STRATEGIC MANAGEMENT PART 1 Contents: • Understanding strategy • Purpose of

strategic management • Distinguishing strategic problem from tactical problem •

Formulation of a strategic plan

A) Understanding strategy:
In understanding strategy two broad views are used, viz., strategic fit concept
and strategic stretch concept. Both are discussed in the following paragraphs. But
before discussing those two concepts, we need to discuss two factors on which
these two concepts lean heavily i.e concept of external and internal environment.
External environment lets one know the industry in which the firm is operating. It
takes into account the product and factor markets. Profitability of the firm
essentially depends on these two markets. Equilibrium conditions in these two
markets determines the profitability. Strategic management monitors the factors
which influence the equilibrium. Internal environment deals with the status of the
resource base of the firm on the basis of which the firm competes in the market.
This concept is encapsulated in the concept of SWOT analysis. SWrefers to internal
environment whereas OT-Refers to the external environment. The essence is that
strength and weaknesses is matched with opportunities and threat to develop
strategy. Now which environment is more important? It is in this regard that the
two broad views or schools of thought differ. Strategic fit concepts or the
classical school lays the importance on the external environment whereas the
strategic stretch concept emphasizes on the internal environment of the firm.
Let’s discuss both of them one by one--1. Strategic Fit concept: Michael Porter
and other eminent classical strategy Gurus have the dominant figure in shaping
this framework of business strategy. According to them, the central thrust of the
strategy is to gain a sustainable competitive advantage over the competitors which
results in the superior profitability of the firm. In their opinion, the
difference in profitability among the firms operating in the industry can be
attributed to the external environment and not to the internal resource base. This
happens due to mobility of factors which wipes out the heterogeneity of the
resource base in the long run. Then the higher profitability is attributed to the
higher adaptive capacity of the firm in adapting to changing external environment.
So monitor the environment, find opportunities and modify the resource base. So
according to this view, strategy is a set of action plans which is used to monitor
the external environment of the firm in order to adapt the firm according to the
changes of the environment aiming at gaining a sustainable competitive advantage.
2. Strategic Stretch concept: This concept evolved out of the quest for success of
Japanese firm in 1970s when they entered the U.S market. It was attributed to the
factor that not the adaptive capacity but to the quality of the resource base that
makes the difference in commercial success. So, the purpose of strategic
management is to improve the quality of the resource base. The notion of core
competencies is closely related to the socalled resource based view of the firm.,
which is most recent model to understand the mechanism for achieving competitive
advantage. It represents a major departure from a strategic approach based on
market driven considerations. But how the firm decides which resource base to use
to gain positive economic profit? The criteria are as follows---
i) Is it easily available? It means that the resources are traded in the market or
not. For example, the raw material or resources should not be easily available to
the competitors. ii) Inimitability: The resource should be such that it cannot be
easily copied by the competitors and hard to copy. There are certain features of
resources which makes it hard to copy: • For • Physical uniqueness: It refers to
acquiring assets which are not available to any other competitor. example: Service
centres of Maruti. Path Dependency: A resource base is developed expending lot
over a long period of time, which the competitor wants to copy or develop has to
spend the same time and i.e will have to follow the same path. This is called path
dependency. example: Corporate image, Goodwill etc.

if amount For •

Causal ambiguity: It means developing excellence in multi areas of which few can
be copied but not the all. It isdeveloping the sum total attribute of
characteristics which are unique.

Scale deterrence: It means coming out with a mammoth size plant then taking down
the cost cannot be copied by the competitors.

which

iii) Durability: Every asset depreciates with use. But to gain sustainable
competitive advantage, firm need to have assets which don’t depreciate with use
such as non-physical asset. For example: Brand name of TATA. iv) Appropriability:
Resources create value. Receiver of the values varies. As a manager, it is the
duty to take care that the value created by firm remains within the firm. A
strategy that is both unique and sustainable generates a significant economic
value. The issue of appropriability addresses the question of who will capture the
resulting economic rent. Sometimes, the owners of the business unit do not
appropriate the totality of the value created because of the gap that might exist
between ownership and control. Non owners might control complementary and
specialized factors that might divert the cash proceeds away from the business.
This type of dissipation of value is called holdup. A notorious example of holdup
in recent business history has taken place in the personal computer industry,
where Microsoft and Intel have captured manufacturing firms the meager 20 percent
remaining.
The second threat for the appropriability of the economic value is referred to as
slack. It measures the extent to which the economic value realized by the business
unit is significantly lower than what potentially could have been created. Slack
is often the result of the inefficiencies or unwarranted benefits that prevent the
accumulation of economic results in the business. While holdup produces a
different distribution of the total wealth created, slack reduces the size of this
wealth. v) Substitutability: If it can be substituted by anything else, then it
can’t be the source of competitive advantage. vi) Superiority: Whether it is of
superior value than the competiting firm or not. vii) Opportunism and timing: One
other condition that is necessary to obtain competitive advantage occurs prior to
establishing superior resource position. It is necessary that the cost incurred in
acquiring the resources are lower than the value created by them. In other words,
the cost implicit in implementing the strategy of business unit should not offset
the value generated by it. This condition is what we aspire to capture under this
requirement of opportunism and timing in order to secure competitive advantage.

B) Purpose of strategic management:

The primary concern of strategic management is to help the firm gain a sustainable
competitive advantage in the market place. Competitive advantage is a competitive
superiority in attracting customers. It helps the firm to gain a continuous
positive economic profit. Now economic profit is defined as --Economic profit=
Profit after tax (PAT) --- Cost of equity capital It is considered as a measure of
competitive advantage because it considers the productivity of all the factor. On
economic profit there is no claimant. Thus it is called free cash which can be
invested in future to meet company’s non-financial goal. The cost of equity
capital is calculated using the capital asset pricing model developed by William
Sharpe. Knowledge of strategic management helps a manager in the following ways—
i) Defining the boundary of the firm: The boundary of the firm has three
aspects--- corporate, horizontal and vertical boundary. • Corporate boundary: It
is not possible for a single firm to rule over the market. Thus instead of looking
at all areas , the firm must decide what are the business areas it wants to look
for and compete. This defines the corporate boundary of the firm.
•

Horizontal boundary: As a manager, a person divides the business of the firm into
different product markets. Now based on resources the firm decides on which
segments it wants to compete. This is called the horizontal boundary of the firm.

Vertical boundary: Vertical boundary means whether the firm only produces the
finished product, or produces both the raw material, end products and distributes
its end product also. These all determines the market place the firm is going to
compete.

ii) Industry analysis: Knowledge of strategic management helps the manager in

analyzing the industry the firm is operating in. It has been found empirically
that the kind of industry the firm operates in, determines its profitability, at
least to the extent of 20-30%. So at every point of time, the manager has to think
that whether the firm should enter the industry in particular or exit. iii)
Positioning in the market place: Positioning means how the firm wants to present
itself in the market. There are three ways to it--• • • Cost leadership strategy—
It means that the firm endeavors to keep the cost of production and distribution
less than any other firm in the industry. Product differentiation—It means that
the firm differentiates its product by features as per the customer requirements.
Focus strategy—It postulates to concentrate at the niche market instead of looking
at all the market.

iv) Internal organization of the firm: It means the administrative system which
the firm can use to narrow down the goal incongruence between the goal of the firm
and goal of individuals. These are— • • • • Management control system (MCS)
Management communication and information system(MCIS) Organisational structure
(OS) Executive compensation system(ECS)

C) Distinguishing strategic problem from tactical problem:

All organizational problem can be categorized as—strategic problem and tactical
problem. There are three characteristics based on which we can distinguish these
two problems--- Range, Scope and End orientation. Let’s discuss each one of them
one by one—
a) Range: When an organizational problem is solved it creates effects across the
organization. The duration of the effect is called range. The longer the range,
more difficult to reverse it. Strategic problem has a longer effect thus a longer
range and tactical problem has a shorter range. b) Scope: Scope of a problem
denotes the area of an organization it encompasses and feels the effect of the
problem. Strategic problem has a larger scope than a tactical problem. c) End
orientation: In order to solve some problem, the end which is going to be achieved
through solving the problem is given and in some cases has to be identified while
solving the problem. In strategic problem, the end result is not given, rather has
ti be identified before embarking on the problem. In case of tactical problem, the
end result is given, e.g. minimize the total transportations cost.

D) Formulation of a strategic plan:

The steps involved in developing a strategic plan can be plotted as follows:
Developing mission statement  Analysis of internal environment  Analysis of
external environment  Developing broad strategies  Developing long term program
 Developing short term program  Implementation.
A strategy project may be conducted in five phase s

Phase I

Phase II Situational Context of Strategy Design

Phase III Dev elopment and assessment of strategic options

Phase IV Specif ication of chosen strategy

Phase V Implementation plan

Project Initialization

• Infor mati on collection and issue anal ysis • Selection of team members • Wor k
pl an • Time pl anni ng

• Market segmentation • Market attracti veness • Competition anal ysis • Synergy

potential • Market position • Cost- and revenue position • Corporate strategy /
business portfolio • Strength and weaknesses / cor e competences

• Definition of strategic • Description of chosen goals options in detail and

definition of related • Differenziati on strategic goals • Organizational, HR •
Business plan related and fi nanci al • Detailed outline of consequences
consequences for • Development of organization and strategic options HRM • Risk /
attractiveness assessment of the options • Choosing of options

• Design of implementati on plan • Timeframe and milestones • Priorities •

Responsi bilities • Resources • Project c ontrolling

TOO L- B OX
MA BE S trategy Consulting January 2007 ©Prof. Friedrich Bock

page 22

Strategic issues at different level:

Corporate strategy deals with basic values and overall vision portfolio of
activities (Strategic Business Units - SBU’s) mission of each strategic business
unit overall allocation of resources Business strategy deals with competitive
positioning of the business unit choice of segments trade-offs, specific strengths
action towards customers Functional strategy deals with development of functional
strengths and resources as required by businesses and the corporation
PART B DEFINING THE BOUNDARY OF THE FIRM Contents: • Vision of a firm • Developing
the mission statement---- Process and contents

A) Vision of a firm:
A vision gives direction for the desired future scope and position of a company:
sIt deals with the future. sIt is ambitious. sIt is expressed in simple terms -
understandable at all levels of the company. sIt does not deal with details, but
is concrete. sIt does not deal with solutions. sIt opens space for creative
forward thinking, based on an (emotionally appealing) “picture” sIt is not a
secret plan but an open declaration. sA vision serves to create a common mind set
throughout the organization. sIt helps to mobilize people. sIt creates momentum
and initiative: “Am I doing enough to increase the fit of my business with the
corporate vision?”

B) Mission of a firm:
Mission of a firm is the expression of its strategic intent. Strategic intent is
the fundamental ends a firm wants to pursue. Mission statement also reveals the
self-concept of the firm. Thus, the mission of the business is a qualitative
statement of overall business position that summarizes the key points with regard
to products, markets, geographic locations and unique competencies. A mission
statement abstracts the important points to guide the development of business.
Besides others there are two pieces of information that must be contained in the
mission statement---Clear definition of current and future business scope and
second the unique competencies that distinguish the firm from others in the same
industry. Following is the detailed description of the contents of the mission
statement--i) Core values: It is the beliefs which guide the behaviour of the
firm. This is to be encoded in the mission statement so that the employees
understand that it has to be followed at any cost. ii) Core purpose: It is the
fundamental end for which an organization exists. It is the very reason of the
existence of the firm in the market. iii) BHAG—It represents Big Hairy Audacious
Goal. This implies, that the mission statement should be organized in such a
manner that it fires up the competitive zeal of the employees. In their celebrated
article, Garry Hamel and C.K.Pralhad state that rather than trimming ambitions to
match available resources, managers should instead leverage resources to reach
seemingly unattainable goals. This challenge is at the heart of a proper mission
statement. iv) Vivid description of future: A mission statement is grossly
incomplete without the clear definition of the expected future business scope.
This has got two dimensions---business and ethical. Business dimensions
includes-------
• •

Scope of the firm: the description of current and future market scope, product
scope, geographical reach scope and customer scope. Positioning strategy: This
explains on what basis the firm wants to compete and how the firm wants itself to
be known in the market. There are two ways to create value for money for
shareholders— cost leadership strategy and product differentiation strategy. The
image of the firm will depend on this positioning strategy. Responsibilities to
the stakeholders: Here the firm has to spell out how it wants to treat its
different stakeholders.

Factors influencing the development of mission statement: Following factors play a

crucial role in developing and shaping the mission statement are as follows: • • •
• Organisational power structure Corporate culture Personal values of CEO Societal
value i) Organisational power structure: In every organization there are two
groups of people viz. Internal stakeholders and External stakeholders which
competes with each other. An organization is a dynamic powerstructure. The group
which wins decides the shape of the mission statement. One author has found out
several power structure which works toward the development of the mission
statement---a) Continuous Chain or Simple mass output system: Here external
stakeholders are the people who decides the mission statement. For example: Stock
exchange and Post office. b) Closed system: Here the external stakeholders are
fragmented and internal stakeholders are more powerful and there is no clear goal
of the firm to follow. c) Command type system: This is the typical power structure
in an organization set up by an entrepreneur or organization passing through
severe crisis. Here the entrepreneur decides the mission statement. No value
system is adhered to. d) Missionary power configuration: This is the type of
organization which works for a voluntary cause. Here the mission statement is
driven by ideology. e) Professional power configuration: This is the
organizational power structure typically found out in consulting firms like TCS,
IBM, Mckinsey etc where some outstanding professional determine the mission
statement. f) Conflictive power configuration: Here the entire organization is
divided into power groups which fight with each other and the group that wins
determines the mission statement. ii) Corporate culture:
Corporate culture is the sum total of beliefs, values, norms, which regulate the
behaviour of an employee in the organization. Since mission gets implemented by
the employees, it’s very much imperative that the organizational culture is taken
into account with due importance while framing the mission statement. iii)
Personal Values of CEO: Personal values of CEO, who is ultimately held responsible
for the company’s growth, determines the mission statement and also his risk
taking ability influences the mission statement. iv) Societal values: Any firm is
a social entity. Societal values is the timeless principle which has evolved in
society over very long period of time and the firm must obey it and comply with
it. Advantages of Mission statement: Developing an mission statement serves
several important purpose, such as……. a) It gives the guidelines as to how to
treat different stakeholders: It is embedded in the mission statement, and of
course in its development, which stakeholder is more important and how to satisfy
them. So, in other words, mission statement sets a priority amongst the
stakeholder, to be served by the organization. It also determines the right of
every stakeholder on the economic value created by the stakeholders. b) Mission
statement helps to avoid strategic opportunism:

c) Mission statement is a tool for communication. It conveys the expectations of

the firm from its employees.
PART C ANALYSIS OF INTERNAL RESOURCE BASE AND ENVIRONMENT Contents: • • • Value
chain analysis Strategic group concept Benchmarking

A) Value chain analysis: (Describe the value chain of a firm and its significance
in strategic planning—2005,[4]) This very concept was propagated by Michael Porter
as a tool of analyzing the firm’s internal environment and resource base. It is an
analytical tool that describes all activities that make up the economic
performance and capabilities of the firm, used to analyze and examine activities
that create value for a given firm. A firm can be conceived of an aggregation of
discrete activities and the competitive edge arises based on how a firm performs
these activities better than its competitors. The cluster of these activities is
called the value chain. The value chain classifies each firm’s activities into two
broad categories: Primary activities and Secondary activities or support
activities. The following figure represents the value chain of a firm: S u p p o r
t a c t i v i . MARGIN

FIRM INFRASTRUCTURE HUMAN RESOURCE MANAGEMENT

TECHNOLOGY DEVELOPMENT

PROCUREMENT

Inbound Logistics

Operations

Outbound logistics

Marketing and sales

Service

MARGIN

<-----------------PRIMARY ACTIVITIES---------------------->

Primary activities: The sequence of activities through which raw materials are
transformed into benefits enjoyed by the customer is called primary
activities.These activities relate directly to the actual creation, development,
manufacture, distribution, sales and servicing of
the product or the service to a customer. Five major activities are involved in
this sequence: inbound logistics, operations, outbound logistics, marketing and
sales and service. Working together, these activities determine the key
operational tasks surrounding the product or services. • Inbound logistics: As the
word implies, inbound logistics deal with the handling of raw materials and
inventory received from the firm’s suppliers. Detail activities include Receiving,
storing, materials handling, warehousing, inventory control, vehicles scheduling
and returns to suppliers. Operations: Operations are the activities and procedures
that transform raw materials, components and other inputs into finished end
products. Detail activities include machining, packaging, assembly, equipment
maintenance, testing, printing, facility operations. Outbound logistics: Outbound
logistics refers to the transfer of finished product to the distribution channel
members. The focus of outbound logistics is on managing the flow and distribution
of products to the firm’s immediate customers such as wholesalers and retailers.
Activities and procedures associated with outbound logistics include inventory
control, warehousing, order processing, delivery schedule maintenance etc.
Marketing and sales: Marketing and sales include advertising, promotion, product
mix pricing, specifying distribution channel members, maintaining channel
relations etc in order to induce and facilitate buyers to purchase the product.
Service: Customer service is a central value adding activity that a firm can seek
to improve over time. It includes installation, repair, training, parts supply and
product adjustment in order to maintain or enhance the value of the product after
sales.

• •

Secondary or support activities: The remaining activities of the value chain are
undertaken to support primary activities. They are therefore referred to as the
secondary or support activities. Support activities help the firm improve co-
ordinations across and achieve efficiency within the firm’s primary value adding
activities. Support activities are located across the first four rows of the
diagram. This includes, procurement, technology development, human resource
management and firm level infrastructure. • • • • Procurement: Securing inputs
(such as raw materials, supplies, and other consumable items and assets) for
primary activities. Technology development: Methods of performing primary
activities are improved (Such as know-how, procedures, technological inputs
needed) Human resource management: Employees who will carry out the primary
activities are recruited, trained, motivated and supervised. Firm infrastructure:
Activities such as accounting, finance, legal affairs, and regulatory compliance
are carried out to provide ancillary support for primary activities.

How value chain analysis matters in strategic planning: As already stated, the
competitive edge arises based on how better the firm performs the activities
involved in the value chain compared to its competitor. For this purpose, each
activity is broken up in sun activities for comparison with the competitors, and
three basic questions are tried to be answered?
i) How can the firm keep the benefits provided to the customers intact keeping the
cost constant? ii) How can the firm increase the benefits provided to the
customers keeping the cost constant? iii) How can the firm increase the benefits
provided to the customer while lowering the cost? For creating competitive
advantage through the value chain analysis while answering these questions, Porter
has suggested the following measures---• • • Reconfigure the value chain
differently from those of the competitors. Perform the activities more efficiently
than the competitors. Outsource the non-core activities: While outsourcing the
following points are needed to be judged judiciously--i) There might be a risk of
non-performance by the supplier, To avoid this, ways of keeping alternative
suppliers, Tapered integration and part outsourcing can be adopted. ii) There
might be a risk of disproportionate value appropriation iii) There can be a high
risk of elimination by suppliers. • Internal integration of value chain
activities: Internal integration of value chain activity gives the following
benefits… i) Improvement of quality ii) Shorten new product development cycle.
iii) By integrating the firm with its external suppliers and buyers it can reduce
inventory holding costs, enhance the ability to customize the product and become
more responsive to customers’ demand. The point to be noted that throughout the
whole analysis every measures are to be taken on the basis of comparison with
suppliers. B) Strategic group concept: Strategic group is a group of firms within
an industry which face the same environmental forces, have same resources and
follow similar strategy in response to the environmental forces. To carry on the
value chain analysis it is very important that the firm identifies the strategic
group to which it belongs. Porter suggests the following dimensions to identify
differences in firm strategies within an industry: i)specialization, ii) brand
identification, iii) a push versus pull marketing strategy, iv) vertical
integration, v)channel selection, vi) product quality, vii) technological
leadership, viii) cost position, ix)service, x) price policy, xi) financial and
operating leverage, xii) relationship with parent company, xiii) relationships
with home and host government. We should try to locate in the same group all firms
with comparable characteristics and following a similar competitive strategy.
Essentially the concept of strategic grouping is a very pragmatic approach aimed
at cataloguing firms within an industry in accordance with the way they have
chosen to seek competitive advantage. This segmentation is useful when one faces a
high diversity of competitive positions in a fairly complex and heterogeneous
industry. Typical examples of this situation are global industries with a wide
variety of players, some being totally international and some purely local. A
useful tool that can guide the separation of strategic group in an industry is the
so called strategic mapping. This is a two dimensional display that helps to
explain the different strategies of the firm. These two dimensions should not be
interdependent because otherwise the map would show an inherent correlation. Most
important, managers must choose those dimensions that are most salient and
relevant to their own particular industry.
Though according to Porter, move from one strategic group to another is very
difficult, because every strategic group creates its own image in the market
place, the following points should be kept in mind: • Strategic groups can shift
over time as the needs of the customers or different technologies evolve in the
marketplace. Therefore managers should not assume that membership in a particular
strategic group permanently locks the firm into a fixed strategy. With sufficient
resources and focus, firms can enter or exit strategic groups over time. Entire
strategic groups and the firms that compose them can emerge and disappear over
time. Thus as the environment changes, the competitive conditions that define a
strategic group may work against the entire collection of the firms, resulting in
the groups long term decline if competitive conditions intensify. In recent years
one of the more enduring trends that have defined a growing number of industries
is the hastening pace of consolidation. Competitors are now seeking to buy or
merge with their rivals to limit the effects of fierce price wars that negatively
impact profitability. Thus consolidation within and among industries can also
markedly redefine the underlying stability and membership of strategic group.

C) Benchmarking: It is the process of continuously measuring and comparing the

business processes against comparable process of the leading organization to
obtain the information that will help the organization to identify and implement
improvement programs. The essence of benchmarking is to contrast the firm’s
performance against some challenging yardsticks. It is a multistep process in
which the firm doing the benchmarking seeks to learn and incorporate process
refinements, even if the model firm is different from its own. The steps in
benchmarking (compared to induatry) are as follows: Step1: The firm identifies
those processes within its own organization that need improvement or attention,
Step 2: Managers try to locate other firms that are particularly distinctive or
excellent in performing or managing those processes. Step 3: The benchmarking firm
contacts the managers of the model firm to learn from their experiences, problems
and solutions. Step 4: The bench marking firm tries to duplicate the successful
practices or processes that seem to performance and better quality. Benefits of
Benchmarking: The benefits of benchmarking are as follows: • • • It sparks the
creativity of internal people. The firm can be the frontrunner of implementing
practices which was never conceived of in the industry. For example: The “BARCODE”
invented by the American agricultural food products association. Targeting the
best, so the firm keeps itself ahead of the other competitors.
Types of Bench marking: There are four types of benchmarking: 1. Historical
benchmarking: It refers to evaluating the firm’s current performance with the
firm’s past performance. The problem here is that the past performance may not be
impressive. Secondly, There can be an illusion of big performance. Thirdly, It may
encourage more of a bad thing. For example, if rejection rate is high, SQC is put
in place and as a result rejection goes down, But this is not a progress. The
question is why should rejection happen at all? Fourthly, Competitor performance
is not considered in this way. 2. Industry Bench marking: It refers to evaluating
one own performance with industry data. The major problem here is—getting stuck in
the middle. Second, unequal bases of comparison, like comparing apple with orange.
3. Functional benchmarking: It refers to finding one activity and finding out the
best practice in that in any strategic group or in any industry and upgrade the
process to that.
PART C ANALYSIS OF EXTERNAL ENVIRONMENT Analysis of external environment of a firm
is necessary while formulating strategy because----i) It affects the business
potential of the firm and therefore its profitability. ii) It influences resource
allocation among businesses in a multibusiness firm. When we consider the external
environment of the firm, we get two layers: i) Operating environment. ii) Remote
environment or macro environment. We will discuss the model used to analyze those
environment one by one:

i) Macro environment:
Macro environment includes all those environmental forces and conditions that have
an impact on every firm and organization within the economy. The main differences
between operating environment and remote environment are ----a) Forces consisting
of macro environment affects all the firm directly or indirectly across the
industry. b) The environmental forces comprising the external macro environment
are given A firm cannot do anything or do very little to influence it. For
analyzing the macro environment we use two models, PEST (Political, Economic,
Social, Technological) and STEEP (Social, Technological, Economic, Ecological,
Political) However without adhering to any particular model, we will describe the
general environments included in macro environment and their effect on strategy
decisions. • Economic environment: The variables included in this environment are
GNP,GDP, Distribution of GDP and GNP, Inflation, Balance of payments(BOP), Size of
external debt. Let’s discuss them one by one.. i) GDP and GNP: GDP includes the
market value of the goods and services produced within the country by domestic and
foreign factors of production whereas GNP includes the value of goods and services
newly produced by domestic factors of production at home and abroad. When a firm
is multinational, GDP and GNP gives the level of wealth in aparticular country and
thus the economic vigour of the country. ii) Distribution of GDP and GNP: How GDP
and GNP is distributed across various industry and area is also important because
it denotes which industry and which location are important.
iii) Inflation: Inflation also poses a big problem because it increases the price
of factors of production and thus to survive the firm has to change the price very
often. Inflation also affects the firm in the following way…. Inflation…> Rise in
bank interest rate….> Rise in prime lending rate….> Investment slows down for
being costly…>Slow economic growth rate. iv) Balance of payments: BOP also
influences the economic environment. Adverse BOP affects in the following way….
Adverse BOP

Import restriction Interest rate hike

Cost of foreign raw material goes up

Foreign companys can’t remit dividend in foreign currency

Business loans get less attractive

Slow economic growth

v) Size of external debt: Size of external debt is also very crucial because this
affects in the following way…… High external debt…..>Import restriction…….>Foreign
currency gets dearer.

Social environment:
Analyzing the social environment is also very important in formulating appropriate
competitive strategy. The main variables included in this environment are as
follows…..

i) Demographics: Demographics is the statistical variables used to define a

population. It influences the firm by dominating the nature of demand, size of
working population etc. ii) Social stratification: Social stratification means how
the society is divided in different castes, tribes, starta etc. This is very
important in case of market segmentation and targeting and desigining the product
offering according to that. iii) Importance of work and result. iv) Employment as
a profession---How people view the work under someone. v) Trust on people--- How
much is the mutual trust among people. vi) Individualism versus collectivism vii)
Consumer buying process—whether it is simple or complex. viii) Educational level—
If it high then tendency to white collar jobs increases. Analyzing social
environment is particularly essential because it helps to solve the following
problem… 1. Mobility of labour. 2. How much important is material reward. 3. How
to meet the social needs in the firm. • Political and legal environment: The
variables included in this environment which influence the strategic decision
are--i) Number of political parties and their ideologies. ii) Form of legal system
(Common law, civil law and theocratic law) iii) Laws related to business issues.
(Health and safety, employment practice, environmental practice, laws related to
export import, group treaties and international business forums) • Technological
environment: Status of fundamental research, development research and technology
are the main variables here. It is important to analyze because it depicts the
scope of innovation and infrastructural facilities that a firm can avail. •
Ecological environment:
The main variable included here are the---1. Status of natural wealth 2. Flora and
fauna 3. Laws relating to utilization and exploitation of ecological resources.
This is very much important because it determines to which extent and how a firm
can use the natural environment of a country to its own benefits.

ii) Analyzing the operating environment—Porter’s five forces model:

Operating environment of a firm refers to the industry to which a firm belongs.
According to Michael E. Porter an industry can be defined as “The group of firms
producing products that are close substitute to each other”. The intensity of
competition in an industry is neither a matter of coincidence or bad luck, rather
competition in an industry is rooted in its underlying economic structure and goes
well beyond the behaviour of the current competitors. According to Porter, the
state of competition in an industry depends on five basic competitive forces
(which is presented in the diagram below). It is imperative to analyze this forces
in order to formulate competitive strategy because the collective strength of
those forces determines the ultimate profit potential in the industry, where
profit potential is measured in terms of long run return on invested capital. Also
knowledge of these underlying sources of competitive pressure highlights the
critical strengths and weaknesses of the company, animates its positioning in its
industry, clarifies the areas where strategic changes may greatest payoffs and
highlights the areas where industry trends promise to hold the greatest
significance as either opportunities or threats. Following is a diagrammatic
representations of the basic five forces underlying the competitiveness of the
industry:

POTENTIAL ENTRANTS

Threat of new entrants

INDUSTRY COMPETITORS SUPPLIERS Bargaining power of suppliers Rivalry among

existing firms BUYERS Bargaining power of buyers

Threat of substitute product or services SUBSTITUTES Let’s now discuss each of

these forces one by one------
1. THREAT OF NEW ENTRANTS: New entrants to an industry bring new capacity, thy
desire to gain market share and often substantial resources. Prices can be bid
down or incumbent’s costs inflated as a result, reducing profitability. The threat
of entry into an industry depends on A) the barriers to entry that are present,
coupled with B) reaction from existing competitors that the entrant can expect.
These are discussed below:

A. Barriers to entry:
There are major seven sources of barriers to entry which are as follows:

i) Economies of scale: Economies of scale refer to declines in unit costs of a

product (or operation or function that goes into producing a product) as the
absolute volume per period increases. Economies of scale deter entry by forcing
the entrant to come in at large scale and risk strong reaction from existing firms
or come in at a small scale and accept a cost disadvantage, both undesirable
options. ii) Product differentiation: Product differentiation means that
established firms have identification and customers loyalties, which stem from
past advertising, customer service, product differences, or simply being first in
the industry. Differentiation creates barrier to entry by forcing entrants to
spend heavily to overcome customer loyalties. This effort usually involves start
up losses and often takes an extended period of time. Such investments in building
a brand name are particularly risky since they have no salvage value if entry
fails. iii) Capital requirements: The need to invest large financial resources in
order to compete creates barrier to entry, particularly if the capital is required
for risky or unrecoverable upfront advertising or research and development. iv)
Switching costs: A barrier to entry is created by the presence of switching costs,
that is, one time costs facing the buyer who witches over from one supplier’s
product to another’s. v) Access to distribution channel: A barrier to entry can be
created by the new entrants’ need to secure r its product. To the extent that
logical distribution channels for the product have already been served by
established firms, the new firm must persuade the channels to accept its product
through price breaks, cooperative advertising allowances and the like, which
reduce profits. vi) Cost disadvantages independent of scale:
Established firms may have cost advantages not replicable by potential entrants no
matter what their size and attained economies of scale. The most critical
advantages are the factors such as the following: a) Proprietary product
technology or patent b) Favourable access to raw materials c) Favourable
locations. d) Government subsidies e) Learning or experience curve effect.

B) Expected retaliation ( Contrived deterrence)

The potential entrant’s expectations about the reaction of existing competitors
also influence the threat of entry. If existing competitors are expected to
respond forcefully to make the entrant’s stay in the industry an unpleasant one,
then the entry may well be deterred. 2. INTENSITY OF RIVALRY AMONG EXISTING
COMPETITORS: Rivalry occurs because one or more competitors either feels the
pressure or sees the opportunity to improve position. Intense rivalry is the
result of a number of interacting structural forces: i) Numerous or equally
balanced competitors: When firms are numerous, the likelihood of mavericks is
great and some firms may habitually believe they can make moves without being
noticed. Even when there are relatively few firms, if they are relatively balanced
in terms of size and perceived resources, it creates instability because they may
be prone to fight each other and have the resources for sustained and vigorous
retaliation. ii) Slow industry growth: Slow industry growth turns competition into
a market share game for firms seeking expansion. Market share competition is a
great deal more volatile than is the situation in which rapid industry growth
insures that firms can improve results just by keeping up with the industry and
where all their financial and managerial resources may be consumed by expanding
with the industry. iii) High fixed or storage costs: High fixed costs create
strong pressures for all firms to fill capacity which often lead to rapidly
escalating price cutting when excess capacity is present. iv) Lack of
differentiation or switching costs: Where the product or service is perceived as a
commodity or near commodity, price and service competition result. v) Capacity
augmented in large increments:
Where economies of scale dictate that capacity must be added in large increments,
capacity additions can be chronically disruptive to the industry supply/ demand
balance particularly where there is a risk of bunching capacity additions. vi)
Diverse competitors: Competitors diverse in strategies, origins, personalities,
and relationships to their parent companies have differing goals and differing
strategies for how to compete and may continually run head on to each other in the
process. vii) High strategic stakes: choice by the buyer is largely based on price
and service, and pressure for intenseRivalry in an industry becomes even more
volatile if a number of firms have high stakes in achieving success there.

viii) High exit barriers: Exit barriers are economic, strategic and emotional
factors that keep companies competing in business even though they may be earning
low or even negative returns on investment. The major sources of exit barriers are
specialized assets, fixed cost of exit, strategic interrelationships, emotional
barriers and government and social reactions. 3. THREAT OF THE BUYERS: Buyers
compete with industry by forcing down the price, bargaining for higher quality or
more services and playing competitors against each other-all at the expense of
industry profitability. A buyer group is powerful if the following circumstances
hold true: i) It is concentrated or purchases large volumes relative to seller
sales: If a large portion of sales is purchased by a given buyer this raises the
importance of the buyer’s business in results. Large volume buyers are
particularly potent forces if heavy fixed costs characterize the industry. ii) The
products it purchases from the industry represents a significant fraction of the
buyer’s cost or purchases: Here buyers are prone to expend the resources necessary
to shop for a favourable price and purchases selectively. When the product sold by
the industry in question is a small fraction of buyer’s cost, buyers are usually
much less price sensitive. iii) The product it purchases from the industry are
standard or undifferentiated: Buyers, sure that they can always find alternative
supplies, may play one company against another. iv) It faces few switching costs:
Switching costs lock the buyer to particular sellers. Conversely the buyer’s power
is enhanced if the seller faces switching costs. v) It earns low profits: Low
profits create great incentive to lower purchasing costs. Highly profitable
buyers, however, are generally less price sensitive and may take a long term view
toward preserving the health of their suppliers. vi) Buyers pose a credible threat
of backward integration: If buyers either are partially integrated or pose a
credible threat of backward integration, they are in a position to demand
bargaining concessions. vii) The industry’s product is unimportant to the quality
of the buyer’s product or services: When the quality of the buyer’s product is
very much affected by the industry’s product, buyers are less price sensitive. For
example: medical equipment. viii) The buyer has full information: Where the buyer
has full information about demand, actual prices, and even supplier costs, this
usually yields the buyer greater bargaining leverage than when information is
poor. 4. THREAT OF THE SUPPLIERS: (Bargaining power of the suppliers) Suppliers
can exert bargaining power over participants in an industry by threatening to
raise prices or reduce the quality of purchased goods and services. Powerful
suppliers can thereby squeeze profitability out of an industry unable to recover
cost increases in its own prices. A supplier group is powerful if the following
apply: i) It is dominated by a few companies and is more concentrated than the
industry it sells to: Suppliers selling to more fragmented buyers will usually be
able to exert considerable influence in prices, quality and terms. ii) It is not
obliged to contend with other substitute products for sale to the industry: The
power of even large, powerful suppliers can be checked if they compete with
substitutes. iii) The industry is not an important customer of the supplier group:
When suppliers sell to a number of industries and a particular industry does not
represent a significant fractions of sales, suppliers are much more prone to exert
powers. If the industry is an important customer, suppliers fortunes will be tied
up to the industry and they will want to protect it through reasonable pricing and
assistance in activities like R&D and lobbying. iv) The suppliers’ product is an
important input to the buyer’s business:
Such an input is important to the success of the buyer’s manufacturing process or
product quality. This raises the supplier power. This is particularly true when
the input is not storable, thus enabling the buyer to build up stocks of
inventory. v) The supplier group’s products are differentiated or it has built up
switching costs: Differentiation or switching costs facing the buyers cut off
their options to play one supplier against another. If the supplier faces the
switching costs the effect is the reverse. vi) The supplier group poses a credible
threat of forward integration: This provides a check against the industry’s
ability to improve the terms on which it purchases.

5. THREAT OF SUBSTITUTES: It becomes high when---i) Existing products have a lower

price performance ratio than the new product. ii) Number of substitutes are very
high iii) Switching costs for the buyers are very low. The point to be noted here,
that here we have to take into account the indirect substitutes such as product
for product (Fax vs. E-mail), Substitution of needs, Generic substitutes and doing
away with the product itself (Tobacco).
PART E
FORMULATING THE STRATEGIES AND POSITIONING THE FIRM IN THE MARKET Contents: A)
Three generic strategies—Cost leadership, Differentiation, Focus. Having analysed
the operating environment through Porter’s five forces model, a firm needs to
decide on the strategies it will adopt. For deciding on the strategies a firm
needs to consider its goal. A firm’s goal is to gain competitive advantage which
is measured by positive economic profit, which is in turn measured by economic
value. Now, Economic value(EV)= B – C Where, B= Perceived utility of a firm’s
product. It is measured by the maximum willingness to pay. This i.e. maximum
willingness to pay is measured by auctioning the new product. C= Opportunity cost
of input resources that are used up to produce and distribute the product. Now to
gain competitive advantage a firm must have…… (B-C) > (B` -- C`) where B` and C`
are same as B and C but for competitors. Now as the gap between (B-C) and (B`--C`)
increases, organization has more liberty. Now we can write, B-C = (B-P)+(P-C) (B-
P) is the consumer surplus and (P-C) is the producers’ surplus. Given this the
firm’s aim is to give more to consumer at a lesser cost i.e to maximize the gap
between (B-C). Now having the aim as mentioned above, M.E.Porter suggests three
generic strategies--i) Product differentiation strategy. ii) Cost leadership
strategy. iii) Focus strategy. Porter’s proposition is to focus on either B or C.,
because the first two set of strategies are mutually exclusive. Cost leadership
strategy focuses on C and product differentiation strategy focuses on B. Now we
will discuss these three strategies one by one—

1. COST LEADERSHIP STRATEGY:

It aims at achieving lowest economic costs with benefits same as the competitors
or bit less. Result is (B-C) greater than equal to (B`-C`). Let’s discuss the
sources of cost leadership--A. Sources of cost leadership strategy: The sources of
cost leadership strategy are as follows:
i) Economies of scale in production: Economies of scale refer to declines in unit
costs of a product (or operation or function that goes into producing a product)
as the absolute volume per period increases. Now if we plot the U shaped average
cost curve, we get to see---

AC AC

Economies of scale

Diseconomies of scale

MES

Production

The volume of production at which average cost is minimum is called the “minimum
efficient scale”. The sources of economies of scale are as follows: • • • • •
Volume of production Specialized equipment. Employee specialization Cost of the
plant (The rule states that if a plant increases by double in size, the cost will
increase by 2α where α = 0.66 to 0.80 Lower fixed cost.
ii) Learning curve effect: Learning curve effect states that direct labour cost of
production goes down by a certain percentage each time accumulated volume of
production gets doubled. For example: if it takes 10 hours to produce 1st unit and
9 hrs to produce second unit, so learning curve effect is 9/10X100=90%. So for the
fourth unit the time will be 9 X 0.9=8.1 hrs. But getting the time amount for the
third unit is not possible in this way. So it is expressed as mathematical
relationship which is depicted by the following diagram--[ The mathematical
relationship is given by the equation y=ax-β where…. x= no of units produced a=
time taken to produce first unit y= Average time to produce y unit β= The
coefficient related to learning curve.

Direct labour cost

y=ax-β

Production Graphical representation of Learning curve effect

The implication is that the existing producer has the accumulated experience in
production for which the cost of production will be lower than a new entrant who
does not have any experience. Example: Following are the data given: Time to
produce first unit= 45 minutes Time to produce second unit=27 minutes Estimate the
learning curve coefficients and average and total time to produce 6 units.
Solution: Here average time to produce two units (y)= (45+27)/2 minutes= 36
minutes So in the equation, y=ax 36=45 (2)
-β -β

, putting a=45, x=2, y=36, we get

Solving we get, β

= 0.3219

Now we want to find out the average and total time to produce 6 units, which are
as follows: Average time(y)= 45(6)-0.3219 minutes Total time={45(6)-0.3219}X 6
minutes. This learning curve effect was found first in aircraft manufacturing
industry during world war II and applicable in case of direct labour cost. Bruce
Henderson, founder of Boston consulting group, this effect is not only applicable
to labour cost but also to all value added costs. Value added costs are defined as
the difference between the total cost of the product and cost of raw materials. He
has given a new name to it, called “Experience curve effect”.

iii) Access to low cost factors of production: Achieving a low overall cost
position often requires a high relative market share or other advantages, such as
favorable access to raw materials. High market share in turn allow economies in
purchasing which lower costs even further. iv) Cost advantages independent of
scale: Established firms may have cost advantages not replicable by potential
entrants no matter what their size and attained economies of scale. The most
critical advantages are the factors such as the following: a) Proprietary product
technology or patent b) Favourable access to raw materials c) Favourable
locations. d) Government subsidies e) Learning or experience curve effect. B.
Specific functional strategy under cost leadership generic strategy: Following are
the different strategies under cost leadership---i) Economies of scale: This
implies producing larger volume in automated structure. This helps reducing the
costs thus contributing to the competitive advantage. ii) Automate parts of manual
process: Automating different parts of a manual process helps reducing costs which
helps make process less expensive. This can also be done by employing high skilled
workers. iii) Redefine product:
This strategy tells to redefine the product in such a way that cost advantage is
far better than benefit disadvantage. For example: Indian postal service and DHL.
Other initiatives that are required to achieve the cost leadership strategy are--•
• • • • Construction of efficient scale activities. Vogorous pursuit of cost
reductions from experience. Tight costs and overhead control. Avoidance of
marginal customer accounts. Cost minimization in areas like R&D, service, sales
force, advertising and so on.

C. Commonly required skills and resources and common organisational structure to

implement cost leadership strategy: i) Commonly required skills and Resources: • •
• • • Substantial capital investment and access to capital. Process engineering
skills. Intense supervision of labour. Product designed for ease in manufacture.
Low cost distribution system.

ii) Common organizational requirements: • • • • Tight cost control. Frequent,

detailed control reports. Structured organization and responsibilities. Incentives
based on meeting strict quantitative targets.

D. Risks of Cost leadership strategy: Cost leadership imposes severe burdens on

the firm to keep up its position, which means reinvesting in modern equipment,
ruthlessly scrapping obsolete assets, avoiding product line proliferation and
being alert for technological improvements. Cost declines with cumulative volume
are by no means automatic, nor is reaping all available economies of scale
achievable without significant attention. Cost leadership is vulnerable to the
same risks as on relying on scale or experience as entry barriers. Some of the
risks are---• • • Technological change that nullifies past investment or learning.
Low cost learning by industry newcomers or followers. Through imitation or through
their ability to invest in state of the art facilities. Inability to see required
product or marketing change because of the attention placed on cost.
•

Inflation in costs that narrow the firm’s ability to maintain enough of price
differential to offset competitors brand images or other approaches to
differentiation.

The classic example of the risks of cost leadership is the Ford motor company of
the 1920s. Ford had achieved unchallenged cost leadership through limitation of
models and varieties, aggressive backward integration, highly automated
facilities, and aggressive pursuit of lower costs through learning. Learning was
facilitated by the lack of model changes. Yet as incomes rose and many buyers had
already purchased a car and were considering their second, the market began to
place more of a premium on styling, model changes, comfort and closed rather than
open cars. Customers were willing to pay a price premium to get such features.
General Motors stood ready to capitalized on this development with a full line of
models. Ford faced enormous costs of strategic readjustment given the rigidity
created by heavy investments in costs minimization of an obsolete model.

2. PRODUCT DIFFERENTIATION STRATEGY:

This generic strategy implies generating more perceived value of the product (B)
than its competitors at the same costs of the competitor or bit higher, such that
(B-C) greater than equal to (B`- C`). The essence of this strategy is creating
something that is perceived industry wide as being unique. A. Approaches to
differentiation: A firm can differentiate along several dimensions such as--• • •
• • Design or brand image (Titan) Technology (Sony, Philips) Features (Nokia)
Customer service (Maruti) Dealer network (Philips, Hero –Honda)

B. Specific strategies under product differentiation strategy: The different

specific strategies under product differentiation generic strategy are as follows:
i) Product features: Increase of product features implies increase of the
perceived value of the product (B) which in turn involves increase in costs which
forces the price to go up. But the firm has to ensure that increase in the
perceived value of the product is greater than the increase in the cost, thus
creating a positive economic value. ii) Timing: Timing of introduction of the new
product is also very crucial to gain competitive advantage. Because the first
entrant always has an advantage of locking in the customers and creating switching
costs.
iii) Location: Competitive advantage is also determined by the location of
factories, warehouses, after sales service points. All these affects the early
availability which helps to gain competitive advantage. iv) Reputation: Reputation
of company, brand also helps to increase the perceived value of the product,
contributing to the competitive advantage. For example, recent marketing of VOLTAS
air conditioner as a “TATA PRODUCT”. v) Cross functional features: Incorporating
cross functional features in the product also contributes towards the competitive
advantage by increasing the perceived value of the product. Example: Camera and
video recording features in mobile phone. vi) Linkage with other firms: Here we
have to remember that horizontal integration is not same as the horizontal
marketing. Two firms coming together to produce a product, to market a product
etc, contributes to the competitive advantage by enhancing the perceived value of
the product. C. Commonly required skills and resources and common organizational
requirements for product differentiation strategy: i) Commonly required skills and
resources: • Strong marketing abilities. • Product engineering. • Creative flair.
• Strong capabilities in basic research. • Corporate reputation for quality or
technological leadership. • Long tradition in the industry or unique combination
of skills drawn from other businesses. • Strong cooperation from channels. ii)
Common organizational requirements: • • • Strong coordination among functions in
R&D, product development and marketing. Subjective measurement and incentives
instead of quantitative measures. Amenities to attract highly skilled labour,
scientists and creative people.

D. Risks of product differentiation strategy: Differentiation involves a series of

risks such as • The cost differential between low cost competitors and the
differentiated firm becomes too great for differentiation to hold brand loyalty.
Buyers thus
• •

sacrifice some of the features, services, or image possessed by the differentiated

firm for large costs savings. Buyers need for the differentiating factor falls.
This can occur as buyers become more sophisticated. Imitation narrows perceived
differentiation, a common occurrence as industries mature.

E. Successful implementation of product differentiation strategy: This will depend

on several factors which are depicted below in the diagram….

High quality service Timely distribution of products through distribution channel

Annual customer survey

Successful implementation

Economic profit

ROI

Dollar investment of the product in warehouse

A string of new products

No of patents

The factors in the first box after the circle in each direction is called the
critical success factors and the following box is the measurement criteria of that
critical success factors. Now all these factors are given weight to be measured.

3. FOCUS STRATEGY:
This strategy postulates selecting or focusing on a particular market, buyer
group, segment of the product line, geographical market etc, then reconfigure the
value chain to satisfy the needs of the customers. This is practiced by
organizations with limited resources or with a very risky product. Although the
low cost and differentiation strategies are aimed at achieving their objectives
industrywide, the entire focus strategy is built around serving a particular
target very well and each functional policy is developed with this in mind. The
strategy rests on the premise that the firm is thus able to serve its narrow
strategic target more efficiently and effectively than competitors who are
competing more broadly. As a result, the firm achieves either differentiation from
better meeting the needs of the particular target or lower costs in serving the
target or both. Even though the focus strategy doesnot achieve low cost or
differentiation from the perspective of the market as a whole, it does achieve one
or both of these positions vis-à-vis its narrow market target. Here to achieve
competitive advantage the firm has to do two things…
i) Create economic value: (Discussed earlier) ii) Capture economic value: This
concept is related with price elasticity of demand. Depending upon that, two
strategies are adopted… a) Margin strategy: This strategy tells to increase the
profitability by concentrating on the increase of unit product margin. b) Share
strategy: This strategy concentrates on increasing the market share resulting in
the sales volume as well as profit. Now we shall compare this strategy with cost
leadership and product differentiation strategy.. Price Elasticity of demand Ep>1
Cost Leadership Small fall in price=>Large increase in sales => Share strategy
i.e. decrease price marginally than competitors and exploit benefit from
increasing market share. Differentiation Small increase in price=>Large fall in
sales=> Share strategy i.e. maintain price parity with the competitors and exploit
benefit of higher market share by giving more perceived value. Big fall in
price=>Little increase Margin strategy: Provide more in sales=> Margin strategy
i.e. benefit at higher price. maintain price parity and lower cost drives the
higher profit margin.

Ep< 1

4. Selection of cost leadership and differentiation strategy:

i) Cost leadership strategy is ideal for commodity market where consumers are
price sensitive. When it is a search product, then also cost leadership strategy
is adopted. ii) Product differentiation strategy is adopted in case of experience
product, non commodity and non-price sensitive product.

5. How to implement the generic strategies:

There are four levers to implement this strategy. They are as following: i)
Management communication and information system. (MCIS) ii) Management control
system. (MCS) iii) Organisation structure (OS) iv) Executive compensation system
(ECS) Now let’s take a look at the comparison of these levers under two generic
strategies: Levers Cost leadership strategy Product differentiation strategy
ORGANISATION STRUCTURE (OS)

1. Few layers in organization structure. 2.Simple, U type reporting relationships.

3. Small corporate staff 4. Focus on narrow range of business.

MANAGEMENT CONTROL SYSTEMS (MCS) EXECUTIVE COMPENSATION SYSTEM (ECS) MANAGEMENT

COMMUNICATION AND INFORMATION SYSTEM. (MCIS)

1. Cross divisional/cross functional product development team. 2. Semi permanent

organization structure to exploit new business opportunities. 3. Isolated pockets
of intensive creative efforts. 1. Tight cost control. 1. Broad decision making
guide 2. Quantitative cost goal. lines. 3. Close supervision of raw 2. Managerial
freedom within materials, labour, inventory and guidelines. overhead. 3. Policy of
experimentation. 4. A cost leadership philosophy. 1. Reward for cost reduction. 1.
Reward for taking risk. 2. Incentive for all employees 2. Reward for creative
flair. involved in cost reduction. 3. Multidimensional performance measurement
system. 1. Strategic plan (Vision, Mission etc.) 2. Budget 3. Company newsletter.
4. Theme of the year.
PART F FUNCTIONAL STRATEGIES
Contents: 1. Economies of scope 2. Strategic gap analysis and Growth strategies
(Ansoff growth strategies) 3. Different growth form- strategic alliance, joint
venture,Diversification, Merger and acquisition. 1. ECONOMIES OF SCOPE: Economies
of scope implies “ When more than one item is produced at a plant, it is cheaper
than producing the items separately in different plants” S, if we produce X and Y,
an the cost function of X and Y are Q(X) and Q(Y) and if the cost function for
producing the items jointly in one plant is Q(X,Y) then.. Q(X,Y)<Q(X,0) + Q(0,Y)
Economies of scope can be observed in other functions other than production such
as purchase, distribution etc. But for economies of scope, the products X and Y
has to be related, preferably to the core competency of the organization. 2.
STRATEGIC GAP ANALYSIS AND ANSOFF GROWTH STRATEGIES: So far we have discussed the
generic strategies and what are the sources of the. Basically generic strategies
set a broad guiding principles as to how would the firm operate in the market
place. But to tackle competitors under different market conditions requires
different set of strategies which helps the firm to grow in the market. These are
called growth strategies. In deciding upon the growth strategies two steps are
involved: i) Strategic gap analysis ii) Deciding on the particular growth
strategies. We will discuss tham one by one: i) Strategic gap analysis: Gap
analysis is basically done to measure the gap between the current situation and
future expected situation. It reveals the gap that has to be fulfilled in futures
on different fonts.
Gap analysis is a very useful tool for helping marketing managers to decide upon
marketing strategies and tactics. Again, the simple tools are the most effective.
There's a straightforward structure to follow. The first step is to decide upon
how you are going to judge the gap over time. For example, by market share, by
profit, by sales and so on. This will help you to write SMART objectives. Then you
simply ask two questions - where are we now? and where do we want to be? The
difference between the two is the GAP - this is how you are going to get there.
Take a look at the diagram below. The lower line is where you'll be if you do
nothing. The upper line is where you want to be.

What is Gap Analysis?

Your next step is to close the gap. Firstly decide whether you view from a
strategic or an operational/tactical perspective. If you are writing strategy, you
will go on to write tactics - see the lesson on marketing plans. The diagram below
uses Ansoff's matrix to bridge the gap using strategies:

Strategic Gap Analysis.

ii) Deciding on particular growth strategies---Ansoff Groqth Matrix:

The Product/Market Grid of Ansoff is a model that has proven to be very useful in
business unit strategy processes to determine business growth opportunities. The
Product/Market Grid has two dimensions: products and markets. Over these 2
dimensions, four growth strategies can be formed.

(Please refer to next page)

FOUR GROWTH STRATEGIES IN THE PRODUCT/MARKET GRID 1. Market Penetration. Sell more
of the same products or services in current markets. These strategies normally try
to change incidental clients to regular clients, and regular client into heavy
clients. Typical systems are volume discounts, bonus cards and Customer
Relationship Management. Strategy is often to achieve economies of scale through
more efficient manufacturing, more efficient distribution, more purchasing power,
overhead sharing. Main target is …..i) Increase the amount and frequency of use.
2. Market Development. Sell more of the same products or services in new markets.
These strategies often try to lure clients away from competitors or introduce
existing products in foreign markets or introduce new brand names in a market. New
markets can be geographic or functional, such as when we sell the same product for
another purpose. Small modifications may be necessary. Beware of cultural
differences. The main target is…..i) Convert the non-users to users and ii) Expand
geographically. 3. Product Development. Sell new products or services in current
markets. These strategies often try to sell other products to (regular) clients.
These can be accessories, add-ons, or completely new products. Cross-selling.
Often, existing communication channels are used. 4. Diversification. Sell new
products or services in new markets. These strategies are the most risky type of
strategies. Often there is a credibility focus in the communication to explain why
the company enters new markets with new products. On the other hand
diversification strategies also can decrease risk, because a large corporation can
spread certain risks if it operates on more than one market. Diversification can
be done in four ways: o Horizontal diversification. This occurs when the company
acquires or develops new products that could appeal to its current customer groups
even though those new products may be technologically unrelated to the existing
product lines. o Vertical diversification. The company moves into the business of
its suppliers or into the business of its customers. o Concentric diversification.
This results in new product lines or services that have technological and/or
marketing synergies with existing product lines, even though the products may
appeal to a new customer group. o Conglomerate diversification. This occurs when
there is neither technological nor marketing synergy and this requires reaching
new customer groups. Sometimes used by large companies seeking ways to balance a
cyclical portfolio with a non-cyclical one.
Now while adopting these strategies a firm can decide to perform in all the
segments of the value chain or decide to outsource some of them depending on the
margin being contributed by the activity.Here comes the question of transactions.
Whether the firm will depend on internal transactions or external market
transactions to accomplish the growth objective Here comes the question of
vertical integration, strategic alliance, tapered integration, Franchisee, Joint
venture. We will discuss them one by one…. A) VERTICAL INTEGRATION: Vertical
integration gives the stages at which the firm operates in the value chain.
According to Porter “vertical integration is the combination of technologically
distinct production, distribution, selling and/or other economic processes within
the confines of a single firm. As such it represents a decision by the firm to
utilize internal or administrative transactions rather than market transactions to
accomplish its economic purpose. For example, a firm with its own sales force
instead could have contracted, through the market, an independent selling
organization to supply the selling services it requires. When a firm owns and
controls the customers subject to the moves closer to the end users of
product/service, it is said to be forwardly vertically integrated. In other words
when the firms owns and controls the downstream activities in a value chain i.e.
outbound logistics, marketing/sales and service it is said to be forward vertical
integration. When a firm owns and controls the input resources subject to it moves
closer to the raw materials resources the firm is said to move closer to the
backward vertical integration. In other words when the firms owns and controls the
upstream activities of its value chain i.e the inbound logistics and raw material
resources it is said the backward vertical interagration. Now, we will discuss the
when and why of vertical integration: • When to go in for vertical integration:
The firm should go in for vertical integration when the following situations are
there.. i) When there are low no of suppliers and distributors. ii) When the value
of an investment in a transaction is much higher than its value in alternate
channel. iii) Uncertainty and complexity of contract. • Benefits of (sources of
competitive advantage) vertical integration:

The benefits of vertical integration depend, first of all, on the volume of

products or services the firm purchases from or sells to the adjacent stage
relative to the size of efficient production facility in that stage. Following are
the benefits of vertical integration: A) Economies of integration: If the volume
of the throughput is sufficient to reap available economies of scale, the most
commonly cited benefit of vertical integration is the achievement of the
economies, or cost savings, in joint production, sales, purchasing, control and
other areas. Following economies can be achieved:
i) Economies of combined operation: By putting technologically distinct operations
together, the firm can sometimes gain efficiencies. In manufacturing, this move,
for example, can reduce the number of steps in the production process, reduce
handling costs, and utilize the slack capacity which arises from indivisibilities
in one stage. ii) Economies of Internal control and coordination: The costs of
scheduling, coordinating operations and responding to emergencies may be lower if
the firm is integrated. Adjacent location of the integrated units facilitates
coordination and control. iii) Economies of information: Integrated operations may
reduce the need for collecting some types of information about the market, or more
likely, may reduce the overall costs of gaining information. The fixed costs of
monitoring the market and predicting supply, demand and prices can be spread over
all parts of the integrated firm, whereas they would have to be borne by each
entity in an uninegrated firm. iv) Economies of avoiding the market: By
integrating, the firm can potentially save on some of the selling, price shopping,
negotiating, and transactions costs of the market transactions. v) Economies of
stable relationships: Both upstream and downstream stages, knowing that their
purchasing and selling relationship is stable, may be able to develop more
efficient, specialized procedures for dealing with each other that would not be
feasible with an independent supplier or customer---where both the buyer and the
seller in the transaction face the competitive risk of being dropped or squeezed
by the other party. B) Tap into technology: Another important benefit of vertical
integration is a tap into technology. In some circumstances it can provide close
familiarity with technology in upstream and downstream businesses that is crucial
to the succees of the base business, a form of economy of information so important
as to deserve separate treatment. C) Assured supply and demand: Vertical
integration assures the firm that it will receive available supplies in tight
periods or that or that it will have an outlet for its products in periods of low
overall demand to the extent that the downstream unit can absorb the output of the
upstream unit. D) Enhanced ability to differentiate: Vertical integration can
improve the ability of the firm to differentiate itself from others by offering a
wider slice of value added under the control of the management. This aspect, for
example,allow better control of channels of distribution in order to offer
superior service or provide opportunities for differentiation through in house
manufacture of proprietary components.
E) Offset bargaining power and input cost distortion: If a firm dealing with
suppliers or customers who weild significant bargaining power and reap returns on
investment in excess of the opportunity cost of capital, it pays for the firm to
integrate even if there are no other savings from integration. Offsetting
bargaining power through integration may not only lower costs of supply (by
backward integration) or raise price realization (by forward integration) but also
allow the firm to operate more efficiently by eliminating otherwise valueless
practices used to cope with the powerful suppliers or customers. F) Elevate entry
or mobility barriers: If vertical integration achieve any of these benefits, it
can raise mobility barriers. The benefits give the integrated firm, in the form of
higher prices, lower costs or lower risks. G) Enter a higher return business: A
firm may sometimes increase its overall return on investment by vertically
integrating. If the stages of production into which integration is being
contemplated has a structure that offers a return on investment greater than the
opportunity cost of capital for th firm, then it is possible to integrate even if
there is no economies of integration per se. H) Defend against foreclosure: Even
if there are no positive benefits of integration, it may be necessary to defend
against foreclosure of access to suppliers or customers if competitors are
integrated. • Costs or disadvantages of vertical integration: The strategic costs
of vertical integration basically involve entry cost,flexibility, balance, ability
to manage the integrated firm, and the use of internal organizational versus
market incentives. A) Cost of overcoming mobility barriers: Vertical integration
obviously requires the firm to overcome the mobility barriers to compete in the
upstream or downstream business. Integration is after all a special case (though a
common one) of the general strategic option of entry into a new business. B)
Increased operating leverage: Vertical integration increases the proportion of a
firm’s costs that are fixed. If the market, for example, all the costs of that
input on the spot market, for example, all the costs of that input would be
variable. C) Elevate and entry and mobility barriers: Vertical integration implies
that the fortunes of a business unit are at least partly tied to the ability of
its in-house supplier or customer (who might be its distribution channel) to
compete successfully. Vertical integration raises costs of changeover to another
supplier or customer relative to contracting with independent entities.
D) Higher overall exit barriers: Integration that further increases the
specialization of assets, strategic interrelationships, or emotional ties to a
business may raise overall exit barriers. E) Capital investment requirements:
Vertical integration consumes capital resources, which have an opportunity cost
within the firm, whereas dealing with an independent entity uses investment
capital or outsiders. Vertical integration must yield a return higher than the to
the firm’s opportunity cost of capital. F) Foreclosure of access to suppliers or
consumer research and/or know how: By integrating the firm may cut itself off from
the flow of technology from its suppliers and customers. Integration usually means
that a company must accept responsibility for developing its own technological
capability rather than piggybackying on others. G) Maintaining balance: The
productive capacities of the upstream and downstream units in the firm must be
held in balance or potential problem arise. The stage of the vertical chain with
excess capacity (or excess demand) must sell some of its output(or purchase some
of its inputs) on the open market or sacrifice the market position. H) Dulled
incentives: Vertical integration means that buying and selling will occur through
a captive relationships. The incentives for the upstream business to perform may
be dulled because it sells in-house instead of competing for the business. I)
Differing managerial requirements: Business can be different in structure,
technology, and management despite having a vertical relationship. Since
vertically linked business transact business with each other,however, there is a
subtle tendency to view them as similar business from a managerial point of view.

Particular benefits in forward vertical integration: i)Improve ability to

differentiate the product: Forward integration can often allow the firm to
differentiate its product more successfully because the firm can control more
elements of the production process or the way the product is sold. For example:
forward integration in retailing sometimes allow the firm to control the
salespersons and other elements of the retailing selling function that help to
differentiate the product.
ii) Access to distribution channels: Forward integration solves the problem of
access to distribution channels and removes any bargaining power the channels
have. iii) Better access to market information: In a vertical chain the underlying
demand for the product (and the decision maker who actually makes the choices
among competing brands) often are located in a forward stage. This stage
determines both the size and the composition of demand of the upstream stages of
production. This is called the demand leading stage. Forward integration into
demand leading stage can provide the firm with critical market information, that
allows the entire vertical chain to function more effectively. iv) Higher price
realization: In some cases forward integration can allow the firm to realize the
higher overall prices by making it possible to set different prices for different
customers for essentially the same product. If the firm integrates into businesses
that should be charged with lower price because its demand is more elastic, it may
realize higher prices on sales to other customers. However other firms selling the
product must also be integrated, or the firm’s product must be differentiated so
that customers will not accept competitor’s products as perfect substitutes. •
Particular benefits with backward vertical integration: As with forward
integration, there are some particular issues that must be examined in considering
backward vertical integration : i) Proprietary knowledge: By producing needs
internally, the firm can avoid sharing proprietary data with its suppliers, who
need it to manufacture component parts or raw materials. Often the exact
specifications for component parts reveal the key characteristics of the final
product’s design or manufacture to the supplier. ii) Differentiation: Backward
integration can allow the firm to enhance differentiation ,though the
circumstances are somewhat different than those of forward integration. BY gaining
control over the production of key inputs, the firm actually may be able to
differentiate its product better or say credibly that it can. • Tapered
integration: Tapered integration is partial integration backward forward, the firm
purchasing the rest of its needs on the open market. It requires that the firm be
able more than support an efficiently sized in-house operation and still have
additional requirements which are met through the market place.
* Benefits of Tapered integration: 1. It allows a firm to increase its sales
without substantial financial outlay. 2. It can use the internal cost data for
negotiation with independent suppliers and customers. Similarly, it can use the
market data to increase the efficiency of the inhouse production facility. 3. It
helps the firm to protect itself against the holdup problem created by the
external suppliers. 4. Tapered integration results in less elevation in fixed
costs than full integration. 5. The degree of taper can be adjusted to reflect the
degree of risk in the market. Independent suppliers can be utilized to bear the
risk of the fluctuations, while in house suppliers maintain steady production
rates. * Disadvantages of tapered integration: 1. Due to shared production it may
happen both the external production facility and outside supplier may fail to
achieve economies of production. 2. Shared production may create problem of co
ordination between internal supply and external supply in terms of product
specification and delivery. 3. By mistake the firm may use the cost data of an
inefficient internal production system for negotiation with external suppliers. 4.
It may happen that managers may like to retain an inefficient internal production
system due to emotional bondage. B) STRATEGIC ALLIANCE: It takes place when two or
more firms agree to collaborate a project, share information or share production
resources. Strategic alliance may be horizontal and vertical. When the two firms
operate in the same stage of the value chain or belong to the same industry, we
get horizontal strategic alliance. When two firms belong to the different stages
of value chain we get vertical strategic alliance. • Types of strategic alliance:
Strategic alliances fall into four categories: i) Product or service alliances:
One company licenses another to produce its product, or two companies jointly
market their complementary products or a new product. ii) Promotional alliances:
One company agrees to carry a promotion for another company’s product or service.
iii) Logistics alliance: One company offers logistical services for another
company’s product. iv) Pricing alliances: One or more companies join in a special
pricing collaboration. It is common for hotel and rental car companies to offer
mutual price discounts.
•

When strategic alliance is good: 1. To avoid barriers to entry. Some government

insists that a foreign company can do business in that country provided it takes a
local national company as partner. 2. To reduce risk when the transaction involves
transaction specific investment in order to avoid cheating by one party. It is
required that both the parties are involved in that transaction specific
investment. 3. To undertake a project that is too big for either party either due
to indivisibility of upfront cost or due to presence of experience curve effects.

Conditions for successful strategic alliance: 1. Goal compatibility: Both parties

must have the same goal. 2. Synergy: There must be a case that this transaction
will create more positive economic value. 3. Value adding: Both must bring some
value to the alliance and both must agree on a fair appropriation of value.

4. Balancing contribution: It is required that one party doesn’t dominate the

other to have the alliance long live. C) JOINT VENTURE: When two or firms joins
hand to form a third independent company, it’s a joint venture. The new company is
not under the corporate governance of any of the parent company. For example, in
India, AVIVA life insurance is a joint venture between Dabur India and Aviva group
of U.K. D) FRANCHISING: Franchising is a contract between a franchiser and
franchisee. Franchiser develops a brand, owns it and has developed a system to
make or sell a good or service. A franchisee is a party which gives the right to
use the brand name and the system developed by the franchiser for a fee. It’s
basically a quasi vertical integration. E) DIVERSIFICATION: When a firm operates
in multiple businesses we call it the firm has diversified. Technically speaking,
“ No single business’s revenue is more than 70% of the group’s revenue and all the
businesses are under the same corporate governance. • Reasons for diversification:
The reasons for a company to diversify are as follows: i) Operational efficiency
of scope: Opeartional efficiency of scope is generated through diversification in
the following way…..
* Shared activities and cost reduction * Shared activities and revenue enhancement
* Core competency. The collective learning in an organization about how to co
ordinate diverse production skill and integrate multiple things or technologies.
It is basically intangible in nature and refers to managerial and technical know-
how, experience and wisdom. Example: a) Birla 3M company: It has developed core
competencies in substrates, adhesive coatings production and now produces Post and
notes, magnetic tapes, photographic film, press sensitive notes and coated
adhesives all of which relate to the core competencies thus enjoying the economies
of scope. b) Honda motor company: It has developed core competency in the
production of engine and power transmission chain which now it leverages in
producing motor cycle, automobiles, power tillers, lawn mowers. ii) Financial
economies of scope: This is realized through….. * Internal market for capital. *
Risk reduction * Tax advantage When a diversified firm has got individual
businesses whose cash flows are perfectly and negatively corerelated, the standard
deviation of cash flows for the diversifies firm will always be the lower than the
sum of S.Ds of cash flows of individual businesses. Also the debt capacity of the
firm goes up because revenue go up. Also under tax law the profit from some
business can be set off against losses other businesses within the same group. As
a result the overall tax liability goes down. iii) Anti-competitive economies
scope: This is realized through two ways: First. Suppose there are two companies,
A and B, which operate in more than two businesses, business 1 and business2, but
B is stronger in business1 and A is stronger in business2. Now if B wants to
create a price war with A in business1, than A can retaliate by creating price war
in business 2. So sometimes companies acquire firm or form a tacit collusion with
competitor to prevent this kind of price war. Second, Expanding market power.
Sometimes a near monopolist firm acquire a firm in a loosing business based on the
profit it earns in the existing business, I initiates predatory pricing in the
newly acquired business to drive out competitor to create a monopolistic situation
after sometime to reap profit in future. iv) Employees and stakeholders incentives
for diversification: It realizes this through the following ways: * Diversify
human capital. * Maximizing managerial compensation. * Diversifying the stake of
non employees stakeholders.
[ N.B: Related diversification: It helps to create more economic value as compared
to that in case of unrelated diversification] • Conditions for diversification: 1.
Structural attractiveness of the market i.e. some industries are inherently more
profitable than others. Thus diversification, if any, should be only attractive
industries. 2. Cost of entry: If cost of entry is higher than the scope for
generation of positive economic value, do not venture into it. The best method is
to identify an undervalued firm and try to acquire it. But in today age, when
information is very difficult to identify an undervalued organization without
others noticing it. 3. Structural linkage between new and existing firm i.e.
linked in terms of any part of the value chain. • Management of diversified
company: A diversified firm is characterized by varied products, markets,
geographical areas, technology etc. Thus it is very difficult to get people
competent to handle all such organization. The organizational structure of a
typical diversified company consists of three layers as follows:

Corporate Headquarter

Division 1

Division 2

Division 3

SBU 1 SBU 1 SBU 2 SBU3

SBU 2

SBU 2

SBU 1

SBU2

SBU 3

First level is the corporate headquarters which plans at strategic level. Second
level consists of the divisions which handles the related businesses. Third level
consists of Strategic business units (SBUs). When the businesses are thinly
related, the corporate office is small, then divisions vanishes and the SBUs comes
directly under corporate supervision.
When the businesses are related i.e. there is a chance of deriving economies of
scope due to presence of certain common activities in the value chain, a division
has to be put up to co ordinate activities of related SBUs. Activities of
corporate head quarters: (Mainly strategic) i) Monitor the performance of
divisions/SBU. ii) Allocation of financial resources. iii) Allocation of human
talent. iv) Makes further investment/divestment decisions. Activities of the
division: (Strategic + Tactical) i) Co ordination of manufacturing, marketing and
production development activities. Activities of SBUs: Before discussing the
function of SBUs let’s understand the concept of SBU. • Concept of SBU: It has got
the following features: a) It must serve an external market. It should not be for
internal purpose. b) It must have a set of external set of competitors which it is
trying to compete with or surpass. c) The SBU manager must be the boss of the
destiny of the SBU. Complete freedom regarding choice of suppliers and choice of
time and position of the market. d) The performance of an SBU can be measured in
terms of its financial status i.e. it should be a true profit and loss centre. F)
CONGLOMERATE: Group of unrelated business is called conglomerate. The above
definition of SBU is only applicable to a conglomerate. But if the SBUs are
related a cost linkage approach has to be taken for defining SBUs. Identify the
companies sharing the resources and club them together under a division or as
SBUs. G) MERGER AND ACQUISITION: Motives for and forms of merger: same as
diversification. This a means of acquiring business. The word “merger” is replaced
by “amalgamation” in Indian context. The companies merging together is called
amalgamating companies and the new company is called the amalgamated company. This
is divided nto two groups: i) Absorption: The company being absorbed looses its
legal entity and its assets gets transferred to to absorbing company. ii)
Consolidation: When two or more companies merge together where only one company
retains its legal identity and others loose their identity it is called
consolidation.
Example: Hindustan computer Ltd, Hindustan investment Ltd, Hindustan software
company ltd and Hindustan retrographics ltd merge together to form Hindustan
computer ltd (HCL). In consolidation shareholders holding not less than 90% share
value of the amalgamating company must become shareholders of the newly
amalgamated company. Types of merger: There are three types of merger: a)
Horizontal merger: Amalgamating companies compete with each other. b) Vertical
merger: Amalgamating companies operate at the different stages of production and
distribution of a product or service. c) Conglomerate merger: Amalgamating
companies operate in unrelated products. Legalities of Merger: In amalgamation,
the management of amalgamating companies operate together. In acquisition it
involves management control of one company by another company. After acquisition
both the company retains their legal entity. According to Sec.372 of companies act
of India,1956,i) acquiring company must hold not less than 10% of the paid-up
equity shares of the acquired company. Ii) This acquisition must be approved in
the AGM of the acquiring company. When an acquisition is hostile in nature, it is
called takeover. Financial aspects of merger: When an amalgamation takes place,
the acquiring company pays cash or shares of acquiring company to the members of
the acquired company. This is called purchase consideration. The financial logic
of merger to be successful is that, if A acquires B, NPV(A+B)> NPV(A)+ NPV(B). In
accounting concept, Economic advantage (EA)= NPV(A+B) – [NPV(A) + NPV (B)] Cost of
margin= (Cash to be paid)- NPV(B) Net economic advantage= EA- cost of margin.
However while calculating the value of NPV(A+B), we follow three methods--i) Supra
normal growth ii) Above normal growth iii) Normal growth. In this way, the whole
planning horizon, i.e. the economic life merger is divided into three levels.
Value of each firm is calculated separately by market capitalisaion. Problem: Let
P acquires Q. Following information is available is available: i) P has 12 lakh
shares @ Rs.50 each ii) Q has 5 lakh shares @ Rs.60 each iii) NPV(P+Q)=25 core iv)
Cash to be paid to Q = 4.5 core. Find out Economic advantage, net economic
advantage, cost of margin. Solution: Economic advantage= NPV(P+Q) – [ NPV(P)+
NPV(Q)] = 25,00,00,000 – [ (150X12,00,000)+(60X5,00,000)] = 25,00,00,000-
21,00,00,000 = 4,00,00,000
Cost of margin = {Cash to be paid to Q – NPV(Q)} = (4,50,00,000-3,00,00,000) = Rs.
1,50,00,000 Net economic advantage= Economic advantage – cost of margin =
4,00,00,0000 – 1,50,00,000 = Rs. 2,50,00,000 Now if shares had been paid instead
of cash, then no.of shares to be issued= 4,50,00,000/150 = 3,00,000 Total no of
shareholders of the new company= 12,00,000+3,00,000=15,00,000 Share value of the
new company= {NPV(P+Q)/ 15,00,000}= Rs.166.67.
PART F PORTFOLIO MANAGEMENT MODELS Contents: 1. BCG matrix 2. GE-Mackinsey matrix
3. ADL matrix. Portfolio management models are used, in case of a diversified
company, to judge the performance of the different businesses or SBUs and to
allocate resources among different SBUs and to decide on strategy to be adopted on
them. Different models are used for this purpose using different criteria and
dimensions. The main ones are : BCG matrix, GE-Mackinsey matrix and Arthur D
Little matrix(ADL). All these models were developed during the chairman ship of
Fred Borch of G.E. At that point of time, G.E had 60 unrelated businesses and was
facing tremendous pressure from the Japanese and European firms. The models were
developed by BCG, Mckinsey and Arthur D.Little separately for the reconstruction
of G.E. All these models are known as strategic fit models. According to this
concept, the source of competitive advantage lies in the external environment and
the firm’s ability to adapt itself to the environment. Thus for formulation of
strategy the external environment is more important than the resource base. Thus
these two dimensional models are easy to visualize and understand. One dimensions
of these models shows the structural attractiveness of the industry while the
other dimension refers to the relative competitive position of the firm within the
industry. These models can be applied not only at the business level but also at
the product market level within the business. The common features of these models
are that all of them provide certain prescriptions about managing the strategic
business units. These three generic decisions are invest, withdraw/divest, hold. •
Assumptions underlying the models:

1. the market has been defined properly to account for the important shared
experience and other interdependences with other markets. This is often a subtle
problem requiring a great deal of analysis. 2. The structure of the industry and
within the industry are such that relative market share is a good proxy for
competitive position and relative costs. This is often not true. 3. Market growth
is a good proxy for required cash investment. Yet profits(and cash flows) depend
on a lot of other things. 1.BOSTON CONSULTING GROUP’S GROWTH/SHARE MATRIX: ( BCG
MATRIX) The growth share matrix is based on the use of industry growth and
relative market share as proxies of 1) The competitive position of a firm’s
business unit in industry and 2) The resulting net cash flow required to operate
in the business unit. This formula reflects the underlying assumptions that the
experience curve is operating and that the firm with largest relative market share
will thereby the lowest cost producer. [ N.B: Causes for using relative market
share instead of absolute market share: BCG has used relative market share to show
the position of the firm compared to its competitors. They have used relative
market share deliberately because in some market if any company holds even a tiny
percentage of the market it will be the market leader. This type of market is
called fragmented market. A market is fragmented when no firm in the market
clearly holds absolute majority market share. ]
These premises lead to a portfolio chart shown like in the following diagram----

HIGH

STAR Moderate + or – cash flow

PROBLEM CHILD Large negative cash flow

Growth 10%

*
CASH COW Large positive cash flow

?
DOGS Modest + or – cash flow

LOW

HIGH

1.0 Relative market share

LOW

Construction of BCG matrix: i) How to calculate relative market share: Suppose we

are calculating the relative market share of the firm at the beginning of 2007,
then the formula for the calculation of relative market share will be----R.M.S=
Sales of the firm for 2006/ Sales of the leading competitor. Suppose there are
three firms in the market having sales 20 million, 10 million, 5 million. Then if
calculate R.M.S for the first firm then the leading competitor will be the firm
having sales of 10 million, but if we calculate the R.M.S for the firm having
sales of 5 million then the leading competitor will be the firm having sales of 20
million. Relative share of 1% is denoted by a vertical line. BCG believes that
combination of these two dimensions gives the higher profitability of the firm
because they believed in economies of scale which has accumulated experience in
production resulting in lower unit cost of production and higher profitability.
Now high relative market share and higher profitability is not related directly
and interlinked through some intervening variable. Thus if we plot the relative in
a graph the resulting graph will be curvilinear in nature the most generic
equation of which can be y=abx. If we take log at the both side we get, log y= log
a + b log x
So here we get the linear relation. So BCG has used the semilogarithmic scale to
plot relative market share on x axis. ii) How to calculate market growth rate:
Market growth rate is defined by the following formula: M.G.R= {sales2006 – sales
2005}/ sales 2005 BCG has arbitrarily assumed that a growth rate above 10% means
market is in the embryonic or growth stage. If it is less than 10% it is in
maturity or decline stage. This 10% mark is denoted by a horizontal line. iii) How
to plot SBUs in BCG matrix: Now for every company we will get a point on the grid
which will denote its market growth rate and relative market share. After getting
the points, we have to draw a circle against each point where the diameter of the
circle will be directly proportional to the sales value of the firm. Feature and
strategic implication of different quadrant: i) STAR: High cash inflow due to high
market share and high growth rate. But high cash outflow due to sustaining the
high growth rate. So the result will be marginally +ve or –ve profit. So it
requires heavy support from corporate management to sustain the growth. The
strategy is to INVEST. ii) CASH COW: In this case, the relative market share is
very high so cash inflow is very high because of very high past investment made
when it was in the growth stage. But now growth has come down, so now the only
requirement is to sustain the dominant position. So in sum it is generating cash
more than the requirement. The strategic option is to HARVEST. iii) PROBLEM CHILD:
It is a high growth market and there is lot of opportunity. But due to some
reason, relative market share is low. To convert a problem child to a star
performer, investment requirement will be very high because internal cash flow is
not adequate due to low relative market share. But if there are no of problem
child, then we have to divide it into two groups, one we will sell off and other
we will invest in. iv) DOGS: It is in a low market share and very low growth rate.
So whatever cash it is generating, is getting consumed to retain its own position
in the market. So there is no prospect in future. So the strategic option is to
DIVEST( Sell off at whatever price is available) or HARVEST ( Not very sure
whether the market will die or not or not getting the price it should get. So let
it be there, but trip its cash flow by not expanding. Let it have its own economic
demise.) Constraints of BCG matrix: i) It sees the different businesses in the
conglomerate as completely unrelated. So that at any point of time any company can
be divested without affecting the group’s performance. It’s not practicable at all
point of time. ii) It assumes capital allocation through internal route is
efficient than external market capital allocation. But according to BCG, it has to
be cash neutral to achieve a high growth. iii) Many people object the name it
gives.
iv) Relationship between high accumulated production experience and high
profitability is not justified. Because the amount of investment it requires to
achieve high sales is very costly to the profitability of the market. v) This is
called transactional model. This gives the picture of the last year. Decision
taken on which may not be right. 2. GE-MCKINSEY’S COMPANY POSITION/INDUSTRY
ATTRACTIVENESS MATRIX: Another technique is the three by three matrix variously
attributed to General electric, Mckinsey and company and Shell. One representative
variation of this technique is shown in the following figure:

The two axes in this approach are the attractiveness of the industry and the
strength or competitive position, of the business unit. Where a particular
business unit fall along this axes is determined by an analysis of that particular
unit and its industry, using the following criteria: A) For business strength: i)
Size ii) Growth iii) Share iv) Position v) Profitability vi) Margins vii)
Technological positions viii) Strengths/weaknesses ix) Image x) Pollution xi)
people. B) Industry attractiveness: i) Size ii) Market growth/pricing iii) Market
diversity iv) Competitive structure v) Industry profitability vi) technical role
vii) Social viii) Environmental ix) Legal x) Human. Depending on where a unit
falls in the matrix, its broad strategic mandate is either to invest capital to
build position, to hold by balancing cash generation and selective cash use or to
harvest or divest. Expected shifts in industry attractiveness or company positions
lead to the need to reassess the strategy. 3. ARTHUR D.LITTLE’S LIFE CYCLE MATRIX:
Refer to SKB notes.