Module 6 – Internal Analysis of the Company

6.1 Opportunity Cost

Opportunity cost – best alternative forgone.

Opportunity costs represent the potential benefits an individual, investor, or
business misses out on when choosing one alternative over another. Understanding
the potential missed opportunities foregone by choosing one investment over
another allows for better decision-making.

6.2 Fixed Costs, Variable Costs and Sunk Costs

In accounting, fixed costs are expenses that remain constant for a period of time
irrespective of the level of outputs. Even if the output is nil, fixed costs are incurred.

Variable costs are expenses that change directly and proportionally to the changes
in business activity level or volume.

A sunk cost refers to a cost that has already occurred and has no potential for
recovery in the future. Sunk costs are a particularly important strategic
consideration for barriers to entry. If the costs of entry are recoverable then they are
not sunk as far as the strategic move is concerned. The fact that a cost was incurred
in the past does not necessarily make it sunk.

6.3 Marginal Analysis

1
 Marginal cost is the cost of producing one more unit. Marginal revenue is the
additional amount gained from the sale of one more unit (taking into account price
reductions on all units where necessary). Profit maximizing output occurs where
marginal cost just equal marginal revenue. Long-term marginal cost is the cost of
making one more item when all inputs can be changed. Often, marginal cost is not
known, and managers are more concerned with average cost. But companies should
accept business as long as marginal costs are covered. If costs have already been
incurred, the price to charge is the revenue-maximizing price.

6.4 Diminishing Marginal Products

Diminishing marginal productivity is the understanding that using additional inputs

will generally increase output, but there also is a point where adding more input
will result in a smaller increase in the output, and there is another point where using
even more input will lead to a decrease in output.

6.5 Profit Maximization

Increase quantity until MC = MR. If the company is a price taker (competitive

market), profit maximizing output is that where marginal costs equal price. When,
however, company has some power over price, we have to look at the marginal
revenue. In this case we sell till marginal revenue equal marginal cost, and then
look at the demand curve to see the quantity that must be sold. The cost of
producing the last unit is equal the additional revenue we will get.

Questions:
What are the additional expected costs?
What are the additional expected revenues?

6.6 Economies of Scale and the Experience Curve

Economies of scale occur where an increase in productive capacity leads to lower

average costs. Economies of scale can only occur where higher capacity leads to a
more efficient combination ofE capital and labour.

The experience curve relates to a reduction in average cost resulting from the total
volume produced to date. It is related to the degree to which employees learn to do
their job more efficiently over time. Simply put the concept behind the Experience

2
 Curve is that the more experience a business has in producing a particular product,
the lower its costs.

The combined effects of economies of scale and experience curve lead to a first-
mover advantage.

6.7 Economies of Scope

The idea refers to a reduction in unit cost as the number of products is increased
rather than the number of units produced. Why it could happen:
• Possibility of sharing inputs among several outputs (a retailer will attract more
people if it carries more products – below a certain number of products,
customers will not show up).
• The good reputation associated with some products may have a beneficial effect
on others.
• There may be significant R&D spill-over effects among different products.

Economies of scope are not an automatic outcome of diversification. If products

are in unrelated markets, using different resources and requiring different
management skills it is just as likely that diseconomies of scope will result as scarce
management skills are spread ever more thinly.

Economies of scope focuses on the average total cost of production of a variety of

goods, whereas economies of scale focus on the cost advantage that arises when
there is a higher level of production of one good.

6.9 Joint Production

Joint production makes cost allocation tricky, because it is not clear which
resources go to which product. Thus, it may be difficult to identify variable costs
and how costs vary with changes in output of the two products.

6.10 Break-even Analysis

How many units would have to be sold before the product starts making a net
contribution?

Break-even = (Fixed Cost) / (Net Contribution per Unit) or

Break‐ even = (Fixed Cost) / (Price – Variable Assets)

3
 Break-even analysis is limited in that it concentrates only on the volume of output
and sales and does not take into account the passage of time.

6.11 Payback Period

How long will it be before the project pays back its start up costs? The calculation
is identical to that of net present value except that the annual cash flows are not
discounted; instead, they are summed until the total becomes positive. The
discounting approach takes into account both the incidence of cash flows over time
and risk factors.

6.12 Accounting Ratios

Financial techniques do not reveal how well resources are actually being deployed.
The objective of calculating accounting ratios is to assess the effectiveness with
which resources have been allocated in the past. It can identify potential weaknesses
in company management.

Revenue and costs must not include changes in assets; the buying and selling of
assets is not directly related to the efficiency with which inputs are being converted
to outputs.

Assets are part of many ratios. Nevertheless, it might be difficult to use them:
- different depreciation rules.
- Many of them are fully depreciated but operational.
- Different accounting methods might make one company look more profitable
than another.
- It is difficult to adjust thousands of assets to current price.
Look at gearing ratios -> (Debt Finance) / (Shareholder equity)

The following ratios are typically encountered in company accounts:

• ROI Return on Investment

4
 • RONA Return on Net Assets
• ROCE Return on Capital Employed
• ROTA Return on Total Assets
• ROE Return on owners’ equity
• Earnings per Share
• Gearing ratio
• Quick ratio (the acid test)

6.13 Benchmarking

A company’s competitive position can only really be assessed in relation to other

companies`in the industry. One way of achieving a perspective on this is to develop
quantifiable measures of performance which can be compared with other firms. The
performance of major competitors can be ascertained from the information in their
annual reports, which contain the main indicators such as return on investment,
return on capital, growth in sales, margins and so on. But given what has been
discussed already, these cannot be taken at their face value, and it is necessary to
ensure that like is compared with like. This means that it is necessary to interpret
published information, and hence comparisons are bound to be approximate.

6.14 Research and Innovation

Competitive advantages are not permanent. Companies have to adapt to innovative

stance, recognize new ideas and changes and be ready to implement them when
they occur.
There are two stages to the problem of allocating resources to research:
• how much to spend
• what criteria to use in order to identify potentially profitable products from the
possibilities produced by research, since the company may have insufficient
resources to exploit all potential products.

It is necessary to decide whether a particular dollar should be spent on research or

competing uses such as marketing new products or investing in new equipment.
One approach for R&D expenses is to adopt a rule of thumb, for example to keep
research expenditure at some constant percentage of total costs, or total sales. It is
not always possible accurately to identify research expenditure in a company.
Problems with joint productions, for example. There might be a spill over effect,
the higher the research expenditure, the lower the development expenditure
required to attain a given objective.
6.15 Resource Management

5
 The management of resources has a direct bearing on the competitive position of
the company; there is little point in producing an ambitious and innovative market
strategy if the goods cannot be produced at a competitive cost. The outcome of
inadequate resource management will inevitably emerge as unnecessarily high
costs.

Approaches to resource planning:

Reactive
• Look one period ahead.
Proactive:
Think about:
• Product life cycles
• Product launch periods
• Selecting a planning horizon
• Developing a resource plan
• Implications for marketing strategy.

Reactive mode: looks what will be happening next period, which may be no more
than a quarter year, and hires and fires accordingly.
Is the company really carrying out a systematic appraisal of future resource
requirements?

Strategic options:
Predicted output greater than predicted demand
Options:
Reactive: discard resources (hiring / firing staff)
Proactive:
- produce to inventory (learning curve)
- reduce price (market share)
- increase marketing (competitive reaction)

Predicted output less than predicted demand

Options:
Reactive: recalculate resources (backlog)
Proactive:
- increase price (market share)
- reduce marketing (competitive reaction)

6.16 Human Resource Management

6
Different types of cultures:

• Power Culture: org revolves around one individual or small group who
dominates decision making and determines how things are done. There is
usually no explicit strategic plan, but if there is one it will tend to reflect the
interests of the dominant leader rather than being based on analysis of the
environment and explicit strategy choice.
• Role Culture: relies on committees, structures, analysis and the applications of
logic. While a small group of senior managers make final decisions, they rely
on procedures and systems and clearly defined rules of communication.
Bureaucratic type of structure that works well in stable environments. External
changes are usually not recognized at an early stage, and the company is not
well equipped to deal with them because it is inflexible.
• Task Culture: orgs that are geared to tackle specific tasks which tend to be of
limited duration. Based on flexible teams which are multidisciplinary. Power
rests within the team structures. Teams must have a great deal of autonomy.
• Personal Culture: individual, pays little attention to the org and is most
concerned with self-gratification. Common with individuals professionals
(architects, consultants).

The type of culture prevalent in the company can have a major impact on how the
organisation reacts to strategic change. The Table below indicates how the cultural
composition relates to competitive advantage and can affect the ability to cope with
strategic change.

Culture and Strategic Change

The broad cultural classifications provide some insight into the alignment of
strategy with culture, and where problems are likely to arise. For example, due to
reduced trade barriers a company investigates expansion into two new foreign
markets; these markets are different from the home market in terms of language,
consumer preferences and incomes, competing products and many other factors.
The types of response that might result, based on Table below, are as follows.

7
6.17 Strategy Integration

Integration strategy also goes by the name of the management control strategy. As
the name implies, it provides the business an option to have control over various
processes like competitors, suppliers, or distributors.

Business-integration strategy has two major types and subtypes: horizontal

integration and vertical integration. They’re as follows.

1. Horizontal Integration
Horizontal integration is the acquisition of business activities that are at the
same level of the value chain in similar or different industries. It is the
acquisition of a related business: a fast-food restaurant chain merging with a
similar business in another country to gain a foothold in foreign markets. A
business should follow the horizontal integration in terms of merging and
acquisition when
• the business could handle the operations of the bigger company

• integration could provide the economies of scale advantage

• competitors don’t have the experience and experience that the company has
already attained

• the business is expanding its operation

8
 2. Vertical Integration
Vertical integration is a competitive strategy by which a company takes
complete control over one or more stages in the production or distribution of a
product. A company opts for vertical integration to ensure full control over the
supply of the raw materials to manufacture its products. It may also employ
vertical integration to take over the reins of distribution of its products.

Types of Vertical Integration

1. Forward Integration: When a business takes over the distribution system
and sells its products/services directly to the customers. For instance, an
automotive and mobile brand opens up its retail showrooms to sell vehicles
and mobile phones directly to the end consumers.
2. Backward Integration: When a business takes control over the supply of
the raw material, it’s backward integration. For instance, a supermarket and
a fruit seller buy the vegetable and fruit farm to control the supply of its
products. An automotive company buys the electronic parts and tire
manufacturing companies to ensure the availability of material.
3. Balanced Integration: As the name implies, balanced integration is a
combination of forward integration and backward integration. Here the
business acquires both raw material supply chain and distribution
channels to control everything.

6.18 The Value Chain

A company is like a chain of value producing activities which starts with inputs at
one end and sales at the other. The overall value is represented by profitability.
Porter broke the value chain down into two main components: primary activities
(logistics of production and sales) and support activities (necessary to run the
company but not directly related to production and sales).

9
Primary activities:
• In-bound logistics: receiving, storing and handling inputs to the production
process.
• Operations: transforming inputs into outputs; this is the physical process of
making, testing and packaging the product.
• Out-bound logistics: moving the product from operations to buyer in the case
of a tangible product and bringing the buyer to the product in the case of many
services.
• Marketing and sales: providing the buyer with information, inducement and
opportunities to buy the product.
• Service: maintaining the value of the product.

Support activities:
• Procurement: the process by which resources are acquired.
• Technology Development: the technology associated with each of the value
activities, including learning by doing, product design and process
development.
• Human Resource Management: the whole business of managing the
workforce.
• Management Systems (Firm Infrastructure): including quality control,
finance and operational planning.

Value chain analysis: the objective is to identify competencies which generate

competitive advantage, aspects of performance in which the company is good
compared with competitors. It also gives a view of strengths and weakness of the
company.

10
 Example of how it can be used in strategic analysis:

6.19 Synergy

A synergy is where the whole is greater than the sum of its parts. In other words,
when two or more people or organizations combine their efforts, they can
accomplish more together than they can separately. They can get more done
working together than they can working apart. In mathematical terms, a synergy is
when 2 + 2 = 5.

Negative synergies also exist. If there is a negative synergy, the whole is less than
the sum of its parts. In other words, people can actually accomplish more by
working alone rather than working together. In mathematical terms, a negative
synergy is when 2 + 2 = 3. An easy example is an overly social work team that
spends too much time 'team building' and not enough time working.

• Synergy is the concept that the value and performance of two companies
combined will be greater than the sum of the separate individual parts.
• If two companies can merge to create greater efficiency or scale, the result is
what is sometimes referred to as a synergy merge.
• The expected synergy achieved through a merger can be attributed to various
factors, such as increased revenues, combined talent and technology, and cost
reduction.

11
 • In addition to merging with another company, a company can also create
synergy by combining products or markets, such as when one company cross-
sells another company's products to increase revenues.
• Companies can also achieve synergy between different departments by setting
up cross-disciplinary workgroups in which teams work cooperatively to
increase productivity and innovation.

6.20 Competence

Different companies are differently good at different things at different times. The
aspects of competitive performance which a company is relatively good at are its
capabilities, or competencies. The notion of distinctive competencies relates to all
of the characteristics of a company which give it a competitive edge.

Distinctive competencies are the areas a company is better at than the competition.
While any techniques can be imitated, it is much more difficult to eliminate the
integration of competencies that make up competitive advantage.

Core competencies stretch SBU’s and integrate them. They coordinate skills and
integrate technology. Core competencies (1) give access to a wide away of markets,
(2) make a contribution to custom benefit, and (3) are difficult to imitate.

Simply put,
• Core competence: A capability that is central to a firm's value-generating
activities.
• Distinctive competence: A capability that is visible to the customer, superior
to other firms' competencies to which it is compared, and difficult to imitate.
• A core competency can only be considered as a distinctive competency only
if a competitive advantage is achieved.

12
 Core competencies can be grouped around (1) resources and (2) routines, Resources
might include fixed costs, building blocks for output (core outputs), and brand
names. Routines are the business and management process a company has long
used and is good at.

The form of diversification can be classified depending on whether it is based on

routines and resources currently residing within the company or routines and
resources which have to be acquired or developed.

Competence Based Diversification

• Routine Based Diversification: in this case new resources need to be added to those
currently available in the company, but the same routines can be used to manage
them. Example: a utility company (electricity) going into gas or water.

13
 • Resource Based Diversification: This occurs when a company starts producing
outputs which utilize existing resources, but which require different routines. To
change current routines and introduce new routines can involve much more
fundamental organizational change than the routine-based diversification outlined
before.
• Replication Based Diversification: the least risky form of diversification because
it is based on an expansion rather than a change in the form of the organization.
• Unrelated Diversification: the only resource shared is the financial structure and
control system. It is particularly risky when firm has to acquire new types of
resources and manage them using routines with which it is unfamiliar. Success rate
is low.

6.21 The Definition of Competitive Advantage

When a company possesses distinctive competencies, it can transform these

attributes into a competitive advantage. A company's competitive advantage over
similar businesses in its market or industry allows it to be more profitable or capture
more market share. Competitive advantage is crucial for a company to be successful
in the long term. Without sufficient competitive advantages, a company eventually
would be overtaken by companies that can compete more efficiently or effectively.

Competitive advantage comprises distinctive competencies that set an organization

apart from competitors, thus giving them an edge in the marketplace.

Barney (1991, offered one of the most comprehensive definitions of competitive

advantage, when he explained that
` "a firm is said to competitive advantage when it is implementing a value
creating strategy which is not simultaneously being implemented by any
current or potential competitors. A firm is said to have a sustainable
competitive advantage when it is implementing a value creating strategy
not simultaneously being implemented by any current or potential
competitors and when these other firms are unable to duplicate the benefits
of this strategy."

Competitive advantage as the ability of a company to make products that provide

more value to the customer than rival products, leading to higher sales and higher
profits for that company. However, the ability to create higher value and to extract
more profit at one point in time is not sufficient for a company to have a competitive
advantage. Rivals will be quick to imitate either the products or the production
processes of a firm and compete for its profits. Competitive advantage is only

14
achieved if a company manages to sustain its edge over its rivals over time. A firm
is said to have a sustainable competitive advantage when other existing or potential
competitors are unable to duplicate it or it proves to be too costly to imitate.

Competitive advantage can emerge for a number of reasons: pure chance,

innovation, first mover advantage, differentiation, and so on. The real issue is
whether competitive advantage is sustainable. Any advantages which the company
has must have certain characteristics which make it difficult for other companies to
emulate what they do.

There are two sources of potentially sustainable competitive advantage:

• Those based on the company’s market position (strategic assets)
• Those based on the internal strengths of the company (distinctive capabilities)

Strategic assets are in fact structural barriers to entry: relative size of the market,
sunk costs, control by legislation or agreement, economies of scale and experience
effects.
Distinctive capabilities take several forms:
• Architecture
• Reputation (difficult and costly to create but can yield significant added value)
• Innovation (unless there is a supportive architecture, innovation is unlikely to
be managed successfully).
• Core competencies

The only way to achieve sustainable competitive advantage is to do things which

competitors cannot imitate or find too costly to imitate.
Two main factors contribute to the protection of competitive advantage:
Causal ambiguity: it is difficult to establish exactly what characteristics of the
company contribute to its success. This is the reason why architecture and core
competencies are so important – the architecture is unique to the company, and core
competencies are difficult to identify.
Uncertain imitability – because of the causal ambiguity, potential competitors are
faced with uncertainty as to whether their attempt at imitation will work.

15