Little Blue Book, 2016 Edition

The Little Blue
Consulting
Handbook
2016 Edition
Tom Spencer © 2016 1

Acknowledgements:
Special thanks to the following people for their valuable insights:
 Matthew O’Sullivan, President of the Global Consulting Group;
 Shishir Pandit, CEO of the Global Consulting Group.

Contents
Introduction ........................................................................................................5
1. Definitions ......................................................................................................6
1.1 Consulting Jargon ....................................................................................6
1.2 Business Terms ........................................................................................9
2. Industry Analysis ......................................................................................... 31
2.1 Macro Environment ............................................................................. 31
2.1.1 PEST Analysis ................................................................................ 31
2.2 Micro Environment.............................................................................. 37
2.2.1 Business Landscape Survey .......................................................... 37
3. Firm Level Analysis .................................................................................... 52
3.1 Profitability ............................................................................................ 52
3.1.1 Profitability Framework ............................................................... 52
3.2 Competitive Advantage ....................................................................... 58
3.2.1 Value Chain Analysis .................................................................... 58
3.3 Competitive Strategy ............................................................................ 63
3.3.1 Porter’s Generic Strategies ........................................................... 63
3.3.2 Strategy and the Internet .............................................................. 67
3.4 Growth Strategy .................................................................................... 69
3.4.1 Product / Market Expansion Matrix ......................................... 69
3.4.2 GE McKinsey 9 Box Matrix ........................................................ 77
3.4.3 BCG Growth Share Matrix .......................................................... 82
3.5 Marketing Strategy ................................................................................ 87
3.5.1 Four Ps Framework ...................................................................... 87
3.5.2 Product Life Cycle Model ............................................................ 92
3.6 Cost Management ................................................................................. 98

3.7 Financial Management ....................................................................... 101
3.7.1 Five C Analysis of Borrower Creditworthiness ...................... 101
3.7.2 Net Present Value........................................................................ 105
3.8 Organisational Cohesiveness ............................................................ 108
3.8.1 McKinsey 7 S Model ................................................................... 108
3.9 Competitive Response ....................................................................... 110
3.10 Corporate Turnaround .................................................................... 112
4. General Concepts and Frameworks ...................................................... 114
4.1 Barriers to Entry ................................................................................. 114
4.2 Cost Benefit Analysis ......................................................................... 118
4.3 Economies of Scale ............................................................................ 121
4.4 Economies of Scope .......................................................................... 125
4.5 Experience Curve ............................................................................... 129
4.6 MECE Framework ............................................................................. 134
4.7 Moral Hazard....................................................................................... 136
4.8 Porter’s Five Forces ........................................................................... 139
4.9 Quantitative Easing ............................................................................ 142
4.10 Rule of 70 ........................................................................................... 143
4.11 SWOT Analysis ................................................................................. 144

Introduction
The Little Blue Book is designed for student consultants and first year
management consultants, and aims to provide key concepts and
frameworks that might be used to analyse business problems, evaluate
situations, and achieve outcomes more quickly and easily than would
otherwise be possible.
This document does not provide a guide to consulting interviews. If you
are looking for such a guidebook, please take a look at our “Guide to
Consulting Interviews”.
The Little Blue Book will be updated from time to time. If you have any
comments, suggestions or feedback, please email the Editors at
editors@spencertom.com.
The Little Blue Book is structured in four (4) parts:
1. Definitions of consulting jargon and business terms;
2. Frameworks for understanding the broader macro environment
and analysing an industry;
3. Frameworks for examining a firm and firm level strategy; and
4. Concepts and frameworks that may prove useful when analysing a
business situation and which are not covered elsewhere.

1. Definitions
1.1 Consulting Jargon
10,000 foot view: A high-level overview of the situation.
80/20 rule: A rule of thumb which holds that 80% of a business
problem can typically be solved by focusing on 20% of the issues.
Add some colour: Make it more interesting/appealing/persuasive.
Adding value: Making a contribution.
AOB: Stands for “any other business” and might be used in a meeting
agenda to block out time for miscellaneous discussion.
At the end of the day: A consultant may use this phrase before
summarising the main thrust of her argument.
B2B: Stands for “business to business” and indicates that a business is
aiming to sell to other businesses rather than to end consumers.
B2C: Stands for “business to consumer” and indicates that a business is
aiming to sell directly to consumers rather than to other businesses.
Bandwidth: Capacity to take on additional work commitments. For
example, “I don’t have any bandwidth this week”.
Big 3: McKinsey, Bain and BCG.
Big 4: Deloitte, EY, KPMG and PwC.
Boil the ocean: Go overboard; undertake an excessive amount of
analysis; fail to follow the 80/20 rule.
Buckets: Categories.
Buy in: Agreement; support. For example, “we need to get buy in from
the client before finalising the report”.

Charge code: A unique code provided for a project which can be used
to record work-related expenses.
Circle back: Follow up with someone at a later point in time.
Close the loop: Completing an item on the agenda or topic of
discussion with everyone being in agreement.
Core client: A client that has a long-standing relationship with the firm.
Deck: PowerPoint slides.
Deep dive: To conduct an extensive examination of a particular issue.
Deliverable: Work product that a consultant needs to provide to her
manager or the client as part of a client engagement.
Development opportunity: A professional shortcoming or area for
improvement that requires attention.
Due diligence: Comprehensive examination of all relevant issues, such
as a review of the client’s business or industry.
Fact pack: A pack of information that provides the essential facts for a
project/industry/company.
Granular: Focusing on the finer details, as in “this analysis needs to be
more granular.”
Hard stop: A stated time after which the person will no longer be
available to continue the meeting/discussion. For example, “I have a
hard stop at 3 o’clock”.
Key: Critical; essential; required; important; central. For example, “the
key issues are X, Y, Z.”
Let me play this back: Words used before providing a summary of the
discussion from the listener’s perspective. This is a helpful technique
which can allow a consultant to clarify her understanding of the key

issues and at the same time sound intelligent by saying something even if
the summary adds no additional insights.
Low hanging fruit: Targets that are easily achievable, issues that can be
quickly resolved, opportunities that can be readily exploited, or problems
that are simple to solve. By picking the low hanging fruit first,
consultants can demonstrate quick results, which can boost the client’s
confidence in the project.
Lots of moving parts: Complex.
Managing upwards: Providing feedback to more senior employees.
MBB: McKinsey, Bain and BCG.
MECE: Pronounced “me see”, and stands for “mutually exclusive,
collectively exhaustive”. It is a principle for grouping information into
distinct categories which, taken together, deal with all available options.
For more information, see “4.6 MECE Framework”.
On the beach: In between assignments. Time spent on the beach may
be spent in training or used for business development.
On the same page: See things from the same perspective.
Out of the box thinking: Thinking that generates novel ideas which
don’t follow neatly from the data.
Ping: Contact someone, as in “I will ping you later via email.”
PIOUTA: Pulled it out of thin air.
Pipeline: Current and upcoming client engagements.
Production: A department of the consulting firm (often outsourced)
that assists in producing material needed for presentations and meetings.
Pushback: Resistance or disagreement, as in “we received some
pushback from the client.”

Right size: Downsize.
Sandwich feedback technique: A structure for providing feedback
that resembles a sandwich – one positive comment, followed by a piece
of feedback, and ending with a positive comment.
Scope: Agreed set of deliverables for a client engagement.
Scope creep: When the client adds, or attempts to add, additional
deliverables which were not agreed in the initial project brief.
Sniff test: A common sense check of a particular idea, proposal or
analysis.
SWAG: Some wild-ass guess.
Take the lead: Take responsibility for something, as in: “Why don’t you
take the lead on this project.”
Takeaways: The key points that should be remembered at the end of a
discussion, meeting or presentation.
Touch base: To meet at a certain time to talk about the project.
Up or out: Many top consulting firms adopt an ‘up or out’ policy.
Employees are expected to advance up to the next level of responsibility
or they will be counselled out of the firm.
Work stream: The tasks that make up a project.
1.2 Business Terms

Anchoring: The common tendency for people to rely too heavily on
readily available information (the “anchor”) when making decisions
involving uncertainty. Anchoring is a cognitive bias relevant in many
business contexts. Here are three (3) examples:
1. Price negotiations: A sophisticated buyer in a price negotiation will
typically want the seller to name the first price. This sets an

anchor, or a maximum price from which the buyer can negotiate
downwards. If the seller names an unrealistically high price then
the sophisticated buyer will typically want to emotionally reject the
price, which might be done by exclaiming shock, disgust or
pretending to walk away. The buyer may still be interested but by
emotionally rejecting the initial offer she hopes to break the
anchor so that negotiations can begin afresh.
2. Sales: Retailers use the “recommended retail price” as an anchor.
At sporadic intervals they can then offer a far more reasonable
“sale price” which draws shoppers to the store in the belief that
they are obtaining a bargain. The sale price seems like a bargain
because it is a reduction from the the recommended retail price,
which acts as an anchor of value in the shopper’s mind.
3. Stock trading: Algorithmic traders can use their knowledge of
anchoring to gain a statistical edge in the stock market. For
example, many traders will use a recent high or low price as an
anchor to determine whether prices are “too high” or “too low”
and an algorithmic trader can use this fact to develop trading
systems that allow her to trade with positive expectation over the
longer term. For a good book on this subject, see Way of the
Turtle by Curtis M. Faith.
Asset (accounting definition): An economic resource that a company
uses to operate its business, e.g. cash, inventories, property, plant and
equipment.
Asset (finance definition): An economic resource that generates cash
every month (i.e. your house and your car are probably not assets under
this definition).
Asset (strategy definition): An economic resource (whether tangible
or intangible) that allows an organisation to provide more value to
customers (whether real or perceived) for a given level of costs.

Bandwagon effect: The common tendency for people to believe
something because many other people already believe it. The
bandwagon effect is relevant in business contexts since it suggests that
the probability of a person purchasing a product is proportional to the
number of people who have already done so. This helps to explain the
existence of fashions, fads and trends.
Barriers to entry: The costs that must be paid by a new market entrant
but not by firms already in the industry. Barriers to entry have the effect
of making a market less contestable and so allow existing firms to
maintain higher prices than would otherwise be possible.
Key barriers to entry might include capital requirements, economies of
scale, network effects, product differentiation, proprietary product
technology, government policy, access to suppliers, access to
distribution channels, and switching costs.
For more information, see “4.1 Barriers to Entry”.
Black Swan: An event that is unpredictable, has significant
consequences, and is (or at least appears to be) retrospectively
explainable. The term “Black Swan” was coined by Nassim Nicholas
Taleb in his book The Black Swan.
Brand: A brand is commonly defined as “a name, mark, logo, symbol or
other identifier used to distinguish a product or organisation”. The
power of a brand derives not from the particular symbol used but from
the stories that people tell about it, and so a brand might more
accurately be defined as “what people say about you (your product, or
your organisation) when you’re not in the room.”
Break-even analysis: Break-even analysis is relevant when trying to
decide whether to launch a new product or invest in a project with high
fixed costs.
Break-even analysis calculates the point at which revenues will equal
associated costs. Break-even analysis can be used to calculate the ‘margin

of safety’, the amount by which revenues are expected to exceed the
break-even point.
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 𝑉𝑜𝑙𝑢𝑚𝑒 =
𝑆𝑎𝑙𝑒 𝑃𝑟𝑖𝑐𝑒 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡
𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 𝑉𝑜𝑙𝑢𝑚𝑒

𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 𝑀𝑎𝑟𝑘𝑒𝑡 𝑆ℎ𝑎𝑟𝑒 =
𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑜𝑙𝑢𝑚𝑒
Break-even analysis is a form of supply side analysis that considers costs

(variable costs and fixed costs). However, it does not consider how
demand may change at different price levels, and so it may make sense
to combine break-even analysis with some form of demand side analysis.
Bundling: Combining products or services together in order to sell
them as a single unit. Bundling can benefit a company by allowing it to
increase sales volume and market share. Bundling can also benefit
customers by allowing them to purchase the bundle for less than the
price of the bundled products if purchased separately.
CAGR: Compound annual growth rate.
1
𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 (# 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠)
𝐶𝐴𝐺𝑅 = ( ) − 1
𝑆𝑡𝑎𝑟𝑡𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒
CFA: Stands for “Chartered Financial Analyst”. For more information,

visit the CFA Institute.
Coase theorem: An economic theorem outlined by Ronald Coase in an
article entitled The Problem of Social Cost published in October 1960 in
the Journal of Law and Economics. The theorem states that if trade in
an externality is possible and there are no transaction costs, bargaining
will lead to an efficient outcome regardless of the initial allocation of
property rights. In practice, poorly defined property rights or obstacles
to bargaining (e.g. transaction costs, lack of an organised market, or the

presence of asymmetric information) tend to prevent Coasian
bargaining.
Comparative advantage: Comparative advantage is an economic
theory that explains the existence of gains from trade.
David Ricardo developed the classical theory of comparative advantage
in 1817 to explain why a country whose workers are more efficient at
producing every good compared with workers in other countries will still
gain from international trade.
In general terms, an individual, firm or country has a comparative
advantage in producing a good if it can produce the good at a lower
Opportunity cost relative to other individuals, firms or countries.
Complimentary goods: Any goods for which an increase in demand
for one leads to an increase in demand for the other. Examples of
complimentary goods include printers and ink cartridges, DVD players
and DVDs, and Microsoft Windows and PCs.
Confirmation bias: The common tendency for people to favour
information that confirms their existing beliefs. Confirmation bias is
relevant in many business contexts. For example, in stock trading
confirmation bias can lead a trader to ignore evidence that her trading
strategies will lose money leading her to be overconfident.
Conglomerate Diversification: A form of diversification where a firm
adds new products that are unrelated to existing products and which
target new customer segments.
Cost benefit analysis: A type of analysis that involves weighing the
total expected costs and benefits of one course of action against one or
more other courses of action. For more information, see “4.2 Cost
Benefit Analysis”.
Credit default swap (CDS): A form of insurance policy which obliges
the seller of the CDS to compensate the buyer in the event that the loan

defaults. In the event of default, the buyer of the CDS would normally
receive money and the seller of the CDS would receive the defaulted
loan (and the right to recover amounts outstanding under the loan).
Cross Rate: The exchange rate between two currencies inferred from
each currency’s exchange rate with a third currency.
Current Ratio: Otherwise known as the “liquidity ratio”, “cash asset
ratio”, “cash ratio” or “working capital ratio”, the current ratio measures
a company's ability to repay short term liabilities.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Customer Lifetime Value: Customer lifetime value is a prediction of

the entire future value that a company expects to derive from its
relationship with a customer. It can be a useful tool for a company that
is trying to decide which customer segments to target and how much to
spend on customer acquisition.
𝐶𝐿𝑉 = 𝑃𝑟𝑜𝑓𝑖𝑡1 + 𝑃𝑟𝑜𝑓𝑖𝑡2 × 𝑃(𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛)2 + 𝑃𝑟𝑜𝑓𝑖𝑡3 × 𝑃(𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛)3 + ⋯
Debt to Asset Ratio: The debt ratio is the ratio of total debt to total
assets, and can be understood as the percentage of a company’s assets
that are financed by debt.
𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
Debt to Equity Ratio: A measure of a company’s financial leverage

calculated by dividing total debt by shareholder’s equity.
𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

Discouraged worker: A person who does not have a job and is
available to work but who has stopped actively looking for work. This
may happen because the unemployed person:
 Becomes discouraged due to previous unsuccessful attempts to
obtain work;
 Believes (reasonably or not) that there are no jobs available in their
industry or location;
 Lacks the skills needed for the jobs which are available, either
because they never had the required skills or because their skills
have eroded due to a long period of unemployment;
 Is discriminated against by prospective employers for some reason
beyond their control (e.g. age, race, gender); or
 Becomes addicted to Twinkies and day time television.
Diseconomies of scale: A situation where the average cost of
production increases as output increases. For more information, see “4.3
Economies of Scale”.
Disruptive innovation: A term coined by HBS Professor Clayton
Christensen to describe the process by which a product or service
initially takes root in simple applications at the bottom of a market and
then consistently moves ‘up market’, eventually displacing established
competitors.
Diversification: In the 3.4.1 Product / Market Expansion Matrix,
originally explained by Igor Ansoff in his 1957 Harvard Business Review
article, diversification is defined as a growth strategy whereby an
organisation develops new products for new markets.
Diversification is a high risk growth strategy, and a company should look
for markets with strong growth and high levels of industry attractiveness
(see “4.8 Porter’s Five Forces”).
Diversification might involve a company adding new products, which
appeal to existing customers (“Horizontal diversification”); it might

involve a company acquiring a customer or supplier (“Vertical
Integration”); or it might involve a company moving into an entirely
new industry (“Conglomerate Diversification”).
Economic indicator: An economic statistic (e.g. the unemployment
rate, GDP, or inflation) which indicates the strength of the economy or
the expected future performance of the economy.
Economies of scale: A situation where the average cost of producing a
unit of output decreases as the quantity of output increases. For more
information, see “4.3 Economies of Scale”.
Economies of scope: A situation where a firm can produce two or
more products at a lower per unit cost than would be possible if it
produced only the one. For more information, see “4.4 Economies of
Scope”.
Elevator pitch: A high-level overview of whatever it is that you are
selling and which is designed to just get the conversation started. For
more information, please read the articles entitled “The Elevator Pitch”
and “12 Tips for Creating an Effective Pitch”.
Equity: Assets minus Liabilities. Equity holders are the owners of the
business.
Expenses: Costs incurred by a business over a specified period of time
to generate the revenues earned during that period. For more
information, read the article entitled “Understanding Financial
Statements 101”.
Externality: Costs incurred or benefits gained by third parties resulting
from an economic activity. Externalities that confer a benefit are
referred to as “positive externalities”, an example of which would be
honey bees kept for honey that help to pollinate neighbouring crops.
Externalities that impose a cost are referred to as “negative
externalities”, an example of which would be a factory that creates air

pollution and imposes health and clean-up costs on the surrounding
community.
Fiscal Policy: Government policy relating to government spending and
taxes.
Fisher Effect: The Fisher effect describes the relationship between real
interest rates, nominal interest rates and inflation. The Fisher effect
states that a change in the nominal interest rate is equal to the real
interest rate plus the inflation rate:
(1 + 𝑖𝑁𝑜𝑚 ) = (1 + 𝑖𝑅𝑒𝑎𝑙 ) × (1 + 𝑟𝑖𝑛𝑓 )
Fixed cost: A cost that does not vary with the quantity of output
produced. It is important to understand that fixed costs are fixed only
in the short term. In the long run nearly all costs are variable. For
example, in the long run a company could renegotiate supply contracts
or move its factories to a lower cost jurisdiction.
Forward Contract: A forward contract is a customized contract to buy
or sell an asset on a future date at a pre-determined price (the forward
price). A forward contract is non-standardized, and so can be used by
businesses to manage risk.
Futures Contract: A futures contract is a standardized contract to buy
or sell an asset on a future date at a pre-determined price (the futures
price). A futures contract is standardized and traded on a futures
exchange. Settlement may take place through physical delivery of the
underlying asset or payment in cash.
Greenspan Put: The monetary policy of Alan Greenspan and the U.S.
Federal Reserve from the late 1980’s to the mid-2000’s, which involved
significantly lowering interest rates in the wake each financial crisis.

Homogenous Product: Any good or service for which buyers perceive
no difference between the products offered by different suppliers.
Examples of homogenous products might include wheat, corn and oil.
Horizontal competition: Competition between entities at the same
stage of production. See also, “Vertical competition”.
Horizontal diversification: A form of diversification where a firm adds
new products that may be unrelated to existing products but are likely to
appeal to existing customers. See also, “Vertical Integration” and
“Conglomerate Diversification”.
Inflation: The rate at which the overall price level for goods and
services is rising.
Investment Operation: An operation which, upon thorough analysis,
promises safety of principal and an adequate return. Operations not
meeting these requirements are speculative (Ben Graham, The
Intelligent Investor).
Joint Production: Production where the production process for two or
more different goods is connected. Producing the goods separately
would result in increased costs. Joint production may occur naturally, for
example a chicken farm produces both chicken wings and chicken
breasts. Joint production may also be used because it provides 4.4
Economies of Scope.
Leverage (common usage): Make use of.
Leverage (investment definition): The use of borrowed capital to
partially or fully fund an investment. Leverage is used when an investor
expects the return on investment to be greater than the cost of debt, in
which case the investor’s return on equity will be greater than the return
on investment. In other words, the returns are leveraged.
Liability (accounting definition): The debt of a company, a claim that
creditors have on the company’s resources.

LIBOR: The London Interbank Offered Rate is a benchmark rate
quoted by the world’s leading banks as a rate of interest that they would
charge financial institutions for short term loans. LIBOR is used
extensively in finance as a first step in calculating appropriate rates of
interest for a variety of financial products.
Liquidity trap: A situation where interest rates are zero (or near zero)
and a central bank is no longer able to stimulate the economy by
controlling short term interest rates. In 2008, the US Federal Reserve
faced a liquidity trap and employed quantitative easing (i.e. electronically
generating money) in an attempt to stimulate the economy.
Loss aversion: A commonly observed behavioural tendency whereby
people prefer to avoid a loss than to make a commensurate gain. For
more information, read the article entitled “Loss Aversion”.
Ludic Fallacy: A term coined by Nassim Nicholas Taleb in The Black
Swan. The term refers to the misuse of games to model real-life
situations. Taleb explains the fallacy as “basing studies of chance on the
narrow world of games and dice.”
Madoff Scheme: See also “Ponzi Scheme”.
Management consulting (Institute of Management Consultants’
definition): The provision to management of objective advice and
assistance relating to the strategy, structure, management and operations
of an organisation in pursuit of its long-term purposes and objectives.
Such assistance may include the identification of options with
recommendations; the provision of an additional resource and/or the
implementation of solutions.
Metcalfe's law: A rule which states that the value of a network is
proportional to the square of the number of connected users (or
connected devices). Metcalfe’s law explains the network effect which
exists for products such as fax machines, telephones, eBay, WhatsApp
and Facebook.

Monopolistic competition: A situation in which consumers are taught
to perceive differences between products. As a result, even though there
may be a large number of producers, each producer has a degree of
control over price.
Monopoly: A situation where a market has only one supplier for a
particular good or service. The term may also be used where one seller
has substantial control of the market. Monopolies are characterised by a
lack of competition and a lack of viable substitutes.
Monopsony: A situation where a market has only one buyer for a
particular good or service. The term may also be used where one buyer
has substantial control of the market. See also “Walmart Effect”.
Moral Hazard: Any situation in which a person or entity is not fully
responsible for the consequences of its actions. As a result, the entity
may take greater risks than it would have otherwise because it is not
responsible for paying the full cost if things go badly. For more
information, see “4.7 Moral Hazard”.
Mortgage Securitisation: A process of packaging and selling mortgage
debt which involves:
1. Purchasing mortgages from banks or mortgage brokers;
2. Packaging the mortgages into large pools; and
3. Selling “shares” in these mortgage pools to investors.
Natural monopoly: An industry where one firm can produce the
desired output at a lower social cost than could be achieved by two or
more firms (social costs being the sum of private and external costs).
Natural monopolies exist because of the existence of economies of scale
and examples include railways, water services, and electric utilities.
Net Present Value: The NPV of an investment is the present value of
the series of expected future cash flows generated by the investment
minus the cost of the initial investment.

𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑛 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒
𝑁𝑃𝑉 = + + ⋯ + + − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)𝑛 (1 + 𝑟)𝑛
𝐶𝐹𝑛 × (1 + 𝑔)
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 =
𝑟−𝑔
Where r = discount rate; CFt = expected cash flow in year t; g = long

term cash flow growth rate.
For more information, see “3.7.2 Net Present Value”.
Network effects: The situation whereby a product or service becomes
more valuable as more people use it (also known as network
externalities). One example is eBay; as more buyers use the online
auction site it becomes more valuable to each seller, and as more sellers
use the site it becomes more valuable to each buyer.
NINJA Loan: Any loan made where the borrower has No Income, No
Job, and No Assets.
Nominal value: A value expressed in dollar terms. For example, if a Big
Mac costs $3 this year and $6 next year, then we would say that the
nominal price of a BigMac has doubled.
Numéraire: An economic term meaning “the unit of account”. In
French, the term means “money”, “coinage” or “face value”. A
country’s currency normally acts as the numéraire and is used to measure
the worth of other goods and services within the country. In the absence
of currency, you could define a “numéraire good” (e.g. salt, copper,
gold) to have a fixed price of 1; the worth of other goods and services
could then be measured relative to the numéraire good.
Oligopoly: A situation where a market is dominated by a small number
of suppliers for a particular good or service. Oligopolies are
characterised by a lack of competition and a lack of viable substitutes.

Each firm in an oligopoly needs to take into account the likely actions
and reactions of other firms when developing its strategic plan of action.
Operating Cash Flow Ratio: A liquidity ratio that measures how well a
company’s current liabilities are covered by cash flow from operations.
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠
𝑂𝐶𝐹 𝑅𝑎𝑡𝑖𝑜 =
Opportunity cost: What you give up in order to obtain something; the

value of the next best alternative.
Option: A derivative financial instrument which grants its owner the
right, but not the obligation, to buy or sell an underlying asset at a pre-
established price for a specified period of time.
Organic growth: Growth that a company can achieve by increasing
output and sales. This excludes growth achieved as a result of mergers
and acquisitions since this growth is purchased not generated internally.
For example, growth that Facebook achieved as a result of its purchase
of Instagram and WhatsApp was not organic growth.
Outcome bias: The tendency for people to judge a decision based on
its outcome rather than the quality of the decision at the time it was
made. For example, a person who learns that a friend made a large profit
from investing in the stock market may, without any additional evidence,
form the view that investing in stocks is a good idea; this person is
suffering from outcome bias.
Overconfidence bias: A common behavioural trait whereby a person’s
confidence in their opinions is invariably higher than the accuracy of
those opinions.
Pareto efficient: An economic allocation is said to be “Pareto efficient”
if no person can be made better off without making at least one person
worse off. Pareto efficiency does not imply that an economic allocation
is fair or equitable.

Perpetuity: A perpetuity is a constant stream of identical cash flows
with no end.
𝐶𝐹𝑎𝑛𝑛𝑢𝑎𝑙 𝐶𝐹𝑎𝑛𝑛𝑢𝑎𝑙 𝐶𝐹𝑎𝑛𝑛𝑢𝑎𝑙
𝑃𝑉 𝑜𝑓 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 = + + +⋯
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3
𝐶𝐹𝑎𝑛𝑛𝑢𝑎𝑙
𝑃𝑉 𝑜𝑓 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 =
𝑟
Where r = discount rate; CFannual = annual cash flow.

Ponzi Scheme: Any kind of fraudulent investment operation that pays
returns to investors from their own money or money paid by subsequent
investors rather than from any profits earned. See also, “Madoff
Scheme”.
Price discrimination: Price discrimination involves setting a different
price for the same product for different customer segments. First degree
price discrimination involves charging each customer a different price
based on their willingness to pay. Second degree price discrimination
involves varying the price according to the quantity demanded. Third
degree price discrimination involves varying the price by location or
customer segment. For example, charging higher prices in expensive
suburbs or tourist locations or offering discounted prices for students.
Price elasticity of demand: A measure of the responsiveness of the
quantity demanded to changes in the price level. Price elasticity of
demand is relevant for pricing strategy and for examining customer price
sensitivity.
%∆𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝐸𝑑 =
%∆𝑃𝑟𝑖𝑐𝑒
If the price elasticity of demand is less than one in absolute value

(|𝐸𝑑 | < 1) then demand is said to be “inelastic”. That is, changes in

price have a relatively small effect on the quantity demanded. As a result,
total revenue will rise if prices are raised.
If the price elasticity of demand is greater than one in absolute value
(|𝐸𝑑 | > 1) then demand is said to be “elastic”. That is, changes in price
have a relatively large effect on the quantity demanded. As a result, total
revenue will rise if prices are lowered.
Price maker: A firm that has some control over the price that it charges
for a product. For example, a Monopoly or a firm operating within
Monopolistic competition.
Price taker: A firm that can change production and sales of a product
without significantly affecting the market price.
Principle-agent problem: The principle-agent problem occurs when a
principal employs an agent to perform duties on its behalf.
The problem arises where there are conflicts of interest between the
principle and the agent (for example, the principle prefers that the agent
exert more effort and the agent prefers to exert less effort), the agent is
not required to pay the full cost if things go badly (that is, there is moral
hazard), and the principle cannot directly monitor the agent’s behaviour
(that is, there is asymmetric information).
An example of where the principle-agent problem arises is in the
relationship between management (the agent) and shareholders (the
principle).
Possible solutions to the principle-agent problem include:
1. Aligning the interests of principle and agent by providing the agent
with performance incentives;
2. Reducing moral hazard by promising the agent an ownership stake
in the organisation;

3. Increasing the ability of the principle to monitor the agent’s
behaviour, for example by requiring the agent to publish detailed
quarterly earnings reports.
Product differentiation: The process of distinguishing a good or
service in order to create an impression of value in the mind of the
customer.
Profit Margin:
Gross Profit Margin: Gross profit margin measures how much of every
dollar of sales revenue remains after subtracting the cost of goods sold.
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝐶𝑂𝐺𝑆
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 1 −
Net Profit Margin: Net profit margin measures how much out of every
dollar of sales revenue a company actually keeps. Net profit margin is
useful when comparing companies in similar industries. A higher net
profit margin indicates a more profitable company that has better
control of its costs.
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =
[𝐶𝑂𝐺𝑆 + 𝐴𝑙𝑙 𝑜𝑡ℎ𝑒𝑟 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠]

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 1 −
Contribution Margin: A cost accounting concept that allows a company

to determine the profitability of individual products.
𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Equivalently:

𝑃𝑟𝑖𝑐𝑒 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑃𝑟𝑖𝑐𝑒
Public good: A public good is a good that a person can consume

without reducing its availability to others (that is, the good is “non-
rival”) and from which no one can be excluded (that is, the good is
“non-excludable”). Examples of public goods might include national
defence, public television, radio, knowledge, fresh air and sunshine.
Pull System of Inventory Control (just in time): The pull system of
inventory control involves producing just enough to fill customer
orders. An advantage of this system is that there will never be excess
inventory and so inventory storage costs are minimized. A disadvantage
of this system is that supplier bottlenecks or limited operating capacity
can lead to ordering backlogs and customer dissatisfaction.
Push System of Inventory Control: The push system of inventory
control involves forecasting customer demand and producing enough to
meet forecast demand. An advantage of this system is that there will
typically be enough products on hand to satisfy customer orders.
Disadvantages include (a) the difficulty of forecasting demand, and (b)
the cost of storing excess inventory if actual demand falls short of
expectations.
Quantitative easing: A monetary policy tool sometimes employed by
central banks to stimulate the economy when conventional monetary
policy becomes ineffective. Quantitative easing involves increasing the
money supply by purchasing government bonds or other financial assets
with newly generated money. For more information, see “4.9
Quantitative Easing”.
Quick (Acid Test) Ratio: The quick ratio is more rigorous than the
current ratio, and measures whether a company has enough short-term
assets to cover short term liabilities without selling inventory.

𝐶𝑎𝑠ℎ + 𝐴⁄𝑅 + 𝑆ℎ𝑜𝑟𝑡 𝑇𝑒𝑟𝑚 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠
𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =
Real value: A value adjusted for inflation or deflation. For example, if a

Big Mac costs $3 this year and $6 next year and inflation is 100%, then
the real price of a BigMac has not changed.
Recency bias: The common tendency for people to place more weight
on recent data or experience compared with earlier data or experience.
An example of recency bias is where a salesperson with an acceptable
long term sales record becomes discouraged after a few consecutive
weeks of unsuccessful sales calls. A few weeks of poor performance can
count in the sales person’s mind as much as a few months or years of
prior success.
Recession: Broadly speaking, a recession is a period of slow or negative
economic growth, usually accompanied by rising unemployment.
Economists sometimes define a recession more formerly as “two
consecutive quarters of falling GDP”.
Replacement value: An estimate of how much it would cost to build
equivalent resources or capabilities from scratch.
Return on Investment: ROI is a performance measure that a company
can use to evaluate the return from an investment or to compare the
returns of a number of different investments.
𝐺𝑎𝑖𝑛 𝑓𝑟𝑜𝑚 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑅𝑂𝐼 =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Revenue: Income generated from trading or, for example, from selling
off an asset or piece of the business. Revenue should be recorded when
the sale is made as opposed to when the cash is received. For more
information, please read the article entitled “Understanding Financial
Statements 101”.

Rule of 70: The Rule of 70 is a simple rule of thumb that can be used to
figure out roughly how long it will take for an investment to double,
given an expected growth rate. The rule can be described by the
following equation:
70
𝑃𝑒𝑟𝑖𝑜𝑑𝑠 𝑡𝑜 𝑑𝑜𝑢𝑏𝑙𝑒 (𝑎𝑝𝑝𝑟𝑜𝑥) =
𝑡ℎ𝑒 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒
For more information, see “4.10 Rule of 70”.

Spillover: Externalities that result from economic activity and affect
people who are not directly involved in the activity. Spillover can be
positive or negative. Pollution that leaks out of a manufacturing plant
and into a local river would have a negative spillover effect on local
fishermen. The beauty of the buildings in Oxford would have a positive
spillover effect on locals and tourists.
Substitute goods: Any goods for which an increase in demand for one
leads to a fall in demand for the other. Substitute goods represent a
form of indirect competition. Examples of substitute goods might
include petroleum and natural gas, or Vegemite and Nutella.
Sunk cost: Sunk costs are expenditures that have already been made,
and which cannot be recovered. Sunk costs should not be factored into
the decision making process when evaluating a potential future course of
action.
Sunk cost fallacy: The common tendency for people to factor amounts
of money already spent – the sunk costs – into their decision-making
process. This is irrational since sunk costs cannot be recovered, and so
are not relevant when making a decision about a future course of action.
An example of the sunk cost fallacy would be where a company factors
past R&D spending into its future pricing strategy.
SWAP Agreement: An agreement to exchange one series of cash flows
for another for a set period of time. One of the series of cash flows will

normally be more uncertain, such as a floating interest rate, foreign
exchange rate, stock price or commodity price. SWAP Agreements are
not traded on an exchange, they are customized contracts traded
between private parties in the over-the-counter market.
Switching costs: Any costs that a customer incurs (for example, time,
money, effort) as a result of changing suppliers, brands or products.
Switching costs will be affected by various factors including the length
of the customer contract, the existence of customer loyalty programs,
and the price performance and compatibility of available complimentary
products.
Underemployment: A situation where a person’s capacity to work is
not fully utilised. This may occur due to (1) over-qualification, (2)
involuntary part-time work, or (3) over-staffing.
Vanilla: Plain or simple version.
Variable cost: A cost that varies with the quantity of output produced.
When making decisions in the short run, variable costs are the only costs
that should be considered because, in the short term, a company cannot
change its fixed costs.
Vertical competition: Competition which takes place between firms at
different stages of production. Suppliers and customers within the
supply chain may be able to exert their bargaining power on firms within
the industry to capture a larger share of industry profits.
Vertical Integration: A form of diversification in which a firm expands
its business to different points in the supply chain. For example, taking
over a supplier (backwards vertical integration) or taking over a
customer (forwards vertical integration).
Backwards vertical integration: A company engages in
backwards vertical integration when it purchases one or more
suppliers that produce inputs that the company uses to produce

final goods or services. For example, a car company might
purchase a tire manufacturer, a glass manufacturer, or an engine
manufacturer. Benefits of backwards vertical integration may
include (1) creating stable supply, (2) ensuring consistent quality of
inputs, and (3) restricting a competitor’s access to essential
supplies.
Walmart Effect: A situation where a single buyer gains substantial
control of a market as the major purchaser of goods or services. See
also, “Monopsony”.
Wealth: [Note that both of the definitions below use “time” as the
relevant yardstick or wealth, not “money”.]
1. Real wealth is discretionary time; money is merely the fuel
(attribution: Alan Weiss);
2. A measure of a person’s ability to survive so many number of days
forward into the future if they were to stop working today
(attribution: Robert Kiyosaki).

2. Industry Analysis
2.1 Macro Environment
2.1.1 PEST Analysis
Understanding the big picture can help reveal hidden
opportunities and threats
1. Background
In 1967, Harvard Professor
Francis Aguilar wrote a
book entitled “Scanning the
Business Environment” in
which he identified four
important factors –
Economic, Technical, Political, and Social – that a business can use to
better understand the big picture.
While the ordering of the letters may have changed, the four factors that
Aguilar identified half a century ago have not, and they form the basis of
PEST Analysis.
2. Relevance
If you are thinking about producing a strategic plan, developing a new
product, entering a new market, engaging in a joint venture, acquiring a
competitor, launching a start-up, or financing a new project then it
probably makes sense to understand the big picture issues that could
affect the project’s success.
Conducting a PEST Analysis can reveal hidden opportunities and
threats, and allow you to adapt your approach to achieve a more
favourable outcome.

3. Importance
There is something inherently appealing about a four-part model, and its
simplicity makes PEST Analysis a convenient and practical tool for
understanding the macro environment.
Conducting a PEST Analysis can be helpful for three reasons:
1. Understanding the facts: Understanding the big picture can help a
business make informed decisions, and avoid making incorrect
assumptions based on past experience;
2. Anticipating change: Understanding the macro environment can
help a business identify trends and anticipate change, allowing it to
take advantage of opportunities and manage potential threats; and
3. Avoiding failure: Understanding the macro environment can help a
business (and its investors) to identify projects that are likely to fail
due to unfavourable conditions. Knowing which battles not to fight
can often be more than half the battle.
4. PEST Analysis Explained

“PEST” is an acronym that stands for “Political, Economic, Social and
Technological” – the four factors that a business will want to consider
when scanning the macro environment.
PEST Analysis is a simple framework that uses these four factors to
examine the macro environment in order to understand the potential
implications for a business unit, product or project. Insights gained from
the analysis can be used to develop a strategic plan of action.
PEST Analysis can be used as part of a broader situation analysis.
Figure 1: Situation Analysis

There is a long list of alternative frameworks that could be used to scan
the macro environment. However, they generally complicate the analysis
by adding factors that could be dealt with more simply using PEST
Analysis. Some of the other variations include:
1. SLEPT: Social, Legal, Economic, Political, and Technological;
2. PESTEL: Political, Economic, Social, Technological,
Environmental, and Legal;
3. PESTELI: Political, Economic, Social, Technological,
Environmental, Legal, and Industry Analysis;
4. STEEPLED: Social, Technological, Economic, Environmental,
Political, Legal, Ethical, and Demographic;
5. PESTLIED: Political, Economic, Social, Technological, Legal,
International, Environmental, and Demographic; and
6. LONGPESTLE: Local, National, and Global versions of PESTLE
(might be useful for multinational organisations).
5. Conducting a PEST Analysis

Conducting a PEST Analysis involves considering issues relating to the
four key factors: Political, Economic, Social, and Technological.
The four factors will vary in significance depending on the nature of the
business. For example, social factors might be relevant for a retail
business, whereas political factors might be more relevant for a
munitions dealer.
The purpose of a PEST Analysis is to identify potential implications for
a specific business unit, product or project, and so it is important to be
clear about the purpose the analysis before commencing.
Below are a range of issues that you might want to consider when
conducting a PEST Analysis.

1. Political
Potential political issues include:
1. Industry regulation – How is the industry regulated? Have there
been any recent changes? Are there any planned changes? Is there
a trend towards regulation or deregulation? Laws and regulations
that may affect a company include tax, competition, employment,
anti-discrimination, consumer protection, environmental,
corporate social responsibility, corporate law, and international
law;
2. Property rights – Are property rights protected? What protections
exist for intellectual property (trademarks, copyrights, patents,
registered designs, trade secrets, software and circuit layouts)?;
3. Labour relations – Consider government policy, trade unions,
lobby groups, and the electoral cycle. Who holds political power?
How might this change at the next election?
4. Rule of law – Does the country have an independent court
system? Is government bureaucracy likely to increase costs or to
create delays? Is corruption widespread? How will it affect the
cost of doing business? Will it prevent projects from being
undertaken?;
5. Stability – Consider the level of political stability, and the
possibility of war and conflict.
2. Economic
Potential economic issues include:
1. Growth – Consider GDP per capita and market growth rates;
2. Monetary policy – Consider inflation, interest rates, and central
bank policy;
3. Government Spending and Investment – Consider government
policy and support including infrastructure investment, and the
availability of grants, subsidies, and tax breaks;

4. Capital markets – Consider the availability of credit, as well as the
liquidity and depth of the capital markets;
5. Labour – Consider labour costs and the unemployment rate. Will
it be possible and feasible to hire skilled workers?
6. Taxes – Consider potential tax issues including corporate, payroll,
employee, and value added taxes;
7. Free Trade – Consider whether there are trade restrictions,
subsidies, tariffs or quotas that could impact the supply of goods
or services;
8. Exchange rates – For companies engaged in cross border trade it
may be important to consider exchange rate volatility and the
need for a SWAP Agreement;
9. Business Cycle – Consider the business cycle, stock market
trends, market prices, and seasonality issues;
10. Consumer confidence; and
11. Industry specific factors.
3. Social
Potential social issues include:
1. Demographic Change – Consider population growth, age
distribution and life expectancy. Are generational shifts likely to
affect customer preferences and market demand?
2. Income Levels – Consider income distribution, average
disposable income, and social mobility;
3. Attitudes towards work;
4. Family size and structure;
5. Health levels, and health consciousness; for example, attitudes
towards smoking and drinking;
6. Education levels;
7. Emphasis on safety;
8. Social norms; for example, people tend to take holidays over
Christmas and in the summer;

9. Fashions, fads, trends, role models, and influential personalities;
10. Buying patterns and consumer preferences. For example, brand
preferences, and attitudes toward product quality, customer
service, fair trade, green, and organic products;
11. Ethnic and religious factors;
12. Cultural and sporting events; and
13. Prohibitions, taboos, and ethical issues.
4. Technological
Technological issues relate to the state of technology and its rate of
change, and may have implications for the competitive intensity of an
industry (for example, new technologies can reduce barriers to entry) or
may lead to disruptive innovation (for example, Amazon, Airbnb, and
Uber).
Potential technological issues include:
1. Technology level and rate of change in an industry;
2. Technology lifecycle;
3. New emerging technologies. For example, 3D printing,
collaborative consumption, wearable technology, driverless cars
and AI;
4. Location of technology hubs or clusters; university and business
partnerships;
5. Supporting infrastructure like high speed internet;
6. R&D spending;
7. Availability of financing for technology and innovative projects;
8. Automation; and
9. Legal frameworks, for example, protection of intellectual property
and support for crowd funding.
6. PEST Analysis Template

If you would like to download a template that can be used to conduct a
PEST Analysis, please click here.

2.2 Micro Environment
2.2.1 Business Landscape Survey
Before taking decisive action, it may be a good idea to assess the
lay of the land
According to Sun Tzu, the quality of decision “is like the well-timed
swoop of a falcon which enables it to strike and destroy its victim.”
Much like a circling falcon overhead, a company needs to take a 10,000
foot view of the business landscape before it can take swift and decisive
action.
The framework outlined in this section provides a structure that
consultants and business leaders can follow to help them examine the
business landscape.
1. Relevance
Having a framework to assess the business landscape is relevant to any
company in the context of making strategic decisions.
In the pursuit of growth, should a company enter a new market, develop
a new product, launch a start-up, form a joint venture, or acquire a
competitor? In the bid to cut costs, should a company reduce
headcount, outsource production to a supplier, or utilize lower cost
distribution channels? How should the company position itself within its
industry?
In order to find answers to key strategic questions, a company and its
executives need to develop a clear understanding of the business
landscape, and this section provides a structured framework that can be
used to guide the exploration process.

2. Importance
Failure to properly assess and understand the
business landscape can have billion dollar
implications and affect the course of an entire
industry.
The story that best illustrates this point was
IBM’s secret project in 1980 to create the
IBM Personal Computer.
As part of the project, IBM made three
surprising decisions:
1. It allowed Microsoft the right to produce the operating system
software and market it separately from the IBM PC;
2. It chose to purchase the microprocessor from Intel; and
3. It opted to make the IBM PC an “open architecture” product,
publishing technical guides to the circuit designs and software
source code.
These three strategic decisions helped to shift market power in the PC
industry away from IBM and towards Microsoft and Intel.
Although the PC market grew quickly, companies like Compaq, Dell and
HP soon reverse engineered the IBM PC and, since IBM had made it an
open architecture product, they were able to sell a large number of
clones, known as IBM compatibles, which dramatically increased the
intensity of competition in the PC industry. Meanwhile, booming PC
sales from multiple vendors provided Microsoft and Intel with a
lucrative and rapidly growing market for operating system software and
microprocessors.
Despite the fact that IBM had set the technology standard in the
personal computer industry, it failed to capture the lion’s share of
industry profits. It helped Microsoft and Intel establish lucrative markets

for themselves, but was not itself able to compete in these new markets
due to high barriers to entry including patents, the 4.5 Experience Curve
effect and 4.3 Economies of Scale.
IBM’s three strategic missteps were a blessing for Microsoft and Intel,
which as of 2015 have a combined market cap of over US$555 billion,
but are an enduring sore point for IBM, which decided to jettison its PC
business to Lenovo in 2005 for a mere US$1.8 billion.
The story of the IBM PC is a cautionary tale. Companies that fail to
assess the business landscape before taking action may find themselves
in an untenable position.
3. Surveying the Business Landscape

A popular way to examine the competitive intensity and attractiveness of
an industry is to use 4.8 Porter’s Five Forces, a technique which was first
outlined by HBS Professor Michael Porter in his 1979 book Competitive
Strategy.
While Porter’s Five Forces remains a useful reference point, and its core
elements are incorporated into the framework outlined in this section, it
is not used directly since it fails in one important respect. It does not
consider the market power and unique characteristics of the company
from whose perspective we are analysing the industry. For example, an
industry may appear attractive from the perspective of a cash rich tech
savvy player like Google but appear quite unattractive from the
perspective of other firms.
Through their strategies, firms have the ability to change industry
structure, and so the business landscape will always need to be assessed
relative to the market power and unique characteristics of a particular
organisation.
In order to assess the business landscape, we will examine the three
entities whose market power, strategies and actions will, in any industry,

affect a firm’s profitability: the customer, the competition and the
company itself.
3.1 Examining the Customer
“There is only one boss. The customer. And he can fire everybody in the company
from the chairman on down, simply by spending his money somewhere else.”
~ Sam Walton, founder of Walmart
A good first step in assessing the business landscape is to examine the
customer, the people whose problems the industry is trying to solve.
Below are eight (8) factors to consider when examining the customer.
1. Customer Identification
Who is the customer?
In trying to identify the customer, remember that the person who makes
the purchase decision, the person who pays (the customer), and the end
user (the consumer) may all be different people. For example, a doctor
may prescribe medicine that will be paid for by an insurance company
(the customer) and ultimately used by a patient (the consumer).
2. Customer Segmentation
Is it possible to group customers into distinct segments?
Customer segmentation can make it easier to understand customer
needs and preferences, the size and growth rate of different revenue
streams, and to identify trends.
It may make sense to segment customers by:
1. Age group;
2. Gender;
3. Income level;
4. Employment status;
5. Distribution channel;

6. Region;
7. Product preference;
8. Willingness to pay;
9. New versus existing customers; or
10.Large versus small customers.
3. Size
How big is the market?
How big is each customer segment?
How many customers are there in each segment, and what is the dollar
value of those customers?
4. Growth
How fast is the market growing?
What is the growth rate of each customer segment?
5. Customer Preferences
What do customers want?
Do different customer segments want different things?
Are the needs and preferences of customers changing over time?
6. Willingness to Pay
How much is each customer segment willing to pay?
How price sensitive is each customer segment? For example, students
will normally be very price sensitive, which means that offering student
discounts can increase units sold by enough to increase total revenue.
7. Bargaining Power
What is the concentration of customers in the market relative to the
concentration of firms?

If there is a small number of powerful customers who control the
market, then it may be necessary to either play by their rules or search
for a more favourable market. Examples of this kind of customer
include Walmart in the market for homeware products, Amazon in the
publishing industry, and the U.S. Department of Defence in the market
for defence equipment.
Do customers face high switching costs?
If customers face high switching costs then this will reduce their
bargaining power, and allow firms to charge higher prices than would
otherwise be possible.
8. Distribution
What is the best way to reach customers? Does each customer segment
have a preferred distribution channel?
Seven (7) distribution channels that a firm might use to reach customers
include:
1. Network marketing;
2. Mail order;
3. Online store;
4. Factory outlet;
5. Retail store;
6. Supermarket; and
7. Department store.
3.2 Examining the Competition
“Competition is not only the basis of protection to the consumer, but is the incentive to
progress.”
~ Herbert Hoover, 31st President of the United States
In order to understand the business landscape it is also important to
understand the competition, and this can be done by examining
Horizontal competition (competition between firms at the same stage of

production) and Vertical competition (competition between firms within
the supply chain).
3.2.1 Horizontal Competition
Competition can come from firms within an industry who are offering
similar solutions to the same group of customers (for example, Pepsi
and Coca Cola).
Competition can also come from firms in other industries who produce
substitutes. Substitutes may have quite different characteristics (for
example, petroleum and natural gas) but they represent a form of
indirect competition because consumers can use them in place of one
another (at least in some circumstances). For example, petroleum and
natural gas might both be used to produce heat and energy.
Below are eleven (11) factors to consider when examining the
competition.
1. Competitor Identification
Who are the company’s major competitors?
Taking Cadbury as an example, some of its major competitors might
include Lindt, Ferrero, Nestlé, Hershey’s and Mars.
What products and services does the competition offer?
2. Substitutes
Who are the company’s indirect competitors? That is, which firms are
producing substitutes?
To identify indirect competitors, it helps to take a broader view of what
the company offers. For example, Cadbury sells chocolate, but more
broadly it might be thought of as a snack food company, and so indirect
competitors might include companies like Lays, Cheetos and Doritos.
3. Competitor Segmentation

Is it possible to segment competitors in a meaningful way? The
competition might be grouped by distribution channel, region, product
line, or customer segment.
For example, the FOX Broadcasting Company might segment the
competition by region. In America, competitors include PBS, NBC, CBS
and ABC. While in Australia, competitors include Channel 7, 9 and 10 as
well as ABC and SBS.
4. Size and Concentration
What are the revenues and market shares of major competitors?
What is the concentration of competitors in the industry? That is, are
there lots of small competitors (a low concentration industry) or a few
dominant players (high concentration industry)? Examples of high
concentration industries include oil, tobacco and soft drinks. Examples
of low concentration industries include wheat and corn.
5. Performance
What is the historical performance of the competition? Relevant
performance measures might include profit margins, net income, and
return on investment.
6. Industry Lifecycle
Where is the industry in its lifecycle: early stage, growth, maturity or
decline?
7. Industry Drivers
What drives the industry: brand, product quality, scale of operations, or
technology?
8. Competitive Advantage
What is the competition good at? How sustainable are these advantages?

What are the competition’s weaknesses? How easily can these
weaknesses be exploited?
9. Competitive Strategy
What competitive strategy is the competition pursuing? Is the
competition producing products that are low cost or differentiated?
What customer segments is the competition targeting?
What is the competition’s pricing and distribution strategies?
What is the competition’s growth strategy? That is, are they seeking
growth by focusing on customer retention, increased sales volume,
entering new markets, or launching new products?
10. Competitive Balance
Is the industry balanced in the sense that competitors have clear and
sustainable positions within the industry? This may be the case where
firms provide customers with different value propositions which appeal
to different consumer preferences.
On the other hand, the industry may be unbalanced where multiple
competitors are trying to become the low cost firm within the industry
resulting in aggressive price competition and declining industry
profitability. Similarly, the industry may be unbalanced by a distant
follower who is making aggressive moves in an attempt to improve its
position, for example by introducing low priced unbranded generic
products.
11. Barriers to entry
The threat posed by potential competitors depends on the level of 4.1
Barriers to Entry.
Key barriers to entry might include capital requirements, economies of
scale, network effects, product differentiation, proprietary product

technology, government policy, access to suppliers, access to
distribution channels, and switching costs.
For more information on barriers to entry, see “4.1 Barriers to Entry”.
3.2.2 Vertical Competition within the Supply Chain
Competition includes not just rivalry between firms operating at the
same stage of production (horizontal competition) but also the
interaction between firms that have the potential to solve all or part of
the end user’s problem, and thereby compete for a share of industry
profits. This naturally includes vertical competition from suppliers and
customers within the supply chain.
Factors that will affect supplier bargaining power include:
1. The number of available suppliers and the strength of competition
between them;
2. Whether suppliers produce homogenous or differentiated
products;
3. The brand recognition of a supplier and its products;
4. The importance of sales volume to suppliers;
5. The cost to the firm of switching suppliers;
6. The availability of supplier substitutes; and
7. The threat of forward integration by the supplier relative to the
threat of backward integration by firms in the industry.
An example of supplier bargaining power comes from the PC industry.
IBM learned about vertical competition the hard way when it helped
Microsoft and Intel gain virtual monopolies over the supply of key
components for the IBM PC.
Factors that will affect customer bargaining power include:
1. The number of customers. If there are fewer customers then each
customer will have more bargaining power;
2. The volume a customer demands relative to a firm’s total output;

3. The availability of substitutes;
4. The cost to the customer of switching firms;
5. The availability of product comparison information; and
6. The threat of backward integration by the customer relative to the
threat of forwards integration by firms in the industry.
An example of customer bargaining power comes from the publishing
industry where Amazon has gained substantial bargaining power due to
its ability to sell and distribute huge volumes of books to end users.
3.2.3 Competitive Intensity
The intensity of competitive rivalry depends on the pressure exerted by
all sources of competition: horizontal competition from direct
competitors and substitutes, and vertical competition from firms at
different points within the supply chain.
Below are twelve (12) factors that will influence the strength of
competition within an industry:
1. Number of firms: The more firms there are in an industry the
stronger will be the competitive rivalry since there will be more
firms competing to serve the same number of customers;
2. Market growth: If the market growth rate slows then this will
increase competition since firms will need to compete more
aggressively to gain new customers;
3. Economies of scale: If firms in the industry have relatively high
fixed costs and low variable costs then this will lead to more
intense rivalry as firms compete to gain market share;
4. Excess capacity: If the industry experiences cyclical demand then
this may result in sporadic industry wide excess capacity leading
to bouts of intense price competition;
5. Switching costs: If customers have low switching costs, then this
will intensify competition as firms compete to retain existing
customers and steal customers from the competition;

6. Product differentiation: If firms in an industry produce
homogeneous products, then firms will be forced to compete on
price. Firms can achieve product differentiation in various ways
including product quality, features, branding and availability;
7. Instability: Diversity of competition (for example, firms from
different countries or cultures) may reduce predictability within a
market and lead firms to compete more aggressively;
8. Entry barriers: Low entry barriers will allow more competitors to
enter the market resulting in more intense competitive rivalry. For
more information on barriers to entry, see “4.1 Barriers to
Entry”;
9. Exit barriers: High exit barriers will increase competition because
firms that might otherwise exit an industry are forced to stay and
compete. A common exit barrier is where a firm has highly
specialized equipment that it cannot sell or use for any other
purpose;
10. Industry shakeout: Where a growing market induces a large
number of firms to enter, a point is likely to be reached where the
industry becomes crowded. When market growth slows, a period
of intense competition, price wars and company failures is likely
to ensue;
11. Substitutes: If the number of substitutes increases, the relative
price performance of substitutes improve, the prices of
substitutes decrease, or customer willingness to substitute
increases, then this will increase the intensity of rivalry within an
industry as firms compete to retain customers; and
12. Bargaining power of suppliers and customers: If suppliers and
customers have more bargaining power then they will be able to
extract a larger share of industry profits. This will reduce the
profitability of firms in the industry, which may lead to more
intense competition, industry consolidation, vertical integration,
and company failures.

3.3 Examining the Company
“Know your enemy and know yourself and you can fight a hundred battles without
disaster.”
~ Sun Tzu
In assessing the business landscape, it is not enough simply to
understand the customer and the competition, it is also important to
understand the firm from whose perspective you are analysing the
industry.
Below are ten (10) factors to consider when examining the company.
1. Performance
What is the historical performance of the company? What is its market
share? If profits are falling, what is the cause of the issue?
2. Competitive Advantage
What resources and capabilities does the company possess? Consider
both tangible assets (property, plant, equipment, inventory and
employees) and intangible assets (brand, patents, copyrights and
specialised knowledge).
How sustainable are the company’s advantages? What are the
company’s weaknesses and can they be remedied?
3. Competitive Strategy
What is the company’s competitive strategy? Is the company producing
products that are low cost or differentiated? Which customer segments
does the company target? (see “3.3.1 Porter’s Generic Strategies”).
What is the company’s pricing, distribution and growth strategies? (see
“3.4.1 Product / Market Expansion Matrix”).
4. Products

What does the company offer and how does it benefit consumers? Does
the product have any downsides or side effects?
Is the product differentiated?
How does the company’s product offering compare with the
competition? Are there substitutes available? Do customers face high
switching costs?
Where does the product fall within its product lifecycle? (see “3.5.2
Product Life Cycle Model”).
What is bundled with the product? For example, customer service,
warranties and spare parts. Are there opportunities to bundle or
unbundle the product in order to increase sales volume?
5. Finances
If the company is considering a particular course of action, does it have
sufficient funds available? Financing may be secured from various
sources including internal cash reserves, bank loans, shareholder loans,
bond issues or sale of shares.
How many units will the company need to sell in order to cover the cost
of the project? Is there sufficient market demand?
6. Cost Structure
In order to understand a company’s cost structure, it helps to break each
business unit down into the collection of activities that are performed to
produce value for customers. The way each activity is performed
combined with its economics will determine a firm’s relative cost
structure within its industry.
Are costs predominantly fixed or variable? How does this compare with
the competition?
For more information on understanding a company’s cost structure, see
“3.6 Cost Management”.

7. Organisational Cohesiveness
Understanding a firm’s inner workings is important since competitive
strategies can fail if they conflict with a firm’s culture, systems and
general way of doing business. The organisational aspects of a firm can
be examined using the 3.8.1 McKinsey 7 S Model.
8. Marketing
What does the company stand for? How do customers perceive the
company and its products? How does the company communicate with
customers?
9. Distribution Channels
What distribution channels does the company use to reach customers
(network marketing, mail order, online store, factory outlets, retail
stores, supermarkets and/or department stores)? Are there other
channels that are more cost effective or which are preferred by
customers?
10. Customer Service
Does the company have a customer loyalty program?
How does the company interact with customers and support its
customers post sale? Are employees empowered to solve problems and
delight customers?
4. Business Landscape Survey Template

If you would like to download a template that can be used to conduct a
survey of the business landscape, please click here.

3. Firm Level Analysis
3.1 Profitability
3.1.1 Profitability Framework
Understanding profitability issues can help executives, consultants
and entrepreneurs to diagnose and respond to falling prices,
declining sales volume and rising costs
Businesses sometimes experience reduced profitability.
This is not necessarily a problem since business sustainability depends
on cash flow, and long term growth can be achieved from capital
accumulation, which shows up on the balance sheet not on the profit
and loss statement.
However, a drop in profits can be concerning if it is unexpected and
unexplained. It can limit a business’s ability to achieve organic growth
and may mean that its existing business model is not sustainable.
1. Profit
2. Revenue 3. Cost
Price Units Sold Variable Costs Fixed Costs
Customer SG&A, Rent, R&D,

COGS: Raw
Pricing Strategy: segmentation; Depreciation,
Materials,
Competitive, Cost Market share; New Interest, Labor
Transport, Energy,
Based, Value Based markets; New (fixed contract),
Labor
products Marketing

1. Profit
Profit equals revenue minus cost.
By considering the broader economy and comparing a business’s
performance numbers with the competition it will be possible to
determine whether declining profitability is a company specific or
industry wide problem.
Assuming the issue is company specific, it will be possible to discover
the source of declining profitability by investigating each branch of the
profit equation, revenue and cost, and drilling down to explore the
company’s current and historical performance figures.
Declining profitability may result from falling prices, declining units
sold, rising costs or a combination of these three factors.
2. Revenue
Revenue can come from various sources including advertising and
product sales and is normally thought of as being a function of price per
unit and units sold. For example, price per widget multiplied by the
number of widgets, or cost per click multiplied by the number of clicks.
Declining revenue can derive from a fall in prices or a reduction in units
sold, and can be examined in four steps.
Step 1: Segmentation
What are the major revenue streams? It will typically be a good idea to
segment units sold, and this might be done by:
1. Product;
2. Product line;
3. Distribution channel;
4. Region;
5. Customer type (new/old, big/small); or
6. Industry vertical.

Step 2: Examination
What percentage of total revenue does each revenue stream represent?
Compare current and historical figures to identify how these percentages
have changed over time.
Step 3: Diagnosis
What is the underlying cause of the problem?
Step 4: Response
Develop a strategic response.
2.1 Diagnosis
If faced with declining prices or sales volume, factors to consider include
the following.
1. Macro Economy
 PEST Analysis: Are there recent or impending changes to the
macro environment? This may include changes to political,
economic, socio-cultural or technological factors.
2. Customers
 Market growth: Has market growth slowed forcing competitors to
compete for market share?
 Customer needs and preferences: Have customer needs and
preferences changed?
 Price Discrimination: Is the fall in prices or sales volume
attributable to a particular customer segment? Can the company
distinguish between customers and charge different prices to
different customer segments? This could be done by offering
quantity discounts or by distinguishing between people in different
groups (e.g. students) or in different locations (e.g. you pay more
for popcorn at the cinemas).

 Distribution Channels: What channels are used to reach
customers? Have new or preferred channels become available?
Has there been a change in the cost effectiveness of existing
channels?
3. Competition
 Rivalry: Have competitors lowered their prices? How does the
company’s product mix, product quality, and cost structure
compare to the competition?
 Substitutes: Has the availability of substitutes increased or the price
performance of substitutes improved?
 Barriers to entry: Has it become easier for new competitors to
enter the industry? For example, the Internet has enabled new
entrants in many established industries including publishing,
newspapers, and taxis.
 Buyer bargaining power: Has there been an increase in customer
bargaining power? For example, Amazon has used its market
dominance to drive down the price of books much to the chagrin
of book publishers.
4. Company
 Market Power: Does the company have market power that might
allow it to raise prices (monopoly, product differentiation,
proprietary technology, economies of scale, network effects)? For
example, De Beers for many years had a monopoly on the
diamond trade which allowed it to keep the price of diamonds
high.
 Products: What products and product mix does the company
offer? How does this compare to the competition? Is there
something different about the products that might allow the
company to raise prices? For example, brand recognition, superior
quality, appealing design, unique product features, or strong
customer service.

 Value chain analysis: Consider value chain activities such as access
to raw materials, operating capacity, inventory handling and
distribution. Are there any bottlenecks or capacity limitations?
2.2 Response
Declining prices
You would be forgiven for thinking that the best way to respond to
falling prices is simply to raise them. But unfortunately things are often
not that simple since a business’s ability to raise prices can often be
constrained.
In response to declining prices, there are three pricing strategies to
consider:
1. Competitive pricing: How do prices compare with the
competition? Is the pricing appropriate given the product’s relative
quality and position within the market? How is the competition
likely to respond to the firm’s pricing strategy?
2. Cost based pricing: Cost based pricing is a simple pricing strategy
that sets price relative to the company’s costs. The price is set by
calculating the company’s per unit cost and adding a margin for
profit.
3. Value based pricing: Value based pricing involves assessing the
customer and setting the price based on the customer’s willingness
to pay.
For further discussion on pricing strategy, see “3.5.1 Four Ps
Framework”.
Declining sales volume
Faced with falling sales volume, there are four growth strategies that a
company might employ: market penetration, market development,
product development, and diversification.

Figure 2: Product/market expansion matrix
For more information on growth strategy, see “3.4.1 Product / Market

Expansion Matrix”.
3. Costs
The third driver of declining profitability is rising costs.
3.1 Diagnosis
If rising costs are driving a decline in profitability, then the cost structure
of the business will need to be examined in order to locate the source of
the cost blow out. This might be done by segmenting costs into value
chain activities: inbound logistics, operations, outbound logistics, sales &
marketing, customer service (see “3.2.1 Value Chain Analysis”).
Have there been any significant changes in the company’s cost drivers?
How do costs compare to the competition?
3.2 Response
After determining the source of rising costs, a firm can develop
strategies to manage and reduce costs. For more information on cost
management, see “3.6 Cost Management”.

4. Profitability Framework Cheat sheet
If you would like to download a cheat sheet that contains all the
essentials of the profitability framework on one page, please click here.
3.2 Competitive Advantage

3.2.1 Value Chain Analysis
To understand which activities provide a business with a
competitive advantage, either through cost advantage or product
differentiation, it is helpful to separate operations into a series of
value-generating activities referred to as “the value chain”
1. Background
Value Chain Analysis is a concept that was first described and
popularised by Michael Porter in his 1985 book, Competitive
Advantage.
2. Relevance
In order to understand the activities that provide a business with a
competitive advantage, either through cost advantage or product
differentiation, it is useful to separate the business operation into a series
of value-generating activities referred to as “the value chain”.
Value Chain Analysis involves identifying all of the important activities
in which a business engages and then determining which ones give the
company a defensible competitive advantage. By doing this, a company
can:
1. Determine which activities are best undertaken internally and
which ones are able to be outsourced or eliminated;
2. Identify and compare its strengths and weaknesses with the
competition; and
3. Identify synergies between activities.

3. Value Chain Analysis Explained
Michael Porter introduced a generic value chain model that comprises a
sequence of activities common to a wide range of firms. Porter
suggested that the activities of a business could be grouped under two
headings:
1. Primary activities: Those that are directly concerned with
creating and delivering a product or service; and
2. Support activities: Those that are not directly involved in
production, but may increase efficiency or effectiveness.
Figure 3: The Generic Value Chain
The firm’s margin or profit depends on its ability to perform these

activities efficiently, so that the amount that the customer is willing to
pay for the products exceeds the cost of the activities in the value chain.
3.1. Primary activities
The primary value chain activities include:
1. Inbound Logistics: Receiving and storing externally sourced
materials;
2. Operations: Manufacturing; the way in which inputs are converted
into final products;

3. Outbound Logistics: Inventory storage and distribution to
customers;
4. Marketing & Sales: Identification of customer needs and
preferences, marketing strategy and sales generation;
5. Service: Supporting customers after products or services have been
sold to them.
3.2. Support activities
Support activities include:
1. Human resource management: Recruitment, training,
development, motivation and compensation of employees;
2. Infrastructure: Includes a broad range of support systems
including organisational structure, planning, management, quality
control, culture, and finance;
3. Procurement: Sourcing resources and negotiating with suppliers;
and
4. Technology development: Managing information, developing and
protecting new products and services, developing more efficient
processes, and improving quality.
4. Application of the Value Chain Analysis

4.1 Steps to take
Value Chain Analysis can be undertaken by following three (3) steps:
1. Break down a company into its key activities under each of the
headings in the model;
2. Identify activities that contribute to the firm’s competitive
advantage either by giving it a cost advantage or creating product
differentiation. At the same time, also identify activities where the
business appears to be at a competitive disadvantage; and
3. Develop strategies around the activities that provide a sustainable
competitive advantage.

4.2 Cost advantage
A business can achieve a cost advantage over its competitors by
understanding the costs associated with each activity and then organising
each activity so that it is as efficient as possible.
Porter identified ten (10) cost drivers related to each activity in the value
chain:
1. 4.3 Economies of Scale;
2. Learning;
3. Capacity utilisation;
4. Linkages among activities;
5. Interrelationships among business units;
6. Degree of vertical integration;
7. Timing of market entry;
8. Firm’s policy on targeting cost or product differentiation;
9. Geographic location;
10. Institutional factors (regulation, union activity, taxes, etc.).
A firm can develop a cost advantage by controlling these ten (10) cost
drivers better than its competitors.
A cost advantage can also be pursued by reconfiguring the value chain.
Reconfiguration means introducing structural changes such as a new
production process, new distribution channels, or a different sales
approach. For example, in 2013 Qantas structurally redefined its
maintenance of aircraft, traditionally conducted by in-house engineers,
by outsourcing this function to private overseas contractors.
4.3. Product differentiation
A firm can achieve product differentiation by focusing on its core
competencies in order to perform them better than its competitors.
Product differentiation can be achieved through any part of the value
chain. For example, procurement of inputs that are unique and not

widely available to competitors, providing high levels of product support
services, or designing innovative and aesthetically attractive products.
5. Issues arising from Value Chain Analysis

5.1. Linkages between value generating activities
Value chain activities are not isolated from one another. Rather, one
value chain activity often affects the cost or performance of other value
chain activities. Linkages may exist between primary activities and also
between primary and support activities.
For example, the design of a product might be changed in order to
reduce manufacturing costs. However, if the new product design
inadvertently results in increased service costs then the total cost
reduction could be less than anticipated.
5.2. Business unit interrelationships
Business unit interrelationships can be identified using the Value Chain
Analysis.
Business unit interrelationships offer opportunities to create synergies
among business units. For example, if multiple business units require the
same raw materials and the procurement process can be coordinated
then bulk purchasing may result in cost reductions. Such
interrelationships may exist simultaneously in multiple value chain
activities.
5.3. Outsourcing
Value Chain Analysis can help management decide which activities to
outsource. It is rare for a business to undertake all primary and support
activities internally. In order to decide which activities to outsource
managers must understand the firm’s strengths and weaknesses, both in
terms of cost and ability to differentiate.
6. Case Example

Below are some of the issues that might be relevant for some of Coca
Cola’s value chain activities:
1. Procurement: Is it more cost effective to procure inputs locally,
regionally or globally? If local procurement is more expensive but
better for the environment and local communities, can this be used
as a point of differentiation? Are there likely to be political or
environmental disturbances that could drive up the cost of key
inputs like corn syrup or aluminium?
2. Operations: How much does a bottling plant cost to build and
run? How often do factories need to be re-engineered? Would it
be more cost effective to outsource bottling? Is bottling
strategically important for product differentiation?
3. Logistics: What is the cost of inventory storage? How is Coca
Cola distributed to customers? How many cans are lost in transit?
4. Marketing & Sales: Are consumer preferences changing over
time? Will people enjoy cherry cola? Are people becoming more
health conscious?
3.3 Competitive Strategy

3.3.1 Porter’s Generic Strategies
Three strategies to achieve above-average performance: cost
leadership, differentiation, and focus
In order to understand Porter’s Generic Strategies, it is helpful to take a
step back and examine the two things which determine a firm’s
profitability in the long run.
The first is industry attractiveness, which is determined in any industry
by the five competitive forces: the threat of entry by new competitors,
the threat of substitutes, the bargaining power of buyers, the bargaining
power of suppliers, and the rivalry among existing firms.

Figure 4: Porter’s Five Competitive Forces that Determine Industry
Profitability
It is the collective strength of these five forces that determine whether

firms in an industry will be able to earn attractive rates of return. In
industries where the five forces are favourable, such as the soft drink
industry, many competitors have earned attractive returns for many
decades. However, where one or more of the forces exerts strong
pressure on industry profitability, such as in the airline industry, few
firms ever do well for long.
Understanding industry structure, as determined by the five forces, will
inform a firm’s decision to enter or exit an industry, and will also be a
key consideration for industry leaders who have the ability to mould
industry structure for better or for worse. For example, Coca-Cola is a
leader in the soft drink industry and could, if it wanted to, encourage the
production and sale of generic unbranded soft drinks. Even if this would
increase Coca-Cola’s profits in the short run, it would also threaten the
structure of the industry. Generic cola may increase the price sensitivity
of buyers, lead to aggressive price competition, and lower barriers to
entry by enabling new competitors to enter the market without a large
advertising budget.

In addition to industry attractiveness, the second thing which determines
a firm’s profitability in the long run (and this is where Porter’s Generic
Strategies comes in) is a firm’s relative position within the industry. That
is, can a firm position itself to achieve above average performance
within its industry? Or put differently, is it possible for a firm to
establish and maintain a competitive advantage?
In his 1985 book Competitive Advantage, Michael Porter explains that
there are two basic sources of competitive advantage that a firm can
possess: cost leadership and differentiation. A firm can also narrow the
scope of its activities to compete in niche segments of the market, and
so there are actually three generic strategies that a firm can adopt to
achieve above-average performance: cost leadership, differentiation, and
focus.
Figure 5: Three Generic Strategies
Porter’s generic strategies are based on the idea that in order to achieve a
competitive advantage a firm needs to make hard choices. Trying to be
all things to all people will put a firm on the fast track to mediocrity, and
so a firm needs to decide what kind of competitive advantage to pursue
and which market segments it should target.
Cost Leadership
As the name suggests, a firm that pursues cost leadership aims to be the
low cost producer in its industry. While the strategy involves a primary

focus on cost reduction, the cost leader will also need to produce
comparable products in order to maintain prices.
If a firm can sustain cost leadership while at the same time charging
prices at or near the industry average, then this strategy can allow a firm
to achieve above average performance.
One danger of the cost leadership strategy is that if there is more than
one aspiring cost leader then this can lead to intense competitive rivalry
and ultimately destroy industry profitability. If a firm wants to be the
cost leader, then its best bet is to get in first in order to deter the
competition.
Differentiation
Differentiation is a strategy in which a firm sets out to provide unique
value to buyers. This may be achieved in various ways including
producing products with unique features, serving buyers through new or
different distribution channels, or by creating perceived differences in
the buyer’s mind through clever marketing.
While the strategy involves a primary focus on “being different” the
differentiator will still need to manage its costs, and will want to reduce
costs in any area that does not contribute to differentiation. If a firm is
able to charge a price premium that exceeds the cost of sustaining its
uniqueness, then the firm will be able to achieve above average returns.
Focus
The focus strategy involves narrowing the scope of competition in order
to serve certain niche segments within the overall market. By serving
these target segments well, the focuser may be able to achieve a
competitive advantage in its niche even though it does not enjoy a
competitive advantage in the market overall.

Stuck in the Middle
While there are three generic strategies for achieving above average
performance, a firm that tries to employ all of these strategies
simultaneously without successfully pursuing any of them faces the risk
of becoming “stuck in the middle”. As such, it may find itself
perpetually outperformed by other firms in the industry that have been
willing to make hard strategic choices about how to compete.
3.3.2 Strategy and the Internet

There are six strategic principles which are relevant to any
company that wants to be profitable online
In an article entitled “Strategy and the Internet” published in the March
2001 edition of the Harvard Business Review, Michael Porter outlined
six principles that he believes internet companies need to follow if they
want to establish and maintain a distinctive strategic position online.
Porter’s six strategic principles are instructive, and we outline them
below.
1. Stand for something

In order for a company to develop unique skills, build the right assets,
and establish a strong reputation it is important to define what the
company stands for so that the company will have continuity of
direction.
2. Focus on profitability
Porter’s second principle, which argues for a focus on online
profitability through the sale of goods or services, is not quite on point.
Many internet based companies focus on “unique visitors” and “page
views” as measures of performance and Porter notes that, at the end of

the day, sustainable profits will only be possible where goods or services
can be provided at a price which exceeds the cost of production.
While it is true that profits are most commonly obtained via the sale of
goods and services, this is not always the case. Porter’s primary focus
on profitability through the sale of goods and services misses a key
insight that successful internet-based companies are typically in the
business of connecting people around a common interest or shared
purpose. In other words, the Internet is not about selling goods and
services, but is about creating markets, building communities and
connecting people. While it is true that a successful internet-based
company may derive profits from the sale of goods and services, it is
also just as likely to generate revenues from advertising, membership
fees and commissions.
3. Offer consumers a unique set of benefits

Good strategy involves being able to provide a distinct set of benefits to
a particular group of consumers. Trying to please every consumer will
not give a company a sustainable competitive advantage.
4. Perform core activities differently

If a company is able to establish a distinctive value chain by performing
key activities differently from its competitors, then this will help the
company establish a sustainable competitive advantage.
5. Specialise
There is no competitive advantage to being a jack of all trades and a
master of none. Porter recommends making trade-offs. By focusing on
certain activities, services or products at the expense of others a
company can establish a unique strategic position.
6. Ensure that all activities reinforce the company’s

strategy

All of a company’s activities are interdependent and, as a result, they
must be coordinated so as to reinforce the company’s overall strategy. A
company’s product design, for example, will affect the manufacturing
process and the way that products are marketed. By coordinating all of
its activities, a company makes it harder for competitors to imitate its
strategy.
3.4 Growth Strategy

3.4.1 Product / Market Expansion Matrix
A framework to help executives, senior managers and marketers
devise strategies for future growth
1. Background
The Product/Market Expansion Matrix (or “Ansoff Matrix” as it is
sometimes called) was developed by a Russian-American mathematician
named Igor Ansoff, and first explained in his 1957 Harvard Business
Review article entitled Strategies for Diversification.
2. Relevance
The Product/Market Expansion Matrix is particularly useful for strategic
planning because it provides a framework to help executives, senior
managers and marketers devise strategies for future growth.
By aiding clear thinking about growth strategy, the Product/Market
Expansion Matrix can help an organisation avoid key risks including:
1. Overlooking available growth strategies;
2. Misunderstanding the implications of pursuing a particular
strategy; and
3. Selecting an inappropriate strategy given the firm’s diversification
objectives.

3. Product/Market Expansion Matrix Explained
The Product/Market Expansion Matrix can help a firm devise a
product-market growth strategy by focusing on four growth alternatives:
1. Market Penetration;
2. Market Development;
3. Product Development; and
4. Diversification.
Figure 6: Product/market expansion matrix
What is a Product-Market Growth Strategy?

A product-market strategy is a description of a firm’s products and
target markets. While this may sound straightforward, it can be difficult
to clearly delineate a target market since it can be defined very broadly
(for example, the transport market) or very narrowly (for example,
domestic air transport in America for cost-conscious business travellers).
In general, a market should not be defined too broadly (or too narrowly)
since a key purpose of market definition is to allow a firm to develop
strategy and make decisions.
In his 1957 paper, Ansoff defined a product-market strategy as “a joint
statement of a product line and the corresponding set of missions which

the products are designed to fulfil.” For example, one of Apple’s
product missions might be to provide consumers with easy-to-use digital
technology, and another mission might be to provide fashion accessories
for Yuppies and young people.
The Four Growth Alternatives
The four alternative growth strategies are:
1. Market Penetration: A strategy to increase sales without departing
from the original product-market strategy. This involves increasing
sales to existing customers and finding new customers for existing
products.
2. Market Development: A strategy to sell existing products to new
markets (normally with some modifications). Ansoff described this
as a strategy “to adapt [the] present product line … to new
missions.” For example, Boeing might adapt an existing model of
passenger aircraft and sell it for cargo transportation.
3. Product Development: A strategy to sell new products, with new
or altered features, to existing markets. Ansoff described this as a
strategy to develop products with “new and different
characteristics such as will improve the performance of the
[existing] mission.” For example, Boeing might develop a new
aircraft design which offers improved fuel economy.
4. Diversification: A strategy to develop new products for new
markets, which can either be related to the current business (e.g.
vertical integration or horizontal diversification) or unrelated (e.g.
conglomerate diversification).
Each of the above strategies represents a different path that a firm can
take to pursue growth. However, in practice, a firm will often implement
more than one strategy at the same time. As Ansoff noted, “a
simultaneous pursuit of market penetration, market development, and
product development is usually a sign of a progressive, well-run business
and may be essential to survival in the face of economic competition.”

4. Selecting a Strategy
A growth strategy can be selected through a three-step process:
1. Setting out all of the available strategies;
2. Applying qualitative criteria to short list the most favourable
alternatives; and
3. Applying a return on investment hurdle to narrow the options still
further.
The discussion below provides a summary of the issues and various
situations in which it may make sense for a firm to select a particular
growth strategy.
4.1 Market Penetration
Market Penetration carries the least implementation risk since a firm is
focusing on its existing products and existing markets, and so should be
able to leverage its existing resources and capabilities.
Pursuing this strategy is likely to make sense if the firm has a strong
competitive advantage, or if the overall size of the market is growing or
can be induced to grow.
4.2 Market Development
Market Development carries more implementation risk than Market
Penetration because a firm is expanding into new markets.
Companies that have successfully pursued this strategy include Coca-
Cola and McDonalds, and it may make sense where:
 The firm’s core competencies relate to its existing products and it
has a strong marketing team;
 The firm can identify opportunities for market development
including chances to reposition the brand, exploit new uses for the
product, or expand into new geographical regions;

 The firm’s resources are organised to produce particular products
and changing the production technology would be costly.
4.3 Product Development
Product Development carries more implementation risk than Market
Penetration because the firm is developing new products.
Companies that have successfully pursued this strategy include 3M,
P&G and Unilever, and it may make sense where:
 The firm understands the needs of its customers, and identifies an
opportunity to sell new products to satisfy new or changing needs;
 The firm operates in a competitive market where continuous
product innovation is necessary to prevent product obsolescence
or commoditisation;
 The firm has large market share and a strong brand;
 The firm’s products benefit from network effects or proprietary
technology, and new products can gain a significant edge by being
first to market;
 The firm operates in a market with strong growth potential;
 The firm identifies opportunities to commercialise new
technology;
 The firm has a strong R&D team.
4.4 Diversification
Diversification carries the most implementation risk since a firm is
simultaneously developing new products and entering new markets, and
may need to develop or acquire new resources and capabilities.
Diversification can enable a firm to achieve three main objectives:
growth, stability, and flexibility. The specific strategies that a firm
employs will differ depending on which of these goals a firm is pursuing.
There are three primary kinds of diversification that a firm might pursue:

1. Vertical Integration: The firm expands its business to different
points in the supply chain;
2. Horizontal Diversification: The firm adds new products that may
be unrelated to existing products but are likely to appeal to existing
customers. For example, Amazon initially sold only books through
its website but has over time added new products such as clothes,
jewellery and electronics;
3. Conglomerate Diversification: The firm adds new products that
are unrelated to existing products and are likely to appeal to new
customer segments. While conglomerate diversification may have
little relationship with a firm’s existing business, a firm might
adopt this strategy in order to:
 Improve profitability by entering a lucrative industry;
 Develop resources and capabilities in a potential new growth
industry;
 Poach top management or key talent;
 Compensate for technological obsolescence;
 Expand the firm’s revenue base so as to improve its perception
in the capital markets and make it easier to borrow money;
 Increase strategic flexibility in an uncertain business
environment; or
 Reduce risk by spreading the firm’s activities across multiple
products and markets, and thereby decrease its vulnerability to
negative Black Swans and unfavourable events such as
economic downturns, increased competitive rivalry, improved
supplier or buyer bargaining power, improved price
performance of substitutes, or reduced barriers to entry.
5. Implementing a Growth Strategy

Below are some suggestions on how to implement each of the four
alternative growth strategies.
5.1 Market Penetration

Market Penetration involves increasing sales of existing products to
existing markets, and could be pursued in the following ways:
1. Pricing:
 Changing product pricing; for example, if demand is relatively
inelastic, then it might be possible to raise prices without a big
drop in sales. Alternatively, prices could be lowered to increase
sales volume;
2. Product:
 Modifying the products or product packaging in order to
broaden their appeal;
 Bundling products together in order to sell them as a single
unit;
 Increasing the size of a product in order to increase the amount
sold per unit;
3. Place:
 Improving distribution channels in order to reach more
customers within existing markets;
 Targeting a market niche in order to grow sales and build
overall market share (this approach may make sense if the firm
is small compared to its competitors);
 Make products available at times and in locations which
correspond with high customer demand (for example, selling
ice cream near the beach, selling Christmas trees in December);
4. Promotion:
 Increasing advertising to promote the product or reposition the
brand;
 Offering quantity discounts (e.g. 2 for 1, Buy One Get One
Free);
 Introducing customer loyalty schemes;
 Improving the quality or size of the sales force;
5. Acquisitions:

 Acquiring a competitor (this approach may make sense in
mature markets where the size of the overall market is not
growing);
6. Cost Management:
 Improving operational efficiency so that increased sales can be
achieved without a proportional increase in costs (this might be
attained due to economies of scale and product rationalisation).
5.2 Market Development
Market Development involves selling existing products to new markets,
or new market segments, and could be pursued in the following ways:
1. Product:
 Modifying the pricing strategy, product and/or product
packaging in order to appeal to different customer segments;
2. Place:
 Utilising new distribution channels to reach new market
segments, for example building an online store;
3. Promotion:
 Marketing products in new locations in order to expand
regionally, nationally or internationally;
 Advertising through different media in order to reach different
customer segments;
4. Acquisitions and Joint Ventures:
 Acquiring a competitor or forming a joint venture or strategic
alliance in order to gain access to new distribution channels.
5.3 Product Development
Product Development involves selling new products to existing markets,
and could be pursued in the following ways:
1. Product:
 Developing new products through R&D or licensing new
technologies;

 Extending an existing product by producing different versions;
for example, Apple released two versions of the iPhone 5, the
iPhone 5C and the iPhone 5S;
 Packaging existing products in new ways; for example, Apple
re-released the iPhone 5 in a range of colourful cases and called
it the iPhone 5C;
2. Place:
 Distributing products manufactured by other firms in order to
increase utilization of an existing distribution channel. For
example, Amazon not only sells and distributes products
through its website but also allows other vendors to do so;
3. Acquisitions and Joint Ventures:
 Acquiring a competitor in order to acquire its product line;
 Forming a joint venture or strategic alliance with a
complementary firm.
5.4 Diversification
Diversification involves selling new products to new markets, and can be
pursued by simultaneously adopting the strategies suggested above for
Market Development and Product Development.
3.4.2 GE McKinsey 9 Box Matrix

The GE-McKinsey 9-Box Matrix offers decentralised corporations
with multiple business units a systematic approach for investing
available cash reserves
1. Background
The 9-Box Matrix was developed as part of work that McKinsey did for
GE in the early 1970s. At that time, GE had around 150 business units
and was faced with the challenge of how to manage such a large number
of business units profitably.

The 9-Box Matrix was developed as a result of the realisation that it is
important to separate the ability of a business to generate cash from the
decision about whether to put more cash into the business.
2. Purpose
The 9-Box Matrix offers any decentralised corporation with multiple
business units a systematic approach to help it decide where to invest its
excess cash reserves.
The 9-Box Matrix solves the problem of trying to compare potentially
very different business units: one might be capital intensive; another
might require high advertising expenditure; a third might have
economies of scale.
Instead of relying on the projections provided by the manager of each
individual business unit, the company can determine whether a business
unit is going to do well in the future by considering two factors:
1. Industry attractiveness; and
2. Competitive advantage.
[It is worth noting that these are the same factors proposed by Professor
Michael Porter in his 1985 book Competitive Advantage.]
3. Using the 9-box Matrix

Figure 7: GE-McKinsey 9-box matrix
Placing each business unit within the 9-Box Matrix offers a framework
for comparison between them.
In order to keep things simple, the framework offers three investment
strategies:
1. Invest/Grow;
2. Selectivity/Earnings; and
3. Harvest/Divest.
Allocating one of these investment strategies to each business unit is the
first step. However, it is important to note that two business units that
have been given the same strategy will not necessarily be treated in the
same way. For example, a strong unit in a weak industry will be in a very
different situation from a weak unit in an attractive industry.
After placing every business unit into one of the nine boxes, there are at
least two questions that need to be asked:
1. If a business unit is in one category, say “selectivity/earnings”, are
there any actions that might be taken to improve its position?
2. If a business unit is to receive money, what does it plan to do with
that money and does this strategy make sense? It is important that

a business unit has a purpose in mind because the best use of
money will vary depending on the industry and on the business
unit. For example, advertising to enhance the brand might work
for one business unit, whereas increasing R&D spending might
work for another.
4. Axes of the 9-box Matrix

The 9-Box Matrix places “industry attractiveness” along the vertical axis,
and “competitive advantage” along the horizontal axis.
4.1 Industry attractiveness
Industry attractiveness refers to industry profitability. That is, how easy
will it be for the average firm to generate above average profits over the
long run? For a straightforward approach to examining industry
attractiveness, see “4.8 Porter’s Five Forces”.
4.2 Competitive advantage
A business unit has a competitive advantage when it is able to achieve
profits that exceed the industry average.
Understanding whether a business unit has a “sustainable competitive
advantage” involves examining its relative position within its industry
and the resources and capabilities that it possesses which will allow it to
maintain and strengthen that position over time.
Relevant considerations might include:
1. Does the business unit benefit from economies of scale or
network effects?
2. Does the business unit enjoy strong brand recognition?
3. Is the business unit more profitable than its competitors? If so,
why so?
5. Available Strategies

5.1 Invest / Grow
A business unit will be in the “invest/grow” category if the prospects
for the industry as a whole are attractive and the business unit’s position
in the industry means that it is likely to do better than most of the other
firms in the industry.
A business unit in this category should be given increased investment
regardless of whether it can generate those funds itself.
5.2 Selectivity / Earnings
Business units in this category are given second priority to those in the
“invest/grow” category. As such, the amount of money spent on
business units in the “invest/grow” category will determine how much is
left over for business units in this category.
When allocating money to a business unit in this category, it is important
to be selective about where the money is spent and monitor earnings
closely. With the right combination of strategies, it may be possible to
move a business unit into the “invest/grow” category. However, if a
business unit doesn’t improve its performance it may be advisable to
reallocate cash to another business unit.
5.3 Harvest / Divest
A business unit will be in the “harvest/divest” category if it is in an
unattractive industry and its competitive position is weak.
There are two potential strategies can be pursued for business units in
this category:
1. Harvest: Increase short-term cash flows as far as possible, even at
the expense of the business unit’s long term future; or
2. Divest: Sell the business unit or liquidate its assets.

3.4.3 BCG Growth Share Matrix
The BCG Growth Share Matrix is a simple conceptual framework
for resource allocation within a firm
1. Background
In 1968, BCG developed the growth share matrix, which is a simple
conceptual framework for resource allocation within a firm.
2. Purpose
The BCG matrix is a simple tool that enables management to:
1. Classify products in a company’s product portfolio into four
categories – Stars, Cash Cows, Question Marks, and Dogs;
2. Index a company’s product portfolio according to cash usage and
generation;
3. Determine the priority that should be given to different products
in a company’s product portfolio; and
4. Develop strategies to tackle various product lines.
3. BCG Growth Share Matrix Explained

The idea behind the growth share matrix is that the amount of cash that
a product uses is proportional to the rate of growth of that product in
the market, and the generation of cash is a function of its market share.
Money generated from high-market-share products can be used to
develop high-growth products.

Figure 8: BCG Growth Share Matrix
Under the BCG matrix, products are classified into four types:
1. Stars are leaders in high growth markets. Stars grow rapidly and
therefore use large amounts of cash. Stars also have a high market
share and therefore generate large amounts of cash. Over time, the
growth of a product will slow. If a Star maintains a high market
share, it will eventually become a Cash Cow. If not, it will become
a Dog.
2. Cash Cows are highly profitable, and require low investment
because they are market leaders in a low-growth market. Growth is
slow and therefore cash use is low, and market share is high and
therefore cash generation is high. Money generated from cash
cows can be used to pay dividends, interest, and overheads, and to
develop Stars and Question Marks.
3. Question Marks are low market share high growth products, and
almost always require more cash than they can generate. If a
Question Mark can improve its market share, it will eventually
become a Cash Cow. If not, it will become a Dog.
4. Dogs generate little cash because of their low market share in a
low growth market. BCG refers to these products as “cash traps”.
Although they may be sold profitably in the market, BCG indicates

that, in terms contributing to growth, Dogs are essentially
worthless.
4. Available Strategies
The BCG matrix offers four alternative strategies:
1. Develop: This strategy is appropriate where a product’s market
share needs to be increased in order to strengthen its market
position. Short-term earnings and profits are forfeited because it is
hoped that the long-term gains will outweigh these short term
costs. This strategy is suited to Stars, as well as Question Marks if
they are to become Stars.
2. Hold: The objective of this strategy is to maintain the current
market share of a product, and is used for Cash Cows so that they
will continue to generate large amounts of cash which can be
invested in Stars and Question Marks.
3. Harvest: Under this strategy, management attempts to increase
short-term cash flows as far as possible (e.g. by increasing prices,
and cutting costs) even at the expense of the products long-term
future. It is a strategy suited to weak Cash Cows or Cash Cows
that are in a market with a limited future. Harvesting is also used
for Dogs, and for Question Marks that have no possibility of
becoming Stars.
4. Divest: The objective of this strategy is to get rid of unprofitable
products and products with low market share in low growth
markets. Money from divestment can then be used to develop and
promote more profitable products. This strategy is typically used
for Dogs and for Question Marks that will not become Stars.
5. Criticisms
The simplicity of the BCG matrix helped to popularise the tool with
management teams around the world. Unfortunately, however, the BCG
matrix is not just simple and easy to remember but also simplistic, and

using the framework without careful consideration could lead to serious
strategic missteps.
Below are four (4) key criticisms of the BCG matrix.
First of all, the BCG matrix encourages managers to focus primarily on
market share at the expense of other factors that may be important for
organisational performance. A myopic focus on market share may lead
managers to:
1. Engage in aggressive price competition leading to the destruction
of industry profits;
2. Focus narrowly on one product or product line, forgetting that
markets are fluid and notoriously hard to define. For example, if
Apple had defined its market as “PCs and laptops” then it would
never have pioneered the iPod, iPhone and iPad; and
3. Ignore other growth alternatives including new product
development, new market entry, and diversification.
A second problem with the BCG matrix is that by classifying a product
into one of four types – Star, Cash Cow, Question Mark, or Dog – it is
essentially forecasting the product’s potential which can result in a self-
fulfilling prophecy. For example, if a product is labelled a Star then it
will receive increased investment and management focus, employees
working on the product are likely to be more motivated, and the product
will therefore be likely to perform much better than it would have
otherwise.
A third problem with the BCG matrix is that it is often difficult to
determine where a product or an industry falls within its life cycle. A
technology product with high market share in a low growth market
might be labelled as a Cash Cow and assigned a “hold” strategy, and so
be given just enough investment to maintain its market share. While this
may be an appropriate strategy for a product in a slow moving industry,
rapidly changing technology may require significant investment in order

to capture new opportunities for growth and innovation. For example,
Microsoft, with its dominant market share for operating system software
in the PC industry has been slow to innovate and slow to release
software for other devices such as smartphones and tablets.
A fourth criticism of the BCG matrix is that it equates high market share
with high cash generating ability. It assumes that a product with higher
market share will generate more cash; however this may not be the case.
In 1970, while outlining the BCG matrix, Bruce Henderson stated that
“Margins and cash generated are a function of market share. High
margins and high market share go together. This is a matter of common
observation, explained by the experience curve effect.”
Henderson’s observation turns out to be an oversimplification of reality
(for a full discussion on this point, see “Implications for Strategy”). If a
product benefits from economies of scale and the experience curve
effect, then higher market share will lead to lower unit costs. However,
this does not necessarily mean that the product will generate more cash
since the amount of cash that a product generates depends on two
variables:
1. Profit margin per unit – It is common for firms to achieve
increased market share by lowering prices, which will lead to lower
profit margins unless sufficient cost savings can be found to offset
the lower price. This means that a product with higher market
share will only generate more cash if the percentage increase in
units sold is greater than the percentage decrease in profit margin
per unit. This will not always be the case, but admittedly it is likely
to occur for the kinds of products that Henderson was talking
about, that is, for products which benefit from economies of scale
and the experience curve effect; and
2. Units sold – In considering a product’s cash generating potential,
companies need to consider not only market share but also market
size since units sold is a function of both. For example, a product

that has a small market share in a large market may have the
potential to generate a lot of cash. This insight is overlooked by
the BCG matrix.
3.5 Marketing Strategy

3.5.1 Four Ps Framework
A useful framework for evaluating the marketing strategy for a
product
The Four Ps Framework involves examining four aspects relevant to a
product’s marketing strategy:
1. Price;
2. Product;
3. Promotion; and
4. Place.
1. Price
The pricing strategy that a firm employs will affect a product’s market
share and profitability.
Depending on the situation, there are many different pricing strategies
that a firm might choose to employ. We can group all of these strategies
under three headings: competitive pricing, cost based pricing, and value
based pricing.
1.1 Competitive pricing
Under this strategy, the price of a product will be affected by the price
of competing products, and by the availability of substitutes.
How do prices compare with the competition? Is the pricing appropriate
given the product’s relative quality and position within the market?
A firm might consider the following competitive pricing strategies:

1. Predatory pricing: Aggressive pricing intended to undercut
competitors and drive them out of the market.
2. Limit pricing: A low price charged by a monopolist in order to
discourage entry into the market by other firms.
3. Penetration pricing: The price is set low in order to gain market
share.
1.2 Cost based pricing
Under this strategy, the price of a product will be determined by the
company’s cost structure and the cost of goods sold.
What is the company’s cost structure? What percentage of costs are
fixed and variable? A company that has high fixed cost and low variable
costs will benefit from economies of scale and may want to lower prices
to increase market share.
A firm might consider the following cost based pricing strategies:
1. Marginal cost pricing: The price of a product is set equal to the
cost of producing one extra unit of output.
2. Target pricing: The price of a product is calculated to produce a
particular return on investment.
3. Cost-plus pricing: Arguably the most basic pricing strategy which
involves setting price equal to the unit cost of production plus a
margin for profit.
1.3 Value based pricing
Under this strategy, pricing will be driven by the perceived value of the
product in the mind of the customer. Perceived value will depend on
various factors include branding, product differentiation, availability, the
customer’s price sensitivity and willingness to pay.
Are customers price sensitive? If prices are changed, how will this affect
sales volume and product perception?
Two (2) practical examples of value based pricing include:

1. A company that manufactures branded Gucci t-shirts that retail for
$80 per shirt, and unbranded t-shirts of the same design and
quality that retail for $30;
2. A movie theatre that sells adult tickets for $20, and sells the exact
same tickets to students for $10.
A firm might consider the following value based pricing strategies:
1. Price discrimination: Setting a different price for the same product
for different customer segments. See “Price discrimination”.
2. Dynamic pricing: A flexible pricing mechanism, which allows
online companies to adjust the price of identical goods to
correspond to a customer’s willingness to pay. This is made
possible by using data gathered from a customer including where
they live, what they buy, and how much they have spent on past
purchases.
3. Market-orientated pricing: Setting a price based upon analysis of
the target market.
4. Psychological pricing: Pricing designed to have a positive
psychological impact. For example, selling a product at $3.95
instead of $4.
5. Skimming: Charging a high price to gain a high profit, at the
expense of achieving high sales volume. This strategy is usually
employed to recoup the initial investment cost in research and
development, commonly used in consumer electronic markets
when a new product range is released since early adopters are
typically less price sensitive.
6. Premium pricing: Keeping the price of a product artificially high in
order to encourage a favourable perception among buyers.
7. Loss leader pricing: A loss leader is a product sold at a low price to
stimulate other profitable sales. For example, the 30 cent soft serve
cone at McDonalds.
8. Seasonal pricing: Adjusting the price depending on seasonal
demand.

2. Product
Is the product a low cost commodity or differentiated?
The major sources of product differentiation include:
1. Vertical differentiation: Products can differ in their quality due
to differences in reliability, comfort, support services, or other
factors. For example, BMW versus Hyundai.
2. Horizontal differentiation: Products can differ in features that
cannot be ordered. For example, different flavours of ice-cream.
3. Availability: Products may be available at different times (e.g.
seasonal fruits) and locations (e.g. ice-cream sold near the beach).
4. Perception: Products can differ in their brand recognition, which
can be influenced through sales and marketing efforts.
How does a product compare with what the competition is offering?
Are their viable substitutes? Do customers face high switching costs?
Successful product differentiation can lead to Monopolistic competition,
a situation where firms retain some control over pricing despite there
being multiple competitors.
3. Promotion
Promotion is used to enhance the perception of a company or its
products in the mind of customers. A promotion may draw people’s
attention to branding, quality, product features, price or availability.
What message is the firm trying to communicate? What is the objective?
Who is the target customer? What is the right promotion medium, reach
(that is, number of people reached through the chosen medium) and
frequency of promotion? What is the firm’s marketing budget?
How does the firm’s marketing strategy differ from the competition?
How might the competition react to the firm’s marketing strategy?

Understanding the customer’s buying decision process can help a firm
decide where and how to influence the customer’s purchase decision.
Information
Awareness Evaluation Purchase Re-puchase
Search
Figure 9: Customer Buying Decision Process
Promotion can be carried out in various ways including:

1. Advertising (digital, TV, newspapers, magazines);
2. Direct Sales (door to door, cold calling, warm calling, direct mail);
3. Indirect Sales (word of mouth);
4. Trade Promotions (price discounting, quantity discounting);
5. Public Relations (donating to charity, sponsoring a sports team,
celebrity appearances).
4. Place
The physical location and availability of a product can be a source of
competitive advantage. For example, if there are two ice-cream stores,
one next to a popular tourist beach and the other in a quiet suburb, we
would reasonably expect that the ice cream store near the beach will be
able to charge higher prices and sell more ice-cream.
A firm should consider the markets and market segments that it wants
to serve. Does the competition serve the same markets and market
segments?
Which inventory control system should the firm use? Should the firm
insource or outsource transportation and logistics?
What distribution channels does the firm use? Which channels are most
closely aligned with the company’s strategy? What are the economics of
the available channels? Do these fit with the intended selling price of
the product? How much control is the company willing to give up in
the delivery of its products? What is the risk that market power shifts to
the channel?

3.5.2 Product Life Cycle Model
The Product Life Cycle Model can be used to analyse the maturity
stage of products and industries
1. Background
The idea of the Product Life Cycle was first developed in 1965 by
Theodore Levitt in an article entitled “Exploit the Product Life Cycle”
published in the Harvard Business Review on 1 November 1965.
2. Benefits
For a business, having a growing and sustainable revenue stream from
product sales is important for the stability and success of its operations.
The Product Life Cycle model can be used by consultants and managers
to analyse the maturity stage of products and industries. Understanding
which stage a product is in provides information about expected future
sales growth and the kinds of strategies that a firm should implement.
3. Product Life Cycle Model

The Product Life Cycle is the name given to the stages through which a
product passes over time. The classic Product Life Cycle has four stages:
1. Introduction;
2. Growth;
3. Maturity; and
4. Decline.

Figure 10: Product Life Cycle Model
3.1 Introduction
At the market introduction stage the size of the market, sales volumes
and sales growth are small. A product will also normally be subject to
little or no competition. The primary goal in the introduction stage is to
establish a market and build consumer demand for the product.
There may be substantial costs incurred in getting a product to the
market introduction stage. Costs may derive from activities such as
thinking of the product idea, developing the technology, determining the
product features and quality, establishing sufficient manufacturing
capacity, preparing the product branding, ensuring trade mark
protection, testing the market, setting up distribution channels, and
launching and promoting the product.
The market introduction stage is likely to be a period of low or negative
profits. As such, it is important that products are carefully monitored to
ensure that sales volumes start to grow. If a product fails to become
profitable it may need to be abandoned.
Factors to consider during the introduction stage include:

 Product development: Research and development of the basic
technology and product concept, determining the product features
and quality level.
 Pricing: Should penetration pricing or a skimming price strategy be
used? A skimming price strategy might be appropriate where there
are very few competitors.
 Distribution: Distribution might be quite selective until consumer
acceptance of the product can be achieved.
 Promotion: Marketing efforts are aimed at early adopters, and seek
to build product awareness and educate potential consumers about
the product.
3.2 Growth
If the public gains awareness of a product and consumers come to
understand the benefits of the product and accept it then a company can
expect a period of rapid sales growth. In the growth stage, a company
will try to build brand loyalty and increase market share.
Profits are driven by increased sales volume due to growth in market
share as well as an increase in the size of the overall market. Profits
might also be driven by cost reductions gained from economies of scale,
and perhaps more favourable market prices. Competition in the growth
stage remains low, although new competitors are expected to enter the
market. When competitors enter the market a company might be subject
to price competition and increase its marketing expenditure.
Factors to consider during the growth stage include:
 Product improvement: Product quality might be improved,
additional features and support services added, and packaging
updated.
 Pricing: If consumer demand is high the price might be maintained
at a high level.

 Distribution: Distribution channels might be added as consumer
demand increases.
 Promotion: Promotion is aimed at a broader audience. A company
might spend a lot of resources on promotion during the growth
stage in order to build brand loyalty.
3.3 Maturity
When a product reaches maturity, sales growth slows and sales volume
eventually peaks and stabilises. This is the stage during which the market
as a whole makes the most profit. A company’s primary objective at this
point is to defend market share while maximising profit.
In this stage, prices tend to drop due to increased competition. A
company’s fixed costs are low because it is has well established
production and distribution. Since brand awareness is strong, marketing
expenditure might be reduced, although increased marketing
expenditure might be needed to retain market share and fight increasing
competition. Expenditure on research and development is likely to be
restricted to product modification and improvement, and perhaps
research into improved production efficiency and product quality.
Factors to consider in a mature product market include:
 Product differentiation: Increased competition in the mature
product market means that a company must find ways to
differentiate its product from that of competitors. Strong branding
is one way to do this.
 Pricing: Prices may be reduced because of increased competition.
Firms in the market should be careful not to start a price war.
 Distribution: Distribution intensifies and incentives may be offered
to encourage preference to be given over competing products.
 Promotion: Promotion will focus on emphasising product
differences and creating/maintaining a strong brand.

3.4 Decline
A product enters into decline when sales and profits start to fall. The
market for that product shrinks which reduces the amount of profit
available to firms in the industry. A decline might occur because the
market has become saturated, the product has become obsolete, or
customer needs or preferences have changed.
A firm might try to stimulate growth by changing its pricing strategy, but
ultimately the product will have to be re-designed, or replaced. High-
cost and low market share firms will be the first to exit the industry.
As product sales decline, a firm has three options:
1. Hold: Maintain production, add new features and find new uses
for the product. Reduce the cost of manufacturing (e.g. move
manufacturing to a low cost jurisdiction). Consider whether there
are new markets in which the product might be sold.
2. Harvest: Continue to offer the product, but reduce marketing
expenditure perhaps by targeting a smaller niche segment of the
market.
3. Divest: Discontinue production, and liquidate the remaining
inventory or sell the product to another firm.
Factors to consider during a declining market include:
 Product consolidation: The number of products may be reduced,
and surviving products rejuvenated.
 Price: Prices may be lowered to liquidate inventory, or maintained
for continued products.
 Distribution: Distribution becomes more selective. Channels that
are no longer profitable are phased out.
 Promotion: Expenditure on promotion is reduced.

4. Criticisms
The Product Life Cycle is useful for monitoring sales results over time
and comparing them to products with a similar life cycle. However, the
Product Life Cycle model is by no means a perfect tool. Products often
do not follow a defined life cycle, not all products go through each stage,
and it is not always easy to tell which stage a product is in at any point in
time. Consequently, the life cycle concept is not well-suited for
forecasting product sales.
The length of each stage will vary depending on the product and the
marketing strategies employed. A Product Life Cycle may be as short as
a few months for a fad or as long as a century or more for a product like
petrol cars. In many markets the product life cycle is longer than the
planning cycle of the organisations involved. Major products often hold
their position for several decades or more, indeed, Coca-Cola was
introduced in 1886 and is still the leading brand of cola.
The Product Life Cycle is only one of many considerations that a
company needs to bear in mind. The product life cycle of many modern
products is shrinking, while the operating life for many of these
products is lengthening. For example, the operating life of durable goods
like household appliances has increased substantially. As a result, a
company that produces these products must take their market life and
service life into account when planning.
Some critics have argued that a Product Life Cycle can become self-
fulfilling. For example, if sales peak and then fall a manager may
conclude that a product is in decline and cut back on marketing, thus
precipitating a further drop in sales.

3.6 Cost Management
1. Cost Structure
In order to understand a company’s costs, it will help to break each
business unit down into the collection of activities that are performed to
produce value for customers. This is an application of Value Chain
Analysis (see “3.2.1 Value Chain Analysis”). The way each activity is
performed combined with its economics will determine a firm’s relative
cost structure within its industry.
In examining a firm’s cost structure, relevant considerations include:
1. What are the business’s fixed costs? For example, Sales General &
Admin, overheads, rent and interest expenses, depreciation, capital
costs, R&D, and wages under fixed employment contracts.
2. What are the business’s variable costs? For example, raw materials,
shipping, energy, sales commissions and performance bonuses.
3. What are the main cost drivers?
4. How have costs changed over time?
5. How does the firm’s cost structure compare to the competition?
A company that has more fixed costs relative to variable costs is said to
have more operating leverage, and will experience a greater percentage
change in profits for a given percentage change in sales. Firms with high
operating leverage tend to be in industries that require large economies
of scale, such as the software industry. Operating leverage is a form of
risk since a company with high operating leverage will require high sales
volumes in order to ensure profitability.
2. Cost Reduction
When developing a cost reduction strategy, three questions to consider
include:
1. How long will it take to reduce major cost drivers?
2. Are the activities strategically important?

3. To what extent do the activities contribute to operational
performance?
Figure 11: Cost reduction decision matrix
A company will want to eliminate or outsource costly activities that have

low strategic importance. If the activity has a low contribution to
operational performance it should probably be eliminated, and if it has a
high contribution to operational performance it can be outsourced.
A company will want to retain control of activities that have high
strategic importance. This can be done by continuing with business as
usual, finding ways to increase efficiency, or forming a strategic alliance
with more capable firms.
Twelve (12) common cost reduction techniques include:
Procurement
1. Consolidate procurement or renegotiate supply contracts;
HR Management
2. Reduce labour costs through decreasing salaries, training, overtime,
benefits and healthcare, introducing employee stock ownership,
and ‘right sizing’;

Technology Development
3. Use IT and digital technology to reduce communication and
organisational costs;
4. Employ more advanced production technology;
Operations
5. Improve the utilisation rate of plant, property and equipment;
6. Outsource manufacturing to a lower cost jurisdiction (for example,
China or India);
7. Relocate the centre of operations to a lower cost city, region or
country;
Logistics
8. Partner with distribution companies (for example, FedEx);
Finance
9. Reduce working capital including inventory and accounts
receivable;
10.Refinance outstanding debt;
11.Buy futures contracts to hedge against changes in commodity
prices and foreign exchange rates;
12.Divest non-core assets.

3.7 Financial Management
3.7.1 Five C Analysis of Borrower
Creditworthiness
When a company is trying to borrow money, executives,
entrepreneurs and consultants need to be aware of the five key
criteria that lenders tend to care about
It is important to understand what lenders look for when they assess a
company’s creditworthiness because companies often need to borrow
money for various purposes: provision of working capital, refinancing
existing debt, paying for operating expenditures, conducting research
and development, undertaking new product development, expanding
into new markets, and pursuing M&A activity.
There are five criteria that most lenders use to assess a borrower’s
creditworthiness:
1. Capacity to generate sufficient cash flows to service the loan;
2. Collateral to secure the loan in case the borrower defaults;
3. Capital that shareholders have invested in the business;
4. Conditions prevailing in the borrower’s industry and the broader
economy; and
5. Character and track record of the borrower and the borrower’s
management.
It is important to bear in mind that lenders don’t give equal weight to
each criterion and will use all five criteria to create an overall impression
of a company’s creditworthiness. Lenders are typically cautious and
weakness in one of the five criteria may offset strength in all of the
others. For example, if a company is in a cyclical industry (e.g.
construction, auto, or aviation) the company may find it difficult to
borrow money during an economic downturn even if the company
shows strength in all of the other criteria. Similarly, if a company’s

management has a bad reputation and poor track record then the
company may find it difficult to borrow money even if it has a strong
financial statement.
Taken together, these five criteria indicate a borrower’s ability and
willingness to repay its debts. As such, if you a company aiming to raise
finance, or are advising such a company, it is important to ensure that
the company can satisfy prospective lenders on each of the five criteria.
Below we consider each of the five criteria in more detail.
1. Capacity
Capacity to repay a loan is the most important criterion used to assess a
borrower’s creditworthiness. The borrower must be able to satisfy the
lender that it has the ability to repay the loan. To satisfy itself of the
borrower’s capacity, the lender will consider various factors including:
1. Profitability: What are the revenues and expenses of the
borrower?
2. Cash flows: How much cash flow does the business generate?
The lender is interested not only in cash flows from operations,
but also cash flows from investing and financing activities. What
are the timing of cash flows with regard to repayment?
3. Payment history: What is borrower’s payment history and track
record of loan repayment?
4. Debt levels: How much debt does the borrower have? How much
debt can the borrower reasonably afford to repay?
5. Industry evaluation: What is the normal debt/liquidity level for
companies in the borrower’s industry?
6. Financial ratios: There are a number of financial ratios, such as
debt and liquidity ratios, that lenders will typically evaluate before
lending money: for example, Debt to Equity Ratio, Debt to Asset
Ratio, Current Ratio, Quick (Acid Test) Ratio, and Operating Cash
Flow Ratio.

2. Collateral
While cash flows are the primary source for the repayment of a loan,
collateral provides lenders with a secondary source of repayment.
Collateral represents the assets that are provided to the lender to secure
a loan. In the event that the borrower defaults, the collateral may be
seized by the lender to repay the loan.
A borrower will usually need to provide a lender with suitable collateral.
To do this, the borrower normally pledges hard assets like real estate,
office equipment or manufacturing equipment. However, accounts
receivable and inventory might also be pledged as collateral.
Service businesses and small companies may find it difficult to provide
lenders with the collateral they require because they have fewer hard
assets to pledge.
If the borrower doesn’t have the necessary collateral, the lender may
require personal guarantees from the borrower’s directors or from a
third party such as the borrower’s parent company.
3. Capital
Capital is the money that shareholders have personally invested in the
business. Capital represents the money that shareholders have at risk if
the business fails.
Lenders are more likely to lend money to a borrower if shareholders
have invested a large amount of their own money in the business. If the
business runs into financial difficulty, then the capital of the business
provides a cushion for repayment of the loan. If shareholders have a
large amount of capital invested in the business, this indicates they have
confidence in the venture and that they will do all that they can to
ensure the borrower does not default on the loan.

4. Conditions
Conditions refer to two factors that the lender will take into account.
Firstly, conditions refer to the overall economic climate, both within the
borrower’s industry and in the economy generally that could affect the
borrower’s ability to repay the loan. For example, during recessions and
periods of tight credit it becomes more difficult for businesses to repay
loans and more difficult for lenders to find money to lend. Thus, during
these periods a business may find it difficult to borrow money and must
present lenders with a flawless loan application.
In considering the overall economic climate a lender may consider
various questions including:
1. What is the current business climate?
2. What are the trends for the borrower’s industry? How does the
borrower fit within them?
3. What is the short and long-term growth potential for the industry?
4. Where does the industry fall within its life cycle? Is it an emerging
or mature industry?
5. Are there any economic or political hot potatoes that could
negatively impact the borrower’s growth?
Secondly, conditions refer to the intended purpose of the loan. The
borrower’s reasons for seeking the loan should be spelt out in detail in
the loan application. Will the money be used to buy new equipment for
expansion? Will the money be used to replenish working capital to
prepare for a seasonal inventory build-up?
5. Character
Character refers to the general impression that the borrower forms
about the prospective lender. The lender will form a subjective
judgement as to whether the borrower is sufficiently trustworthy to
repay the loan.

Lenders want to place their money with companies that have impeccable
credentials. Relevant factors that a lender may consider in deciding
whether the borrower is sufficiently trustworthy include:
1. What is the character of each member of the management team?
2. What reputation do management have in the industry and the
community?
3. What educational background and level of experience does
management have?
4. What is management’s track record?
5. What is the overall consumer perception of the borrower?
6. Is the borrower progressive about its waste disposal, quality of life
for its employees, and charitable contributions?
7. Does the borrower have a track record of fulfilling its obligations
in a timely manner?
8. What is the borrower’s payment history and track record of loan
repayment?
9. Are there any legal actions pending against the borrower? If so,
what is the reason for these legal actions?
3.7.2 Net Present Value

NPV is a simple tool that executives and consultants can use to
determine whether an investment should be undertaken. The NPV
of an investment is the present value of the series of expected cash
flows generated by the investment minus the cost of the initial
investment
The net present value (NPV) of an investment is the present value of the
series of expected cash flows generated by the investment minus the
cost of the initial investment, and can be written as follows:
𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑛 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒
𝑁𝑃𝑉 = + + ⋯ + + − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)𝑛 (1 + 𝑟)𝑛
𝐶𝐹𝑛 × (1 + 𝑔)
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 =
𝑟−𝑔

Where r = discount rate; CFt = expected cash flow in period t; g = long
term cash flow growth rate.
NPV is a simple tool used to assess whether an investment should be
undertaken. As a general rule, assuming you have selected an appropriate
discount rate, only investments that yield a positive NPV should be
considered for investment.
1. The Discount Rate

The rate used to discount future cash flows to their present value is an
important variable in the net present value calculation. The choice of
discount rate will depend on the situation.
1.1 Cost of capital
One option is to use a firm’s weighted average cost of capital.
However, there are two potential problems with using the cost of capital
for the discount rate. Firstly, it may not be possible to know what the
cost of capital will be in the future. Secondly, the cost of capital does not
take into account opportunity costs. A positive NPV calculation tells us
that the investment is profitable, but does not tell us whether the
investment should be undertaken because there may be even more
profitable investment opportunities.
1.2 Opportunity Cost
A second option is to use a discount rate that reflects the opportunity
cost of capital. The opportunity cost of capital is the rate which the
capital needed for the project could return if invested in an alternative
venture. Obviously, where there is more than one alternative investment
opportunity, the opportunity cost of capital is the expected rate of return
of the most profitable alternative.

2. Potential Issues
2.1 Negative future cash flows
One potential problem with NPV is that if the future cash flows are
negative (for example, a mining project might have large clean-up costs
towards the end of a project) then a high discount rate is not too
cautious but too optimistic. A way to avoid this problem is to explicitly
calculate the cost of financing losses after the initial investment.
2.2 Adjusting for risk
Another common pitfall is to adjust for risk by adding a premium to the
discount rate. Whilst a bank might charge a higher rate of interest for a
risky project that does not necessarily mean that this is a valid way to
adjust a net present value calculation. One reason for this is that where a
risky investment results in losses, a higher discount rate in the NPV
calculation will reduce the impact of such losses below their true
financial cost.
2.3 Negative NPV
The general rule is that only those investments that yield a positive NPV
should be considered for investment. However, this will only be true if
you have selected an appropriate discount rate. For example, if the
appropriate discount rate is 15% but you used a higher discount rate to
calculate NPV, then obtaining a negative NPV does not mean that the
project should be rejected.

3.8 Organisational Cohesiveness
3.8.1 McKinsey 7 S Model
The 7 S Model can help executives and consultants understand the
inner workings of an organisation, and can provide a guide for
organisational change
1. Background
Developed around 1978, the 7 S model first appeared in a book called
The Art of Japanese Management by Richard Pascale and Anthony
Athos, and also featured in In Search of Excellence by Tom Peters and
Robert Waterman.
McKinsey has adopted the 7 S model as one of its basic analysis tools.
2. Relevance
The 7 S model is a useful diagnostic tool for understanding the inner
workings of an organisation. It can be used to identify an organisation’s
strengths and sources of competitive advantage, and also to identify the
reasons why an organisation is not performing effectively. As such, the 7
S model can be a useful analysis tool for mangers, consultants, business
analysts and potential investors.
The 7 S model can provide a guide for organisational change. The
framework maps a group of interrelated factors, all of which influence
an organisation’s ability to change. The interconnectedness among each
of the seven factors suggests that significant progress in one area will be
difficult without working on the others. The implication is that, if
management wants to successfully establish change within an
organisation, they must work on all of the factors, and not just one or
two.

3. McKinsey 7 S Model
The 7 S model describes seven factors which together determine the way
in which an organisation operates. The seven factors are interrelated
and, as such, form a system that might be thought to preserve an
organisation’s competitive advantage. The logic is that competitors may
be able to copy any one of the factors, but will find it very difficult to
copy the complex web of interrelationships between them.
Figure 12: McKinsey 7 S Model
The seven (7) factors considered by the 7 S model include:

1. Shared values refer to the values that are widely held and
practiced within the organisation and which form its core guiding
principles. Shared values may include things like the purpose of
the organisation and its long term vision for the future. For
example, the core guiding principle at McKinsey is
‘professionalism’.
2. Strategy refers to the plans that a company has for gaining a
sustainable competitive advantage (e.g. low cost or differentiated
products; new product development and entering new markets).

3. Skills refers to the competencies of the organisation, the skills and
experience of staff, management practices, and the ability to
innovate.
4. Structure refers to the way in which an organisation’s people and
business units relate to each other. This includes organizational
structure, communication channels, and chain of command.
5. Staffing refers to the recruitment, selection, training,
development, and management of talent.
6. Style refers to the work culture, the leadership style of upper
management and the way things are done in the course of day-to-
day operations.
7. Systems refers to the organisation’s processes and procedures for
things like budgeting, communication, recruitment, compensation,
and performance reviews.
3.9 Competitive Response

A competitor’s recent or impending actions may make it necessary for
an organisation to respond.
When placed in this kind of situation, an organisation should first
examine the business situation to see what kind of response might be
appropriate.
 Have customer needs and preferences changed?
 What actions have the competition taken or threatened to take?
Are they offering new or different products? Have they changed
their pricing strategy? Are they using new suppliers, raw materials
or distribution channels? Have they gained market share or entered
new markets? Have they changed their cost structure or improved
their operating efficiency?
Potential competitive responses might include:
 Mimic: Observe the competitor and mimic its behaviour;

 Attack: Seek to undermine the competition by poaching key
employees, entering one of its other markets, launching a patent
lawsuit, or attacking it in the media;
 Product innovation: Redesign, repackage or improve existing
products;
 Product development: Introduce new products;
 Pricing: Change the pricing strategy. See “3.5.1 Four Ps
Framework”;
 Marketing: Increase marketing efforts in order to improve brand
recognition;
 Customer service: Improve customer service and introduce
customer loyalty programs;
 New market entry: Enter new markets. This might be achieved
by launching a start-up, acquiring a competitor, or forming a joint
venture;
 Control suppliers and channels: Monopolize key suppliers and
distribution channels through acquisition or by entering into long
term contracts.
Case Example
A situation might unfold in which CanadaCo, the largest discount
retailer in Canada by market share, is forced to respond to a competitive
threat from USCo, the largest discount retailer in the United States,
which has decided to expand into Canada by purchasing CanadaCo’s
competition. The question is, how should the CEO of CanadaCo
respond?
In the CanadaCo example, it would be important to test the hypothesis
that USCo has a cost advantage due to economies of scale in the US
market. A cost advantage would allow USCo to provide lower prices to
Canadian consumers and, as a result, USCo’s entry into the Canadian
market might be expected to reduce CanadaCo’s market share.

Once the business situation and the relative strengths and positions of
USCo and CanadaCo are fully understood, it will then be possible to
formulate a competitive response.
CandaCo could opt to do nothing, or respond in one or more of the
following ways:
1. Change its pricing strategy;
2. Hire top executives away from USCo;
3. Acquire or merge with a competing company;
4. Rouse customer loyalty through rewards programs and customer
service;
5. Mimic USCo’s behaviour by entering the US market; or
6. Market CanadaCo’s products in order to build brand recognition.
3.10 Corporate Turnaround

When faced with the challenge of turning around and restructuring a
company, it is important to ask a variety of questions to determine the
source of the problem. For example:
 What is the state of the economy?
 What have been the prevailing trends in the industry? Are
competitors facing the same problems?
 Are there issues with the company’s finances? Is the company
publicly traded or privately held?
Below are eight (8) actions that a company might pursue as part of a
turnaround:
1. Examine and understand the company, its finances and operations;
2. Talk to key stakeholder including suppliers, distributors and
customers;
3. Review the company’s culture, management team and existing
talent;
4. Review the company’s products and services;

5. Secure funding to give the company the sufficient time and
resources in order to pursue a turnaround strategy;
6. Establish and prioritize short term and long term goals;
7. Prepare a business plan;
8. Prioritize small successes in order to build positive momentum.

4. General Concepts and
Frameworks
This section contains concepts and frameworks designed to enhance
your understanding and ability to analyse business situations more
quickly and easily.
4.1 Barriers to Entry

Barriers to entry represent costs that must be paid by a new market
entrant but not by firms already in the industry. Barriers to entry reduce
the threat posed by potential competitors by making a market less
contestable, and allow existing firms to maintain higher prices than
would otherwise be possible.
Below are eight (8) examples of barriers to entry:
1. Economies of Scale
The existence of economies of scale in an industry creates a barrier to
entry. Since existing firms are already producing they are often in a
better position to exploit economies of scale than a new entrant and, as
such, can often undercut on price. A new entrant is forced either to
accept the cost disadvantage or enter the industry on a large scale (which
increases the likely financial loss if they are later forced to exit the
industry).
2. Network Effects
If existing products or services in the industry benefit from Network
effects then this will make it more difficult for new firms to enter the
industry.
3. Product Differentiation

If there is a high level of product differentiation in the industry then this
creates a barrier to entry since new entrants will not be able to compete
merely on price, but will need to provide a unique value proposition.
Sources of product differentiation include:
3.1 Branding: If existing firms and products have strong brand
recognition then this will deter new entrants. If customers perceive
existing products as unique or high quality then a new entrant will need
to spend more money to educate customers about the unique qualities
and benefits of its products. This will increase the cost of gaining
market share and deter entry into the market.
3.2 Customer service: If existing firms have strong customer
relationships formed through customer service and customer loyalty
programs then this will make it more difficult for new entrants to gain
market share.
3.3 Product differences: Existing products in the industry may be
different due to differing design, quality, benefits, features, or
availability.
4. Capital Requirements
High start-up costs: High fixed start-up costs will deter new firms from
entering an industry. Examples of capital intensive industries with high
fixed start-up costs include automotive and telecommunications.
High sunk costs: If a large portion of the start-up costs cannot be
recovered (that is, they are Sunk costs) then a new entrant risks having
to absorb the loss if it decides to exit the industry. Examples of sunk
costs include:
 Specialised assets: Highly specialised technology or equipment that
cannot be used for other purposes and which cannot be sold (or
can only be sold at a steep discount); and

 Industry specific expenditure: Industry specific expenditure, such
as marketing or R&D, which cannot be used to benefit the firm’s
operations in other industries.
5. Intangible Assets
Proprietary product technology: The existence of proprietary product
technology represents a barrier to entry. If an existing product is
protected by patent then it will not be possible for a new entrant to use
the patented technology without permission from the patent owner.
Specialised knowledge: Incumbents may possess specialised knowledge,
skills or qualifications which are difficult or costly to acquire, e.g. legal or
medical certifications.
6. Access to Suppliers and Buyers
Access to suppliers: If a new entrant cannot gain access to raw materials
then this represents a barrier to entry. If existing firms have exclusive
long term contracts with suppliers, or existing firms own key suppliers,
then this will make it more difficult for a new entrant to obtain the raw
materials it needs to operate effectively in the industry.
Access to buyers: If a new entrant cannot gain access to buyers then this
represents a barrier to entry. If there are a limited number of wholesale
or retail distribution channels, or existing firms have exclusive long term
contracts with distributors then this will make it difficult for a new
entrant to reach the customer. For example, McDonalds often has stores
in key central locations which makes it more difficult for new fast food
restaurants to enter the market.
Switching costs: If customers face high switching costs, then it will be
more difficult for a new entrant to gain market share. Switching costs
will be affected by various factors including the length of customer
contracts, the existence of customer loyalty programs, and the price
performance and compatibility of complimentary products.

7. Government Policy
7.1 Government Regulation
The government may limit or restrict entry into a market by requiring
market participants to obtain a licence or other government approval in
order to carry on business; examples include taxi licenses, safety
standard compliance certificates, mining permits, and investment
approvals.
In extreme cases, the government may make competition illegal by
establishing a statutory monopoly. For example, AT&T had a statutory
monopoly in the telecommunications industry in the United States until
the early 1980s.
7.2 Tariffs and Subsidies
Government regulations that subsidise or tax the activity of all industry
participants do not represent a barrier to entry. For example, tariffs,
quotas or subsidies that apply equally to incumbents and new entrants
are not barriers to entry.
That being said, tariffs and quotas may pose barriers to entry where they
protect the market share of existing firms or prevent new firms from
gaining access to buyers or suppliers. Similarly, subsidies may pose a
barrier to entry where they operate solely or predominantly for the
benefit of incumbents.
8. Competitive Response
A potential entrant’s expectations about how existing firms will respond
to market entry by a new player will affect their entry decision. If a
potential entrant reasonably expects, or irrationally fears, that existing
firms will compete aggressively then this may deter entry.
Expectations of a strong competitive response from incumbents will be
higher where:

1. Industry growth is slow, which means the industry will not be able
to absorb new entrants without the profitability of incumbents
being hurt;
2. Incumbents have a lot of fighting potential including large cash
balance, strong cash flow, unused credit facilities, or clout with
government, distribution channels and customers; and
3. Incumbents are likely to cut prices due to industry wide excess
capacity or a desire to retain market share.
4.2 Cost Benefit Analysis

The cost benefit analysis is a basic analysis framework that involves
weighing up the costs and benefits of one course of action against one
or more other courses of action.
1. Relevance
The cost benefit analysis is one of the most straightforward ways to
compare one course of action against another. Business leaders need to
constantly evaluate options, and consultants are paid to provide
recommendations to help executives make these decisions.
2. Cost Benefit Analysis Explained

The cost-benefit analysis is one of the most basic analysis frameworks
that can be used to examine a business problem, and involves weighing
up the expected costs and benefits of one course of action against
another.
Understanding the relative benefits and costs of the available options
can make it easier to select a course of action and identify whether
further information is required.

3. Case Example
Consider the following situation. Your client is a mining company and
presents the following problem, “We currently own and operate a gold
mine, Mine A, and we are trying to decide whether to expand Mine A or
build a second mine, Mine B. Which project should we undertake?”
In this problem there are three possible options:
1. Expand Mine A;
2. Build Mine B; or
3. Do nothing.
To make a recommendation, it is necessary to consider the benefits and
costs of each potential course of action.
In this example, the benefits are the expected revenues from pursuing
each option (revenue=quantity x price), and might be estimated using a
discounted cash flow model.
Costs derive from various sources, and there are four types of cost to
consider:
1. Sunk costs;
2. Fixed costs;
3. Variable costs; and
4. Opportunity costs.
1. Sunk Costs
Sunk cost are expenditures that have already been made and which
cannot be recovered. As a result, they should not be factored into the
decision-making process.
For example, in our mining example the original cost of building Mine A
is a sunk cost. The money was spent in the past, it cannot be recovered,
and so it should not affect the current decision.

2. Fixed Costs
Fixed costs are costs that do not vary with the quantity of output
produced.
In our mining example, fixed costs might include things like rent, wages,
land taxes, utilities and overheads.
It is important to remember that fixed costs are fixed only in the short
term. For example, wages may be a fixed cost in the short term if the
company cannot vary the number of employees due to contractual
obligations. In the long run, however, these contracts could be
renegotiated. In the long run, nearly all costs are variable, even things
like rent, because a company can always move its operations to new
premises or to a lower cost jurisdiction.
3. Variable Costs
Variable costs are costs that vary with the quantity of output produced.
In our mining example, the main variable costs would be the cost of
extracting ore from the ground, and the cost of transportation.
When making decisions in the short run, variable costs are the only costs
that should be considered because a company will not be able to change
its fixed costs.
4. Opportunity costs
The opportunity cost of pursuing a course of action is what must be
given up in order to pursue it.
In our mining example, failing to consider opportunity costs could lead
to the wrong decision being made.
For example, if expanding Mine A is expected to produce a $1 million
profit and building Mine B is expected to produce a $2 million profit,
which project should the company pursue?

Building Mine B appears favourable, but the company also needs to
consider the opportunity cost. If ‘business as usual’ is expected to
produce an even greater profit, then the opportunity cost of pursuing
either project exceeds the expected payoffs, and so the company should
not take action.
4.3 Economies of Scale

Economies of scale exist where the average cost of producing a unit of
output decreases as the quantity of output increases.
1. Relevance
There are many instances when, for a firm to make a sensible decision or
for a government to engage in sound policy making, an understanding of
economies of scale is helpful.
1.1 Barriers to entry
The existence of economies of scale in an industry creates a barrier to
entry (for more information, see “4.1 Barriers to Entry”). This is
relevant for firms that benefit from economies of scale and want to
deter new entrants from entering their industry. This might be done by
investing in excess capacity, which can be used to compete aggressively
in response new entrants.
1.2 Natural monopoly
An industry is a natural monopoly if one firm can produce the desired
output at a lower social cost than two or more firms. That is, a natural
monopoly exhibits economies of scale in social costs. Examples of
industries that are natural monopolies include railways, water, electricity,
telecommunications, and postal services.
Since it is always more efficient for one firm to expand than for a new
firm to be established, the dominant firm in a natural monopoly often

has significant market power. As a result, it will make sense for these
firms to be highly regulated or publicly-owned.
1.3 Free trade
Economies of scale provide a justification for free trade policies since a
firm may require more customers than are present in the domestic
market in order to fully benefit from economies of scale. For example,
it is unlikely that Airbus, based in Toulouse, would be able to operate
profitably if it could only sell aeroplanes within France.
2. Importance
In the early 20th century, by using assembly lines to mass produce the
Model T Ford, Henry Ford became one of the richest and best-known
men in the entire world.
Economies of scale provide a company with two key benefits:
1. Increased market share: Lower per unit costs can allow a
company to reduce prices and increase market share. Economies
of scale allow larger companies to be more competitive and to
undercut smaller firms.
2. Higher profit margins: If a company is able to maintain prices,
then lowering the average cost per unit will result in higher profit
margins.
3. Economies of Scale Explained

Economies of scale may result from the increased output of an
individual firm (internal economies of scale) or from the growth of the
industry as a whole (external economies of scale).

Figure 13: Economies of scale exist where the average cost of
producing a unit of output decreases as the quantity of output increases
3.1 Internal economies of scale

Internal economies of scale are the cost savings that accrue to a firm as
its output increases. A firm will benefit from internal economies of scale
where it has high fixed costs and low variable costs since it will be able
to spread fixed costs over more units of output as production increases.
Below are seven (7) potential sources for internal economies of scale:
1. Lower input costs: A larger firm may have more bargaining power
with suppliers that it can use to negotiate lower prices for raw
materials by bulk buying or entering long term contracts.
2. Efficient technology: As output increases it may become
economical for a firm to invest in more advanced production
technology leading to lower average costs.
3. Research and development: Research and development is a large
fixed cost for many firms. As a company increases output, R&D
can be spread over more units of output.
4. Access to finance: A large company will typically find it easier to
borrow money, to access a broader range of financial instruments,
and may be able to borrow at lower interest rates.

5. Marketing: Many marketing costs are fixed costs, and so as output
increases a firm can spread this cost over a larger number of units
thereby reducing the average marketing cost per unit.
6. Specialisation of labour: In a larger company, employees are able
to become more specialised in the tasks that they perform. For
example, different managers might specialise in operations,
marketing, human resources and finance. Specialist managers are
likely to be more effective and efficient since they are likely to have
a higher level of experience as well as role specific training and
qualifications.
7. Learning by doing: Workers will improve their productivity by
regularly repeating the same tasks (see “4.5 Experience Curve”).
3.2 External economies of scale
External economies of scale arise when firms benefit from the way in
which the industry is organised.
Below are three (3) potential sources of external economies of scale:
1. Improved transport and communication links: As an industry
becomes established in a particular location, the government is
likely to provide better transport and communication links to the
region. This benefits firms as they will be able to reduce related
expenses. Improved transport will also allow firms to attract more
customers, and recruit from a broader pool of employees.
2. Industry specific training and education: As an industry becomes
more dominant, universities will offer more courses tailored for a
career in that industry. For example, the rise of the IT industry led
to a proliferation of IT courses. Firms benefit from being able to
recruit from a larger pool of appropriately skilled employees.
3. Growth of support industries: If a network of suppliers and other
support industries grows alongside the main industry then firms
will be able to purchase higher quality inputs at lower cost.

4. Diseconomies of scale
‘Diseconomies of scale’ exist where the average cost of production
increases as output increases. As a firm grows it is likely to become more
complex to manage and run. Diseconomies may result from increasing
bureaucracy, problems with motivating a larger work force, greater
barriers to innovation and entrepreneurial activity, and increased agency
costs (see “Principle-agent problem”).
4.4 Economies of Scope

Economies of scope exist where a firm can
produce two or more products at a lower per unit
cost than would be possible if it produced only
one of them.
Economies of scope is an idea that was first
explored by John Panzar and Robert Willig in an
article published in 1977 in the Quarterly Journal
of Economics entitled “Economies of Scale in
Multi-Output Production”.
1. Relevance
The title of Panzar and Willig’s landmark article may not sound very
interesting, but it does make one thing clear; economies of scope and
economies of scale are closely related concepts.
Economies of scale is a fairly well known concept relevant to big
producers like Intel, Microsoft, Boeing and Toyota.
In contrast, economies of scope is a lesser known concept particularly
relevant to small and medium sized enterprises (SMEs) that may not
have access to large markets or the ability to produce at scale.
SMEs are important because they represent the overwhelming majority
of global business activity, and are the world’s main source of job

creation and economic growth. For example, SMEs account for around
99% of businesses in Europe (Economist Intelligence Unit 2011).
2. Importance
Economies of scope provide firms with two key benefits:
1. Lower average costs: If a company diversifies its product
offering it may be able to lower the average cost of production.
For example, McDonalds offers a range of different products
(burgers, fries, sundaes, salads, etc.). As a result, it can achieve
lower per unit costs by spreading overheads across a broader range
of products. Lower per unit costs allow a company to enjoy higher
profit margin on each unit sold, or lower the price it charges
customers in order to increase market share.
2. Diversified revenue streams: By producing multiple products, a
firm can diversify its sources of revenue, which reduces the risk
associated with product failure.
3. Economies of Scope Explained

Economies of scope exist where a firm can produce two or more
products at a lower average per unit cost than would be possible if it
produced only one of those products. Economies of scope have been
found to exist in a range of industries including banking, publishing,
distribution, and telecommunications.
Economies of scope and economies of scale are related concepts. The
distinction is that ‘economies of scale’ refers to the situation where the
average per unit cost of production decreases as output increases, whereas
‘economies of scope’ refers to the situation where the average per unit
cost of production decreases as the number of different products increases.

Figure 14: Economies of scope exist where the average cost of producing
a unit of output decreases as the number of different products increases.
3.1 Sources of Economies of Scope

Below are seven (7) potential sources of economies of scope:
1. Common inputs: Using more of the same inputs will increase a
firm’s bargaining power with suppliers. For example, Kleenex
manufactures a range of products which use the same raw
materials: tissues, napkins, paper towels, facial tissues, incontinence
products and Huggies nappies.
2. Joint production facilities: Plant and equipment can be more fully
utilised. For example, a dairy manufacturer may be able to use its
existing dairy production facilities to produce a range of different
dairy based products: milk, butter, cheese and yoghurt.
3. Shared overhead costs: Overheads can be shared across multiple
products. For example, McDonalds can produce hamburgers,
French fries and salads at a lower average per unit cost than would
be possible if it produced only one of these products. Each
product shares overhead costs such as food storage, preparation
facilities, restaurant space, toilets, car parks and play equipment.
4. Marketing: Marketing and advertising costs can be shared across
products. For example, Proctor & Gamble produces hundreds of

products from Gillette razors to Old Spice aftershave, and can
therefore afford to hire expensive designers and marketing experts
and spread the cost across a broad range of products.
5. Sales: Selling products is easier when it is possible to provide
customers with a range of options … “Would you like fries with
that?”
6. Distribution: Shipping a range of products is more efficient than
shipping a single product. For example, Amazon sells an extremely
broad range of products, which enables it to negotiate favourable
deals with freight companies.
7. Diversified revenue streams: A firm that sells multiple products
will have lower revenue risk because it is less dependent on any
one product to sustain sales. More stable cash flows are attractive
for three reasons:
a. They can be used to negotiate more favourable credit terms
with banks.
b. A strong cash position can also be used to extend credit to
customers and thereby increase sales.
c. More stable cash flows can allow a firm to be more innovative
with new product launches because the failure of any one
product will have less impact on total revenues.
4. Diseconomies of scope
A firm that offers too many products may begin to incur an increase in
average per unit costs with each additional product offered. Reasons for
diseconomies of scope may include:
1. Diluted competitive focus;
2. Lack of management expertise;
3. Higher raw material costs due to bottlenecks or shortages; and
4. Increased overhead costs.

4.5 Experience Curve
The Experience Curve captures the predictable and persistent
relationship between increasing production experience and
declining costs
1. Background
The Learning Curve, a concept which predates the Experience Curve,
was first described by German psychologist Hermann Ebbinghaus in
1885 as part of his studies into human memory.
In 1936, T.P. Wright described the effect of learning on production
costs in the aircraft industry showing that required labour time dropped
by 10 to 15 percent with every doubling of production experience.
In 1966, Bruce Henderson and the Boston Consulting Group conducted
research for a major semiconductor manufacturer, in which they
introduced the concept of the Experience Curve and revealed that unit
production costs fell by 20 to 30 percent every time production
experience doubled.
How did BCG’s “Experience Curve” differ from the earlier concept of
the “Learning Curve”?
Well, in essence the two concepts capture the same big idea:
performance improves with experience in a predictable and persistent
manner.
In his 1968 article, Bruce Henderson attempted to distinguish the two
concepts by explaining that the Learning Curve relates only to labour
and production inputs, whereas the Experience Curve focuses on total
costs. In other words, the Experience Curve is intended to be a more
comprehensive measure of how costs decline with production
experience.

2. The Experience Curve
The Experience Curve captures the relationship between a firm’s unit
production costs and production experience. Research has shown that a
firm’s costs typically fall by a predictable amount for every doubling of
production experience.
Source: Wikipedia
Unit production costs tend to decline at a consistent rate as a firm gains

production experience, however the rate typically varies from firm to
firm and from one industry to another.
The interesting thing about the Experience Curve is not that a firm’s
performance improves with experience, we would expect as much, but
instead that performance tends to improve with experience at a
predictable rate.
This is surprising. What might explain the Experience Curve effect?
3. The Experience Curve Effect

In his 1968 article, Bruce Henderson noted that:
“… reductions in costs as volume increases are not necessarily
automatic. They depend crucially on a competent management
that seeks ways to force costs down as volume expands.
Production costs are most likely to decline under this internal
pressure. Yet in the long-run the average combined cost of all

elements should decline under the pressure for the company to
remain as profitable as possible. To this extent the [Experience
Curve] relationship is [one] of normal potential rather than one of
certainty …”
While falling costs may not occur with certainty, the Experience Curve
effect has proved to be pervasive and has been shown to exist for
different firms and across a broad range of different industry sectors.
It must be the case then that declining costs are the result of certain
innate human and organisational factors rather than from a specific
identifiable cause, such as the brilliance of a rock star management team
or the well power pointed recommendations of a top consulting firm.
If top executives and consultants are not the key source of persistent
organisational learning, then what is?
There does not yet appear to be a definitive answer to this question,
however seven (7) factors that are likely to contribute to the Experience
Curve effect include:
1. Optimised Procurement: As a firm gains production experience
it will learn more about its suppliers, which will allow it to optimise
its procurement practices. Increased production may also give a
firm more bargaining power with suppliers;
2. Labour efficiency: As employees gain production experience they
will develop skills, learn shortcuts, and find ways to produce more
with less;
3. Standardisation: Over time processes and product parts are likely
to become standardised allowing for more streamlined production;
4. Specialisation: As production volume increases a firm is likely to
hire more employees, allowing each of them to specialise in a
narrower range of tasks and thereby perform more efficiently;
5. Product Refinement: A firm may engage in significant R&D and
marketing prior to and during the initial product launch. As it

learns more about the product and its customers it will be able to
refine the product, which may allow the firm to reduce ongoing
R&D and marketing costs;
6. Automation: Increased production volume may make it feasible
for a firm to adopt more automated and advanced production
technology and IT systems; and
7. Capacity Utilisation: If a firm has incurred large set up costs,
then increasing production will allow it to spread these fixed costs
across a larger number of units.
4. Implications for Strategy

The Experience Curve effect shows that a firm’s production costs
decline in a predictable way as it gains production experience.
What are the implications for corporate strategy?
In 1968, in light of BCG’s research, Bruce Henderson took the view that
a firm should price its products as low as would be necessary to
dominate their market segment, or else it should probably stop selling
them. The same year BCG also developed the growth share matrix, a
framework which recommends allocating resources within a firm
towards products that are, or are likely to become, market leaders.
The clear and resounding message from Henderson and BCG was
“dominate the market or don’t bother”.
The thinking behind this simple view was that a company with market
share leadership would be able to gain production experience more
quickly than its rivals and so would be able to achieve a self-sustaining
cost advantage.
As it turns out though, pursuing market share leadership will not always
be the best approach as there are four (4) countervailing factors that may
neutralise the benefits of market share leadership.

Firstly, market share may not confer a cost advantage since firms can
learn not just from production experience but also from books, courses,
formal training, conferences, reverse engineering, talking to suppliers,
hiring consultants, and by poaching staff from the competition.
Secondly, if multiple firms pursue market share leadership at the same
time then this may create intense competitive rivalry leading to price
competition and a decline in industry profitability.
Thirdly, new entrants can often avoid going head to head with the
market share leader by creating more advanced products or by using
more efficient production technology. This can allow new players to leap
frog the competition and force existing firms to play catch up by
investing heavily in R&D, forming strategic alliances or acquiring the
new players before they are able to grow and dominate the market.
Fourthly, even if market share leadership does confer a cost advantage
there are other ways to compete effectively. Firms can also gain a
competitive advantage by creating differentiated products or by targeting
a niche market segment (see “3.3.1 Porter’s Generic Strategies”).
So, where does this leave us?
Well, a firm that aims to be the cost leader within its industry will
probably want to pursue market share leadership since the Experience
Curve effect and 4.3 Economies of Scale are two significant factors that
will allow it to reduce costs.
However, a firm that aims to compete by providing differentiated
products or by targeting a market niche may find the pursuit of market
share leadership to be incompatible with its chosen strategy. A firm that
provides unique or targeted products will generally be able to charge
higher prices and this will naturally limit potential sales volume. If it
makes its products more generic or more widely available in an attempt
to gain market share, then this may reduce the uniqueness of its
products and require the firm to lower prices. Therefore, a firm that tries

to make its products both differentiated and ubiquitous will run the clear
risk of failing to achieve either strategy.
In short, market share leadership is likely to be appropriate for firms that
are competing on the basis of cost leadership. It is unlikely to be the
correct strategy for every firm or in every situation.
4.6 MECE Framework

MECE (pronounced “me see”) stands for
“mutually exclusive and collectively
exhaustive” and is one of the hallmarks of
problem solving at McKinsey (The
McKinsey Way by Ethan M. Rasiel).
1. Benefit of the MECE Framework

The MECE framework can aid clear thinking about a business problem
by:
1. Helping to avoid double counting – categories of information are
grouped so that there are no overlaps; and
2. Helping to avoid overlooking information – all categories of
information taken together should cover all possible options.
2. MECE
MECE is a framework used to organise information which is:
1. Mutually exclusive: Information is grouped into categories that
are separate and distinct; and
2. Collectively exhaustive: All categories taken together should deal
with all possible options without leaving any gaps.
3. MECE Tree Diagram

The MECE tree diagram is a way of graphically organising information
into categories which are mutually exclusive and collectively exhaustive.

The diagram as a whole represents the problem at hand; each branch
stemming from the starting node of the tree represents a major issue
that needs to be considered; each branch stemming from one of these
major issues represents a sub-issue that needs to be considered; and so
on.
A major issues list should not contain more than five issues, with three
being the ideal number (see Rule of Three). If you are not able to
categorise a problem in five major issues then consider creating a
category of “other issues”.
The MECE framework can be applied to a wide variety of business
problems, for example, Coca-Cola might ask the question “what is the
source of declining global profitability”? To answer this question, Coca-
Cola might use a MECE tree diagram to help it identify the source of
the issue.
Figure 15: MECE Tree Diagram
4. Resources
For more information on the MECE framework, see Barbara Minto’s
book Pyramid Principle.

4.7 Moral Hazard
“Moral hazard is when they take your money and then are
not responsible for what they do with it.”
~ Gordon Gekko
Moral Hazard refers to any situation where a person
is not fully responsible for the consequences of
their actions. As a result, they may take greater risks
than they would have otherwise.
1. Relevance
The 2008 financial crisis caused the largest recession since the great
depression. According to the US Department of the Treasury as many
as 8.8 million jobs were lost and $19.2 trillion in household wealth was
wiped out (US Treasury Report).
At the heart of the great recession was a concept known as “moral
hazard”.
2. What is Moral Hazard?

Moral Hazard is a concept that is often misunderstood by politicians,
journalists and economists. And so we turn to Hollywood for clarity.
Gordon Gekko in the movie Wall Street captured the nature of Moral
Hazard very concisely when he explained that “moral hazard is when
they take your money and then are not responsible for what they do
with it.”
Gekko may well have borrowed his definition from Paul Krugman,
Professor of Economics at Princeton University, who described Moral
Hazard as “… any situation in which one person makes the decision
about how much risk to take, while someone else bears the cost if things
go badly.”

It is worth noting that “Moral Hazard” is an economic concept and does
not necessarily imply immorality or unscrupulous dealing.
Below are six (6) examples of where Moral Hazard shows up in practice.
1. Insurance: The provision of insurance is the most common
example of where Moral Hazard tends to arise.
For example, if you have comprehensive private health insurance
you are more likely to visit the doctor. You may also engage in
more risk taking behaviour, like bungy jumping or sky diving,
because you are not responsible for paying the medical bill if
things go wrong.
Malcolm Gladwell provides an amusing example of “Universal
Pepsi Insurance”:
“Moral hazard” is the term economists use to describe the
fact that insurance can change the behaviour of the person
being insured. If your office gives you and your co-workers
all the free Pepsi you want—if your employer, in effect,
offers universal Pepsi insurance—you’ll drink more Pepsi
than you would have otherwise.
2. Mortgage Securitisation: Mortgage securitisation is another
example of where Moral Hazard shows up.
The US government, motivated by a desire to expand home
ownership, for many years actively encouraged bankers to make
loans to people with poor credit ratings. Fannie Mae and Freddie
Mac, two large government sponsored enterprises, carried out this
policy through a process known as “mortgage securitisation”.
Moral Hazard occurred because the banks and mortgage brokers
who originated the loans were able to on-sell the loans to Fannie
Mae and Freddie Mac, and so were not on the hook if lenders
ultimately defaulted. As a result, they had an incentive to make as

many loans as possible, even to people with extremely poor credit
ratings.
3. The Greenspan Put: The Greenspan Put is another example of
where Moral Hazard comes into play.
Since the late 1980’s the Federal Reserve followed a policy of
significantly lowering interest rates in the wake each financial crisis
(often referred to as the Greenspan Put). Lowering interest rates
has the effect of increasing the amount of money available in the
economy which prevents the economy from deteriorating further
and stops asset prices from falling. As a result, investors were
encouraged to take excessive risks because they knew that the Fed
would lower interest rates if a financial crisis ensued.
4. Bank Bailouts: The provision of bank bailouts by government is
another example of where Moral Hazard occurs.
In 2008, in the wake of the sub-prime mortgage crisis, the US
government created a US$700 billion Troubled Asset Relief
Program (known as TARP) to buy financial assets from banks and
other financial institutions. The bailout was intended to stabilise
financial markets, make sure that credit markets remained liquid
and prevent a repeat of the great depression. A worthy goal,
however a big problem with TARP was that it created a large
Moral Hazard. If banks learn that government will bail them out
during periods of financial instability, then they have an incentive
to take excessive risks in the future.
5. Private Equity: Private equity vehicles are another example of
where Moral Hazard can show up.
Assume, for example, that investors give a private equity firm $100
million to invest. If the fund makes a profit of $20 million then the
fund managers might take fees of 20%, or $4 million. On the other
hand, if the fund loses $20 million then the investors lose money

but the fund managers are not required to reimburse the investors.
Since the managers do not have to pay the cost if things go badly
they have a strong incentive to take excessive risks.
6. The Limited Liability Company: The limited liability company
presents an often overlooked example of where Moral Hazard
takes place.
Companies often link executive remuneration with the company’s
performance on the stock market. The reason for doing this is to
align the interests of executives with the interests of shareholders,
in an attempt to reduce the Principle-agent problem.
If the company performs well and its stock price rises then
shareholders are happy and executives are paid a bonus (which
might be in the form of cash or shares). However, if the company
performs poorly then shareholders lose, while executives still
receive their base salary and are not required to compensate
shareholders. Since executives are not responsible for paying the
full cost if things go badly, they have an incentive to take excessive
risks in order to boost the company’s short term stock price in the
hope of securing their bonuses.
4.8 Porter’s Five Forces

The Porter’s Five Forces framework is used to determine the
competitive intensity and attractiveness of an industry
1. Background
Harvard Business School Professor Michael Porter, in his 1979 book
Competitive Strategy, developed the Porter’s Five Forces.
The Porter’s Five Forces framework is used to determine the
competitive intensity and attractiveness of an industry (attractiveness in
this context refers to the overall industry profitability).

The framework can be used in the context of deciding whether to enter
a new market.
In determining the competitive intensity of an industry, Porter’s Five
Forces include three forces from Horizontal competition (1, 2 and 3),
and two forces from Vertical competition (4 and 5):
1. Existing competition: How strong is the rivalry among existing
firms?
2. Barriers to entry: What is the threat posed by new entrants?
3. Substitutes: What is the threat posed by substitutes?
4. Supplier bargaining power: How much bargaining power do
suppliers have?
5. Customer bargaining power: How much bargaining power do
customers have?
Figure 16: Porter’s Five Forces
1. Existing Competition
Factors contributing to increased competitive rivalry among exiting
firms include:
 Increased number of firms,
 Slower market growth rate,
 Low product differentiation,
 Low switching costs,

 Industry wide excess capacity,
 High fixed costs / economies of scale,
 High exit barriers.
For more information on the factors that will influence the strength of
competition within an industry, see “3.2.3 Competitive Intensity”.
2. Barriers to entry
The threat posed by new players entering the market will depend on the
level of barriers to entry. High barriers to entry will reduce the rate of
entry by new firms, and allow firms already in the industry to charge
higher prices than would otherwise by possible.
Barriers to entry might include capital requirements, economies of scale,
network effects, product differentiation, proprietary product technology,
government policy, access to suppliers, access to distribution channels,
and switching costs.
For more information on barriers to entry, see “4.1 Barriers to Entry”.
3. Substitutes
Substitute products represent a form of indirect competition because
consumers can use substitute products in place of one another (at least
in some circumstances). For example, natural gas is a substitute for
petroleum.
The threat posed by substitutes will depend on various factors,
including:
1. Switching costs: The cost to customers of switching to a substitute
product or service;
2. Buyer propensity to substitute;
3. Relative price-performance of substitutes; and
4. Perceived level of product differentiation.
4. Supplier Bargaining Power

Suppliers provide inputs to firms in an industry, for example, labour and
raw materials. The ability of suppliers to extract a larger share of industry
profits depends on the level of supplier bargaining power.
For more information on the factors that can affect supplier bargaining
power, see “3.2.2 Vertical Competition within the Supply Chain”.
5. Customer Bargaining Power

Customers are the purchasers of goods and services produced by firms
in the industry. The ability of customers to extract a larger share of
industry profits depends on the level of customer bargaining power.
For more information on the factors that can affect customer
bargaining, see “3.2.2 Vertical Competition within the Supply Chain”.
4.9 Quantitative Easing

Quantitative easing is a monetary policy tool sometimes employed by
central banks to stimulate the economy when conventional monetary
policy becomes ineffective.
Normally, the central bank carries out expansionary monetary policy by
lowering short-term interest rates through the purchase of short-term
government securities. However, when the short-term interest rate gets
close to zero it becomes impossible to lower the short-term interest rate
further and so this policy tool can no longer be used to stimulate the
economy (this is known as the liquidity trap).
When faced with the liquidity trap, the central bank can shift the focus
of monetary policy away from interest rates and towards increasing the
money supply (that is, quantitative easing). To increase the money
supply, the central bank creates new money electronically and uses it to
buy financial assets from financial institutions. This leads to an increase
in the excess reserves held by these financial institutions, and the central
bank hopes that banks will use these funds to increase lending and
stimulate the economy.

If the central bank increases the money supply too quickly, then this is
likely to lead to price inflation since there will be more money chasing
the same number of goods and services.
4.10 Rule of 70
The Rule of 70 is a simple rule of thumb that can be used to figure
out roughly how long it will take for an investment to double,
given an expected growth rate
The Rule of 70 is a simple rule of thumb that can be used to figure out
roughly how long it will take for an amount to double, given an expected
growth rate.
The rule can be described by the following equation:
70
𝑃𝑒𝑟𝑖𝑜𝑑𝑠 𝑡𝑜 𝑑𝑜𝑢𝑏𝑙𝑒 (𝑎𝑝𝑝𝑟𝑜𝑥 ) =
𝑡ℎ𝑒 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒
For example, if the world’s GDP is growing at 4% per year then global
GDP will double in about 17 years.
70
𝑌𝑒𝑎𝑟𝑠 𝑡𝑜 𝑑𝑜𝑢𝑏𝑙𝑒 𝐺𝐷𝑃 = = 17.5 ≈ 17
4
If your company’s revenue is growing at 10% per month then revenues

will double in about 7 months.
70
𝑀𝑜𝑛𝑡ℎ𝑠 𝑡𝑜 𝑑𝑜𝑢𝑏𝑙𝑒 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = =7
10

4.11 SWOT Analysis
SWOT Analysis is a strategic planning tool used to evaluate the
strengths, weaknesses, opportunities, and threats involved in a
business venture
1. Background
Albert Humphrey is credited with inventing the SWOT analysis
technique.
2. SWOT Analysis
SWOT analysis is a strategic planning tool used to evaluate the
Strengths, Weaknesses, Opportunities, and Threats involved in a
business venture. It involves specifying the objective of the business
venture and identifying the internal and external environmental factors
that are expected to help or hinder the achievement of that objective.
After a business clearly identifies the objective, SWOT analysis involves:
1. Examining the strengths and weaknesses of the business (internal
factors); and
2. Considering the opportunities presented and threats posed by
business conditions, for example, the strength of the competition
(external factors).
By identifying its strengths, a company will be better able to think of
appropriate strategies to take advantage of new opportunities. By
identifying weaknesses and threats, a company will be better able to
identify changes that need to be made to improve performance and
protect the value of its current operations.
3. Criticisms
SWOT analysis has two clear weaknesses. Firstly, using SWOT analysis
may persuade companies to write lists of Pros and Cons, rather than
think about what needs to be done to achieve objectives. Secondly, there

is a risk that the resulting lists will be used uncritically and without clear
prioritisation. For example, weak opportunities might be used to balance
strong threats.
4. Case example
To help understand SWOT analysis, consider the strategy of a
hypothetical soft drinks manufacturer called “Coca-Cola”. Coke is
currently the market leader in the manufacture and sale of sugary
carbonated drinks and has a strong brand image. Sugary carbonated
drinks are currently an extremely profitable line of business. The
company’s goal is to develop strategies to achieve sustained profit
growth in future.
1. Strengths
Coke’s strengths are its resources and capabilities that provide it with a
competitive advantage in the market place, and help it to achieve its
strategic objective. Coke’s strengths might include:
1. Strong product brand names,
2. Large number of successful drink brands,
3. Good reputation among customers,
4. Low cost manufacturing, and
5. A large and efficient distribution network.
2. Weaknesses
Weaknesses include the attributes of Coke’s business that may prevent it
from achieving its strategic objective. Coke’s weaknesses might include:
1. Limited range of healthy beverage options, and
2. Large manufacturing capacity makes it difficult to change
production lines in order to respond to changes in the market.

3. Opportunities
Changing business conditions may reveal new opportunities for profit
and growth. Coke’s opportunities might include:
1. New markets into which Coke could expand, and
2. The absence of a dominant global manufacturer of healthy
beverages may leave a gap in the market.
4. Threats
Changing business conditions may present certain threats. Coke’s threats
might include:
1. Shifting consumer preferences away from Coke’s core products,
and
2. New government regulations that prevent the acquisition of large
competing soft drink companies.
5. Proposed strategy
Based on the foregoing analysis, the main opportunity for Coca-Cola
might be the rising popularity of healthy beverages, such as water and
fruit juice. The main threat may be the dominance of Coca-Cola and the
increasing number of anti-trust regulations that prevent Coke from
acquiring competing manufacturers. A possible strategy could therefore
be to find small manufacturers of healthy beverages with quality
products. Purchasing these small companies will not raise competition
concerns. Coke might use its strong brand name, manufacturing capacity
and distribution networks to obtain strong market penetration for the
newly acquired beverages.

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1.2 Business Terms

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𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 𝑉𝑜𝑙𝑢𝑚𝑒

Break-even analysis is a form of supply side analysis that considers costs

CFA: Stands for “Chartered Financial Analyst”. For more information,

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Customer Lifetime Value: Customer lifetime value is a prediction of

Debt to Equity Ratio: A measure of a company’s financial leverage

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Where r = discount rate; CFt = expected cash flow in year t; g = long

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Opportunity cost: What you give up in order to obtain something; the

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Where r = discount rate; CFannual = annual cash flow.

If the price elasticity of demand is less than one in absolute value

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[𝐶𝑂𝐺𝑆 + 𝐴𝑙𝑙 𝑜𝑡ℎ𝑒𝑟 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠]

Contribution Margin: A cost accounting concept that allows a company

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Public good: A public good is a good that a person can consume

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Real value: A value adjusted for inflation or deflation. For example, if a

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For more information, see “4.10 Rule of 70”.

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4. PEST Analysis Explained

Figure 1: Situation Analysis

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5. Conducting a PEST Analysis

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6. PEST Analysis Template

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3. Surveying the Business Landscape

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