development of a dependence ethos fostered by many years of misguided government aid policies. As a result the rate of new business start ups is roughly half the rate in England; this is in marked contrast to a small state such as Singapore, where the government has been at least as interventionist but in a totally different way. It is the existence of conditions which contribute to sustaining competitive advantage in a dynamic sense which is important. A country can offer favourable factor conditions, in particular those that are highly specialised to the needs of particular industries. But this is only part of the story; it
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can also offer favourable demand conditions in the form of sophisticated home consumers who continually force firms to produce the right things. The willingness of British governments to bail out ‘lame ducks’ in manufacturing industries contributed to the lack of incentive to invest in the innovations which would sustain competitive advantage. One of the dangers of protectionism is that local companies have little incentive to retain competitive advantage; the current situation in India, where British cars and motorcycles of the 1970s are still produced and sold in large numbers, is an illustration of how consumers as well as companies stand to lose from a lack of international competition. The most extreme example of all is the plight of companies in the Eastern Bloc economies which had been so conditioned by their national environment that the notions of profitability and cost control were unknown. The impact of the national environment on the competitiveness of individual companies is largely determined by the following influences: • • • • Domestic factor conditions Related and supporting industries Demand conditions Strategy, structure and rivalry all of which interact to affect the competitiveness of individual companies. • Factor conditions: highly specialised resources develop in different countries over time; the development of computer businesses in Silicon Valley in California meant that there was a large pool of highly skilled manpower. Related and supporting industries: all types of computer related industries are to be found in Silicon Valley; few computer manufacturers would consider setting up business in Spain, for example, where there is a lack of accessible suppliers. Demand conditions: sophisticated consumers force companies to innovate and shape their market orientation. The dominance of Japanese cameras is partly explained by the popularity of amateur photography in Japan; the success of German motor manufacturers in producing quality cars as opposed to mass produced cheap cars is partly due to the German respect for quality engineering. Strategy, structure and rivalry: a country which fosters competition at home potentially breeds a strong core of companies which is capable of competing in the international arena. There are few instances of powerful international companies emerging from protected or subsidised home markets. The highly protected British car industry was unable to compete in the 1970s and virtually ceased to exist. Japanese companies, which had been subject to intense home competition, invested heavily in new car plants in Britain in the 1980s.

When assessing its international competitive position, a company needs to determine whether its competitive advantage is due to country specific or company specific attributes. This is of fundamental importance to the way in which it can exploit foreign markets.
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If the advantage is country specific then foreign markets can be exploited by exporting. This is because the impact of the national environment discussed above which will become apparent in a cost advantage. If the advantage is company specific it can invest in the country concerned provided that these advantages can be transfered from one country to another. This partly explains why Japanese car makers invested heavily in Britain: their management skills and production techniques were company specific and hence transferable.

The problem is that it may not be obvious, even to the company itself, how much of its competitive advantage is due to the two influences. In addition, exchange rate uncertainty can influence locational decisions because producing in the country where the company sells its products insulates it from potentially unfavourable exchange rate movements. Decision makers thus have to trade off perceived competitive advantages against exchange rate risks.

4.4

Forecasting: What Will Happen Next?
From the strategy viewpoint, the main reason for trying to understand what is happening in the economy is to provide a basis for predicting the future course of events. Since no one can look into the future with any degree of certainty, this amounts to trying to ascertain what is likely to happen. A cynical manager might ask, if it is impossible to predict the future with accuracy, is there really any point to making forecasts? The answer to this is that even vague predictions can be valuable. For example, for companies whose products are highly GNP elastic it makes a difference if national income is likely to increase or decrease; it follows that it would be useful to predict whether national income is likely to increase or decrease next year. In other words, the direction of change is important in its own right; it may be possible to go further and predict the dimension of change, but often the very fact of predicting an increase or a decrease is the major determinant of strategy. Any action which has future consequences takes a view of future events, if only by default; therefore it is better to be explicit about what is thought likely to happen. For example, during the second half of 1991 in the UK politicians repeatedly claimed that the preconditions for economic recovery existed and that the country could look forward to 1992 with a great deal of confidence. However, it was never made clear what these preconditions actually were, and a manager who understood the basic principles of macroeconomics would have treated such claims with a great deal of caution. As it turned out, it took another three years for significant improvements in the economy to become apparent. One problem facing managers is the number of forecasts available. Practically every day professional forecasters issue predictions of what is going to happen next week, month or year: some are academically prestigious, such as the London Business School, some are issued by well known stockbrokers and can affect the behaviour of the stock market. Can any use be made of these forecasts? The simple answer is no, because all forecasters share the same poor track record. Some are right in some cases, others are right in others, and there is always someone ready to claim that their institution successfully predicted

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current events. In fact, forecasters seem to share the ability to miss really big changes. For example, the UK unemployment rate began falling in 1987 after five years of rates exceeding 11 per cent. It was at least a year before many commentators interpreted the continuing reduction as a long term trend; in other words, almost all forecasters followed rather than predicted the change. A company which recognised early in 1988 that labour markets would be much tighter by 1990 would have taken a different approach to manpower planning than a company which assumed that unemployment rates would remain high indefinitely. One of the greatest failures of economic forecasters was the inability to predict the slump in the UK economy in 1991; this was followed by the failure to predict the increase in growth in 1994. Table 4.4 shows some of the predictions for GDP growth for 1991 and 1994 made by some of the most prestigious forecasters around, compared with what actually happened.
Table 4.4 Forecasting UK GNP
GNP % growth 1991 Actual Confederation of British Industry James Capel Morgan Grenfell UK Treasury National Institute for Economic and Social Research London Business School GNP % growth 1994 4.0 2.4 3.0 2.0 2.5 2.8 2.4

− − −

2.2 0.8 0.4 0.4 0.5 0.8 1.4

No forecaster even came close to predicting what would happen in 1991. The difference between the highest of the predictions for GNP growth (+1.4 per cent) and the actual outcome (−2.2 per cent) is not trivial for those companies whose product has a high income elasticity. A company which acted on the basis of the London Business School forecast and increased its output in the expectation of a significant increase in demand would have found itself with substantial unsold inventories by the end of 1991. The forecasters were better for 1994, in the sense that they all got the sign correct. But this was not surprising, because by that time the economy had been growing for a year. No forecaster spotted that the economy was about to grow at a historically high rate in 1994, and certainly none predicted a higher growth rate than actually occurred. A manager might reasonably ask whether the disparity in the forecasts was due to the way they were carried out, i.e. that some methods are likely to be more successful than others. In fact, there are a number of approaches to forecasting, ranging from the intuitive to the highly quantitative. For example, the London Business School model, which performed worst for 1991, is highly sophisticated and is operated by economists of considerable experience; the UK Treasury bases its forecasts on one of the most complex models of any economy in existence (known as the Treasury Model). There is virtually no connection between the statistical complexity of the forecasting models and their accuracy.
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The simplest approach to forecasting is to discover one statistic which serves as a reasonable indicator of what is likely to happen next, and this statistic is known as a leading indicator. A leading indicator is a statistic which signals when changes are about to happen in the economy, or in a particular industry. For example, the number of housing starts would be an obvious leading indicator to use for a business in the glazing industry, because a prospective reduction in the number of houses completed would have an impact on the number of windows required. Most leading indicators are chosen because they have served as predictors in the past, but there is no guarantee that they will perform effectively in the future. This is an example of using statistical association as the basis for prediction rather than causal relationships; the trouble is that no one can predict when a leading indicator is likely to lose its predictive power. There is a very good reason for forecasts being wrong: unpredictable events occur which cannot themselves be foreseen. The forecasting procedure must assume that no major events occur to disrupt the orderly operation of the economy; unforeseeable events such as the oil price increases of the early 1970s and reductions in the mid 1980s, the ending of Communism and war in the Middle East, can combine to rob forecasts of any accuracy they might have had. The characteristic of exogenous shocks is that they cannot be predicted in the statistical sense, i.e. the use of past data and the extrapolation of trends are of no help. Many forecasts might have been correct if exogenous shocks had not occurred, but it is virtually impossible to find this out after the event because of the problem of isolating the various influences. So is it possible to make any sense of what is happening in the economy, given that highly sophisticated teams of economic forecasters have such obvious difficulty? One approach is to think in terms of the business cycle. In most countries periods of boom tend to be followed by periods of depression, which in turn tend to be followed by periods of boom, resulting in a cyclical pattern which is repeated over and over again. Economic growth is by no means uniform. Economists have made many attempts to measure the duration of the business cycle, and there is some evidence of the existence of long term, medium term and short term cycles which have a certain degree of regularity. If managers could identify the stage of the business cycle even approximately it would clearly help in planning generally. However, inspection of historical data reveals that although cycles are often clear in retrospect, it is extremely difficult to predict when the next stage of the cycle will occur; in fact managers find that economic activity generally is so variable that it is difficult enough to determine which stage of the cycle they are currently operating in, never mind attempting to predict future changes. One method of approaching the problem is to think of the business cycle as being comprised of three main components: the general trend over time, the underlying smooth cycle, and random fluctuations. Figure 4.4 shows how a seemingly random series of actual observations can have an underlying structure in terms of the cycle and the trend. The statistical technique which corrects for cyclical and trend effects is known as series decomposition. It is not necessary to understand how this technique works, so much as to be able to ask the correct questions when assessing cyclical
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Actual Trend Cycle

Business cycle

Index

Time

Figure 4.4

Interpreting the business cycle

data. These questions are: 1 2 3 What is the trend? What is the underlying cyclical pattern? What random influences are likely to be disturbing the trend?

In the case of an economy, the trend is the long term growth rate in potential output; this varies significantly between countries. Some indication of the underlying cyclical pattern can be obtained by finding the time between previous peaks and troughs of unemployment rates. Random influences include changes in government economic policy and exchange rate fluctuations. It needs to be stressed that no one is able to predict the business cycle with any degree of accuracy, but it is possible to form a rational view as to whether the economy is in the upswing or the downswing. Figure 4.1 provides a real life example, where it can be seen that there have been cyclical changes in UK GNP since the early 1970s around the trend line of potential output. Given the gap between actual and potential output in 1992, it is not difficult to see that recovery to full employment was a long way off. It is important to visualise the business cycle in broad terms as depicted in Figure 4.4. This is because managers have to make some assumption about where the economy is in the cycle (unless they ignore the issue altogether and hope for the best). Ignoring the fluctuations around the cycle, consider the differences in a manager’s attitude to a proposed investment depending on where he thinks the economy is on the cycle. If he thinks it is half way towards the peak he will probably be in favour of the investment. But if he believes that the economy has reached the peak and is ready to fall back into recession he may well conclude that this is the wrong time to invest. If managers are not explicit about their expectations then such decisions will be taken by default. Naturally enough, managers feel confused about what is likely to happen next because of the many views expressed by economists and politicians; but the question can
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still be posed: ‘is this a sensible course of action given our particular expectation of what is going to happen to GNP in the next two years?’

4.5

PEST Analysis
It is now clear that trends and events in the national and international economy need to be monitored because of their impact on the company. It is also necessary to be able to interpret forecasts, because every decision undertaken implies some assumptions about the future, so it is as well to make them explicit. But the macroeconomy is only one dimension of the overall environment; others are social changes, changes in tastes and preferences, technological changes, ecological, political and so on. The checklist of Political Economic Social Technological factors provides a useful framework for assessing these influences; at one level the PEST analysis is nothing more than four lists, and as such is of little value. But the identification of a range of relevant factors, and an analysis of the relationships among them, can provide important insights into the company’s prospects. • Political: changes in the political climate are usually relatively slow but they can have far reaching implications for company operations. For example, the change from a largely right wing to left wing government may herald the emergence of stricter laws on monopoly behaviour and relaxation of labour laws in favour of employees. Economic: many relevant macroeconomic influences have been discussed in this Module. The economic effects of factors at the market level will be discussed in the next Module. Social: Many changes in society can have impacts on the company; for example, changes in the demographic composition of the population have implications for manufacturers of baby products. Changes in social norms, such as attitudes to marriage, divorce and to the optimum number of children in a family, have implications for many consumer products. The information tends to be qualitative rather than quantitative, and there is no specific conceptual structure involved; however, an awareness of societal changes is central to wide strategy issues, and the identification of potential opportunities and threats. Social analysis is complementary to economic analysis, in that economic factors operate within the given social structure; for example, predicting social changes can help to explain why demand curves are likely to shift in the future. The fact that information is qualitative does not mean that it cannot be used in an analytical fashion. Typically, qualitative information will indicate whether something is likely to increase, decrease, or remain unchanged; knowing about the direction of change can be extremely valuable on its own, independent of the expected dimension of change. Opportunities may lie in the anticipation of new trends, while threats may be identified in factors such as changing fashions. Technological: technological change is a continuous process, but it can also happen in short bursts, for example, the impact of new technologies such as cellular telephone systems and the internet has fundamental implications for the way in which business is conducted. While it is important to see the
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relevance of new technologies at an early stage, it is also necessary to be aware of the continuing nature of technological change in most industries; unless new methods and techniques are incorporated into company systems, and the company is willing to invest in new approaches, competitive advantage can disappear with alarming speed. To show how PEST analysis can be made specific consider the case of a monopolistic electricity utility which has recently been privatised. Political • Recent elections resulted in a new government which is more inclined to stricter regulation and opening up the market. • The new government is committed to subsidising domestic house insulation. • There is increasing international political agreement to cut pollution. Economic • New gas fields are being opened up with implications for the price of gas. • There are several indications of a slow down in economic activity which will have a significant effect on industrial demand for energy of all types. • The price of coal on international markets has started to increase. Social • There is a rising public awareness of the need to conserve energy. • The aversion to nuclear energy is increasing. • The number of single occupancy households is predicted to increase by 25% over the next two decades. Technological • Improved techniques for insulating houses are being developed. • Studies have shown that alternative energy sources such as wind, water and solar power are now cost effective. If the company had confined its environmental analysis to the economic dimension alone, it would have been concerned about the imminent economic slow down, competition from gas and higher costs of coal. But the wider PEST analysis shows that the company is likely to be squeezed by political events and by changing social trends which are possibly going to find expression through improved insulation and alternative power sources. In the longer term the outlook for the company looks troubled and now is the time to consider strategic responses.

4.6

Environmental Scanning
The PEST analysis deals with what is known about the environment, but it is possible to take this a step forward by speculating about the future, given the limited information available at the moment. For example in the early 1980s few computer industry companies even imagined the importance of personal computers and the impact it would have on their industry. The end of the Cold

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War in 1990 and the destruction of the Berlin Wall heralded a major change in trading relationships, but who would have predicted that ten years after the end of communism Russia would still be in severe financial trouble? Environmental scanning is an attempt to predict these changes and assess their implications for the company. In effect this involves monitoring a wider range of variables than would normally be included in the PEST analysis to raise managers’ consciousness of what the future might hold and where opportunities and threats are likely to emerge. Environmental scanning is in a sense an attempt to predict well beyond the extrapolations of short term forecasting and market research type information; it is therefore bound to be highly subjective, and it could be argued that it is so speculative that it serves no useful purpose. On the other hand, it can be argued that it serves as a kind of early warning system which, when it is correct, easily justifies the resources which it uses.

4.7

Scenarios
Once some projections of possible futures have been made they can be used as the basis of scenarios; this has already been introduced as a component of gap analysis and in the discussion about the impact of changes in GNP on revenues and costs. It needs to be reiterated that a scenario is not a forecast, but it is an attempt to investigate the implications of possible futures for the company. In some instances it may be based on a short run issue, such as the likely impact of a price reduction by a major competitor; the potential impact on market share and the cash flow implications can be mapped out, or the implications for the company’s profitability of matching the price reduction. A long term scenario is much more speculative, and many managers doubt their value. However, put yourself in the position of a European financial services company in 1990 and visualise the implications of inflation falling to zero by the year 2000. Financial products such as insurance policies are typically sold on the basis of nominal interest rates. But if inflation disappears the interest rate will tend to fall to its real long term level of about 3%. When the inflation rate fell to almost zero by 1998 most insurance companies were unprepared for the impact on expected payouts. Furthermore, inflation was not the only major change in the 1990s; direct telephone selling had altered the basis of competition in the market for many financial products. The very fact of thinking about these potential futures could have an impact on the company’s long term strategic planning.

4.8

The Economy and Profitability
It has been argued that the state of the economy has significant implications for the operation of the individual company, and consequently for its strategy. Because of this the main macroeconomic concepts relating to the determination of economic activity, and related issues such as the inflation rate and the exchange rate, have been discussed in some detail. The various factors affecting the company can now be brought together to identify the likely impact of economic conditions on company operations; these include the effects on sales and revenues, competitive conditions and input costs.

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4.8.1

Implications for Company Sales and Revenues
The impact of changes in economic activity on the sales of a product depends on the responsiveness of the demand for that product to changes in GNP. For example, the demand for potatoes is not likely to be affected by changes in GNP as much as the demand for hi-fi sets. The degree of responsiveness is known as GNP elasticity; a product is usually said to be elastic with respect to GNP when a 1 per cent change in GNP leads to a greater than 1 per cent change in the demand for the product; it is inelastic when a 1 per cent change in GNP leads to a less than 1 per cent change in demand. While it is impossible to estimate GNP elasticity with accuracy, a rough idea of the magnitude can be useful. This can be derived from the characteristics of the product, for example, whether it is a potato or a hi-fi set. The difference between the two could be quite significant; for example, the GNP elasticity for hi-fi sets might be 1.5, i.e. a 1 per cent change in GNP would result in a 1.5 per cent change in the demand for the product, while that for potatoes might be zero. To show this explicitly, take the case where, due to a world-wide recession, GNP is expected to fall by 4 per cent next year, and the company currently has 15 per cent market share of the hi-fi market. The GNP elasticity is 1.5; Table 4.5 shows the difference between assuming GNP elasticity to be zero and 1.5.
Table 4.5
GNP elasticity 0.0 1.5 1.5

Revenue and GNP elasticity
Total market 1 000 940 940 Market share (%) 15 15 16 Total sales 150 141 150 % change

−6.0
0

If GNP elasticity were assumed to be zero, sales would turn out to be 6 per cent lower than expected. By taking a realistic view of the likely elasticity the company could decide on the response to adopt in the face of a declining total market: for example, a strategy designed to maintain sales volume would involve attempting to increase market share from 15 per cent to 16 per cent. The converse of this situation, given in Table 4.6, shows how GNP elasticity can be used to identify an opportunity rather than a threat; imagine that GNP is expected to grow next year by 5 per cent due to expansionist fiscal and monetary policies.
Table 4.6
GNP elasticity 0.0 1.5 1.5

Revenue and GNP growth
Total market 1 000 1 075 1 075 Market share (%) 15 15 16 Total sales 150 161 172 7.5 15 % change

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Using a reasonable estimate of GNP elasticity, it could be predicted that sales would be 7.5 per cent higher than if the elasticity were assumed to be zero; an opportunity which presents itself is to grab a slightly larger market share in the growing market, leading to a 15 per cent growth in sales. When the economy starts to grow strongly, an effective response might well be to concentrate resources on those products with a relatively high GNP elasticity. The GNP elasticity does not tell the whole story about the connection between GNP and demand for a product. It is not only the size of GNP which is important, but also the distribution of national expenditure among its components. For example, a reduction in income tax, which leads to an increase in disposable incomes and hence to consumption expenditure, may be accompanied by a reduction in government expenditure due to the end of the Cold War, the net effect of which is to leave GNP unchanged. Consequently, those industries which rely on government expenditure on defence, such as the electronics industry, may find market size reduced, while those in consumer goods industries, such as TV sets, may find market size increased. At the same time, the government may have increased the rate of interest, which would affect the demand for investment goods. It is therefore possible for individual sectors of the economy to have a falling market size despite a relatively high level of growth in the economy as a whole. 4.8.2

Competitive Reaction and the Economic Environment
Having identified the various relationships between change in GNP and demand for the product and the likely consequences for the company, attention can then be turned to how competitors will behave in the light of the changing circumstances. If competitors have not carried out analyses of GNP trends and elasticities, the company may have an advantage by being the first to take defensive action in the face of a potentially decreasing market, or by being the first to take the initiative to take advantage of a predicted increase in market size. However, if competitors do have the same kind of information at their disposal, will they not react in the same way as our company? For example, in the declining market case shown above, competitors may attempt to protect their sales by reducing price in order to increase market share. Since it is impossible for all companies to increase market share, some company is bound to suffer as a result. It is likely that the outcome would be a general reduction in the price of the product. Consider what happens to the company which had not attempted to make predictions and found itself in a declining market in which competitors are acting aggressively in order to protect their total sales volume. The company would then have a falling market share in a declining market with a decreasing competitive price. The combined effect of these influences could be catastrophic despite the fact that the reductions in total market, market share and price were relatively small individually. This can be illustrated as shown in Table 4.7. In Period 2a, despite the fact that the total market fell by only 5 per cent, market share by 2 per cent and price by 10 per cent, the cumulative effect on total revenue was a reduction of 23 per cent. Thus a set of changes in market and

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Table 4.7
Period 1 2a 2b

Volatile revenues
Total market 100 95 90 Market share (%) 20 18 15 Price 10 9 8 Total revenue 200 154 108 % change

− 23 − 46

competitive conditions originating in a reduction in GNP could have significant implications for cash flow and profitability. In Period 2b, the changes are larger, but are by no means unknown in real life. For example, the shipping business is continuously faced with substantial changes in trade flows and prices due to exchange rate fluctuations, with implications for competitive reaction. The 10 per cent reduction in total market size, accompanied by a 5 per cent fall in market share and a 20 per cent reduction in price virtually halves total revenue. Companies which consider that the state of the economy has only a marginal impact on their performance and their strategy are ignoring the connection between changes in the economy and the behaviour of competitors. 4.8.3

Implications for Inputs and Company Costs
It was discussed at 4.3.3 above that input prices are likely to vary with the level of economic activity, and that wage rates in particular have a tendency to increase when the unemployment rate is low, but not to decrease when the unemployment rate is high. Reverting once more to the basic model of costs, consider a company which has anticipated a 10 per cent increase in demand due to GNP growth; it intends to respond by increasing purchase of inputs by 10 per cent. There are three views on what will happen to input prices: 1 2a 2b They will all be unchanged They will all increase by 5 per cent Labour and Materials will increase by 15 per cent, Capital by 10 per cent
Cost scenarios
Labour Units Base 1 2a 2b 100 110 110 110 Wage 100 100 105 115 50 55 55 55 Capital Units Price 200 200 210 220 Materials Units 500 550 550 550 Price 20 20 21 23 30 000 33 000 34 650 37 400 Total cost % change

Table 4.8
Scenario

+ 10 + 16 + 25

The implications of the three scenarios for total cost are as shown in Table 4.8. In Scenario 2a, the actual increase in total cost is 16 per cent rather than the 10 per cent which would be expected if factor prices were unchanged, because of marginal increases in the prices of inputs. In Scenario 2b, which characterises ‘overheated’ local factor markets, the cost increase is 25 per cent. Since it is unlikely that significant changes in GNP will occur without changes
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in the prices of inputs, it would be naive to ignore these potential price changes. Calculations of the viability and cash flow implications of increasing sales by 10 per cent in this case could be totally misleading if no attention is paid to the likely impact of wider economic influences. This, of course, is the other side of the discussion at 4.8.1, where increases in GNP might appear to lead to strategic opportunities. It must be recognised that the impact of a change in GNP is not confined to the sales and revenue side, and it may well turn out that anticipated increases in cost may cancel out the potential revenue benefits of a marketing strategy designed to take advantage of an increased market size caused by an increase in GNP. This brings us to the main conclusion concerning the impact of macroeconomic changes on company strategy. Changes in overall economic activity can affect sales, by the effect on purchasing power, and costs, by the effect on wage rates and investment costs; but potentially the greatest impact results from the competitive actions which the changes trigger off. The real threat from ignoring changes in the economy as a whole lies in the fact that competitors who do analyse these events can take pre-emptive action, leading to a loss in competitive position from which is likely to be difficult to recover.

4.9

Environmental Threat and Opportunity Profile: Part 1
While it is clearly important to understand the main factors which affect the national and international economy, the range of variables is so large that it is necessary to develop a method of systemising how changes in the economic environment might relate to the company’s strategy. One method of approaching this is to draw up a profile of how changes in the environment are likely to present threats and opportunities. A full environmental profile would include factors specific to the market in which the company operates, therefore at this stage only the factors relating to the economy as a whole will be incorporated. A fuller version of the environmental threat and opportunity profile (ETOP) is presented at the end of Module 5. Because of the complexity of the macroeconomic environment it is necessary to use all the tools at your disposal to identify potentially important factors. There is no single prescribed approach, but the following framework is quite comprehensive. 1 2 3 4 5 Use the PEST approach as a checklist. Apply macroeconomic ideas to economy wide influences. Consider international factors both in terms of exchange rates and international competitive influences. Use the environmental scanning approach to think beyond the immediate situation. Put together some scenarios to help put factors into context.

To put all this together into an ETOP the following steps can be undetaken. The first step is to list the relevant environmental factors which have been identified. The second step is to analyse whether each is likely to exert a positive
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or negative impact on potential sales and costs, and whether there appear to be openings for competitive response. The third step is to attempt to determine the relative importance of the threats and opportunities, and rank them accordingly; in the absence of hard data it may not be possible to make much progress with this step. There are no hard and fast rules for the design of the profile; it is a device for making explicit information and views on the economic environment. Table 4.9 is an example of an ETOP based on a company whose health food product is currently being sold in domestic and foreign markets. The company has identified a number of potentially important developments. The very fact of setting up the profile can be revealing; for example, a product may have a substantial number of negative entries against potential sales and positive entries against potential costs, suggesting that this is a product whose competitive advantage is under threat. However, the mere incidence of pluses and minuses may give a misleading picture in the absence of some indication of the relative importance of the different factors; for example, it may turn out that the positive entries are all potentially insignificant compared to the negative entries.
Table 4.9
Sector International Macroeconomic

Environmental threat (−) and opportunity (+) profile
Threat or opportunity

− + − +

Expected appreciation of exchange rates Growth in Eastern Bloc economies Tax rate increase to fight inflation Prospect of reduced interest rates

Consider each of the sectors in the example. International THREAT: EXCHANGE RATE Because of better trade figures and increased North Sea oil production it is estimated that the exchange rate will increase by about 10 per cent against currencies in the countries where the product is currently being sold. Other things being equal, this will cause a 10 per cent increase in its price in these countries. However, profit margins are already low and a reduction of 10 per cent in returns in order to hold the price at its current level will lead to losses on these sales. OPPORTUNITY: EASTERN BLOC Increased sales in the Eastern Bloc economies can be expected in the longer term; however, these will constitute a relatively low proportion of total sales for the next five years. Macroeconomic THREAT: TAX RATE INCREASE The recent tax rate increase will hit relatively affluent income groups hardest, and these comprise 90 per cent of the current market. OPPORTUNITY: INTEREST RATE REDUCTION
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Since health foods are not financed by loans the reduction in interest rates will have little effect on sales. However, reduced personal debt charges may help mitigate the effect of the tax increase. This brief outline suggests that the immediate threats outweigh the opportunities. Changes in both the exchange rate and the tax rate are likely to hit the value of sales, and this will not be compensated for by the effect of reduced interest rates; the Eastern Bloc holds out the prospect of long term sales growth at best. Without going through a process such as this it is unlikely that the company would have a clear understanding of the current threats and opportunities posed by the macro environment.

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Review Questions
The economic statistics shown in Table 4.2 referred to the position in the early part of this year compared to last year. The statistics below show what actually happened by the end of the year. Table 4.10 More economic indicators
Early year Economic indicator Gross National Product Industrial output Retail sales (volume) Investment expenditure Unemployment rate Inflation rate Wage inflation rate Recent changes 0.5% End year Change over year

−1.5% −1.1% −3.2%
Current value 6.2% 9.7% 10.0%

−2.2% −0.1% −0.3% −5.0%
9.0% 4.5% 7.5%

1

The CEO of the machine tool company had to decide whether to expand in the early part of the year or wait until more information became available. In the light of what actually happened by the end of the year, what would have been the correct decision early in the year? In the absence of a dramatic recovery in the economy, what do you think will happen to the inflation rate and wage costs next year? Assume that the company currently has 10 per cent market share, but that competitors are likely to take steps to protect their sales volume during the recession. Set out a scenario for revenues.

2 3

Case: Revisit Porsche: Glamour at a Price
Construct an ETOP for Porsche using the information in the case in Module 3.

Reference
1 Porter, M. (1990) The Competitive Advantage of Nations, New York: Free Press.

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The Company and The Market
Contents
5.1 5.2 5.2.1 5.2.2 5.2.3 5.2.4 5.2.5 5.3 5.3.1 5.3.2 5.3.3 5.4 5.4.1 5.4.2 5.5 5.5.1 5.5.2 5.6 5.7 5.7.1 5.7.2 5.7.3 5.7.4 5.7.5 5.8 5.8.1 5.8.2 5.9 5.10 5.10.1 5.10.2 5.10.3 5.10.4 5.10.5 5.11 5.11.1 The Market The Demand Curve Demand Factors Demand Curve and Revenue Demand Curve and Market Share Demand Curve and Marketing Expenditure Estimating the Demand Curve Competitive Reaction Game Theory The Kinked Demand Curve Competitive Pricing Segmentation The Effect of Product Differentiation Pricing in Segments Product Quality Dimensions of Quality Quality and Strategy Product Life Cycles Portfolio Models The BCG Relative Share Growth Matrix Other Portfolio Models Limitations of Portfolio Models Portfolio Models and Corporate Strategy Strategy and Product Information Supply The Industry Supply Curve and Strategy Shifting the Industry Supply Curve Markets and Prices Market Structures Perfect Competition Monopoly Barriers to Entry Contestable Markets Competition among the Few: Oligopoly The Role of Government Government and Rule Making 5/3 5/3 5/5 5/6 5/8 5/10 5/12 5/13 5/13 5/16 5/17 5/18 5/21 5/23 5/24 5/27 5/29 5/31 5/34 5/35 5/38 5/39 5/39 5/43 5/43 5/44 5/44 5/45 5/47 5/48 5/50 5/51 5/53 5/54 5/54 5/54

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5.11.2 5.11.3 5.12 5.12.1 5.13 5.14 5.15

Government and Regulating Government and Allocating The Structural Analysis of Industries Profiling the Five Forces Strategic Groups An Overview of Macro and Micro Models Environmental Threat and Opportunity Profile: Part 2

5/55 5/56 5/57 5/59 5/60 5/61 5/62 5/64 5/64 5/64 5/65 5/66 5/67 5/71 5/73

Review Question 1 Review Question 2 Case 1: Apple Computer (1991) Case 2: Salmon Farming (1992) Case 3: Lymeswold Cheese (1991) Case 4: Cigarette Price Wars (1994) Case 5: A Prestigious Price War (1996) Case 6: An International Romance that Failed: British Telecom and MCI (1998)

Learning Objectives
• • • • • • • • • • To develop a framework for analysing market demand. To analyse product life cycles. To show the relevance of the BCG portfolio matrix for strategy. To demonstrate the importance of supply side cost factors. To show why prices vary. To demonstrate the effect of different market structures. To assess the importance of product quality. To show why governments intervene in the market and how this can affect individual companies. To show how non-economic variables can be included in market analysis. To include market factors in the environmental threat and opportunity profile.

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Strategists

Objectives

Who decides to do what

The macro environment

The industry environment

Internal factors

Competitive Analysis and diagnosis position
Feedback

Generic strategy alternatives

Strategy variations

Strategy choice

Choice

Resources and structure

Resource allocation

Evaluation and control

Implementation

5.1

The Market
The market mechanism is the principal method by which resources are allocated in industrialised economies. After decades of debate on the relative merits of markets and planning, the breakdown of the centrally planned economies of Eastern Europe in the late 1980s illustrated the superiority of markets in allocating resources efficiently. An understanding of how markets operate provides managers with insights into the behaviour of customers and competitors. Furthermore, a knowledge of the weaknesses, as well as the strengths, of the market system is the starting point for understanding the legitimate role of government, and provides the framework within which government actions can be understood. At the corporate level the type of market issues confronted include ‘Are we in the right markets?’ and ‘What resources should be allocated to the development of our various markets?’ At the business unit level the type of questions the company addresses include ‘What price should we be charging for our product?’ and ‘How much should we be spending on marketing?’ Since many strategy problems are related to demand and/or supply issues, the first step is to develop the role of demand and supply analysis.

5.2

The Demand Curve
It is intuitively obvious that the higher the price charged for a product, the less will be sold, other things being equal. This is the basis for the economic concept

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of the demand curve, which shows the relation between the price of a good and the amount which would be bought at each price. A typical demand curve is shown in Figure 5.1, together with the quantities which would be purchased at two prices P1 and P2 . If the quantity changes by a large relative amount when price is changed, the demand curve is said to be ‘elastic’, and if the quantity is not affected much by changes in price it is said to be ‘inelastic’ (the elasticity concept can be expressed mathematically, but here we concentrate on the general meaning of the idea). In the Figure the price fell by half from P1 to P2 , while the quantity bought increased by about three times from Q1 to Q2 . This demand curve is therefore elastic in the range Q1 to Q2 .

P1

Price ($)

P2

Demand

Q1

Q2

Q3

Quantity

Figure 5.1

The demand curve

From the manager’s viewpoint, the important characteristic of the demand curve is what happens to total revenue when price is changed. This is what the elasticity tells in a shorthand form. For any price the demand curve provides the basis to calculate the total revenue from the quantity which would be sold:
Revenue1 = P1 × Q1 Revenue2 = P2 × Q2

These revenues are represented by the areas drawn under the demand curve in Figure 5.1 at the two prices. It is obvious that Revenue2 is greater than Revenue1 , thus the statement that the demand curve is elastic below P1 means that reducing the price increases the revenue. On the other hand, the statement that the demand curve is inelastic below P1 means that a price reduction will result in lower revenue. Thus a relatively simple item of information about the shape of the demand curve can have important implications for pricing strategy. It must be appreciated that the assumption made in drawing the demand curve is that other things do not change as price changes. This means that the prices of other goods and services are not changed, that the incomes of buyers do not change, that their tastes do not change, and so on. The only variable which is allowed to change is the price. The approach based on allowing only
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one variable to change is widely used in economics, and is usually referred to as ceteris paribus: holding other things constant. The objective of this approach is not to ignore the potential impact of other factors, but to make it possible to focus on the likely effects relating to individual factors. A natural reaction of many managers on being introduced to the concept of the demand curve and the ceteris paribus approach is that it does not relate to the world they live in, where everything changes at once in a dynamic fashion. In fact, the approach is not meant to be about the real world directly, but is a powerful method of focusing on individual variables and how they affect the company. Unless a degree of abstraction from real life is achieved it is impossible to think in terms of ‘what if’; it is the abstraction from real life which many managers find difficult, but without making this abstraction they will find it difficult to follow economic discussions. 5.2.1

Demand Factors
Different factors affect demand for a product in different ways; for example, some affect the market as a whole, while others affect only potential company sales. DETERMINANTS OF MARKET SIZE: • Product life cycle • Business cycle • Exogenous shocks • GNP elasticity • Exchange rates DETERMINANTS OF MARKET SHARE: • Price • Marketing The factors which influence the total market are usually outside the control of the company. The product life cycle could lead to a reduction in market size because the market had become saturated and demand only remained for replacement. The business cycle is affected by the factors discussed at 4.4. Exogenous shocks can be due to factors such as government regulation on the allowable emissions from car exhausts. GNP elasticity varies among products, and some implications for cash flows were discussed at 4.8.1. Exchange rates are impossible to predict with any degree of consistency and can also have substantial effects on cash flow. On the other hand, pricing and marketing decisions affect the market share which the company achieves out of the given total market. In terms of the demand curve, all of the variables except for price affect the position of the demand curve; it is useful to think of the direction in which the demand curve is likely to be shifted by a particular change, and the possible order of magnitude. Thus when a number of changes occur in the economic environment at one time some idea of the potential net impact can be obtained. For example, a predicted increase in GNP next year might shift the demand

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curve to the right, but a reduction in tariff barriers might lead to increased foreign competition and would shift the demand curve to the left; because the product has a low GNP elasticity it might be concluded that the net effect will be a shift to the left of the demand curve. Attention can then be focused on the likely shape of the demand curve, and the possible impact of a price reduction as a means of maintaining sales. Thus when sales change, whether up or down, demand ideas can be used to think conceptually about what is happening and hence contribute to developing an appropriate response. The shipping industry is faced with a particularly extreme problem in terms of shifting demand curves. Exchange rates between pairs of countries often change significantly in a relatively short time, and have a major effect on trade flows (market size). The outcome of a change in exchange rates may be that demand on the outward leg increases and demand on the return leg falls, leading to vessels sailing full in one direction and half full in the other. When exchange rates start to change a shipping company can use information on demand conditions to take marketing and pricing actions in response to the potential return leg problem. 5.2.2

Demand Curve and Revenue
When the company is deciding whether to alter price, the question managers face is how responsive the quantity sold will be to the change in price; this question is actually about the shape of the demand curve. If the company is operating in a highly competitive market (often referred to as a perfect market), it has no choice on which price to charge; if it sets its price above the going level it will make no sales, and since profit margins have been competed away it will go out of business if it sets a price lower than competitors. However, most companies face a sloping demand curve of the type shown in Figure 5.1, and are able to exercise some choice on price. With some information, however vague, about the shape of the demand curve, the company would be able to predict the effect of a change in price on the revenue from selling the product. Imagine a company which is deciding whether to reduce price from $10 to $9 in order to increase sales. Two possible quantity outcomes have been suggested by the market researchers, i.e. that volume will increase by a low or by a high amount as shown in Table 5.1.
Table 5.1
Outcome Original Low High

Two possible quantity outcomes – a low or high volume increase
Price ($) 10 9 9 Quantity 100 105 120 Revenue ($) 1 000 945 1 080

The difference between the two estimates is important: the low estimate would result in a reduction in revenue, the high estimate in an increase. Another way of expressing this is that the low estimate occurs on an inelastic demand curve, and the high estimate on an elastic demand curve. Referring back to Figure 5.1, the company would like to have sufficient information on the demand curve to suggest whether
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Revenue = P1 × Q1 is greater or less than P2 × Q2

When an attempt is made to estimate the shape of a demand curve, the information available usually relates to prices relatively close to the existing price. In the example above the estimates would refer to a small part of the demand curve in each case. In fact, it is misleading to talk in terms of an ‘elastic’ or ‘inelastic’ demand curve because whether it is elastic or inelastic actually depends on where the reading on the demand curve is taken. Referring back to Figure 5.1, it is obvious that at a high price the revenue is zero, i.e. price times quantity is zero because quantity is zero; at a zero price the revenue is also zero. Thus, starting from the top of the demand curve and moving down, price times quantity increases up to a point, and then decreases. In fact, every straight line demand curve has a point at which revenue is maximised. This can be shown by the information derived from a demand curve as shown in Table 5.2.
Table 5.2
Price ($) 0 1 2 3 4 5 6 7 8 9 10 11 12 13

Price, quantity and revenue
Quantity 100 95 90 85 80 75 70 65 60 55 50 45 40 35 Revenue ($) (Price 0 95 180 255 320 375 420 455 480 495 500 495 480 455 89.5 41.7 25.5 17.2 12.0 8.3 5.5 3.1 1.0

× Quantity)

Change in revenue (%)

−1.0 −3.0 −5.2

Revenue increases as the price is increased up to 10 per unit, and then falls as price is increased further. Thus the impact of a price change on revenue depends on the current position on the demand curve. At some points on the demand curve the impact of a change in price may be quite substantial compared to other points. For example, increasing the price from $5 to $6 results in a 12 per cent increase in revenue, while the increase from $9 to $10 increases revenue by only 1 per cent. There is clearly a payoff from collecting as much information as possible on the shape of the demand curve facing the company, and its current position on the demand curve. The value of abstracting from real life now becomes apparent, because the manager can question whether the right price is being charged now: should it perhaps have been higher or lower? In other words, the manager can compare the current situation with what it might have been if the price had been set at
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a different level, i.e. ceteris paribus. The manager can now think in terms of whether revenues have been maximised in the past, and what might be done to maximise revenues in the future. 5.2.3

Demand Curve and Market Share
The emphasis in marketing strategy tends to be on market share because, as will be seen later, market share is an important determinant of competitive advantage. Since market share and the demand curve are derived from similar information, there is a direct relationship between them. If the company’s objective were to increase market share, information on the shape of the demand curve would indicate the scale of price reductions required to increase sales by the required amount, and the implications for revenue. It is revealing to translate market share objectives into demand curve terms, because doing so may reveal that the market share objective implies a demand curve which common sense suggests is impossible. For example, take two companies who both wish to increase their share of the total market by 2.5 per cent, starting from rather different market shares as shown in Table 5.3.
Table 5.3
Company A B

Increase in market share and demand
Current market share (%) 5 50 Increase desired (%) 2.5 2.5 Increase in demand (%) 50 5

If both companies were faced with the demand curve shown in Figure 5.1, and were both charging P1 , it is obvious that company A would have to think in terms of a much larger price reduction to achieve its objective than Company B. But if the demand curve were relatively steep (i.e. inelastic), even company B might have to reduce price substantially to achieve the 5 per cent increase in demand required to increase market share by 2.5 per cent. It is not necessary to have accurate empirical estimates of the demand curve to obtain this type of perspective. A rough indication of price responsiveness might be obtainable from sales staff, and the feasibility of the desired changes can be investigated. For example, if it seems that a relatively large price reduction will be required to boost market share to the desired level, competitors will be alerted and may well react. This would cause the demand curve facing the company to shift to the left, i.e. making it possible only to sell less at each price. On the other hand, a relatively small price reduction may go unnoticed. In this case the idea of the demand curve is useful because it forces managers to be explicit about the expected impact of price changes on the quantity bought. Very often, the simple question ‘What does this suggest about the shape of the underlying demand curve?’ clarifies a somewhat confused discussion. Referring back to the basic model of income:
Revenue = Total market × Market share × Price

The demand curve expresses this as:
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Revenue = Total units sold × Price

In order to develop the connection between the demand curve and market share, assume that the price charged by the individual company does not have any effect on the total market for the product; it is also assumed that competitors do not follow suit, hence the effect of a price increase will be to reduce market share. Table 5.2 showing the impact on revenue of moving along the demand curve can now be expanded to take market share into account by assuming that the company is selling in a market where the total amount sold by all companies is 400 units per period.
Table 5.4
Price ($) 0 1 2 3 4 5 6 7 8 9 10 11 12 13

Changes in market share and revenue
Quantity 100 95 90 85 80 75 70 65 60 55 50 45 40 35 Market share (%) 25.0 23.8 22.5 21.3 20.0 18.8 17.5 16.3 15.0 13.8 12.5 11.3 10.0 8.8 Revenue ($) 0 95 180 255 320 375 420 455 480 495 500 495 480 455 89.5 41.7 25.5 17.2 12.0 8.3 5.5 3.1 1.0 Change in revenue (%)

−1.0 −3.0 −5.2

The main point to emerge from Table 5.4 is that a reduction in market share can be associated with an increase in revenue; for example, if the current price were $6 per unit giving a market share of 17.5 per cent, revenue could be increased by increasing the price to $7 per unit giving the lower market share of 16.3 per cent. On the other hand, a reduction in price from $12 to $11 will increase both market share and revenue. The effect depends on the current position on the demand curve. If the objective were to maximise revenue, the optimum price to charge would be $10 per unit, giving a market share of 12.5 per cent. One of the strategic goals often pursued by companies is to increase market share. This could lead to a disagreement between those advocating a higher market share, which it is argued will contribute to competitive advantage, and those who point out that the higher market share may be associated with a lower revenue. The arguments relating to the potential advantages of increased market share do not depend only on the immediate impact on revenues; some of the complex arguments relating to the strategic importance of market share are dealt with below in relation to portfolio models.

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5.2.4

Demand Curve and Marketing Expenditure
The notion of the demand curve is not only applicable to the connection between price and quantity sold, holding other things constant. It is perfectly feasible to include price among the other things held constant, and vary another factor such as marketing expenditure. The connection between marketing expenditure and the quantity sold might be as shown in Figure 5.2.

Sales

Marketing expenditure ($)

Quantity

Figure 5.2

Marketing expenditure and sales

Figure 5.2 shows how the quantity sold, at the prevailing price, might change with the level of marketing expenditure. The slope of the line gives an indication of how responsive sales would be to different levels of marketing expenditure; the returns on marketing expenditure could be assessed by comparing the additional marketing expenditure required to generate additional revenue. The curve has been drawn to represent how it becomes increasingly difficult to achieve additional sales through increases in marketing expenditure alone, and that beyond a certain point there is a zero impact on sales. The rationale for a marketing campaign, which involves increased marketing expenditure, must be that the company is currently located on the part of the marketing response curve which is not vertical. However, in real life discussions it is rare to encounter an explicit statement of what the shape of the response curve is likely to be, where the company is currently positioned, and the expected movement along the response curve as a result of marketing actions. Yet these factors are crucial to deciding how much resources should be devoted to marketing. An alternative approach is to consider the likely effect of changes in marketing expenditure on the demand curve. For example, it might be predicted that after a marketing campaign more of the product will be sold at each price than before. In other words, marketing expenditure shifts the demand curve to the right, as shown in Figure 5.3. Before the marketing expenditure was undertaken, revenue would have been P1 × Q1 , and after the expenditure it would be increased to P1 × Q2 . The joint impact of additional marketing expenditure and a price change can be assessed directly by comparing the revenue generated on the original demand curve with
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Demand (2) Demand (1)

Price ($)
P1

Q1 Quantity

Q2

Figure 5.3

Marketing expenditure – shifting the demand curve

that on the new demand curve. But thinking about the effect of marketing effort in this way reveals something which is not altogether obvious: in order to shift the demand curve it is necessary to change people’s preferences; in other words, you have to persuade people to buy more of this product and less of something else (or save less). It is not necessary to have a deep knowledge of psychology to know that it is very difficult to change a person’s mind, particularly by indirect methods such as advertising and promotion. It is fairly obvious that to have any impact at all a marketing campaign must involve a lot of resources, i.e. cost a lot of money, and it needs to be pursued for a significant length of time, otherwise nobody will notice. You should try to recall successful marketing campaigns; for example, Pepsi was reputed to have spent $500 million in 1996 simply on changing the colour of its can. The combination of a shift of the demand curve and a movement along the demand curve is a powerful tool in developing marketing strategy. It is extremely important to be able to visualise the two different effects; it is intuitively attractive to suggest combining a price reduction with an increase in marketing expenditure in order to win a higher market share. However, it is still important to consider the likely individual effects, because the increase in expenditure may have no impact at the margin because the company is near the top of the response curve shown in Figure 5.2. The distinction between a shift along the demand curve and a shift of the demand curve is a very important one. There are many factors which can change the position of the demand curve, and most of these are outside the control of the company. For example, if the price of a substitute good were to fall, it is to be expected that the demand curve would move to the left, i.e. fewer units would be purchased at each price. The same shift would occur if the price of a complementary good were to increase; for example, an increase in the price of gin will lead to a reduction in the sales of tonic because the two are consumed together. Thus when analysing the market, one question which should
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be considered is the likely impact of extraneous effects on the demand curve for the company’s product. This perspective helps in formulating a strategic response to changes in market conditions and to the actions of competitors; for example, a company in another market may not appear to be of competitive importance until it reduces the price of a substitute product, or increases the price of a complement. The shift of the demand curve arising from an action on the part of the company, such as an increase in marketing expenditure, differs from a demand curve shift caused by the type of factor suggested above which lies outside the control of the company. In terms of the basic model of revenue
Revenue = Total market × Market share × Price

It is unlikely that the marketing effort of any one company will significantly affect the total market for a product. Thus an increase in marketing expenditure causes an increase in market share at a given price out of a given market, while an increase in the price of a substitute results in an increased total market; the latter leads to a higher level of sales at the existing market share and price. Some shifts in the demand curve have implications for market share, while others do not. There are thus important strategic reasons for distinguishing between a shift along a demand curve and a shift of the demand curve: • • • 5.2.5 It is necessary to focus on the potential impact of a price change on its own. A shift of the demand curve can be caused by factors outside the control of the company. It is difficult to change the position of the demand curve.

Estimating the Demand Curve
Given the many influences which affect demand in the real world, is it possible to produce accurate estimates of the demand curve rather than relying on personal experiences? The general problem of estimating demand curves is shown in Figure 5.4. In this example only two observations on price and quantity are available, X and Y, which were obtained in different time periods. Thus the observations X and Y relate to prices and quantities at times when the assumption of other things being unchanged does not apply. Consequently, the line drawn through X and Y is labelled ‘Not a demand curve’; this line does not provide a relationship between price and quantity, and it would be misleading to use it as a guide to pricing strategy. In fact, since so many determining factors can change between each observation on price and quantity, any attempt to draw a line between two observations is likely to be misleading. The company economist can provide the manager with a highly sophisticated statistical analysis which purports to take into account changes in the factors which affect the position of the demand curve. This should be treated with caution, and the manager should ask himself whether

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Demand Q1

Demand Q2

Price $

X

Y

Not a demand curve

Quantity

Figure 5.4

How not to estimate a demand curve

the statistical analysis is doing more than joining irrelevant points as in Figure 5.4. This does not mean that the attempt to estimate the demand curve is futile, because there may be a considerable amount of relevant information available both of a statistical and of a subjective nature, particularly at the industry level. However, while it may be possible to derive reasonable estimates of the industry demand curve, the manager should maintain a healthy cynicism of statistical approaches to the demand curve facing the individual company.

5.3

Competitive Reaction
The great imponderable in analysing markets is to predict how competitors are likely to react to strategic moves. The attempt to predict competitive reaction presents many dilemmas, and the important point is to be aware that such dilemmas exist, rather than attempt to prescribe complex gaming rules.

5.3.1

Game Theory
A well known example is the ‘zero sum game’, where any gain made by one party is at the expense of the other. In the cigarette market for example, total sales are virtually static or declining, and one cigarette company can increase its sales only at the expense of competitors. There is a considerable body of evidence to suggest that cigarette smoking is harmful and many doctors conclude from this that advertising should be banned; cigarette advertising is defended by the manufacturers on the basis that it affects market share rather than entices more people to smoke, i.e. it is a zero sum game. An industry comprised of two competitors may find it of mutual benefit to have a tacit agreement on prices. In this way they can carve up the market between them and make a profit acceptable to both. However, each company is faced with the possibility that if it were suddenly to cut prices dramatically it

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might put the other out of business, or attract a substantial part of the other’s business. But if the other company reacted very fast, and had the resources to cope with further price reductions, the net outcome might be lower prices with both companies being worse off. This is known as a ‘price war’. When attempting to frame a game strategy companies are faced with potential costs and benefits, all associated with a high degree of uncertainty. Managers can use what information they have about competitors to assess probabilities, and perhaps identify a course of action which appears to have a good chance of success. Such competitor information might include estimates of financial reserves, attitudes to uncertainty, company morale, the strength of the marketing department, previous successes and failures in new ventures, and the efficiency of the market intelligence department. A profile of competitors’ strengths and weaknesses can help indicate the likely response to different courses of action. However, the dominant characteristic of competitor reaction is unpredictability, and the company must be prepared for a variety of responses to any competitive action. But even with full information on competitors it can be impossible to arrive at an optimum strategy. A game which illustrates this and has important implications for business behaviour is the ‘prisoner’s dilemma’. Imagine the police are trying to make two suspects confess to a major crime, but they have no evidence; they tell each prisoner that 1 if he confesses: A he will go free if the other remains silent B he will go to prison for 7 years if the other also confesses if he remains silent: A he will be sent to prison for 1 year on a minor charge if the other remains silent B he will go to prison for 10 years if the other confesses.

2

Imagine you are that prisoner: what is your best course of action? Table 5.5 is a decision matrix which shows the number of years you will spend in prison for each possible action depending on what your partner in crime does.
Table 5.5
You Silent Confess

Decision matrix
Partner Silent 1 0 Confess 10 7

The answer is clear – if you stay silent the best you can hope for is 1 year in prison, and the worst is 10 years, whereas by confessing you either go free or spend 7 years in prison. In this case your best option is to confess, and this is independent of what your partner in crime does. This one-off event is artificial, but it does contain important lessons for cooperative behaviour, for example when businesses enter into joint enterprises or strategic alliances. Imagine what might happen if you have gone to prison and served 7 years. Given that research
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into criminals has shown that prison has very little effect on behaviour, assume that you and your partner commit the same crime and end up in exactly the same position once more. Both of you know very well by this time that if both of you do stay silent then you will spend only 1 year in prison, so will your experience affect your behaviour this time round? If you are convinced that your partner sees the virtue of not confessing then it is in your interest to confess, because that way you go free. But the same logic applies to your partner, so once again you will both end up confessing and going back to prison for 7 years. The point of the dilemma is that not only does the situation lead to an outcome which is not in the best interests of either party, but experience does not lead to a different outcome. Turning to the parallel with the business world, you would immediately point out that the two parties are free to discuss what they should do, and as a result of their collusion would agree to stay silent, hence serving only 1 year. But this is a true dilemma: once you have reached the agreement then you have an incentive to confess, because you will go free. The only way out of this dilemma is to introduce another variable which gives an incentive to stick to the agreement. This variable is the knowledge that the situation will be repeated an unknown number of times. Why an unknown number of times? Because after each 1 year sentence it is worthwhile to enter into the agreement, but if it is known that this is the last time then both of you will have an incentive to break it. A great deal of stress is laid on trust and commitment in cooperative business ventures. For example, both parties have an incentive to conceal information on true costs and profits, and both have to be sure that the other will not break ranks and make a profit at the expense of the other. But if agreements are not legally binding, both parties are continually faced with the equivalent of the prisoner’s dilemma. One way of building trust is to make a commitment to the venture which would make it costly to break ranks. In the absence of significant financial commitments it is not difficult to see why cooperation in a competitive environment is so fragile and difficult to maintain. You may feel that this devalues the concept of trustworthiness as a moral virtue. But in the business setting it is necessary to be realistic about the likely actions of business partners and interpret them in terms of the incentives involved. As you might imagine game theory is a complex subject; while it is highly mathematical it provides important insights into behaviour. The prisoner’s dilemma has what is known as a dominant strategy equilibrium because the best strategy is independent of the choice of the other party. If there is not a dominant strategy then it is necessary to estimate the other party’s likely response. The logic then becomes rather involved, but it is worth noting that an equilibrium strategy can be achieved in a variety of situations; the mathematician Nash demonstrated the circumstances under which each party makes the best response given what the other has chosen to do. But the fundamental point of the original dilemma is unaltered: unless there is trust and commitment to a course of action there is always an incentive for one party to break ranks.

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5.3.2

The Kinked Demand Curve
The demand curve is usually thought of as the amount which consumers wish to buy at different prices, holding other things constant. However, in the light of 5.3.1, one factor which may not remain constant is the price charged by competitors. For example, if the company reduced price by 10 per cent, and all competitors followed suit, the impact of the price reduction on sales may be minimal; however, if competitors did not react then the impact on sales would be much greater. When there are relatively few competitors in a market it could be argued that the notion of a measurable demand curve for an individual company has little operational meaning because its shape and position depends on competitive reaction, which in turn cannot be predicted. Does this mean that the concept of the demand curve cannot be used in this situation? In fact, the demand curve provides a useful method of incorporating knowledge about competitive conditions with the idea of price elasticity. Take the case where a company has not changed the price of its product for some time; this price is also charged by competitors. If the company were to increase its price it knows that none of its competitors would follow suit, and that many customers would be lost when they realised that the product could be obtained cheaper elsewhere. If the company were to lower its price, it knows that its competitors would follow suit, and that there would be very little increase in demand. The idea of a sharp reduction in demand resulting from a price increase, and very little increase in demand resulting from a price reduction, is illustrated by the kinked demand curve shown in Figure 5.5.

P

Kink

Price ($)

Demand

Q Quantity

Figure 5.5

The kinked demand curve

The current price is P, and above that price the demand curve is virtually horizontal (i.e. highly elastic), indicating that even a marginal price increase will lead to a substantial reduction in demand. At prices below P the demand
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curve is relatively steep (i.e. highly inelastic), indicating that price reductions will have very little impact on sales. The shape of the kinked demand curve has important implications for sales revenue. At 5.2.2 it was shown that revenue, i.e. price times quantity, changes along the demand curve, and that on a straight line demand curve there was one position at which revenue was maximised. In the example, which is probably typical of kinked demand curves in real life, revenue is maximised at the current price, i.e. at price P sales revenue (P × Q) is maximised. This has important strategic implications for the company. If the company is not making profit on a product, it is unlikely to be possible to improve net contribution by increasing the price because any price increase would lead to a substantial loss in sales. On the other hand, if the company wishes to increase market share by reducing the price, it follows that when the price is reduced total revenue will be smaller than it otherwise would have been, and hence so will net contribution. When competitive conditions suggest that the demand curve is kinked, the attempt to increase market share by reducing price can only be justified if future net contribution will be significantly higher than it otherwise would have been to compensate for the revenue forgone in creating the higher market share. This means that there is a trade-off between giving up revenues now in order to increase market share, and the expectation of higher revenues in the future when price can be returned to its original level at the higher market share. As market conditions change the extent to which the demand curve is kinked may also change. For example, if two or three competitors take over a number of small companies in the industry, it is to be expected that the part of the demand curve below the kink will steepen. Thus when discussing competitive reaction, it is useful to frame the issue in terms of whether the demand curve is likely to have a significant kink, and what the slope of the demand curve both above and below the kink is likely to be. The idea of the kinked demand curve has an important strategic implication for pricing: if it is thought that the demand curve is kinked it follows that it is necessary to make a significant price change and stick with it. Otherwise the price change will have virtually no effect because of competitor reaction. But the danger is that a competitive pricing move may lead to a price war the outcome of which is unpredictable. 5.3.3

Competitive Pricing
Price setting can be used as a competitive tool and short term revenue flows may be sacrificed in the pursuit of wider strategic objectives. The three main forms of competitive pricing are price leadership, limit pricing and predatory pricing. • Price leadership: the dominant firm in the industry announces its price changes before all other firms, which then match the leader’s price. The problem for the price leader is that it has to retaliate against defectors to maintain credibility, and this can be difficult to achieve without sending out conflicting signals; in fact, it is difficult to see how the price leader
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can penalise a defector without penalising all of the smaller companies in the industry. The smaller firms should benefit because they do not need to worry that rivals will secretly reduce price to steal market share, and hence it is in their interest to adopt a passive pricing role. But in a continually changing competitive environment price leadership is bound to be a fragile situation. Limit pricing: this is an attempt by a firm to erect an entry barrier by charging a low price in order to deter entry; this is only worthwhile if it has a cost advantage and can set the price low enough to deter entry but still make a profit. However, in reality incumbent firms should not limit price because potential entrants will recognise that any price reductions prior to entry are artificial. Once entry occurs, it would make no sense for the incumbent to continue to suppress price. This is because the lost profit opportunities from having previously set the limit price are sunk: once the entrant is in the market, the incumbent should attempt to maximise future profits. On the other hand, the potential entrant cannot be certain that the incumbent will in fact attempt to maximise profits after his entry, so it then becomes a game where the incumbent attempts to affect the potential entrant’s expectations about his subsequent behaviour. It is obviously too simple to think of limit pricing simply as a method of keeping out potential competitors by making returns appear low; it is really an issue of expectations. Predatory pricing: in this case a firm sets a price with the objective of driving new entrants or existing firms out of business. In order to make this strategy work it is necessary for the predator to have some strength, such as a large cash reserve or relatively low costs, which other firms in the industry do not share. This approach could work where a competitor is known to be financially unstable, but otherwise it is likely to lead to competitive reaction, and we are back to the two person zero sum game.

These approaches to competitive pricing are typically encountered in textbooks, but they are rarely found in practice. Probably this is because they characterise extreme forms of competitive behaviour which do not occur much in real life. It is unrealistic to expect one firm to set prices in a competitive market, where changes are occurring all the time; firms rarely expect to be able to deter competitors from entry by engaging in a price war, and recognise that their real future lies in competing effectively rather than trying to destroy competition; the same applies to eliminating existing competition – it is one thing to try to win market share by pricing competitively, but it is quite another to set out deliberately to ruin a competitor. The point is that competition cannot be avoided, and a price change which deters or eliminates one competitor is unlikely to have a permanent effect on competitive pressures.

5.4

Segmentation
From the strategy viewpoint, it is often misleading to think in terms of a product which is sold to a homogeneous group of consumers. The theory of competition in markets starts with the assumption that consumers have identical characteristics and have full information about the prices charged for the product; this leads

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to the notion of a single demand curve for the product, and implies a marketing strategy which concentrates on the average consumer. However, an appraisal of the potential worth of a product may be radically altered by relaxing these assumptions and investigating potential market segments based on variations from the average consumer, and the marketing strategies which might be able to exploit them. It may be found that a 5 per cent price reduction may lead to a 1 per cent increase in sales volume, suggesting that the product is price inelastic. However, the additional sales due to lower prices may be concentrated among consumers in the lowest income group; rather than offering a price reduction to everyone in the market, it would be more effective to offer the price reduction only to those in the group who are likely to respond. In this case the lowest income group is a segment of the market. Thus a market segment is a group of consumers within a broader market who possess a common set of characteristics, and consumers in a segment respond to market mix variables in broadly the same way. An example of a company which focuses on a particular segment is Cray Research, which manufactures super computers. The economic idea underlying segmentation is that the market demand curve is the summation of the demand curves for market segments; these segment demand curves can vary significantly in their characteristics. The objective in segmentation is to identify different groups according to their characteristics, estimate how they are likely to react to different selling approaches directed at them, and allocate marketing effort accordingly. For example, assume that a company has carried out market research which has established that the price elasticity for one of its products varies among segments. In terms of the basic model of revenue, segmentation can be expressed as follows.
Revenues = Total markets × Market shares × Prices

where s = 1, 2, . . . , n and n = segments of the market The company would attempt to set Price in each of the n segments so that the sum of the Revenues is greater than the original revenue from the non-segmented market. There are many characteristics on the basis of which the market can be segmented, such as income, social class, geographical location, age, sex, family size, educational background, etc. When the segments are not separated geographically it may not be feasible to charge different prices among segments, and in this case the marketing thrust would accentuate product characteristics which have a particular appeal to individuals in the different segments. There are in fact four main characteristics which a segment needs to have if it is to be potentially exploitable: 1 2 Identifiable: there must be sufficient common features that enable the segment to be identified in the market place. Demand related: the identified segment must have at least one characteristic which translates into demand terms, such as the willingness to pay more for a high quality product.
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3

4

Adequate size: the segment needs to be large enough to generate a potentially attractive return on the investment required to exploit it; this is where techniques such as break even analysis are particularly important. Attainable: if the segment cannot be reached by available marketing and advertising approaches there is no point to embarking on the investment. For example, before launching the Lexus motor car the makers had to be convinced that they could reach high income individuals in sufficient numbers; given the fierce competition which already existed among high profile brands such as Jaguar, Mercedes and BMW in this segment this was a formidable undertaking.

From this a number of key steps can be identified for carrying out a segmentation analysis.

Identify the Most Important Segmentation Variables
The fundamental issue here is whether there are general criteria which can be used in determining which variables are likely to be most important and in what circumstance. The problem is that markets are individual in nature, and hence no such criteria exist. The best that can be done is to approach the issue in a structured fashion, for example: • • • identify the key product characteristics derive the characteristics of the target segment identify the location of the target segment; location can be in the physical sense or by income, social class etc.

While it is not possible to provide more than a set of general rules for such a structure, it is essential that this stage is pursued quite deeply so that the company understands where the basis for competitive advantage is likely to lie.

Construct a Segmentation Matrix
The identified variables can be combined with other information about the industry to produce a matrix which can identify where segmentation gaps potentially exist. A simple example is to construct a matrix of restaurant ethnic types and quality in a particular city; this could take the following form. Type Chinese Japanese Indian Mexican Italian High 3 1 2 6 Quality Medium 7 1 10 5 4 Low 5 15 10 9

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This classification suggests that there is a gap in the market for high quality Mexican and low quality Japanese restaurants. But care must be taken at this point, because the fact that these gaps have been identified does not mean that they can be profitably filled. For example, there are very few low quality Japanese restaurants anywhere because of their accent on fresh produce. The various criteria outlined above have also to be taken into account before deciding whether an investment is worthwhile. It is always necessary to bear in mind that in a competitive economy there is usually a very good reason for such gaps existing: they have already been tested and found to be unprofitable.

Analyse Segment Attractiveness
This is a complex process, and involves the use of a variety of strategic models depending on the circumstances. These tools include demand and supply analysis, market structures, barriers to entry and many others which will be developed later in the course.

Identify the Key Success Factors
The key success factors are the necessary, but not sufficient, conditions for success. It is possible to identify those activities which must be completed as a precondition for success. Unless close attention is paid to the identification of these factors there is little chance that the segment will be effectively exploited. For example, from the matrix above it might be concluded that there is a gap for another high quality Japanese restaurant. Some key success factors involved in exploiting this segment are: • • • 5.4.1 identify a source of totally fresh sea food; obtain the services of a highly qualified Japanese cook (who are very rare); find and decorate premises which provide a Japanese ‘look and feel’.

The Effect of Product Differentiation
For some products it may be virtually impossible to differentiate among consumers on the basis of product characteristics because the product does not lend itself to this approach; for example, there is little difference between one grain of wheat and another. But it may be possible to change the characteristics of a product in ways which will have particular appeal to different types of segment. An obvious example is a car; for the low income family with young children the optimum car is certainly not a two seater high performance sports car which is relatively expensive both to purchase and run. The product can be thought of as a bundle of characteristics which appeal to different consumers in different ways. Product differentiation extends the concept of segmentation to the determination of which bundle of characteristics should be incorporated in the version of the product targeted at each group. There are times when differentiation may be more apparent than real. Differentiation may simply be a perception on the part of potential buyers, for

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example aspirin is sold under many brand names and all of them simply cure headaches. However, real or perceived differentiation has implications for marketing strategy and pricing policy. Consumer characteristics can be matched with potential product characteristics to identify those market segments where it is likely to be worthwhile to differentiate the product. The two most important determinants of a product’s success are likely to be the price of the product compared to similar products, and the degree to which consumers perceive the product as a different offering. Data on consumer perceptions of relative price and differentiation can be generated by market research, and the approximate position of the product in Figure 5.6 can be identified.
High Perceived differentiation vs competitive brands Success likely

Success highly uncertain

Failure likely High Perceived price vs competitive brands

Low

Figure 5.6

Perceived price / differentiation

The model tells some rather obvious things: a product with low perceived differentiation and high perceived relative price is likely to fail; a product with high perceived differentiation and low perceived relative price is likely to succeed. Despite the apparent simplicity of the approach, the model is remarkably powerful in identifying potential strategies. For example, if current development and pricing plans suggest that a product will fall into the ‘uncertain’ area, a possible strategy response is to adjust price and/or mount an advertising campaign designed to increase perceived differentiation to get into the ‘success likely’ area. There is little point to pursuing plans which seem destined to produce a product in the ‘failure likely’ area. The model can also be used to derive a launch strategy. A product which has high perceived differentiation can be put on the market at a relatively high price at first and then abandoned, or the price reduced when competitors react and the perceived difference is eroded. In the electronics industry during the 1980s Hewlett Packard consistently entered new markets with high priced
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differentiated calculators in the knowledge that their competitive advantage would be relatively short lived. This is because the technology could be copied; the subsequent entry of new competitors bid away monopoly profits, but by that time Hewlett Packard had made its return and could move on to another differentiated product. 5.4.2

Pricing in Segments
It goes without saying that market conditions differ among segments, and that different prices can be charged in each. However, it may well be the case that there are virtually no differences in the cost of products sold in different segments; for example, where segments are based on geographical rather than product differentiation there may be no difference in the production cost in each. What is the optimum price to charge in each segment? This topic has been extensively treated in economics, and is known as discriminating monopoly. The economic theory is relevant here because the effect of segmentation is to confer some degree of monopoly power to the company in the different segments; it also stresses the importance of market rather than cost conditions when setting prices. Without elaborating the theory (which can be found in any intermediate level economics textbook), it will come as no surprise that the conclusion arrived at is that, in pursuit of profit maximisation, a monopolist will charge different prices in different markets depending on demand conditions. The monopolist will charge a higher price in a market with a low demand elasticity than in a market with a high demand elasticity. This follows despite the fact that the marginal cost of production is identical in each market. In terms of the basic model, the theory is concerned with finding the price in each market for which revenue minus cost is maximised. The implication for pricing is clear: if different demand conditions exist in different parts of the market different prices should be charged, even though costs are the same in each. There is a real payoff from finding out what the different demand conditions are, rather than setting a uniform price in all parts of the market. This is because total profit from the uniform price is lower than the sum of profits obtained from differential pricing. This arises from selling more of the product at a lower price in the segments where demand is relatively responsive to price, and less of the product at a higher price in segments where demand is relatively unresponsive to price. Segmentation is therefore a potentially powerful tool for transforming a loss-making product into a profitable product without changing anything but the price charged to different groups of consumers. Marketing practitioners have turned segmentation into an operational tool for exploiting markets. The first step is to carry out research to determine the characteristics of different segments of the market, and the product characteristics which might best match with them. The second step is to derive estimates of price and income elasticities; in marketing terminology, this is often expressed as price and income responsiveness. The additional feature added by marketing strategy is that the product itself is adjusted to match as closely as possible the

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demand characteristics of the different segments, or advertising campaigns are mounted to affect the perception of potential consumers that differences exist in different brands of the same product. Because resources are required to differentiate products, marginal cost may not be identical in the different market segments; however, the principle of differential pricing based on market conditions still applies despite the fact that production costs are different. The theory of price discrimination, on which differentiation is based, can be developed further to demonstrate that there are limits to the extent of segmentation depending on the impact of segmentation on costs. The potentially higher revenues from segmenting the market, differentiating the product and setting different prices can be balanced against the additional costs incurred in each segment in order to obtain an approximation to the limits imposed by cost differences. Market segmentation is a good example of how economic, accounting and marketing approaches can be integrated to provide a conceptual structure to deal with the diverse information encountered in real life. For example, marketing ideas identify a product where segmentation is potentially viable; economic ideas are used to measure demand characteristics, and emphasise the role of marginal cost in decision making; accounting ideas are applied to abstract marginal cost. It can be noted that relevant accounting information on marginal costs is essential for making rational segmenting decisions: unless the marginal costs relating to product differentiation are properly estimated, the result may be what appears to be a successful marketing strategy in terms of capturing market share, but poor profits because the use of the wrong costs led to a misallocation of resources.

5.5

Product Quality
One of the most frequently encountered methods of product differentiation is by reference to the superior quality of a company’s product or service. But while many managers believe that part of their company’s appeal to customers is attributable to the superior quality of their products, they are often vague about exactly what the quality difference comprises. The consumer magazines, such as Which? in the UK, which carry out comparative studies of products made by different companies often find that products differ only marginally, and that their definition of a ‘best buy’ often bears little relation to manufacturers’ advertising claims. This confusion is not restricted to consumers; disagreement is often encountered among employees within a given company on what constitutes quality. Some take the view that quality depends on the production process, in other words it depends on how the product is made; others feel that quality depends on reliability in use. There are several approaches to the definition and measurement of quality, therefore it is important that managers are clear about what they mean by quality prior to allocating resources either to increasing quality or exploiting it in the market place.

Transcendent Quality
The philosophical approach to quality is based on a form of circular reasoning which robs the concept of operational use for decision making purposes.
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Essentially, the Platonic definition relates quality to high standards of excellence and achievement which can only be recognised in the light of experience. Thus a painting by a great master appeals to an art critic who has devoted a large part of his life to the study of art, but will be little more than a pretty picture to a 16-year-old who has had no art education. The pursuit of transcendent standards by managers is unlikely to be related to commercial criteria given the difficulty of defining what comprises these standards.

Product Based Quality
A product can be viewed as a bundle of characteristics, most of which are susceptible to some form of measurement. For example, compare flying from London to New York first class in a Boeing 747 with flying Concorde. Concorde takes less time, and this can be measured. However, first class is more comfortable than the rather cramped Concorde, and different passengers will have different views on how great the difference in comfort actually is. There is therefore no guarantee that passengers would agree on which is the higher quality flight. Those who actually chose to fly Concorde have obviously decided that it provides a higher quality service for the price charged. The characteristics approach has considerable power in classifying products and identifying what it is that consumers are willing to pay for, but product characteristics are not necessarily determinants of product quality; this is because quality may be dependent on how well the characteristics are produced or combined together. Sometimes manufacturers incorporate characteristics which have little relevance to consumers, but which are thought to enhance the quality image of the product. For example, it does not matter much to the average consumer that a particular make of watch will function at 100 metres below water. While the resulting image of dependability may help sales of the watch, the cost of building a case which can withstand high pressure may far outweigh the return from the additional sales. In that sense it could be claimed that the watch had ‘too much’ quality. This notion of quality also applies to service industries, where quality and consistency are closely linked; most people have had the experience of recommending a restaurant which failed to deliver the same quality for someone else. The consistency characteristic is important, because if it has not been achieved the consumer can have no confidence that he will be able to buy the same product each time. But consistency is not actually part of the quality itself, which in the restaurant depends on the raw materials and the ability of the chef. There can be very high costs associated with improving dimensions of quality. For example, an important quality dimension in electricity supply is the incidence of interruptions. It is impossible to guarantee zero interruptions to all consumers and everyone accepts this; however, consumers would not be satisfied with hourly interruptions. Imagine that the supply company operated with a 5 per cent probability that the average consumer will have an interruption during any one month period. A huge number of complaints were received and the company decided to improve on the 5 per cent figure. It might well discover
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that the cost of reducing the probability to 4 per cent was relatively low, but the cost of reducing it a further point to 3 per cent was twice as much, while the cost of getting down to 2 per cent was ten times as much. The electricity supply company would then try to balance up the marginal costs with the increase in consumer satisfaction. For example, if consumers were unable to tell the difference between 3 per cent and 2 per cent it might be worthwhile reducing the probability to 3 per cent but no further.

User Based Quality
This approach departs from the functionally based product characteristic differentiation, and enters the conceptual minefield of what it is that contributes to quality in the eyes of the consumer. An economic interpretation is that product quality variations cause differences in the position of the demand curve for products which are otherwise identical. But it is difficult to determine what these quality variations might be. For example, take the case of two products which have identical functional characteristics; what is left to vary? One might look better than the other to many consumers, or have what is typically referred to as a ‘better design’. For example, this is a feature ascribed to different makes of electric kettle, where the appearance can be changed but it is virtually impossible to alter the functional characteristics: the kettle still boils water and nothing else. Almost every user based definition of quality can be reinterpreted as a functional, measurable characteristic. For example, durability, flexibility, strength and speed are all definable as functional characteristics. One marketing approach is to attempt to identify ‘ideal points’, which are precise combinations of characteristics which provide maximum satisfaction to consumers. This takes into account that the interaction of different quality dimensions can produce more utility than the sum of the individual parts. While this can provide useful guidelines, it is really an operational application of quality characteristics in relation to consumer satisfaction rather than a method of defining quality itself.

Production Based Quality
This approach relates to production in conformance with specifications. Notions such as getting it right first time, statistical quality control, and designs intended to reduce the scope for manufacturing mistakes, all have the objective of producing the same product each time. To some extent the manufacturing based approach can be interpreted as a cost reduction exercise, with the objective of producing a given set of product characteristics at the lowest average cost. While a component of the concept of quality is that each unit performs to the design standards, it begs the question of what comprises the quality standard in the first place, and why the particular array of characteristics was originally chosen.

Value Based Quality
This is a hybrid notion which combines the price, or production cost, with the quality. According to this definition, a running shoe costing $600 is not a quality
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product, since no one would buy it. This definition can be interpreted in terms of the economic ideas of marginal and total utility. The value based definition of the running shoe hinges on the fact that at the margin consumers would be unwilling to pay the high marginal cost associated with virtually undetectable marginal differences in product characteristics. The marginal cost associated with improving aspects of the running shoe’s characteristics becomes progressively higher, while the additional utility which the consumer obtains from increments to these characteristics continually declines. Thus while the total utility which the consumer would obtain from the $600 running shoe would be much higher than for a shoe costing $120, consumers do not value the difference at $480. Many cases do exist, however, where seemingly marginal differences in characteristics are translated into very large price differences which consumers are willing to pay. An obvious example is the willingness to pay three times as much for a Rolls-Royce as a Jaguar; it might be argued that the marginal utility of the additional $150 000 is less than the dimly perceived additional comfort and performance of the Rolls-Royce. Indeed, it may be that the quality difference has been established by prolonged advertising campaigns, which have stressed the quality aspects of the product process without being clear what the quality difference amounts to for the consumer. Rolls-Royce advertising campaigns have stressed the care taken over the production standard of every single component, but whether this can be translated to the consumer in terms of an identifiable difference in utility in use is left open. Whether it matters to the consumer that a particular part of the car is ‘hand built’ is another matter; producers are often confused about the difference between the production process and the final characteristics of the product. Managers should attempt to determine when a particular production process merely adds to costs rather than to market appeal. The Morgan car company, a British company which makes a range of old style sports cars, refused to alter its production processes in line with technology, and insisted that the whole car be built ‘by hand’; while this helped to foster the image of a unique product, the costs associated with this form of quality were such that the firm ran into serious financial problems. The Morgan car company could not translate the hand built image into a price which consumers were willing to pay. It is possible that a great deal of what is thought of as quality rests on a perception which is reinforced by the norms of society. It may well be that a market does exist for a $600 Gucci running shoe, which is merely a standard running shoe with the exclusive label attached. 5.5.1

Dimensions of Quality
A framework for assessing the multidimensional nature of quality can be generated by being explicit about the potential dimensions of quality, for example Garvin1 suggests: • • • performance features reliability
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• • • • •

conformance durability serviceability aesthetics overall perceived quality

It is not claimed that these dimensions can be defined precisely, but it is possible for informed consumers to rate these dimensions to reflect their own perceptions. It is reasonable to conclude that a product which achieves a low rating on all dimensions will also have a low weighting for overall perceived quality. This can by taken further by asking a sample of consumers to rate a product’s characteristics to use as the basis for identifying those dimensions which contribute to the average consumer’s perception of overall quality. This implies a relationship between overall perceived quality and the individual dimensions of the following type:
Perceived Quality = a1 × Performance + a2 × Features + . . . + a7 × Aesthetics

where a1 , . . . , a7 are weights Without entering into the details, statistical methods can be used to estimate the weights which determine the contribution which each dimension makes to overall perceived quality. For example, it may be found that the dimension with the highest contribution to overall quality is ‘durability’ in the case of photocopiers, and ‘features’ in the case of video recorders. The results can provide information on the basis of which to differentiate the product, and to determine which product characteristics should be enhanced. It is likely that people of different backgrounds will attribute different weights to different dimensions; statistical techniques, such as cluster analysis, can be used to relate market segments and product dimensions. The process of identifying dimensions of quality and segmenting the market makes it potentially possible to identify exploitable niches and identify which quality dimensions have the potential for profitable development. For example, it might be found that higher income groups give a higher weighting to aesthetics than lower income groups; this would clearly be a valuable item of information for the purposes of targeting an advertising campaign. A similar approach uses the price as the dependent variable and various product characteristics as the explanatory variables. The relationship would look like this for a washing machine:
Price = b1 × Capacity + b2 × Spin speed + . . . + b7 × Reliability

where b1 , . . . , b7 are weights The statistical analysis would be carried out for a variety of washing machines and the estimated weights would show how much consumers are willing to pay for different characteristics. This is known as a hedonic price index and is a useful measure of the value of product characteristics since it measures what consumers are willing to pay for. While the statistical analysis is rarely done in practice, the process is implicitly carried out every time a pricing decision is made for a differentiated product.
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5.5.2

Quality and Strategy
A considerable amount of research has been carried out into the relationship between product characteristics and market performance; the findings provide some pointers which are helpful for strategy formulation. Some quality related issues which might appear to be self-evident are not necessarily true. For example, quality and price may be expected to be positively related, other things being equal, because of the additional production costs associated with higher quality. However, when different dimensions of quality are taken into account, the price-quality relationship is obscure. This means that a company cannot assume that it will be able to charge a higher price after having improved the perceived quality of its product. Another finding relates to quality and advertising; it might be expected that quality and advertising expenditure are positively related, given the higher returns to advertising for higher quality products. Again, the evidence is ambivalent. It may be the case that investment in higher perceived quality is a substitute for advertising expenditure. The trouble is that consumers do not always have much direct information on quality, and it is necessary to infer quality from the behaviour of others. For example, in 1994 American Express launched an advertising campaign based on the length of time that famous people had been subscribers; the clear implication is that the quality of American Express service can be inferred from the fact that many famous people were willing to be associated with it. There is some evidence that quality is positively related to market share, suggesting that investment in perceived quality has paid off in the past in marketing terms. There is also some evidence that quality and profitability (as measured by ROI) are correlated. Thus on balance, there is some evidence that the pursuit of quality may generate returns in terms of competitive advantage and profits. However, while the empirical evidence suggests that important influences are at work, it is not clear cut, and the payoff from quality may vary substantially depending on the circumstances. The high quality ice cream made by H¨ aagen-Dazs is a major success in America and Japan; it was launched in Europe in 1990 and had a significant impact on the ice cream market, causing existing producers such as Nestl´ e and Unilever to introduce their own luxury brands and heightening the awareness of quality ice cream among European consumers. But five years later H¨ aagen-Dazs was still making substantial losses and had a relatively small share of the market. Thus having virtually created the high quality ice cream market in Europe, H¨ aagen-Dazs was unable to profit from it; there are many reasons for the lack of profitability, including the logistics of the ice cream market, the scale of operations and the reaction of competitors. But the clear message is that a product with a high perceived quality does not guarantee financial viability. While quality appears to be a potentially powerful strategy tool, it is difficult to be precise about exactly how it might contribute to company success:
Managers must learn to think carefully about how their approach to quality changes as a product moves from design to market, and they must devise ways to cultivate these multiple perspectives. Attention must be focused on the separate dimensions of quality; markets must be closely examined for any untapped quality niches; and the organisation must be tailored to support the desired focus. Once these

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approaches have been adopted, cost savings, market share gains, and profitability improvements can hardly be far behind.2

The idea that quality is a fundamental determinant of success has generated an approach known as total quality management (TQM). As its name suggests, quality in all its dimensions is pursued with a high degree of rigour and commitment. Notions of quality are brought to the forefront of awareness, and include all aspects of company performance through production processes and customer service. Some countries have introduced formal quality standards against which companies can be appraised; for example, in the UK the BS5750 award signals that a company has met various quality criteria relating to production processes. But the pursuit of TQM is by no means an exact science because of the difficulty of defining quality and providing the incentives which will make quality initiatives work. TQM took on the characteristics of a philosophy rather than a particular business technique, and is greatly dependent for its success on the energy and commitment of the approach in particular circumstances. TQM is a relatively recent development and gained its momentum during the 1980s, but by the mid 1990s scepticism had set in. This occurred because, while there were some well publicised instances where TQM appeared to have been successful (for example Rank Xerox and Motorola), surveys revealed that up to 80 per cent of TQM initiatives failed. Systematic research on the issue3 concludes that the features most generally associated with TQM, such as quality training, process improvement and benchmarking, do not in themselves produce competitive advantage; this is probably because these can be imitated by competitors without necessarily being associated with a TQM programme. However, some tacit and behavioural features such as an open culture, employee empowerment and executive commitment do appear to be associated with advantage. In other words these tacit characteristics, and not TQM tools and techniques, drive TQM success, and organisations that acquire them can perform relatively better than competitors without the accompanying TQM ideology. From the perspective of the basic model of revenue and cost, the various notions of quality can be related to the determinants of revenue and cost. Revenue Outlay = = Total market Number of workers Units of capital Units of material × × × × Market share Wage rate Price Price × + + Price

Discussions on quality can benefit from identifying which areas of revenue and/or cost are likely to be affected by different quality dimensions, and in which market segments. One of the effects of TQM was to demonstrate that there was not necessarily a trade-off between quality and cost, and many companies which successfully implemented TQM programmes reported simultaneous increases in productivity and quality. However, it may be that successful TQM programmes have merely eliminated inefficiencies in companies and after this has been achieved there is no such thing as a costless improvement in quality. Table 5.6 shows how it might be possible to relate variations in different quality dimensions to potential implications for market share and production
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cost in a particular market segment; the entries would depend on the circumstances facing the individual company.
Table 5.6
Dimension Performance Reliability Conformance Aesthetics

The effect of quality
Impact on market share High High Low Medium production cost High Low Medium Low

For this company a relatively low production cost incurred to improve reliability would lead to a potentially high impact on market share. While improvements in performance are also likely to lead to a high impact on market share, the high cost associated with performance may make it a less attractive option than improving aesthetics. This cost based approach is at odds with TQM, which holds that all aspects of quality are important because of the interdependence of the various functions in the company.

5.6

Product Life Cycles
The notion of product life cycles has implications for all aspects of strategy. Managers are well aware that markets are not static, and that they are continually changing in terms of growth rates and competitive conditions; the product life cycle is a powerful tool for systemising many of the changes in these factors by providing an overview of the evolution of the market for a product, thus enabling managers to interpret the current market situation and future prospects in a structured manner. It is a widely held view that the product lives of many goods are likely to continue to shorten as the pace of technological change and information transfer increases. The product life cycle is depicted in Figure 5.7, which is a general representation rather than referring to any particular product. Introduction: the product is invented and introduced to the market; it can take some time for information about the product to be disseminated Growth: the product becomes increasingly well known, markets are penetrated and it possibly replaces other products Maturity: all markets are exploited and there is no further increase in sales Decline: the product is superseded by technological progress, or substitutes appear Since industries are composed of products the idea of the life cycle can be generalised to the industry level, and Figure 5.7 can be regarded as either referring to a product or to the industry. Everyone is familiar with industry life cycles in broad terms, for example, the very high rates of growth in the personal computer market, which have now slackened off as the industry approaches maturity, or the decline of the cigarette industry in Western countries as information on the health risk of smoking reduces the number of consumers. In fact, as the pace of

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Market size

Maturity
Decline

Growth

Introduction

Time

Figure 5.7

Product life cycle

technological change has increased in the past few decades, it is generally felt that product life cycles have generally shortened; this certainly seems to be the case for most consumer durables. While the idea of the life cycle is a very general one, and varies according to the product and the country, it is an essential tool of strategic analysis because the company’s estimate of where the industry is on the life cycle has important implications for strategic behaviour. This is because the stage in the product life cycle affects profitability, capacity utilisation and competitive reaction. • Introduction The company will be investing in new productive capacity and spending relatively high amounts on marketing to bring the product to the notice of consumers. Cash flows will be negative, and during this period the company will have little idea of how the market is going to develop, what competitors will appear, and in fact whether its investments are likely to be justified. Growth As sales start to increase the company has to invest further in productive capacity, typically ahead of market demand, and has to meet the challenge of new entrants; despite the costs involved in entering a new and growing market, there are potentially very high returns from the first mover advantage. However, if the company wishes to maintain its market share in a growth market, it is necessary to increase sales, and this involves aggressive marketing and relatively low prices. If the company wishes to increase market share during this stage, with the aim of being one of the market leaders when the product cycle reaches maturity, it is necessary to be even more aggressive. During this period it is unlikely that the product will produce significant profits because – marketing expenditure will be relatively high – prices will be set relatively low – capacity will be underutilised in the expectation of increased orders
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Maturity During this stage the company is able to gear its productive capacity to demand, and techniques such as Just In time can be introduced to minimise costs. If the company has not gained a significant market share by the time the market matures it will find it very difficult to do so because taking customers away from competitors is difficult and costly; on the other hand, if the company has achieved a high market share it will have the basis for a strong competitive advantage. Unless there is strong competitive pressure price does not need to be set below that of competitors to keep the existing market share, and marketing expenditure can be reduced. Thus once the market has stabilised selling costs can be reduced and this generates the potential for substantial positive net cash flows. Decline The company has to decide whether to exit the industry, or phase out its productive capacity. This is not the time to be undertaking new investments, which is why it is important that companies recognise the threat posed by this stage of the life cycle.

The product life cycle model needs to be seen in the context of the business cycle. If consumer incomes are increasing, this may cause an increase in market size during the mature part of the life cycle, at a time when significant increases would not normally be expected. Real product life cycles will not be smooth but will have an uneven pattern depending on the extent to which the product is affected by economic circumstances. It is obviously difficult to differentiate business cycle effects from the underlying product life cycle. However, it is important to do so, because the strategy implications of a fall in sales due to a temporary reduction in consumer incomes differ from those due to the onset of the end of the product life cycle. There are various approaches to defining the product life cycle; some analysts use the pattern of company sales, others total market sales, and others profit generation. It is therefore important to define what is meant by the market. For example, definitions of the market for TV sets include: 1 2 3 4 5 The The The The The total number of TV sets in existence. total number of TV sets sold this year. total value of TV sets sold this year. number of TV sets sold by the company this year. value of TV sets sold by the company this year.

Definition one tells us how many people are using TV sets, not how many people are likely to buy a TV set and how much they are likely to spend, which is the concern of producers and sellers of TV sets; definitions two and three are of direct interest to companies in the industry since they relate to potential sales volumes and revenues. Definitions four and five are the outcome of the company’s strategy; it is obviously a mistake to define the market in terms of the sales which the company actually makes, rather than in terms of the total
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sales of the product. Definition two is the same definition of the Total Market used in the basic model of revenue:
Revenue = Total market × Market share × Price

In the absence of significant changes in Market Share and Price, the Total Market drives revenue over the product life cycle. Thus any information about the likely shape and duration of the product life cycle would be of immense value to the company. Predictions of product life cycles are as imprecise as any other type of forecasting, but some product characteristics can help to generate a rough idea of what the life cycle might look like. • Substitutes: can the want which the product satisfies be performed in some other way which has not yet been marketed? For example, the telex machine (which few people now know about) was the method of sending messages world-wide until the advent of the fax machine in the mid 1980s, which did the same job but was easier to use and did not need messages to be typed in. The fax heralded the end of the telex product life cycle, but it was impossible to predict in, say, 1970 when such a substitute would appear. Technology: if there is rapid technological change a product may soon be superseded by something superior and probably cheaper. Again, it is impossible to predict obsolescence but technological advances can be incorporated into new products quite quickly. Durability and replacement: some goods are bought for immediate consumption, such as food, while others are bought for the services they will generate some time into the future, such as a TV set. Once everyone who wants a TV set has one then sales will be dependent on replacement demand.

This is not an exhaustive list of the factors which are likely to affect the product life cycle. The individuals who work with a product, both on production and sales, will typically have a detailed knowledge of the product in relation to the market and can often provide a reasoned outline of how they see the product life cycle developing. As you might expect, there is some debate about the validity of the product life cycle concept, and whether it is of universal applicability. The research into product life cycles has revealed that they have many shapes, durations and sequences, and this has added to the doubts which many people have. However, the fact that product life cycles take many forms does not necessarily mean that the idea of product life cycles is useless. The idea provides a structure within which data can be interpreted and, as will be seen, is an important dimension of a more general strategic framework.

5.7

Portfolio Models
The concepts of demand analysis, differentiation and segmentation are important components in the formulation of strategy. But a major drawback of the economic approach is the use of comparative statics, which compares one time period with another, rather than taking the passage of time explicitly into account. It is

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the dynamic development of markets and competition over time which makes strategy so complex. The portfolio model approach incorporates dynamics into the interpretation of product positioning. 5.7.1

The BCG Relative Share Growth Matrix
The best known of the portfolio models focuses on two factors: relative market share, and the stage of the product life cycle. The relative market share is defined in terms of the company’s market share compared to that of its leading competitors. The implications of relative market share are potentially important for competitive advantage, and arise from two influences. 1 Economies of scale: as the productive capacity of the company increases average cost falls (up to some limiting size). The higher a company’s market share the larger must be its productive capacity compared to its competitors. A sale made by one company is a sale not made by another company, thus the higher the market share of one company, the smaller must be competing companies on average, and the less their opportunities to capture economies of scale. When economies of scale exist, it follows that the higher the market share of a company compared to that of competitors, the lower will be its relative unit cost. This assumes, of course, that the larger company is sufficiently efficient to benefit from potential economies of scale. The experience effect: a company with the highest market share to date must have a higher cumulative output to date than its competitors, and hence its labour force has the potential to be higher up the learning curve, resulting in lower per unit labour costs. As a company produces additional units of output, other factors also contribute to continuing cost reductions; these include fewer rejects and better designed production lines. The combination of the effect of the learning curve and these influences results in what is known as the experience curve; research suggests that each doubling of output leads to a 20 per cent reduction in unit cost because of experience effects.

2

Thus having a high market share confers two types of cost advantage on the company: economies of scale and experience effects. The combination of the two is a potentially important determinant of relative production costs. Expanding the basic model to include unit cost gives the following: Revenue Outlay = = Total market × Market share Number of workers × Wage rate Units of capital × Price Units of material × Price Outlay / (Total market × Market share) × + + Price

Unit cost

=

The potential advantage conferred by a higher market share is that unit cost will be lower than that of competitors.
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The stage of the product life cycle is of central importance to strategy, because both revenue and costs are significantly affected by what is happening to the total market.

Product Cycle Growth Stage
In the growth part of the cycle, i.e. when Total Market is increasing, existing customers are increasing their orders and/or new customers are appearing. If the company wishes to maintain or increase market share it must capture the new customers, because these new customers have to make a choice among the companies competing for them. In a growing market it is typically necessary to adopt an aggressive selling strategy, which may involve both charging a lower price than competitors and relatively high marketing expenditures. Furthermore, in a growing market it is inevitable that the company will have excess capacity; in fact it is essential to build capacity ahead of demand and this also adds to cost. Thus having a relatively high market share in a growing market does not guarantee that the product will be profitable, because of marketing expenditure and the lower price charged to maintain or increase market share. While the company may have a relatively high market share during this phase, any economy of scale advantage is unlikely to be reflected in a high level of profit.

Product Cycle Mature Stage
Once the market stops growing market share becomes more secure because there are no new customers appearing, and competitors have to take action in the form of increased marketing effort and/or reduced price to induce customers to change their allegiance. Price does not need to be set below that of the competition to keep the existing market share, and marketing expenditure can be reduced. Once revenues have stabilised, selling costs are reduced which, coupled with economies of scale and experience effects, generate the potential for substantial positive net cash flows.

Market share and market growth therefore both have potentially significant implications for costs and revenues; the next step is to combine this into a single model as shown in Figure 5.8.4 Individual products can be positioned in the matrix depending on their relative market share and the current market growth rate. The matrix provides the basis for a general classification of products according to which quadrant they fall into. While the classification can be no more than approximate, given that the four quadrants shade into one another, the quadrants provide a powerful tool for identifying important characteristics which relate to the performance of products in the market.

The Dog
A product which has a low market share in a stable market, and which is not making profits currently, stands little chance of making profits in the future. This is because the costs of increasing market share are likely to outweigh the potential gains. The costs of increasing market share will be high because the
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High Stars Question Marks

Market growth rate

Cash Cows

Dogs

Low High Relative market share Low

Figure 5.8

BCG market growth / relative share matrix

Source: Hedley, Barry D. (1977) ‘Strategy and the Business Portfolio’, in Long Range Planning, Vol. 10. Elsevier Science. Copyright c 1977 Barry D. Hedley. Reprinted with permission from Elsevier Science.

market has stabilised and it will be necessary to divert customers from competing companies; this can only be done by increased marketing expenditure and/or price reductions, and this is likely to lead to competitive reaction, the prospect of which adds considerably to the uncertainty of the exercise. A Dog may have already cost the company a considerable amount in development and marketing, and managers may feel averse to abandoning a product which has already cost so much. This reasoning is false, because costs incurred in the past are sunk and have no bearing on the future. Abandoning the Dog will release scarce resources which could be put to more profitable use. It does not follow that because a product lies in this part of the matrix it cannot make profits. It may occupy a niche, or there may be limited economies of scale, which mean that the market is supplied by a relatively large number of companies each of which has a small market share. In this case it is the relatively efficient company which makes the most profit. Therefore it does not follow that all products in this quadrant make losses; but if a product is not currently making profits and is being produced as efficiently as possible, it has little future.

The Question Mark
The product in this sector is called a Question Mark because it may become either a Dog or a Star as the market matures. If market share can be increased before the growth in the market stops it will become a Star; if not it will become a Dog. These are the products which are liable to run at a loss, and managers are
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faced with a difficult problem in deciding how much resources it is worthwhile investing in the future of a Question Mark.

The Star
The objective with such a product is to maintain market share until market growth ceases. The product incurs relatively high marketing costs because of the competition for new customers as market size increases.

Cash Cow
This is the product which is achieving economies of scale, is further up the experience curve than competitors, and is faced with relatively costless competition. From time to time the company may have to take action to ward off competition against a Cash Cow but, by and large, this is the product which makes the company money. The BCG model is an example of how market information can be used to develop strategy and provides indicators of the appropriate course of action to follow with individual products.

Back to the Demand Curve
At this stage we should not lose sight of the relevance of demand curve analysis which related revenue changes to changes in price and market share in terms of movements along, and movements of, the demand curve. In the growth stage of the cycle, demand analysis can be used to provide an indication of the price which would have to be charged to achieve the sales volumes which would maintain or increase market share. However, the revenue implications discussed at 5.2.3 are largely irrelevant at this stage because the objective is not to maximise profit but to lay the foundation for a cash cow. Once the market has stabilised, i.e. the total market has stopped growing, the question of the optimum market share can be addressed. The demand curve analysis demonstrated that pursuit of market share for its own sake could lead to total revenue being less than otherwise would be the case. It may well be the case that a higher price and lower market share would be more profitable for a given cash cow. However, one of the advantages of portfolio analysis is that it focuses attention on a longer run view of costs, and the possible implications of a lower market share for competitors’ costs. Demand analysis is merely one step in the determination of competitive advantage and profit maximisation. 5.7.2

Other Portfolio Models
The salient characteristic of other portfolio models is that they are more complex than the BCG matrix, and take into account many more variables. This means that they cannot be fully displayed in matrix form because they have too many dimensions. For example, the McKinsey portfolio model has two general dimensions of business strength and industry attractiveness. Business strength takes into account such variables as capacity utilisation and relative costs, and industry attractiveness takes into account variables such as growth rate, profitability, cost trends and industry structure. The variables are weighted

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in terms of relative importance, and scored to give an overall rating for the two dimensions. It is possible to tailor the McKinsey model much more closely to the individual company than the BCG model, which relies on more aggregate variables. 5.7.3

Limitations of Portfolio Models
The objective of portfolio models is to systemise diverse types of information, and as such they are based on a series of assumptions. It should come as no surprise to find that not all ‘Dogs’ lose money, or that not all ‘Cash Cows’ are indeed big money generators. The reason for this is that the assumptions of the BCG model may be violated. On the cost side, there may be no significant economies of scale in the industry thus depriving the company of a source of cost advantage; it may be that in some circumstances there are diseconomies of scale. What appears likely is that economies of scale are likely to be significant up to a certain size, and beyond that differences in company size make little difference to average cost. The advantages from experience effects are continually being eroded because it becomes progressively more difficult to move up the curve. Although the company which has had a relatively high market share will enjoy a cost advantage due to experience effects sooner than other companies, they will eventually catch up and erode this Cash Cow characteristic. Indeed, relative market share may not adequately reflect the product’s competitive position because of a combination of barriers to entry, product differentiation and market segmentation. The Dog may be in a market in which all sizes of company make profits; on the other hand the lack of barriers to entry may result in a Cash Cow being continually under competitive threat. Market growth may not be associated with relatively high selling costs. For example, if the industry is already relatively short of capacity there may be virtually no effective competitors, and individual companies are able to do no more than keep pace with the demand which comes to them with a minimum of marketing and competitive action. However, this is likely to be a temporary phenomenon, and many companies have been caught unprepared when high growth rates came to a sudden end and the industry very quickly moved to a situation of excess capacity.

5.7.4

Portfolio Models and Corporate Strategy
The product portfolio is an essential tool in the management of individual products through the life cycle. It also provides a useful perspective on the mix of products which comprise a corporation. Is there such a thing as an optimum portfolio? A company which is comprised only of ‘Cash Cows’ will remain static by definition, and is liable to suffer substantial reductions in cash flows as products come to the end of their life cycle. However, too many ‘Question Marks’ and ‘Stars’ may drain company resources. An optimum portfolio could be defined as one in which the ‘Cash Cows’ generate sufficient cash flows to produce adequate returns to shareholders and the cash necessary to develop the

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potential of ‘Question Marks’ and ‘Stars’ to replace the ‘Cash Cows’ in time. If the company had ambitions to grow, the balance between ‘Cash Cows’, ‘Stars’ and ‘Question Marks’ would be adjusted accordingly. Portfolio selection is not a mechanistic process based on the selection of products as they appear in the BCG matrix. There are many difficulties involved in identifying which ‘Question Marks’ and ‘Stars’ are likely to succeed. The portfolio decision will depend on the various risks involved, and the company’s attitude to risk bearing. Furthermore, the variables in the matrix do not capture all relevant product characteristics. A company may have an optimum portfolio in the sense that it has no loss-making ‘Dogs’, and several ‘Stars’ and ‘Question Marks’ which will replace ageing ‘Cash Cows’. But products are not conceptual entities to be guided through the stages of the product life cycle; managers have to know a lot about their products, including how to make them at the lowest cost and sell them effectively against competitors. A portfolio which is comprised of totally unrelated products in a diversified company may be virtually unmanageable, and there is no guarantee that the corporation is adding value by including all of them in the portfolio. Consideration needs to be given to developing a portfolio in which products are linked in such a way as to benefit from the competencies of the corporation. Diversifications which are intended to optimise the portfolio, in the sense that there is a balance between the cost of the stars and the profitability of the cash cows, may be totally misguided; the company can end up with an unmanageable portfolio, and this has been a contributing factor to the failure of so many diversifications in the past. Portfolio models can be used for more than the determination of company priorities. If they have validity for one company, they may have validity for competitors; competitors can be analysed in terms of whatever information is available on their product positioning in the BCG matrix, and this can serve as the basis for competitive strategies. Take the case where the company is concerned about the development of a competitor’s ‘Star’ versus its own ‘Star’. Is the appropriate strategy to mount an attack on the ‘Star’ directly? Presumably the competitor is prepared to accept the drain on resources which the development of a ‘Star’ demands, therefore he may be prepared to fight back. The appropriate strategy may well be to attack the competitor’s ‘Cash Cow’, with the objective of reducing the competitor’s cash flow surpluses which are necessary to finance the development of the ‘Star’. A competitor may decide to undertake a change of direction through diversification into new markets; the fact that this results in a preponderance of ‘Stars’ and ‘Question Marks’ has implications for the total resources available to the competitor in common markets. Portfolio analysis of competitors can provide insights into what their reaction is likely to be to competitive action, and may provide a means of predicting when competitors are likely to make a strategic move. The portfolio model throws light on the principal agent problem between corporate and SBU CEOs. The SBU manager may be unwilling to dispose of a ‘Star’ which is seen as having considerable future potential; but from the corporate viewpoint the product may not fit with the company’s aggregate portfolio and more value could be created by selling it and allocating the
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resources elsewhere. The process of selecting the optimal portfolio can be envisaged in terms of the markets and products in which the company is currently or potentially operating. A systematic approach to identifying the components of the portfolio strategy was developed by Ansoff7 , and he defined what he called the growth vector which interpreted the direction in which the company intended to develop its portfolio. The growth portfolio was originally specified in terms of the company mission in relation to its product; rather than explore the growth vector in terms of company mission, which Ansoff defined in a particular manner, Figure 5.9 builds on Ansoff’s approach and develops a growth vector in terms of markets and products.
Products Current New

Currently operating Markets New entry

Penetration: increase market share

Product replacement

Market development: new uses, segments, etc.

Diversification

Figure 5.9

Components of a growth vector

Penetration
If the company wishes to grow relative to competitors on the basis of the products which it sells in existing markets it can only do so by increased penetration, and hence by an increase in market share. If the market is mature it follows that sales can only be gained at the expense of incumbents, while if the market is growing the company must continuously acquire a larger share of market growth than competitors. For the mature market, this can be interpreted as developing a dog into a cash cow, while for a growth market as developing a question mark into a star. Either way, growth depends on pricing and marketing strategies relating to the company’s current operations, while benefiting from the company’s accumulated experience in production. During the late 1990s European car makers were faced with a mature market but there was massive overcapacity in car production world wide. The scale of some European car makers was too small to compete with the main global players, and many car companies attempted to increase their market penetration by acquiring established and prestigious makes. BMW acquired Britain’s Rover and Rolls Royce, while VW acquired Bentley.

Product replacement
It may be concluded that no further penetration by the current version of the
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product can be achieved, and it is necessary to add characteristics and perhaps abandon some existing characteristics; it could also be due to the product approaching the end of the product life cycle. The replacement can be an enhancement of an existing product or a totally revised version with a different set of characteristics, but it is important that it at least fulfils the requirements of the replaced product, and/or satisfies changing consumer preferences. This type of growth involves the company in investment in product development and a shift away from the set of products in which it has built up expertise producing efficiently and marketing effectively. However, the company is able to capitalise on its knowledge of the market, its brand name and its existing distribution systems. One of the most significant product enhancements in the car business during the 1990s was the advent of the off-road vehicle. Instead of purchasing a standard road car, many consumers selected the high-body, four wheel drive, rugged off road vehicle; this was a car with a completely different set of characteristics, but within a few years every major car maker had such a vehicle in its portfolio. It was not a new concept, as Britain’s Rover car company had been producing the world famous Range Rover for several decades; but the new entrants went for more luxury, better handling and state of the art technology – the very characteristics which sold standard road cars anyway.

Market development
The search for new markets for existing products can take a number of forms, such as finding markets in new geographical locations and identifying unexploited segments or niches. This means that new techniques need to be developed for selling products with known characteristics, and this requires effective strategies for market entry. This in turn raises issues relating to the product life cycle, as entry into a growth market requires a different approach to entry into a mature market. But as with market penetration, the success of the growth strategy depends on pricing and marketing approaches. The Korean car maker Daewoo entered the British market in the early 1990s with a standard range of cars, but used a fixed price selling approach which market research suggested would appeal to many car buyers. The idea was that there were no salespeople in the showroom and that no negotiation would take place on the price. Despite the fact that the Daewoo cars were no better than other makes in their range, the company made significant inroads into the British market.

Diversification
In this context diversification has a particular meaning, in that the company enters new markets with a new set of products and is therefore akin to the notion of unrelated diversification discussed at 7.4.1. In this case there is no direct experience of marketing strategy which can be applied, while the company has no experience of production. Car makers often have a wide portfolio of car types, and often have interests in lorries (or trucks) and buses; but few have productive capacity in earth moving equipment, for example. An interesting exercise is to try to identify car companies which have moved into the diversification part of the matrix. No growth strategy will ever fit exactly into a particular segment of the matrix, but this simple classification helps to interpret the impact of a particular course
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of action on the product portfolio, and the extent to which it fits with the current knowledge of markets and products. The matrix can be greatly elaborated to incorporate dimensions such as geographical location and product technologies, but the fundamental message is the same: make explicit the direction of change in which the growth strategy will take the company, and incorporate this into the design of the portfolio. 5.7.5

Strategy and Product Information
In the business school, or business seminar, setting managers are always more comfortable discussing actual product examples than discussing abstract products, usually a ‘widget’. Think about the items of information on a product which you need to make decisions; these include: • • • • • • • price elasticity income elasticity the effect of marketing on the position of the demand curve competitive conditions in the industry size and growth of the market relative market share product life cycle

The reason managers would like to know what the product actually is must be because they feel such knowledge would give additional insights into these characteristics. But knowing whether a particular business problem relates to the plastics rather than the cheese industry does not make any difference to the underlying issues. There is no doubt that each time a new product is analysed the problems seem to some extent unique. But the objective of a market analysis is to go beyond the immediate product characteristics and quantify the conceptual factors as far as possible.

5.8

Supply
Attention tends to be focused on the demand side of company performance, but supply and cost considerations are equally important in the determination of competitive advantage. The supply curve for an industry shows the amount which companies in total would be willing to sell at different prices, holding other factors constant. The position and shape of the supply curve depends on production costs; it is reasonable to conclude that the higher the price on the market the greater the quantity companies in aggregate would be willing to supply, therefore it is to be expected that the supply curve will be upward sloping. A typical supply curve is as shown in Figure 5.10. At price P the total quantity supplied by the industry would be Q. If price were higher than P then more than Q would be supplied, and vice versa. The slope of the supply curve depends on the cost structure of the companies in the industry.

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Supply

Price
P

Q

Quantity

Figure 5.10

The supply curve

5.8.1

The Industry Supply Curve and Strategy
The shape of the industry supply curve has implications for company strategy. For example, if it is anticipated that there will be an increase in demand for a product, a relatively steep sloping supply curve will result in an increase in price, whereas a more horizontal supply curve suggests that there will be relatively little price increase and that the increase in demand will lead to a relatively large increase in the quantity sold. Different views on the shape of the industry supply curve thus suggest different strategies in response to shifts in demand. If the supply curve is thought to be inelastic, the response to an increase in demand (which is a shift to the right of the demand curve) would simply be to do nothing and take advantage of the expected increase in market price. On the other hand, if the supply curve is elastic, price will not increase by much, and to take advantage of the potential for increased sales it would be necessary to ensure that adequate productive capacity is available and that market share is at least maintained at its current level. There are many factors which affect the elasticity of the industry supply curve. The current level of capacity utilisation, the cost of increasing capacity, the availability and wage costs of additional employees, the availability of raw materials, the potential for foreign competitors to enter the market are all potentially important, and tend to change over time. For example, a sudden change in preferences towards pure wool garments would probably not result in price increases until the current stocks of wool were exhausted. After that point the supply curve would be inelastic because of the time lag involved in increasing the number of sheep and waiting for the next shearing season.

5.8.2

Shifting the Industry Supply Curve
Any factor which changes costs will have an effect on the supply curve. For example, an increase in the price of oil is an increase in material price, causing unit cost to be higher at each level of output; this has the effect of shifting the industry supply curve to the left, i.e. at each price companies would be willing

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to supply less than before. The leftward shift in the supply curve caused by an increase in the price of oil is illustrated in Figure 5.11.

Supply (2) Supply (1) Price
P

Q2

Q1

Quantity

Figure 5.11

Shifting the supply curve to the left

A shift to the right would occur if the opposite happened, i.e. if the price of oil fell. The extent to which the curve shifts depends on the proportion of total costs represented by oil. For example, in the transport industry a 30 per cent reduction in oil prices could lead to a significant shift in the supply curve, while the industry supply curve for women’s clothing would be virtually unaffected.

5.9

Markets and Prices
Prices are determined by the interaction of demand and supply. The production of goods and services depends on the costs which companies incur in supplying different quantities. The demand for goods and services depends on what people are willing to pay for different quantities. The interaction of demand and supply produces prices, which serve as signals to seller and buyers. An understanding of price determination makes it possible to make predictions about the outcome of changes in both demand and supply conditions. The idea of price determination is simple. In Figure 5.12 the price will tend to move towards P, known as the equilibrium price. If the price is higher than P then companies will produce more than consumers are willing to buy, and the price will fall. If it is lower than P then consumers will attempt to buy more than companies are willing to produce, hence bidding up prices. Managers may feel that the idea of equilibrium price is of limited use because in real life prices are continually changing, and nobody knows what the equilibrium price is for any particular product. However, demand and supply analysis is a powerful tool both for understanding market conditions and for predicting what is likely to happen in the future.

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Supply

Price
P

Demand Q

Quantity

Figure 5.12

Demand, supply and price determination

To demonstrate the power of demand and supply analysis using a rudimentary knowledge of the shapes of demand and supply curves, take the case of the shipping business, which is characterised by enormously fluctuating vessel prices. For example, the price of the average 60 000 tonne cargo vessel fell by one third between 1981 and 1982, and increased by one third between 1986 and 1987. The application of demand and supply analysis reveals that such fluctuations are an inevitable outcome of the shipping market. In Figure 5.13 the price is set at P1 in the first time period by the intersection of the demand and supply curves. The supply curve is inelastic in the short run because the only way to increase the supply of shipping services immediately is to increase speed and take vessels out of storage, and this adds relatively little to the quantity produced by the existing stock. The shift to the right of the demand curve in period 2 is therefore not associated with an immediate large proportionate increase in supply, and the price rises to P2 . By the later time period 3, shipyards have reacted to the higher price and increased the stock of vessels. This has the effect of reducing the price to P3 . In period 4 the demand falls back to its original level, and since the supply is now higher than in the first time period, this has the effect of causing the price to fall to P4 . A rudimentary knowledge of supply, demand and price determination predicts exactly what happens in the shipping business, and also reveals that price fluctuations are likely to be a permanent feature of the shipping market (this is an example of what is known as the cobweb theory in economics). If a manager is convinced that the demand for shipping services is likely to increase, he should buy vessels now because the price is bound to increase by a large amount when the demand makes itself felt. Any factor which alters the position of the industry demand or supply curves will have an impact on market prices. The extent of this impact depends on the shape of the demand and supply curves. In the shipping industry the effects are
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Supply (1) Supply (3) and (4) P2 P3

Price

P1 P4

Demand (2)

Demand (1) and (4)

Vessels

Figure 5.13

Fluctuating prices

large because of the inelastic supply curve. If the supply curve had been elastic the impact on prices would have been much less. It will be noted here that the analysis was not expressed in terms of actual prices, nor was there any attempt to be accurate. Demand and supply analysis uses the concept of equilibrium price, which does not exist in real life because transactions are taking place all the time around the equilibrium point; all buyers and sellers would have to have complete information about each other for all transactions to take place at the equilibrium point, and that is clearly impossible. However, the analysis does enable us to make predictions about the direction and rough magnitude of change, taking account of what is known about the slopes of the demand and supply curves, and to base our actions on the knowledge that, in the absence of other changes, this is how things will generally work out. Thus a relatively limited amount of information on demand and supply conditions for an industry can enable managers to assess the impact of events such as the entry of competitors (increase in supply) and the emergence of substitutes (reduction in demand).

5.10 Market Structures
Casual observation reveals that market structures vary markedly among industries. The market for wheat is comprised of many relatively small producers, none of which can individually affect the price; telephone services are supplied by a few very large companies; for example, in the UK British Telecom had a government monopoly until it was privatised in 1986, and ten years later it faced significant competition from companies such as Mercury. It is not usually appreciated by managers that market structure is the main determinant of long term profitability, and an understanding of market structures is central to developing strategy.
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5.10.1

Perfect Competition
Managers typically react to the idea of ‘perfect’ competition with the response that it does not exist in real life, and that it is therefore completely irrelevant to real life decision making. Nothing could be further from the truth. In economics, a ‘perfect’ market is one where the product is homogeneous, there are no barriers to entry, no economies of scale, universal availability of information on prices and quantities and a large number of sellers and buyers; the result is that no firm can charge more than the market price and the demand curve is horizontal. In this market situation no monopoly profits are made, i.e. firms make only the opportunity cost of capital.

Marginal Cost Average Cost

Price P Demand 0 Q Quantity

Figure 5.14

Perfect competition

Figure 5.14 helps in visualising the competitive influences at work. The average cost curve of the firm is usually depicted as being U-shaped because up to some point additional output leads to lower unit cost but beyond that point unit costs start to increase; the average cost curve includes the opportunity cost of capital; this is also known as the normal rate of profit. The demand curve is horizontal to represent the fact that all firms are price takers in the industry; this horizontal demand curve lies at a tangent to the lowest point on the average cost curve, representing the fact that prices are pushed down to the lowest level consistent with making the opportunity cost of capital. So the firm is a price taker at price 0P. Output is set at the profit maximising point 0Q where marginal cost equals marginal revenue. At this output no monopoly profits are made. Figure 5.14 represents the theoretical situation in perfect competition when the market is in equilibrium; because of the complexity of real life this situation will never actually be achieved, but this limiting case demonstrates that there are powerful forces at work affecting profitability depending on the degree of competition. At the very least, managers should have a rough understanding of the degree
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of competition in their industry, using the conditions for perfect competition as a benchmark. One feature of this model often puzzles managers: the horizontal demand curve, which seems to mean that if you charge above the market price you sell nothing, while if you charge below it everyone wants to buy from you (but there is no point because you are making a loss). In most people’s experience an increase in price leads to a loss of some sales, but not all, and a reduction in price leads only to a modest increase in sales, at best. This is due to the fact that in real life markets are not perfect, and market imperfections such as differentiation and imperfect consumer knowledge are the norm. Is this market model unrealistic? Consider what happened in the market for personal computers. The personal computer market was originally characterised by very high start up costs because of the R&D required prior to production. As the technology was disseminated, the need to undertake expenditure on R&D was reduced, and the differences between personal computers virtually disappeared, with the only distinguishing feature being price. Thus, for those outside the industry in the early 1980s, entry was almost impossible because of the lead and market share built up by the main players such as IBM; for those inside the industry their position looked relatively secure. However, when the technology was disseminated and ‘IBM clones’ could be built and sold virtually at marginal cost, the situation was reversed. By 1990 many people who used personal computers did not care what make they were; this is because personal computers had become homogeneous goods, all doing much the same thing. Once the initial developments had been made it became relatively simple to enter the market: the components could be purchased and assembled; this meant that barriers to entry had largely disappeared, and many firms entered the industry producing clones. Most of these entrants did not appear to be at any particular cost disadvantage. At the same time users became much more educated, and information on personal computers became widely available through the many computer magazines which appeared. Since the conditions for perfect competition had appeared by the late 1980s, it was a simple matter to predict that computer companies would stop making monopoly profit on the production of personal computers, and would merely make at best the opportunity cost of capital. A further factor was that the marginal cost of making an additional computer was very low; it was thus likely that intense competition would push prices down towards marginal cost, which was much lower than average cost. This was precisely what happened by the early 1990s, when it became widely acknowledged that making personal computers was not profitable (i.e. the price was lower than average cost), and this was one of the factors which contributed to the difficulties experienced by major computer companies at this time. This was one of the factors which led to IBM reporting the largest corporate losses of any company in history in 1992. Since the existence of the conditions for perfect competition means that profits above the opportunity cost of capital cannot be sustained, an important dimension of strategic analysis is to identify where markets are not perfect, and capitalise on these factors. For example, barriers to entry are a market imperfection which enable companies to make monopoly profits. In the personal
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computers case one course of action was to attempt to introduce the imperfection of non-homogeneity, i.e. to differentiate the product further; this was done by many competitors, and included selling a package of services which included maintenance and software support, and introducing new features such as colour, more memory, portability and high speed processors. None of these features could provide companies with more than a transitory advantage because of the speed with which the technology can be disseminated and the fact that new ideas (such as bundling) can be easily imitated. 5.10.2

Monopoly
At the other extreme from perfect competition the industry is comprised of only one producer, the monopolist, whose demand curve is the industry demand curve for the product. This demand curve slopes from left to right because the company is not a price taker, i.e. it can sell more by lowering the price. Figure 5.15 can help in visualising how profits are made in monopoly.

Marginal Cost Average Cost

P
Price
C

Demand
Marginal Revenue 0

Q

Quantity

Figure 5.15

Monopoly

The profit maximising output is again where marginal cost equals marginal revenue, i.e. at 0Q; the price is 0P, which is the price the market is willing to pay for the quantity 0Q. The difference between the average cost 0C and the price 0P is the monopoly profit per unit, and the shaded area shows the total monopoly profits. These profits, of course, are likely to be continually under threat as market conditions change. One way of visualising the competitive pressures on a monopolist is to imagine what happens to the position of the demand curve if a competitor enters the industry. This would cause the demand curve to be forced down to the left (this is known as monopolistic competition, which sounds like a contradiction in terms). If all firms had the same cost curves it would be worthwhile for competitors to enter the industry until the demand curve was at a tangent
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to the average cost curve; at this point no monopoly profits would be made. To counteract this, companies attempt to maintain their monopoly profits by capitalising on market imperfections such as barriers to entry and product differentiation. The effects of competition do not act only on the demand side. On the cost side, you could imagine the average cost curve moving from right to left as competition for inputs increases and the prices of labour, capital and materials increase. This would also have the effect of reducing monopoly profits. Sometimes companies are able to affect competitive conditions in factor markets, for example by entering into agreements with trade unions. While the analysis of markets has been theoretical, the messages from Figure 5.14 and 5.15 are quite clear: a manager needs to continually address the following types of issue: • • • • What is happening to the demand curve? What is happening to the cost curve? What market imperfections do we depend on for our profits? Are there potential market imperfections which we have not yet capitalised on?

5.10.3

Barriers to Entry
Up to this point barriers to entry have not been defined, but given the importance of barriers to entry in maintaining monopoly profits, it is clear that they are an important dimension of competitive advantage. Any firm enjoying monopoly profits will be continually concerned about the threat from potential entrants. The incumbent monopolist will be motivated to find out if there are ways in which barriers to entry can be erected, or if there are existing barriers which make entry impossible and hence will protect its monopoly profit. In fact, both entry and exit are common, and research suggests that on average there is a 30–40 per cent turnover in companies every five years. Barriers to entry can be classified as structural or strategic. The difference between these is that structural barriers are outside the control of the firm while strategic barriers depend on specific actions undertaken by the firm to deter entry. Structural barriers include: • Size of the market: because of investment and infrastructure costs it may not be feasible for more than one company to operate in the industry. A well known example is electricity generation and supply, where duplication of electricity lines would clearly be wasteful. This is usually known as a natural monopoly, and was the rationale for nationalisation; but the experience of privatisation in the UK has demonstrated that infrastructure can be shared among competing firms in a variety of ways, and the UK electricity market was opened to free competition in 1998. Sunk costs: it is not only the costs of entry which are important, but the costs of exit. It is usually assumed that a high capital entry cost deters entrants, but this is not necessarily the case. Certainly a high investment requirement
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limits the number of potential entrants, but the fact is that there are many large companies in the world. Consider the case of an airline: it costs a great deal to obtain an aeroplane and set up a route, but the aeroplane can always be sold. The route set up costs are sunk because they cannot be recovered on exit; this is the real financial barrier to entry. At first it might seem a paradox, but in fact the barrier to exit is just as important as the barrier to entry. Control by legislation or tacit agreement: De Beers controls supply in the diamond market and fixes the world price of diamonds; inventions are provided with patent protection for a fixed period so that inventors can gain a benefit from their activities. It is always difficult to predict how long tacit agreements will last; for example, the most powerful cartel in the world at one time – OPEC – was for many years unable to maintain high oil prices in the face of the development of supply from non-OPEC countries. Economies of scale: The idea of economies of scale is based on the long run average cost curve of the firm, as shown in Figure 5.16. The long run average cost curve shows how unit costs vary with different scales of output: the long run average cost curve is a sort of envelope formed by the many short run average cost curves. If the incumbent firm is well down the long run average cost curve, it is clear that entrants have to come in at a large scale otherwise they will be at a significant cost disadvantage.

Cost

Long run average (or unit) cost

Output per period

Figure 5.16

Economies of scale

Experience effect: reductions in unit cost occur as the labour force learns by doing, more effective practices are adopted, materials wastage is reduced and so on; but it becomes progressively difficult to achieve experience gains and after some time there is no further benefits at the margin. If the experience effect is significant it will convey a significant first mover advantage to the incumbent firms in an industry, and new entrants start off at a cost disadvantage. But the difference between the experience effect and economies of scale is that new entrants will start to move up the experience curve, whereas scale economies can only be captured by increasing the size of the firm. The limitations of the experience effect mean that it cannot
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provide an incumbent firm with a permanent entry barrier in the form of a cost advantage. Strategic barriers include limit pricing and predatory pricing discussed in 5.3.3, where it was pointed out that the long term effectiveness of such actions is doubtful. Since competitive pressures are not always obvious, it is not surprising that there is very little research evidence on the effectiveness of strategic barriers or entry deterrent behaviour. However, managers report that they frequently engage in such strategies, especially to protect new products. This is most likely because of the lack of information on the part of potential entrants as to underlying profitability. It takes time to generate information on the likely returns from competitive action, and setting a low price can serve as a misleading signal to potential entrants. While competition usually cannot be avoided in the long run, entry deterring strategies may provide sufficient time for the company to build up market share and achieve scale economies which might not have been possible had entrants been enticed into the market earlier. 5.10.4

Contestable Markets
It is doubtful if strategic barriers to entry can be effective in the absence of structural barriers. It is quite likely that where structural barriers are low entry deterring strategies would be ineffective because the cost to the incumbent would exceed the benefit. In this case entry is so attractive that the incumbent should not waste time trying to prevent it. A market in which entry costs are not sunk, and exit can be achieved costlessly, is known as a perfectly contestable market. The ability to exit without having made any capital commitment guarantees freedom of entry, and the fear of hit-and-run raids forces incumbents to set prices lower than they would have done otherwise. If sunk costs are zero, would-be entrants do not have to worry about the kinds of retaliatory measures that incumbents might implement, because if the entrants find they cannot make a profit they can simply exit. If incumbents realise this, then they will set their prices so as to stop the entrants from wanting to enter in the first place. Hence, whether there is one firm or several firms actually operating in it at any time, a perfectly contestable market never offers the incumbent(s) more than the normal rate of profit. This explains why many companies which apparently have a monopoly do not actually make monopoly profits; this is a different situation from a true monopoly which does not make profits because it is relatively inefficient as a result of the absence of direct competition. For a firm contemplating entry, it is clearly important to differentiate between the two cases. Contestability will not have the effect of controlling profits if the incumbent company is able to exercise market power in such a way as to erect artificial barriers to entry. This was one of the issues involved in the case of Microsoft, which was accused of using its monopoly of the Windows operating system to make it difficult for other software manufacturers to enter, among other things, the internet browser market. It was not the fact that Microsoft dominated the market and made enormous profits which was the problem; instead it was the

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perception that free market forces were not being allowed to play their role. These issues are, of course, never very clear and Microsoft was involved in anti-trust litigation for years with the US government. 5.10.5

Competition among the Few: Oligopoly
When there are relatively few competitors in a market the likely reaction of competitors to changes in pricing and marketing strategy must be taken into account. This is obviously a situation in which game theory is important; this is where the kind of thinking depicted by the prisoner’s dilemma discussed at 5.3.1 comes into play. Another way of looking at it is in terms of the kinked demand curve, discussed at 5.3.2. In this market the outcomes cannot be predicted because they depend on the reactions of the individuals; for example, a price increase by one company as a result of higher costs may result in all other competitors raising their prices by a similar amount, or one of the companies may see an opportunity to grab a larger market share and may therefore reduce price. The indeterminate outcomes in this situation can result in the bidding away of potential monopoly profits which might be attained because of market imperfections.

5.11 The Role of Government
Although the market is an efficient resource allocator, there are some areas in which it does not appear to function very well. Why does the market allow pollution to occur? What is the optimum amount to spend on defence? The manager should be able to view ‘market failure’ issues in context; the fact that ‘market failures’ exist does not mean that the price system itself should be abandoned. It does mean that managers should understand why government is involved in the economy, and recognise when it is fulfilling a positive role. An understanding of this aspect of government is an important input into PEST analysis and environmental scanning; it can also add an important dimension to the construction of scenarios particularly when it is anticipated that there may be a change of government. 5.11.1

Government and Rule Making
The government is responsible for determining the framework of rules within which markets function. These vary significantly among countries and can have profound implications for individual companies; some aspects of government rule making are: • Employment law: in Europe there are many laws which govern employment contracts, and these severely limit the mobility of labour, while in the US employees have fewer statutory rights. The fact that it is much more difficult and costly to shed excess labour in Europe than in the US is considered by many economists to be the main reason for Europe’s much higher unemployment rates.
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Monopoly: when a single company becomes large enough to dominate an industry, it becomes less subject to competitive pressures. Consequently, there may be little incentive to pursue efficiency (although the theory of contestable markets casts some doubt on this), and the company may not act in the public interest, however this is defined. In such circumstances the government can break-up the monopoly into smaller competing companies. Such legislation frequently causes heated debate about the definition of monopoly and monopoly power, and there is often doubt as to the ultimate impact on social welfare. These disagreements are reflected in the fact that the law in the US is much more opposed to the formation of monopolies than the law in Europe. Health and safety at work: since increasing both safety and health standards tends to add to costs without any observable positive impact on revenues, it is often maintained that companies will tend to operate at the lowest standards possible. An opposing view is that in a competitive labour market those companies which do offer higher standards will be able to attract the best and most productive members of the labour force. Whatever the rights and wrongs of the argument, governments do take an active role in setting standards, which can have significant cost implications for companies. Separation of management and ownership: professional managers typically do not own their companies, and are only indirectly accountable to shareholders (the Principal/Agent problem). There is therefore a role for government in deciding what comprises lawful behaviour on the part of those actually running companies, and the extent to which they can be made responsible to shareholders for their actions.

It is not just the existence of these rules which affects companies, but the fact that they are liable to be changed when governments change. For example, the Thatcher government which was elected in Britain in 1979 took about five years to change radically the approach to monopolies and public ownership; in fact, within a decade the selling of public companies (privatisation) was being undertaken by governments all over the world. The fact that the framework varies significantly among countries can have significant implications for international expansion, since it is not an easy matter to adapt to a completely different regulatory regime. 5.11.2

Government and Regulating
One of the best known instances of government regulation is the attempt to reduce pollution. Where pollution occurs, it is the outcome of ‘externalities’, i.e. costs and benefits which do not accrue to the parties involved in an exchange. Inspection of the basic model of costs shows clearly that there is no separate cost entry for costs to the environment such as pollution, or for any other costs which are borne by other producers or consumers. This would not be a cause for concern if material price included an allowance for pollution, but we know that it does not. The cost which is actually paid by the company is known as private cost, and the cost to the company plus the cost to the environment is known as social cost. Since producers do not bear the

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costs of pollution the industry supply curve is derived from private cost, not social cost; in other words it lies too far to the right, and too much is produced, resulting in a misallocation of resources. Where externalities occur there is a case for government action in some form. It may simply be to ‘internalise’ the externality, i.e. to set up a framework within which the costs and benefits can be traded off among affected parties. For example, a chemical company which pollutes a river could be awarded the fishing rights in the river; if the company attempts to maximise profits this will lead to the optimum level of pollution. If this is not possible government intervention may take the form of regulating output, setting emission standards, or imposing taxes designed to equalise private and social cost. Government regulations include requirements to fit scrubbers to coal fired electricity stations, which increases the price of electricity to companies and individuals; some governments require catalytic convertors to be fitted to the exhausts of all cars, and this cost is ultimately borne by the road user. At the very least, managers should have an awareness of the externalities in their industry and whether these are likely to be subject to government regulation in the future. 5.11.3

Government and Allocating
Another area of market failure occurs when it is not possible to exclude nonpayers from consuming a good or service. The most obvious is defence, because once defence for a country is provided it is not possible to exclude from being defended those who do not wish to pay. Another characteristic of such goods, known as public goods, is that if they were to be provided by individuals or companies, the amount provided would not be optimum. An example is where two shipping companies may individually consider it worthwhile to build a lighthouse to prevent vessels sinking on the rocks. But the optimum number of lighthouses is one, not two. Unless there is collective action, in the form of collusion between the two shipping companies or government action, two lighthouses may be built, which is one too many. On the other hand, each company may wait in the hope that the lighthouse will be built by the other, resulting in no lighthouses. A possible solution might appear to be to bring the companies together to agree to share the cost of building one lighthouse; an agreement can be reached between the two companies to build the lighthouse, but after it has been built one of the parties may refuse to pay. Since both are aware that this might occur, neither may be willing to take the chance that the other may not honour the agreement, with the result that no lighthouse is actually built. The chances of one lighthouse being constructed in the absence of government action are therefore remote. The provision of public goods is one of the legitimate roles of government. But it is also important to the individual company, which should recognise when it is entering a market where public goods are involved. Demand is dictated by what the government perceives to be the ‘right’ quantity, and this may be affected by political and philosophical views. For example, during election campaigns politicians tend to promise increases in those expenditures which they think will result in gaining the most votes. Managers should be able to form realistic views on the credibility of such statements of intent. When the Berlin wall came

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down in 1989 companies in defence industries should immediately have started to anticipate the likely effect on defence expenditures.

5.12 The Structural Analysis of Industries
The economic models of market structure demonstrate that the degree of competition in an industry is the result of structural factors over which individual companies have little control. A firm in an approximately competitive market has no option but to be a price taker; a firm in a monopoly position may be able to limit competition, but entry deterring strategies may have a limited effect because of contestability; oligopolists have to exercise restraint because of retaliation from major competitors. In an attempt to make explicit the various factors which determine competitive conditions within an industry, Porter5 identified what became known as the five forces. The basic idea is that the degree of competition, or rivalry, within an industry depends on the threats posed by potential new entrants and substitutes, coupled with the bargaining power of suppliers of factor inputs to the industry and the bargaining power of the purchasers of industry output. The five forces are thus • • • • • Threat of new entrants Threat of substitutes Suppliers’ bargaining power Buyers’ bargaining power Industry competitors’ rivalry

Porter’s view is that the collective strength of these competitive forces determines the ability of firms in an industry to earn rates of return on investment above the opportunity cost of capital. There is a close connection between the five forces approach and the analysis of perfect competition in section 5.10.1; in perfect competition there are low barriers to entry (high threat of new entrants), a homogeneous product (everyone makes the same thing so each company’s output is a substitute), freedom to purchase from competing suppliers (low suppliers’ bargaining power), and well educated consumers (high buyers’ bargaining power in that they can purchase from any company). In the absence of scale economies, this leads to industry rivalry comprising many companies each of which is a price taker. Now take the case where there are high barriers to entry (perhaps because of scale economies) and no threat of substitutes (perhaps because of a patent); as a result the bargaining power of buyers is limited. In this case industry rivalry takes the form of a monopoly, where one company dominates the market. The five forces model therefore explains why the company is currently making monopoly profits, but it can also be used to consider what will happen when the patent expires: will substitutes emerge and will barriers to entry fall? The following are a selection of issues to consider when applying the five forces framework to a particular competitive situation.
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Industry Competitors’ Rivalry In order to assess the intensity of rivalry, start by assessing the number of competitors in the industry. – Large number of relatively small firms: approximates to perfect competition. – A few large firms: competition among the few, with implications for competitive reaction. – One dominant firm: monopoly or price leadership. Another dimension is the extent to which firms are able to segment the market by differentiating their product. The extent to which this will lead to profits above the cost of capital depends on market conditions. For example, if there are many competitors the cost of differentiation may eventually be balanced by the additional price which can be charged for the differentiated product, and hence there will be no long term profit advantage. Where there are few firms differentiation can be used as a competitive tool in addition to price. Threat of New Entrants The threat posed by new entrants depends on the barriers to entry discussed at 5.10.3. The issues which companies should address include: – Economies of scale: do existing firms have an advantage because of their size? – Regulation: are there laws or legal requirements which inhibit potential competitors? Are these likely to be relaxed in the future as the government adopts a less direct role in the economy? – Entry price: is there a price at which entry will appear attractive to firms outside the industry? – Technological factors: where entry in the past has been difficult because of high R&D costs, the firm may eventually be at risk because the technology becomes disseminated. Threat of Substitutes To a large extent the emergence of substitutes depends on technological progress. One way of assessing the potential for substitutes is to use the product characteristics approach to assess whether there are characteristics of the final product which uniquely depend on the production process. For example, wool can only be produced from sheep, but many of the characteristics of woollen cloth can be achieved by artificial fibres. The impact of the emergence of a substitute is to reduce the total size of the market, as opposed to the entry of competitors who attempt to achieve a market share at the expense of existing firms in the industry. The response to these is different. Suppliers’ Bargaining Power This depends on the degree of competition in supplier markets, and whether the firm is paying a price which includes profits over and above the opportunity cost. It is clearly important to determine whether the firm is paying more or less for its inputs than other firms in the industry.
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Monopoly: the best known is probably trade unions which have a monopoly over the supply of labour and which can set the price of labour above the competitive level. – Monopsony: some firms are large enough to act as monopoly buyers and can ensure that they pay no more than the competitive price, and may pay less than smaller competing firms. Buyers’ Bargaining Power It is essential for the firm to have some knowledge of the characteristics of demand and buyer power. – Price elasticity: how responsive are sales to changes in price; is the demand curve likely to be ‘kinked’? – Income elasticity: how dependent are sales on the level of economic activity? As consumers get better off will they buy more or less of the product? – Information: are consumers well informed about the characteristics of competing products? Is this likely to change in the future? Bear in mind that free flow of information is one of the conditions for perfect competition, and the more educated consumers are the less it may be possible to attract sales by accenting spurious differences among products. – Brand identity: is market share dependent on brand loyalty or relative prices? – Buyer groups: are there relatively few large buyers who can exert an influence on price?

5.12.1

Profiling the Five Forces
Consider two companies which have carried out a five forces analysis and have come up with the following: Company Threat of new entrants Threat of substitutes Bargaining power of suppliers Bargaining power of buyers Industry rivalry 1 High High Low Low Low 2 Low Low High High High

This classification identifies two totally different competitive situations. • Company 1 will focus on potential competitors and technological change. It will be able to obtain competitive prices from suppliers through the operation of market forces and it will probably enjoy a high degree of brand loyalty. It will not be subject to significant price competition. Company 2 will focus on trying to get better deals from suppliers, marketing aggressively to buyers, and on its cost and price position relative to competitors. It will not be concerned with changes to the market either from new entrants or from substitute products.
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Now consider the case where the profiles refer to the same company, where the first profile is where the company is now and the second is the scenario which the CEO predicts will apply within the next three years. This expected change in the profile would be the outcome of analysing the PEST framework and environmental scanning. This insight into a change in the five forces profile should cause the company to start changing its focus in the expectation of significant changes in the market. It is often found in practice that a major cause of company failure is the lack of recognition of changes in the balance of competitive forces and the consequent lack of appropriate action.

5.13 Strategic Groups
It may not be immediately obvious where in an industry competitive forces actually arise; there may be many firms in an industry but not all of them may be direct competitors. One approach is to identify strategic groups, which are sets of firms in an industry which are similar to one another and different from firms outside the group on one or more key dimensions of their characteristics and strategy. Identifying the groups makes it possible for the firm to find close and distant competitors and analyse the likely competitive implications of changes in strategy. But while this sounds fine in principle it is difficult to apply in practice because of the many variables which could be used to classify competitors; these include organisation (scale, degree of vertical integration or diversification, distribution channels), product characteristics (quality, image, level of technology) or even financial structure (return on assets, gearing). It is necessary to use a degree of imagination in order to obtain insights into the strategic groupings within the industry. For example, two important variables might be identified and mapped against each other to see how firms in the industry cluster together. An example is in the restaurant business in a cosmopolitan city where there are many ethnic restaurants, all of which offer different styles of cooking. Take the three most numerous types of ethnic restaurant: Indian, Chinese and Thai. At first sight it might appear that these three styles of restaurant are not in direct competition; however, they compete on more than cooking style. There are at least two dimensions besides style: quality and degree of specialisation. There is no question that restaurants target different levels of quality within the same ethnic group; within their broad style restaurants specialise in different ways, for example, in fish, seafood, vegetarian and region. It is instructive to think of a number of ethnic restaurants and plot them on a graph as shown in Figure 5.17. I have carried this out for my own city of Edinburgh, and find that the clusters are quite pronounced as shown. Basically, there are four clusters, and it is within these that a great deal of competition arises rather than between, say, high quality and low quality Indian restaurants. This example uses two characteristics of product differentiation to identify the strategic group. Another dimension could be the number of restaurants under one owner: there may be significant economies in purchasing and minimising excess capacity with increasing numbers of restaurants. Since the definition of the industry group is dependent on the selection of relevant variables it is far
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from being an exact science. But attempting to define the strategic group can provide a perspective on competitive pressures which is not apparent from aggregate data.

Quality
1

2

4 3

Specialisation

Figure 5.17

Strategic groups: ethnic restaurants

5.14 An Overview of Macro and Micro Models
By this time it will be apparent that there is a battery of models which can be applied to analyse various aspects of the economic and competitive environment. Since each model focuses on different aspects of the environment no single model can be relied on to derive an overall view of the threats and opportunities presented by the environment. The following scheme sets out the main models and their focus. Macro models Macroeconomics Focus Determination of GNP and business cycles, GNP elasticity, interest rates, inflation, unemployment and their relationship to company costs, revenues and profits National market factors which relate to the source of competitive advantage Predicting changes in key factors in the economy and the market place Checklist of factors which may affect the company in the future Identifying and tracking potentially important changes Speculating about the future and assessing the company’s ability to respond

Competitive advantage of nations Forecasting PEST Environmental scanning Scenarios

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Micro models Demand and supply Market structures Game theory Segmentation Differentiation Quality Life cycle Portfolio models Strategic groups Five forces analysis

Focus Interpreting the impact of changes in market conditions Types of competition and intensity of rivalry Deriving competitive response with limited information Identifying unexploited opportunities in existing markets Product positioning Determinant of demand and differentiation Dynamic product management Strategic management Company positioning Identifying competitive forces

The macro models are used to identify trends and changes in the variables which affect the market in which the company operates; the micro models are specific to the industry and identify the company’s position within its immediate competitive environment. At this stage it might occur to you to wonder how companies can be effectively managed without the application of these models to identify both what is happening in the general environment and interpreting the company’s competitive position. One answer is that perhaps managers can develop an intuitive grasp of these ideas through experience and hence apply them implicitly; another is that most companies actually have little real idea of their competitive positioning and succeed more by good luck than intent.

5.15 Environmental Threat and Opportunity Profile: Part 2
The idea of the ETOP was introduced at 4.9 as a method of systemising diverse information in order to formulate an overall strategic view. The example used was that of a health food product being sold in domestic and foreign markets, and potential threats and opportunities presented by changes in the national and international economy were identified and discussed. Table 5.7 shows the ETOP expanded to take account of some of the market factors discussed in this module. Having listed the potential threats and opportunities, an attempt can be made to determine their relative importance.

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Table 5.7
Sector International Macroeconomic Microeconomic

Environmental threat (−) and opportunity (+) profile
Threat or opportunity

Socioeconomic Market Supplier

− + − + − + − − + − + − +

Expected appreciation of exchange rate Growth in Eastern Bloc economies Tax rate increase to fight inflation Prospect of reduced interest rates Price of alcohol falling in real terms Shop opening regulations repealed Competition within the strategic group Report on sugar: no health influence Increase in outdoor activities More substitutes appearing Growth has been steady Strikes in prospect Take-over by multinational

Microeconomic THREAT: PRICE OF ALCOHOL It is unlikely that wine and beer are substitutes for health foods, although they are both widely regarded as luxury goods. Some income which may have been spent on health foods may now be spent on alcohol. OPPORTUNITY: SHOP OPENING HOURS The repeal of shop opening hours means that advantage can be taken of the increase in shopping as a leisure activity. The more that health foods can be brought to people’s notice the higher sales will be. THREAT: COMPETITION IN THE STRATEGIC GROUP Many more specialty food shops are opening: the strategic group includes more than health food shops. Socioeconomic THREAT: SUGAR IS GOOD FOR YOU A recent report on sugar suggests that within the bounds of normal consumption it is not related to health. This could undermine the general trend towards what is perceived as healthy living. The perceived quality of health foods is possibly being undermined. OPPORTUNITY: THE OUTDOOR LIFE The implication for healthy living generally of the increase in outdoor pursuits is not yet clear. Health foods are not regarded as a method of maintaining stamina for energetic sports. Market THREAT: SUPPLY INCREASING More and more health food products are appearing, the industry supply curve is moving to the right and competitive pressure is increasing. OPPORTUNITY: CONTINUED MARKET GROWTH
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The market has seen steady growth in the past 5 years, and the increase in tax rates is likely to reduce this temporarily at most. Thus while the demand curve has been shifting to the right so has the supply curve; this has implications for the general price level in this market. Supplier THREAT: LABOUR DISPUTE The supplier’s workforce is threatening to go on strike in protest against the take-over, and there is a real prospect of interruption in supply; alternative suppliers are geographically remote and difficult to communicate with. OPPORTUNITY: PROSPECT OF EFFICIENT SUPPLY The main supplier has been unreliable in the past, and the take-over would almost certainly lead to an increase in efficiency. It was concluded in Module 4 that on balance the national and international environment posed more threats than opportunities. The market orientated part of the profile suggests a further balance in favour of threats: alternatives such as alcohol and sugar are becoming more attractive, competitive pressures are increasing, and there is a prospect of supply disruption. On the other hand there is a prospect of long term growth in the market, and more efficient supply in the future. While the ETOP has not provided ready made answers to strategy, it has enabled us to bring together many ideas in a framework which makes it possible to identify key issues in context.

Review Question 1
Bring together the information from Modules 4 and 5 on the health food manufacturer, and analyse it using Porter’s framework for the structural analysis of industries.

Review Question 2
The CEO of a major company recently said that he did not see how the five forces analysis could be helpful in strategic decision making. He said that it gives the impression that all of the forces are equally important, that it seems overly concerned with threats rather than opportunities and that it does not deal with internal issues. Can you counter these arguments and make a case for the relevance of the five forces analysis?

Case 1: Apple Computer (1991)
The Apple Macintosh personal computer was launched in 1984 into a fast growing market which was already dominated by IBM and compatible models. The distinguishing features of the Macintosh were its copyrighted user interface (which made the Macintosh relatively easy to use) and graphics features; it was also not compatible with the IBM. Users committed to the Macintosh seem almost to be zealots, and consider it to be far superior to the IBM design; others
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seem indifferent. The decision was made at the time of launch to price the Macintosh significantly above the IBM range. The Macintosh was launched with a marketing budget which exceeded Apple Computer’s total R&D budget. The launch was encouraging to start with, in the sense that it quickly gained 10 per cent of the market; however, market share was not significantly increased thereafter. Subsequently, a key concern of the company was to achieve gross margins of at least 50 per cent, with the objective of ploughing a great deal back into the development of more powerful computers; the R&D budget increased by about two times in real terms between 1986 and 1990, and in 1987 the Macintosh II was launched with colour and fast processors. However, market share remained at about 10 per cent during the late 1980s, and this was barely large enough to provide software innovators with the potential market required to justify the development of new products. By 1990 the Windows interface was developed for the IBM compatible personal computer, which gave the cheaper IBMs much the same characteristics as the Macintosh. In the Autumn of 1990 Apple cut its prices by about 40 per cent and a range of new low cost Macintoshes was introduced. The effect of this on sales was quite dramatic: six months later quarterly sales had doubled, and after a year were running at 85 per cent higher than before the price cuts. However, most of the increase was at the lower end of the product range, and Apple had to shed 10 per cent of its labour force six months after the price cuts; it has now reallocated its resources to be a supplier of high volume, low margin boxes. The problem is that this means it cannot support its previous R&D efforts, and Apple has entered into joint development deals, one with its rival IBM.

Questions
1 2 Analyse the Apple experience using the models developed in this Module. What future do you predict for Apple Computer?

Case 2: Salmon Farming (1992)
The salmon farming industry developed rapidly in Scotland during the 1980s, but by the early 1990s producers experienced substantial problems. It was generally felt that the 6300 Scottish salmon farming jobs, and the £120 million which had so far been invested in the industry, were in danger of being lost. The mid-1991 crisis was caused by Norwegian fish farmers dumping salmon in the European Community to get rid of a huge surplus. By 1991 salmon farming was the main source of employment in many west coast Scottish communities; its output value was greater than that of beef and lamb. However, the industry lost £15 million during 1990. The problems were not unique to Scotland, and many Norwegian fish farms had also gone bankrupt; this was because the price had been forced down all over Europe. Over 90 per cent of salmon consumed is now farmed; the wild variety commands a substantial price premium, and there is widespread concern that the farmed variety is inferior to wild salmon.
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The following is abstracted from a letter from the chief executive of the Scottish Salmon Growers Association (SSGA) to the Prime Minister.
There is a clear view among my members of all political persuasions that this vital industry is simply being ignored and let down by your government. This uniquely Scottish industry which has infused so much life back into the Highlands and Islands economy is about to be destroyed by the piratical trading activities of a non-member of the EU. I can see personal tragedies happening because of this situation. People are in debt to the bank, their houses are at stake, and there is intense pressure on their families.

The SSGA wants the European Commission to impose a duty on Norwegian salmon. Many farms have made employees redundant, and some have sold out to the big multinationals. But even these are experiencing difficulties; Marine Harvest, which is part of Unilever, lost around £19 million last year on its world-wide operations. The allegations of dumping are based on incidents such as the arrival of 250 tonnes of Norwegian salmon in France, which caused the price to drop by 30 per cent to £1.50 per pound, at which price it is claimed that farmers were losing £0.40 per pound. In the US, a charge of dumping was found to be proved against Norway in 1990; Norway gave an undertaking that it would not happen again; recently the US introduced a 26 per cent duty on Norwegian salmon, which effectively ended imports. One fish farm claimed that the price they were paid in the UK had halved in three years, and that their survival depended on a price recovery. A salmon tourist centre was opened in 1991, which cost £0.5 million to construct. It is expected to attract 65 000 visitors per year.

Questions
1 2 Explain why the salmon farming industry is subject to low profits and highly fluctuating prices. What are the prospects for the salmon farming industry? Discuss the action which existing UK producers might take to improve their competitive position.

Use the Strategy Report framework in Appendix 1 to organise your analysis, and set it out as though you were reporting to a strategy client.

Case 3: Lymeswold Cheese (1991)
When Lymeswold cheese was taken off the market in 1991 it had an emotional impact on the British people far in excess of its economic importance; maybe this is because it was seen as yet another great British disaster along the lines of Concorde and the coal mining industry. France is famous for the quality of its food and wine, and in particular it has a reputation for fine cheese. The British made a direct challenge to the
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market for soft blue cheeses with the introduction by Dairy Crest in 1982 of Lymeswold, which resembled French blue Brie and German Cambozola. During the early 1980s British consumers were becoming increasingly sophisticated, and the consumption of soft cheeses was growing by 30 per cent per year. The launch was more successful than expected, and within a short time there were shortages due to a lack of productive capacity. This meant that Dairy Crest had to make a choice of which customers to supply, and the decision was made to carry on supplying supermarkets, who were its existing customers, rather than delicatessens. In 1983 additional capacity was created and productive output was increased to 4000 tonnes per year. However, despite the early success sales never exceeded 2000 tonnes per year; to make matters worse, demand started to fall after 1986. A massive advertising campaign was mounted both in Britain and abroad, but the decline continued. Customers were not very happy about the cheese and a typical complaint was that it was too often bland or immature. There was no evidence that Dairy Crest improved its quality control in order to ensure that the quality of the cheese was at least consistent. Furthermore, Lymeswold is relatively mild and does not go runny as it matures, compared to Brie which is runny and has a much more distinctive taste. Some retailers felt that consumers used Lymeswold as a stepping stone to the more sophisticated continental cheeses. Dairy Crest is an arm of the Milk Marketing Board, which is a farmer-owned legal monopoly buyer of milk. Identify what went wrong.

Case 4: Cigarette Price Wars (1994)
It was the dumbest decision in corporate history. They have ruined one of the best brand names in the world and have created permanent damage. Henry Kravis, Wall Street buyout specialist, addressing Harvard Business School. It is commercial suicide. All that investment in the brand, then you tell people that you can now buy for less than $2 what was worth $2.15 until yesterday. The buyer is never going to believe you again. Bruce Davidson, tobacco analyst at the broker Smith New Court.

Kravis was referring to the decision by Philip Morris to cut the price of Marlboro cigarettes by 20 per cent. He was not, however, an unbiased observer, having been responsible in 1989 for a take-over of RJR Nabisco, which responded by cutting the prices on their Camel and Winston brands. Financial markets expect the price war will have a significant impact on the profitability of cigarette companies – Philip Morris’ share price fell from $64 to $51 (23 per cent) within minutes of the announcement of the price reduction, and fell further to $46 the following week. Wall Street itself took fright and fell by 50 points. However, the notion that Philip Morris have simply ruined a brand name must be seen against the wider economic forces against which the Marlboro brand has been struggling for a considerable time

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The Total Market for Cigarettes
The total market for cigarettes has been declining for some years, although it is growing in the Far East and east Europe. In the context of a declining market, the total US market is price inelastic; advertising campaigns are primarily aimed at increasing or maintaining the market share of individual brands. There is no expectation that the Marlboro price cut will increase total cigarette sales. However, despite the declining market the major companies have been able to increase profits because of technological progress. Productivity has increased dramatically; in five years daily production has increased from 7500 per minute to 15 000, with accompanying cost reductions.

Changing Competitive Conditions
Technological progress and falling costs have played a part in the introduction of cheaper discount cigarettes. Figure 5.18 shows the growth in the market share of discounted cigarettes. At the same time Marlboro’s market share has been in decline, as shown in Figure 5.19. Sales dropped by 366 million packs in 1992, costing $200m in profit, according to stockbrokers’ estimates. It is not surprising that the discounted brands made such inroads into the premium brands’ market share given the disparity in price between the two; for example Price of cheapest discount brand: $0.69 Price of Marlboro: $2.15

40

30

%

20

10

0 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

Figure 5.18

Discounted cigarettes as % of US market

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32 30 28 % 26 25.8 24 22 88 91 92 22.2 93 24.3 30

Figure 5.19

Marlboro market share

Consumers have probably asked themselves what it is about a particular cigarette that makes it worth three times as much as another. The Marlboro advertising strategy was targeted at 18-to-24-year-old men, on the basis that smokers tend to stay with the same brand for years. The cowboy based advertising campaign has been familiar since the mid 1950s, and many observers consider that Marlboro is the world’s best marketed product. However, in 1988 Camel introduced a campaign using a camel image called Joe. By 1991 Camel’s market share was 4 per cent, and it was generally felt that Camel was taking market share from Marlboro.

Market Position
The dominance of Marlboro in the cigarette market is illustrated in Figure 5.20, which shows market shares by volume.
% 30 25.8

20

10 4.0 4.6 4.6 4.7 5.4

7.5 2.8 3.1 3.2

0
Virginia Slims Merit Benson & Hedges Camel Doral Kool Newport Salem Winston Marlboro

Figure 5.20

US cigarette market shares

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But the ability of the main competitors to wage a price war depends on more than the success of the individual brands. The overall market shares of the two main competitors are shown in Table 5.8.
Table 5.8 Market shares
Premium Philip Morris (Marlboro etc.) RJR Nabisco (Camel etc.) 34 19 Discount 8 10

In 1989, Kravis’ partnership fund KKR took over RJR Nabisco for $25 billion, of which only $3 billion was from the KKR buyout fund; KKR is much more heavily in debt than Philip Morris.

Rationale for Price Cuts
On the basis of the price differential, it follows that the margins on discount cigarettes are relatively small, and there is little scope for the discount producers to reduce their prices significantly in response to the Marlboro cuts. This means that the differential between Marlboro and the premium brands will be significantly reduced, and it is hoped that this will be sufficient to entice smokers back to the premium brand.

Ominous Signs for the UK?
The structure of the UK cigarette market is shown in Figure 5.21. Benson & Hedges and Silk Cut are owned by American Brands, a US conglomerate. Consider the sequence of events in the US. The big companies began by ignoring their small rivals, then they started to imitate them by producing their own discount brands, and finally they started to compete with them directly on price.
% 20 17.1 15

10 7.3 5 2.3 0
Raffles 100 Embassy Filter JP Lambert Special & Butler Regal JP Embassy Superkings No. 1 Berkeley Superkings

8.8 5.3 2.7 3.7 3.7 4.0 6.1

Silk Cut

Benson & Hedges

Figure 5.21

UK cigarette market shares

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Questions
1 Was Philip Morris completely mistaken in cutting the price of Marlboro, as the two observers claim? Or was Philip Morris’ reaction an inevitable outcome of market conditions? How effective do you think the Marlboro price cut will be in arresting the fall in market share and/or recovering some of the market share lost? If you were in charge of Benson & Hedges in the UK, what effect would the events in the US have on your strategic thinking?

2 3

Case 5: A Prestigious Price War (1996)
The newspaper business in Britain has seen many circulation wars, mainly among what are known as the ‘tabloids’ – newspapers containing a high proportion of novelty items and sport aimed at a mass readership. Competitive action has usually taken the form of TV games, huge promotional outlays and competitions, with price cuts being viewed very much as a last resort. In September 1993 the media magnate Rupert Murdoch slashed the price of his Sun tabloid, already Britain’s biggest selling daily, down to 20p. He then did the unthinkable by cutting the price of the Times, possibly the world’s most prestigious quality newspaper, from 45p to 30p. Hitherto, the notion that ‘quality’ newspapers could become involved in such unseemly behaviour was regarded by establishment figures as tantamount to undermining one of Britain’s great institutions. The ‘quality’ newspapers pride themselves on their serious treatment of news, and appeal unashamedly to the professional and business classes. Clearly Murdoch considered that even among such people the price of their newspaper had a significant impact on their choice of daily newsreading. In June 1994, nine months after the Times price reduction, Conrad Black, another media tycoon and owner of the Daily Telegraph, decided to enter the price war by reducing its price from 48p to 30p. The Daily Telegraph had historically sales of about twice the Times, and while being a ‘quality’ newspaper has always had a wider appeal, and has some characteristics of a tabloid. Up to June 1994 Black had kept ‘aloof’ from the price war, but in May daily sales of the Daily Telegraph fell below the 1 million mark, while sales of the Times exceeded half a million. This seems to have been the trigger which caused Black to reduce the price of the Daily Telegraph. Immediately, Murdoch reduced the price of the Times by a further 10p.

The Competitors
What of the other players in the market? The Financial Times (recognisable by its pink newsprint) did not enter the fray, partly because it has a world market and concentrates on financial news. Its sales increased by about 5 per cent during the period September 1993 to June 1994. The Guardian appeals to the left wing and liberal minded middle classes; it did not enter the price war either, and its sales were virtually unchanged. But the Guardian was losing about £6 million per year. The Independent first appeared in 1986, and is targeted as a quality paper for independently minded ‘yuppie’ readers and is generally regarded as
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lacking dynamism and identity. It reduced its price to 20p for one day in June 1994, and during the period its sales dropped by 16 per cent. The daily sales figures in September 1993 and June 1994 for the quality newspapers are shown in Table 5.9.
Table 5.9
Times Daily Telegraph Financial Times Guardian Independent

Quality newspapers daily sales (000)
Sept 93 354 1008 287 404 332 June 94 517 993 300 402 277

Financial Resources
Anyone who gets involved in a price war needs to have resources to live through the inevitable cash flow problems. Murdoch controls News International, which in 1993 reported profits of £440 million; he predicted that sales of the Times would reach 700 thousand by the end of 1996, and that the Times would be profitable ‘by the end of the decade’. The Daily Telegraph reported profits of £41 million in 1993. Conrad Black controlled 57 per cent of its shares through his holding company Hollinger. In May 1994 Black sold 12.5 million shares in the Daily Telegraph at 587p each. The day after the price cut was announced the price fell significantly, temporarily reaching 332p, knocking about £280 million off the company’s stock market value. Black called this a ‘ludicrous over-reaction’ by the stock market. However, the shares in other newspapers fell by similar amounts as shown in Table 5.10.
Table 5.10 Some share price movements that day
Share price Fall (%) Daily Telegraph News International (Times) Mirror Group (Independent) United Newspapers (Daily Express)

−39 −8 −24 −19

The Main Players
The view of Conrad Black was that he merely reacted to a predator, and was protecting his market share by reducing the price. ‘It is a Darwinian crusade by Murdoch’ he said; presumably he meant that this was a war of the survival of the fittest. For his part, Murdoch denied that News International was trying to kill off its newspaper rivals; his objective was to reposition the Times to reach a wider audience.
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The Outlook
By July 1996 the Times was able to boast that it had doubled its circulation since August 1993 while the Daily Telegraph had remained more or less static. It was claimed that more people between the ages of 25–44 now read the Times than any other quality daily newspaper. It also pointed out that the 17 page Sports section, Times Sport, was the largest of any daily newspaper.

Questions
1 2 Analyse the competition in the quality newspaper market. Do you think the Daily Telegraph share price reduction was simply ‘ludicrous over-reaction’ on the part of stock exchange investors?

Case 6: An International Romance that Failed: British Telecom and MCI (1998)
It was going to be the biggest transatlantic merger in history: British Telecom (BT), the giant supplier of UK telephone services and MCI, America’s second largest long-distance telecoms carrier. BT had first bought 20% of MCI in 1993 and in 1996 BT made a $24 billion bid for the remaining 80%. But a few months later the value of the takeover had been devalued by $5 billion, and another suitor – WorldCom – stepped in with a bid of $30 billion. BT’s hopes of building a major international telecoms presence had ground to a halt. So what went wrong?

The BT MCI rationale
BT’s intention was to build on its existing alliance with MCI to offer multinational firms one-stop worldwide telecoms services. MCI hoped to use BT’s skills and financial strength to enter America’s vast market for local telephone calls; this business was controlled by regional companies known as ‘Baby Bells’.

MCI and Expansion in the US
Various reports suggested that the merger might not achieve its strategic aims in the US. 1 MCI’s core business was the mature market for long-distance telephone calls inside the US. Critics pointed out that this could make little contribution to the corporate customers sought by BT. During the period up to 1995 there had been a significant liberalisation of the US telecoms market, and it was to take advantage of this that MCI was trying to enter the local markets. But it turned out to be much more difficult than expected, and in the first quarter of 1997 MCI won only $80 million of local market business; this was less than 2% of MCI’s normal quarterly revenue. This was bad enough, but by September 1997 MCI announced an unexpectedly high loss of $800 million on its domestic operations. It was
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3

4

known that a loss was likely, given the intense competitive pressures in the industry, but the size of the loss came as a surprise to everyone, including BT. A major problem was that to enter the local markets MCI would have to build the local network itself or interconnect with the circuits of ‘Baby Bell’ operators. In fact, US law allows the ‘Baby Bells’ a great deal of freedom to challenge the terms of interconnection in the courts and with state regulators, with the result that after a year of deregulation it was still almost impossible to challenge the ‘Baby Bells’. MCI did announce that it was going to build its own exchanges and circuits, but nobody knew how much this was likely to cost. Deregulation works both ways, and the mature long distance internal market was, in its turn, opening to competition from the ‘Baby Bells’; indeed, because of existing local competition, the ‘Baby Bells’ do not have many of the characteristics of semi monopolists like MCI who have been operating in a mature market for quite some time. Furthermore, there is now talk of Internet telephony; therefore there are no guarantees that alliances based on existing technology will dominate the telecoms market in the future. In fact, MCI’s sales growth had dipped sharply from the beginning of 1996, as shown on Figure 5.22.
% Increase on year earlier 25

20 15

10

5 0 1996(1) 1996(2) 1996(3) 1996(4) 1997(1) 1997(2)

Figure 5.22

MCI’s sales

What Drove BT to International Expansion?
BT is generally regarded as a great British success story. It transformed itself from a monopolistic high cost producer in the mid 1980s to a lean producer after it was privatised. Its success in cutting costs was greater than expected, and to date it has shrugged off competition from other suppliers in the UK. But perhaps BT fell into a number of traps in its approach to MCI. Critics maintained that BT had
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• • •

overstated the value of its target. focused on new business at the expense of its existing markets. drawn unreliable parallels between its own experience in Britain and conditions in the US. The fact that BT had transformed itself from being a flabby giant did not necessarily generate insights into the competitive potential of the ‘Baby Bells’.

Would They Fit?
Little was said in the press about the potential problems of getting BT and MCI working together. These were two massive operations, and integrating their markets would necessarily involve close working relationships. The feasibility of integrating the cultures of organisations from different countries and competitive environments was open to question

But There Was Something There
The announcement of MCI’s losses was not the only shock BT received. In September 1997 WorldCom made a bid of $30 billion for MCI, which was the biggest takeover bid in history. MCI shares immediately increased in value by about 20%. What was it about a merger with WorldCom that could produce such value? First of all, WorldCom was relatively young: it was still less than 15 years old by the time it made its bid for MCI and was regarded by the market as innovative and dynamic. Second, it focused on carrying data for businesses rather than voice calls over long distances. In 1996 it spent $14 billion on MFS Communications, which is a telecoms and Internet access company. It then spent $1.2 billion on the network services units of CompuServe and America Online. These were the latest in a series of deals which made WorldCom the largest provider of Internet services in the world and an important player in local, long distance and international telephony. To back up these services WorldCom had almost total fibre optic coverage in the US and a substantial satellite coverage. All this could be combined with MCI’s known brand marketing expertise and billing systems to take local business away from the Baby Bells. WorldCom reckoned that the two companies would save $2.5 billion in costs per annum immediately, and this could grow to $5 billion in five years. Another potential benefit was that WorldCom has a reputation for realigning management in its new companies, and this might be beneficial to MCI.

Into the New Competitive Environment
Even if the takeover is successful, there are severe competitive challenges ahead for WorldCom. Total revenues from local calls are likely to grow only slowly during the next few years, while the cost of long distance calls in the US fell by 50% between 1994 and 1997; international prices fell by 60% in the same period. Furthermore, other global alliances involving companies such as AT&T are also competing for the same business.

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Question
Did BT really understand competition in the US telecoms market?

References
1 2 3 4 5 6 7 Garvin, D.A. (1986) ‘What does product quality really mean?’, Sloan Management Review, Vol. 26, No. 1. Ibid. Powell, T.C. (1995) ‘Total Quality Management as competitive advantage’, Strategic Management Journal, Vol. 16, pp. 15–37. Boston Consulting Group (1970) The Product Portfolio Concept: Perspective No 66. Boston Consulting Group. Porter, M.E. (1980) Competitive Strategy: Techniques for Analyzing Industries and Competitors, New York: Free Press. ‘Dumping crisis threatens salmon farming’, The Scotsman, 10 July 1991. Igor Ansoff (1987) Corporate Strategy, McGraw Hill.

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Internal Analysis of the Company
Contents
6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10 6.11 6.12 6.13 6.14 6.15 6.16 6.17 6.18 6.19 6.20 6.21 6.22 6.23 6.24 6.25 6.26 Opportunity Cost Fixed Costs, Variable Costs and Sunk Costs Marginal Analysis Diminishing Marginal Product Profit Maximisation Economies of Scale and the Experience Curve Economies of Scope Production Costs Joint Production Break-Even Analysis Payback Period Accounting Ratios Benchmarking Sensitivity Analysis Research and Innovation Development Resource Management Human Resource Management Vertical Integration The Value Chain Diversification Synergy Competence Strategic Architecture The Definition of Competitive Advantage Strategic Advantage Profile 6/2 6/4 6/5 6/8 6/10 6/11 6/13 6/14 6/15 6/16 6/17 6/18 6/21 6/23 6/24 6/26 6/31 6/33 6/35 6/38 6/40 6/41 6/44 6/49 6/50 6/53 6/55 6/57 6/60 6/61

Case 1: Analysing Company Accounts Case 2: Analysing Company Information Case 3: Lufthansa Has a Rough Landing (1993) Case 4: General Motors: the Story of an Empire (1998)

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Learning Objectives
• • • • • • • • • • To apply economic efficiency concepts. To use accounting ratios to assess company efficiency. To apply techniques such as sensitivity analysis. To analyse company characteristics such as research, development, resource management and financial controls. To identify where the benefits from synergy might arise. To explore the complexity of managing human resources To assess the importance of vertical integration and the value chain. To identify core competence. To define competitive advantage. To develop a company strategic advantage profile.

Analytical tools from different disciplines are used to generate a picture of the current and potential operations of the company in order to assess the effectiveness with which resources have been allocated in the past, identify the sources of competitive advantage and estimate the strengths and weaknesses of the company with a view to identifying how threats may be countered and opportunities may be pursued.

Strategists

Objectives

Who decides to do what

The macro environment

The industry environment

Internal Competitive Analysis and diagnosis position factors
Feedback

Generic strategy alternatives

Strategy variations

Strategy choice

Choice

Resources and structure

Resource allocation

Evaluation and control

Implementation

6.1

Opportunity Cost
Because of constraints on the resources available to any company, the decision to follow a certain course of action is simultaneously a decision not to pursue alternatives. The best alternative forgone is the opportunity cost of the action chosen. Business discussions tend to focus on financial costs, and whether the company can afford a course of action, rather than what that course of action precludes. For example, take the case of a company which is currently constrained by the availability of cash, and the Board has decided that at the most an additional $1 million can be spent now on future market prospects. The marketing manager has put in a strong case for increasing marketing expenditure

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by $1 million. His case was built on the following reasoning. First, he converted the increased market share which he reckoned he could generate with this increased marketing to an expected future stream of additional net revenue, which was discounted to the present to produce a Net Present Value of $0.5 million. Since the Net Present Value was positive he argued that the available $1 million should be allocated to his department. Furthermore, he argued that the main competitors in this field were also suffering from cash constraints and there was little prospect of a major competitive reaction to his proposed strategy, with the result that there was a low level of risk associated with this course of action. The finance director asked other departments to produce proposals using the same type of approach, paying attention to the degree of risk associated with each, and was presented with the following additional options: 1 2 3 4 leave the money in the bank to earn interest spend more on research spend more on product development reduce product prices

The options to spend more on research (2) and product development (3) were evaluated on the basis of the additional net revenues each was expected to generate in the future from spending an additional $1 million, discounted back to the present. Research expenditure of $1 million was expected to yield a Net Present Value of $0.4 million, but with a high degree of risk; additional product development was expected to yield a Net Present Value of $0.35 million, with less risk than the research option. The evaluation of the returns on a price reduction (4), also produced by the marketing department, was carried out in a slightly different way. It was estimated that a 20 per cent price reduction for one year would result in a 4 per cent increase in market share from the following year, which would continue indefinitely; the price reduction would cause net revenue to be $1 million less than it otherwise would have been during the first year, with a subsequent increase in net revenue when the price was subsequently returned to its previous level. This option was also evaluated in Net Present Value terms, giving a value of $0.45 million; the marketing department also felt that this option involved a relatively low level of risk. The options can be summarised as shown in Table 6.1.
Table 6.1
Option Increased marketing Reduce prices Increased research Increased development Money in bank

Presenting alternatives
NPV $million 0.50 0.45 0.40 0.35 0.00 Low Low High Medium None Risk

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The opportunity cost, in purely financial terms, of spending the $1 million on marketing is to reduce prices because this is the next best alternative; since these two options have a similar level of risk they can be compared directly. However, the ranking of the other two active options is a matter of judgement because, while increased research has a higher NPV than increased development, it also has a higher degree of risk. Leaving the money in the bank is a poor option in terms of generating value. It is not strictly true that the risk associated with money in the bank is ‘none’, because there might be an unexpected fall in the interest rate and a substantial increase in the inflation rate, i.e. the real rate of interest may go negative. Presentation of the options in opportunity cost terms is an important step in helping managers to identify relevant trade-offs and establish priorities. The idea can be used to evaluate resource allocation options at all levels in the company; from the strategy viewpoint the opportunity cost concept helps to focus on the following questions: ‘Have we identified all relevant options?’ and ‘How do the options compare with each other?’

6.2

Fixed Costs, Variable Costs and Sunk Costs
At first sight the distinction between fixed and variable costs might appear to be so obvious as not to require discussion. However, many accounting systems ignore the fact that some costs are fixed and some are variable with respect to changes in output. One widespread practice is to allocate overheads such as central administration costs to each product on a per unit basis. In the previous example the return on a price reduction was estimated, and the estimate of the future net cash flows would obviously have taken into account expected future production costs. However, an arbitrary allocation of ‘overheads’ to the additional output would have given an entirely different result in terms of the future net cash flow and the net present value, despite the fact that the additional output had no impact on ‘overheads’. Many accountants are firmly convinced that each product must bear its share of overheads. Application of this principle can lead to misallocation of resources. Perhaps an even more serious error is to take sunk costs into account in current decision making. Sunk costs are the costs which were incurred in the past, and as a result cannot vary with respect to output. It may well be that past expenditure can be used as a guide to what expenditure might be in the future, but it is senseless to attempt to allocate sunk costs to variations in current output. Factory rent is an example of a fixed cost; since it does not vary with output it has no implication for the quantity which should be produced; when considering the proposal to increase output by 10 per cent, there is no point to reallocating factory rent over the new range of output and changing the calculation of unit cost. Doing so would not reveal whether it was worthwhile to increase output. Materials are a variable input, hence the cost of materials must be taken into account in deciding the level of output. Expenditure on development incurred last quarter is a sunk cost, and therefore has no bearing on whether to continue developing a product. One of the classical

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mistakes is to say ‘We have spent so much on this product that we MUST continue with it.’ Reverting to the basic model of costs makes it possible to clarify which costs are relevant when making decisions about individual products:
Outlayp = Number of workersp × Wage rate + Units of capitalp × Price + Units of materialp × Price Unit costp = Outlayp /Outputp

where p = individual product The model helps to identify which inputs vary with output, and then assign costs to those inputs. This may not be simple to do in practice, and given the complexity of modern companies there is an incentive to use existing cost accounting procedures which are intended to approximate to the relevant costs; however, there is no guarantee that the costs produced by existing procedures are actually those which will lead to rational decisions. When making strategy decisions it is obviously important to make sure that the appropriate costs are taken into account; merely posing questions about whether costs are fixed, variable or sunk can suggest where accounting cost data may be misleading. Sunk costs are a particularly important strategic consideration for barriers to entry, as discussed at 5.10.3; if the costs of entry are recoverable then they are not sunk as far as the strategic move is concerned. The fact that a cost was incurred in the past does not necessarily make it sunk.

6.3

Marginal Analysis
One of the outcomes of failing to distinguish between fixed and variable cost is that decision makers focus on average costs, and this can often be a major error. It has been pointed out that companies often allocate overhead costs to products irrespective of whether these costs are directly related to changes in output. The concept of marginal cost is a development of the notion that only relevant costs should be taken into account in making pricing and output decisions. The marginal cost principle is simple enough, being the change in costs as output varies. In terms of the basic model:
Marginal cost = Outlayq+1 − Outlayq

where q = level of output Since the marginal cost excludes fixed cost, it can be significantly lower than average cost; thus when making output and pricing decisions the marginal cost can be used as a guide to the minimum acceptable price. The company can compare the marginal cost of production with the market price when deciding how much to produce. In fact, the marginal principle provides the basis for a decision rule: carry on producing and selling so long as the marginal cost is less than the price. In most instances it is likely that marginal cost is constant or increasing, at least in the short run. The combination of increasing marginal cost and the
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rule that it is worthwhile to produce and sell when marginal cost is less than price leads to a decision rule on setting output: carry on producing and selling until marginal cost and price are equal. Beyond this point marginal cost will be greater than price and a loss will be made on each unit. The rule is more difficult to apply when it is necessary to reduce price in order to increase sales; in this case marginal cost is not compared with price but with the additional revenue generated by increased sales, taking account of the reduction in price. The additional amount gained from the sale of each additional unit is known as marginal revenue; when it is not necessary to reduce the price in order to sell additional units then marginal revenue and price are equal. The concept of the margin is typically associated with small changes which are continually undertaken in the quest for efficiency. The questions to which marginal analysis can be applied include: ‘How many units should the company produce and sell?’, ‘How much should be spent on development?’ and ‘How much should be spent on marketing?’ The analytical issue which is common to these questions is: ‘Does the last dollar spent generate at least a dollar of revenue?’ If not, there is little point in spending it. The benefit of thinking in marginal terms is that it focuses on the costs and benefits associated with specific actions. It will often be found that marginal costs are difficult to quantify, and the marginal revenues, since they occur in the future, can only be estimated; while measurement presents a real difficulty in applying the marginal principle, it should not be used as an excuse to revert to a conventional historical accounting approach. Some decisions may not be regarded as marginal in the sense that they affect the whole company. The decision to enter a new market may require a change in company organisation, and it may be difficult to visualise what is meant by marginal cost and marginal revenue. In economics, the distinction is drawn between short run and long run marginal cost. One way of describing the difference between the two is that in the short run the productive capacity of the company is held constant, and only variable inputs are allowed to change; long run marginal cost allows all inputs to vary, including these which are typically regarded as ‘fixed’ in real life. While it is difficult to be precise about the distinction between the two in practice, the underlying theory allows for changes in all dimensions of a company’s operations. Consequently, the marginal approach need not be concerned only with small changes. What is important is that the marginal concept is used to identify those costs and revenues which will be affected by the decision. In accounting terms, this is sometimes referred to as ‘relevant costs’; in arriving at relevant costs the emphasis is on the extraction of marginal cost from the confusing array of real life accounting information. The marginal concept can be applied to most aspects of decision making. For example, what is the value of the additional output associated with the hiring of one more worker, or the installation of one more assembly line? Given the importance of marginal analysis to decision making, it is striking that managers are often unaware of the idea; perhaps this is due to companies’ information collection approaches, which tend to concentrate on average rather than marginal data. Another important application is in marginal cost pricing. Often a company finds that it faces ‘one-off’ situations when prices have to be
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negotiated. For example, in the hotel business a potential customer walks in off the street and asks how much a room is for the night; the reply is usually the ‘rack rate’, which is the full undiscounted price for the room. But if the hotel is not completely full, what is the lowest price the manager should be willing to accept? It is simply the marginal cost of providing the room for the customer that night, and managers should have some idea of what this is. But typically the minimum acceptable price set by managers is the average cost. Companies often lose potentially profitable business because they do not appreciate that the appropriate minimum price is the marginal cost, not the average cost, when making deals at the margin. Recognition of the importance of marginal cost also has implications for the degree of empowerment which can be devolved to employees; in the hotel example the hotel company is made better off by every marginal deal which generates more than the marginal cost. The duty manager can be provided with appropriate incentives and encouraged to haggle at the margin so long as he does not strike deals at below marginal cost; otherwise the marginal business will be lost. An important application of marginal analysis relates to the selling of inventories as a product’s life cycle draws to a close. Take the case where the company expects to have an inventory of 800 units of the product in the final quarter of the product life, and does not intend to produce any additional units during that quarter. Given that there are no production costs, and assuming that selling costs are zero, what price should be charged for the product inventory in the final quarter? The type of response which this question elicits includes: 1 2 3 ‘As high a price as the market will bear’ ‘A price which will clear all of the inventory’ ‘A price which will cover the costs of production’

All of these are wrong. In this case the marginal cost is zero, so attention is focused on marginal revenue, and this leads to the demand concept developed at 5.2.2 and the revenue maximising price. If a price of $1 million is charged then zero units will be sold; if a price of zero is charged, then all units will be sold. In between these two extremes is a price at which the revenue obtained from sales will be maximised, irrespective of whether or not all units have actually been sold. As shown in Figure 6.1, a straight line demand curve has been drawn for illustration. At price P and quantity 500 price times quantity is maximised. This is also the point at which marginal revenue is zero. Since all costs have already been incurred, the appropriate price is the revenue maximising price. The application of mistaken notions of revenue maximisation at this stage could cost the company a great deal in terms of lost revenue. But what might this revenue maximising price be? The manager only has one chance to set the price, and will not know if this was the revenue maximising price or not. However, some knowledge of market conditions can help. If the company is operating in conditions of oligopoly, or competition among the few, it is likely to be faced with the kinked demand curve at 5.3.2. Since this is the last quarter of the product life cycle and there are no future strategic implications
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Revenue = Price x Quantity

Price

P

Demand = average revenue

500

Marginal revenue 1000

Quantity

Figure 6.1

Selling product inventory: the revenue maximising price

relating to market share, the answer is to set the price to the competing level, and that will maximise revenue. It might be estimated that the revenue maximising price would result in sales greater than the inventory available. In this case the revenue maximising price is that at which all of the units would be sold. It is obviously difficult to estimate this price with any degree of accuracy, but there are potentially substantial revenue implications from addressing this issue directly.

6.4

Diminishing Marginal Product
Why should marginal cost vary? It must be because the productivity of resources varies at the margin, i.e. as output varies different resource inputs are required to produce a given increase in output, and this is reflected in the marginal cost. It is to be expected that the more resources which are directed to an activity, the greater will be the output. However, the additional output will not always be in proportion to the additional resources. The case traditionally used in economics textbooks is that of a hectare of land, which is a fixed factor of production, and farm workers, the numbers of whom can be varied. When there are relatively few workers, each additional worker will add a proportionately higher quantity to output as opportunities for division of labour are exploited. However, beyond a certain point it becomes more and more difficult to wrest additional output from the land, no matter how many additional workers are used. Eventually, the additional output from the additional worker will be zero. At this point the marginal product of labour is zero. By and large companies operate in the range at which additional resources yield diminishing increases to output. This has important implications for determining the scale of company operations. For example, when deciding how many workers to employ, a company will keep on hiring additional workers up to the point at which the value of the additional product is just equal to the wage rate. While the additional revenue may be difficult to quantify in practice, the hiring of additional workers must be based on the implicit belief of managers that the value of the additional output will be at least as great as the additional

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wage cost. The concept of diminishing marginal product applies to most aspects of company activities: it becomes increasingly difficult to wrest each additional percentage point of market share; in this sense the marginal product of marketing expenditure diminishes. When developing products, it becomes more and more difficult to add features which customers are willing to pay for; thus the marginal product of development effort also decreases. The idea of diminishing marginal product is shown in Figure 6.2, where the connection between total and marginal product is demonstrated.

Total Product

Output

Marginal Product

Variable inputs

Figure 6.2

Total and marginal product

Marginal product increases and then decreases; when additional inputs add zero to output then marginal product becomes zero. The notion of diminishing marginal product can also be applied to the allocation of resources among company activities. For example, consider the case where it was felt that the marginal productivity of marketing effort was very high, while the marginal productivity of new product design engineering was low. This is shown in Figure 6.3, where the current resource allocation is 0X to marketing and 0Y to design engineering.

Output ($)

Marginal product marketing

Marginal product engineering

0 X W1 Input ($) W2 Y

Figure 6.3

Resource allocation

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Total output could be increased by diverting some resources to marketing from design engineering. Imagine one dollar is taken from engineering – this results in the small amount of output at Y being given up; now allocate the dollar to marketing, and the large output at X is obtained instead. The optimum allocation is at 0W1 and 0W2 where the marginal products are equal; any deviation from this allocation leads to a reduction in total output. Whether the allocation could be achieved in practice raises practical issues, because it may be difficult to substitute resources among diverse activities at short notice. The concept is also relevant at the corporate level, where SBUs are competing for scarce funds. The guiding corporate principle is to identify the value of the marginal product of the SBUs, and allocate resources to each up to the point at which the values of the marginal products are equal. In Figure 6.3 the two activities represented could be SBUs. The corporate manager might argue that the notion of the marginal productivity of an SBU is much too difficult to estimate. But efficient resource allocation demands that the principle be observed, and even a rough indication of marginal productivity can reveal whether corporate resources are being allocated in the right directions. The discussion at 1.4.1 on the concerns of corporate and business strategy also involved the marginal principle: the reason that the allocation to Groups in Table 1.2 is less efficient than allocation directly to SBUs is because it violates the condition that the marginal products are equal; compare the two and you will see for yourself!

6.5

Profit Maximisation
It is a short step from the discussion on marginal analysis at 6.4 to arrive at the concept of profit maximisation. It was concluded that the company should keep on increasing its output until the marginal cost was equal to the price. Below this level of output the marginal cost is less than the price, hence profit could be increased by increasing output; above this level the marginal cost is greater than the price, and profit could be increased by reducing output. Thus when the company is faced with a market price over which it has no control the profit maximising output is that where marginal cost equals price. But when the company does exert some influence on the price charged, i.e. it can sell more by charging a lower price and less by charging a higher price, the impact on total revenue from a change in sales is not simply equal to the price times the number of units involved. At 5.2 it was shown that revenue changes as price and quantity sold changes, and that the extent of this change depends on the position on the demand curve. The change in revenue is known as the marginal revenue, and is usually defined as the change in total revenue from selling one more unit. When it is necessary to reduce the price to sell additional units, the marginal revenue is clearly less than the price. The issue then is whether the marginal cost is less than or greater than the marginal revenue. The profit maximising output in this case is when marginal cost and marginal revenue are equal, i.e. when the cost of producing the last unit is just equal to the revenue obtained from selling it. In the discussion on marginal analysis, it was concluded that this provided a decision rule on how much to produce; it now emerges that this is also the profit maximising output.

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In real life, where many changes are not marginal, where costs and revenues are not known with any certainty, where problems of market share, relative costs, competitor reaction, and so on tend to dominate decision making, the idea of profit maximisation might at first appear to be of limited usefulness. But it can be illuminating to use the profit maximisation framework when evaluating competing courses of action. The two questions ‘What are the additional expected costs?’ and ‘What are the additional expected revenues?’ are really about profit maximisation. Any course of action where only a weak case exists for asserting that the additional revenues are greater than the additional costs must be viewed with some reserve. A proper understanding of what is meant by profit maximisation is useful to managers for another reason. Many managers feel defensive about the representation of company goals as primarily directed towards profit maximisation. The expression has come to have overtones of the ‘unacceptable face of capitalism’, and gives the impression that the company’s objective is to extort as much as possible from the consumer while delivering the least possible in return. In fact, the notion of profit maximisation is concerned with efficient resource allocation given the tastes and preferences of consumers; the great economist Adam Smith pointed out that everyone can be made better off through the pursuit of profit maximisation, since this leads to the most efficient use of resources in an economy. There is nothing morally reprehensible about the pursuit of profit maximisation within the set of legal rules decided by a democratic government.

6.6

Economies of Scale and the Experience Curve
The concept of economies of scale was introduced at 5.10.3 because of its importance as an entry barrier; it starts from the notion of comparative statics, i.e. what the cost of production would be at different scales of operation. It is concerned with the average cost of production in relation to the productive capacity of a company. For example, if the productive capacity of a company were doubled, economies of scale would exist if the average cost fell. The empirical evidence on economies of scale is mixed: in some industries it is significant, and in others it hardly exists. The difficulty in attempting to measure the impact of scale economies in real life is that it is not merely the increase in productive capacity which is relevant, but whether the higher productive capacity is based on a more efficient combination of labour and capital. It may be that some larger companies have not selected the optimum combination of inputs, and hence do not benefit from potential scale economies; this does not mean to say that they do not exist and that they might not be exploited by some companies in an industry. It may be that the difficulties of managerial coordination beyond some company size make it impossible to benefit from potential scale economies. In 1995 two very large Japanese banks, Mitsubishi Bank and Bank of Tokyo, merged to create by far the largest bank in the world with assets of well over $500 billion; this is close to the value of Britain’s annual gross national product. But none of the reports on the merger discussed its rationale in terms of potential economies of scale; in fact, the Bank of Tokyo announced that there would be no job losses as a result of the merger. While the rationale for the merger may well be justified in terms of factors such as global

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presence and coordination of a wider range of financial products, the possibility that such a gigantic organisation would start to run into diseconomies of scale does need to be addressed explicitly. Economies of scale tend to be confused with the experience curve, which relates to the reduction in average costs resulting from the total volume of output to date. For example, one of the factors contributing to the experience curve is the degree to which employees learn to do their job more efficiently over time. Experience is a dynamic notion which, while being related to economies of scale in that the larger a company the more output it will have produced, is conceptually independent of economies of scale. The research carried out on this issue reveals that the effect of experience varies among companies and industries; it is to be expected that the evidence on experience will be mixed because of factors such as variations in production techniques by industry, differences in managerial ability to take advantage of its potential effects and exogenous shocks. The empirical evidence suggests that a doubling of output has the potential to lead to a 20 per cent reduction in average cost. Whether this can be used as a benchmark for individual companies is a matter for managers to resolve, but there seems little doubt that there is a potential for experience effects in most areas of activities. An important aspect of the empirical findings is that the effect is not linear, i.e. it takes successive doubling of output to achieve the same proportional cost reduction. This would produce a relationship between experience and unit cost of the shape illustrated in Figure 6.4.

Unit cost

X1

Y1

X2

Y2

Cumulative output

Figure 6.4

The experience curve and unit cost

As cumulative output increases movement up the experience curve (down the unit cost curve) becomes slower, because each additional 20 per cent cost reduction requires a doubling of output. The advantage conferred by experience is thus continually being eroded. In Figure 6.4 company Y has a substantial unit cost advantage over company X at the first point, when cumulative output to date was Y1 and X1 respectively. By the second point company Y has increased its cumulative lead in output terms, i.e. output Y2 is now much greater than output X2 , but the unit cost advantage has almost disappeared.
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The difference between economies of scale and experience effects has strategic implications. If there are significant experience effects to be exploited, the company has a limited time to take advantage of them because of the reducing percentage effect as cumulative output is increased. If there are also significant economies of scale in the industry, the company which is first in and is bigger than competitors has the potential for an early cost advantage. A company which feels it has a cost advantage over rivals should attempt to identify where the advantage is derived. If it is from experience effects, the advantage can be expected to decline over time; if it is from economies of scale the advantage will be retained so long as competing companies do not increase in size. The combination of economies of scale and experience effects confers a significant first mover advantage in new markets. The company which is first in is potentially able to grab the largest market share and thus benefit from whatever economies of scale exist; followers start at a higher point on the experience curve and are thus faced with a two pronged cost disadvantage.

6.7

Economies of Scope
Economies of scope are similar to economies of scale, but the idea refers to a reduction in unit cost as the number of products is increased rather than the number of units produced. The idea bears a resemblance to synergy, which is discussed in 6.21. There are a number of reasons why it may be cheaper for one firm to produce two goods than for two firms to do so. • The possibility of sharing inputs among several outputs: for example, the cellophane tape manufacturer 3M had capabilities in adhesives which could be used in making adhesive message notes; retailers sell many items – Sainsbury’s sells about 30 000 items – because below some critical number customers do not find it worthwhile to come in. The good reputation associated with some products may have a beneficial effect on others: for example, the quality image of Rolls Royce cars carries over to its aero engines. There may be significant R&D spill-over effects among different products; for example, advanced heat resistant materials developed for turbines have applications in kitchen utensils. Enhanced ability to compete in a range of related industries with a coordinated strategy: this comes back to the potential benefits from a related portfolio of businesses; given the problems of diversification such potential benefits may be no more than wishful thinking.

Economies of scope are clearly by no means an automatic outcome of diversification. If products are in unrelated markets, using different resources and requiring different management skills it is just as likely that diseconomies of scope will result as scarce management skills are spread ever more thinly.

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6.8

Production Costs
The modern literature on costing reveals that there is disagreement between academic and practising accountants on how to determine the costs of production for decision making purposes. An indication of the scope of this debate can be obtained from the titles of major articles written by accounting theorists • • • How cost accounting systematically distorts product costs;1 Yesterday’s accounting undermines production;2 One cost system isn’t enough.3

The investigations carried out by researchers into accounting practice reveal that many companies have accounting systems which do not generate information on costs which are relevant to decision making. This is partly because many accountants studied for their qualification before accounting education started to take account of management accounting issues, and partly because companies do not realise that their accounting system has not been adapted in line with changes in the company and its competitive environment. Many accounting systems are simply incapable of providing an answer to the question of how much it costs to produce a particular product, and how costs vary as the level of output changes. Dissatisfaction with accounting techniques is not confined to the accounting profession. There has always been disagreement between economists and accountants in this area; while not all accountants hold the same views on costs, the debate can be characterised as follows. Economists accuse accountants of ignoring economic ideas when reporting costs, while accountants respond that economists do not understand the difficulties involved in producing information in day to day business. The debate has centred on the concept of marginal versus average costs, and on expected future costs versus historical costs. On the marginal versus average costs issue, economists maintain that accountants should identify the marginal cost of production (as discussed at 6.3) so that the cost of expansion or contraction can be sensibly compared with changes in revenues; accountants typically argue that average costs, which include arbitrary cost allocations, are appropriate because all costs have to be taken into account. On the future versus historical cost issue, economists argue that sunk costs should be excluded from decision making information, and that the only use for historical costs is to provide guidance on what costs are likely to be in the future; accountants argue that unless all historical costs are taken into account a biased view of costs is obtained. The problem facing the manager is that accounting systems are complex, and it may be difficult for the non specialist accountant to determine whether they are doing the proper job. The application of economic concepts can go some way towards cutting through the technical complexity of accounting systems. The general principle to apply is that if the company accounting system does not provide information which is consistent with economic concepts there is a good chance that mistaken decisions will be made. Some of the factors affecting unit cost are illustrated in Figure 6.5.
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Figure 6.5

Factors determining unit cost

This is by no means a complete or definitive picture of how unit cost is determined: for example, it does not include economies of scale; but it demonstrates that the analysis of unit cost is much more than an accounting exercise. Not only is it necessary to understand how influences such as learning effects and attrition rates affect unit cost, but there are linkages between these factors which make it difficult to disentangle their individual effects. For example, hiring policies can have implications for the amount of overtime working required, which in turn can have an impact on the attrition rate, which in turn affects the position on the learning curve; at the same time factor prices are affected by the business cycle, while exogenous shocks, such as a sudden and unexpected fluctuation of prices on commodity markets, make it difficult to identify how underlying unit costs are changing. It is clearly important to determine whether an increase in unit cost is due to factors outside the control of the company – business cycle effects and exogenous shocks – and which affect all companies, or whether it is due to the management of labour, in which case the cost increase will have a negative impact on the company’s competitive position.

6.9

Joint Production
The classic case of joint production is that of a sheep, which produces both wool and mutton; it is impossible to disentangle the inputs devoted to the two outputs. Companies which produce more than one product are often faced with the problem of joint production, leading to attempts by accountants to allocate costs among outputs. An example is activity based costing, which can go a long way towards identifying costs as generated by resource use. The concept of joint

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production has important implications for cost analysis: if the resources devoted to a particular output cannot be identified, neither can the costs. Any attempt to allocate joint production costs among products is artificial, no matter what arguments are used to justify the method chosen. While there may be many reasons for allocating joint costs, the manager should be aware that allocated costs may be irrelevant for decision making purposes. The existence of joint costs imposes a complication on the use of variable costs as an item of information for decision making purposes; since some costs vary with changes in the output of two products it may not be possible to identify variable costs separately. This is one reason why accounting procedures become so complex as to be almost impenetrable in the attempt to identify which product is causing costs to vary. Joint production has some tricky strategic implications because it may not be possible to produce certain products on their own and compete effectively with those produced under conditions of joint production. For example, a farmer who pays little attention to rearing lambs for sale will have to derive all his income from the sale of wool.

6.10 Break-Even Analysis
There are many ways of using information on fixed cost, variable cost and selling price to obtain a perspective on the desirability of proceeding with a new project. A relatively straightforward question is: ‘How many units would have to be sold before the product starts making a net contribution?’ This is known as break-even analysis. A simple version of break-even analysis, which assumes that unit cost and price will not vary with output, is as follows. On the cost side, total cost incurred as output is increased is:
Total cost = Sales × Variable unit cost + Fixed cost

On the revenue side, the total revenue generated by the product is:
Total Revenue = Sales × Price

It is then a simple matter to solve for the Sales at which Total cost equals Total revenue:
Sales × Price = Sales × Variable unit cost + Fixed cost Sales × (Price − Variable unit cost) = Fixed cost Fixed cost Break-even = Net contribution per unit

You simply take the fixed cost and divide that by the difference between price and unit cost. The break-even chart is shown in Figure 6.6. This type of calculation is central for developing strategy. The most obvious question which can be addressed with this information is whether the total sales requirement is attainable before the product makes a positive cash contribution. This focuses attention on the factors affecting potential total sales over time. Estimates of cumulative sales will be based on the marketing information available on market size and market share, and can be expressed as
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Revenue

$

Cost

Cumulative output

Figure 6.6

Break-even chart

Cumulative sales = (Total market × Market share)1 + (Total market × Market share)2 + ... + (Total market × Market share)t

where 1, 2, . . . , t = product life cycle periods Break-even analysis adds a dimension to the appraisal of a course of action which is missing from the discounting approach. Sensitivity analysis can be used to identify conditions under which the product will not even cover its production costs. It is possible to take factors such as potential experience effects into account, and break-even analysis can help identify possible courses of action, such as aiming at efficiency improvements, which could transform the prospects for a product. Break-even analysis is obviously limited in that it concentrates only on the volume of output and sales, and does not take into account the passage of time; however, it does present a useful picture of potential costs and revenues.

6.11 Payback Period
A question often asked by managers is: ‘How long will it be before the project pays back its start up costs?’ This is important from the viewpoint of anticipated corporate cash flows, and is not revealed by break-even analysis, which concentrates on sales volume. The calculation is identical to that of net present value (see 3.12.2) except that the annual cash flows are not discounted; instead, they are summed until the total becomes positive, as shown in Table 6.2.
Table 6.2
Cash Flow Payback

Payback

−A 1 −A 1

A2 A2− A1

A3 A2+ A3− A1

An A2+ A3+ ... + An− A1

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The payback period is the length of time until the running total becomes positive. There is some dispute as to whether the payback period adds to the information produced by a properly executed net present value analysis. The discounting approach takes into account both the incidence of cash flows over time and risk factors; in theoretical terms the argument that the company needs to predict its net cash position is irrelevant, because a bank which used the same NPV criterion as the company would be willing to lend money against the security of the expected future income stream. This suggests that there is no such thing as ‘running out of cash’ for an investment which has a positive NPV. However, from the corporate viewpoint there are situations in which the payback criterion may have implications for the selection of the product portfolio. For example, the prospect of increasing the ratio of debts to assets may be unacceptable, even for a short period. Whether the notions of break-even and payback appeal to the financial purist is irrelevant; what is important is to generate information on different aspects of investments so that corporate decision makers can arrive at a well balanced view of the implications of different courses of action.

6.12 Accounting Ratios
The company has at its disposal a great deal of information which it can use in identifying the effectiveness with which resources are being, or have been, allocated. It is at this point that an apparent disagreement between the practitioners of finance and those of accounting needs to be clarified. Various problems in using ROI as an investment appraisal criterion have been discussed; the balance is heavily in favour of using the formal tools of financial appraisal in determining how resources should be deployed in the future. But formal financial techniques do not reveal how well resources are actually being deployed; the questions which confront the company include: Are we moving up the learning curve? Are we producing the level of sales value per person employed which we originally thought possible? Are we making effective use of our capital? Are we keeping inventories under control? The list of questions relating to effectiveness is endless, but they can be tackled by using historical accounting information relating to costs and revenues. Therefore the theory of finance provides the tools for allocating resources in the future; accounting procedures reveal the efficiency with which resources have been allocated to date. Accountants usually try to identify a set of useful ratios which relate inputs and outputs in a meaningful fashion, and track these over time. It goes without saying that individual ratios have limitations, but it is not suggested that ratios should be used blindly. Rather, they provide information on different dimensions of company performance. The objective of calculating accounting ratios is to assess the effectiveness with which resources have been allocated in the past. The ratios are a useful tool for analysing accounts; they help to reduce the amount of information in the accounts which require analysis, and can identify potential weaknesses in company management. Since the objective of ratios is to simplify the complexity
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of accounting information, it would be pointless to use a vast number of ratios. However, there is no definitive set of ratios which will provide the correct information for managers; not only are there many ratios to choose among, individual ratios can be defined in different ways. It is therefore necessary to select a number of potentially useful ratios which can be employed over a period of time to ensure the consistency of the information from which the ratios are derived. The following ratios are typically encountered in company accounts: • • • • • • • ROI Return on Investment RONA Return on Net Assets ROCE Return on Capital Employed ROTA Return on Total Assets Value Added Earnings per Share Gearing ratio

To ensure that these ratios produce performance measures which relate to the efficiency with which resources are allocated, appropriate measures of revenues, costs and assets must be used. While it may appear obvious, it needs to be stressed that revenues and costs must not include changes in the portfolio of assets; the buying and selling of assets is not directly related to the efficiency with which inputs are being converted to outputs. However, inspection of published company accounts reveals that the sale or acquisition of assets is often slipped into the accounts, perhaps to disguise a particularly good or bad year. The importance of understanding what accounts are telling you cannot be overestimated. In his book the stockbroker Smith4 asked a simple question: how can it be that companies which appear to be financially sound can suddenly go bankrupt? He cited the example of Polly Peck as one of the most blatant examples of financial deception, but he pointed out that the signs of financial malaise were detectable if you knew what to look for in the published accounts. He then went on to ask what the average investor should know, and he identified 11 practices which could be misleading, although they were not illegal. Smith constructed a table, which became notorious for its ‘blobs’, which simply listed major companies and how many of these dubious practices they pursued. Although the information was in the public domain, his analysis touched a sensitive nerve with the companies concerned and with his employers. The upshot was that Smith was fired and the reputations of the companies with a lot of ‘blobs’ were badly affected. Since assets appear in the bottom line of most of the measures, it is important that they are calculated in a manner which is consistent with the opportunity cost of the resources tied up in the company. In practice, it is extremely difficult to assign a value to assets. In the first instance, many assets were purchased in the past and have depreciated through use and obsolescence. The book value attributed to them by accounting procedures may bear little relation to what the asset would realise on the market, nor to the replacement cost of the asset. Two companies may have identical performance in terms of RONA, but because of different accounting methods one may appear to be performing more profitably.
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The notion of replacement value raises another issue, i.e. that of inflation. For example, the book value may be based on a price paid several years ago, but since then inflation could have led to all round price increases of 50 per cent. Since revenues are in current price terms, it would seem to make sense to adjust the asset value to current price terms. But this could be virtually impossible in practice, given that the company may have hundreds of assets of different vintages. It would be an impossible task to generate data on replacement value of all assets each time the RONA was calculated. Take the case of an asset costing $100 purchased four years ago, during which time inflation has been 50 per cent, and the asset has been depreciated over five years using the straight line method. Table 6.3 shows possible calculations of asset value.
Table 6.3 Different asset values
$20 $30 $100 $150

Current book value Current book value inflation adjusted Historical cost Replacement cost

A further problem is which assets to include in the calculation. All firms are faced with the problem of lease or buy with respect to the acquisition of assets, and the choice can have a significant impact on the ratio because a change from owning to leasing moves the entry from the bottom to the top line. Consider the case shown in Table 6.4 of a company which has the revenues, costs and assets shown in Year 1.
Table 6.4
Year Revenue Costs Assets RONA

RONA calculations
1 $M 20 10 100 10% 2 $M 20 12 100 8%

In the following year the company decides to sell an asset for $10M, and lease a replacement for $2M per annum; nothing else changes, and the result is shown in Year 2; the cash received from the sale is now treated as part of company assets. The operational efficiency of the company has not changed, but the RONA has fallen. Has the company become less efficient? Companies have three sources of finance: retained profits, equity issues and loans. Over a period of time the company will finance its activities by various combinations of these three, and the availability of finance will ultimately constrain its strategic capabilities. Companies typically start their lives by raising finance from shareholders and as time goes on profits are generated and distributed (in part to these shareholders); the rest is paid in dividends and tax. The total shareholder equity is thus the original equity finance plus the retained profits. The company can fund expansion by issuing more shares (equity) or
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by incurring debt; this type of debt is typically in the form of long term loans for specific investment projects rather than the short term loans necessary for covering variations in short term cash flow. The main difference between debt finance and equity finance is that the interest on debt takes priority over payments of dividends to shareholders, and must be paid no matter how profits fluctuate; the more debt there is in relation to equity then the more dividends will fluctuate with profitability. If the interest cannot be paid then the company goes bankrupt. This means that the shareholders bear the risk of fluctuations in profit and therefore look for a higher return on their funds than the providers of loan finance. As a result it is cheaper to finance investments by debt, but each time this is undertaken the risk to existing shareholders increases. A measure of the risk associated with debt financing is the gearing ratio, defined as
Debt finance Shareholder equity

which is usually expressed as a percentage. It is a simple matter to calculate a company’s gearing ratio, but the real question is: what is the optimal gearing ratio for a particular company? There are a number of factors which have to be taken into account. • A company which has a sound track record will be regarded as a good loan prospect by banks and should have little difficulty raising debt for growth. A company which has not taken advantage of this, and has constrained its growth to finance by retained earnings, may not be taking advantage of opportunities. This could be an indication of a cautious and risk averse management, or perhaps of a management with little strategic vision. The higher the gearing ratio, say around 100%, the more reliant it is on steady and non fluctuating profits over time. This is likely to make banks nervous and beyond some point it will be difficult or impossible to raise additional finance no matter how attractive the investment might appear to be. The company needs to balance off dividend payments against the loss of flexibility which may result from a high gearing ratio.

There is therefore no optimal gearing ratio which applies to all companies, or even to a given company over a period. A company which has embarked on a strategic initiative may have a high gearing ratio, while a company which has established itself as a market leader and has little room for expansion in existing markets may have a low gearing ratio. But on a profitability basis they may be considered equally successful.

6.13 Benchmarking
A company’s competitive position can only really be assessed in relation to other companies in the industry. One way of achieving a perspective on this is to develop quantifiable measures of performance which can be compared with
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other firms. The performance of major competitors can be ascertained from the information in their annual reports, which contain the main indicators such as return on investment, return on capital, growth in sales, margins and so on. But given what has been discussed already, obviously these cannot be taken at their face value, and it is necessary to ensure that like is compared with like. This means that it is necessary to interpret published information, and hence comparisons are bound to be approximate. While it is important to develop a picture of the company’s relative financial strength in relation to competitors, the objective of doing so is to provide information for strategic purposes rather than to attempt to emulate the performance of other companies. This is because there is no guarantee that competitors are pursuing best practice. The type of question which needs to be addressed includes Why are competitors’ return on capital greater or less than ours, and what does this tell us about our own use of resources? How does competitors’ financial strength (in terms of gearing, cash reserves etc.) compare with ours, and what flexibility does this give them? There are many dimensions of company performance, and benchmarking measures can be applied to just about everything: delivery times, stockholding ratios, manpower turnover, etc. Benchmarking is clearly an important diagnostic tool because it can indicate where resources might be deployed more efficiently. But there are at least two reasons why benchmarking must be treated with caution if it is to be used as a guide to achieving competitive advantage. 1 It is virtually impossible to compare like with like. It is not always apparent that there are differences which can render comparison meaningless or misleading. Some questions which need to be posed include: are the portfolios of the companies sufficiently similar? Are there synergies which cannot be easily identified? Are products at similar stages in the life cycle? Are competitive conditions similar? These questions are particularly important when international comparisons are being made because competitive conditions for otherwise similar products can be greatly different. An example of this is the market for telephone services in the US and the UK, which is dealt with in Module 5 Case 6. Measurable dimensions of company performance are unlikely to reveal how competitive advantage is achieved, otherwise the characteristics would already have been imitated. It is how performance is achieved, rather than the fact that it is being achieved, which is needs to be identified, but this is very difficult to achieve. The UK retailer Marks and Spencer served as a benchmark for other retailers for many years; but when it lost its competitive advantage it was actually quite difficult to pinpoint exactly what had gone wrong.

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6.14 Sensitivity Analysis
When making predictions about the future it is not possible to be precise, but it is possible to have some idea of the range of values likely to be associated with important variables. At the very least, the best possible and worst possible scenario for each important variable can be projected. Sensitivity analysis is related to the investigation of scenarios, but is conducted at a more detailed level. One approach is to use the investment appraisal framework as shown in Table 6.5.
Table 6.5
minus Outlay = Number of workers Units of capital Units of material equals contribution in each period

Base contribution calculation
Revenue = Total market

× × × ×

Market share Wage rate Price Price

× + +

Price

It may be felt by forecasters that the values used in the appraisal are unlikely to be significantly wrong; however, some managers may express reservations, for example, about the prospects for the labour market due to predictions that the economy is likely to be entering a new period of sustained growth. This could result in wage rates being 20 per cent higher than would otherwise be the case. The framework can be adjusted to take this possibility into account as shown in Table 6.6.
Table 6.6
minus Outlay = Number of workers Units of capital Units of material equals contribution in each period

Adjusted contribution calculation
Revenue = Total market

× × × ×

Market share Wage rate Price Price

× × +

Price 1.2

+

It may be that because wage costs are a relatively small proportion of total cost, a 20 per cent higher wage rate would have little impact on the profitability of the investment. On the other hand, it may turn out that the attractiveness of the investment is highly responsive to the wage rate. This could cause managers to take a rather different view of the desirability of undertaking this investment rather than alternatives. Sensitivity analysis can be carried out in relation to different dimensions of performance. For example, the impact of the potentially higher wage rate on NPV, break-even, payback and cash flow can be investigated. Sensitivity analysis is therefore a powerful technique for generating a perspective on the potential returns from a course of action. It identifies which are the crucial variables, and where unexpected threats may exist. It can pin-point issues about which
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attempts to obtain more information should be undertaken before a decision is taken. A somewhat less obvious aspect of sensitivity analysis is to identify the combination of circumstances which are necessary to ensure success. In the example above, sensitivity analysis might have revealed that a 10 per cent higher price for either labour or capital would lead to failure, as would a market share of 14 per cent or less. Managers must then seriously address the issue of whether it is likely that the following will actually occur: Market share greater than 14 per cent; and Wage rate no more than 10 per cent greater; and Capital price no more than 10 per cent greater. Put in this way, this might appear to be an unlikely combination of circumstances. The reason that some projects fail is the lack of recognition that their success was actually dependent on the simultaneous occurrence of several favourable circumstances.

6.15 Research and Innovation
The great historian Schumpeter developed the idea of ‘creative destruction’, whereby periods of comparative quiet are punctuated by shocks when old sources of competitive advantage are destroyed and replaced by new ones. He argued that the entrepreneurs who exploit the opportunities created by the shocks go on to achieve positive profits during the next period of calm. Thus dynamic resource allocation is more important than static efficiency, and in the historical sense competitive conditions are not permanent; this idea offers a different perspective to the notion that competitive advantage can never be permanent because it is continually being eroded by competitors. Thus one of the requirements for achieving competitive advantage is to adopt an innovative stance, recognise new ideas and changes and be ready to implement them when they occur. A modern advocate of the importance of innovation is D’Aveni5 who argues that due to technological progress and information technology the sources of competitive advantage are being eroded at an increasing rate. The answer is to disrupt existing sources of advantage in the industry and create new ones. In the context of ‘hypercompetition’ the best the firm can do is seek to achieve a sequence of temporary advantages that keep it ahead of the rest of the industry. If this is true then an awareness of research and innovation is central to company success. All companies are faced with a dilemma when attempting to decide how much to spend on research. It is well established that the returns on research expenditure are potentially high in many industries. A large scale research project6 carried out in the US back tracked innovations, and found that the rate of return on research expenditure was of the order of 30 per cent. However, this rate of return related only to those inventions which reached the marketing stage, and did not take into account failures. The research demonstrated that the rate of return on successful research is high, but left open the issue of the
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return on total research expenditure by companies, given that a proportion of research does not lead to marketable products. There are in fact two stages to the problem of allocating resources to research: how much to spend, and what criteria to use in order to identify potentially profitable products from the possibilities produced by research, since the company may have insufficient resources to exploit all potential products. It could be argued that since so little is known about the likely success of new products, the most efficient approach is simply to develop products on a ‘first come’ basis, and tailor research expenditure to produce the number of new products which the company is capable of dealing with. To do this it would be necessary to have some idea of the productivity of research expenditure in terms of producing new ideas. It is interesting to note that although many academic economists have spent the past thirty years attempting to identify a relationship between research expenditure and the production of inventions, the findings have been at the aggregate level and consequently this type of research has produced no guidelines on which an individual company can base its research expenditure decisions. This is partly due to the fact that in aggregate there is a reasonably stable output of inventions by the economy, but for the individual company it is highly unlikely that marketable ideas will occur at a constant rate over time. The production of ideas, so far as the individual company is concerned, is likely to be unpredictable and sporadic, with periods when there are no new ideas and others when there are too many to deal with. The identification of the potential returns from research expenditure is only part of the story, since the company must also consider the opportunity cost of research expenditure. In the extreme case, it is self-evident that there is no point in generating more inventions than can be developed and marketed. But decisions are not normally concerned with extreme cases, and it is necessary to decide whether a particular dollar should be spent on research, or competing uses such as marketing new products or investing in new equipment. This involves a trade-off among the need to spend sufficient to produce new products in the future to ensure the long term viability of the company, and the additional cash which could be generated by increased sales, and cost savings which might be made by using new equipment. The fact that the opportunity cost comparison is based on largely unpredictable returns in the perhaps distant future against more identifiable revenue and cost advantages arising from other courses of action means that the research department is particularly susceptible to changes in the company’s fortunes. In times of difficulty, the argument that it will not matter all that much if research expenditure is reduced for a period to help solve short term cash flow problems is usually persuasive, given that if cash flow problems are not solved the company may go out of business and there would be no need for research expenditure. However, in companies where the research department has a highly prestigious staff with a strong power base, the department may be insulated from such immediate considerations as cash flow. Given the many influences which affect research, it is likely that most company decisions on research expenditure are based on considerations other than the likely rate of return. The first step in taking a rational view of research expenditure is therefore
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to be clear about the basis on which decisions have been taken in the past: has the allocation of resources been determined by short term considerations, by individual personalities, or by other factors such as the fear of what competitors are spending? One approach is to adopt a rule of thumb, for example to keep research expenditure at some constant percentage of total costs, or total sales. The benefit to the manager of taking this approach is that the formula can be worked out on a basis which is agreeable to all concerned, and therefore may serve to avoid conflict until such time as the outcome derived from the rule is no longer acceptable, while ensuring that research expenditure will remain within reasonable bounds. The potential cost to the company is that the process is arbitrary and may result in a misallocation of resources. A complicating factor is that it is not always possible accurately to identify research expenditure in a company. There is a significant amount of joint production involved in research and development output. Researchers typically spend part of their time on product development, and consequently the expenditure devoted to research into potential products (sometimes called pure research) can only be estimated. An outcome of the joint production of research and development is that there may be a spill-over effect: the higher is research expenditure, the lower the development expenditure required to attain a given development objective. Thus expenditure on research which does not generate prototypes may not be totally wasted, in that it causes development expenditure to be lower than it otherwise would have been. Bringing these various factors together, the quest for efficiency in research expenditure can be assisted by identifying the most important indicative factors and assessing their relative importance. RESEARCH EXPENDITURE: INDICATIVE FACTORS • Measurement of research expenditure • Past research budget: constant or variable • Expenditure as proportion of sales, total cost • Track record of new ideas • Spill-over effects • Power base

6.16 Development
Product development starts when the product is selected for development from the prototype stage, and often continues after launch and throughout the product life. In order to maintain market share, companies continually upgrade their products in line with new technologies and customer expectations. It is important to be clear about the difference between the outcome of research and development inputs. Research expenditure results in the creation of a prototype which is potentially profitable. However, this leaves various questions to be tackled, including how much should be spent on developing the product, when it should be launched, what price should be charged, what marketing effort should be devoted to it, and so on. These questions cannot be answered
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in a vacuum, i.e. only with reference to the product itself, because there are opportunity costs associated with each course of action. For example, it may not be worth developing a potentially viable prototype because the marketing department would not be able to sell it without reducing other, more profitable, activities. The development of a product sets the stage for a series of conflicts among groups whose objectives differ. • The development engineer has an interest in producing what is regarded as a ‘good’ product by his peers; this might involve characteristics of construction and operation which may be understood only by engineers. The development engineer also wants to make sure that the product will function in all possible circumstances, since his own reputation and career prospects will be affected by association with a product which has a poor reputation for performance and durability. He will therefore concentrate on maximising some aspects of ‘quality’ which were discussed at 5.5. The financial controller wishes to keep costs within budget limits, and exerts continual pressure on the development engineer to seek the most economical solutions to technical problems. The marketing manager wants to get the product to customers as soon as possible, as he sees competitors moving in and making entry to the market progressively difficult. He will wish to gain first mover advantage which may well be more important than characteristics such as product reliability in the short to medium term. Thus the marketing manager will not be so concerned with marginal improvements to the product specification, and will push for as early a launch date as possible. The corporate manager will be concerned with the alternative uses to which the resources might be put, and at the same time has to worry about the motivation of both the development engineers and marketing staff.

In many companies these different groups do not communicate directly, and individually they feel that those in other functions have little appreciation of the real problems associated with turning out a profitable product. There is no simple answer to the issue, but a contribution to reconciling these differences would be to ensure that the different groups communicate and attempt to make compromises which will result in a profitable outcome. It is possible to address the issue of whether the company is allocating its development resources efficiently. Once a prototype has been identified as potentially viable, the relevant question is ‘How much should be spent on developing it?’ Managers often reply that since there are so many unknowns the question has no operational relevance. However, a considerable amount of information is available which can be used in structuring the decision. The first step is to apply the microeconomic concept of marginal analysis, and concentrate attention on marginal cost and marginal benefit. Does the last dollar spent on development yield more or less than an additional dollar of profit?
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This is much more than an exercise in prediction, because the issue is central to decision making under uncertainty in general. It is worth pondering the following: The decision to increase development expenditure by one dollar must be based on the implicit assumption that the marginal benefit is at least one dollar. If the manager does not believe this to be the case the decision to spend an additional dollar is irrational. There is no sense in a manager claiming that development expenditure is based purely on guesswork; it is illogical to spend the money unless there is a basis for believing that on balance there is an acceptable probability of achieving an economic return on the investment. Is it possible to go beyond ‘gut feeling’ and develop a rationale for this belief? At this point, in real life, the accountant is likely to make the point that not only are the expected marginal revenues unknown, but the identification of marginal cost may not be possible using the existing accounting system. This may be due to accounting systems which should be able to generate the costs relevant to marginal decisions but which cannot. The accountant may attempt to argue that average costs should be used, but this is due to lack of understanding of the concept of marginal analysis. How can expected marginal benefit be estimated? One method is to regard the development stage as the period during which the launch date characteristics are determined. These launch date characteristics include expected market share, unit cost and selling price. In fact, the dialogue which takes place among engineers, marketers, accountants and financial analysts is largely concerned with identifying what these launch date characteristics are likely to be depending on how much is spent during the development stage. For example, design engineering expenditure will affect market share at launch; this is because the function of design engineering is to align product specifications with the perceived wants of potential customers. Production engineering expenditure determines the production techniques and hence unit cost at launch. Thus the launch date, or start values, for both market share and unit cost are derived during the development stage. Market research can provide information on the expected selling price at launch date, the size of the market and the product life cycle. However, this is only part of the story. After launch date, market share and unit cost are determined by marketing strategy and production management respectively. The marketing department can produce an estimate of how both market share and prices will develop over the product life cycle, while the production department can provide estimates of unit cost, taking into account such factors as learning effects over the product life. For example, the net revenue for a given year can be estimated as follows:
Net revenuet = Market sharet × Total markett × (Pricet − Unit costt )

where t = time period This gives a stream of expected revenues in the future which, together with the development expenditure, can be discounted to the present to give a net present
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value. Changes in development expenditure are associated with a change in at least one of the variables, and the impact of the change on the expected stream of revenues can be calculated; this is the marginal revenue associated with the change in development expenditure. Comparisons of the expected net present values of different courses of action can then be made. Apart from the need to discount future revenues the problems of risk and uncertainty must be faced. How likely is the market share to be achieved? Will competitive pressures increase and the competing price decline? Will economic conditions change and in turn affect both demand for the product and input prices? The structure outlined above makes it possible to use sensitivity analysis to identify the impact of different assumptions. For example, it may be found that it is worth doubling development expenditure simply to achieve an additional 1 per cent market share. One benefit of the approach is that it can identify situations where additional expenditure is clearly uneconomic. The important lesson here is to structure the issue in such a way that assumptions can be made explicit and the implications measured as far as possible. This is the difference between taking an informed decision and operating on the basis of ‘gut feeling’. The fact that a company has a history of successful R&D management does not guarantee that it will continue to have success. To return to IBM, up to 1991 IBM was one of the most successful managers of R&D in the world; the company had over 30 000 patents, and two researchers had won the Nobel prize. But despite this the new technologies developed by IBM were often beaten to the market. For example, IBM was one of the first companies to design a RISC microprocessor, but was the fourth to commercialise the device. On 26th November 1991 IBM announced a ‘fundamental redefinition’ of its businesses, with the accent on shifting power from corporate headquarters to the people making and selling products. One of the objectives was to make the company more flexible so that it could take more immediate advantage of new products and markets. But to do this it is necessary to integrate innovation with the market place, and IBM suffered from the widespread problem that the marketing department understood its customers and wanted to get new products into the market as soon as possible, while the R&D department understood the technology and had little idea of precisely what customers want from a product. Too often this led to the situation where the wrong product was produced too late. By decentralising it was hoped that researchers would be brought closer to the real issues confronted by marketers, and good ideas would not be unnecessarily delayed by their progress through the corporate decision making structure. The discussion on research, innovation and development can be brought together into a single model which identifies the stages which must be passed in bringing an idea from the inventor’s head to successful market exploitation. This can be visualised as a process in Figure 6.7. This whole process can be termed ‘innovation’ because each stage requires new thinking. When viewed as a process two distinct management problems become apparent: • •
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each stage must be managed effectively the link between stages must be efficient
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Invention Prototype Patent Development Launch Market exploitation

Figure 6.7

Innovation as a process

Stepping through the stages the following issues emerge from the previous discussion. • Invention: what incentives exist to ensure that new ideas will be generated? There are formidable problems of intellectual property rights and principal agent issues involved here. Invention to prototype: what mechanism exists to ensure that investment in an idea can be undertaken to see if it works? There needs to be some screening mechanism otherwise many useless ideas will be investigated. Prototype: what criteria are used to determine what has the potential to be produced and sold? Prototype to patent: is the delay in patenting justifiable or should this stage be by-passed? Patent: what protection is likely to be afforded by a patent? At this stage it might be found that the invention cannot be defined well enough for patenting purposes and this raises issues as to how easily it might be imitated. Patent to development: how are prototypes prioritised in the overall development programme? For example, if a first mover advantage is essential a prototype may require a high priority but this means interfering with the current order. Development: how much should be spent? Development to launch: the natural conflict between engineers and marketers needs to be overcome. Launch: to make an initial market impression it is essential to ensure that the product is positioned properly in terms of differentiation and price. Launch to market exploitation: it is necessary to decide whether the launch has been successful and further resources devoted to exploitation or whether the product should be abandoned. This will depend on the market share
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• • • •

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captured, the reaction of competitors, predicted changes in consumer tastes etc. Market exploitation: the product is now entrenched as part of the product portfolio; but new and different products may require different marketing approaches to existing products.

The process reveals that there are many possibilities for delay within each stage, if it is not monitored effectively, and between each stage, if there are insufficient incentives and effective procedures for taking products through each transition. It is instructive to consider the IBM experience and identify those aspects of the process which were not being managed well and led to the lags between invention and market exploitation. What emerges is that for this process to be effective an organisation needs to pay a great deal of attention to incentives and be adaptable to changing priorities at different stages.

6.17 Resource Management
The management of resources has a direct bearing on the competitive position of the company; there is little point in producing an ambitious and innovative market strategy if the goods cannot be produced at a competitive cost. In fact, the outcome of inadequate resource management will inevitably emerge as unnecessarily high costs. How can the company set about rationalising its approach to resource planning and allocation, given the continuously changing demand for the factors of production due to market conditions and product life cycles? Varying product life cycles, changes in productivity and transition among products can result in major variations in factor requirements. Without some foresight the company may find itself hiring and firing in an indiscriminate fashion. The first step is to identify the company’s approach to resource planning. Two general approaches to resource planning, the reactive and the proactive, can be characterised as follows: • • REACTIVE Look one period ahead PROACTIVE Think about – product life cycles – product launch periods – selecting a planning horizon – developing a resource plan – the implications for marketing strategy

The reactive mode simply looks at what will be happening next period, which may be no more than a quarter year, and hires and fires accordingly. In many companies this is precisely what happens, in that lip service is paid to resource planning but in fact operations are conducted from day to day.
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The proactive mode takes into account the product life cycles and launch dates for the company’s products; a time horizon is selected, beyond which so little is known that it is pointless to attempt to predict. Then calculations of resource requirements are made, taking into account learning effects, inventories, and so on; this is integrated with marketing strategy to ensure that the resource plans are consistent with marketing objectives. Clearly, there are various methods of rationalising the approach, but the important issue is to identify whether the company is really carrying out a systematic appraisal of future resource requirements. If an identifiable structure does not exist, it is likely that the company is hiring and firing in the reactive mode. All companies are faced with indivisibilities and lags in acquiring resources. This makes it impossible to produce exactly the amount of output likely to be sold in any period; it is, therefore, instructive to investigate the implications of both over and under production. Consider the case shown in Table 6.7 where, with existing resources, predicted output for an individual product will be greater than predicted sales in a particular quarter.
Table 6.7
Options Discard resources Produce to inventory Reduce price Increase marketing

Predicted output greater than predicted demand
Issues Hiring/firing staff Learning curve Market share Competitive reaction

The reactive option might be to divert resources from that product. These resources could be kept employed but not used, or allocated to another product, or fired, in which case firing costs would be incurred. The problem is that any learning built up in the labour force may be lost, because if employees are subsequently re-allocated to the product they may start again at the bottom of the learning curve. There are therefore a number of potential costs associated with this option which might not be obvious at the time, but which become apparent later when the company starts to realise that its costs are higher than those of competitors. The point to bear in mind is that competitors may not be making these mistakes, and may end up with lower unit costs. A proactive option is to produce for inventory, with a view to ceasing production before the end of the product life cycle. This avoids firing costs, and ensures that labour keeps moving up the learning curve; against this must be set the additional cost of holding inventories. There is, of course, no point in producing for inventory if the market is not large enough ultimately to sell off everything produced. However, even a rudimentary degree of foresight can avoid this error. Another reason for holding inventory is to ensure that unexpected future increases in demand can be satisfied. The optimum inventory to hold for this purpose depends on the assessment of future prospects, and this involves prediction and risk analysis. An option which goes beyond the technical issues of reconciling output with expected sales is to reduce price and/or increase marketing expenditure, with the objective of actually selling the excess of production. In this case production
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and marketing managers must work closely. There are many marketing strategy issues which must be taken into account prior to attempting to increase sales simply because there is an expected inventory. These include the responsiveness of sales to price changes (price elasticity), the effect of increased marketing expenditure on the position of the demand curve, the expected impact on revenues over the rest of the product life, and competitive reaction; if competitors match the lower price there may be no net benefit in terms of increased revenue. If market share were increased, would the production department be able to increase output over the rest of the product life? To alter marketing strategy for a relatively short period may be counter-productive in the long run. The opposite case is shown in Table 6.8 when predicted output with existing resources is less than predicted demand.
Table 6.8
Options Reallocate resources Increase price Reduce marketing

Predicted output less than predicted demand
Issues Backlog Market share Competitive reaction

The reactive option may be to reallocate resources from other products for which there is already an inventory, or attempt to hire more resources. Reallocation will generate hidden costs in terms of the learning curve, while hiring more resources will result in hiring costs. If the increase in demand is short lived, the costs of meeting the higher level of demand could be much greater than the value of the additional sales. It is therefore necessary to take a view on how long the excess demand is likely to persist. There are other options which may not be immediately obvious. Since part of the demand which is not satisfied will disappear through backlog withdrawals in any case, the price could be raised, and/or marketing expenditure reduced, to equalise demand and supply; this would have the effect of leaving no unsatisfied customers, since only those willing to pay the higher price would actually buy the product. From the marketing strategy viewpoint, it is necessary to determine what impact this will have on market share, and whether it will be permanent; in other words, it is not just the market share this quarter which might be affected, but market share over the rest of the product life cycle. Competitors may react aggressively by taking the opportunity to reduce their prices, thus causing a much greater impact on market share than would otherwise be the case.

6.18 Human Resource Management
Effective human resource management is important for strategy for two reasons. First, the people in a company are a resource like any other, and the determinants of how effectively that resource operates can be affected by strategic change. Second, when strategic changes are introduced they have to be implemented by people, and resistance to change can exert a powerful constraint on success. Adaptability and the ability to cope with strategic change is a major
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objective of human resource management. One of the main characteristics of an organisation is its culture, which comprises its set of beliefs, values and managerial approaches; this culture is reflected in its structures, systems ad approach to the development of strategy. The culture itself is derived from the company’s past history, type of leadership, the people involved, its use of technology and resources. But since each company has a different history and different combinations of people and other resources the culture of each is likely to be unique. However, four broad types of culture can be identified which provide a basis for understanding how the workforce is likely to react to change.7 1 Power Culture The organisation tends to revolve around one individual (or small group), who dominates decision making and determines how things are done. This culture usually occurs in a relatively new or small company which is entrepreneurial in nature. However, as this type of organisation grows it becomes increasingly difficult to maintain central control, and there is a tendency for smaller groups to form who are, in their turn, dominated by their own leaders. In this type of organisation there is unlikely to be an explicit strategic plan, but if there is one it will tend to reflect the interests of the dominant leader rather than being based on analysis of the environment and explicit strategy choice. An example of this type of culture is in the newspaper industry, where the old style proprietors dictated editorial approach and newspaper layout. Role Culture This is a distinctive type of organisation which relies on committees, structures, analysis and the application of logic. While a small group of senior managers make final decisions, they rely on procedures and systems and clearly defined rules of communication. This bureaucratic type of structure works well when the environment is stable, but the fact that it relies on rules and procedures means that external changes are not typically recognised at an early stage, and the company is not well equipped to deal with them because it is relatively inflexible. Major changes tend to be dealt with by a change in the top management team. This type of culture is prevalent in the civil service and the old style retail banks and their strategic changes tend to be slow and methodical. Task Culture This type of culture arises in organisations which are geared to tackle specific tasks which tend to be of limited duration. The organisation is based on flexible teams who tackle assignments, and these teams will typically be multidisciplinary, and power rests within the team structures. As a result control relies largely on the efficiency of the individual teams, and top management must allow teams a great deal of autonomy. This culture is apparent in advertising agencies and consultancies; it is less appropriate for factory style operations, although the team approach is being used increasingly in all work environments. Personal Culture While this culture does not occur often in business, it is as well to be aware of it. In this case the individual pays little attention to the organisation and
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is most concerned with self gratification. All strategic responses depend on the inclination of the individual, and hence are unpredictable. Voluntary workers are a good example, but individual professionals such as architects or consultants working as lone people within larger organisations can fall into this category. But this form of culture itself is unlikely to permeate an entire organisation. The type of culture prevalent in the company will have a major impact on how the organisation reacts to strategic change. Table 6.9 indicates how the cultural composition relates to competitive advantage and the ability to cope with strategic change.
Table 6.9
Culture Power Role Task Personal Achieve competitive advantage Lacks analysis Slow Flexible Lack focus Cope with strategic change Unpredictable Resistant Change is norm Unpredictable

These broad classifications therefore provide some insight into the alignment of strategy with culture, and where problems are likely to arise. It is unlikely that any single organisation will exhibit only features of one culture. However, it is possible to consider the extent to which the different forms of culture exist in an organisation, and which is most dominant and at what time. This can provide insights into the strategic approach and how it changes over time. But it is necessary to invoke a warning here. When problems arise in implementing strategy they are often ascribed to cultural problems, because these are actually difficult to identify and it is virtually impossible to do anything about them in the short term. Thus the failure can be ascribed to ‘cultural problems’ which are outside anyone’s control. But what might appear to be a cultural problem may in fact be due to the more general principal agent problem, for example the incentive system may not be aligned with revised strategic objectives.

6.19 Vertical Integration
Every product has a supply chain which starts from the extraction of raw materials and involves manufacture, distribution and sales to the final customer; a woollen garment starts as grass in a field which is turned into a sheep which produces the wool which is sheared and spun into yarn which is knitted into a garment in the latest fashion which is distributed to stores and so on. Vertical integration relates to the part of the supply chain which is controlled by a company. Forward integration occurs when a farmer becomes involved in the marketing of wool to garment manufacturers; this is the role of the British Wool Marketing Board which attempts to give British farmers more control of the prices and end uses of their product. Backward integration occurs when manufacturers purchase farms, perhaps with the intention of ensuring the
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supply of certain types of wool, although there are probably very few instances of this happening. The degree of vertical integration is closely bound up with the business definition of the company as discussed at 3.2. Every company is to some extent vertically integrated. But what is the rationale for vertical integration? This comes down to the well known question of whether the company should make something itself or buy it from some other company. There are various potential benefits and costs of using the market rather than producing internally. The benefits include: • • Market firms can achieve economies of scale which the company’s purchases would be insufficient to generate on their own. Market firms are subject to the discipline of the market; it is unnecessary to implement rigorous internal controls to ensure efficiency. The costs include: • • • The coordination of production flows may be compromised because the supplier may have other priorities from time to time. Private information may be leaked to competitors who also use the same suppliers. Transaction costs may be incurred.

There is no general answer to these issues, but they do need to be addressed in the light of the circumstances facing each company. There are three incorrect arguments commonly used to justify making rather than buying in from the market: • To avoid paying the costs necessary to make the product – this is wrong even if the company currently has excess capacity since the costs have to be borne by someone. To avoid paying a profit margin to other firms – it is not whether the supplier makes a profit that is important, but whether the profit made is higher than could be made by the company were it to undertake the activity itself. Given a lack of experience and scale effects this is doubtful. To avoid paying high prices during periods of peak demand or scarce supply – again it is relative profitability which is relevant; if the supplier operates in a competitive market the company could not make the product any more cheaply because the higher price reflects higher input costs.

On the other hand, it needs to be recognised that a complete contract with a market supplier cannot be achieved in the way that an internal contract can. There are at least three reasons for this. • • Life is too complex to draw up a contract which can take all eventualities into account; the contract arrived at reflects bounded rationality. There are severe difficulties involved in specifying and measuring performance with any accuracy; for example, defining the thrust of an engine exactly and then predicting its wear and tear over time. Neither party is willing to reveal all information to the other, and this may place the buyer at a disadvantage.
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A potential difficulty that most companies are aware of is the ‘holdup’ problem: a party in a contractual relationship may be able to exploit the other party’s vulnerability once the contract has been agreed. This is something which cannot be evaluated in financial terms before the event. There are a number of ways by which internal organisation can better resolve the holdup problem than arm’s-length market contracting. • Vertical integration gives access to more powerful governance structures in the sense that disputes can be settled by internal administrative mechanisms such as recourse to general rules or informal mediation. Because of the guarantee that the internal relationship will be continuous and must be lived with there is more incentive to get things right. Depending on the company culture, vertically integrated divisions may be more likely to behave in a cooperative fashion because they see themselves bound together in a common purpose. One point of view is that the balancing of incentives for competitive and cooperative behaviours among autonomous units within a firm is the single most important task of top management. The sociology of organisations opens up potential avenues for discouraging opportunistic behaviour and achieving cooperative outcomes that are not available in a market contract setting. Of course, these outcomes are likely to be difficult to achieve in practice.

• •

The point that emerges clearly from this discussion is that if the company decides to make rather than buy in competitive markets it will generate some formidable principal/agent problems. As a result a great deal of management resources will be devoted to resolving these. A major problem is that the internal pricing system must perform the same function which the market would have performed – otherwise it becomes impossible to monitor the performance of the sections of the vertical chain and identify where value is being created or destroyed. For example, internal prices which are based on accounting conventions rather than market conditions are likely to provide misleading cost signals. One method of resolving the problem is to allow managers the option of buying from outside suppliers if their price is lower; this has the effect of applying the discipline of the market to the components of the vertical chain, while hopefully enabling the company to achieve the potential benefits of vertical integration outlined above. The vertical and horizontal integration of companies has always been a source of concern to those who felt that companies would grow so big that they would dominate their markets and then be in a position to hold consumers to ransom. But this is not how it works in practice. The case of ICI and Hanson was discussed at 3.12.6 in relation to the creation of shareholder wealth. This was a case where a large company comprised of many separate parts, some of which were independent of each other, would benefit from a demerger. But ICI is a company producing in a number of competitive markets, and its size does not of itself provide it with monopoly powers. Take the case of a vertically integrated company with substantial monopoly power such as British Gas, and track the product from discovery of gas supplies through distribution to the final consumer. Should British Gas do its own exploration, production and
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distribution? If not, should it in fact exist as a vertically integrated company in the first place? In 1992 the stockbroker Kleinwort Benson produced an analysis of the break-up value of British Gas compared to its current share price value. The analysis was as shown in Table 6.10.
Table 6.10
Division Pipelines Distribution Exploration/production Other Net debt Total 1992 share price
Source: Kleinwort Benson

Break-up value of British Gas
Asset value (£bn) 11.5 3.1 5.3 1.7 2.5 19.1 13.9 259 Trading value (£bn) 6.6 2.9 3.4 1.0 Value per share (p) 155 68 80 24

If the analyst was correct the break-up value was about 25 per cent higher than the corporate value. One reason for this is that the vertically integrated company is a conglomerate of companies each operating in a completely different market. For example, British Gas ‘buys’ internally both exploration and retail services. The study demonstrated that British Gas achieves few real benefits from vertical integration.

6.20 The Value Chain
A company can be visualised as a chain of value producing activities which starts with inputs at one end and sales at the other; the overall value is represented by profitability, but it is difficult to disaggregate company activities in such a way that the contribution of each to value production can be identified. Porter8 tackled this problem by breaking the value chain down into two main components: primary activities, which are basically the logistics of production and sales, and support activities, which are necessary for the effective functioning of the company, but which are not directly related to production and sales. The primary activities are: • • • In-bound logistics: receiving, storing and handling inputs to the production process. Operations: transforming inputs into outputs; this is the physical process of making, testing and packaging the product. Out-bound logistics: moving the product from operations to buyer in the case of a tangible product, and bringing the buyer to the product in the case of many services. Marketing and sales: providing the buyer with information, inducement and opportunities to buy the product. Service: maintaining the value of the product.
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Each of these primary activities can be identified and analysed to determine its contribution to the value created by the company. But it is not just the effectiveness with which these primary activities are performed that is important, but their linkages among each other and with the following support activities: • • Procurement: the process by which resources are acquired. Technology development: the technology associated with each of the value activities, including learning by doing, product design and process development. Human resource management: the whole business of managing the workforce. Management systems: including quality control, finance and operational planning.

• •

The notion of value which is used in value chain analysis is how the ultimate user views the product in relation to competitive products. Unfortunately this is almost impossible to measure, and it is usually necessary to use other measures, such as operating margin, profit or shareholder value. Once some idea of competitive differences has been established the value chain can be analysed to identify how these are determined by its components. The objective is to identify distinctive competencies which generate competitive advantage; these distinctive competencies are aspects of performance where the company is particularly good compared with competitors. However, the value chain is not just a tool for analysing company effectiveness and identifying the basis for competitive advantage. An understanding of the value chain is important for identifying strategic options as it helps to provide an overview of the strengths and weaknesses of the company in a competitive setting. Simply disaggregating the activities of the company into a chain and analysing the components may not tell the whole story, as it may be the linkages between value activities which contribute to competitive advantage. This has implications for strategy, because while competitors can copy success in identifiable areas such as distribution channels or resource management by using techniques such as benchmarking, it is almost impossible to replicate the linkages among the components because these are unique to the company. The ability to capitalise on company characteristics which are embedded in the organisational structure is one of the underlying factors which contribute to a sustainable competitive advantage. Marks & Spencer, the British retailer, is famous for the linkages which it established with producers and the resulting guarantee of high quality; it was also a leader in human resource management which was also linked to a high standard of customer service. While each of the elements in the Marks & Spencer value chain could be imitated, it turned out to be almost impossible for other retailers to imitate the linkages between them; as a result Marks & Spencer retained its place as one of the most profitable retailers in the world for several decades. However, by 1998 some serious problems with the value chain had emerged; for example, weaknesses in Marks & Spencers’ procurement policies led to a build up of unwanted stocks amounting to about £150 million. The image of quality and value which had been built up by purchasing from British suppliers was undermined by switching to foreign suppliers because British
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suppliers were relatively expensive. To cap it all, a series of board room battles undermined the company’s image as a leader in human resource management. As these problems with the value chain emerged, it came as no surprise that Marks & Spencer sales and profits fell dramatically at the end of 1998 and the share price fell by 14 per cent.

6.21 Diversification
As in the case of vertical integration, the firm needs to confront the issue of the optimal degree of diversification. The evidence available on the relative performance of diversified companies demonstrates that it is not an automatic recipe for success. Porter tracked the performance of 32 firms which were involved in acquisitions, and concluded that there had been virtually no benefit in any of the cases. Some accounting studies have been carried out on the degree of diversification and performance, using measures such as return on investment. There is no obvious connection between the two, and it seems that profits are more likely to be determined by industry profitability rather than by diversification itself. A detailed study9 on stock price outcomes found three main effects: 1 2 3 The combined value of parent and target firms tended to rise following the announcement of a take-over, but this was usually temporary. A preponderance of abnormal returns accrue to target firm shareholders. Acquiring firm shareholders eventually receive small statistically insignificant returns.

Given this lack of positive evidence that there is much real gain from diversification, why has it been such a popular corporate pastime? There are four main incentives to diversify: to minimise risk, to capture economies of scope, to add value through the parenting function and to benefit from synergy. The first of these can be dealt with quite briefly, as it is now recognised as a means of minimising management risk but not shareholder risk. The objective of stabilising cash flows over time is a weak rationale for diversifying, and certainly provides no basis for expecting any value production. The idea of economies of scope was developed at 6.7, and it was concluded that the pursuit of economies of scope might as easily lead to value destruction rather than value creation. Prahalad and Bettis argue that managers of diversified firms may see themselves as deriving economies of scope through their proficiency in spreading scarce top management skills across apparently unrelated business areas through the application of their dominant management logic (this idea was introduced at 1.4.2); this is the way in which managers conceptualise the business and make critical resource allocations – be it in technologies, product development, distribution, advertising or human resource management. The dominant management logic has a direct effect when managers develop specific skills, e.g. information systems, and seemingly unrelated businesses rely on these skills for success. There is a danger that the dominant management logic rationale can be mistakenly applied by managers who perceive themselves as possessing above average general management skills. Furthermore, without
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detailed knowledge about a particular business it is impossible to know at the time of the diversification whether the new business fits the dominant management logic or whether the managerial skill is above average. In the absence of obvious relationships between businesses, claims that economies of scope derive from a dominant management logic are difficult to defend. Richard Branson’s business empire was outlined at 2.2, and is a good example of a highly diversifed portfolio with nothing to bind it together. In 1996 there were 27 companies in the group arranged in divisions: • • • • • • Travel and tourism, including Virgin Atlantic Airways, Virgin Clubs and Hotels and Virgin Airships and Balloons; Retail and Cinema; Media and Entertainment, with companies in publishing, television and radio; Consumer Products, including Virgin Cola, Virgin Jeans and Virgin Cosmetics; Design and Modelling; Financial Services, which is a major venture in the direct selling by telephone of financial products.

An obvious linkage among these enterprises is the dominant management logic of Branson himself, which is characterised by a high level of activity and commitment. But there is a limit to how far this resource can be spread. Another potential linkage lies through brand stretching; while there may be a real impact here, the underlying rationale for a relationship between cola and financial services is unclear. It is therefore difficult to see what the individual companies stand to gain in the long term from being part of a group which was created by a random process of diversification.

6.22 Synergy
Synergy appears to have first been mentioned by Ansoff10 in 1968. The notion differs from economies of scale and experience in that it is independent of the size of the company, or of the total output to date. Synergy should lead to the situation where a corporation is valued at more than the sum of the value of its individual parts if they could be separated. In business terms, synergy can be thought of as the 2 + 2 = 5 effect; Fuller defines it as . . . behavior of integral, aggregate, whole systems unpredicted by behavior of any
of their components or subassemblies of their components taken separately from the whole.11

Some successful companies attribute at least part of their success to synergy. It is therefore important to determine whether synergy can be predicted and therefore capitalised on in formulating strategy. For example, no one would expect a synergistic effect from a company which produces ball bearings taking over a company producing ice cream; but is it possible to use the concept as
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an operational tool to tell the ball bearing company which type of company to take-over? While the idea of synergy has an intuitive appeal it turns out to be a difficult principle to pin down in practice. There are two problems in attempting to benefit from synergy as a consequence of company actions. The first is to identify where the benefits of synergy are likely to be generated. The second is that there is little empirical evidence which can guide the company in individual situations; in other words, synergy may be little more than wishful thinking on the part of companies engaged in expansion who have heard that synergy is an outcome of diversification.

The Components of Synergy
Synergy is often described as an almost mystical effect which makes itself apparent in cost and marketing advantages, without being explicit about the mechanism which actually causes these effects. There are in fact a number of areas from which the effects of synergy are likely to originate. • CORPORATE MANAGEMENT There may be possibilities for individual SBUs to share common indivisible resources, and to eliminate excess capacity. However, this is not a case of 2+2=5, but simply making the optimum use of capacity. This benefit is more properly related to production management. A different corporate management issue is that similarity among SBUs may make them more amenable to management than a series of SBUs in unconnected markets. This begs the question of what is meant by ‘similar’. An SBU which has recently been added to the company may produce similar products, but may have inherited a management structure and ethos which is totally alien to the corporation. Synergy at the corporate level may be identifiable after the event, but whether the addition of any given SBU to an existing company would generate a positive synergistic impact is impossible to predict. ECONOMIES OF SCALE While synergy is different from economies of scale, it is possible that some dimensions of scale economies can be captured by diversification into similar products. This is related to the notion that there is a carry over from experience in similar production and selling environments, and is obviously similar to economies of scope; operating in a series of similar markets has elements of doing more of the same thing, which is the notion of scale and experience effects. This argument is not very compelling to the economist, whose rigorous definition of economies of scale takes into account the optimum deployment of labour and capital. The mere fact of expanding some functions is no guarantee that scale economies will result. VERTICAL INTEGRATION The potential for economies was discussed at 6.18. These economies are related to capacity utilisation, transport costs and so on. They are usually related to more efficient use of resources, and do not really accord with the notion of 2 + 2 = 5.

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CAPACITY UTILISATION A company may have concealed excess capacity, in the sense that its labour force could undertake additional tasks without significant increases in wages or numbers employed, factory space may not be fully utilised, and so on. This potential benefit resembles that of similar SBUs making use of each other’s spare capacity from time to time. JOINT PRODUCTION It has already been discussed how joint production permeates the modern multi-product company. Take the case of two sheep farmers, one of whom produced only wool and the other produced only meat. If they were to merge their operations there would obviously be scope for sheep producing both wool and meat. There are likely to be many instances of much more subtle benefits from joint production in modern companies. INNOVATIVE STIMULUS The mere fact of incorporating another area of activity may spark off new ideas and approaches. While this is an undoubted possibility, it is unlikely to be predictable.

Even a rudimentary examination of the sources of synergy throws up an important point: while synergy may exist it is unlikely to be predictable unless there is a clear resource sharing effect. From the strategy viewpoint there is no basis on which to conclude that a particular course of action would lead to a predictable reduction in costs due to synergy. It is likely that synergy is the outcome of complex interaction effects specific to individual companies, with the contributing factors varying from case to case.

Empirical Evidence
Because of the problems of defining and identifying synergy, it is extremely difficult to generate data which can be used as the basis of statistical analysis. An attempt has been made using the large scale PIMS database, which contained questions relating to synergy potential in the fields of sales, operations, investment and management.12 The approach adopted was to compare the ROI of companies which claimed synergistic potential with the ROI of those which did not. The outcomes demonstrated that while the overall return to synergy was positive, the pattern of returns was mixed. In summary, it was found that: • On average, synergy has a significant effect on ROI, but the magnitude depends on both the specific generating components and the type of business. Among the four components of synergy affecting ROI, the results across all SBUs suggest that on the average sales synergy results in higher ROI. Operating synergy has a mixed pattern; for example, purchases from other SBUs depress ROI, and sales within the company have no effect on ROI. Investment synergy depresses ROI. Management synergy increases ROI. None of the business types analysed benefit from synergy across all four dimensions of synergy.
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This study suggests the impact of synergy varies substantially with circumstances, and that synergy may have negative as well as positive effects. Thus, despite its intuitive appeal, and despite the exhortations of management texts to capitalise on synergy, it cannot be taken for granted that potential synergy will have a positive impact on ROI. Perhaps this is not surprising in view of the difficulty of identifying where synergy effects are likely to be derived. A great deal more information requires to be generated on this issue prior to formulating usable rules for managers. From the strategy viewpoint, managers should confront claims that benefits will accrue from synergy with questions about where the effects are likely to come from, and what evidence exists that they will be significant in this instance. To put the potential benefits from diversification into context, bear in mind that some of the most successful companies in history have stayed with their original product, and everyone knows about them. Coca Cola, Pepsi and McDonald’s are world-wide brands, and these companies have truly ‘stuck to the knitting’.

6.23 Competence
The fact that competition exists among companies at all, and that companies are continually going out of business and being replaced by others, suggests that different companies are relatively good at different things at different times. The aspects of competitive performance which a company is relatively good at are its capabilities, or competencies (both terms are widely used). The notion of distinctive competencies relates to all of the characteristics of a company which give it a competitive edge. But very often it is not so much being particularly good at one thing which generates competitive advantage, but the integration of competencies into a value-generating chain. This is because individual competencies can be imitated and hence do not generate a sustainable competitive advantage, while the benefits of organisational integration are much more difficult to identify and copy. Thus while technique based competence is a necessary condition for competitive advantage it is not a sufficient condition: it is also necessary for individual competencies to be better than those of competitors, and to have the competencies combined in such a way that the resulting organisation cannot be readily imitated. The notion of core competencies arises from addressing the question of what business the company should be in. This question is of importance to companies involved in restructuring, delayering, downsizing or however they choose to describe their attempts to rationalise activities. But it is also important to companies which are concerned with expansion, and feel that they have the capability to grow and thrive, but are perhaps not sure what is the source of their competitive advantage. The idea of core competencies was introduced at 1.4.2. Prahalad and Hamel use the example of two large companies in the evolving information technology business; these were NEC, which, they contended, adopted a core product approach, and GTE which maintained an SBU mentality. Prahalad and Hamel attribute the success of NEC compared with GTE to the approach it adopted. They argue that the collective learning in the organisation must be able to
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• • •

coordinate diverse production skills integrate multiple streams of technologies organise work to deliver value and that this requires

• • •

communication involvement commitment The conventional SBU mentality leads to

under-investment in developing core competencies. This is because the SBUs concentrate on their own effectiveness without taking a wider view of their linkages with the rest of the company. imprisoned resources within the SBU. While the principles of capital budgeting are understood as a method of allocating resources there is no comparable mechanism for allocating human skills that embody core competencies. bounded innovation. Individual SBU managers will pursue only those innovations which relate to their own operations and will ignore, or not recognise the importance of, hybrid opportunities.

The message which comes across is that the organisation of a company into SBUs may be highly efficient, but if SBU autonomy is carried too far it may stand in the way of developing a long term competitive advantage. Furthermore, the capital budgeting approach to resource allocation may be inappropriate because it is not possible to relate future cash flows to core competencies. But this still does not answer the question of what comprises core competence. Because of the difficulty of identifying core competence in a conceptual sense, it is easier to say what it is not: • • • outspending others on R&D shared costs, for example, SBUs sharing excess capacity vertical integration.

In order to identify a core competence there are three tests which can be applied. It • • • gives potential access to a wide array of markets makes a significant contribution to perceived customer benefits of the end product is difficult to imitate.

Core competencies are likely to be relatively rare, and Prahalad and Hamel reckon that there are probably no more than five or six per company. If they are not recognised, companies can unwittingly surrender core competencies when cutting internal investments – cost centres – in favour of outside suppliers. It is therefore essential to distinguish between divesting a business and losing a
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core competence. By its nature, the cost of losing a core competence cannot be calculated in advance, but it may lead to a significant reduction in company performance. Furthermore, a core competence may take a decade or more to build up – so with no core competence a company will find it difficult to enter emerging markets. Prahalad and Hamel contend that the superior performance of NEC over GTE was due to NEC’s conformance with the core competence approach. But with the passage of time their conclusions appear to be a little less secure. While NEC performed better than GTE, during the ten years up to 1996 NEC’s shares lagged behind the average of the stockmarket by 28 per cent; in fact, much of its financial success was due to its semiconductor business which is related to the world shortage in memory chips. Critics have also argued that until 1991 NEC was organised in ten vertically integrated divisions which were controlled by powerful and independent leaders in a manner which was not conducive to synergy. It was only in 1991 that the company was reorganised into three horizontal groups, which was one year after Prahalad and Hamel completed their study. While this perspective does not necessarily invalidate the argument put forward by Prahalad and Hamel the fact that the evidence is so mixed demonstrates just how difficult it is to use the notions of competence as a source of competitive advantage. It follows that core competencies lead to core products, but it may be as difficult to identify a core product as a core competence. For example, a core product might be a component rather than a complete end product; Canon supplies 84 per cent of laser printer ‘engines’ but has only a small percentage of the laser printer market. Thus end product market share may not reflect the underlying core competence. Core competencies can be viewed as the pool of experience, knowledge and systems etc. that exist in the corporation as a whole, and do not reside within any given SBU, which can be deployed to reduce the cost or time required either to create a new strategic asset or expand the stock of an existing one. A technique for using the concept of competencies using categories of competence which can be utilised in diversification, rather than attempting to define competencies precisely, has been developed by Chiesa and Manzini13 . They start by identifying three levels of competence. • Systems, which comprise the goals, culture and organisational design of the company; it is at this level that the opportunities for diversification are identified. Distinctive capabilities, which are the repeatable patterns enabling the coordinated and integrated deployment of knowledge and resources within the company. These can be exploited in the process of diversification by transferring bundles of skills and technologies. Core outputs, which can be exploited for different or new products and services in new markets.

These levels of competence can be decomposed to routines and resources; for example, the distinctive capabilities are essentially routines, while the core inputs are resources. The form of diversification can then be classified depending on whether it is based on routines and resources currently residing within the
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company or routines and resources which have to be acquired or developed. Chiesa and Manzini devised a classification based on routines and resources, and Figure 6.8 is developed from their specification.

Acquired

Routine based

Unrelated

Resources Current Replication based Resource based

Current Routines

Developed

Figure 6.8

Competence based diversification

While the classification is bound to be imprecise in real life, each of these forms of diversification has distinctive characteristics depending on the use which is made of currently available resources and routines within the company. A particular feature of the classification is that it breaks down ‘related’ diversification into three categories, and an examination of these helps to interpret the way in which diversification occurs.

Routine Based Diversification
In this case new resources need to be added to those currently available in the company, but the same routines can be used to manage them. The biggest company in Scotland is ScottishPower which has diversified from being an electricity utility company into water, gas and telecommunications. New resources were required for several of these new products, and the top management claim that the same competences (or routines) are relevant for the management of different types of utility. In particular, the customer can be provided with a package deal covering electricity, gas, water and telecommunications. This is a clear case where the systems and distinctive capabilities provide a strong set of routines which can serve as the basis for diversification.

Resource Based Diversification
This occurs when a company starts producing outputs which utilise existing resources but which require different routines. The British university system is world renowned for the excellence of its education, and Edinburgh Business School (EBS) set about delivering this education in the form of the MBA by distance learning. But the conventional routines which deliver class-based educational outputs were incompatible with distance learning, and it was necessary
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for EBS to develop a totally new set of routines to deliver current educational assets. The existing routines included regular student-teacher contact, periodic graded assignments, student peer group interaction and academic counselling. The new routines included self contained teaching packages, self assessment and the use of sophisticated examinations to measure performance. To change current routines and introduce new routines can involve much more fundamental organisational change than the routine based diversification outlined above.

Replication Based Diversification
This should be the least risky form of diversification because it is based on an expansion rather than a change in the form of the organisation. A major change in the British financial market in the past few years has been the diversification of building societies (which are mutually owned organisations) into providers of the full range of banking services. Previously building societies had specialised in providing mortgages for house purchase, and typically charged relatively low rates to borrowers and paid low (but safe) interest rates to savers. During the period up to the mid 1980s, when they were the only providers of housing finance, there was an imbalance in supply and demand in the market for housing finance and building societies had to ration available funds. When banks started competing in this market the building societies found that a substantial part of their business was lost, and they reacted by diversifying into activities previously undertaken only by banks. The building societies utilised their existing resources, in the form of a network of branches and experienced personnel, and applied the routines which they already had for the management of house finance to a wider range of services. It could well be that replication based diversification is the underlying reason for the success of building societies in the highly competitive personal financial sector. During the mid 1990s several building societies were floated on the stock exchange, and this resulted in large windfall gains for mutual shareholders, reflecting the enormous value added which their replication based diversification had produced.

Unrelated Diversification
The extreme form of unrelated diversification where the only resource shared is the financial structure and control system. There are, of course, numerous examples of companies which have diversified into areas which are unrelated in terms of resources and routines; the Virgin business portfolio outlined in 6.20 is an example. It seems fairly obvious that diversification is particularly risky when the firm has to acquire new types of resources and manage them using routines with which it is unfamiliar. It could be argued that much of the Virgin portfolio is in the ‘entertainment’ business and these businesses are therefore related. But it is worth considering the resources and routines required to produce tourism, cinema, TV and publishing; this would give a different answer on relatedness. It is probable that few boards consider possible diversification strategies using this type of classification, and hence tend to embark on the process without a clear notion of how far from the core activities of the company a particular diversification is taking them.
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Diversification Trajectory
It is possible to introduce a dynamic element and try to plot the trajectory, or direction in the matrix, of a company’s diversification over time. The ScottishPower diversification was described above as being primarily routine based. However, a closer examination of each acquisition reveals an underlying direction. The first acquisition was largely replication based: ManWeb was another electricity company in England. The next step was more routine based: Southern Water was a medium sized water company in the south of England. It then moved towards the unrelated area through the development of a telecommunications business. While this classification is clearly open to alternative interpretations, top management should perhaps look at this trajectory as a warning sign that the company is starting to move away from its core.

6.24 Strategic Architecture
The way in which the company’s collection of unique attributes is combined together is known as strategic architecture. The strategic architecture of the company is derived from the idea of the value chain and the core competencies upon which competitive advantage is based. It is a network of relational contracts within or around the firm. Firms establish relationships with their employees (internal architecture), with their suppliers or customers (external architecture), or among a group of firms engaged in related activities (networks). The value of architecture lies in the capacity of organisations which establish it to create organisational knowledge and routines, to respond flexibly to changing circumstances and to achieve easy and open exchanges of information. Each of these is capable of creating an asset for the firm, i.e. organisational knowledge which is more valuable than the sum of individual knowledge, flexibility and responsiveness which extends to the institution as well as to its members. Strategic architecture is unique to every company; if it were not so, then it could be imitated and would not contribute to sustainable competitive advantage. It has already been discussed how value chain analysis did not fully describe Marks & Spencer because of the linkages between elements in the value chain. The fact that Marks & Spencer found it extremely difficult to recover its competitive advantage suggests that tackling the individual elements in the value chain was not sufficient and that something fundamental had happened to its strategic architecture. While it is difficult to be precise about the components of strategic architecture some insight into it should help the company identify which core competencies to build. The attempt to be explicit about strategic architecture forces organisations to identify and commit to the technical and production linkages across SBUs that have the potential to create a distinct competitive advantage.

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6.25 The Definition of Competitive Advantage

Strategists

Objectives

Who decides to do what

The macro environment

The industry environment

Internal Competitive Analysis and diagnosis position factors
Feedback

Generic strategy alternatives

Strategy variations

Strategy choice

Choice

Resources and structure

Resource allocation

Evaluation and control

Implementation

Competitive advantage can emerge for a number of reasons: pure chance, innovation, first mover advantage, differentiation and so on. The real issue is whether competitive advantage is sustainable. It was discussed at 5.10.1 that with the conditions which prevail under perfect competition there is no such thing as competitive advantage. It is only when the conditions for perfect competition are not met that an opportunity arises to make monopoly profits. The trouble is that these monopoly profits are always under threat. Existing competitors become more efficient, or copy what relatively efficient companies do, and unless there are effective barriers to entry the fact that monopoly profits are being made will act as an incentive for new entrants. Therefore any advantages which the company has must have certain characteristics which make it difficult for other companies to emulate what they do. There are two sources of potentially sustainable competitive advantage: those based on the company’s market position and those based on the internal strengths of the company; the former are termed strategic assets and the latter distinctive capabilities. Strategic assets are in fact the structural barriers to entry discussed at 5.10.3: relative size of the market, sunk costs, control by legislation or agreement, economies of scale and experience effects. Distinctive capabilities take several forms, some of which have already been dealt with. • • Architecture. Reputation: this conveys information to consumers and is particularly important in markets where product quality can only be identified through long term experience. Reputation is difficult and costly to create but can yield significant added value. Innovation: because of the costs and uncertainties associated with innovation firms often fail to gain competitive advantage from it. Unless there is a supportive architecture innovation is unlikely to be managed successfully. Core competencies.
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It emerges clearly from the previous discussions that the only way to achieve sustainable competitive advantage is to do things which competitors cannot imitate, or find too costly to imitate. Two main factors contribute to the protection of competitive advantage: • Causal ambiguity: it is difficult to establish exactly what characteristics of the company contribute to its success. This is the reason why architecture and core competencies are so important: the architecture is unique to the company, and core competencies are difficult to identify. Uncertain imitability: because of the causal ambiguity, potential competitors are faced with uncertainty as to whether their attempt at imitation will work.

It might seem surprising that competitive advantage is so difficult to define. You look around the world and see companies which have been highly profitable for a long time, and it is tempting to attribute this to sustainable competitive advantage. But you have to ask why such companies have lower costs, superior products, better reputations or whatever; this is not easy to answer given that competitors always have an incentive to enter the market in pursuit of these high profits. The fact is that very few firms have been able to generate a long term sustainable competitive advantage. While it is difficult to define sustainable competitive advantage, it is instructive to consider the characteristics of a ‘Cash Cow’ which contribute to competitive advantage, at least in the short term. Table 6.11 shows some of the main elements of competitive advantage in a stable market where a company has a relatively high market share.
Table 6.11
Characteristic High market share No new customers Contracts exist Fixed plant capacity Stable labour force

Competitive advantage in a stable market: cash cow
Advantage Relatively low cost Barriers to entry Low selling costs Full utilisation Top of experience curve Source Asset Asset Architecture Asset Asset

This is not necessarily an exhaustive list of the elements of competitive advantage, but managers should have a clear idea of the foundations of competitive advantage in their own case. If the product has a relatively high market share, but does not appear to have a cost advantage, it is necessary to determine whether this is because of poor resource management or because economies of scale and experience effects are insignificant; analysing the value chain might throw some light on this. The fact that there are no new customers in a stable market is a potential barrier to entry. However, if companies are entering the industry and taking away customers, this suggests that the company is not satisfying customers as well as competitors are. Since contracts exist, and customer loyalty is established, the resources devoted to marketing can be reduced; if selling costs are still high the marginal product of marketing resources may be very low. Since demand is stable, it follows that production can be stabilised and resources geared to the level of demand, resulting in fixed plant capacity.
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If capacity is not fully utilised it may be because of indivisibilities; this can arise because production machinery is available only in certain sizes. Finally, a stable labour force has the potential to progress up the learning curve; this potential will not exist if turnover rates are high. But it may be that some of these advantages are not sustainable in the particular case, or that the company has a mistaken idea of market share because it has calculated its share out of the industry rather than out of the strategic group. Finally, the value chain can be combined with many competitive ideas to assess the company’s strategic capability (see Table 6.12).
Table 6.12
Dimension Primary activities In-bound logistics Operations Bargaining power of suppliers Benchmarking Experience Synergy Economies of scale Out-bound logistics Marketing and sales Distribution channels Market share Bargaining power of buyers Pricing Quality Service Support activities Procurement Technological development Human resource management Management systems Vertical integration Economies of scope Innovation process Culture Leadership Dominant logic Competence Linkages Profitability Architecture Definition of profit Accounting ratios Financial structure Shareholder value Repeat orders

Assessing strategic capability
Issues

The Porter value chain is not the definitive model of value creation, and it needs to be adapted for individual circumstances; for example, it tends to be visualised in terms of manufacturing, and in the service industries categories such as after sales service can be difficult to apply. The important point is to
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identify those factors which affect different components of a particular value chain and how they combine together to generate the end result: profitability and shareholder value.

6.26 Strategic Advantage Profile
In Modules 4 and 5 the various factors relating to the national, international and market environment were combined together into an Environmental Threat and Opportunity Profile. The same approach can be used for the internal characteristics of the company by constructing a profile which summarises where competitive strengths or weaknesses are likely to lie. An attempt can then be made to rank the strengths and weaknesses to generate a balanced view of the company and its potential. An example of a profile is as shown in Table 6.13 for a company which produces electronic engine controls. This is not a definitive profile and there are various ways of setting it up; for example, the components of the value chain could be used as the classification. A detailed analysis of each characteristic requires the application of most of the ideas developed in this and other Modules. A relatively brief discussion of each is presented below. Bear in mind that it may not always be possible to classify a particular characteristic unambiguously as a strength or a weakness.
Table 6.13
Internal area Research Development Production Marketing Finance

Strategic advantage profile
Competitive strength (+) or weakness (−)

+ − + − + − + − + −

Recently invented a temperature control Team has a narrow vision Reduced lead time by 15% Costs are usually overrun by 20% Working at full capacity High labour turnover rate Computerised customer databank Lack of technically qualified salespeople Share price is buoyant Lack of liquidity

RESEARCH STRENGTH: A NEW CONTROL SYSTEM The invention of a new temperature control mechanism could be the beginning of a series of related products and refinements. The company may have a core competence in this area. WEAKNESS: NARROW VISION This technology is notoriously susceptible to competition from similar developments once the basic idea has been launched because it can be imitated. Because of the enthusiasm for the latest invention the whole research department is now devoted to working on it, but the real potential for maintaining a competitive edge may well be to concentrate their efforts elsewhere.

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DEVELOPMENT STRENGTH: QUICKER TO MARKET As a result of improved communications between marketing and development, the engineers saw the benefit to the company from first mover advantage, and identified areas where development compromises can be made which have reduced lead times. This linkage is an aspect of the strategic architecture which affects competitive advantage. WEAKNESS: COST OVERRUNS Unfortunately, it has not been possible to control development costs, and new products which looked initially attractive have turned out to be dubious investments; with the increased pressure to meet tighter deadlines overruns may increase. An early application of sensitivity analysis would have helped to predict the likely scale of these issues and the implications for cash flows. OPERATIONS STRENGTH (OR WEAKNESS): EFFICIENT CAPACITY UTILISATION The company is currently operating at full capacity, with the implication that a system exists which can control costs. However, if the company is intending to attempt to increase market share, or launch new products, the fact that new capacity will have to be acquired could lead to delays and lack of responsiveness to changes in the market. WEAKNESS: HIGH TURNOVER The relatively high turnover rate means that the costs of hiring are higher than they otherwise would be, and the labour force is on average not as far up the learning curve as it would be if the labour force were more stable. In fact, it is partly because of the full capacity operation that the turnover rate is so high. MARKETING STRENGTH: VAST DATABASE Customer and potential customer details have been entered into a database, making it possible to target specific segments and allocate marketing effort more effectively. WEAKNESS: SHORTAGE OF SKILLS Customers are making increasingly sophisticated technological demands on salespeople who are often performing the role of consultant; highly qualified salespeople are difficult to recruit and command very high salaries. FINANCE STRENGTH: HIGH SHARE PRICE In common with other growing high technology companies the share price has been steadily increasing over the past three years, making the company virtually immune from take-over attempts. WEAKNESS: LACK OF CASH Previous development cost overruns and the potential costs of the new control system are likely to lead to a serious cash shortage next year.

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On the face of it the company is full of new ideas, is dynamic and growing, and has an increasing market value; it looks set to develop further on the basis of its new product line. However, the weaknesses are formidable: the likely reliance on one product line in a highly competitive area, the unpredictable development costs, the problems of increasing capacity, the lack of marketing resources and the cash constraint could combine to render the company illiquid with limited prospects of increasing sales revenues significantly in the short term.

Case 1: Analysing Company Accounts
The accounts in Table 6.14 refer to two separate years of AcmeSpend operations reflecting the large investment undertaken to tool up for a new production line. You are going to have to analyse the company using only these numbers. • • • Use financial ratios to compare company performance in the two years paying particular attention to the appropriate measure of profitability. Can it be deduced that the investment programme was responsible for any increase in profitability? What strategic implications can be drawn from the analysis?

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Table 6.14
YEAR 1 OPERATING ACCOUNT Sales revenue 8 075 Cost of goods sold 4 890 Gross profit 3 185 Corporate HQ Factory costs Hire and fire New product development Total overhead Operating surplus CASH FLOW OUTLAY Material purchase Short-term loan interest Long-term loan interest Wage cost Line cost Product development Product marketing Total overhead Total outlay 500 200 189 1 000 1 889 1 296 YEAR 2 OPERATING ACCOUNT Sales revenue 11 466 Cost of goods sold 5 405 Gross profit 6 061 Corporate HQ Factory costs Hire and fire New product development Total overhead Operating surplus CASH FLOW OUTLAY Material purchase Short-term loan interest Long-term loan interest Wage cost Line cost Product development Product marketing Total overhead Total outlay 1 000 500 70 700 2 270 3 791 0 INCOME 1 426 0 1 320 1 690 1 520 200 900 2 270 9 326 Interest on assets 60

INCOME 1 743 260 220 2 030 2 579 500 750 1 889 9 970 Interest on assets 61

Sales revenue Total income Net cash flow

8 075 8 136 −1 834

Sales revenue Total income Net cash flow

11 467 11 527 2 201

BALANCE SHEET FIXED ASSETS Factory Plant & equipment TOTAL FIXED ASSETS CURRENT ASSETS Raw materials Final goods Cash TOTAL CURRENT ASSETS TOTAL ASSETS OWNERS EQUITY DEBT Short term Long term TOTAL DEBT TOTAL LIABILITIES

5 000 7 000 12 000 2 000 885 1 000 3 885 15 885 11 885 2 000 2 000 4 000 15 885

BALANCE SHEET FIXED ASSETS Factory 9 000 Plant & equipment 14 000 TOTAL FIXED ASSETS CURRENT ASSETS Raw materials 1 000 Final goods 448 Cash 1 000 TOTAL CURRENT ASSETS TOTAL ASSETS OWNERS EQUITY DEBT Short term 0 Long term 12 000 TOTAL DEBT TOTAL LIABILITIES

23 000

2 448 25 448 13 448

12 000 25 448

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Case 2: Analysing Company Information
The following information on a hypothetical company comprises: • • The annual accounts for the company including profit and loss account, cash flow position and the balance sheet (Table 6.15). Marketing and production information on the three products and the three development products, together with a set of accounts for each (Tables 6.16 and 6.17). The following discussion took place on the day these figures became available. CEO These results are very promising and show a good return on our assets. Our investment programme two years ago is bearing fruit: we upgraded the Box, launched the Hinge and increased our research and development so that we now have three products in the development stage all of which we shall be able to launch in the next couple of years. ACCOUNTANT I actually have some reservations about our resource allocation. The Hinge is making very little profit and I think we should get rid of it; the Pin is going to have a very low profit margin and it is not worth spending any more developing it. I am also a bit worried about the performance of the Lid. MARKETING MANAGER You have to bear in mind that the Hinge was launched into a highly competitive growing market only two years ago, and so we have to stick with it. The Lid was unexpectedly subjected to increased price competition when AceComponents entered the market a year ago. On the other hand the Box was our original staple product and continues to be the main source of our cash flows; but Production seems to have let us down and we are not satisfying all orders. We need to use these cash flows to support the rest of our portfolio. I cannot agree with the Accountant that we should abandon the Pin because we have already spent $1.2 million developing it. PRODUCTION MANAGER I am having a terrible time. Since we upgraded the Box I have tried to introduce new working practices but have lost a lot of people. We are also producing far too many Hinges. Your job is to analyse the company information in the light of this discussion and build up a picture of its current and potential profitability and of how efficiently it has been allocating resources, and to arrive at conclusions about what it should do in the future. The issues to address are as follows. 1 2
Strategic Planning

Review the company as a whole in terms of its profitability and asset position. Analyse the three products and make recommendations for each.
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3 4

Analyse the three development products and assess their potential profitability. Make recommendations for future expenditure on each product. Set up a strategic advantage profile.
Acme Plc
Operating Account ($000) SALES REVENUE 14 304 4 220

Table 6.15

COST OF GOODS SOLD

10 084 GROSS PROFIT

Operating Account: Overheads and Operating Surplus ($000) Factory rents Owned factory Overheads Hiring and redundancy Cost Research expenditure Development Expenditure Company marketing TOTAL OVERHEAD 200 100 300 750 1 300 800 3 450 OPERATING SURPLUS Cash Flow ($000) OUTLAY Factory purchase Material purchase Loan interest Wage cost Line cost Product marketing Total overhead Total outlay 2 500 480 3 680 1 890 1 500 3 450 13 500 Sales revenue Total income Net cash flow Balance Sheet ($000) FIXED ASSETS Factory Plant TOTAL FIXED ASSETS CURRENT ASSETS Raw materials Finished goods Cash TOTAL CURRENT ASSETS TOTAL ASSETS OWNERS’ EQUITY DEBT Loan TOTAL DEBT TOTAL LIABILITIES 4 000 4 000 9 985 5 985 1 000 2 985 3 000 6 985 9 985 2 000 1 000 3 000 14 304 16 314 2 814 Interest on assets 210 INCOME Factory sale 1 800 770

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Table 6.16
Composition of demand Orders

Report on products
Box Lid Hinge Composition of supply 4 590 100 4 690 6 120 63 6 183 3 840 63 3 903 Output Inventory (start year) TOTAL SUPPLY Distribution of supply Warranty replacements Sales to backlog Sales to orders 100 0 4 450 17.8 0 63 0 6 120 12.0 817 63 0 3 840 8.0 2 877 3 550 1 000 4 550 5 500 1 500 7 050 5 280 1 500 6 780 Box Lid Hinge

Warranty demand TOTAL DEMAND

Working time (%) Labour attrition rate (%) Price ($/unit) Competing price ($/unit) Product marketing Unit cost ($/ unit) Cost of goods sold

130 11

120 10

100 4

Market share (%) Inventory (end year)

1 200 1 200 300 480 2 183

900 900 700 759 4 693

900 1 400 500 822 3 208 SALES REVENUE ($000) GROSS PROFIT ($000) 5 340 3 157 5 508 815 3 456 248

Table 6.17
Predictions:

R & D report
Pin Holder 5 35 000 800 700 9.0 6 40 000 1 000 750 10.0 Ratchet 7 50 000 1 500 800 14.0 Time until launch (years) 1 2 1 Estimated market peak Warranty returns % 70 000 3 60 000 4 60 000 5 Pin Holder Ratchet

Product life (years) Market at launch Competing price ($/unit) Production cost ($/unit) Market share (%)

Development expenditure: This year To date 500 1 200 500 1 400 300 1 500

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Case 3: Lufthansa Has a Rough Landing (1993)
The well known German airline fell on hard times after a period of expansion in the 1980s, and Table 6.18 shows how profits declined from DM260 million in 1989 to a loss of DM301 million by 1991.
Table 6.18 Lufthansa’s record
1987 Turnover (DMm) Pre-tax profit (DMm) Employees Seat kilometres offered (m) Seat kilometres sold (m) Seat load factor (%) Number of aircraft 10 961 207 47 150 57 000 40 000 70 151 1988 11 845 241 49 056 61 700 42 500 69 155 1989 13 055 260 51 942 65 000 44 900 69 197 1990 14 447 142 57 567 75 500 50 600 67 220 1991 16 101

−301
61 791 81 700 52 300 64 275

Capital spending in the three years up to 1991 was DM8 billion. In 1992 Lufthansa intended to take 26 aircraft out of service, and was looking for a partner to help develop the US market. The total market for air travel during the period was as shown in Table 6.19.
Table 6.19 Total air travel
1987 Passenger kilometres flown (billions) % change from previous year 1 600 10 1988 1 700 6.3 1989 1 800 5.9 1990 1 900 5.6 1991 1 800

−5.3

Lufthansa was not alone in making losses in 1991. Four major airlines made bigger losses, the largest loss for the year being 30 per cent higher than Lufthansa’s. The world’s scheduled airlines in total made a loss of 0.5 per cent on revenues in 1991, compared with a loss of 0.8 per cent on revenues in 1990.
Table 6.20
Rank 1 2 3 4 5 6 7 8 9 10

Airlines ranked by km flown
Airline American United Delta Northwest Continental Million km 132 500 132 400 108 400 86 800 66 700 65 900 54 900 54 700 53 400 52 300

British Airways USAir Japan Air Lines Air France Lufthansa

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Lufthansa was the tenth largest airline in the world by 1991 in terms of the number of passenger kilometres travelled (excluding Aeroflot). However, it is small (40 per cent) in comparison with the large US carriers American and United (Table 6.20).

Question
Analyse the Lufthansa strategy, assess why it is making losses, and suggest what it might do in the future.

Case 4: General Motors: the Story of an Empire (1998)
By 1998 General Motors was still one of the biggest companies in the world, with over 600 000 employees and sales of over $160 billion. The company had an important impact on management and industrial organisation during the twentieth century, primarily because of the foresight of its founder, Alfred Sloan. During the 1920s Sloan was the first to introduce a divisional type structure whereby the company was decentralised and the individual parts were subjected to detailed control systems. GM was also vertically integrated, making most of the components which went into its cars. The company was the model for the management theorist Peter Drucker who did much of the pioneering work in management theory during the 1940s. But for the past decade industry analysts have criticised GM. The company’s performance on the stock exchange suggests that it has lost its competitive edge. Until the mid 1980s GM’s share price moved broadly in line with the market, but since then it has fallen increasingly far behind the Dow Jones Index, and is now about 70% below. Analysts claim that the total value of GM’s shares can in fact be accounted for by its parts company (Delphi), its financing company (GMAC) and by its 75% stake in Hughes Electronics. This suggests that GM’s industrial operation is itself worth very little to shareholders. How could such a mighty industrial enterprise reach such a state? One of the original strengths of GM, its divisional structure, has resulted in the duplication of many functions, such as marketing and development, with the result that GM’s competitive advantage has been undermined over the years as world trade in cars has become increasingly open. In fact, GM has come in for a good deal of criticism over the years, for example its labour relations could be greatly improved: in the four years to 1998 GM suffered about 12 major strikes, while Ford had one; during 1998 it was claimed that one strike alone cost GM $2 billion. It has been relatively slow to introduce new products and it has been slow to react to changing market circumstances, with executives seemingly relying on the sheer size of the organisation to shelter behind. One objective measure of car company performance is the time it takes to produce a car, as shown in Figure 6.9. To some extent these differences can be accounted for by the type of product. For example, a substantial part of GM’s output is for luxury cars. However, the fact that GM’s labour input per car is over 10% greater than Ford’s is clearly a problem.
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4 3 2 1 0 Nissan Honda Toyota Ford Chrysler GM

Figure 6.9

Man days per car (US)

Source: The Harbour Report.

How has GM reacted?
Obviously GM’s management has been aware of the problems confronting the company, and various actions have been undertaken. A major restructuring was undertaken in 1984 when GM split its American operations into two parts: the high quality Buick-Oldsmobile-Cadillac and Chevrolet-Pontiac. Subsequent action was piecemeal until in 1998 the chairman, Jack Smith, embarked on several initiatives including: • selling off its parts company, Delphi. It had been observed that GM had probably not been using its buyer power effectively by being vertically integrated. centralising sales, service and marketing systems. While this might save up to $300 million per year, it would also mean that the divisional structure based on car types would cease to exist; for example, the notion that Cadillac was fundamentally different from Pontiac would probably disappear, and they would be marketed as GM cars. The number of car platforms would be cut significantly from the current 16. constructing a different type of car plant, which would be smaller than the standard GM type and would focus on the construction of modules assembled by suppliers. consolidating worldwide operations into a single global unit. This would not only cut out layers of management, but would enable the company to change designs and rationalise production. reducing the number of showrooms. It was reckoned that GM has too many car showrooms, and it has been estimated that one fifth of costs are incurred after the car leaves the factory. relating managers more closely to their responsibilities. The layered management structure means that responsibilities are often not clearly defined; attempts to overcome this include appointing engineers to oversee individual products for a lengthy period – perhaps up to ten years. One criticism which has been levelled at GM’s top executives is that their background is in finance, and do not have the insight of the heads of companies such as Volkswagen and Ford, whose executives came up through car production.
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Not everyone is convinced that these changes have a sound business rationale, but are the outcome of senior executives jockeying for position. For example, the marketing changes could be seen as a victory for Ron Zarrella, the head of marketing; the globalisation initiative as a victory for Rick Wagoner, who is due to succeed Jack Smith, over Lou Hughes, head of international operations. An important question is not whether GM is able to restructure, but whether its efforts will bring it up with its competitors. Volkswagen is Europe’s largest car manufacturer, and it has already reduced the number of platforms to four, while even seemingly totally different cars share many components. GM’s great rival Ford initiated a global integration programme in 1994 which is thought to have saved Ford $3 billion per year. But it is widely recognised that the Ford programme was successful only because of the commitment of its chief executive, Scotsman Alex Trotman. Many doubt whether GM’s bureaucratic structure can deliver such fundamental changes. Another major problem is the confrontational style of management, which has led to the strikes in recent years; in October 1998 GM announced that it would be shedding 25 000 employees, of whom 20 000 would be in the US; it was estimated that some 10 000 of the US jobs would come from middle management. The prospects for a successful change programme do not seem too bright. Perhaps the greatest challenge facing GM is to ensure that it continues to make cars which people will wish to buy in preference to others. In the face of increased competition, and the high standards of reliability common in cars nowadays, this is becoming difficult. A good example is the experience of the Cadillac model, which has a worldwide reputation as a luxury car. GM used to sell 300 000 Cadillacs each year in America, but this has slumped to 200 000 in the past decade; during the 1980s Cadillac was overtaken by Mercedes, BMW and Toyota (Lexus) which, for one thing, highlighted the Cadillac’s poor reliability. During the mid 1980s Cadillac responded by building smaller cars, many of which were in fact indistinguishable from the humbler Buick range. Lincoln is now America’s top selling luxury brand, it has consolidated its position by being one of the first in the market with a sport-utility vehicle. Cadillac now faces the problem of producing cars which appeal to new, and younger, customers as well as its existing older customers. This will not be easy.

Question
Discuss GM’s reaction to the changing competitive environment using strategic models.

References
1 Cooper, R. and Kaplan, R.S. (1987) ‘How cost accounting systematically distorts product costs’, in Bruns, W.J. and Kaplan, R.S. (eds) Accounting and Management: Field Study Perspectives, HBR Press. Kaplan, R.S. (1984) ‘Yesterday’s accounting undermines production’, Harvard Business Review, July–August.

2

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3 4 5 6 7 8 9 10 11 12 13

Kaplan, R.S. (1988) ‘One cost system isn’t enough’, Harvard Business Review, January– February. Smith, T. (1996) Accounting for Growth, Random House (second edition). D’Aveni, R. (1994) Hypercompetition: Managing the Dynamics of Strategic Manoeuvering, New York: Free Press. Mansfield, E. et al. (1977) ‘Social and private rates of return from industrial innovations’, Quarterly Journal of Economics, Vol. 19. Handy, C. (1993) Understanding Organisations, 4th edition, Penguin. Porter, M.E. (1985) Competitive Advantage: Creating and Sustaining Superior Performance. New York: Free Press. Jensen, M.C. and Ruback, R.S. (1983) ‘The market for corporate control: the scientific evidence’, Journal of Financial Economics 11, pp. 5–50. Ansoff, H.I. (1968) Corporate Strategy, Harmondsworth: Penguin. Fuller, R.B. (1975) Synergetics, Macmillan. Mahajan, V. and Wind, Y. (1988) ‘Business synergy does not always pay off’, Long Range Planning, Vol. 2, No. 1. Chiesa, V. and Manzini, R. (1997) ‘Competence Based Diversification’, Long Range Planning, Vol 30, No 2, pp. 209–217.

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Module 7

Making Choices among Strategies
Contents
7.1 7.2 7.3 7.3.1 7.3.2 7.3.3 7.3.4 7.4 7.4.1 7.4.2 7.4.3 7.4.4 7.4.5 7.4.6 7.5 7.5.1 7.5.2 7.5.3 7.5.4 7.5.5 7.5.6 7.5.7 A Structure for Rational Choice Strengths, Weaknesses, Opportunities and Threats Generic Strategies Corporate Level Generic Options Business Level Generic Options Decision Maker Generic Strategies Generic Strategies and Company Performance Identifying Strategic Variations Related and Unrelated Options Vertical Integration Acquisitions Alliances and Joint Ventures International Expansion From Generics to Options Strategy Choice Shareholder Wealth Performance Gaps Corporate Management SBU Management Risk and Uncertainty Analysis Managerial Perceptions From SWOT to Generics 7/2 7/3 7/5 7/5 7/11 7/14 7/16 7/17 7/17 7/19 7/19 7/23 7/23 7/25 7/26 7/27 7/30 7/30 7/33 7/34 7/38 7/42 7/43 7/43 7/43 7/43 7/44 7/44 7/45 7/48

Case 1: Revisit Salmon Farming Case 2: Revisit Lymeswold Case 3: Revisit a Prestigious Price War Case 4: Revisit General Motors Case 5: The Rise and Fall of Amstrad (1993) Case 6: What Is a Jaguar Worth? (1992) Case 7: Good Morning Television Has a Bad Day (1993) Case 8: The Rise and Fall of Brands (1996)

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Learning Objectives
• • • • • To To To To To develop a structure for making rational choices. apply the SWOT framework. identify generic strategies. analyse strategic options. identify the role of different interest groups in the choice process.

Strategists

Objectives

Who decides to do what

The macro environment

The industry environment

Internal factors

Competitive Analysis and diagnosis position
Feedback

Generic strategy alternatives

Strategy variations

Strategy choice

Choice

Resources and structure

Resource allocation

Evaluation and control

Implementation

7.1

A Structure for Rational Choice
The objective of an analysis of choice is to investigate the structures within which choices are made among competing alternatives. Inspection of real life cases reveals that in many instances no choice was actually made, and that the company was simply carried along by the force of events, perhaps ending up with a dominant market position as the result of good fortune, which it then capitalised on. In other instances choices were made, but on such a nonstructured basis that no general lessons can be drawn from the experience. The problem of drawing lessons from the experience of companies is compounded by the fact that different perspectives on the same choice can come to the conclusion either that the outcome was fortuitous or that it was the result of a structured choice approach. This is partly due to the difficulty of determining after the event what actually happened during the choice-making process; managers are as prone as anyone else to justifying their actions. There is a tendency to superimpose a structure on a series of events which, at the time they took place, were unstructured. Probably emergent strategies are the norm, but do not tend to be recognised as such. By this stage of the strategy process a great deal of analysis has been carried out. First, the company objectives have been scrutinised, and a view on the desired state of the company formulated. Second, the macroeconomic environment has been evaluated to determine the likely course of business conditions. Third, the markets within which the company operates, or intends to operate, have been analysed and an environmental threat and opportunity profile

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constructed. Fourth, the company itself has been examined, and a strategic advantage profile drawn up. However, no matter how detailed and sophisticated the analysis has been, it has not generated an automatic course of action; what the analysis will have done is to identify many relevant factors and estimate their relative importance, thus providing the basis on which an informed choice can be made.
Evolutionary extensions of the satisficing theme suggest that, by trial and error, some management teams may succeed in developing sets of strategic themes and tactical routines that match the current environment rather well. Other teams, which experiment with different decision rules, may fail to generate adequate returns. If the business environment changes, we should not presume that a formerly successful organisation will come up with – we might say mutate – a new set of procedures that will serve it so well. In a sense, then, we may liken the firm’s decision rules to genes, with the environment selecting out some corporate genes and allowing others to survive, not because they are the fittest but because there is sufficient space for them in the competitive market.1

7.2

Strengths, Weaknesses, Opportunities and Threats
The profiles of environmental threats and opportunities, and company strengths and weaknesses, can be combined together to identify where matches occur between the two. This is known as an analysis of strengths, weaknesses, opportunities and threats (SWOT). For example, a threat might have been identified as a result of the entry of foreign competition due to the relaxation of trade barriers; corresponding to this might be a weakness in company marketing, where the sales force has recently been depleted and the distribution system is already having difficulty in delivering orders on time. SWOT analysis is an essential first step in assessing what the company needs to do to protect its current market position, and in identifying potential strategic thrusts which can capitalise on company strengths and market opportunities. The framework for matching up environmental and company characteristics will depend on the individual case; the SAP described at 6.26 can be used as a starting point. Assume that an opportunity (from the ETOP) has been identified in the form of a government decision to reduce investment in railways and increase investment in the road network; one of the main markets for the new engine control is in very large trucks. A threat is the relaxation of trade barriers. This sector of the market will therefore start to grow faster in the near future. Which of the strengths and weaknesses shown in Table 7.1 matches with the opportunity? The company has a strength in the potential to be among the first on the market with an improved product, based on the new temperature control and the recent reduction in development lead times. However, production is a weakness in that capacity will require to be increased and labour productivity improved. On the marketing side, while the ability to identify potential customers is a strength, the shortage of personnel actually to do the selling is a weakness. Company finance comprises a potential weakness: development costs are likely to be high (due to overruns), investment will be required in additional productive

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Table 7.1
Internal area Research Development Production Marketing Finance

Strategic advantage profile
Competitive strength (+) or weakness (−)

+ − + − + − + − + −

Recently invented a temperature control Team has a narrow vision Reduced lead time by 15% Costs are usually overrun by 20% Working at full capacity High labour turnover rate Computerised customer databank Lack of technically qualified salespeople Share price is buoyant Lack of liquidity

capacity, and a training programme for technical salespeople needs to be set up. The company will be financially stretched because these expenditures will be undertaken before any additional revenue is received from sales. The company’s ability to pursue the opportunity is constrained by production, marketing and financial weaknesses, and it is in the light of this that the decision will be made on how to proceed with this product, or whether to abandon it and do something else entirely. The analysis can be set out in a schematic form to provide an overview of how the factors match up as shown in Table 7.2.
Table 7.2
Strengths Potentially first in market Marketing database

SWOT analysis
Weaknesses Full capacity Low labour productivity Lack of salespeople Cash flow

Opportunities Truck market expansion

Threats Foreign competition

It becomes obvious that the company’s strengths lie in what it might be able to do, and as a result these strengths do not match very well with the opportunity of expanding into the truck market. The weaknesses relate to the company’s ability to bring the new product to the market, capture the new segment, and match aggressive foreign competition. At this point it is worth stressing the point that a meaningful SWOT analysis is the outcome of a great deal of painstaking effort: the Environmental Threats and Opportunities Profile is constructed from the application of a vast array of concepts to the economy and to the market; the Strategic Advantage Profile is built up from a similarly large number of ideas applied to the internal operation of the organisation. It is not always a simple matter to categorise factors and recognise opportunities and threats for what they are; for example, low margins may result from attempting to develop a star, while high margins may invite new entrants. That is why it is so important to understand the core disciplines and be able to think through the implications of market information.
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7.3

Generic Strategies
Who decides to do what

Strategists

Objectives

The macro environment

The industry environment

Internal factors

Competitive Analysis and diagnosis position
Feedback

Generic strategy alternatives

Strategy variations

Strategy choice

Choice

Resources and structure

Resource allocation

Evaluation and control

Implementation

A dictionary definition of ‘generic’ is ‘applicable to any member of a group or class’. Generic strategies are therefore associated with broad classifications of strategy; in military terms this would involve being an aggressor or defender, or perhaps being neutral. The business generic strategy options are usually represented differently at corporate and business levels. At the corporate level the generic options are related to the scope of the company and the directions it will pursue, for example the development of new products or the acquisition of companies to increase the product portfolio. At the business level, generic choice relates to competing in the business area which the company presently occupies. These generic strategies are the basis on which the company attempts to build its competitive advantage; without a clear idea of the generic strategy which it is pursuing, a company is likely to end up with no identifiable strategy with the result that it will lack direction and strategic intent. 7.3.1

Corporate Level Generic Options
Reverting to the military analogy, the ultimate generic option is whether to go to war or not; having gone to war generic options include whether to attack or defend, to wage war in one theatre or several and when to allocate resources to land, air or sea forces. The generic choice determines the framework within which subsequent actions will be undertaken. In the case of business, generic strategies are concerned with issues such as what business the company is in, how diversified it should be and whether it should aim for horizontal and/or vertical integration; within the framework of these choices it is useful to think in terms of stability, expansion, retrenchment, or combinations. At first sight, these strategy options might appear to be nothing more than common sense, in that there is nothing else a company can do but stay the same, get smaller, expand, or change the mix of its activities. However, in strategy terms the choice should have been determined by the outcome of comprehensive analyses of the economic environment, the market and the company itself, and managers ought to be explicit about which generic alternative they are pursuing and why.

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The definition of the generic options of stability, expansion and retrenchment raises a number of problems because there are so many dimensions of company performance. By and large, these ideas relate to the scale and scope of a company’s operations. For example, for a single product company expansion can be defined as attempting to increase market share, and hence total revenue; a more ambiguous case would be the attempt to increase total revenue by increasing the quality and the price of the product, which could lead to a lower volume of output and hence lower market share. For a multiple product company expansion relates to the revenues from the individual products, together with the introduction of new products. It is important to be clear about what the strategy options are NOT. For example, an expansion strategy cannot be defined as increasing profitability, which can be the outcome of the efficiency with which the company has achieved its objectives. Increased profitability could be achieved by contracting the company’s activities, and therefore could be associated with a retrenchment generic strategy. The generic strategy is one of the means by which the end of profitability may be achieved.

Stability
The initial inclination is to regard this as being ‘no change’; however, the fact that managers do not perceive objectives in terms of increasing markets, introducing new products or acquiring new businesses, does not mean that the company is in a steady state. An analysis of external and internal factors may have revealed one or more of the following. RELATIVELY SMALL PERFORMANCE GAP The matching of the strategic advantage profile to the environmental threat and opportunity profile may have revealed that desired and actual states would converge without any significant change to the company’s policies. MARKETS ARE MATURE Portfolio analysis may have revealed that current markets are no longer in their growth stage, and that further expansion of market share is unlikely to pay dividends. Analysis of product life cycles may have revealed that current products have relatively long life cycles, and that in the meantime there is no need to invest in new products to take their place. INTERNAL WEAKNESSES An analysis of the efficiency with which the company allocates its resources may have revealed that production processes are based on out of date equipment, that inventories could be reduced, that inadequate training is being undertaken and that labour productivity is falling. As a result unit costs are higher than they need be, and if the company were to embark on expansion it would rapidly find itself at a cost disadvantage compared with its competitors. The stability strategy is therefore primarily concerned with increasing efficiency, investment in labour-saving capital items, the introduction of just-in-time procedures, and other actions which will bring costs under control.

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UNSTABLE FINANCIAL HISTORY The previous record of the company may have been characterised by marked swings in profitability and dividends paid to shareholders. As a result managers may feel that the share price is not a proper reflection of the true value of the company, and that there is a danger of hostile take-over. One way to generate a stable track record may be to make no significant changes in company objectives and operations. POOR ECONOMIC PROSPECTS Analysis of the national and international economy may have revealed that the business cycle is on the downturn, that markets are likely to decrease, and the company should prepare itself for increased competitive pressure as competitors attempt to maintain their competitive position. COMPETITIVE THREAT The elimination of trade barriers may have opened up the prospect of increased competition from foreign companies who are known to be more efficient at marketing and producing quality goods on time. Managers may consider that the company has to marshal its resources in order to meet this perceived threat, rather than dissipating them on relatively unknown prospects. PERCEIVED COSTS OF CHANGE Expansion is usually associated with change, and individuals are often averse to change in organisations. One way of attempting to avoid the painful effects of change is to pursue a strategy of stability. The trouble is that stability does not guarantee a static organisation, and many companies have found that they must initiate significant changes merely to maintain their market position. The generic strategy may be pursued for the wrong reason; the longer such a philosophy survives in a company the more difficult it will become to introduce the changes which will ultimately be forced on it. MANAGERS AVERSE TO RISK Managers may feel that the prospect of loss greatly outweighs potential gains from expansion. If the company is already perceived as being successful, there is a decided attraction to carrying on with what has been done in the past rather than embarking on new enterprises. Even to maintain their market position is an achievement for many companies in a rapidly changing competitive environment. In fact, at any one time the great majority of companies are likely to be pursuing a generic strategy of stability. This might well be accompanied by substantial internal changes which are necessary in order to maintain market position. The list of reasons above suggests that stability is not necessarily a trivial option.

Expansion
It is to be expected that a generic strategy may be forced on a company by the course of events: for example, portfolio analysis may have revealed that markets
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for most products are still in the growth stage and that it is necessary to expand in order to maintain market shares. There are several reasons why a company may actively pursue a strategy of generic expansion. DIVERSIFYING RISK It may be felt that an increased portfolio of products reduces the risk for the company as a whole. Whether diversification actually does reduce the risks facing the company is another matter; some of the issues relating to diversification of risk were discussed at 6.20. Whatever the rights and wrongs of this method of dealing with risk, there is no doubt that the desire to diversify risk gives management a strong motivation to expand. SEARCHING FOR COMPETENCIES A line of business may fit with the perceived competencies of the company, and although the expansion does not meet normal investment criteria, in the eyes of corporate management it may contribute to the company’s long run competitive advantage. ECONOMIES OF SCALE Investigation of the cost structure of the company and its competitors may suggest that there are significant economies of scale to be exploited. In a mature industry the additional sales can only be achieved by increasing market share at the expense of competitors; in a growing market it is necessary to grow faster than competitors if a dominant market position is to be achieved. EXPERIENCE EFFECTS This is similar to the economies of scale case, with the qualification that the potential advantage is only available for a limited period. BUILDING ADVANCE CAPACITY It would not be surprising to find many companies following an expansion strategy when general economic conditions are improving. However, by the time that economic conditions start to improve it may be too late to expand, because of shortages of capital and labour. Some companies take the opportunity of a recession to expand their operations in order to be ready for the next upswing. MANAGERIAL MOTIVATION In some companies the remuneration of top management is related to total revenue rather than profitability. This naturally leads to a preference for expansion over stability. Managers who are not rewarded on this basis may still regard their personal long term success as largely dependent on being responsible for a growing company. It is expanding companies which catch the headlines, and the managers associated with expansion benefit from the aura of success. Not all of the factors acting in favour of an expansionist strategy are directly related to increasing company value. There is a widespread feeling among managers that if a company is growing it must be basically healthy, but a
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company which is pursuing an expansion strategy for the wrong reasons could be weakening its long term competitive potential.

Retrenchment
Under this heading come the notions downsizing, delayering and restructuring. These initiatives are undertaken in the quest for a more efficient organisation either in terms of shedding businesses which are not seen as part of the company’s core competence or in terms of enhancing labour productivity. This is the strategy which many managers often do not want to be associated with, because it implies that mistakes have been made in the past. This is why many companies find it necessary to appoint a new CEO when retrenchment is necessary, or to use independent consultants to advise on retrenchment policies. But if the notion of retrenchment can be divorced from that of profitability, and the emotive objections overcome, managers can see that retrenchment is not necessarily brought about by incompetence and can be a perfectly logical strategy. PRODUCT LIFE CYCLES Some products may be nearing the end of their life cycles and there are no replacements available to which the company can divert resources. Managers may decide it is better to wait and see whether new products can be developed in the areas in which the company has expertise, rather than diversifying into areas of high uncertainty. DOGS It is not unknown for companies which are ‘cash rich’ to diversify into numerous areas in which they have little experience. Subsequently, it may transpire that some of the acquisitions are ‘dogs’, using the BCG definition. Since such products are almost impossible to salvage, because the costs of increasing their competitive advantage far outweigh the potential returns, the appropriate strategy is to divest. OVEREXTENDED MARKETS Internal analysis may have revealed that, at the margin, the company is losing money on some customers. This can arise from maintaining a production, sales and distribution network which incurs very high marginal costs, while the revenue from many customers is relatively low due to competitive pressures. In economic terms, the marginal cost exceeds the marginal revenue, and the remedy is to cut back on the scale of operations. Companies are often able to identify customers that it is not worth having, because, for example, the delivery cost may be high, because extremely favourable terms had to be offered to get the order in the first place, or because resources were already working at full capacity and filling the order caused disruption. Retrenchment will increase profitability because losses at the margin are avoided. Retrenchment can therefore be associated with rationalisation and a drive to greater efficiency. These positive reasons need to be distinguished from retrenchment caused by a series of poor decisions which managers attempt to counter by selling productive assets, or imposing economies on the organisation which provide no more than a temporary solution to cash flow problems.
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Combination
There are two ways of looking at combination strategies. First, they occur when a multiple SBU company is pursuing different generic strategies in relation to individual SBUs, and it is impossible to characterise the generic strategy for the company as a whole as stability, expansion or retrenchment. Second, the company can pursue a different generic policy sequentially, so that the current generic policy can only be interpreted in the context of the grand overall strategy design. OPPORTUNITY COST It was discussed at 6.1 that the real cost of a course of action is the best alternative forgone. Analysis of markets may reveal that some resources could be put to better use and that they should be redeployed. However, in order to release these resources it may be necessary to reduce some current activities, and this involves a retrenchment strategy. The period of retrenchment may be protracted, depending on the circumstances. The overall generic strategy may be stability or expansion, depending on the markets into which the company is diverting resources. PRODUCT PORTFOLIO Because of the unpredictability of product successes and failures, and the objective of maintaining a portfolio as outlined at 5.7, the company may have no alternative but to go through periods of expansion and retrenchment. Furthermore, at any time the multiple SBU company is likely to find that some SBUs are expanding and others are in retrenchment simply because of their individual product portfolios. If a sufficiently long term view is taken, it could be argued that all companies pursue a combination generic strategy, because that is the way things are likely to turn out. However, it is revealing to consider the combination option explicitly because it introduces a time dimension into the generic approach.

Assessing Generic Strategies
It is clear that different generic strategies are appropriate in different circumstances. The influences outlined above will partly determine which generic strategy a company will follow in the pursuit of its objectives. The question naturally arises of what criteria ought to be employed in deciding on which generic strategy to pursue, given that in any circumstance there will be influences acting in different directions. A large part of the answer lies at 3.12.6 under ‘Shareholder Wealth’, from which the question is derived: ‘Which generic strategy will add most value to the company?’ This focuses attention on the ultimate objective of the company rather than on the means by which the objective might be achieved. It is illogical to opt for expansion if it is likely to reduce the value of the company, or if retrenchment would add value. In spite of the emotive implications of the generic alternatives, the distinction between means and ends must be maintained; otherwise the company will find itself embarking on a course of action which in reality has nothing to commend it other than its emotional appeal to managers.
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7.3.2

Business Level Generic Options
The focus here is on the effective exploitation of individual product markets, as opposed to the overall resource allocation problem facing corporate level strategists. This is the responsibility of the SBU, which may have a product portfolio of its own to consider. The generic approaches can be classified according to the strategy adopted towards individual products, or the strategy approach adopted by the SBU towards the exploitation of a group of products. At the product level the focus is on achieving competitive advantage in a given market. Porter2 identified four main generic strategies: overall cost leadership, differentiation, focus and no distinctive strategy.

Overall Cost Leadership
The objective is to achieve a situation where unit costs are significantly lower than those of other companies in the industry, thus producing higher profits than competitors and the ability to mount a defence against competitive threats. This strategy is partly based on the BCG concept of the advantage conferred by relatively high market share; this cost advantage derives from those economies of scale and experience effects which, by definition, are not available to smaller companies. The strategy implies two specific preoccupations. First, the company must attempt to achieve the market share which has the potential to generate the cost advantages desired. This market share must, of course, be achievable; there is no point to adopting a strategy of cost leadership when existing industry giants control 80 per cent of the market. Second, the company must be continually concerned with efficient resource allocation, and be at the forefront of technological developments which have the potential to reduce costs. Once it has achieved the cost advantage it will be continually concerned with maintaining it. For example, it has already been stressed that experience effects are transitory, that competitive conditions continually change with the result that economies of scale are always under threat, and that international developments can lead to the entry of previously excluded efficient producers. Taken together, these two preoccupations suggest that the product is not differentiated and is capable of high volume low cost production. The cost leadership strategy can be seen as an investment process. Costs are incurred initially in winning market share and setting up efficient production techniques. Subsequently the net cash flows will be higher than they otherwise would have been because of the unit cost advantage.

Differentiation
The effect of product differentiation was discussed at 5.4.1, the effect of differentiation being to increase profits by segmenting the market and enabling different prices to be charged in different segments. In this case there is less preoccupation with market share, because the company is continually redefining the market; it may in fact have 100 per cent market share in the segment for the particular combination of differentiated characteristics which it has produced. Because the product is not homogeneous, less attention is paid to relative costs.
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Obviously, the company must be able to charge a price differential which will compensate it for the additional costs incurred in differentiation, and it would be irrational to ignore cost behaviour altogether; however, the overriding objective is not to produce at a lower cost than competitors, but to produce something which is seen as being different from competitors. The strategic process involves searching for and adding some characteristic such as superior quality or service associated with the product; it may not be a real effect, but may be an image consciously created by the company. The salient characteristic of the strategy is that the company is primarily concerned with capitalising on the perceived characteristics of the product. This approach can be adapted to identify product position by plotting the main differentiating variables against each other and locating both the company’s and competing brands within it. For example, brands of Scottish malt whisky are usually described in terms of their ‘smoothness’ and ‘peatiness’ (if you don’t drink whisky you just have to take this on trust). Some of the eighty or so brands of malt whisky are plotted in Figure 7.1. There is plenty of scope for discussion about where precisely each brand should be located; the important point is that there are clear differences among brands when their characteristics are plotted in this way.

Smoothness Glenmorangie

Talisker

Laphroaig

Peatiness

Figure 7.1

Malt whisky: perceived quality

Thus there are significant differences between brands, and it is clear that the brands are targeting consumers of different tastes. But this positioning picture does not tell one important item of information: how much additional are people prepared to pay for more ‘peatiness’ or more ‘smoothness’ or some combination of the two? To get some insight into this it is necessary to return to the idea of hedonic price indices discussed at 5.5. It is typically not possible to carry out a statistical analysis, but it is certainly possible to pose the question ‘How much are consumers likely to be willing to pay for a significant increase in one of the characteristics?’
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Focus
The previous generic strategies involved different ways of meeting competition and achieving an advantage: in the first case this was by lower costs, and in the second by altering product characteristics. The focus strategy is different in that it typically involves the identification of market niches where it is possible to avoid confrontation with competitors. Within the niche the company can focus on cost or differentiation. It is not a high volume alternative, and it pays little attention to market share. The niche may be a part of the market which requires specialised attention, very fast guaranteed delivery, or some other characteristic which high volume producers cannot provide because of the homogeneous nature of their product.

Stuck in the Middle
A salient feature of the three generic strategies is that the companies specialise in a particular approach to the market; they specialise in production processes, individualised products or identifying unsatisfied consumers. A company which does not specialise is likely to be continuously adjusting its competitive focus in response to changes in the market, with the result that it is ‘stuck in the middle’; such an undefined strategy is likely to be associated with relatively poor performance, because the marketing effort of such a company is likely to be confused: at any one time it may not be clear whether marketing managers are attempting to achieve market share, differentiate the product in the eyes of the consumer, or find unexploited opportunities Thus the scale of operations is not large enough to generate a cost advantage while the product is not differentiated enough to justify a price premium.

Competitive Scope and Competitive Advantage
The competitive scope of the company in relation to its potential competitive advantage is summed up in Figure 7.2. This synthesis of scope and generic strategy demonstrates that the company still has to make a decision between cost and differentiation even if it has identified a narrow target or niche. In the broad target case cost leadership is used as a method of achieving a degree of market dominance, while in the narrow target case the cost focus defines the market niche. For example, in the car market the large producers compete against each other primarily on cost for the small compact class; in the luxury sector there is an emphasis on differentiation. In the cheapest segment of the market the focus is on cost and relatively low volumes, while the highly specialist cars, such as super performance cars, have a differentiation focus. Once the broad decision on which generic strategy to pursue has been taken, it follows that attention will be focused on different areas. Table 7.3 sets out the types of activity which are likely to associated with the generic strategies. It follows that the skills required to pursue the different generic strategies are different, and switching from one generic to another has implications for the total design of the value chain.

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COMPETITIVE ADVANTAGE LOWER COST DIFFERENTIATION

BROAD TARGET COMPETITIVE SCOPE

COST LEADERSHIP

DIFFERENTIATION

NARROW TARGET

COST FOCUS

DIFFERENTIATION FOCUS

GENERIC STRATEGIES

Figure 7.2 Table 7.3
Cost leadership

Competitive scope and competitive advantage Cost leadership, differentiation and focus: related activities
Concerns and characteristics Optimum plant size Process engineering skills Simple product design Quantitative incentives Tight resource controls Tight financial reporting system Achieving economies of scale

Generic strategy

Differentiation

Branding Design Marketing Advertising Service Quality Creativity in R&D

Focus

Matching products with customers After sales service Dedicated work force

7.3.3

Decision Maker Generic Strategies
The approach to strategy is partly dependent on the characteristics of the decision maker; where decisions are made by a number of individuals, for example in a

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board of directors, it is the overall or dominant characteristic of the group which is important. The following characteristics provide insights into how decision makers are likely to behave in different circumstances.3 • • • • Prospector Analyser Defender Reactor

The Prospector is primarily concerned with the identification of new market opportunities, and issues relating to internal organisation take second place. The Analyser is characterised by sophisticated internal information systems and detailed investigation of options, but this is unlikely to be followed up by the type of action undertaken by the Prospector. The Defender is concerned with maintaining the current market position without exhibiting a great deal of initiative in developing new market opportunities. Finally, the Reactor simply deals with circumstances as they arise. These dominant characteristics may be relevant only to a specific period, and will obviously change as managers are replaced. They may also be determined by market conditions, for example, a Prospector may be forced to become a Defender in the face of unexpectedly fierce competition. The classification is not prescriptive, in the sense of recommending that a company should strive to change from one classification to another in order to improve performance, but does help towards understanding how the company has reached the position it is in, and the type of strategy which might win general support. For example, there is little prospect of support for an aggressive approach to new markets in a company dominated by Defenders. At the corporate level the dominant characteristic of the chief executive is a fundamental determinant of the course which the company will take. For example, Lord King of British Airways was a prospector who saw a future for a defunct airline; the corporate raiders such as Goldsmith and Hanson were prospectors of a different type, in that their vision of opportunities lay in identifying the failures of other managers. The top management of IBM adopted a reactive stance to changing competitive conditions, and were apparently unable to analyse and understand what was happening to them. At the SBU level the two generic product strategies of differentiation and cost leadership can be combined with the SBU decision maker classification to explain the approach which different types of SBU might adopt towards the identification and pursuit of new products, or towards the development of existing products in new markets as shown in Table 7.4.
Table 7.4 Emphasis on new product-market growth
Heavy emphasis Prospector Differentiate Cost leader Aggressive pursuit of new products and markets Analyser Seeking expansion in related products and markets Defender Maintain difference Maintain low cost No emphasis Reactor No clearly defined strategy

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Prospectors are primarily concerned with pursuing growth by differentiated or low cost products, and are probably indifferent to which characteristic generates potential competitive opportunities. Analysers will tend to start from the base of a strong core business, and will expand into related areas; this is because Analysers are unwilling to enter markets on which they have little information and no experience. Defenders will tend to be operating in mature markets, and are concerned with maintaining the position of ‘cash cows’; Defenders’ attitudes may be largely conditioned by the fact that they are operating in mature markets. Reactors, as might be expected, simply wait until the pressure of events forces some course of action upon them; at times Reactors will behave like one of the other three types, but there will be no consistency in their approach over time. This illustration might at first appear to be painfully obvious; however, experience suggests that many managers do not have a clear idea of which classification their company falls within. Many managers would like to be characterised as Prospectors, but in fact they are Reactors; managers who feel that they do not always seize opportunities should ask themselves whether this is because of an aversion to risk or because they are basically Analysers. This type of classification has a potential payoff in real life. When the opportunity for product-market growth arises, an SBU CEO can start by identifying the main behavioural characteristics of the organisation, identify whether the SBU is a Prospector or a Reactor, and see from the matrix how he is likely to behave in the circumstances. The important issue is whether the previous orientation of the company is likely to be effective in the circumstances which will face it in the future; the Defender, for example, can consider whether it is worth attempting to introduce organisational change to instill elements of Analyser and Prospector to encourage the investigation and pursuit of new opportunities. 7.3.4

Generic Strategies and Company Performance
It is reasonable to ask what the most appropriate generic strategy might be given the circumstances of the company, the positioning of its products, and the past behaviour of managers. There are three main issues to bear in mind when attempting to relate generic strategies to company performance. First, the point has already been made that the generic strategy is a means, while company performance is the end. Therefore a stability strategy is not necessarily less profitable than an expansionist strategy, and the cost leader is not necessarily less profitable than the differentiator. Second, it has been argued that the underlying measure of profitability relates to the value added by alternative courses of action, and this is not necessarily reflected in changes in short term cash flows. However, in some cases value added may not be the immediate concern of decision makers; for example, a family may wish to maintain control of a company despite the fact that its value would be increased by expansion. Third, the data do not exist on which to apply the scientific method of hypothesis testing. Therefore, any conclusions drawn on the most appropriate strategy are likely to be heavily conditioned by the experience of the individual strategist.

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7.4

Identifying Strategic Variations

Strategists

Objectives

Who decides to do what

The macro environment

The industry environment

Internal factors

Competitive Analysis and diagnosis position
Feedback

Generic strategy alternatives

Strategy variations

Strategy choice

Choice

Resources and structure

Resource allocation

Evaluation and control

Implementation

The generic strategies provide the framework within which the company formulates its individual strategy. By the time the company arrives at this stage it will have amassed a considerable quantity of information on itself and its markets, any performance gaps, and the fit between its own potential and market opportunities. It will have identified whether it is expanding or contracting at the corporate level, and the strategic emphasis which it has exhibited in the past at the SBU level. The next step is to identify which courses of action are available in order to achieve the identified objectives. This is a formidable task because the range of options from which real choices can be made is virtually limitless. But the whole strategy process would fall apart if the decision maker were presented with such a wide range of potential courses of action that comparisons could not be made. There is clearly a need to set out some general principles so that the most relevant strategy options can be identified. Within the context of a given generic strategy some broad classifications can serve to reduce the options which have to be evaluated. For example, a company which wishes to pursue a generic expansion strategy can consider internal versus external market development, horizontal versus vertical integration, and being innovative rather than imitative. The decision to pursue one of these options immediately reduces the strategic options. It is at this point that SWOT analysis is brought to bear – the alignment of strengths and opportunities helps to identify the appropriate generic strategy. 7.4.1

Related and Unrelated Options
The problem of diversification, and the difficulty of generating value from diversifications, has been discussed at some length. Given this, it might seem that a related diversification is preferable to an unrelated diversification. At first sight there appear to be many compelling arguments in favour of staying in the business that you know most about; for example, marketing and selling techniques are known, production processes are similar and many administrative

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and distributive overheads can be shared among similar products, and the nature of the competition is well known (or it should be). But there are some reasons why it may not be possible to expand in existing markets; for example, competitive legislation may make any further increases in market share illegal, or the company is cash rich and has already exploited existing markets as far as it is considered economic to do so. Take the case of a company currently producing baby food which is faced with a declining demand for its product because of demographic changes. It has the option of moving into the production of tinned food with a special appeal to young children, or diversifying into the production of toys; diversifying into a different type of food product appears to be a more closely related diversification than getting involved in producing toys. The factor which makes both related is that they are both in markets involving children. The trouble is that this ranking of relatedness may focus on the wrong variables. In fact, the research carried out during the past thirty years has established little agreement on the contribution of related diversification to competitive advantage. The case has been strongly made4 that this is because traditional measures of relatedness look only at the industry or market level whereas what really matters is relatedness among strategic assets. Research suggests that the factors which contribute to long run returns are • the potential to reap economies of scope across SBUs that can share the same strategic asset; this could be a common distribution system, and in the case of the baby food manufacturer diversifying into toys would mean setting up a distribution system with toy shops instead of food stores. the potential to use a core competence in the new SBU; this could be an understanding of marketing child products, and it may be equally relevant to both options. the potential to utilise a core competence to create a new strategic asset in a new business faster; thus while the existing distribution system is common for both types of food product, the knowledge of how to build up the system may still confer a competitive advantage in the toy market. the potential for related diversification to expand the company’s pool of core competencies as it learns new skills; the lessons learned in building a toy distribution system may be relevant to the existing food distribution system.

The usual arguments in favour of related options, which are based on costs, efficiency and market knowledge, may generate only a short term advantage because these attributes can be replicated. The four types of relatedness above are less obvious, and could provide a totally different perspective on what appears to be an unrelated diversification, which is so defined because the products involved are physically different. The arguments in favour of unrelated options have tended to be less precise and more difficult to quantify than those for apparently related options. For example, managers may feel that diversification reduces the risk of the company failing, or that there is positive synergy to be gained from unrelated activities, or there may be peak load capacity problems which can be evened out by branching into products with a different seasonal demand.
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There is clearly much more to the issue of relatedness than meets the eye, and companies need to take a serious introspective look at themselves prior to adopting a stance on the relationship between a possible new course of action and current capabilities. 7.4.2

Vertical Integration
Vertical integration involves movement into other parts of the production chain by which raw materials are converted into final products; some of these activities may be related, others totally unrelated. The potential costs and benefits associated with vertical integration were discussed at 6.18, where the question of the optimal degree of integration was discussed. The car company which takes over a steel rolling business is an example of backward integration, but it is unlikely that the steel company will only produce steel for the car company itself; the further into other parts of the production chain the company moves the less likely it will be to produce only for, or buy only from, itself, and it may find it owns a series of companies each supplying a different market, of which the supply to the company itself at each stage may only be a relatively small part. The vertical integration thus starts to present similar types of problems as related and unrelated options; the company may benefit in some ways from the integration, but the benefits may be swamped by the costs of unrelated diversification. Forward integration involves the company carrying out the functions of its customers; a typical example is when a company distributes its output instead of using contractors, or opens its own retail outlets. Much the same considerations apply as in backward integration. For example, it is unlikely that the company is currently the only supplier for the forward customer, and integration can again have the characteristics of an unrelated diversification. A variation on this strategy is to adopt the role of a captive company, where a large proportion of output is purchased by a single customer, and that customer actually performs some of the functions which would normally be carried out by the company itself. Whether the captive company is an economically sound organisation, or whether being captive is a sign of weak management, depends on the circumstances; for example, in the car components industry many profitable captive companies have existed for a long time. The crucial question which must always be borne in mind is whether, taking everything into consideration, the company would add value by controlling other parts of the productive chain. The case of British Gas, discussed at 6.18, demonstrates that vertical integration may not be an efficient option.

7.4.3

Acquisitions
Instead of undertaking internal action through the mobilisation of the company’s own resources to achieve objectives, the company can undertake external action by taking over or merging with another company. This is an activity most associated with Britain and the US until the late 1990s. Some of the more important reasons for considering acquisition are unrealised value potential,

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buying into markets, reducing competitive pressures, the quest for synergy, balancing the portfolio and developing core competence.

Recognising Unrealised Value
Some chief executives have a skill in identifying companies which have not fully exploited their value opportunities. The activities of such a company may be unrelated to the current business of the potential acquirer, whose competence is perceived to be in adding value independent of the type of business. It is instructive to try to identify the areas in which the company’s performance might be inadequate, because unless these can be identified it is difficult to understand the rationale for a take-over in the first place. At its simplest level, the rationale for a take-over depends on whether the current share value of the company could be increased by a reallocation of resources. Reasons for a company being undervalued include: DEVELOPMENT EXPENDITURE HAS BEEN INEFFICIENTLY SPENT The predator may feel that because of inadequate expenditure on product development, the potential market share is lower and unit cost higher than they should be. MARKETING STRATEGY HAS NOT PURSUED OPPORTUNITIES The predator may spot opportunities for product differentiation and market segmentation which he considers will transform the profitability of products which are currently poor cash generators. RESOURCE MANAGEMENT HAS BEEN POOR The predator may conclude that unit costs are higher than in similar companies, and that opportunities exist to reduce costs simply by improving resource management. EXPECTED INCREASE IN DEMAND The predator may expect an upturn in the demand for the company’s products because of an improvement in general economic conditions. WEAK PRODUCTS The predator may identify products which do not contribute to shareholder wealth; divesting them will release resources for more productive purposes. This is not an exhaustive list of factors which may contribute to an undervalued share price, but it illustrates that to a large extent a predator’s motivation is based on a perception of the company which is not reflected in the market valuation. He may, of course, be wrong. The extent to which predators can be wrong can be quite startling, as Table 7.5, a history of some acquisitions from the 1980s, shows. All the research studies in this field come to the conclusion that take-overs rarely create value. In the majority of cases it has been found that the value of the bidder’s shares falls after the take-over, while many studies point to longer term negative effects on the profitability of the acquired business units. Even in Japan, where take-overs and mergers have only become important since the mid 1980s, there is no evidence that the activity has improved profitability or growth.
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Porter’s famous study5 found that about 75 per cent of all unrelated acquisitions were divested within a few years, as were 60 per cent of acquisitions in entirely new industries.
Table 7.5
Date 1986 1988 1988 1989 1989

Take-over performance
Acquisition Ted Bates Triangle John Crowther Ogilvy & Mather William Hill & Mecca Price $450 A$3bn £217m £560m £685m Shares then 750p A$11 181p 652p 407p Shares 1992 22p A$6.40 Bust 58p 7p

Company Saatchi & Saatchi News Corp. Coloroll WPP Brent Walker

In fact it is not sufficient in itself to conclude that a company has not realised its value potential; certain other conditions also need to be satisfied. First, it is important that no other potential acquirer has arrived at the same conclusion; if a competitive bidding situation results then it is likely that all potential gains will be captured in the purchase price. Second, it is necessary to realise the potential gains, and this can clearly be very difficult. The four potential benefits of parenting were discussed in 1.4.2, and each of these was associated with a paradox which raised serious doubts about the ability of a parent corporate organisation to add value in the long run. It may be possible to add value on a once for all basis by remedying managerial weaknesses; but whether there is any gain to be had beyond that from retaining ownership of the company is open to question. The danger is that the take-over will eventually result in value destruction rather than value creation, as is so evident from the instances in Table 7.5. One of the most spectacular examples of value destruction in recent times was the take-over of NCR, a US computer company, by AT&T, the US telecoms company. In 1991 AT&T paid $7.5 billion for NCR; during the next five years it ran up losses of $2 billion before spinning NCR off, at which time it was worth about $4 billion.

Buying Market Share
Take the case of a company which currently has 20 per cent market share in a mature market and has decided, on the basis of the analysis of costs and competitive conditions, that its long term prospects would be greatly enhanced by increasing market share to 30 per cent. At the moment it is operating at full capacity, therefore in order to increase market share it has to invest in new plant and mount a marketing strategy which will take customers away from its competitors. The outcome of the marketing strategy is unknown because the reaction of competitors cannot be predicted with any degree of certainty; the company may simply find itself involved in a price war without any permanent increase in market share. Not only does a take-over make it possible to avoid the costs of the competitive thrust required to achieve the increase in market share, but the labour force in the acquisition will be relatively high on the experience curve.
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Reducing Competitive Pressures
Governments are continually on the lookout for companies which attempt to achieve monopoly power. In the US there is a formidable set of anti trust laws, and in Britain the Monopolies Commission has the power to veto take-overs which it considers are not in the public interest. In any case, monopoly power does not automatically mean that monopoly profits will be earned, due to the influence of contestable markets discussed in 5.10.4.

Synergy
There may be potential gains from sharing resources and making better use of capacity. The difficulties of capitalising on synergy were discussed in 6.21, and the history of acquisitions which attempted to take advantage of synergy has not been encouraging. There are no guarantees that economies of scope will automatically ensue.

Balancing the Portfolio
Rather than introduce a new product into the portfolio from scratch, the company may be on the lookout for a Star or Question Mark which fits with its existing portfolio and has the potential to be developed into a Cash Cow. The issue of strategic fit is crucial here, because it is unlikely that such a company can be purchased at a discount to its true value, particularly if it has been run efficiently in the past. The value added by such a product will depend on its contribution to the long term competitive advantage of the acquiring company, and is probably dependent on issues such as synergy and economies of scope. Unless there is an underlying value added to be gained, the mere fact of adding the product to the portfolio for the sake of completeness does not guarantee that it will add value to the company as a whole.

Core Competencies
The acquisition may have the potential to fit with the strategic direction of the company in the sense that it complements the set of difficult-to-replicate skills and attributes on which the company’s competitive advantage is based, while being consistent with the company’s dominant management logic. It may also be seen as fitting with the company’s strategic architecture in terms of the linkages in the value chain. These characteristics of the acquisition may lead to a long term addition to competitive advantage and hence to value added. But it is not possible to subject such an acquisition to an analysis of cash flow implications and possible return on investment; the point about core competencies is that they are difficult to define and are by their nature unique to the situation, otherwise they would have been copied already. There is no obvious way of identifying the potential contribution to core competencies before the event, so it has to be recognised that this option is based on a general view of the strategic thrust and how the components of the company fit, without being explicit about how the value added outcome will be generated.

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7.4.4

Alliances and Joint Ventures
Alliances and joint ventures take many forms, including licensing agreements, franchise agreements, relational contracting, relational management, consortia, virtual corporations, virtual functions and joint ventures. It is not the details of these which are important so much as the underlying rationale for strategic alliances in the first place. It has already been discussed at 7.4.3 that the success rate of mergers and take-overs has been low; it is therefore important to determine whether or not this form of cooperative action leads to better results. Although in Porter’s study mentioned in 7.4.3 the rate of divestment of joint ventures was lower (50 per cent compared with 75 per cent), other research has found no significant long term effects of joint venture activity on profitability in any industrial sector. Given this, the real issue is why companies should choose an arm’s-length contract rather than entering into a full merger. This is of particular importance given the problem of the prisoner’s dilemma discussed in 5.3.1; no contract can cover all eventualities, and one side always has an incentive to cheat in some way. One view is that a strategic alliance is a poor substitute for a merger.6
There have been plenty of articles in the last few years about all the cross-border mergers in Europe. In fact, the more interesting issue is why there have been so few. There should be hundreds of them, involving tens of billions of dollars, in industry after industry. But we’re not seeing it. What we’re seeing instead are strategic alliances and minority investments. Companies buy 15 percent of each other’s shares. Or two rivals agree to cooperate in third markets but do not merge their home market organisations. I worry that many European alliances are poor substitutes for what we try to do – complete mergers and cross-border rationalisation.

7.4.5

International Expansion
There is no difference in principle in moving into a foreign market compared with opening up new domestic markets. The same considerations of strategic opportunities and threats and competitive advantage must be taken into account. But it has to be recognised that competitive conditions may be significantly different in another country. The competitive advantage of a company relates to its strengths relative to the competition in the market where it currently operates. The fact that a company has a competitive advantage in one location does not mean that it can be readily transferred abroad. An example is the Japanese car maker Honda: in Japan it had about 10 per cent market share and was dwarfed by Nissan with about one fifth of the market and Toyota with about one third; but for years Honda sold many more cars in the US than either of its big domestic competitors. The explanation is that in Japan both Toyota and Nissan were much stronger in terms of marketing and control of the distribution system, but these advantages could not be transferred to the US. Honda used its competencies in car engines and receptiveness to US marketing ideas to give it a clear lead in the US. Another instance is the attempts by Hong Kong hotel groups to capitalise on their reputations, which were earned in Hong Kong, for being the best hotels in the world. The leading hoteliers, such as the Mandarin

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Oriental and the Peninsula, successfully established operations in other parts of Asia. But it proved far more difficult to do so in the US and Britain because the essential ingredient of high quality service is a relatively high ratio of service staff per room; since wage rates are much higher in the US and Britain it proved impossible to maintain the same ratio without making the hotel impossibly expensive. These hotels are thus at no advantage compared with established chains when attempting to differentiate through excellence of service. It is therefore necessary to focus on the elements of competitive advantage which can be transferred. In the case of Nissan and Toyota it was not the strength of their distribution systems in Japan which was potentially transferable, but their knowledge of how to build and efficiently operate large distribution systems; but because of the differences between Japan and the US it is doubtful if even the knowledge was transferable. Successful hotels are more than buildings and physical features, since all hotel designers and builders are trying to produce an attractive environment; unless the service offered is significantly different, and is perceived to be so by customers, then no transfer of advantage has taken place. Besides the problem of transferring advantages, there are several variables which complicate operations on the international scene. • Volatile exchange rates present serious problems; some of the problems presented were discussed at 4.3.4 under ‘Exchange Rate Fluctuations’. The fact that exchange rates cannot be predicted with any certainty, and the fact that relatively significant changes can take place in a short period, can make nonsense of cost and revenue predictions in foreign markets. One way of hedging against exchange rate movements as part of an expansionist strategy is to produce as closely as possible to consumers. This means setting up productive units in the countries where the markets are. For example, in the late 1980s Fiskars, a company producing knives in Finland, had the option of attempting to enter the UK market by exporting to the UK. The purchasing power parity of the UK pound against the Markka at the time suggested that the Markka was about 20 per cent overvalued; unless the Finnish knives were reduced in price by 20 per cent they would be relatively highly priced in the UK; another way of looking at this is that the overvaluation caused relative production costs in Finland to be 20 per cent higher than they would have been in the UK. An alternative strategy was for Fiskars to acquire a UK knife producer, or set up a production unit in the UK, thus insulating itself against variations in the exchange value of the pound. In the event Fiskars purchased Wilkinson Sword, a famous company of razor blade makers in the UK, and Gerber, a successful knife maker, in the US. Relative factor costs vary by country. For example, the ratio of the cost of labour to the cost of capital is lower in the US than in Europe, leading to more capital intensive production in Europe. It may be more efficient to shift the production of labour intensive goods to the US to take advantage of the relatively cheap labour. Productivity varies widely among countries. For example, for many years the UK had a lower output per worker in the manufacturing sector than any other major country in the European Community. To some extent this
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was overcome in the 1990s, when the UK experienced the highest growth in productivity in Europe. This increase in productivity was spearheaded by new Japanese car plants which were able to overcome restrictive labour practices. But in those industries in which productivity is still relatively low companies may find it more efficient to produce goods outside the UK. Governments often protect home production. This takes many forms, including the minimum ‘domestic-content’ requirement. Protectionism can make it necessary to set up productive units in a country which would otherwise not be attractive. Cultural norms can vary fundamentally by country, and are ignored at the company’s peril. For many years the Ford Motor Company in the UK attempted to manage its factories using the management philosophy and approach (and many managers) of the US. This contributed significantly to a decade of labour problems. The economies of different countries rarely move exactly in step, and therefore the information gathering and interpreting function is greatly increased with each additional foreign market. This issue should not be underestimated, given the importance of relevant information to the identification of opportunities and threats and the formulation of strategy.

7.4.6

From Generics to Options
At the corporate level the generic strategy chosen requires the implementation of an option. The process is illustrated in Figure 7.3. While the list of options is not exhaustive Figure 7.3 demonstrates the logic of the choice process. For example, expansion at the corporate level can involve investment in existing assets, acquiring another company or entering the international arena. These options are not mutually exclusive, for example international expansion would be accompanied by some degree of investment.

Generic strategy Corporate Expansion Stability Retrenchment Investment Cost control Downsize

Options Acquisition Defend Divest International Restructure Rationalise

Business Cost leadership Differentiation Focus

Scale economies Segmentation Niche

First mover Branding Service

Experience Research Reliability

Figure 7.3

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But at the same time these corporate choices must be underpinned by business level generic strategies. For example, in a diversified company different products may require different business level approaches, so there is no reason that expansion, for example, would be associated with cost leadership rather than differentiation. On the other hand when a company is in retrenchment mode ,and has decided to rationalise, cost leadership and focus may be more appropriate than differentiation. The important issue is to recognise the need to align the different levels of strategy with appropriate options.

7.5

Strategy Choice

Strategists

Objectives

Who decides to do what

The macro environment

The industry environment

Internal factors

Competitive Analysis and diagnosis position
Feedback

Generic strategy alternatives

Strategy variations

Strategy choice

Choice

Resources and structure

Resource allocation

Evaluation and control

Implementation

At 3.12.6 the value of the company was developed as the present value of the future cash flows expected to be generated by the company, and this was termed shareholder wealth. The strategy choice problem can therefore be expressed as the identification and selection of the strategy option which maximises shareholder wealth. Since a full analysis of expected future cash flows would have taken into account risks and uncertainties, the selection of the optimum strategy could be regarded as more or less automatic; it would be, after all, irrational to select a strategy which does not produce the highest possible shareholder wealth. In principle, therefore, all steps in the process of strategy choice should be directed towards identifying this option. Unfortunately, while shareholder wealth is an important conceptual benchmark to use in evaluating strategies, the real world is too complex to be expressed in the form of a single value which represents the optimum strategy; there are two reasons for this. 1 The future is too uncertain to be captured in a cash flow projection. Thus while most strategy writers concern themselves with the idea of value creation, there is no agreement on how it can be measured in an uncertain future. The strategy is concerned with the means as well as the ends. The shareholder wealth analysis can quantify a well defined course of action, while
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strategy must be framed in such a way as to be feasible for those carrying it out and must take into account the many intangible factors which affect decision making. Many factors intervene which make the connection between proposed courses of action and the impact on shareholder wealth difficult to identify. In discussing the factors which affect strategy choice, therefore, the shareholder wealth model can only be taken only as a starting point. 7.5.1

Shareholder Wealth
The following example is based on the calculation of shareholder wealth in 3.12.6, and uses the same assumptions of a five year planning horizon and 15 per cent cost of capital. The expected cash flows over the planning period, and the resulting impact on shareholder wealth, resulting from three generic strategies can be compared as shown in Table 7.6.
Table 7.6
Strategy Stability Expansion Retrenchment

Strategy options and shareholder wealth ($million)
Cash flows Year Shareholder wealth 857 1041 973 1 100 2 110 50 70 3 120 200 80 4 130 210 90 5 140 220 100 6+ 140 220 100

−100
500

The potential cash flows from the three options have been derived from analyses of markets, competition, opportunities, threats, environmental factors and so on. The stability option, which is based on carrying on as at present, exhibits a constant growth in cash flow over the period because of slight sales growth and anticipated cost savings, and generates shareholder wealth of $857 million. The expansion option is based on investment in new capacity, the development and introduction of new products, and a marketing strategy designed to achieve significant market shares by Year 3. By that time cash flow will be almost twice as high as in the stability option. Despite the substantial cash outflow in the first year, and the low cash flow in the second year, the expansion option produces an increase of $184 million in shareholder wealth over the stability option. While it may be concluded that the expansion option is an automatic choice over stability, managers may be unwilling to face the prospect of two years of cash flow problems, and the likely poor short term profitability reports. The retrenchment option might arise because the company has discovered that by disinvesting it can concentrate resources on the longer term development of its core business. Therefore, although cash flows will lag behind those of the other two options from Years 3 to 5, the large positive cash flow in Year 1 contributes to shareholder wealth of $973 million which, while lower than the expansion option, is $116 million greater than the stability option. If managers are unwilling to face the implications of the expansion option, then retrenchment has decided value advantages over the stability option.
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One of the conceptual difficulties of the shareholder wealth approach is that it collapses all future expectations to the present. It may appear odd that the different prospects of the expansion and retrenchment options in Year 5 are associated with much the same shareholder wealth at the present; the expansion option implies a company with a portfolio of products with relatively high market shares and an equilibrium long term cash flow more than double that of the retrenchment option. This arises because of the discounting process, which takes into account the opportunity cost of capital, and the fact that no further growth in cash flows is assumed after the end of the planning period. If managers conclude that the planning period does not adequately take into account the longer term implications of the different strategies then the planning period itself can be amended accordingly; however, this does not alter the principles on which the analysis is based. A further powerful application of shareholder wealth analysis is to break down the activities of the company and estimate the contribution which each makes to the total value of the company. For example, in the retrenchment example a part of the company had been identified which was subtracting from shareholder wealth; by getting rid of it shareholder wealth was increased. Take the case of a company which has three SBUs, the largest of which produces computer equipment, the second largest provides maintenance services, and the smallest produces software and application consulting services (this scenario is loosely based on the famous Apricot Computer case investigated by Sir John Harvey Jones in his TV series ‘Troubleshooter’). Such a company will typically regard the production of equipment as being the ‘core’ business on which the others are built. However, as often happens, the maintenance and consulting SBUs develop markets which are independent of the equipment which the company produces, and start to behave as independent entities. The question then arises of identifying which SBUs are contributing most to the value of the company as a guide to future resource allocation. This type of situation is represented by the example in Table 7.7, which uses the stability option in the previous example disaggregated into three SBUs. Obviously there are problems associated with allocating costs to the SBUs, but for the purposes of the analysis this is assumed to be relatively unimportant. The current and future revenues from selling products and services are dominated by the ‘core’ business of SBU 1; it generates about two thirds of company revenue and incurs about two thirds of total cost. However, it has the lowest shareholder wealth of the three SBUs, while the smallest SBU of the three in terms of total revenue has the highest shareholder wealth. Taking the costs in Year 1 as an indication of the total allocation of resources, the mismatch shown in Table 7.8 emerges between resources deployed and value created.

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Table 7.7
SBU 1

Resource allocation and shareholder wealth ($million)
Cash flows Year Shareholder wealth 1 500 480 209 20 200 165 254 35 75 30 333 796 45 100 2 530 495 35 205 170 35 85 45 40 110 3 540 520 20 220 170 50 110 60 50 120 4 560 530 30 225 275 50 110 60 50 130 5 580 540 40 230 190 40 120 60 60 140 60 140 40 40 6+

Revenue Cost Cash flow

2

Revenue Cost Cash flow

3

Revenue Cost Cash flow

Total

Cash flow

Table 7.8

Resource allocation and value creation (%)
SBU 1 SBU 2 32 24 SBU 3 42 4 26 71

Shareholder wealth Resource allocation

This indicates that the ‘core’ business consumes 71 per cent of company resources, while producing 26 per cent of shareholder wealth; the smallest SBU consumes 4 per cent of resources and produces 42 per cent of shareholder wealth. Because SBU 1 is seen as the ‘core’ business, it is likely that managers devote more than 71 per cent of total management time to trying to make it pay. In choosing among strategy options, management ought to address the following questions. First, are the activities of SBUs 2 and 3 really dependent on the production of equipment? If no clear linkages among products can be identified it is unlikely that producing them in the same company produces value over and above what could be achieved if they were produced independently. Second, if not, should resources be re-allocated from SBU 1 to SBUs 2 and 3? It could turn out that the long term future of the company lies in providing maintenance for a range of manufacturers and pursuing further innovative consulting possibilities. However, at the moment, it is likely that these SBUs are starved of resources and managerial inputs because of preoccupation with the ‘core’ business. It must be stressed that shareholder wealth analysis at this aggregate level can only be indicative of the value creation activities of the company because of the need to make arbitrary assumptions about the allocation of joint costs and predictions of future costs and revenues. However, even if costs were incorrect by 10 per cent for SBU 3, the same general result would emerge. This approach can throw into sharp relief the fact that a company may be oblivious to the evolving nature of its business, and may be encumbered with a management which developed the company through its initial stages but cannot now see beyond that. A major problem in applying shareholder wealth analysis is that it implies that the future can be predicted with some degree of certainty. There are many
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circumstances where future events are so uncertain that the error associated with the calculations is too great to permit their use. For example, the decision to develop and introduce a new product may be based on little more than an unquantifiable perception that a market for the product can be expected, but much depends on developments in other products, changes in consumer tastes, the behaviour of competitors, and so on. While Shareholder Wealth analysis is clearly an important tool in those cases where the future can be estimated with some degree of certainty, and focuses attention on the potential of different courses of action to generate value, there is still a need for tools which can be applied to what are essentially leaps into the unknown. 7.5.2

Performance Gaps
The notion of performance gaps was developed at 3.3 as being the difference between the expected outcome if the company carried on as at present, and the desired outcome. The desired outcome itself would be an amalgamation of company characteristics designed to meet overall company objectives; for example, in the shareholder wealth analysis there may be several strategies which would accomplish the expansion option. In this case the company would wish to have additional products and higher market shares by Year 5 than would occur if no changes were made to current policies. The identification of this desired future state greatly narrows the range of feasible strategic options. The application of gap analysis therefore has immediate benefits by identifying the appropriate options from which the strategy choice ought to be made. • • The gap identifies whether the company should be pursuing a generic strategy of stability, expansion or retrenchment. The extent of the gap indicates whether the company has to undertake a significant reallocation of resources in order to close the gap; for example, the company may have specified an ambitious objective in terms of market share, but it may turn out that the gap is relatively small, and that closing the gap does not involve a significant change in direction. Within the generic strategy the ways of closing the gap can be identified; for example, whether strategy should be concentrated on external or internal factors, such as marketing effort as opposed to cost control.

By structuring the question of where the company is actually going compared to where managers would like it to go, the gap approach reduces the array of strategy alternatives to those which have direct relevance to the company’s objectives and to its potential capacity. What might appear to be a painfully obvious process requires managers to step back from the actual running of the company and identify in an objective manner options which might not be intuitively obvious were the gap not identified in the first place. 7.5.3

Corporate Management
When the company is comprised of a portfolio of products, the problem facing corporate management is to decide on the components of the portfolio while

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SBU management is concerned with the management of the products selected. The portfolio approach developed at 5.7 is fundamental to this issue, and the role of corporate management is to attempt to select the optimum portfolio of products for the company. There are many criteria which can be applied to the selection process, depending on the circumstances and the objectives of the company. Taking the BCG matrix of market share and market growth as an example, the most obvious strategy option is to eliminate the Dogs. However, beyond this it becomes difficult to lay down hard and fast rules for using the BCG matrix. The company needs to have Stars to replace the Cash Cows when they come to the end of the product life cycle; but how many and of what type depends on their fit with the existing portfolio and how it is likely to develop. The Question Marks can pose an intractable problem; while the company can wait for the Stars to become Cash Cows as the market matures and ceases to grow, the Question Marks cannot be transformed into Stars without a substantial investment in resources. Projections of the product life cycle and the reaction of competitors are necessary before making a choice of which Question Marks to pursue and which to abandon. A complicating factor is that the company may have to make a strategic response to other companies which are developing their portfolios. For example, everything might depend on who is first to transform a Question Mark into a Star; a potentially attractive Question Mark may have no future because of the early action of a competitor; or the company may have to abandon a Question Mark because a Cash Cow is coming under competitive threat, and resources are required to maintain its competitive advantage. But given these problems, the portfolio approach is a powerful tool in identifying the areas into which the company should be putting its resources. The weakness of the approach lies in identifying which products to put into the matrix in the first place. An increase in the number of products which involves entry into new markets poses an array of new uncertainties for the company because it is venturing out of its established markets and products, and typically into new technologies. The aim is thus to achieve a balanced but linked portfolio. One method of assessing the risks involved is the ‘familiarity’ matrix7 as shown in Figure 7.4.

Market factors

New unfamiliar New familiar Base

Medium High High

Low Medium

Low Low Medium
New unfamiliar

High

Base

New familiar

Technologies or services embodied in the product

Figure 7.4

Familiarity matrix

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Some research suggests that the more familiar the company is with new markets and technologies, the more likely is success. Different strategies have been suggested for dealing with varying degrees of newness as revealed by the matrix. For example, in the bottom left hand sector the appropriate strategy is based on internal financing, while in the top right hand it is based on the use of venture capital. The limited research data available also suggest that the probability of failure is reduced by selecting the appropriate financing strategy for the sector in the familiarity matrix. While the research suggests that the familiarity matrix approach may have some measurable benefits, the real contribution it makes is to help clarify the extent to which the company is willing to venture outside its current business portfolio. Each new venture should be subject to a project appraisal which makes explicit what is known and projected. Table 7.9 demonstrates an example of value generation based on the complete life cycle of a product.
Table 7.9
Year Development Sales value Production cost Expected cash flow Net present value

Project appraisal ($million)
1 8 2 8 27 13 36 18 18 45 24 21 52 23 29 21 12 9 3 4 5 6 7

−8
33

−8

14

The product life cycle has been estimated to last for no more than seven years, with growth up to Year 5, a short period of stability, and a sudden drop in Year 7. After Year 7 the market is to all intents and purposes finished. The development department has asked for a budget of $16 million spread over two years to bring the product to market. The marketing department has come up with a series of sales estimates, and based on their predictions of sales volumes the production department has estimated production costs. The combination of development costs and expected future income and production costs leads to the expected cash flow profile over the life of the product. Assuming a cost of capital of 15 per cent, the current estimates lead to an NPV of $33 million. In principle, when there are a number of projects to choose among, they would be chosen in the order of their NPVs. However, the project appraisal is better regarded as a technique for investigating the properties of products and relative strategic attractiveness. This is because every variable which enters into the calculation is subject to a degree of uncertainty, and in addition each product has to be evaluated in terms of its fit with the characteristics of the company as a whole. Corporate strategy tends to be concerned with many intangible factors which are not susceptible to measurement, and where it is difficult to identify rules which promote effective decision making. There is no objective answer to the ‘right’ balance of products of different types and at different points in the portfolio matrix; there is no hard and fast criterion to apply when selecting which new market to enter; there is typically no single answer to resource allocation when SBUs are competing with each other. However, the approaches
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outlined above can help corporate strategists introduce some order into the process and ensure that options are evaluated in a consistent fashion. The limitation of attempting to represent options by alternative cash flows becomes apparent when the company starts to look at options in terms of distinctive capabilities and competencies; these can be regarded as vehicles for generating long term competitive advantage, but it is impossible to translate them into hard and fast cash flow terms. Furthermore, the implications for portfolio management go far beyond those of the BCG approach; the portfolio needs to be comprised of linked elements which are susceptible to effective management. This brings us back to the issue of parenting and value added: the company must confront the issue of whether it is feasible to add value by pursuing different options. This forces the company to think about its strategic architecture and whether it can identify competencies and linkages which are going to be difficult to replicate and which have the potential to convey a degree of competitive advantage in more than the short term. 7.5.4

SBU Management
The SBU is best thought of as being a single product entity to avoid repetition of the corporate issues relating to the product portfolio. At this level strategy choice is concerned with the exploitation of products and markets, and with ensuring that resources are allocated efficiently. The overall objective is to achieve a competitive advantage in the products on which corporate management has decided to concentrate. The type of issue which SBU management focuses on includes the impact of market share on ROI, the type of markets to aim at, and the methods of achieving relatively low unit cost. One method of making explicit the impact of different product based strategies is to expand the project appraisal approach used by corporate management, as shown in the scenario in Table 7.10.
Table 7.10
Year Development Total market Market share Price Unit cost Contribution Cumulative cash flow Net present value ($M) (000) ( %) ($) ($) ($M) ($M) ($M)

Project appraisal
1 8 100 2 8 120 150 13 1 395 692 13 200 15 1 200 630 18 15 250 15 1 200 610 21 36 15% 250 15 1 395 600 29 65 100 15 1 395 600 9 74 3 4 5 6 7

−8
33

−16

−3

Cost of capital

This scenario framework makes explicit a large number of assumptions which are often only dimly perceived by managers. The total market profile is derived from the analysis of the product life cycle. The market is expected to grow to 150 000 by the time the product is launched, continue growing to 250 000 in Year
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5, and end in Year 7. The market share and price are closely related; the product is expected to be launched with 13 per cent market share, and subsequently to be increased to 15 per cent partly as a result of the price reduction in Year 4, which is to be maintained through Year 5 in order to consolidate the market share. The unit cost is expected to decline throughout the product life as the experience effect builds up; however, beyond Year 6 these are not expected to be significant as production is run down. Contribution reaches its peak in Year 6, when the product has the characteristics of a ‘cash cow’: a relatively high market share in a mature market, and benefiting from experience effects. The cumulative cash flow indicates how long it takes for the product to payback the investment, i.e. the payback period. Once the model has been set up in this form it is a relatively simple matter to investigate different scenarios. For example, the worst possible case could be assessed for all variables together, possibly involving a smaller total market, lower market share and a slower reduction in unit cost. An additional outcome of the sensitivity analysis is the identification of crucial variables; for example, it might emerge that there is some doubt about the potential size of the market, and in fact if the total market does not reach at least 230 000 the project will generate a negative NPV. A scenario can be constructed to investigate different marketing strategies, such as the potential for converting a Question Mark into a Cash Cow. In the example, there could be substantial advantages in aiming at a 20 per cent market share in Year 4 rather than 15 per cent. However, this might involve reducing the price to $900 for Year 4; the payoff would be the ability to charge a higher price in Year 5 and a more pronounced experience effect. What would the outcomes have to be to justify the massive price reduction in Year 4? The scenario framework generates the answer in terms of the impact on NPV. The scenario approach clarifies the payoffs from different potential courses of action, depending on the assumptions made. While being a powerful tool, it does not provide an automatic choice criterion because of the many uncertainties and imponderables. For example, competitive reaction to the price reduction in Year 4 may be immediate, causing no increase in market share, while a smaller price reduction might have gone relatively unnoticed because it was not perceived by competitors as a significant threat. However, managers typically have sufficient information to make entries in many of the boxes in the scenario matrix, which can then be used as the basis for sensitivity analysis. 7.5.5

Risk and Uncertainty Analysis
Strategy decisions are by their nature forward looking; therefore all strategy options are uncertain. Choices are continually being made among options which are uncertain in different degrees. It is not sufficient to carry out a sophisticated discounted cash flow analysis of an investment and make decisions based on the highest expected net present value. All managers are concerned about the chances that events will actually turn out as they have been predicted, and would like to have some idea of the risks associated with different outcomes. In extreme cases managers should be able to deal with risk fairly confidently; for example, in 1995 in the UK advertisements appeared for investments in ostrich farming. The investment involved buying one or more ostriches to be cared

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for on a farm and which would produce chicks which would be sold on. The advertisements offered 58 per cent return per annum. On the face of it this was a highly risky investment for two reasons. First, the rate of return clearly had an enormous risk premium, given that the rate of interest at the time was about 6 per cent; second, up to 1995 the sale of ostrich meat for human consumption in Europe was not significantly greater than zero. The astonishing thing was that although no financial institutions were willing to invest in ostriches, many individuals committed significant amounts of cash to the venture; it came as no surprise that the business turned out to be bogus. However, this is an extreme case and the choice is not typically so obvious: managers are faced with the problem of making trade-offs between the prospect of varying returns and possibilities of failure. Most managers wish to determine whether the prospect of an uncertain future can be incorporated into decision making in a structured fashion. The first step is to ascertain what information is actually available about the likelihood of future events. At first, managers tend to disregard the notion that anyone can predict the likelihood of future events occurring, but in fact it is widely accepted that subjective knowledge can provide a usable perspective on risk. For example, a salesman can be asked for his assessment of the chances that the sales of his product will double next year. He may well reply ‘one chance in two hundred’, or ‘too low to be measurable’; however, he may think that there is about one chance in 4 of sales increasing by 20 per cent next year. More detailed questioning may reveal that on balance he thinks it more likely that sales will increase rather than decrease. By asking the salesman what the chances are, we are really asking him to assign probabilities to possible future outcomes, and the pattern of responses is termed a probability distribution. The salesman’s responses might be as shown in Table 7.11.
Table 7.11 Expected value
Probability 0.05 0.10 0.20 0.40 0.25 Expected value (000s)

Change in sales (000s)

−20 −10
0

−1.0 −1.0
0.0 4.0 5.0 Expected value 7.0

+10 +20
Average 0

Assume that the salesman has identified five possibilities: that sales will fall by 20 000 or 10 000, remain the same, or increase by 10 000 or 20 000; the reasons for arriving at these estimates are unimportant. The average of these expectations is zero, i.e. adding the possibilities of change and dividing by 5 gives zero. However, in the second column the salesman has expressed his subjective probabilities of these outcomes: for example, he reckons that there is only one chance in 20 that sales will fall by 20 000, but 4 chances in 10 that they will increase by 10 000. The third column is obtained by multiplying the probability by the possible outcome. For example, the probability of a
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20 000 increase is .25, giving an expected increase of 5000. The summation of these expected outcomes comes to 7000, i.e. taking the salesman’s subjective probabilities into account he expects sales to increase by 7000 next year rather than the zero suggested by the simple average. Since the 7000 estimate takes into account what the salesman feels he knows about the future it can be argued that it is a better basis for decision making than concluding that there will be no change in sales. It is usually found that people who are familiar with particular markets and production processes are able to express future outcomes in terms of their chances of occurrence, and this information can be used in a systematic fashion. It will come as no surprise that there is a good deal of controversy surrounding the use of subjective probabilities, and much depends on the credibility which individual managers attach to the information obtained. But even if managers have reservations about the probabilistic approach, it can still be used to provide a perspective on risk which may otherwise not be appreciated. Take the example in Table 7.12, where three potential outcomes from an investment have been identified and the risk associated with each estimated.
Table 7.12 Average outcome and expected value
Probability 0.1 0.2 0.7 Expected value

Outcome

−100
50 200 Average 50

−10
10 140 Expected value 140

The most likely outcome in this case is that the investment will yield an outcome of 200. This contributes to the fact that the average outcome is only 50 compared to the expected value of 140 when the probabilities are taken into account. The expected value of 140 would be used to compare this project with projects of broadly similar characteristics. When decisions on investments are continually being taken, the proponents of the subjective probabilistic approach argue that over time the company will be more profitable than if it had used the unweighted average approach. Whether this is true or not depends on the extent to which subjective probabilities contain real information. The table of possible outcomes and probabilities ignores an important issue, namely the attitude of managers to risk. A particular manager may feel that even though the probability of losing 100 is only one in ten, this is still an unacceptable risk because it would result in the company going bankrupt. This is known as risk aversion, and it would result in the manager preferring an investment with a lower expected value which did not contain the risk of bankruptcy in the probability distribution. The expected value approach can conceal the fact that risks are not symmetrical, and therefore it would be folly to base decisions on the expected values alone no matter what the ‘law of large numbers’ states, because the company may end up with a portfolio of projects each of which contained the potential to bankrupt it. It is a well established fact that individuals do not always act in accordance with ‘expected utility maximisation’, i.e. do not always
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choose an alternative with the highest expected outcome. Consider the options in Table 7.13.
Table 7.13
Option A B

Choosing an expected value
Outcome 2 000 100 Probability 0.05 0.50 Expected value 100 50

Despite the fact that the expected value of A is greater than B, a significant proportion of people would choose B. This is because there are many other factors affecting choice beside the expected value. To some individuals it is preferable to have a good chance of winning even a small amount than a very small chance of winning a very large amount. There is another type of risk which cannot be quantified because the future event itself cannot be foreseen. For example, no one knows whether an earthquake will occur next week, or whether a carefully planned just-in-time organisation is going to fall apart because of human error. What is known is that something, sometime, is going to go wrong with plans and expectations. This type of risk is often referred to as uncertainty, and defies any attempt at quantification. But given that it does exist it is necessary to make some allowance for it; for example, how much additional inventory is it worth holding just in case there is an unexpected materials shortage? Despite the fact that the chances of a shortage occurring seem remote, a manager may feel inclined to hold a substantial inventory because the very existence of the company would be placed in jeopardy if orders could not be met in time. Because of the existence of uncertainty, it is essential that strategies are constructed which have the potential to adapt to circumstances which turn out to be radically different to those anticipated. If the strategy is inflexible it will be impossible to respond to events as they unfold, with the result that the strategy would have to be abandoned at an early stage. One way of tackling this is through contingency planning, which involves making sure that the strategy is capable of responding to a wide variety of scenarios, and keeping options open as long as possible. Thus one of the difficulties in formulating strategy is the need to take into account the unknowable as well as the likelihood of events not turning out as predicted. In the second case it is possible to take a reasoned view on the position to adopt in the event of adverse circumstances, and take action to provide insurance against loss, such as holding high inventories and identifying second best market opportunities. But the first case poses a set of problems to which previously calculated solutions cannot be applied because managers cannot foresee what the event might be, never mind the likelihood of its occurrence; for example, much of the outcome of strategy depends on the actions of competitors, which may often be unforeseeable, and exogenous events can occur which completely alter the characteristics of the market. The notion of contingency planning can be applied to the second case by identifying alternative courses of action to undertake should certain events transpire. In the first case it makes little sense to develop a contingency plan because the range of possible events
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is limitless. But this does not alter the fact that managers need to have some alternative course of action in mind if future events make the pursuit of the current strategy impossible. There are therefore two types of contingency planning: first is the technical process of attempting to minimise the probability of loss due to risk, and identifying alternative courses of action in the event of potential outcomes; second is the strategic response to major unpredictable events. The first of these can be tackled by the application of ideas from the business disciplines, but the second poses more intractable problems. Responses to this type of problem are almost wholly determined by managerial attitudes and perceptions. Another factor which has a bearing on the choice between risky alternatives is the desire to diversify the portfolio of risks. For example, a company which is currently making refrigerators may prefer to diversify into pocket TVs rather than freezers because the risks associated with refrigerators are less correlated with the risks associated with TVs and more correlated with the risks associated with freezers. When times are bad for refrigerators the positive cash flow from TVs can be used to keep refrigerator production going and vice versa. The idea that diversification can help guarantee the company’s survival is a compelling justification for seeking opportunities to diversify risk. However, the manager should consider whether the benefits from diversification are imaginary or real. One way to approach this is to ask whether the share price of a company producing refrigerators and TVs is greater than the sum of the share price of two companies producing the two goods. After all, a shareholder could diversify his risks by buying shares in the two companies, and may prefer this to a composite share. Furthermore, if the company feels that it is worthwhile to ‘bail out’ the TV company from time to time, the same thing must apply to the financial market as a whole, which will always be willing to provide finance for a company which has a positive net present value. 7.5.6

Managerial Perceptions
The application of sophisticated information gathering and analytical techniques does not of itself generate a strategy choice. At the end of the day someone has to weigh up the arguments for and against different courses of action and arrive at a decision on strategy. This someone may be the CEO, or it may be a group of decision makers, and the process by which the decision is finally arrived at may be obscure; after the event it may be identified as logical incrementalism or emergent strategies. Those who carried out the analyses may feel that little attention was paid to their conclusions; or the CEO may draw opposite conclusions to the analysts from precisely the same information; analysts themselves may feel that the CEO does not fully comprehend the implications of their findings. It is in fact very difficult for outside observers to assess the rationality of decision making processes in a particular organisation; this is because the personal objectives of decision makers may not be known, and therefore the weighting which they attribute to different factors cannot be taken into account when attempting to explain their decisions. However, there are a number of factors which bear on decision makers which might help to explain observed behaviour.

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External Dependence
All companies depend on other companies to some extent: many companies concentrate on relatively few customers, and some companies are dependent on relatively few suppliers. Some managers may see a particular degree of external dependence as a potential threat, while others may see it as a strength. There is no hard and fast rule, but the CEO who dislikes the idea of increasing the level of dependence is unlikely to consider seriously a strategy which relies on such a change, no matter how attractive it may appear in terms of adding value. Another form of external dependence is when a majority shareholder exerts influence on decision making; in such a situation some managers may be unwilling to take strategy decisions because they feel that they do not really control the company.

Attitudes to Risk
A great deal can be done to quantify the risks facing the company. However, managers vary in their attitude to risk, and what might appear a reasonable degree of risk to one manager may be unacceptable to another. This can be generalised to the company culture to some extent, and some companies do portray themselves as being relatively risk averse; this attitude can rub off on the individual managers, with the result that strategy options which imply a fair degree of risk will not be seriously considered at any level. A practical technique for taking risk aversion into account is to use a ‘minimax’ criterion. This involves selecting the option with the lowest potential loss independent of the probabilities associated with predicted returns. An example of how this might work in practice is illustrated by the potential outcomes from the two investments shown in Table 7.14.
Table 7.14 Minimax decision making
Investment A NPV ($m) 140 50 Probability 0.8 0.2 0.1 100 80 Investment B NPV ($m) Probability 0.7 0.2 0.1

−20
Expected NPV 120

−10
85

Investment A gives a higher expected NPV of $120 million compared to $85 million for investment B; however, investment B would be chosen because it has a lower potential loss. Strong arguments in favour of investment A could be suggested; for example, it has a higher probability of a higher NPV. However, whether investment A is preferable to investment B cannot be resolved on the basis of the numbers alone. A note of caution needs to be interjected on the portrayal of a company as risk averse on the basis of its past behaviour. It is often observed when running simulations in management programmes that managers avoid taking decisions which involve significant changes because they claim that their company culture is conservative and risk averse. However, this confuses conservatism towards
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making changes, with risk aversion: this ‘conservative’ approach is not based on an explicit analysis of risk factors, and therefore it may not be recognised that avoiding change can incur higher risks than decisions involving a reallocation of resources. Indeed, managers are often observed to have a form of decision paralysis in which they are unwilling to stray far from what has been done in the past, no matter how poor the results of past strategy have been. Some companies are better portrayed as being ‘risk ignorant’ rather than ‘risk averse’.

Previous Strategies
The process of strategy is continually evolving, and because of changing circumstances no particular strategy can be regarded as sacrosanct. The time may come when a major strategy decision needs to be taken which involves a significant change from previous strategies. However, managers may have invested substantial personal resources in the identification and implementation of strategy to date, and the current strategy may be regarded as a component of the corporate culture. In such circumstances, managers may be unwilling to make significant changes until external factors force a response; this can cause a company to adopt a passive stance to strategy. Indeed, the very success of the previous strategy may contain the seeds of future disaster because of the natural tendency to take refuge in a tried and tested approach.

Managerial Power Relationships
All organisations have their own internal politics. The process of decision making has infinite variety, from the friendly compromise reached between brothers running a family business, to the autocratic dictates of a powerful CEO in charge of a large multinational. The aversion to external dependence on the part of the powerful CEO might dominate decision making, despite the fact that all of the analyses carried out support a greater degree of external dependence, and that most managers in the company are in favour of it. To some extent this is related to the principal/agent issue, where the objectives of managers are not necessarily consistent with those of shareholders. For example, an SBU manager may be opposed to a strategy which involves retrenchment of his SBU despite the fact that it is in the interests of the company as a whole; he may have a strong influence on strategy choice because he is regarded as one of the ‘elder statesmen’ in the company. He will probably not present his opposition in terms of personal predilection; however, those knowing his attachment to the SBU could probably predict that he would oppose the strategy without necessarily knowing on what grounds he would do so. The experience of running simulations with groups of managers reveals that more time is typically spent on arriving at decisions than analysing information and working out alternative courses of action. Teams of managers often feel that they have wasted a great deal of their time in fruitless discussion, and that decisions were not always arrived at on the basis of analysis alone. This is a reflection of what happens in real life management teams, in that decisions are difficult to arrive at, and it would be naive to presume that the available facts speak for themselves and enable decisions to be arrived at relatively painlessly.
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Consensus Decisions: The Paradox of Voting
Some companies pride themselves on an egalitarian approach to decision making, where each manager involved in the team has an equal weighting; in this case, when there is no obvious decision because trade-offs have to be made, there may be recourse to a vote. It is usually felt that a straight vote has two benefits: it eliminates the power of any individual, and it enables the weight of opinion to sway the decision. However, voting is as subject to manipulation as any other decision technique, although it is less obvious to the participants. The following example is based on three unlikely friends, a miser, a health freak and a drunk, who are trying to decide whether to build a house or not. The three individuals consider the problem as follows: The miser will not wish to build a house, preferring instead to keep the money in the bank. Failing that, the miser’s preference is to build the cheapest house possible, i.e. a house without a bar. The health freak will wish to build a house, naturally without a bar. Failing that, the health freak’s preference is to keep the money in the bank, because building a house with a bar would be bad for his health. The drunk will wish to build a house with a bar, and failing that would rather leave the money in the bank, where there is a chance it might be available to spend on drink. The options are therefore: A B C House / Bar House No House

The ranking which the three friends put on the options are shown in Table 7.15.
Table 7.15
Preference Miser Health freak Drunk

Option rankings
First No house House House / Bar Second House No house No house Third House / Bar House / Bar House

A straight vote would not resolve the issue, because each individual has a first preference for a different option. Counting the number of first, second and third preferences reveals Table 7.16.
Table 7.16 Counting the rankings
Order of preference First House / Bar House No house 1 1 1 Second 0 1 2 Third 2 1 0

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The No House option is the clear winner, because it has one First and two Seconds; this could be regarded as the natural preference of the group which would be revealed after discussion, and on the assumption that all three individuals are equally weighted. However, the matter is not necessarily resolved in this way because, since there are three in the group, they appoint the health freak as chairman. His first observation is that the problem is too complicated to resolve by a single vote, and that the problem should be structured. Therefore, he poses the question ‘Do we want a house or not?’ Since there are two Firsts in favour of a House or a House/Bar, on the basis of a majority vote it is agreed that a house should be built. The three then vote on what type of house to build; their preferences are shown in Table 7.17.
Table 7.17
Preference Miser Health Freak Drunk

The second vote
First House House House / Bar Second House / Bar House / Bar House

The House option now has two first preferences, and is the clear winner. In fact, this was what the health freak wanted in the first place. This may in fact be what so called impartial chairmen do: they make a guess at the preferences of the members of the group, and then use this to structure decisions so that they get what they want. This outcome is a variation on the concept known as the paradox of voting, which can be used to demonstrate that A is preferred to B, B is preferred to C, but that C can be preferred to A. The fact that voting procedures can lead to such paradoxes, as well as being open to the type of manipulation described above, should be borne in mind by managers who believe that they are part of a consensus decision making team.

7.5.7

From SWOT to Generics
There are clearly many influences bearing on strategic choice. But in a perfect world, how would we use all available information, quantitative and nonquantitative, objective and subjective, to arrive at a decision? This is where the SWOT analysis comes in as a guide to the selection of the generic strategy and the most appropriate strategy variation. Having identified the appropriate entries for each box in the SWOT matrix and made some judgements of their relative importance from the ETOP and SAP analyses, the next step is to align the strengths with the opportunities and the weaknesses with the threats. This should start to give some insight into the ‘big picture’, or to be more specific, into the most appropriate corporate strategy: expansion or retrenchment. Then the best business generic can be identified together with the strategy variation. The choice process is shown in Figure 7.5.

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SWOT

STRATEGY

Corporate Strengths Opportunities Expansion

Business Low cost

Variation Alliance

Threats

Weaknesses

Retrench

Differentiated niche

Divest

Figure 7.5

Choice process

The figure shows two diametrically opposed outcomes of a SWOT analysis. One analysis has identified an alignment of strengths and opportunities which opens the possibility of expansion by alliance. The other shows that the alignment of weaknesses and threats is such that the company should retrench and focus on a niche; this could be the outcome of recognising that it is ‘stuck in the middle’. What happens if both of these are identified within the same SWOT analysis? That is when the CEO has some tough choices to make and really starts to earn her money.

Case 1: Revisit Salmon Farming
In Module 5 you were asked to evaluate the prospects for the future of the salmon farming industry. Carry out a SWOT analysis for a typical salmon farm and derive a generic strategy.

Case 2: Revisit Lymeswold
In Module 5 you discussed what went wrong with Lymeswold cheese. Revisit the case and devise a strategy for success.

Case 3: Revisit a Prestigious Price War
In Module 5 you analysed competition in the quality newspaper market. What action would you recommend for the Daily Telegraph, and what do you think its prospects would be?

Case 4: Revisit General Motors
In Module 6 you analysed General Motors. Suggest a strategy for the future of GM, and be clear about your reasoning.

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Case 5: The Rise and Fall of Amstrad (1993)
Amstrad was something of an electronics industry phenomenon in the 1980s under the leadership of Alan Sugar. The basis of the company’s success was to offer consumers products which did not depend on a technological breakthrough but were based on Sugar’s understanding of what consumers really want. In the late 1970s the Tower System integrated the amplifier, tuner and cassette deck in one unit and brought sophisticated hi-fi systems within the reach of just about everyone. Amstrad then moved on to a low cost, one plug computer system which brought word processing cheaply to a mass market. The company then moved into cheap facsimile machines, video recorders and satellite dishes. Company profits climbed steadily from 1980 from practically zero to about £20 million by 1985. In 1986 profits more than doubled, in 1987 they doubled again, and in 1988 reached £160 million. They then proceeded to halve in 1989, fell again in 1990 and 1991, and a loss was forecast for 1992. As would be expected, the price of Amstrad shares peaked in 1987, and lost about 90 per cent of their value by 1992. A major element of Sugar’s strategy was to move out of a product as soon as competition became tough and margins were eroded. However, Amstrad did not leave the personal computer market when margins virtually disappeared, and found itself saddled with unsold stocks of out of date computers and was relatively slow to introduce new eye-catching products. At the moment the company has a range of new products on offer, such as a user-friendly notepad personal computer and a videophone. However, the formula of selling easy to use electronic goods at low prices has been taken up by other companies. The company went public in 1980, and in 1992 Sugar attempted but failed to buy back all the shares. The objective of buying back the shares was to renew Sugar’s absolute control over the company, and make it possible to revert to his original strategic vision. However, the shareholders considered that the deal proposed was not in their best interests.

Question
Classify the Amstrad strategy in as many dimensions as you can using the ideas developed in this Module, and apply ideas from previous Modules to interpret the situation in which Amstrad finds itself.

Case 6: What Is a Jaguar Worth? (1992)
The Ford Motor Company took over the British prestige car company Jaguar in November 1989 for about £1.5 billion. Two years later Jaguar lost £60 million in the third quarter, and prospects were not good, for example sales in the US had fallen from 24 000 cars in 1987 to 10 000 cars in 1989. Even at the time of the take-over Jaguar was not making a profit, so why was such a large amount paid for the company? Jaguar had very little value in terms of hard assets – probably no more than £250 million according to the company accounts; however, it had a reputation and established share in the luxury car market, and £1.1 billion of the purchase price was regarded as ‘goodwill’ by Ford. Furthermore, when the
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Ford executives arrived at the Jaguar factory after the take-over they discovered that the much vaunted recovery which Jaguar had experienced during the 1980s under the direction of Sir John Egan had not extended to efficient working practices and quality control; costs were still relatively high, and the workforce had not adopted modern team-working methods. One Ford executive even compared Jaguar unfavourably with Russian plants. The first action taken by Ford was to scrap the J-type model under development, which was described as being ‘overweight, under-powered and over budget’. The workforce was trimmed by 30 per cent in two years, and steps were taken to improve reliability, which was causing the car to generate poor customer satisfaction ratings. Face-lifts were carried out to the XJS and the XK6 models, but otherwise no changes were made to the product line. The problems had been compounded by the entry of the Japanese into the market with the Lexus, which was much the same price as a Jaguar and had already gained an outstanding reputation for quality and reliability. The Lexus had increased its sales in the US at a time when the market had slumped and Jaguar sales fell dramatically. One suggestion for the high price paid is that in 1989 Ford had a cash mountain of some $9 billion, and was looking for an opportunity to put this to work. One route to expansion was to enter the luxury car market, and GM had already expressed an interest in Jaguar in the role of a minority shareholder with an injection rumoured to be about £600 million. This could therefore be seen as a pre-emptive bid to ensure that Ford entered the luxury car market with a ready made product and an established market share.

Question
Use the list of reasons for a take-over to identify the areas in which Ford might have reckoned that there was potential for creating value by investing a significant proportion of this cash mountain in Jaguar.

Case 7: Good Morning Television Has a Bad Day (1993)
The following is an account of the experience of Good Morning Television (GMTV) from the time of making a successful bid for the UK advertiser-financed breakfast TV franchise in October 1991 until early 1993, three months after it started broadcasting on January 1, 1993.

The Bid
The regional independent TV franchises in the UK were auctioned in October 1991, to take effect from January 1993. The terms of the bid were an annual fee that an applicant would pay to the Treasury for a licence covering a period of ten years. This licence conveyed a local monopoly to the franchise holder of advertiser-financed television. In the case of breakfast TV it conveyed the right to broadcast national breakfast programmes; the only other advertising-financed
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breakfast programme supplier was the minority Channel 4 Daily breakfast business and arts programme which attracted a very small audience. Thus at the time the franchise for breakfast TV was regarded as being largely a monopoly. The two qualifications for a successful bid, beyond the price offered, were 1 2 Programme schedules had to meet a minimum quality threshold (not made explicit and at the discretion of the IBA). Applicants also undertook to pay a proportion of their advertising revenue to the Treasury. This varied according to the level of advertising expected.

The procedure adopted was to weed out the applicants with the lowest defined quality, and then award the franchises on the basis of the highest bids. The bids revealed that competition varied greatly among regions. For example, in some regions there was only one bidder and the amount bid was practically zero. In others the incumbent was already highly successful, such as TV-am, and the incumbent was ousted by an aggressive competitor. In the case of TV-am, which was the most successful breakfast TV show among the three terrestrial stations in the UK, the winning bid by GMTV amounted to £34.6 million per annum, together with 15 per cent of advertising revenue. Table 7.18 is a selection of the 16 franchise bids, and shows the extent of bid variation, and the surplus bid, which was the difference between the winning bid and the next best (which was not necessarily the incumbent’s bid). In some cases this is negative because quality was taken into account. There was only one breakfast franchise up for auction.
Table 7.18
Winner GMTV LWT Meridian Scottish Tyne-Tees

Auction results for ITV franchises (£million)
Winning bid 34.6 7.6 36.5 0.0 15.1 Incumbent TV-am same TVS same same Incumbent’s bid 14.1 same 59.7 same same Surplus bid 1.3

−27.8 −23.2
0.0 10.0

Some incumbent companies, such as Scottish, were faced with no competition, and did not pay anything for their new franchise. Other incumbents, such as Tyne-Tees, paid substantially more than competitors. On the other hand Meridian took over from an incumbent with a much smaller bid, i.e. the surplus bid was negative.

The Competition
GMTV’s business plan envisaged advertising revenues of £80 to £90 million for 1993, based on the TV-am market share of over 65 per cent. At the time the bids were submitted breakfast TV was dominated by the three terrestrial stations: the BBC (which is not advertiser-financed), TV-am and Channel 4. After a shaky start in the early 1980s, when the TV-am audience fell to about 200 000 viewers and there were only two advertisers, TV-am appointed Mr Greg Dyke
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to revamp its image, and by the time of his departure in the late 1980s TV-am had a dominant market share, and was one of the most profitable TV companies in the world. By 1991 the breakfast competition to which TV-am was exposed was not troublesome. The competitors were the news based TV show on the BBC, and the business and arts show on Channel 4 Daily. At this point satellite TV had still to make an impression.

Enter The Big Breakfast and satellite
GMTV took over with a fanfare of publicity from TV-am in January 1993, and introduced a line-up of new presenters in largely the same format as TV-am. However, the old formula did not work quite so well, and by February market share had fallen by 20 per cent. Why? Real competition had arrived in October 1992 from Channel 4 in the form of a production company called Planet 24, partly owned by the pop singer Bob Geldof. The Big Breakfast was like no other breakfast show, paying scant attention to topical events and personalities, but offering a frenetic assortment of games items aimed largely at a younger audience. By January 1993 The Big Breakfast had 15 per cent of the housewife audience, compared with 47 per cent for GMTV, and 37 per cent of the audience for children aged 5 to 15, compared with 32 per cent for GMTV. At the same time BSkyB, the satellite station, started to make inroads into the breakfast TV market as the number of viewers installing satellite dishes started to increase dramatically.

What Monopoly Profit?
In its first year of operation, based on the expected response of advertisers to the lower viewing figures, GMTV expected to produce revenues of £65 million against its business plan forecast of £80–£90 million. On the cost side • • • programming costs came to around £30 million per year; the £34.6 million licence fee had to be paid regardless of revenue; annually 15 per cent of revenues go to the Treasury.

Combining these costs, it appears that GMTV needed revenues of about £75 million per year simply to break-even. Unless GMTV could deliver larger audiences advertising revenue looked set to decline.

Come back Mr Greg Dyke
History can repeat itself. In February 1993, ten years after saving TV-am, Mr Greg Dyke was appointed to GMTV with the same remit. He was widely quoted as saying ‘This is not a cash crisis. We have five big shareholders who are all in this for the long term.’ Both the male and female anchor personalities were replaced by the end of February, only two months after the first broadcast. Their replacement presenters had actually anchored the TV-am show right up to December 1992 when it went off the air. GMTV also signed up a cartoon series based on characters from the Super Nintendo video game, which had sold in millions during 1992.
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Questions
1 2 3 Analyse the competitive environment facing a franchise bidder. What strategic errors did GMTV make from bid submission up to the arrival of Greg Dyke? What strategic options are available to Greg Dyke?

Case 8: The Rise and Fall of Brands (1996)
The heyday for brands
During the 1980s many companies capitalised on consumer loyalty to brands by increasing prices in excess of the inflation rate, and firms such as Kellogg and Heinz increased profits by about 15 per cent per year. In 1988 the value placed on brands was reflected in the following acquisition prices. Buyer Kohlberg Kravis Roberts Philip Morris Nestl´ e Taken over RJR Nabisco Kraft Rowntree Price Paid ($ billion) 25 13 5 Book Value ($ billion) 12 3 1

Admittedly, Book Value does not fully reflect the value of a company, but it is clear that predators were willing to pay substantial amounts for well known brand names. For example, by 1990 shares in US packaged-food firms were trading at a 30 per cent premium to Standard & Poor’s 500-stock index.

Brands lose their magic
By the early 1990s some influences had emerged which undermined the domination of brands. First, there was a recession in the early 1990s which led to increased competition among established brands. There was a plethora of special offers for branded goods which may have started to make consumers more price aware. Second, retailers began developing their own-label products. The effect of these two factors can be gauged from the fact that on 2nd April 1993 Philip Morris reduced the price of Marlboro cigarettes, regarded by many as the most successful brand in history. The price reduction was primarily due to the fact that Marlboro had been losing market share to unknown brands for several years, rather than losing share to the other major brands. The immediate impact of the price reduction was that 23 per cent was wiped off the value of Philip Morris shares. But there was also a knock-on effect, and shares in RJR, Procter & Gamble, Coca-Cola, PepsiCo, Quaker Oats and Gillette all suffered. Consumer research studies found that the proportion of shoppers willing to seek out particular brands and pay more for them fell sharply during the early 1990s; it was also found that the market share of the top three brands among
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many categories of supermarket goods dropped. By 1994 own-label brands took 36 per cent of grocery sales in the UK and 24 per cent in the US. There seem to be three main reasons for this • Perceived product parity: by 1993 research suggested that about two thirds of consumers world-wide believe there were ‘no relevant or discernible differences’ between rival brands across a wide range of products. In fact, consumers are often faced with a staggering variety of brand choice. This has partly been due to technological advances which made it possible to imitate a wide variety of goods; in 1992 16 800 new products were introduced in the US, 30 per cent more than five years previously. There are 200 brands of breakfast cereal in the US and 100 perfumes in Argentina. It may also be partly due to increasingly educated consumers who spend more rationally. Promotion monster: with the combination of recession and a huge increase in the number of brands, retailers began to auction shelf space (particularly in the US). Retailers were also given more discretion over pricing, and in Britain this sometimes led supermarkets to sell top brands at below cost as loss leaders. Own-label threat: not only was there a surge in own-label brands, but consumers are right that there is often no difference in quality. This is partly because most big branded-goods manufacturers started producing own-label products for supermarkets; once consumers became aware of this the magic associated with the brand name was lost. Another dimension to the own-label brand was that supermarkets starting to use their own label (‘good food costs less at Sainsbury’) as a brand in its own right; this served as an umbrella to cover hundreds of products.

The advertising industry took the stance that increased expenditure on advertising would shore up brand loyalty. But, with the advent of satellite and cable television and the proliferation of channels, audiences were fragmenting with the result that uniform advertising was no longer possible.

Some reactions
Clearly companies had to adapt in the face of these changing market conditions, and their reactions took different forms.

What Procter & Gamble did
This changing market posed difficulties for giant firms like Procter & Gamble, which had 2300 brand varieties in 1992. During 1992 Procter & Gamble slashed the wholesale prices of about 70 per cent of its products, and eliminated discounts to retailers to reward customer loyalty with low prices. This policy caused some adverse reaction; for example many retailers who relied on discounts went as far as denying shelf space to Procter & Gamble, while rivals stepped in with generous promotion deals of their own. Market research carried out by Salomon Brothers suggested that Procter & Gamble’s market share fell in 90 per cent of
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its product categories. At the same time, Procter & Gamble discovered that 25 per cent of its brands accounted for only 2 per cent of sales and scrapped some old brands. It is likely that well known brands of shampoo and toothpaste will disappear in the near future.

What Pepsi did
In 1996 Pepsi spent a reputed $500 million on changing the colour of its cola can.

What Unilever did
Unilever merged its ‘marketing’ and ‘sales’ departments into a series of ‘business groups’ focusing on consumer research and product development, and set up a separate ‘customer development’ team responsible for relations with retailers across all brands. The aim is to make everyone the ‘champion of the brand’, rather than those who used to be labelled ‘marketing’. In fact, this type of reaction is typical of a number of large companies, and some authorities are predicting the demise of the marketing department as an entity; some companies have turned their attention from ‘re-engineering’ their production departments to applying the same logic to the marketing department.

Questions
1 Why should the price of shares in companies like Coca Cola fall as a result of a price cut in Marlboro cigarettes? After all, in 1988 the value of brands (i.e. the difference between market value and book value) was enormous. Does this suggest that the stock market is totally illogical? Explain what was happening in the market for brands using strategy models. Discuss the three types of response.

2 3

References
1 2 3 4 5 6 7 Earl, P.E. (1995) Microeconomics for Business and Marketing, E. Elgar, Cheltenham, p. 148. Porter, M.E. (1985) Competitive Advantage, New York: The Free Press. Miles, R.E. and Snow, C.C. (1978) Organizational Strategy, Structure and Process, McGraw-Hill. Markides, C.C. and Williamson, P.J. (1994) ‘Related diversification, core competencies and corporate performance’, Strategic Management Journal, Vol. 15, pp. 149–65. Porter, M.E. (1987) ‘From competitive advantage to corporate strategy’, Harvard Business Review, May–June, pp. 43–59. Taylor, W. (1991) ‘The logic of global business: an interview with ABBs’ Percy Barnevik, Harvard Business Review, March–April, pp. 90–105. Roberts, E.B. and Berry, C.A. (1985) ‘Entering new businesses: selecting strategies for success’, Sloan Management Review, Vol. 26, No. 3, Spring.

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Implementing and Evaluating Strategy
Contents
8.1 8.2 8.3 8.3.1 8.3.2 8.3.3 8.3.4 8.3.5 8.3.6 8.3.7 8.4 8.4.1 8.4.2 8.5 8.6 8.7 Implementing Plans Organisational Structure Resource Allocation Management of Change Critical Success Factors Management Style Budgets Incentives and Alignment Setting Sales Targets Resource Planning Evaluation and Control Monitoring Market Share Monitoring Profitability Feedback The Augmented Process Model Postscript: Strategic Planning Works 8/2 8/3 8/6 8/6 8/7 8/7 8/8 8/9 8/10 8/11 8/12 8/14 8/15 8/18 8/19 8/23 8/24 8/24 8/25 8/27 8/30 8/33

Review Exercise Case 1: The Body Shop (1992) Case 2: Daimler in a Spin (1996) Case 3: Eurotunnel – a Financial Hole in the Ground (1996) Case 4: The Balanced Scorecard Case 5: Revisit An International Romance that Failed: British Telecom and MCI

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Learning Objectives
• • • • • Methods of resource allocation in the strategic context. Methods for evaluating the effective use of resources. Assessing the role of feedback. Analysis of ongoing competitive position. Augment the strategic process model.

8.1

Implementing Plans

Strategists

Objectives

Who decides to do what

The macro environment

The industry environment

Internal factors

Competitive Analysis and diagnosis position
Feedback

Generic strategy alternatives

Strategy variations

Strategy choice

Choice

Resources and structure

Resource allocation

Evaluation and control

Implementation

In the models of the strategic planning process developed in Module 2, the implementation stage is visualised as starting after the choice of strategy has been made. Once implementation gets under way it is to be expected that there will be a constant process of feedback with earlier stages. As resources are mobilised it may become apparent that the original objectives are unattainable, that predicted costs were too low, that likely competitive reaction was overestimated and that the full range of strategy choice was not realised. This may make it difficult to isolate implementation as an independent activity in practice. However, by treating implementation as an independent part of the strategy process, the manager is forced to recognise that no matter what sophisticated analysis has been undertaken to arrive at a strategic choice, at the time the choice is made it is possible that nothing has been produced and nothing has been sold. In other words, choosing strategy is not an end in itself; unless there is a mechanism for making it happen it is a somewhat pointless activity. At this stage it needs to be reiterated that strategic planning is really a process and is not necessarily accompanied by a detailed set of plans. The strategy may have been arrived at in an incrementalist manner, or it may have emerged in response to changing circumstances; the generic strategy, perhaps of expansion through cost leadership, might be perceived only in general terms. In fact, the temptation to translate a generic strategy into a set of procedures and well defined goals may be counter-productive because it robs the company of the ability to adapt to changing circumstances; feedback and continuous reaction are
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important elements of the process model. But even a vague concept of where the company is headed and the strategy it has selected to achieve its objective has implications for how resources are allocated and their use monitored. In what follows the use of the term ‘plan’ therefore refers to management’s perception of the strategic plan rather than to a plan in the formal sense.

8.2

Organisational Structure

Strategists

Objectives

Who decides to do what

The macro environment

The industry environment

Internal factors

Competitive Analysis and diagnosis position
Feedback

Generic strategy alternatives

Strategy variations

Strategy choice

Choice

Resources and structure

Resource allocation

Evaluation and control

Implementation

There are many ways of organising a company, and companies often have a structure which exists as the consequence of historical influences; little explicit consideration may have been given to whether the company structure is suited to meeting the company’s objectives. This is the question of whether structure follows strategy or vice versa: the company structure can influence company operations in such a fundamental fashion that it may dictate the strategic direction; many managers consider that company structure and planning cannot be treated separately. Among other things the organisational structure affects the power structure, determines who allocates resources, identifies responsibilities for undertaking action and affects the effectiveness with which resources are deployed. This means that a change in organisational structure can lead to changes in company performance, both in the short and long term, as different views on strategy assume importance and resources are redeployed. The difficulty is to establish criteria on the basis of which the most appropriate structure for individual companies can be determined. The two main types of company structure are the functional (also known as U form) and divisional (also known as M form). The functional structure groups employees according to the type of work which they do: FUNCTIONAL STRUCTURE Research, Development Production Marketing Finance, Accounting
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An alternative structure, which pays less attention to specialities, splits the company into a series of divisions; the division can be based on products or geographical boundaries, and typically each division will have its own functional structure. This structure developed because of the coordination problems of the U form. It also contributes to resolving the principal/agent problem in that divisional profitability can be more easily measured than functional returns. DIVISIONAL STRUCTURE Household electrical Industrial electrical Electronic Software The divisional structure is more likely to be encountered when the company has a differentiated product portfolio; however, a single-product company which operates in different countries, or services distinctly different types of customer in a given country, can have a divisional structure. The extent to which divisions are independent of the corporate centre varies among companies; in some cases the divisions have considerable freedom of action and could be classified as SBUs. These are only two of the many possible types of company structure, but they vary sufficiently to demonstrate that companies in a similar business may be organised along totally different lines. The issue of which type of structure is most appropriate to a particular company, or whether a possible strategic thrust should be accompanied by a change in structure, is not susceptible to a simple answer. There are advantages and disadvantages associated with different types of structure, and the relative importance of these will depend on the circumstances of the individual company. Some of the advantages and disadvantages of functional and divisional structures are displayed in Table 8.1.
Table 8.1
Advantages Specialisation Division of labour Simplifies training Preserves strategic control Advantages Divisional performance can be expressed in terms of profit Coordination among functions Develops broadly trained managers

Structure: advantages and disadvantages
Functional structure Disadvantages Coordination among functions Concentration on functional rather than company objectives Coordination among departments Lack of broadly trained managers Divisional structure Disadvantages Coordination among specialised areas Communication between functional specialists Duplication of functional services Loss of strategic control to divisional managers

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These advantages and disadvantages are by no means exhaustive, and there could be disagreement in the individual case as to what actually comprises an advantage or disadvantage. There are a number of methods of obtaining a perspective on different structures. One is to pose the question as to how different forms of organisation are likely to contribute to the creation of value. For example, the introduction of a large corporate structure may have little impact other than to increase costs, and in this sense would have a negative impact on company value. Another is to ask if a structure is likely to be consistent with, or flexible enough to deal with, predicted changes; for example, a company organised on functional lines may find this structure incapable of delivering a planned increase in market share in selected segments of the market because more product specialists are required with the appropriate production back-up. A less common form of structure is the matrix. This approach is valuable in principle when economies of scope provide a rationale for organising along more than one dimension. The problem is that those at the intersections report to two hierarchies and have two bosses. This can lead to serious problems of direction and control, and can lead to employees lacking focus. This type of organisation is ready made to cause principal/agent problems. Another approach which has been found useful in certain circumstances is networks, where work groups may be organised by function, geography or customer base. Relationships among groups are governed more by often changing implicit and explicit requirements of common tasks than by formal lines of authority. Again, this structure raises problems of direction and control. Given the potential impact which structure has on company performance and the ability to achieve objectives, it is important not to allow the issue to be resolved by default. Although it is difficult to identify the most appropriate structure, it may be possible to recognise a structure which is inconsistent with company characteristics. When selecting the appropriate structure it is necessary to balance trade-offs between scale and scope economies, transaction costs, agency costs and information flows. There is no single prescription, and the best organisation depends on individual circumstances. It is important to be clear about the extent to which structure follows strategy. It was discussed in 1.4 how company structure has evolved in response to changing market demands and developments in strategic approaches: from the original functional form through divisionalisation, diversification and finally reverting to restructuring and downsizing. The structure must be seen as a method of resource allocation which is relevant to the company objectives, the competitive environment and the strategy being pursued.

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8.3

Resource Allocation

Strategists

Objectives

Who decides to do what

The macro environment

The industry environment

Internal factors

Competitive Analysis and diagnosis position
Feedback

Generic strategy alternatives

Strategy variations

Strategy choice

Choice

Resources and structure

Resource allocation

Evaluation and control

Implementation

All companies are continually faced with the problem of allocating resources. The difficulties of achieving efficient resource allocation are exacerbated when the company decides on a strategic change which involves the allocation of resources to new uses. The conversion of a plan into a course of action requires a system of resource allocation which ensures that the necessary resources are acquired and activated to achieve the objectives of the plan. 8.3.1

Management of Change
By its nature, reallocation of resources involves changing what people do. A company which has been operating in mature markets for some time may find this much more difficult to achieve than prospector type companies which have a history of innovation, growth and diversification. The British economy has long been associated with reluctance to change on a large scale; from the mid 1960s miners, shipbuilders and steelworkers wished to remain in jobs which were becoming progressively uneconomic, and were not only unwilling to change to other jobs but wanted to carry on doing their existing jobs in the same way as they had always done. The notion that a job belonged to an employee led to decades of job demarcation disputes, and strikes aimed at ‘saving jobs’ which were in direct opposition to market forces. Every company which attempts to undertake change faces the problem of change implementation. In order to cope with change many companies lay a great deal of stress on a corporate culture which rewards adaptability, innovation and flexibility. Such companies believe that this ethos is conducive to the introduction of changes which save costs, increase productivity, and get people to do things better and think of better things to do. The important point for managers to bear in mind is that reallocation of resources is not simply a matter of investing, retooling, and hiring new people. Even a relatively modest reallocation may present insuperable problems for companies which have fostered a ‘no change’ mentality amongst their workforce.

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On the positive side, there are a number of techniques which can be applied to implement change, and these have been effective in a variety of settings. The techniques include survey feedbacks, team building, confrontation and transactional analysis; in the strategy context, the detail of how these approaches work is less important than that managers recognise when the organisation is in need of help in facilitating change. 8.3.2

Critical Success Factors
The notion of critical success factors has its roots in network and critical path analyses originally developed for use in military planning. In principle the idea is simple: a project is set out as a sequential network of events with the objective of identifying the critical path, which is the minimum time for the project. Inspection of the network reveals that there are some things which must happen before others become possible. The same general approach can be adopted in strategy implementation, but because of the complexity of the process, and the fact that so much is unknown about the future, it is really only possible to identify events which must occur, or things which must be done, in order to ensure that the strategy has a chance of coming to fruition. It is not a straightforward matter to identify critical success factors. It is necessary to have a detailed understanding of available resources, the resources which will be required, the sequence of events and how individuals are likely to react to the changes which they will experience. A critical success factor can be the acquisition of a capital asset or it could be the installation of an appropriate incentive structure. When it is found that a strategy is not being implemented as effectively as originally expected it is more than likely that a critical factor has been overlooked; the reason that the whole process has ground to a halt is because that is the nature of a critical success factor.

8.3.3

Management Style
The current management team may not be well equipped to implement a strategy which involves a significant degree of change. For example, a company which decides to diversify will require the senior management team to become more concerned with corporate level decision making rather than running a single product line. The current finance officer may not have the experience and skills required to handle financial planning in a diversified company; the personnel officer may have no experience in introducing significant change into an organisation, and integrating new and existing activities. At the SBU level, the type of manager who has successfully run a ‘Cash Cow’ may not have the innovative approach to market development and risk taking required to transform a ‘Star’ into a money-making proposition. The stock of management skills in the company may not match the requirements of strategic change. Apart from the skills which the individual managers possess, leadership style and company culture exert a significant impact on the ability of the organisation to undertake change. Companies vary substantially in their approaches to leadership: some lay stress on a hierarchical structure, and adopt a dictatorial

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approach to decision making; others attempt to be democratic, making efforts to involve employees at all levels in the management process by adopting such policies as ‘open door’ and management by walking about. In the Amstrad case (Module 7) the company was virtually indistinguishable from its leader, Alan Sugar. In some instances it may appear obvious that the management style is not consistent with planned strategic changes; for example, a medium sized family run business which has in the past firmly concentrated control among family members, and developed a company culture of subservience to family decisions, may find it difficult to diversify and develop new markets where an innovative workforce will be essential. Porsche (Module 3) was owned by the family and seemed slow to react to strategic challenges. As in the case of company structure, it is not possible to prescribe the optimum management style for a particular company. However, it should be possible to identify gaps in management skills and potential inconsistencies between planned and current organisational requirements. 8.3.4

Budgets
The problem of allocating budgets is encountered at many levels, but for strategy purposes these can be reduced to two: the corporate and SBU or functional levels. At the corporate level the overall budget is rationed among competing alternatives, typically on the basis of proposals submitted by SBUs. Some of the issues involved in corporate budget policy were discussed at 1.3. At the SBU or functional level it is necessary to allocate funds to individual managers so that they can carry out the tasks which are required to achieve the objectives of each investment; the investment appraisal which revealed that the net cash flows generate a positive NPV does not usually take into account uncertainty as to how costs will actually be incurred and resources deployed. At the corporate level it could be argued that no budget constraint exists, because any investment which generates a positive NPV ought to attract funds from the market; by definition, this is a project which generates a return greater than the company’s cost of capital. In principle, the capital rationing situation described at 1.4.1 should not occur. However, there are many reasons why a company may be unable to raise money on the market to finance investments. The most obvious one is when the market does not agree with the company’s estimate of future returns; the track record of the company’s managers may be such that the market views their plans with considerable reserve. Another reason is that the company may be unwilling to reveal its intentions to competitors. The desirability of an investment may depend on achieving a competitive advantage which would be impossible if competitors knew what the company’s strategy was likely to be. In fact, strategic options are often difficult to define with the precision which will attract investors. It is one thing to use investment appraisal to attempt to estimate the relative value implications of alternative strategies, but it is quite another to translate this into a convincing investment plan. It therefore seems likely that the company will be faced with a budget constraint when allocating available funds among competing investments. The theory of finance can provide a solution to the capital rationing problem of

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determining which combination of investments will add most to shareholder wealth within the context of the chosen strategy. However, the application of sophisticated capital rationing techniques does not necessarily resolve the budget allocation problem. This is because the formal capital rationing solution is in terms of a combination of investments, and may exclude some investments with higher NPVs than those included. It may be difficult to explain to an SBU manager that his proposed investment, with a relatively high NPV, has been excluded because of the application of an obscure financial technique. It is obviously important to use appropriate financial techniques to identify the most profitable budget allocation; whether it is feasible is another matter. One way to avoid the difficulties associated with capital rationing is to set across-the-board budget limits; this has the advantage that all SBUs are treated in the same way, and in turn the SBUs can set across-the-board limits, since this is consistent with corporate policy. However, such an approach is inconsistent with principles of efficient resource allocation. The whole emphasis of the strategic planning process has been on the identification of activities with different potential payoffs and directing resources accordingly. For example, if the objective were to increase the market shares of products currently being produced, it would make little sense to increase the research budget at the same time simply because the marketing budget was to be increased. On the other hand, if there is no sensible budgetary control, when companies are faced with adverse market conditions and decide to follow a retrenchment strategy the first thing that is usually done is to cut back on those budgets which can be manipulated without affecting current performance. Training, research and maintenance budgets are often pruned to achieve an immediate increase in ROI without proper consideration of the overall resource allocation implications. This is often justified by senior management on the grounds that survival is the primary concern and refinements can come later. This reaction is probably inevitable when senior management concentrates attention on short term cash flows rather than on the concept of shareholder wealth, which puts short term cash flows into context. At the functional level the SBU manager is confronted with many imponderables. If a new market is being entered he has to decide how much to allocate to marketing and over what period. The marketing manager has to decide how much to allocate to market research, advertising, promotions and so on. By the time the original funds have been parcelled up and allocated to the various functions, it may be difficult to identify specific expenditure with the original project. The original investment appraisal assumed that the cash would be used efficiently at the functional level. The management problem at this level is to ensure that this happens, but there may be relatively few guidelines to assist managers who are in the front line. An ostensibly attractive strategy may flounder because budgets are disseminated throughout the organisation in a haphazard fashion. 8.3.5

Incentives and Alignment
Ideally, incentives should be related to the value creating activities of the company; in other words, the incentive system should reward individuals for adding value. This is an important step in resolving the principal agent problem. But,

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given the difficulty of determining value for the company as a whole, it is clearly impossible to parcel out the components of added value to managers and employees. On the other hand, it should be possible to recognise when the incentive system is not aligned with the value creation objective. For example, a production manager who is rewarded for minimising inventories can cause havoc with a marketing strategy aimed at achieving an increased market share. It is important for managers to recognise that the incentive system may be at fault when the performance of individuals does not match expectations. In fact, one of the barriers to change is that incentive systems are not reviewed to ensure that they are consistent with revised company and individual objectives; what is perceived as being unwillingness to change may be partly due to the fact that individuals can see that a proposed change is not to their advantage given the existing system of incentives. It is a basic fact of life that managers and employees will be unwilling to change their behaviour if the benefits of doing so are perceived as being lower than the costs to themselves. A change in the incentive system can go a long way towards easing the implementation of change and contributing to the alignment of individual and company objectives. 8.3.6

Setting Sales Targets
The allocation of resources to selling is a basic determinant of strategic success, given that the mechanism by which target market share is achieved is by setting sales targets to SBUs and to individual salespeople. Companies use sales targets to give the sales force an idea of what is expected of them, and to serve as part of an incentive system. But what criteria can be used to determine what the target market share should be, or how many units should be sold by a particular sales group in a particular segment of the market? Attention is usually not directed towards how much should be sold, but on how much can be sold; however, concentrating on the maximisation of sales with existing sales resources does not address the underlying resource problem. The resource allocation question can be framed in the following fashion using the concept of marginal analysis:
Is Marginal Revenue > Marginal Cost?

If the additional revenue associated with the last unit sold is greater than the additional cost incurred in making the sale, then it is worthwhile aiming for that level of sales. While it is important to bear this principle in mind, it is difficult to apply in practice because the information available is in terms of expectations of revenues and costs:
Is Additional Expected Net Revenue > Additional Expected Cost?

Furthermore, the evaluation cannot be made simply in terms of the price versus the unit cost because an increased sales effort which results in a higher market share can contribute to long term competitive advantage. For example, a higher market share could lead to the ability to set higher prices in the future, and to a lower unit cost because of economies of scale and experience effects. While the expected revenues and costs are difficult to estimate with precision, it is useful to attempt an approximation which will make explicit how the sales
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Module 8 / Implementing and Evaluating Strategy

target fits into the general goal of value creation. In the absence of information on expected revenues and costs many managers set the objective of maximising sales as a second best; this may be a reasonable basis for ongoing decisions on sales, but it has the potential to promote a serious misallocation of resources. The trade-offs can be put in context in a similar fashion to the determination of target market share by applying the basic income and cost model:
Net income = Total market × Market share × (Price − Unit cost)

Sensitivity analysis can be used to project different scenarios over the product life cycle; the discounting approach can be used to evaluate different scenarios in NPV terms. This can help indicate the appropriate level of sales, and provide managers with a degree of confidence that the revenue from selling the last unit is at least as high as the cost of producing and selling it. A further dimension of marginal cost relates to the opportunity cost, rather than the financial cost, of additional sales when the product is sold in a number of segments. If the resources available to allocate to selling the product are limited, they should be allocated among different segments of the market such that the marginal benefit equals the marginal cost in the different segments. If this condition did not hold, net revenue could be increased by allocating resources from those activities where marginal cost was greater than marginal benefit to those where marginal cost is less than marginal benefit. 8.3.7

Resource Planning
If the company is ever going to achieve a competitive advantage, it must set up procedures to ensure that resources are used efficiently and that the components and linkages of the value chain are effective. A fundamental requirement in effective resource planning is that the production department knows what it is meant to produce; this means setting up communications between marketing and production so that each can understand the other’s viewpoint. For example, it is often found that the production department is frustrated by continuously changing volumes of orders, and as a result cannot always react with fast delivery times; the marketing department may feel that reasonable notice of orders is always given, and that the production department is inefficient and not really interested in fulfilling the needs of hard won customers. Effective communication between marketing and production would reveal the likely incidence of bulk orders, provide guidance to production on how much inventory the marketing department feels that it can reasonably live with, and enable the marketing department to appreciate the difficulties of capacity utilisation and inventory control, and the benefits of a relatively stable production schedule. Resource planning has implications for all aspects of the company’s performance. The application of sophisticated just-in-time approaches can reduce inventory costs significantly, the smoothing of peaks and troughs in production schedules can create the stable environment necessary to develop a company culture, the introduction of new technology at appropriate times enables the company to make use of new skills and techniques, and a systematic approach to resource planning is the foundation for monitoring costs.

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8.4

Evaluation and Control
Who decides to do what

Strategists

Objectives

The macro environment

The industry environment

Internal factors

Competitive Analysis and diagnosis position
Feedback

Generic strategy alternatives

Strategy variations

Strategy choice

Choice

Resources and structure

Resource allocation

Evaluation and control Implementation

The strategic planning approach is initially based on expectations. When the plan is implemented it is necessary to measure and evaluate actual performance to find out if the expectations are being fulfilled. When the component parts of the plan have been made explicit, the plan provides a benchmark against which actual outcomes can be compared, so that when variations between expected and actual outcomes occur their causes can be investigated. For example, it may be found that the net contribution from a particular product is lower than anticipated in the plan; this could occur for a variety of reasons, for example because the selling price turned out to be lower than predicted, or because productivity was lower, or because market share turned out to be harder to win. The reason for the shortfall will suggest whether action should be taken to achieve the original objectives, or whether the plan itself needs revision in the light of events; it is essential to identify whether the deviation from the plan is due to causes within the control of the company. This process contributes to the conversion of the plan from wishful thinking to a means by which the company is enabled to exert control over its performance. The case of Barings bank and the losses generated by Leeson were discussed at 4.3.4 as an example of the risks associated with operating in the international market place. There is more to this case than simply the magnitude of the risks involved, because it revealed a lack of strategic control on the part of Barings. The same lack of control was apparent at Daiwa, whose trader Toshihide Iguchi lost ev