S P English

Strategic
Planning
Professor Alex Scott MA, MSc, Phd
SP-A4-engb 1/2018 (1007)

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Strategic Planning
Academic Director of Edinburgh Business School, The Graduate School of Business, Heriot-Watt
University, Alex Scott is an economist and has published over thirty research papers into efficiency in
education, efficient use of energy, energy and the environment and the cost to the taxpayer of govern-
ment industrial aid programmes. He is a pioneer in developing and carrying out research into new
educational techniques, particularly economic and business simulations. He invented and developed the
Profiler which is a central feature of the EBS Learning Websites.
Alex Scott’s executive teaching includes running strategic planning sessions for groups of senior managers,
widening the perspectives of functional managers, and teaching financial specialists the principles of how
economies function in today’s highly complex and interdependent world. Among the companies for which
he has run management programmes are American Express, British Rail, British Telecom, Cathay Pacific,
Fiskars, Hewlett-Packard, National Health Service, ScottishPower, Scottish Widows, Swiss Bank Corpora-
tion.
First Published in Great Britain in 1991.
Alex Scott 1991, 1993, 1997, 1998, 2003, 2007
The right of Professor Alex Scott to be identified as Author of this Work has been asserted in accord-
ance with the Copyright, Designs and Patents Act 1988.
All rights reserved; students may print and download these materials for their own private study only and
not for commercial use. Except for this permitted use, no materials may be used, copied, shared, lent,
hired or resold in any way, without the prior consent of Edinburgh Business School.
Contents
Using the Course Package xi

Cases xi
Your Learning Style xiii
Module 1 Introduction to Strategy, Planning and Structure 1/1
1.1 Strategic Planning: The Context 1/1

1.2 What Is Strategic Planning? 1/3
1.3 The Process of Strategy and Decision Making 1/26
1.4 Business and Corporate Strategy 1/42
1.5 The Development of Strategic Ideas 1/43
1.6 Is Strategic Planning Only for Top Management? 1/48
Review Questions 1/50
Module 2 Modelling the Strategic Planning Process 2/1
2.1 The Modelling Approach 2/1

2.2 Strategy Making 2/8
Case 2.1: Rover Accelerates into the Fast Lane (1994) 2/14
Case 2.2: The Millennium Dome: How to Lose Money in the Twenty-First
Century (2001) 2/16
Case 2.3: The Rise and Fall and Rise of Starbucks: How the Leader Makes a
Difference (2012) 2/20
Module 3 Company Objectives 3/1
3.1 Setting Objectives 3/2

3.2 From Vision to Mission to Objectives 3/3
3.3 The Gap Concept 3/7
3.4 Credible Objectives 3/9
3.5 Quantifiable and Non-Quantifiable Objectives 3/10
3.6 Aggregate Objectives 3/12
3.7 Disaggregated Objectives 3/13
3.8 The Principal–Agent Problem 3/14
3.9 Means and Ends 3/16
3.10 Behavioural versus Economic and Financial Objectives 3/17
3.11 Economic Objectives 3/17
3.12 Financial Objectives 3/19
Strategic Planning Edinburgh Business School v

Contents
3.13 Social Objectives 3/28

3.14 Stakeholders 3/29
3.15 Ethical Considerations 3/36
3.16 Are Objectives SMART? 3/38
Case 3.1: Porsche: Glamour at a Price (1993) 3/40
Case 3.2: Fresh, But Not So Easy (2013) 3/42
Module 4 The Company and the Economy 4/1
4.1 The Company in the Economic Environment 4/2

4.2 Revenue and Costs: The Basic Model 4/2
4.3 The Workings of the Economy 4/4
4.4 Forecasting: What Will Happen Next? 4/20
4.5 PEST Analysis 4/24
4.6 Environmental Scanning 4/26
4.7 Scenarios 4/27
4.8 The Economy and Profitability 4/29
4.9 Environmental Threat and Opportunity Profile: Part 1 4/33
Case 4.1: Revisit Porsche: Glamour at a Price 4/36
Case 4.2: An International Romance that Failed: British Telecom and MCI (1998) 4/36
Case 4.3: Lego Rebuilds the Business (2008) 4/38
Module 5 The Company and the Market 5/1
5.1 The Market 5/2

5.2 The Demand Curve 5/2
5.3 Competitive Reaction 5/13
5.4 Segmentation 5/18
5.5 Product Quality 5/25
5.6 Product Life Cycles 5/31
5.7 Portfolio Models 5/35
5.8 Supply 5/45
5.9 Markets and Prices 5/47
5.10 Market Structures 5/50
5.11 The Role of Government 5/57
5.12 The Structural Analysis of Industries 5/60
5.13 Strategic Groups 5/67
5.14 First Mover Advantage 5/68
5.15 An Overview of Macro and Micro Models 5/71
5.16 Is Competition Changing? 5/72
5.17 Environmental Threat and Opportunity Profile: Part 2 5/73
vi Edinburgh Business School Strategic Planning

Contents

Case 5.1: Apple Computer (1991) 5/75
Case 5.2: Salmon Farming (1992) 5/76
Case 5.3: Lymeswold Cheese (1991) 5/77
Case 5.4: Cigarette Price Wars (1994) 5/77
Case 5.5: A Prestigious Price War (1996) 5/81
Case 5.6: Revisit An International Romance that Failed: British Telecom and MCI 5/83
Case 5.7: The Timeless Story of Entertainment (2005) 5/83
Case 5.8: Revisit Fresh, But Not So Easy 5/85
Case 5.9: Revisit Lego Rebuilds the Business 5/85
Module 6 Internal Analysis of the Company 6/1
6.1 Opportunity Cost 6/2

6.2 Fixed Costs, Variable Costs and Sunk Costs 6/4
6.3 Marginal Analysis 6/5
6.4 Diminishing Marginal Product 6/8
6.5 Profit Maximisation 6/10
6.6 Estimating Production Costs 6/11
6.7 Accounting Techniques: Break-Even, Pay back and Sensitivity 6/14
6.8 Accounting Ratios 6/17
6.9 Benchmarking 6/22
6.10 Research and Development 6/23
6.11 Human Resource Management 6/29
6.12 The Scope of the Company 6/32
6.13 The Value Chain 6/40
6.14 Competence 6/43
6.15 Strategic Architecture 6/50
6.16 Strategic Advantage Profile 6/54
Case 6.1: Analysing Company Accounts 6/57
Case 6.2: Analysing Company Information 6/59
Case 6.3: Lufthansa Has a Rough Landing (1993) 6/62
Case 6.4: General Motors: The Story of an Empire (1998) 6/63
Case 6.5: Driving Straight (2011) 6/65
Module 7 Making Choices among Strategies 7/1
7.1 A Structure for Rational Choice 7/2

7.2 Strengths, Weaknesses, Opportunities and Threats 7/3
7.3 Generic Strategies 7/7
7.4 Identifying Strategic Variations 7/20
7.5 Strategy Choice 7/34
Strategic Planning Edinburgh Business School vii

Contents

Case 7.1: Revisit Salmon Farming 7/52
Case 7.2: Revisit Lymeswold Cheese 7/52
Case 7.3: Revisit A Prestigious Price War 7/52
Case 7.4: Revisit General Motors: The Story of an Empire 7/52
Case 7.5: The Rise and Fall of Amstrad (1993) 7/52
Case 7.6: What Is a Jaguar Worth? (1992) 7/53
Case 7.7: Good Morning Television Has a Bad Day (1993) 7/54
Case 7.8: The Rise and Fall of Brands (1996) 7/57
Case 7.9: The Veteran Returns (2007) 7/59
Module 8 Implementing and Evaluating Strategy 8/1
8.1 Implementing Strategy 8/2

8.2 Organisational Structure 8/3
8.3 Resource Allocation 8/8
8.4 Evaluation and Control 8/16
8.5 Feedback 8/19
8.6 The Augmented Process Model 8/23
8.7 Postscript: Strategic Planning Works 8/27
Case 8.1: The Body Shop (1992) 8/28
Case 8.2: Daimler in a Spin (1996) 8/29
Case 8.3: Eurotunnel: A Financial Hole in the Ground (1996) 8/32
Case 8.4: The Balanced Scorecard 8/34
Case 8.5: Revisit An International Romance that Failed: British Telecom and MCI 8/37
Case 8.6: Vuitton: Expensive Success (2007) 8/37
Case 8.7: Implementation: The Missing Link (2006) 8/39
Case 8.8: Revisit Fresh, But Not So Easy 8/41
Case 8.9: Revisit The Timeless Story of Entertainment 8/41
Case 8.10: Revisit Driving Straight 8/41
Case 8.11: Revisit Lego Rebuilds the Business 8/41
Appendix 1 Strategy Report A1/1

Appendix 2 Practice Final Examinations A2/1
Some Tips on Analysing Cases and Questions 2/1
Practice Final Examination 1 2/4
Practice Final Examination 2 2/9
Appendix 3 Guide to Strategic Planning Practice Final Examinations A3/1

Guide to Practice Final Examination 1 3/1
Guide to Practice Final Examination 2 3/11
viii Edinburgh Business School Strategic Planning

Contents
Appendix 4 Answers to Review Questions A4/1

Module 1 4/1
Module 2 4/7
Module 3 4/23
Module 4 4/31
Module 5 4/36
Module 6 4/59
Module 7 4/79
Module 8 4/97
References R/1
Index I/1
Strategic Planning Edinburgh Business School ix

Using the Course Package
It is widely accepted that strategic planning is extremely difficult to teach effectively.
This is because, at the MBA level, it is not sufficient to know about the subject – it
is necessary to be able to apply ideas in order to carry out strategic analysis of real
problems. While there are many strategy models on which analyses can be based,
the strategic approach also requires the application of a great many ideas and models
drawn from the core business disciplines; this is what gives substance to strategic
analysis and this integrative element is why strategic planning is typically regarded as
the capstone course in MBA programmes. The Strategic Planning course has been
written to be stand alone but you will find it a much richer learning experience if
you have already studied the other six core disciplines. From the pragmatic point of
view experience has shown that the failure rate for students who tackle Strategic
Planning first is relatively high.
A further problem is that strategy solutions are to a large extent a matter of per-
sonal judgement. A strategic planning analysis is judged on the structure and
approach of the analysis and the justification for policy proposals rather than the
proposals themselves. While it may be possible to recognise that recommendations
are unlikely to be successful because of misunderstandings about the basic business
tools which are applied, it is usually difficult to judge how good or bad the results of
a particular set of recommendations are likely to be because no one really knows
what is going to happen in the future. In real life strategy is undertaken in a con-
stantly changing environment which is full of uncertainty, and it is difficult to
replicate these conditions in the classroom. But it is obvious when students are
using analytical ideas rather than adopting a subjective and unstructured approach.
The approach adopted in this course is based on cases. There are review exercises
and short questions which are intended to reinforce your comprehension of specific
topics, and the overall objective of the course is to enable you to apply strategic
analysis to real life issues.
Cases
The case method is the most widely used technique for teaching strategic planning,
and was pioneered at Harvard Business School. The case is a powerful teaching tool
in class because it enables students to tackle real life examples, which have been
abstracted and structured by teachers, and to present, discuss and defend their
analysis. The case method as used in class teaching cannot be implemented for
distance learning because it is based on interaction among students and between
students and teacher. In this course each case has been analysed fully by the
professor, and many of the cases have been used in a similar form in examinations
and the analysis has benefited from the wisdom of large numbers of students. Each
case has been analysed using a variety of business models, and as you work through
the course you will learn by analysing the cases and comparing your solutions with
those of the professor. It may often be the case that you consider your analysis to be
Strategic Planning Edinburgh Business School xi

superior to the professor’s; this is all to the good, particularly if you can justify your
position.
The case method is a static approach, in that you analyse a given situation, but
cannot then experience how a proposal might work out in practice, and how it
might need to be adjusted as time proceeds. Strategic planning is a dynamic process
in real life, and no case can capture this fully. A drawback of the case method is
therefore that you will not have to live with the consequences of your strategy
recommendations.
Feedback on student performance presents difficulties when using cases in the
distance learning mode. The professor’s analysis provides a benchmark against
which you can evaluate your own answer, but it cannot be regarded as a ‘perfect
answer’ to the case. This is because there can be legitimate disagreement on the
weights to ascribe to different aspects of the issue, such as the relative importance
of different types of risk. Therefore the professor’s analysis can be regarded as an
analytical framework within which you can judge the quality of your own thinking.
The Profiler Cases enable you to judge your strengths and weaknesses on the basis
of a large number of cases which, taken together, provide a more accurate indication
of your comprehension and analytical ability than individual cases.
One of the difficulties in using real life cases is that they typically touch on many
issues. Several of the cases in the course attempt to focus on particular topic areas,
but the cases in the earlier modules will be difficult to analyse fully because you do
not have many of the analytical tools available with which to tackle them. It is,
however, a useful exercise to attempt cases without having the benefit of a full
framework because there are still many lessons to be learned from applying what
you do know.
Because strategic planning is about applying ideas to the real world it is important
that you tackle the exercises, in the form of cases, review questions and short
questions, and assess your analysis in relation to the model answers provided. You
will find that many issues are elaborated on and reinforced in the model answers and
these are an essential complement to the ideas developed in the text. In fact, the text
and the exercises must be regarded as a single learning tool.
The Timeless Nature of Strategy: The View from Now

An important feature of these cases is that they are not based on privileged infor-
mation or in-depth analysis of the organisations concerned; they have been
constructed from information freely available in the public domain (i.e. internet,
newspaper reports, magazine articles, television programmes and company reports).
The cases demonstrate that strategic problems recur and that events which hap-
pened in the past are as relevant and informative as those happening right now. The
point of the strategic analysis is to demonstrate how strategic tools are used at a
given time; subsequent events may or may not be quite what was expected as
changes in the environment, both internal and external, unfold.
The View from Now appended to each exercise and case solution provides a
current perspective on how events actually transpired and the extent to which the
xii Edinburgh Business School Strategic Planning

strategic analysis of the case was borne out by future events. You may wish to
consider what this section is likely to contain before reading it.
That men do not learn very much from the lessons of history is the most im-
portant of all the lessons of history.
Aldous Huxley
Those who cannot learn from history are doomed to repeat it.
George Santayana
Your Learning Style

As you are probably well aware different teachers have different styles and these
styles can be equally effective in their different ways. There are no strict rules for
being an effective teacher – although there are many pitfalls that need to be avoided;
teacher training courses are designed to provide potential teachers with the tools of
their trade, but how they implement these is a matter of individual discretion. Apart
from this there is the issue of how the learning experience should be structured. The
fact is that different students learn in different ways and no single class formula will
suit everyone perfectly. Some students learn by participating in class while others are
unwilling to make a contribution; some students learn from small group interaction
while others find the experience difficult to deal with.
So whether you are an independent learner or attending classes it is up to you
how you decide to learn about strategy. Bear in mind that even if you attend classes
they will rarely exceed one quarter of the recommended 200 hours of study time so
most of your learning will be on your own. Two totally different learning models
reported by students were equally successful for them. One student worked through
each module and spent a lot of time on each case or review question both analysing
the problem and comparing the outcome with the analysis provided before proceed-
ing to the Short Questions, the Profiler Cases and the Practice Final Examinations.
Her intention was to build up comprehension in an incremental fashion. Another
student started by reading Module 1 to Module 8 without attempting the cases or
review exercises with the intention of gaining a general perspective; he then went
back to the beginning and worked through the cases and exercises before attempt-
ing the Short Questions, etc. in the same way as the previous student. Each felt that
this approach was right for him or her. Whichever approach you adopt bear in mind
that strategic planning is not an individual discipline which is unrelated to the core
courses; when ideas from the core courses are used you may often find it worth-
while to revisit the relevant text to refresh your mind on ideas which are discussed
and applied in the strategic context.
But there is one important piece of advice which you should keep in mind what-
ever your learning style: do not get obsessed with detail. For example, some of
the cases contain numerical information relating to company accounts and market
position; you might make a computational mistake when using these numbers but
that is not important for the course, although it would be important in real life.
Strategic Planning Edinburgh Business School xiii

What is important is that the conclusions you arrive at are consistent with whatever
numerical answers you have produced. Strategic planning is about the big picture
and the quality of your thinking; if you lose sight of that you will find yourself in the
classic position of not being able to see the wood for the trees.
xiv Edinburgh Business School Strategic Planning

Module 1
Introduction to Strategy, Planning and

Structure
Contents
1.1 Strategic Planning: The Context ..........................................................1/1
1.2 What Is Strategic Planning? ..................................................................1/3
1.3 The Process of Strategy and Decision Making ................................. 1/26
1.4 Business and Corporate Strategy ...................................................... 1/42
1.5 The Development of Strategic Ideas ................................................. 1/43
1.6 Is Strategic Planning Only for Top Management? ........................... 1/48
Review Questions ........................................................................................... 1/50
Learning Objectives
 The meaning of strategic planning as it is used in business.
 To visualise strategy as a structure of thought that can be applied to the complex
strategy process.
 The role of the scientific approach.
 The different strategy concerns at the corporate and business levels.
 How the major approaches to strategy have developed.
1.1 Strategic Planning: The Context

It has been mentioned that strategic planning is usually the capstone course in MBA
courses; it is therefore useful to look at what the core courses are concerned with
and how strategic planning fits with them. Because the core courses are taught
individually it is easy to get the impression that they are independent of each other,
but this is far from the case. The following story shows how the core courses
contribute to implementing a new product launch; it also demonstrates that lack of
understanding of any one core discipline can lead to failure on its own.
 Organisational behaviour: this subject should come at the top of the list of
requirements for any management course because if you cannot handle people
then you are not a manager. It is as simple as that. The fact is that organisations
are run by people, and if you have no understanding of what motivates people
and how they interact in the organisational setting then you are unlikely to get an
efficient response from the people you are managing. A new product launch
typically involves organisational change and if the organisation is unable to adapt
to new requirements in terms of working practices and different customer needs
Strategic Planning Edinburgh Business School 1/1

Module 1 / Introduction to Strategy, Planning and Structure
there is little chance of the product launch succeeding. Organisational change is

unlikely to happen by itself and unless you have a grasp of the organisational
culture, understand how to motivate and influence people and are able to design
appropriate reward systems and job designs, you will have little control over
what happens.
 Economics: everything that happens in business is related to economic influ-
ences and these operate at three levels. At the highest level it is necessary to have
some understanding of how the economy operates. Every business is affected by
the business cycle, the rate of interest, the exchange rate and government eco-
nomic policies; therefore you need to ask whether the product should be
launched now, when all the signs are that the economy is heading for recession,
or should it be delayed until there is an improvement? This is particularly im-
portant for consumer products that are greatly affected by disposable incomes.
The next level concerns how markets operate and how prices are determined.
What types of competitive forces prevail in the industry? Does the new product
have any monopolistic characteristics that will enable relatively high profits to be
made or is it entering an already highly competitive market where it is unlikely
that profits higher than the opportunity cost of capital can be generated? If the
competitive environment is not understood it is quite possible that the product
will be doomed to failure from the outset. The third level concerns ideas about
efficiency, primarily based on marginal analysis. Rational decision making is
based on an understanding of relevant costs and benefits, and serious mistakes
are often made because efficiency ideas are not understood. It is not just a ques-
tion of whether the costs of developing and launching the product will
eventually be repaid; it is also necessary to make decisions on how much to
spend on marketing and other activities. Without a firm grasp of efficiency prin-
ciples such decisions are likely to be random. Taking the three levels together,
launching at the wrong time, into the wrong market with an unnecessarily costly
product is a certain recipe for failure.
 Marketing: there is little point to being able to manage people and make
rational economic decisions if you cannot sell effectively in markets. Marketing is
often mistakenly thought of as advertising, but advertising is simply one of many
marketing tools. Marketing is the complex process of relating product character-
istics to market demand and attempting to win competitive advantage in a
dynamic competitive setting. Why is it that some brands of detergents are much
more successful than others, despite the fact that the majority of people cannot
say if one brand performs better than another? If the new product is priced
about the same as competitors but has no particularly distinguishing features is it
likely to succeed? Unless the new product is positioned so that it is relatively
attractive to potential consumers there is little likelihood of success.
 Finance: you may be running your company well and selling effectively, but
managers always have to bear in mind that perhaps they should have been doing
something different which is more profitable than the new product launch. How
is the choice among competing courses of action made in a world of uncertainty?
Finance takes all available information on projected future cash flows and sub-
jects them to rigorous evaluation; the choice here may have been between
1/2 Edinburgh Business School Strategic Planning

revamping an existing product or launching a new product; the projected cash

flows both in and out are totally different while the risks associated with each are
also different. The tools of financial theory provide you with a quantitative solu-
tion to such problems, and this takes you a long way towards deciding on the
most appropriate course of action. In the absence of this analysis it is possible
that the decision will not only fail to create as much value as possible but may
result in the destruction of value; in other words it would be a failure.
 Accounting: you may have decided on the best course of action using financial
techniques, but that decision in turn is dependent on available accounting data.
In a company which produces more than one product it is difficult to isolate
relevant costs, so it is quite possible that the wrong costs may have been used as
the basis for the decision in the first place. Further, if the cost of the new prod-
uct is not known the price may be set such that it makes a loss. Clearly the
application of inappropriate accounting principles is a sure road to disaster.
 Project management: while it may appear to be a good idea to embark on the
new product launch on the basis of initial marketing research and cost estimates,
unless you understand how to implement projects effectively there is a good
chance that the launch will fail. The success of the launch will depend on meet-
ing criteria centred on time, cost and quality because the product will have to be
on the market by a certain date, the development and production costs will have
to be maintained within budget and the quality has to be as good as competitors’.
There are therefore strong links between project management and the other core
disciplines: organisational behaviour techniques are used for team building, fi-
nance and accounting techniques are used to ensure that the appropriate costs
are measured and financial evaluation carried out and, possibly most crucially,
marketing needs to be consulted about the connection between quality as it af-
fects differentiation and market positioning. Therefore the time, cost and quality
trade-off cannot be carried out in isolation. In addition, the launch of a new
product generates risk. As the launch progresses project management tools map
the risk profile and monitor it and tools such as earned value analysis and trade-
off analysis enable different combinations of time, cost and performance, both at
present and at the projected end condition, to be assessed. Clearly, the lack of
the project management approach can result in a haphazard product launch. A
major problem confronting organisations is that they do not realise that their
approach to managing change is haphazard because they are not aware that most
change activities are projects in their own right and should be managed as such.
 Strategic planning: the areas covered by the six core disciplines can be identi-
fied quite precisely and it is clear that they all have a crucial role to play in
running a company. Strategic planning is less easy to define, and the content and
role of strategic planning is what the rest of this course is about.
1.2 What Is Strategic Planning?

Strategic planning is a complex activity and before attempting a definition it is useful
to compare its degree of complexity with another complex activity: economic policy
making, which has a general similarity with strategic planning in that strategic

planning is concerned with running a company and economic policy is concerned

with running the economy of a country. The study of macroeconomics reveals the
complexity of fiscal and monetary policy and the many ideas and theories which are
involved; furthermore, there are no completely right or wrong economic policy
decisions because information has to be interpreted and conflicting theories
reconciled. Although the scale of a company is very much less than that of an
industrialised country such as the UK or Japan the job of business policy making is
probably just as complex. That is one reason why effective CEOs are as rare as
effective Presidents, Prime Ministers and Central Bank Governors; in fact, effective
CEOs are typically paid much more than government ministers. The complexity of
economic policy becomes apparent when a list of the issues involved is compiled
together with an example of how the government attempts to influence each.
Issue Government action

Growth of GNP Stimulate innovation
Unemployment Reduce taxes
Inflation Increase taxes
The budget balance Increase taxes
The role of markets Reduce regulation
The trade balance Stimulate exports
The rate of interest Increase the money supply
The exchange rate Sell currency reserves
Income redistribution Increase welfare payments
Pollution Tax polluting firms
Government expenditure Control government departments
Business investment Improve confidence in the economy
This list is by no means complete; in fact, the list could be extended to fill this
page. The government is involved in a wide variety of actions in attempting to
influence these issues and there is typically disagreement about which action is most
appropriate. When we turn to strategic planning it is not difficult to generate a list of
equal length; the entries in the following list are accompanied by the type of
question that is posed by the core disciplines.
Issue Question Core discipline

Profitability Are we creating value? Finance
Growth in sales Where are we on the product life cycle? Marketing
Market share Are we in an oligopoly? Economics
Relative costs Have we an efficient management accounting Accounting
system?
Competitive position Do we have a competitive advantage? Strategic planning
Pricing What is the elasticity of demand? Economics
Environmental scanning What is happening to the economy? Economics

Issue Question Core discipline

Human resource manage- Why is our attrition rate so high? Organisational behaviour
ment
Timing new product launch Are we clear about the time, cost and quality Project management
trade-offs?
Dividend policy Are our shareholders happy? Finance
Company culture Why are we resistant to change? Organisational behaviour
This random list of issues leads to questions that involve the core disciplines but
it is not necessarily immediately evident to managers which core discipline will be
useful in addressing the issue and the question. Many real life business discussions
flit among these issues and questions without any structure and in ignorance of the
fact that there is a body of knowledge that can be brought to bear in resolving the
questions. One of the main outcomes of this course is that you will be able to
structure strategy discussions and identify how concepts can be applied.
The theories of microeconomics and macroeconomics are used to make sense of
the relationships among the many variables involved in the economy and to provide
an understanding of how economies operate; this provides the basis for interpreting
government economic policy making. The approach in strategic planning is to bring
together business concepts and ideas in order to understand how companies (and
other organisations) operate in a competitive environment, develop an understand-
ing of the inter-relationships involved, and hence provide the basis for arriving at
explanations of why companies have succeeded or failed in the past and how they
might operate successfully in the future.
Looking at the list of strategic planning issues there is an item called ‘environ-
mental scanning’. This activity is concerned with monitoring the environment within
which the company operates and assessing the extent to which current and potential
changes in that environment are likely to impact on the company. But the macroe-
conomic environment is largely determined by the state of the economy, which in
turn is greatly influenced by economic policy making. Thus to make sense of the
macroeconomic environment it is necessary to have some understanding of
economic policy making and its implications. The need to understand economic
policy making is not confined to government policy makers and it is subsumed into
strategic analysis. In other words, managers are fooling themselves when they claim
that issues such as government economic policy have no relevance to their decision
making: everything is relevant to strategic planning.
Ignorance of the business disciplines means that we often do not understand the
world round about us. For example, take the case of Madonna, the singer and
actress. Madonna is an entertainment phenomenon: she is recognised worldwide
and has been the world’s highest paid female entertainer; but it is generally accepted
that her singing does not compare well with a properly trained voice, her dancing
does not appear to be significantly better than the dancers in her chorus line and her
films have not been particularly successful, suggesting that her acting is not of the
highest calibre; she does not play a musical instrument. Looked at from this
perspective, we must be missing something because it is not obvious what gives

Madonna her competitive edge that kept her in the top rank for over two decades. It
is not just that she was successful, she maintained that success and appears to have
achieved that enviable state: sustainable competitive advantage.
One way of tackling this is to think of Madonna as a business enterprise rather
than an individual performing on stage or screen. The overall objective of the
Madonna business was to achieve stardom and resources were mobilised to achieve
this. The contribution of the core disciplines can be identified as follows.
Core discipline Contribution to Madonna Inc

Organisational behaviour Select a group of musicians, dancers, songwriters,
directors, producers, etc. to build an effective team
Economics Carve out a monopoly position
Marketing Change image in line with changing consumer
preferences; develop brand loyalty
Accounting Implement effective cost control system
Finance Ensure the availability of financial resources for major
investments in recordings, films and stage shows
Project management Stage amazing personal performances efficiently
Madonna’s long-term success now starts to make sense: what she did particularly
well was to exercise business skills rather than performing skills. So what is to stop
other highly competent performers imitating Madonna? That is a difficult question,
but she has the brand (hence attracting fans, who might not like this analysis) and
the resources to move fast in line with public tastes.
The point here is not to denigrate Madonna, who is beyond doubt a fine per-
former, but to try to understand what confers competitive advantage on her. It
cannot be her innate performing skills because these are not unique, so it must be
the ‘something missing’ that we have attempted to identify using business ideas.
While another singer who behaved in the same business fashion as Madonna might
be successful, there are many other factors at work. These include the business
ability of the singer, the effectiveness of the business team built up, the selection of
the correct marketing approach in relation to the singer’s characteristics and the
ability to adapt to changing preferences. Thus while behaving like Madonna may
increase the chances of success for a particular singer, there is no guarantee that
it will do so. In addition, relatively few singers (and this applies to the population
generally) have the vision to conceive of themselves as a business and to apply
business principles to what they do. So to a large extent most singers would not be
able to act in the same way as Madonna even if it was pointed out to them that this
was the route to success.
Now you should be starting to think more deeply about the world around you:
nothing is as it appears to be.

1.2.1 Managers’ Definitions of Strategy

Over many years I have posed the question ‘What do you understand by strategy?’
to experienced executives attending management programmes, and each time the
groups have responded with a wide range of answers including the following:
1. Knowing where you are going and how you are going to get there.
2. Setting a clear set of objectives and mobilising resources to achieve them.
3. Thinking in the long rather than the short term.
4. Working out how to do better in the market place than your competitors.
5. Deriving and selecting a course of action.
There are some common threads running through these definitions, but individ-
ually they could lead to different courses of action. For example, definition 2
focuses on objectives, but does not differentiate between short term and long term
as in definition 3; definition 4 is the only one explicitly concerned with markets;
definition 5 is the only one which explicitly considers choice.
It is not unusual to obtain ten different definitions from a single group. These
managers are typically involved in formulating and implementing strategy so it might
appear strange that there is such apparent confusion about what is meant by the
term. One of the main outcomes of this course is that you will emerge with a clear
understanding of what is meant by strategic planning and you will be able to
converse with your peers in a meaningful manner. It would be very difficult for the
five individuals who provided the above definitions to have a sensible discussion
because they would all be focusing on different things.
1.2.2 Academic Definitions of Strategy

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

A pattern in a stream of decisions; the pattern may not be comprehensive, uni-

fied or integrated.1
This raises the question as to whether strategic planning is a conceptually valid

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

guidelines for coordinating activities so that the firm can cope with and influ-
ence the changing environment. Strategy articulates the firm’s preferred
environment and the type of organisation it is striving to become.5
The point of reproducing these definitions is to demonstrate that there is no

more agreement regarding what is meant by strategy among academics than
practising senior managers. Each of these quotes can be interpreted as saying
different things. The first definition seems to suggest that strategy can only be
understood after the event, and is revealed by studying what management actually
did. The second claims that strategy is a proactive process where long term goals are
determined before the event and resources deployed accordingly. The third portrays
strategy as a pattern of objectives which define what the company is and intends to
be in a broad sense. The fourth presents strategy as a set of guidelines which will
help it operate in a changing environment. The fact that there are such different
perspectives on the issue suggests that some observers will see strategic behaviour
where others will not.

A different perspective on strategy can be derived from economics: the forces of

competition ensure that, on average, successful companies are those which, by
chance or otherwise, choose the most effective strategies. As a result it might be
expected that successful companies would tend to exhibit various characteristics of
strategic planning contained in the definitions, such as identification of objectives,
plans and guidelines for dealing with the unexpected, and effective allocation of
resources. Since many companies have a record of success stretching over decades,
it is reasonable to conclude that there is scope for distilling lessons from their
experience and formalising these into a set of generally applicable principles.
1.2.3 Three Approaches to Strategic Planning

Since strategy is such a troublesome concept to define it is to be expected that there
are several ways of approaching the idea. In theoretical terms strategy can be
regarded as a purely planning exercise, or a course of action which emerges over
time, or as the outcome of the resources which are available to the company.
Given that there are three theoretical approaches to strategy it is perhaps not
surprising that executives and academics arrive at a variety of definitions. As would
be expected the academic journals contain a great deal of discussion regarding the
precise meaning of the three approaches and their relative merits so the following
account is only an outline.
The Planning Approach

This approach is based on the notion that once a set of objectives has been deter-
mined and the business environment analysed and forecasts made, a plan can be
worked out by senior management which is then passed down for implementation;
this plan is then adhered to over the planning time scale. This is usually thought of
as the strategic planning approach, and it has been claimed by its supporters that
this prescriptive form of strategy is rational and objective; but as Mintzberg6 and
many others have pointed out, it makes a number of assumptions about the world
which are highly questionable.
 The future can be predicted accurately enough to make rational choices. It is in fact a
widespread fallacy that the future can be predicted with any realistic degree of
accuracy. At the macro level economists disagree quite markedly on the econom-
ic prospects for any given country during the course of the next year; such
forecasts can never take into account unforeseeable events such as the collapse
of the Russian financial system in 1998 leading to the crisis of the hedge fund
LTCM, on whose board were the finance gurus Myron Scholes and Robert C
Merton. The Black-Scholes valuation method is world famous and is dealt with
in the Finance course. At the micro level market innovations can have fundamen-
tal effects which are also impossible to predict, such as the introduction of direct
telephone insurance selling in the UK in the early 1990s and the emergence of
eBay and Google in the early 2000s. One reason that many market changes are
impossible to predict is that they are dependent on the unique vision of individ-
uals; if such unique vision did not exist there would be virtually no scope for
competitive action in the first place. At the macro level the collapse of the Ice-

landic banking system in 2008 and of the Cypriot banking system in 2013 hap-
pened in spite of the efforts of the major European countries to contain the
financial crisis.
 It is possible to detach strategy formulation from everyday management. In arriving at a
strategy it is necessary to have a full set of data which can be subjected to analy-
sis and from which conclusions can be drawn. But this assumes that there is
some technique whereby the relevant information is extracted from the organisa-
tion, and from individual managers, and presented to strategy makers in a tidy
bundle. This dodges the question of who is to decide on which information is
relevant, and indeed whether the information is readily available. Furthermore, as
events unfold information is continually evolving and can go out of date very
quickly. As a consequence everyday management is closely tied in with strategy
formulation because it is in everyday events that information is generated.
 It is possible to forego short-term benefit in order to gain long-term advantage. In a situation of
uncertainty, and lack of knowledge about the future because of the difficulties of
forecasting mentioned above, it may often appear preferable to reap short-term
benefits that can be achieved with a high degree of certainty rather than waiting for
highly uncertain returns. It can also be extremely difficult to convince those who
lose in the short term that the trade-off is worthwhile. Trading off the short term
against the long term implies some form of discounting which in turn involves
quantifying the cash flows associated with both short-term and long-term actions;
the implicit discount rate for many companies may be so high that short-term
benefit will always be preferred to highly uncertain long term gains. As a result
many companies may find it virtually impossible to undertake action which relates
to the long term when there are viable short-term options.
 The strategies proposed are capable of being managed in the way proposed. Any strategic
initiative which involves change is dependent on company personnel adapting
and working in alignment with company objectives. One of the major lessons of
Organisational Behaviour is that change management is one of the most problemat-
ical areas of strategy implementation and it cannot be taken for granted. Time
and again it is found in practice that prescriptive actions simply do not take the
human dimension adequately into account.
 The chief executive has the knowledge and power to choose among options. He does not need to
persuade anyone, nor compromise his decisions. This takes a naive view of leadership and
how it is exercised. In reality, very few business leaders can behave like dictators,
and certainly not for very long. It is necessary to achieve consensus and broad
agreement at all levels of the organisation to achieve objectives effectively. The
fact of selecting one option implies that some individuals will be made better off
and some worse off (or perceive that this is the case) than they otherwise would
have been so compromises are inevitable during the implementation process.
 After careful analysis, strategy decisions can be clearly specified, summarised and presented; they
do not need to be altered because circumstances outside the company have changed. This is
perhaps one of the greatest and most potent fallacies: it is never possible to
avoid ambiguity completely, and it is potentially lethal to ignore changing com-
petitive circumstances. One of the most important reasons for company failure

is the lack of a feedback mechanism and the channels of communication that

make it possible for decision makers to adapt to changing circumstances.
 Implementation is a separate and distinctive phase that only comes after a strategy has been
agreed. This assumption is possibly a reflection of the fact that the implementa-
tion stage of strategy has always received much less attention than the more
glamorous and exciting areas of objective setting and strategy choice. In reality
nothing ‘just happens’, and an essential part of strategy making is to evaluate the
feasibility of different courses of action. It may well be desirable, on financial
grounds, to close a factory, but the actual process of achieving this may have
widespread and damaging effects on the company as a whole.
During the early 1960s the notion of prescriptive planning was quite popular and
many corporations set up corporate strategic planning departments. However,
experience has revealed that the attempt to drive corporate strategy in this restrictive
fashion is unproductive. A major problem arises when individuals become commit-
ted to the strategic plan and not to the success of the company; this can occur when
performance measures have been expressed in financial terms and the pursuit of
favourable financial reports takes precedence over longer term issues.
Emergent Strategy
This approach starts from a different premise: that people are not totally rational
and logical. The extent of this irrationality has been the subject of research and the
general findings accord with common sense.
 Managers can only handle a relatively small number of options.
 Managers are biased in their interpretation of data – in fact any data set can be
interpreted in a number of legitimate ways, and it is not surprising that managers
often select the interpretation which backs up their previously determined views.
 Managers are likely to seek a satisfactory solution rather than maximise profits.
 Organisations consist of coalitions of interest groups. The implementation of
decisions depends on negotiation and compromise between those groups, lead-
ing to unpredictable outcomes.
 When making decisions, managers pay as much attention to a company’s culture
and politics as to factors such as resource availability and external factors.
According to this approach strategy is not planned before the event but emerges
over time in an unpredictable manner and hence may appear to have little structure;
it is therefore argued that the claim of a cause and effect relationship between
analysis and strategy choice and implementation is fundamentally flawed.
There is another very good reason why there is a limited use of information in
decision making: the world is actually too complex to be understood by the human
brain. Rationality has to be seen in the context of what is possible in the real world,
rather than what might be done in an ideal world. The term used to describe
rationality when it is impossible to take into account the complexity of real life is
‘bounded rationality’; the decision maker is rational given the information available,
but is quite aware that more information could be obtained at a cost. In economics
it is argued that decision makers act in accordance with profit maximisation, but it is
impossible to reconcile strict profit maximisation with bounded rationality. This

means that a different view of decision making has to be taken and the term
‘satisficing’7 was invented to reflect the fact that decision makers collect information
and defer selecting a course of action until the costs of further delay and infor-
mation collection are considered to be greater than the potential benefits of
searching out a better option. Thus rather than simply attempting to maximise
profit, the decision maker satisfies himself that there is nothing more to be gained
from further delay. This helps to explain why decision makers are so eager to find
out what management gurus have said and are continually searching for ways of
making sense of the real world. To decision makers any information is better than
no information, and it does not matter very much to them that the information they
are acting on does not accord with accepted views of proper scientific enquiry.
Another way of looking at this is to make up a list of things which the company
does not know with any certainty when about to launch a new product; for example
 how customers will perceive quality;
 how far it will be possible to meet production cost targets;
 how competitors will react;
 when a substitute will appear on the market;
 the impact on sales of a one-year delay in launch.
It is certainly possible to collect some information on such issues, but it will not
be complete and is likely to be unreliable. In fact, it turns out that you cannot
actually get hold of the really important information and it is always necessary to
make assumptions and to take many things on trust.
However, it can be argued that just because the world is a complex and changing
place does not mean that decision makers should simply sit back and let things
happen and that there is still a role for the proactive approach. The arguments for
proactive action include the following, in no particular order.
 While there are bound to be adjustments to corporate objectives as time goes on,
the company can still be directed along the general lines of a broad mission. The
board need to do more than simply react to changing circumstances.
 There is a need for efficient resource allocation; if this is not tackled resources
might as well be allocated randomly.
 While compromises need to be made with interest groups within the organisa-
tion, this is more of a constraint than a barrier to action. Decisions still have to
be taken, and it is nonsense to avoid this simply because people are difficult to
manage.
 In many cases investments take a considerable time to reach fruition, therefore a
degree of long term planning is inevitable.
 Satisficing is in itself a rational basis for choice, since it is better to make an
informed judgement on the basis of some information than no information at
all, or to ignore information altogether.
 The act of attempting to plan at least makes the basis for management action
clear.

Therefore there is some middle ground between trying to plan for all eventuali-
ties and simply reacting to events as they occur.
Resource Based Strategy

This approach lays emphasis on the internal resources available to the company.
While it does not overlook the importance of the competitive environment, it starts
from the basic premise that strategy is primarily concerned with the search for
competitive advantage and to a large extent the source of competitive advantage
rests within the company’s resources. The resource based view does not focus so
much on the actual labour and capital deployed by the company, but rather on the
way in which these resources are utilised. A successful company is not a passive
collection of resources which reacts to changes in the competitive environment, but
one that develops the ability to take advantage of opportunities as they arise and to
create the opportunities themselves by innovative behaviour.
The resource based approach uses various terms for different types of resources.
Without going into detail at this stage it is important to distinguish among them.
Resources include physical resources, human resources, financial resources and
intellectual resources. Competences arise from the continual deployment and
integration of resources over time and across activities. Core competences are
necessary for successful performance. Distinctive capabilities are competences
superior to competitors. Taken together these can be regarded as the company’s
strategic capabilities.
The role of strategic capabilities in creating sustainable competitive advantage
depends on several characteristics, including the following.
 Rarity: some resources and competences are so scarce that only a few firms have
access to them. This raises the question of how companies acquire such re-
sources and competences when they are rare; they would clearly command a
high price on the open market.
 Complexity: competences are nurtured from many linkages among resources and
activities that are mostly impossible to identify and replicate.
 Causal ambiguity: because of the difficulty of attributing cause and effect the
causes of superior performance are unclear, even to company insiders.
 Culture: competences may be embedded in the organisational culture and cannot
be replicated outside the context of the particular company.
A major problem with the resource based approach is that it shrouds success in
mystery. It would appear that core competences are so rare and difficult to imitate
that sustainable competitive advantage is unique to every company that possesses it.
The question that then arises is how sustainable competitive advantage arises in the
first place. It may be the case that successful companies are not necessarily there
because anyone has superior insight in organisational design or strategic fit. Instead
there are typically many views in the company regarding the capabilities a particular
activity requires and it is the market, rather than the visionary executive, that selects
the most effective match. It can be argued that strategic capabilities are established
by market forces rather than being designed, which is consistent with the economic
perspective on strategic success discussed above.

The implication is that, by definition, there is nothing to be gained from analysing

successful (or unsuccessful) companies. That is not the view taken in this course.
There are, of course, many things that cannot be fully explained. But there is a great
deal that can be explained by the application of appropriate strategic concepts and
tools.
1.2.4 Rittel’s Tame and Wicked Problems

It should be clear from the preceding discussions that strategic planning, or strategy,
is a complicated subject. If you think of strategy as being a problem to solve, say for
a particular company, it does not take long to realise that it is incredibly complex;
the trouble is that there is a lot of confusion about what the terms ‘difficult’ and
‘complex’ actually mean. At one time, for example, it was thought that the problem
of running an economy efficiently was solvable in the sense that a sufficiently
powerful computer program could work out all input requirements for feasible
outputs and allocate resources accordingly. The planners in the old Soviet econo-
mies fell into this trap, and were of the opinion that it if you worked at it long
enough it would be possible to plan the economy. But what if the basic premise
were totally wrong, i.e. it is not possible even in principle to plan an economy or a
company with any degree of precision? The implications of this are quite profound
because if the notion that a ‘perfect’ plan is mistaken in principle we move into
different conceptual territory.
Here is a warning before you tackle the rest of this section. Some students find
this argument somewhat academic and feel that it merely defines the difference
between ‘scientific’ and ‘non‐scientific’ problems. However, this is not the case
because the distinction is between different types of problem, whether they are
defined as scientific or not. It is usually felt that strategy problems are difficult
because they are complex, but the shortcoming of focusing on complexity becomes
clear when problems are classified as ‘tame’ or ‘wicked’ in the sense used by Rittel8.
In this scheme, wicked means much more than incredibly complex. For example,
consider Fermat’s Last Theorem; in about 1637 the mathematician Fermat noted
that he had a proof for the proposition that there were no three numbers which
would fit the expression
xn + yn = zn
where n > 2
The trouble was that he claimed not to have sufficient room in the margin to
elaborate the proof. The search for the proof occupied many mathematicians for the
next three hundred years, and it was not until 1993 that Andrew Wiles, after many
years of effort, found the solution using highly refined and abstract mathematical
concepts. There is no doubt that Fermat’s Last Theorem is an incredibly complex
problem, but consider it in the light of Rittel’s distinction between tame and wicked
characterised in Table 1.1.

Table 1.1 Tame and Wicked problems

Property Tame Wicked
1 Ability to formulate Can be written down No definitive formulation
the problem
2 Relationship between Can be formulated Understanding problem is
problem and solution independently of solution same as solving it
3 Testability Either true or false Solutions good or bad
relative to each other
4 Finality Clear solution No clear end and no
obvious test
5 Tractability Identifiable list of operations No exhaustive identifiable
can be used list of operations
6 Level of analysis Can identify root cause Never sure whether a
problem or a symptom
7 Reproducibility Can be tested over again Only one try: no room
as in a laboratory for trial and error
8 Replicability May occur often Unique
Is Fermat’s Last Theorem a tame or wicked problem? The following classifica-

tion suggests that it is overwhelmingly a tame problem, despite its great difficulty
and complexity. You may disagree with some of the individual classifications, but it
is unlikely that more than two categories can be unambiguously classified as wicked.
Classifying Fermat’s Last Theorem as Tame (T) or Wicked (W)

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

clear difference between mathematical problems and strategic problems.

1 It is difficult to formulate the problem not only because it is complex, but W

because the same information can be interpreted in many ways.
2 The process of formulating and understanding the problem goes a long way W
towards solving it. This is partly because there are so many dimensions to
strategy issues.
3 The scientific approach cannot be used to test solutions (see later). W
4 It is not clear where the problem ends because of real world dynamics. It is W
impossible even to visualise the time frame over which a proposed solution
will prevail.
5 There are many techniques which can be applied, and no agreement on W
which is most effective in which circumstances. This is characterised by
management ‘fads’ which come and go regularly.
6 The cause is usually not clear, and symptoms are often confused with W
problems; for example, a falling market share may be a symptom of
diminishing competitive advantage.
7 Opportunities typically only present themselves once, and it is impossible W
to go back in time and try again.
8 Each business problem is unique, although it may share common features W
with other situations.
While there is room for discussion on the extent to which each issue can be
classified as tame or wicked, there is no doubt that strategic planning emerges
overwhelmingly as a wicked problem. Managers may feel that they understand
strategy problems better than Fermat’s Last Theorem, and that they could never
remotely understand the solution to the Theorem; but in fact it is meaningless to
compare the two types of problem because they are intrinsically different.
For example, consider the case of a company that is losing market share. What is
the root cause? The type of argument and suggested solutions that might be
submitted by different managers are as follows.

Manager Argument Solution

Marketing The product is no longer sufficiently differentiated Reduce price
manager compared with competitors so customers are no longer
willing to pay our price
Production The marketing department does not give us sufficient Improve
manager warning to meet orders communications
R&D Not enough has been spent on development in the past Spend more on R&D
manager few years at a time when competitors have been
improving their products
Finance Because of falling profitability it has been necessary to Reallocate resources
director economise and it was decided to cut back R&D rather
than attempt to slash budgets across the board
Accountant Funds could be obtained if investments were financed Borrow from the bank
by borrowing instead of by retained earnings, which
have largely disappeared
Strategist Falling market share is a symptom of a deeper problem, Company management
which is that company management is reactive and is both the problem
unstructured and the solution
This discussion, variations of which occur repeatedly in real life, touches on all
eight Rittel properties. There is no agreement on formulating the problem (1). Each
formulation suggests its own solution: lower the price, increase R&D expenditure,
borrow money, or whatever; but if the strategist is right, then understanding the
problem is the solution (2). None of the suggested solutions provides a full answer
(3). It is not possible to test which solution will solve the problem (4). There is no
agreement on how the problem can be solved (5). The strategist claims the problem
is a symptom (6). There is only one opportunity for action before the company goes
bankrupt (7). The set of circumstances facing the company is unique in its experi-
ence (8).
It was stated earlier that there is no agreement among executives or academics
about the definition of strategy. Given the intractable nature of many business
problems this does not now appear surprising.
1.2.5 The Origins of Strategy and Tactics

The roots of the word ‘strategy’ lie in the Greek strategos, meaning a general, stratos
meaning an army, and agein meaning to lead. Some dictionaries define strategy as the
planning and implementation of military campaigns; its meaning has widened in
common use to include activities such as gaming and business, in which planning
and the implementation of plans are undertaken. In the expression ‘strategic
planning’ the term ‘planning’ is therefore tautological, since it is already included in
the concept of strategy. Despite the tautology, the term has now been accepted in
general use, particularly in business schools and in the literature relating to strategic
activities in business. Given the origins of strategy, it is not surprising to find that
many of the ideas of military strategy have been carried over to business strategy;

these include setting objectives, identifying strengths and weaknesses, organising

resources accordingly and evaluating outcomes.
Tactics is a notion which is closely related to strategy. Again, the meaning can be
clarified by the Greek roots: taktikos meaning fit for arranging, and taktos meaning
ordered. The military definition relates to the science or art of manoeuvring in the
presence of the enemy. Thus, in the military context, strategy is deciding what is to
be done, and tactics is deciding how individual objectives are to be achieved.
The attempt to transplant these military ideas into business has led to some de-
gree of confusion. The basic reason for this is that running a business is not truly
analogous to fighting a war, although there are many similarities in a competitive
environment. Figure 1.1 is by no means definitive, but it gives an impression of the
difference between military and business strategy.
Armed forces
Military Enemy
Resources
Competitors
Business Customers
Market
Figure 1.1 Business and military strategy

The primary objective in military strategy is to defeat the enemy, and this is done
by direct attack on the enemy’s forces and/or by destroying the enemy’s resources.
However, in business the objective is to get people to buy the company’s products
and make a profit in so doing. The company does not attack competitors directly in
the sense of killing their sales forces and burning their factories. The path to success
lies in activities such as capturing market share and controlling costs. This may lead
to the weakening of competitors, but their destruction is not a precondition of
success; competition never really goes away, and the manager who thinks that the
removal of a major competitor will permit profits to be made without interference
does not really understand the market place. There is always the possibility of new
competitors appearing.
In practice the difference between strategy and tactics is not clear cut in the busi-
ness context, and the term strategy tends to be used in relation to any action with
long term implications. Decision makers usually tend to think in terms of formulat-
ing strategies to achieve objectives decided at the level above them. Thus in business
strategic planning is a combination of strategic and tactical decisions, and it is
probably pointless to attempt to distinguish between them. Given the imprecision
of the terminology, and the activity itself, it is not surprising to find that various

terms are used to describe the process: they include strategic management, business
strategy, business policy, corporate planning and long range planning.
1.2.6 Strategy and the Scientific Approach

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

that the scientific method is unduly constrictive, and the major discoveries have not
been made as a result of following it. In fact, this view holds that discoveries are
much more the result of lateral thinking and chance events, and that subsequently
they are made respectable by framing the discoveries in the scientific manner.
Thomas Kuhn pointed out that the prevailing mode of thought, or scientific
paradigm, determines what is thought of as science, and the paradigm itself is
subject to change over time. The scientific paradigm that the earth is flat and is
orbited by the sun was only overturned after a great deal of controversy; similarly,
the scientific approach outlined above is just a paradigm of thought, and is not even
rigorously applied in physics, a discipline in which there is a great deal of speculative
thinking.
It is intuitively attractive to apply the scientific method to strategy making and, by
following the approach used to estimate economies of scale, identify criteria for
effectiveness which can be applied in a variety of circumstances. But when attempt-
ing to apply the scientific method to the question of what course of action is likely
to lead to success for a company, we are faced with several intractable problems.
 As indicated above, there are different views on what strategic planning actually
is; for example, many studies have attempted to measure the impact of planning
systems on company performance, but planning systems and strategic planning
are not necessarily closely related.
 The types of company, the environments in which they operate, and the prob-
lems facing them, are so different that it is difficult to do more than draw general
similarities among companies and situations. In other words, the range of varia-
bles which would have to be controlled for is enormous.
 There may be significant interactions among variables; for example, economies
of scale may only occur in certain circumstances, and the use of company size on
its own as an indicator of potential economies of scale may be misleading. An-
other way of expressing this is that the company as a whole is more than the sum
of its individual parts, and undue emphasis on disaggregating the functions and
characteristics of a company can obscure the overall picture.
 Companies and their markets change with the passage of time, and combined
with the inevitable lags between actions and outcomes, it becomes impossible to
disentangle cause and effect. In other words, it cannot be inferred with certainty
that a company succeeded either because it made the right decisions or because
circumstances turned out to be favourable in relation to what it did. It is easy to
fall into the trap of post hoc, ergo propter hoc, i.e. the fallacious reasoning of being
after this, therefore being because of this.
 The wicked nature of many business problems means that the scientific ap-
proach cannot be applied (testability, reproducibility, replicability).
So there are two levels of problem in trying to find out anything about the real
world. First, the scientific method cannot provide definite answers; at best it is a
rigorous approach which identifies the necessary steps in an investigation. Second,
the data available in real life do not make it possible to test hypotheses about
strategy.

The problem of dealing with large numbers of interacting variables subject to lags
is not unique to the analysis of strategic planning; research into education is another
example where student, teacher and social characteristics are notoriously difficult to
measure, and interaction effects between teachers and students are likely to be
important. Researchers have to make a choice between two approaches to educa-
tional studies: concentrate on relatively few institutions in depth, or carry out a
large-scale survey on many institutions. The large-scale study cannot take into
account as many variables as the in-depth study, and may omit many potentially
important variables; furthermore, those variables included in the study may not be
the most important but merely those most susceptible to measurement. However,
the results obtained in the large-scale study are likely to be of general applicability;
while the small-scale study can take into account many more variables the results
cannot be generalised because they may be particular to the cases studied. There are
therefore costs and benefits associated with both large-scale and in-depth method-
ologies.
Research into strategy is dominated by the in-depth approach, which means that
any prescription for ‘best practice’ strategy is usually corroborated by reference to
relatively few cases. A feature of the strategy literature is that it is heavily spiced with
anecdotes, and evidence in favour of hypotheses comes in the form of what is
sometimes known as casual empiricism. But if there is no scientific proof in favour of
different courses of action, how is it that experts in strategy command very high fees
for telling companies what they should be doing? To some extent there is a degree
of fashion in strategy advice. There is no doubt that experts have offered different
prescriptions for strategy approaches: that consistency of delivery is the key issue;
that striving for higher quality is a major success factor in its own right; that
diversification is an essential aspect of company growth; that company success
depends on the identification and exploitation of core competencies; that interna-
tionalisation is the engine of growth; that a strong home base is a prerequisite for
international success. The scientifically trained may find it puzzling that so much
credibility is attached to prescriptions which have no empirical foundation. On the
other hand, managers point out that they have to operate in an environment in
which the scientific approach cannot be applied, that the anecdotal approach is
better than nothing, and it is necessary to use what we do know in order to intro-
duce rationality into decision making.
One of the best-known attempts to identify the company characteristics which
lead to strategic success is contained in the book In Search of Excellence.9 The authors’
quest for the characteristics of excellent companies was based on a non-random
sample of 43 US companies which fulfilled stringent market conditions for success;
these included three measures of growth and long term wealth creation over a 20
year period, three measures of return on capital and sales, and the view of industry
experts on the company’s innovative track record. With the resources at their
disposal it was possible to interview 21 of the companies in depth, and conduct less
intensive studies on the remainder. The research identified eight attributes which
characterised the excellent, innovative companies as defined. Without going into the
details of these attributes, the authors acknowledge that ‘Most of these eight
attributes are not startling.’ They also acknowledge that the eight attributes were not

present to the same degree in all of the companies studied; however, the authors
claimed that there was a preponderance of the eight in each company, and that the
general traits of the companies were obvious. This is something which we have to
take on trust. The point here is not to criticise the research, but to use it as an
example of how difficult it is to find out anything from the experience of actual
companies.
The authors also acknowledge that they cannot guarantee that the companies will
remain in the excellent category, but they do maintain that these companies will
cope with adversity better than companies which do not have their attributes. This
brings us to the logical problem in interpreting the research findings: the companies
were defined as being excellent on the basis of being good market performers and
having a good innovative track record; another way of looking at this conclusion is
to say that successful companies stand a better chance of being successful in the
future, and the attributes identified in the research may have little to do with future
success. It does seem rather odd that all of the excellent companies exhibited the
identified attributes; there is clearly a danger here of having identified companies as
being excellent on the basis of the attributes in the first place, because that was what
the researchers were looking for. Because business conditions are continually
changing, it is difficult to falsify or verify the authors’ claim of continuing success;
there is no doubt that the 43 companies in the study have gone in different direc-
tions: Wang Laboratories failed as did Digital Equipment, and General Motors’
market share in the US dropped from 55 per cent to 25 per cent, the company
losing $4 billion in 1991; on the other hand companies such as Disney Productions
have continued to be highly successful. But this is not the whole story, since Disney
found it extremely difficult to transplant its successful US operations into France –
the troubled history of Euro Disney is discussed in Practice Final Examination 2.
An important issue is whether they have performed, and will continue to per-
form, as a group better than companies which did not exhibit the excellent
attributes; this would be the subject of another research project. On balance it
seems that the research did not identify all the attributes of successful companies,
nor can we be confident that those which it did identify were relatively important.
For example, it may be that the history of these companies since 1982 can be
explained by changes in competitive conditions, and the degree of competitive edge
conferred on them by the identified attributes had only a minor impact on their
performance.
An attempt to determine whether strategy making processes rather than other
company characteristics make a difference to company performance was carried out
by Hall and Banbury.10 This was a large-scale study which obtained responses from
over 300 companies, and it is interesting for the light which it sheds on the prob-
lems of carrying out research in the area rather than in the statistical findings
themselves (which are hedged with qualifications because of the limitations of the
study). The objective of the study was to concentrate on whether a strategy process
was followed rather than what it was; for example, the split between the rational and
the incremental approaches was considered too simple to be useful. What the
authors considered important was the accumulation of strategy skills over time, or
the development of a strategy making process capability; this is clearly a subjective

variable and is open to interpretation based on the information provided by the

respondents. They pointed out that the one variable which cannot be used as a
performance measure is current profitability, because of lagged effects; this means it
is necessary to use measures such as new product development, innovation, social
responsiveness and growth, all of which are also subject to subjectivity and may be
irrelevant in certain cases. By and large, it was found that strategic process capability
counts: that the more firms in the study were able to develop competence in
multiple modes of strategy making processes then the higher their performance. But
the authors make a telling point which makes it impossible to draw specific lessons
from the study: the direction of causation may be the other way round, and it may
be that successful firms adopt processes which accord with the definitions of
strategic process capability. This is a particular problem when looking at a cross
section of companies at one time, where it is not possible to pursue the dynamics of
strategy making and performance. So even a well specified and conducted study
which produces statistically significant findings may contain little more than a
description of the way the world is.
The main problem in trying to relate cause and effect is that strategy is also con-
cerned with the behaviour of competitors. Decisions are not only taken in the
context of unpredictable outcomes, such as market growth and the business cycle,
but have to take into account confrontation with other companies, each of which is
trying to achieve a competitive advantage. If one company is capable of carrying out
an analysis of market conditions, it stands to reason that other companies can do so
also, and may well have exactly the same information at their disposal. Strategy
decisions may then become something of a guessing game, where managers attempt
to predict what competitors will do rather than analyse options derived from
financial and economic appraisal. As a result an elaborate and sophisticated strategy
based upon the latest thinking in the business disciplines may be associated with
failure because a major competitor did something totally unexpected. Another way
of looking at this is that strategy is about the unknowable as well as the unpredict-
able.
This account is by no means a full review of the research that has been carried
out in this field or the continuing research programme. But it serves to demonstrate
the intractable nature of research in the strategy area and why the research has little
impact on practising managers: it is virtually impossible to prove or disprove any
hypothesis relating to strategic decision making. You may wonder why, in that case,
anyone would bother to carry out academic research in such a potentially unreward-
ing area. In the academic arena the fact that it is difficult does not mean it is not
worth trying to understand how the world works; at the very least, appreciating the
insights into the difficulty of testing hypotheses provides managers with a perspec-
tive on which to judge unsubstantiated assertions made by business gurus who
charge very high fees for extolling platitudes.
It is not usually appreciated how the lack of an appreciation of the scientific
approach affects everyday discussion and decisions. For example, the board of
directors of a large company enrolled the services of a world famous business guru
to advise on the appointment of a new CEO. The guru advised that the main
characteristic of the new CEO should be decisiveness because the previous CEO

had allowed the focus of the organisation to become blurred. So the hypothesis
underlying this assertion is that there is a causal relationship between decisiveness
and company success. The following demonstrates the sequence of steps that could
be taken to determine the truth or otherwise of the assertion.
Start by framing research question Does a decisive CEO lead to success?
Is the converse true? A non-decisive CEO leads to failure
Since this is not necessarily true qualify A decisive CEO leads to higher success than a
the statement non-decisive CEO
This is too deterministic: qualify further A decisive CEO has a higher probability of
success than a non-decisive CEO
But the conditions need to be con- A decisive CEO leads to a higher probability
trolled of success than a non-decisive CEO, all other
things being equal
Is this a testable hypothesis? Necessary to measure variables
Define terms Decisive; Non-decisive; Success; All other
things
How do you achieve all other things Collect masses of data
being equal?
Which direction is causation? It could be that success makes leaders appear to
have been decisive
Consider a functional relationship Success = f(decisiveness, price, competitors, first
mover, etc.)
Rittel It may be a wicked problem not amenable to
this kind of analysis
Anything can be ‘proved’ depending on Select variables, measurements, specification,
the use of evidence lags, statistical techniques, etc.
By the time these steps have been worked through it is obvious that the original
statement is no more than an assertion and does not lend itself to systematic proof.
In fact, using any of the steps to frame a question is probably sufficient to expose
the weakness of the argument. For example, a Director could ask the guru ‘Can you
define your terms?’ or ‘What is the direction of causation?’ A major benefit of
understanding the scientific approach is being able to ask the right questions.
But this is not the end of the story. The advice was based on lack of organisa-
tional focus, so is the real causation that decisiveness leads to increased
organisational focus leads to success? We now have two research questions instead
of one, with the link between decisiveness and success becoming increasingly
tenuous. This is an example of Rittel’s property 6 – we are having difficulty identify-
ing the root cause. This analysis provides additional insight into why strategy
discussions tend to appear haphazard; for example, there are unrecognised hypothe-
ses and terms are not defined.

1.2.7 Strategic Planning and Strategic Thinking

So far we have seen that strategic planning is a complex activity, that it has many
definitions, that there are at least three different approaches to strategy, that strategy
has the characteristics of a wicked problem, and that the scientific method cannot
be applied to strategy. By this time you might well feel that we have not been able to
pin down exactly what strategic planning is, but all is not lost. We can in fact arrive
at a useful definition of what strategic thinking is about.
It emerges from the discussion in Section 1.2.2 that functional specialists tend to
regard business issues from their own perspective. Take the case of a new product
launch. To the organisational behaviour manager a new product launch means
internal change and its management; to the marketer it means market research and
consumer behaviour; the economist is concerned with whether it is the right time to
be investing in expansion; to the accountant it means break-even analysis; to the
financer it means discounted cash flow and the rate of return; to the project
manager it means making time, cost and quality trade-offs. Therefore to visualise the
implications of a new product launch for a company it is necessary to synthesise the
business disciplines.
To complicate matters the fact that business problems are wicked means that
they tend to be loosely defined and it is not always clear what the problem is and it
is never quite clear whether a satisfactory solution has been arrived at. A company
may embark on change for a variety of reasons; at one level it may be because it
seems like a good idea to launch a new product, while at another level the company
is at a stage when it needs to diversify its portfolio because its existing products are
nearing the end of their product life cycles. Furthermore, the competitive environ-
ment is dynamic and constantly changing, with the result that yesterday’s answers
may be overtaken by today’s competitor reactions. This means that it is necessary to
bring very high-level evaluation skills to bear in choosing among competing courses
of action.
So at this stage we have identified two skills which are fundamental to strategic
thinking: synthesis and evaluation. These two skills can be plotted as in Figure 1.2.

High
Identify relevant models Strategic Thinking
Synthesis
Core MBA subjects:
Organisational Behaviour
Project Management Use prescribed models
Economics
Marketing
Finance
Accounting
Low High
Evaluation
Figure 1.2 Strategic thinking

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

Strategy decisions are by their nature complex, and involve many imponderables.
The selection of a course of action depends on the availability and interpretation of
information, analysis, intuition, emotion, political awareness and many other factors.
Different individuals and groups emphasise different aspects and, in the sense that a
strategy decision is an advance into the unknown, there is no correct course of
action; all that can be done is to interpret the current situation, form expectations

about the future, and act according to personal views on risk and the likely course of
events. It is usually possible to identify courses of action which are unlikely to be
successful, and in that sense understanding the strategy process can have real
benefits in helping to avoid disastrous courses of action. It must be stressed at the
outset that it is naive to suggest that strategy decision making can be expressed in a
mechanistic fashion, where the optimum course of action is identified solely on the
basis of an analytical investigation. However, it would be defeatist to conclude that
strategic planning is not susceptible to structured analysis.
1.3.1 Strategy Dynamics

It is important to stress from the outset that strategy problems cannot be analysed
and resolved and then more or less forgotten about. In real life the day never comes
when strategy decisions are made and all problems are solved. This is because the
environment within which the company competes is constantly changing: products
move through the life cycle; new companies enter the market; consumer preferences
change; government regulations change; major political events alter markets both
domestically and internationally. Thus the functional view of management, i.e. the
view that there is a set number of objectives to be tackled by individual managers
which, taken together, determine the effectiveness of the company, is a limited
interpretation of the strategy problems which companies face. Strategy can only be
properly understood in a dynamic rather than a static setting.
It is only relatively recently that scientists have discovered the peculiar properties
of complex interdependent non-linear dynamical systems. The best-known exam-
ples are in weather forecasting, where the models are so complex that changes in the
inputs have unpredictable effects; in fact, the patterns over time produced by such
systems are highly sensitive to initial conditions. It was discovered that a great deal
of what was thought to be random was in fact deterministic but chaotic, in the sense
that it could be described mathematically but exhibited what appeared to be random
behaviour. This led to renewed interest in modelling the behaviour of the stock
market, the behaviour of which has always defeated attempts at prediction. Needless
to say, this has not been at all successful (or if it has been no one is saying). A
company can be regarded as a complex dynamical system interacting with its
environment; this can be modelled in such a way that relatively small changes in the
environment will at times cause significant changes in company performance. If the
performance of companies is chaotic it is impossible to model them or to predict
their behaviour; the firm itself can be regarded as a complex adaptive system which
attempts to develop rules which will enable it to function in the complex environ-
ment. At first, this might seem to be a bit theoretical, but it is as well to bear in mind
the possibility that the business system itself is possibly not capable of being
explained or predicted because of dynamical effects.
To pursue the dynamic dimension of strategy the following example examines
the process by which a Mythical Company arrives at a strategy decision. It is not
derived from a specific ‘real life’ company example because it is designed to bring
out many facets of strategy without relating it to a specific case; it is partly based on

discussions monitored in management groups running simulations of companies

and analysing company cases.
The CEO of this Mythical Company is cast in the role of strategic planner, and
every day he comes into work he asks himself questions like the following:
 How well are we performing?
 What should we be doing in the future?
 How can we achieve successful change?
1.3.2 The Mythical Company

The company is engaged in the production of electrical components for both
consumers and companies. It has been in existence for five years, and currently
produces three products which are related to each other both in their productive
and market characteristics (Plugs, Switches and Fuses). Current sales amount to
about $350 million per annum, and the company employs about 300 people. Of
these, 250 are employed in manufacturing, and the remaining 50 in research,
development, administration and marketing. The company is organised into three
product divisions.
From now on we follow the CEO as he pursues his role in strategic management
by tackling his three questions.
1.3.3 How Well Are We Performing?

CEO’S STATEMENT TO THE BOARD
The company has been making a profit for the past three years, but there are
signs of increasing competitive pressures in existing markets; the research de-
partment has some products under development which at this stage seem to
have the potential to generate profits, but might entail some change of direction.
The first step is to get reports on current activities from each functional area in
the company; these reports should be expressed in non-numerical terms because
we are concerned with the overall view at this stage rather than the precise de-
tails.
ACCOUNTING REPORT
The company is currently making 14 per cent return on assets. But the Plug,
which was launched last year, is currently making a negative contribution to
overall performance, and profitability would be increased by abandoning it.
While our overall operating surpluses generate a good return on assets, our cash
flow position is not good because of current expenditure on research and devel-
opment. Are we convinced that there is a long term payoff from continued
expenditure on research and development at the current level?
RESEARCH AND DEVELOPMENT REPORT
We currently have four products under development which will be ready for
launch in the next year. These will complement our existing product lines, and
one of them represents a major technological breakthrough. Furthermore, we

have a highly productive team engaged in the search for new ideas, and we are
confident that we shall continue to produce a stream of potentially profitable
prototypes in the future; these are, after all, the life blood of our company, since
without new products we shall not last very long. The company should not
adopt a short-sighted and restrictive approach to our budget.
MARKETING REPORT
We are in a highly competitive market, and the product life cycles are quite short,
and may become shorter in the future. We have two cash generating products in
the Switch and the Fuse, and a potentially profitable product in the form of the
Plug. At the moment the Switch and the Fuse are subsidising the Plug, but the
prospects for the Plug are very good in the longer term; we cannot make deci-
sions on abandoning the Plug on the basis of its historical contribution. It is
essential that we not only keep the Plug on the market, but that we continue to
search for new products. We need to increase our product portfolio if we are to
accommodate the combination of life cycle effects and increased competition.
However, we should be wary of diversifying into areas where we have no experi-
ence of selling, and where production skills may be different. While market
shares are reasonably secure for the Switch and the Fuse, our technological ad-
vantage in both has been undermined by imitators from abroad; it looks as
though we can expect the selling price of both to fall by about 20 per cent over
the next couple of years as competition intensifies.
FINANCE REPORT
The marketing department has provided projections of demand for the four
products which are in the development stage, and the accounting department has
provided details of likely cost. A detailed financial appraisal suggests that only
two of the four projects currently being developed seem capable of generating an
adequate rate of return. Development of the two poorest products should be
abandoned, and we should devote more resources to basic research, i.e. to identi-
fying new market opportunities. The marketing department has pointed out the
problems of moving into new markets; however, there may be some advantage
to diversifying our portfolio of risks.
ECONOMIC REPORT
The economy has been in a depression for the last couple of years, but the gov-
ernment’s more liberal monetary policy seems likely to cause a substantial
stimulus to economic activity. In fact, if the economy had been in better shape
we would have been more profitable than we have been. We should be looking
forward to buoyant demand in most sectors during the next year. However, the
international sector has become increasingly uncertain. It is likely that the cur-
rency will depreciate and this would be to our advantage in export markets.
However, there is a move towards protectionism which could have serious con-
sequences for our sales in some countries.

PRODUCTION REPORT
We have not coordinated production and orders very well, and we have built up
substantial inventories of Switches and Plugs, while we have backlog orders for
Fuses. We should be diverting resources to the production of Fuses at the ex-
pense of Switches and Plugs. However, if we switch manpower about we may
adversely affect productivity. It may be more cost effective to sacrifice sales of
the Fuse because of the increase in unit cost which would result from reducing,
even temporarily, output of the Switch and Plug. Furthermore, I have some
reservations about the accounting department’s conclusion that the Plug is a
liability; we have been producing a substantial proportion of output for invento-
ry; the problem is not that we are incurring high production costs, but that we
are not actually selling what we are making. We currently have a poor system for
communicating production requirements.
MANPOWER REPORT
We have now developed a skilled and motivated labour force, and this is reflect-
ed in the fact that unit labour costs are now 10 per cent lower than they were
three years ago. We have been able to provide stable employment for the labour
force and a general feeling of confidence in job security with the result that the
attrition rate is minimal.
CEO’S SUMMARY
We now have information on which to base an analysis of our strengths and
weaknesses. Our strength is that we have carved out profitable markets for two
products, and there are some signs that our third will make a contribution to
profits in the future. We have a company which has a structure and workforce
which provides us with a potential cost advantage; we also have a productive
research department. We have some internal weaknesses, such as the fact that we
are not always coordinating production and sales, with consequent inventories
and backlogs. Our main weakness is external; there are ominous signs that com-
petition is increasing in our established markets and if we wish to grow it may
have to be in a different direction. We may not be equipped to do this.
1.3.4 What Should We Be Doing in the Future?

CEO’S STATEMENT
There are three broad strategies which we could follow. First, we could carry on
doing the same things as in the past, and accept that our markets are likely to
come under increasing competitive pressure. We can rely on the invention of
new products to carry us into new markets as the old ones disappear. Second, we
could attack our existing markets more aggressively, attempt to maintain or in-
crease market share, and accept that this will lead to short-term reductions in
profitability. However, over the longer period this has the potential to pay off.
Third, we could combine the second option with expansion into new markets to
diversify our activities. I have had some informal discussions with Easy Tur-
bines, who would welcome a friendly takeover because of their cash flow

problems. This would give us a relatively painless entry into the turbine market,
but carries the risk that we do not know much about making turbines or the
turbine market. However, this will provide us with a basis from which to grow in
the longer term. We now require a report from each functional area on potential
future courses of action.
RESEARCH AND DEVELOPMENT REPORT
Given the four products we are currently developing, and the number of ideas
which we have for prototypes, we see the possibility for significant diversified
expansion in the medium term. All we need is an additional $5 million over the
next year to speed up the launch of our development projects.
FINANCE REPORT
Our colleagues in research are being a bit optimistic, because only two of the
products they are working on seem capable of generating a positive NPV at the
current cost of capital, even on the most optimistic marketing estimates. Fur-
thermore, we have not been explicit enough in the past in relation to the
measurement of risk, and our attitude to risk taking. The risk adjusted rates of
return suggest that we should stay in the markets we have already developed, and
only venture into new ones as a last resort. However, the fact that Easy Turbines
has cash flow problems at the moment means that we might be able to acquire it
at a bargain basement price.
ECONOMIC REPORT
The prospects for the economy are good, and profitability will increase next year
even if we do not change our current marketing strategy. However, it is likely to
be difficult to increase market shares because the price elasticity of demand for
our products is quite low. The new products should be highly successful on
launch, because they are mainly aimed at export markets and there are signs that
the currency is going to depreciate significantly in the next few months. Longer
term prospects will be partly dependent on diplomatic solutions to increased
protectionism.
MARKETING REPORT
There is a limit to how long we can stay in our established markets. Our Cash
Cows could come under competitive attack at any time. We need to diversify to
stay alive in the long run, and the four products which the research department
have on the stocks would fit the bill perfectly. Some of them may not seem fi-
nancially attractive, but the financial analysis takes a very narrow approach to the
benefits of developing a new range of products. I am not sure about the pro-
posal to enter the turbine market through acquisition because at this stage I do
not know much about that market. I would like to know if Easy Turbines’ cash
flow problems have been due to sales problems.

ACCOUNTING REPORT
If we try to follow a strategy of diversification we shall quickly run out of cash,
because the pay back period of the new products on the stocks is quite long,
even assuming that the marketing department is not being overly optimistic in
relation to expected sales. Furthermore, the measures of return on investment
and capital employed will be adversely affected, and this is likely to affect our
share price, perhaps making us susceptible to takeover, never mind us taking
over Easy Turbines. I think the idea of taking over another company is far too
speculative and is not a realistic option.
PRODUCTION REPORT
At the moment we have spare factory capacity, and there is no problem in re-
cruiting more labour, given the current state of employment in the local area.
However, if we do embark on expansion into new products we shall have to
undertake a major training programme.
MANPOWER REPORT
Any attempt to diversify must take into account that an infusion of labour, and a
change in what people are doing, may have substantial implications for morale.
The attempt to exploit new markets will require a change in what people do, and
we shall have to ensure that we have the backing of the complete workforce to
achieve success. There is little doubt that we shall be faced with many problems
in implementing a growth and diversification strategy, and we may be faced with
much higher attrition rates and lower productivity growth than in the past. In
this situation there is a real productivity payoff from better communications,
incentives geared to performance, and the development of a company culture.
CEO’S SUMMARY
The immediate threat facing us is that we are in danger of isolating ourselves in
declining markets where competition is becoming increasingly fierce. The poten-
tial threat facing us is that if we decide on expansion we are moving into
unknown markets which have a high degree of risk; this move may make us
open to takeover. While we could pre-empt this by taking over Easy Turbines, I
do not think the idea of diversifying through takeover is appropriate at this stage:
as far as I know, the chances of such a venture being successful in the long run
are not high – in any case it would take a long time to set up the financial infra-
structure necessary even to think about making a friendly bid for a company.
However, there are clearly many opportunities. We have the resources to exploit
our existing markets, and we have products which can be used to broaden our
portfolio. The price of the company’s shares on the stock market has been rea-
sonably stable for some time. However, the board feels that our shares are
undervalued, and that the market has not taken into account the recent relatively
large expenditures on research and development. One of the board members
recently received this confidential report on us from his stockbroker.

MARKET ANALYST’S REPORT

This company displayed strong growth for the first three years of its existence.
Since then it has tended to rest on its laurels, despite the fact that it is in a highly
competitive and changing market. Recent expenditures on research and devel-
opment have tended to depress profitability, and to some extent this has been
reflected in the share price. But there is no guarantee as yet that the company
management has the vision to maintain its current market position, or to diversi-
fy into related markets which will lead to continued growth.
It is therefore time that we shed the image of conservatism and proved to the
market that we have the ability to grow and generate profits in the long run.
There are clearly different views on what course the company should pursue. For
example, the finance department is opposed to expansion because of reservations
about the new products, but do think that an acquisition might be the way forward.
The marketing department is in favour of expansion because of optimism concern-
ing future prospects for a diversified company, and the economics department is in
favour of expansion but has reservations about the marketing strategy. The CEO’s
job is then to arrive at a decision which will be supported by the functional manag-
ers, since without them nothing can be made to work; he must acknowledge the fact
that while each of the functional managers is able to offer a reasoned exposition of
how things are and what the company should do, each is preoccupied with his or
her own viewpoint. You will notice that each functional manager tends to talk his or
her own ‘language’. If the CEO is not educated in management he might find some
of the discussion baffling; for example, the marketing manager referred to product
life cycles, the accountant to return on assets, the finance manager to a positive
NPV, the economist to monetary policy and so on. In the course of a discussion like
this each manager cannot keep asking the others to define terms. So in order to
develop a strategy from the range of views it is essential that the full implications of
what might appear to be innocuous statements are appreciated by everyone con-
cerned, and in particular by the CEO who is charged with the responsibility of
deciding what to do next. The process by which the decision is arrived at would be a
story in its own right, but suffice it to say that the management team is persuaded by
the CEO’s vision of shedding the company’s conservative image, and agrees to
pursue an expansionary, diversified strategy but without attempting to acquire Easy
Turbines.
1.3.5 How Can We Achieve Successful Change?
The CEO set the functional managers to work to prepare a programme for change.
Based on their understanding of what needs to be achieved in their individual areas
the team arrives at a five point plan.
1. Attempt to attain a higher degree of competitive advantage in existing products
and step up research and development efforts.
2. Improve resource planning by introducing ‘just in time’ techniques and co-
ordinating more closely with marketing.
3. Improve market intelligence and improve economic analysis.
4. Introduce more rigorous control systems to monitor company performance.

5. Communicate company goals to everyone; develop an incentive system and

company culture so that individuals can identify with the company’s objectives.
The exact details of how the new company objective is attained will depend on
how events unfold.
1.3.6 Strategy and Crises
Why do managers find it so difficult to get together to devise and implement
company strategy? Part of the answer is that there are many pressing problems that
must be dealt with on a day to day basis which divert attention from strategy, which
is perceived as not bearing on the immediate problems facing managers. Imagine
that the outcome of the strategy discussions is circulated on Wednesday. By Friday
the following incidents have occurred.
CASH FLOW
A major customer has run into problems and will not be able to settle current
accounts for six months. This means that cash flow for the next six months will
be negative.
MEMO from Accounting Department to CEO. In view of the additional
cash flow strains which the proposed strategy changes will involve, the strategy
changes should be shelved.
JAPANESE INVASION
In a surprise announcement, the Japanese have revealed the development of an
electrical device which will reduce market share of the Fuse by about 5 per cent,
unless a strong marketing offensive is launched.
MEMO from Marketing Department to CEO. All marketing resources will
have to be diverted to meet the Japanese challenge for the next few months; the
strategy changes should be shelved.
HEAD-HUNTED
The finance director has been head-hunted.
MEMO from Finance Department to CEO. In view of the many complex
financial issues which will be raised by the proposed strategy, we must have a
finance director of experience and vision; until we can recruit a replacement the
strategy changes should be shelved.
DEVELOPMENT COST OVERRUNS
Some unexpected problems have been encountered and the development de-
partment will not be able to bring the new products to the market within the
original projected budget.
MEMO from Development Department to CEO. We need to re-evaluate our
options but, given the turmoil in the Finance Department, this will not be possi-
ble for some time; the strategy changes should be shelved.

LABOUR RELATIONS
The first attempt at communicating the new strategy was disastrous. After a
preliminary discussion labour representatives interpreted the proposed changes
as an attempt to increase productivity at the expense of a deterioration in work-
ing conditions; the notion of a new incentive system was criticised severely.
MEMO from Personnel Department to CEO. It looks like it will take more
time than we thought to sell the proposed strategy to the workforce; the strategy
changes should be shelved until such time as we can achieve progress on this
front.
No doubt more issues will crop up the following Monday, and will continue to
emerge. The salient point is that even though the individual managers have agreed
with the overall interpretation of the current state of the company and what it
should be doing in the future, their own immediate concerns naturally appear to be
more urgent than the implementation of a course of action which has no obvious
short-term payoff. This is an example of one of the problems identified with the
planning approach to strategy: It is possible to forego short-term benefit in order to gain long-
term advantage. In this case it is turning out to be very difficult to make that trade-off.
The CEO now has several options.
 He can agree with his managers, and shelve the changes until times are more
favourable; he will be aware that this is likely to be a fond hope.
 He can attempt to amend the proposed changes to take account of what has
happened; in this case he will find himself attempting to hit a target which never
stops moving.
 He can point out that the strategy is based on an agreed vision of the company
as it exists and the necessity to adjust to the changing market place; the crises are
evidence that the company does need a strong sense of direction so that man-
agement is not merely a series of reactions to everyday events. The job of the
managers is to achieve the general objectives given that these crises are always
going to occur.
But there is another way of looking at the problems which have arisen and the
individual managers’ reaction to them. The CEO decided on a course of action and
set his managers the specific task of determining what should be done. But it seems
that no one was given the job of determining how the five point plan would actually
be implemented. Thus the CEO’s approach was strong on identifying objectives and
courses of action, but weak on implementation; as a result the overall plan was
vulnerable to the types of crisis which occurred.
It must be accepted that no plan can be inflexible, and that it should be modified
as additional information becomes available; the crisis events can be regarded as
new information to take into account in refining the overall strategy. For example,
the Japanese invasion is indicative of the fact that competitive pressures are chang-
ing more quickly than anticipated, and that some resources should be diverted to
protecting the Fuse; where these resources should come from is a problem for the
management team.

1.3.7 Elements of Strategic Planning

Apart from recognising that some degree of forward thinking is important, is it
possible to extract any lessons of general applicability from what happened? The
CEO asked various questions of the specialist managers, they generated a lot of
information and opinions, and finally a course of action was decided on. In fact
there are five aspects of what happened which are important to recognise. First,
individual managers used a structure of thought to tackle problems within their area.
Second, managers applied this structure to the analysis of data. Third, the CEO
integrated the different types of analysis presented by the managers in order to
arrive at a decision. Fourth, a control system was devised to monitor the allocation
of resources. Finally, the door was left open to modify the strategy as events
unfolded. These components of strategic planning are worth considering in some
detail.
Structure
The first thing the CEO did was to ask functional managers to provide information
on the current state of the company. He expected to get different information from
each because the functional managers bring different types of expertise to the issue.
For example, the finance manager used the theory of finance to evaluate alterna-
tives; the marketing manager used the theory of competitive advantage to work out
marketing strategies; the economist used macroeconomic theories to explain and
predict the impact of government policies on product markets; the manpower
manager used theories of group behaviour and motivation in drawing up work
schemes. These theories provide functional managers with a structure within which
to tackle problems. This structure is comprised of a body of theory which introduc-
es order into the complexities of the real world; without a structure the answers
which any of the functional managers produced could have been based on com-
pletely irrelevant factors, and this would not have been apparent. That is why it was
noted earlier that each manager appeared to be speaking a particular language.
In order to make sense out of the complexity of life it is necessary to impose an
intellectual structure on events and processes. A theoretical structure makes it
possible to tackle new problems in a systematic manner; the lack of general princi-
ples which can be applied to seemingly different issues leads to inconsistency, and to
an impartial observer decisions may appear to be taken at random. When there is no
structure, managers will not appreciate that apparently different situations share
common themes and are susceptible to similar types of analysis and solution. It is
something of a paradox that while most companies would like to have a system for
allocating resources in the long run, i.e. a means of seeing how things fit together,
which potential opportunities should be pursued, and how resources should be
mobilised to take advantage of them, it is not necessarily appreciated that this
presupposes structured thinking. For example, everyone is aware that prices vary
over time. But what is not always obvious is that relative prices often change
significantly, because changes in relative prices are often masked by general price
changes, i.e. inflation. A manager needs to be aware of the difference between
nominal and real price changes, be able to identify where there have been significant

changes in relative prices, and then be able to analyse the factors which have caused
relative prices to change. For this it is necessary to have a theory of supply, demand
and price determination.
An aspect of business which makes the application of structured approaches
difficult is that the manager’s average day is characterised by a continuous sequence
of seemingly unrelated activities; many researchers have attempted to record and
classify managers’ daily routines with the objective of identifying what comprises
efficient managerial behaviour. A general finding is that the effective manager needs
to do more than provide fast, efficient reaction to events as they occur; it is also
necessary for managers to have a structure within which priorities can be established
and objectives identified.
The notion of a conceptual structure can be generalised from the individual spe-
cialities to the company as a whole. The lack of a structured approach to planning
activities can lead to a reactive management style and arbitrary decision-making
criteria. It is a common observation in business that individual managers become
frustrated by apparently arbitrary decisions which do not relate to any overall
purpose; decisions which may be unpleasant for the individual can be made ac-
ceptable if they are seen to occur within a recognisable framework. When it comes
to making choices between competing alternatives, the absence of a structure within
which to allocate resources can lead to the company developing a random portfolio
of products; it is possible for the company to exist and grow indefinitely in such a
manner, but it is continually faced with the prospect of being confronted by
problems which might have been avoidable or predictable within an understood
structure.
In the Mythical Company, the CEO imposed a general structure on the infor-
mation presented to him by thinking in terms of the company’s strengths and
weaknesses, together with the threats posed by changes in market conditions and
the opportunities existing in related markets. By balancing up these categories he
arrived at his vision, or the strategic thrust which the company would follow.
Analysis
The information provided by the functional managers was in the form of analyses
based on their individual areas of expertise. A structure is of little use in business
unless it can be applied to real world problems. Many advanced economic theories
comprise a powerful structure of thought, but they have no relevance to business
because they cannot be used to analyse issues which arise in companies. In this case
each functional manager analysed the information relevant to his or her part of the
company’s operation and came up with a variety of conclusions.
The structure of thought requires to be supplemented with tools and techniques
of analysis in order to make sense of relationships and data. Information available in
real life often appears to be conflicting, and at times downright useless: this can lead
to the ‘don’t confuse me with the facts’ syndrome. The ability to make sense of data
and interpret statistics requires an understanding of basic concepts – in finance,
accounting, economics and marketing – which enable data to be manipulated and
events better understood; for example, why is it that when the price of gin rises the

quantity of tonic sold falls and the quantity of whisky sold increases? The reason is
that gin and tonic are complements, while gin and whisky are substitutes; when the
price of gin increases relative to the price of whisky, some drinkers will substitute
whisky for gin. Since gin and tonic are complements, the quantity of tonic pur-
chased will fall with the quantity of gin purchased. The extent to which the
quantities of gin, tonic and whisky purchased will change depends on the respon-
siveness of demand to price changes, otherwise known as elasticity.
Analytical techniques also help to identify what information is important and
what is irrelevant; in modern life the problem is typically not the lack of infor-
mation, but the lack of relevant information. For example, there is plenty of
information available on the sales of gin, tonic and whisky over time, by geograph-
ical area, across different social groups, by brand and so on. But the really important
information is difficult to obtain: the price elasticity of gin and the degree of
substitution between gin and whisky.
Many managers take the view that management is an art rather than a science,
and that concentration on data is counter-productive. It is, of course, naive to
suggest that management problems can always be solved by recourse to numbers,
and by statistical and financial calculations. However, rigour and analysis should not
be confused with manipulation of numbers. Sometimes all that is available is
qualitative rather than quantitative information, but this does not imply that analysis
is irrelevant. For example, at the very least it is useful to know whether we are
dealing with positive or negative quantities, such as whether cash flow is likely to be
positive or negative; the rough order of magnitude may be all that can be concluded
from available information, but even this can be useful in determining whether a
project is likely to be within a company’s resources. The non-quantitative analytical
approach can help identify whether the balance of influences is favourable or not to
a potential course of action. Always bear in mind that your competitors will also be
trying to make as much sense as possible from available data so adopting a non-
analytical approach could put the company at a serious disadvantage.
To summarise, the following issues have an important bearing on the analytical
approach.
1. Do not confuse rigour with numbers.
2. Precision is not essential.
3. Data can be expressed as:
 relative orders of magnitude
 positive or negative
 quantitative or qualitative
A rigorous approach to issues does not necessarily mean that numbers are in-
volved; the use of theories and concepts to clarify problems and evaluate potential
solutions can be independent of the precise numerical quantities. Conversely, the
fact that numbers are presented as part of an argument is no guarantee of the rigour
with which the argument itself has been developed.
All information about markets, finance and the economy is subject to a degree of
error. This means that there is nothing to be gained by attempting to be highly

accurate; while the appearance of several figures after the decimal point may impress
the unwary, such precision is spurious. Rather than concentrating on the accuracy of
calculations, there are some general issues to which attention should be paid when
dealing with numbers.
 Whether the orders of magnitude suggested by the numbers are large or small in
relation to the operations involved. If the relative magnitude of the numbers is
small, the issue is of minor importance; for example, a marketing analyst may
predict that the cost of introducing a new brand to maintain market share is
around $5 million, but if the total value of sales is $385 million there is not much
to be gained by attempting to be more exact about the figure of $5 million. It is
sensible to avoid spending time refining relatively unimportant items of infor-
mation.
 Whether the numbers are positive or negative; for example, is a market expected
to increase or decrease in the future, or are cash flows likely to be positive or
negative?
 Impressionistic or qualitative information has a role as opposed to numerical
information. For example, a feeling that fashions were likely to change in the late
1980s as a result of the change in attitudes towards wearing animal fur could not
be quantified, but it had important strategic implications for manufacturers of
fur coats. A fur company which realised early on what was happening could have
investigated the likely effect of, say, a 10 per cent reduction in demand for fur
coats and decide whether production should be reduced immediately and inven-
tories run down to a new level; it could also attempt to predict the effect on
prices using its knowledge of demand and supply conditions in the fur market,
and produce a forecast of the implications for cash flows. The company could
also investigate the implications of a continuing fall in demand, or stabilisation of
demand at the new low level, or an eventual return to original levels as manufac-
turers took action to counter the ‘endangered species’ argument. Compare the
likely competitive position of such a company with one which made no prepara-
tion for the change in market conditions and suddenly found itself in a situation
of unsold stocks, falling prices and cash flow difficulties.
This perspective on the effective use of information can help to throw light on
the seeming contradiction between what theory says managers should do, and what
they are actually observed to do. The theory suggests that managers should make
careful use of information in analysing situations and arriving at conclusions. But
the research reveals that managers have a tendency to rely on abbreviated and verbal
accounts. The argument above suggests that in the first instance it is important for
managers to determine the direction of change and the rough order of magnitude; in
many instances the course of action which these suggest may be virtually unaltered
by more detailed information which, because of the errors associated with infor-
mation, may itself be suspect. As a result, there are likely to be significantly
diminishing returns at the margin to the effort devoted to analytical detail. This
leads to the paradoxical situation that the educated manager is able to identify what
information is really required to deal with a particular issue, and the level of detail to
arrive at an informed conclusion in an economical manner, but that this behaviour

may appear to be shallow and impressionistic when observed by a researcher who

concentrates only on identifying the use of detail.
Integration
In the example discussed above, the CEO was faced with a variety of analyses based
on different structures. His task was then to integrate them; no single functional
manager provided the perspective to decide which of the strategy options to pursue.
The CEO added a vision of where the company was going and an overview of the
information provided by the functional managers in arriving at a strategic thrust.
Each of the business disciplines has a part to play in developing the overall strat-
egy; an important management skill is to recognise when specific disciplines can be
applied, and to identify the tools and concepts relevant to different situations. It is
not necessary for the manager himself to be able to carry out a financial appraisal or
a marketing study, but it is necessary to be able to see when such studies are
required, to understand them well enough to make constructive criticism, to
visualise the relative importance of the various results, and to be able to fit the
results into the formulation of strategy. The role of the individual business disci-
plines in successfully achieving a new product launch was outlined in Section 1.1. It
is the manager’s job to ensure that the appropriate techniques are applied at the
right time, and the manager needs to be able to grasp the meaning of the diverse
types of information which different techniques generate.
Integration is an essential component of strategy because specific recommenda-
tions in one area can have implications for other aspects of company operations.
For example, a proposal to abandon a product may be based on a financial appraisal
which suggests that the value of the company would be increased because the
product is currently losing money; the financial argument needs to be weighed up
against potential negative effects. The personnel department might argue that the
effect on employee motivation and commitment could be serious because everyone
feels that it is a ‘worthwhile’ product to make; the production department might
claim that while the product has a poor accounting contribution it has helped to
eliminate excess capacity in the past, and this is not reflected in the accounts; the
marketing department might argue that the product is still at an early stage in the
evolution of its life cycle and has a substantial longer term potential. The strategy
problem is to incorporate and reconcile the implications of the specialist disciplines,
which in this case suggest different courses of action.
Control
It was recognised by several functional managers that it was necessary to control
performance. In the light of the many crises which the company would be facing, it
was clear that it would be essential to attempt to determine how well resources were
being allocated in the pursuit of the strategy goals.
In order to monitor the performance of the company it is necessary to devise
measures which generate information on how well objectives are being attained. A
variety of measurements can be used to evaluate company performance such as
Return on Investment and Profit Margin, and the efficiency with which resources
have been allocated can be judged by measures such as Asset Turnover, Contribu-

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

has to make decisions on how to adapt to these changes. In the longer term the
CEO would require feedback on the implementation of the strategy and measures
of company performance.
An effective process which enables a company to react to changes in the envi-
ronment is crucial for long-term success in a dynamic market setting. One of the
fallacies of the planning approach to strategy identified in Section 1.2.3 was: After
careful analysis, strategy decisions can be clearly specified, summarised and presented; they do not
need to be altered because circumstances outside the company have changed.
1.4 Business and Corporate Strategy

It is useful at an early stage to draw a distinction between business and corporate
strategy because the concerns of decision makers differ at the two levels. The firm
upon which much economic theory is based is a single product entity operating in a
well-defined market. But it is obvious that a large proportion of economic activity
takes place in firms of various forms: some produce a range of outputs (horizontal
integration), some produce not only the final output but several or all of the
intermediate products (vertical integration), some market a given product in
different ways in separate markets (Pepsi-Cola), some market the product in much
the same way in separate markets (McDonald’s). The diversity of forms can be
simplified by looking at a firm as a ‘corporation’ of different activities, and focusing
on the running of the corporation as opposed to the individual firms that comprise
it.
In order to make the analysis manageable the corporate firm can be visualised as
a group of strategic business units (SBUs) which are directed by a corporate
headquarters. An SBU is an operating division of a company which serves a distinct
product-market segment or a well-defined set of customers or a geographic area.
The SBU is given the authority to make its own decisions within corporate guide-
lines.
The strategic questions addressed by SBUs include:
 What is the market?
 Which segments are products aimed at?
 What is the competition?
 Can a sustainable competitive advantage be achieved?
The strategic goals pursued by an SBU may be independent of other SBUs within
the corporation. Indeed, those working in an SBU may be unaware that another
company is part of their own corporation. Corporate strategy is therefore concerned
with issues including
 determining the portfolio of SBUs;
 allocating resources among SBUs;
 developing new business ventures;
 appointing SBU CEOs.

While the concerns of corporate and SBU strategy differ there are many common
themes, such as interpreting diverse information, allocating resources effectively,
and reconciling the short and long term. A recurrent theme is the extent to which
corporate structure adds value to the SBUs and whether the corporate entity is
worth more or less than the sum of its SBUs independently. The rationale for
having a corporate structure in the first place is that the costs of the corporate
structure are less than the benefits which it bestows on SBUs, otherwise the break-
up value of the corporation would be greater than its current value.
1.5 The Development of Strategic Ideas

Given the plethora of books about business and the apparent influence of business
gurus it is natural to assume that companies are driven by modern ideas and theories
about strategic planning. But it can be argued that strategic ideas have been the
outcome of the evolution of companies in their economic environments.
The history of the corporation in Table 1.2 shows how the pursuit of value crea-
tion has led to changes in corporate strategies over time, and how ideas relating to
corporate strategy have been greatly influenced by the outcome of previous strategic
approaches. (This outline owes a great deal to Goold, Campbell and Alexander.11)
The division of history into decades is an approximation to the time periods
involved.
Table 1.2 Corporate history and strategic ideas

Decade Strategic issues Strategic concepts Corporate strategies
1950s Centralised control Devolve responsibility Divisionalisation
1960s Maintain growth General management Diversification
skills plus Synergy
1970s Manage diversity Portfolio planning Balanced portfolio
1980s Poor performance of Shareholder value Restructuring
diversification
Value destruction Stick to the knitting
Hostile takeovers
Early 1990s Core business Core competences Linked portfolios
Dominant logic Downsizing
Parenting advantage
Late 1990s Globalisation Economies of scale Mega mergers
Global reach
2000s Knowledge Identify and maintain Knowledge management
tacit knowledge
The following brief discussion touches on many issues that will be dealt with in
detail later in the course.

Divisionalisation
After about the mid-1930s companies such as GM, Du Pont and Standard Oil had
grown too large and complex to be managed with their previous functional organi-
sation. The decentralisation of activities into divisions heralded the start of the
distinction between business and corporate strategy. But the optimal level of
decentralisation has never been established. For example, divisions (or SBUs)
typically have the power to hire and fire, but this does not extend to the appoint-
ment of divisional CEOs and other senior divisional executives; divisions often do
not have freedom of action over investment and major projects are usually referred
back to corporate headquarters; sometimes marketing strategy is set centrally and
sometimes it is left to the discretion of divisional CEOs. Thus while the concept of
decentralisation apparently made large corporations more manageable it raised
fundamental issues of control.
Diversification
It was during the 1960s that the notion of general management skills which could be
used effectively in any business setting began to be developed, and was associated
with the growth and development of the first business schools whose objective was
to identify and teach the common core of business skills. By the 1960s the estab-
lished markets of many large companies had entered the mature stage, and
opportunities for growth were now perceived to lie in diversification of activities.
This built on divisionalisation, and new companies were brought under the corpo-
rate umbrella as additional divisions (or SBUs). A compelling argument during this
period was that the assimilation of different, but related, businesses under the
corporate umbrella would lead to synergy. The quest for synergy provided a
powerful rationale for diversification through acquisition, because it offered the
promise of creating value beyond that which the business would have done were it
left on its own. Synergy in fact turned out to be elusive; this ought not to have been
surprising, because the benefits were based more on hope than on evidence (this is
dealt with in detail in Section 6.12.2). The quest for synergy often led to value
destruction rather than value creation, and this corporate weakness sowed the seeds
for later corporate strategies. Another reason advanced for diversification was risk
spreading (dealt with in Section 6.12.1); this was a questionable basis for corporate
strategy because it spread management risk rather than shareholder risk.
As the number of takeovers increased, the forces of competition led to increased
prices for acquisitions, and this reduced the scope for value creation. In fact, as take-
over prices began to reflect not only the current but the potential value of compa-
nies, diversification often led to the destruction of value because companies were
caught up in takeover battles, and ended up literally paying too much for their
acquisitions. At the same time the notion of the generalist manager started to come
under criticism: it started to become clear that ‘management’ could not be viewed as
independent of the particular business, and the emphasis turned to the importance
of focused skills.

Portfolio Planning
Economic conditions changed in the 1970s with slower national growth rates,
recession, and historically high inflation: at the same time it was generally felt that
competitive pressures had increased with advances in technology, reduction of trade
barriers and the growth of the Pacific rim economies with the result that the market
environment was much more complex and unpredictable than in the 1960s. The
management of diversity was increasingly recognised to be a problem, and the
search for a balanced portfolio of products led to the development of the portfolio
approach to product management (dealt with in detail in Section 5.7).
It was now widely recognised that unless the corporate centre could identify
value creating potential that had not already been realised and which had not been
recognised by another bidder, the company would pay the full price of a takeover,
including potential value increases. At the same time capital markets had developed
to a level of sophistication far greater than in the 1960s, and the argument that a
portfolio must include high profit products (Cash Cows) to pay for products which
had still to generate profits (Stars and Question Marks) no longer applied with the
same force; this is because in many ways internal financing is not more efficient than
external financing. It is questionable whether an investment project which cannot
satisfy external financiers should be funded by retained earnings; it is reasonable to
ask whether shareholders would be willing to invest their funds in an internal
project rather than in some other company which offers a potentially higher return.
Restructuring
The inability of many companies to manage and add value to diverse portfolios led
to takeovers by corporate raiders who saw opportunities for releasing value from
failed corporate strategies. This development was largely confined to the US and the
UK partly because of their more developed capital markets and the independence of
corporations from banks. The scale of the takeover strategy was staggering: in the
US in 1988 over 2000 companies were acquired with a total market value of over
$850 billion. The takeover battles made the specialists into household names:
Goldsmith, Milken, Kravis and Boesky (who went to jail) in the US, Hanson and
White in the UK (both of whom were rewarded with the title of Lord). The
excitement of these times was captured in the film Wall Street in 1987 starring
Michael Douglas as Gordon Gekko, to whom ‘greed is good’. The search for value
creation focused on cash flows and led to the development of techniques known as
value-based planning, which include discounted cash flows and net present values.
These financial ideas are central to understanding company valuations and value
creation but they had been largely ignored in the preceding decades.
The approaches adopted to release value in diversified companies included delay-
ering, which involved reducing management structures, and divestment, which
involved selling off parts of the corporation. The Peters and Waterman study
mentioned above concluded that successful firms had a focus (they called it ‘stick to
the knitting’); they concluded that diversified companies had performed less well
than those which concentrated on a core activity. There was now a great deal of
concern about pseudo-professional managers who knew nothing about the busi-

nesses they were running. The inevitable conclusion was that many corporations
were destroying value by the 1980s; it was no wonder their break-up value was often
found to be greater than their corporate value.
Core Businesses
Available evidence suggests that the performance of conglomerates has not been
improved by takeovers. Clearly some radical thinking was required if conglomerates
were to remain viable in the long run. The process of restructuring implies the
selection of appropriate core businesses which remain once the process of breaking
up is complete. But it is not necessarily obvious where a company’s core advantages
lie. One possible answer was to focus on related diversifications; but this would not
necessarily solve the problem of value destruction because related activities do not
necessarily reduce complexity, and there are no guarantees that the simple fact of
running two apparently related businesses under the same corporate umbrella will
lead to overall cost reductions. An alternative approach was to utilise the company’s
dominant general management logic by selecting companies in strategically similar
industries.
A dominant general management logic is defined as the way in which managers

conceptualise the business and make critical resource allocation decisions – be
it in technologies, product development, distribution, advertising or in human
resource management.12
A rather different view is that the only valid justification for a diversified compa-
ny is sharing resources and particular competitive advantages – which came to be
called core competences13 – across businesses; otherwise diversification is nothing
more than mutual fund portfolio management. One view is that businesses compris-
ing the diversified company should be viewed as a collection of competences. Even
a poorly performing business, in terms of financial indicators, may make a signifi-
cant contribution to overall company performance in terms of competence. But it is
difficult to transform this idea into practice, because it means suspending the
normal investment criteria which had been so useful in the era of value-based
planning. It is difficult in practice to predict how companies will achieve benefits
from corporate strategies based on supply chain linkages, core competences and
synergy.
Benefits of synergy are now truly legendary. Diversification and synergy have
become virtually inseparable in texts and business language. Yet … those par-
ticular benefits show an almost unshakeable resolve not to appear when it
becomes time for their release.14
While there is no doubt that the concept is important, it is not unreasonable to

conclude that linking businesses by core competences is neither a necessary nor
sufficient condition for success.

Parenting Advantage
A different approach is to identify the real benefits that might accrue from being
part of a corporate conglomerate. Goold et al. identify four potential ways by which
the corporate parent might add value together with reservations attached to each.
1. Stand-alone influence: the parenting activities include agreeing and monitoring
performance targets, approving major capital expenditures and selecting business
unit managing directors; the parenting influence may extend to product-market
strategies, pricing and human resource management. But it can be argued that
the more the parent extends its influence into the affairs of the individual busi-
nesses, the more likely it is that it will destroy value; this is the 10 per cent versus
100 per cent paradox: why should a parent manager working part time do better
than a business manager working full time?
2. Linkage influence: the parent can encourage relationships to capitalise on
synergy. But in the absence of a parent, business managers are free to establish
linkages without parental involvement; so why should the parent do any better?
This is the ‘enlightened self-interest’ paradox.
3. Functional and services influence: the parent can provide functional leadership
and cost effective services. But this creates a supplier insulated from outside
competition, and it is difficult to guarantee that internal suppliers will be as effi-
cient as the market. This is the ‘beating the specialists’ paradox.
4. Corporate development activities: the main role of the parent is usually seen as
buying and selling businesses, creating new businesses, and redefining business-
es. This amounts to changing the businesses in the corporate portfolio. But since
the weight of research indicates that the majority of corporately sponsored ac-
quisitions, new ventures and business redefinitions fail to create value, the odds
against success are long; this is the ‘beating the odds’ paradox.
While there is a potential role for the parent in the areas outlined above, it has to
be recognised that success is not guaranteed and that there are formidable obstacles
in the path of value creation. Given these obstacles, it is not surprising to find that
value has often been destroyed rather than created, and when the parent organisa-
tion is responsible for poor executive appointments, invalid objectives,
inappropriate strategies, and unsuitable review processes the potential for value
destruction is multiplied.
Globalisation
As trade barriers continued to fall, through the work of the World Trade Organisa-
tion and the formation of trading blocs such as the European Union, and capital
markets transcended national frontiers, companies increasingly found themselves
competing in an international market place. Companies in many industries began to
fear that nationally based operations would stand little chance against powerful
multinationals. Thus the late 1990s witnessed huge international mergers in indus-
tries such as financial institutions, telecommunications, energy supply, car
production and pharmaceuticals. While the arguments in favour of mega mergers
are clearly persuasive enough to provide companies with the incentive to embark on
these ventures, it is an open question whether the outcome in the longer term will

be viable, value generating operations. There is no guarantee that scale economies

will be realised, nor is there any guarantee that size will confer a real competitive
advantage in servicing distinctive local markets for goods and services.
Knowledge
It has always been difficult to build sustainable competitive advantage because
eventually anything can be imitated. In an environment of fast technological change
companies started to realise that part of their advantage lay in the knowledge and
unique skills of their experienced employees. It became a priority to identify and
classify knowledge so that it could be maintained and disseminated as required. But
it soon became apparent that the really important bits of knowledge were extremely
difficult to identify because they resided within specific individuals and were largely
learned on the job; this became known as ‘tacit’ knowledge. This presented organi-
sations with a real problem: competitive advantage and innovation depend on a
resource that cannot readily be identified or controlled. Techniques of knowledge
management began to be developed to tackle these imponderables.
1.6 Is Strategic Planning Only for Top Management?

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

Some organisational behaviour experts maintain that it is not so much the existence
of a plan which benefits the company, but the process by which a plan is developed;
this process leads to relationships among employees, and approaches to the job,
which would otherwise be missing. Apart from this general potential benefit, the
company stands to benefit in several ways from managers’ comprehension of
strategic planning.
 The individual manager is enabled to see where his or her sub-unit fits into the
overall system of objectives, and is able to interpret corporate objectives in that
light. The manager competing for scarce resources has a better understanding of
the true opportunity cost of his or her demands. Similarly, the manager is in a
better position to understand instances where cooperation is required; the reason
for such cooperation might not be obvious in the context of a limited set of
objectives. In many circumstances, managers can be excused for feeling that
decisions are simply made at the whim of their superiors since they do not ap-
preciate the overall resource allocation picture and have no understanding of the
direction in which the company is headed. This reasoning applies to all aspects
of management education, i.e. that a better appreciation of company functions
provides individuals with a more balanced view of the actions of others; com-
prehension of strategic planning has a particularly powerful role to play in the

elimination of unnecessary conflicts, and the associated effects on morale and

productivity.
 The manager will better understand which of his or her potential proposals are
likely to contribute to the overall plan; the manager will also be in a position to
produce arguments for a proposal which will be consistent with the objectives of
higher level managers.
 Because strategies are developed in a dynamic fashion, managers who are
actually involved in the process of making the company’s strategy work may not
be aware of the strategy within which they are operating. For example, economic
circumstances may lead to a change in general objectives and the criteria used to
judge company performance; it cannot be taken for granted that managers will
have an up-to-date appreciation of the company’s current strategy.
Thus, company-wide knowledge of the approach to strategic planning, and the
process by which it is arrived at, can have a positive impact on resource allocation
within the company by helping to minimise unnecessary conflict and to provide an
overall sense of direction. It is difficult for managers to feel part of a team working
towards a common goal when that goal is not clear to them and they do not see
how their individual actions contribute to achieving it.
Individual Benefits of Understanding Strategic Planning

If comprehension of strategic planning generates returns to the company, it is
clearly worthwhile for the company to persuade managers to spend time learning
about it. However, individual managers must have incentives to spend time on this
activity. The payoff to the individual manager comes in two ways. First, since the
manager will achieve a better understanding of where the company is going, and
what it is attempting to achieve, he or she should be able to take advantage of this to
predict changes likely to occur in the organisation which will be personally advanta-
geous, or disadvantageous. Second, proposals and arguments submitted to higher
level managers will be consistent with and relevant to the aspirations of the manag-
er’s superiors, and this can enhance prestige and career prospects.
But not everyone wishes to be educated in strategic planning; many employees
are content to operate within their locus of control, or comfort zone. The complexi-
ty of decision making and the realisation that competitive forces can lead to job
losses at any time can lead to feelings of insecurity and unease. A seemingly enlight-
ened policy of management education can have adverse effects. There are therefore
both benefits and costs associated with the communication of strategic planning.
Understanding Strategic Planning: Who Should Pay?

The fact that there are benefits both to the company and to the individual raises an
interesting issue concerning who should pay for the education. Since individuals
benefit from understanding strategic planning they have an incentive to pay some-
thing towards their education; the same goes for the company. However, since both
parties will obtain some benefit the issue of who should pay is a negotiating point.
There is a maximum amount which the company is willing to pay for any individu-

al’s strategic planning education, and there is a maximum amount which any
individual is willing to pay for his or her own education. In principle, the compro-
mise will fall in between these two extremes. In practice, it is often not possible for
such a negotiation to take place, and this accounts for the fact that some individuals
are willing to pay for their own education, and some companies are willing to pay
for some employees’ education.
Review Questions
1.1 The following is a hypothetical statement by the chief executive officer of a medium
sized company producing packaged breakfast cereals.
The people who sell strategic planning are certainly on to a good thing. They
don’t define their product, they have no measure of success or failure when
applying their methods, many of them seem to provide contradictory solutions,
and they can provide no proof whatsoever that they have done any good. As an
ex-army man I know a lot about strategy, and in my business I simply keep an
eye on who is doing what in the market, try to make sure my costs are under
control and keep my customers and my employees as happy as I reasonably
can. I have given up trying to look more than a year ahead, because every time I
have done so in the past, events have turned out to be completely unpredicta-
ble. In the past 10 years we have managed a 12 per cent return on capital and
have kept our market share. I don’t think I have much to learn from studying
strategic planning.
This CEO gives the impression of being complacent, and perhaps he has good reason for
feeling this way. Think up a series of questions which might unsettle him.
1.2 Analyse the strategic planning experiences of the Mythical company in terms of the
three approaches to strategy: planning, emergent and resource based.
1.3 Assess the Mythical company’s five point plan in terms of business unit and corporate
strategy.
1.4 Assess the experience of the Mythical company’s CEO in terms of Rittel’s properties.
1.5 Sometime in the future the Mythical company ran into another problem. About halfway
through the financial year the company finance director informed the CEO that half year
profits were much reduced and that there was little prospect of maintaining the
performance of the past three years. The CEO gathered his senior management team to
discuss the reasons for this setback and hired a strategy consultant to contribute. This is
an extract from the discussion.
CEO: I don’t think our profit problem is simply due to external events such as the recent
problems with the economy. It seems to me that it is more to do with the way we do
things – I am not certain that we are acting as efficiently as we could be.
Operations manager: we have actually invested heavily in more productive assets and in
training programmes in the last two years. I am not sure there is much more we can do
in that respect.
Marketing manager: I don’t think we exploited the market opportunities for our new
range of products as well as we could have done. We invested a great deal in attempting

to capture an increased share of the market early on last year; when that didn’t work
we should have channelled a lot more resources into the marketing effort. We should
have allowed for changing market conditions.
Finance director: but we had no spare resources.
CEO: we put a lot of effort into the plan and it was a great disappointment when it didn’t
work out. Maybe we need to spend even more time planning in the future.
Marketing manager: what is the point of planning in ever more detail when we can’t seem
to react to the unexpected?
Operations manager: that is a defeatist attitude. We just don’t spend enough time
collecting and analysing information.
Strategy consultant: you are approaching the strategy problem from two different
perspectives; once you have recognised this you might be able to work out where to go
from here.
What did the strategy consultant mean?

Module 2
Modelling the Strategic Planning

Process
Contents
2.1 The Modelling Approach........................................................................2/1
2.2 Strategy Making ......................................................................................2/8
Case 2.1: Rover Accelerates into the Fast Lane (1994) ............................. 2/14
Case 2.2: The Millennium Dome: How to Lose Money in the
Twenty-First Century (2001) .............................................................. 2/16
Case 2.3: The Rise and Fall and Rise of Starbucks: How the Leader
Makes a Difference (2012) .................................................................. 2/20
Learning Objectives
 To represent the complex strategy process in terms of a model.
 To show how strategic planning depends on the evolution of the company.
 To identify who makes strategy.
2.1 The Modelling Approach

A model of the strategic planning process provides a structure within which strategy
problems can be analysed. A model is a structured method of thinking which
enables the component parts of complex processes to be identified and related to
each other; this does not imply that the process of strategic planning occurs in
individual companies exactly as described by a model. No model can describe a
process exactly; for example, in economics the objective of most models is to
summarise important causal economic relationships so that a view can be developed
of how the economy operates; an economic model does not aspire to represent the
world with total accuracy, but it is intended to capture some of the main elements
which determine how the economy functions. The economic model can then be
used as the basis for explaining what is currently happening, and predicting what is
likely to happen in the future.
A strategic planning model is not based on cause and effect relationships in the
same way as an economic or financial model. A strategic planning model is an
attempt to rationalise the complex processes of company decision making where the
connection between cause and effect is obscure. When trying to make sense of
complicated human interactions it is inevitable that an observer will have to use
subjective impressions of what is actually happening. Since subjective impressions

Module 2 / Modelling the Strategic Planning Process
are used to interpret how strategy processes work, a strategic planning model can
take various forms. The fact that such variety exists is not a weakness of the
modelling approach, as the power of the modelling approach lies in simplifying and
making understandable what at first sight appears to be impenetrable; different
models can throw light on different aspects of the strategy process.
It is essential to think explicitly in terms of models from the beginning. Whenev-
er you attempt to explain what is happening in the world, or express a view as to
how things should be done, you are implicitly using a model within which your ideas
are structured. For example, the issue of how to eliminate the US budget deficit was
an important concern in the early 1990s. Many people thought that this could be
achieved simply by increasing the tax rate; to hold such a view this group must have
had an implicit model of the economy in which an increase in taxes would lead to
higher tax revenues. However, an alternative model, in which increased taxes could
lead to lower incomes and hence to reduced tax revenues, is also feasible. The
problem is that neither model could be proved nor disproved at the time, and
people often lost sight of the fact that they were really disagreeing about an implicit
model of the economy rather than the objective of eliminating the budget deficit.
In companies, different views on the process of how to plan are based on differ-
ent models of how strategic planning works, whether this is recognised explicitly or
not. It was discussed previously how managers often have completely different
definitions of strategic planning; this is usually associated with differences in their
views of how planning should work in practice. For example, some managers
believe that planning should take the form of a series of specified targets, together
with a monitoring and control system; other managers feel that this approach is
unnecessarily rigid and that an informal, flexible approach is more effective. These
views are based on two different models of the planning process.
2.1.1 The Components of a Model

The strategic planning model shown in Table 2.1 represents planning as a flow
process.
Table 2.1 A simple strategic model

Sequence Activity
1 Setting goals
2 Forecasting payoffs
3 Forecasting shortfalls
4 Identifying potential strategies
5 Selecting the best strategy mix
6 Organisation and implementation
7 Control and reappraisal
8 Feedback to previous activities
The model identifies seven activities which occur in a logical progression: Step 1
is concerned with identifying company goals, which may be in the form of market

shares or rates of return; Steps 2 and 3 are concerned with forecasts which identify
the potential payoffs and problems associated with different courses of action; from
these potential alternatives the strategy option is chosen in Steps 4 and 5; having
decided what to achieve, Step 6 is concerned with how to achieve it by identifying
critical success factors and allocating resources; finally, in Step 7, procedures are set
up to monitor how effectively the objectives are being achieved, together with an
ongoing system of reappraisal to ensure that the company can react to changing
circumstances. This finally leads back to Step 1 as new goals and alternative strate-
gies are identified. The model attempts to extract ‘a pattern in a stream of decisions’.
A cynic might argue that this model is logically invalid and as such offers no
insight into real life processes. A telling criticism is that it is impossible to set goals
without some sort of prediction, and therefore forecasting must precede the setting
of goals. It can be argued that goals which are set without attempting to look into
the future are little better than random and may turn out to be unrealistic. Taking
the argument further, if goals can be redefined at any time, the whole process must
fold up since the model suggests that Steps 2 to 7 depend on the goals. If they do
not depend on the goals, then why is the model set up like this in the first place?
The cynic’s argument is persuasive, but it is usually easy to pick holes in someone
else’s conceptual framework. The real response to the cynic is to say ‘I agree. Now
you do better.’ The strength of this simple model is that it identifies important
components of the strategic planning process, suggests that attention should be paid
to the order in which different tasks are tackled, takes into account that the process
is dynamic and feeds back on itself, and perhaps most important of all, provides a
structure for discussing strategy issues.
The feedback process is crucial to understanding the role of the model. It is naive
to suggest that a company works through the seven steps and ends up with a
‘strategy’. The experience of the Mythical Company in Module 1 demonstrated the
importance of the dynamic element in the process. Feedback will continually cause
managers to re-evaluate predictions, re-assess the chosen strategy mix, and so on. In
fact, one view is that feedback is the most important element in the strategic
planning process, and is the means by which the organisation learns by experience.
There is little point in adhering to a strategic plan which no longer relates to the
environment within which the company is operating, hence the importance of the
‘learning organisation’ which is able to adapt to change instead of ignoring it. The
notion of ‘logical incrementalism’15 is based on the contention that a company can
only start with certain strategic thrusts in mind, which are general notions of what
should be done in the future, and that these are refined as time progresses in an
iterative fashion. Given the many imponderables facing managers, it is clearly
impossible to predict the future of a particular market, and the resources available to
the company, with any degree of precision; therefore pursuing a set of objectives
without taking into account the ongoing course of events hardly makes sense.
The debate on the validity of models is not unique to strategic planning. The
famous economist Milton Friedman advanced the argument that the real test of a
model is how well it predicts events. If it is able to predict accurately and consistent-
ly then it does not matter if economists disagree on the validity of the underlying
economic relationships. Opponents of this view claim that a model must be based

on sound theories before its predictions can have credibility; without these it is
impossible to explain why predictions turn out to be wrong. This argument has led
to heated exchanges in academic journals, and the philosophical issue has yet to be
resolved. So far as the modelling of strategic planning is concerned, there is a limited
amount of theory which can be applied, and the models are intended to be explana-
tory rather than predictive; in principle, their usefulness can be judged only on the
contribution which they make to understanding and improving the process of
strategic planning.
In the model illustrated above, the ordering of the steps is based on a logical
framework which may not exist in real life, and there is scope for debate about
which part of the process ought to come first in practice; while most managers will
agree from their experience that the seven steps do occur, they are not necessarily
consecutive. This is because additional information and perspectives generated
during the later stages can cause reversion to an earlier step. The model is an
attempt to represent a dynamic process in a static setting; thus while the conceptual
structure may be valid, it may be impossible to observe in practice.
An important attribute of a model lies in providing the basis for a check that the
necessary steps have been carried out prior to committing the company to a course
of action. For example, Step 3, which is concerned with identifying potential
weaknesses, may have been virtually ignored in the process of developing the
strategic plan; the mere fact of focusing attention on this aspect could change the
emphasis of the strategy, once it has been discovered that there are potential
weaknesses which have not been taken into account. A subsequent revision of Step
4, which is concerned with identifying alternative strategies, might reveal that the
original goals were much too ambitious because no feasible strategy seems likely to
achieve them.
2.1.2 Benefits and Costs of the Modelling Approach

All approaches to problems have benefits and costs, and if a particular approach is
adopted it must be because the perceived benefits outweigh the perceived costs. The
idea of using a modelling approach to strategic planning can give rise to heated
argument: those in favour consider that actions undertaken without a structured or
theoretical base are little more than random; those against consider that it is naive to
approach issues in this way and that the modelling approach constrains rather than
enriches understanding of decision making. There is no clear cut answer to this
argument, and typically both sides can provide instances where both structured and
unstructured approaches to decision making have been effective; disagreements in
this area cannot be resolved by recourse to data, and the difficulties of applying the
scientific approach in this area were discussed at Section 1.2.6. However, it is
impossible to identify general principles from unstructured and one-off examples,
and the anecdotal approach to strategic planning, while usually entertaining, gives no
real indication of why the particular circumstances led to success rather than to
failure. Furthermore, there is a natural tendency to concentrate attention on strategic
approaches associated with success rather than failure, which biases the conclusions
generated by the anecdotal approach. If there is no carry over from one case to

another then the very attempt to teach strategic planning is open to question.
Therefore, to the extent that there are general principles involved, the modelling
approach is valid; it could be argued that to dismiss the possibility of modelling the
process is to deny the existence of general strategic principles.
The following are some of the benefits and costs which might be associated with
modelling the strategic planning process.
Costs and Benefits of Modelling Planning
 Benefits
 Provides a structure
 Simplifies complex processes
 Acts as a check list
 Identifies areas of disagreement
 Costs
 Imparts a mechanistic impression to the process
 Introduces rigidity to a dynamic process
 Gives impression that strategy can be derived from a model
It is important to realise that a strategy model is not a prescription for how stra-
tegic planning should be carried out. It is intended to help in understanding strategy
making, and does not imply that a company should adopt a particular planning
system which itself might constrain the inventiveness and innovation on which
much of strategic planning depends. Therefore the effective use of a strategic model
depends on capitalising on the benefits and avoiding the costs as far as possible.
2.1.3 The Strategic Process Model
A more detailed model, shown in Figure 2.1, indicates the tasks involved at the
various stages of the process.

Strategists Objectives Who decides

to do what
The macro The industry Internal Competitive Analysis and

environment environment factors position diagnosis
Feedback
Generic strategy Strategy Strategy Choice

alternatives variations choice
Resources and Resource Evaluation Implementation

structure allocation and control
Figure 2.1 The strategic process model

This model conveys more information than the previous one about the activities
related to the process of strategic planning, and uses different explanatory headings.
For example, four areas have been identified in which analysis and diagnosis should
be carried out; these include the general environment, which is concerned with the
state of the economy and social trends, competition within the industry, the internal
strengths and weaknesses of the company, and its current and potential competitive
position. Steps 6 and 7 in the previous model are included under Implementation,
which is concerned with the organisational structure of the company, techniques for
efficient resource allocation, and the measurement of outcomes.
Despite the differences in detail, both models follow the general pattern of decid-
ing what to do, finding out different ways of doing it, selecting one of them, and
finally tracking the outcomes while keeping options open as far as possible at all
stages. At the end of the day, it could be argued that even the most unstructured,
adventurous entrepreneur implicitly follows a grand design along these lines.
The process model can be thought of as a paradigm, as discussed in Section 1.2.2.
In 1994 a group of prominent academics in the field of strategy attended a confer-
ence on the topic ‘Strategy: search for new paradigms’ and the complete issue of the
Summer 1994 issue of the Strategic Management Journal was devoted to their delibera-
tions. In the Introduction the Editor-in-Chief of the Journal, Dan Schendel,16 noted
that he had organised a similar conference in 1977 with broadly the same objective
of identifying what the field of strategy was about. At the time the conclusion was
that strategy was really a flow process which involved the six steps of goal formula-

tion, environmental analysis, strategy formulation, strategy evaluation, strategy

implementation and strategy control. This was the first time that these ideas had
been brought together to form a cohesive structure. Schendel felt that seventeen
years after the first attempt to articulate the paradigm it still remained the basic way
of thinking about strategy; since 1994 there have been no fundamental develop-
ments in how strategy is visualised. This does not suggest there have been no
development in strategic concepts and ideas, but these new ideas fit within the
framework of thought which describes the strategic process. The functional process
model shown in Figure 2.1 follows Schendel’s notion of a paradigm; but instead of
six steps there are five and the boxes contain the same ideas.
An appreciation of the strategy process model is fundamental to understanding
strategy issues because the model provides a framework within which concepts and
ideas can be located. The model provides a basis for formulating questions when
addressing strategy problems, and these tend to be common among different
situations. The general questions which arise from the model include
1. Do the strategists have the appropriate characteristics for the type of company?
Have they formulated clear objectives?
2. Has adequate analysis of the environment and the company been carried out?
3. Was an appropriate choice of strategy made in the light of the potential options?
4. Were company resources used effectively to achieve the strategic objectives?
5. Was the company able to learn from subsequent feedback and adapt according-
ly?
The power of the model can be demonstrated by briefly considering the case of
Eurotunnel (the case is dealt with in detail in Module 8) which was a joint project
between the British and French governments and opened in 1994. It was a commer-
cial disaster and over a decade later efforts were still being made to refinance it.
How could such a prestigious project, with so many resources and the best brains
behind it, go so badly wrong? Consider the answers to the questions above.
1. The objective was to dig a tunnel rather than the maximise profit. Any business
venture that does not have the primary objective of profit maximisation must be
regarded with reservations.
2. The potential competitive reaction of the ferry companies was not understood:
they did not disappear the day Eurotunnel opened. Operating costs were under-
estimated.
3. It was not clear whether Eurotunnel based its competitive advantage on low
price or speed of crossing so its choice of strategy was confused.
4. Eurotunnel had many implementation problems, including fires and break-
downs, leading to public concern about the safety of the undersea crossing.
5. Even after it became clear that Eurotunnel was going to be subject to competi-
tion from ferries and cheap airlines the company acted as though it would
achieve monopoly power; in other words it did not appear to learn from its mis-
takes.
One of the most important outcomes of the process model approach is to recog-
nise that there is typically no single reason for company failure or success. When
attempting to explain why a particular company got into difficulties there is a

tendency to answer in terms of a single factor, for example that the market turned
down, that technology moved on, or whatever. But it is unlikely that any one factor
can really account for failure, since companies are run by people who are able to
adapt to changing circumstances. The root causes of failure lie in the strength or
weakness of the company’s strategic process; it then becomes a question of how
many areas of weakness can a strategic process bear. In the case of Eurotunnel it
appears that there were significant weaknesses in all parts of the strategic process
and that is why it went so wrong.
The approach adopted in the remainder of this course follows the process model
and develops the concepts and models necessary to conduct analysis within each of
the boxes and evaluate the strategic process; it starts by looking at strategy makers
and company objectives, then goes on to discuss the company in the economic
environment – both at the economy-wide and market levels; this is followed by an
analysis of the internal factors affecting competitive advantage which leads on to an
analysis of strategic choice; implementation, control and feedback are the final parts
of the story. Strategic planning is thus not a plan or a blueprint for company success
but a framework for understanding strategy making. The first step in analysing the
various aspects of the strategic planning process is to consider who makes strategy
in the first place.
2.2 Strategy Making

to do what

Feedback

Resources and Resource Evaluation

structure and control Implementation
allocation
Individuals, not companies, make decisions, but the decisions taken are constrained
by the organisation and its traditions. The relative importance of individuals versus
organisations has always been a topic of debate; the emphasis varies among compa-
nies depending on their age, the personalities of individual managers, and many
other factors. An important outcome of the Peters and Waterman research into
company excellence was that a strong leader, who made the company excellent in
the first place, was a recurring factor in almost every case. In fact, you will observe
in everyday life that one of the first things which companies do when they encoun-
ter severe problems is to change the leader. There is no doubt that the leader can set

the style for the whole organisation. Perhaps the most extreme cases occur in sports
management, where unsuccessful football teams typically react by firing the manag-
er. The success of the Asda chain of superstores in the UK between 1992 and 1996,
when the Asda share price grew at twice the rate of the stock exchange index, was
largely attributed to Archie Norman; during his five years as CEO he not only
changed the company culture and rescued it from collapse under £1 billion of debt,
but also fought a wider battle against price fixing and had a significant effect on
competition in the retail industry. When Norman decided to become chairman in
1996, with the avowed intention of ultimately going into politics (subsequently he
failed to make any impact whatsoever in the political arena), the market took fright
and many articles appeared in the financial press suggesting that most commentators
felt that the future success of the company was dependent on Norman and very
little else. The value which companies place on leadership can be very high: for
example, in 1996 GEC, the giant electrical conglomerate, offered George Simpson
(who had been chief executive of Rover Group and Lucas Industries) a remunera-
tion package worth £10 million; but in this case the major shareholders felt that he
could not possibly be worth this and forced the board to renegotiate.
The best-known tycoon in Britain is Richard Branson, who initially made his
fortune from building up the Virgin record company and is now known for his
airline company Virgin Atlantic; he is also well known for piloting a speedboat
across the Atlantic in record time and undertaking highly dangerous ballooning
expeditions. A champion of competition with a clear dislike of monopolies, he
challenged British Airways by obtaining slots at Heathrow and providing standards
of service which rapidly gained a significant share of the market in the face of
intense competition. But it is not widely known that Branson’s business empire
spans retailing, media, design and modelling, and financial services besides his
airline, which accounts for only about half of the £1.8 billion value of his compa-
nies. In a Sunday Times interview in October 1996 Branson stated that his next
priority would be to develop a structure for his group so that its existence will not
be threatened by his disappearance.
We know from everyday experience that different individuals have different
objectives, view the same information in different ways, and often act differently
depending on the decision-making environment. Those who sit on boards or
committees often feel that decisions arrived at would have been different had the
decisions been taken by any individual member of the group. Thus the setting of the
company’s objectives may appear to be arbitrary to the extent that it is dependent
on who is involved at the time. This raises the question: If the setting of objectives
is not systematic, is there any point in attempting to be systematic about meeting
these objectives? The answer is that objectives are set by people, with their particu-
lar insights into the world, together with all their defects, but they are the only ones
we have.

2.2.1 Strategy and the Evolution of the Company

The typical company is continuously evolving, and the roles undertaken by decision
makers are to some extent dependent on the stage of the company’s evolution,
which can be classified in three stages: the small single product company, the
integrated company, and the large diversified company. Only a very small minority
of companies actually ‘evolve’ in the sense that they end up as large diversified
companies. However, the classification makes it possible to characterise the role of
the strategy maker as follows:
Small or Single product company with little formal structure con-

Entrepreneurial trolled by the owner-manager.
Integrated Single product-line company with vertically integrated
manufacturing and specialised functional organisation. The
owner-manager still retains control over strategic decisions,
but most operating decisions are delegated through policy.
Diversified Multi-product company with formalised managerial systems
which are evaluated by objective criteria, such as return on
investment. Product and market decisions are delegated to
the heads of SBUs.
In smaller companies the individual owner plays a dominant role in determining

strategy, but in the larger, diversified company it may be difficult to identify strate-
gists. The latter is the type of company in which ownership and control tend to be
differentiated, with managers answerable to shareholders rather than to individual
owners. In fact, many aspects of the company’s operations depend on the stage of
evolution of the company. For example, the ability of a company to undertake
radical innovation depends on its stage in evolution, with large diversified compa-
nies facing the problem of how to stimulate innovative activity within the
company’s structure. When a company reaches a certain size there is a tendency for
bureaucratic procedures to become dominant, with the result that a significant
proportion of resources is devoted to maintaining the status quo, and innovation is
seen as a costly and disruptive form of behaviour.

2.2.2 Strategists

to do what

Feedback


allocation
The implication of the life cycle approach to company evolution is that strategists
with different characteristics are required for companies at different stages. This
leads to problems in ensuring that the right type of person is in charge. For example,
there are many instances of entrepreneurial strategists who develop a company but
are unsuited to running a conglomerate in a stable market; it is not always obvious
to such individuals when they should stand aside.
It is often difficult to identify the ‘ultimate’ strategic planner in companies which
have developed beyond the stage of owner/manager control. The functions carried
out by managers are complex, and are continuously changing. While managers tend
to feel that they understand their own function, there is relatively little systematic
information available on how managers actually spend their time. Some research has
been carried out into managerial styles and approaches; but it is extremely difficult
to carry out research in this area because it is necessary to observe what managers
actually do on the job. Because of the labour intensive nature of the research, it is
virtually impossible to generate information on a large sample, and the information
produced has to be interpreted by the observer as events occur, resulting in a high
degree of subjectivity. While the research has produced some information about
what managers actually do, it has been unable to identify causal relationships
between behaviour and outcomes. In general terms, it has not been possible to
identify which characteristics contribute in what degree to being a good manager in
real life; in particular, very little has been found out about what comprises an
effective strategic planner.
Examples of the difficulty involved in identifying the characteristics of an effec-
tive strategic planner can be seen in the books written by successful managers. The
accounts are typically idiosyncratic, and it is virtually impossible to identify the key
characteristics which contributed to success rather than to failure. This is partly
because few professional managers are trained in the scientific approach, and this is
compounded by the fact that their accounts are at least partially concerned with
portraying themselves in a favourable light.

One of the best-known research findings is that there is a significant difference

between what general managers actually do and what theory suggests that they
ought to do. For example, when seeking out information, theorists suggest that the
general manager should think in terms of obtaining data which will enable thorough
organisational and environmental analysis to be carried out, which in turn will assist
the manager in arriving at effective strategies. However, research suggests that
general managers prefer verbal sources and that they avoid documented infor-
mation; their approach is impressionistic rather than detailed. Added to this is the
widely known fact, which does not require research to verify it, that there are
significant differences in management style: some general managers are naturally
reflective while others tend to be doers. There is therefore no particular reason to
expect that observed management behaviour will be identical for different individu-
als; what is not known is whether such variation has an impact on effectiveness. The
observer based research has not uncovered significant connections between
management style and effectiveness.
Since the activities of managers cannot be readily classified and fitted into a mod-
el of behaviour, the precise role of different managers in the strategic planning
process is not subject to hard and fast rules. The roles which managers play depend
on many factors unique to the individual company; for example, in companies with
a rigid hierarchical structure the process may be concentrated on one person, such
as the managing director.
Strategic planning can be regarded as a multidimensional role which is undertak-
en by many individuals working at different levels. For example, there are corporate
level strategists, typically the board of directors and the CEO; below these are the
SBU strategists, who comprise executives, planning departments and consultants. In
some cases the pinnacle of the strategic planning process is occupied by the general
manager who sits at the top of the decision-making process. Thus control of the
strategic planning process can rest in the hands of different people. This does not
mean that the process itself cannot be identified and analysed, but it does suggest
that companies should give some thought to how the function is undertaken in their
organisations. If no one is very sure about who is carrying out the strategic planning
function, it could well be that the process itself could be greatly improved.
Our attempt to categorise the experiences of the Mythical Company helps to
explain why the attempts to identify what managers do, and the functions of
strategic planners, have produced little in the way of results. A glance at the process
model of Figure 2.1 suggests one good reason for this: the whole process is very
complex. There are 12 separate boxes in the process model, each of which may
relate to a number of functional specialists. In any one day a manager may be
involved in evaluation and control problems, discussions on strategy variations,
investigating changes in the competitive environment, and resource allocation
problems. Sometimes the activities in these boxes may overlap, and the manager
may give very little thought to why particular actions are being undertaken in terms
of the general strategy picture, being only aware that specific problems need to be
solved quickly. The trouble is that immediate solutions may be mistaken when
viewed against the backdrop of the process model; for example, decisions on

resource allocation may be made solely with reference to accounting rather than
taking relevant marketing information into account.
The process model also provides insights into the complexity of the management
function in terms of the roles which managers are required to adopt at different
times; because of the fluid nature of everyday events the manager is likely to flit
from one role to another without giving the matter conscious thought. The four
‘eggs’ on the right hand side of the process model serve to identify several roles as
follows.
 Strategist, entrepreneur and goal setter. Even in large companies these functions are
not the sole domain of the chief executive, and some aspects are typically de-
volved to managers. While managers are to some extent constrained by existing
plans and commitments, they have a role to play in making decisions about po-
tential investments, reacting to changing circumstances, identifying new courses
of action and so on.
 Analyser and competitor. The manager needs to be constantly aware of changes in
the economic environment, the efficiency of the company, and its competitive
position. The process of information collection and analysis is time consuming,
and it is necessary for managers to filter out what is unimportant and focus on
factors which are likely to impact significantly on the firm. Managers are typically
keenly aware that time spent on analysing is at the expense of more immediate
concerns and this role tends to be given a low priority because of its lack of im-
mediate payoff.
 Strategy decision maker. It is rare that major strategy decisions are taken without
wide managerial consultation. Options must be identified and different points of
view brought to bear in order to assess the costs and benefits associated with
each. At times the manager will be involved in higher level strategy assessment,
and at others will be making devolved strategy type decisions.
 Implementer and controller. Once decisions have been taken the manager has a major
role to play in making them happen. This involves allocating resources and is
typically thought of as being the major role a manager has to perform, but in fact
it is only one of several, and it may not consume most time. As well as allocating
resources, the manager has to monitor how effectively resources are being uti-
lised, and this means that systems must be set up which adequately measure
performance.
 Communicator. As new information becomes available and competitive conditions
change the manager has to ensure that everyone is kept aware of changes in
direction as far as possible.
There is more to the problem of management than complexity and competing
demands on the manager’s time and intellectual resources. There is also a degree of
conflict inherent in the different roles. For example, the manager needs to set up
systems which ensure that resources are used efficiently; but these very systems may
introduce inflexibility and resistance to the very changes which the manager sees are
necessary in the role as competitor. The objectives and mission of the firm may be
expressed in general and non-measurable terms, while the control systems tend to
be based on financial measurements; the two approaches may be difficult to

reconcile. Thus as well as being charged with the task of resolving conflicts of
interest in the firm, the manager must also deal with the internal conflicts caused by
these roles.
Review Questions
2.1 Apply the process model of Figure 2.1 to the Mythical Company’s strategy making in
Module 1. Allocate the various reports and actions to the boxes and evaluate each stage
of the process represented by the eggs; use the model to evaluate the overall effective-
ness of the strategy making process in the Mythical Company.
Case 2.1: Rover Accelerates into the Fast Lane (1994)

The British car industry has a history from the early 1970s of poor productivity, bad
labour relations, out of date models and falling market share. But by the early 1990s the
prestige name of Rover was making a comeback, and the company was steadily moving
back into profitability. Rover is in fact the remnants of the giant British Leyland which
produced (amongst other cars) the well-known Austin and Morris marques, and which
competed directly with Ford and GM as a volume car maker. In 1980 British Leyland
had 33 per cent of the UK market, but this had fallen to 14 per cent by the beginning of
1993.
100
100
60 60 60 50
50 25
0
–50 –5
–50 –50 –50
–100
–150
–200
–250
–300
–350
–350
84 85 86 87 88 89 90 91 92 93 94
Figure 2.2 Rover profit/loss (£million)

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

cent of the company was making a loss of about £100 million.

The market performance of Rover by 1993 was outstanding in many respects. During
1993 continental Europe was in recession, while the UK was emerging from recession.
The sales picture is shown in Table 2.2.
Table 2.2 Rover’s relative sales growth in 1993

Area Total market Rover sales
growth growth
UK +5% +9%
Europe −20% +5%
How Rover Got There

The recovery was not an overnight affair, but dated back 15 years or more. Rover was
fortunate to have had two outstanding leaders who paved the way for future success.
During the late 1970s Sir Michael Edwardes effectively ended the long-term labour
unrest in British Leyland by much improved labour relations policies, and forged the link
with Honda which gave Rover access to modern car technology. His successor, Sir
Graham Day, provoked a cultural revolution by convincing his managers that Rover was
no longer a volume producer which could compete with Ford and GM; this was not
easy, because he had to convince long serving managers that the company did not have
the volumes to be a low cost producer. He changed the name to Rover and disposed of
the Austin and Morris marques. Rover established partnerships with a few key suppliers
and as a result restrained cost increases and improved systems reliability.
In 1985 Rover’s break-even output was 500 000 cars per year; by 1993 this was
down to 400 000, and the objective was to reduce this further in line with being a niche
producer. The CEO in 1993, George Simpson, felt that there was plenty of scope for a
‘medium sized, slightly upmarket, semi-autonomous’ car maker. However, he felt that
the future for European car makers was unclear because there would be significant
levels of overcapacity for up to 10 years, and this might lead to price wars. Rover would
also need to raise a significant level of long-term debt if it was to develop a new small
car to replace the Metro.
Enter BMW
Table 2.3 Structure of Rover in 1993
£billion
Sales 4.0
Assets 1.4
Debt 0.4
The structure of Rover in 1993 was as shown in Table 2.3. At the beginning of 1994
Rover was purchased, in a surprise move, by BMW for £529 million; this caused a little
trouble with the Japanese car maker Honda, which had technology agreements with
Rover and owned 20 per cent of the company. BMW’s chairman, Bernd Pischetsrieder,
declared his intention to revolutionise Rover in two ways: by turning it into a brand as
strong as BMW, and doubling or trebling its sales worldwide. For example, in 1994

Rover expected to sell only 13 000 cars in Germany, while Pischetsrieder wanted to
increase this to between 80 000 and 120 000 cars per year. One major change designed
to achieve this would be to install in the UK BMW’s logistics technology for building
cars in response to individual customer specification; the problem confronting BMW
was that Rover was locked into the Honda method of producing identical cars in
batches of 30.
While Rover had increased productivity, the UK motor industry as a whole was still
relatively uncompetitive, and the indices of unit labour costs for a selection of countries
in 1993 are shown in Figure 2.3.
120
100
80
60
40
20
0
Germany UK US Japan
Figure 2.3 Motor industry unit labour costs (Germany = 100)
1 In what ways had the Rover management failed to maximise value by 1994?
2 Do you think that Rover was a good buy for £529 million in 1994, bearing in mind that
not all potential strategic gains can be expressed in financial terms?
3 Discuss the strategies of Edwardes, Day and Pischetsrieder using the process model.
Case 2.2: The Millennium Dome: How to Lose Money in the Twenty-
First Century (2001)
The Millennium Dome was designed to mark Britain’s triumphant entry into the new
millennium and, as the Prime Minister Mr Tony Blair said, it was going to be ‘the
greatest show on earth’. But after six months of operation both the chairman and the
CEO had been sacked and it was eating up public money at the rate of about £20 million
per month while little more than half the expected number of visitors had turned up.
What could have caused this drastic outcome for such a high profile national invest-
ment?
The Millennium Dome was conceived by the Conservative government in the mid-
1990s and was taken on by the Labour government which was elected in 1997; howev-
er, newspaper reports at the time suggested that a significant minority of Cabinet

Ministers were opposed to the idea.

The original notion was that the Dome would open for the Millennium celebrations
and its attractions would subsequently stay open for a year; after that the Dome would
be sold to the highest bidder, most probably for scrap. It was to be funded by a
combination of Lottery grants through the Millennium Commission and company
sponsorship; these companies would figure prominently in the various zones within the
Dome.
Mission and Objectives

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

The New Millennium Experience Company (NMEC) was responsible for running the
Dome and projected in 1997 that the Dome would attract 11 million paying customers
during the Millennium year, and that 1 million free visits would also be provided. Despite
the fact that advance ticket sales were very poor the NMEC still adhered to this
forecast by January 2000. Later that month the figure was revised down to 10 million
and the NMEC still claimed that the Dome would break even over the course of the
year. By May 2000 the Dome had attracted only 2 million paying customers and the
prospect of meeting the target looked remote. In June the target was reduced to 6
million. By the end of the year 5 million visitors actually turned up.
The grand opening was a farce, with many VIPs being stranded at the railway station
for hours. Subsequently there were many complaints of the length of time spent in

queues. In August 2000 a government report concluded that an important reason for
the poor attendance figures was the lack of a ‘wow’ factor: the exhibits were all
interesting but none of them really captured the imagination.
What Was Spent on the Dome

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

The original projections were
£million
Sponsorship 150
Commercial activities 194
Final sale value (probably for scrap) 15
Total 359
It is assumed that the ‘commercial activities’ refer to the sales of tickets. If this were
the case it would appear that from the outset the Dome was expected to have a
financial shortfall of £139 million.
The tickets were priced at a basic £20 per adult and £16.50 per child; special rates
were set for families and parties so it is likely that the average price paid was in the
region of £17. Using this figure the following revenues would have been generated with
the three estimates of attendance.
£million
11 million (up to January 2000) 187
10 million (from end January 2000) 170
6 million (from June 2000) 102
The figure of £187 million is not far away from the original estimate of £194 million.
However, using the 6 million figure for visitors the shortfall increases from £139 million
to £231 million. This amounts to a subsidy of about £40 for every ticket sold.

Pouring the Cash In

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

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

In July 2000 it was announced that a consortium backed by Nomura International was to
invest more than £800 million in the Dome to turn it into a huge entertainment resort
with hotels, restaurants, shops and offices; some £200 million would be spent on
refurbishing the Dome and its exhibits in order to attract tenants. The investment
included a payment of £53 million to NMEC. However, agreement could not be reached
on the details and Nomura withdrew; no credible bid was subsequently received and the
contents of the Dome were auctioned off for a few million pounds at the beginning of
2001.
1 Assess the Dome as a financially viable concept if its life had not been restricted to one
year.
2 Discuss the fortunes of the Dome using the process model.

Case 2.3: The Rise and Fall and Rise of Starbucks: How the Leader
Makes a Difference (2012)
In 1987 Howard Schultz bought the small coffee shop chain Starbucks; Schultz led its
national and international development and stepped down in 2000. By 2007 it had
grown to over 16 000 stores and 200 000 employees; sales and profits grew quarterly
and the stock price continued rising. But suddenly Starbucks lost its magic and sales fell,
the stock price dropped alarmingly and it became clear that the company was in trouble.
At this point Schultz decided to intervene; he returned as CEO in January 2008,
determined that the company he had founded and devoted much of his life to was not
going to fail.
Firing the CEO

When Schultz stepped back from day to day operations, Jim Donald took over; he had
been in charge of Wal-Mart’s grocery operations and had subsequently turned round
Safeway and Pathmark. Donald was an exceptional communicator, but Schultz felt that
as an outsider Donald did not really appreciate the Starbucks philosophy. Despite his
great respect for Donald, Schultz did not think they could resolve their different
approaches to the business.
Signs of Discontent
Individuals had begun privately approaching Schultz in 2006 expressing concern about
the direction the company was taking. The general feeling was that the objective of
growth for its own sake was undermining the business. Starbucks had always invested
ahead of the growth curve by investing in new roasting and distribution facilities before
store openings. A major concern was that the rate of new store openings was starting
to exceed the rate of investment in back-up facilities.
The Broad Outcome

The fortunes of Starbucks are captured in the stock price movements from 2002
onwards. In 2002 the share price was $10; it grew to $40 by 2006, fell to $9 during the
financial crisis and increased to $40 by 2011.
The stock price actually jumped 8 per cent the day after Schultz took over as CEO,
but this did not last. On Black Tuesday 29 July 2008 Starbucks reported its first
quarterly loss of $6.7 million.
The Product
It is essential that the quality of the product delivered to the customer is as high as
possible. One of the first steps was to ensure that the baristas (those who serve the
coffee) knew how to pour a proper cup of espresso. But training was a major logistical
problem and Schultz’s radical solution was to close all 7100 US stores for a day. DVD
players and a training film were shipped to every store. This not only enabled the
training exercise but also generated a great deal of media coverage.
The warm breakfast sandwich was a big money-maker, but Schultz had always resist-
ed it. He felt that it did not fit with the company’s rationale and that the cooking smell
enveloped the store. Store managers were not concerned because the sandwich helped
them meet their sales targets. This had led to conflict between Schultz and Jim Donald.

All attempts to get rid of the smell failed and the only solution was to discontinue the
breakfast sandwiches, a decision that Schultz made unilaterally.
But this was only part of what Schultz saw as the loss of Starbucks’s unique identity.
He felt that the loss of aroma, the re-steaming of milk, the too-tall espresso machines,
etc. were all symptoms of a company that had lost its way. One of his first actions as
CEO was to send an email to the management team entitled ‘The commoditisation of
the Starbucks Experience’. The memo was leaked and caused a public furore – the first
realisation that Schultz had of the power of the internet.
Starbucks had extended the brand into entertainment, with kiosks of CDs for sale
and joint productions with companies such as Concord Records. Starbucks also sold
books, often by unknown authors.
From the outset an attempt was made to build a Starbucks community by providing
full healthcare benefits and equity in the form of stock options; at the time no other US
company offered these benefits to part-time employees. When Starbucks started to
make losses, Schultz refused to cut back on these benefits, even when requested to do
so by major shareholders.
Company Growth
Starbucks’s growth had been truly spectacular, with 20 000 stores outside the US. A
great deal of effort went into identifying optimal store sites and the development of
adaptable store designs. The expansion was not only in stores, with agreements also
being signed with major hotel and upmarket supermarket chains. The focus was on
‘comps’, the monthly growth of same-store sales; in January 2008 this fell to 1 per cent
after 16 years of 5 per cent growth or more. Schultz had recognised that the desire to
increase comps by individual stores could have adverse effects, such as the store he
walked into that was full of stuffed animals. The manager justified this in terms of its
effect on the comps. Therefore, Schultz made another unilateral decision that the comps
would no longer be reported, thus freeing management from what he saw as the
tyranny of short-term financial objectives.
Corporate Social Responsibility

Starbucks sponsored youth and literacy programmes worldwide (about $47 million
contributed between 2000 and 2005), and employees were encouraged to participate in
voluntary service. Efforts were made to ensure that supplies were ethically sourced by
working with Conservation International and Fairtrade. Schultz saw these initiatives as
an integral part of what Starbucks represented and promoted them, despite the fact that
they had no impact on short-term profitability.
The Way Forward

Schultz formulated a number of questions:
 How many stores were underperforming, why and where?
 How many stores could be opened, and where, without further cannibalisation?
 How far was the supply chain operation being stretched?
 Where was Starbucks spending more money than necessary to achieve the same,
or better, results?
 Did Starbucks have the right people with the right skills for everything that needed

attention?
From his own observations Schultz identified the following problems:
 Retail partners unmotivated
 Turnover rates too high
 Poor training procedures
 Employee reviews and pay rises inconsistent
 Scheduling of shifts inefficient
 Many baristas looked on it as just a job
 Lack of incentives for baristas to look on the stores with a sense of ownership
 Store managers were reporting good results when they were making a loss
 Haphazard inventory
 Floors and tables dirty
 Food losing freshness
 Too much waste
 Baristas worked hard but there was still too long a wait for customers to be
served
 Technology was outdated: no laptops for mobile executives and back room com-
puters without graphics
 An antiquated DOS system on electronic cash registers requiring transactions to
be entered in a strict order
This was a formidable list and Schultz could see that it was not enough to fix the
problems individually but that actions had to be welded together.
What Schultz Did

Schultz set about repairing the company on a wide front, and the following list gives an
impression of the range of activities involved, in no particular order.
 Introduce the Mastrena coffee machine, which grinds each shot
 Buy the Clover company, which produces a machine to make coffee as well as a
French press
 Introduce a reward card
 Set up MyStarbucksIdea.com, a social networking site
 Introduce Pike Place Roast, which was positioned as a reinvention of brewed
coffee
 Invest in new laptops and electronic cash registers
 Offer a free coffee to everyone voting in the elections of November 2008
 Take out $400 million in supply chain costs
 Develop Via, an instant coffee that proved to be as good as ground coffee in blind
tastings
 Enforce the build criterion to earn $2 in the first year for each $1 invested (by
2008 the ratio was being missed in hundreds of stores)
 Close 600 US stores
There were some failures, such as Sorbetto. The machine led to a great deal of waste
and took 1.5 hours to clean at the end of the day; the product contained a lot of sugar,
going against the healthy food trend; and costs were higher than anticipated because of

freighting the base ingredient from Italy and the worsening exchange rate.
The comps began improving in April 2009 and by 2010 revenues were a record and
the consolidated profit margin the highest ever. Schultz put the success down to the
achievement of what he termed the seven pillars.
1. Be the undisputed coffee authority: Pike Place Roast, Mastrena, Clover.
2. Engage and inspire our partners.
3. Ignite the emotional attachment with our customers: loyalty programme, MyS-
tarbucksIdea.com, social media, digital venture, lean techniques.
4. Expand our global presence: expansion in China, new store designs and concepts,
mercantile stores.
5. Be a leader in ethical sourcing and environmental impact: sourcing and helping
local communities with Fairtrade, voluntary service, recycling.
6. Create innovative growth platforms worthy of our coffee.
7. Deliver a sustainable economic model: cost reduction, supply chain improve-
ments, store technology, building senior team.
1 Identify the changes that Schultz made to the strategic process (i.e. what happened
before and after Schultz’s return).

Module 3
Company Objectives
Contents
3.1 Setting Objectives...................................................................................3/2
3.2 From Vision to Mission to Objectives ..................................................3/3
3.3 The Gap Concept....................................................................................3/7
3.4 Credible Objectives ................................................................................3/9
3.5 Quantifiable and Non-Quantifiable Objectives ................................ 3/10
3.6 Aggregate Objectives .......................................................................... 3/12
3.7 Disaggregated Objectives ................................................................... 3/13
3.8 The Principal–Agent Problem ............................................................ 3/14
3.9 Means and Ends .................................................................................... 3/16
3.10 Behavioural versus Economic and Financial Objectives.................. 3/17
3.11 Economic Objectives ........................................................................... 3/17
3.12 Financial Objectives ............................................................................. 3/19
3.13 Social Objectives .................................................................................. 3/28
3.14 Stakeholders ......................................................................................... 3/29
3.15 Ethical Considerations ........................................................................ 3/36
3.16 Are Objectives SMART? ..................................................................... 3/38
Case 3.1: Porsche: Glamour at a Price (1993) ............................................ 3/40
Case 3.2: Fresh, But Not So Easy (2013) ..................................................... 3/42
Learning Objectives
 To investigate the many dimensions of company objectives.
 To demonstrate the connection between business definition, mission and
objectives.
 To show how company objectives determine strategy formulation.
 To demonstrate the link between capital markets, company valuation and
company objectives.

Module 3 / Company Objectives
3.1 Setting Objectives

to do what

Feedback


allocation
It is often difficult for managers to answer the fundamental question ‘What are we
trying to achieve?’ In the rough and tumble of a competitive environment many
managers are apt to reply ‘Keeping the company in business, and surviving another
day in the job.’ Managers tend to be concerned with reacting to changing circum-
stances, seizing opportunities as they arise, and trying to ensure effective
performance from both themselves and their subordinates. Managers may well ask
whether it really does help matters to have some overall objective for the company,
given that it is difficult enough to survive from day to day and to meet short-term
targets. However, whatever the relevance of company objectives to individual
managers might be, one issue needs to be clarified from the outset: all organisations
need to have some understanding of what they are trying to achieve; otherwise their
actions may as well be random.
This point may be considered banal and obvious, but in fact the confusion be-
tween plans and objectives pervades many areas of activity. For example, when the
government is deciding on its budgetary policy, i.e. setting government expenditure,
tax rates and money supply, it must have some objective in mind in terms of real
income per head, inflation and unemployment; if not, it would not matter which
policies were undertaken. But try to get any member of the government to be
explicit about the objectives which the government is attempting to achieve, and see
how far you get. At the level of the company, some managers become so involved
in the planning process that they overlook what it is meant to achieve; there is a
danger that managers confuse the means by which ends are to be achieved with the
ends themselves.
Since strategy is at least partly concerned with confrontation with competitors, it
may not always be advisable for a company to be explicit about its objectives. For
example, a company may identify an increased market share in a particular market
segment as a major policy objective. However, if competitors became aware of this
they could pre-empt the company’s moves by reducing prices, with the result that
the company becomes worse off than before. There is clearly a balance to be struck
between informing managers about objectives and ensuring that competitors cannot

pre-empt strategic moves. Reluctance on the part of senior managers to be specific

about company objectives may help account for the fact that many companies
express their objectives in terms of bland ‘mission statements’ which are devoid of
operational implications. It is also likely that in the early stages of strategy formula-
tion it is not possible to identify more than the general thrust of strategy so at this
stage it is not possible to be specific.
The mission statement can be an important dimension of the company objective
because it captures the attitudes and expectations of employees and provides a
general focus for its activities with which people can identify. Although the mission
may not be an operational idea, it can provide the general framework over time
within which strategies are worked out. However, it needs to be borne in mind that
a company is a collection of many individuals, each with their own set of goals, and
it may not be possible to find a general statement of intent which is consistent with
these sub-goals and which will galvanise everyone in a common purpose. Whether
the mission statement is a powerful, visionary focus for company activity, or
whether it is no more than a meaningless compromise depends on the individual
circumstances.
3.2 From Vision to Mission to Objectives

One of the primary roles of the CEO is to develop a long-term view of what the
company is about and the markets within which it should be operating. This is
sometimes referred to as the vision because it is not expressed in detailed terms and
is perhaps no more than a broad thrust within which the company will be directed.
But it is necessary to translate this vision into a tangible set of directions which can
be used by employees to direct their efforts in a manner which is consistent
throughout the organisation. There are a number of steps which are necessary to
achieve this:
1. Develop the mission statement.
2. Disaggregate the mission.
3. Derive objectives.
There is no absolutely right or wrong way to proceed in developing objectives
which serve as the basis for directing resources, but it needs to be recognised that if
objectives are to serve a useful function they need to be logically thought out.
The mission statement needs to have several characteristics including the follow-
ing.
 Serve as a definition of the business the organisation is in.
 Be clearly understood by employees.
 Provide a focus for activities.
The characteristic which raises most difficulty is defining the business of the
organisation. Because this issue is of central importance it is worth spending some
time considering how the definition might be arrived at.

3.2.1 Defining the Business of the Organisation

In a world of constant change it is worth stepping back on a regular basis and
confronting the issue of what business the company is actually in; this is because
markets can change without managers being aware of the fact because they are too
closely involved in the day to day running of the company to appreciate wider
events. For example, the executive board of a football club may run the club under
the impression that they are in the sport business; but if they realised that the club
was really in the entertainment business they would take a wider range of issues into
account apart from winning matches which, although clearly a priority, does not
necessarily maximise earnings; issues such as sponsorship, media rights, merchandis-
ing, selecting the most appropriate competitions and so on all contribute to building
the entertainment brand.
It is not always obvious what the business definition is even in a product market.
Take the case of a soft drinks company, where a few questions reveal potentially
significant differences in business definition.
1. Does the company control all stages of production or does it purchase all
ingredients and merely mix and bottle?
2. Does the company control distribution and marketing channels?
3. Does the company compete in the soft drinks or beverage market?
4. Is the drink a standalone or is it also intended as a mixer?
 Question 1 relates to the productive scope of the company, i.e. the extent to
which it buys in its inputs and hence how it perceives its own supply chain.
For example, a soft drinks company which makes its own bottles has a whole
series of concerns absent from a company which buys its bottles from a bot-
tle making company. In particular, it has to be concerned with the efficiency
of its own bottle making plant, rather than relying on the forces of the market
to enable it to purchase bottles at the lowest cost. The scope of the company
also impacts on the skill set which the company needs to develop, and has an
effect on how the company focuses its resources. For example, the company
which buys in bottles needs a negotiator who can work out deals with bottle
manufacturers which generate a competitive price and a guarantee of sup-
plies; the company which makes its own bottles needs to recruit individuals
with productive expertise in this function. These are clearly quite different
skill sets.
 Question 2 relates to the market positioning of the product; for example, the
company may produce soft drinks for ‘own brand’ supermarket products,
and have little need for marketing the product in its own right. This is of
fundamental importance for company expansion, because the own brand
producer can only expand if its customer base grows or by finding more large
customers to supply, while the company which markets directly to consumers
can increase its sales by marketing more aggressively.
 Question 3 relates to the breadth and focus of the business definition; for
example, soft drinks are sold alongside alcoholic drinks in restaurants and
public houses, and could be promoted as an alternative to alcoholic drinks.

Or it might be possible to present the soft drink as an alternative to coffee,

which contains caffeine and is a mild stimulant.
 Question 4 relates to the target markets; for example, tonic water is relatively
rarely consumed on its own and is usually mixed with gin. It is unlikely that
tonic water could be aimed at both this market and the health market.
The first step, then, in arriving at a vision for the company and its future is to
understand properly what business the company is in. Unless this is clearly defined
the company vision is likely to be meaningless at best, and misleading at worst.
3.2.2 Deriving the Mission Statement

Once the business definition has been arrived at it is possible to derive a statement
of how the company intends to operate within that business area. The statement
may be related to factors such as the following.
 the quality of the company’s products;
 the degree of differentiation;
 the geographical area which it intends to serve;
 the segment of consumers which it targets.
Reverting to the hypothetical soft drinks company discussed above, the mission
statement could take the following forms depending on how the business is
visualised.
 To deliver high energy drinks to active individuals who care about their health.
 To service the soft drink needs of supermarket chains who need a high-quality,
dependable product to market under their umbrella brand.
 To target teenage consumers who want a brightly coloured effervescent drink in
an unusually shaped container.
Each of these mission statements provides employees with a different focus, and
implies a different allocation of resources and marketing approaches. But the
operational usefulness of the mission statement can be exaggerated, and it can often
be argued that the mission statement is merely a description of what the company is
rather than providing any new direction to employees. For example, the company
may have been producing own brand drinks to supermarkets since it began busi-
ness, so the introduction of a mission statement has virtually no impact on
employees.
Sometimes the mission is a statement of where senior management wish the
organisation to be at some point in the future. For example, a company might aspire
to be the market leader in terms of market share, and therefore the mission state-
ment is based not only on what business the company is in, but where it would like
to be positioned within the relevant market. But in these cases it is important not to
produce a mission which employees see as being unattainable and to which they
cannot relate. The consequences could be quite far reaching, as middle managers
and employees may develop a cynical view of senior management and their aspira-
tions.

3.2.3 Disaggregating the Mission

The mission statement for the company as a whole can be quite general, but it needs
to be modified and applied to individual parts of the organisation to ensure, as far as
possible, that the focus of functional departments is aligned with the vision of the
senior managers. The missions of functional departments could be expressed as
follows.
 Corporate security’s mission is to protect corporate personnel in an unobtrusive
fashion by preventative measures whenever possible.
 Human resources’ mission is to identify and develop effective leaders, create
high performance teams and enable individuals to maximise their potential.
While such mission statements might appear to be obvious, in their turn they can
have a major influence on the focus of the functional departments. For example,
compare the following mission statements with those above.
 Corporate security’s mission is to provide a feeling of corporate security by a
high profile stance of uniformed patrols and fast response.
 Human resources’ mission is to focus on the development of the individual
rather than that of groups and foster the benevolent culture created by its
founder.
The type of security personnel required for the first mission statement would, of
course, be totally different to those required for the second. The focus of human
resources on developing leaders and effective teams rather than actively pursuing
the development of individuals as a top priority implies different criteria for
recruitment and promotion.
3.2.4 Setting Objectives

Once the general vision of the company has been established, and the mission
identified, it is necessary to determine what has to be achieved for the mission to be
successful. While the mission can be expressed in general terms, it is necessary to
state the objectives at least partly in terms of measurable performance targets; in the
absence of identifiable targets the mission can have little operational significance
and will probably be acknowledged but largely ignored by managers at all levels.
Objective setting introduces accountability into the pursuit of the company vision,
so it is not productive to use vague terms such as ‘increase market share’ or ‘increase
the return on assets employed’.
It is also essential to ensure that objectives are consistent. The CEO may set the
objectives of cutting unit cost and maintaining market share in a highly competitive
market. If the cost cut is interpreted as being equally applicable to all activities the
outcome will be a reduction in the marketing budget, which is certainly not con-
sistent with maintaining market share.

3.3 The Gap Concept

The notion of performance gaps is closely connected with the setting of objectives
in the sense that it shows what has to be accomplished in order to achieve specified
objectives. The gap concept is concerned with the difference between expected and
desired future states. There are two steps in identifying a performance gap. The first
is to decide what the desired future state is at a specified time in the future; this can
be expressed in terms of new products, market shares, profitability and so on. The
second is to analyse the state the company is likely to be in at that time if no changes
to strategy are made. The difference between the expected and the desired state is
the performance gap. The salient issue here is comparison of expected future states,
and not comparison of the current state with the desired future state. It may be that
the current state is far removed from the desired state, but this may not result in a
change in strategy simply because of the impact of the passage of time.
Present Future
New
strategy Desired
outcome
Current
position Performance
gaps
Expected
Existing outcome
strategy
Figure 3.1 Performance gaps

An illustration of the gap concept is shown in Figure 3.1. The gap can be deter-
mined once objectives have been set in terms of desired future states. Since the gap
has to be closed in order to achieve the objective, or the future desired state of the
company, the closing of the gap could be interpreted as the company objective. This
is not quite consistent with the definition of an objective, since the closing of the
gap is a means to an end, not the end itself. It may turn out that identification of the
gap results in a modification of the company objective, because it transpires that the
gap cannot be closed; there is continual feedback between objective setting and gap
analysis.
The problem facing planners is to make projections of total company perfor-
mance; this can be complicated, and is typically carried out by using the scenario
approach (dealt with in detail in Section 4.7). A scenario comprises a series of ‘what
if’ projections, and should not be confused with a forecast. For example, if the
desired future state involved achieving a 3 per cent higher market share in two years,
a scenario could be investigated whereby marketing expenditure would be increased
by 30 per cent during the next two years. The resulting scenario would include the

impact on cash flow, the likely effect on market share, the reaction of competitors,
and the identification of what additional measures might be required, such as a price
reduction and increased productive capacity. This is clearly a difficult process, but it
is of considerable value in focusing attention on the potentially most important
factors determining the ability to achieve objectives.
Once the gap has been identified, three questions can be tackled:
 Does the gap arise because of external or internal factors?
 Does the company have potential resources to close the gap?
 Can a strategy be developed which will close the gap?
A revealing outcome of gap analysis is that while it may appear that the differ-
ence between the current and the desired state is not large, there may well be a
substantial difference between expected and desired states. Gap analysis can reveal
that the company is not actually moving in the direction desired, and closing such a
gap may imply substantial redeployment of resources and changes in marketing
strategy. For example, a furniture company may have a leading market position as a
maker of high-quality handmade modern furniture produced on commission. The
owners have decided that the current and the desired states are identical. But the
workforce is ageing and it is extremely difficult to replace their skills; machine made
furniture is becoming increasingly indistinguishable from handmade furniture.
Before long the company will be in danger of losing a significant proportion of its
productive capacity and perhaps a major part of its existing market. The expected
state is far away from the desired state and closing the gap will require attention to
be paid to both resources and markets.
Broadly speaking, there are two reasons for the emergence of gaps: those factors
outside and those within the control of the company. If the gap is due to factors
outside the control of the company, such as a predicted reduction in market size and
product prices, the original company objectives may be revealed as unfeasible
because the changes in the market are too great to counter. There is clearly no point
in pursuing a target level of sales and revenues if market conditions will make it
impossible to achieve; this would lead to a waste of resources, and could have far
reaching implications for employee incentives and commitment. Other external
factors might be aggressive competitor actions or government intervention, both of
which it might be possible to counter by appropriate marketing policies. The fact
that gaps are due to external causes does not necessarily mean that the company can
do nothing about them, but those instances where they cannot be fully counteracted
need to be recognised.
Internal gap constraints arise when the current allocation of resources is not
consistent with achieving the future desired state. The process of resource realloca-
tion may not be easy because some managers may be unwilling to cut back on
resources in some areas and increase them in others when there is no immediate and
obvious benefit. Another internal gap factor arises when the resources available to
the company are insufficient in quantity or quality to achieve the desired objective.
Capital equipment may be obsolete, managers may not be sufficiently enterprising
or labour might not have the necessary skills. Internal gap factors are related to the
mobilisation of resources, and as such are more likely to lie within the control of the

company. However, it may well be that the restructuring of the company implied by
some internal gap factors is too great to be accomplished with the skills and finance
at its disposal.
One reason for the existence of a gap is that the current incentive system is con-
sistent with what is expected to happen as opposed to what is desired. Given the
issues of timing discussed above, it is necessary to ensure that the workforce is given
the appropriate motivation to change objectives and behaviour at the required times.
It is necessary to initiate a system of incentives which converts the gap closing
objective, which is conceptual in nature, into a series of attainable objectives. This
can be difficult to achieve, and it may be somewhat difficult for a strategist to
convince managers that they need to alter their behaviour at a time when the
company is performing well, and when there may not appear to be a great deal of
difference between current and desired positions.
3.4 Credible Objectives

Setting objectives, including the determination of future desired states, is not an
activity which can be carried out in isolation from the particular circumstances of
the company. There is no point to setting objectives, even where these are derived
from the company mission, which employees think cannot be achieved and hence
do not serve as a guide for resource allocation. Thus the setting of objectives is
partly dependent on past decisions and on the state of the company at the moment,
as well as on perceived market opportunities. The setting of realistic objectives is a
dynamic process which is constantly under review. It would be naive to characterise
objectives as immutable goals set by isolated policy makers, and the process model
emphasises the feedback which makes it possible to adjust objectives in the light of
experience.
It might be deduced from the fact that objectives need to be constantly revised
that it is easier to frame them in loose terms which can cover a variety of situations;
this has the added advantage that objectives will not impose too much constraint on
the company’s operations. The danger inherent in this approach is that loose
objectives may be interpreted merely as wishful thinking by those charged with
implementing them. Objectives must be relevant to the managers involved and seen
to be achievable if they are to have credibility and operational validity. Another
point of view on this is that ‘stretch’ objectives can push employees beyond what
they thought they were capable of despite the fact that the objectives may not have
been regarded as credible at the outset. There is clearly a balance to be struck and it
is a matter of judgement as to how much ‘stretch’ can be applied.
This is where gap analysis can play an important role. An objective may not ap-
pear to be feasible at the present, but in terms of gap analysis it can be demonstrated
that it is achievable in relation to where the company is expected to be in the future.
For objectives to be credible they must also be consistent. To pursue this further, a
company with four product divisions sets the following three objectives.
1. Increase market share for all products by 3 per cent.
2. Reduce costs overall by 4 per cent.

3. Reduce employee turnover rates by 5 per cent.

This set of objectives leads to the following concerns.
 How to increase market share when costs are reduced.
 Divisions that have already maximised market share are not only penalised but
may find it impossible to increase market share further.
 Divisions that have already reduced costs are being penalised.
 Employee turnover is a component of cost and the attempt to reduce it is likely
to increase cost.
The outcome is confusion and a perception of unfair treatment. It is likely that
experienced managers, when confronted with this set of objectives, would dismiss
them out of hand.
3.5 Quantifiable and Non-Quantifiable Objectives

Company objectives can be expressed in terms of a single variable, such as a target
rate of return on investment. However, few companies claim to focus on only one
objective, and companies typically express objectives in terms of a number of
components or characteristics. For example, a company objective might be defined
as
 being associated with high-quality products;
 having a happy and stable workforce;
 having a dominant market share;
 generating a specified rate of return on investment.
Some of these components are not readily measurable, and hence their relative
importance is difficult to identify. For example, what is meant by ‘high-quality’
needs to be made explicit, because it may not be possible to have both a ‘high-
quality’ product, as defined by the development engineers, and a dominant market
share. To a large extent factors such as ‘happiness’ and ‘quality’ can only be meas-
ured subjectively, and it is inevitable that different managers will attach different
weights to these components of the company objective. It is reasonable to ask
whether there are any guidelines which managers can use in attempting to determine
the relative importance of such intangible factors.
Some light can be shed on this issue by considering how managers make deci-
sions in enterprises where the value of outputs cannot be measured because the
output is not sold on the market, for example in deciding where to build a new road,
or whether to set up a national park. This problem is addressed by using the tools of
cost benefit analysis, which attempts to determine the values which society assigns
to such factors as the value of a human life saved, or a stretch of scenic water made
available for leisure use. The handling of intangibles in cost benefit analysis has
lessons for managers who wish to incorporate non-measurable components into
company objectives.
Take the case of a new bypass which is expected to cut journey times round a
town by 20 per cent on average, but which involves the destruction of a local beauty

spot. Calculations can be made of the impact of the road on national income, taking
into account the initial investment, time savings, relative accident rates and so on;
while the answer cannot be exact, the outcome will be an approximate figure which
is likely to lie within an upper and a lower bound. Assume that the analysis suggests
that there is a 95 per cent chance that the impact on national income will be
between $20 million and $25 million. The decision can then be framed as: Is the
local beauty spot worth $20 million to $25 million?
It is then up to society, usually through its elected representatives in government,
to decide on the trade-off in the light of this information. It would be nonsense for
a cost benefit analyst to assign a value of, say $14 million to the beauty spot and
therefore conclude that the investment was worthwhile because the net gain to
society was likely to be between $6 million and $11 million (i.e. between $20 million
minus $14 million and $25 million minus $14 million). A complicating factor is that
the issue may not be decided on the basis of relative values because there are
distributional problems involved; those who pay, i.e. the locals who stand to lose
their beauty spot, will not necessarily receive full compensation. But the equity
problem should not obscure the conceptual point that a rational view on the relative
value of the beauty spot can be obtained from the facts available about the cost in
terms of opportunity cost; this is an important component of the final decision.
In the case of a company, an indirect approach can be taken to derive the relative
value of unquantifiable objectives. The first step is to decide on a unit of account
which is both measurable and important to managers. An obvious contender is
return on investment (ROI), since at the end of the day the company must have a
positive ROI to stay in business. Second, attempts can be made to determine how
change in the non-quantifiable objective is related to changes in ROI. For example,
resources devoted to the creation of a happy and stable labour force may at first be
accompanied by increases in ROI, but after a certain level of expenditure additional
resources allocated to this end may result in a net reduction in ROI; or a company
may estimate that expenditure on a new social club, while seen as highly desirable by
most employees, is unlikely to have significant positive effects on productivity, and
consequently will reduce ROI by 1 per cent. This provides the company with an
objective measure of the cost of the social club in terms of ROI; the company may
still think that the effect of the social club on welfare is worthwhile, but it will
undertake the expenditure in the full knowledge of what it is really costing.
A more complex allocation problem arises when there is a constraint on
resources and it is estimated that the allocation of resources to either of two non-
quantifiable objectives, such as welfare and product quality, will result in an
increased ROI. In principle, it is possible to determine the allocation of available
resources between the two objectives which results in the highest impact on ROI.
For example, the available budget may be $500 thousand, and spending an
additional $100 000 on each results in the impact on ROI shown in Table 3.1.

Table 3.1 Expenditure and ROI

Expenditure ($000) Increase in ROI
Additional Total Welfare Quality
+100 100 0.2 0.25
+100 200 0.1* 0.2
+100 300 0.04 0.1*
+100 400 0.02 0.02
+100 500 0.01 0.0
* optimum allocation
There is a relatively high payoff from the first $100 000 spent on each, but this
rapidly decreases. The highest joint impact on ROI is obtained by spending
$200 000 on welfare and $300 000 on quality, giving an increase of:
0.85% = 0.2 + 0.1 + 0.25 + 0.2 + 0.1
Any reallocation between them would result in a lower increase in ROI; for ex-
ample switching $100 thousand from quality to welfare would result in an increase
of:
0.79% = 0.2 + 0.1 + 0.04 + 0.25 + 0.2
The fundamental issue here is to visualise the issue in terms of trade-offs and
opportunity cost. The final decision may well be based on other factors, but the
expression of the alternatives in terms of a common unit of account such as ROI is
a powerful technique for focusing what otherwise is likely to be a highly subjective
and probably emotive discussion. It is worth stressing this point because many
managers are simply unaware that non-quantifiable objectives can sometimes be
translated into quantitative terms.
3.6 Aggregate Objectives

The corporate objective as derived from the mission statement is an aggregate
concept in the sense that it applies to overall company performance, size, target
markets, financial structure and so on. The specification of corporate aggregate
objectives has profound implications for the structure of the company and the
operations of SBUs.
Aggregate objectives are sometimes indistinguishable from mission statements
and may be expressed in vague terms such as ‘being in the transport business’ or
‘being innovative and quality orientated’; this is possibly because it is difficult to
visualise a single objective which applies to a range of products and SBUs. One way
of combining these is to use the notion of maximising shareholder wealth (or
shareholder value17); this idea is discussed in detail at Section 3.12.6. The notion of
maximising shareholder wealth is central to corporate strategy, and the rationale for
framing the company objective in this form can be expressed as follows:

Those who criticise the goal of share value maximisation are forgetting that
stockholders are not merely the beneficiaries of the corporation’s financial suc-
cess, but also the referees who determine the management’s financial power.
Any management – no matter how powerful and independent – that flouts the
financial objective of maximising share value does so at its own peril.18
One important reason for adopting a quantitative view of aggregate objectives is

that it can be used as a measure of the effectiveness of corporate executives. The
separation between ownership and control is a well-known problem (known in
economics as the principal–agent problem and dealt with in Section 3.8), and can
result in a wide divergence between the objectives of managers and shareholders.
An obvious example is where the remuneration of corporate executives is related to
the size of the corporation, which may not be consistent with maximising share-
holder wealth.
3.7 Disaggregated Objectives

The process of converting corporate or aggregate objectives to a series of objectives
for managers at lower levels raises many difficulties. This is because it is necessary to
interpret the aggregate objective in terms which are realistic, consistent and achieva-
ble, and make sense to managers at each level in the company. A prerequisite is to
identify the individual objectives which must be achieved in pursuit of the aggregate
objectives. For example, there is little point in telling a sales force manager that the
corporate objective is to achieve 15 per cent rate of return on investment. Instead,
the manager needs to be told what level of sales is consistent with the objective of a
15 per cent rate of return. In the absence of explicit guidance, the sales force
manager may attempt to maximise the sales of all products in response to the
general objective, while the optimum corporate strategy may be to maintain market
share at the current level and take over a key competitor. An example of how
objectives might be set at different levels, partly determined by the constraints faced
by the company at the corporate level, is as follows:
 CORPORATE OBJECTIVE
Achieve target ROI
 MEANS
Maintain market share
Take over competitors
 CONSTRAINTS
Existing productive capacity
Sharply increasing marginal cost
Current high debt ratio
 SBU OBJECTIVES
Maintain existing market shares
Control costs

 CONSTRAINTS
No investment capital
 SALES OBJECTIVES
Maintain market shares
 PRODUCTION OBJECTIVES
Increase productivity
Reduce inventories
The objectives set by corporate headquarters may not be consistent with the
objectives of individual managers. For example, a sales manager may see his career
prospects being dependent on maximising sales rather than restricting sales to some
predetermined level; the manager may fight against a cut in marketing expenditures
because from his viewpoint this will lead to missed opportunities. It may be very
difficult to convince the marketing manager that it is not in the corporate interest to
pursue what he perceives as being potentially profitable opportunities. This is an
example of the principal–agent problem which is discussed in Section 3.8.
Ensuring consistency with corporate objectives is not the only problem; some
managers may perceive their objectives as being in conflict with those of other
managers. For example, consider the following objectives:
 SALES OBJECTIVES
Increase market share
 PRODUCTION OBJECTIVES
Reduce inventories
The marketing manager will want to have access to sufficient inventories so that
new customers can be supplied immediately, otherwise some marketing resources
will be wasted. The production manager will have an incentive to tailor production
and inventories in relation to historic and immediate demand requirements, and will
have no incentive to respond to the marketing manager’s case that supplies must be
available to satisfy unpredictable new orders as they arise.
3.8 The Principal–Agent Problem

The problem which permeates management at all levels is the need to strike a
bargain with subordinates which ensures that the manager’s objectives are met
without the need for constant monitoring of activity. The personal objectives of an
individual manager may include maximisation of wealth, ambition, desire for a quiet
life, desire to avoid confrontation, and so on. There is no guarantee that the
manager will place the company’s objectives high in this personal set of priorities.
For example, a CEO may have a remuneration package which includes a bonus for
growth in current profits; to ensure that current profits continue to grow the CEO
may reduce expenditure on R&D, which has the effect of increasing current profit
at the expense of long-term competitiveness.
The problem is to generate a series of incentives which ensure that corporate and
SBU objectives are achieved. This involves drawing up a contract between the
manager (principal) and the subordinate (agent) which ensures that the agent attempts

to achieve the objectives laid down in the contract. By and large, the manager is
contracted by superiors to carry out certain functions, and then is left free to deter-
mine how they are to be achieved. In the absence of close monitoring, the fact that
the terms of the contract are not being adhered to may not become evident for some
time, and during that time a misallocation of resources can occur. To exacerbate the
problem, the individual manager has an incentive to conceal the fact that objectives
have not been achieved, and will possibly attempt to ascribe an unsuccessful outcome
to other factors, such as supply problems lying outside the manager’s control. The
root cause of the principal–agent problem is asymmetric information: the agent always
has more information than the principal. The misallocation of resources can be
compounded by invoking the efforts of accountants and other specialists in attempt-
ing to find out what has gone wrong, while the problem really lies with the contract
and incentive system.
The difficulty of ensuring that the agent acts in the interests of the principal can
become apparent when one company mounts a takeover bid for another. This
always has the effect of initially increasing the share price of the target company. If
the managers running the target company had acted in the best interests of the
shareholders then this could not happen, because they would have run the company
efficiently and exploited opportunities, all of which would have been reflected in the
current share price. In these circumstances it would appear that the outsider actually
knows more about the company than the incumbent management, and has spotted
opportunities for increasing shareholder wealth which these managers have not. The
trouble is that there is no effective mechanism by which shareholders can ensure
that their managers act efficiently; this is because the ownership of the company is
spread among many shareholders while the running of the company is concentrated
in the hands of relatively few senior managers and board members.
An example of the lack of control on the part of shareholders occurred in the
UK in the years following the privatisation of huge nationalised industries
including gas and water utilities. In all cases the existing management received
enormous increases in remuneration, and the argument that it was necessary to
pay such large salaries in order to attract the best talent appeared spurious to most
shareholders because they had been in the job prior to privatisation. In the case of
British Gas this coincided with a high degree of dissatisfaction with the provision
of gas as measured by the number of official complaints received by the gas
regulator, and in 1995 the British Gas Annual General Meeting was attended by a
pig named Cedric (the unfortunate CEO of British Gas was called Cedric Brown)
brought by a group of dissatisfied small shareholders. In the event it proved
impossible for the small shareholders to censure the management board because
the large institutional investors supported the existing management. The privatised
Water Companies caused similar dissatisfaction; for example, the people of
Yorkshire (one of the rainiest areas in Europe) had to suffer restricted supplies
because of water shortages at a time when management freely admitted that about
one third of all water was being lost through leaks in the pipes. Once more it
proved impossible for the small shareholders to oust what they perceived as
incompetent and greedy top management. The executives of major banks were
still receiving huge bonuses six years after their collapse in 2008. No position is

taken here on whether the top management of these organisations were in fact
greedy and incompetent; the point is that a significant minority of shareholders
felt that they were but were unable to do anything about it.
3.9 Means and Ends

An issue which is closely related to the process of disaggregating objectives is the
difference between means and ends, i.e. what is to be achieved ought to be differen-
tiated from how it is to be achieved; the distinction between means and ends is not
always clear cut when applied to many real-life situations, and this can lead to
confusion as to the nature of objectives. For example, the objective of a company
may be to achieve a 15 per cent rate of return on investment. The extent to which
this is best achieved by a happy and stable workforce, or by being associated with
high-quality products, depends on subjective judgements concerning the contribu-
tion of each to the profit objective; because of the importance a company lays on a
happy and stable workforce, many managers, and their subordinates, may gain the
impression that this is an objective of the company. Strictly speaking, it is a means
to an end.
As an alternative to specifying aggregate and disaggregated objectives, the process
of achieving a corporate objective could be set out as a series of means to achieve
the desired end as follows:
 END
Achieve 15 per cent ROI
 MARKETING MEANS
Achieve 23 per cent market share
Improve quality
Achieve more effective quality control
 PRODUCTION MEANS
Reduce unit cost by 4 per cent
Stabilise labour force
Improve sports facilities
Some managers might argue that the distinction between means and ends is
merely a semantic issue, and has no operational significance. However, the notion
can be applied in many real life situations. For example, the issue of providing
amenable working conditions can generate heated discussions; it is important to
discover if the parties are disagreeing about the level of expenditure because of
differing views on the contribution of working conditions to productivity or because
one party to the argument feels that good working conditions are desirable in their
own right. In the former case a judgement can be reached based on differing
estimates of productivity, but in the latter there can be no recourse to facts because
the matter hinges on a question of individual value systems. Some managers see
good working conditions as an end in itself, others as a means to an end.

3.10 Behavioural versus Economic and Financial Objectives

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

Those who have not been instructed in economics often assume that economic and
financial objectives are the same, but this is not necessarily the case. Economists
have always taken into account motives which cannot be expressed in financial or
monetary terms. In fact, the first question asked by an economist when analysing
behaviour is ‘What is being maximised?’ The reason for expressing the issue in this
way is that, unless an objective is specified, decisions and actions could be random
because the consequences do not matter. The idea of maximisation takes the notion
of objectives a stage further, in that it takes into account the fact that additional
resources devoted to the achievement of any particular objective are likely to yield
diminishing returns after some point. For example, a company may have the
objective of maximising the contribution from the sales of a certain product; this
does not imply that a limitless amount of resources should be devoted to the
product because, after a certain level, it becomes virtually impossible to increase
market share without disproportionate increases in marketing expenditure, causing

contribution to decline. Thus the notion of maximisation combines an objective

with a resource allocation implication, i.e. additional resources should be devoted to
the achievement of an objective up to the point where additional resources have no
positive impact. (Formally known as diminishing marginal product.)
The confusion between economic and financial objectives is partly accounted for
by the fact that, when constructing theories of behaviour, economists assume that
individuals attempt to maximise their welfare or happiness, and companies attempt
to maximise profits. While it is accepted that this is a simplified version of what
motivates individuals and companies, these assumptions are normally regarded as
being strong enough to capture a large element of motivation. Naturally, there has
always been debate about the extent to which individuals and companies attempt to
maximise anything. The best-known objection is that altruism, both on the part of
individuals and companies, is an example of non-maximising behaviour. However,
this is not necessarily the case, because it may be that the altruistic individual derives
more satisfaction from giving some money away to the poor than by spending it,
and is therefore maximising satisfaction by giving money away. Companies which
donate cash to causes such as charities, orchestras and sports may be pursuing
similar objectives: their shareholders are jointly willing to forgo some income for
altruistic purposes, and/or the management considers that there is a market payoff
from at least some of these activities.
A strong position on maximisation is that actions which are inconsistent with
maximising welfare are illogical for the individual, because a preferred position is by
definition one which makes the individual happier. Similarly, it is illogical for a
company to act in a manner which is inconsistent with profit maximisation, because
in a competitive market it will eventually be driven out of business. In fact, despite
the arguments surrounding it, the welfare and profit maximisation concept is
consistent with a wide variety of behaviour and provides the theoretical basis for
analysing and explaining many economic phenomena.
The central role which profit maximisation plays as a company objective can be
illustrated by considering the impact of any other objective on profits. For example,
a company which pursues what it considers to be enlightened labour relations
policies may cause labour productivity to be lower than it otherwise would have
been, putting the company at a potential competitive disadvantage. Similarly, if the
company has a policy of high-quality output, the rationale must be that policy
makers believe the consequences for segmentation, market share and hence profits
are worthwhile; otherwise, insistence on quality may place the company under
threat. Thus when setting objectives, policy makers need to pay attention to the
potential contribution of each option to long run profits. This approach may appear
at first to be somewhat ruthless; managers may consider that there is little point in
running a company which is not a pleasant place to work. However, in a competi-
tive labour market, companies which are not pleasant to work in are likely to have
more difficulty in recruitment and turnover rates than those which are pleasant,
with implications for productivity and costs. Indeed, economists argue that the
operation of the market is the vehicle by which many improvements in working
conditions are introduced into companies: those which do not improve conditions

in line with the general desires of the working population are likely to end up at a
competitive disadvantage.
A practical objection which is often levelled at the notion of profit maximisation
is that it is an unattainable ideal because of the vast number of options which would
have to be evaluated to find the one which maximises profit. The problem of
bounded rationality, and its solution known as ‘satisficing’, which involves choosing
the first alternative which meets a predetermined criterion of acceptability, was
discussed in Section 1.2.3. An example of a satisficing criterion is the ‘hurdle’ rate
used in financial appraisal, where the most profitable among a set of identified
alternatives is accepted only if it generates a return higher than the ‘hurdle’ rate.
A further objection is that companies exist in a continuously changing dynamic
environment, and there is no such thing as a single profit maximising decision.
Decisions are of varying importance to the company, and many decisions have to be
taken at relatively short notice leaving little opportunity for detailed analysis. This is
a valid criticism of the idea of profit maximisation, as it may well be impossible to
ascertain the connection between profit maximisation and decision making, given
the number of issues which bear on individual decisions in a dynamic setting. For
example, it may be decided not to undertake a potentially profitable investment
because the company is marshalling its resources for a strategic assault in a different
market; taken in isolation the decision may not appear to be consistent with profit
maximisation, but in the wider strategic sense it is. This is illustrative of the fact that
the simple textbook objective of profit maximisation is difficult to translate into real
life actions; the issue then becomes whether companies act in a manner which is
generally consistent with the concept of profit maximisation.
Empirical research reveals that few companies actually express their objectives in
terms that an economist would recognise as approximating to long run profit
maximisation. A possible explanation for this finding is that the profit maximisation
objective is a self-fulfilling prophecy, in that the competitive process weeds out
those companies which do not follow policies broadly consistent with it. If this is
true, then the company which is explicit in defining its profit maximisation objective
in a strategic planning context is likely to be taking account of one of the major
forces determining company survival. In the broad sense a company that does not
have profit maximisation as its ultimate goal is unlikely to succeed; this was one of
the weaknesses in the strategic process identified in the case of Eurotunnel dis-
cussed in Section 2.1.3. There is, of course, plenty of scope for not-for-profit
organisations such as charities to pursue non-profit maximising objectives, but any
claims by commercial companies that they are aiming to ‘do good’ must be regarded
with scepticism.
3.12 Financial Objectives

The application of financial concepts makes it possible to quantify the profit
maximisation objective. In economics, the profit maximisation objective is ex-
pressed in terms of comparative statics, i.e. it is assumed that all future cash flows
can be collapsed to a present value so that projects which are undertaken at the

present with different cash flows in the future can be compared. The application of
rigorous financial appraisal to the quantification of objectives is of basic importance
in understanding shareholder wealth creation, and it is necessary at this stage to
outline the main financial concepts which underlie the approach. The intention is
not to present a full exposition of financial concepts and theory, but simply to
indicate those areas of finance which are of particular relevance in the derivation of
measures of company objectives.
3.12.1 Discounting and Present Value

The notion of discounting is fundamental to understanding financial appraisal. It is
the technique for converting streams of future positive and negative net cash flows
into current terms. It takes account of the fact that a dollar in the future, say in five
years’ time, is worth less than a dollar now because a dollar now can be invested to
produce a stream of income over the next five years.
The value of a dollar in one year’s time is the original dollar plus the interest for
the year, i.e.
Dollar in one year = 1 × (1 + r)
where r is the rate of interest.
Looking at a dollar which is received in a year’s time, the value today of one
dollar is:
1
Dollar today
1
The value today of a dollar in two years’ time is:
1
Dollar today
1 1
1
1
This can be generalised to give the value today of a dollar at any time in the fu-
ture:
1
Dollar today
1
where n is the number of years in the future.
Thus by using the rate of interest and the time period, it is possible to express a
dollar in what is known as ‘present value’ terms. This makes it possible to compare
the value of cash received at different times.
X
X dollars today
1
3.12.2 Net Present Value

When an investment is undertaken, the cash flow pattern is usually negative at the
beginning, when the expenditures are made, and positive thereafter when the

investment generates income. A typical cash flow stream associated with an invest-
ment is:
―A1, A2, A3, …, An
where A1 = expenditure in Year 1, and A2, …, An = income in Years 2 to n.
The net present value (NPV) is found by summing the discounted streams of
future expenditure and income over the life of a project:
NPV ⋯
1 1 1 1
where r = cost of capital to the company
If the NPV is positive, the investment yields a value over its life, and is worth
considering. Typically the choice between potential projects is made on the basis of
which generates the higher NPV. If a project has a negative NPV the company
would be better off putting the money in the bank. One way of assessing strategy
options is to think in terms of cash flows: what are the initial costs of the strategy
and what are the expected cash flows? As will be seen, it is typically not possible to
reduce strategic choice to such a straightforward calculation, but the approach is
valuable in focusing on a very important aspect of the strategy process, namely the
potential for generating cash flows.
3.12.3 Capitalised Value

Imagine you were given a bond which provided an annual income of $100; how
much would you be willing to sell this bond for? You would be willing to consider
any offer of at least the amount which, when invested at the current rate of interest,
gave an income of $100 per year. If the current interest rate were 5 per cent you
would work out the following:
Income stream Capital sum Interest rate
100 Capital sum 0.05
therefore
Income stream
Capital sum
Interest rate
100
Capital sum 2000
0.05
Thus the capitalised value of a stream of income is found by dividing the annual
income by the interest rate. The same reasoning applies to a constant stream of
costs. Any future stream of income or cost can be converted to a capitalised value.
Another way of looking at this is that a guaranteed income and a capital sum
come to the same thing. Take the case of holding a share in a company: divide the
expected income by the going interest rate and you obtain an approximation to the
share price. You would, in fact, add a premium to the interest rate to reflect your
estimate of risk associated with that company. One method of evaluating the return
on a share is to use the price earnings ratio. For example, a ratio of 20 suggests that
the interest rate (plus risk premium) is 5 per cent. Why do some shares have very
high price earnings ratios, i.e. low rates of return? It is because earnings are expected

to grow in the future; for example, if the growth rate in earnings was expected to be
1 per cent for ever, the capitalised value of the income stream shown above would
be approximately:
100
Capital sum 2500
0.05 0.01
This gives a current price earnings ratio of 25. Thus the value of a share, or the
value of any asset, is determined by the expected future income stream accruing from
that asset. In fact, the calculation demonstrates that the share value is quite sensitive
to relatively marginal changes in expectations of future growth rates. This is why
companies go to great lengths to maintain confidence in their prospects and why
they are averse to releasing information which might affect the financial market’s
perception. Thus the Annual Report is usually an optimistic document and rarely
contains unexpected bad news such as a major loss; if a loss is in prospect a profit
warning will be issued so that when the information does become public the impact
on the share price is not catastrophic.
In July 1996 the shares in Great Universal Stores, a UK home shopping to finan-
cial services conglomerate, fell by 35p to 637p after reporting a rise of 3.25 per cent
in profits over the previous year. This was in fact GUS’s 48th consecutive year of
profit increases. How could the share price fall when reported profits had increased?
The answer is that market analysts had expected a much larger increase in profits,
and this expectation had been included in the share price. When the ‘disappointing’
news became public the price immediately adjusted to a revised profit expectation.
3.12.4 Choice of Interest Rate: The Cost of Capital

When carrying out NPV calculations it is necessary to select a rate of interest to use
for discounting. The obvious choice of interest rate is the cost to the company of
raising money on the open market, and this is usually termed the cost of capital.
There are two methods of raising finance: debt and equity. The cost of finance from
the two sources can be significantly different, and thus the proportion of finance
raised by the two methods can affect the composite cost of capital.
So far as debt is concerned, the relevant rate of interest is the cost to the compa-
ny of the capital over the planning period, i.e. the rate of interest payable on debt
which matures at the end of the planning period. The cost of debt cannot be
determined on a historical basis; it is the cost of new debt which determines the true
present value of future cash flow streams. It may not be possible to predict the cost
of debt precisely because a company may operate on the basis of short-term debts,
with continuous loan restructuring. However, the best estimate of the cost of debt is
the interest rate on a loan of the appropriate duration, not the cost of debt in the
past.
Equity finance raises a number of problems, the most obvious of which is that
the rate of return on equity is not known, and therefore must be estimated. In
conceptual terms, the rate of return which should be estimated is the implicit rate of
return, which is the rate that just induces shareholders to purchase equity in the
company. The implicit rate has two components: the risk free rate and an allowance
for risk, known as the equity risk premium. The risk free rate comprises the market

rate plus the expected inflation rate; the risk free rate is partly a function of the
current interest rate, and partly determined by expectations. It can be approximated
to by the rate of return offered on long-term government debt, which is the nearest
thing to a risk free investment available on the market. The equity risk premium is
based on the market assessment of the risk associated with the company. This is
affected by the track record of the company’s managers, past dividend payments
and profitability.
The theory known as capital asset pricing provides a perspective on the appropri-
ate method of calculating and allowing for risk. The objective of this theory is to
explain what determines the value of a company’s shares by taking into account
different forms of risk, and it is an important part of modern finance theory. The
value of the common stock of a company can be interpreted as the capitalised value
of the future expected stream of income from the stock, i.e. the expected future
stream of dividends. The capitalised value of the future expected stream depends on
the current interest rate plus an adjustment for risk. It is the approach to risk which
differentiates the capital asset pricing model. In simplified terms, the appropriate
risk is that which cannot be eliminated by holding the shares of the company in a
portfolio. This is known as non-diversifiable risk. It is estimated by taking into
account not only the variability of a company’s dividends in the past, but the
correlation between company dividends and those paid by the rest of the market.
(The Beta coefficient is a well-known method of calculating risk of this type.)
An important implication of the capital asset pricing model is that the discount
rate applied to individual investments by the company should include the measure
of non-diversifiable risk; this is because the company is in competition for funds,
and suppliers of funds require information on risk when structuring their portfolios.
While there are many problems associated with measuring the appropriate cost of
capital for the company, it is important that the issues of the cost of debt, the risk
free rate and the equity risk premium are taken into account. If a discount rate is
used which does not properly represent the cost of capital the calculation will
generate misleading information on value creation. The connection between market
performance and the discount factor which should be applied to investments is one
of the important links between capital markets and what managers actually do.
The external perception of the company has a double edged effect. If the finan-
cial market takes a pessimistic view of future expected cash flows then the share
price will suffer, as was the case for GUS; at the same time, if the company is seen
as a risky proposition the cost of raising equity finance will be significantly in-
creased. It is not surprising that companies try to project an image of stability with
secure growth prospects. In the turbulent business environment of today this is
extremely difficult to maintain for any length of time.
3.12.5 Return on Investment

The profit maximisation objective can be expressed as maximising the rate of return
on investment; in practical terms this involves taking into account a stream of
investments over time, changes in interest rates, liquidity and cash flow require-
ments, tax incidence, the portfolio of assets, dividend payments, and many other

considerations. Because of the difficulty of reducing these complex calculations to a

single figure managers tend to use measures which can be calculated relatively easily.
Perhaps the most widely used is return on investment (ROI), which is usually
expressed as net income divided by value of assets in a particular year. The main
drawback associated with using ROI as a company objective is that the figures for
both asset values and income are historical. It therefore may not capture the income
earning potential of the company produced by recent investment. Furthermore, the
figure used for the value of assets is typically arbitrary, being the result of accounting
depreciation procedures. On the other hand, it is often contended that despite the
deficiencies of ROI, it still contains sufficient useful information for determining
company objectives. Critics contend that this is not necessarily the case, and ROI
may actually produce misleading information, which may be worse than having no
information at all, since adherence to a mistaken objective could result in misallocat-
ing resources.
Table 3.2 is designed to illustrate the main pitfalls associated with using ROI; it
shows the cash flows resulting from an initial investment of $1 million which is
depreciated over five years using the straight line method.
Table 3.2 Return on investment over time

Year 1 2 3 4 5
Cash flows 175 250 350 400 400
− Depreciation 200 200 200 200 200
Net income −25 50 150 200 200
Book value start year 1000 800 600 400 200
− Depreciation 200 200 200 200 200
Book value end year 800 600 400 200 0
Average book value 900 700 500 300 100
Return on investment −2.8% 7.1% 30.0% 66.7% 200%
The ROI varies between −2.8 per cent and 200 per cent during the five years;
different depreciation conventions would lead to different series of ROIs. It is
difficult to relate the ROIs for different years to relative cash flows. For example,
the increase in ROI from 7.1 per cent in Year 2 to 30 per cent in Year 3 is partly due
to the increase in cash flow and partly due to the lower book value which appears in
the denominator; the 200 per cent ROI in Year 5 is based on the same cash flow as
the 66.7 per cent in Year 4. It is therefore virtually impossible to use the ROI
calculations as the basis for choosing among competing investment possibilities.
One method of generating a single ROI is to calculate the average ROI using the
average book value and the average net income, this gives an ROI of 23 per cent.
The drawback of this calculation is that it takes no account of the distribution of
cash flows over time; the discounting approach gives an Internal Rate of Return of
15 per cent (the interest rate which just gives an NPV of zero); thus not only does
the ROI calculation provide results which are difficult to interpret, but the ROI
calculation may result in an overestimate of the rate of return on the investment.

Despite the difficulties associated with ROI it should not be dismissed as irrele-
vant to decision making. While it may provide a misleading view of the rate of
return on a single investment, the average ROI for a company as a whole, which is
comprised of returns derived from many assets of various vintages, may be suffi-
ciently accurate to monitor a company’s performance. For example, if the ROI were
to fall from 18 per cent to 8 per cent from one year to the next, this is a clear signal
that something is amiss and that resources are not being utilised as efficiently in the
second year. This may be a ‘red herring’ at times, but it is unlikely that major
changes in the company’s ROI are due merely to accounting conventions. The fact
is that accounting information is extremely difficult to use in an unambiguous
fashion, but it is the only information available and it is essential that as much use of
it is made as possible.
3.12.6 Shareholder Wealth

This definition of company objectives originates from the proposition that the
primary objective of a company is to maximise the wealth of those who own it,
namely the shareholders. It ignores value which may accrue to other stakeholders
because they do not have a direct impact on the allocation of financial resources
among companies. The approach is similar to that of working out a capitalised
value:
Expected income stream
Shareholder wealth
Interest rate
The market forms its view on the expected income stream on the basis of pub-
lished company accounts, the track record of the company, and announcements
about company plans. The interest rate which is used to derive the capitalised value
will contain an allowance for the risk associated with the company. This measure of
shareholder wealth differs from the total capitalisation of the company on the stock
market; it is more useful than market capitalisation because while there is a connec-
tion between share value and effective management in the long run, share value on
its own cannot be used as a day to day company objective because it also varies with
many factors, such as the state of the stock market as a whole, which are unrelated
to company operations. Shareholder wealth analysis is based on a detailed analysis of
the revenue generating potential of the various parts of the business, and hence may
often bear little relation to the market valuation.
There are several stages in estimating shareholder wealth.
 Stage 1: Decide on the Planning Period
The planning period is that period during which meaningful projections can be
made, and is typically around five years in real life.
 Stage 2: Determine the Cost of Capital
The process of determining the cost of capital is described in Section 3.12.4.
 Stage 3: Decide on the Residual Cash Flow
This is the constant net cash flow predicted after the end of the planning period.
 Stage 4: Determine the Cash Flows during the Planning Period
This depends on investment and marketing strategies.

 Stage 5: Calculate Net Present Value of Cash Flows during the Planning
Period
The process is explained in Section 3.12.2.
 Stage 6: Calculate the Present Capitalised Value of the Residual Cash
Flow
The process for calculating the capitalised value is explained in Section 3.12.3
 Stage 7: Add the Net Present Value, Capitalised Residual Value,
Marketable Securities minus Debt
The current debts of the company must be set against expected future income,
and any assets which are not involved in wealth production must be added to the
total. There is a distinction between the value to shareholders of wealth-
producing assets (which could be sold on the market), and non-wealth-
producing assets. The former cannot be sold without reducing the expected
stream of income, therefore to add them in would be double counting. The latter
are the result of past wealth generation which have not been distributed to
shareholders.
Table 3.3 Estimating shareholder wealth ($million)

Cash flows Year
Shareholder PV flows PV residual 1 2 3 4 5 6+
wealth
857 393 464 100 110 120 130 140 140
Table 3.3 is an example of a shareholder wealth calculation using a 5 year plan-

ning period and a cost of capital of 15 per cent. The cash flows start at $100 million
and increase to $140 million by Year 5; from Year 6 on it is assumed that cash flows
will be constant at $140 million. The Present Value of the cash flows from Year 1 to
Year 5 is $393 million, and the Present Value of the residual is $464 million. (By the
way, if you carry out the calculation bear in mind that the capitalised residual is
discounted from the end of year 5, i.e. for 5 years rather than 6.) In this case the
present value of the residual cash flow is greater than the present value of cash flows
during the planning period. It should be clear from the above that the calculations
made by the company, using all the information available on future prospects, is
unlikely to accord with the market valuation of shares. However, it is a fair indica-
tion of the underlying value creation potential of the company. This is a more
sophisticated approach than simply using a constant growth factor in perpetuity,
because it takes into account that the company cannot be expected to grow indefi-
nitely. In the absence of persuasive information on the planning period and
potential growth of net cash flows it can be assumed that current net cash flow will
continue indefinitely and the simple calculation of capitalised value can be used.
This approach to value creation has important implications for the perspective
taken on potential strategies because the ultimate test of a strategy is whether it is
likely to add to shareholder wealth. It concentrates attention on the impact of
strategies on future cash flows, and forces managers to be explicit about how
potential cash flows will be generated. Because it is a company-wide idea, the impact

of strategies on the cash flows of the company as a whole is taken into account,
enabling a wider perspective on investment appraisal, which typically focuses on
directly relevant cash flows.
An additional use of the shareholder wealth approach is to break down the com-
pany into its value generating components. It is a revealing exercise to estimate
which activities generate value and compare these to the activities on which manag-
ers spend their time. This is developed further in Section 7.5.1.
The notion of using shareholder value as a company objective might at first
appear to be somewhat unrealistic, being based on projections of cash flows and the
residual value which may have little operational meaning to individual managers.
However, the underlying idea is simple, and should be borne in mind by managers
at all levels in an organisation; posing the question ‘in what sense is this activity
adding value to the company?’ is a powerful method for focusing the mind on the
relevance of alternative courses of action.
Shareholder wealth is in fact used by sophisticated stock exchange analysts to
assess the underlying effectiveness of companies. During 1991 Lord Hanson, a
noted takeover expert, bought a very small percentage of the huge British company
Imperial Chemical Industries (ICI). Immediately there was public concern that this
previously successful company, with its distinguished record of R&D, would fall
prey to asset stripping. Fears were expressed that the huge ICI R&D programme
would be abandoned if Hanson was successful, and ICI mounted a vigorous
defence. But a different viewpoint was expressed by New York analyst Mark
Gressle (employed by Stern Stewart), who uses a model of shareholder value
creation (which he calls Market Value Added, or MVA); the MVA technique is
similar to the shareholder wealth approach described above. Gressle argued that in
the period 1984 to 1988 Hanson had generated £2.7 billion in wealth for investors
compared to the £0.5 billion generated by ICI. In fact, some quite famous compa-
nies have been wealth destroyers, according to the MVA model, which identified
some famous British wealth destroyers as shown in Table 3.4.
Table 3.4 Wealth destruction

Wealth destroyed Capital invested
1984–1988 (£million) (£million)
British Aerospace 1 240 1 787
General Electrics Co. 1 064 4 240
Allied-Lyons 533 6 345
British Telecom 413 13 024
Source: Stern Stewart, Extel.
The Gressle argument is quite simple: could Hanson generate more wealth for
shareholders than the existing management? The market seemed to think so,
because the value of ICI increased significantly when Hanson made his initial share
purchase. However, mainly as a result of poor publicity, Hanson did not proceed
with the takeover, but he did sell his shares for a substantial profit! He thus achieved

some of the wealth gain which he might have generated if the takeover had gone
ahead.
Three months after Hanson sold his shares in ICI, it was announced that the
company would split into two parts: ICI and ICI Biosciences (later named Zeneca),
the latter specialising largely in pharmaceuticals, which was a distinctive part of the
company. This ‘demerger’ was a clear recognition of the fact that size and diversity
are not necessarily efficient; it also corroborated the Gressle argument about ICI’s
ability to create wealth compared to Hanson’s.
3.13 Social Objectives

There is plenty of scope for disagreement among those managers whose objectives
can be characterised as profit maximisation; these disagreements revolve around the
appropriate measure of profitability. However, there is another body of thought
which takes the view that companies should have objectives which are much
broader in scope than simply maximising profits. These objectives might include the
minimisation of pollution and creating employment opportunities for the disadvan-
taged and for those who live in depressed areas. The notion that companies have a
wider responsibility to the community gained momentum after 2000 and has gained
the formal title of Corporate Social Responsibility (CSR). Many companies claim to
take CSR into account in their decision making and Annual Reports often contain a
section on CSR.
The problems facing companies that wish to pursue CSR policies are the lack of
definition of what comprises CSR and a great deal of muddled thinking on whether
CSR is appropriate in the first place. The view that companies should pursue social
objectives can be criticised on the grounds that not only is any other goal than profit
maximisation bad for the company, but it can result in a misallocation of resources
so that everyone ends up worse off. This, of course, is consistent with the view that
the interests of society as a whole are served by the self-seeking actions of individu-
als, while the undesirable side effects of the market can be tackled through collective
action using elected governments; thus attempts by individual companies to
shoulder the role of government are misguided.
The arguments against incorporating social objectives into company objectives or
pursuing a CSR agenda are, first, the lack of efficiency criteria. The most obvious
difficulty which a company faces when attempting to incorporate objectives relating
to civil rights or ecology is the determination of how much of its scarce resources to
devote to any particular social end and determining whether the allocation of
resources is efficient. Given the difficulty managers have in determining the
efficiency of resource allocation within the company itself, such a venture is bound
to be frustrating. It may be that there is a real return on being associated with a
‘green’ approach to production, so in this case ecological concern is really a form of
marketing expenditure; furthermore, these returns may only be achieved in the long
term. The second argument relates to the self-interest of the shareholders. Any
company pursuing social objectives which incur costs the company would not
otherwise bear has to compete against rivals who are pursuing a purely profit

maximising set of objectives; this means that the company will have higher relative
costs. If this leads to lower returns then rational shareholders will withdraw their
funds and invest elsewhere.
The underlying issue here is what is referred to by economists as ‘efficiency ver-
sus equity’. The efficiency issue is concerned with maximising the output of goods
and services. The equity issue is how the output should be distributed among
members of society. It may be that the pursuit of equity, in the form of CSR, is
consistent with profit maximisation; but where it is not companies need to tread
carefully.
3.14 Stakeholders
A variety of individuals and groups have an interest in the organisation and some
influence on the way it is managed; those individuals and groups are categorised as
the stakeholders. The notion of stakeholder extends well beyond the shareholders, or
owners of the company, to include managers, employees, customers, suppliers,
creditors, the local community and the government.
3.14.1 Stakeholder Interest

Each stakeholder has a different type of interest in the company, for example the
shareholders are concerned with the return on their investment, and the safety of
their capital, while customers are concerned with the quality of the product they
purchase and after sales service. Thus each stakeholder has an expectation of some
return from the company which is not necessarily expressed in financial terms.
An outline of the various stakeholders and their interest is shown in Table 3.5.
Table 3.5 Stakeholders and their interests

Stakeholder Interest
Shareholders Return on investment
Risk
Managers Salary
Advancement
Employees Salary
Advancement
Security
Fair treatment
Suppliers Prompt payment
Repeat orders
Customers Relative value for money
Quality
Availability

Stakeholder Interest
Creditors Cash flow
Financial stability
Local community Lack of negative externalities
Employment prospects
Government Payment of taxes
Lawful operation
The main characteristic of this classification is that the interests of the different
stakeholders are completely different and this raises the possibility of conflicts of
interest. Given the potential for conflicts of interest it is clearly important to
determine priorities, i.e. which stakeholder interests are most important.
It could be argued that this is really a discussion about how society should be run,
for example, in a general sense should employees or shareholders be regarded as
more important? An individual’s judgement on this is likely to be affected by which
group he or she is in, for example it is quite natural for an employee to consider that
day to day involvement with the company is more important than that of the
shareholder who may never have been inside the door. It is important to be explicit
about the issue of shareholder priorities because it has implications for the efficiency
with which the company can be operated. The following are the type of arguments
you will encounter on stakeholder priorities, but it is important that you keep an
open mind on the issue. Furthermore, this discussion is conducted in terms of a
commercial organisation; the not-for-profit sector, which includes education, health
provision and charities, will differ in many respects.
Shareholders
The shareholders can be regarded as the most important because they provide the
capital for the company and if it does not operate efficiently shareholders can
withdraw their funds and invest it in something more profitable. In this respect the
shareholders provide a service to the rest of the economy by directing resources to
those operations which provide the highest financial returns; in that sense everyone
benefits from the freedom of choice to pursue the best return on their money.
On the other hand it can be argued that shareholders tend to take a short-term
view of company prospects and it is not safe to leave the destiny of companies to
their discretion. This in turn becomes an argument about how efficiently capital
markets work, and the fact is that no method has yet been discovered which is as
effective as capital markets in directing the allocation of resources in the economy as
a whole. Central planning was exposed as a failure with the fall of communism;
variations on free market operations have been tried, but amount to attempts at
influencing the way the market works rather than replacing it.
So far as the company is concerned, it needs to be recognised that shareholders
control the supply of capital, and if their interests are not met in the form of a rate
of return which is comparable to other investment opportunities then the company
will most likely cease to exist. It is because of this that it is often concluded that

shareholder interest is the highest priority stakeholder and companies ignore this at
their peril.
Managers
Managers comprise the group which is charged with determining the direction,
scope and effectiveness of the business. They are responsible for the allocation of
resources, and it is largely upon them that the stakeholders depend for their returns.
In addition, if managers make the wrong decisions the employees lose their jobs and
customers are deprived of the company’s products. It can thus be argued that
managers are the most important stakeholders and therefore should be rewarded
accordingly.
While this is true, there is also a market in managers, and so long as the company
treats them at least as well as companies which might compete for their services
then they do not need to be singled out for special treatment. Their stakeholder
priority is high, but it need not be at the expense of shareholder or employee
returns.
Employees
It is on the productive effort of employees that the success of the company de-
pends. But exactly the same argument applies in the case of managers: there is a
market in employees which determines the conditions under which they are
employed, and again it is unnecessary to single them out for special stakeholder
treatment above and beyond that dictated by the market.
Suppliers
The stakeholder priority depends on the number of suppliers which the company
uses. The five forces model discussed at Section 5.10 highlights the bargaining
power of suppliers; where the company is greatly dependent on one supplier it
follows that its stakeholder priority is relatively high. But before assigning too high a
priority to suppliers it is necessary to determine whether the company can substitute
for other suppliers, or increase the number of suppliers. If there is a high degree of
dependence on a supplier then this may be a case for vertical integration, but
typically recourse to the market will reveal that there are plenty of other suppliers.
It may be that a long-term relationship has been developed with certain suppliers
which provides security of supplies, flexibility and so on. But it has to be recognised
that there are costs as well as benefits in such a relationship, and if dependence on
particular suppliers is found to have an unjustified influence on the management
and direction of the company then the stakeholder priority must be reconsidered.
Customers
It is clearly important to provide customers with what they want, but this is because
they can take their custom elsewhere in competitive markets. Other than the
obvious fact that the company sells to customers, it is difficult to see what priority
should be accorded to customers as stakeholders.

Creditors
As capital markets have become increasingly competitive the interests of individual
creditors has diminished. If the creditor has made a realistic estimate of the client
then it will be reasonably confident that its debts will be serviced and need have no
other interest in the company.
Local Community
Companies depend on their local community for employees, services, land, planning
permission and so on; the local community depends on the company for employ-
ment and the creation of wealth. Both sides benefit from the arrangement and in
this respect it is important for the company to live in harmony with the local
community.
There is no doubt that the local community has a valid stakeholder interest, and
this needs to be taken into account in company decision making.
Government
So long as the company pays its taxes and acts according to the law there is no need
for the government to figure in its decision making. In a market economy the role
of the government is to set the rules of the game and monitor that they are being
adhered to. The government really has no stakeholder interest beyond this for
market companies. In government run organisations such as the civil service this is
not the case, but here the government acts as a shareholder and it is in that sense
that it has a high stakeholder priority.
3.14.2 Stakeholder Influence

While it can be argued that in principle some stakeholders should have little interest
in the company, the existence of legislative, institutional and historical factors can
imbue stakeholders with a significant degree of influence; for example, a strong
trade union can result in employees having a significant impact on major company
decisions. In the not-for-profit sector there are typically many interest groups who
have to be consulted.
While the profile of stakeholder influence varies among different companies, the
following indicates the factors which determine how important that influence is
likely to be.
Shareholders
Despite their importance, shareholders usually exert little influence on major
company decisions or how the company is run from day to day. Large companies
typically have many shareholders and they are geographically isolated, coming
together, if at all, only for the annual general meeting. Power rests with the execu-
tives, and it is only in exceptional circumstances that CEOs are censured or
dismissed at the AGM; this is an aspect of the principal–agent problem discussed at
Section 3.8.

In some cases large financial institutions, which manage portfolios for pension
funds and investment trusts, may have a significant shareholding in a particular
company; if the institutional shareholders together take a similar view on a particular
issue they may wield some power over company executives at the AGM. In smaller
companies, which are family owned or have a few partners, the shareholders wield a
direct influence on company operations. But in this case they typically play the dual
role of shareholders and managers, and this negates the principal–agent problem.
Managers
By and large the influence of managers increases with the size of the company and
the influence of shareholders diminishes. The independence of managers also
depends on the type of remuneration package – whether it is related to absolute
profits, growth in sales, successful acquisitions, or whatever. Ideally, the manage-
ment incentive structure would be aligned with shareholder interests, which are
largely profit maximisation, but this is notoriously difficult to achieve. There are
many examples of CEOs receiving huge salary increases at the same time as
company fortunes are falling – this is usually because remuneration incentives are
lagged and are related not to current but to past performance.
One method of attempting to align the two is to make the CEO a shareholder by
giving stock options instead of direct remuneration. While the outcome of this
should be the maximisation of shareholder wealth, the CEO has an incentive to
cash in the options at the most opportune time, and this may not be consistent with
long-term profit maximisation. In principle, the role of the non-executive board
members, and an independent chairman, is to provide the countervailing power
which will balance up the interests of managers and stakeholders, but given the
limited time which the non-executives spend in the company, and the fact that
directorships are often interlocking, the non-executives often wield little real power.
Employees
There was a time in the UK when trade unions had sufficient numerical strength,
and the backing of legislation, to ensure that employees had a significant impact on
company decision making. The changes in the legislation in the 1980s, coupled with
an absolute decline in trade union membership led to a significant reduction in this
form of employee influence. In some countries, such as Germany, employee
influence is much higher because of labour legislation which is more favourable to
employees than is the case in the UK. Thus much depends on the individual country
and its legislation.
However, employees wield influence in a different way. It is not feasible for a
company to replace its entire workforce at a stroke. Even if it were, the new
employees would start off far down the experience curve and productivity and
competitiveness would be severely undermined. Thus the company is to a great
extent dependent on the skills and attributes of the current employees. In this case it
is not so much the direct influence of employees on company decision making
which is important, but the extent to which they are able and willing to collaborate
in the changes which strategic decision-making involves. This in turn depends on

the company culture, organisational structure, incentives and so on. The more
specific the employee skill sets are to the individual company the more important
this factor is likely to be.
Suppliers
As discussed above, the important considerations are the number of suppliers and
the availability of substitutes.
Customers
The five forces model reveals that the number of customers or customer groups
largely determines customer influence. On the other hand, if there are few substi-
tutes for the company’s products this power will be greatly diminished.
Creditors
Companies tend to build relationships with sources of credit, such as banks, so that
they can rely on a fast and fairly sympathetic reaction to credit requirements. Some
companies have representatives of creditors on the board; this is usually the
outcome of venture capital being provided by banks for high risk start-ups who
wish to monitor their investments. But typically this involvement diminishes as the
management establishes a track record.
Companies have the option of financing investments from retained earnings,
obtaining loans, or a combination of both. It could be argued that a company which
has become so dependent on a particular bank that it exerts influence on company
operations only has itself to blame. In principle, the influence wielded by the bank is
to decide whether to provide a loan, and it does this in competition with other
banks. Where a relationship has been established it can be costly to change creditor,
but this is an issue of costs and benefits rather than creditor influence. The fact that
the company is highly geared may constrain its activities, but it is difficult to see how
the creditor can exert direct influence on the company unless it has put the credi-
tors’ funds at risk.
Local Community
The influence of the local community is in the form of a series of constraints. For
example, if the company develops a reputation as a good employer, it will typically
have little difficulty in recruiting at the going wage rate; however the opposite is
likely to apply if its reputation is suspect. If the company pollutes the locality it will
probably have difficulty obtaining permission for expansion.
Government
Apart from regulation, the government can influence companies by its own role as a
purchaser and its policies on subsidies and trade. The purchasing influence affects
companies in the defence industry, subsidies affect companies in the sectors which
the government is attempting to encourage, and trade policy affects importers and
exporters. Again the extent of stakeholder influence depends on the individual case.

3.14.3 Mapping Stakeholders

Stakeholder influence and priority can have a significant impact on how an organisa-
tion operates and on its potential for change. The constraints imposed by
stakeholder influence are not always recognised and one of the reasons why things
often do not turn out as expected is that the interests of stakeholders have not been
taken into account. One approach is to map the potential importance of stakehold-
ers according to their influence and priority.
Consider a company which is family owned and the family maintains a close
control on the business, uses mostly unionised labour and supplies a single custom-
er; one of the owners is currently considering moving into new markets. The
stakeholder map relating to this potential course of action might look like:
Stakeholder Influence Priority

Shareholders (family) High High
Managers Low High
Employees High Low
Existing customers Low High
Suppliers Low High
The potential move into new markets can then be considered in the light of the
priorities attributed to and the influence wielded by stakeholders; this form of
mapping makes it possible to focus on those stakeholders who are likely to have a
major influence on successful change. For example, in this case while employees
have a low priority they have a potentially high influence on the outcome. Closer
investigation may reveal that the change would be constrained by
 the attitudes of the other shareholders;
 the willingness of the employees to accept change.
An organisational change which is not accompanied with some form of stake-
holder mapping may well run into constraints which could have been identified well
in advance.
The stakeholder map can usefully be presented diagrammatically as shown in
Figure 3.2.

High
Employees
Shareholders
Influence
Customers
Managers
Suppliers
Low High
Priority
Figure 3.2 A stakeholder map

Clearly the precise location of each stakeholder is a matter of subjective judge-
ment, but the diagram immediately identifies clusters of stakeholders, who may
therefore require a similar degree of consideration, and outliers such as the share-
holders who in this case occupy a unique position. Any movement in the relative
positions of stakeholders can be tracked over time as a means of identifying the
changing power structure confronting the company.
A final point must be made in response to those who consider that the whole
notion of stakeholders is irrelevant to a profit maximising company, for example for
many of the reasons outlined under the discussion of stakeholder priorities. The fact
is that stakeholders do wield varying degrees of influence in any organisation and
often decisions taken reflect an implicit mapping of stakeholders on the part of
senior management. If this implicit mapping turns out to be seriously in error then it
is quite likely that outcomes will not turn out as intended.
3.15 Ethical Considerations

The extreme characterisation of a manager as a Dickensian capitalist with no moral
feeling other than the desire to make money is rarely encountered in real life;
managers are just the same as anyone else, and have a set of moral values based on
parents, education, religion and so on. Managers strive as hard as anyone else to act
in a way which is consistent with their moral outlook. In the complex world of
business it is usually very difficult to define appropriate moral codes of conduct. At
Section 3.9 it was pointed out that managers should attempt to be clear about the
distinction between means and ends. A related issue is whether a particular means
justifies a particular end. By the nature of production, costs are incurred in the
creation of output; sometimes these costs can be very high to some of the individu-
als involved. However, moral issues are never simple to resolve; for example, at
Section 3.13 it was argued that companies which attempt to meet social rather than
profit related objectives may do more harm than good, and in that sense their well-

meaning attempts could be regarded as immoral. It could be argued that the

advocates of Corporate Social Responsibility are attempting to prescribe their ethical
stance on business, i.e. that companies have a moral obligation to take account of
negative externalities.
Many management issues are related to moral dilemmas, but these are often to
do with society generally rather than the individual company. For example, in
Britain during the eighteenth century children were employed to work in factories
and mines in very poor conditions; if society in general was morally satisfied with
this arrangement, in what sense was the individual employer acting in an immoral
fashion? A striking example of a change in moral values was witnessed in the late
1980s in relation to the wearing of fur coats. Large sections of the population
adopted the view that it was morally wrong to make and wear animal fur coats
because it directly or indirectly led to the endangerment of species. The moral
arguments related to this issue cannot be addressed here but some relevant ques-
tions are:
 Does it matter if tigers disappear? Species are eliminated all the time, so what is
so special about big cats?
 There can be genuine disagreement on the contribution of wearing fur coats to
the endangerment of species; what are the real facts relating to wearing animal
furs?
 What proportion of the population does it take to decide whether something is
immoral or not? It is bad luck for a manager to wake up one morning and find
that he or she is no longer acting in a moral fashion.
Some companies impose a code of ethics on their employees, such as never ac-
cepting bribes. This is somewhat difficult to enforce in countries where bribery is
socially acceptable, and is not seen as immoral behaviour. To some observers, such
ethical attitudes are reminiscent of the zeal with which missionaries attempt to
transplant their concepts of morality into other societies. On the other hand, it may
simply be the case that such companies are using moral values as a means towards
the end of promoting an image of honesty, integrity and dependability which will
enhance their competitive potential.
To summarise, moral behaviour is difficult to define for companies and for man-
agers. The manager may find it counter-productive to take a stand ‘for the sake of
principle’ when that principle is based on a series of dubious premises.
The impact which ethical considerations can have on a company became evident
when Shell attempted to dispose of the obsolete Brent Spar oil rig by sinking it in
the North Sea. The company had carried out exhaustive scientific analyses of the
various options, and sinking had emerged as the clear favourite in terms of envi-
ronmental pollution and cost. However, Greenpeace took the view that the oil rig
would be the cause of major pollution on the sea bed, and would lead to many more
such disposals. A campaign to boycott Shell petrol stations was instigated, and a
group of protestors occupied the oil rig at sea. Eventually, Shell backed down and
moved the Brent Spar to a location where it could be dismantled on land. Soon
afterwards, Shell announced its intention to invest $2.6 billion in a Nigerian gas
plant. Environmentalists claimed that Shell had been responsible for most of the

pollution in the Niger Delta during the past 40 years, and that this investment would
make things even worse. Shell came under intense pressure not to proceed with this
investment. The rights and wrongs of the Brent Spar and Nigerian issues are not the
issue: the fact is that these ethical issues had a significant effect on the company.
Not only is it virtually impossible to incorporate ethical issues into company
objectives, but surveys report that practising managers have little idea of what
ethical behaviour should be. Many felt that performing well and being loyal to the
company constituted behaving ethically, while less than one third of employees
believed that their companies respected employees who blew the whistle on
unethical practices. Given the nature of ethical dilemmas it should come as no
surprise that such confusion exists.
3.16 Are Objectives SMART?

A useful acronym that captures many of the dimensions of objectives discussed
above is SMART which stands for Specific, Measurable, Achievable, Relevant and
Time-bound. Some versions use ‘Realistic’ instead of ‘Relevant’, but there is not
much difference between ‘Achievable’ and ‘Realistic’, while ‘Relevant’ has a particu-
lar strategic implication.
 Specific objectives are unambiguous and convey what outcome, action or
behaviour is required. For example, it is not specific enough to state ‘we will
enter the French market’ because this will mean different things to different
people. The intended market share, pricing and marketing approach will clarify
what the objective will involve.
 Measurable is the ability to evaluate achievement using numbers, rates, frequen-
cies or percentages. For example, ‘achieve 10 per cent market share’ is a
measurable objective that is understood by everyone.
 Achievable objectives are those which employees believe can be reached. For
example, if the objective set for entering the French market is to win 20 per cent
market share and the largest existing competitor in the market currently has only
10 per cent market share it is unlikely that many employees will be convinced
that the objective is achievable. As a result there will be little commitment to
actually making it happen.
 Relevant objectives are linked to the organisation’s strategy and achievement of
the objective is seen to move the business towards its goals. The more clearly
aligned with the wider success of the organisation, the more motivated people
are likely to be in achieving the objectives. On the other hand, targets which are
not aligned (or the alignment is not clarified) are unlikely to be taken seriously.
For example, entering the French market may be seen as diverting resources
from the company’s core UK market.
 Time-bound: the progress towards the objectives can be measured against an
agreed time frame, not only for the ultimate deadline but for stages along the
way. For example, ‘achieve 10 per cent market share in France after one year and
20 per cent after two years’. This means that at each agreed ‘milestone’ towards
achieving the goal progress can be assessed according to the schedule.

Typically it is asserted that objectives ‘should’ be SMART but in practice it is

unlikely that objectives will meet these strict criteria fully. For example, it may not
be possible to specify a time period so the Time-bound criterion may have to be
sacrificed; it is then a question of how far away from SMART does an objective
have to be before it is rendered useless. There is no simple answer to that. In
addition, there are various qualifications associated with each criterion.
 Specific objectives will tend to be disaggregated; it may be impossible to be
specific about aggregate objectives such as ‘improve quality in order to meet
increased competition due to technological progress’. It is also important not to
confuse the means and ends, given that it is typically easier to be specific about
the means than the ends.
 Measurable: some objectives are by their nature non-quantifiable, such as ‘to
have a happy and stable workforce’. But just because they are not strictly meas-
urable does not mean they should be left out of the equation.
 Achievable: different things can appear achievable and credible to different
people. The top management team may believe that the company is capable of
delivering a successful new market entry into France but this view may not be
shared by middle management. It is often possible to identify after the event that
the objective was not achievable but this may not be apparent when the decision
is being made.
 Relevant: it is clearly important that objectives are aligned with the resource
capabilities of the company – or the other way round. The resource based view
of strategy discussed in Section 1.2.3 highlighted the difficulty of identifying
strategic capabilities based on company resources; therefore, it may not always
be obvious whether an objective is aligned with strategic capabilities.
 Time-bound: while it may appear to add definition to the objectives to relate
them to a time scale it has to be recognised that it is impossible to predict the
future with any degree of certainty. That is a major defect of the planning ap-
proach to strategy identified in Section 1.2.3. What can be concluded if 10 per
cent market share in France is actually achieved after one year? Perhaps no more
than that the guess was right.
So we can pose the question: are SMART objectives really smart? There is no
doubt that the acronym ensures that attention is focused on important dimensions
of objectives and so long as these reservations are borne in mind it is a useful
framework.
Review Questions
3.1 Set out the skill sets relevant to two travel agents, one specialising in business and the
other in holidays. Do you think it would be easy for an experienced business travel
agent to move to a holiday company?

3.2 Here are three different definitions of the business of specialist security companies.
i. Providing bodyguards for VIPs.
ii. Protection against electronic invasion of computer systems.
iii. Screening individuals applying for high level appointments.
What are the main skills which you would associate with each? Could one individual fill
all three roles?
3.3 The public body responsible for the health services of a city of approximately 5 million
inhabitants produced the following mission statement:
To provide the best possible standards of care for the sick and infirm, and to
generate a high level of awareness of health issues with the emphasis on pre-
vention rather than cure.
Rewrite this mission statement in an operational fashion, and justify your version.
3.4 The CEO of the Mythical Company in Module 1 did not deal with objective setting in
the explicit manner set out in this module.
i. Apply the gap concept to objective setting in the Mythical Company.
ii. Interpret objective setting in the Mythical Company in terms of the main headings in
this module.
3.5 An industrial cleaning company has three divisions under the CEO and provides
corporate services of Human Resources and Accounting to the three divisions.
Each division has one SBU; these are a factory producing high powered water cleaners, a
small chemical plant producing abrasive cleaning fluid and fleet of mobile cleaning teams
which tackle difficult industrial cleaning jobs. The sales turnover of SBU1:SBU2:SBU3 is
3:2:1. The SBU1 manager has suggested that the salaries of the three SBU managers
should also be in the ratio 3:2:1. It turns out that the only two in favour of the idea are
the SBU1 manager and the accounting manager from Corporate Services.
Set out a discussion between the CEO, the two corporate services officers and the
three SBU managers showing why each agrees or disagrees with the proposal.
Case 3.1: Porsche: Glamour at a Price (1993)

Everyone knows what a Porsche car is, and its brand image is unique: it is an expensive,
luxurious high performance sports status symbol which any major manufacturer would
be happy to have in its stable. The company itself is rather unique, in that Porsche is a
privately owned company and is run by a very wealthy family whose personal life is little
affected by the fortunes of the company, at least in the short term. The family has
recently embarked on a programme of rationalisation, and is unwilling to sell Porsche to
one of the major manufacturers, several of whom have expressed interest.
Porsche car sales reached a record high in the mid-1980s, peaking at about 50 000
cars per year. But by 1991 sales were down to half these levels and the company started
making losses. Figure 3.3 shows recent world sales, where the general downward trend
from 1986 is clearly visible.

At its peak Porsche made profits of about DM120 million on a turnover of about
DM5 billion; in 1990 profit was DM17 million on a turnover of DM3.1 billion; in 1991
the loss was DM66 million on a turnover of DM2.7 billion. However, the company has
no debt and holds net cash assets of about DM600 million.
Figure 3.4 shows sales to Western Europe and the US from 1982 to 1992. The pattern
of total sales was dominated by the very large changes in the US market. To some extent
this was due to a fluctuating exchange rate, and the movements of the mark against the
dollar are shown in Figure 3.5.
60
(in thousands) 50
40
30
20
10
0
82 83 84 85 86 87 88 89 90 91 92
Figure 3.3 Porsche world sales
30
28 Western Europe
26 US
24
22
(in thousands)
20
18
16
14
12
10
8
6
4
2
0
82 83 84 85 86 87 88 89 90 91 92
Figure 3.4 Porsche sales in Western Europe and US

Analysts take the view that the company is too small to carry on competing now that
the market is dominated by very large manufacturers. Critics claim that the cars are old

fashioned and relatively expensive, and that the company has not attempted to meet the
type of competition appearing from Japan at the luxury end of the sports car market.
The company claims that it will introduce a new range of sports cars in 1995.
25 Annual changes
20
15
10
Percentage
–5
–10
–15
–20
82 83 84 85 86 87 88 89 90 91 92
Figure 3.5 The mark against the dollar
1 Analyse Porsche’s competitive position over 10 years.
2 Discuss the principal–agent problem in Porsche and how this might affect the setting of
objectives.
Case 3.2: Fresh, But Not So Easy (2013)

The headline in October 2012 was ‘Tesco halts new Fresh & Easy stores in the US’. The
intention was to try to drive Tesco’s loss-making Fresh & Easy business into profit; the
original plan had been to open 230 stores in the US by the end of 2012 but this had
been cut back to 200. Tesco was a retailing phenomenon based in the UK and by 2007 it
was the third largest grocery retailer in the world behind Wal-Mart and Carrefour.
Under the leadership of the legendary Sir Terry Leahy it had entered the US market on
the basis of meticulous planning and a clear vision of how it would differentiate from the
incumbents. The risk was that Tesco stood to lose about $1 billion, but that would have
little impact on a company that made $5 billion profit in 2006. Sir Terry said, ‘If it
succeeds then it’s transformational.’
But five years later Fresh & Easy was still making losses amounting to $120 million in
the first six months of 2012 despite the fact that the number of profitable stores had
increased from 30 to 55 during the previous year.

In 2007 many observers considered entering the US an ill-advised move given the
dominance of Wal-Mart in the US and the fact that the US grocery market was mature.
But Sir Terry reckoned that it was a sound business move because Tesco’s competitive
advantage differed from Wal-Mart’s.
Preparing the Ground

In its previous foreign operations Tesco focused on tailoring stores to local needs. The
approach in the US was to be totally different. First, the trial of a store in Santa Monica
was conducted in secrecy and customers were told that it was really a film set. The
openings were planned to be fast and numerous – for example, 21 stores in Phoenix
opening almost simultaneously. According to Sir Terry entry had to be significant;
otherwise imitators could move in before critical mass is achieved. He said, ‘In retailing
there aren’t huge barriers to entry. That’s one of the reasons you can’t hang around and
trial this thing. You have to launch and go.’ Clearly that meant Tesco had to commit to a
gamble; Warren Buffet appeared to think the gamble worthwhile because he purchased
3 per cent of Tesco shares to become one of its largest shareholders.
Second, the market research was exhaustive: Tesco executives and researchers spent
weeks living with US families to determine what affected their buying behaviour. The
city of Phoenix was studied for a year before Tesco approached the Greater Phoenix
Economic Council to seek help in finding retail sites.
Third, Tesco had a much more ambitious plan than simply entering a mature and
lucrative market; the intention was to change the way Americans shop and eat, in effect
creating a new market. This was clearly a tall order.
Tackling the Market

A salient feature of the US grocery market was the split between luxury (Whole Foods)
and cheap (Wal-Mart) stores. Stores in the middle (Kroger, Safeway) had been
squeezed: their margins were always under pressure from Wal-Mart and at the same
time they incurred high infrastructure costs to maintain their ‘quality’ image. Tesco
aimed to build on its UK success of appealing to all sectors of the market and focus on
the middle market. It aimed to target this market in three ways.
First, it would concentrate on small stores holding a relatively small, high-quality
stock. The idea was that the combination of convenience and quality was something new
in the US.
Second, stores would stock ‘ready meals’ that were familiar to the British but virtual-
ly unknown in the US. There appeared to be a hole in the market here but why should
it exist? The reason had to do with the US grocery supply chain, where costs had been
beaten down by competition. The result was that there were only two types of ready-
made meals available: those that last because they have been preserved and those
prepared from raw ingredients in the store. While Americans were good at moving
goods large distances and keeping them cheap, the British specialised in regular, frequent
deliveries to city centres. The British supply chains were more efficient, so small stores
could switch from sandwiches at mid-day to ready-made suppers in the afternoon.
Because labour is relatively more expensive in the UK, economies of scale in centralised
food preparation had been exploited to make meals that can last for a few days and the
variety is enormous – the typical UK supermarket stocks about 50 different meals.
Tesco was the most successful UK retailer in the production of ready meals.

Third, Tesco had been at the forefront of technological change in its supply chain. For
example, it was the first to use trucks that have separate compartments for frozen,
chilled and ordinary food, making it possible to sell groceries in small stores at super-
market prices. Another application of technology is the use made of its shopper
database. Correlations between purchases are used to fine tune stocks, with the result
that stores serving different areas can be completely different. It is also able to identify
unexpected correlations, such as the fact that families buying baby products also buy
more drinks because young parents do not have the time to go out to pubs and
restaurants. The important point is that Tesco acts fast when it identifies a particular
correlation or buying trend.
What Does History Say?

It is a fact that few retailers have successfully entered a mature market in a developed
country. For example, Sainsbury’s, Marks & Spencer and Carrefour have all failed in the
US. One explanation for this is that food retailing is still a local industry: one consulting
company has found, for example, that a 40 per cent market share in one market is much
more profitable than a 10 per cent market share in four markets. Even Wal-Mart, with
its successful formula in the US, has not always been able to export it abroad, having had
to withdraw from Germany because it could not adapt to local conditions.
Some Doubtful Issues

Many observers doubted that the UK business model would work in the US. Some
pointed to the difference in travel habits, with many Tesco stores in the UK being
located near to subway and railway stations. It was argued that Americans would be
much less likely to purchase ready meals on the way home. Tesco reckoned that the
trend to healthy eating would be in its favour with its focus on organic products. It also
projected itself as healthy and green, with the development of energy-efficient stores.
On the other hand, Tesco intended to take advantage of US shopping habits. Ameri-
cans shop more frequently than the British because they have to visit more retailers
because of lack of choice. Tesco’s aim was to supply more focused choice so that
shoppers would have confidence that they could get all they need at one shop.
One retail analyst pointed out that Tesco had been in too much of a hurry to expand
and had selected some store sites that lacked visibility; some stores had been located in
areas hardest hit by the slump in the housing market. The poor state of the economy
since 2007 had made people unwilling to change their shopping habits. He went on to
say that Fresh & Easy was defined by what it is not rather than what it is: ‘It is not a full-
scale supermarket, not a boutique grocer, not a low-cost warehouse; that is not a great
way to build a business.’
Should Tesco Pull Out of the US?

There is no such thing as a world brand in food retailing, in the same way as Zara and
Gap in clothing. Therefore, Tesco entered the US under the name Fresh & Easy because
it was felt that it would appeal to US consumers. Some retail analysts reckoned that
brand awareness was still developing and it was too early to abandon the US.
Sir Terry’s successor, Philip Clarke, had not made a decision by October 2012. He
had already sold Tesco’s Japanese operation so he was not afraid to make tough
decisions. But after cutting off US capital spending he merely stressed that Fresh & Easy

‘must do better’. That left the issue open.
1 Assess Sir Terry’s objective of entering the US market using the headings in Module 3.

Module 4
The Company and the Economy

Contents
4.1 The Company in the Economic Environment .....................................4/2
4.2 Revenue and Costs: The Basic Model ...................................................4/2
4.3 The Workings of the Economy .............................................................4/4
4.4 Forecasting: What Will Happen Next? ............................................. 4/20
4.5 PEST Analysis....................................................................................... 4/24
4.6 Environmental Scanning ..................................................................... 4/26
4.7 Scenarios ............................................................................................... 4/27
4.8 The Economy and Profitability........................................................... 4/29
4.9 Environmental Threat and Opportunity Profile: Part 1.................. 4/33
Case 4.1: Revisit Porsche: Glamour at a Price ............................................ 4/36
Case 4.2: An International Romance that Failed: British Telecom and
MCI (1998) ............................................................................................ 4/36
Case 4.3: Lego Rebuilds the Business (2008) ............................................... 4/38
Learning Objectives
 To demonstrate why an understanding of the economy is important for manag-
ers.
 To show how different aspects of the economy affect the company.
 To develop a framework for analysing the state of the economy and understand-
ing economic forecasts.
 To show how competitive forces are influenced by economic events.
 To use data derived from environmental scanning to develop an environmental
threat and opportunity profile.

Module 4 / The Company and the Economy
4.1 The Company in the Economic Environment

to do what

Feedback


allocation
It probably seems like a statement of the obvious that before a company can
identify its strategic possibilities it must form a systematic view of the environment
and its likely impact on the company, taking into account economic, political and
social factors. To many managers this means no more than a general awareness of
what is going on in the world at large. However, the development of a systematic
view involves much more than general awareness. The process is known as envi-
ronmental scanning, and provides information which can be used to construct a
political, economic, social and technological (PEST) review of the environment and
an environmental threat and opportunity profile (ETOP). The quantity of infor-
mation to which managers are exposed is vast: from external sources it includes
newspaper reports, statistical publications, trade journals and reports; from internal
sources it includes management accounts, balance sheets, performance measures,
market surveys, and consultancy reports. In the face of this quantity of information,
the basic point to bear in mind is that no matter what issue is under investigation
some simple rules can be applied: identify important variables, simplify them as far
as possible, and subject them to appropriate analyses.
4.2 Revenue and Costs: The Basic Model

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

Revenue Total market Market share Price

On the cost side, the company makes expenditures on the acquisition and de-
ployment of productive factors:
Outlay Number of workers Wage rate
Units of capital Price
Units of material Price
In real life these revenues and costs are often difficult to allocate to specific time
periods and products. However, the conceptual model focuses attention on the
importance of factors such as market share and prices. The factors which affect the
variables in the model include those shown in Table 4.1.
Table 4.1 Some determining factors

Variable Determining factors
Total market National income; Foreign national income; Population; Preferences;
Competing products; Product life cycle
Market share Price; Marketing expenditure; Marketing strategies; Competitor
marketing expenditure; Competitor strategies
Price Demand conditions; Competitive reaction; Competitive advantage;
Market segmentation
Workforce Labour market conditions; Regional supply variations; Wage rate
offered; Working conditions
Wage rate Labour market conditions; Unemployment rate
Capital Capacity of the capital goods sector
Capital price Capital market conditions
Materials Capacity of suppliers
Materials price Materials market conditions
While the list of determining factors is by no means complete, this display illus-
trates that it is necessary to have an understanding of a wide range of influences in
order to develop a comprehensive picture of company performance. For example, it
is not sufficient to recognise that revenue has fallen because of a reduction in
market share. In developing potential courses of action to remedy the fall in market
share the underlying causes must be identified and addressed. The reduction in
market share may have been caused by a decrease in the price charged by competi-
tors which the company has not matched, or by a strategic allocation of marketing
resources by competitors which has resulted in the loss of important customers. The
model is useful not only for providing a structure for investigating those products
which the company is currently producing, but it can also be applied to those which
it might produce in the future. The answer to the question ‘What market should we
be in?’ requires the analysis of many influences common to current products,
although quantification is bound to be less precise and the answers more specula-
tive.
The relative importance of the factors in the table will depend on the individual
circumstances of the company. These factors themselves are in turn all dependent to

some extent on the general state of economic activity. For example, the state of the
business cycle has implications for the emergence of competing products, competi-
tor reactions, demand conditions, labour market conditions and the unemployment
rate. It follows that since company strategies are conditioned by the overall econom-
ic environment, it is important to have an understanding of what determines the
behaviour of the economy as a whole.
4.3 The Workings of the Economy

to do what

Feedback


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

Some writers on strategy take the position that there is no point to analysing the
economy because the behaviour of the economy is unpredictable and, in any case,
economists continually disagree about the causes of changes in important variables
such as the level of economic activity, interest rates and exchange rates. While it is
true that many things are unpredictable (forecasting will be dealt with at Section
4.4), this is not a valid argument for ignoring them. If a general understanding of
macroeconomics was irrelevant to strategy the subject would certainly not be
included in the MBA syllabus. It will emerge in this module that macroeconomic
analysis is an important element of environmental scanning, and can provide the
basis for strategic action.
Although managers may not be aware of it, their attitudes and management styles
can be greatly affected by general economic conditions. A brief outline of recent
UK economic history has lessons for all countries. During the 1950s and 1960s the
UK experienced relatively stable prices, growth rates, unemployment rates and
inflation rates. To some extent this was a worldwide phenomenon, and rapid change
was something which companies were not exposed to; this set of conditions
contributed to the development of a complacent generation of UK management
which seemed incapable of dealing with the increasing pace of change which started
about the beginning of the 1970s; in fact, management was regarded as an activity
for which training was irrelevant, and the idea that management ideas could be
formalised was an alien concept. By the mid-1970s the stable scenario had been
destroyed; global depression in the mid-1970s was partly caused by the trebling of
oil prices, which in turn caused substantial economic upheavals. This period also
saw the end of stable international exchange rates with the collapse of the Bretton
Woods agreement in 1973, and the emergence of powerful competition from the
Far East economies. It is no secret that UK managers were ill equipped to deal with
these changes, and the economic traumas of the 1970s, which included 25 per cent
inflation rates, poor productivity growth, the loss of important foreign markets and
endless labour disputes, were at least partly caused by lack of foresight and adapta-
bility on the part of managers.
The period up to 1979 also saw a significant increase in the extent to which gov-
ernments attempted to regulate the level of economic activity. The share of
government in the economy (measured by the sum of government expenditures on
goods and services and transfer payments) increased to well over 40 per cent of
national income by 1979, and the notorious ‘stop-go’ policies which were utilised in
response to economic fluctuations seemed at times to make the situation worse
rather than better. The incomes policy introduced in the mid-1970s, which was a
misguided attempt to reduce the inflation rate, coupled with very high marginal tax
rates, led to a significant reduction in incentives for managers generally. By the end
of the 1970s the prevailing view was that government would continue to increase its
involvement in the economy, and managers should learn to function in a govern-
ment dominated economy. A prolonged period of intervention had undermined the
ethos of self-reliance and personal initiative; the result was a marked reluctance to
take risks and undertake new ventures.
The pace of change and the volatility of economic activity and related factors
increased in the 1980s. In the UK there were substantial changes in unemployment

rates, industrial output, inflation rates, interest rates, productivity, exports, imports,
capital flows, and exchange rates. But a major change in the political climate had led
to the election of a right wing free market orientated government under the leader-
ship of Margaret Thatcher in 1979. There was a conscious effort on the part of
government to disengage from the economy and allow market forces to operate
more freely; this in turn led to deregulation, selling state owned companies, and
lower marginal tax rates. These economic changes affected individual company
performances in many ways. For example, by the late 1980s the UK was experienc-
ing a boom, with record growth rates and the lowest unemployment rate for 10
years; in particular, asset prices spiralled, and many successful large companies
started to diversify into property, while those already in the property business began
to extend themselves. To many observers it seemed that the pinnacle of credit and
unfettered expectations on which this boom depended was unstable, but developers
pressed on regardless. After the economic downturn in 1990 the bubble burst and
there were many disasters, the best known being the Canary Wharf development –
the largest building in London – which went bankrupt before it was even occupied.
Economic circumstances had led yet again to a ‘gold rush’ outlook on the part of
managers, who did not seem to appreciate that they were gambling entirely on the
continuation of boom time conditions. A rudimentary understanding of economics
might have given cause for concern about the inflationary pressures being generated
during the boom and the possibility that the government might be forced to take
deflationary measures.
The major recession which the UK experienced from 1991 to 1993 was relatively
short lived, but recovery from the recession was very slow, and by the late 1990s the
unemployment rate was still well above the 1990 level. By the mid-1990s the
economy had improved dramatically in real terms: productivity had soared, the
inflation rate was low compared with other major economies, the interest rate was
historically low, and the economy was the fastest growing in Europe. But despite
this managers were greatly affected by the experience of the early 1990s recession,
and the absence of a ‘feel good’ factor was a generally accepted fact; confidence on
the part of both consumers and producers was low, leading to an unwillingness to
spend on the part of consumers and to invest on the part of companies. In the mid-
1990s it was as if companies felt that the prosperity was fragile and that recession
could return at any time. The Dotcom boom that erupted in the late 1990s led many
to conclude that a new ‘business paradigm’ had emerged; those misguided enough
to be taken in by this nonsense were in for a rude awakening when the stock market
crashed in 2000 and many of the Dotcom companies went out of business.
Managers who have not been educated in general economic principles can be
excused for finding it difficult, or impossible, to explain the various changes
observed in the economy, which is subject to a seemingly perplexing variety of
influences of the type described above. It has already been pointed out that manag-
ers are bombarded with information of all kinds; information on economic
conditions arrives in the form of news reports, national and international statistics,
news commentaries by experts, and reports prepared by specialists who may be
independent economic consultants, stockbrokers, or employed by the company. The
problem facing the manager is to decide which information is relevant, and interpret

it in order to form a view on what is happening in the economy as a whole; this is a

prerequisite to deriving implications for the industry and the company itself.
Managers therefore often ask if it is possible to make sense of the multitude of
factors which they have to take into account, and whether anything can be done to
accommodate them. This is in fact the area of study known as macroeconomics. A
sample of what macroeconomic theories cover is:
 the determination of GNP through the interaction of demand and supply in the
economy as a whole, and the effect of changes in both demand and supply fac-
tors; full employment output, actual output, the unemployment rate and the
inflation rate;
 the role of expectations;
 money supply and the rate of interest;
 the rate of interest and investment expenditure;
 factors affecting the demand for and supply of imports and exports;
 the determination of the exchange rate and international financial flows.
4.3.1 Understanding and Using Economic Information

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

Last year This year (early)
Economic indicator Change over year Recent changes
Gross national product 3.2% 0.5%
Industrial output 1.1% −1.5%
Retail sales (volume) 4.3% −1.1%
Investment expenditure −1.1% −3.2%
Current value
Unemployment rate 5.8% 6.2%
Inflation rate 9.3% 7.0%
Wage inflation rate 12.2% 8.0%
The general impression of the state of economic activity from the viewpoint of
last year is that the economy was growing both in terms of total output and con-
sumer expenditure, and that there was very little unemployment. However, there
were two ominous signs: investment expenditure was declining and both prices and
wages were increasing at a relatively high rate. Signs that the economy is ‘overheat-
ing’ include shortages of labour, the inflation rate increasing and wage rate increases
running well ahead of increases in productivity; in that case it is to be expected that
the government will take steps to remedy this by increasing the rate of interest.

However, there is scope for disagreement about how ‘bad’ or ‘good’ things actually
are; for example, what is a high compared to a low rate of unemployment? In the
early 1970s the UK unemployment rate was about 3 per cent, and in the early 1980s,
it reached 12 per cent; by that time there seemed little chance that the unemploy-
ment rate would ever fall again to the level of the 1970s. By 2005 the rate was down
to under 5 per cent which would have been considered high in the 1970s. Economic
information must be interpreted in the context of current conditions.
From Table 4.2 it can be deduced that by early in the current year there had been
a significant slowdown in economic activity. The growth in output had virtually
ceased, both industrial output and consumer expenditure were declining, and the
inflation rate had fallen. The unemployment rate had increased and this had
contributed to the reduction in wage rate inflation. It is quite clear from these few
statistics that the ‘boom’ economy of the previous year had ground to a halt, and
this had strategic implications for companies in the current year, depending on
which markets they were operating in.
It is not necessary for managers to have a detailed understanding of how the
statistics in the table were arrived at in order to derive strategy implications. Take
the case of a manufacturer of machine tools which was working close to full
capacity at the beginning of the current year: should it increase or decrease capacity
now? This company produces for the investment sector, i.e. it does not produce for
final consumers; therefore, the CEO had to make deductions about the likely future
for the investment sector. Assume he only has last year’s data available; the follow-
ing deductions can be made:
 The increase in gross national product (GNP) during the previous year was
largely due to an increase in consumer expenditure (see the increase in retail
sales); in other words, the economy was experiencing a consumer boom.
 The consumer boom had not led to an increase in capital equipment, as can be
seen from the fact that investment expenditure had fallen. In fact, industrial
output had not grown as much as retail sales. Companies must have been selling
from inventories and/or imports must have increased.
 Wage costs were rising faster than the inflation rate.
The CEO could start by assessing what would happen to net cash flow if the
conditions for the previous year carried on through the rest of the current year using
the basic model of revenues and costs:
Revenue = Total market × Market share × Price

Revenue = 0.99 × 1 × 1.093
= 1.08
This application of the basic model of revenue makes a number of assumptions:

the price of output is assumed to move in line with the inflation rate (i.e. multiplied
by 1.093), market share is assumed to remain unchanged (i.e. multiplied by 1), and
the change in market size is assumed to be equal to the change in investment

expenditure (i.e. multiplied by 0.99). The net effect is that cash flows would increase
by about 8 per cent.
Table 4.2 provides less information on which to judge the likely change in out-
lays:
Outlay = Number of workers × Wage rate +

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

4.3.2 Supply and Demand in the Economy

This section revisits the major ideas of macroeconomics in a brief fashion and is
intended to provide you with an overall perspective on the issues involved and an
appreciation of the implications of macroeconomic analysis for strategic thinking. In
order to develop some basic ideas about how the economy operates the first step is
to think in terms of the goods and services which the economy produces rather
than the income which accrues to individuals.
The total value of goods and services produced in one year is known as gross
national product (GNP).
At any one time the maximum output which the economy could produce is con-
strained by the resources available. The total output which the economy could
produce if the labour force were fully employed and there were no excess capacity is
known as potential or full employment GNP. Given the substantial variations in
the unemployment rate it is immediately clear that the actual output of the
economy is not necessarily equal to potential output. A useful perspective on the
connection between potential and actual output is to define potential output as the
output which the economy could produce with the labour force working the
standard work week on average, and the unemployment rate at a level which
accommodates structural changes in the economy. Over time the pattern of
potential and actual output might be as shown in Figure 4.1.
300
Potential GNP
GNP 1980 Prices
280
260
£bn
240
220
200
1 2 3 4 5 6 7 8 9 10 11 12
Year
Figure 4.1 Potential and actual GNP

This pattern is based on twelve years’ experience of a typical economy. In Year 1
there was a very low unemployment rate associated with actual output being equal
to or above potential output. But how could actual output exceed potential output?
This occurs when there are shortages of labour and a great deal of overtime is being
worked. Actual output remained marginally higher than potential output until Year 4
when there was a slump due to a worldwide recession and the gap between actual

and potential increased substantially. The economy picked up again and by Year 7
actual output equalled potential output. There was then a boom year before the
economy collapsed yet again. When actual output was greater than potential output
the unemployment rate was low, and vice versa. But it should be noted that even
although actual output fell well below potential output in Year 10 GNP was much
higher than in Year 1. The pattern from Year 10 to Year 12 shows that the economy
can grow but the unemployment rate can remain high because of the gap between
actual and potential output.
Given the importance of the concepts of potential and actual output, the first
question the manager should ask is: what is the difference between potential and
actual output?
By framing the issue in this way, it is possible to explain how the unemployment
rate can increase despite the fact that actual output is increasing; the effect on the
unemployment rate depends on the relative rates of growth of potential and actual
output. The important factor is the gap between potential and actual output, and
this will be reflected in the current rate of unemployment. The relationship between
the unemployment rate and the gap between potential and actual output is not exact
because of changes in the definition of unemployment and changing labour market
conditions, and the connection between the two tends to change over long periods
of time. To put this in context, it is useful to think of unemployment as being
comprised of three elements:
1. Structural unemployment: this is typically associated with large-scale disruptions
in the economy when whole industries close down, for example the mining in-
dustry in the UK in the 1980s, or changes towards service based economies
which have occurred in all mature economies during the past twenty years. The
impact of structural changes on the long-term unemployment rate depends on
how quickly the working population adapts to new conditions. Structural unem-
ployment has grown in relative importance in mature economies in the past few
decades.
2. Frictional unemployment: the pool of unemployed can be regarded as the
outcome of a flow process, which is continually being added to as people decide
to change jobs, and reduced as people find jobs. If the cost of unemployment is
reduced, perhaps because of an increase in unemployment compensation, then
individuals may spend longer in job search, thus increasing the number of people
in the unemployment pool. There are many factors which affect how long indi-
viduals choose to remain unemployed, and there is little which can be done
about it in the short term.
3. Demand related unemployment: this is the element caused by the difference
between actual and potential output. It can be seen from Figure 4.1 that the
difference between actual and potential output varies dramatically over relatively
short periods, therefore it is to be expected that demand related unemployment
will also vary in the short run.
By thinking of the issue in these terms it is possible to interpret statistics such as
‘the rate of unemployment was 2.8 per cent in Year 1, 11.8 per cent in Year 10 and
5.8 per cent in Year 12’. There was an increase over the period in structural and

frictional unemployment, but between years 6 and 10 the reduction in demand

related unemployment greatly exceeded the increase in the other forms of unem-
ployment. This is a simplified approach to the behaviour of the economy using
actual and potential output coupled with the different types of unemployment but it
does provide a realistic interpretation of what is happening in the world.
4.3.3 Unemployment and Inflation

One reason why managers are sceptical of economics is that the debates on the
causes of inflation often seem to be contradictory, and mostly baffling to the non-
economist. In fact, the ideas which underlie the determinants of inflation are quite
simple, but they are rarely explained properly in the contexts of political debate or
newspaper analysis.
It is a well-known feature of market economies that when the economy ap-
proaches full employment there is a pronounced tendency for supply bottle-necks to
emerge, and as a result wage rates, capital costs and material prices tend to increase.
Improvements in expectations fuelled by a reduction in the unemployment rate
leads companies to bid up the price of resources in local markets, particularly where
labour is concerned. On the other hand, when there is significant unemployment
the wage rate is rarely observed to decline; it might be expected that when there is
an excess supply of labour the price of labour (i.e. the wage rate) might be expected
to fall, leading to the eventual elimination of unemployment. However, the labour
market does not operate like that; wage rates are ‘sticky’ when labour market
conditions suggest that there ‘should be’ a reduction. At the same time, there is
excess demand for final goods and services, which tends to push prices up. Taken
together, these influences are known as ‘demand pull’ inflation; generally, people
think of it in terms of ‘too much money chasing too few goods’.
It is a reasonable proposition that the lower the unemployment rate, the higher
will be the wage inflation rate, and this relationship was investigated in the 1950s by
Phillips, who estimated the trade-off between the unemployment rate and the wage
inflation rate. Nowadays the relationship is usually expressed in terms of the
inflation rate and the unemployment rate, and looks something like that shown in
Figure 4.2.

Inflation rate (%)

Phillips curve
Unemployment rate (%)
Figure 4.2 The Phillips curve

However, during the 1970s there was an onset of historically high unemployment
and inflation rates at the same time, which the ideas underlying the Phillips curve
suggested should not happen because as the unemployment rate increased the
inflation rate should fall. This became known as ‘stagflation’. One way of explaining
what had happened was that the Phillips curve had shifted, and at the new position
the trade-off between unemployment and inflation was different. This is shown in
Figure 4.3.

Inflation rate (%)
Phillips curve
Unemployment rate (%)
Figure 4.3 The shifting Phillips curve

But what might have caused the curve to move? And if the curve could move all
over the place, did it have any operational use? The answer to the first question was
that a new variable had entered the arena: expectations; once inflation existed in
the economy everyone expected that it would continue and made their forward
contracts accordingly, causing the inflation rate to carry on unchanged although the
unemployment rate was greatly increased. The answer to the second question was
that the Phillips curve was still important if something could be done about expecta-
tions.
The policy objective therefore became to shift the Phillips curve back to the left
so that the trade-off between unemployment and inflation would occur at a lower
level. Since this shift could only be accomplished by eliminating the expectation that
inflation would continue in the future, the debate then shifted to how this change in
expectations might be brought about. This led to one of the ‘monetarist’ policy
ideas, which was to keep the growth in the money supply constant and hence
remove the expectation that the government would accommodate inflation in the
future. This policy has been greatly misrepresented, and in most people’s minds
monetarists are probably associated with the idea of reducing the money supply.
This is incorrect, since the monetarist policy was directed towards removing the
expectation that future inflation would be accommodated by increases in the money
supply, therefore the solution was to make it clear that money supply would only be
allowed to grow by a predetermined percentage each year. Another approach was
simply to increase the unemployment rate and wait until the inflation rate itself fell,
and this would certainly eliminate expectations of future inflation. A potential
advantage of the monetarist approach was that it raised the possibility of eliminating
expectations without incurring the high cost of unemployment.

From the strategic viewpoint managers should therefore be aware that once
factor prices have increased because of inflation caused by excess demand, it will be
some time before the wage inflation rate is likely to fall. Managers with an under-
standing of the determinants of inflation would have recognised that the inflation
which built up in the UK in the late 1980s was likely to remain for some time, and
would probably lead to government actions designed to eliminate excess demand. A
likely consequence would be restrictive monetary and fiscal policies leading to a
significant reduction in the growth rate of GNP. Once the inflation rate had fallen
to about 1.5 per cent and remained at that level for two or three years in the late
1990s it was reasonable to expect that government policy would no longer be
directed towards reducing the inflation rate further. This view of economic pro-
spects could have important implications for the timing of a company’s strategy. By
the mid-1990s the UK inflation rate had fallen to its lowest level for 30 years, and a
great deal of debate centred on whether inflationary expectations had finally been
purged from the economy. Bear in mind that expectations do not operate only at
the economy-wide level; it is a salutary lesson to sit back and imagine that you are
about to make a forward contract of some sort in your own business; this could be
renting a photocopier for five years, agreeing with a supplier a fixed price for four
years, or deciding whether to go for a fixed interest or variable interest loan. What
allowance for inflation over the period would you build into your negotiating
stance? And why?
4.3.4 The International Economy

Few companies are immune from international factors. Those which sell directly in
foreign markets are continuously exposed to changes in trading conditions; under
conditions of relatively free trade even those companies which sell only in domestic
markets are open to competition from imports. Consequently, companies ought to
be concerned with factors such as differences in local and foreign inflation rates,
variable exchange rates, and the impact of economic conditions on competitive
advantage. Ignoring the potential impact of international factors is not really an
option.
Relative Inflation Rates

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

Exchange Rate Fluctuations

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

change (%)
Year Exchange rate Devaluation Revaluation
1981 0.52 24
1982 0.62 19
1983 0.69 11
1984 0.86 25
1985 0.69 20

Year Exchange rate Devaluation Revaluation

1986 0.68 1
1987 0.53 22
1988 0.55 4
1989 0.62 13
1990 0.53 15
1991 0.57 12
Table 4.3 shows the extent to which the exchange rate of the UK pound against
the US dollar varied during the 1980s; this is not an untypical period and the relative
values have continued to fluctuate wildly. By 2013 the pound/dollar rate stood at
0.65, having reached 0.70 in 2009. These fluctuations have significant implications
for predicting the cash flows from foreign markets. For example, a company making
plans two years ahead in 1989 in the UK would not have known that the pound
would be revalued by 15 per cent the following year. Imagine that the company
expected to sell 5000 units per year at $1000, giving revenue of $5 million; what
would this be worth in pounds in 1990? And could the company really expect to sell
that amount with a 15 per cent increase in price?
It is clearly difficult to plan ahead in such an unstable economic environment.
However, a company which incorporated potential exchange rate movements in its
scenario planning would have had some idea whether this type of fluctuation was
potentially disastrous, and could have developed a contingency plan to activate in
the event of a revaluation of the magnitude which occurred in 1990. In fact, little
did managers expect that in 1992 Britain would drop out of the European Exchange
Rate Mechanism due to international speculative pressure, and that the pound
would depreciate against all European currencies by about 15 per cent.
In the light of these factors, the company stands to benefit strategically by taking
a view on what is expected to happen to the exchange rate when trading interna-
tionally. For example, if the company is convinced that a particular currency is
undervalued in relation to the domestic currency, a potential strategy is to break into
the market now and establish market share in the knowledge that losses will be
incurred until a revaluation takes place. Or if a company is evaluating a potential
investment in a country, the prospect of a revaluation of that country’s currency
could have major implications for the timing of the cash flows necessary to carry
out the investment.
Many companies argue that they are in the business of making and selling their
products, and are not in the business of foreign exchange dealing. Others justify
ignoring possible future changes on the grounds that they do not see what they can
do about them. However, a decision to ignore the problem of uncertain exchange
rates is equivalent to adopting the view that there will be no changes in the future;
this is as much a response as a forecast that changes will occur.
There are various methods of hedging bets in relation to exchange rates, for
example buying currency forward; this makes it possible to predict future cash
flows, but it means that the company will not gain from any favourable movements

in the exchange rate. It is not possible for a company to cover future exchange rates
entirely, because cash flows will extend for years in the future, and these cash flows
are difficult to predict with any degree of certainty. There is no reason to view
exchange rate risks as being different from the other uncertainties facing the
company, and given the volatility of the international economy it makes sense to
attempt to identify risks and incorporate them into decision making.
As the risks inherent in an unstable international monetary system have in-
creased, a great deal of ingenuity has been applied to finding ways of hedging these
risks. The whole world knows about the activities of Nick Leeson, the ‘rogue’
Barings bank trader who lost £800 million on the foreign exchange market and
destroyed one of Britain’s oldest and most respected banks in the process; Leeson
was able to do what he did because his superiors had no understanding of how the
market in options worked. The risks generated by the foreign exchange markets
affect everyone, for example the Barings bondholders lost everything and had no
idea that their cash was at risk to such an extent.
The Competitive Advantage of Nations

The role which national location can play in influencing the competitive position of
companies was developed by Michael Porter19 who pointed out that competitive
advantage is often strongly concentrated in a few locations; for example, the
clustering of electrical distribution equipment in Sweden, tunnelling equipment in
Switzerland, large diesel trucks in the US and microwaves in Japan. Porter identified
several ways in which a nation can affect the competitive advantage of individual
companies.
 A firm’s home nation plays a critical role in shaping managers’ perceptions about
the opportunities that can be exploited by supporting the accumulation of valua-
ble resources and capabilities and creating pressures on the firm to innovate,
invest and improve over time. The impact of the history and environment of a
country is often obvious. For example, Scotland is a small country with a long
history of industrial decline and the development of a dependence ethos fostered
by many years of misguided government aid policies. As a result the rate of new
business start-ups is roughly half the rate of that in England; this is in marked
contrast to another small state such as Singapore, where the government has
been at least as interventionist but in a totally different way.
 It is the existence of conditions which contribute to sustaining competitive
advantage in a dynamic sense which is important. A country can offer favourable
factor conditions, in particular those that are highly specialised to the needs of
particular industries. But this is only part of the story; it can also offer favourable
demand conditions in the form of sophisticated home consumers who continu-
ally force firms to produce the right things. One of the dangers of protectionism
is that local companies have little incentive to retain competitive advantage; be-
cause of protectionism in India British cars (known as the Ambassador) designed
in the 1970s were still produced and sold in large numbers into the 21st century;
but once the relaxation of protectionism had an impact the Ambassador rapidly
disappeared from major cities; this illustrates how consumers as well as compa-

nies stand to lose from a lack of international competition. The most extreme
example of all was the plight of companies in the Eastern Bloc economies after
the Berlin Wall came down which had been so conditioned by their national
environment that the notions of profitability and cost control were unknown.
The impact of the national environment on the competitiveness of individual
companies is therefore largely determined by the following influences:
 domestic factor conditions;
 related and supporting industries;
 demand conditions;
 strategy, structure and rivalry.
all of which interact to affect the competitiveness of individual companies.
 Domestic factor conditions: highly specialised resources develop in different countries
over time; the development of computer businesses in Silicon Valley in Califor-
nia meant that there was a large pool of highly skilled manpower.
 Related and supporting industries: all types of computer related industries are to be
found in Silicon Valley; few computer manufacturers would consider setting up
business in Spain, for example, where there is a lack of accessible suppliers.
 Demand conditions: sophisticated consumers force companies to innovate and
shape their market orientation. The dominance of Japanese cameras is partly
explained by the popularity of amateur photography in Japan; the success of
German motor manufacturers in producing quality cars as opposed to mass
produced cheap cars is partly due to the German respect for quality engineering.
 Strategy, structure and rivalry: a country which fosters competition at home poten-
tially breeds a strong core of companies which is capable of competing in the
international arena. There are few instances of powerful international companies
emerging from protected or subsidised home markets. The highly protected
British car industry was unable to compete in the 1970s and virtually ceased to
exist. Japanese companies, which had been subject to intense home competition,
invested heavily in new car plants in Britain in the 1980s.
An important strategic conclusion can be drawn from this. When assessing its
international competitive position, a company needs to determine whether its
competitive advantage is due to country specific or company specific attributes. This
is of fundamental importance to the way in which it can exploit foreign markets.
 If the advantage is country specific then foreign markets can be exploited by
exporting. This is because the impact of the national environment discussed
above will confer a cost advantage.
 If the advantage is company specific it can invest in the country concerned
provided that these advantages can be transferred from one country to another.
This partly explains why Japanese car makers invested heavily in Britain: their
management skills and production techniques were company specific and hence
transferable.
The problem is that it may not be obvious, even to the company itself, how
much of its competitive advantage is due to the two influences. That means that

serious strategic mistakes can be made by misunderstanding the basis of competitive

advantage. In addition, exchange rate uncertainty can influence locational decisions
because producing in the country where the company sells its products insulates it
from potentially unfavourable exchange rate movements. Decision makers thus
have to trade off perceived competitive advantages against exchange rate risks.
The oft used phrase ‘think global act local’ can be misleading as a basis for inter-
national expansion. It makes sense to produce locally only in certain circumstances,
i.e. when competitive advantage is company rather than country based. Transferring
competitive advantage is clearly dependent on managing local resources effectively
and this has to take into account factors such as cultural differences. The successful
transfer of competitive advantage by Japanese car makers to the UK involved the
introduction of different work practices under a largely UK management. So even
when local production does make sense due regard has to be taken of local condi-
tions.
4.4 Forecasting: What Will Happen Next?

From the strategy viewpoint, the main reason for trying to understand what is
happening in the economy is to provide a basis for predicting the future course of
events. Since no one can look into the future with any degree of certainty, this
amounts to trying to ascertain what is likely to happen. A cynical manager might ask,
if it is impossible to predict the future with accuracy, is there really any point to
making forecasts? The answer to this is that even vague predictions can be valuable.
For example, for companies whose products are highly GNP elastic it makes a
difference if national income is likely to increase or decrease; it follows that it would
be useful to predict whether national income is likely to increase or decrease next
year. In other words, the direction of change is important in its own right; it may be
possible to go further and predict the dimension of change, but often the very fact
of predicting an increase or a decrease is the major determinant of strategy. Any
action which has future consequences takes a view of future events, if only by
default; therefore it is better to be explicit about what is thought likely to happen.
One problem facing managers is the number of forecasts available. Practically
every day professional forecasters issue predictions of what is going to happen next
week, month or year: some are academically prestigious, such as the London
Business School, some are issued by well-known stockbrokers and can affect the
behaviour of the stock market. Can any use be made of these forecasts? The simple
answer is no, because all forecasters share the same poor track record. Some are
right in some cases, others are right in others, and there is always someone ready to
claim to have successfully predicted current events. In fact, forecasters seem to
share the ability to miss really big changes. For example, the UK unemployment rate
began falling in 1987 after five years of rates exceeding 11 per cent. It was at least a
year before many commentators interpreted the continuing reduction as a long-term
trend; in other words, almost all forecasters followed rather than predicted the
change. A company which recognised early in 1988 that labour markets would be
much tighter by 1990 would have taken a different approach to manpower planning

than a company which assumed that unemployment rates would remain high
indefinitely.
One of the greatest failures of economic forecasters was the inability to predict
the slump in the UK economy in 1991; this was followed by the failure to predict
the increase in growth in 1994. Table 4.4 shows some of the predictions for GNP
growth for 1991 and 1994 made by some of the most prestigious forecasters
around, compared with what actually happened. While this happened some time ago
the same thing is repeated over and over.
Table 4.4 Forecasting UK GNP

GNP % GNP %
growth 1991 growth 1994
Actual −2.2 4.0
Confederation of British Industry −0.8 2.4
James Capel −0.4 3.0
Morgan Grenfell 0.4 2.0
UK Treasury 0.5 2.5
National Institute for Economic and Social 0.8 2.8
Research
London Business School 1.4 2.4
No forecaster even came close to predicting what would happen in 1991. The
difference between the highest of the predictions for GNP growth (+1.4 per cent)
and the actual outcome (−2.2 per cent) is not trivial for those companies whose
product has a high GNP elasticity. A company which acted on the basis of the
London Business School forecast and increased its output in the expectation of a
significant increase in demand would have found itself with substantial unsold
inventories by the end of 1991. The forecasters were better for 1994, in the sense
that they all got the sign correct. But this was not surprising, because by that time
the economy had been growing for a year. No forecaster spotted that the economy
was about to grow at a historically high rate in 1994, and certainly none predicted a
higher growth rate than actually occurred.
A manager might reasonably ask whether the disparity in the forecasts was due to
the way they were carried out, i.e. that some methods are likely to be more success-
ful than others. In fact, there are a number of approaches to forecasting, ranging
from the intuitive to the highly quantitative. For example, the London Business
School model, which performed worst for 1991, is highly sophisticated and is
operated by economists of considerable experience; the UK Treasury bases its
forecasts on one of the most complex models of any economy in existence (known
as the Treasury Model). There is virtually no connection between the statistical
complexity of the forecasting models and their accuracy.
A practical approach to forecasting is to identify a statistic which serves as a
reasonable indicator of what is likely to happen next, and this statistic is known as a
leading indicator. For example, the number of housing starts would be an obvious

leading indicator to use for a business in the glazing industry, because a prospective
reduction in the number of houses completed would have an impact on the number
of windows required. Most leading indicators are chosen because they have served
as predictors in the past, but there is no guarantee that they will perform effectively
in the future. This is an example of using statistical association as the basis for
prediction rather than causal relationships; the trouble is that no one can predict
when a leading indicator is likely to lose its predictive power.
There is a very good reason for forecasts being wrong: unpredictable events
occur. The forecasting procedure must assume that no major events occur to
disrupt the orderly operation of the economy; unforeseeable events such as the oil
price increases of the early 1970s and reductions in the mid-1980s, the ending of
Communism and war in the Middle East, can combine to rob forecasts of any
accuracy they might have had. The characteristic of exogenous shocks is that they
cannot be predicted in the statistical sense, i.e. the use of past data and the extrapo-
lation of trends are of no help. Many forecasts might have been correct if exogenous
shocks had not occurred, but it is virtually impossible to find this out after the event
because of the problem of isolating the various influences.
So is it possible to make any sense of what is happening in the economy, given
that highly sophisticated teams of economic forecasters have such obvious difficul-
ty? One approach is to think in terms of the business cycle. In most countries
periods of boom tend to be followed by periods of depression, which in turn tend
to be followed by periods of boom, resulting in a cyclical pattern which is repeated
over and over again. Economic growth is by no means uniform. Economists have
made many attempts to measure the duration of the business cycle, and there is
some evidence of the existence of long-term, medium-term and short-term cycles
which have a certain degree of regularity. However, inspection of historical data
reveals that although cycles are often clear in retrospect, it is extremely difficult to
predict when the next stage of the cycle will occur; in fact managers find that
economic activity generally is so variable that it is difficult enough to determine
which stage of the cycle they are currently operating in, never mind attempting to
predict future changes.
One method of approaching the problem is to think of the business cycle as
being comprised of three main components: the general trend over time, the
underlying smooth cycle, and random fluctuations. Figure 4.4 shows how a seem-
ingly random series of actual observations can have an underlying structure in terms
of the cycle and the trend.

Actual Business cycle

Trend
Cycle
Index
1 2 3 4 5 6 7 8 9 10 11 12
Year
Figure 4.4 Interpreting the business cycle

The statistical technique which corrects for cyclical and trend effects is known as
series decomposition. It is not necessary to understand the statistical technicalities of
the technique so much as to be able to ask the correct questions when assessing
cyclical data. These questions are:
1. What is the trend?
2. What is the underlying cyclical pattern?
3. What random influences are likely to be disturbing the trend?
In the case of an economy, the trend is the long-term growth rate in potential
output; this varies significantly between countries. Some indication of the underlying
cyclical pattern can be obtained by finding the time between previous peaks and
troughs of unemployment rates. Random influences include changes in government
economic policy and exchange rate fluctuations. It needs to be stressed that no one
is able to predict the business cycle with any degree of accuracy, but it is possible to
form a rational view as to whether the economy is in the upswing or the down-
swing. Figure 4.1 is derived from the UK experience and shows cyclical changes in
UK GNP around the trend line of potential output. Given the gap between actual
and potential output in Year 10, it is not difficult to see that recovery to full em-
ployment was a long way off.
It is important to visualise the business cycle in broad terms as depicted in Fig-
ure 4.4. This is because managers have to make some assumption about where the
economy is in the cycle (unless they ignore the issue altogether and hope for the
best). Ignoring the fluctuations around the cycle, consider the differences in a
CEO’s attitude to a proposed investment depending on where he thinks the
economy is on the cycle.
 If he thinks it is halfway towards the peak he will probably be in favour of the
investment.

 But if he believes that the economy has reached the peak and is ready to fall back
into recession he may well conclude that this is the wrong time to invest.
If managers are not explicit about their expectations then such decisions will be
taken by default. Naturally enough, managers feel confused about what is likely to
happen next because of the many views expressed by economists and politicians;
but the question can still be posed: ‘is this a sensible course of action given our
particular expectation of what is going to happen to GNP in the next two years?’
4.5 PEST Analysis

It is now clear that trends and events in the national and international economy
need to be monitored because of their impact on the company. It is also necessary
to be able to interpret forecasts, because every decision undertaken implies some
assumptions about the future, so it is as well to make them explicit. But the macro-
economy is only one dimension of the overall environment; others are social
changes, changes in tastes and preferences, technological changes, ecological,
political and so on. The checklist of Political Economic Social Technological
factors provides a useful framework for assessing these influences; at one level the
PEST analysis is nothing more than four lists, and as such is of little value. But the
identification of a range of relevant factors, and an analysis of the relationships
among them, can provide important insights into the company’s prospects.
 Political: changes in the political climate can have far reaching implications for
company operations. For example, the change from a largely right wing to left
wing government may herald the emergence of stricter laws on monopoly be-
haviour and relaxation of labour laws.
 Economic: many relevant macroeconomic influences have been discussed in this
Module. The economic effects of factors at the market level will be discussed in
Module 5.
 Social: many changes in society can have impacts on the company; for example,
changes in the demographic composition of the population have implications for
manufacturers of baby products. Changes in social norms, such as attitudes to
marriage, divorce and to the optimum number of children in a family, have im-
plications for many consumer products. The information tends to be qualitative
rather than quantitative, and there is no specific conceptual structure involved;
however, an awareness of societal changes is central to wide strategy issues, and
the identification of potential opportunities and threats. Social analysis is com-
plementary to economic analysis, in that economic factors operate within the
given social structure; for example, predicting social changes can help to explain
why demand curves are likely to shift in the future. The fact that information is
qualitative does not mean that it cannot be used in an analytical fashion. Typical-
ly, qualitative information will indicate whether something is likely to increase,
decrease, or remain unchanged; knowing about the direction of change can be
extremely valuable on its own, independent of the expected dimension of
change. Opportunities may lie in the anticipation of new trends, while threats
may be identified in factors such as changing fashions.

 Technological: technological change is a continuous process, but it can also

happen in short bursts, for example, new technologies such as mobile telephones
and the internet have had fundamental implications for the way in which busi-
ness is conducted. While it is important to see the relevance of new technologies
at an early stage, it is also necessary to be aware of the continuing nature of
technological change in most industries; unless new methods and techniques are
incorporated into company systems, and the company is willing to invest in new
approaches, competitive advantage can disappear with alarming speed.
To show how PEST analysis can be made specific consider the case of a monop-
olistic electricity utility which has recently been privatised. It runs several coal fired
power stations, two of which are 25 years old, and one 15 year old nuclear power
station.
Political
 Recent elections resulted in a new government which is more inclined to stricter
regulation and opening up the market.
 The new government is committed to subsidising domestic house insulation.
 There is increasing international political agreement to cut pollution.
Economic
 New gas fields are being opened up with implications for the price of gas.
 There are several indications of a slowdown in economic activity which will have
a significant effect on industrial demand for energy of all types.
 The price of coal on international markets has started to increase.
Social
 There is a rising public awareness of the need to conserve energy.
 The aversion to nuclear energy is increasing.
 The number of single occupancy households is predicted to increase by 25 per
cent over the next two decades.
Technological
 Improved techniques for insulating houses are being developed.
 Studies have shown that alternative energy sources such as wind, water and solar
power are now cost effective.
If the company had confined its environmental analysis to the economic dimen-
sion alone, it would have been concerned about the imminent economic slowdown,
competition from gas and higher costs of coal. But the PEST analysis identifies a
range of wider threats as follows.

Factor Issues Threat

Political The company is likely to be constrained by the new government, exposed High
to increased competition and possibly lower demand than expected
Economic The imminent economic slowdown, competition from gas and higher costs High
of coal
Social Trends which are possibly going to find expression through improved High
insulation and alternative power sources
Technological Research into alternative energy sources starting to pay off High
The PEST profile reveals that the company has much more to worry about than
adapting to the demands of privatisation. Instead of focusing only on cost and price
issues it has to take into account the political constraints, social changes and the
potential impact of alternative energy sources; some of these factors may not have
an immediate impact but they cannot be ignored.
4.6 Environmental Scanning

A PEST analysis deals with what is known about the environment at a particular
time and is usually carried out when an important decision has to be made, for
example investing in a new product or entering a new market. What is typically
overlooked is that it is necessary to monitor continuously all of the PEST type
variables. The reason that companies are often caught unawares by changes in
consumer preferences, or by changes in government policy, is not that such events
were not reported in the media but because no one in the company has responsibil-
ity for monitoring what is happening in the environment and bringing important
issues to the attention of decision makers. A classic example was the advent of
microcomputers: many mainframe computer manufacturers, including IBM, did not
appear to recognise a major change was under way and several went out of business;
another was the rise in popularity of SUVs at the expense of standard cars, and
major manufacturers such as GM and BMW took years to recognise that a new
market segment had developed. There is also the danger of imagining that changes
are occurring when they are not. For example, telephony companies bid astronomi-
cal sums for third generation mobile phone licences without apparently giving
serious consideration to whether consumers would be willing to pay for the addi-
tional services nor, indeed, whether the technology could be developed such that an
acceptable rate of return could be made on the investment; companies were caught
up in a bidding frenzy because they saw that everyone else was doing it.
Environmental scanning is the process of keeping in touch with changes in the
environment and is an important component of the feedback part of the strategic
process. But in practice it is an extremely difficult activity to undertake; for example,
what are the characteristics of the person to be given responsibility for environmen-
tal scanning? What specific direction can be given regarding what to look for? Many
CEOs would be unconvinced of the productivity of such a role.
But it is not just the identification of potential opportunities and threats that is
the problem; it is communicating these to decision makers. Managers typically do

not wish to read detailed reports and analyses and usually regard discussions of what
might happen as a distraction from getting on with the job. This is when managerial
planning meetings, often in the form of ‘away days’ become important, when senior
managers leave the organisation as a group to focus on the future of the business.
Again, the trouble with most ‘away days’ is that they tend to become focused on
current problems and environmental scanning is pushed into the background.
Anyone who has run strategy sessions for companies knows how difficult it is to get
senior executives to focus on such issues, and their level of ignorance about the
competitive environment can be surprising to observers who are not familiar with
the problems inherent in effective environmental scanning.
It is often tempting to conclude that a company failed to respond to changing
conditions because it did not have an effective environmental scanning process. But
how does a company know that it needs such a process? Some years ago one of our
MBA graduates contacted me to explain that only after studying the Economics
course did he understand the type of competition in his industry and as a result he
had initiated a Marketing study to determine how the company’s competitive
approach could be improved. One of the outcomes was that the company set up an
environmental monitoring group under his direction to monitor PEST type chang-
es. What is revealing here is that the company had not recognised the need for such
an activity in the first place; it took an MBA educated manager to identify the need
and persuade the CEO that it was worthwhile. It is probably not an exaggeration to
claim that the majority of companies carry out virtually no environmental scanning
and are actually unaware of the need for it.
4.7 Scenarios
Once some projections of possible futures have been made they can be used as the
basis of scenarios; this has already been introduced as a component of gap analysis
and in the discussion about the impact of changes in GNP on revenues and costs. It
needs to be reiterated that a scenario is not a forecast, but it is an attempt to
investigate the implications of possible futures for the company. In some instances
it may be based on a short run issue, such as the likely impact of a price reduction
by a major competitor; the potential impact on market share and the cash flow
implications can be mapped out, or the implications for the company’s profitability
of matching the price reduction. A long-term scenario is much more speculative,
and many managers doubt their value. However, put yourself in the position of a
European financial services company in 1990 and visualise the implications of
inflation falling to zero by the year 2000. Financial products such as insurance
policies are typically sold on the basis of nominal interest rates. But if inflation
disappears the interest rate will tend to fall to its real long-term level of about 3 per
cent. When the inflation rate fell to almost zero by 1998 most insurance companies
were unprepared for the impact on expected payouts. Furthermore, inflation was
not the only major change in the 1990s; direct telephone selling had altered the basis
of competition in the market for many financial products. The very fact of thinking
about these potential futures could have an impact on the company’s long-term
strategic planning.

There is more to scenario planning than meets the eye, because it is based on a
premise that makes many people uncomfortable, namely, that it is impossible to
foretell the future and possibly dangerous to attempt to do so. A scenario is actually
a narrative about a particular way in which the future might take shape. It is there-
fore a story about what could happen if particular assumptions hold true. It is not
an attempt to say what will happen. Instead, the idea is to compare the scenario’s
implications with the implications of rival scenarios and then examine the costs of
being prepared to cope with these possible futures.
The approach is usually associated with Shell International Petroleum Company.
The Shell senior planners had been disturbed by the quality of their own predictions
round about the time of the 1973 oil price rises, and developed the method as a
means of coping with a great deal of uncertainty over oil supplies, prices and related
issues. However, they encountered resistance to this approach from colleagues; this
is because to most people, planning is an activity that should reduce uncertainty
rather than increase awareness of it – and there is a widespread predisposition to
converting alternative scenarios to single point or line estimates. This is what the
Shell planners encountered, and they reckoned that it took about eight years for
management to accept that scenario planning was an appropriate tool for develop-
ing strategy.
The PEST analysis carried out in Section 4.5 can be used to illustrate the con-
struction of different scenarios. In Scenarios A and B one factor has been selected
from each of the PEST headings and extrapolated three years from now.
PEST Scenario A Scenario B

Political All householders are eligible for The government has ruled that all coal
subsidies of 75% of the cost of insula- fired power stations must reduce their
tion. emissions by 50% within five years.
Economic Four new gas fields in the North Sea Because of a series of natural disasters
have been brought on line increasing the price of coal has doubled on
supply by 30%. international markets.
Social Because of voter hostility the govern- The number of single occupancy homes
ment has decided not to restart the has increased much more quickly than
nuclear power station building pro- expected and is now expected to
gramme and to decommission existing increase by 30% in the next five years.
nuclear power stations.
Technological A new cavity wall insulation material Economic studies have now shown that
has been developed that is 30% cheaper alternative energy sources are never
than alternatives and can be installed going to be cost effective.
by the householder.

The implications of these changes would be broadly as follows.

PEST Scenario A Scenario B
Political Householders who install insulation will High costs will be incurred in installing
use less energy therefore demand will pollution extraction equipment.
fall.
Economic The price of gas, a competing fuel, will The cost of the main input, coal, is
fall; it will probably be necessary to increasing therefore the cost of produc-
reduce the price of electricity to remain ing electricity will increase.
competitive.
Social Investment plans will have to be The demand for energy will increase as
brought forward. the number of households increases.
Technological As householders install cheaper insula- No more customers will be lost for this
tion demand for energy will fall. reason; therefore demand will be
unaffected.
The two scenarios present different possibilities for the future not only because
of the magnitude of the changes but because of their combination. The potential
impacts of the scenarios on the company are completely different.
 Scenario A portrays a future of falling demand because of the combination of
political actions and technological change; prices will also probably fall and so a
significant fall in revenue (price x quantity sold) can be expected. At the same
time investment will have to be undertaken to replace the nuclear power station.
The combination of lower revenues and the investment cost may lead to cash
flow problems. But it is possible that the falling demand may make it possible to
decommission the nuclear power station without building a replacement imme-
diately.
 Scenario B has two major influences on the cost side: pollution control and
increased input costs. The demand side is, however, quite positive. In this case
the focus could be on controlling costs to maintain competitiveness while taking
advantage of the buoyant demand. As a result the need to invest in pollution
control equipment is not likely to cause major cash flow problems.
The PEST analysis identifies the potential threats and opportunities in the envi-
ronment. The scenarios consider what might happen if various threats and
opportunities materialise. It is clearly impossible to take action now that will enable
both divergent futures to be accommodated in three years’ time, but since these
futures are feasible it is important to determine how flexible the organisation is and
how well it is equipped to face the types of uncertainty identified.
4.8 The Economy and Profitability

It has been argued that the state of the economy has significant implications for the
operation of the individual company, and consequently for its strategy. Because of
this the main macroeconomic concepts relating to the determination of economic
activity, and related issues such as the inflation rate and the exchange rate, have been

discussed in some detail. The various factors affecting the company can now be
brought together to identify the likely impact of economic conditions on company
operations; these include the effects on sales and revenues, competitive conditions
and input costs.
4.8.1 Implications for Company Sales and Revenues

The impact of changes in economic activity on the sales of a product depends on
the responsiveness of the demand for that product to changes in GNP. For
example, the demand for potatoes is not likely to be affected by changes in GNP as
much as the demand for hi-fi sets. The degree of responsiveness is known as GNP
elasticity; a product is usually said to be elastic with respect to GNP when a 1 per
cent change in GNP leads to a greater than 1 per cent change in the demand for the
product; it is inelastic when a 1 per cent change in GNP leads to a less than 1 per
cent change in demand. While it is impossible to estimate GNP elasticity with
accuracy, a rough idea of the magnitude can be useful. This can be derived from the
characteristics of the product, for example, whether it is a potato or a hi-fi set. The
difference between the two could be quite significant; for example, the GNP
elasticity for hi-fi sets might be 1.5, i.e. a 1 per cent change in GNP would result in a
1.5 per cent change in the demand for the product, while that for potatoes might be
zero.
To show this explicitly, take the case where, due to a worldwide recession, GNP
is expected to fall by 4 per cent next year, and the company currently has 15 per
cent market share of the hi-fi market. The GNP elasticity is 1.5; Table 4.5 shows the
difference between assuming GNP elasticity to be zero and 1.5 using the basic
model of revenue developed in Section 4.2.
Table 4.5 Revenue and GNP elasticity

GNP Total market Market Total sales % change
elasticity share (%)
0.0 1 000 15 150
1.5 940 15 141 −6.0
1.5 940 16 150 0
If GNP elasticity were assumed to be 1.5, sales would turn out to be 6 per cent
lower than expected. By taking a realistic view of the likely elasticity the company
could decide on the response to adopt in the face of a declining total market: for
example, a strategy designed to maintain sales volume would involve attempting to
increase market share from 15 per cent to 16 per cent. The converse of this situa-
tion, given in Table 4.6, shows how GNP elasticity can be used to identify an
opportunity rather than a threat; imagine that GNP is expected to grow next year by
5 per cent due to expansionist fiscal and monetary policies.

Table 4.6 Revenue and GNP growth

GNP Total Market Total sales % change
elasticity market share (%)
0.0 1 000 15 150
1.5 1 075 15 161 7.5
1.5 1 075 16 172 15
Using an estimate of 1.5 for GNP elasticity, it is predicted that sales would be 7.5
per cent higher than if the elasticity were assumed to be zero; an opportunity which
presents itself is to grab a slightly larger market share in the growing market, leading
to a 15 per cent growth in sales. When the economy starts to grow strongly, an
effective response might well be to concentrate resources on those products with a
relatively high GNP elasticity.
The GNP elasticity does not tell the whole story about the connection between
GNP and demand for a product. It is not only the size of GNP which is important,
but also the distribution of national expenditure among its components. For
example, a reduction in income tax, which leads to an increase in disposable
incomes and hence to consumption expenditure, may be accompanied by a reduc-
tion in government expenditure due to the end of the Cold War, the net effect of
which is to leave GNP unchanged. Consequently, those industries which rely on
government expenditure on defence, such as the electronics industry, may find
market size reduced, while those in consumer goods industries, such as TV sets,
may find market size increased. At the same time, the government may have
increased the rate of interest, which would affect the demand for investment goods.
It is therefore possible for individual sectors of the economy to have a falling
market size despite a relatively high level of growth in the economy as a whole.
4.8.2 Competitive Reaction and the Economic Environment

Having identified the various relationships between change in GNP and demand for
the product and the likely consequences for the company, attention can then be
turned to how competitors will behave in the light of the changing circumstances. If
competitors have not carried out analyses of GNP trends and elasticity, the compa-
ny may have an advantage by being the first to take defensive action in the face of a
potentially decreasing market, or by being the first to take the initiative to take
advantage of a predicted increase in market size. However, if competitors do have
the same kind of information at their disposal, will they not react in the same way as
our company? For example, in the declining market case shown above, competitors
may attempt to protect their sales by reducing price in order to increase market
share. Since it is impossible for all companies to increase market share, some
company is bound to suffer as a result. It is likely that the outcome would be a
general reduction in the price of the product.
Consider what happens to the company which had not attempted to make pre-
dictions and found itself in a declining market in which competitors are acting
aggressively in order to protect their total sales volume. The company would then
have a falling market share in a declining market with a decreasing competi-

tive price. The combined effect of these influences could be catastrophic despite
the fact that the reductions in total market, market share and price were relatively
small individually. This can be illustrated as shown in Table 4.7.
Table 4.7 Volatile revenues

Period Total Market Price Total % change
market share (%) revenue
1 100 20 10 200
2a 95 18 9 154 −23
2b 90 15 8 108 −46
In Period 2a, despite the fact that the total market fell by only 5 per cent, market
share by 2 per cent and price by 10 per cent, the cumulative effect on total revenue
was a reduction of 23 per cent. Thus a set of changes in market and competitive
conditions originating in a reduction in GNP could have significant implications for
cash flow and profitability. In Period 2b, the changes are larger, but are by no means
unknown in real life. For example, the shipping business is continuously faced with
substantial changes in trade flows and prices due to exchange rate fluctuations, with
implications for competitive reaction. The 10 per cent reduction in total market size,
accompanied by a 5 per cent fall in market share and a 20 per cent reduction in price
virtually halves total revenue. Companies that think the state of the economy has
only a marginal impact on their performance and their strategy are ignoring the
connection between changes in the economy and the behaviour of competitors.
4.8.3 Implications for Inputs and Company Costs

It was discussed at Section 4.3.3 above that input prices are likely to vary with the
level of economic activity, and that wage rates in particular have a tendency to
increase when the unemployment rate is low, but not to decrease when the unem-
ployment rate is high. Using the basic model of costs from Section 4.2, consider a
company which has anticipated a 10 per cent increase in demand due to GNP
growth; it intends to respond by increasing purchase of inputs by 10 per cent. There
are three views on what will happen to input prices:
1 They will all be unchanged.

2a They will all increase by 5 per cent.
2b Labour and Materials will increase by 15 per cent, Capital by 10 per cent.

Table 4.8 Cost scenarios

Scenario Labour Capital Materials Total cost % change
Units Wage Units Price Units Price
Base 100 100 50 200 500 20 30 000
1 110 100 55 200 550 20 33 000 +10
2a 110 105 55 210 550 21 34 650 +16
2b 110 115 55 220 550 23 37 400 +25
The implications of the three scenarios for total cost are as shown in Table 4.8.
In Scenario 2a, the actual increase in total cost is 16 per cent rather than the 10 per
cent which would be expected if factor prices were unchanged, because of marginal
increases in the prices of all inputs. In Scenario 2b, which characterises ‘overheated’
local factor markets, the cost increase is 25 per cent. Since it is unlikely that signifi-
cant changes in GNP will occur without changes in the prices of inputs, it would be
naive to ignore these potential price changes. Calculations of the viability and cash
flow implications of increasing sales by 10 per cent in this case could be totally
misleading if no attention is paid to the likely impact of wider economic influences.
This, of course, is the other side of the discussion at Section 4.8.1, where increas-
es in GNP might appear to lead to strategic opportunities. It must be recognised
that the impact of a change in GNP is not confined to the sales and revenue side,
and it may well turn out that anticipated increases in cost may cancel out the
potential revenue benefits of a marketing strategy designed to take advantage of an
increased market size caused by an increase in GNP.
This brings us to the main conclusion concerning the impact of macroeconomic
changes on company strategy. Changes in overall economic activity can affect sales,
by the effect on purchasing power, and costs, by the effect on wage rates and
investment costs; but potentially the greatest impact results from the competitive
actions which the changes trigger off. The real threat from ignoring changes in the
economy as a whole lies in the fact that competitors who do analyse these events are
likely to take pre-emptive action, leading to a loss in competitive position from
which it is likely to be difficult to recover.
4.9 Environmental Threat and Opportunity Profile: Part 1

While it is clearly important to understand the main factors which affect the national
and international economy, the range of variables is so large that it is necessary to
develop a method of systemising how changes in the economic environment might
relate to the company’s strategy. One method of approaching this is to draw up a
profile of how changes in the environment are likely to present threats and oppor-
tunities. A full environmental profile would include factors specific to the market in
which the company operates, therefore at this stage only the factors relating to the
economy as a whole will be incorporated. A fuller version of the environmental
threat and opportunity profile (ETOP) is presented at the end of Module 5.

Because of the complexity of the macroeconomic environment it is necessary to

use all the tools at your disposal to identify potentially important factors. There is no
single prescribed approach, but the following framework is quite comprehensive.
1. Use the PEST approach as a checklist.
2. Apply macroeconomic ideas to economy-wide influences.
3. Consider international factors both in terms of exchange rates and international
competitive influences.
4. Use the environmental scanning approach to think beyond the immediate
situation.
5. Put together some scenarios to help put factors into context.
6. Build a profile of opportunities and threats.
To put all this together into an ETOP the following steps can be undertaken.
The first step is to list the relevant environmental factors which have been identi-
fied. The second step is to analyse whether each is likely to exert a positive or
negative impact on potential sales and costs, and whether there appear to be
openings for competitive response. The third step is to attempt to determine the
relative importance of the threats and opportunities, and rank them accordingly; in
the absence of hard data it may not be possible to make much progress with this
step. There are no hard and fast rules for the design of the profile; it is a device for
making explicit information and views on the economic environment. Table 4.9 is
an example of an ETOP based on a company whose health food product is
currently being sold in domestic and foreign markets. The company has identified a
number of potentially important developments.
The very fact of setting up the profile can be revealing; for example, a product
may have a substantial number of negative entries against potential sales and
positive entries against potential costs, suggesting that this is a product whose
competitive advantage is under threat. However, the mere incidence of pluses and
minuses may give a misleading picture in the absence of some indication of the
relative importance of the different factors; for example, it may turn out that the
positive entries are all potentially insignificant compared to the negative entries.
Table 4.9 Environmental threat (−) and opportunity (+) profile

Sector Threat or opportunity
International − Expected appreciation of exchange rates
+ Growth in Eastern Bloc economies
Macroeconomic − Tax rate increase to fight inflation
+ Prospect of reduced interest rates
Consider each of the sectors in the example.

International
THREAT: EXCHANGE RATE
Because of better trade figures and increased North Sea oil production it is esti-
mated that the exchange rate will increase by about 10 per cent against currencies
in the countries where the product is currently being sold. Other things being

equal, this will cause a 10 per cent increase in its price in these countries. How-
ever, profit margins are already low and a reduction of 10 per cent in returns in
order to hold the price at its current level will lead to losses on these sales.
OPPORTUNITY: EASTERN BLOC
Increased sales in the Eastern Bloc economies can be expected in the longer
term; however, these will constitute a relatively low proportion of total sales for
the next five years.
Macroeconomic
THREAT: TAX RATE INCREASE
The recent tax rate increase will hit relatively affluent income groups hardest, and
these comprise 90 per cent of the current market.
OPPORTUNITY: INTEREST RATE REDUCTION
Since health foods are not financed by loans the reduction in interest rates will
have little effect on sales. However, reduced personal debt charges may help
mitigate the effect of the tax increase.
This brief outline suggests that the immediate threats outweigh the opportunities.
Changes in both the exchange rate and the tax rate are likely to hit the value of sales,
and this will not be compensated for by the effect of reduced interest rates; the
Eastern Bloc holds out the prospect of long-term sales growth at best.
Review Questions
4.1 The economic statistics shown in Table 4.2 referred to the position in the early part of
this year compared to last year. The statistics below show what actually happened by
the end of the year.
Table 4.10 More economic indicators

Early year End year
Economic indicator Recent changes Change over year
Gross national product 0.5% −2.2%
Industrial output −1.5% −0.1%
Retail sales (volume) −1.1% −0.3%
Investment expenditure −3.2% −5.0%
Current value
Unemployment rate 6.2% 9.0%
Inflation rate 9.7% 4.5%
Wage inflation rate 10.0% 7.5%
1. The CEO of the machine tool company had to decide whether to expand in the
early part of the year or wait until more information became available. In the light of
what actually happened by the end of the year, what would have been the correct
decision early in the year?

2. In the absence of a dramatic recovery in the economy, what do you think will
happen to the inflation rate and wage costs next year?
3. Assume that the company currently has 10 per cent market share, but that competi-
tors are likely to take steps to protect their sales volume during the recession. Set
out a scenario for revenues.
Case 4.1: Revisit Porsche: Glamour at a Price

1 Construct an ETOP for Porsche using the information in the case in Module 3.
Case 4.2: An International Romance that Failed: British Telecom and

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

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

Various reports suggested that the merger might not achieve its strategic aims in the
US.
1. MCI’s core business was the mature market for long-distance telephone calls inside
the US. Critics pointed out that this could make little contribution to the corporate
customers sought by BT.
2. During the period up to 1995 there had been a significant liberalisation of the US
telecoms market, and it was to take advantage of this that MCI was trying to enter
the local markets. But it turned out to be much more difficult than expected, and in
the first quarter of 1997 MCI won only $80 million of local market business; this was
less than 2 per cent of MCI’s normal quarterly revenue. This was bad enough, but by
September 1997 MCI announced an unexpectedly high loss of $800 million on its
domestic operations. It was known that a loss was likely, given the intense competi-
tive pressures in the industry, but the size of the loss came as a surprise to
everyone, including BT.
3. A major problem was that to enter the local markets MCI would have to build the
local network itself or interconnect with the circuits of Baby Bell operators. In fact,
US law allows the Baby Bells a great deal of freedom to challenge the terms of inter-
connection in the courts and with state regulators, with the result that after a year

of deregulation it was still almost impossible to challenge the Baby Bells. MCI did
announce that it was going to build its own exchanges and circuits, but nobody knew
how much this was likely to cost.
4. Deregulation works both ways, and the mature long distance internal market was, in
its turn, opening to competition from the Baby Bells; indeed, because of existing
local competition, the Baby Bells do not have many of the characteristics of semi
monopolists like MCI who have been operating in a mature market for quite some
time. Furthermore, there is now talk of internet telephony; therefore there are no
guarantees that alliances based on existing technology will dominate the telecoms
market in the future.
In fact, MCI’s sales growth had dipped sharply from the beginning of 1996, as shown
on Figure 4.5.
% Increase on year earlier

25
20
15
10
0
1996(1) 1996(2) 1996(3) 1996(4) 1997(1) 1997(2)
Figure 4.5 MCI’s sales
What Drove BT to International Expansion?

BT is generally regarded as a great British success story. It transformed itself from a
monopolistic high cost producer in the mid-1980s to a lean producer after it was
privatised. Its success in cutting costs was greater than expected, and to date it has
shrugged off competition from other suppliers in the UK. But perhaps BT fell into a
number of traps in its approach to MCI. Critics maintained that BT had
 overstated the value of its target;
 focused on new business at the expense of its existing markets;
 drawn unreliable parallels between its own experience in Britain and conditions in
the US. The fact that BT had transformed itself from being a flabby giant did not
necessarily generate insights into the competitive potential of the Baby Bells.
Would They Fit?

Little was said in the press about the potential problems of getting BT and MCI working
together. These were two massive operations, and integrating their markets would
necessarily involve close working relationships. The feasibility of integrating the cultures

of organisations from different countries and competitive environments was open to

question.
But There Was Something There

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

Even if the takeover is successful, there are severe competitive challenges ahead for
WorldCom. Total revenues from local calls are likely to grow only slowly during the
next few years, while the cost of long distance calls in the US fell by 50 per cent
between 1994 and 1997; international prices fell by 60 per cent in the same period.
Furthermore, other global alliances involving companies such as AT&T are also compet-
ing for the same business.
1 Draw up a PEST analysis.
2 What would you be looking for when conducting environmental scanning?
3 Suggest the basis for two scenarios for the future of WorldCom after the takeover of
MCI.
Case 4.3: Lego Rebuilds the Business (2008)

Lego not only produces a building toy; it also builds its brand. In the year 2000, Lego
was named ‘Toy of the Century’ by Fortune magazine and the British Association of Toy
Retailers. It was the sixth-largest toy maker in the world and in 2001 its operating profit
was DKr736 million on sales of DKr9000 million (8 per cent on sales). But by 2003 sales

had fallen by 25 per cent and the operating loss was DKr1565 million; debt had soared
to DKr5000 million and there were rumours that Lego would be taken over by Mattel,
the world’s biggest toy maker. Lego was turned round quickly after that and by 2005
sales had increased by 4 per cent and operating profit was DKr459 million (7 per cent
on sales). Clearly something had gone badly wrong after 2000 and subsequently
something appeared to have gone right.
Lego was founded in 1932 by Ole Kirk Christiansen and the founder’s grandson still
retains majority ownership of the Lego group. In 2004 Mr Jørgen Vig Knudstorp was
appointed CEO to replace Mr Christiansen, who had held the post for 25 years; Mr
Knudstorp was recruited in 2001 from McKinsey and had headed the Lego Group
strategy office as well as being Chief Financial Officer.
By the beginning of the twenty-first century, the traditional toy industry was facing
several problems. First, in many developed countries the birth rate was falling and that
meant fewer customers in the target group: boys aged five to nine. Second, the toy
market generally stopped growing around 2000. Third, there had been a continual
increase in low-cost copycat products that required protective measures to ensure that
the brand was not undermined. Fourth, there was a proliferation of high-tech gadgets
aimed specifically at young children. These factors did not appear overnight and, in fact,
while the situation reached crisis point in 2003, Lego had by that time been faced with
falling sales and profits for about six years.
Lego had a long-standing programme of diversification, one of the best known being
the Legoland parks, located in Denmark, the UK, the US and Germany. Lego attempted
to become a ‘lifestyle’ brand with lines of clothing, watches and video games. It also
tried to attract more girls to its brand, but that meant diversifying into a whole new
range of products, including the Lego Belville, with models portraying family life, horses
and fairytales. Lego also developed tie-ins with film successes, including Star Wars and
Harry Potter.
From early 2004 firm action was taken to reverse Lego’s fortunes under Mr Knud-
storp. The Christiansen family injected DKr800 million as an indication of their
commitment to the future of Lego. Mr Knudstorp stated, ‘We had become arrogant –
we didn’t listen to customers any more.’ The scene was set for a radical overhaul of this
long-established business and the decision was made to focus on the company’s core
business: making toys. In other words, Mr Knudstorp decided to fix the company rather
than reinvent it.
Accordingly, the Legoland parks were sold off to the Blackstone Group, a private
equity firm, although Lego retained a 30 per cent shareholding. The decision was taken
partly to alleviate the pressing financial problems, but it was recognised that running
theme parks diverted management attention from the core toy-making business. It was
decided that some of the diversifications were sufficiently close to the toy-making core
to be worth keeping, so the film tie-ins continued to be developed (for example, Lego
Star Wars).
A close look was taken at costs; factories in high-cost areas such as Switzerland and
the US were closed down and production transferred to Eastern Europe. At the same
time the workforce was reduced by about 20 per cent. New products were centred on
the classic Lego brick and the long-standing themes of Castle, Pirates and Viking were
given a new lease of life. The production time from new concept to delivery to retailers
was significantly reduced to about one year.
The relationship with retailers, who are the direct customers, was reviewed and a

determined effort was made to bind customers more closely to the company. This
involved the development of a new website where customers can experience and
purchase Lego products, a virtual model-building website, the Lego Club, which
encourages interaction among fans of Lego, and exclusive tours of the premises.
Mr Knudstorp also tackled the management structure. He simplified the various
layers and introduced a performance-based pay scheme to foster a more commercial
culture. He also fostered a scheme for more frank communications between managers
and employees. One Lego employee said, ‘We were not used to speaking about money’.
1 To what extent did Lego’s problems arise because of changes in the environment? Why
was Lego so slow to react?

Module 5
The Company and the Market

Contents
5.1 The Market ..............................................................................................5/2
5.2 The Demand Curve ................................................................................5/2
5.3 Competitive Reaction ......................................................................... 5/13
5.4 Segmentation ....................................................................................... 5/18
5.5 Product Quality.................................................................................... 5/25
5.6 Product Life Cycles .............................................................................. 5/31
5.7 Portfolio Models ................................................................................... 5/35
5.8 Supply .................................................................................................... 5/45
5.9 Markets and Prices .............................................................................. 5/47
5.10 Market Structures ............................................................................... 5/50
5.11 The Role of Government .................................................................... 5/57
5.12 The Structural Analysis of Industries ................................................ 5/60
5.13 Strategic Groups .................................................................................. 5/67
5.14 First Mover Advantage ........................................................................ 5/68
5.15 An Overview of Macro and Micro Models ......................................... 5/71
5.16 Is Competition Changing?................................................................... 5/72
5.17 Environmental Threat and Opportunity Profile: Part 2.................. 5/73
Case 5.1: Apple Computer (1991) ................................................................ 5/75
Case 5.2: Salmon Farming (1992) ................................................................. 5/76
Case 5.3: Lymeswold Cheese (1991) ............................................................ 5/77
Case 5.4: Cigarette Price Wars (1994) ........................................................ 5/77
Case 5.5: A Prestigious Price War (1996) ................................................... 5/81
Case 5.6: Revisit An International Romance that Failed: British
Telecom and MCI ................................................................................ 5/83
Case 5.7: The Timeless Story of Entertainment (2005)............................. 5/83
Case 5.8: Revisit Fresh, But Not So Easy ..................................................... 5/85
Case 5.9: Revisit Lego Rebuilds the Business .............................................. 5/85
Learning Objectives
 To develop a framework for analysing market demand.
 To analyse product life cycles.
 To show the relevance of the BCG portfolio matrix for strategy.
 To demonstrate the importance of supply side cost factors.
 To show why prices vary.

Module 5 / The Company and the Market
 To demonstrate the effect of different market structures.

 To assess the importance of product quality.
 To show why governments intervene in the market and how this can affect
individual companies.
 To show how non-economic variables can be included in market analysis.
 To include market factors in the environmental threat and opportunity profile.

to do what

Feedback


allocation
5.1 The Market

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

It is intuitively obvious that the higher the price charged for a product, the less will
be sold, other things being equal. This is the basis for the economic concept of the
demand curve, which shows the relation between the price of a good and the

amount which would be bought at each price. A typical demand curve is shown in
Figure 5.1, together with the quantities which would be purchased at two prices P1
and P2. If the quantity changes by a large relative amount when price is changed, the
demand curve is said to be ‘elastic’, and if the quantity is not affected much by
changes in price it is said to be ‘inelastic’ (the elasticity concept can be expressed
mathematically, but here we concentrate on the general meaning of the idea). In the
figure the price fell by half from P1 to P2, while the quantity bought increased by
about three times from Q1 to Q2. This demand curve is therefore elastic in the range
Q1 to Q2.
P1
Price ($)
P2
Demand
Q1 Q2 Q3 Quantity
Figure 5.1 The demand curve

From the manager’s viewpoint, the important characteristic of the demand curve
is what happens to total revenue when price is changed. This is what the elasticity
tells in a shorthand form. For any price the demand curve provides the basis to
calculate the total revenue from the quantity which would be sold:
Revenue1 = P1 × Q1
Revenue2 = P2 × Q2
This is a simplified version of the basic model of revenue developed in Section
4.2; the implications of the demand curve for market share are discussed in Section
5.2.2. These revenues are represented by the areas drawn under the demand curve in
Figure 5.1 at the two prices. It is obvious that Revenue2 is greater than Revenue1,
thus the statement that the demand curve is elastic below P1 means that reducing
the price increases the revenue. On the other hand, the statement that the demand
curve is inelastic below P1 means that a price reduction will result in lower revenue.
Thus one item of information about the shape of the demand curve has important
implications for pricing strategy. Discussions among managers on pricing policy is
often constrained by the fact that they do not recognise they are disagreeing about
price elasticity; the simple observation that a price reduction will lead to higher
revenue if the product is price elastic and lower revenue if it is inelastic can help
focus attention on the central issue: what is known about price elasticity?

With some information, however vague, about the shape of the demand curve, the
company would be able to predict the effect of a change in price on the revenue from
selling the product. Imagine a company which is deciding whether to reduce price
from $10 to $9 in order to increase sales. Two possible quantity outcomes have been
suggested by the market researchers, i.e. that volume will increase by a low or by a
high amount as shown in Table 5.1.
Table 5.1 Two possible quantity outcomes – a low or high volume

increase
Outcome Price ($) Quantity Revenue ($)
Original 10 100 1 000
Low increase 9 105 945
High increase 9 120 1 080
The difference between the two estimates is important: the low estimate would
result in a reduction in revenue, the high estimate in an increase. Another way of
expressing this is that the low estimate occurs on an inelastic demand curve, and the
high estimate on an elastic demand curve. Referring back to Figure 5.1, the compa-
ny would like to have sufficient information on the demand curve to suggest
whether
Revenue = P1 × Q1 is greater or less than P2 × Q2
When an attempt is made to estimate the shape of a demand curve, the infor-
mation available usually relates to prices relatively close to the existing price. In the
example above the estimates would refer to a small part of the demand curve in
each case. In fact, it is misleading to talk in terms of an ‘elastic’ or ‘inelastic’ demand
curve because whether it is elastic or inelastic actually depends on where the reading
on the demand curve is taken. Referring back to Figure 5.1, it is obvious that at a
high price the revenue is zero, i.e. price times quantity is zero because quantity is
zero; at zero price the revenue is also zero. Thus, starting from the top of the
demand curve and moving down, price times quantity increases up to a point, and
then decreases. In fact, every straight line demand curve has a point at which
revenue is maximised. This can be shown by the information derived from a
demand curve shown in Table 5.2.
Table 5.2 Price, quantity and revenue

Price ($) Quantity Revenue ($) Change in
(Price × Quantity) revenue (%)
0 100 0
1 95 95
2 90 180 89.5
3 85 255 41.7
4 80 320 25.5
5 75 375 17.2
6 70 420 12.0

Price ($) Quantity Revenue ($) Change in

(Price × Quantity) revenue (%)
7 65 455 8.3
8 60 480 5.5
9 55 495 3.1
10 50 500 1.0
11 45 495 −1.0
12 40 480 −3.0
13 35 455 −5.2
Revenue increases as the price is increased up to 10 per unit, and then falls as
price is increased further. Thus the impact of a price change on revenue depends on
the current position on the demand curve. At some points on the demand curve the
impact of a change in price may be quite substantial compared to other points. For
example, increasing the price from $5 to $6 results in a 12 per cent increase in
revenue, while the increase from $9 to $10 increases revenue by only 1 per cent.
There is clearly a payoff from collecting as much information as possible on the
shape of the demand curve and the current position on the demand curve.
The value of abstracting from real life now becomes apparent, because the man-
ager can question whether the right price is being charged now: should it perhaps
have been higher or lower? In other words, the manager can compare the current
situation with what it might have been if the price had been set at a different level.
The manager can now think in terms of whether revenues have been maximised in
the past, and what might be done to maximise revenues in the future.
It must be appreciated that the assumption made in drawing the demand curve is
that other things do not change as price changes. This means that the prices of
other goods and services are not changed, that the incomes of buyers do not
change, that their tastes do not change, and so on. The only variable which is
allowed to change is the price. The approach based on allowing only one variable to
change is widely used in economics, and is usually referred to as ceteris paribus:
holding other things constant. The objective of this approach is not to ignore the
potential impact of other factors, but to make it possible to focus on the likely
effects relating to individual factors.
A natural reaction of many managers on being introduced to the concept of the
demand curve and the ceteris paribus approach is that it does not relate to the world
they live in, where everything changes at once in a dynamic fashion. In fact, the
approach is not meant to be about the real world directly, but is a powerful method
of focusing on individual variables and how they affect the company. Unless a
degree of abstraction from real life is achieved it is impossible to think in terms of
‘what if’; it is the abstraction from real life which many managers find difficult, but
without making this abstraction they will find it difficult to follow economic
discussions.

5.2.1 Demand Factors

Different factors affect demand for a product in different ways; for example, some
affect the market as a whole, while others affect only potential company sales.
DETERMINANTS OF MARKET SIZE:
 Product life cycle
 Business cycle
 Exogenous shocks
 GNP elasticity
 Exchange rates
DETERMINANTS OF MARKET SHARE:
 Price
 Marketing
The factors which influence the total market are usually outside the control of the
company. The product life cycle could lead to a reduction in market size because the
market had become saturated and demand only remained for replacement. The
business cycle is affected by the factors discussed at Section 4.4. Exogenous shocks
can be due to factors such as government regulation on the allowable emissions
from car exhausts. GNP elasticity varies among products, and some implications for
cash flows were discussed at Section 4.8.1. Exchange rates are impossible to predict
with any degree of consistency and can also have substantial effects on cash flow.
On the other hand, pricing and marketing decisions affect the market share which
the company achieves out of the given total market.
In terms of the demand curve, all of the variables except for price affect the
position of the demand curve; if the demand curve shifts to the right consumers are
willing to buy more at all prices and if the demand curve shifts to the left consumers
are willing to buy less at all prices as shown in Figure 5.3. It is therefore useful to
think of the direction in which the demand curve is likely to be shifted by a particu-
lar change, and the possible order of magnitude. When a number of changes occur
in the economic environment at one time some idea of the potential net impact can
be obtained, although the outcome may be complicated. For example, a predicted
increase in GNP next year might shift the demand curve to the right, but a reduc-
tion in tariff barriers might lead to increased foreign competition and would shift
the demand curve to the left; because the product has a low GNP elasticity (and
hence changes in GNP have little effect on the position of the demand curve) it
might be concluded that the net effect will be a shift to the left of the demand
curve. Attention can then be focused on the likely shape of the demand curve, and
the possible impact of a price reduction as a means of maintaining sales. Thus when
sales change, whether up or down, demand ideas can be used to think conceptually
about what is happening and hence contribute to developing an appropriate
response.
The shipping industry is faced with a particularly extreme problem in terms of
shifting demand curves. Exchange rates between pairs of countries often change
significantly in a relatively short time, and have a major effect on trade flows
(market size) and hence the position of the demand curve. The outcome of a change

in exchange rates may be that demand on the outward leg increases and demand on
the return leg falls, leading to vessels sailing full in one direction and half full in the
other. When exchange rates start to change a shipping company can use information
on demand conditions to take marketing and pricing actions in response to the
potential return leg problem. The important step is to visualise changes in the
environment in terms of the position and shape of the demand curve.
5.2.2 Demand Curve and Market Share
The emphasis in marketing strategy tends to be on market share because, as will be
seen later, market share is an important determinant of competitive advantage. Since
market share and the demand curve are derived from similar information, there is a
direct relationship between them. If the company’s objective were to increase
market share, information on the shape of the demand curve would indicate the
scale of price reductions required to increase sales by the required amount, and the
implications for revenue. It is revealing to translate market share objectives into
demand curve terms, because doing so may reveal that the market share objective
implies a demand curve which common sense suggests is impossible. For example,
take two companies who both wish to increase their share of the total market by 2.5
per cent, starting from different market shares as shown in Table 5.3.
Table 5.3 Increase in market share and demand

Company Current market Increase desired Increase in
share (%) (%) demand (%)
A 5 2.5 50
B 50 2.5 5
If both companies were faced with the demand curve shown in Figure 5.1, and
were both charging P1, it is obvious that company A would have to think in terms of
a much larger price reduction to achieve its objective than Company B. But if the
demand curve were relatively steep (i.e. inelastic), even company B might have to
reduce price substantially to achieve the 5 per cent increase in demand required to
increase market share by 2.5 per cent.
It is not necessary to have accurate empirical estimates of the demand curve to
obtain this type of perspective. A rough indication of price responsiveness might be
obtainable from sales staff, and the feasibility of the desired changes can be investi-
gated. For example, if it seems that a relatively large price reduction will be required
to boost market share to the desired level, competitors will be alerted and may well
react. This would cause the demand curve facing the company to shift to the left, i.e.
making it possible only to sell less at each price. On the other hand, a relatively small
price reduction may go unnoticed.
In this case the idea of the demand curve is useful because it forces managers to
be explicit about the expected impact of price changes on the quantity bought. Very
often, the simple question ‘What does this suggest about the shape of the underlying
demand curve?’ clarifies a somewhat confused discussion.
Referring back to the basic model of revenue:


The demand curve expresses this as:
Revenue Total units sold Price
In order to develop the connection between the demand curve and market share,
assume that the price charged by the individual company does not have any effect
on the total market for the product; it is also assumed that competitors do not
follow suit, hence the effect of a price increase will be to reduce market share.
Table 5.2 showing the impact on revenue of moving along the demand curve can
now be expanded to take market share into account by assuming that the company
is selling in a market where the total amount sold by all companies is 400 units per
period.
Table 5.4 Changes in market share and revenue

Price ($) Quantity Market share Revenue ($) Change in
(%) revenue (%)
1 95 23.8 95
2 90 22.5 180 89.5
3 85 21.3 255 41.7
4 80 20.0 320 25.5
5 75 18.8 375 17.2
6 70 17.5 420 12.0
7 65 16.3 455 8.3
8 60 15.0 480 5.5
9 55 13.8 495 3.1
10 50 12.5 500 1.0
11 45 11.3 495 −1.0
12 40 10.0 480 −3.0
13 35 8.8 455 −5.2
The main point to emerge from Table 5.4 is that a reduction in market share can
be associated with an increase in revenue; for example, if the current price were $6
per unit giving a market share of 17.5 per cent, revenue could be increased by
increasing the price to $7 per unit giving the lower market share of 16.3 per cent.
On the other hand, a reduction in price from $12 to $11 will increase both market
share and revenue. The effect depends on the current position on the demand
curve. If the objective were to maximise revenue, the optimum price to charge
would be $10 per unit, giving a market share of 12.5 per cent.
One of the strategic goals often pursued by companies is to increase market
share. This could lead to a disagreement between those advocating a higher market
share, which it is argued will contribute to competitive advantage, and those who
point out that the higher market share may be associated with lower revenue. The
arguments relating to the potential advantages of increased market share do not

depend only on the immediate impact on revenues; some of the complex arguments
relating to the strategic importance of market share are dealt with in Section 5.7.
5.2.3 Demand Curve and Marketing Expenditure

The notion of the demand curve is not only applicable to the connection between
price and quantity sold, holding other things constant. It is perfectly feasible to
include price among the other things held constant, and vary another factor such as
marketing expenditure. The connection between marketing expenditure (in this
context marketing expenditure refers to all aspects of the marketing function) and
the quantity sold might be as shown in Figure 5.2.
Sales
Marketing expenditure ($)
Quantity
Figure 5.2 Marketing expenditure and sales

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

Demand (2)
Demand (1)
Price ($)
P1
Q1 Q2
Quantity
Figure 5.3 Marketing expenditure – shifting the demand curve

Before the marketing expenditure was undertaken, revenue would have been P1 ×
Q1, and after the expenditure it would be increased to P1 × Q2. The joint impact of
additional marketing expenditure and a price change can be assessed directly by
comparing the revenue generated on the original demand curve with that on the
new demand curve. But thinking about the effect of marketing effort in this way
reveals something which is not altogether obvious: in order to shift the demand
curve it is necessary to change people’s preferences; in other words, you have to
persuade people to buy more of this product and less of something else (or save
less). It is not necessary to have a deep knowledge of psychology to know that it is
very difficult to change a person’s mind, particularly by indirect methods such as
advertising and promotion. It is fairly obvious that to have any impact at all a
marketing campaign must involve a lot of resources, i.e. cost a lot of money, and it
needs to be pursued for a significant length of time, otherwise nobody will notice.
You should try to recall successful marketing campaigns; for example, Pepsi was
reputed to have spent $500 million in 1996 simply on changing the colour of its can.
The combination of a shift of the demand curve and a movement along the
demand curve is a powerful tool in developing marketing strategy. It is extremely
important to be able to visualise the two different effects; it is intuitively attractive to
suggest combining a price reduction with an increase in marketing expenditure in
order to win a higher market share. However, it is still important to consider the
likely individual effects, because the increase in expenditure may have no impact at
the margin because the company is near the top of the response curve shown in
Figure 5.2.
The distinction between a shift along the demand curve and a shift of the demand
curve is a very important one. There are many factors which can change the position
of the demand curve, and most of these are outside the control of the company. For
example, if the price of a substitute good were to fall, it is to be expected that the
demand curve would move to the left, i.e. fewer units would be purchased at each
price. The same shift would occur if the price of a complementary good were to

increase; for example, an increase in the price of gin will lead to a reduction in the
sales of tonic because the two are consumed together. Thus when analysing the
market, one question which should be considered is the likely impact of extraneous
effects on the demand curve for the company’s product. This perspective helps in
formulating a strategic response to changes in market conditions and to the actions
of competitors; for example, a company in another market may not appear to be of
competitive importance until it reduces the price of a substitute product, or increas-
es the price of a complement.
The shift of the demand curve arising from an action on the part of the compa-
ny, such as an increase in marketing expenditure, differs from a demand curve shift
caused by the type of factor suggested above which lies outside the control of the
company. In terms of the basic model of revenue
It is unlikely that the marketing effort of any one company will significantly affect
the total market for a product. Thus an increase in marketing expenditure causes an
increase in market share at a given price out of a given market, while an increase in
the price of a substitute results in an increased total market; the latter leads to a
higher level of sales at the existing market share and price. Some shifts in the
demand curve have implications for market share, while others do not.
There are thus important strategic reasons for distinguishing between a shift along
a demand curve and a shift of the demand curve:
 It enables the focus to be on the potential impact of a price change on its own.
 A shift of the demand curve can be caused by factors outside the control of the
company.
 It is difficult to change the position of the demand curve.
Another reason for increasing marketing expenditure is to improve brand loyalty;
this will have the effect of making existing buyers less price sensitive and can be
interpreted as reducing the elasticity of demand. The potential impact is shown in
Figure 5.4.
Demand (2)
Demand (1)
Price ($)
P1
Q1
Quantity
Figure 5.4 Marketing and elasticity

In Figure 5.4 the company is charging price P1 and selling Q1 on Demand(1). The
impact of marketing expenditure is to change the shape of Demand(1) to De-
mand(2) above price P1. That means price could be increased above P1 and fewer
sales would be lost than before while the result of reducing price would be un-
changed. Changing the shape of the demand curve is subject to the same constraints
as shifting the demand curve: it is very difficult to do and it takes a long time.
Further, it is unlikely that a firm would embark on a campaign to increase customer
loyalty with the aim of only increasing the price. It is more likely that the objective
would be to make the demand curve itself less liable to shift in response to competi-
tive actions such as reducing price. The ultimate objective of a marketing campaign
may be to shift the demand curve to the right and reduce its elasticity; but it would
be rare indeed to find the rationale for a marketing campaign expressed in such
terms.
5.2.4 Estimating the Demand Curve
Given the many influences which affect demand in the real world, is it possible to
produce accurate estimates of the demand curve rather than relying on personal
experiences? The general problem of estimating demand curves is shown in
Figure 5.5.
Demand Q2
Demand Q1
X
Price $
Y
Not a demand curve
Quantity
Figure 5.5 How not to estimate a demand curve

In this example only two observations on price and quantity are available, X and
Y, which were obtained in different time periods. Thus the observations X and Y
relate to prices and quantities at times when the assumption of other things being
unchanged does not apply. Consequently, the line drawn through X and Y is
labelled ‘Not a demand curve’; this line does not provide a relationship between
price and quantity so it would be misleading to use it as a guide to pricing strategy.
In fact, since so many determining factors can change between each observation
on price and quantity, any attempt to draw a line between two observations is likely
to be misleading. The company economist can provide the manager with a highly
sophisticated statistical analysis which purports to take into account changes in the
factors which affect the position of the demand curve. This should be treated with

caution, and the manager should ask whether the statistical analysis is doing more
than joining irrelevant points as in Figure 5.5.
This does not mean that the attempt to estimate the demand curve is futile, be-
cause there may be a considerable amount of relevant information available both of
a statistical and of a subjective nature, particularly at the industry level. However,
while it may be possible to derive reasonable estimates of the industry demand
curve, the manager should maintain a healthy cynicism of statistical approaches to
the demand curve facing the individual company.
5.3 Competitive Reaction

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

A well-known example is the ‘zero sum game’, where any gain made by one party is
at the expense of the other. In the cigarette market in Western countries, for
example, total sales are virtually static or declining and one cigarette company can
increase its sales only at the expense of competitors. There is a considerable body of
evidence to suggest that cigarette smoking is harmful and many doctors conclude
from this that advertising should be banned; cigarette advertising is defended by the
manufacturers on the basis that it affects market share rather than entices more
people to smoke, i.e. it is a zero sum game.
An industry comprised of two competitors may find it of mutual benefit to have
a tacit agreement on prices. In this way they can carve up the market between them
and make a profit acceptable to both. However, each company is faced with the
possibility that if it were suddenly to cut prices dramatically it might put the other
out of business, or attract a substantial part of the other’s business. But if the other
company reacted very fast, and had the resources to cope with further price
reductions, the net outcome might be lower prices with both companies being
worse off. This is known as a ‘price war’. When attempting to frame a game strategy
companies are faced with potential costs and benefits, all associated with a high
degree of uncertainty. Managers can use what information they have about competi-
tors to assess probabilities, and perhaps identify a course of action which appears to
have a good chance of success. Such competitor information might include esti-
mates of financial reserves, attitudes to uncertainty, company morale, the strength of
the marketing department, previous successes and failures in new ventures, and the
efficiency of the market intelligence department. A profile of competitors’ strengths
and weaknesses can help indicate the likely response to different courses of action.
However, the dominant characteristic of competitor reaction is unpredictability, and
the company must be prepared for a variety of responses to any competitive action.
But even with full information on competitors it can be impossible to arrive at an
optimum strategy. A game which illustrates this and has important implications for

business behaviour is the ‘prisoner’s dilemma’. Imagine the police are trying to make
two suspects confess to a major crime, but they have no evidence; they tell each
prisoner that
1. if he confesses:
A. he will go free if the other remains silent
B. he will go to prison for 7 years if the other also confesses
2. if he remains silent:
A. he will be sent to prison for 1 year on a minor charge if the other remains
silent
B. he will go to prison for 10 years if the other confesses.
Imagine you are that prisoner: what is your best course of action? Table 5.5 is a
decision matrix which shows the number of years you will spend in prison for each
possible action depending on what your partner in crime does.
Table 5.5 Decision matrix

Partner
You Silent Confess
Silent 1 10
Confess 0 7
The answer is clear – if you stay silent the best you can hope for is 1 year in pris-
on, and the worst is 10 years, whereas by confessing you either go free or spend 7
years in prison. In this case your best option is to confess, and this is independent of
what your partner in crime does. This one-off event is artificial, but it does contain
important lessons for cooperative behaviour, for example when businesses enter
into joint enterprises or strategic alliances where there are potential benefits from
cheating, perhaps by overstating costs, making secret deals with customers, and so
on.
To illustrate the dangers imagine what might happen if you have gone to prison
and served 7 years. Given that research into criminals has shown that prison has
very little effect on behaviour, assume that you and your partner commit the same
crime and end up in exactly the same position once more. Both of you know very
well by this time that if both of you do stay silent then you will spend only 1 year in
prison, so will your experience affect your behaviour this time round? If you are
convinced that your partner sees the virtue of not confessing then it is in your
interest to confess, because that way you go free. But the same logic applies to your
partner, so once again you will both end up confessing and going back to prison for
7 years. The point of the dilemma is that not only does the situation lead to an
outcome which is not in the best interests of either party, but experience does not
lead to a different outcome.
Turning to the parallel with the business world, you would immediately point out
that the two parties are free to discuss what they should do, and as a result of their
collusion would agree to stay silent, hence serving only 1 year. But this is a true
dilemma: once you have reached the agreement then you have an incentive to
confess, because you will go free, and so your partner will have exactly the same

incentive so again you will both confess. The only way out of this dilemma is to
introduce another variable which gives an incentive to stick to the agreement. This
variable is the knowledge that the situation will be repeated an unknown number of
times. Why an unknown number of times? Because after each 1 year sentence it is
worthwhile to enter into the agreement, but if it is known that this is the last time
then both of you will have an incentive to break it.
A great deal of stress is laid on trust and commitment in cooperative business
ventures. For example, both parties have an incentive to conceal information on
true costs and profits, and both have to be sure that the other will not break ranks
and make a profit at the expense of the other. But if agreements are not legally
binding, both parties are continually faced with the equivalent of the prisoner’s
dilemma. One way of building trust is to make a commitment to the venture which
would make it costly to break ranks. In the absence of significant financial commit-
ments it is not difficult to see why cooperation in a competitive environment is so
fragile and difficult to maintain. You may feel that this devalues the concept of
trustworthiness as a moral virtue. But in the business setting it is necessary to be
realistic about the likely actions of business partners and interpret them in terms of
the incentives involved.
5.3.2 The Kinked Demand Curve

The demand curve is usually thought of as the amount which consumers wish to
buy at different prices, holding other things constant. However one factor which is
unlikely to remain constant is the price charged by competitors. For example, if the
company reduced price by 10 per cent in a market with two other competitors and
both of these followed suit, the impact of the price reduction on sales would be
minimal; however, if competitors did not react then the impact on sales would be
much greater. When there are relatively few competitors in a market it could be
argued that the notion of a measurable demand curve for an individual company has
little operational meaning because its shape and position depends on competitive
reaction, which in turn cannot be predicted. Does this mean that the concept of the
demand curve cannot be used in this situation? In fact, the demand curve provides a
useful method of incorporating knowledge about competitive conditions with the
idea of price elasticity.
Take the case where a company has not changed the price of its product for
some time; this price is also charged by competitors. If the company were to
increase its price it knows that none of its competitors would follow suit, and that
many customers would be lost when they realised that the product could be
obtained cheaper elsewhere. If the company were to lower its price, it knows that its
competitors would follow suit so there would be very little increase in demand. The
idea of a sharp reduction in demand resulting from a price increase, and very little
increase in demand resulting from a price reduction, is illustrated by the kinked
demand curve shown in Figure 5.6.

P Kink
Price ($)
Demand
Q
Quantity
Figure 5.6 The kinked demand curve

The current price is P, and above that price the demand curve is virtually hori-
zontal (i.e. highly elastic), indicating that even a marginal price increase will lead to a
substantial reduction in demand. At prices below P the demand curve is relatively
steep (i.e. highly inelastic), indicating that price reductions will have very little impact
on sales. The shape of the kinked demand curve has important implications for sales
revenue. At Section 5.1 it was shown that revenue, i.e. price times quantity, changes
along the demand curve, and that on a straight line demand curve there was one
position at which revenue was maximised. In the example, which is probably typical
of kinked demand curves in real life, revenue is maximised at the current price, i.e.
at price P sales revenue P × Q is maximised.
This has important strategic implications for the company. If the company is not
making profit on a product, it is unlikely to be possible to improve net contribution
by increasing the price because any price increase would lead to a substantial loss in
sales. On the other hand, if the company wishes to increase market share by
reducing the price, it follows that when the price is reduced total revenue will be
smaller than it otherwise would have been, and hence so will net contribution.
When competitive conditions suggest that the demand curve is kinked, the attempt
to increase market share by reducing price can only be justified if future net contri-
bution will be significantly higher than it otherwise would have been to compensate
for the revenue forgone in creating the higher market share. This means that there is
a trade-off between giving up revenues now in order to increase market share, and
the expectation of higher revenues in the future when price can be returned to its
original level at the higher market share.
As market conditions change the extent to which the demand curve is kinked
may also change. For example, if two or three competitors take over a number of
small companies in the industry, it is to be expected that the part of the demand
curve below the kink will steepen. Thus when discussing competitive reaction, it is

useful to frame the issue in terms of whether the demand curve is likely to have a
significant kink, and what the slope of the demand curve both above and below the
kink is likely to be.
The idea of the kinked demand curve has an important strategic implication for
pricing: if it is thought that the demand curve is kinked it follows that it is necessary
to make a significant price change and stick with it. Otherwise the price change will
have virtually no effect because of competitor reaction. But the danger is that a
competitive pricing move may lead to a price war the outcome of which is unpre-
dictable.
5.3.3 Competitive Pricing

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

otherwise it is likely to lead to competitive reaction, and we are back to the two-
person zero sum game.
These approaches to competitive pricing are encountered in textbooks, but they
are rarely, if ever, found in practice. Probably this is because they characterise
extreme forms of competitive behaviour which do not occur much in real life. It is
unrealistic to expect one firm to set prices in a competitive market, where changes
are occurring all the time; firms rarely expect to be able to deter competitors from
entry by engaging in a price war, and recognise that their real future lies in compet-
ing effectively rather than trying to destroy competition; the same applies to
eliminating existing competition – it is one thing to try to win market share by
pricing competitively, but it is quite another to set out deliberately to ruin a competi-
tor. The point is that competition cannot be avoided, and a price change which
deters or eliminates one competitor is unlikely to have a permanent effect on
competitive pressures.
5.4 Segmentation
It is often misleading to think in terms of a product which is sold to a homogeneous
group of consumers. The theory of competition in markets starts with the assump-
tion that consumers have identical characteristics and have full information about
the prices charged for the product; this leads to the notion of a single demand curve
for the product, and implies a marketing strategy which concentrates on the average
consumer. However, an appraisal of the potential worth of a product may be
radically altered by relaxing these assumptions and investigating potential market
segments based on variations from the average consumer, and the marketing
strategies which have the potential to exploit them. It may be found that a 5 per
cent price reduction may lead to a 1 per cent increase in sales volume, suggesting
that the product is price inelastic. However, the additional sales due to lower prices
may be concentrated among consumers in the lowest income group; rather than
offering a price reduction to everyone it would be more effective to offer the price
reduction only to those in the group who are likely to respond. In this case the
lowest income group is a segment of the market. Thus a market segment is a group
of consumers within a broader market who possess a common set of characteristics,
and consumers in a segment respond to marketing variables in broadly the same
way. An example of a company which focuses on a particular segment is Cray
Research, which manufactures super-computers.
The economic idea underlying segmentation is that the market demand curve is
the summation of the demand curves for market segments; these segment demand
curves can vary significantly in their characteristics. The objective in segmentation is
to identify different groups according to their characteristics, estimate how they are
likely to react to different selling approaches directed at them, and allocate market-
ing effort accordingly.
For example, assume that a company has carried out market research which has
established that the price elasticity for one of its products varies among segments. In
terms of the basic model of revenue, segmentation can be expressed as follows.

Revenues = Total markets × Market shares × Prices

where s = 1, 2, …, n and
n = segments of the market
The company would attempt to set Price in each of the n segments so that the
sum of the Revenues is greater than the original revenue from the non-segmented
market. There are many characteristics on the basis of which the market can be
segmented, such as income, social class, geographical location, age, sex, family size,
educational background, etc. When the segments are not separated geographically it
may not be feasible to charge different prices among segments, and in this case the
marketing message would accentuate product characteristics which have a particular
appeal to individuals in the identified segments.
There are four main characteristics which a segment needs to have if it is to be
potentially exploitable:
1. Identifiable: there must be sufficient common features that enable the segment to
be identified in the market place.
2. Demand related: the identified segment must have at least one characteristic which
translates into demand terms, such as the willingness to pay more for a high-
quality product.
3. Adequate size: the segment needs to be large enough to generate a potentially
attractive return on the investment required to exploit it; this is where accounting
techniques such as break-even analysis are particularly important.
4. Attainable: if the segment cannot be reached by available marketing and advertis-
ing approaches there is no point to embarking on the investment.
For example, before developing and launching the Lexus motor car into the
premium car market the makers knew that there is a large worldwide market for
high-quality motor cars (identifiable), that customers were willing to pay several times
the price of a standard car for this quality (demand-related), that the segment was large
enough to support many high-quality models (adequate size), but they had to be
convinced that they could reach high income individuals in sufficient numbers
(attainable); given the fierce competition which already existed among high profile
brands such as Jaguar, Mercedes and BMW in this segment attainability was a
formidable undertaking.
From this a number of key steps can be identified for carrying out a segmentation
analysis.
Identify the Most Important Segmentation Variables

The fundamental issue here is whether there are general criteria which can be used
in determining which variables are likely to be most important and in what circum-
stance. The problem is that markets are individual in nature hence no such criteria
exist. The best that can be done is to approach the issue in a structured fashion, for
example:
 identify the key product characteristics
 derive the characteristics of the target segment

 identify the location of the target segment; location can be in the physical sense
or by income, social class, etc.
While it is not possible to provide more than a set of general rules for such a
structure, it is essential that this stage is pursued thoroughly so that it is understood
where the basis for competitive advantage is likely to lie.
Construct a Segmentation Matrix

The identified variables can be combined with other information about the industry
to produce a matrix which can identify where segmentation gaps potentially exist.
A simple example is to construct a matrix of restaurant ethnic types and quality in
a particular city; this could take the following form.
Quality
Type High Medium Low
Chinese 3 7 5
Japanese 1 1
Indian 2 10 15
Mexican 5 10
Italian 6 4 9
This classification suggests that there is a gap in the market for high-quality Mex-
ican and low-quality Japanese restaurants. But care must be taken at this point,
because the fact that these gaps have been identified does not mean that they can be
profitably filled. For example, there are very few low-quality Japanese restaurants
anywhere because of their emphasis on fresh produce. It is necessary to bear in
mind that in a competitive economy there is usually a very good reason for such
gaps existing: they have already been tested and found to be unprofitable.
Analyse Segment Attractiveness

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

The key success factors are the necessary, but not sufficient, conditions for success.
There are certain activities which must be completed as a precondition for success.
Unless close attention is paid to the identification of these factors there is little
chance that the segment will be effectively exploited. For example, from the matrix
above it might be concluded that there is a gap for another high-quality Japanese
restaurant. Some key success factors involved in exploiting this segment are:
 identify a source of totally fresh sea food;

 obtain the services of a highly qualified Japanese cook (who are very rare);
 find and decorate premises which provide a Japanese ‘look and feel’.
A major reason for the failure of product launches is that little systematic atten-
tion has been paid to the criteria for a successful segment when all that is necessary
is to address a few simple questions: what are the characteristics of the customers in
the segment, are they likely to be willing to pay for the product, are there enough of
them and can they be reached? A further cause of failure is that a potentially
profitable segment has not been effectively exploited by carrying out the steps based
on the key success factors. For example, think of a restaurant you know that has
failed (it happens all the time) and consider how many of the criteria it did not fulfil
and the likely flaws in the segmentation analysis.
5.4.1 Pricing in Segments

It goes without saying that market conditions differ among segments, and that
different prices can be charged in each. However, it may well be the case that there
are virtually no differences in the cost of products sold in different segments; for
example, where segments are based on geographical rather than product differentia-
tion there may be no difference in the production cost in each. What is the optimum
price to charge in each segment? This topic has been extensively analysed in
economics, and is known as discriminating monopoly. The economic theory is
relevant here because the effect of segmentation is to confer some degree of
monopoly power to the company in the different segments; it also stresses the
importance of market rather than cost conditions when setting prices.
Without elaborating the theory it will come as no surprise that the conclusion
arrived at is that, in pursuit of profit maximisation, a monopolist will charge
different prices in different markets depending on demand conditions.
The monopolist will charge a higher price in a market with a low demand
elasticity than in a market with a high demand elasticity.
This follows despite the fact that the marginal cost of production is identical in
each market. In terms of the basic model of revenue and cost, the theory is con-
cerned with finding the price in each market for which revenue minus cost is
maximised.
The implication for pricing is clear: if different demand conditions exist in differ-
ent parts of the market different prices should be charged, even though costs are the
same in each. There is a real payoff from finding out what the different demand
conditions are, rather than setting a uniform price in all parts of the market. This is
because total profit from the uniform price is lower than the sum of profits ob-
tained from differential pricing. This arises from selling more of the product at a
lower price in the segments where demand is relatively responsive to price, and less
of the product at a higher price in segments where demand is relatively unrespon-
sive to price. Segmentation is therefore a potentially powerful tool for transforming
a loss-making product into a profitable product without changing anything but the
price charged to different groups of consumers.

Market segmentation is a good example of how economic, accounting and mar-

keting approaches can be integrated to provide a conceptual structure to deal with
the diverse information encountered in real life. For example, marketing ideas
identify a product where segmentation is potentially viable; economic ideas are used
to measure demand characteristics, and emphasise the role of marginal cost in
decision making; accounting ideas are applied to calculate marginal cost. Relevant
accounting information on marginal costs is essential for making rational segment-
ing decisions: unless the marginal costs relating to product differentiation are
properly estimated, the result may be what appears to be a successful marketing
strategy in terms of capturing market share, but poor profits because the use of the
wrong costs led to a misallocation of resources.
Pricing in segments affects all of us much more than you might realise. Why are
there so many prices for identical airline seats on a given route? It is because the
market has been segmented into different types of traveller. Why does a supermar-
ket chain charge higher prices for goods sold in a small city centre branch than in a
huge out of town shopping mall? It is because city centre shoppers are a different
segment. It is a salutary lesson to think of the world about you as market segments.
You might be able to spot instances where segmentation is potentially viable but do
not appear to have been exploited; you then have to wonder whether it has been
identified by someone else but has not actually been worthwhile.
5.4.2 Product Differentiation

For some products it may be virtually impossible to differentiate among consumers
on the basis of product characteristics because the product does not lend itself to
this approach; for example, there is little difference between one grain of wheat and
another. But it may be possible to change the characteristics of a product in ways
which will have particular appeal to different types of segment. An obvious example
is a car; for the low income family with young children the optimum car is certainly
not a two-seater high-performance sports car which is relatively expensive both to
purchase and run. The car can be thought of as a bundle of characteristics which
appeal to different consumers in different ways. Product differentiation extends the
concept of segmentation to the determination of which bundle of characteristics
should be incorporated in the version of the product targeted at each group.
There are times when differentiation may be more apparent than real. Differenti-
ation may simply be a perception on the part of potential buyers, for example
aspirin is sold under many brand names and all of them simply cure headaches.
However, real or perceived differentiation has implications for marketing strategy
and pricing policy. Consumer characteristics can be matched with potential product
characteristics to identify those market segments where it is likely to be worthwhile
to differentiate the product.
The two most important determinants of a product’s success are likely to be the
perception of its price compared to similar products, and the degree to which
consumers perceive the product as a different offering. A product can be approxi-
mately located in Figure 5.7.

High
Perceived differentiation vs competitive brands

Success likely
Success highly uncertain
Failure likely
Low High
Perceived price vs competitive brands
Figure 5.7 Perceived price/differentiation

The model tells some rather obvious things: a product with low perceived differ-
entiation and high perceived relative price is likely to fail; a product with high
perceived differentiation and low perceived relative price is likely to succeed.
Despite the apparent simplicity of the approach, the model is remarkably powerful
in identifying potential strategies. For example, if current development and pricing
plans suggest that a product will fall into the ‘uncertain’ area, a possible strategy
response is to adjust price and/or mount an advertising campaign designed to
increase perceived differentiation to get into the ‘success likely’ area. There is little
point to launching a product that seems destined to land in the ‘failure likely’ area.
But every year thousands of new consumer products are launched and most are
failures for the simple reason that they are not seen as being different from what is
on the market already and are not priced low enough to compensate.
The model can be used to derive a launch strategy. A product which has high
perceived differentiation can be put on the market at a relatively high price at first
and then abandoned, or the price reduced when competitors react and the perceived
difference is eroded. In the electronics industry during the 1980s Hewlett-Packard
consistently entered new markets with high priced differentiated calculators in the
knowledge that their competitive advantage would be relatively short lived. This is
because the technology could be copied; the subsequent entry of new competitors
caused the calculator to shift down in the matrix but by that time Hewlett-Packard
had made its return and could move on to another differentiated product. This
pattern was repeated in the 2000s with Apple tablets and smart phones. It is not
always possible to do this because it is very difficult to convince consumers that a
new product launched into a market with many existing competitors is really much
different; for example, a new chocolate biscuit has to make its presence felt against
hundreds of existing makes, so at the start it is likely that the new biscuit will have a

low perceived differentiation and will be located in the ‘failure likely’ sector or, at
best, the ‘success highly uncertain’ sector.
In the period leading up to launch it is necessary to make time, quality and cost
trade-offs. If the project is managed to a tight time schedule and costs are con-
strained it may be necessary to launch with a lower quality than originally intended
resulting in launching into the ‘failure likely’ sector. When the project management
team focus on a notion of ‘absolute’ rather than relative quality, disaster can result.
The position in the matrix is unlikely to be static. An existing chocolate biscuit
that is located in the top right hand section of the ‘success likely’ sector will have its
position eroded by other new makes and improvements to other existing makes. It
is therefore not necessary for the physical characteristics of the product to change
for it to move within the matrix; competitive action can lead to a movement down
the matrix because its relative perceived quality has changed.
It may appear odd that price is expressed in perceived rather than in actual terms
as used in demand analysis. But the fact is that consumers position the price of
products on the basis of perceptions. To take an extreme example, a luxurious
Mercedes car costing $200000 is without doubt a high priced item. But it does not
appear highly priced compared with a Rolls-Royce costing $400000. Given that both
makes have a plethora of desirable features and are both built to highly exacting
standards, what is it that gives the Rolls-Royce its edge? It is perceived by its target
market as being of even higher quality than the Mercedes and that puts it into the
‘success likely’ sector somewhere to the right of the Mercedes. (Go back to Fig-
ure 5.7 and try locating the two cars: it really does work.)
The role of marketing can be interpreted in terms of product positioning in the
matrix. The creation and maintenance of brand loyalty help to maintain a product’s
position in the ‘success likely’ sector. But it is an open question whether marketing
effort alone can shift a product from ‘failure likely’ up to ‘success likely’; it is likely
that some development input would also be required to increase the physical appeal
of the product for such a significant movement in the matrix to be achieved. A
major problem is that movement within the matrix is not symmetrical in the sense
that it can be easy to lose perceived differentiation but it is very difficult to move
back up. For example, the Perrier mineral water brand suffered a severe blow when
it was discovered that benzene was entering the production process and millions of
bottles had to be recalled; a similar thing happened when Dell laptop computers
began bursting into flames and 4 million were recalled. It was not easy to rebuild
these brands.
It follows that a major strategic implication of the matrix is that companies need
to be aware not only of the current product position but where it is likely to go.
That depends on competitor actions, technological change, changes in consumer
preferences, etc. Companies that carry out no environmental scanning and do not
apply frameworks such as PEST or ETOP may well find that a product has shifted
downwards in the matrix but they were not aware of it. Consider the case of a fur
coat seller described in Section 1.3.7: the desirable aspects of fur disappeared and in
a sense differentiation collapsed to zero and it became difficult to sell a fur coat at
any price for quite a long time until attitudes to farmed fur started to change. The

outcome was that the demand curve (Section 5.2) shifted far to the left and for
some types of fur coat may have disappeared altogether.
5.5 Product Quality

One of the most frequently encountered methods of product differentiation is by
reference to the superior quality of a company’s product or service. But while many
managers believe that part of their company’s appeal to customers is attributable to
the superior quality of their products, they are often vague about exactly what the
quality difference comprises. The consumer magazines, such as Which? in the UK,
carry out comparative studies of products made by different companies and often
find that products differ only marginally, and that their definition of a ‘best buy’
often bears little relation to manufacturers’ advertising claims. Confusion about
quality is not restricted to consumers; disagreement is often encountered among
employees within a given company on what constitutes quality. Some take the view
that quality depends on the production process, in other words it depends on how
the product is made; others feel that quality depends on reliability in use. There are
several approaches to the definition and measurement of quality; therefore it is
important that managers are clear about what they mean by quality prior to allocat-
ing resources either to increasing quality or exploiting it in the market place.
Transcendent Quality
The philosophical approach to quality is based on a form of circular reasoning
which robs the concept of operational use for decision-making purposes. The
Platonic definition relates quality to high standards of excellence and achievement
which can only be recognised in the light of experience. Thus a painting by a great
master appeals to an art critic who has devoted a large part of his life to the study of
art, but will be little more than a pretty picture to a 16 year old who has had no art
education. The pursuit of transcendent standards by managers is unlikely to be
related to commercial criteria given the difficulty of defining what comprises these
standards.
Product-Based Quality
A product can be viewed as a bundle of characteristics, most of which are suscepti-
ble to some form of measurement. For example, compare flying from London to
New York first class in a Boeing 747 with flying Concorde. Concorde took less
time, and this could be measured. However, first class is more comfortable than the
rather cramped Concorde, and different passengers will have different views on how
great the difference in comfort actually is. There is therefore no guarantee that
passengers would agree on which is the higher-quality flight. Those who actually
chose to fly Concorde obviously decided that the combination of flight time and
cabin comfort provided a higher quality service than standard first class for the price
charged.
Sometimes manufacturers incorporate characteristics which have little relevance
to consumers, but which are thought to enhance the quality image of the product.

For example, it does not matter much to the average consumer that a particular
make of watch will function at 100 metres under water. While the resulting image of
dependability may help sales of the watch, the cost of building a case which can
withstand high pressure may far outweigh the return from the additional sales. In
that sense it could be claimed that a watch had ‘too much’ quality.
This notion of quality also applies to service industries, where quality and con-
sistency are closely linked; most people have had the experience of recommending a
restaurant which failed to deliver the same quality for someone else. The consistency
characteristic is important, because if it has not been achieved the consumer will
have no confidence in subsequent purchases. But consistency is not actually part of
the quality itself, which in the restaurant depends on the raw materials and the
ability of the chef.
There can be very high costs associated with improving dimensions of quality.
For example, an important quality dimension in electricity supply is the incidence of
interruptions. It is impossible to guarantee zero interruptions to all consumers and
everyone accepts this; however, consumers would not be satisfied with hourly
interruptions. Imagine that the supply company operated with a 5 per cent probabil-
ity that the average consumer will have one interruption during any one month
period. A huge number of complaints were received and the company decided to
improve on the 5 per cent figure. It might well discover that the cost of reducing the
probability to 4 per cent was relatively low, but the cost of reducing it a further
point to 3 per cent was twice as much, while the cost of getting down to 2 per cent
was ten times as much. The electricity supply company would then try to balance up
the marginal costs with the increase in consumer satisfaction. For example, if
consumers were unable to tell the difference between 3 per cent and 2 per cent it
might be worthwhile reducing the probability to 3 per cent but no further.
User-Based Quality
This approach departs from the functionally based product characteristic differentia-
tion and attempts to identify what contributes to quality in the eyes of the
consumer. It has already been argued that differentiation is perceived and the same
applies to the quality important dimension. But it is difficult to determine what these
quality variations might be. For example, take the case of two products which have
identical functional characteristics; what is left to vary? One might look better than
the other to many consumers, or have what is typically referred to as a ‘better
design’. For example, this is a feature ascribed to different makes of electric kettle,
where the appearance can be changed but it is virtually impossible to alter the
functional characteristics: the kettle still boils water and nothing else.
Almost every user-based definition of quality can be reinterpreted as a functional,
measurable characteristic. For example, durability, flexibility, strength and speed are
all definable as functional characteristics. One marketing approach is to attempt to
identify ‘ideal points’, which are precise combinations of characteristics which
provide maximum satisfaction to consumers. This takes into account that the
interaction of different quality dimensions can produce more utility than the sum of
the individual parts. While this can provide useful guidelines, it is really an opera-

tional application of quality characteristics in relation to consumer satisfaction rather

than a method of defining quality itself.
Production-Based Quality
This approach relates to production in conformance with specifications. Notions
such as getting it right first time, statistical quality control, and designs intended to
reduce the scope for manufacturing mistakes, all have the objective of producing the
same product each time. To some extent the manufacturing based approach can be
interpreted as a cost reduction exercise, with the objective of producing a given set
of product characteristics at the lowest average cost. While a component of the
concept of quality is that each unit performs to the design standards, it begs the
question of what comprises the quality standard in the first place, and why the
particular array of characteristics was originally chosen.
Value-Based Quality
This is a hybrid notion which combines the price, or production cost, with the
quality. According to this definition, a running shoe costing $600 is not a quality
product, since no one would buy it. This definition can be interpreted in terms of
the economic ideas of marginal and total utility. The value-based definition of the
running shoe hinges on the fact that at the margin consumers would be unwilling to
pay the high marginal cost associated with virtually undetectable marginal differ-
ences in product characteristics. The marginal cost associated with improving
aspects of the running shoe’s characteristics becomes progressively higher, while the
additional utility which the consumer obtains from increments to these characteris-
tics continually declines. Thus while the total utility which the consumer would
obtain from the $600 running shoe would be much higher than for a shoe costing
$120, consumers do not value the difference at $480.
Many cases do exist, however, where seemingly marginal differences in character-
istics are translated into very large price differences which consumers are willing to
pay. An obvious example is the willingness to pay three times as much for a Rolls-
Royce as a Jaguar; it might be argued that the marginal utility of the additional
$270 000 is less than the dimly perceived additional comfort and performance of the
Rolls-Royce. Indeed, it may be that the quality difference has been established by
prolonged advertising campaigns, which have stressed the quality aspects of the
product process without being clear what the quality difference amounts to for the
consumer. Rolls-Royce has always stressed the care taken over the production
standard of every single component, but whether this can be translated to the
consumer in terms of an identifiable difference in utility in use is left open. Whether
it matters to the consumer that a particular part of the car is ‘hand built’ is another
matter; producers are often confused about the difference between the production
process and the final characteristics of the product. Managers should attempt to
determine when a particular production process merely adds to costs rather than to
market appeal. The Morgan car company, a British company which makes a range
of old style sports cars, refused to alter its production processes in line with tech-
nology, and insisted that the whole car be built ‘by hand’; while this helped to foster

the image of a unique product, the costs associated with this form of quality were
such that the firm ran into serious financial problems. The Morgan car company
could not translate the hand built image into a price which consumers were willing
to pay. This can be interpreted as faulty segmentation analysis in terms of the
‘demand related’ criterion.
5.5.1 Dimensions of Quality

A framework for assessing the multidimensional nature of quality can be generated
by defining the potential dimensions of quality, for example Garvin20 suggests:
 performance
 features
 reliability
 conformance
 durability
 serviceability
 aesthetics
 overall perceived quality
It is not claimed that these dimensions can be defined precisely, but it is possible
for informed consumers to rate these dimensions to reflect their own perceptions. It
is reasonable to conclude that a product which achieves a low rating on all dimen-
sions will also have a low weighting for overall perceived quality. This can be taken
further by asking a sample of consumers to rate a product’s characteristics to use as
the basis for identifying those dimensions which contribute to the average consum-
er’s perception of overall quality. This implies a relationship between overall
perceived quality and the individual dimensions of the following type:
Perceived quality = a1 × Performance + a2 × Features + … + a7 × Aesthetics
where a1, …, a7 are weights
Statistical methods can be used to estimate the weights which determine the
contribution which each dimension makes to overall perceived quality. For example,
it may be found that the dimension with the highest contribution to overall quality is
‘durability’ in the case of photocopiers, and ‘features’ in the case of video recorders.
The results can provide information on the basis of which to differentiate the
product, and to determine which characteristics should be enhanced.
It is likely that people of different backgrounds will attribute different weights to
different dimensions; statistical techniques, such as cluster analysis, can be used to
relate market segments and product dimensions. The process of identifying dimen-
sions of quality and segmenting the market makes it potentially possible to identify
exploitable niches and identify which quality dimensions have the potential for
profitable development. For example, it might be found that higher income groups
give a higher weighting to aesthetics than lower income groups; this would clearly be
a valuable item of information for the purposes of targeting an advertising cam-
paign.

A similar approach uses the price as the dependent variable and various product
characteristics as the explanatory variables. The relationship would look like this for
a washing machine:
Price = b1 × Capacity+ b2 × Spin speed+…+ b7 × Reliability
where b1, …, b7 are weights
The statistical analysis would be carried out for a variety of washing machines
and the estimated weights would show how much consumers are willing to pay for
different characteristics. This is known as a hedonic price index and is a useful
measure of the value of product characteristics since it measures what consumers
are willing to pay for. While the statistical analysis is rarely done in practice, the
process is implicitly carried out every time a pricing decision is made for a differen-
tiated product.
5.5.2 Quality and Strategy

A considerable amount of research has been carried out into the relationship
between product characteristics and market performance; the findings provide some
pointers which are helpful for strategy formulation. Some quality related issues
which might appear to be self-evident are not necessarily true. For example, quality
and price may be expected to be positively related, other things being equal.
However, when different dimensions of quality are taken into account, the price-
quality relationship is not statistically significant. This means that a company cannot
assume that it will be able to charge a higher price after having improved the quality
of its product. Another finding relates to quality and advertising; it might be
expected that quality and advertising expenditure are positively related, given the
higher returns to advertising for higher quality products. Again, the evidence is
ambivalent. It may be the case that investment in higher perceived quality is a
substitute for advertising expenditure. The trouble is that consumers do not always
have much direct information on quality, and it is necessary to infer quality from the
behaviour of others. For example, in the 1990s American Express launched an
advertising campaign based on the length of time that famous people had been
subscribers; the clear implication is that the quality of American Express service can
be inferred from the fact that many famous people were willing to be associated
with it.
The payoff from quality can vary substantially depending on the circumstances.
The high-quality ice cream made by Häagen-Dazs is a major success in America and
Japan; it was launched in Europe in 1990 and had a significant impact on the ice
cream market, causing existing producers such as Nestlé and Unilever to introduce
their own luxury brands and heightening the awareness of quality ice cream among
European consumers. But five years later Häagen-Dazs was still making substantial
losses and had a relatively small share of the market. Thus having virtually created
the high-quality ice cream market in Europe, Häagen-Dazs was unable to profit
from it; there are many reasons for the lack of profitability, including the logistics of
the ice cream market, the scale of operations and the reaction of competitors. But
the clear message is that a product with a high perceived quality does not guarantee
financial viability.

The idea that quality is a fundamental determinant of success has generated an

approach known as total quality management (TQM). As its name suggests, quality
in all its dimensions is pursued with a high degree of rigour and commitment.
Notions of quality are brought to the forefront of awareness, and include all aspects
of company performance through production processes and customer service. Some
countries have introduced formal quality standards against which companies can be
appraised; for example, in the UK the BS5750 award signals that a company has met
various quality criteria relating to production processes. But the pursuit of TQM is
by no means an exact science because of the difficulty of defining quality and
providing the incentives which will make quality initiatives work. TQM took on the
characteristics of a philosophy rather than a particular business technique, and is
greatly dependent for its success on the energy and commitment of the approach in
particular circumstances. TQM gained momentum during the 1980s, but by the
mid-1990s scepticism had set in. This occurred because, while there were some well-
publicised instances where TQM appeared to have been successful (for example
Rank Xerox and Motorola), surveys revealed that up to 80 per cent of TQM
initiatives failed. Systematic research on the issue21 concludes that the features most
generally associated with TQM, such as quality training, process improvement and
benchmarking, do not in themselves produce competitive advantage; this is proba-
bly because these can be imitated by competitors without necessarily being
associated with a TQM programme. However, some tacit and behavioural features
such as an open culture, employee empowerment and executive commitment do
appear to be associated with advantage. In other words these tacit characteristics,
and not TQM tools and techniques, drive TQM success, and organisations that
acquire them can perform relatively better than competitors without the accompa-
nying TQM ideology.
From the perspective of the basic model of revenue and cost, the various notions
of quality can be related to the determinants of revenue and cost.

Discussions on quality can benefit from identifying which aspects of revenue

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

Table 5.6 The effect of quality

Impact on
Dimension market share production
cost
Performance High High
Reliability High Low
Conformance Low Medium
Aesthetics Medium Low
For this company a relatively low production cost incurred to improve reliability
would lead to a potentially high impact on market share. While improvements in
performance are also likely to lead to a high impact on market share, the high cost
associated with performance may make it a less attractive option than improving
aesthetics. This cost based approach is at odds with TQM, which holds that all
aspects of quality are important because of the interdependence of the various
functions in the company. No clear strategic message emerges from all this, but it
does appear that the pursuit of quality rather than quality itself can convey ad-
vantages on the company. There is a connection between quality in the wide sense
and perceived differentiation but it is by no means direct or clear.
5.6 Product Life Cycles

The concepts of demand analysis, differentiation and segmentation are important
components in the formulation of strategy. But a major drawback of the economic
approach is the use of comparative statics, which compares one time period with
another, rather than taking the passage of time explicitly into account. It is the
dynamic development of markets and competition over time which makes strategy
so complex. The product life cycle approach incorporates dynamics explicitly into
strategic analysis. Managers are well aware that markets are not static, and that they
are continually changing in terms of growth rates and competitive conditions; the
product life cycle is a powerful tool for systemising many of the changes in these
factors by providing an overview of the evolution of the market for a product, thus
enabling managers to interpret the current market situation and future prospects in a
structured manner. The product life cycle is combined with other factors in Section
5.7 to develop the portfolio approach which is a powerful strategic tool both at the
corporate and product level.
The product life cycle is depicted in Figure 5.8 as a general representation rather
than referring to any particular product.
 Introduction: the product is invented and introduced to the market; it can take
some time for information about the product to be disseminated
 Growth: the product becomes increasingly well known, markets are penetrated
and it possibly replaces other products
 Maturity: all markets are exploited and there is no further increase in sales

 Decline: the product is superseded by technological progress, or substitutes

appear
Market size
Maturity
Growth Decline
Introduction
Time
Figure 5.8 Product life cycle

Since industries are composed of products the idea of the life cycle can be gener-
alised to the industry level, and Figure 5.8 can be regarded as either referring to a
product or to the industry. Everyone is familiar with industry life cycles in broad
terms, for example, the very high rates of growth in the personal computer market,
which slackened off as the industry approached maturity, or the decline of the
cigarette industry in Western countries as information on the health risk of smoking
reduces the number of consumers. Within the industry cycles individual products
have cycles, such as the original IBM PC and cigarette brands such as Capstan. The
product life cycle of the original IBM PC ended when it was replaced by higher
specification machines while very strong Capstan cigarettes were replaced by filtered
brands with lower tobacco content.
While the idea of the life cycle is very general and varies according to the product
and the country, it is an essential tool of strategic analysis because the company’s
estimate of where the industry is on the life cycle has important implications for
strategic behaviour. This is because the stage in the product life cycle affects
profitability, capacity utilisation and competitive reaction.
 Introduction
The company invests in new productive capacity and spends relatively high
amounts on marketing to bring the product to the notice of consumers. Cash
flows are negative, and the company has little idea of how the market is going to
develop, what competitors will appear and whether investments are likely to be
justified.
 Growth
As sales start to increase the company invests further in productive capacity,
typically ahead of market demand, and has to meet the challenge of new en-
trants. To maintain market share in a growth market, it is necessary to increase
sales (because market share is sales divided by market size), and this involves
aggressive marketing and relatively low prices. If the company wishes to increase
market share during this stage, with the aim of being one of the market leaders

when the product cycle reaches maturity, it is necessary to be even more aggres-
sive.
During this period it is unlikely that the product will produce significant profits
because
 marketing expenditure will be relatively high
 prices will be set relatively low
 capacity will be underutilised in the expectation of increased orders
 Maturity
During this stage the company is able to gear its productive capacity to demand,
and techniques such as just in time can be introduced to minimise costs. If the
company has not gained a significant market share by the time the market ma-
tures it will find it very difficult to do so because taking customers away from
competitors is difficult and costly; on the other hand, if the company has
achieved a high market share it will have the basis for a strong competitive ad-
vantage. Price does not need to be set below that of competitors to keep the
existing market share, and marketing expenditure can be reduced. Thus once the
market has stabilised selling costs can be reduced and this generates the potential
for substantial positive net cash flows.
 Decline
The company has to decide when to exit the industry and phase out its produc-
tive capacity. This is not the time to be undertaking new investments, which is
why it is important that companies recognise the arrival of this stage.
 The Transition From Growth to Maturity
A crucial stage in the product life cycle occurs when the transition occurs from
growth to maturity. Given that the management of products in the two stages is
so different it is necessary for the company to make changes during the transi-
tion. Many companies do not recognise in time that the transition has started
and lose their competitive advantage. In the growth stage it is to be expected that
profits will be relatively low because of the high costs incurred in marketing
aggressively and maintaining excess capacity. When the market ceases to grow
carrying on with these policies can lead to losses and company failures. That is
why the transition is sometimes known as the ‘shakeout’.
In practice it is not a simple matter to avoid the problems of transition because it
is very difficult to identify when the market is approaching maturity. It is difficult
to detect when the market growth rate has started to fall; forecasting is notori-
ously difficult and if the company moves too soon it will lose sales because of
lack of capacity. Apart from the difficulty of identifying the transition companies
often adopt a mind set during the growth stage that is unwilling to recognise that
conditions are different and it is time to adopt a new approach.
The product life cycle model occurs in the context of the business cycle. Increas-
ing consumer incomes can cause an increase in market size during the mature part
of the life cycle, at a time when significant increases would not normally be ex-
pected. Real product life cycles are not smooth but have an uneven pattern
depending on the extent to which the product is affected by economic circumstanc-
es. It is obviously difficult to differentiate business cycle effects from the underlying

product life cycle. However, it is important to do so, because the strategy implica-
tions of a fall in sales due to a temporary reduction in consumer incomes differ
from those due to the onset of the end of the product life cycle. In the former
market position should be defended and in the latter the market should be exited.
The main differences in strategy over the course of the product life cycle can be
summarised as follows.
Decision Introduction Growth Transition Maturity Decline

Price Low Low Increase Market Market
Marketing High High Reduce Low Low
Capacity High High Reduce JIT Reduce
Investment High High Reduce Replacement Zero
This is not a prescription for success but is indicative of the changes in emphasis
that companies have to consider as the product moves through the life cycle; there
is plenty of scope for strategic moves as opportunities are identified, for example a
competitor may go out of business during the mature stage and action can be taken
to attract more customers. Just in time (JIT) techniques are applicable only during
the maturity stage. There is a significant benefit to be gained from focusing on
inventory control when demand is fairly stable, but when the market is growing the
primary requirement is to ensure that there is sufficient capacity to meet increased
orders. Application of JIT during this stage can lead to lost orders and ultimately to
the loss of competitive advantage because market share will be lower than it
otherwise would have been.
The stage of the product life cycle also has implications for market entry. A
product launched into the growth stage does not necessarily confront incumbents
because it can attract sales from new customers. But a product launched into the
mature stage has to attract customers from incumbents, which involves some
combination of low prices, high marketing expenditure and differentiation.
There are various approaches to defining the product life cycle; some analysts use
the pattern of company sales, others total market sales, and others profit generation.
It is therefore important to define what is meant by the market. For example,
definitions of the market for TV sets include:
1. The total number of TV sets in existence.
2. The total number of TV sets sold this year.
3. The total value of TV sets sold this year.
4. The number of TV sets sold by the company this year.
5. The value of TV sets sold by the company this year.
Definition one tells us how many people are using TV sets, not how many people
are likely to buy a TV set and how much they are likely to spend, which is the
concern of producers and sellers of TV sets; definitions two and three are of direct
interest to companies in the industry since they relate to potential sales volumes and
revenues. Definitions four and five are the outcome of the company’s strategy; it is a
mistake to define the market in terms of the sales which the company actually

makes, rather than in terms of the total sales of the product. Definition two is the
same definition of the Total Market used in the basic model of revenue:
In the absence of significant changes in Market Share and Price, the Total Market
drives revenue over the product life cycle. Thus any information about the likely
shape and duration of the product life cycle would be of immense value to the
company. Predictions of product life cycles are as imprecise as any other type of
forecasting, but some factors help to generate a rough idea of what the life cycle
might look like.
 Substitutes: can the want which the product satisfies be performed in some
other way which has not yet been marketed? For example, the telex machine
(which few people now know about) was the method of sending messages
worldwide until the advent of the fax machine in the mid-1980s, which did the
same job but was easier to use and did not need messages to be typed in. The fax
heralded the end of the telex product life cycle, but it was impossible to predict
in, say, 1970 when such a substitute would appear.
 Technology: if there is rapid technological change a product may soon be
superseded by something superior and probably cheaper. Again, it is impossible
to predict obsolescence but technological advances can be incorporated into new
products quite quickly. It was impossible to predict in the 1980s that fax would
itself be superseded by email when the internet developed.
 Durability and replacement: some goods are bought for immediate consump-
tion, such as food, while others are bought for the services they will generate
some time into the future, such as a TV set. Once everyone who wants a TV set
has one then sales will be dependent on replacement demand.
This is not an exhaustive list of the factors which are likely to affect the product
life cycle. The individuals who work with a product, both on production and sales,
will typically have a detailed knowledge of the product in relation to the market and
can often provide a reasoned outline of how they see the product life cycle develop-
ing.
As you might expect, there is some debate about the validity of the product life
cycle concept, and whether it is of universal applicability. The research into product
life cycles has revealed that they have many shapes, durations and sequences, and
this has added to the doubts which many people have. However, the fact that
product life cycles take many forms does not necessarily mean that the idea of
product life cycles is useless. The idea provides a structure within which data can be
interpreted and, as will be seen, is an important dimension of a more general
strategic framework.
5.7 Portfolio Models

A company can be visualised as a portfolio of products with different characteristics
that determine their market positions. These characteristics are related to market
variables and not to the physical attributes of the products so it is possible to

visualise a single product company as having a portfolio to the extent that its
product is sold in different market segments. The notion of a portfolio raises the
question of whether there is an optimal portfolio, i.e. whether one set of products is
in some sense superior to another.
5.7.1 The BCG Relative Share Growth Matrix

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

Unit cost = Outlay / (Total market × Market share)
The potential advantage conferred by a higher market share is that unit cost will
be lower than that of competitors.

Product Cycle Growth Stage

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

Once the market stops growing market share becomes more secure because there
are no new customers appearing, and competitors have to take action in the form of
increased marketing effort and/or reduced price to induce customers to change
their allegiance. Price does not need to be set below that of the competition to keep
the existing market share, and marketing expenditure can be reduced. Once reve-
nues have stabilised, selling costs are reduced which, coupled with economies of
scale and experience effects, generate the potential for substantial positive net cash
flows.
Market share and market growth therefore both have potentially significant im-
plications for costs and revenues; the next step is to combine these into a single
model as shown in Figure 5.9.22

High
Stars Question Marks
Market growth rate
Cash Cows Dogs
Low
High Low
Relative market share
Figure 5.9 BCG market growth/relative share matrix

Source: Hedley, Barry D. (1977) ‘Strategy and the Business Portfolio’, in Long Range
Planning, Vol. 10. Elsevier Science. Copyright © 1977 Barry D. Hedley. Reprinted with
permission from Elsevier Science.
Individual products can be positioned in the matrix depending on their relative
market share and the current market growth rate. The matrix provides the basis for
classifying products according to which quadrant they fall into. While the classifica-
tion can be no more than approximate, given that the four quadrants shade into one
another, the quadrants provide a powerful tool for identifying important characteris-
tics which relate to the performance of products in the market.
The Dog
A product which has a low market share in a stable market, and which is not making
profits currently, stands little chance of making profits in the future. This is because
the costs of increasing market share are likely to outweigh the potential gains. The
costs of increasing market share will be high because the market has stabilised and it
will be necessary to attract customers from competitors; this can only be done by
increased marketing expenditure and/or price reductions, which is likely to lead to
competitive reaction, the prospect of which adds considerably to the uncertainty of
the exercise. A Dog may have already cost the company a considerable amount in
development and marketing so managers may feel averse to abandoning a product
which has already cost so much. This reasoning is false, because costs incurred in
the past are sunk and have no bearing on the future. Abandoning the Dog will
release scarce resources which could be put to more profitable use.

It does not follow that because a product lies in this part of the matrix it cannot
make profits. It may occupy a niche, or there may be limited economies of scale,
resulting in the market being supplied by a relatively large number of companies
each of which has a small market share. In this case it is the relatively efficient
company which makes the most profit. Therefore it does not follow that all
products in this quadrant make losses; but if a product is not currently making
profits and is being produced as efficiently as possible, it has little future.
The Question Mark

The product in this sector is called a Question Mark because it may become either a
Dog or a Star as the market matures. If market share can be increased before the
growth in the market stops it will become a Star; if not it will become a Dog. These
products are liable to run at a significant loss, and managers are faced with a difficult
problem in deciding how many resources it is worthwhile investing in the future of a
Question Mark.
The Star
The objective with such a product is to maintain market share until market growth
ceases and it converts into a Cash Cow after the transition. The product incurs
relatively high marketing costs because of the competition for new customers as
market size increases. It also needs to be competitively priced to ensure that market
share is not lost.
Cash Cow
This product achieves economies of scale, is further up the experience curve than
competitors and, since demand has stabilised, resources can be aligned closely with
demand. It is now possible to apply JIT and reduce marketing expenditure. Since
the price set is the same as competitors who do not have these cost advantages the
Cash Cow has the potential to generate significant positive cash flows.
Applying the BCG Matrix

In order to use the BCG matrix effectively it is necessary to recognise that the
classification is based on two variables only: market growth and market share. Often
it will be difficult to obtain accurate information on these variables: the precise
location on the product life cycle is always a matter of judgement and it may not be
possible to obtain accurate information on competitors’ market shares. The strategy
implications of some different BCG classifications combined with market character-
istics are outlined below. Because of the differences in the strategy actions in each
case it is clearly important to determine as far as possible where a product is located.
The problem is similar to that of forecasting the business cycle discussed in Section
4.4: it is very difficult to be precise about the state of the business cycle or location
in the BCG matrix but there are serious strategic implications in both cases.

BCG Characteristic Strategy implication

classification
Cash Cow Profitable Defend
Cash Cow Loss making Missed transition: review capacity, investigate
JIT, consider pricing and elasticity
Cash Cow Declining sales Entering decline stage; reduce capacity, market-
and market ing and investment
share un-
changed
Dog Profitable Probably no economies of scale; potentially
vulnerable so monitor closely
Dog Loss making Divest
Star Large losses Possibly entering transition to maturity: cut back
on capacity and marketing
Star Losing market Increase marketing and reduce price
share
Question Severe losses Determine if there is sufficient time to develop
Mark into Star
Question Gaining Maintain resource allocation to develop into Star
Mark market share
The classification makes it possible to ask the right questions and take appropri-
ate action; for example, if a Cash Cow is making losses it is likely that costs are not
being controlled effectively; if a Star is losing market share it may be because it is
being managed as if it were a Cash Cow.
Back to the Demand Curve

At this stage we should not lose sight of demand curve analysis which related
revenue changes to changes in price and market share in terms of movements along,
and movements of, the demand curve. In the growth stage of the cycle demand
analysis can be used to provide an indication of the price which would have to be
charged to achieve the sales volumes which would maintain or increase market
share. However, the revenue implications discussed at Section 5.2 are largely
irrelevant at this stage because the objective is not to maximise short run profit but
to lay the foundation for a Cash Cow. Once the market has stabilised, i.e. the total
market has stopped growing, the question of the optimum market share can be
addressed. The demand curve analysis demonstrated that pursuit of market share for
its own sake could lead to total revenue being less than otherwise would be the case.
It may well be the case that a higher price and lower market share would be more
profitable for a Cash Cow; this, however, is a difficult judgement to make given the
potential for increased competitive pressure if market share were to be reduced.

5.7.2 Other Portfolio Models

The salient characteristic of other portfolio models is that they are more complex
than the BCG matrix, and take into account many more variables. This means that
they cannot be fully displayed in matrix form because they have too many dimen-
sions. For example, the McKinsey portfolio model has two general dimensions of
business strength and industry attractiveness. Business strength takes into account
such variables as capacity utilisation and relative costs, and industry attractiveness
takes into account variables such as growth rate, profitability, cost trends and
industry structure. The variables are weighted in terms of relative importance, and
scored to give an overall rating for the two dimensions. It is possible to tailor the
McKinsey model much more closely to the individual company than the BCG
model, which relies on more aggregate variables. Because the additional complexity
does not add significantly to strategic insight, these models will not be pursued
further.
5.7.3 Limitations of Portfolio Models

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

5.7.4 Portfolio Models and Corporate Strategy

The product portfolio is an essential tool in the management of individual products
through the life cycle. It also provides a useful perspective on the mix of products
which comprise a corporation. Is there such a thing as an optimum portfolio? A
company which is comprised only of ‘Cash Cows’ will remain static by definition,
and is liable to suffer substantial reductions in cash flows as products come to the
end of their life cycle. However, too many ‘Question Marks’ and ‘Stars’ may drain
company resources. An optimum portfolio could be defined as one in which the
‘Cash Cows’ generate sufficient cash flows to produce adequate returns to share-
holders and the cash necessary to develop the potential of ‘Question Marks’ and
‘Stars’ to replace the ‘Cash Cows’. If the company had ambitions to grow, the
balance between ‘Cash Cows’, ‘Stars’ and ‘Question Marks’ would be adjusted
accordingly.
Portfolio selection is not a mechanistic process based on the selection of prod-
ucts as they appear in the BCG matrix. There are many difficulties involved in
identifying which ‘Question Marks’ and ‘Stars’ are likely to succeed. The portfolio
decision will depend on the risks involved and the company’s attitude to risk
bearing. Furthermore, the variables in the matrix do not capture all relevant product
characteristics. A company may have an optimum portfolio in the sense that it has
no loss-making ‘Dogs’, and several ‘Stars’ and ‘Question Marks’ which will replace
ageing ‘Cash Cows’. But products are not conceptual entities to be guided through
the stages of the product life cycle; managers have to know a lot about their
products, including how to make them at the lowest cost and sell them effectively
against competitors. A portfolio which is comprised of totally unrelated products in
a diversified company may be virtually unmanageable so there is no guarantee that
the corporation is adding value by including all of them in the portfolio. Considera-
tion needs to be given to developing a portfolio in which products are linked in such
a way as to benefit from the competencies of the corporation which relates back to
the resource based view of strategy discussed in Section 1.2.3. Diversifications
which are intended to optimise the portfolio, in the sense that there is a balance
between the cost of the Stars and the profitability of the Cash Cows, may be totally
misguided; the company can end up with an unmanageable portfolio, and this has
been a contributing factor to the failure of many diversifications in the past.
Portfolio models can be used for more than the determination of company prior-
ities. If they have validity for one company, they have validity for competitors;
competitors can be analysed in terms of whatever information is available on their
product positioning in the BCG matrix, and this can serve as the basis for competi-
tive strategies. Take the case where the company is concerned about the
development of a competitor’s ‘Star’ versus its own ‘Star’. Is the appropriate strategy
to mount an attack on the ‘Star’ directly? Presumably the competitor is prepared to
accept the drain on resources which the development of a ‘Star’ demands, therefore
may be prepared to fight back. The appropriate strategy may well be to attack the
competitor’s ‘Cash Cow’, with the objective of reducing the competitor’s cash flow
surpluses that are used to finance the development of the ‘Star’.

A competitor may decide to undertake a change of direction through diversifica-

tion into new markets; the fact that this results in a preponderance of ‘Stars’ and
‘Question Marks’ has implications for the total resources available to the competitor
in common markets. Portfolio analysis of competitors can provide insights into
what their reaction is likely to be to competitive action and when they are likely to
make a strategic move.
The portfolio model throws light on the principal–agent problem between cor-
porate and SBU CEOs. The SBU manager may be unwilling to dispose of a ‘Star’
which is seen as having considerable future potential; but from the corporate
viewpoint the product may not fit with the company’s aggregate portfolio and more
value could be created by selling it and allocating the resources elsewhere.
The process of selecting the optimal portfolio can be envisaged in terms of the
markets and products in which the company is currently or potentially operating. A
systematic approach to identifying the components of the portfolio strategy was
developed by Ansoff,25 and he defined what he called the growth vector, which
interpreted the direction in which the company intended to develop its portfolio.
The growth portfolio was originally specified in terms of the company mission in
relation to its product; rather than explore the growth vector in terms of company
mission, which Ansoff defined in a particular manner. Figure 5.10 builds on
Ansoff’s approach and develops a growth vector in terms of markets and products.
Products
Current New
Currently Penetration: Product replacement

operating increase market share
Markets
New Market development: Diversification

entry new uses, segments, etc.
Figure 5.10 Components of a growth vector
Penetration
If the company wishes to grow relative to competitors on the basis of the products
which it sells in existing markets it can only do so by increased penetration, and
hence by an increase in market share. If the market is mature it follows that sales
can only be gained at the expense of incumbents, while if the market is growing the
company must continuously acquire a larger share of market growth than competi-
tors. For the mature market, this can be interpreted as developing a Dog into a Cash
Cow, while for a growth market as developing a Question Mark into a Star. Either
way, growth depends on pricing and marketing strategies relating to the company’s
current operations, while benefiting from the company’s accumulated experience in

production. During the late 1990s European car makers were faced with a mature
market but there was massive overcapacity in car production worldwide. The scale
of some European car makers was too small to compete with the main global
players so many car companies attempted to increase their market penetration by
acquiring established and prestigious makes. BMW acquired Britain’s Rover and
Rolls-Royce and VW acquired Bentley.
Product Replacement
It may be concluded that no further penetration by the current version of the
product can be achieved, and it is necessary to add characteristics and perhaps
abandon some existing characteristics; it could also be due to the product approach-
ing the end of the product life cycle. The replacement can be an enhancement of an
existing product or a totally revised version with a different set of characteristics,
but it is important that it at least fulfils the requirements of the replaced product,
and/or satisfies changing consumer preferences. This type of growth involves the
company in investment in product development and a shift away from the set of
products in which it has built up expertise. However, the company is able to
capitalise on its knowledge of the market, its brand name and its existing distribu-
tion systems. One of the most significant product enhancements in the car business
during the 1990s was the advent of the off-road vehicle. Instead of purchasing a
standard road car, many consumers selected the high-body, four wheel drive, rugged
off-road vehicle; this was a car with a completely different set of characteristics, but
within a few years every major car maker had such a vehicle in its portfolio. It was
not a new concept, as Britain’s Rover car company had been producing the world
famous Range Rover for several decades; but the new entrants went for more
luxury, better handling and state of the art technology – the very characteristics
which sold standard road cars anyway.
Market Development
The search for new markets for existing products can take a number of forms, such
as finding markets in new geographical locations and identifying unexploited
segments or niches. This means that new techniques need to be developed for
selling products with known characteristics, and this requires effective strategies for
market entry. This in turn raises issues relating to the product life cycle, as entry into
a growth market requires a different approach to entry into a mature market. But as
with market penetration, the success of the growth strategy depends on pricing and
marketing approaches. The Korean car maker Daewoo entered the British market in
the early 1990s with a standard range of cars, but used a fixed price selling approach
which market research suggested would appeal to many car buyers. The idea was
that there were no salespeople in the showroom and that no negotiation would take
place on the price. Despite the fact that the Daewoo cars were no better than other
makes in their range, the company made significant inroads into the British market.
While it might have been a marketing success in the short term, by the early 2000s
Daewoo had gone bankrupt and been acquired by General Motors who rebranded
the range as Chevrolet and abandoned the fixed price approach.

Diversification
In this context diversification has a particular meaning, in that the company enters
new markets with a new set of products and is therefore akin to the notion of
unrelated diversification discussed at Section 7.4.1. In this case there is no direct
experience of marketing strategy which can be applied, while the company has no
experience of production. Car makers often have a wide portfolio of car types, and
often have interests in lorries (trucks) and buses; but few have productive capacity in
earth moving equipment, for example. An interesting exercise is to try to identify car
companies which have moved into the diversification part of the matrix.
5.7.5 Strategy and Product Information

In the business school setting managers are always more comfortable discussing
actual product examples than discussing abstract products, usually a ‘widget’. Think
about the items of information on a product which you need to make decisions;
these include:
 price elasticity;
 income elasticity;
 the effect of marketing on the position of the demand curve;
 competitive conditions in the industry;
 size and growth of the market;
 relative market share;
 product life cycle.
The reason managers would like to know what the product actually is must be
because they feel such knowledge would give additional insights into these charac-
teristics. But knowing whether a particular business problem relates to the plastics
rather than the cheese industry does not make any difference to the underlying
issues. There is no doubt that each time a new product is analysed the problems
seem to some extent unique. But the objective of a market analysis is to go beyond
the immediate product characteristics and quantify the conceptual factors as far as
possible.
5.8 Supply
Attention tends to be focused on the demand side of company performance, but
supply and cost considerations are equally important in the determination of
competitive advantage. The supply curve for an industry shows the amount which
companies in total would be willing to sell at different prices, holding other factors
constant. The position and shape of the supply curve depends on production costs;
it is reasonable to conclude that the higher the price on the market the greater the
quantity companies in aggregate would be willing to supply, therefore it is to be
expected that the supply curve will be upward sloping. A typical supply curve is as
shown in Figure 5.11.

Supply
Price
P
Q Quantity
Figure 5.11 The supply curve

At price P the total quantity supplied by the industry would be Q. If price were
higher than P then more than Q would be supplied, and vice versa. The slope of the
supply curve depends on the cost structure of the companies in the industry.
5.8.1 The Industry Supply Curve and Strategy

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

5.8.2 Shifting the Industry Supply Curve

Any factor which changes costs will have an effect on the supply curve. For
example, an increase in the price of oil causes unit cost to be higher at each level of
output; this has the effect of shifting the industry supply curve to the left, i.e. at each
price companies would be willing to supply less than before. The leftward shift in
the supply curve caused by an increase in the price of oil is illustrated in Figure 5.12.
Supply (2)
Supply (1)
Price
Q2 Q1 Quantity
Figure 5.12 Shifting the supply curve to the left

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

Prices are determined by the interaction of demand and supply. The production of
goods and services depends on the costs which companies incur in supplying
different quantities. The demand for goods and services depends on what people are
willing to pay for different quantities. The interaction of demand and supply
produces prices, which serve as signals to seller and buyers. An understanding of
price determination makes it possible to make predictions about the outcome of
changes in both demand and supply conditions.

Supply
Price
P
Demand
Q Quantity
Figure 5.13 Demand, supply and price determination

The idea of price determination is simple. In Figure 5.13 the price will tend to
move towards P, known as the equilibrium price. If the price is higher than P then
companies will produce more than consumers are willing to buy, and the price will
fall. If it is lower than P then consumers will attempt to buy more than companies
are willing to produce, hence bidding up prices. Managers may feel that the idea of
equilibrium price is of limited use because in real life prices are continually changing,
and nobody knows what the equilibrium price is for any particular product. Howev-
er, demand and supply analysis is a powerful tool both for understanding market
conditions and for predicting what is likely to happen in the future.
To demonstrate the power of demand and supply analysis using a rudimentary
knowledge of the shapes of demand and supply curves, take the case of the shipping
business, which is characterised by enormously fluctuating vessel prices. For
example, the price of the average 60 000 tonne cargo vessel fell by one third
between 1981 and 1982, and increased by one third between 1986 and 1987. The
application of demand and supply analysis reveals that such fluctuations are an
inevitable outcome of the shipping market.
In Figure 5.14 the price is set at P1 in the first time period by the intersection of
the demand and supply curves. The supply curve is inelastic in the short run because
the only way to increase the supply of shipping services immediately is to increase
speed and take vessels out of storage, and this adds relatively little to the quantity
produced by the existing stock.

Supply (1)
Supply (3) and (4)
P2
P3
Price
P1
Demand (2)
P4
Demand (1) and (4)
Vessels
Figure 5.14 Fluctuating prices

The shift to the right of the demand curve in period 2 is therefore not associated
with an immediate large proportionate increase in supply, and the price rises to P2.
By the later time period 3, shipyards have reacted to the higher price and increased
the stock of vessels. This has the effect of reducing the price to P3. In period 4 the
demand falls back to its original level, and since the supply is now higher than in the
first time period, this has the effect of causing the price to fall to P4. A rudimentary
knowledge of supply, demand and price determination predicts exactly what
happens in the shipping business, and also reveals that price fluctuations are likely to
be a permanent feature of the shipping market (this is an example of what is known
as the cobweb theory in economics). If a manager is convinced that the demand for
shipping services is likely to increase, it follows that the appropriate action is to buy
vessels now because the price is bound to increase by a large amount when the
demand makes itself felt.
Any factor which alters the position of the industry demand or supply curves will
have an impact on market prices. The extent of this impact depends on the shape of
the demand and supply curves. In the shipping industry the effects are large because
of the inelastic supply curve. If the supply curve had been elastic the impact on
prices would have been much less. It will be noted here that the analysis was not
expressed in terms of actual prices, nor was there any attempt to be accurate.
Demand and supply analysis uses the concept of equilibrium price, which does not
exist in real life because transactions are taking place all the time around the
equilibrium point; all buyers and sellers would have to have complete information
about each other for all transactions to take place at the equilibrium point, and that
is clearly impossible. However, the analysis does enable us to make predictions
about the direction and rough magnitude of change, taking account of what is
known about the slopes of the demand and supply curves, and to base our actions

on the knowledge that, in the absence of other changes, this is how things will
generally work out.
Thus a relatively limited amount of information on demand and supply condi-
tions for an industry can enable managers to assess the impact of events such as the
entry of competitors (increase in supply) and the emergence of substitutes (reduc-
tion in demand).
5.10 Market Structures

Casual observation reveals that market structures vary markedly among industries.
The market for wheat is comprised of many relatively small producers, none of
which can individually affect the price; for example, in the UK British Telecom had
a government monopoly until it was privatised in 1986; it now competes against
many companies, particularly mobile system operators. It is not usually appreciated
by managers that market structure is the main determinant of long-term profitabil-
ity, and an understanding of market structures is central to developing strategy.
5.10.1 Perfect Competition

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

Marginal Cost
Average Cost
Price
P
Demand
0
Q Quantity
Figure 5.15 Perfect competition

Figure 5.15 helps in visualising the competitive influences at work. The average
cost curve of the firm is usually depicted as being U-shaped because up to some
point additional output leads to lower unit cost but beyond that point unit costs
start to increase; the average cost curve includes the opportunity cost of capital; this
is also known as the normal rate of profit. The demand curve is horizontal to
represent the fact that all firms are price takers in the industry; this horizontal
demand curve lies at a tangent to the lowest point on the average cost curve,
representing the fact that prices are pushed down to the lowest level consistent with
making the opportunity cost of capital. So the firm is a price taker at price 0P.
Output is set at the profit maximising point 0Q where marginal cost equals marginal
revenue. At this output no monopoly profits are made. Figure 5.15 represents the
theoretical situation in perfect competition when the market is in equilibrium;
because of the complexity of real life this situation will never actually be achieved,
but this limiting case demonstrates that there are powerful forces at work affecting
profitability depending on the degree of competition. At the very least, managers
should have a rough understanding of the degree of competition in their industry,
using the conditions for perfect competition as a benchmark.
One feature of this model often puzzles managers: the horizontal demand curve,
which seems to mean that if you charge above the market price you sell nothing,
while if you charge below it everyone wants to buy from you (but there is no point
because you are making a loss). In most people’s experience an increase in price
leads to a loss of some sales, but not all, and a reduction in price leads only to a
modest increase in sales, at best. This is due to the fact that in real life markets are
not perfect, and market imperfections such as differentiation and imperfect con-
sumer knowledge are the norm.
Is this market model unrealistic? Consider what happened in the market for
personal computers. The personal computer market was originally characterised by
very high start-up costs because of the R&D required prior to production. As the

technology was disseminated, the need to undertake expenditure on R&D was

reduced, and the differences between personal computers virtually disappeared, with
the only distinguishing feature being price. For those outside the industry in the
early 1980s, entry was almost impossible because of the lead and market share built
up by the main players such as IBM; for those inside the industry their position
looked relatively secure. However, when the technology was disseminated and ‘IBM
clones’ could be built and sold virtually at marginal cost, the situation was reversed.
By 1990 many people who used personal computers did not care what make they
were; this is because personal computers had become homogeneous goods, all
doing much the same thing. Once the initial developments had been made it became
relatively simple to enter the market: the components could be purchased and
assembled; this meant that barriers to entry had largely disappeared, and many firms
entered the industry producing clones. Most of these entrants did not appear to be
at any particular cost disadvantage. At the same time users became much more
educated, and information on personal computers became widely available through
the many computer magazines which appeared. Since the conditions for perfect
competition had appeared by the late 1980s, it was a simple matter to predict that
computer companies would stop making monopoly profit on the production of
personal computers, and would merely make at best the opportunity cost of capital.
A further factor was that the marginal cost of making an additional computer was
very low; it was thus likely that intense competition would push prices down
towards marginal cost, which was much lower than average cost. This was precisely
what happened by the early 1990s, when it became widely acknowledged that
making personal computers was not profitable (i.e. the price was lower than average
cost), and this was one of the factors which contributed to the difficulties experi-
enced by major computer companies at this time. This was one of the factors which
led to IBM reporting the largest corporate losses of any company in history in 1992.
Since the existence of the conditions for perfect competition means that profits
above the opportunity cost of capital cannot be sustained, an important dimension
of strategic analysis is to identify where markets are not perfect, and capitalise on
these factors. For example, barriers to entry are market imperfections which enable
companies to make monopoly profits. In the personal computers case one course of
action was to attempt to introduce the imperfection of non-homogeneity, i.e. to
differentiate the product further; this was done by many competitors, and included
selling a package of services which included maintenance and software support, and
introducing new features such as colour, more memory, portability and high speed
processors. None of these features could provide companies with more than a
transitory advantage because of the speed with which the technology can be
disseminated and the fact that new ideas (such as bundling) can be easily imitated.
From time to time some makers have risen to dominance because of their innova-
tive marketing approaches but such advantages have not been maintained over the
long haul because of the perfectly competitive features of the industry.

5.10.2 Monopoly
At the other extreme from perfect competition the industry is comprised of only
one producer, the monopolist, whose demand curve is the industry demand curve
for the product. This demand curve slopes from left to right because the company is
not a price taker, i.e. it can sell more by lowering the price. Figure 5.16 can help in
visualising how profits are made in monopoly.
Marginal Cost
Average Cost
P
Price
Demand
Marginal Revenue
0
Q Quantity
Figure 5.16 Monopoly

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

While the analysis of markets has been theoretical, the messages from Figure 5.15
and Figure 5.16 are quite clear: a manager needs to continually address the following
types of issue:
 What is happening to the demand curve?
 What is happening to the cost curve?
 What market imperfections do we depend on for our profits?
 Are there potential market imperfections which we have not yet capitalised on?
5.10.3 Barriers to Entry

Up to this point barriers to entry have not been defined, but given the importance
of barriers to entry in maintaining monopoly profits, it is clear that they are an
important dimension of competitive advantage. Any firm enjoying monopoly profits
will be continually concerned about the threat from potential entrants. The incum-
bent monopolist will be motivated to find out if there are ways in which barriers to
entry can be erected, or if there are existing barriers which make entry impossible
and hence will protect its monopoly profit. In fact, both entry and exit are common,
and research suggests that on average there is a 30–40 per cent turnover in compa-
nies every five years.
Barriers to entry can be classified as structural or strategic. Structural barriers are
outside the control of the firm while strategic barriers depend on actions undertaken
by the firm that deter entry. Structural barriers include:
 Size of the market: because of investment and infrastructure costs it may not be
feasible for more than one company to operate in the industry. A well-known
example is electricity generation and supply, where duplication of electricity lines
would clearly be wasteful. This is usually known as a natural monopoly, and was
the rationale for nationalisation; but the experience of privatisation in the UK
has demonstrated that infrastructure can be shared among competing firms in a
variety of ways since the UK electricity market was opened to free competition
in 1998.
 Capital requirements: it is typically necessary to undertake significant investment
expenditure in order to enter a new market, and some industries require amounts
which can be difficult to raise unless the company already has a secure track
record; the capital requirement itself can pose a major threat to the entrant
should the enterprise fail and the investment costs cannot be recovered.
 Sunk costs: it is not only the costs of entry which are important, but the costs of
exit. It is usually assumed that a high capital entry cost deters entrants, but this is
not necessarily the case. Certainly a high investment requirement limits the num-
ber of potential entrants, but the fact is that there are many large companies in
the world. Consider the case of an airline: it costs a great deal to obtain an aero-
plane and set up a route, but the aeroplane can always be sold. The route set-up
costs are sunk because they cannot be recovered on exit; this is the real financial
barrier to entry. At first it might seem a paradox, but in fact the barrier to exit is
just as important as the barrier to entry.

 Control by legislation or tacit agreement: De Beers controls supply in the diamond

market and fixes the world price of diamonds; inventions are provided with
patent protection for a fixed period so that inventors can gain a benefit from
their activities. It is always difficult to predict how long tacit agreements will last;
for example, the most powerful cartel in the world at one time – OPEC – was
for many years unable to maintain high oil prices in the face of the development
of supply from non-OPEC countries.
 Economies of scale: The idea of economies of scale is based on the long run average
cost curve of the firm, as shown in Figure 5.17. The long run average cost curve
shows how unit costs vary with different scales of output: the long run average
cost curve is a sort of envelope formed by the many short run average cost
curves. If the incumbent firm is well down the long run average cost curve, it is
clear that entrants have to come in at a large scale otherwise they will be at a
significant cost disadvantage.
Cost
Long run average

(or unit) cost
Output per period
Figure 5.17 Economies of scale

 Experience effect: reductions in unit cost occur as the labour force learns by doing,
more effective practices are adopted, materials wastage is reduced and so on; but
it becomes progressively difficult to achieve experience gains and after some
time there are no further benefits at the margin. If the experience effect is signif-
icant it will convey a significant first mover advantage to the incumbent firms in
an industry, and new entrants start off at a cost disadvantage. But the difference
between the experience effect and economies of scale is that new entrants will
start to move up the experience curve, whereas scale economies can only be
captured by increasing the size of the firm. The limitations of the experience
effect mean that it cannot provide an incumbent firm with a permanent entry
barrier in the form of a cost advantage.
Strategic barriers arise from competitive actions undertaken by the company, and
include:
 Reputation: the company can aim at building up a high degree of brand loyalty by
emphasising characteristics such as quality and reliability; this is particularly im-
portant in industries where it is difficult for consumers to obtain comparable

information on different products, for example products which are purchased

only rarely like expensive white goods.
 Pricing: when the threat of entry emerges the company can reduce price as a
deterrent (the doubtful long-term effectiveness of limit pricing and predatory
pricing is discussed at Section 5.3.3) but this can really only work where the
company is a monopolist; otherwise the price reduction might be seen as a com-
petitive move against other incumbents. Furthermore, there is a real danger in
many countries of breaching anti-competitive legislation.
 Access to distribution channels: while the new entrant may have a product which
compares in quality and cost to the incumbent’s, this can be of little avail if the
incumbent controls distribution. When the UK electricity and gas monopolies
were privatised one of the major changes in the attempt to introduce competi-
tion was to separate production and distribution.
Since competitive pressures are not always obvious, it is not surprising that there
is very little research evidence on the effectiveness of strategic barriers or entry
deterrent behaviour. However, managers report that they frequently engage in such
strategies, especially to protect new products. This is most likely because of the lack
of information on the part of potential entrants as to underlying profitability. It
takes time to generate information on the likely returns from competitive action,
and setting a low price can serve as a misleading signal to potential entrants. While
competition usually cannot be avoided in the long run, entry deterring strategies
may provide sufficient time for the company to build up market share and achieve
scale economies which might not have been possible had entrants been enticed into
the market earlier. It is likely that in many cases entry barriers are more imagined
than real; entry barriers can disappear with alarming speed because of technological
change. Any company that feels its competitive advantage is secure because of entry
barriers needs to maintain its environmental scanning activities because the chances
are that the barriers will disappear at some point. The problem is that not only is the
company exposed to competition but may not realise it.
5.10.4 Contestable Markets

It is doubtful if strategic barriers to entry can be effective in the absence of structur-
al barriers. It is quite likely that where structural barriers are low entry deterring
strategies would be ineffective because the cost to the incumbent would exceed the
benefit. In this case entry is so attractive that the incumbent should not waste time
trying to prevent it. A market in which entry costs are not sunk, therefore exit is
costless, is known as perfectly contestable. The ability to exit without having made
any capital commitment guarantees freedom of entry, and the fear of hit-and-run
raids forces incumbents to set prices lower than they would have done otherwise.
If sunk costs are zero this structural barrier does not exist thus would-be entrants
do not have to worry about the kinds of retaliatory measures that incumbents might
implement, because if the entrants find they cannot make a profit they can simply
exit. If incumbents realise this, then they will set their prices so as to stop the
entrants from wanting to enter in the first place. Hence, whether there is one firm
or several firms actually operating in it at any time, a perfectly contestable market

never offers the incumbent(s) more than the normal rate of profit. This explains
why many companies which apparently have a monopoly do not actually make
monopoly profits; this is a different situation from a true monopoly which does not
make profits because it is relatively inefficient as a result of the absence of direct
competition. For a company contemplating entry, it is clearly important to differen-
tiate between the two cases; the entrant might be able to undercut an inefficient
monopolist but in a contestable market it is likely that the monopolist is already
efficient because of potential competitive forces.
5.10.5 Competition among the Few: Oligopoly

When there are relatively few competitors in a market the likely reaction of competi-
tors to changes in pricing and marketing strategy must be taken into account. This is
obviously a situation in which game theory is important and is where the kind of
thinking depicted by the prisoner’s dilemma discussed at Section 5.3.1 comes into
play. Another way of looking at it is in terms of the kinked demand curve, discussed
at Section 5.3.2. In oligopoly the outcomes cannot be predicted because they
depend on the reactions of the individuals; for example, a price increase by one
company as a result of higher costs may result in all other competitors raising their
prices by a similar amount, or one of the companies may see an opportunity to grab
a larger market share and may therefore reduce price. The indeterminate outcomes
in oligopoly can result in price wars that bid away potential monopoly profits.
Because of the speed with which competitors can react to price changes competi-
tion in oligopoly typically takes the form of differentiation and building the brand.
The focus tends to be on quality but, as discussed in Section 5.5, it is difficult to
determine which aspects of quality to concentrate on and in any case it takes time to
build the quality image. The problem is that all incumbents are trying to achieve
competitive advantage by acting on characteristics other than price and it is very
difficult to outperform rivals.
5.11 The Role of Government

Although the market tends to allocate resources effectively there are some areas in
which it does not appear to function very well. Why does the market allow pollution
to occur? Why can national defence not be provided by the market? These are
known as market failures and will always occur in a market economy. The manager
should be able to view ‘market failure’ issues in context; the fact that ‘market
failures’ exist does not mean that the market system itself should be abandoned. It
does mean that managers should understand that government has a legitimate role
in the economy because of market failures; but many governments go far beyond
what economists regard as a legitimate role and control many commercial activities
such as public utilities. An understanding of this aspect of government is an
important input into PEST analysis and environmental scanning; it can also add an
important dimension to the construction of scenarios particularly when it is antici-
pated that there may be a change of government.

5.11.1 Government and Rule Making

One of the legitimate functions of the government is to determine the framework of
rules within which markets function. These vary significantly among countries and
can have profound implications for individual companies; some aspects of govern-
ment rule making are:
 Employment law: in Europe there are many laws which govern employment
contracts that severely limit the mobility of labour, while in the US employees
have fewer statutory rights. The fact that it is much more difficult and costly to
shed excess labour in Europe than in the US is considered by many economists
to be the main reason for Europe’s much higher unemployment rates. Labour
laws can be a constraint on companies, for example, high firing costs can put a
company at a competitive disadvantage internationally.
 Monopoly: when a single company becomes large enough to dominate an
industry, it becomes less subject to competitive pressures. Consequently, there
may be little incentive to pursue efficiency (although the theory of contestable
markets casts some doubt on this), and the company may not act in the public
interest, however this is defined. In such circumstances the government can
break up the monopoly into smaller competing companies. Such legislation fre-
quently causes heated debate about the definition of monopoly and monopoly
power, and there is often doubt as to the ultimate impact on social welfare.
These disagreements are reflected in the fact that the law in the US is much
more opposed to the formation of monopolies than the law in Europe. The
point at which a company is deemed to have too much monopoly power is diffi-
cult to determine but it is a major preoccupation for companies that are pursuing
acquisitions; for example, the Monopolies Commission on the UK has the pow-
er to suspend a takeover bid while an investigation of the impact on the public
good is carried out.
 Health and safety at work: since increasing both safety and health standards
tends to add to costs without any observable positive impact on revenues, it is
often maintained that companies will tend to operate at the lowest standards
possible. An opposing view is that in a competitive labour market those compa-
nies which do offer higher standards will be able to attract the best and most
productive members of the labour force thus gaining competitive advantage.
Whatever the rights and wrongs of the argument, governments do take an active
role in setting standards, which can have significant cost implications for com-
panies. In the UK there have been various attempts to generate an ethos of
effective health and safety in companies that is seen as being a normal part of the
management function but these initiatives have met with limited success. As
countries become more prosperous there is increasing concern with health and
safety and companies that have moved to developing economies to benefit from
lower labour costs will have to confront the issue sooner or later.
 Separation of management and ownership: professional managers typically do
not own their companies, and are only indirectly accountable to shareholders
(the principal–agent problem). There is therefore a role for government in decid-
ing what comprises lawful behaviour on the part of those actually running

companies, and the extent to which they can be made responsible to sharehold-
ers for their actions. Corporate governance scandals such as Enron have led to
much tighter rules on corporate behaviour, such as the Sarbanes-Oxley act in the
US.
It is not just the existence of these rules which affects companies, but the fact
that they are liable to be changed when governments change. That is another reason
for developing an effective environmental scanning process. For example, the
Thatcher government which was elected in Britain in 1979 took about five years to
change radically the approach to monopolies and public ownership; in fact, within a
decade the selling of public companies (privatisation) was being undertaken by
governments all over the world. The fact that the framework varies significantly
among countries can have significant implications for international expansion, since
it is not an easy matter to adapt to a completely different regulatory regime.
5.11.2 Government and Regulating

One of the best-known instances of government regulation is the attempt to reduce
pollution. Where pollution occurs, it is the outcome of ‘externalities’, i.e. costs and
benefits which do not accrue to the parties involved in an exchange. Inspection of
the basic model of costs shows clearly that there is no separate cost entry for costs
to the environment such as pollution, or for any other costs which are borne by
other producers or consumers.
The cost which is actually paid by the company is known as private cost, and the
cost to the company plus the cost to the environment is known as social cost. Since
producers do not bear the costs of pollution the industry supply curve is derived
from private cost, not social cost; in other words the supply curve lies too far to the
right, and too much is produced, resulting in a misallocation of resources.
Where externalities occur there is a case for government action in some form. It
may simply be to ‘internalise’ the externality, i.e. to set up a framework within which
the costs and benefits can be traded off among affected parties. For example, a
chemical company which pollutes a river could be awarded the fishing rights in the
river; if the company attempts to maximise profits it has to take into account the
impact of pollution on the revenue from fishing so this will lead to the optimum
level of pollution. If this is not possible government intervention may take the form
of regulating output, setting emission standards, or imposing taxes designed to
equalise private and social cost. Government regulations include requirements to fit
scrubbers to coal fired electricity stations, which increases the price of electricity to
companies and individuals; some governments require catalytic convertors to be
fitted to the exhausts of all cars, and this cost is ultimately borne by the road user.
At the very least, managers should have an awareness of the externalities in their
industry and whether these are likely to be subject to government regulation in the
future. This has become a serious issue for many companies as concern over global
warming and carbon emissions have increased. The fact is that all activities produce
externalities of some kind so companies ignore them at their peril.

5.11.3 Government and Allocating

Another area of market failure occurs when it is not possible to exclude non-payers
from consuming a good or service. The most obvious is defence, because once
defence for a country is provided it is not possible to exclude from being defended
those who do not wish to pay. Another characteristic of such goods, known as
public goods, is that if they were to be provided by individuals or companies, the
amount provided would not be optimum. An example is where two shipping
companies may individually consider it worthwhile to build a lighthouse to prevent
vessels sinking on the rocks. But the optimum number of lighthouses is one, not
two. Unless there is collective action, in the form of collusion between the two
shipping companies or government action, two lighthouses may be built, which is
one too many. On the other hand, each company may wait in the hope that the
lighthouse will be built by the other, resulting in no lighthouses. A possible solution
might appear to be to bring the companies together to agree to share the cost of
building one lighthouse; an agreement can be reached between the two companies
to build the lighthouse, but after it has been built one of the parties may refuse to
pay. Since both are aware that this might occur, neither may be willing to take the
chance that the other may not honour the agreement, with the result that no
lighthouse is actually built. The chances of one lighthouse being constructed in the
absence of government action are therefore remote.
The provision of public goods is one of the legitimate roles of government. But it
is also important to the individual company, which should recognise when it is
entering a market where public goods are involved. Demand is dictated by what the
government perceives to be the ‘right’ quantity, and this may be affected by political
and philosophical views. For example, during election campaigns politicians tend to
promise increases in those expenditures which they think will result in gaining the
most votes. Managers should be able to form realistic views on the credibility of
such statements of intent. When the Berlin wall came down in 1989 companies in
defence industries should immediately have started to anticipate the likely effect on
defence expenditures.
5.12 The Structural Analysis of Industries

The economic models of market structure demonstrate that the degree of competi-
tion in an industry is the result of structural factors over which individual companies
have little control. A firm in an approximately competitive market has no option but
to be a price taker; a firm in a monopoly position may be able to limit competition,
but entry deterring strategies may have a limited effect because of contestability;
oligopolists have to exercise restraint because of retaliation from major competitors.
In an attempt to make explicit the various factors which determine competitive
conditions within an industry, Porter23 identified what became known as the five
forces. The basic idea is that the degree of competition within an industry depends
on the threats posed by potential new entrants and substitutes, coupled with the
bargaining power of suppliers of factor inputs to the industry and the bargaining
power of the purchasers of industry output. The five forces are thus

 industry competitors’ rivalry;

 threat of new entrants;
 threat of substitutes;
 suppliers’ bargaining power;
 buyers’ bargaining power.
Porter’s view is that the collective strength of these competitive forces deter-
mines the ability of firms in an industry to earn rates of return on investment above
the opportunity cost of capital. Another way of looking at the five forces is that they
identify the areas in which the conditions for perfect competition do not apply; it
has already been pointed out that while the conditions for perfect competition are
rarely found, in those instances where they are approximated to then companies
tend to make the opportunity cost of their capital, i.e. there are no monopoly
profits.
The following are a selection of issues to consider when applying the five forces
framework to a particular competitive situation.
 Industry Competitors’ Rivalry
In order to assess the intensity of rivalry, start by considering the number of
competitors in the industry:
Number of firms Type of market Basis for competition

Many Perfect Price
Few Oligopoly Differentiation
One Monopoly Price (to deter entrants)
In one sense the intensity of rivalry decreases from perfect competition to

monopoly. In comparative static terms a company in a perfect market in
equilibrium earns the opportunity cost of capital (normal profit) while a
monopolist earns more than normal profit. But in a dynamic sense rivalry might
appear to be different. Consider the following three cases.
 A market that is moving towards perfect competition (because the product is
becoming homogeneous and barriers to entry are falling) may contain many
companies that are acting in an aggressively competitive manner by cutting
prices and increasing marketing; but a market that has reached a situation ap-
proximating to equilibrium may not show much evidence of competitive
activity.
 It is possible for oligopolists to exist in tacit harmony for considerable peri-
ods but suddenly to embark on a price war where competition is overt.
 A monopolist may be in a highly contestable market that makes it impossible
to earn significantly higher than normal profit.
The market structure (perfect competition, oligopoly or monopoly) largely de-
termines the profit that can be made. But competitive pressures may not be
evident to the observer, as in the case of contestability which is based on poten-
tial competitors. Therefore the intensity of rivalry cannot be assessed merely by
observing the behaviour of competitors. Additional insights into rivalry can be

gained from taking the product life cycle into account as the following scenarios
demonstrate.
Life cycle stage Competitive actions Rivalry

Introduction First mover Low
Growth Competing for increased market share High
Transition Competing to establish Cash Cow High
Maturity Companies defend position Low
Decline Attempt to protect sales rather than market High
share
Establishing the intensity of rivalry therefore requires several influences to be

taken into account; these include market structure, the product life cycle and
recent competitive activity.
The strategic implication of intense rivalry is that the company has to be careful
about any action that will be interpreted as an attempt to win market share from
competitors. Product improvements, a new marketing campaign or a new pricing
structure are all likely to lead to immediate competitive response.
 Threat of New Entrants
The threat posed by new entrants depends on the barriers to entry discussed at
Section 5.10.3. The issues which companies should address include:
 Economies of scale: do existing firms have an advantage because of their
size?
 Regulation: are there laws or legal requirements which inhibit potential com-
petitors? Are these likely to be relaxed in the future as the government adopts
a less direct role in the economy?
 Entry price: is there a price at which entry will appear attractive to firms out-
side the industry?
 Technological factors: where entry in the past has been difficult because of
high R&D costs, the firm may eventually be at risk because the technology
can be copied.
It is not a simple matter to identify and assess the risk of entry. In the examples
above the threats may lie in the future rather than the present and could be iden-
tified by a PEST analysis. Once the potential risk has been identified a response
can be worked out to maintain the barrier to entry. If no response is feasible a
strategy to respond to the impact of entry needs to be determined. The danger
for many companies is that they do not recognise the potential threat from new
entrants until it is too late because they focus on what competitors are actually
doing rather than the conditions that make entry attractive.
 Threat of Substitutes
To a large extent the emergence of substitutes depends on technological pro-
gress. This is a continuous threat and highlights the importance of
environmental scanning to keep track of ongoing developments. Because of the
wide ranging and unpredictable pattern of technological progress it is very diffi-
cult to predict under what circumstances substitutes are likely to appear. In fact it

may be difficult to recognise a substitute when it does appear because it may be

accompanied by a change in consumer preferences or prices. For example, air
travel was not regarded as a close substitute for rail travel until the advent of cut
price airlines and the realisation by people who had never flown that it was a
viable alternative. The rail link between London and Paris has suffered greatly
from the impact of cheap airlines.
At times it may be difficult to distinguish between a new entrant and the emer-
gence of a substitute product. A new entrant will have a similar product and will
compete mainly on price. The substitute has characteristics that fulfil the same
consumer needs and effectively reduces the market size. It is important to distin-
guish between them because the strategic response is different: a new entrant can
be met with reduced prices and an increase in marketing but this will not work
for a substitute because consumers no longer wish to buy the original product.
 Suppliers’ Bargaining Power
This depends on the degree of competition in supplier markets and the number
of companies in the industry. For example, there are many thousands of farmers
in the UK while retailing is dominated by four supermarket chains; farmers claim
that the supermarkets have excessive buying power and that they are unable to
obtain a price that provides a reasonable return on farming. The two extreme
cases are where the company is the sole purchaser of an input (monopsony), and
where the supplier is the sole provider for the industry (monopoly). In the case
of monopsony the supplier has low bargaining power and in the case of monop-
oly the supplier has high bargaining power; the typical situation will be
somewhere in between the two and the balance of bargaining power is often
difficult to identify. In the case of the supermarkets versus farmers the balance
lies in favour of the supermarkets hence suppliers have low bargaining power.
But this extends only to the big supermarkets and it is probable that small retail-
ers pay significantly higher prices and hence are at a cost disadvantage.
A well-known example of high bargaining power is when labour unions are
powerful enough to negotiate more favourable remuneration than would be
possible for an unorganised work force. What is less obvious is the bargaining
power of workers with scarce skills, for example in financial markets some in-
vestment specialists command very high salaries because they are perceived to be
able to ‘beat the market’. It is important for companies to identify as far as pos-
sible where the balance of bargaining power lies with different suppliers so that
they do not end up paying more for inputs than competitors.

 Buyers’ Bargaining Power

The bargaining power of buyers depends on a number of factors, including the
extent to which a product is a necessity, the number of competing sellers and
substitutes. It can be argued that this is all captured in the elasticity of demand
for the company’s product, but the difficulty facing companies is that it is very
difficult to estimate the elasticity of demand so it is necessary to use a variety of
information to estimate where the balance of bargaining power lies. The factors
to take into account include the following.
 Monopoly power: this depends on the number of competitors in the market;
but the number of companies in the market may not be a good guide because
the company may have a local monopoly.
 Brand identity: a strong brand such as Gucci results in a degree of loyalty
among buyers.
 Switching costs: for many products there are no costs to the buyer in switch-
ing from one seller to another because the products are homogeneous and
widely available. There may be a significant switching cost for consumer du-
rables because it is necessary to gather information about other makes. Retail
stores and airlines attempt to increase switching costs by their loyalty cards
because switching results in losing the accumulated credit points.
 Number of buyers: many companies in the defence industry only sell to the
government; in this case prices are set by negotiation.
 Income elasticity: this is partly determined by the extent to which a product is
a necessity; people buy more of luxury goods as incomes increase, but typical-
ly consumers have plenty of choice of luxury goods. The higher the income
elasticity the higher tends to be buyer bargaining power.
 Perceived differentiation: some buyers may be convinced that the product
has better characteristics than competitors, for example it may have the repu-
tation of reliability or high quality. See Section 5.4.2 for a full discussion.
 Information: this depends on the extent to which consumers are well in-
formed about the characteristics of competing products. Freely available
information is one of the conditions for perfect competition, and the more
educated consumers are the more difficult it is to establish brand loyalty.
Any estimate of buyer power is bound to be approximate, but it is usually possi-
ble to identify where buyer power is relatively high or low. For example, take the
case of an ‘own brand’ hair shampoo compared to one of the well-known makes,
that sells at a higher price, and assess them in terms of the above factors.

Factor Own brand Buyer Branded Buyer

power power
Monopoly power The only one in the shop Low Many competing brands High
Brand identity Unknown to buyers High Many buyers rely on brand Low
reputation
Switching cost Part of everyday purchases High Find out characteristics of Low
other makes
Number of buyers Very large High A particular segment Low
Income elasticity Regarded as necessity Low Regarded as luxury High
Perceived None High The segment thinks it has Low
differentiation certain desirable features
Information Can be gained by experience High Satisfied buyers have no Low
incentive to collect infor-
mation on other makes
Each factor has been classified as ‘high’ or ‘low’ to demonstrate that the own
brand is subject to relatively higher buyer bargaining power on all but two of the
criteria than the branded make. You may well interpret the buyer power differ-
ently depending on your own experience but it is possible to arrive at an estimate
of the buyer power in a fairly objective manner. The conclusion from this analy-
sis is that buyer bargaining power is high for the own brand shampoo and low
for the branded shampoo. This comes as no surprise but it is often not so obvi-
ous.
5.12.1 Profiling the Five Forces

Consider two companies which have carried out a five forces analysis and have
come up with the following:
Company 1 2
Threat of new entrants High Low
Threat of substitutes High Low
Bargaining power of suppliers Low High
Bargaining power of buyers Low High
Industry rivalry Low High
This classification identifies two totally different competitive situations with

important implications for strategic action.
 Company 1 will focus on potential competitors and technological change.
 Company 2 will focus on trying to get better deals from suppliers, marketing
aggressively to buyers, and on its cost position relative to competitors.
Now consider the two profiles in a different way: the first profile refers to the
company now and the second is an estimate for three years in the future. The
company will have to change its strategic focus as above to accommodate the

changes in competitive conditions. These are clearly important conclusions, but in

real life it is a fact that very few companies understand the competitive forces
operating on them and are unaware that these are changing over time. Companies
often fail to react to changing competitive conditions because they simply did not
know they were occurring.
One of the big changes that occurred in the UK grocery business was the closure
of many small city centre groceries because of the arrival of the edge of town
supermarkets. But now the major supermarket chains are opening ‘in town’ stores in
an apparent reversal of the trend. Can this be explained in terms of the five forces?
The situation before the supermarkets appeared and after supermarkets had set up
‘in town’ stores is shown below.
Competitive force Before supermarkets After supermarkets

Threat of new entrants Local monopolies: Low Filled vacant niche Low
barriers to entry
Threat of substitutes Out of town shopping High Out of town shopping Low
now exists
Bargaining power of suppliers Small scale High Large scale buyers Low
Bargaining power of buyers Lack of choice Low Desire for convenience Low
Industry rivalry Local monopolies Low Still local monopolies Low
According to this analysis the competitive pressures acting on the small retailers
were the threat of substitutes from out of town shopping centres and their lack of
buying power resulting in relatively high prices. This combination drove them out of
business; subsequently the supermarkets filled the vacant niches but were not now
faced with the threat of substitutes and had the buying power to ensure that ‘in town’
prices were competitive with the edge of town centres. Thus they were able to
capitalise on the desire for convenience. The forces are, of course, open to a different
interpretation but it does appear that the supermarkets were able to alter the balance
of the forces and hence opened up an opportunity.
5.12.2 Criticisms of the Five Forces Model

While the five forces model is an extremely effective technique for analysing
competitive forces, it does have some potential drawbacks and it does not provide
the answers to all issues relating to competitive analysis.
 It gives the impression that all forces are equally important in the determination of competitive
position. It has been argued that the customer, or buyer, is the most important
dimension of competitive advantage and that the five forces approach disguises
this. However, this criticism misses the point about a framework of analysis; the
five forces is merely a structure within which various influences can be exam-
ined, and while it is probably true that most of the time buyers are important, in
some circumstances other influences might be just as important.
 It focuses on threats, whereas many companies engage in cooperation and alliances. Such
collaboration may be precluded if, for example, all suppliers are regarded as

threats. But again this misses the point: if suppliers are identified as a potential
threat it could be that one method of eliminating this threat is to enter into an
alliance. The function of the model is to help identify competitive pressures
rather than provide a prescriptive solution.
 It does not deal with internal issues such as human resources and efficiency. This being the
case, the model must be regarded as one important component when building
up an overall view of competitive positioning.
Despite these criticisms the five forces model is a powerful tool for analysing
competitive influences and deriving an understanding of the company’s competitive
advantage; it is an essential tool for deriving appropriate strategies at the choice
stage, but it does not do the work for you.
5.13 Strategic Groups

It may not be immediately obvious where in an industry competitive forces actually
arise; there may be many firms in an industry but not all of them may be direct
competitors. One approach is to identify strategic groups, which are sets of firms in
an industry which are similar to one another and different from firms outside the
group on one or more key dimensions of their characteristics and strategy. Identify-
ing the groups makes it possible for the firm to identify close and distant
competitors and analyse the likely competitive implications of changes in strategy.
But while this sounds fine in principle it is difficult to apply in practice because of
the many variables which could be used to classify competitors; these include
 organisation: scale, degree of vertical integration or diversification, distribution
channels;
 product characteristics: quality, image, level of technology;
 financial structure: return on assets, gearing.
It is necessary to use a degree of imagination to obtain insights into the strategic
groupings within the industry. For example, two important variables might be
identified and mapped against each other to see how firms in the industry cluster
together. An example is the restaurant business in a cosmopolitan city where there
are many ethnic restaurants, all of which offer different styles of cooking. Take the
three most numerous types of ethnic restaurant: Indian, Chinese and Thai. At first
sight it might appear that these three styles of restaurant are not in direct competi-
tion; however, they compete on more than cooking style. There are at least two
dimensions besides style: quality and degree of specialisation. There is no question
that restaurants target different levels of quality within the same ethnic group; within
their broad style restaurants specialise in different ways, for example, in fish,
seafood, vegetarian and region. It is instructive to think of a number of ethnic
restaurants and plot them on a graph as shown in Figure 5.18.

Quality
1
2
4
3
Specialisation
Figure 5.18 Strategic groups: ethnic restaurants

I have carried this out for my own city of Edinburgh, and find that the clusters
are quite pronounced as shown. Basically, there are four clusters, and it is within
these that a great deal of competition arises rather than between, say, high-quality
and low-quality Indian restaurants.
This example uses two characteristics of product differentiation to identify the
strategic group. Another dimension could be the number of restaurants under one
owner: there may be significant economies in purchasing and minimising excess
capacity with increasing numbers of restaurants. Since the definition of the industry
group is dependent on the selection of relevant variables it is far from being an
exact science. But attempting to define the strategic group can provide a perspective
on competitive pressures which is not apparent from aggregate data.
5.14 First Mover Advantage

The expression ‘first mover advantage’ has been used several times because it is
intuitively attractive to conclude that the first entrant, or one of the first entrants,
has an advantage over later entrants by being known to consumers first and reaping
experience effects. But it is necessary to be clear about where these advantages stem
from, whether they are likely to be transitory and whether there are any costs of
being a first mover. The discussion of first mover has been deferred to this stage
because it draws on most of the models developed so far.
The first step is to be precise about what is meant by first mover because in
practice the term tends to be used loosely. Strictly speaking, in terms of the product
life cycle it means the company that invented the product and brought it to market.
In normal usage it often refers to companies that entered in the introductory stage
or in the early growth stage. This discussion assumes that the first mover is the
inventing company, but the discussion applies equally well to other early entrants.
When the product is first launched there is no guarantee that it will be positioned
in the ‘success likely’ sector of the perceived price and differentiation matrix; even if
it is it may not stay there as imitators enter the market and charge a lower price. The
inventor Dyson developed a new concept in vacuum cleaners that does not use a

bag. The Dyson ‘G-force’ was launched in Japan in 1991 at $2000 each; subsequent
developments reduced the cost and it became the fastest selling vacuum in the UK
and is now marketed internationally. There have been many imitators but Dyson is
still the market leader, to the extent that the phrase ‘to Dyson’ is entering common
usage in the same way that ‘to Hoover’ did. This suggests that Dyson has main-
tained its position in the ‘success likely’ sector of the matrix; this has required
judicious marketing and continual product development. Not all innovators are so
successful and are quickly overtaken by imitators.
A potential advantage may be gained from economies of scale and the experience
effect. Economies of scale result in average cost decreasing with output as discussed
in Section 6.12.1. Experience effects arise from the reduction in average costs
resulting from the total volume of output to date. For example, one of the factors
contributing to the experience curve is the degree to which employees learn to do
their job more efficiently over time. Experience is a dynamic notion which, while
being related to economies of scale in that the larger a company the more output it
will have produced, is conceptually independent of economies of scale.
The research carried out on experience reveals that the effect of experience varies
among companies and industries; it is to be expected that the evidence on experi-
ence will be mixed because of factors such as variations in production techniques by
industry, differences in managerial ability to take advantage of its potential effects
and exogenous shocks. The empirical evidence suggests that a doubling of output
has the potential to lead to a 20 per cent reduction in average cost. Whether this can
be used as a benchmark for individual companies is a matter for managers to
resolve, but there seems little doubt that there is a potential for experience effects in
most areas of activities. An important aspect of the empirical findings is that the
effect is not linear, i.e. it takes successive doubling of output to achieve the same
proportional cost reduction. This would produce a relationship between experience
and unit cost of the shape illustrated in Figure 5.19.
Unit cost
X1 Y1 X2 Y2
Cumulative output
Figure 5.19 The experience curve and unit cost

As cumulative output increases movement up the experience curve (down the
unit cost curve) becomes slower, because each additional 20 per cent cost reduction

requires a doubling of output. The advantage conferred by experience is thus

continually being eroded. In Figure 5.19 company Y has a substantial unit cost
advantage over company X at the first point, when cumulative output to date wasY1
and X1 respectively. By the second point company Y has increased its cumulative
lead in output terms, i.e. output Y2 is now much greater than output X2, but the unit
cost advantage has almost disappeared.
The difference between economies of scale and experience effects has strategic
implications. If there are significant experience effects to be exploited, the company
has a limited time to take advantage of them because of the reducing percentage
effect as cumulative output is increased. If there are also significant economies of
scale in the industry, the company which is first in and is bigger than competitors
has the potential for an early cost advantage. A company which feels it has a cost
advantage over rivals should attempt to identify where the advantage is derived. If it
is from experience effects, the advantage can be expected to decline over time; if it
is from economies of scale the advantage will be retained so long as competing
companies do not increase in size.
The combination of economies of scale and experience effects confers a poten-
tially significant first mover advantage in new markets. The company which is first
in is potentially able to grab the largest market share and thus benefit from whatever
economies of scale exist; followers start at a higher point on the experience curve
and are thus faced with a two pronged cost disadvantage. But the experience effect
is soon eroded while the advantage of economies of scale will disappear if competi-
tors catch up in terms of market share.
There are significant costs associated with being first mover. These include bear-
ing the costs of experimentation and failure, developing production techniques and
marketing the unknown product to bring it to the attention of consumers. Freddy
Laker invented the idea of the cheap ‘no frills’ airline. He went bankrupt but budget
airlines now have a significant share of the market and there is no dominant player.
Thus being the first mover confers potential benefits which then have to be
capitalised on. This can be visualised as developing a product through the BCG
matrix: ensure that the advantage is realised in the growth stage as a Star which then
transforms into a Cash Cow. The first mover is in a position to capitalise on
experience effects and economies of scale, but it is an important strategic issue
whether being first generates an advantage over an entrant later in the growth stage.
A later entrant sometimes gains ‘second mover advantage’ by not having to bear the
same level of R&D, failure and risk and with consumer awareness having been
aroused by the first mover.
At the height of the Dotcom boom many held the view that first mover ad-
vantage was crucial on the internet and huge amounts of money were invested in
start-ups that subsequently failed. Successful internet enterprises such as eBay and
Amazon were not actually first movers; they were among the early movers but their
success has been due to the application of basic business principles.
In summary, being first mover confers a potential advantage but it does not
guarantee success. Once the product is on the market the market issues covered in
Module 4 and Module 5 need to be addressed.

5.15 An Overview of Macro and Micro Models

By this time it will be apparent that there is a battery of models which can be
applied to analyse various aspects of the economic and competitive environment.
Since each model focuses on different aspects of the environment no single model
can be relied on to derive an overall view of the threats and opportunities presented
by the environment. The following scheme sets out the main models and their
focus.
Macro models Focus

Macroeconomics Determination of GNP and business cycles, GNP
elasticity, interest rates, inflation, unemployment
and their relationship to company costs, revenues
and profits
Competitive advantage of National market factors which relate to the source
nations of competitive advantage
Forecasting Predicting changes in key factors in the economy
and the market place
PEST Checklist of factors which may affect the company
in the future
Environmental scanning Identifying and tracking potentially important
changes
Scenarios Speculating about the future and assessing the
company’s ability to respond
Micro models Focus
Demand and supply Interpreting the impact of changes in market
conditions
Market structures Types of competition and intensity of rivalry
Game theory Deriving competitive response with limited infor-
mation
Segmentation Identifying unexploited opportunities in existing
markets
Differentiation Product positioning
Quality Determinant of demand and differentiation
Life cycle Dynamic product management
Portfolio models Strategic management
Strategic groups Company positioning
Five forces analysis Identifying competitive forces
First mover advantage Capitalise on early lead
The macro models are used to identify trends and changes in the variables which
affect the market in which the company operates; the micro models are specific to
the industry and identify the company’s position within its immediate competitive

environment. At this stage it might occur to you to wonder how companies can be
effectively managed without the application of these models to identify both what is
happening in the general environment and interpreting the company’s competitive
position. One answer is that perhaps managers can develop an intuitive grasp of
these ideas through experience and hence apply them implicitly; another is that most
companies actually have little real idea of their competitive positioning and succeed
more by good luck than intent.
5.16 Is Competition Changing?

There is a body of opinion which holds that competition has become much more
severe than in the period up to about 1990. It is claimed that the ‘rules of the game’
have changed and that now there is no such thing as sustainable competitive
advantage and companies have to be in a state of continual change just to remain in
the market. The reasons for this radical shift, it is claimed, include:
 the increased pace of technological change;
 improvements in communications;
 the internet;
 globalisation.
So fundamental are these changes that a couple of new terms have been coined –
‘hypercompetition’ and ‘dynamic competition’ – to characterise the new competitive
regime. As a result companies have to think afresh about the basis of competitive
advantage. As might be expected from the discussion on statistical analysis in
Section 1.2.6 there is no empirical evidence to back up this assertion and it is
typically presented as a self-evident truth.
There is no doubt that competitive forces vary among industries and over time.
The whole point of this module has been to develop tools to assess these forces.
For example, the clothing fashion industry is very fast changing and success
depends on understanding and reacting to changes in preferences very quickly: so
the fashion industry can be classified as ‘hypercompetitive’. But the fact is that the
fashion industry has always been like that. The stance taken here is that the view
that competition has radically changed is profoundly mistaken. A glance at the
overview in Section 5.15 tells us why: the typical manager has little knowledge of the
range of analytical tools that need to be applied to understand the evolving competi-
tive environment and has always had a poor appreciation of competitive forces. The
message of ‘hypercompetition’ and ‘dynamic competition’ is therefore being peddled
to a gullible audience.
By this stage you should be able to pose a number of questions about ‘hyper-
competition’ based on the models. These include:
Are markets becoming more perfectly competitive?
Are product life cycles becoming shorter?
Are the five forces becoming more powerful?
The answers to these questions are likely to be ‘yes’ for some industries and ‘no’
for others. But whether the answer is ‘yes’ or ‘no’ is irrelevant because we know that

competitive conditions keep changing: the real issue is that the tools of analysis are
the same no matter how the intensity of competition is labelled.
5.17 Environmental Threat and Opportunity Profile: Part 2

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

International − Expected appreciation of exchange rate
+ Growth in Eastern Bloc economies
Macroeconomic − Tax rate increase to fight inflation
+ Prospect of reduced interest rates
Microeconomic − Price of alcohol falling in real terms
+ Shop opening regulations repealed
− Competition within the strategic group
Socioeconomic − Report on sugar: no health influence
+ Increase in outdoor activities
Market − More substitutes appearing
+ Growth has been steady
Supplier − Strikes in prospect
+ Takeover by multinational
Microeconomic
THREAT: PRICE OF ALCOHOL
It is unlikely that wine and beer are substitutes for health foods, although they
are both widely regarded as luxury goods. Some income which may have been
spent on health foods may now be spent on alcohol.
OPPORTUNITY: SHOP OPENING HOURS
The repeal of shop opening hours means that advantage can be taken of the
increase in shopping as a leisure activity. The more that health foods can be
brought to people’s notice the higher sales will be.

THREAT: COMPETITION IN THE STRATEGIC GROUP

Many more specialty food shops are opening: the strategic group includes more
than health food shops.
Socioeconomic
THREAT: SUGAR IS GOOD FOR YOU
A recent report on sugar suggests that within the bounds of normal consump-
tion it is not related to health. This could undermine the general trend towards
what is perceived as healthy living. The perceived quality of health foods is pos-
sibly being undermined.
OPPORTUNITY: THE OUTDOOR LIFE
The implication for healthy living generally of the increase in outdoor pursuits is
not yet clear. Health foods are not regarded as a method of maintaining stamina
for energetic sports.
Market
THREAT: SUPPLY INCREASING
More and more health food products are appearing, the industry supply curve is
moving to the right and competitive pressure is increasing.
OPPORTUNITY: CONTINUED MARKET GROWTH
The market has seen steady growth in the past 5 years, and the increase in tax
rates is likely to reduce this temporarily at most. Thus while the demand curve
has been shifting to the right so has the supply curve; this has implications for
the general price level in this market.
Supplier
THREAT: LABOUR DISPUTE
The supplier’s workforce is threatening to go on strike in protest against the
takeover, and there is a real prospect of interruption in supply; alternative suppli-
ers are geographically remote and difficult to communicate with.
OPPORTUNITY: PROSPECT OF EFFICIENT SUPPLY
The main supplier has been unreliable in the past, and the takeover would almost
certainly lead to an increase in efficiency.
It was concluded in Module 4 that on balance the national and international
environment posed more threats than opportunities. The market orientated part of
the profile suggests a further balance in favour of threats: alternatives such as
alcohol and sugar are becoming more attractive, competitive pressures are increas-
ing, and there is a prospect of supply disruption. On the other hand there is a
prospect of long-term growth in the market, and more efficient supply in the future.
While the ETOP has not provided ready-made answers to strategy, it has enabled us
to bring together many ideas in a framework which makes it possible to identify key
issues in context.

Review Questions
5.1 Bring together the information from Module 4 and Module 5 on the health food
manufacturer and analyse the degree of competition using Porter’s five forces.
Case 5.1: Apple Computer (1991)

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

Case 5.2: Salmon Farming (1992)

The salmon farming industry developed rapidly in Scotland during the 1980s, but by the
early 1990s producers experienced substantial problems. It was generally felt that the
6300 Scottish salmon farming jobs, and the £120 million which had so far been invested
in the industry, were in danger of being lost. The mid-1991 crisis was caused by
Norwegian fish farmers dumping salmon in the European Community to get rid of a
huge surplus.
By 1991 salmon farming was the main source of employment in many west coast
Scottish communities; its output value was greater than that of beef and lamb. However,
the industry lost £15 million during 1990. The problems were not unique to Scotland,
and many Norwegian fish farms had also gone bankrupt; this was because the price had
been forced down all over Europe. Over 90 per cent of salmon consumed is now
farmed; the wild variety commands a substantial price premium, and there is widespread
concern that the farmed variety is inferior to wild salmon.
The following is abstracted from a letter from the chief executive of the Scottish
Salmon Growers Association (SSGA) to the Prime Minister.
There is a clear view among my members of all political persuasions that this
vital industry is simply being ignored and let down by your government. This
uniquely Scottish industry which has infused so much life back into the High-
lands and Islands economy is about to be destroyed by the piratical trading
activities of a non-member of the EU. I can see personal tragedies happening
because of this situation. People are in debt to the bank, their houses are at
stake, and there is intense pressure on their families.
The SSGA wants the European Commission to impose a duty on Norwegian salmon.
Many farms have made employees redundant, and some have sold out to the big
multinationals. But even these are experiencing difficulties; Marine Harvest, which is part
of Unilever, lost around £19 million last year on its worldwide operations.
The allegations of dumping are based on incidents such as the arrival of 250 tonnes of
Norwegian salmon in France, which caused the price to drop by 30 per cent to £1.50
per pound, at which price it is claimed that farmers were losing £0.40 per pound. In the
US, a charge of dumping was found to be proved against Norway in 1990; Norway gave
an undertaking that it would not happen again; recently the US introduced a 26 per cent
duty on Norwegian salmon, which effectively ended imports.
One fish farm claimed that the price they were paid in the UK had halved in three
years, and that their survival depended on a price recovery.
A salmon tourist centre was opened in 1991, which cost £0.5 million to construct. It
is expected to attract 65 000 visitors per year.
1 Explain why the salmon farming industry is subject to low profits and highly fluctuating
prices.
Use the Strategy Report framework in Appendix 1 to organise your analysis, and set it out as
though you were reporting to a strategy client.

Case 5.3: Lymeswold Cheese (1991)

When Lymeswold cheese was taken off the market in 1991 it had an emotional impact
on the British people far in excess of its economic importance; maybe this is because it
was seen as yet another great British disaster along the lines of Concorde and the coal
mining industry.
France is famous for the quality of its food and wine, and in particular it has a reputa-
tion for fine cheese. The British made a direct challenge to the market for soft blue
cheeses with the introduction by Dairy Crest in 1982 of Lymeswold, which resembled
French blue Brie and German Cambozola. During the early 1980s British consumers
were becoming increasingly sophisticated, and the consumption of soft cheeses was
growing by 30 per cent per year.
The launch was more successful than expected, and within a short time there were
shortages due to a lack of productive capacity. This meant that Dairy Crest had to make
a choice of which customers to supply, and the decision was made to carry on supplying
supermarkets, who were its existing customers, rather than delicatessens.
In 1983 additional capacity was created and productive output was increased to 4000
tonnes per year. However, despite the early success sales never exceeded 2000 tonnes
per year; to make matters worse, demand started to fall after 1986. A massive advertis-
ing campaign was mounted both in Britain and abroad, but the decline continued.
Customers were not very happy about the cheese and a typical complaint was that it
was too often bland or immature. There was no evidence that Dairy Crest improved its
quality control in order to ensure that the quality of the cheese was at least consistent.
Furthermore, Lymeswold is relatively mild and does not go runny as it matures,
compared to Brie which is runny and has a much more distinctive taste. Some retailers
felt that consumers used Lymeswold as a stepping stone to the more sophisticated
continental cheeses.
Dairy Crest is an arm of the Milk Marketing Board, which is a farmer-owned legal
monopoly buyer of milk.
1 Identify what went wrong.
Case 5.4: Cigarette Price Wars (1994)

It was the dumbest decision in corporate history. They have ruined one of the
best brand names in the world and have created permanent damage.
Henry Kravis, Wall Street buyout specialist, addressing Harvard Business
School.
It is commercial suicide. All that investment in the brand, then you tell people
that you can now buy for less than $2 what was worth $2.15 until yesterday.
The buyer is never going to believe you again.
Bruce Davidson, tobacco analyst at the broker Smith New Court.
Kravis was referring to the decision by Philip Morris to cut the price of Marlboro
cigarettes by 20 per cent. He was not, however, an unbiased observer, having been

responsible in 1989 for a takeover of RJR Nabisco, which responded by cutting the
prices on their Camel and Winston brands. Financial markets expect the price war will
have a significant impact on the profitability of cigarette companies – Philip Morris’s
share price fell from $64 to $51 (23 per cent) within minutes of the announcement of
the price reduction, and fell further to $46 the following week. Wall Street itself took
fright and fell by 50 points. However, the notion that Philip Morris have simply ruined a
brand name must be seen against the wider economic forces against which the Marlboro
brand has been struggling for a considerable time.
The Total Market for Cigarettes

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

Technological progress and falling costs have played a part in the introduction of
cheaper discount cigarettes. Figure 5.20 shows the growth in the market share of
discounted cigarettes. At the same time Marlboro’s market share has been in decline, as
shown in Figure 5.21.
Sales dropped by 366 million packs in 1992, costing $200m in profit, according to
stockbrokers’ estimates.
It is not surprising that the discounted brands made such inroads into the premium
brands’ market share given the disparity in price between the two; for example
Price of cheapest discount brand: $0.69
Price of Marlboro: $2.15

40
30
% 20
10
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992
Figure 5.20 Discounted cigarettes as % of US market
32
30 30
28
%
26
25.8
24.3
24
22.2
22
88 91 92 93
Figure 5.21 Marlboro market share

Consumers have probably asked themselves what it is about a particular cigarette
that makes it worth three times as much as another. The Marlboro advertising strategy
was targeted at 18-to-24-year-old men, on the basis that smokers tend to stay with the
same brand for years. The cowboy based advertising campaign has been familiar since
the mid-1950s, and many observers consider that Marlboro is the world’s best market-
ed product. However, in 1988 Camel introduced a campaign using a camel image called
Joe. By 1991 Camel’s market share was 4 per cent, and it was generally felt that Camel
was taking market share from Marlboro.
Market Position
The dominance of Marlboro in the cigarette market is illustrated in Figure 5.22, which

shows market shares by volume.
%
30
25.8
20
10
7.5
5.4
4.0 4.6 4.6 4.7
2.8 3.1 3.2
0
Virginia Merit Benson Camel Doral Kool Newport Salem Winston Marlboro
Slims & Hedges
Figure 5.22 US cigarette market shares

But the ability of the main competitors to wage a price war depends on more than
the success of the individual brands. The overall market shares of the two main
competitors are shown in Table 5.8.
Table 5.8 Market shares

Premium Discount
Philip Morris (Marlboro, etc.) 34 8
RJR Nabisco (Camel, etc.) 19 10
In 1989, Kravis’s partnership fund KKR took over RJR Nabisco for $25 billion, of
which only $3 billion was from the KKR buyout fund; KKR is much more heavily in debt
than Philip Morris.
Rationale for Price Cuts

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

The structure of the UK cigarette market is shown in Figure 5.23.
Benson & Hedges and Silk Cut are owned by American Brands, a US conglomerate.
Consider the sequence of events in the US. The big companies began by ignoring
their small rivals, then they started to imitate them by producing their own discount
brands, and finally they started to compete with them directly on price.

%
20
17.1
15
10 8.8
7.3
6.1
5.3
5 4.0
3.7 3.7
2.7
2.3
0
Raffles Embassy JP Lambert Embassy JP Regal Berkeley Silk Benson
100 Filter Special & Butler No. 1 Superkings Superkings Cut & Hedges
Figure 5.23 UK cigarette market shares
1 Was Philip Morris completely mistaken in cutting the price of Marlboro, as the two
observers claim? Or was Philip Morris’s reaction an inevitable outcome of market
conditions?
2 How effective do you think the Marlboro price cut will be in arresting the fall in market
share and/or recovering some of the market share lost?
3 If you were in charge of Benson & Hedges in the UK, what effect would the events in
the US have on your strategic thinking?
Case 5.5: A Prestigious Price War (1996)

The newspaper business in Britain has seen many circulation wars, mainly among what
are known as the ‘tabloids’ – newspapers containing a high proportion of novelty items
and sport aimed at a mass readership. Competitive action has usually taken the form of
TV games, huge promotional outlays and competitions, with price cuts being viewed
very much as a last resort. In September 1993 the media magnate Rupert Murdoch
slashed the price of his Sun tabloid, already Britain’s biggest selling daily, down to 20p.
He then did the unthinkable by cutting the price of the Times, possibly the world’s most
prestigious quality newspaper, from 45p to 30p. Hitherto, the notion that ‘quality’
newspapers could become involved in such unseemly behaviour was regarded by
establishment figures as tantamount to undermining one of Britain’s great institutions.
The ‘quality’ newspapers pride themselves on their serious treatment of news, and
appeal unashamedly to the professional and business classes. Clearly Murdoch consid-
ered that even among such people the price of their newspaper had a significant impact
on their choice of daily newsreading.
In June 1994, nine months after the Times price reduction, Conrad Black, another
media tycoon and owner of the Daily Telegraph, decided to enter the price war by
reducing its price from 48p to 30p. The Daily Telegraph had historically sales of about

twice the Times, and while being a ‘quality’ newspaper has always had a wider appeal,
and has some characteristics of a tabloid. Up to June 1994 Black had kept ‘aloof’ from
the price war, but in May daily sales of the Daily Telegraph fell below the 1 million mark,
while sales of the Times exceeded half a million. This seems to have been the trigger
which caused Black to reduce the price of the Daily Telegraph. Immediately, Murdoch
reduced the price of the Times by a further 10p.
The Competitors
What of the other players in the market? The Financial Times (recognisable by its pink
newsprint) did not enter the fray, partly because it has a world market and concentrates
on financial news. Its sales increased by about 5 per cent during the period September
1993 to June 1994. The Guardian appeals to the left wing and liberal minded middle
classes; it did not enter the price war either, and its sales were virtually unchanged. But
the Guardian was losing about £6 million per year. The Independent first appeared in
1986, and is targeted as a quality paper for independently minded ‘yuppie’ readers and is
generally regarded as lacking dynamism and identity. It reduced its price to 20p for one
day in June 1994, and during the period its sales dropped by 16 per cent.
The daily sales figures in September 1993 and June 1994 for the quality newspapers
are shown in Table 5.9.
Table 5.9 Quality newspapers daily sales (000s)

Sept 93 June 94
Times 354 517
Daily Telegraph 1008 993
Financial Times 287 300
Guardian 404 402
Independent 332 277
Financial Resources
Anyone who gets involved in a price war needs to have resources to live through the
inevitable cash flow problems. Murdoch controls News International, which in 1993
reported profits of £440 million; he predicted that sales of the Times would reach 700
thousand by the end of 1996, and that the Times would be profitable ‘by the end of the
decade’.
The Daily Telegraph reported profits of £41 million in 1993. Conrad Black controlled
57 per cent of its shares through his holding company Hollinger. In May 1994 Black sold
12.5 million shares in the Daily Telegraph at 587p each. The day after the price cut was
announced the price fell significantly, temporarily reaching 332p, knocking about £280
million off the company’s stock market value. Black called this a ‘ludicrous over-reaction’
by the stock market. However, the shares in other newspapers fell by similar amounts
as shown in Table 5.10.

Table 5.10 Some share price movements that day

Share price
Fall (%)
Daily Telegraph −39
News International (Times) −8
Mirror Group (Independent) −24
United Newspapers (Daily Express) −19
The Main Players

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

Telecom and MCI
1 Did BT really understand competition in the US telecoms market?
Case 5.7: The Timeless Story of Entertainment (2005)

By the beginning of 2003 a strange thing had happened in the entertainment business:
many of the great leaders, famous for their vision and showmanship, had lost their jobs.
Examples included Steve Case from AOL Times Warner, Tommy Mottola from Sony
Music, Thomas Middlehoff from Bertelsmann, Pierre Lescure from Canal Plus and Jean-
Marie Messier from Vivendi. They were replaced by conventional-looking businessmen
in the shape of Andrew Lack (Sony Music), who had never worked in the record
industry, and Jean-René Fourtou (Vivendi), who came from pharmaceuticals. So what
was going on?
There appeared to be some recognition that there was a need to return to the basics

of the industry (whatever that might be). For example, Peter Chernin of NewsCorp
asked, ‘Where did the industry get the grandiose idea that the media business was on
the way to complete and utter reinvention?’ He felt that it was time to relearn the old
lessons that the industry depended on fostering creativity and producing entertainment
that people are willing to pay for.
But producing what people are willing to pay for is tricky. Disney, the world leader in
animation, produced at a cost of $140 million Treasure Planet, which flopped in the 2002
Christmas season and forced the company to revise its 2002 financial results with a $74
million write-down. But Home Box Office (HBO), a relatively small competitor,
produced a series of commercial successes including Sex and the City and The Sopranos,
which also pleased the critics.
Is Scale the Answer?

Given that HBO is a small part of the AOL Time Warner conglomerate, size does not
appear to be the main factor. Viacom’s Tony Redstone suggested that bad management
rather than size is the barrier to creativity. So what is good management in the enter-
tainment business? It is usually claimed that it is such an odd business that no one can
define what good management actually is.
Is Entertainment Really Different?

There certainly seem to be at least three unusual characteristics of entertainment.
1. It is greatly dependent on occasional hits; it is a fact of life that few films make
money, few records make the charts, and most TV series fail. When a hit turns
into a flop, as most eventually do, they tend to drag the fortunes of the company
down with them.
2. It is very difficult to predict success; past success is no guarantee of future box
office success. The well-known screen writer William Goldman (who wrote the
screenplay for Butch Cassidy and the Sundance Kid and many other films) said in his
book Adventures in the Screen Trade, ‘in this business nobody knows anything’.
3. Talented people are very difficult to handle. Stars are famously temperamental.
This means that entertainment managers must have two characteristics themselves.
1. They must be willing to take risks and act decisively and quickly in the face of
changing tastes.
2. They must be able to manage the interface between the need to make profits
(which requires cost control, targeted marketing and so on) and creative think-
ing. This is where two entirely different cultures come into contact and the
manager has to be careful not to identify too closely with either. Certainly the
manager must not make the mistake of concluding that he or she is the creative
thinker.
What Did HBO Actually Do?

A closer look at HBO might help to explain how the balance between operational
control and artistic freedom might be achieved.
At first sight, HBO is just another part of the huge AOL Time Warner empire. But,
in fact, it is quite independent and has a distinct identity. It employs less than 2 per cent
of AOL employees and is physically separated from the rest of the organisation. Thus it
has created a small, almost boutique-type identity within the parent organisation and has

been granted creative independence.

It appears that HBO employees have a clear idea of what they are trying to achieve.
HBO takes pride in producing original and difficult dramas, which often apparently have
no place in the conventional TV schedules, which are driven by the need to generate
high ratings. The sense of purpose has been reinforced by the stability of its top
management, particularly obvious in an industry which has a high turnover. Its CEO until
2002 was with HBO for 23 years and his successor had been with HBO for 17 years.
HBO has a policy of giving its writers artistic freedom; while this may not always
work it has the effect of making HBO a very attractive place for good writers to work.
They know they will be subjected to minimal interference. The idea was to liberate
creative writers so that they can push out the frontiers of TV drama. In fact, it is often
the directors and writers who approach HBO with ideas rather than the other way
round.
HBO is to some extent insulated from immediate market pressures because it ob-
tains its revenues from subscriptions rather than from advertising, so it does not have to
worry about the immediate impact of ratings.
Is this the recipe for success?
 Carve out small creative units within a big company.
 Give them their own identity.
 Give them creative freedom and minimise bureaucracy.
 Maintain operational and financial controls to avoid profligate spending.
History shows that entertainment companies have tended to swing from letting
creative types rule to imposing stringent financial controls. When the boom times come,
profligacy becomes the order of the day and lasts until the next series of flops. In fact,
the replacements at the beginning of this story were mostly evicted because their
companies had started making losses and the firing of the flamboyant CEO was seen as
the first step in reintroducing financial and operational controls. So it looks like there is
a pendulum in action which perhaps HBO has been able to avoid.
1 Assess competitive conditions in the entertainment business using the five forces.
2 How did HBO mitigate the five forces?
Case 5.8: Revisit Fresh, But Not So Easy

1 Assess competitive conditions facing Tesco in the US grocery market.
2 How did Tesco intend to overcome adverse competitive forces?
Case 5.9: Revisit Lego Rebuilds the Business

1 Use the five forces to illustrate how the competitive environment had changed by year
2000 and list the actions taken by Mr Knudstorp to counter these.

Module 6
Internal Analysis of the Company

Contents
6.1 Opportunity Cost....................................................................................6/2
6.2 Fixed Costs, Variable Costs and Sunk Costs .......................................6/4
6.3 Marginal Analysis ....................................................................................6/5
6.4 Diminishing Marginal Product ...............................................................6/8
6.5 Profit Maximisation ............................................................................. 6/10
6.6 Estimating Production Costs .............................................................. 6/11
6.7 Accounting Techniques: Break-Even, Pay back and Sensitivity ..... 6/14
6.8 Accounting Ratios ................................................................................ 6/17
6.9 Benchmarking ...................................................................................... 6/22
6.10 Research and Development ................................................................ 6/23
6.11 Human Resource Management .......................................................... 6/29
6.12 The Scope of the Company ................................................................ 6/32
6.13 The Value Chain .................................................................................. 6/40
6.14 Competence ......................................................................................... 6/43
6.15 Strategic Architecture ........................................................................ 6/50
6.16 Strategic Advantage Profile................................................................ 6/54
Case 6.1: Analysing Company Accounts ...................................................... 6/57
Case 6.2: Analysing Company Information ................................................. 6/59
Case 6.3: Lufthansa Has a Rough Landing (1993) ....................................... 6/62
Case 6.4: General Motors: The Story of an Empire (1998) ....................... 6/63
Case 6.5: Driving Straight (2011) .................................................................. 6/65
Learning Objectives
 To apply economic efficiency concepts.
 To use accounting ratios to assess company efficiency.
 To apply techniques such as sensitivity analysis.
 To analyse company characteristics such as research, development, resource
management and financial controls.
 To identify where the benefits from synergy might arise.
 To explore the complexity of managing human resources.
 To assess the importance of vertical integration and the value chain.
 To identify core competence.
 To define competitive advantage.

Module 6 / Internal Analysis of the Company
 To develop a company strategic advantage profile.

The external macro and competitive environments are the setting within which the
company mobilises its resources in the pursuit of competitive advantage. It is
therefore necessary to identify the match between company resources and capabili-
ties and the opportunities which that external environment presents; thus
understanding the competitive environment is a necessary but not sufficient
condition for formulating strategy. The idea that company resources and capabilities
are the foundation for profitability has become known as the resource based view of
the company, as discussed at Section 1.2.3, where the central theme is to determine
how value is added by the various activities of the company and how the value
creating framework might be developed in the future. Thus the thrust of company
analysis is to assess the effectiveness with which resources have been allocated in
the past, develop principles that can be applied to allocate resources in the future
and estimate the strengths and weaknesses of the company with a view to identify-
ing how threats may be countered and opportunities may be pursued.
There are two views on how to align resources with opportunities. One is that
the company’s resources can be manipulated in an efficient manner in the pursuit of
a particular course of action. Another is that organisational change is very difficult
to achieve and the notion that resources can be adjusted in line with changes in
strategy is far too naive; furthermore, it is argued, changes in the external environ-
ment occur so quickly, and are so unpredictable, that over time flexibility of
resources is the important issue rather than the precise degree of alignment at any
one time. As with most things in life, the reality lies somewhere between the two
extremes and, depending on the circumstances, flexibility and efficiency can assume
different levels of importance.

to do what

Feedback


allocation
6.1 Opportunity Cost

Because of constraints on the resources available to any company, the decision to
follow a certain course of action is simultaneously a decision not to pursue other
options. The best option forgone is the opportunity cost of the action chosen.

Business discussions tend to focus on financial costs, and whether the company can
afford a course of action, rather than what that course of action precludes. For
example, take the case of a company which is currently constrained by the availabil-
ity of cash, and the board has decided that at the most an additional $1 million can
be spent now on future market prospects. The marketing manager has put in a
strong case for increasing marketing expenditure by $1 million. His case was built
on the following reasoning. First, he converted the increased market share which he
reckoned he could generate with this increased marketing to an expected future
stream of additional net revenue, which was discounted to the present to produce a
Net Present Value of $0.5 million. Since the NPV was positive he argued that the
available $1 million should be allocated to his department. Furthermore, he argued
that the main competitors in this field were also suffering from cash constraints and
there was little prospect of a major competitive reaction to his proposed strategy,
with the result that there was a low level of risk associated with this course of action.
The finance director asked other departments to produce proposals using the same
approach, paying attention to the degree of risk associated with each, and was
presented with the following additional options:
1. Leave the money in the bank to earn interest.
2. Spend more on research.
3. Spend more on product development.
4. Reduce product prices.
The options to spend more on research (2) and product development (3) were
evaluated on the basis of the additional net revenues each was expected to generate
in the future from spending an additional $1 million, discounted back to the present.
Research expenditure of $1 million was expected to yield NPV of $0.4 million, but
with a high degree of risk; additional product development was expected to yield
NPV of $0.35 million, with less risk than the research option. The evaluation of the
returns on a price reduction (4), also produced by the marketing department, was
carried out in a slightly different way. It was estimated that a 20 per cent price
reduction for one year would result in a 4 per cent increase in market share from the
following year, which would continue indefinitely; the price reduction would cause
net revenue to be $1 million less than it otherwise would have been during the first
year, with a subsequent increase in net revenue when the price was subsequently
returned to its previous level. This option was also evaluated in NPV terms, giving a
value of $0.45 million; the marketing department also felt that this option involved a
relatively low level of risk.
The options are summarised in Table 6.1.

Table 6.1 Presenting alternatives

Option NPV Risk
$million
Increased marketing 0.50 Low
Reduce prices 0.45 Low
Increased research 0.40 High
Increased development 0.35 Medium
Money in bank 0.00 None
The opportunity cost, in purely financial terms, of spending the $1 million on

marketing is to reduce prices because this is the next best option; since these two
options have a similar level of risk they can be compared directly. However, the
ranking of the next two options is a matter of judgement because, while increased
research has a higher NPV than increased development, it also has a higher degree
of risk. Leaving the money in the bank is a poor option in terms of generating value,
but that is the penalty for avoiding risk.
Presenting options in opportunity cost terms is an important aid to help manag-
ers identify relevant trade-offs and to establish priorities. The idea can be used to
evaluate resource allocation options at all levels in the company; from the strategy
viewpoint the opportunity cost concept helps to focus on the following questions:
‘Have we identified all relevant options?’ and ‘How do the options compare with
each other?’
6.2 Fixed Costs, Variable Costs and Sunk Costs

At first sight the distinction between fixed and variable costs might appear to be so
obvious as not to require discussion. However, many accounting systems ignore the
fact that some costs are fixed and some are variable with respect to changes in
output. One widespread practice is to allocate overheads such as central administra-
tion costs to each product on a per unit basis. In the previous example the return on
a price reduction was estimated, and the estimate of the future net cash flows would
obviously have taken into account expected future production costs. However, an
arbitrary allocation of ‘overheads’ to the additional output would have given an
entirely different result in terms of the future net cash flow and the net present
value, despite the fact that the additional output had no impact on ‘overheads’.
Many accountants are firmly convinced that each product must bear its share of
overheads. Application of this principle can lead to misallocation of resources and is
an example of how an accounting convention can impact on strategic decision
making.
Perhaps an even more serious error is to take sunk costs into account in current
decision making. Sunk costs are the costs which were incurred in the past, and as a
result cannot vary with respect to output. It may well be that past expenditure can
be used as a guide to what expenditure might be in the future, but it is senseless to
attempt to allocate sunk costs to variations in current output.

Factory rent is an example of a fixed cost; since it does not vary with output it
has no implication for the quantity which should be produced. When considering a
proposal to increase output by 10 per cent there is no point to reallocating factory
rent over the new range of output and changing the calculation of unit cost. Doing
so would not reveal whether it was worthwhile to increase output.
Expenditure on development incurred in the past is a sunk cost and therefore has
no bearing on whether to continue developing a product. One of the classic
mistakes is to say ‘We have spent so much on developing this product that we
MUST continue with it.’
Given the complexity of many companies there is an incentive to use existing
cost accounting procedures which are intended to approximate to the relevant costs;
however, there is no guarantee that the costs produced by existing procedures are
actually those which will lead to rational decisions. When making strategy decisions
it is obviously important to make sure that the appropriate costs are taken into
account; merely posing questions about whether costs are fixed, variable or sunk can
suggest where accounting cost data may be misleading. Sunk costs are a particularly
important strategic consideration for barriers to entry, as discussed at Section 5.10.3;
if the costs of entry are recoverable then they are not sunk as far as the strategic
move is concerned.
6.3 Marginal Analysis

One of the outcomes of failing to distinguish between fixed and variable cost is that
decision makers focus on average costs, and this can often be a major error because
it means that overhead costs are allocated irrespective of whether they are directly
related to changes in output. The concept of marginal cost is a development of the
notion that only relevant costs should be taken into account in making pricing and
output decisions. The marginal cost principle is simple enough, being the change in
costs as output varies. In terms of the basic model of costs:
Marginal cost = Outlayq + 1 − Outlayq
where q = level of output
Since the marginal cost excludes fixed cost, it can be significantly lower than
average cost; thus when making output and pricing decisions the marginal cost can
be used as a guide to the minimum acceptable price. The company can compare the
marginal cost of production with the market price when deciding how much to
produce. In fact, the marginal principle provides the basis for the profit maximising
rule: carry on producing and selling so long as the marginal cost is less than the
price.
This rule is difficult to apply when it is necessary to reduce price in order to
increase sales; in this case marginal cost is not compared with price but with the
additional revenue generated by increased sales, taking account of the reduction in
price. The additional amount gained from the sale of each additional unit is known
as marginal revenue.

The concept of the margin is typically associated with small changes which are
continually undertaken in the quest for profit maximisation. The questions to which
marginal analysis can be applied include: ‘How many units should the company
produce and sell?’, ‘How much should be spent on development?’ and ‘How much
should be spent on marketing?’ The analytical issue which is common to these
questions is: ‘Does the last dollar spent generate at least a dollar of revenue?’ If not,
there is little point in spending it. The benefit of thinking in marginal terms is that it
focuses on the costs and benefits associated with specific actions. It will often be
found that marginal costs are difficult to quantify, and the marginal revenues, since
they occur in the future, can only be estimated; while measurement presents a real
difficulty in applying the marginal principle, it should not be used as an excuse to
revert to a conventional historical accounting approach.
Some decisions are not marginal in the sense that they affect the whole company.
The decision to enter a new market may require a change in company organisation,
and it may be difficult to visualise what is meant by marginal cost and marginal
revenue. In economics, the distinction is drawn between short run and long run
marginal cost. One way of describing the difference between the two is that in the
short run the productive capacity of the company is held constant, and only variable
inputs are allowed to change; long run marginal cost allows all inputs to vary,
including these which are typically regarded as ‘fixed’ in real life. Consequently, the
marginal approach need not be concerned only with small changes. What is im-
portant is that the marginal concept is used to identify those costs and revenues
which will be affected by the decision. In accounting terms, this is sometimes
referred to as ‘relevant costs’; in arriving at relevant costs the emphasis is on the
extraction of marginal cost from the confusing array of real life accounting infor-
mation.
The marginal concept can be applied to most aspects of decision making. For
example, what is the value of the additional output associated with the hiring of one
more worker, or the installation of one more assembly line? Given the importance
of marginal analysis to decision making, it is striking that managers are often
unaware of the idea; perhaps this is due to companies’ information collection
approaches, which tend to concentrate on average rather than marginal data.
Another important application is in marginal cost pricing. Often a company finds
that it faces ‘one-off’ situations when prices have to be negotiated. For example, in
the hotel business a potential customer walks in off the street and asks how much a
room is for the night; the reply is usually the ‘rack rate’, which is the full undis-
counted price for the room. But if the hotel is not completely full, what is the lowest
price the manager should be willing to accept? It is simply the marginal cost of
providing the room for the customer that night, and managers should have some
idea of what this is. But typically the minimum acceptable price set by managers is
the average cost. Companies often lose potentially profitable business because they
do not appreciate that the appropriate minimum price is the marginal cost, not the
average cost, when making deals at the margin. Recognition of the importance of
marginal cost also has implications for the degree of empowerment which can be
devolved to employees; in the hotel example the hotel company is made better off
by every marginal deal which generates more than the marginal cost. The duty

manager can be provided with appropriate incentives and encouraged to haggle at

the margin so long as he does not strike deals at below marginal cost.
An important application of marginal analysis relates to the selling of inventories
as a product’s life cycle draws to a close. Take the case where the company expects
to have an inventory of 800 units of the product in the final quarter of the product
life, and does not intend to produce any additional units during that quarter. Given
that there are no production costs, and assuming that selling costs are zero, what
price should be charged for the product inventory in the final quarter?
The type of response which this question elicits includes:
1. ‘As high a price as the market will bear’
2. ‘A price which will clear all of the inventory’
3. ‘A price which will cover the costs of production’
All of these are wrong.
In this case the marginal cost is zero, so attention is focused on marginal revenue,
and this leads to the demand concept developed at Section 5.2.2 and the revenue
maximising price. If a price of $1 million is charged then zero units will be sold; if a
price of zero is charged, then all units will be sold. In between these two extremes is
a price at which the revenue obtained from sales will be maximised, irrespective of
whether or not all units have actually been sold.
Revenue = Price x Quantity

Price
P Demand = average revenue
500 Marginal revenue 1000
Quantity
Figure 6.1 Selling product inventory: the revenue maximising price

As shown in Figure 6.1, a straight line demand curve has been drawn for illustra-
tion. At price P and quantity 500 price times quantity is maximised. This is also the
point at which marginal revenue is zero. Since all costs have already been incurred,
the appropriate price is the revenue maximising price. The application of mistaken
notions of revenue maximisation at this stage could cost the company a great deal in
terms of lost revenue.
But what might this revenue maximising price be in practice? The manager only
has one chance to set the price, and will not know if this was the revenue maximis-
ing price or not. It is likely that by the end of the product life cycle the company will
have some information about demand conditions so at least an approximation can

be made, given that the underlying principle of revenue maximisation is understood

and that managers are not fooled by the erroneous arguments above.
6.4 Diminishing Marginal Product

Why should marginal cost vary? It must be because the productivity of resources
varies at the margin, i.e. as output varies different resource inputs are required to
produce a given increase in output, and this is reflected in the marginal cost. It is to
be expected that the more resources which are directed to an activity, the greater
will be the output. However, the additional output will not always be in proportion
to the additional resources. The case traditionally used in economics textbooks is
that of a hectare of land, which is a fixed factor of production, and farm workers,
the numbers of whom can be varied. When there are relatively few workers, each
additional worker will add a proportionately higher quantity to output as opportuni-
ties for division of labour are exploited. However, beyond a certain point it becomes
more and more difficult to wrest additional output from the land, no matter how
many additional workers are used. Eventually, the additional output from the
additional worker will be zero. At this point the marginal product of labour is zero.
By and large companies operate in the range at which additional resources yield
diminishing increases to output. This has important implications for determining the
scale of company operations. For example, when deciding how many workers to
employ, a company will keep on hiring additional workers up to the point at which
the value of the additional product is just equal to the wage rate. While the addition-
al revenue may be difficult to quantify in practice, the hiring of additional workers
must be based on the implicit belief of managers that the value of the additional
output will be at least as great as the additional wage cost. The concept of diminish-
ing marginal product applies to most aspects of company activities: for example, it
becomes increasingly difficult to wrest each additional percentage point of market
share so the marginal product of marketing expenditure diminishes. When develop-
ing products, it becomes more and more difficult to add features which customers
are willing to pay for; thus the marginal product of development effort also decreas-
es.
The idea of diminishing marginal product is shown in Figure 6.2, where the con-
nection between total and marginal product is demonstrated.

Total Product
Output
Marginal Product
Variable inputs
Figure 6.2 Total and marginal product

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

marketing engineering
Output ($)
0
X W1 W2 Y
Input ($)
Figure 6.3 Resource allocation

Total output could be increased by diverting some resources to marketing from
design engineering. Imagine one dollar is taken from engineering – this results in the
small amount of output at Y being given up; now allocate the dollar to marketing,
and the large output at X is obtained instead. The optimum allocation is at 0W1 and
0W2 where the marginal products are equal; any deviation from this allocation leads
to a reduction in total output. Whether the optimum allocation could be achieved in
practice raises practical issues, because it may be difficult to substitute resources
among diverse activities at short notice; it is also impossible to measure the outputs
associated with each with any degree of accuracy. The underlying principle holds,

however, and managers should always be looking at the current allocation of

resources with a critical eye.
The concept is also relevant at the corporate level, where SBUs are competing for
scarce funds. The guiding corporate principle is to identify the value of the marginal
product of the SBUs, and allocate resources to each up to the point at which the
values of the marginal products are equal. In Figure 6.3 the two activities represent-
ed could be SBUs. The corporate manager might argue that the notion of the
marginal productivity of an SBU is much too difficult to estimate. But again efficient
resource allocation demands that the principle be observed, and even a rough
indication of marginal productivity can suggest whether corporate resources are
being allocated in the right directions.
6.5 Profit Maximisation

It is a short step from the discussion on marginal analysis at Section 6.3 to arrive at
the concept of profit maximisation. It was concluded that the company should keep
on increasing its output until the marginal cost was equal to the price. Below this
level of output the marginal cost is less than the price, hence profit could be
increased by increasing output; above this level the marginal cost is greater than the
price, and profit could be increased by reducing output. Thus when the company is
faced with a market price over which it has no control the profit maximising output
is that where marginal cost equals price. But when the company does exert some
influence on the price charged, i.e. it can sell more by charging a lower price and less
by charging a higher price, the impact on total revenue from a change in sales is not
simply equal to the price times the number of units involved. At Section 5.2 it was
shown that revenue changes as price and quantity sold changes, and that the extent
of this change depends on the position on the demand curve. The change in
revenue is known as the marginal revenue, and is usually defined as the change in
total revenue from selling one more unit. When it is necessary to reduce the price to
sell additional units, the marginal revenue is clearly less than the price. The issue
then is whether the marginal cost is less than or greater than the marginal revenue.
The profit maximising output in this case is when marginal cost and marginal
revenue are equal, i.e. when the cost of producing the last unit is just equal to the
revenue obtained from selling it. In the discussion on marginal analysis, it was
concluded that this provided a decision rule on how much to produce; it now
emerges that this is also the profit maximising output.
In real life, where many changes are not marginal, where costs and revenues are
not known with any certainty, where problems of market share, relative costs,
competitor reaction, and so on tend to dominate decision making, the idea of profit
maximisation might at first appear to be of limited usefulness. But it can be illumi-
nating to use the profit maximisation framework when evaluating competing
courses of action. The two questions ‘What are the additional expected costs?’ and
‘What are the additional expected revenues?’ are really about profit maximisation.
Any course of action where only a weak case exists for asserting that the additional
revenues are greater than the additional costs must be viewed with some reserve. As

in the case of optimisation it is understanding the underlying principle that is

important because it helps in framing the right kind of question.
6.6 Estimating Production Costs

The discussions of the economic ideas of opportunity cost, fixed, variable and sunk
cost, marginal analysis, diminishing marginal product and profit maximisation have
touched on the problem of measurement of both revenues and costs. The literature
on costing reveals that there is disagreement between academic and practising
accountants on how to determine the costs of production for decision-making
purposes. An indication of the scope of this debate can be obtained from the titles
of major articles written by accounting theorists
 How cost accounting systematically distorts product costs.26
 Yesterday’s accounting undermines production.27
 One cost system isn’t enough.28
The investigations carried out by researchers into accounting practice reveal that
many companies have accounting systems which do not generate information on
costs relevant to decision-making. Many accounting systems are simply incapable of
providing an answer to the question of how much it costs to produce a particular
product, and how costs vary as the level of output changes.
Dissatisfaction with accounting techniques is not confined to the accounting
profession. There has always been disagreement between economists and account-
ants in this area; while not all accountants hold the same views on costs, the debate
can be characterised as follows. Economists accuse accountants of ignoring eco-
nomic ideas when reporting costs, while accountants respond that economists do
not understand the difficulties involved in producing information in day to day
business. The debate has centred on the concept of marginal versus average costs,
and on expected future costs versus historical costs. On the marginal versus average
costs issue, economists maintain that accountants should identify the marginal cost
of production so that the cost of expansion or contraction can be sensibly com-
pared with changes in revenues; accountants typically argue that average costs,
which include arbitrary cost allocations, are appropriate because all costs have to be
taken into account. On the future versus historical cost issue, economists argue that
sunk costs should be excluded from decision making information, and that the only
use for historical costs is to provide guidance on what costs are likely to be in the
future; accountants argue that unless all historical costs are taken into account a
biased view of costs is obtained.
The problem facing the manager is that accounting systems are complex, and it
may be difficult for the non-specialist accountant to determine whether they are
doing the proper job. The application of economic concepts can go some way
towards cutting through the technical complexity of accounting systems by follow-
ing the general principle that if the company accounting system does not provide
information which is consistent with economic concepts there is a good chance that
mistaken decisions will be made.

A major factor that contributes to the intractable problem of identifying costs is

joint production. The classic case of joint production is that of a sheep, which
produces both wool and mutton; it is impossible to disentangle the inputs devoted
to the two outputs. The concept of joint production has important implications for
cost analysis: if the resources devoted to a particular output cannot be identified,
neither can the costs. Any attempt to allocate joint production costs among prod-
ucts is artificial, no matter what arguments are used to justify the method chosen.
While there may be many reasons for allocating joint costs, the manager should be
aware that allocated costs are likely to be misleading.
The existence of joint costs imposes a complication on the use of variable costs
as an item of information for decision-making purposes; since some costs vary with
changes in the output of two products it may not be possible to identify variable
costs separately. Joint production has some tricky strategic implications because it
may not be possible to produce certain products on their own and compete
effectively with those produced under conditions of joint production. For example,
a farmer who pays little attention to rearing lambs for sale will have to derive all
income from the sale of wool.
An approach that has been developed to overcome the deficiencies of traditional
costing techniques is activity-based costing (ABC). The principle of ABC is that
activities (e.g. production planning, quality inspection), rather than products, cause
costs to be incurred. The difference between a set of traditional cost accounting
categories and activity-based analysis is shown in Table 6.2.
Table 6.2 Traditional cost accounting and activity-based cost account-

ing
Traditional categories ($) Cost of performing specific
activities ($)
Wages and salaries 500 000 Liaison with suppliers 150 000
Supplies 100 000 Process orders 120 000
Travel 50 000 Handle deliveries 50 000
Rental 150 000 Internal processing 250 000
Operating expenses 100 000 Quality assurance 200 000
Troubleshooting 130 000
Total 900 000 Total 900 000
Using traditional categories it is difficult to determine whether the wages and

salaries cost is high or low from one year to the next because the costs are not
associated with specific activities; the activity-based approach reveals that over one
third of total cost is attributable to quality assurance and troubleshooting. This
provides a different perspective on where the company is incurring cost. Besides
focusing attention on activities rather than cost categories, the activity-based
approach draws attention to the notion of value added; in this case the issue of
whether quality assurance and troubleshooting together add more than $330 000 of
value can be addressed. It may be concluded that these activities indeed generate a

value in excess of their cost, but it is important to recognise the potential for
misallocation of resources which can arise because the cost structure is not under-
stood.
Activity-based costing is not a completely objective method of determining costs
because it requires cost drivers to be identified (those activities or factors which
generate cost) whose definition is a matter of judgement; for example, troubleshoot-
ing is not a well-defined role. While ABC may be superior to conventional methods
in some circumstances it is not possible to be absolutely certain because there is
scope for disagreement on the cost drivers, particularly under conditions of joint
production. Consequently ABC is not a complete solution to the accounting
problem.
The complexity of the accounting problem can be seen by attempting to identify
cost drivers and how they affect unit cost as illustrated in Figure 6.4.
Attrition Learning More output
Unit cost
Hiring/firing Overtime/undertime
Business cycle Factor prices
Exogenous shocks
Figure 6.4 Factors determining unit cost

This is by no means a complete or definitive picture of how unit cost is deter-
mined: for example, it does not include economies of scale; but it demonstrates that
the analysis of unit cost is much more than an accounting exercise. Not only is it
necessary to understand how influences such as learning effects and attrition rates
affect unit cost, but there are linkages between these factors which make it difficult
to disentangle their individual effects. For example, hiring policies can have implica-
tions for the amount of overtime working required, which in turn can have an
impact on the attrition rate, which in turn affects the position on the learning curve;
at the same time factor prices are affected by the business cycle, while exogenous
shocks, such as a sudden and unexpected fluctuation of prices on commodity
markets, make it difficult to identify how underlying unit costs are changing. It is

clearly important to determine whether an increase in unit cost is due to factors

outside the control of the company – business cycle effects and exogenous shocks –
and which affect all companies, or whether it is due to the management of labour, in
which case the cost increase will have a negative impact on the company’s competi-
tive position.
6.7 Accounting Techniques: Break-Even, Pay back and

Sensitivity
Despite these reservations about the accuracy of accounting figures even approxi-
mations can help to answer three strategic questions: how many units need to be
sold before the investment is covered, how long it takes until the initial outlay is
paid back and what happens if some of the assumptions are wrong. Taken together
these are powerful questions: the first seeks to determine whether a new product is a
feasible proposition, the second clarifies a dimension of the risk and the third
identifies what success really depends on. The calculations are quite simple and easy
to understand and complement the standard NPV calculation. The NPV provides a
theoretically correct basis for determining whether a project should be undertaken
and for selection among competing projects, but it does not provide insights into
feasibility and the implications of projects for overall cash flow.
6.7.1 Break-Even Analysis

A simple version of break-even analysis, which assumes that unit cost and price will
not vary with output, is as follows. On the cost side, total cost incurred as output is
increased is:
Total cost Sales Variable unit cost Fixed cost
On the revenue side, the total revenue generated by the product is:
Total revenue Sales Price
It is then a simple matter to solve for the Sales at which Total cost equals Total
revenue:
Sales Price Sales Variable unit cost Fixed cost
Sales Price Variable unit cost Fixed cost
Fixed cost
Break‐ even
Price Variable unit cost
You simply take the fixed cost and divide that by the difference between price
and unit cost. The break-even chart is shown in Figure 6.5.

Revenue
$
Cost
Cumulative output
Figure 6.5 Break-even chart

The most obvious question which can be addressed with the result is whether the
total sales requirement is attainable before the product makes a positive cash
contribution. This focuses attention on the factors affecting potential total sales
over time. Estimates of cumulative sales can be derived from the basic model of
revenues and will be based on marketing information concerning market size and
market share
Cumulative sales Total market Market share
Total market Market share
⋯
Total market Market share
where 1, 2, …, t = product life cycle periods
The outcome may be, for example, that the market share required is 30 per cent
but no existing competitor has more than 15 per cent; the issue of whether it is
feasible to expect to do better than competitors who have been in the market for
some time can then be addressed. The calculation can be made more complex by
taking factors such as potential experience effects into account; the analysis can also
help identify possible courses of action, such as aiming at efficiency improvements
to reduce costs, which could make a product launch appear more feasible. Break-
even analysis is obviously limited in that it concentrates only on the volume of
output and sales, and does not take into account the passage of time. Its main
strategic contribution is to relate the costs incurred in the development and launch
of a product to its market setting, since revenues cannot be generated without
incurring costs.
6.7.2 Pay back Period

The question ‘How long will it be before the project pays back its start-up costs?’ is
important from the viewpoint of anticipated corporate cash flows. The calculation is
identical to that of net present value (see Section 3.12.2) except that the annual cash
flows are not discounted; instead, they are summed until the total becomes positive,
as shown in Table 6.3.

Table 6.3 Pay back

Cash flow −A1 A2 A3 An
Pay back −A1 A2 − A1 A2 + A3 − A1 A2 + A3 + … + An − A1
The pay back period is the length of time until the running total becomes posi-
tive.
There is some dispute as to whether the pay back period adds to the information
produced by a properly executed net present value analysis. The discounting
approach takes into account both the incidence of cash flows over time and risk
factors; in theoretical terms the argument that the company needs to predict its net
cash position is irrelevant, because a bank which used the same NPV criterion as the
company would be willing to lend money against the security of the expected future
income stream. This suggests that there is no such thing as ‘running out of cash’ for
an investment which has a positive NPV.
However, from the corporate viewpoint there are situations in which the pay
back criterion may have implications for the selection of the product portfolio. For
example, the prospect of increasing the ratio of debts (the gearing ratio) to assets
may be unacceptable or the bank may not take the same view of the risks as the
company. Whether the notions of break-even and pay back appeal to the financial
purist is irrelevant; what is important is to generate information on different aspects
of investments so that corporate decision makers can arrive at a well balanced view
of the implications of different courses of action.
6.7.3 Sensitivity Analysis

When making predictions about the future it is not possible to be precise, but it is
possible to obtain some idea of the range of values likely to be associated with
important variables. At the very least, the best possible and worst possible scenario
for each important variable can be projected. Sensitivity analysis is related to the
investigation of scenarios, but is conducted at a more detailed level.
One approach is to use the investment appraisal framework as shown in Ta-
ble 6.4.
Table 6.4 Base contribution calculation

minus
equals contribution in each period
It may be felt by forecasters that the values used in the appraisal are unlikely to
be significantly wrong; however, some managers may express reservations, for
example, about the prospects for the labour market due to predictions that the
economy is likely to be entering a new period of sustained growth. This could result

in wage rates being 20 per cent higher than would otherwise be the case. The
framework can be adjusted to take this possibility into account as shown in Ta-
ble 6.5.
Table 6.5 Adjusted contribution calculation

minus
Outlay =
Number of workers × Wage rate × 1.2 +
equals contribution in each period
It may be that, because wage costs are a relatively small proportion of total cost, a
20 per cent higher wage rate would have little impact on the profitability of the
investment. On the other hand, it may turn out that the return from the investment is
highly responsive to the wage rate, causing managers to take a rather different view of
the desirability of the investment.
Sensitivity analysis can be carried out for various dimensions of performance. For
example, the impact of the potentially higher wage rate on NPV, break-even, pay
back and cash flow can be investigated. Sensitivity analysis is therefore a powerful
technique for generating a perspective on the potential returns from a course of
action. It identifies which are the crucial variables, and where unexpected threats
may exist. It can pin-point issues about which attempts to obtain more information
should be undertaken before a decision is taken. A somewhat less obvious aspect of
sensitivity analysis is to identify the combination of circumstances which are
necessary to ensure success. In the example above, sensitivity analysis might have
revealed that a 10 per cent higher price for either labour or capital would lead to
failure, as would a market share of 14 per cent or less. Managers must then seriously
address the issue of whether it is likely that the following will actually occur:
 market share greater than 14 per cent;
 wage rate no more than 10 per cent greater; and
 capital price no more than 10 per cent greater.
Put in this way, this might appear to be an unlikely combination of circumstanc-
es. The reason that some projects fail is the lack of recognition that their success
was actually dependent on the simultaneous occurrence of several favourable
circumstances.
6.8 Accounting Ratios

The company has at its disposal a great deal of information which it can use in
identifying the effectiveness with which resources are being, or have been, allocated.
It is at this point that an apparent disagreement between the practitioners of finance
and those of accounting needs to be clarified. Various problems in using ROI as an
investment appraisal criterion have been discussed; the balance is heavily in favour

of using the formal tools of financial appraisal in determining how resources should
be deployed in the future. But formal financial techniques do not reveal how well
resources are actually being deployed; the questions which confront the company
include: Are we moving up the learning curve? Are we producing the level of sales
value per person employed which we originally thought possible? Are we making
effective use of our capital? Are we keeping inventories under control? The list of
questions relating to effectiveness is endless, but many of them can be tackled by
using historical accounting information on costs and revenues. Therefore the theory
of finance provides the tools for allocating resources in the future; accounting
procedures reveal the efficiency with which resources have been allocated to date.
Accountants usually try to identify a set of useful ratios which relate inputs and
outputs in a meaningful fashion, and track these over time. It goes without saying
that individual ratios have limitations, but it is not suggested that ratios should be
used blindly. Rather, they provide information on different dimensions of company
performance.
The objective of calculating accounting ratios is to assess the effectiveness with
which resources have been allocated in the past. The ratios are a useful tool for
analysing accounts; they help to reduce the amount of information in the accounts
which require analysis, and can identify potential weaknesses in company manage-
ment. Since the objective of ratios is to simplify the complexity of accounting
information, it would be pointless to use a vast number of ratios. However, there is
no definitive set of ratios which will provide the correct information for managers;
not only are there many ratios to choose among, individual ratios can be defined in
different ways. It is therefore necessary to select a number of potentially useful
ratios which can be employed over a period of time to ensure the consistency of the
information from which the ratios are derived. The following ratios are typically
encountered in company accounts:
 ROI Return on investment
 RONA Return on net assets
 ROCE Return on capital employed
 ROTA Return on total assets
 ROE Return on owners’ equity
 Earnings per share
 Gearing ratio
 Quick ratio (the acid test)
To ensure that these ratios produce performance measures which relate to the
efficiency with which resources are allocated, appropriate measures of revenues,
costs and assets must be used. For example, the problem of determining exactly
what is in the denominator (i.e. arriving at the current value of assets) when calculat-
ing ROI was discussed in Section 3.12.5; also while it may appear obvious, revenues
and costs should not include changes in the portfolio of assets because the buying
and selling of assets are not directly related to the efficiency with which inputs are
converted to outputs. However, inspection of published company accounts reveals
that the sale or acquisition of assets is often slipped into the accounts, perhaps to
disguise a particularly good or bad year.

The importance of understanding what accounts are telling you cannot be over-
estimated. In his book the stockbroker Smith29 asked a simple question: how can it
be that companies which appear to be financially sound can suddenly go bankrupt?
He pointed out that the signs of financial malaise are detectable if you knew what to
look for in the published accounts. He then went on to ask what the average
investor should know, and he identified 11 practices which could be misleading,
although they were not illegal. Smith constructed a table, which became notorious
for its ‘blobs’, which simply listed major companies and how many of these dubious
practices they pursued. Although the information was in the public domain, his
analysis touched a sensitive nerve with the companies concerned and with his
employers. The upshot was that Smith was fired and the reputations of the compa-
nies with a lot of ‘blobs’ were badly affected.
To provide some insight into the general problems of calculating ratios a few of
them are discussed in more detail.
RONA Return on Net Assets
Since assets appear in the bottom line of most of the measures, it is important that
they are calculated in a manner which is consistent with the opportunity cost of the
resources tied up in the company. In practice, it is extremely difficult to assign a
value to assets. In the first instance, many assets were purchased in the past and
have depreciated through use and obsolescence. The book value attributed to them
by accounting procedures may bear little relation to what the asset would realise on
the market, nor to the replacement cost of the asset. Two companies may have
identical performance in terms of RONA, but because of different accounting
methods one may appear to be performing more profitably.
The notion of replacement value raises another issue, i.e. that of inflation. For
example, the book value may be based on a price paid several years ago, but since
then inflation could have led to all round price increases of 50 per cent. Since
revenues are in current price terms, it would seem to make sense to adjust the asset
value to current price terms. But this could be virtually impossible in practice, given
that the company may have hundreds of assets of different vintages. It would be an
impossible task to generate data on replacement value of all assets each time the
RONA was calculated.
Take the case of an asset costing $100 purchased four years ago, during which
time inflation has been 50 per cent, and the asset has been depreciated over five
years using the straight line method. Table 6.6 shows possible calculations of asset
value.
Table 6.6 Different asset values
Current book value $20
Current book value inflation adjusted $30
Historical cost $100
Replacement cost $150

A further problem is which assets to include in the calculation. All firms are faced
with the problem of lease or buy with respect to the acquisition of assets, and the
choice can have a significant impact on the ratio because a change from owning to
leasing moves the entry from the bottom to the top line. Consider the case shown in
Table 6.7 of a company which has the revenues, costs and assets shown in Year 1.
Table 6.7 RONA calculations

Year 1 2
$m $m
Revenue 20 20
Costs 10 12
Assets 100 100
RONA 10% 8%
In the following year the company decides to sell an asset for $10m, and lease a
replacement for $2m per annum; nothing else changes, and the result is shown in
Year 2. The cash received from the sale is now treated as part of company assets so
there is no change to the denominator; the lease has been added to cost resulting in
a reduction in net revenue, i.e. the numerator. The operational efficiency of the
company has not changed, but the RONA has fallen. Has the company become less
efficient?
Gearing Ratio
Companies have three sources of finance: retained profits, equity issues and loans.
Over a period of time the company will finance its activities by various combina-
tions of these three, and the availability of finance will ultimately constrain its
strategic capabilities. Companies typically start their lives by raising finance from
shareholders and as time goes on profits are generated and distributed (in part to
these shareholders); the rest is paid in dividends and tax. The total shareholder
equity is thus the original equity finance plus the retained profits. The company can
fund expansion by issuing more shares (equity) or by incurring debt; this type of
debt is typically in the form of long-term loans for specific investment projects
rather than the short-term loans necessary for covering variations in short-term cash
flow.
The main difference between debt finance and equity finance is that the interest
on debt takes priority over payments of dividends to shareholders, and must be paid
no matter how profits fluctuate; the more debt there is in relation to equity then the
more dividends will fluctuate with profitability. If the interest cannot be paid then
the company goes bankrupt. This means that the shareholders bear the risk of
fluctuations in profit and therefore look for a higher return on their funds than the
providers of loan finance. As a result it is cheaper to finance investments by debt,
but each time this is undertaken the risk to existing shareholders increases.
A measure of the risk associated with debt financing is the gearing ratio, defined
Debt
as (usually expressed as a percentage).
Shareholder equity

Debt
Another measure is
Total assets
While the former ratio is most widely used the choice between them does not
matter so long as the same one is used over time. The normal accounting conven-
tion is to use long-term debt in the numerator but it is not always possible to
distinguish long and short-term debt in a company that has a complex financial
portfolio.
In principle, it is a simple matter to calculate a company’s gearing ratio, but the
real question is: what is the optimal gearing ratio for a particular company? There
are a number of factors which have to be taken into account.
 A company which has a sound track record will be regarded as a good loan
prospect by banks and should have little difficulty raising debt for growth. A
company which has not taken advantage of this, and has constrained its growth
to finance by retained earnings, may not be taking advantage of opportunities.
This could be an indication of a cautious and risk averse management, or per-
haps of a management with little strategic vision.
 The higher the gearing ratio the more reliant is the company on steady and non-
fluctuating profits over time. This is likely to make banks nervous and beyond
some point it will be difficult or impossible to raise additional finance no matter
how attractive the investment might appear to be. The company needs to bal-
ance off dividend payments against the loss of flexibility which may result from a
high gearing ratio.
There is therefore no optimal gearing ratio which applies to all companies, or
even to a given company over a period. A company which has embarked on a
strategic initiative may have a high gearing ratio, while a company which has
established itself as a market leader and has little room for expansion in existing
markets may have a low gearing ratio. But on a profitability basis they may be
considered equally successful.
Quick Ratio
A measure of debt exposure is provided by the quick ratio which takes into account
that current assets include inventory which is not readily convertible into cash. The
quick ratio removes inventory from the ratio of current assets to liabilities:
Current assets Inventories
Quick ratio
Current liabilities
This ratio provides a test of the company’s ability to pay its maturing obligations
and as such is a different perspective on risk to the gearing ratio.
Applying the Ratios

Taken together the ratios provide a picture of the return on assets, the proportion
financed by debt and debt exposure. From the strategic perspective this reveals, in
broad terms, how efficiently the company is being run, its ability to raise further
debt and its exposure to risk.

Despite their apparent simplicity the implications of the ratios are profound.
Take the case of a company that is considering breaking into the European market
with a well-established product requiring an investment of about 10 per cent of
current net assets. The following are two possible sets of ratios.
Ratio Scenario A Scenario B

RONA 5% 15%
Gearing 85% 40%
Quick ratio 0.8 1.2
Scenario A depicts a company that is earning about the same as the going rate of
bank interest, has borrowed almost to the limit of its capacity and would be unable
to meet current liabilities in the event of an unexpected reversal. Scenario B is a
company that has been making high returns for shareholders, has plenty of borrow-
ing capacity and is not exposed to current liabilities. The evidence of inefficiency,
costly debt and risk exposure in Scenario A suggests that the venture into Europe
would probably lead to bankruptcy; in fact, it is doubtful that a bank would finance
such a significant investment given the poor track record and the current high level
of debt. In Scenario B the company is starting from an efficient base, could put an
attractive case to potential lenders and, although the quick ratio might worsen, it is
unlikely to give cause for concern.
6.9 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.
While it is important to develop a picture of the company’s relative financial
strength in relation to competitors, the objective of doing so is to provide infor-
mation for strategic purposes rather than to attempt to emulate the performance of
other companies. This is because there is no guarantee that competitors are pursu-
ing best practice. The type of question which needs to be addressed includes
 Why are competitors’ return on capital greater or less than ours, and what does
this tell us about our own use of resources?
 How does competitors’ financial strength (in terms of gearing, cash reserves,
etc.) compare with ours, and what flexibility does this give them?
There are many dimensions of company performance so benchmarking measures
can be applied to just about everything: delivery times, stockholding ratios, man-
power turnover, etc. Benchmarking is clearly an important diagnostic tool because it

can indicate where resources might be deployed more efficiently. For example, it
may reveal things about the company about which it is ignorant; for example, a
company simply may not know that distribution systems used by retailers can be
adapted efficiently to a manufacturing setting.
But there are at least two reasons why benchmarking must be treated with cau-
tion if it is to be used as a guide to achieving competitive advantage.
1. It is virtually impossible to compare like with like. It is not always apparent that
there are differences which can render comparison meaningless or misleading.
Some questions which need to be posed include: are the portfolios of the com-
panies sufficiently similar? Are there synergies which cannot be easily identified?
Are products at similar stages in the life cycle? Are competitive conditions simi-
lar? These questions are particularly important when international comparisons
are being made because competitive conditions for otherwise similar products
can be greatly different. An example of this is the market for telephone services
in the US and the UK dealt with in Module 5 Case 6.
2. Measurable dimensions of company performance are unlikely to reveal how
competitive advantage has been achieved, otherwise the characteristics would
already have been imitated. It is how performance is achieved, rather than the
fact that it is being achieved, which is difficult to identify and is something which
competitors are unlikely to divulge. The UK retailer Marks & Spencer served as a
benchmark for other retailers for many years; but it lost competitive advantage
very quickly bringing into question what other retailers had actually been
benchmarking against.
6.10 Research and Development

The great historian Schumpeter developed the idea of ‘creative destruction’,
whereby periods of comparative quiet are punctuated by shocks when old sources
of competitive advantage are destroyed and replaced by new ones. He argued that
the entrepreneurs who exploit the opportunities created by the shocks go on to
achieve positive profits during the next period of calm thus dynamic resource
allocation is more important than static efficiency. It follows that one of the
requirements for achieving competitive advantage is to adopt an innovative stance,
recognise new ideas and changes and be ready to implement them when they occur.
In recent times it is hard to imagine what a period of ‘comparative quiet’ might be;
the view that competitive forces have become increasingly strong was discussed in
Section 5.16. But whether competition proceeds in cycles or not and whether
competitive forces have become stronger in recent years is beside the point:
research and development are both important ingredients of competitive advantage
in many industries.
6.10.1 Research and Innovation

All companies are faced with a dilemma when attempting to decide how much to
spend on research. The returns on research expenditure are potentially high in many
industries, for example a large-scale research project30 carried out in the US back

tracked innovations and found that the rate of return on research expenditure was
about 30 per cent. However, this rate of return related only to those inventions
which reached the marketing stage, and did not take into account failures. The
research demonstrated that the rate of return on successful research is high, but left
open the issue of the return on total research expenditure by companies, given that
a proportion of research does not lead to marketable products.
There are in fact two stages to the problem of allocating resources to research:
deciding how much to spend, and identifying potentially profitable products among
the possibilities produced by research. It could be argued that since so little is
known about the likely success of new products, the most efficient approach is
simply to develop products on a ‘first come’ basis, and tailor research expenditure to
produce the number of new products which the company is capable of dealing with.
But to do this it would be necessary to have some idea of the productivity of
research expenditure in terms of producing new ideas. It is interesting to note that
although many academic economists have spent the past fifty years attempting to
identify a relationship between research expenditure and the production of inven-
tions, the findings have been at the aggregate level and consequently this type of
research has produced no guidelines on which an individual company can base its
research expenditure decisions. This is partly due to the fact that in aggregate there
is a reasonably stable output of inventions by the economy, but for the individual
company it is highly unlikely that marketable ideas will occur at a constant rate over
time. The production of ideas, so far as the individual company is concerned, is
likely to be unpredictable and sporadic, with periods when there are no new ideas
and others when there are too many to deal with.
The identification of the potential returns from research expenditure is only part
of the story, since the company must also consider the opportunity cost of research
expenditure. In the extreme case, it is self-evident that there is no point in generat-
ing more inventions than can be developed and marketed. But decisions are not
normally concerned with extreme cases, and it is necessary to decide whether a
particular dollar should be spent on research, or competing uses such as marketing
new products or investing in new equipment. This involves a trade-off among the
need to spend sufficient to produce new products in the future to ensure the long-
term viability of the company, and the additional cash which could be generated by
increased sales, and cost savings which might be made by using new equipment.
The fact that the opportunity cost comparison is based on largely unpredictable
returns in the perhaps distant future against more identifiable revenue and cost
advantages arising from other courses of action means that the research department
is particularly susceptible to changes in the company’s fortunes. In times of difficul-
ty, the argument that it will not matter all that much if research expenditure is
reduced for a period to help solve short-term cash flow problems is usually persua-
sive, given that if cash flow problems are not solved the company may go out of
business and there would be no need for research expenditure. However, in
companies where the research department has a highly prestigious staff with a
strong power base, the department may be insulated from such immediate consider-
ations as cash flow. Given the many influences which affect research, it is likely that
most company decisions on research expenditure are based on considerations other

than the likely rate of return. The first step in taking a rational view of research
expenditure is therefore to be clear about the basis on which decisions have been
taken in the past: has the allocation of resources been determined by short-term
considerations, by individual personalities, or by other factors such as the fear of
what competitors are spending? One approach is to adopt a rule of thumb, for
example to keep research expenditure at some constant percentage of total costs, or
total sales. The benefit to the manager of taking this approach is that the formula
can be worked out on a basis which is agreeable to all concerned while ensuring that
research expenditure will remain within reasonable bounds. The potential cost to
the company is that the process is arbitrary and may result in a misallocation of
resources.
A complicating factor is that it is not always possible accurately to identify re-
search expenditure in a company. There is a significant amount of joint production
involved in research and development output. Researchers typically spend part of
their time on product development, and consequently the expenditure devoted to
research into potential products (sometimes called pure research) can only be
estimated. An outcome of the joint production of research and development is that
there may be a spill-over effect: the higher is research expenditure, the lower the
development expenditure required to attain a given development objective.
Bringing these various factors together, the quest for efficiency in research ex-
penditure can be assisted by identifying the most important indicative factors and
assessing their relative importance.
RESEARCH EXPENDITURE: INDICATIVE FACTORS
 Measurement of research expenditure
 Past research budget: constant or variable
 Expenditure as proportion of sales, total cost
 Track record of new ideas
 Spill-over effects
 Power base
Consider the following profiles for Companies A and B.

Indicative factor Company A Company B

Measurement of research Not separated from Activity-based costing
expenditure development budget estimates
Past research budget: Not known Constant – regarded as a
constant or variable background activity
Expenditure as propor- Not known – thought to ABC estimate of 1%
tion of sales, total cost average about 2%
Track record of new ideas 5 potential ideas in two 3 potential ideas in two
years years
Spill-over effects None identified Significant inputs to
development stage
Power base Research director on Research director reports
main board and has to Finance director
significant share holding
In Company A the research director is accountable only to the board and runs
the activity without tight controls; in fact, very little information is available about
the inputs to research. Company B treats research like any other activity with a
system of accountability and a clearer understanding of resource inputs. Which is
more effective? The research director in Company A could point to the superior
track record of potentially marketable ideas produced while the finance director in
Company B could claim that the activity was much more cost effective because it
consumed a lower proportion of resources. The trouble is that the value of the
output of the research activity cannot be estimated in either case. The two compa-
nies have different views on how the research activity should be run and there is no
real basis on which to choose between them.
6.10.2 Development
Product development starts when the product is selected for development from the
prototype stage, and often continues after launch and throughout the product life.
In order to maintain market share, companies continually upgrade their products in
line with new technologies and customer expectations. It is important to be clear
about the difference between the outcome of research and development inputs.
Research expenditure results in the creation of a prototype which is potentially
profitable. However, this leaves various questions to be tackled, including how
much should be spent on developing the product, when it should be launched, what
price should be charged, what marketing effort should be devoted to it, and so on.
These questions cannot be answered in a vacuum, i.e. only with reference to the
product itself, because there are opportunity costs associated with each course of
action. For example, it may not be worth developing a potentially viable prototype
because the marketing department would not be able to sell it without reducing
other, more profitable, activities.

During the development stage the time, cost and quality trade-offs are made that
define the product launch. This can result in a series of conflicts among groups
whose objectives differ.
 The development engineer has an interest in producing a ‘high-quality’ product
that might involve characteristics of construction and operation which may be
understood only by engineers. The development engineer also wants to make
sure that the product will function in all possible circumstances because profes-
sional reputation and career prospects are affected by association with a product
which has a poor record of performance and durability. The development engi-
neer will therefore concentrate on maximising product and production-based
‘quality’ discussed at Section 5.5.
 The financial controller wishes to keep costs within budget limits, and exerts
continual pressure on the development engineer to seek the most economical
solutions to technical problems.
 The marketing manager wants to get the product to customers as soon as
possible in the hope of gaining first mover advantage which may well be more
important than characteristics such as product reliability in the short to medium
term. Thus the marketing manager will not be concerned with marginal im-
provements to the product specification that will not affect perceived
differentiation significantly and will push for as early a launch date as possible.
In many companies these different groups do not communicate directly, and
individually they feel that those in other functions have little appreciation of the real
problems associated with turning out a profitable product. There is no simple
answer to the issue, but recognition that trade-offs are essential in managing a
project would make the trade-off process explicit.
The fact that a company has a history of successful R&D management does not
guarantee that it will continue to have success. To return to IBM, up to 1991 IBM
was one of the most successful managers of R&D in the world; the company had
over 30 000 patents, and two researchers had won the Nobel Prize. But despite this
the new technologies developed by IBM were often beaten to the market. For
example, IBM was one of the first companies to design a RISC microprocessor, but
was the fourth to commercialise the device. On 26th November 1991 IBM an-
nounced a ‘fundamental redefinition’ of its businesses, with the accent on shifting
power from corporate headquarters to the people making and selling products. One
of the objectives was to make the company more flexible so that it could take more
immediate advantage of new products and markets. But to do this it was necessary
to integrate innovation with the market place, and IBM suffered from the wide-
spread problem that the marketing department understood its customers and
wanted to get new products into the market as soon as possible, while the R&D
department understood the technology and had little idea of precisely what custom-
ers wanted from a product. Too often this led to the situation where the wrong
product was produced too late. By decentralising it was hoped that researchers
would be brought closer to the real issues confronted by marketers, and good ideas
would not be unnecessarily delayed by their progress through the corporate deci-
sion-making structure.

The discussion on research, innovation and development can be brought togeth-

er into a single model which identifies the stages which must be passed in bringing
an idea from the inventor’s head to successful market exploitation. This can be
visualised as a process in Figure 6.6.
Invention
Prototype
Patent
Development
Launch
Market exploitation
Figure 6.6 Innovation as a process

This whole process can be termed ‘innovation’ because each stage requires new
thinking. When viewed as a process two distinct management problems become
apparent:
 each stage must be managed effectively; and
 the link between stages must be efficient.
Stepping through the stages the following issues emerge from the previous dis-
cussion.
 Invention: what incentives exist to ensure that new ideas will be generated?
There are formidable problems of intellectual property rights and principal–
agent issues.
 Invention to prototype: what mechanism exists to ensure that investment in an
idea can be undertaken to see if it works? There needs to be some screening
mechanism otherwise many useless ideas will be investigated.
 Prototype: what criteria are used to determine what has the potential to be
produced and sold?
 Prototype to patent: is the delay in patenting justifiable or should this stage be
bypassed?
 Patent: what protection is likely to be afforded by a patent? At this stage it might
be found that the invention cannot be defined well enough for patenting pur-
poses and this raises issues as to how easily it might be imitated.
 Patent to development: how are prototypes prioritised in the overall develop-
ment programme? For example, if a first mover advantage is essential a
prototype may require a high priority but this means interfering with the current
order.

 Development: how much should be spent?

 Development to launch: the natural conflict between engineers and marketers
needs to be overcome.
 Launch: to make an initial market impression it is essential to ensure that the
product is positioned properly in terms of differentiation and price.
 Launch to market exploitation: it is necessary to decide whether the launch has
been successful and further resources devoted to exploitation or whether the
product should be abandoned. This will depend on the market share captured,
the reaction of competitors, predicted changes in consumer tastes, etc.
 Market exploitation: the product is now entrenched as part of the product
portfolio; but new and different products may require different marketing ap-
proaches to existing products.
The process demonstrates that it is a long way from invention to market exploita-
tion; that is one reason why lone inventors have such difficulty in capitalising on
their originality. The process also reveals that there are many possibilities for delay
within each stage if each is not monitored effectively; there is also scope for delays
between each stage if there are insufficient incentives and effective procedures for
taking products through each transition. In fact, the whole process is fragile in the
sense that a project can be blocked at any one of a number of points. In the case of
IBM, innovation was not stifled given its track record of patents but management of
the process was not effective compared with competitors.
6.11 Human Resource Management

Effective human resource management is important for strategy for two reasons.
First, the people in a company are a resource like any other, and the effectiveness of
that resource is affected by strategic change. Second, when strategic changes are
introduced they have to be implemented by people; the ability to adapt to change
can exert a powerful constraint on success. Adaptability and the ability to cope with
strategic change is a major objective of human resource management. One of the
main characteristics of an organisation is its culture, which comprises its set of
beliefs, values and managerial approaches; this culture is reflected in its structures,
systems and approach to the development of strategy. The culture itself is derived
from the company’s past history, type of leadership, the people involved, its use of
technology and resources. Since each company has a different history and different
combinations of people and other resources the culture of each is likely to be
unique. However, four broad types of culture can be identified which provide a
basis for understanding how the workforce is likely to react to change.31
1. Power Culture
The organisation tends to revolve around one individual (or small group), who
dominates decision making and determines how things are done. This culture
usually occurs in a relatively new or small company which is entrepreneurial in
nature. Sometimes the power culture is maintained in large organisations, for
example in the newspaper industry, where the old style proprietors dictated edi-
torial approach and newspaper layout. In this type of organisation there is

unlikely to be an explicit strategic plan, but if there is one it will tend to reflect
the interests of the dominant leader rather than being based on analysis of the
environment and explicit strategy choice.
2. Role Culture
The organisation relies on committees, structures, analysis and the application of
logic. While a small group of senior managers make final decisions, they rely on
procedures and systems and clearly defined rules of communication. This bu-
reaucratic type of structure works well when the environment is stable, but the
fact that it relies on rules and procedures means that external changes are not
typically recognised at an early stage, and the company is not well equipped to
deal with them because it is relatively inflexible. Major changes tend to be dealt
with by a change in the top management team. This type of culture is prevalent
in the civil service and the old style banks where strategic changes tended to be
slow and methodical. While the role culture has remained dominant in the civil
service the banking sector has witnessed a transformation, for example with the
emergence of the Royal Bank of Scotland as the fifth biggest bank in the world
in five years under the guidance of the new CEO appointed in 1998, Sir Fred
Goodwin. It is possible to change the role culture of an organisation but it is not
easy.
3. Task Culture
This type of culture arises in organisations which are geared to tackle specific
tasks of limited duration. The organisation is based on flexible teams who tackle
assignments, and these teams will typically be multidisciplinary, and power rests
within the team structures. As a result control relies largely on the efficiency of
the individual teams, and top management must allow teams a great deal of au-
tonomy. This culture is apparent in advertising agencies and consultancies; it is
less appropriate for factory style operations, although the team approach is being
used increasingly in all work environments. The culture also arises because peo-
ple in general tend to be task orientated and want to get on with the job in hand.
The outcome is a mindset where management at all levels is perceived as a series
of tasks and no one takes responsibility for the wider view of company strategy.
The task itself can be large scale and daunting, such as running a petrochemical
plant; but despite how it might appear to the plant manager it is still a task. The
task orientated plant manager will not think about issues such as the marketing
of the output, the product mix or even whether the plant should exist.
4. Personal Culture
In this case the individual pays little attention to the organisation and is most
concerned with self-gratification. All strategic responses depend on the inclina-
tion of the individual hence are unpredictable. Voluntary workers are a good
example, but individual professionals such as architects or consultants working
as lone people within larger organisations can fall into this category. This form of
culture is unlikely to permeate an entire organisation but where it occurs it clearly
presents management challenges.
The type of culture prevalent in the company can have a major impact on how
the organisation reacts to strategic change. Table 6.8 indicates how the cultural

composition relates to competitive advantage and can affect the ability to cope with
strategic change.
Table 6.8 Culture and strategic change

Culture Achieve competitive Cope with strategic
advantage change
Power Lacks analysis Unpredictable
Role Slow Resistant
Task Flexible Change is norm
Personal Lack focus Unpredictable
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 6.9, are as follows.
Table 6.9
Culture Achieve competitive advantage Cope with strategic change
Power Decides to enter only one of the Does not consult so causes
markets because of personal significant internal upheaval
impressions
Role Has difficulty integrating foreign Misses first mover advantage
language speakers and deciding
who will take charge
Task Sets up International Division and Copes with country differences
seconds key workers
Personal Recruits a multi-lingual manager to New manager lacked direction
see it through and could not cope
While things might not work out like this in practice the message is clear: culture
has the potential to affect strategic outcomes in a fundamental manner. In terms of
the process model different cultures will focus on different activities and it is
possible to assess the strengths and weaknesses of the various strategic processes;
but to a large extent the culture determines whether the process itself can be
changed. Many governments have experimented with secondments: senior civil
servants spend a year or two in industry and senior executives spend time in a
government department. The results are rarely encouraging and an important factor
is that the individuals find themselves in a cultural environment that they cannot
cope with.
It is unlikely that any single organisation will exhibit only features of one culture.
However, it is possible to identify roughly the extent to which the different forms of
culture exist in an organisation, and which is most dominant and at what time.

It is necessary to invoke a warning here. When problems arise in implementing

strategy they are often ascribed to cultural problems, because these are actually
difficult to identify and it is virtually impossible to do anything about them in the
short term. Thus failure can be attributed to ‘cultural problems’ which are outside
anyone’s control. But what might appear to be a cultural problem may in fact be due
to the more general principal–agent problem, for example the incentive system may
not be aligned with revised strategic objectives.
6.12 The Scope of the Company

A company needs to define the business it is in to arrive at a sensible mission
statement and derive objectives as discussed in Section 3.2.1. Not all companies
focus exclusively on the production of one output and many have to make funda-
mental decisions about what range of products to include in the portfolio. In a
broad sense this is a decision on diversification and the issues which this raises are
economies of scale and scope, diversification, synergy and vertical integration.
6.12.1 Economies of Scale, Economies of Scope and Diversification

The concept of economies of scale relates to what the unit cost of production
would be at different scales of operation. It is concerned with the average cost of
production in relation to the productive capacity of a company; for example, if the
productive capacity of a company were doubled, it would benefit from economies
of scale if the cost per unit fell. Economies of scale can emerge for a number of
reasons.
 Indivisibilities: this is usually associated with machinery, where there is a minimum
size for most machines, such as in a steel plant, and each addition either to size
or capacity comes in discrete amounts. For example, it may not be possible to
increase the size of a steel plant by, say, 5 per cent, because an additional line
may be 40 per cent of the existing plant size. The idea also applies to human
resources, for example a company may need an additional accountant but hiring
one will generate excess capacity in the accounting department.
 Technical relationships: in most capital intensive industries there is a declining
relationship between capacity and unit cost; for example, it does not cost twice
as much to build an oil tanker of twice the capacity because capacity is deter-
mined by length multiplied by height multiplied by width.
 Specialisation: originally this idea related to breaking down mass production
processes into their component parts, so that individual workers became ex-
tremely adept at a small number of tasks. This mechanistic view of how
employees work effectively has been largely discredited and it has been recog-
nised that specialist work teams (quality circles) generate a more efficient and
motivated workforce; but the same underlying idea of specialisation still operates
as work groups become more adept at handling their particular part of the pro-
duction process. In a wider sense, specialisation is more feasible as the size of the
company increases in areas such as ‘knowledge’ workers, where large companies
have their own IT departments, specialist financial analysts and so on.

The empirical evidence on economies of scale is mixed: in some industries it is

significant and in others it hardly exists. The difficulty in attempting to measure the
impact of scale economies in real life is that it is not merely the increase in produc-
tive capacity which is relevant, but whether the higher productive capacity is based
on a more efficient combination of labour and capital. It may be that some larger
companies have not selected the optimum combination of inputs and hence do not
benefit from potential scale economies; this does not mean to say that they do not
exist and that they might not be exploited by some companies in an industry. It may
also be the case that the difficulties of managerial coordination beyond some
company size make it impossible to benefit from potential scale economies.
Newspaper reports of mergers and acquisitions usually focus on the scale economies
which will be generated by shedding employees; but it is often difficult to differenti-
ate between efficiency gains, which occur when a more effective management team
is installed, and genuine scale economies, which are realised when capacity and
output are more closely aligned.
The incidence of scale economies helps explain why some industries are domi-
nated by a few monopolistic companies while others are characterised by a large
number of small companies. There are pronounced scale economies in industries
such as electricity production and car manufacturing; however, in industries such as
specialised machine tool production there may be considerably less scope for
economies of scale. One of the problems faced by state regulators is to ensure that
competitive pressures can be brought to bear in an industry dominated by a
monopolist without sacrificing scale economies.
Economies of scope are similar to economies of scale, but the idea refers to a
reduction in unit cost as the number of products is increased rather than the
number of units produced. The scale economies argument is that if two companies
were merged which produce the same product then the resulting unit cost would be
lower. The scope economies argument is that if two companies were merged which
produce different (but related in some way) products the unit cost of both would be
reduced. The idea has similarities with synergy, which is discussed in Section 6.12.2.
There are a number of reasons why it may be cheaper for one firm to produce two
goods than for two firms to do so.
 The possibility of sharing inputs among several outputs; these inputs can take
the form of physical resources or specific skills and competencies. For example,
the cellophane tape manufacturer 3M had capabilities in adhesives which could
be used in making adhesive message notes; retailers sell many items – Tesco sells
about 30 000 product lines – because below some critical number customers do
not find it worthwhile to come in.
 The good reputation associated with some products may have a beneficial effect
on others: for example, the quality image of Rolls-Royce cars carries over to its
aero engines.
 There may be significant R&D spill-over effects among different products; for
example, advanced heat resistant materials developed for turbines have applica-
tions in kitchen utensils.

 Enhanced ability to compete in a range of related industries with a coordinated

strategy: this comes back to the potential benefits from a related portfolio of
businesses; given the problems of diversification such potential benefits may be
no more than wishful thinking.
The rationale for the potential of economies of scope begs an important question
for a company that produces more than one product: is total cost lower than it
would be if the company were split up into its component product parts? The fact is
that economies of scope are by no means the automatic outcome of diversification,
although they are typically used as the justification for diversification in the first
place. A company whose products compete in unrelated markets using different
resources and different management skills might be faced with diseconomies of
scope as scarce management skills are spread ever more thinly. It is therefore
necessary to take a hard look at the portfolio of products to assess what contribu-
tion the portfolio actually makes to competitive advantage in individual markets.
While the notions of economies of scale and scope are by no means precise it is
likely that the intuitive hope that the effects will work together lies behind the desire
of many CEOs to pursue company growth as an objective in its own right. The
notion that ‘bigger is better’ is probably based on the feeling that economies of scale
and scope will somehow emerge. But as we have seen the mechanism by which this
will happen is not clear and there is no guarantee that the outcome of growth will be
lower cost.
In the pursuit of economies of scope, how far should a company diversify from
its core business? Some corporations are little more than financial holding compa-
nies with no obvious link among products while others keep within an identifiable
group such as chemicals or engineering. The crucial issue is the relatedness of the
diversification and that is not always obvious. For example, a company may diversi-
fy from the production of domestic gas boilers to service and maintenance under
the impression that this is a related diversification; but from another perspective it is
not related because the company started with a manufacturing business but has now
moved into the service business which requires a different skill set. Given the level
of risk associated with diversification it is worth considering the motivation for
diversification in the first place. Apart from the pursuit of economies of scope and
synergy there are at least three management motives.
 To minimise risk: diversifying is a means of minimising management risk but not
shareholder risk. The objective of stabilising cash flows over time is a weak ra-
tionale for diversifying, and certainly provides no basis for expecting any value
production.
 To add value through the parenting function: the value creation potential of parenting
was discussed at Section 1.5, and was found to be on the whole unconvincing.
 To apply the dominant management logic: managers of diversified firms may see
themselves as deriving economies of scope through their proficiency in spread-
ing scarce top management skills across apparently unrelated business areas
through the application of their dominant management logic; this is the way in
which managers conceptualise the business and make critical resource allocations
in technologies, product development, distribution, advertising and human re-

source management. The dominant management logic has a direct effect when
managers develop specific skills, for example in information systems, and seem-
ingly unrelated businesses rely on these skills for success. But without detailed
knowledge about a particular business it is impossible to know at the time of the
diversification whether the new business fits the dominant management logic. In
the absence of obvious relationships between businesses, claims that economies
of scope derive from a dominant management logic are difficult to defend.
Richard Branson’s business empire is a good example of a highly diversifed port-
folio with nothing obvious to bind it together. In the late 1990s there were 27
companies in the group arranged in divisions:
 Travel and Tourism, including Virgin Atlantic Airways, Virgin Clubs and Hotels
and Virgin Airships and Balloons;
 Retail and Cinema;
 Media and Entertainment, with companies in publishing, television and radio;
 Consumer Products, including Virgin Cola, Virgin Jeans and Virgin Cosmetics;
 Design and Modelling;
 Financial Services, which is a major venture in the direct selling by telephone of
financial products.
A possible linkage among these enterprises is the dominant management logic of
Branson himself, which is characterised by a high level of activity and commitment.
But there is a limit to how far this resource can be spread. Another potential linkage
lies through shared reputation; while there may be a real impact here, the underlying
rationale for a relationship between cola and financial services is unclear. It is
therefore difficult to see what the individual companies stand to gain in the long
term from being part of a group which was created by an apparently random
process of diversification.
There is a good deal of confusion in most managers’ minds about the three ideas
of scale, scope and diversification. They are closely linked and may at times contrib-
ute to added value but there are no guarantees.
6.12.2 Synergy
The concept of synergy differs from economies of scale and experience effects in
that it is independent of the size of the company and total output to date; in a sense
it is the same concept as economies of scope which relates specifically to the impact
of diversification on unit cost. Synergy should also lead to the situation where a
corporation is valued at more than the sum of the value of its individual parts if they
could be separated.
It is difficult to provide a precise definition of synergy; typically it is described as
being the result of combining activities together in such a way that the whole is
greater than the sum of the parts. Because of the impact of the notion of synergy on
strategy it is worth exploring it in some detail.
Some successful companies attribute at least part of their success to synergy. It is
therefore important to determine whether synergy can be predicted and capitalised
on in formulating strategy. For example, no one would expect a synergistic effect

from a company which produces ball bearings taking over a company producing ice
cream; but is it possible to use the concept as an operational tool to tell the ball
bearing company which type of company to take over? While the idea of synergy
has an intuitive appeal it turns out to be a difficult principle to pin down in practice.
There are two problems in attempting to benefit from synergy as a consequence
of company actions. The first is to identify where the benefits of synergy are likely
to be generated. The second is that there is little empirical evidence which can guide
the company in individual situations; in other words, synergy may be little more than
wishful thinking on the part of companies engaged in expansion who have heard
that synergy is an outcome of diversification.
Synergy is often described as an almost mystical and unpredictable effect which
makes itself apparent in cost and marketing advantages but without being explicit
about the mechanism which actually causes these effects. There are in fact a number
of areas from which the effects of synergy are likely to originate.
 Corporate Management
There may be possibilities for individual SBUs to share common indivisible re-
sources, and to eliminate excess capacity. However, this is not a case of 2+2=5,
but simply making the optimum use of capacity. This benefit is more properly
the outcome of efficient production management. A different corporate man-
agement issue is that similarity among SBUs may make them more amenable to
management than a series of SBUs in unconnected markets. This begs the ques-
tion of what is meant by ‘similar’. An SBU which has recently been added to the
company may produce similar products, but may have a management structure
and ethos which is totally alien to the acquirer. Synergy at the corporate level
may be identifiable after the event, but whether the addition of any given SBU to
an existing company would generate a positive synergistic impact is impossible to
predict.
 Economies of Scale
While synergy is different from economies of scale, it is possible that some di-
mensions of scale economies can be captured by diversification into similar
products. This is because there may be a carry over from experience in similar
production and selling environments, and is obviously similar to economies of
scope; operating in a series of similar markets has elements of doing more of the
same thing, which is the notion of scale and experience effects. This argument is
not very compelling to the economist, whose rigorous definition of economies
of scale takes into account the optimum deployment of labour and capital. The
mere fact of expanding some functions is no guarantee that scale economies will
result.
 Vertical Integration
The potential for economies is discussed at Section 6.12.3. These economies are
related to capacity utilisation, transport costs and so on that are the result of
more efficient use of resources, and do not really accord with the notion of
2+2=5.

 Capacity Utilisation
A company may have concealed excess capacity, in the sense that its labour force
could undertake additional tasks without significant increases in wages or num-
bers employed, factory space may not be fully utilised, and so on. The potential
benefit resembles that of similar SBUs making use of each other’s spare capacity
from time to time. But realising and deploying this excess capacity is not straight-
forward; if there is no overall plan to coordinate capacity usage across SBUs any
benefits are likely to be opportunistic and unpredictable.
 Joint Production
The effect of joint production on identifying cost was discussed at Section 6.6.
Take the case of two sheep farmers, one of whom produced only wool and the
other produced only meat. If they were to merge their operations there would
obviously be scope for the original sheep to produce both wool and meat. But
whether there is significant scope for capitalising on potential joint production
possibilities in complex modern companies is unknown.
 Innovative Stimulus
The mere fact of incorporating another area of activity may spark off new ideas
and approaches. While this is an undoubted possibility, it is unlikely to be pre-
dictable.
Even a rudimentary examination of the sources of synergy throws up an im-
portant point: while synergy may exist it is unlikely to be predictable unless there is a
clear resource sharing effect. From the strategy viewpoint there is no basis on which
to conclude that a particular course of action would lead to a predictable reduction
in costs due to synergy. Synergy is the outcome of complex interaction effects
specific to individual companies, with the contributing factors varying from case to
case. To put the potential benefits from diversification into context, bear in mind
that some of the most successful companies in history have stayed with their
original product, and everyone knows about them. Coca-Cola, Pepsi-Cola and
McDonald’s are worldwide brands, and these companies have truly ‘stuck to the
knitting’.
6.12.3 Vertical Integration

Every product has a supply chain which starts from the extraction of raw materials
and involves manufacture, distribution and sales to the final customer; a woollen
garment starts as grass in a field which is turned into a sheep which produces the
wool which is sheared and spun into yarn which is knitted into a garment in the
latest fashion which is distributed to stores and so on. Vertical integration relates to
the part of the supply chain which is controlled by a company. Forward integration
occurs when a farmer becomes involved in the marketing of wool to garment
manufacturers; this is the role of the British Wool Marketing Board which attempts
to give British farmers more control of the prices and end uses of their product.
Backward integration occurs when manufacturers purchase farms, perhaps with the
intention of ensuring the supply of certain types of wool, although there are
probably very few instances of this happening. The degree of vertical integration is

closely bound up with the business definition of the company as discussed at

Section 3.2.
Every company is to some extent vertically integrated. But what is the rationale
for vertical integration? This comes down to the well-known question of whether
the company should make something itself or buy it from some other company.
There are various potential benefits and costs of using the market rather than
producing internally. The benefits include the following.
 Market firms can achieve economies of scale which the company’s purchases
would be insufficient to generate on their own.
 Market firms are subject to the discipline of market competition; it is unneces-
sary to implement rigorous internal controls to ensure efficiency.
The costs include the following.
 The coordination of production flows may be compromised because the supplier
may have other priorities from time to time.
 Private information may be leaked to competitors who also use the same
suppliers.
 Transaction costs may be incurred.
Thus a company has to balance up the efficiency benefits of using the market
against the fact that using the market can expose it to risk. But there are also some
specific costs associated with internal production which have to be brought into the
equation.
 There can be a mismatch in the optimal scale of production between stages of
production. It is unlikely that scale economies will be achieved at the same out-
put for the different products.
 Business at different stages can be radically different and present different
strategic problems.
 The risk inherent at each stage ceases to be independent and risks which affect
one stage will have an effect on other stages of production. This compounding
of risk is an often overlooked cost of vertical integration.
The decision on vertical integration therefore involves making complex trade-
offs; to make a rational choice it is necessary to recognise that there are two
incorrect arguments commonly used to justify making rather than buying in from
the market.
 To avoid paying a profit margin to other firms – it is not whether the supplier
makes a profit that is important, but whether the profit made is higher than
could be made by the company were it to undertake the activity itself. Given a
lack of experience and scale effects this is doubtful.
 To avoid paying high prices during periods of peak demand or scarce supply –
again it is relative profitability which is relevant; if the supplier operates in a
competitive market the company could not make the product any more cheaply
because the higher price reflects higher input costs.

On the other hand, it needs to be recognised that a complete contract with a

market supplier cannot be achieved in the way that an internal contract can. There
are at least four reasons for this.
 Life is too complex to draw up a contract which can take all eventualities into
account; the contract arrived at depends on the extent of bounded rationality, i.e.
at what point it is decided that additional contractual clauses are not worthwhile.
 There are severe difficulties involved in specifying and measuring performance
with any accuracy; for example, defining the thrust of an engine exactly and then
predicting its wear and tear over time.
 Neither party is willing to reveal all information to the other, and this may place
the buyer at a disadvantage. Asymmetric information is a feature of the
principal–agent problem.
 A potential difficulty that most companies are aware of is the ‘holdup’ problem:
a party in a contractual relationship may be able to exploit the other party’s vul-
nerability once the contract has been agreed. This is an example of the prisoner’s
dilemma where the parties have an incentive to default.
There are a number of factors that may lead to a better resolution of these prob-
lems by vertical integration rather than arm’s-length market contracting.
 Vertical integration gives access to more powerful governance structures in the
sense that disputes can be settled by internal administrative processes.
 Because of the guarantee that the internal relationship will be continuous and
must be lived with there is more incentive to get things right. One resolution to
the prisoner’s dilemma was that both parties would be committed to collaborate
for an unspecified time.
 Vertically integrated divisions may be more likely to behave in a cooperative
fashion because they see themselves bound together in a common purpose.
But there is no guarantee that these influences will actually lead to a more effi-
cient resolution of any of these problems, particularly holdup; it may well be that the
holdup problem is something that has to be lived with. In principle, to remove the
holdup problem implies controlling all inputs to the process, and even vertical
integration does not resolve that because inputs have to be purchased no matter
how far backwards the integration goes. Furthermore, if the company decides to
make rather than buy in competitive markets, it will face the usual principal–agent
problems. Another major problem is that the internal pricing system must perform
the same function which the market would have performed, otherwise it becomes
impossible to monitor the performance of different sections of the vertical chain
and identify where value is being created. For example, internal prices which are
based on accounting conventions rather than market conditions are likely to provide
misleading cost signals.
Another option is a hybrid solution: allow managers the option of buying from
outside suppliers if their price is lower. This has the effect of applying the discipline
of the market to the components of the vertical chain.
An argument against vertical integration in principle has been the concern that
companies would grow so big that they would dominate their markets and then be

in a position to hold consumers to ransom. But this is not how it works in practice.
Take the case of a vertically integrated company with substantial monopoly power
such as British Gas, and track the product from discovery of gas supplies through
distribution to the final consumer. Should British Gas do its own exploration,
production and distribution? If not, should it in fact exist as a vertically integrated
company in the first place? In the 1990s the stockbroker Kleinwort Benson pro-
duced an analysis of the break-up value of British Gas compared to its current share
price value. The analysis was as shown in Table 6.10.
If the analyst was correct the break-up value was about 25 per cent higher than
the corporate value. One reason for this is that the vertically integrated company is a
conglomerate of companies each operating in a completely different market. For
example, British Gas ‘bought’ internally both exploration and retail services. The
study demonstrated that British Gas achieved few real benefits from vertical
integration.
Table 6.10 Break-up value of British Gas

Division Asset value Trading value Value per
(£bn) (£bn) share (p)
Pipelines 11.5 6.6 155
Distribution 3.1 2.9 68
Exploration/production 5.3 3.4 80
Other 1.7 1.0 24
Net debt 2.5
Total 19.1 13.9
1992 share price 259
Source: Kleinwort Benson.
It is clear from the discussion that the attempt to increase the scope of the com-
pany by vertical integration raises many complex issues. But there is a good deal of
nonsense written in business books about vertical integration. It is often asserted
that the benefits of vertical integration are self-evident so they hardly need to be
discussed. The process is also characterised as ‘capturing’ suppliers or customers;
this, of course, is based on a military interpretation of strategy – what is more likely
is that the company will ‘capture’ a major liability.
6.13 The Value Chain

A company can be visualised as a chain of value producing activities which starts
with inputs at one end and sales at the other; the overall value is represented by
profitability, but it is difficult to disaggregate company activities in such a way that
the contribution of each to value production can be identified. Porter32 tackled this
problem by breaking the value chain down into two main components: primary
activities, which are basically the logistics of production and sales, and support
activities, which are necessary for the effective functioning of the company.

The primary activities are:

 In-bound logistics: receiving, storing and handling inputs to the production
process.
 Operations: transforming inputs into outputs; this is the physical process of
making, testing and packaging the product.
 Out-bound logistics: moving the product from operations to buyer in the case of
a tangible product, and bringing the buyer to the product in the case of many
services.
 Marketing and sales: providing the buyer with information, inducement and
opportunities to buy the product.
 Service: maintaining the value of the product.
While this is a useful classification of primary activities it does not necessarily fit
well with all organisations so it is usually necessary to use judgement in constructing
a value chain. The primary activities cannot operate on their own but need support
in a variety of ways.
The support activities are:
 Procurement: the process by which resources are acquired.
 Technology development: the technology associated with each of the value
activities, including learning by doing, product design and process development.
 Human resource management: the whole business of managing the workforce.
 Management systems: including quality control, finance and operational plan-
ning.
The notion of value Porter used is how the ultimate user views the product in
relation to competitive products. Unfortunately this is almost impossible to meas-
ure, and it is usually necessary to use other measures, such as operating margin,
profit or shareholder value. The value chain is not just a tool for analysing company
effectiveness and identifying the basis for competitive advantage. An understanding
of the value chain is important for identifying strategic options as it helps to provide
an overview of the strengths and weaknesses of the company in a competitive
setting.
Simply disaggregating the activities of the company into a chain and analysing the
components may not tell the whole story because the linkages between value
activities contribute to competitive advantage. This has implications for strategy,
because while competitors can copy success in identifiable areas such as distribution
channels or resource management, it is almost impossible to replicate the linkages
among the components because these are unique to the company. The ability to
capitalise on company characteristics which are embedded in the organisational
structure is one of the underlying factors which contribute to sustainable competi-
tive advantage. Marks & Spencer, the British retailer, used to be famous for the
linkages which it established with producers and the resulting guarantee of high
quality; it was also a leader in human resource management which was also linked to
a high standard of customer service. While each of the elements in the Marks &
Spencer value chain could be imitated, it turned out to be almost impossible for
other retailers to imitate the linkages between them; as a result Marks & Spencer

retained its place as one of the most profitable retailers in the world for several
decades. However, by 1998 some serious problems with the value chain had
emerged; for example, weaknesses in Marks & Spencer’s procurement policies led to
a build-up of unwanted stocks amounting to about £150 million. The image of
quality and value which had been built up by purchasing from British suppliers was
undermined by switching to foreign suppliers because British suppliers were
relatively expensive. To cap it all, a series of board room battles undermined the
company’s image as a leader in human resource management. As these problems
with the value chain emerged, it came as no surprise that Marks & Spencer sales and
profits fell dramatically at the end of 1998 and the share price fell by 14 per cent.
The following example shows how a value chain that can confer competitive
advantage may be constructed. The potential for competitive advantage does not lie
in effective performance of each activity because that can always be imitated. It lies
in the fact that the activities are integrated and that the chain is capable of respond-
ing effectively to change. The ‘Reaction to increased competition’ column shows the
type of changes that the value chain must be capable of to provide an effective
response to a competitor who has launched a higher quality product.
Value chain Effective operation Reaction to increased

competition
Primary activities
In-bound Efficient warehousing and JIT Adapt warehouses and im-
logistics inventory control prove inventory control
techniques
Operations Quality circles Improve quality control
Benefit from experience effect
Out-bound Develop distribution channels Improve delivery standards
logistics
Marketing Position product in ‘success Promote positive image
and sales likely’ sector
Service Establish customer Demonstrate features of
relationships improved product
Aim for repeat orders
Support activities
Procurement Negotiate effectively Identify new suppliers
Technological Continuously improve and Focus on production quality
development differentiate product improvements
Human Provide incentives aligned Design new quality orientated
resource with objectives training programmes
management
Management Develop competences Identify new competences that
systems Management development relate to quality
programmes

A weakness in any one of the ‘Effective operations’ can have a serious impact on
the operation of the value chain as a whole. For example, poor inventory control
can lead to high costs and inability to meet the orders produced by the marketing
effort. But it also emerges that if any activity is incapable of change in the face of
competitive action the resulting value chain will be equally ineffective. For example,
if it is not possible to identify the required product improvements the company will
lack the right product to meet the challenge.
The development of competitive advantage rests in the creation of an organisa-
tion that can achieve excellence in each activity and keep on doing so. That depends
on the changes in each activity being in harmony, for example there is little point to
implementing the new marketing strategy before the improved product is ready for
production. It is the uniqueness of such a value chain and the difficulty of imitating
it that results in sustainable competitive advantage.
The question then arises of how to create such an organisation. That requires
management of the value chain as a whole and an understanding of the linkages
among the components. The value chain is not a set of consecutive actions that
have to be executed in turn: it must be visualised as a holistic system and that,
needless to say, is very difficult to achieve. There is no doubt that the idea of
constructing a competitive value chain is a difficult area both conceptually and
operationally. It is not surprising that very few companies fully understand their
value chains and CEOs are continually perplexed by the inability of their organisa-
tions to recognise and react to competitive challenges.
6.14 Competence
The fact that competition exists among companies at all, and that companies are
continually going out of business and being replaced by others, suggests that
different companies are relatively good at different things at different times. The
aspects of competitive performance which a company is relatively good at are its
capabilities, or competencies (both terms are widely used). The notion of distinctive
competencies relates to all of the characteristics of a company which give it a
competitive edge. The value chain discussion demonstrated that it is not so much
being particularly good at one thing which generates competitive advantage, but the
integration of competencies into a value-generating chain. This is because individual
competencies can be imitated and hence do not generate sustainable competitive
advantage, while the benefits of organisational integration are much more difficult
to identify and copy. Thus while technique based competence is a necessary
condition for competitive advantage it is not a sufficient condition: it is also
necessary to have the competencies combined in such a way that the resulting
organisation cannot be readily imitated.
The notion of core competencies arises from addressing the question of what
business the company should be in. This question is of importance to companies
involved in restructuring, delayering, downsizing or however they choose to
describe their attempts to rationalise activities. But it is also important to companies
which are concerned with expansion, and feel that they have the capability to grow

and thrive, but are perhaps not sure what is the source of their competitive ad-
vantage.
The idea of core competencies was introduced at Section 1.2.6. Prahalad and
Hamel developed the concept of core competence primarily to understand the basis
of competitive advantage for large diversified corporations; they used the example
of two large companies in the evolving information technology business; these were
NEC, which, they contended, adopted a core product approach, and GTE which
maintained an SBU mentality. Prahalad and Hamel attribute the success of NEC
compared with GTE to the approach it adopted to competence.
As a first step they argue that the collective learning in the organisation must be
able to:
 coordinate diverse production skills;
 integrate multiple streams of technologies; and
 organise work to deliver value.
This can be visualised as the effective management of a complex value chain that
has many products and processes at each stage; organisational learning is the ability
built up over a period to perform these functions better than competitors. To
achieve this it is necessary to develop an ethos within the company that promotes
 communication;
 involvement; and
 commitment.
A workforce that is well informed, where individuals feel part of the process and
are committed to organisational objectives is clearly a precondition for the imple-
mentation of an effective value chain.
Large companies are typically organised into strategic business units (SBUs) for
the historical reasons discussed in Section 1.5. While acknowledging that the SBU
approach has led to major improvements in effectiveness compared with centralisa-
tion Prahalad and Hamel argue that a hidden cost is that it leads to a mindset within
SBUs that runs counter to the development of company-wide core competences.
This conventional SBU mentality leads to:
 Under-investment in developing core competencies. This is because the SBUs
concentrate on their own effectiveness without taking a wider view of their link-
ages with the rest of the company.
 Imprisoned resources within the SBU. While the principles of capital budgeting
are understood as a method of allocating resources there is no comparable
mechanism for allocating human skills that embody core competencies.
 Bounded innovation. Individual SBU managers will pursue only those innova-
tions which relate to their own operations and will ignore, or not recognise the
importance of, hybrid opportunities.
The message which comes across is that the organisation of a company into
SBUs may be highly efficient, but if SBU autonomy is carried too far it may stand in
the way of developing sustainable competitive advantage. Furthermore, the capital
budgeting approach to resource allocation may be inappropriate because it is not

possible to relate future cash flows to core competencies. But this still does not
answer the question of what comprises core competence. Because of the difficulty
of identifying core competence in a conceptual sense, it is easier to say what it is not.
 Outspending competitors on R&D.
 Sharing costs, for example, SBUs sharing excess capacity.
 Vertical integration.
Core competences are not the outcome of R&D expenditures, in fact the pursuit
of new products may dilute existing competences; shared costs are one of the
potential dimensions of synergy and vertical integration raises fundamental issues
regarding the business definition. To identify a core competence there are three tests
which can be applied:
 it gives potential access to a wide array of markets;
 it makes a significant contribution to perceived customer benefits of the end
product; and
 it is difficult to imitate.
The key test is that the competence is difficult to imitate. Because they are so
difficult to generate core competencies are likely to be relatively rare, and Prahalad
and Hamel reckon that there are probably no more than five or six per company. If
they are difficult to imitate they are also probably difficult to recognise, but if they
are not recognised companies can unwittingly surrender core competencies when
contracting out or divesting. It is therefore essential to distinguish between divesting
a business and losing a core competence. By its nature, the cost of losing a core
competence cannot be calculated in advance, but it may lead to a significant
reduction in company performance. Furthermore, a core competence may take a
decade or more to build up – so with no core competence a company will find it
difficult to enter emerging markets. Prahalad and Hamel contend that the superior
performance of NEC over GTE was due to NEC’s conformance with the core
competence approach. But with the passage of time their conclusions appear to be a
little less secure. While NEC performed better than GTE, during the 10 years up to
1996 NEC’s shares lagged behind the average of the stock market by 28 per cent; in
fact, much of its financial success was due to its semiconductor business which was
boosted by the world shortage of memory chips. Critics have also argued that until
1991 NEC was organised in ten vertically integrated divisions which were controlled
by powerful and independent leaders in a manner which was not conducive to
synergy. It was only in 1991 that the company was reorganised into three horizontal
groups, which was one year after Prahalad and Hamel completed their study. While
this perspective does not necessarily invalidate the argument put forward by
Prahalad and Hamel the fact that the evidence is so mixed demonstrates just how
difficult it is to activate competence as a source of competitive advantage.
It follows that core competencies lead to core products, but it may be as difficult
to identify a core product as a core competence. For example, a core product might
be a component rather than a complete end product; at one time Canon supplied 84
per cent of laser printer ‘engines’ but had only a small percentage of the laser printer
market. Thus end-product market share may not reflect the underlying core
competence. Core competencies can be viewed as the pool of experience,

knowledge and systems, etc. that exist in the corporation as a whole, and do not
reside within any given SBU, which can be deployed to reduce the cost or time
required either to create a new strategic asset or expand the stock of an existing one.
The discussion so far has focused on the difficulty of defining and identifying a
core competence, so it might be concluded that it is an intangible and unique
attribute of certain successful companies. But using the main characteristics of core
competences the following list shows how these relate to the core competence of
effectively managing the value chain in the company whose value chain was analysed
in Section 6.13.
Core competence Value chain management

characteristic
Difficult to identify The competence is spread across several
managers
Difficult to imitate The management group is comprised of a unique
set of individuals with their own
incentives and commitment
Do not reside within SBUs Each SBU is regarded as part of the value chain
Relatively rare Even this one core competence has the potential
to generate competitive advantage
This core competence of value chain management is embedded within the com-
pany and it is doubtful if the individuals involved could replicate it in a different set
of circumstances. Compare this with the statement by the CEO of a high tech start-
up company ‘Our core competence is innovation: we invent and deliver new
products to the market’. On reflection, this interpretation of innovation suggests
two core competencies: inventiveness and delivery to the market. These measure up
against the characteristics as follows.
Core competence Inventiveness Deliver

characteristic
Difficult to identify Certain individuals are The route to market in-
known to possess the volves development,
ability to invent marketing, etc.
Difficult to imitate No one has a monopoly on Venture capitalists specialise
inventiveness in bringing new products to
the market
Do not reside within Inventions usually emerge It is the job of SBUs to
SBUs from the R&D department, deliver to the market
which can be regarded as
an SBU
Relatively rare New ideas and inventions New products are brought
appear all the time to the market all the time

Neither ‘inventiveness’ nor ‘deliver’ has the characteristics of a core competence

because there is nothing particularly unusual about them in terms of the characteris-
tics; the CEO may feel that the combination of both is a unique attribute that
amounts to a core competence; but while the combination may be relatively rare it is
certainly not unique. This analysis possibly reveals one reason that so many high
tech start-up companies fail: they thought they had a core competence when in fact
they did not.
A technique for using the concept of competencies using categories of compe-
tence which can be utilised in diversification, rather than attempting to define
competencies precisely, was developed by Chiesa and Manzini.33 They start by
identifying three levels of competence.
 Systems, which comprise the goals, culture and organisational design of the
company; it is at this level that the opportunities for diversification are identified.
 Distinctive capabilities, which are the repeatable patterns enabling the coordinat-
ed and integrated deployment of knowledge and resources within the company.
These can be exploited in the process of diversification by transferring bundles
of skills and technologies.
 Core inputs, which can be exploited for different or new products and services
in new markets.
These levels of competence can be decomposed to routines and resources; for
example, the distinctive capabilities are essentially routines, while the core inputs are
resources. The form of diversification can then be classified depending on whether
it is based on routines and resources currently residing within the company or
routines and resources which have to be acquired or developed.
Acquired Routine based Unrelated
Resources
Current Replication based Resource based
Current Developed
Routines
Figure 6.7 Competence based diversification

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

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. ScottishPower is one
of the biggest companies in Scotland and diversified from being an electricity utility
company into water, gas and telecommunications. New resources were required for
several of these new products but the top management claimed that the same
competences (or routines) were relevant for the management of different types of
utility. In particular, the customer could be provided with a package deal covering
electricity, gas, water and telecommunications. It was claimed that existing systems
and distinctive capabilities provided a strong set of routines that served as the basis
for diversification.
Resource Based Diversification

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

This should be the least risky form of diversification because it is based on an
expansion rather than a change in the form of the organisation. A major change in
the British financial market in the past few years has been the diversification of
building societies (which are mutually owned organisations) into providers of the
full range of banking services. Previously building societies had specialised in
providing mortgages for house purchase, and typically charged relatively low rates to
borrowers and paid low (but safe) interest rates to savers. During the period up to
the mid-1980s, when they were the only providers of housing finance, there was an
imbalance in supply and demand in the market for housing finance and building
societies had to ration available funds. When banks started competing in this market
the building societies found that a substantial part of their business was lost, and
they reacted by diversifying into activities previously undertaken only by banks. The
building societies utilised their existing resources, in the form of a network of

branches and experienced personnel, and applied the routines which they already
had for the management of house finance to a wider range of services. It could well
be that replication based diversification is the underlying reason for the success of
building societies in the highly competitive personal financial sector. During the
mid-1990s several building societies were floated on the stock exchange, and this
resulted in large windfall gains for mutual shareholders, reflecting the enormous
value added which their replication based diversification had produced.
Unrelated Diversification
This is the extreme form of unrelated diversification where the only resource shared
is the financial structure and control system. There are, of course, numerous
examples of companies which have diversified into areas which are unrelated in
terms of resources and routines; the Virgin business portfolio outlined in Section
6.12.1 is an example. It seems fairly obvious that diversification is particularly risky
when the firm has to acquire new types of resources and manage them using
routines with which it is unfamiliar. It could be argued that much of the Virgin
portfolio is in the ‘entertainment’ business and these businesses are therefore
related. But it is worth considering the resources and routines required to produce
tourism, cinema, TV and publishing; this would give a different answer on related-
ness. It is probable that few boards consider possible diversification strategies using
this type of classification, and hence tend to embark on the process without a clear
notion of how far from the core activities of the company a particular diversification
is taking them.
Diversification Trajectory
A closer examination of ScottishPower shows how the trajectory might vary from
what was intended. The ScottishPower board had described diversification as being
primarily routine based. The first acquisition was replication based: ManWeb was
another electricity company in England that needed to be made more efficient. The
next step was routine based: Southern Water was a medium sized water company in
the south of England and benefited from ScottishPower’s competence as a utilities
operator. ScottishPower then moved into the unrelated area by developing a
telecommunications business that did not share either routines or resources. Finally,
ScottishPower moved back to replication based diversification by taking over
PacificCorp, a US electricity company. The trajectory then went into reverse:
ScottishPower divested its telecommunications business and its water utility. It
therefore ended up with only its replication based diversifications, i.e. other electrici-
ty companies. (PacificCorp was also sold but this was because of problems specific
to the US energy market.) The withdrawal from water and electricity could have
been due to the fact that the board did not recognise at the time just how far away
from their core activities the diversification trajectory was taking the company and
the risks involved. Having retracted to its core electricity business ScottishPower
was acquired by the Spanish energy giant, Iderbola. It is possible that the long-term
impact of a decade of poorly understood diversification weakened ScottishPower
and made it a target for takeover.

6.15 Strategic Architecture

The way in which the company’s collection of unique attributes is combined
together is known as strategic architecture. The strategic architecture of the compa-
ny is derived from the idea of the value chain and the core competencies upon
which competitive advantage is based. Firms establish relationships with their
employees (internal architecture), with their suppliers or customers (external
architecture), or among a group of firms engaged in related activities (networks). In
principle, the value of architecture lies in the capacity of organisations to create
organisational knowledge and routines, to respond flexibly to changing circumstanc-
es and to achieve open exchanges of information. Each of these creates an asset for
the firm in the form of organisational knowledge which is more valuable than the
sum of individuals’ knowledge, and organisational flexibility.
It is difficult to apply the notion of strategic architecture as an operational tool.
First, strategic architecture is unique to every company; if it were not so, then it
could be imitated and would not contribute to sustainable competitive advantage. It
has already been discussed how value chain analysis did not fully describe Marks &
Spencer because of the linkages between elements in the value chain. 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 ad-
vantage is sustainable. It was discussed at Section 5.10.1 that with the conditions
which prevail under perfect competition there is no such thing as competitive
advantage. It is only when the conditions for perfect competition are not met that
an opportunity arises to make monopoly profits. The trouble is that these monopoly
profits are always under threat. Existing competitors become more efficient, or copy
what relatively efficient companies do, and unless there are effective barriers to
entry the fact that monopoly profits are being made will act as an incentive for new
entrants. Therefore any advantages which the company has must have certain
characteristics which make it difficult for other companies to emulate what they do.
There are two sources of potentially sustainable competitive advantage: those based
on the company’s market position and those based on the internal strengths of the
company; the former are termed strategic assets and the latter distinctive capabilities.
Strategic assets are in fact the structural barriers to entry discussed at Section
5.10.3:
 relative size of the market;
 sunk costs;
 control by legislation or agreement;
 economies of scale and experience effects.
Distinctive capabilities include the following:
 architecture;
 reputation;
 innovation; and
 core competences.

It emerges from the previous discussions that the only way to achieve sustainable
competitive advantage is to do things which competitors cannot imitate, or find too
costly to imitate. Two main factors contribute to the protection of competitive
advantage:
 Causal ambiguity: it is difficult to establish exactly what characteristics of the
company contribute to its success. This is the reason why architecture and core
competencies are so important: the architecture is unique to the company, and
core competencies are difficult to identify.
 Uncertain imitability: because of the causal ambiguity, potential competitors are
faced with uncertainty as to whether their attempt at imitation will work.
It might seem surprising that the factors contributing to competitive advantage
are so difficult to identify. You look around the world and see companies which
have been highly profitable for a long time, and it is tempting to attribute this to
lower costs, superior products, better reputations or whatever. But you have to ask
why such companies have such attributes in the first place; this is not easy to answer
given that competitors always have an incentive to enter the market in pursuit of
high profits. The fact is that very few firms have been able to generate long run
competitive advantage.
The use of the expressions ‘short run (or short term)’ and ‘long run (or long
term)’ leads to a great deal of confusion, particularly when applied to the notion of
competitive advantage so it is necessary to clarify the meaning in the strategic
context. The terminology is made more complicated by the use of the term ‘sustain-
able’ which, when applied to competitive advantage, means much the same thing as
‘long run’; in the following discussion ‘sustainable’ and ‘long run’ can be inter-
changed. There are several strategic operational definitions of the short and long
run; for example, the difference can be expressed in terms of the time period in
which performance is measured: the short run could be profitability targets in the
next two years while the long run could be profitability on a recurrent basis over a
five year horizon. But this type of definition is arbitrary and actually misses the
point: the difference is one of type rather than of time period.
In economics the terms have particular meanings that are not related to actual
time periods, i.e. the short run is the period in which only one factor of production
varies, while in the long run all factors are variable; this distinction is essential for
understanding ideas such as economies of scale. In strategic terms the distinction is
between actions that are intended to deal with immediate issues, such as reducing
cost to avoid bankruptcy, rather than those that deal with the basis on which the
company competes, such as building competences, developing a portfolio and
adjusting market position to generate competitive advantage. There is often a
conflict between the need to deal with the immediate imperatives and building long-
term competitive advantage; these conflicts are a permanent feature of companies in
a volatile environment in which there is a continual need to make trade-offs. This
situation greatly complicates the pursuit of competitive advantage because the long
run objective is continuously obscured by immediate concerns; this is one reason
why many organisations find it difficult to ‘think strategically’.

This was one of the major issues that arose in the Mythical Company case devel-
oped in Module 1: the management team had agreed about the basis on which the
company would compete but immediate events made it virtually impossible to
pursue the CEO’s vision. There is actually quite a lot involved here. You might find
it instructive to review the Mythical management team’s strategic intention in
relation to the kind of short-term problems that arose: in the Rittel sense the team
had identified the root cause of the company’s problems and was going to tackle it.
The recognition of the problem was almost the same as solving it. But individually
they were forced to come up with a short-term fix to their immediate problems, i.e.
to delay. In real life it is often found that short run solutions are proposed for a long
run problem because it is not recognised for what it is: the loss of competitive
advantage.
The economic and strategic definitions can be characterised as follows:
Time period Economics Strategy

Short run Vary one factor of Deal with cash flow problems, react
production to competitors, seize new
opportunities
Long run Vary all factors of Develop a linked portfolio, build on
production core competence, focus on generic
strategies
There is a parallel between the economic and the strategic definitions in the sense
that both are based on concepts rather than defined time periods. Long run
competitive advantage cannot be expected to last forever – its duration will depend
on how long it takes competitors to build an equivalent advantage.
While it is difficult to define long run or sustainable competitive advantage, it is
instructive to consider the characteristics of a ‘Cash Cow’ which contribute to
competitive advantage. Table 6.11 shows some of the main elements of competitive
advantage in a stable market where a company has a relatively high market share.
Table 6.11 Competitive advantage in a stable market: Cash Cow

Characteristic Advantage Source
High market share Relatively low cost Asset
No new customers Barrier to entry Asset
Customer loyalty Reputation Distinctive capability
Fixed plant capacity Full utilisation Asset
Stable labour force Top of experience curve Asset
This is not an exhaustive list of the elements of competitive advantage but it

emerges that the competitive advantage of a Cash Cow is based on a combination of
strategic assets and distinctive capabilities. If the product has a relatively high
market share, but does not appear to have a cost advantage, it is necessary to
determine whether this is because of poor resource management or because

economies of scale and experience effects are insignificant; analysing the value chain
might throw some light on this. The fact that there are no new customers in a
stable market is a potential barrier to entry. However, if companies are entering the
industry and taking away customers, this suggests that the company is not satisfying
customers as well as competitors are. Since customer loyalty is established, the
resources devoted to marketing can be reduced; if selling costs are still high the
marginal product of marketing resources may be very low. Since demand is stable, it
follows that production can be stabilised and resources geared to the level of
demand, resulting in fixed plant capacity. If capacity is not fully utilised it may be
because of indivisibilities; this can arise because production machinery is available
only in certain sizes. Finally, a stable labour force has the potential to progress up
the learning curve; this potential will not exist if turnover rates are high.
There is no guarantee that the competitive advantage associated with a Cash Cow
will be sustainable. The mix of strategic assets and distinctive capabilities certainly
constitute a barrier to entry but how long it will last is unknown.
Finally, the value chain can be combined with many competitive ideas to assess
the company’s strategic capability (see Table 6.12).
Table 6.12 Assessing strategic capability

Dimension Issues
Primary activities
In-bound logistics Bargaining power of suppliers
Operations Benchmarking
Experience
Synergy
Economies of scale
Out-bound logistics Distribution channels
Marketing and sales Market share
Bargaining power of buyers
Pricing
Quality
Service Repeat orders
Support activities
Procurement Vertical integration
Economies of scope
Technological development Innovation process
Human resource management Culture
Leadership
Management systems Dominant logic
Competence
Linkages Architecture

Dimension Issues
Profitability Definition of profit

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

In Section 4.9 and Section 5.15 the various factors relating to the national, interna-
tional and market environment were combined together into an Environmental
Threat and Opportunity Profile. The same approach can be used for the internal
characteristics of the company by constructing a profile which summarises where
competitive strengths or weaknesses are likely to lie. An attempt can then be made
to rank the strengths and weaknesses to generate a balanced view of the company
and its potential. An example of a profile is as shown in Table 6.13 for a company
which produces electronic engine controls. This is not a definitive profile and there
are various ways of setting it up; for example, the components of the value chain
could be used as the classification.
A detailed analysis of each characteristic requires the application of most of the
ideas developed in this and other modules. A relatively brief discussion of each is
presented below. Bear in mind that it may not always be possible to classify a
particular characteristic unambiguously as a strength or a weakness.
Table 6.13 Strategic advantage profile

Internal Competitive strength (+) or weak-
area ness (−)
Research + Recently invented a temperature control
− Team has a narrow vision
Development + Reduced lead time by 15%
− Costs are usually overrun by 20%
Production + Working at full capacity
− High labour turnover rate
Marketing + Computerised customer databank
− Lack of technically qualified salespeople
Finance + Share price is buoyant
− Lack of liquidity

RESEARCH
STRENGTH: A NEW CONTROL SYSTEM
The invention of a new temperature control mechanism could be the beginning
of a series of related products and refinements. The company may have a core
competence in this area.
WEAKNESS: NARROW VISION
This technology is notoriously susceptible to competition from similar develop-
ments once the basic idea has been launched because it can be imitated. Because
of the enthusiasm for the latest invention the whole research department is now
devoted to working on it, but the real potential for maintaining a competitive
edge may well be to concentrate their efforts elsewhere. The task culture can lead
to a limited vision.
DEVELOPMENT
STRENGTH: QUICKER TO MARKET
As a result of improved communications between marketing and development,
the engineers saw the benefit to the company from first mover advantage, and
identified areas where development compromises can be made which have re-
duced lead times. This linkage improvement will increase the effectiveness of the
value chain.
WEAKNESS: COST OVERRUNS
Unfortunately, it has not been possible to control development costs, and new
products which looked initially attractive have turned out to be dubious invest-
ments; with the increased pressure to meet tighter deadlines overruns may
increase. An early application of sensitivity analysis would have helped to predict
the likely scale of these issues and the implications for cash flows.
PRODUCTION
STRENGTH (OR WEAKNESS): EFFICIENT CAPACITY
UTILISATION
The company is currently operating at full capacity, with the implication that a
system exists which can control costs. However, if the company intends to in-
crease market share, or launch new products, the fact that new capacity will have
to be acquired could lead to delays and lack of responsiveness to changes in the
market.
WEAKNESS: HIGH TURNOVER
The relatively high turnover rate means that the costs of hiring are higher than
they otherwise would be, and the labour force is on average not as far up the
learning curve as it would be if the labour force were more stable. It is partly
because of the full capacity operation that the turnover rate is so high; but it
does demonstrate a weakness in the human resource management support func-
tion.

MARKETING
STRENGTH: VAST DATABASE
Customer and potential customer details have been entered into a database, mak-
ing it possible to target specific segments and allocate marketing effort more
effectively. This strengthens the marketing element of the value chain.
WEAKNESS: SHORTAGE OF SKILLS
Customers are making increasingly sophisticated technological demands on
salespeople who are often performing the role of consultant; highly qualified
salespeople are difficult to recruit and command very high salaries. The customer
service element of the value chain is thus in danger.
FINANCE
STRENGTH: HIGH SHARE PRICE
In common with other growing high technology companies the share price has
been steadily increasing over the past three years, making the company virtually
immune from takeover attempts.
WEAKNESS: LACK OF CASH
Previous development cost overruns and the potential costs of the new control
system are likely to lead to a serious cash shortage next year. The lack of detailed
financial data makes it impossible to be more than speculative; the analysis of
data is pursued in Case 1 and Case 2.
On the face of it the company is full of new ideas, is dynamic and growing, and
has an increasing market value; it looks set to develop further on the basis of its new
product line. However, the weaknesses are formidable: the likely reliance on one
product line in a highly competitive area, the unpredictable development costs, the
problems of increasing capacity, the lack of marketing resources and the cash
constraint could combine to render the company illiquid with limited prospects of
increasing sales revenues significantly in the short term. Another way of looking at
this is that various weaknesses in the value chain have been identified despite the
fact that some actions have been taken that will strengthen some of the compo-
nents. The central issue is whether it has the resources and management to maintain
its competitive advantage.

Review Questions
Case 6.1: Analysing Company Accounts
The accounts in Table 6.14 refer to two separate years of AcmeSpend operations reflecting the large
investment undertaken to tool up for a new production line. You are going to have to analyse the company
using only these numbers but by this time you should be able to develop insights into the strengths and
weaknesses of the company.
Table 6.14 AcmeSpend

YEAR 1 YEAR 2
OPERATING ACCOUNT OPERATING ACCOUNT
Sales revenue 8 075 Sales revenue 11 466
Cost of goods sold 4 890 Cost of goods sold 5 405
Gross profit 3 185 Gross profit 6 061
Corporate HQ 500 Corporate HQ 1 000

Factory costs 200 Factory costs 500
Hire and fire 189 Hire and fire 70
New product 1 000 New product 700
development development
Total overhead 1 889 Total overhead 2 270
Operating surplus 1 296 Operating surplus 3 791
0
CASH FLOW CASH FLOW
OUTLAY INCOME OUTLAY INCOME
Material purchase 1 743 Material purchase 1 426
Short-term loan interest 260 Interest on assets 61 Short-term loan interest 0 Interest on assets 60
Long-term loan interest 220 Long-term loan interest 1 320
Wage cost 1 816 Wage cost 1 557
Line cost 1 190 Line cost 1 520
Product development 500 Product development 200
Product marketing 750 Product marketing 900
Total overhead 1 889 Sales revenue 8 075 Total overhead 2 270 Sales revenue 11 467
Total outlay 8 368 Total income 8 136 Total outlay 9 193 Total income 11 527
Net cash flow −232 Net cash flow 2 334
BALANCE SHEET BALANCE SHEET

FIXED ASSETS FIXED ASSETS
Factory 5 000 Factory 9 000
Plant & equipment 7 000 Plant & equipment 14 000
TOTAL FIXED ASSETS 12 000 TOTAL FIXED ASSETS 23 000
CURRENT ASSETS CURRENT ASSETS
Raw materials 2 000 Raw materials 1 000
Final goods 885 Final goods 448
Cash 1 000 Cash 1 000
TOTAL CURRENT ASSETS 3 885 TOTAL CURRENT ASSETS 2 448
TOTAL ASSETS 15 885 TOTAL ASSETS 25 448
OWNERS’ EQUITY 11 885 OWNERS’ EQUITY 13 448
DEBT DEBT
Short term 2 000 Short term 0

Long term 2 000 Long term 12 000

TOTAL DEBT 4 000 TOTAL DEBT 12 000
TOTAL LIABILITIES 15 885 TOTAL LIABILITIES 25 448
Note: Materials used in production were 1243 in Year 1 and 1176 in Year 2.
1 Use financial ratios to compare company performance in the two years paying particular
attention to the appropriate measure of profitability.
2 Can it be deduced that the investment programme was responsible for any increase in
profitability?
3 What strategic implications can be drawn from the analysis?

Case 6.2: Analysing Company Information

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

Operating Account ($000)
SALES REVENUE 14 304
COST OF GOODS SOLD 10 084
GROSS PROFIT 4 220
Operating Account: Overheads and Operating Surplus ($000)
Corporate headquarters 1 300
Hiring and redundancy 300
cost
Research expenditure 550
Development expenditure 1 300
TOTAL OVERHEAD 3 450
OPERATING 770
SURPLUS

Cash Flow ($000)

OUTLAY INCOME
Factory purchase Factory sale 1 800
Material purchase 2 500
Loan interest 480 Interest on assets 210
Wage cost 3 680
Line cost 1 890
Product marketing 1 500
Total overhead 3 450 Sales revenue 14 304
Total outlay 13 500 Total income 16 314
Net cash flow 2 814
Balance Sheet ($000)
FIXED ASSETS
Factory 2 000
Plant 1 000
TOTAL FIXED ASSETS 3 000
CURRENT ASSETS
Raw materials 1 000
Finished goods 2 985
Cash 3 000
TOTAL CURRENT 6 985
ASSETS
TOTAL ASSETS 9 985
OWNERS’ EQUITY 5 985
DEBT
Loan 4 000
TOTAL DEBT 4 000
TOTAL LIABILITIES 9 985
Table 6.16 Report on products

Box Lid Hinge Box Lid Hinge
Composition of Composition of supply
demand
Orders 4 590 6 120 3 840 Output 3 550 5 500 5 280
Warranty demand 100 63 63 Inventory (start 1 000 1 500 1 500
year)
TOTAL DEMAND 4 690 6 183 3 903 TOTAL SUPPLY 4 550 7 050 6 780

Distribution of supply
Warranty replace- 100 63 63

ments
Sales to backlog 0 0 0
Sales to orders 4 450 6 120 3 840
Working time (%) 130 120 100 Market share (%) 18 12 8
Labour attrition rate 11 10 4 Inventory (end 0 817 2 877
(%) year)
Price ($/unit) 1 200 900 900

Competing price 1 200 900 1 400
($/unit)
Product marketing 300 700 500 SALES REVENUE 5 340 5 508 3 456
($000)
Unit cost ($/ unit) 480 759 822 GROSS PROFIT 3 157 815 248
($000)
Cost of goods sold 2 183 4 693 3 208
Table 6.17 R & D report

Pin Holder Ratchet Pin Holder Ratchet
Predictions:
Product life (years) 5 6 7
Market at launch 35 000 40 000 50 000 Estimated market 70 000 60 000 60 000
peak
Competing price 800 1 000 1 500 Warranty returns % 3 4 5
($/unit)
Production cost 700 750 800
($/unit)
Market share (%) 9.0 10.0 14.0 Time until launch 1 2 1
(years)
Development expenditure:
This year 500 500 300
To date 1 200 1 400 1 500
You are confronted with a great deal of information and it is necessary to use every tool at your dis-
posal to glean conclusions. It is possible that some of the comments made by the managers have significant
implications for the interpretation of Acme data. You have to bear in mind that this is a snapshot at one
point in time and ideally you would like to have information on past years; however, you can arrive at
many conclusions on the basis of even this limited information. In real life you would always like to have
more information but it is necessary to make do with what you have.
Your job is to analyse the company information in the light of this discussion and build up a picture of

its current and potential profitability and of how efficiently it has been allocating resources, and to arrive
at conclusions about what it should do in the future.
1 Review Acme in terms of its corporate profitability and asset position.
2 Analyse the three products and make recommendations for each.
3 Analyse the three development products and assess their potential profitability.
4 Set up a strategic advantage profile.
Case 6.3: Lufthansa Has a Rough Landing (1993)

The well-known German airline fell on hard times after a period of expansion in the
1980s, and Table 6.18 shows how profits declined from DM260 million in 1989 to a loss
of DM301 million by 1991.
Table 6.18 Lufthansa’s record

1987 1988 1989 1990 1991
Turnover (DMm) 10 961 11 845 13 055 14 447 16 101
Pre-tax profit (DMm) 207 241 260 142 −301
Employees 47 150 49 056 51 942 57 567 61 791
Seat kilometres offered (m) 57 000 61 700 65 000 75 500 81 700
Seat kilometres sold (m) 40 000 42 500 44 900 50 600 52 300
Seat load factor (%) 70 69 69 67 64
Number of aircraft 151 155 197 220 275
Capital spending in the three years up to 1991 was DM8 billion. In 1992 Lufthansa
intended to take 26 aircraft out of service, and was looking for a partner to help
develop the US market.
The total market for air travel during the period was as shown in Table 6.19.
Table 6.19 Total air travel

1987 1988 1989 1990 1991
Passenger kilometres flown (billions) 1 600 1 700 1 800 1 900 1 800
% change from previous year 10 6.3 5.9 5.6 −5.3
Lufthansa was not alone in making losses in 1991. Four major airlines made bigger
losses, the largest loss for the year being 30 per cent higher than Lufthansa’s. The
world’s scheduled airlines in total made a loss of 0.5 per cent on revenues in 1991,
compared with a loss of 0.8 per cent on revenues in 1990.

Table 6.20 Airlines ranked by km flown

Rank Airline Million km
1 American 132 500
2 United 132 400
3 Delta 108 400
4 Northwest 86 800
5 Continental 66 700
6 British Airways 65 900
7 USAir 54 900
8 Japan Air Lines 54 700
9 Air France 53 400
10 Lufthansa 52 300
Lufthansa was the tenth largest airline in the world by 1991 in terms of the number
of passenger kilometres travelled. However, it is small (40 per cent) in comparison with
the large US carriers American and United (Table 6.20).
1 Analyse the Lufthansa strategy, assess why it is making losses, and suggest what it might
do in the future.
Case 6.4: General Motors: The Story of an Empire (1998)

By 1998 General Motors was still one of the biggest companies in the world, with over
600 000 employees and sales of over $160 billion. The company had an important
impact on management and industrial organisation during the twentieth century,
primarily because of the foresight of its founder, Alfred Sloan. During the 1920s Sloan
was the first to introduce a divisional type structure whereby the company was
decentralised and the individual parts were subjected to detailed control systems. GM
was also vertically integrated, making most of the components which went into its cars.
The company was the model for the management theorist Peter Drucker who did much
of the pioneering work in management theory during the 1940s.
But for the past decade industry analysts have criticised GM. The company’s perfor-
mance on the stock exchange suggests that it has lost its competitive edge. Until the
mid-1980s GM’s share price moved broadly in line with the market, but since then it has
fallen increasingly far behind the Dow Jones Index, and is now about 70 per cent below.
Analysts claim that the total value of GM’s shares can in fact be accounted for by its
parts company (Delphi), its financing company (GMAC) and by its 75 per cent stake in
Hughes Electronics. This suggests that GM’s industrial operation is itself worth very little
to shareholders.
How Could Such a Mighty Industrial Enterprise Reach Such a State?

One of the original strengths of GM, its divisional structure, has resulted in the duplica-
tion of many functions, such as marketing and development, with the result that GM’s
competitive advantage has been undermined over the years as world trade in cars has
become increasingly open. In fact, GM has come in for a good deal of criticism over the

years, for example its labour relations could be greatly improved: in the four years to
1998 GM suffered about 12 major strikes, while Ford had one; during 1998 it was
claimed that one strike alone cost GM $2 billion. It has been relatively slow to introduce
new products and it has been slow to react to changing market circumstances, with
executives seemingly relying on the sheer size of the organisation to shelter behind.
One objective measure of car company performance is the time it takes to produce a
car, as shown in Figure 6.8.
0
Nissan Honda Toyota Ford Chrysler GM
Figure 6.8 Man days per car (US)

Source: The Harbour Report.
To some extent these differences can be accounted for by the type of product. For
example, a substantial part of GM’s output is for luxury cars. However, the fact that
GM’s labour input per car is over 10 per cent greater than Ford’s is clearly a problem.
How Has GM Reacted?

Obviously GM’s management has been aware of the problems confronting the company,
and various actions have been undertaken.
A major restructuring was undertaken in 1984 when GM split its American opera-
tions into two parts: the high-quality Buick-Oldsmobile-Cadillac and Chevrolet-Pontiac.
Subsequent action was piecemeal until in 1998 the chairman, Jack Smith, embarked on
several initiatives including:
 selling off its parts company, Delphi. It had been observed that GM had probably not
been using its buyer power effectively by being vertically integrated;
 centralising sales, service and marketing systems. While this might save up to $300
million per year, it would also mean that the divisional structure based on car types
would cease to exist; for example, the notion that Cadillac was fundamentally differ-
ent from Pontiac would probably disappear, and they would be marketed as GM
cars. The number of car platforms would be cut significantly from the current 16;
 constructing a different type of car plant, which would be smaller than the standard
GM type and would focus on the construction of modules assembled by suppliers;
 consolidating worldwide operations into a single global unit. This would not only cut
out layers of management, but would enable the company to change designs and
rationalise production;
 reducing the number of showrooms. It was reckoned that GM has too many car
showrooms, and it has been estimated that one fifth of costs are incurred after the
car leaves the factory;

 relating managers more closely to their responsibilities. The layered management

structure means that responsibilities are often not clearly defined; attempts to over-
come this include appointing engineers to oversee individual products for a lengthy
period – perhaps up to 10 years. One criticism which has been levelled at GM’s top
executives is that their background is in finance, and theyfTh do not have the insight
of the heads of companies such as Volkswagen and Ford, whose executives came up
through car production.
Not everyone is convinced that these changes have a sound business rationale, but
are the outcome of senior executives jockeying for position. For example, the marketing
changes could be seen as a victory for Ron Zarrella, the head of marketing; the globali-
sation initiative as a victory for Rick Wagoner, who is due to succeed Jack Smith, over
Lou Hughes, head of international operations.
An important question is not whether GM is able to restructure, but whether its
efforts will bring it up with its competitors. Volkswagen is Europe’s largest car manufac-
turer, and it has already reduced the number of platforms to four, while even seemingly
totally different cars share many components. GM’s great rival Ford initiated a global
integration programme in 1994 which is thought to have saved Ford $3 billion per year.
But it is widely recognised that the Ford programme was successful only because of the
commitment of its chief executive, Scotsman Alex Trotman. Many doubt whether GM’s
bureaucratic structure can deliver such fundamental changes. Another major problem is
the confrontational style of management, which has led to the strikes in recent years; in
October 1998 GM announced that it would be shedding 25 000 employees, of whom
20 000 would be in the US; it was estimated that some 10 000 of the US jobs would
come from middle management. The prospects for a successful change programme do
not seem too bright.
Perhaps the greatest challenge facing GM is to ensure that it continues to make cars
which people will wish to buy in preference to others. In the face of increased competi-
tion, and the high standards of reliability common in cars nowadays, this is becoming
difficult. A good example is the experience of the Cadillac model, which has a worldwide
reputation as a luxury car. GM used to sell 300 000 Cadillacs each year in America, but
this has slumped to 200 000 in the past decade; during the 1980s Cadillac was overtaken
by Mercedes, BMW and Toyota (Lexus) which, for one thing, highlighted the Cadillac’s
poor reliability. During the mid-1980s Cadillac responded by building smaller cars, many
of which were in fact indistinguishable from the humbler Buick range. Lincoln is now
America’s top selling luxury brand; it has consolidated its position by being one of the
first in the market with a sport-utility vehicle. Cadillac now faces the problem of
producing cars which appeal to new, and younger, customers as well as its existing older
customers. This will not be easy.
1 Discuss GM’s reaction to the changing competitive environment using strategic models.
Case 6.5: Driving Straight (2011)

In June 2004 Mr Sergio Marchionne took over as CEO of Fiat, at the urging of the
Agnelli family, the dominant shareholder. The company needed action: its image had
suffered because of ageing models and output was about 70 per cent of capacity. The
factories were inflexible because of lack of investment and intransigent unions resistant

to change. Net debt had risen to $6.3 billion and losses were increasing; a $4 billion
convertible bond would fall due in August 2005.
By the time of the Geneva motor show in April 2008, Fiat was able to display the Fiat
500 as European car of the year, together with a new range of Lancia models and the
Alfa Romeo 8C Spider. At the same time Fiat Group reported a trading profit for the
first quarter of $1.1 billion, up 29 per cent on the year before and well ahead of
expectations. In 2007 Fiat Group made a record trading profit of $4.5 billion, which in
turn was two-thirds up on 2006, and paid off its net debt. Taking June 2004 as the
starting point, Fiat shares had grown over twice as much as those of Renault or
Peugeot. Clearly something important had happened in four years to create appealing
new products, profitability and confidence.
The New Boss

Mr Marchionne already had a reputation as a corporate troubleshooter, but he certainly
did not fit the bill as a suave Italian executive; he had been brought up in Canada,
qualified as a lawyer and accountant, and revelled in a direct and confrontational
management style. In particular he hated corporate politics and hierarchies and he
refused to wear a business suit. He was aghast that Fiat’s senior executives communi-
cated with each other through their secretaries. He said:
The single most important thing was to dismantle the organisational structure.
We tore it apart in 60 days, removing a large number of leaders who had been
there a long time and who represented an operating style that lay outside any
proper understanding of market dynamics. We flattened out the structure and
gave some relatively young people a huge amount of scope.
Fiat Group was a major company with 180000 employees, about a quarter of whom
work in Italy. It had three major parts and the revenue split was:
 cars: 50 per cent (of which Fiat 40 per cent)
 CNH: agricultural and construction equipment 20 per cent
 Iveco: trucks and commercial vehicles 19 per cent
 other: 11 per cent
Mr Marchionne decided that the key to Fiat Group’s success was to fix the car divi-
sion because that was where the losses were coming from and if things continued it
would bring down the entire group.
Fix the Finances

Fiat had been in partnership with General Motors (GM) for five years but the arrange-
ment was not working. The attempt to share platforms, engines and purchasing had not
produced economies of scale and had actually eroded Fiat’s ability to act independently.
GM had a ‘put option’ on the Fiat car division and Mr Marchionne persuaded GM to sell
the option back for $2 billion in 2005. While this helped Fiat’s cash division, it now
meant that there was no ‘parachute’, which was worrying, given the extent of Fiat’s
losses. But at least Mr Marchionne now had complete freedom of action. He went on to
float a rights issue in 2005, which raised enough to pay off the convertible loan; this
would have been impossible when Mr Marchionne took over, so he had clearly con-

vinced the market in only one and a half years that Fiat had a future.
Get the Product Right

The first step in rejuvenating the Fiat range of cars was the launch of the Grande Punto
at the end of 2005. It was stylish and had a quality feel; ironically, it was built on the GM
Corsa platform but it was an instant success and sold 1 million in less than three years.
This was followed by the Bravo in 2007, which did not break new technical ground but
focused on styling. This was the result of giving freedom to Mr Marchionne’s ‘kids’ and
bringing all Fiat Group’s styling divisions together into a striking building in the Turin
Mirafiori complex under the overall charge of Mr Lorenzo Ramaciotti, who used to be
design chief at Pininfarina. Mr Ramaciotti restored design as a core competence of the
manufacturing process and the success of the Fiat 500 gave his design team confidence
that they were as good as anyone.
Another factor in their success was the speed with which both the 500 and the
Bravo were brought to market. Computer simulations were used instead of the
traditional prototypes and provided the opportunity to experiment with many more
design features. The time from ‘design freeze’ to production was cut from 26 months to
18 months. This reduced the need to forecast the market so far ahead and increased
the chances of getting the design right.
Fiat exploited the fact that its cars are relatively fuel-efficient based on its power-
train technology. Some years back Fiat made the mistake of licensing its ‘common rail’
diesel technology to Bosch because of its financial weakness. Fiat’s new Multiair
technology that does away with camshafts and valve gear is a small, relatively powerful
engine with minimal CO2 emissions and will not be licensed to other manufacturers.
Despite this record of innovation, the number of platforms was still too high: for
example, almost every part of an Alfa Romeo (down to the last screw) could be
different from that on a similar sized Fiat. The intention was to reduce the number of
platforms from about 20 down to 6 in 2012.
Carrying It All Forward

Mr Marchionne’s success was not confined to Fiat. In 2009 he guided the formation of a
strategic alliance between Fiat Group and the Chapter 11 bankrupt US auto giant
Chrysler, with the support of the US and Canadian governments and trade unions. Less
than two years later, following its emergence from Chapter 11, Chrysler returned to
profitability and repaid all government loans. Under Marchionne’s leadership, Fiat and
Chrysler came together to create a leading global player in the automobile sector, taking
advantage of the product portfolios, purchasing power and distribution capabilities of
both partners. Mr Marchionne became chairman and CEO of Chrysler.
1 What changes did Mr Marchionne make to the internal operations of Fiat?

Module 7
Making Choices among Strategies

Contents
7.1 A Structure for Rational Choice ...........................................................7/2
7.2 Strengths, Weaknesses, Opportunities and Threats ..........................7/3
7.3 Generic Strategies ..................................................................................7/7
7.4 Identifying Strategic Variations.......................................................... 7/20
7.5 Strategy Choice ................................................................................... 7/34
Case 7.1: Revisit Salmon Farming ................................................................ 7/52
Case 7.2: Revisit Lymeswold Cheese............................................................ 7/52
Case 7.3: Revisit A Prestigious Price War ................................................... 7/52
Case 7.4: Revisit General Motors: The Story of an Empire ....................... 7/52
Case 7.5: The Rise and Fall of Amstrad (1993) ........................................... 7/52
Case 7.6: What Is a Jaguar Worth? (1992) .................................................. 7/53
Case 7.7: Good Morning Television Has a Bad Day (1993) ....................... 7/54
Case 7.8: The Rise and Fall of Brands (1996) .............................................. 7/57
Case 7.9: The Veteran Returns (2007) ......................................................... 7/59
Learning Objectives
 To develop a structure for making rational choices.
 To apply the SWOT framework.
 To identify generic strategies.
 To analyse strategic variations.
 To identify the influences affecting the choice process.

Module 7 / Making Choices among Strategies
7.1 A Structure for Rational Choice

to do what

Feedback


allocation
The objective of an analysis of choice is to investigate the structures within which

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

7.2 Strengths, Weaknesses, Opportunities and Threats

The profiles of environmental threats and opportunities, and company strengths
and weaknesses, can be combined together to identify where matches occur
between the two. This is known as an analysis of strengths, weaknesses, opportuni-
ties and threats (SWOT). For example, a threat might have been identified as a
result of the entry of foreign competition due to the relaxation of trade barriers;
corresponding to this might be a weakness in company marketing, where the sales
force has recently been depleted and the distribution system is already having
difficulty in delivering orders on time. SWOT analysis is an essential first step in
assessing what the company needs to do to protect its current market position, and
in identifying potential strategic thrusts which can capitalise on company strengths
and market opportunities to create sustainable competitive advantage.
The framework for matching up environmental and company characteristics will
depend on the individual case; the SAP described at Section 6.16 can be used as a
starting point. Assume that an opportunity (from the ETOP) has been identified in
the form of a government decision to reduce investment in railways and increase
investment in the road network; one of the main markets for the new engine control
is in very large trucks. A threat is the relaxation of trade barriers. This sector of the
market will therefore start to grow faster in the near future. Which of the strengths
and weaknesses shown in Table 7.1 matches with the opportunity?
Table 7.1 Strategic advantage profile

Internal area Competitive strength (+) or weakness (−)
Research + Recently invented a temperature control
− Team has a narrow vision
Development + Reduced lead time by 15%
− Costs are usually overrun by 20%
Production + Working at full capacity
− High labour turnover rate
Marketing + Computerised customer databank
− Lack of technically qualified salespeople
Finance + Share price is buoyant
− Lack of liquidity
The company has a strength in the potential to be among the first on the market
with an improved product, based on the new temperature control and the recent
reduction in development lead times. However, production is a weakness in that
capacity will require to be increased and labour productivity improved. On the
marketing side, while the ability to identify potential customers is a strength, the
shortage of personnel actually to do the selling is a weakness. Company finance
comprises a potential weakness: development costs are likely to be high (due to
overruns), investment will be required in additional productive capacity, and a
training programme for technical salespeople needs to be set up. The company will
be financially stretched because these expenditures will be undertaken before any

additional revenue is received from sales. The company’s ability to pursue the
opportunity is constrained by production, marketing and financial weaknesses, and
it is in the light of this that the decision will be made on how to proceed with this
product, or whether to abandon it and do something else entirely.
The analysis can be set out in a schematic form to provide an overview of how
the factors match up as shown in Table 7.2.
Table 7.2 SWOT analysis

Strengths Opportunities
Potentially first in market Truck market expansion
Marketing database
Weaknesses Threats
Full capacity Foreign competition
Low labour productivity
Lack of salespeople
Cash flow
It becomes obvious that the company’s strengths lie in what it might be able to
do, and as a result these strengths do not match very well with the opportunity of
expanding into the truck market. The weaknesses relate to the company’s ability to
bring the new product to the market, capture the new segment, and match aggres-
sive foreign competition.
The alignment among the SWOT factors has implications for the conclusions
drawn from the entries. Two types of alignment are as follows.
Strengths Oppportunities
Weaknesses Threats
Type A
Type A is the match most people envisage emerging from a SWOT analysis,
where there are clear implications for the organisation: mobilise strengths to take
advantage of opportunities and tackle weaknesses to counter threats.

Strengths Oppportunities
Weaknesses Threats
Type B
The implications of Type B are different. The threats are not a cause for concern
because of their match with existing strengths. But it is not possible to take ad-
vantage of market opportunities because of the match with weaknesses. It is
therefore necessary to convert weaknesses to strengths in order to exploit opportu-
nities.
At this point it is worth stressing the point that a meaningful SWOT analysis is
the outcome of a great deal of painstaking effort: the Environmental Threats and
Opportunities Profile is constructed from the application of a vast array of concepts
to the economy and to the market; the Strategic Advantage Profile is built up from a
similarly large number of ideas applied to the internal operation of the organisation.
It is not always a simple matter to categorise factors and recognise opportunities and
threats for what they are; for example, low margins may result from attempting to
develop a Star, while high margins may invite new entrants. That is why it is so
important to understand the core disciplines and be able to think through the
implications of market information.
While SWOT might appear to be a fairly straightforward tool there are several
complications that need to be borne in mind. In practice SWOT is used for several
purposes, there are ambiguities involved in locating factors in the matrix and the
dynamic environment can quickly render the analysis obsolete.
 Used for Several Purposes
There are at least three uses to which SWOT analysis can be put. First, to famil-
iarise executives with the company and its operations and to develop an
understanding of how different functions fit together. Second, to generate an
understanding of the basis on which the company competes and its strengths
and weaknesses. Third, to provide a basis for deciding on strategic moves and
the allocation of resources. The context in which each of these is undertaken can
be radically different. For example, the first may be part of a team building exer-
cise where there is little analytical depth associated with the exercise; the second
could be part of a diagnostic initiative aimed at identifying why various projects
have failed in the past; the third could be the outcome of a rigorous analytical
review involving significant inputs from functional specialists and external con-
sultants. Managers are likely to have conflicting views on the relevance of SWOT

based on their experience and those who have experienced SWOT only in the
first context may regard it as a relatively trivial activity and may not be able to
recognise the third application for what it is: a serious attempt to determine the
future of the organisation.
 Ambiguity
A factor can appear to be both an opportunity and a threat, or both a strength
and a weakness, at the same time. For example, on-line banking is a threat to
existing banks but an opportunity for those banks willing to mobilise resources
to take advantage of it; a dynamic CEO can be a strength in terms of identifying
and pursuing market opportunities but a weakness because of lack of attention
to the detail of implementation. This problem can be only partially resolved by
the application of rational analysis because the ambiguity is real. So it is essential
to recognise where ambiguity exists and make it explicit. In fact, visualising po-
tential opportunities and threats typically involves the exercise of imagination
and the SWOT framework can serve as the stimulus for inventive thinking.
 Dynamics
Achieving competitive advantage is a moving target (Section 1.3.1). Change can
impact on a wide variety of factors such as the price of inputs, availability of
inputs, market size, competitive price and emergence of new markets.
The problem is to determine what action is most appropriate in response to
different types of change. For example, to some extent the current generic strat-
egy is independent of changing circumstances; it is only when the basis on which
the company competes changes that the business definition and the generic ap-
proach needs to be altered. Other types of change can be interpreted in terms of
their impact on such factors as the components of the five forces, the shape of
the product life cycle and positioning in the price differentiation matrix.
Dynamics have a similar effect as ambiguities in SWOT analysis. Both require a
degree of imagination to visualise what might happen so it is a mistake to assume
that SWOT analysis is a purely factual exercise. There are bound to be conflicts
of opinion when constructing a SWOT and it is important to realise this from
the outset.

7.3 Generic Strategies

to do what

Feedback


allocation
A dictionary definition of ‘generic’ is ‘applicable to any member of a group or class’.

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

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

The definition of the generic options of stability, expansion and retrenchment

raises a number of problems because there are so many dimensions of company
performance. By and large, these ideas relate to the scale and scope of a company’s
operations. For example, for a single product company expansion can be defined as
attempting to increase market share, and hence total revenue; a more ambiguous
case would be the attempt to increase total revenue by increasing the quality and
the price of the product, which could lead to a lower volume of output and hence
lower market share. For a multiple product company expansion relates to the
revenues from existing products, together with the introduction of new products. It
is important to be clear about what the strategy options are NOT. For example, an
expansion strategy cannot be defined as increasing profitability, which can be the
outcome of the efficiency with which the company has achieved its objectives.
Increased profitability could be achieved by contracting the company’s activities,
and therefore could be associated with a retrenchment generic strategy. The generic
strategy is one of the means by which the end of profitability may be achieved.
Stability
The initial inclination is to regard this as being ‘no change’; however, the fact that
managers do not perceive objectives in terms of increasing markets, introducing
new products or acquiring new businesses, does not mean that the company is in a
steady state. An analysis of external and internal factors may have revealed one or
more of the following.
RELATIVELY SMALL PERFORMANCE GAP
The matching of the strategic advantage profile to the environmental threat and
opportunity profile may have revealed that desired and actual states would con-
verge without any significant change to the company’s policies.
MARKETS ARE MATURE
Portfolio analysis may have revealed that current markets are no longer in their
growth stage, therefore further expansion of market share is unlikely to pay divi-
dends. Analysis of product life cycles may have revealed that current products
have relatively long life cycles, and that in the meantime there is no need to in-
vest in new products to take their place.
INTERNAL WEAKNESSES
An analysis of the efficiency with which the company allocates its resources may
have revealed that production processes are based on out of date equipment,
that inventories could be reduced, that inadequate training is being undertaken
and that labour productivity is falling. As a result unit costs are higher than they
need be, and if the company were to embark on expansion it would rapidly find
itself at a cost disadvantage compared with its competitors. This stability strategy
is therefore primarily concerned with increasing efficiency, investment in labour-
saving capital items, the introduction of just in time procedures, and other ac-
tions which will bring costs under control.

UNSTABLE FINANCIAL HISTORY

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

Expansion
There are several reasons why a company may actively pursue a strategy of generic
expansion.
DIVERSIFYING RISK
It may be felt that an increased portfolio of products reduces the risk for the
company as a whole. While increasing the portfolio does not diversify sharehold-
er risk it does diversify management risk, which can give management a strong
motivation to expand.
SEARCHING FOR COMPETENCIES
A line of business may fit with the perceived competencies of the company so in
the eyes of corporate management it may contribute to the company’s long run
competitive advantage despite the fact that, financially, it might not appear to be
worthwhile.
ECONOMIES OF SCALE
Investigation of the cost structure of the company and its competitors may sug-
gest that there are significant economies of scale to be exploited. In a mature
industry the additional sales can only be achieved by increasing market share at
the expense of competitors; in a growing market it is necessary to grow faster
than competitors if a dominant market position is to be achieved.
EXPERIENCE EFFECTS
This is similar to the economies of scale case, with the qualification that the po-
tential advantage is only available for a limited period.
BUILDING ADVANCE CAPACITY
It would not be surprising to find many companies following an expansion strat-
egy when general economic conditions are improving. However, by the time that
economic conditions start to improve it may be too late to expand, because of
shortages of capital and labour. Some companies take the opportunity of a reces-
sion to expand their operations in order to be ready for the next upswing.
MANAGERIAL MOTIVATION
In some companies the remuneration of top management is related to total rev-
enue rather than profitability. This naturally leads to a preference for expansion
over stability. Managers who are not rewarded on this basis may still regard their
personal long-term success as largely dependent on being responsible for a grow-
ing company. It is expanding companies which catch the headlines, and the
managers associated with expansion benefit from the aura of success.
Not all of the factors acting in favour of an expansionist strategy are directly
related to increasing company value. There is a widespread feeling among managers
that if a company is growing it must be basically healthy, but a company which is
pursuing an expansion strategy for the wrong reasons could be weakening its long-
term competitive potential.

Retrenchment
Under this heading come the notions downsizing, delayering and restructuring.
These initiatives are undertaken in the quest for a more efficient organisation either
in terms of shedding businesses which are not seen as part of the company’s core
competence or in terms of enhancing labour productivity. This is the strategy which
many managers often do not want to be associated with, because it implies that
mistakes have been made in the past. This is why many companies find it necessary
to appoint a new CEO when retrenchment is necessary. But if the notion of
retrenchment can be divorced from that of profitability, and the emotive objections
overcome, managers can see that retrenchment is not necessarily brought about by
incompetence and can be a perfectly logical strategy.
PRODUCT LIFE CYCLES
Some products may be nearing the end of their life cycles and there are no re-
placements available to which the company can divert resources. Managers may
decide it is better to wait and see whether new products can be developed in the
areas in which the company has expertise, rather than diversify into areas of high
uncertainty.
DOGS
It is not unknown for companies which are ‘cash rich’ to diversify into numerous
areas in which they have little experience. Subsequently, it may transpire that
some of the acquisitions are ‘Dogs’, using the BCG definition. Since Dogs are
almost impossible to salvage, because the costs of increasing their competitive
advantage far outweigh the potential returns, the appropriate strategy is to divest.
OVEREXTENDED MARKETS
Internal analysis may have revealed that, at the margin, the company is losing
money on some customers. This can arise from maintaining a production, sales
and distribution network which incurs very high marginal costs, while the reve-
nue from many customers is relatively low due to competitive pressures. In
economic terms, the marginal cost exceeds the marginal revenue, and the remedy
is to cut back on the scale of operations. Companies are often able to identify
customers that it is not worth having because, for example, the delivery cost may
be high, because extremely favourable terms had to be offered to get the order in
the first place, or because resources were already working at full capacity and
filling the order caused disruption. Retrenchment will increase profitability be-
cause losses at the margin are avoided.
Retrenchment can therefore be associated with rationalisation and a drive to
greater efficiency. These positive reasons need to be distinguished from retrench-
ment caused by a series of poor decisions which managers attempt to counter by
selling productive assets, or imposing economies on the organisation which provide
no more than a temporary solution to cash flow problems.
Combination
There are two ways of looking at combination strategies. First, they occur when a
multiple SBU company is pursuing different generic strategies in relation to individ-

ual SBUs, and it is impossible to characterise the generic strategy for the company as
a whole as stability, expansion or retrenchment. Second, the company can pursue a
different generic policy sequentially, so that the current generic policy can only be
interpreted in the context of the dynamic overall strategy.
OPPORTUNITY COST
It was discussed in Section 6.1 that the real cost of a course of action is the best
alternative forgone. Analysis of markets may reveal that some resources could be
put to better use and that they should be redeployed. However, in order to re-
lease these resources it may be necessary to reduce some current activities, and
this involves a retrenchment strategy. The period of retrenchment may be pro-
tracted, depending on the circumstances. The overall generic strategy may be
stability or expansion, depending on the markets into which the company is
diverting resources.
PRODUCT PORTFOLIO
Because of the unpredictability of product successes and failures, and the objec-
tive of maintaining a portfolio, the company may have no alternative but to go
through periods of expansion and retrenchment. Furthermore, at any time the
multiple SBU company is likely to find that some SBUs are expanding and oth-
ers are in retrenchment simply because of their individual product portfolios.
If a sufficiently long-term view is taken, it could be argued that all companies
pursue a combination generic strategy, because that is the way things are likely to
turn out. However, it is revealing to consider the combination option explicitly
because it introduces a time dimension into the generic approach.
Assessing Generic Strategies

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

The focus here is on the effective exploitation of individual product markets, as
opposed to the overall resource allocation problem facing corporate level strategists.

This is the responsibility of the SBU, which may have a product portfolio of its own
to consider. The generic approaches can be classified according to the strategy
adopted towards individual products, or the strategy approach adopted by the SBU
towards the exploitation of a group of products.
At the product level the focus is on achieving competitive advantage in a given
market. Porter34 identified four main generic strategies: cost leadership, differentia-
tion, focus and no distinctive strategy.
Cost Leadership
The objective is to achieve a situation where unit costs are significantly lower than
those of other companies in the industry, thus producing higher profits than
competitors and the ability to mount a defence against competitive threats. This
strategy is similar to the BCG concept of the advantage conferred by relatively high
market share; this cost advantage derives from those economies of scale and
experience effects which, by definition, are not available to smaller companies.
The strategy implies two specific preoccupations. First, the company must at-
tempt to achieve the market share which has the potential to generate the cost
advantages desired. This market share must, of course, be achievable; there is no
point to adopting a strategy of cost leadership when existing industry giants control
80 per cent of the market. Second, the company must be continually concerned with
efficient resource allocation, and be at the forefront of technological developments
which have the potential to reduce costs. Once it has achieved the cost advantage it
will be continually concerned with maintaining it. For example, it has already been
stressed that experience effects are transitory, that competitive conditions continual-
ly change with the result that economies of scale are always under threat, and that
international developments can lead to the entry of previously excluded efficient
producers. Taken together, these two preoccupations suggest that the product is not
differentiated and is capable of high volume low cost production.
The cost leadership strategy can be seen as an investment process. Costs are
incurred initially in winning market share and setting up efficient production
techniques. Subsequently the net cash flows will be higher than they otherwise
would have been because of the unit cost advantage.
Differentiation
The effect of product differentiation was discussed in Section 5.4.2, the effect of
differentiation being to increase profits by segmenting the market and enabling
different prices to be charged in different segments. In this case there is less
preoccupation with market share, because the company is continually redefining the
market; it may in fact have 100 per cent market share in the segment for the
particular combination of differentiated characteristics which it has produced.
Because the product is not homogeneous, less attention is paid to relative costs.
Obviously, the company must be able to charge a price differential which will
compensate it for the additional costs incurred in differentiation, and it would be
irrational to ignore cost behaviour altogether; however, the overriding objective is

not to produce at a lower cost than competitors, but to produce something which is
seen as being different from competitors.
The strategic process involves searching for and adding some characteristic such
as superior quality or service associated with the product; it may not be a real effect,
but may be an image consciously created by the company. The salient characteristic
of the strategy is that the company is primarily concerned with capitalising on the
perceived characteristics of the product. This approach can be adapted to identify
product position by plotting the main differentiating variables against each other
and locating both the company’s and competing brands within it. For example,
brands of Scottish malt whisky are usually described in terms of their ‘smoothness’
and ‘peatiness’ (if you don’t drink whisky you just have to take this on trust). Some
of the eighty or so brands of malt whisky are plotted in Figure 7.1. There is plenty
of scope for discussion about where precisely each brand should be located; the
important point is that there are clear differences among brands when their charac-
teristics are plotted in this way.
Smoothness
Glenmorangie
Talisker
Laphroaig
Peatiness
Figure 7.1 Malt whisky: perceived quality
Focus
The previous generic strategies involved different ways of meeting competition and
achieving an advantage: in the first case this was by lower cost and in the second by
altering product characteristics. The focus strategy is different in that it typically
involves the identification of market niches where it is possible to avoid confronta-
tion with competitors. Within the niche the company can focus on cost or
differentiation.
It is not a high volume option, and it pays little attention to market share. The
niche may be a part of the market which requires specialised attention, very fast
guaranteed delivery, or some other characteristic which higher volume producers
cannot provide because of the additional cost.
Once a company has established itself in a niche it can make a high rate of return
because it is able to avoid direct competition with much larger competitors and in

effect act like a monopolist; this lack of direct competition can lead to inefficiencies
in production and what might appear to be a bizarre marketing strategy. The
Morgan car company in the UK makes somewhat eccentric sports cars that appeal
to a minority of enthusiastic drivers. For many years the cars were partly hand built
and the factory was antiquated with virtually no attention paid to time and motion
or productive efficiency. There was a waiting list of three or four years for delivery.
Consultants suggested that Morgan should invest in a more efficient factory and
increase production to reduce the waiting list and increase the profit margin. The
directors were not convinced because they felt that changing the build approach
would undermine the perception of differentiation, while increasing production and
sales could bring them into direct competition with the larger sports car makers,
against whom they certainly could not compete. In the event Morgan invested in
some production improvements but did not significantly increase output. The
Morgan directors had a clear perception of the basis of its competitive advantage
and the limits imposed by the focus strategy.
Stuck in the Middle

A salient feature of the three generic strategies is that the companies specialise in a
particular approach to the market; they specialise in production processes, individu-
alised products or identifying unsatisfied consumers. A company which does not
specialise is likely to be continuously adjusting its competitive focus in response to
changes in the market, with the result that it is ‘stuck in the middle’; such an
undefined strategy is likely to be associated with relatively poor performance,
because the marketing effort of such a company is likely to be confused: at any one
time it may not be clear whether marketing managers are attempting to achieve
market share, differentiate the product in the eyes of the consumer, or find unex-
ploited opportunities. Thus the scale of operations is not large enough to generate a
cost advantage while the product is not differentiated enough to justify a price
premium.
The Morgan car company could well have ended up stuck in the middle if it had
introduced modern production methods and aimed at a wider market: it would have
lost much of its differentiation which was partly based on the eccentric approach to
production while it would have been far too small to compete effectively at the price
of roughly comparable mass produced sports cars.
It does not always follow that low cost leadership and differentiation are mutually
exclusive. Some companies have successfully combined low cost leadership and
differentiation; Benetton manufactures highly differentiated clothes and runs an
international production and retail chain that is efficient and enables Benetton to
charge relatively low prices. The underlying reason for success is that Benetton
understood what it was trying to do whereas most companies end up being stuck in
the middle because they have reacted to events without having a clear vision of the
basis of competitive advantage.

Competitive Scope and Competitive Advantage

The competitive scope of the company in relation to its potential competitive
advantage is summed up in Figure 7.2.
COMPETITIVE ADVANTAGE
LOWER COST DIFFERENTIATION
BROAD COST LEADERSHIP DIFFERENTIATION

TARGET
COMPETITIVE
SCOPE
NARROW COST FOCUS DIFFERENTIATION

TARGET FOCUS
GENERIC STRATEGIES
Figure 7.2 Competitive scope and competitive advantage

This synthesis of scope and generic strategy demonstrates that the company still
has to make a decision between cost and differentiation even if it has identified a
narrow target or niche. In the broad target case cost leadership is used as a method
of achieving a degree of market dominance, while in the narrow target case the cost
focus defines the market niche. For example, in the car market the large producers
compete against each other primarily on cost for the small compact class; in the
luxury sector there is an emphasis on differentiation.
Once the broad decision on which generic strategy to pursue has been taken, it
follows that attention will be focused on different activities. Table 7.3 sets out the
types of activity and business focus associated with the generic strategies.
Table 7.3 Cost leadership, differentiation and focus: related activities

Generic strategy Concerns and characteristics
Cost leadership Optimum plant size
Process engineering skills
Simple product design
Statistical quality control
Quantitative incentives
Tight resource controls
Tight financial reporting system

Generic strategy Concerns and characteristics

Achieving economies of scale
Differentiation Branding
Design
Marketing
Advertising
Service
Quality
Creativity in R&D
Focus Matching products with customers

After sales service
Dedicated work force
It follows that the skills required to pursue the different generic strategies are
different, and switching from one generic to another has implications for the design
of the value chain. This is a reason why acquisitions fail; for example, if a cost leader
takes over a differentiator there will be a mismatch in just about every dimension
which may be attributed to differences in company cultures, but in fact it is more
fundamental than that. Unless the value chain and the generic strategy are aligned
there is a real danger that the company will lose either its cost leadership or differen-
tiation and end up in that unwelcoming place: stuck in the middle.
7.3.3 Decision Maker Generic Strategies

The approach to strategy is partly dependent on the characteristics of the decision
maker; where decisions are made by a number of individuals, for example in a board
of directors, it is the overall or dominant characteristic of the group which is
important. The following characteristics provide insights into how decision makers
are likely to behave in different circumstances.35
The Prospector is primarily concerned with the identification of new market
opportunities so issues relating to internal organisation take second place.
The Analyser is characterised by sophisticated internal information systems and
detailed investigation of options, but this is unlikely to be followed up by the type of
action undertaken by the prospector.
The Defender is concerned with maintaining the current market position with-
out exhibiting a great deal of initiative in developing new market opportunities.
The Reactor simply deals with circumstances as they arise.
These dominant characteristics may be relevant only to a specific period, and will
obviously change as managers are replaced. They may also be determined by market
conditions, for example, a prospector may be forced to become a defender in the
face of unexpectedly fierce competition. The classification is not prescriptive, in the
sense of recommending that a company should strive to change from one classifica-

tion to another in order to improve performance, but does help to understand how
the company has reached the position it is in, and the type of strategy which might
win general support. For example, there is little prospect of support for an aggres-
sive approach to new markets in a company dominated by defenders.
At the corporate level the dominant characteristic of the chief executive is a
fundamental determinant of the course which the company will take. For example,
Lord King of British Airways was a prospector who saw a future for a defunct
airline; the corporate raiders such as Goldsmith and Hanson were prospectors of a
different type, in that their vision of opportunities lay in identifying the failures of
other managers. The top management of IBM adopted a reactive stance to changing
competitive conditions, and were apparently unable to analyse and understand what
was happening to them.
At the SBU level the two generic product strategies of differentiation and cost
leadership can be combined with the SBU-decision maker classification to explain
the approach which different types of SBU might adopt towards the identification
and pursuit of new products, or towards the development of existing products in
new markets as shown in Table 7.4.
Table 7.4 Emphasis on new product-market growth

Heavy emphasis No emphasis
Prospector Analyser Defender Reactor
Differentiate Aggressive Seeking expansion Maintain No clearly
pursuit of new in related products difference defined strategy
Cost leader products and and markets Maintain low
markets cost
Prospectors are primarily concerned with pursuing growth by differentiated or

low cost products, and are probably indifferent to which characteristic generates
potential competitive opportunities. Analysers will tend to start from the base of a
strong core business, and will expand into related areas; this is because analysers are
unwilling to enter markets on which they have little information and no experience.
Defenders will tend to be operating in mature markets, and are concerned with
maintaining the position of ‘Cash Cows’; reactors, as might be expected, simply wait
until the pressure of events forces some course of action upon them; at times
reactors will behave like one of the other three types, but there will be no consisten-
cy in their approach over time.
This illustration might at first appear to be painfully obvious; however, experi-
ence suggests that many managers do not have a clear idea of which classification
their company falls within. Many managers would like to be characterised as
prospectors, but in fact they are reactors; managers who feel that they do not always
seize opportunities should ask themselves whether this is because of an aversion to
risk or because they are basically analysers. The classification has a potential payoff
in real life. When the opportunity for product-market growth arises, an SBU CEO
can start by identifying the main behavioural characteristics of the organisation,
determine whether the SBU is a prospector or a reactor, and see from the matrix

how it is likely to behave in the circumstances. The important issue is whether the
previous orientation of the company is likely to be effective in the circumstances
which will face it in the future; for example, if the CEO considers the SBU is
primarily defender orientated he can consider whether it is worth attempting to
initiate an organisational change programme to instill elements of analyser and
prospector. But the organisational stance is an aspect of company culture and that is
probably going to be very difficult to change.
7.3.4 Generic Strategies and Company Performance

It is reasonable to ask what the most appropriate generic strategy might be given the
circumstances of the company, the positioning of its products, and the past behav-
iour of managers. There are three main issues to bear in mind when attempting to
relate generic strategies to company performance. First, the point has already been
made that the generic strategy is a means, while company performance is the end.
Therefore a stability strategy is not necessarily less profitable than an expansionist
strategy, and the cost leader is not necessarily less profitable than the differentiator.
Second, it has been argued that the underlying measure of profitability relates to the
value added by alternative courses of action, and this is not necessarily reflected in
changes in short-term cash flows. In some cases value added may not be the
immediate concern of decision makers; for example, a family may wish to maintain
control of a company despite the fact that its value would be increased by expan-
sion. Third, the data do not exist on which to apply the scientific method of
hypothesis testing. Therefore, any conclusions drawn on the most appropriate
strategy are likely to be heavily conditioned by the experience of the individual
strategist.
It makes sense to query the payoff from the different corporate level strategies
but you might think this is irrelevant at the business strategy level because a compa-
ny is hardly likely to choose a differentiation strategy in a market where products are
homogeneous. This happens when previously differentiated products become
‘commodities’. For example, early laptops could be differentiated on the basis of
dimensions, weight, size and clarity of screen and computing power; but they rapidly
became indistinguishable as technology progressed so that, although laptops are
advertised as being different, the only way to make significant profits is to pursue
cost leadership. Companies that did not spot this and carried on with their differen-
tiation focus, undertaking the wrong activities as in Table 7.3, went out of business.
An opportunity may arise to differentiate a homogeneous product; this happened in
the mobile phone market where games, cameras, internet, email, satellite navigation
and television were progressively added. But, of course, each level of differentiation
soon became homogeneous and it was back again to cost leadership.

7.4 Identifying Strategic Variations

to do what

Feedback


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

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

shared among similar products, and the nature of the competition is well known (or
it should be). There are four main incentives to diversify: to minimise risk, to
capture economies of scope, to add value through the parenting function and to
benefit from synergy. The first of these can be dealt with quite briefly, as it is now
recognised as a means of minimising management risk but not shareholder risk. The
objective of stabilising cash flows over time is a weak rationale for diversifying, and
certainly provides no basis for expecting any value production.
The idea of economies of scope was developed in Section 6.12.1, and it was
concluded that the pursuit of economies of scope might as easily lead to value
destruction rather than value creation. Prahalad and Bettis argue that managers of
diversified firms may see themselves as deriving economies of scope through their
proficiency in spreading scarce top management skills across apparently unrelated
business areas through the application of their dominant management logic; this is
the way in which managers conceptualise the business and make critical resource
allocation decisions regarding technologies, product development, distribution,
advertising, human resource management and so on. The dominant management
logic could have a direct effect when managers develop specific skills, e.g. in
information systems, and seemingly unrelated businesses rely on these skills for
success. But without detailed knowledge about a particular business it is impossible
to know at the time of the diversification whether the new business fits the domi-
nant management logic. In the absence of obvious relationships between businesses,
claims that economies of scope derive from dominant management logic are
difficult to defend.
There are reasons why it may not be possible to expand in existing markets; for
example, competitive legislation may make further increases in market share illegal,
or the company is cash rich and has already exploited existing markets as far as it is
considered economic to do so. Take the case of a company currently producing
baby food which is faced with declining demand for its product because of demo-
graphic changes. It has the option of moving into the production of tinned food
with a special appeal to young children, or diversifying into the production of toys;
diversifying into a different type of food product appears to be a more closely
related diversification than getting involved in producing toys. The factor which
makes both related is that they are both in markets involving children. The trouble
is that this ranking of relatedness may focus on the wrong variable. The factors
which are likely to contribute to long run returns are
 the potential to reap economies of scope across SBUs that can share the same
strategic asset; this could be a common distribution system, and in the case of
the baby food manufacturer diversifying into toys would mean setting up a dis-
tribution system with toy shops instead of food stores;
 the potential to use a core competence in the new SBU; this could be an
understanding of marketing child products, and it may be equally relevant to
both options;
 the potential to utilise a core competence to create a new strategic asset in a new
business faster; thus while the existing distribution system is common for both

types of food product, the knowledge of how to build up the system may still
confer a competitive advantage in the toy market;
 the potential to expand the company’s pool of core competencies as it learns
new skills; the lessons learned in building a toy distribution system may be rele-
vant to the existing food distribution system.
The usual arguments in favour of related options, which are based on costs,
efficiency and market knowledge, may generate only a short-term advantage because
these attributes can be replicated. The four types of relatedness above are less
obvious, and provide a different perspective on what appears to be an unrelated
diversification. It is not clear whether the food or toy option is more related.
To illustrate the benefits of not taking relatedness at its face value consider the
case of a company that produces industrial office cleaning equipment. It is now the
market leader in its market segment – city centre high technology office blocks –
and the new CEO feels that the time is right to expand from this secure base. He
has identified two options: to establish an SBU that undertakes office cleaning
mainly using the company’s equipment or to invest in a production line producing
domestic vacuum cleaners. The CEO argues in favour of the former option
because, as he says ‘We know the office cleaning business and this will increase the
market for our own cleaners’. Some executives agree, some disagree, while the
strategic planner argues that both options are totally misguided. The strategist argues
as follows.

Four factors Cleaning service Domestic appliance

Economies of scale There is no scale potential The production process
across SBUs combining a production of heavy duty industrial
operation with a service components for a
provider specialised market
differs from that for
light weight units for a
mass market.
Use an existing core The skill sets are different This only applies if there
competence for producing and market- is some activity that the
ing a product and a service company already excels
in that can be used more
effectively in the
domestic appliance
company
Use an existing core The acquisition amounts to The industrial and
competence to create vertical integration with all domestic markets are so
a new strategic asset the problems of make different that there is
versus buy little prospect of increas-
ing entry barriers by
combining the two
companies
Expand the pool of It is difficult to visualise Some production and
core competencies which competencies could product marketing skills
be shared may be complementary
The strategist has recognised that the first option is an attempt to integrate pro-
duction and service companies and the fact that they are in the same market
segment is irrelevant; the second can be visualised as expansion where both product
and market are unfamiliar. As a result there is likely to be very little benefit from
expansion in either case. Thus in terms of the competence based expansion trajecto-
ry of Section 6.14 there is little commonality between either routines or resources
with the result that both options lie in the ‘Diversification’ sector. This is probably
not a popular conclusion for the CEO and is an example of how a strategist is often
the bearer of news that conflicts with ‘common sense’ conclusions which do not
recognise the elusive nature of competitive advantage.
There is clearly much more to the issue of relatedness than meets the eye, and
companies need to take a serious introspective look at themselves prior to adopting
a stance on the relationship between a possible new course of action and current
capabilities.
7.4.2 Vertical Integration

Vertical integration involves movement into other parts of the production chain by
which raw materials are converted into final products; some of these activities may
be related, others totally unrelated. The potential costs and benefits associated with

vertical integration were discussed in Section 6.12.3, where the question of the
optimal degree of integration was discussed. The car company which takes over a
steel rolling business is an example of backward integration, but it is unlikely that
the steel company will only produce steel for the car company itself; the further into
other parts of the production chain the company moves the less likely it will be to
produce only for, or buy only from, itself, and it may find it owns a series of
companies each supplying a different market, of which the supply to the company
itself at each stage may only be a relatively small part. Vertical integration thus
presents similar types of problems as related and unrelated options; the company
may benefit in some ways from integration, but the benefits may be swamped by the
costs of unrelated diversification.
Forward integration involves the company carrying out the functions of its cus-
tomers; a typical example is when a company distributes its output instead of using
contractors, or opens its own retail outlets. Much the same considerations apply as
in backward integration. For example, it is unlikely that the company is currently the
only supplier for the forward customer, and integration can again have the charac-
teristics of an unrelated diversification.
The crucial question which must always be borne in mind is whether, taking
everything into consideration, the company would add value by controlling other
parts of the productive chain. The case of British Gas, discussed in Section 6.12.3,
demonstrates that vertical integration is often not an efficient variation.
7.4.3 Acquisitions
Instead of undertaking internal action through the mobilisation of the company’s
own resources to achieve objectives, the company can undertake external action by
taking over or merging with another company. The evidence available on the
relative performance of acquisitions demonstrates that it is not an automatic recipe
for success. Many studies have demonstrated that the majority of acquisitions
produce very little value for the acquiring company and that the most common
outcomes are as follows.
1. The combined value of parent and target firms tended to rise following the
announcement of a takeover, but this is usually temporary.
2. Most returns accrue to target firm shareholders.
3. Acquiring firm shareholders eventually receive small statistically insignificant
returns.
Given this lack of positive evidence that there is much real gain from acquisition,
why has it been such a popular corporate pastime? The justification hinges on the
idea that there is a strategic fit between the two companies in the form of unrealised
value potential, buying into markets, reducing competitive pressures, the quest for
synergy, balancing the portfolio and developing core competence.
Recognising Unrealised Value

Some chief executives have a skill in identifying companies which have not fully
exploited their value opportunities. The activities of such a company may be

unrelated to the current business of the potential acquirer, whose competence is in

adding value independent of the type of business. It is instructive to try to identify
the areas in which the company’s performance might be inadequate, because unless
these can be identified it is difficult to understand the rationale for acquisition.
Reasons for a company being undervalued include:
DEVELOPMENT EXPENDITURE HAS BEEN INEFFICIENTLY
SPENT
The predator may feel that because of inadequate expenditure on product devel-
opment, the potential market share is lower and unit cost higher than they
should be; the predator may feel that the company’s products can be shifted
upwards in the perceived price differentiation matrix.
MARKETING STRATEGY HAS NOT PURSUED OPPORTUNITIES
The predator may spot opportunities for product differentiation and market
segmentation which he considers will transform the profitability of products
which are currently poor cash generators.
RESOURCE MANAGEMENT HAS BEEN POOR
The predator may conclude that unit costs are higher than in similar companies,
and that opportunities exist to reduce costs by improving resource management
throughout the value chain.
EXPECTED INCREASE IN DEMAND
The predator may expect an upturn in the demand for the company’s products.
WEAK PRODUCTS
The predator may identify products which do not contribute to shareholder
wealth; divesting them will release resources for more productive purposes. This
argument would hold for a company with several Dogs in its portfolio, but the
predator needs to be careful not to divest Stars.
This is not an exhaustive list of factors which may contribute to an undervalued
share price, but it illustrates that to a large extent a predator’s motivation is based on
a perception of the company which is not reflected in the market valuation. He may,
of course, be wrong. The extent to which predators can be wrong can be quite
startling, as Table 7.5, a history of some acquisitions from the 1980s, shows.

Table 7.5 Takeover performance

Date Company Acquisition Price Shares Shares
then 1992
1986 Saatchi & Saatchi Ted Bates $450 750p 22p
1988 News Corp. Triangle A$3bn A$11 A$6.40
1988 Coloroll John Crowther £217m 181p Bust
1989 WPP Ogilvy & Mather £560m 652p 58p
1989 Brent Walker William Hill & £685m 407p 7p
Mecca
All the research studies in this field come to the conclusion that takeovers rarely
create value. In the majority of cases it has been found that the value of the bidder’s
shares falls after the takeover, while many studies point to longer term negative
effects on the profitability of the acquired business units. Even in Japan, where
takeovers and mergers have only become important since the mid-1980s, there is no
evidence that the activity has improved profitability or growth. Porter’s famous
study36 found that about 75 per cent of all unrelated acquisitions were divested
within a few years, as were 60 per cent of acquisitions in entirely new industries.
In fact it is not sufficient in itself to conclude that a company has not realised its
value potential; certain other conditions also need to be satisfied. First, it is im-
portant that no other potential acquirer has arrived at the same conclusion; if a
competitive bidding situation results then it is likely that all potential gains will be
captured in the purchase price. Second, it is necessary to realise the potential gains in
practice, and this can clearly be very difficult. The four potential benefits of parent-
ing were discussed in Section 1.5, and each of these was associated with a paradox
which raised serious doubts about the ability of a parent corporate organisation to
add value in the long run. It may be possible to add value on a once for all basis by
remedying managerial weaknesses; but whether there is any gain to be had beyond
that from retaining ownership of the company is open to question. The danger is
that the takeover will eventually result in value destruction rather than value
creation, as is so evident from the instances in Table 7.5.
Buying Market Share

Take the case of a company which currently has 20 per cent market share in a
mature market and has decided, on the basis of the analysis of costs and competitive
conditions, that its long-term prospects would be greatly enhanced by increasing
market share to 30 per cent. At the moment it is operating at full capacity, therefore
in order to increase market share it has to invest in new plant and mount a market-
ing strategy which will take customers away from its competitors. The likely
outcome of the marketing strategy is unknown because the reaction of competitors
cannot be predicted with any degree of certainty; the company may simply find itself
involved in a price war without any permanent increase in market share which is the
outcome of a zero sum game. Not only does a takeover make it possible to avoid
the costs of the competitive thrust required to achieve the increase in market share,

but the labour force in the acquisition will be relatively high on the experience
curve.
Reducing Competitive Pressures

Governments are continually on the lookout for companies which attempt to
achieve monopoly power. In the US there is a formidable set of antitrust laws, and
in Britain the Monopolies Commission has the power to veto takeovers which it
considers are not in the public interest. In any case, monopoly power does not
automatically mean that monopoly profits will be earned, due to the influence of
contestable markets discussed in Section 5.10.4.
Synergy
There may be potential gains from sharing resources and making better use of
capacity. The difficulties of capitalising on synergy were discussed in Section 6.12.2,
and the history of acquisitions which attempted to take advantage of synergy has not
been encouraging.
Balancing the Portfolio

Rather than introduce a new product into the portfolio from scratch, the company
may be on the lookout for a Star or Question Mark which fits with its existing
portfolio and has the potential to be developed into a Cash Cow. The issue of
strategic fit is crucial here, because it is unlikely that such a company can be pur-
chased at a discount to its true value, particularly if it has been run efficiently in the
past. The value added by such a product will depend on its contribution to the long-
term competitive advantage of the acquiring company, and is probably dependent
on issues such as synergy and economies of scope. Unless there is an underlying
value added to be gained, the mere fact of adding the product to the portfolio for
the sake of completeness does not guarantee that it will add value to the company as
a whole.
Core Competencies
The acquisition may have the potential to fit with the strategic direction of the
company in the sense that it complements the set of difficult-to-replicate skills and
attributes on which the company’s competitive advantage is based, while being
consistent with the company’s dominant management logic. It may also be seen as
fitting with the company’s strategic architecture in terms of the linkages in the value
chain. These characteristics of the acquisition may lead to a long-term addition to
competitive advantage and hence to value added. But it is not possible to subject
such an acquisition to an analysis of cash flow implications and possible return on
investment; the point about core competencies is that they are difficult to define and
are by their nature unique to the situation, otherwise they would have been copied
already. There is no obvious way of identifying the potential contribution to core
competencies before the event, so it has to be recognised that this option is based
on a general view of the strategic thrust and how the components of the company
fit, without being explicit about how the value added outcome will be generated.

Justifying the Acquisition: Strategic Fit

This appears to be a formidable list of reasons that can be marshalled in favour of
an acquisition. The trouble is that each factor is subject to interpretation and
different conclusions can be drawn for a given acquisition target. For example, take
the case of Acme, a company that manufactures a range of electronic gadgets and is
considering the acquisition of Protech, a smaller rival that has a portfolio of three
products: Optimiser, Calculator and Transmitter; Acme’s portfolio already includes
a version of the Optimiser but not the other two. The following arguments are
based on exactly the same information but depending on the view taken the
acquisition can be made to appear highly attractive or potentially disastrous.
Rationale Arguments for Arguments against

Recognising unrealised value Very convincing as below Not recommended as below
Development expenditure Optimiser lacks features Focus has been on useful not
has been inefficiently offered by competitors cosmetic features
spent
Marketing strategy has not No promotion in tabloid Doubtful if the cost could be
pursued opportunities newspaper recovered
Resource management has There are reports of high It looks like the entire value
been poor attrition rates and the produc- chain is weak and it may not
tion facility is out of date be possible to fix it
Expected increase in Recent industry sales suggest The Optimiser market is
demand the Optimiser and Calculator mature and recent increases
are in the growth stage of the have been due to short run
product life cycle factors
Weak products The Calculator is a Dog and The Calculator is profitable
can be divested because there are no econo-
mies of scale in this market
Buying market share Provides an opportunity to Would still be well below
increase market share of market share of two main
Optimiser competitors so does not
confer Cash Cow benefits
Reducing competitive pressures One less competitor to worry Real competition comes from
about two big players: does not alter
five forces profile
Synergy Can eliminate Protech’s HQ HQ costs are a small propor-
costs tion of total cost
Balancing the portfolio The Transmitter is a Star The Transmitter is a Question
Mark
Core competencies Reinforce competencies in No new identifiable
electronics competencies
This illustrates why many apparently attractive acquisitions are doomed from the
start: the case for has been constructed on the basis of an interpretation of the facts

that favours the acquisition while the arguments against have been ignored or not
even recognised.
7.4.4 Alliances and Joint Ventures

Alliances and joint ventures take many forms including licensing agreements,
franchise agreements, relational contracting, relational management, consortia,
virtual corporations, virtual functions and joint ventures. It is not the details of these
which are important so much as the underlying rationale for strategic alliances in the
first place. It is known that the success rate of mergers and takeovers has been low;
it is therefore important to determine whether or not this form of cooperative
action leads to better results. Research has found no significant long-term effects of
joint venture activity on profitability in any industrial sector. One reason for this is
probably the prisoner’s dilemma: no contract can cover all eventualities and one side
always has an incentive to cheat in some way.
In addition, collaborative ventures raise principal–agent problems that are not
encountered in the single company; for example, the chain of command may not be
clear with the result that accountability is uncertain.
7.4.5 International Expansion

There is no difference in principle in moving into a foreign market compared with
opening up new domestic markets. The same considerations of strategic opportuni-
ties and threats and competitive advantage must be taken into account. But it has to
be recognised that competitive conditions may be significantly different in another
country. The competitive advantage of a company relates to its strengths relative to
the competition in the market where it currently operates. The fact that a company
has a competitive advantage in one location does not mean that it can be readily
transferred abroad. It was discussed in Section 4.3.4 that competitive advantage can
be country specific or company specific and this determines whether it is appropri-
ate to export to a foreign market or shift production there. But even if competitive
advantage is company specific it does not follow that it can be transferred abroad.
An example is the Japanese car maker Honda: in Japan it had about 10 per cent
market share and was dwarfed by Nissan with about one fifth of the market and
Toyota with about one third; but for years Honda sold many more cars in the US
than either of its big domestic competitors. The explanation is that in Japan both
Toyota and Nissan were much stronger in terms of marketing and control of the
distribution system, but these advantages could not be transferred to the US. Honda
used its competencies in car engines and receptiveness to US marketing ideas to give
it a clear lead in the US. Another instance is the attempts by Hong Kong hotel
groups to capitalise on their reputations, which were earned in Hong Kong, for
being the best hotels in the world. The leading hoteliers, such as the Mandarin
Oriental and the Peninsula, successfully established operations in other parts of
Asia. But it proved far more difficult to do so in the US and Britain because the
essential ingredient of high-quality service is a relatively high ratio of service staff
per room; since wage rates are much higher in the US and Britain it proved impos-
sible to maintain the same ratio without making the hotel impossibly expensive.

These hotels are thus at no advantage compared with established chains when
attempting to differentiate through excellence of service.
It is therefore necessary to focus on the elements of competitive advantage which
can be transferred. In the case of Nissan and Toyota it was not the strength of their
distribution systems in Japan which was potentially transferable, but their knowledge
of how to build and efficiently operate large distribution systems; but because of the
differences between Japan and the US it is doubtful if even the knowledge was
transferable. Successful hotels are more than buildings and physical features given
that these can be produced by many hotel designers; unless the service offered is
significantly different, and is perceived to be so by customers, then no transfer of
advantage has taken place.
Besides the problem of transferring advantages, there are several variables which
complicate operations on the international scene.
 Volatile exchange rates present serious problems; some of which were discussed
in Section 4.3.4. The fact that exchange rates cannot be predicted with any cer-
tainty, and the fact that relatively significant changes can take place in a short
period, can make nonsense of cost and revenue predictions in foreign markets.
One way of hedging against exchange rate movements as part of an expansionist
strategy is to produce as closely as possible to consumers. This means setting up
productive units in the countries where the markets are. For example, in the late
1980s Fiskars, a company producing knives in Finland, had the option of at-
tempting to enter the UK market by exporting to the UK. The purchasing power
parity of the UK pound against the Markka at the time suggested that the Mark-
ka was about 20 per cent overvalued; unless the Finnish knives were reduced in
price by 20 per cent they would be relatively highly priced in the UK; another
way of looking at this is that the overvaluation caused relative production costs
in Finland to be 20 per cent higher than they would have been in the UK. An
alternative strategy was for Fiskars to acquire a UK knife producer, or set up a
production unit in the UK, thus insulating itself against variations in the ex-
change value of the Markka. In the event Fiskars purchased Wilkinson Sword, a
famous company of razor blade makers in the UK, and Gerber, a successful
knife maker, in the US. This is an example of the ‘think global act local’ notion.
 Relative factor costs vary by country. For example, the ratio of the cost of labour
to the cost of capital is lower in the US than in Europe, leading to more capital
intensive production in Europe. It may be more efficient for a European com-
pany to shift the production of labour intensive goods to the US to take
advantage of the relatively cheap labour. But this cost advantage is swamped by
the relatively low labour costs in emerging economies that led to the phenome-
non of ‘offshoring’ that resulted in the relocation of millions of jobs.
 Productivity varies widely among countries. For example, for many years the UK
had a lower output per worker in the manufacturing sector than any other major
country in the European Community. To some extent this was overcome in the
1990s, when the UK experienced the highest growth in productivity in Europe.
This increase in productivity was spearheaded by new Japanese car plants which
were able to overcome restrictive labour practices. But in those industries in

which productivity is still relatively low companies may find it more efficient to
produce goods outside the UK.
 Governments often protect home production. This takes many forms, including
the minimum ‘domestic-content’ requirement. Protectionism can make it neces-
sary to set up productive units in a country which would otherwise not be
attractive.
 Cultural norms can vary fundamentally by country, and are ignored at the
company’s peril. For many years the Ford Motor Company in the UK attempted
to manage its factories using the management philosophy and approach (and
many managers) of the US. This contributed significantly to a decade of labour
problems.
 The economies of different countries rarely move exactly in step, and therefore
the information gathering and interpreting function is greatly increased with each
additional foreign market. This issue should not be under-estimated, given the
importance of relevant information to the identification of opportunities and
threats and the formulation of strategy.
With so many factors to take into account international expansion involves diffi-
cult decisions because of the need to make trade-offs among the factors. Take the
case of a US based company that has decided it can transfer its competitive ad-
vantage to countries A and B and has to choose one of them. The profiles of the
two countries in terms of the international factors are as follows.
International Country A Country B

factor
Exchange rates Highly unstable against Officially pegged to the dollar
the dollar for five years
Factor costs Wage rate 25% of US Wage rate 35% of US
Productivity No information; poorly Estimated to be 50% of US
educated workforce
Government High import tariffs No import tariffs
Culture Tendency to accept ‘Laid back’ and does not respond
authority well to structured management
Economic Slow but steady growth Major swings in the
performance for 10 years business cycle
This poses a very complex choice problem. For example, Country A has an un-
stable currency but a stable economy while Country B is the opposite; Country A
has a lower wage rate but productivity may be very low for some time because of
the poor educational standards; Country A may be more receptive to the US
management approach; Country A has a protected market while Country B is likely
to be subject to competition from companies exporting from the US. There is no
formula for balancing the trade-offs against each other and arriving at an optimal
choice so the final choice is dependent to a large extent on subjective interpretation.
There is clearly a lot that can go wrong so international expansion is often a high
risk undertaking.

7.4.6 From Generics to Variations

At the corporate level the generic strategy chosen requires the implementation of a
variation. The process is illustrated in Figure 7.3. While the list of variations is not
exhaustive Figure 7.3 demonstrates the logic of the choice process. For example,
expansion at the corporate level can involve investment in existing assets, acquiring
another company or entering the international arena. These options are not mutually
exclusive, for example international expansion would be accompanied by some
degree of investment.
Generic strategy Variations
Corporate
Expansion Investment Acquisition International
Stability Cost control Defend Restructure
Retrenchment Downsize Divest Rationalise
Business
Cost leadership Scale economies First mover Experience
Differentiation Segmentation Branding Research
Focus Niche Service Reliability
Figure 7.3 From generics to variations

These corporate choices must be underpinned by business level generic strate-
gies. For example, in a diversified company different products may require different
business level approaches, so there is no reason that expansion, for example, would
be associated with cost leadership rather than differentiation. On the other hand
when a company is in retrenchment mode and has decided to rationalise, cost
leadership and focus may be more appropriate than differentiation. The important
issue is to recognise the need to align the different levels of strategy with appropri-
ate variations.
A strategic variation which is to contribute to long run competitive advantage
must satisfy a number of criteria including the following.
 Consistency with objectives: an option may appear to be attractive, but it may not fit
with the company’s stated objectives. For example, the objective may be to
achieve market dominance in the domestic market, hence international expan-
sion would not be consistent.
 Suitability in terms of company resources: SWOT analysis is of crucial importance in
determining suitability, because the point of the SWOT analysis is to identify the
alignment between company strengths and market opportunities. For example, a
company may have a particular strength in cost control systems, but this may not
fit with the market opportunities for differentiated products.
 Feasibility: to some extent this is a matter of alignment, but even if the organisa-
tion has the resources the changes required to implement the variation may be
impossible to achieve; in addition, the commitment of key personnel must be

obtained. Even if an option appears to be consistent and suitable, the intangible

dimensions of organisational development may make it unworkable.
The selection of the appropriate strategic variation is never going to be straight-
forward. For example, take the case of a successful machine tool business which has
amassed a large cash reserve and the board has decided on a corporate generic
strategy of expansion. It has been decided that all strategic variations are consistent,
suitable and feasible. Which variation should be selected? Potential arguments for
and against each variation are set out below.
Strategic variation For Against

Related and unrelated Potential for synergy Difficult to define
relatedness
Vertical integration Direct control over Lose market discipline
supplier
Acquisitions Potential of unrealised May bid away potential
value benefits
Joint ventures and Avoid implementation Prisoner’s dilemma
alliances problems
International expansion Transfer competitive Exchange rate volatility
advantage
The important point is that there are always going to be arguments for and
against the adoption of any strategic variation. Therefore the ‘best’ variation will
depend on the circumstances. How do these variations compare with simply
distributing the cash to shareholders in the form of dividends? This depends on
whether the board thinks it is possible to generate a better return for shareholders
than they would have obtained elsewhere; at the very least the rate of return would
have to be higher than the market average.

7.5 Strategy Choice

to do what

Feedback


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

7.5.1 Shareholder Wealth

It is instructive to consider how shareholder wealth can be determined by the choice
of strategy, and why it is important to bear in mind the potential implications of a
choice for shareholder wealth despite the problems inherent in its calculation. For
example, the rationale for expansion is typically justified on the basis of delivering
greater shareholder wealth than either stability or retrenchment; but in fact there is
no automatic connection between shareholder wealth and any corporate generic
choice.
The following example is based on the calculation of shareholder wealth in
Section 3.12.6 and uses the same assumptions of a five year planning horizon and 15
per cent cost of capital. The expected cash flows over the planning period, and the
resulting impact on shareholder wealth, resulting from three generic strategies, are
compared in Table 7.6.
Table 7.6 Strategy options and shareholder wealth ($million)
Cash flows Year
Shareholder
Strategy wealth 1 2 3 4 5 6+
Stability 857 100 110 120 130 140 140
Expansion 1041 −100 50 200 210 220 220
Retrenchment 973 500 70 80 90 100 100
The potential cash flows from the three options have been derived from analyses
of markets, competition, opportunities, threats, environmental factors and so on.
 The stability option, which is based on carrying on as at present, exhibits a
constant growth in cash flow over the period because of slight sales growth and
anticipated cost savings, and generates shareholder wealth of $857 million.
 The expansion option is based on investment in new capacity, the development
and introduction of new products, and a marketing strategy designed to achieve
significant market shares by Year 3. By that time cash flow will be almost twice
as high as in the stability option. Despite the substantial cash outflow in the first
year, and the low cash flow in the second year, the expansion option produces an
increase of $184 million in shareholder wealth over the stability option. While it
may be concluded that the expansion option is an automatic choice over stabil-
ity, managers may be unwilling to face the prospect of two years of cash flow
problems, and the likely poor short-term profitability reports.
 The retrenchment option arises because the company has discovered that by
disinvesting it can concentrate resources on the longer term development of its
core business. Therefore, although cash flows will lag behind those of the other
two options from Years 3 to 5, the large positive cash flow in Year 1 contributes
to shareholder wealth of $973 million which, while lower than the expansion
option, is $116 million greater than the stability option. If managers are unwilling
to face the implications of the expansion option, then retrenchment has decided
value advantages over the stability option.

A conceptual difficulty posed by the shareholder wealth approach is that it col-

lapses all future expectations to the present. It may appear odd that the different
prospects of the expansion and retrenchment options in Year 5 are associated with
much the same shareholder wealth at the present; the expansion option implies a
company with a portfolio of products with relatively high market shares and an
equilibrium long-term cash flow more than double that of the retrenchment option.
This arises because of the discounting process, which takes into account the
opportunity cost of capital, and the fact that no further growth in cash flows is
assumed after the end of the planning period. If managers conclude that the
planning period does not adequately take into account the longer term implications
of the different strategies then the planning period itself can be amended according-
ly; however, this does not alter the principles on which the analysis is based.
A further powerful application of shareholder wealth analysis is to break down
the activities of the company and estimate the contribution which each makes to
total value. For example, in the retrenchment example a part of the company had
been identified which was subtracting from shareholder wealth; by getting rid of it
shareholder wealth was increased. Take the case of a company which has three
SBUs, the largest of which produces computer equipment, the second largest
provides maintenance services, and the smallest produces software and application
consulting services (this scenario is loosely based on the famous Apricot Computer
case investigated by Sir John Harvey Jones in his TV series ‘Troubleshooter’). Such
a company will typically regard the production of equipment as being the ‘core’
business on which the others are built. However, as often happens, the maintenance
and consulting SBUs develop markets which are independent of the equipment
which the company produces, and start to behave as independent entities. The
question then arises of identifying which SBUs are contributing most to the value of
the company as a guide to future resource allocation. The situation is represented by
the example in Table 7.7, which uses the stability option in the previous example
disaggregated into three SBUs. Obviously there are problems associated with
allocating costs to the SBUs, but for the purposes of the analysis it is assumed that
the estimates are fairly accurate.
Table 7.7 Resource allocation and shareholder wealth ($million)
Cash flows Year
SBU Shareholder 1 2 3 4 5 6+
wealth
1 Revenue 500 530 540 560 580
Cost 480 495 520 530 540
Cash flow 227 20 35 20 30 40 40
2 Revenue 200 205 220 225 230
Cost 165 170 170 275 190
Cash flow 270 35 35 50 50 40 40
3 Revenue 75 85 110 110 120
Cost 30 45 60 60 60

Cash flows Year

SBU Shareholder 1 2 3 4 5 6+
wealth
Cash flow 360 45 40 50 50 60 60
Total Cash flow 857 100 110 120 130 140 140
The current and future revenues from selling products and services are dominat-
ed by the ‘core’ business of SBU 1; it generates about two thirds of company
revenue and incurs about two thirds of total cost. However, it has the lowest
shareholder wealth of the three SBUs, while the smallest SBU of the three in terms
of total revenue has the highest shareholder wealth. Taking the costs in Year 1 as an
indication of the total allocation of resources, the mismatch shown in Table 7.8
emerges between resources deployed and value created.
Table 7.8 Resource allocation and value creation (%)
SBU 1 SBU 2 SBU 3
Shareholder wealth 26 32 42
Resource allocation 71 24 4
This indicates that the ‘core’ business consumes 71 per cent of company resources,
while producing 26 per cent of shareholder wealth; the smallest SBU consumes 4 per
cent of resources and produces 42 per cent of shareholder wealth. Because SBU 1 is
seen as the ‘core’ business, it is likely that managers devote more than 71 per cent of
total management time to trying to make it pay. In choosing among strategy options,
management ought to address the following questions. First, are the activities of SBUs
2 and 3 really dependent on the production of equipment? If no clear linkages among
products can be identified it is unlikely that producing them in the same company
produces value over and above what could be achieved if they were produced
independently; this raises the question of whether the company really understands its
own value chain. Second, if not, should resources be reallocated from SBU 1 to SBUs
2 and 3? It could turn out that the long-term future of the company lies in providing
maintenance for a range of manufacturers and pursuing further innovative consulting
possibilities. However, at the moment, it is likely that these SBUs are starved of
resources and managerial inputs because of preoccupation with the ‘core’ business.
It must be stressed that shareholder wealth analysis at this aggregate level can only
be indicative of the value creation activities of the company because of the need to
make arbitrary assumptions about the allocation of joint costs and predictions of
future costs and revenues. However, even if costs were incorrect by 10 per cent for
SBU 3, the same general result would emerge. This approach can throw into sharp
relief the fact that a company may be oblivious to the evolving nature of its business,
and may be encumbered with a management which developed the company through
its initial stages but cannot now see beyond that.
A major problem in applying shareholder wealth analysis is that it implies that the
future can be predicted with some degree of certainty. There are many circumstances
where future events are so uncertain that the error associated with the calculations is

too great to permit their use. For example, the decision to develop and introduce a
new product may be based on little more than an unquantifiable perception that a
market for the product can be expected, but much depends on developments in other
products, changes in consumer tastes, the behaviour of competitors, and so on. While
Shareholder Wealth analysis is clearly an important tool in those cases where the
future can be estimated with some degree of certainty, and focuses attention on the
potential of different courses of action to generate value, there is still a need for tools
which can be applied to what are essentially leaps into the unknown.
7.5.2 Performance Gaps
The notion of performance gaps was developed in Section 3.3 as being the differ-
ence between the expected outcome if the company carried on as at present, and the
desired outcome. In the shareholder wealth analysis there may be several strategies
which would accomplish the expansion option but identification of the desired
future state greatly narrows the range of feasible strategic options. The application
of gap analysis helps to identify the appropriate options from which the strategy
choice ought to be made.
 The gap identifies whether the company should be pursuing a generic strategy of
stability, expansion or retrenchment.
 The extent of the gap indicates whether the company has to undertake a
significant reallocation of resources in order to close the gap; for example, the
company may have specified an ambitious objective in terms of market share,
but it may turn out that the gap is relatively small, and that closing the gap does
not involve a significant change in direction.
 Within the generic strategy the ways of closing the gap can be identified; for
example, whether strategy should be concentrated on external or internal factors,
such as marketing effort as opposed to cost control.
By structuring the question of where the company is actually going compared to
where managers would like it to go, the gap approach reduces the array of strategy
alternatives to those which have direct relevance to the company’s objectives and to
its potential capacity. What might appear to be a painfully obvious process requires
managers to step back from the actual running of the company and identify in an
objective manner options which might not be intuitively obvious were the gap not
identified in the first place.
7.5.3 Corporate Management

When the company is comprised of a portfolio of products, the problem facing
corporate management is to decide on the components of the portfolio while SBU
management is concerned with the management of the products selected. The
portfolio approach developed in Section 5.7.1 is fundamental to this issue, and the
role of corporate management is to attempt to select the optimum portfolio of
products for the company. There are many criteria which can be applied to the
selection process, depending on the circumstances and the objectives of the
company.

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

Market factors
New familiar High Medium Low
Base High High Medium
Base New familiar New unfamiliar
Technologies or services embodied in the product
Figure 7.4 Familiarity matrix

It is important for management to be aware of the extent to which the choice is
likely involve the company in situations about which it has limited information and
experience. A choice in the top right quadrant ought not to be undertaken without
consideration of the extent to which company resources are likely to be able to
deliver profits in an unfamiliar environment.

For example, take the case of a company producing construction toys for the 5 to
10 age group that has decided to enter the games market. There are two options:
 Electronic games for teenagers.
 Board games for the 5 to 10 age group.
In terms of the growth vector in Figure 5.10 both options fall into the New
Product and New Entry categories suggesting Diversification. But there is a
significant difference in the degree of familiarity: the company is unfamiliar with
both electronic technology and the teenage market; it can adjust its production
process to make board games and it understands how to sell to the 5 to 10 age
group. That means the electronic game would be classed as ‘low’ familiar and the
board game as ‘medium’ familiar. The electronic game market might appear to be
much more attractive than the board game market but the organisation may not be
able to cope with the changes necessary to succeed in the relatively unfamiliar
market
Corporate strategy tends to be concerned with many intangible factors which are
not susceptible to measurement, and where it is difficult to identify rules which
promote effective decision making. There is no objective answer to the ‘right’
balance of products of different types and at different points in the portfolio matrix;
there is no hard and fast criterion to apply when selecting which new market to
enter; there is typically no single answer to resource allocation when SBUs are
competing with each other. However, the approaches outlined above can help
corporate strategists introduce some order into the process and ensure that options
are evaluated in a consistent fashion.
The limitation of attempting to represent options by alternative cash flows be-
comes apparent when the company starts to look at options in terms of distinctive
capabilities and competencies; these can be regarded as techniques for generating
sustainable competitive advantage, but it is impossible to translate them into hard
and fast cash flow terms. Furthermore, the implications for portfolio management
go far beyond those of the BCG approach; the portfolio needs to be comprised of
linked elements which are susceptible to effective management. This brings us back
to the issue of parenting and value added: the company must confront the issue of
whether it is feasible to add value by pursuing different options. This forces the
company to think about its strategic architecture and whether it can identify
competencies and linkages which are going to be difficult to replicate and which
have the potential to convey a degree of competitive advantage in more than the
short term.
7.5.4 SBU Management

The SBU is best thought of as being a single product entity to avoid repetition of
the corporate issues relating to the product portfolio. At this level strategy choice is
concerned with the exploitation of products and markets, and with ensuring that
resources are allocated efficiently. The overall objective is to achieve a competitive
advantage in the products on which corporate management has decided to concen-
trate. The type of issue which SBU management focuses on includes the impact of

market share on ROI, the type of markets to aim at, and the methods of achieving
relatively low unit cost. One method of making explicit the impact of different
product-based strategies is to use the project appraisal approach as shown in the
scenario in Table 7.9.
Table 7.9 Project appraisal

Year 1 2 3 4 5 6 7
Development ($m) 8 8
Total market (000s) 100 120 150 200 250 250 100
Market share (%) 13 15 15 15 15
Price ($) 1 395 1 200 1 200 1 395 1 395
Unit cost ($) 692 630 610 600 600
Contribution ($m) 14 17 22 30 12
Cumulative cash flow ($m) −8 −16 −2 15 37 67 79
Net present value ($m) 34 Cost of capital 15%
This scenario framework makes explicit a large number of assumptions which are
often only dimly perceived by managers. The total market profile is derived from
the analysis of the product life cycle. The market is expected to grow to 150 000 by
the time the product is launched, continue growing to 250 000 in Year 5, and end in
Year 7. The market share and price are closely related; the product is expected to
be launched with 13 per cent market share, and subsequently to be increased to 15
per cent partly as a result of the price reduction in Year 4, which is to be maintained
through Year 5 in order to consolidate the market share. The unit cost is expected
to decline throughout the product life as the experience effect builds up; however,
beyond Year 6 this is not expected to be significant as production is run down.
Contribution reaches its peak in Year 6, when the product has the characteristics of
a ‘Cash Cow’: a relatively high market share in a mature market, and benefiting from
experience effects. The cumulative cash flow indicates how long it takes for the
product to pay back the investment. Once the model has been set up in this form it
is a relatively simple matter to investigate different scenarios by using sensitivity
analysis. For example, the worst possible case could be assessed for all variables
together, possibly involving a smaller total market, lower market share and a slower
reduction in unit cost. An additional outcome of the sensitivity analysis is the
identification of crucial variables; for example, it might emerge that there is some
doubt about the potential size of the market; if the total market does not reach at
least 230 000 the project will generate a negative NPV.
A scenario can be constructed to investigate different marketing strategies, such
as the potential for converting a Question Mark into a Cash Cow. In the example,
there could be substantial advantages in aiming at a 20 per cent market share in Year
4 rather than 15 per cent. However, this might involve reducing the price to $900
for Year 4; the payoff would be the ability to charge a higher price in Year 5 and a
more pronounced experience effect. What would the outcomes have to be to justify

the massive price reduction in Year 4? The scenario framework generates the answer
in terms of the impact on NPV.
The scenario approach clarifies the payoffs from different potential courses of
action, depending on the assumptions made. While being a powerful tool, it does
not provide an automatic choice criterion because of the many uncertainties and
imponderables. For example, competitive reaction to the price reduction in Year 4
may be immediate, causing no increase in market share, while a smaller price
reduction might have gone relatively unnoticed because it was not perceived by
competitors as a significant threat. However, managers typically have sufficient
information to make entries in many of the boxes in the scenario matrix, which can
then be used as the basis for sensitivity analysis.
7.5.5 Risk and Uncertainty Analysis

Strategy decisions are by their nature forward looking; therefore all strategy options
are uncertain. Choices are continually being made among options which are
uncertain in different degrees. It is not sufficient to carry out a sophisticated
discounted cash flow analysis of an investment and make decisions based on the
highest expected net present value. All managers are concerned about the chances
that events will actually turn out as they have been predicted, and would like to have
some idea of the risks associated with different outcomes. In extreme cases manag-
ers should be able to deal with risk fairly confidently; for example, in 1995 in the
UK advertisements appeared for investments in ostrich farming. The investment
involved buying one or more ostriches to be cared for on a farm and which would
produce chicks which would be sold on. The advertisements offered 58 per cent
return per annum. On the face of it this was a highly risky investment for two
reasons. First, the rate of return clearly had an enormous risk premium, given that
the rate of interest at the time was about 6 per cent; second, up to 1995 the sale of
ostrich meat for human consumption in Europe was not significantly greater than
zero. The astonishing thing was that although no financial institutions were willing
to invest in ostriches, many individuals committed significant amounts of cash to
the venture; it came as no surprise that the business turned out to be bogus.
However, this is an extreme case and the choice is not typically so obvious: manag-
ers are faced with the problem of making trade-offs between the prospect of varying
returns and possibilities of failure. Most managers wish to determine whether the
prospect of an uncertain future can be incorporated into decision making in a
structured fashion.
The first step is to ascertain what information is actually available about the like-
lihood of future events. At first, managers tend to disregard the notion that anyone
can predict the likelihood of future events occurring, but in fact it is widely accepted
that subjective knowledge can provide a usable perspective on risk. For example, a
salesman can be asked for his assessment of the chances that the sales of his
product will double next year. He may well reply ‘one chance in two hundred’, or
‘too low to be measurable’; however, he may think that there is about one chance in
4 of sales increasing by 20 per cent next year. More detailed questioning may reveal
that on balance he thinks it more likely that sales will increase rather than decrease.

By asking the salesman what the chances are, we are really asking him to assign
probabilities to possible future outcomes, and the pattern of responses is termed a
probability distribution. The salesman’s responses might be as shown in Table 7.10.
Table 7.10 Expected value

Change in sales (000s) Probability Expected value (000s)
−20 0.05 −1.0
−10 0.10 −1.0
0 0.20 0.0
+10 0.40 4.0
+20 0.25 5.0
Average Expected value
0 7.0
Assume that the salesman has identified five possibilities: that sales will fall by
20 000 or 10 000, remain the same, or increase by 10 000 or 20 000; the reasons for
arriving at these estimates are unimportant. The average of these expectations is
zero, i.e. adding the possibilities of change and dividing by 5 gives zero. However, in
the second column the salesman has expressed his subjective probabilities of these
outcomes: for example, he reckons that there is only one chance in 20 that sales will
fall by 20 000, but 4 chances in 10 that they will increase by 10 000. The third
column is obtained by multiplying the probability by the possible outcome. For
example, the probability of a 20 000 increase is .25, giving an expected increase of
5000. The summation of these expected outcomes comes to 7000, i.e. taking the
salesman’s subjective probabilities into account he expects sales to increase by 7000
next year rather than the zero suggested by the simple average. Since the 7000
estimate takes into account what the salesman feels he knows about the future it can
be argued that it is a better basis for decision making than concluding that there will
be no change in sales.
Thus people who are familiar with particular markets and production processes
are able to express future outcomes in terms of their chances of occurrence, and this
information can be used in a systematic fashion. It will come as no surprise that
there is a good deal of controversy surrounding the use of subjective probabilities,
and much depends on the credibility which individual managers attach to the
information obtained. But even if managers have reservations about the probabilis-
tic approach, it can still be used to provide a perspective on risk which may
otherwise not be appreciated. Take the example in Table 7.11, where three potential
outcomes from an investment have been identified and the risk associated with each
estimated.

Table 7.11 Average outcome and expected value

Outcome Probability Expected value
−100 0.1 −10
50 0.2 10
200 0.7 140
Average Expected value
50 140
The most likely outcome in this case is that the investment will yield an outcome
of 200. This contributes to the fact that the average outcome is only 50 compared to
the expected value of 140 when the probabilities are taken into account. The
expected value of 140 would be used to compare this project with projects of
broadly similar characteristics. When decisions on investments are continually being
taken, the proponents of the subjective probabilistic approach argue that over time
the company will be more profitable than if it had used the unweighted average
approach. Whether this is true or not depends on the extent to which subjective
probabilities contain real information.
The table of possible outcomes and probabilities ignores an important issue,
namely the attitude of managers to risk. A particular manager may feel that even
though the probability of losing 100 is only one in ten, this is still an unacceptable
risk because it would result in the company going bankrupt. This is known as risk
aversion, and results in the manager preferring an investment with a lower expected
value which did not contain the risk of bankruptcy in the probability distribution.
The expected value approach can conceal the fact that risks are not symmetrical,
and therefore it would be folly to base decisions on the expected values alone no
matter what the ‘law of large numbers’ states, because the company may end up
with a portfolio of projects each of which contained the potential to bankrupt it. It
is a well-established fact that individuals do not always act in accordance with
‘expected utility maximisation’, i.e. do not always choose the option with the highest
expected outcome. Consider the options in Table 7.12.
Table 7.12 Choosing an expected value

Option Outcome Probability Expected value
A 2 000 0.05 100
B 100 0.50 50
Despite the fact that the expected value of A is greater than B, a significant pro-
portion of people would choose B. This is because there are many other factors
affecting choice beside the expected value. To some individuals it is preferable to
have a good chance of winning even a small amount than a very small chance of
winning a very large amount.
There is another type of risk which cannot be quantified because the future event
itself cannot be foreseen. For example, no one knows whether an earthquake will
occur next week, or whether a carefully planned just in time organisation is going to

fall apart because of human error. What is known is that something, sometime, is
going to go wrong with plans and expectations. This type of risk is often referred to
as uncertainty, and defies any attempt at quantification. But given that it does exist it
is necessary to make some allowance for it; for example, how much additional
inventory is it worth holding just in case there is an unexpected materials shortage?
Despite the fact that the chances of a shortage occurring seem remote, a manager
may feel inclined to hold a substantial inventory because the very existence of the
company would be placed in jeopardy if orders could not be met in time.
Because of the existence of uncertainty, it is essential that strategies are con-
structed which have the potential to adapt to circumstances which turn out to be
radically different to those anticipated. If the company is inflexible it will be
impossible to respond to events as they unfold, with the result that the strategy
would have to be abandoned at an early stage. One way of tackling this is through
contingency planning, which involves making sure that the strategy is capable of
responding to a wide variety of scenarios, and keeping options open as long as
possible.
Thus one of the difficulties in formulating strategy is the need to take into ac-
count the unknowable (uncertainty) as well as the likelihood of events not turning
out as predicted (risk). In the case of risk it is possible to take a reasoned view on
the position to adopt in the event of adverse circumstances, and take action to
provide insurance against loss, such as holding high inventories and identifying
second best market opportunities. But uncertainty poses a set of problems to which
previously calculated solutions cannot be applied because managers cannot foresee
what the event might be, never mind the likelihood of its occurrence; for example,
much of the outcome of strategy depends on the actions of competitors, which may
often be unforeseeable, and exogenous events can occur which completely alter the
characteristics of the market.
The notion of contingency planning can be used to cope with both risk and
uncertainty by identifying alternative courses of action to undertake should certain
events transpire. There are two types of contingency planning: first is the technical
process of attempting to minimise the probability of loss due to risk, and identifying
alternative courses of action in the event of identifiable potential outcomes; second
is the strategic response to major unpredictable events. The first of these can be
tackled by the application of ideas from the business disciplines, but the second
poses more intractable problems. Responses to this type of problem are almost
wholly determined by managerial attitudes and perceptions.
7.5.6 Managerial Perceptions

The application of sophisticated information gathering and analytical techniques
does not of itself generate a strategy choice. At the end of the day someone has to
weigh up the arguments for and against different courses of action and arrive at a
decision on strategy. This someone may be the CEO, or it may be a group of
decision makers, and the process by which the decision is finally arrived at may be
obscure; after the event it may be identified as logical incrementalism or emergent
strategies. Those who carried out the analyses may feel that little attention was paid

to their conclusions; or the CEO may draw opposite conclusions to the analysts
from precisely the same information; analysts themselves may feel that the CEO
does not fully comprehend the implications of their findings. It is in fact very
difficult for outside observers to assess the rationality of decision-making processes
in a particular organisation; this is because the personal objectives of decision
makers may not be known, and therefore the weighting which they attribute to
different factors cannot be taken into account when attempting to explain their
decisions. However, there are a number of factors which bear on decision makers
which might help to explain observed behaviour.
External Dependence
All companies depend on other companies to some extent: many companies
concentrate on relatively few customers, and some companies are dependent on
relatively few suppliers. Some managers may see a particular degree of external
dependence as a potential threat, while others may see it as a strength. In terms of
the five forces, dependence on an external supplier results in a high degree of
supplier bargaining power and servicing relatively few customers leads to a high
degree of buyer bargaining power. The combination of the two would lead to a
precarious competitive position. But the CEO may perceive that the benefits of
guaranteed supplies and loyal customers compensates for the potential hazards.
Another form of external dependence is when a majority shareholder exerts
influence on decision making; in such a situation the principal–agent problem
emerges and some managers may be unwilling to take strategy decisions because
they feel that they do not really control the company.
Attitudes to Risk
A great deal can be done to quantify the risks facing the company. However,
managers vary in their attitude to risk, and what might appear a reasonable degree of
risk to one manager may be unacceptable to another. This can be generalised to the
company culture to some extent, and some companies do portray themselves as
being relatively risk averse; this attitude can rub off on the individual managers, with
the result that strategy options which imply a fair degree of risk will not be seriously
considered at any level.
A practical technique for taking risk aversion into account is to use a ‘minimax’
criterion. This involves selecting the option with the lowest potential loss independ-
ent of the probabilities associated with predicted returns. An example of how this
might work in practice is illustrated by the potential outcomes from the two
investments shown in Table 7.13.

Table 7.13 Minimax decision making

Investment A Investment B
NPV ($m) Probability NPV ($m) Probability
140 0.8 100 0.7
50 0.2 80 0.2
−20 0.1 −10 0.1
Expected NPV 120 85
Investment A gives a higher expected NPV of $120 million compared to $85

million for investment B; however, investment B would be chosen because it has a
lower potential loss. Strong arguments in favour of investment A could be suggest-
ed; for example, it has a higher probability of a higher NPV. However, whether
investment A is preferable to investment B cannot be resolved on the basis of the
numbers alone.
Another factor which has a bearing on the choice between risky alternatives is
the desire to diversify the portfolio of risks. For example, a company which is
currently making refrigerators may prefer to diversify into pocket TVs rather than
freezers because the risks associated with refrigerators are less correlated with the
risks associated with TVs and more correlated with the risks associated with
freezers. When times are bad for refrigerators the positive cash flow from TVs can
be used to keep refrigerator production going and vice versa. The idea that diversifi-
cation can help guarantee the company’s survival is a compelling justification for
seeking opportunities to diversify risk. However, the manager should consider
whether the benefits from diversification are imaginary or real.
One way to approach this is to ask whether the share price of a company produc-
ing refrigerators and TVs is greater than the sum of the share price of two
companies producing the two goods. After all, a shareholder could diversify risk by
buying shares in the two companies, and may prefer this to a composite share.
Furthermore, if the company feels that it is worthwhile to ‘bail out’ the TV company
from time to time, the same thing must apply to the financial market as a whole,
which will always be willing to provide finance for a company which has a positive
net present value.
A note of caution needs to be interjected on the portrayal of a company as risk
averse on the basis of its past behaviour. It is often observed when running simula-
tions in management programmes that managers avoid taking decisions which
involve significant changes because they claim that their company culture is con-
servative and risk averse. However, this confuses conservatism towards making
changes, with risk aversion: this ‘conservative’ approach is not based on an explicit
analysis of risk factors, and it is typically not realised that avoiding change can incur
higher risks than decisions involving a reallocation of resources; avoiding action is
not a neutral decision. Indeed, managers are often observed to develop a form of
decision paralysis in which they are unwilling to stray far from what has been done
in the past, no matter how poor the results of past strategy have been. Some
companies are better portrayed as being ‘risk ignorant’ rather than ‘risk averse’.

Previous Strategies
The process of strategy is continually evolving, and because of changing circum-
stances no particular strategy can be regarded as sacrosanct. The time always comes
when a major strategy decision needs to be taken which involves a significant
change from previous strategies. However, managers may have invested substantial
personal resources in the identification and implementation of strategy to date and
see no reason to change how things are done. In such circumstances, managers may
be unwilling to make significant changes until external factors force a response.
Indeed, the very success of previous strategy may contain the seeds of future
disaster because of the natural tendency to take refuge in a tried and tested ap-
proach.
An example is when an industry moves through the transition from growth to
maturity at which point it becomes appropriate to adopt a defender rather than a
prospector stance. In the past building inventories, pricing aggressively and spend-
ing large amounts on marketing produced growing sales and increased market share;
the desire to adhere to previously successful behaviour can lead to failure to
recognise that the transition to maturity has started and can help explain why many
companies do not adapt to the new competitive environment. It also leads to the
situation where a product that exhibits Cash Cow characteristics – high market share
in a mature market – does not generate relatively high profit.
Managerial Power Relationships

All organisations have their own internal politics. The process of decision making
has infinite variety, from the friendly compromise reached between brothers
running a family business, to the autocratic dictates of a powerful CEO in charge of
a large multinational.
To some extent this is related to the principal–agent issue, where the objectives
of managers are not necessarily consistent with those of shareholders. For example,
an SBU manager may be opposed to a strategy which involves retrenchment of his
SBU despite the fact that it is in the interests of the company as a whole; he may
have a strong influence on strategy choice because he is regarded as one of the ‘elder
statesmen’ in the company.
Consensus Decisions: The Paradox of Voting

Some companies pride themselves on an egalitarian approach to decision making,
where each manager involved in the team has an equal weighting; in this case, when
there is no obvious decision because trade-offs have to be made, there may be
recourse to a vote. It is usually felt that a straight vote has two benefits: it eliminates
the power of any individual, and it enables the weight of opinion to sway the
decision. However, voting is as subject to manipulation as any other decision
technique, although it is less obvious to the participants.
The following example is based on three unlikely friends, a miser, a health freak
and a drunk, who are trying to decide whether to build a house or not. The three
individuals consider the problem as follows:

The miser will not wish to build a house, preferring instead to keep the money in
the bank. Failing that, the miser’s preference is to build the cheapest house possible,
i.e. a house without a bar.
The health freak will wish to build a house, naturally without a bar. Failing that,
the health freak’s preference is to keep the money in the bank, because building a
house with a bar would be bad for his health.
The drunk will wish to build a house with a bar, and failing that would rather
leave the money in the bank, where there is a chance it might be available to spend
on drink.
The options are therefore:
A. House / Bar
B. House
C. No House
The ranking which the three friends put on the options are shown in Table 7.14.
Table 7.14 Option rankings

Preference First Second Third
Miser No house House House / Bar
Health freak House No house House / Bar
Drunk House / Bar No house House
A straight vote would not resolve the issue, because each individual has a first
preference for a different option. Counting the number of first, second and third
preferences reveals Table 7.15.
Table 7.15 Counting the rankings

Order of preference
First Second Third
House / Bar 1 0 2
House 1 1 1
No house 1 2 0
The No House option is the clear winner, because it has one First and two Sec-
onds; this could be regarded as the natural preference of the group which would be
revealed after discussion on the assumption that all three individuals are equally
weighted. However, the matter is not necessarily resolved in this way because, since
there are three in the group, they appoint the health freak as chairman. His first
observation is that the problem is too complicated to resolve by a single vote, and
that the problem should be structured. Therefore, he poses the question ‘Do we
want a house or not?’ Since there are two Firsts in favour of a House or a
House/Bar, on the basis of a majority vote it is agreed that a house should be built.
The three then vote on what type of house to build; their preferences are shown in
Table 7.16.

Table 7.16 The second vote

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

Consider the case of Acme that is considering entering into an alliance with Tempco
to enter a foreign market. The following shows how two different management
teams might view the alliance purely on the basis of perception.
Managerial perception Management team A Management team B

External dependence We need to have com- We can benefit from
plete control of sharing responsibility for
marketing, major decisions
pricing, distribution, etc.
Attitudes to risk We can’t rely on Tempco Tempco stand to lose as
to stick to the contract in much as us
a foreign country
Previous strategies Organic growth has It is time to try a new
worked for us in the past approach
Managerial power Tempco’s CEO is highly Tempco’s CEO is
relationships ambitious and forceful impressive and successful
Consensus decisions We demand a majority Decisions should be
on the joint board taken only by the two
CEOs
acting together
The two management teams are diametrically opposed purely on the basis of
perceptions. No matter what the arguments in favour of the alliance with Tempco
actually are it is difficult to see that Management team A could be persuaded to go
ahead. On the other hand Management team B is favourably disposed to the alliance

in principle. This rather extreme example of perceptual differences demonstrates

why decisions are rarely taken purely on the basis of facts and rational discussion.
7.5.7 From SWOT to Generics

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

niche
Figure 7.5 Choice process

The figure shows two diametrically opposed outcomes of a SWOT analysis. One
analysis has identified an alignment of strengths and opportunities which opens the
possibility of expansion by alliance. The other shows that the alignment of weak-
nesses and threats is such that the company should retrench and focus on a niche;
this could be the outcome of recognising that it is ‘stuck in the middle’. What
happens if both of these are identified within the same SWOT analysis? That is
when the CEO has some tough choices to make and really starts to earn her money.
It is also an opportunity for inventive thinking: is there some way of operating on
the weaknesses so that the need to retrench is avoided while leaving the way open
for expansion? It is sometimes argued that the benefit of SWOT analysis is that it
does not just identify where the company is but provides a framework for thinking
about what might be. After all, it is thinking differently that ultimately confers

Review Questions
Case 7.1: Revisit Salmon Farming

1 Carry out a SWOT analysis for a typical salmon farm and derive a generic strategy.
Case 7.2: Revisit Lymeswold Cheese

1 In Module 5 you discussed what went wrong with Lymeswold cheese. Revisit the case
and devise a strategy for success.
Case 7.3: Revisit A Prestigious Price War

1 In Module 5 you analysed competition in the quality newspaper market. What action
would you recommend for the Daily Telegraph, and what do you think its prospects
would be?
Case 7.4: Revisit General Motors: The Story of an Empire

1 In Module 6 you analysed General Motors. Suggest a strategy for the future of GM, and
be clear about your reasoning.
Case 7.5: The Rise and Fall of Amstrad (1993)

Amstrad was something of an electronics industry phenomenon in the 1980s under the
leadership of Alan Sugar. The basis of the company’s success was to offer consumers
products which did not depend on a technological breakthrough but were based on
Sugar’s understanding of what consumers really want. In the late 1970s the Tower
System integrated the amplifier, tuner and cassette deck in one unit and brought
sophisticated hi-fi systems within the reach of just about everyone. Amstrad then moved
on to a low cost, one plug computer system which brought word processing cheaply to
a mass market. The company then moved into cheap facsimile machines, video record-
ers and satellite dishes.
Company profits climbed steadily from 1980 from practically zero to about £20
million by 1985. In 1986 profits more than doubled, in 1987 they doubled again, and in
1988 reached £160 million. They then proceeded to halve in 1989, fell again in 1990 and
1991, and a loss was forecast for 1992. As would be expected, the price of Amstrad
shares peaked in 1987, and lost about 90 per cent of their value by 1992.
A major element of Sugar’s strategy was to move out of a product as soon as compe-
tition became tough and margins were eroded. However, Amstrad did not leave the
personal computer market when margins virtually disappeared, and found itself saddled
with unsold stocks of out of date computers and was relatively slow to introduce new
eye-catching products. At the moment the company has a range of new products on

offer, such as a user-friendly notepad personal computer and a videophone. However,

the formula of selling easy to use electronic goods at low prices has been taken up by
other companies.
The company went public in 1980, and in 1992 Sugar attempted but failed to buy
back all the shares. The objective of buying back the shares was to renew Sugar’s
absolute control over the company, and make it possible to revert to his original
strategic vision. However, the shareholders considered that the deal proposed was not
in their best interests.
1 Classify the Amstrad strategy in as many dimensions as you can using the ideas
developed in this module, and apply ideas from previous modules to interpret the
situation in which Amstrad finds itself.
Case 7.6: What Is a Jaguar Worth? (1992)

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

1 Use the list of reasons for a takeover to identify the areas in which Ford might have
reckoned that there was potential for creating value by investing a significant proportion
of this cash mountain in Jaguar.
Case 7.7: Good Morning Television Has a Bad Day (1993)

The following is an account of the experience of Good Morning Television (GMTV)
from the time of making a successful bid for the UK advertiser-financed breakfast TV
franchise in October 1991 until early 1993, three months after it started broadcasting
on January 1, 1993.
The Bid
The regional independent TV franchises in the UK were auctioned in October 1991, to
take effect from January 1993. The terms of the bid were an annual fee that an applicant
would pay to the Treasury for a licence covering a period of 10 years. This licence
conveyed a local monopoly to the franchise holder of advertiser-financed television. In
the case of breakfast TV it conveyed the right to broadcast national breakfast pro-
grammes; the only other advertising-financed breakfast programme supplier was the
minority Channel 4 Daily breakfast business and arts programme which attracted a very
small audience. Thus at the time the franchise for breakfast TV was regarded as being
largely a monopoly.
The two qualifications for a successful bid, beyond the price offered, were
1. Programme schedules had to meet a minimum quality threshold (not made explicit
and at the discretion of the IBA).
2. Applicants also undertook to pay a proportion of their advertising revenue to the
Treasury. This varied according to the level of advertising expected.
The procedure adopted was to weed out the applicants with the lowest defined
quality, and then award the franchises on the basis of the highest bids.
The bids revealed that competition varied greatly among regions. For example, in
some regions there was only one bidder and the amount bid was practically zero. In
others the incumbent was already highly successful, such as TV-am, and the incumbent
was ousted by an aggressive competitor. In the case of TV-am, which was the most
successful breakfast TV show among the three terrestrial stations in the UK, the
winning bid by GMTV amounted to £34.6 million per annum, together with 15 per cent
of advertising revenue.
Table 7.17 is a selection of the 16 franchise bids, and shows the extent of bid varia-
tion, and the surplus bid, which was the difference between the winning bid and the next
best (which was not necessarily the incumbent’s bid). In some cases this is negative
because quality was taken into account. There was only one breakfast franchise up
for auction.

Table 7.17 Auction results for ITV franchises (£million)

Winner Winning bid Incumbent Incumbent’s Surplus bid
bid
GMTV 34.6 TV-am 14.1 1.3
LWT 7.6 same same −27.8
Meridian 36.5 TVS 59.7 −23.2
Scottish 0.0 same same 0.0
Tyne-Tees 15.1 same same 10.0
Some incumbent companies, such as Scottish, were faced with no competition, and
did not pay anything for their new franchise. Other incumbents, such as Tyne-Tees, paid
substantially more than competitors. On the other hand Meridian took over from an
incumbent with a much smaller bid, i.e. the surplus bid was negative.
The Competition
GMTV’s business plan envisaged advertising revenues of £80 to £90 million for 1993,
based on the TV-am market share of over 65 per cent. At the time the bids were
submitted breakfast TV was dominated by the three terrestrial stations: the BBC (which
is not advertiser-financed), TV-am and Channel 4. After a shaky start in the early 1980s,
when the TV-am audience fell to about 200 000 viewers and there were only two
advertisers, TV-am appointed Mr Greg Dyke to revamp its image, and by the time of his
departure in the late 1980s TV-am had a dominant market share, and was one of the
most profitable TV companies in the world. By 1991 the breakfast competition to which
TV-am was exposed was not troublesome. The competitors were the news based TV
show on the BBC, and the business and arts show Channel 4 Daily. At this point satellite
TV had still to make an impression.
Enter The Big Breakfast and Satellite

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

In its first year of operation, based on the expected response of advertisers to the
lower viewing figures, GMTV expected to produce revenues of £65 million against its

business plan forecast of £80–£90 million. On the cost side

 programming costs came to around £30 million per year;
 the £34.6 million licence fee had to be paid regardless of revenue;
 annually 15 per cent of revenues go to the Treasury.
Combining these costs, it appears that GMTV needed revenues of about £75 million
per year simply to break-even. Unless GMTV could deliver larger audiences advertising
revenue looked set to decline.
Come Back Mr Greg Dyke

History can repeat itself. In February 1993, 10 years after saving TV-am, Mr Greg Dyke
was appointed to GMTV with the same remit. He was widely quoted as saying ‘This is
not a cash crisis. We have five big shareholders who are all in this for the long term.’
Both the male and female anchor personalities were replaced by the end of February,
only two months after the first broadcast. Their replacement presenters had actually
anchored the TV-am show right up to December 1992 when it went off the air. GMTV
also signed up a cartoon series based on characters from the Super Nintendo video game,
which had sold in millions during 1992.
1 Analyse the competitive environment facing a franchise bidder.
2 What strategic errors did GMTV make from bid submission up to the arrival of Greg
Dyke?
3 What strategic options are available to Greg Dyke?

Case 7.8: The Rise and Fall of Brands (1996)

The Heyday for Brands
During the 1980s many companies capitalised on consumer loyalty to brands by
increasing prices in excess of the inflation rate, and firms such as Kellogg and Heinz
increased profits by about 15 per cent per year. In 1988 the value placed on brands was
reflected in the following acquisition prices.
Price paid Book value

Buyer Taken over ($billion) ($billion)
Kohlberg Kravis Roberts RJR Nabisco 25 12
Philip Morris Kraft 13 3
Nestlé Rowntree 5 1
Admittedly, book value does not fully reflect the value of a company, but it is clear
that predators were willing to pay substantial amounts for well-known brand names. For
example, by 1990 shares in US packaged-food firms were trading at a 30 per cent
premium to Standard & Poor’s 500-stock index.
Brands Lose Their Magic

By the early 1990s some influences had emerged which undermined the domination of
brands. First, there was a recession in the early 1990s which led to increased competi-
tion among established brands. There was a plethora of special offers for branded goods
which may have started to make consumers more price aware. Second, retailers began
developing their own-label products. The effect of these two factors can be gauged from
the fact that on 2nd April 1993 Philip Morris reduced the price of Marlboro cigarettes,
regarded by many as the most successful brand in history. The price reduction was
primarily due to the fact that Marlboro had been losing market share to unknown
brands for several years, rather than losing share to the other major brands. The
immediate impact of the price reduction was that 23 per cent was wiped off the value of
Philip Morris shares. But there was also a knock-on effect, and shares in RJR, Procter &
Gamble, Coca-Cola, Pepsi-Cola, Quaker Oats and Gillette all suffered.
Consumer research studies found that the proportion of shoppers willing to seek out
particular brands and pay more for them fell sharply during the early 1990s; it was also
found that the market share of the top three brands among many categories of super-
market goods dropped. By 1994 own-label brands took 36 per cent of grocery sales in
the UK and 24 per cent in the US.
There seem to be three main reasons for this
 Perceived product parity: by 1993 research suggested that about two thirds of
consumers worldwide believe there were ‘no relevant or discernible differences’
between rival brands across a wide range of products. In fact, consumers are often
faced with a staggering variety of brand choice. This has partly been due to techno-
logical advances which made it possible to imitate a wide variety of goods; in 1992
16 800 new products were introduced in the US, 30 per cent more than five years
previously. There are 200 brands of breakfast cereal in the US and 100 perfumes in
Argentina. It may also be partly due to increasingly educated consumers who spend
more rationally.

 Promotion monster: with the combination of recession and a huge increase in the
number of brands, retailers began to auction shelf space (particularly in the US).
Retailers were also given more discretion over pricing, and in Britain this sometimes
led supermarkets to sell top brands at below cost as loss leaders.
 Own-label threat: not only was there a surge in own-label brands, but consumers
are right that there is often no difference in quality. This is partly because most big
branded-goods manufacturers started producing own-label products for supermar-
kets; once consumers became aware of this the magic associated with the brand
name was lost. Another dimension to the own-label brand was that supermarkets
starting to use their own label (‘good food costs less at Sainsbury’s) as a brand in its
own right; this served as an umbrella to cover hundreds of products.
The advertising industry took the stance that increased expenditure on advertising
would shore up brand loyalty. But, with the advent of satellite and cable television and
the proliferation of channels, audiences were fragmenting with the result that uniform
advertising was no longer possible.
Some Reactions
Clearly companies had to adapt in the face of these changing market conditions, and
their reactions took different forms.
What Procter & Gamble Did

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

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

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

1 Why should the price of shares in companies like Coca-Cola fall as a result of a price
cut in Marlboro cigarettes? After all, in 1988 the value of brands (i.e. the difference
between market value and book value) was enormous. Does this suggest that the stock
market is totally illogical?
2 Explain what was happening in the market for brands using strategy models.
3 Analyse the impact of the three types of response on the strategic process.
Case 7.9: The Veteran Returns (2007)

In 2004, Coca-Cola, the world’s biggest soft-drinks firm, was experiencing one of the
greatest crises of its 121 year history, so its directors looked for an outsider to turn the
company around. But Neville Isdell was not the first or even the second choice of Coca-
Cola’s directors. Only after rejections from James Kilts, then boss of Gillette, a consum-
er goods giant, and Carlos Gutierrez, then boss of Kellogg, a food firm, did they turn to
Mr Isdell, then aged 62, who was in retirement after having spent 40 years with the
company. He did not hesitate to accept the invitation, having been passed over for
Coca-Cola’s top job in 1997 and again in 2000, which had prompted his early retire-
ment. Mr Isdell had worked in South Africa, Australia, the Philippines and Germany and
had been responsible for taking Coca-Cola into new markets in India, the Middle East
and the former Soviet Union; he ended up in charge of European operations.
Mr Isdell had a reputation as a hands-on manager and his first action on returning to
the company was to investigate its troubles for himself. He criss-crossed the world in
100 days to listen to employees of all ranks in many of the 200 countries where Coca-
Cola sells. What he found were sliding sales, demoralised staff, ineffective marketing and
a lack of leadership. He concluded that the most valuable brand in the world was
experiencing a crisis of confidence. ‘We had lost our belief in our ability to win,’ said Mr
Isdell.
Back at Coca-Cola’s base in Atlanta, Georgia, Mr Isdell shared his findings with the
company’s top executives. The result of what he called a ‘cathartic process’ was the
Manifesto for Growth, a 10 year plan to revive the company. The main points of the
Manifesto were:
 Improve the production and marketing of Coca-Cola, Sprite and Fanta, the fizzy
drinks that account for about four-fifths of the firm’s sales.
 Spend an additional $400 million on marketing to counteract the finding that the
power of the Coca-Cola brand was slipping. The current marketing spend is about
$1 billion, so this is a significant increase, although the time period is not mentioned.
 Strengthen Coca-Cola’s portfolio of non-carbonated and ‘functional’ drinks. Bottled
water, sports and energy drinks, and fruit juice are now the main sources of new
business in the soft-drinks industry, with growth rates seven times higher than those
for carbonated sugary drinks, sales of which have lost their vigour as a result of
concerns over obesity.
 Buy Glackau, an American maker of vitamin-enhanced water, for $4.1 billion, which
was Coca-Cola’s largest acquisition to date. Subsequently, however, Coca-Cola lost
out to its rival, Pepsi, in a battle to acquire Sandora, a Ukrainian juice company.
Mr Isdell once ran Coca-Cola Beverages, a European bottler, so he paid close atten-

tion to the company’s poor relations with many of its bottling companies. Under
agreements that sometimes date back more than a century, Coca-Cola supplies
concentrate to local bottlers, which then make and distribute soft drinks. The actual
production and distribution of Coca-Cola follows a franchising model. The Coca-Cola
Company only produces a syrup concentrate, which it sells to various bottlers through-
out the world who hold Coca-Cola franchises for one or more geographical areas. The
bottlers produce the final drink by mixing the syrup with filtered water and sugar (or
artificial sweeteners) and then carbonate it before filling it into cans and bottles, which
the bottlers then sell and distribute to retail stores, vending machines, restaurants and
food service distributors. Mr Isdell gave the bottlers permission to team up with other
firms in order to cater better to the boom in healthy drinks. Since Coca-Cola owns
stakes in many bottlers, and owns some outright, this was another way to diversify.
Coca-Cola Enterprises, a big American bottler in which Coca-Cola owns a large stake,
now distributes Arizona, a ready-to-drink tea made by Ferolito, Vultaggio & Sons, an
American iced-tea company. Mr Isdell also increased Coca-Cola’s stake in some
bottlers, or bought them outright.
Mr Isdell’s efforts started to yield results fairly quickly. Coca-Cola’s share price rose
by 20 per cent during 2006, and in the first quarter of 2007 sales jumped by 17 per cent,
to $6.1 billion, and profits increased by 14 per cent compared with a year earlier.
Analysts at Stifel Nicolaus, a financial-services firm, considered these results the best
evidence that Mr Isdell’s plan was working and that his long-term aims were sound.
Bonnie Herzog, a beverage analyst at Citigroup, upgraded Coca-Cola to a ‘buy’ rating
for the first time in four years, mainly because of the Glackau takeover. It showed that
the firm is ‘getting its act together’, she said.
But others remained sceptical. Robert van Brugge of Sanford Bernstein, an invest-
ment research company, thought the acquisitions of Glackau and Fuze, an American
juice and tea firm, were good deals, but both are relatively small companies. Static sales
in the developed world need a lift, he said. Europe, America and Japan accounted for
roughly 70 per cent of profits, but recorded low growth in 2006. And many new drinks,
such as Coke Blak, a coffee-infused soft drink, and Gold Peak, an iced tea, were flops.
According to Euromonitor, a market research company, Coca-Cola has been losing
global market share since 2000. Pepsi appears to have done a better job of moving into
health drinks in America and, because it makes snacks as well as soft drinks, has another
business as a hedge, which Coca-Cola does not. Mr Isdell had no plans to diversify into
snacks because he wanted to fix things inside Coca-Cola first.
He pointed out at the end of 2006 that his firm has beaten analysts’ expectations in
each of the past 10 quarters, though he admitted, ‘We are not declaring victory yet.’
Some analysts would have preferred more radical measures, such as bolder acquisitions
and job cuts. But they thought an insider was unlikely to make drastic changes and have
actually been surprised by how much Mr Isdell achieved. Clearly, it is fatal to underesti-
mate the difficulty of stopping the rot at a huge firm like Coca-Cola. But for Mr Isdell to
be seen as the company’s saviour it was felt that he needed faster growth.
1 Conduct a SWOT analysis and assess the choices Mr Isdell made to ensure the future of
Coca-Cola, taking into account that he was a Coca-Cola veteran.

Module 8
Implementing and Evaluating

Strategy
Contents
8.1 Implementing Strategy ..........................................................................8/2
8.2 Organisational Structure .......................................................................8/3
8.3 Resource Allocation................................................................................8/8
8.4 Evaluation and Control ....................................................................... 8/16
8.5 Feedback ............................................................................................... 8/19
8.6 The Augmented Process Model ......................................................... 8/23
8.7 Postscript: Strategic Planning Works ............................................... 8/27
Case 8.1: The Body Shop (1992) ................................................................... 8/28
Case 8.2: Daimler in a Spin (1996) ............................................................... 8/29
Case 8.3: Eurotunnel: A Financial Hole in the Ground (1996) .................. 8/32
Case 8.4: The Balanced Scorecard ............................................................... 8/34
Telecom and MCI ................................................................................ 8/37
Case 8.6: Vuitton: Expensive Success (2007)............................................... 8/37
Case 8.7: Implementation: The Missing Link (2006) .................................. 8/39
Case 8.8: Revisit Fresh, But Not So Easy ..................................................... 8/41
Case 8.9: Revisit The Timeless Story of Entertainment ............................ 8/41
Case 8.10: Revisit Driving Straight ............................................................... 8/41
Case 8.11: Revisit Lego Rebuilds the Business ............................................ 8/41
Learning Objectives
 Methods of resource allocation in the strategic context.
 Methods for evaluating the effective use of resources.
 Assessing the role of feedback.
 Analysis of ongoing competitive position.
 Augment the strategic process model.

Module 8 / Implementing and Evaluating Strategy
8.1 Implementing Strategy

to do what

Feedback


structure allocation and control Implementation
In the strategic planning process model the implementation stage is visualised as

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

8.2 Organisational Structure

to do what

Feedback


allocation
There are many ways of organising a company and the existing structure may be the
consequence of historical influences; little explicit consideration may have been
given to whether the company structure is suited to meeting the company’s objec-
tives. This can be a major oversight because the company structure can influence
company operations in such a fundamental fashion that it may dictate the strategic
direction. Among other things the organisational structure affects the power
structure, determines who allocates resources, identifies responsibilities for under-
taking action and affects the effectiveness with which resources are deployed. This
means that a change in organisational structure can lead to changes in company
performance, both in the short and long term, as different views on strategy assume
importance and resources are redeployed. The difficulty is to establish criteria on the
basis of which the most appropriate structure for individual companies can be
determined.
The main types of company structure are:
 functional (U form)
 divisional (M form)
 holding company
 matrix
 networks
The functional structure groups individuals according to their specialities rather than
around products.
FUNCTIONAL STRUCTURE
Research & Development
Production
Marketing
Finance & Accounting
A problem with the functional structure is that individual products may have
different production requirements and may require particular marketing approaches.

It is then necessary to assign responsibility for products to groups of individuals,

just as would happen in the divisional structure.
The divisional structure splits the company into divisions that can be based on
products or geographical boundaries and, typically, each division will have its own
functional structure. It contributes to resolving the principal–agent problem in that
divisional profitability can be more easily measured than functional returns. A
divisional structure might look something like the following, where each division is
an SBU with its own functional structure.
DIVISIONAL STRUCTURE: BY PRODUCT
Component Function
Corporate Parenting
SBU Electrical Household and industrial electrical switchgear
SBU Travel Business travel agent
SBU Software Tailored database software solutions
SBU Drinks Health drinks targeted at fitness clubs
The divisional structure is more likely to be encountered when the company has a
differentiated product portfolio; however, a single product company which operates
in different countries, or services distinctly different types of customer in a given
country, can have a divisional structure.
DIVISIONAL STRUCTURE: BY GEOGRAPHIC AREA
Component Area
Corporate US
SBU US Comm Commercial customers
SBU US Dom Domestic customers
SBU Canada The Eastern Seaboard
SBU Mexico Mexico City
The extent to which divisions are independent of the corporate centre varies
among companies and is independent of product or area specialisation. For exam-
ple, the product SBUs in a given country may be given almost complete autonomy
on hiring, firing and investment while international SBUs may be subjected to close
financial and planning control.
The holding company structure is one where the conglomerate has no particular logic
to the incorporation of the individual businesses and the centre plays a less direct
role in the determination of strategy than in the divisional company. The role of the
centre is mainly in allocating resources among the businesses and exploiting
opportunities through investment, acquisitions, mergers, joint ventures and allianc-
es. The holding company structure is much looser than the divisional structure,
although the financial controls which it imposes on the individual businesses may be
extremely strict. A holding company might take the following form:

HOLDING STRUCTURE
Component Function
Corporate Financial control
Financial consultancy wholly owned subsidiary
Grain distribution wholly owned subsidiary
Turbine importing 60% ownership in joint venture
Sugar beet refining 20% minority shareholding
The holding structure is similar to the divisional product example above in that
there are several apparently unrelated products in the portfolios. But the Corporate
function in the holding structure is confined to financial control while the divisional
Corporate function extends to various dimensions of parenting.
The matrix structure is valuable in principle when economies of scope provide a
rationale for organising along more than one dimension. The problem is that many
individuals report to two hierarchies and have two bosses. This can lead to prob-
lems of direction and control. The matrix structure is ready-made to cause
principal–agent problems.
In the network structure work groups may be organised by function, geography or
customer base. Relationships among groups are governed more often by changing
implicit and explicit requirements of common tasks than by formal lines of authori-
ty. Again, this structure raises problems of direction and control.
Table 8.1 Structure: advantages and disadvantages

Functional structure
Advantages Disadvantages
Specialisation Coordination among functions
Division of labour Concentration on functional rather than
company objectives
Simplifies training Coordination among departments
Preserves strategic control Lack of broadly trained managers
Divisional structure
Divisional performance can be Coordination among specialised areas
expressed in terms of profit
Communication between functional
specialists
Coordination among functions Duplication of functional services
Develops broadly trained managers Loss of strategic control to divisional
managers

Holding structure
Risk spreading Probable lack of synergy
Financial strength for new market entry Game theory problems
Matrix structure
Flexibility and adaptability Slow decision making – general agreement
required
Less bureaucratic Specific responsibility often unclear
Close coordination Highly dependent on effective teams
The advantages and disadvantages displayed in Table 8.1 are by no means ex-
haustive, and there can be disagreement in the individual case as to what actually
comprises an advantage or disadvantage. For example, a domestic electrical appli-
ance manufacturer located in England decided to expand into France; because of
different specifications required in France and the different language the board
considered setting up a separate manufacturing division in France rather than
producing in England and maintaining the functional structure. This led to polarisa-
tion of views on the part of these who wished to maintain the current structure and
those who were in favour of establishing two divisions.
The following arguments were put by the finance director. ‘We stand to lose the
specialisation of functions that make us a highly effective management team; there is
also less scope for division of labour among production units when the control of
the labour force is split between two SBU CEOs. Training becomes much more
difficult to coordinate and we lose at least some control of the strategy implemented
in France. At the same time it will become much more difficult to coordinate and
specialist activities such as accounting and human resource management and there
will be unnecessary duplication of functions.’
The human resources director took the opposite view. ‘It is time that we stopped
thinking in terms of functions and focused on the business as a whole. We need to
develop a cohort of broadly trained managers who can deal with complexity rather
than continually referring back to functional specialists. We shall also be able to
measure the success of the two operations properly.’
Both sides of the argument are compelling so how might the decision be resolved
other than by the CEO making a subjective decision based on his own managerial
perceptions?
Consider the question of how different structures are likely to contribute to the
creation of value. For example, the creation of a corporate centre may have little
impact other than to increase costs so would have a negative impact on company
value.
Consider which structure is likely to be consistent with, or flexible enough to deal
with, predicted changes; for example, if the French market is suddenly exposed to

new entrants the division structure could be able to react more quickly and effec-
tively.
Given the potential impact which structure has on company performance and the
ability to achieve objectives, it is important not to allow the issue to be resolved by
default. Although it is difficult to identify the most appropriate structure, it may be
possible to recognise a structure which is inconsistent with company characteristics.
When selecting the appropriate structure it is necessary to balance trade-offs
between scale and scope economies, transaction costs, agency costs and information
flows. There is no single prescription, and the best organisation depends on
individual circumstances.
Compare the structures in terms of the company value chain as follows (the
‘advantage’ column assigns + for an advantage of Divisional over Functional and
vice versa).
Value chain Functional Divisional Advantage

Primary activity
In-bound logistics Requires central warehouse Possible to operate JIT +
plus distribution
Operations Two different production Dedicated production lines +
processes on site
Out-bound logistics Orders shipped from Production near +
England to France customers
Marketing One department dealing Dedicated marketing teams +
with different markets
Service Service teams spend a long Service teams know the +
time travelling language and are near
customers
Support activity
Procurement Economies of scale in Direct access to French +
purchasing suppliers
Technology Product specifications can Products may diverge −
be kept in step
Human resource No cultural problems Require dedicated HRM −
management team for French employees
Management systems Single integrated Management teams focused +
management process on different markets
On this interpretation the divisional value chain is clearly superior in terms of

primary activities but has some disadvantages in support activities. A decision has to
be made on which is likely to be the more efficient value chain.
It is important to be clear about the extent to which structure follows strategy. It
was discussed in Section 1.5 how company structure has evolved in response to
changing market demands and developments in strategic approaches: from the

original functional form through divisionalisation, diversification and finally

reverting to restructuring and downsizing. The structure, as a method of resource
allocation, should be aligned to the company objectives and the competitive
environment.
8.3 Resource Allocation

to do what

Feedback


allocation
All companies are continually faced with the problem of allocating resources.
Typically a company will have procedures for allocating resources among competing
uses; these include setting budgets, using predetermined accounting rules, bargaining
among SBU CEOs and so on. The central issue is the extent to which the resource
allocation procedure is aligned with the strategic thrust.
Take the case where a company is attempting to develop a Star product into a
Cash Cow and where the resource allocation rule is that the budget for the SBU this
year must be within 10 per cent of last year’s. In order to develop increased sales
and market share it is necessary to build advance capacity and probably produce for
inventory; this will require more than a 10 per cent increase in resources for a year
or two while the additional input of resources will not be accompanied by an
increase in profitability. The resource allocation procedure is clearly not aligned with
the strategic thrust. Unless the strategic decision to develop the product is accom-
panied by a change in the resource allocation rule it will simply not happen. Thus at
any one time it is necessary to consider the alignment between what the company is
attempting to achieve and the current methods of resource allocation and recognise
that, when a strategic change is undertaken, it may be necessary to change the
approach to resource allocation. It is not always a case of the resources being
unavailable which leads to a failure to achieve objectives, but inappropriate methods
for ensuring that resources are directed towards efficient uses. This may seem to be
almost alarmingly obvious to an observer, but resource allocation procedures within
organisations are typically well embedded and can be very difficult to change.
The value chain can be used to focus on the alignment between strategic objec-
tives and resource allocation. Instead of attempting to ensure that the functional
parts of the company are provided with adequate resources, attention can be turned

to the extent to which the activities that generate value function effectively and that
the linkages among them are exploited. For example, a company about to undertake
expansion into new markets needs to increase its sales force; there is a direct link to
the human resource support activity dependent on the communication channel
between the marketing department and HR. From the marketing department’s
perspective the effectiveness of the recruitment drive will depend on the following
questions.
 Does the HR department have sufficient resources to mount a recruitment
programme?
 Does the HR department have experience in this type of recruitment?
From HR’s perspective the important question is:
 Has an accurate profile of the desired type of sales person been identified?
If the answer to all three questions is ‘yes’ it can be concluded that there is an
effective link between marketing and HR and the chain is capable of adapting to the
new requirements. But if the answer to all three questions is ‘no’ both the link
between marketing and HR and the HR support activity are weak. The problem is
unlikely to be resolved in the short run by allocating more resources to HR because
the HR deficiency is in skills rather than manpower, while new personnel would
take time to build the company linkages which are currently missing. It is all too easy
to assume that a previously effective HR department can deliver a new set of
outputs.
The problems of resource allocation are typically not solved by spending more
on certain activities or switching resources from one use to another. Alignment of
resources with objectives and construction of an effective value chain require an
understanding of the subtleties of the strategic process.
8.3.1 Management of Change

By its nature, reallocation of resources involves changing what people do. A
company that has been operating in mature markets for some time may find change
much more difficult to achieve than prospector type companies that have a history
of innovation, growth and diversification. For example, for a long time the British
workforce was associated with reluctance to change; from the mid-1960s miners,
shipbuilders and steelworkers wished to remain in jobs which were becoming
progressively uneconomic and were not only unwilling to change to other jobs but
wanted to carry on doing their existing jobs in the same way as they had always
done. The notion that a job belonged to an employee led to decades of job demar-
cation disputes and strikes aimed at ‘saving jobs’ which were in direct opposition to
market forces.
In order to cope with change many companies attempt to develop a corporate
culture which rewards adaptability, innovation and flexibility and thus create an
atmosphere conducive to the introduction of changes which save costs, increase
productivity, and get people to do things better and think of better things to do.
This is difficult to achieve and is certainly not attainable in a short space of time.
Change also has to be implemented in the context of the dominant culture of the

company. In Section 6.11 the likely implications of culture for the ability to cope
with strategic change was summarised in Table 6.8, part of which is reproduced
below.
Culture Cope with strategic change
Power Unpredictable
Role Resistant
Task Change is norm
Personal Unpredictable
The example in Section 6.11, based on entering a foreign market, suggested that
the task culture would be most able to cope with change in that case; the prevailing
culture will clearly complicate the process of change management because the
approach adopted for, say, a task culture is unlikely to be appropriate for a power
culture. Reallocation of resources is not simply a matter of investing, retooling, and
hiring new people. Even a relatively modest reallocation may present insuperable
problems for companies which have fostered a ‘no change’ mentality amongst their
workforces. On the positive side, there are a number of techniques which can be
applied to implement change including survey feedbacks, team building, confronta-
tion and transactional analysis; in the strategy context, the detail of how these
approaches work is less important than that managers recognise when the organisa-
tion is in need of help in facilitating change. For example, managers in a power
culture may simply be baffled by the fact that their change initiatives keep failing
because they cannot perceive the principal–agent problems confronting them.
A major tool in implementing change and resolving the principal–agent problem
is the incentive system, but it can also comprise a significant barrier to change. For
example, a production manager who is rewarded for minimising inventories can
cause havoc with a marketing strategy aimed at achieving an increase in market
share. It is important for managers to recognise that the incentive system may be at
fault when the performance of individuals does not match expectations; it was
pointed out in Section 6.11 that the culture may be blamed for resistance to change
when in fact it is due to non-aligned incentives.
In fact, one of the barriers to change is that incentive systems are not reviewed to
ensure that they are consistent with revised company and individual objectives; what
is perceived as being unwillingness to change may be due to the fact that individuals
can see that a proposed change is not to their advantage given the existing system of
incentives. It is a basic fact of life that managers and employees will be unwilling to
change their behaviour if the benefits of doing so are perceived as being lower than
the costs to themselves. Realigning the incentive system can go a long way towards
easing the implementation of change.
The incentive system is not entirely financially based because individuals are also
motivated by promotion prospects, recognition and job satisfaction so it can be
difficult to align all elements of the incentive system to company objectives. To
demonstrate how difficult it can be to achieve alignment of financial incentives
alone imagine a large multinational company that has decided to realign itself as a

low cost high-quality producer to face increased global competition from companies
in fast growing emergent economies; the following set of objectives was devised for
the SBUs.
1. Achieve a minimum of 20 per cent return on sales
2. Reduce direct unit cost by 3 per cent per annum
3. Achieve at least third place in terms of market share in all 10 international
markets
4. Develop a reputation for product quality and top-class after sales service
As an incentive each SBU CEO would be rewarded for every 1 per cent increase
in return on sales above 20 per cent and would be penalised for each 1 per cent
below the 3 per cent cost reduction target.
There are several problems here. First, it will come as no surprise that the com-
pany was dominated by a power culture; the board felt that everyone would ‘fall into
line’, particularly given the penalty for not reaching the target. Second, the objectives
conflict with each other. It is doubtful if it is possible to achieve a reputation for
quality while reducing unit cost; it is also difficult to see how market share can be
increased while costs are reduced. Third, an across the board reduction in costs
penalises SBUs that were already relatively efficient and who will therefore find it
difficult to reduce costs further. Fourth, the return on sales objective does not have
a specific incentive associated with it. Fifth, the incentives are a mixture of reward
and punishment. Individuals do not respond well to negative incentives. So the
incentives do not serve as an effective method of dealing with the principal–agent
problem, but at the same time it has to be recognised that all the objectives are
probably unattainable because some of them are incompatible.
To sum up, strategy implementation typically involves the management of change
and this involves recognition of the principal–agent problem, appreciation of
company culture, awareness of techniques that can facilitate change and design of
appropriate incentive systems. There is clearly a great deal that can go wrong so it is
not surprising that strategy often founders at this stage.
8.3.2 Critical Success Factors

The notion of critical success factors has its roots in network and critical path
analyses originally developed for use in military planning. In principle the idea is
simple: a project is set out as a sequential network of events with the objective of
identifying the critical path, which is the minimum time for the project. Inspection
of the network reveals that there are some things which must happen before others
become possible. The same general approach can be adopted in strategy implemen-
tation, but because of the complexity of the process, and the fact that so much is
unknown about the future, it is really only possible to identify events which must
occur, or things which must be done, in order to ensure that the strategy has a
chance of coming to fruition.
It is not a straightforward matter to identify critical success factors. It is necessary
to have a detailed understanding of available resources, the resources which will be
required, the sequence of events and how individuals are likely to react to the

changes which they will experience. A critical success factor can be the acquisition
of a capital asset or it could be the installation of an appropriate incentive structure.
When it is found that a strategy is not being implemented as effectively as originally
expected it is more than likely that a critical factor has been overlooked; the reason
that the whole process has ground to a halt is because that is the nature of a critical
success factor.
To identify critical success factors it is necessary to determine what must definite-
ly be achieved to ensure success. The resulting list sets the scene for the actual
implementation process because it identifies the immediate priorities. But deciding
how to deal with the critical success factor is just as important as identifying it in the
first place. Take the cases of attempting to convert a Question Mark to a Star
compared with turning a Star into a Cash Cow. Four critical success factors have
been identified that are common to both and the action associated with each is
shown below.
Factor Star to Cash Cow Question Mark to Star

Capacity Eliminate excess capacity Maintain excess capacity
Marketing Be prepared to reduce as market Maintain at high level
matures
R&D Reduce Maintain at high level
Price Set to competitive level Set lower than competitors
It is immediately apparent that it is not sufficient simply to identify the critical

success factors because the action associated with each is different in the two cases.
Adopting the ‘Star to Cash Cow’ actions in the ‘Question Mark to Star’ situation
would lead to disaster.
8.3.3 Management Style

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

decision making; others attempt to be democratic, making efforts to involve

employees at all levels in the management process by adopting such policies as
‘open door’ and management by walking about. In some instances it may appear
obvious that the management style is not consistent with planned strategic changes;
for example, a medium sized family run business which has in the past firmly
concentrated control among family members, and developed a company culture of
subservience to family decisions, may find it difficult to diversify and develop new
markets where an innovative workforce will be essential. Porsche (Module 3) was
owned by the family and seemed slow to react to strategic challenges.
As in the case of company structure, it is not possible to prescribe the optimum
management style for a particular company. However, it should be possible to
identify gaps in management skills and potential inconsistencies between planned
and current organisational requirements.
8.3.4 Budgets
The problem of allocating budgets is encountered at many levels, but for strategy
purposes these can be reduced to two: the corporate and SBU levels. At the
corporate level the overall budget is rationed among competing alternatives,
typically on the basis of proposals submitted by SBUs. At the SBU or functional
level resources are allocated to individual managers so that they can carry out the
tasks which are required to achieve the objectives of each investment; the invest-
ment appraisal which calculated that the net cash flows generate a positive NPV
does not usually take into account uncertainty as to how costs will actually be
incurred and resources deployed as the project is implemented.
To demonstrate the difficulty of allocating scare resources among SBUs consider
the case of a company that has two business groups each comprised of three SBUs.
When an SBU requests capital, it states the amount required and the value which it
would create by using the capital. For the moment, the precise method of deriving
this value does not matter. Corporate headquarters has received bids from the two
business groups and the details of the value created by the SBUs are shown in
Table 8.2.
Table 8.2 Capital requested and value created
Group A Group B
SBU Capital Value created Capital Value created
requested ($000) requested ($000)
($000) ($000)
1 100 80 100 50
2 100 40 100 50
3 100 30 100 50
Total 300 150 300 150
The corporate role is to ensure that a set of rules exists which leads to efficient
resource allocation, since every resource allocation decision cannot be subjected to

detailed analysis because of the volume of funding requests. There are at least two
approaches to corporate resource allocation:
1. Use competitive bidding; the component parts of the company compete with
each other for scarce funds, on the assumption that this competitive element will
go a long way towards ensuring efficient resource allocation. The method used in
this case is to allocate capital between the groups according to the ratio of the
total requested by each and the group manager then allocates capital to the SBUs
using the criterion of value created. This appears to be an efficient procedure
because it combines the notion of the demand for capital by groups with effi-
cient allocation within groups. It also serves the function of being clear to
everyone concerned and provides group managers with financial accountability
for their SBUs.
2. Allocate capital directly to the individual SBUs using the ratio of value added. This
approach by passes the group structure and reduces the responsibility of group
executives.
The two policies result in different allocations of resources. Take the case where
the company has only $400 000 available rather than the $600 000 requested. The
group allocation approach dictates that $200 000 be allocated to each group because
they requested the same amount originally, i.e. the ratio of the value of requests was
1:1. The group managers would then allocate $100 000 each to their two top value
creating SBUs. The outcome of allocating capital to groups compared to SBUs
directly is compared in Table 8.3.
Table 8.3 Allocation to groups and SBUs
Value created ($000)
To group To SBU
Group A
SBU1 80 80
SBU2 40
SBU3
Group B
SBU1 50 50
SBU2 50 50
SBU3 50
Total 220 230
The allocation to groups results in value creation of $220 000 compared to
$230 000 by allocation directly to SBUs. In the first case corporate policy, which is
based on a strategy of competitive bidding between groups, leads to a misallocation
of resources which is not apparent to managers in charge of the individual SBUs.
However, there may be arguments in favour of retaining the group allocation policy
which cannot be measured in immediate financial terms; for example, Group A
might be seriously weakened by being starved of investment capital during a period
when Group B’s SBUs were producing relatively attractive investment opportuni-

ties. There is typically a long-term dimension to corporate budgeting which cannot

be quantified.
The SBU CEO is confronted with many imponderables. For example, if a new
market is being entered a decision has to be made regarding how much to allocate
to marketing and over what period (as well as to an increase in capacity). The
marketing manager in turn has to decide how much to allocate to market research,
advertising, promotions and so on; it is assumed that the individuals charged with
these tasks will carry them out effectively but, of course, there are no guarantees. By
the time the original funds have been parcelled up and allocated to the various
functions, it may be difficult to identify specific expenditure with the original
project. The original investment appraisal assumed that the cash would be used
efficiently at the functional level. The management problem at this level is to ensure
that this happens, but there may be relatively few guidelines to assist managers who
are in the front line. The efficiency concepts, such as marginal analysis, developed in
Module 6 can be deployed but it has to be recognised that they are difficult to apply
given the diversity of demands on managers’ time that accompanies implementation.
An ostensibly attractive strategy may fail because budgets are disseminated through-
out the organisation in a haphazard fashion. The reason that budget allocation can
be haphazard is that the process involves at least five levels and there is a great deal
that can go wrong, as follows.
Decision Rationale What can go wrong

Corporate expansion Perceived market opportunities Pursue growth for its own sake
SBU projects Investment appraisal Optimistic view of potential cash
flows
Allocation among SBUs Capital rationing Approach may be inefficient
Allocation to functions Efficiency principles Too busy to apply them
Allocation to activities Priorities and tactics Inefficient personnel
When viewed from this perspective the budgeting issue is simply another way of
looking at the general management issue of how to resolve the principal–agent
problem.

8.4 Evaluation and Control

to do what

Feedback


structure allocation and control Implementation
The strategic planning approach is initially based on expectations. When the plan is
implemented it is necessary to measure and evaluate actual performance to find out
if the expectations are being fulfilled. When the component parts of the plan have
been made explicit, the plan provides a benchmark against which actual outcomes
can be compared, so that when variations between expected and actual outcomes
occur their causes can be investigated. For example, it may be found that the net
contribution from a particular product is lower than anticipated in the plan; this
could occur for a variety of reasons, for example because the selling price turned out
to be lower than predicted, or because productivity was lower, or because market
share turned out to be harder to win. The reason for the shortfall will suggest
whether action should be taken to achieve the original objectives, or whether the
plan itself needs revision in the light of events; it is essential to identify whether the
deviation from the plan is due to causes within the control of the company.
The case of Barings bank and the losses generated by Leeson were discussed in
Section 4.3.4 as an example of the risks associated with operating in the internation-
al market place. There is more to this case than simply the magnitude of the risks
involved, because it revealed a lack of strategic control on the part of Barings. The
same lack of control was apparent at Daiwa, whose trader Toshihide Iguchi lost
even more than Leeson – £900 million – in the foreign exchange market. These two
cases generated losses in a relatively short time, but this was not the case for Yasua
Hamanaka of Sumitumo, who controlled so much of the copper market that he was
known as ‘Mr Five Percent’; he lost £1300 million over a ten year period, and
managed to conceal what he was doing for most of that time. While these are
extreme examples, a lack of strategic control over internal processes can have severe
repercussions. In 2008 it emerged that the banking system as a whole was woefully
deficient in strategic control.
Companies vary greatly in how they attempt to control planning outcomes. Some
companies rely largely on financial indicators, while others take into account a wider
range of measures which reflect competitive positioning. The attempt to control and
evaluate planning outcomes is complicated by the degree to which planning has

been undertaken in the first case; when the planning process is vague, for example,
the only measures which might be seen as relevant are financial ratios. Companies
can be categorised according to their degree of planning and approach to control.
Loose Planning
High
control control
Degree of planning
Strategic
Medium control
Financial
Low control
Flexible Tight strategic Tight financial
Type of control
Figure 8.1 Degree of planning and type of control

Loose control companies have a high planning influence but adopt a flexible
approach to evaluation and control. This could have the effect that managers are
not provided with the type of incentive and evaluation which consistently relates
their actions to the overall purposes of the strategy. At the other extreme, Financial
Control companies rely largely on financial measures of performance which can
miss many of the aspects of strategic control which are necessary to ensure that
plans are actually being achieved; this type of company uses tight financial control as
a substitute for a planning approach. In the middle of the range is the company
which uses a variety of control methods and gives a balanced weighting to planning
and control influences.
Clearly this classification is by no means precise but companies can be entered
into the matrix in a rough fashion; for example, a company which is run by a
financially minded CEO who insists on the development of detailed plans backed
up with clear financial targets, but with no attention paid to factors such as market
share, sales growth and competitor performance, could be classified as ‘Financial
Control’. The point of the classification is not to imply that some companies are
better or worse than others, but to provide insight into the approach to evaluation
and control. For example when markets are subject to rapidly changing technologi-
cal development, the approach characterised by ‘Financial Control’ may be
inappropriate.
In order to make the control process manageable the following steps have been
derived from observation of actual company practice.
 Select relatively few appropriate objectives.
 From these objectives derive suitable targets.

 Identify a series of milestones to be tracked over time; these serve as bench-

marks for evaluating strategic performance and provide early warning of
deviations from expected outcomes.
 Since many of the objectives and targets cannot be measured with accuracy a
great deal of ongoing subjective evaluation is necessary.
To see how this might work in practice take the case of a company that is about
to launch an apparently innovative bread toaster that automatically adjusts the
heating elements for the type of bread inserted; but this is an already crowded
market and there is some doubt as to whether the new features will lead to success.
The four types of planning control identified in Figure 8.1 are assessed against the
four control actions listed above.
Control Loose Planning Financial Strategic

step
Few Vague: high-quality, Achieve 15% Generate 15% Achieve competitive
objectives high-tech profile market share ROI within 3 advantage
within 3 years years
Derive Imprecise notions 8% market 5% ROI Year 1, Relative market share
targets share Year 1, 10% ROI Year
12% Year 2 2
Milestones None Actual versus Allow 1% Performance relative
desired market variation each to
share year competitors
Subjective No understanding of None None Does it look like
evaluation what has been achieved competitive advantage
so likely to be irrelevant has been achieved?
There are significant differences in the use of the control steps among the four
classes. This interpretation suggests that the Loose control approach is too vague to
control the process in any dimension. The Planning control class sets specific
market criteria but judges the outcome purely on the basis of whether these have
been achieved rather than taking other variables into account, even subjectively. The
Financial control class is much the same, except that it is even more constrained by
financial measures. The Strategic control class uses a combination of measurable
and subjective criteria that enable judgements to be exercised in the light of chang-
ing circumstances. If this interpretation is more or less correct it suggests that the
Loose, Planning and Financial classes are likely to have considerable difficulty in
determining what is happening to the strategy. The danger is that the CEOs think
they are in control and are thus unaware that things are going wrong until it is too
late to do much about it.

8.5 Feedback

to do what

Feedback


allocation
Companies often do not pay explicit attention to feedback as a key factor in the
strategy process. This might seem surprising, given that strategy occurs in a dynami-
cally changing environment; the scope of these environmental changes is enormous,
ranging from the way the economy is performing to unexpected competitive moves
on the part of competitors. It is not sufficient to scan the environment and monitor
company performance; it is necessary to be able to act on information and changes
as they occur. At the very least the company must have effective communication
channels, have the ability to adapt and learn from experience.
 Communication channels: how is information disseminated both upwards and
downwards in the organisation? It is difficult in practice to set up procedures
that ensure information is communicated to the individuals who can take appro-
priate action. The most effective communication structure depends on
circumstances. For example, compare how information might be disseminated in
a company organised along functional lines with one organised divisionally. In
the functional organisation the marketing department may identify a change in
market trends for a particular product, but is likely to have difficulty communi-
cating the implications to other departments. In the divisional company the SBU
can react to the market change, but there may be no means of communication
with the corporate centre which needs to know what is happening to the com-
pany product portfolio. Setting up the communication channel is only one step
in the process: it is also necessary to ensure that information is communicated to
the right people.
 Ability to adapt: the fact that effective communication channels exist does not
guarantee that appropriate action will be taken. The impact of company culture
on the ability to cope with strategic change was discussed in Section 8.3.1 where
it was concluded that only the task culture can be relied on to support change;
given that culture is difficult to alter in the short run it is likely that most compa-
nies will be faced with significant resistance to change. Is it possible to develop
acceptance of change within the constraints of the dominant company culture?
There is a difference between obtaining agreement to a given change and build-

ing an organisation that is conducive to change as an ongoing process. A great

deal depends on individuals and their willingness to listen to information which
may often not be to their liking, be prepared to admit mistakes and be proactive.
There are various organisational behaviour techniques for tackling this issue but
there is no guarantee of success.
 Learning organisation: anyone with experience of education knows how
difficult it can be to develop learning abilities in individuals. The challenge is
even greater for organisations. The crucial issue is whether the organisation is
able to learn from and build on experience. Taking the example of a change in
market trends, can the organisation look back to a similar event and use that as a
starting point, or is it necessary to reinvent the wheel each time? It is not wheth-
er the individuals concerned learn how to react to events, but whether the
organisation as a whole capitalises on the learning of the individuals.
It is tempting to set up a system of formalised meetings at departmental, inter-
departmental and divisional levels and hope that the structure will take care of
feedback requirements. But setting up a formalised structure does not ensure that
feedback will be integrated into the strategic process because the structure is simply
a form of communication channel; it is also necessary for the company to be
adaptable and have the capacity to learn.
Returning to the Mythical company of Module 1, how does it measure up in
terms of feedback?
Feedback factor Mythical company

Communication channels There appeared to be free and open communication
between the CEO and the management team
Ability to adapt Mythical appears to be dominated by a role culture;
this suggests that there would be resistance to change
Learning organisation None of the functions appeared to have learned how
to deal with the unexpected
Despite the open discussion, the submission of proposals and agreement on a
course of action all members of the management team came up with a reason for
delay. The Memos could be interpreted as evidence of widespread resistance to
change so the events were merely excuses to maintain the status quo. As a result the
feedback component was negative.
The process model can be used to systemise feedback. The following takes a
selection of events, relates them back to the process model and identifies a salient
issue that needs to be tackled in each case.

Event Process model compo- Issue

nent
Disagreement between Board and Strategist Principal–agent problem
CEO
Early withdrawal after new Objectives Mistaken business definition
market entry
CEO resigns over disagreement Who decides to do what Conflicting objectives
with Board
New government regulation Macro environment Poor environmental scanning
destroys 10% of business
Product unprofitable after four Industry environment Missed transition from growth to
years maturity in product life cycle
New product launch failed Internal analysis Did not carry out break-even
analysis
Facing unexpected competitive Competitive position Change in five forces profile
pressures
CEO accused of making Analysis and diagnosis No systematic use of data
subjective decisions
Cannot drive down cost enough Generic strategy alterna- Stuck in the middle
to make profit tives
Acquisition had to be sold on at a Strategy variations Unrelated diversification
loss
Decision taken to expand despite Strategy choice Managerial perception that
reduced profit growth is good for its own sake
Major organisational changes in Choice Cannot interpret implications of
each of the past three years SWOT
Complaints that HQ is out of Resources and structure No parenting contribution
touch
New product launched two years Resource allocation Critical success factors not
late identified
Lost direction: company lurches Evaluation and control Inappropriate strict financial
from one crisis to another control
Low level of job satisfaction and Implementation Incentive system not aligned with
high attrition changed strategy
Repeat of failed product launch Feedback Not a learning organisation
two years ago
As events unfold the component of the process that needs to be revisited can be
identified together with the issues that need to be addressed. Sometimes the issue
will be complex, for example a principal–agent problem or a series of weak linkages
in the value chain; other times the issue may be relatively simple, for example,
ensuring that appropriate financial evaluation is carried out. The overall intention is
to ensure that the strategy process remains robust in the face of dynamic events.

Finally, we can return to the Mythical company again and the five events that
triggered memos from the management team recommending that the strategy be
abandoned.
Event Process model Issue

component
CASH FLOW Internal analysis Analyse underlying profitability
HEAD-HUNTED Value chain should not be dependent on
one person
DEVELOPMENT COST Innovation process poorly managed
OVERRUNS
JAPANESE INVASION Resource allocation Investigate efficiency of marketing
department
LABOUR RELATIONS Implementation Overall process of implementation not
addressed
This interpretation suggests that cash flow might not be a problem depending on
underlying profitability, that the loss of the finance director is only one link in the
value chain, that development cost overruns should be avoided in the future and
that the Japanese invasion can be coped with; the labour relations issue is difficult
but there is certainly room for negotiation. This suggests that the apparent dilemma
facing the CEO in the light of these events is illusory: if the strategic process is
robust the company should be able to cope with them.
On reflection you may take a different view of the events affecting the Mythical
company. Whatever interpretation you arrive at is all right so long as you have a
valid rationale. But bear in mind that the future of the company is at stake so the
cost of getting it wrong can be high.

8.6 The Augmented Process Model

to do what

Feedback


allocation
Competitive conditions continually change depending on the performance of the

company and the reactions of competitors. A key aspect of implementing strategy is
to be aware at all times of the company’s competitive position; it cannot be assumed
that the initial market conditions identified at the analysis stage will continue
unchanged as events unfold. An overall view of the company’s competitive position
is obtained by integrating models into the strategic process model.
Effective use of the process model requires the application of a battery of con-
cepts and models as shown in Table 8.4. To some extent it is a matter of discretion
where a particular idea appears, for example, many accounting techniques are used
for both internal analysis and evaluation and control, and competence is an internal
factor which may also guide strategic choice. While this is a forbidding list it is
actually not exhaustive, as there are many concepts from the core disciplines which
could be applied to specific strategy issues but which are not included; a strategy
analysis could in principle include every idea from the core disciplines, but it is up to
the individual analyst to determine which ideas are relevant to the particular case
and integrate them into a structure. It is clear from this display that it is only by the
consistent application of a wide range of tools that a company’s competitiveness can
be properly assessed.
It is the integration of the process model with analytical ideas and models which
provides a structure within which competitiveness can be assessed in the wide sense.
It will rarely be found that a company is ‘perfect’ in terms of every single idea and
model: the trick is to identify the areas in which a company is particularly strong or
weak, and which factors have contributed to its success or failure. This is not an
easy thing to do, and it is a typical misconception that success or failure can be
attributed to a single factor. Perhaps the most demanding intellectual challenge of all
is to apply the ideas to a company and identify the seeds of success or failure before
either actually occurs.
Strategy problems vary widely, and not all models are applicable to all cases. One
of the skills in strategic analysis is to identify which models and ideas are applicable
to a particular case and to use them to evaluate options. This takes us back to the

concept of strategic thinking developed in Section 1.2.7. The sheer variability of real
life and the range of potentially applicable concepts mean that different analysts may
focus on different aspects of the problem and as a result two valid analyses may
produce different outcomes. This does not necessarily mean that partial analyses are
wrong, because even if all models and concepts were applied there is still the
problem of attributing relative importance to each in arriving at conclusions.
While the integrated approach in Table 8.4 provides a basis for evaluating the
ongoing competitive position, the individual ideas and concepts can be applied to a
variety of strategic issues including new product development and launch, invest-
ment appraisal, entering new markets, the rationale for takeovers, make versus buy,
and many others. It needs to be borne in mind that all such issues typically have
implications beyond their own confines, and the process model in Table 8.4 should
always be kept in mind as a means of setting individual issues within the overall
strategic context.

Table 8.4 The augmented process model
Who Decides To Do Analysis And Diagnoses Analysis And Diagnoses Choice Implementation
What (cont’d)
Objectives The general environment Internal factors Generic strategy alternatives Resources and structure
Business definition Macroeconomic analysis: Value chain Corporate and business Divisional, functional,
Mission unemployment, inflation, Shareholder value analysis strategy matrix
Shareholder wealth interest rate, exchange rate Competence Stability, expansion, Managerial style
Gap analysis Forecasting Architecture retrenchment Critical success factors
Means and ends Competitive advantage of Experience curve Combination Incentives
Ethics nations Economies of scale Cost leadership
Profit maximisation Environmental scanning Innovation Differentiation Resource allocation
Growth vector PEST Economies of scope Focus Opportunity cost
Stakeholder map Scenarios Synergy Segmentation Marginal analysis
Credible, quantifiable, Joint production Optimisation
disaggregated, economic, The industry and international Opportunity cost Strategy variations Budgets
financial environment Marginal analysis Diversification: related Critical success factors
Demand and supply, price Ratios and unrelated
Strategists determination, elasticity Gearing Vertical integration Evaluation and control
Principal agent Barriers to entry Cash flow Mergers and acquisitions Performance measures
Prospector, analyser, Forms of competition: Benchmarking Joint ventures and Ratios
defender, reactor perfect, imperfect, oligopoly, Human resource management alliances Degree of Planning and
Risk aversion monopoly Culture: power, role, task, Pricing: leadership, limit, type of Control
Team composition Segmentation personal predatory Monitoring systems
Group dynamics Differentiation
Quality Competitive position Strategy choice
Strategic groups Product life cycle Risk analysis
Market share Managerial perceptions
Portfolio analysis Net present value
Perceived differentiation Familiarity
Strategic groups Scenarios
Competitive reaction Break-even
First mover Pay back
Five forces Sensitivity
Elements of competitive advantage SWOT
ETOPS Game theory
Strategic advantage profile
Feedback
Communication
Management style
Adaptability
Learning organisation

It emerges from the augmented process model that all the models you have en-
countered so far in this course, and in other courses, are strategic models in that
they contribute to the overall strategic analysis. So a question which asks you to
apply strategic models means that you have to search for relevant models and apply
them to the issue.
This complexity is what makes strategic analysis such an intellectually demanding
subject. But if you bear in mind that a structured approach coupled with the
identification of relevant models is the key to strategic insight you will have learned
the most important strategic lesson of all. Without going into a great deal of detail,
the following outlines the sorts of question which continually need to be addressed
when monitoring and evaluating strategy.
 Who Decides to Do What
Originally objectives were set on the basis of a vision of the company’s future,
which in turn would have been derived from a view of how the company might
grow, and the application of ideas such as gap analysis. The appropriateness of
these objectives is affected by the principal–agent issue (where the shareholders
might not have the same objectives as the CEO) and the characteristics of the
chief decision makers in the company. Ongoing questions include: is the per-
ceived performance gap being closed, are the objectives are still consistent with
current competitive conditions and was the strategy selected largely determined
by the prospector qualities of the CEO rather than the outcome of serious strat-
egy appraisal?
 Analysis and Diagnoses
It is clearly a mistake to treat the analysis and diagnoses stage as a once for all
activity. Environmental scanning should be a continuous process. The way in
which value is produced by the internal operations of the company is certainly
not static, and changes in cost structure and value creation are inevitable as the
company moves up the experience curve, benefits from economies of scale,
launches new products and invests in R&D; the impact of many of these chang-
es on costs is not always obvious. Bringing these internal and external factors
together to assess the ongoing competitive position is a first step, which requires
to be supplemented by questions relating to the stage in the product life cycle,
the product portfolio, product differentiation, changes in the five forces profile
and the identification of the company’s strengths and weaknesses in relation to
potential opportunities and threats; again, all of these are subject to change, of-
ten at short notice, and companies that are unresponsive to changes in
competitive conditions may actually be oblivious to what is actually happening.
 Choice
While the main strategic choice may have been made in the past it is essential to
question whether the choice is being pursued as originally intended and whether
the choice is still appropriate. For example, the choice may have been to pursue
a highly differentiated niche and grow by acquisition; the passage of time may
reveal that the niche has been poorly defined, that the market is wider than antic-
ipated and companies are competing mainly on the basis of price rather than
quality, while the acquisition process has delivered higher productive capacity

but with increased costs and poor company morale. It is the alignment of the
chosen strategy with subsequent events which will greatly determine future suc-
cess, but as time goes by the company may have no mechanism for ensuring that
the strategy does not drift.
 Implementation and Feedback
Again the issue of alignment arises: are company structure and resource alloca-
tion consistent with the strategy? Does the company have procedures in place
which provide relevant information on competitive performance? Is company
structure flexible enough to respond to changes in competitive conditions?
8.7 Postscript: Strategic Planning Works

This Strategic Planning course has gone to considerable lengths to demonstrate how
the ideas of the business disciplines can be utilised and integrated in arriving at
strategy decisions. But to some extent strategy can be boiled down to getting the big
picture right, and directing resources accordingly. A supreme example of how the
general principles can be applied is the case of Sir William Burrell, who inherited the
family steamship company in the late nineteenth century and ran it with such
success that he was able to retire relatively young and devote the rest of his life to
collecting artefacts which are now housed in the Burrell Museum in Glasgow. He
made an enormous amount of money out of shipping. How? The following is an
extract from a letter written by the eminent Scottish architect Sir Robert Lorimer to
an Australian friend in January 1902.
His [Sir William Burrell’s] scheme is really the nimblest I’ve ever struck. He
sells his fleet when there is the periodical boom and then puts his money into 3
per cent stock and lies back until things are absolutely in the gutter – soup
kitchen times – everyone starving for a job. He then goes like a roaring lion.
Orders a dozen steamers in a week, gets them built at rock bottom prices, less
than half what they’d have cost him last year. Then by the time they’re deliv-
ered to him things have begun to improve a little bit and there he is ready with
a tip top fleet of brand new steamers and owing to the cheap rate he’s had
them built at, ready to carry cheaper than anybody. Sounds like a game anyone
could play at but none of them have the pluck to do it. They simply sit and look
at him ‘making money like slate stones’ as he expresses it.
Burrell carried out analyses of the national and international economy, and the
operation of the shipping market; he understood concepts such as opportunity cost,
and he had figured out how to build a company with a potential competitive
advantage; he had a clearly defined set of objectives, and a strategy designed to
achieve them; he evaluated the outcomes so that he could decide when to reallocate
resources and move into and out of the market. Or did he?

Review Questions
8.1 In an entertaining article in the Financial Times Peter Wilson37 identified seven myths
which can combine to sink a small company when faced with a recession:
1. Nobody knows our business better than we do.
2. The company would not survive without me.
3. We aren’t affected by competition.
4. Cutting overheads will ensure survival.
5. Borrowing money is risky.
6. Quality matters, not price.
7. We have all the information we need.
Debunk these myths.
Case 8.1: The Body Shop (1992)

In the middle of 1991 The Body Shop International attracted a great deal of press
attention because of its remarkable record of growth during the past decade and the
apparent disregard for conventional business decorum demonstrated by its charismatic
founder, Anita Roddick. She has publicly stated that City people ‘do her head in’, and
make her head ‘burst with boredom’; she describes her business in terms of ‘magic’ and
‘naivety’. This is language which does not appeal to investment analysts, who are more
at home with profit and loss accounts and cash flow projections.
The Body Shop is well known in the UK, and retails a wide range of cosmetics and
related goods whose distinguishing feature is that they are not tested on animals. The
operation started in one shop in 1976, and by 1991 had 580 stores worldwide, with a
stock market value of £470 million. Sales have grown at about 30 per cent per year for
some time, and the accounts reported in 1991 showed a growth in profits from £14.5
million in the previous year to £20 million. While Roddick’s husband Gordon, who is
also The Body Shop’s financial director, acknowledged that the company could not be
immune from recession, profit projections for 1992 predicted another growth year of
about 30 per cent to between £26 million and £28 million.
There are a number of reasons why The Body Shop could maintain its profit growth
during a recession. The first is that ‘small-ticket’ items are not greatly affected immedi-
ately by a halt in the growth of personal incomes. The second is that The Body Shop
continues to expand its operations. In 1991 there were 173 shops in the UK, and there
was still plenty of scope for growth; for example, up till that time The Body Shop had
only targeted towns with populations greater than 50 000. Third, The Body Shop
franchises shops and can thus increase the size of the chain without increasing over-
heads. Despite its public image, The Body Shop is in fact a manufacturer and wholesaler
rather than a retailer. Fourth, while The Body Shop is now in 37 countries, the overseas
chains are still relatively small. The Body Shop charter, which is to bring ‘humanity, goals
and values’ to business, to care for its customers and to ‘generate joy and excitement’ is
seen as being particularly appealing to the US market. Roddick has also publicly es-
poused causes such as Amnesty International, and has created an image for The Body
Shop which emphasises cooperation with employees, concern for the environment and
high standards of integrity.
The confidence concerning future profits is reflected in The Body Shop share price.

In mid-1991 the price/earnings ratio was 28, and it has been as high as 50. One analyst
was reported as saying that the shares were still ‘screaming cheap’ even at this level. On
the other hand, some brokers worry about the dependence of the company on a
charismatic leader.
1 Is The Body Shop’s success due to a new kind of haphazard management invented by
Anita Roddick?
2 Account for the relatively high price/earnings ratio.
Case 8.2: Daimler in a Spin (1996)

In 1992 Daimler-Benz, which was Germany’s largest company and reportedly Europe’s
largest manufacturing firm, was handing out a glossy document called ‘The New Age’. In
it, Daimler’s chairman at the time, Edzard Reuter, boasted how he had transformed the
firm from a car maker into an ‘integrated technology group’ involved in aerospace,
microelectronics and several kinds of transport which would be big enough to compete
with the giants of America and Japan. Since 1985 Daimler had spent more than DM8
billion ($6 billion) on acquisitions which included the bulk of Germany’s defence and
aviation industries. But despite this massive effort Daimler’s worth on the stock market
fell from DM53 billion in 1986 to DM35 billion in 1995. At the 1995 annual general
meeting shareholders accused Mr Reuter of being ‘the biggest annihilator of capital in
the land’.
Competitive Environment
To some extent Mr Reuter could claim that circumstances beyond his control had led
to the problems; the cold war ended in 1989 leading to a huge reduction in the demand
for arms and the world market for civil aircraft collapsed in the late 1980s. On the other
hand, while Daimler’s purchase of AEG in 1986 had provided access to a wide range of
markets from white goods to trains, AEG did not have a dominant place in any of its
markets and it could be argued that Mr Reuter had added the wrong kind of product to
Daimler’s portfolio.
Germany has long been famous as the land of ‘stakeholder’ capitalism, where compa-
nies are run for parties other than shareholders, such as workers and suppliers.
Managers and bankers tend to club together, and ordinary shareholders are by and large
neglected. This has been strongly contrasted with the apparent ‘short termism’ of
British and American capitalism where the creation of shareholder value has always
taken precedence, and many critics claimed that this has been at the expense of longer
term prosperity. Thus Daimler was considered to be taking a long-term view at the time
it was making its acquisitions, and it took some time for shareholders to realise that the
company was destroying shareholder value rather than creating it. Despite its aggressive
role in taking over other companies, Daimler itself was insulated from takeovers:
Deutsche Bank, which is Germany’s biggest bank, owned about a quarter of Daimler,
and another shell company owned about another quarter.
Changing the CEO

Mr Reuter was not oblivious to the difficulties facing Daimler and made many important

changes by the time he left in 1995. He had broken with German convention by having
Daimler’s shares listed in the US, he introduced stringent accounting rules and control
processes, and by 1994 even started a divestment programme by selling off the AEG
white goods businesses.
In May 1995 a new CEO, Mr Jurgen Schrempp, was appointed and brought a totally
different perspective to the company. He started by announcing a loss of DM1.57 billion
for the first half of 1995, which he partly blamed on the decline of the US dollar.
However, it was not so much the reason for the loss that was important as the fact that
it was publicly recognised; there was widespread feeling that the previous management
would have avoided admitting such an unprecedented event. Mr Schrempp also laid
stress on the pursuit of profits rather than strategy for its own sake, and insisted that
the real owners of the company were shareholders, to whom management was
responsible. He set in motion a major programme of divesting substantial parts of the
business with the objective of getting back to the core of transport. He went further
than Mr Reuter by stating his intention to divest all businesses whose pre-tax return was
less than 12 per cent on capital employed. Mr Schrempp also shifted power from the
subsidiaries such as Mercedes to the parent. In the past Daimler’s managing board set
guidelines for the four subsidiaries but let them manage themselves. Mr Schrempp’s
board was to determine strategy and budgets for all businesses in the group (numbering
35 in 1995) and in the process become a much tighter conglomerate rather than what
was previously no more than a cluster of businesses.
There were, of course, problems with this new orientation. First, the aerospace
division is at the mercy of currency markets and politicians. Second, the notion of a
‘transport group’ strategy is perhaps no less nebulous than the original programme of
diversification. Third, Mercedes-Daimler makes up two-thirds of Daimler sales, but
analysts have detected signs of potential weakness in the car sector; Mercedes’ share of
the German passenger car market dropped from 11 per cent in 1985 to 7 per cent in
1995. Market share in fact reached a low of 6 per cent in 1992. Increased competition
looms from another major German car company, BMW, which had acquired Britain’s
Rover car company, and under a strong CEO has the potential to exploit international
economies of scale.
By early 1996 Mr Schrempp had rid Daimler of Fokker, and left the Dutch govern-
ment to worry about the future of its 7800 employees. After a group board meeting Mr
Schrempp announced ‘Profitability must take precedence over revenues.’ He conceded
that Daimler must shrink, rather than expand, back to profitability.
The full year loss for 1995 was DM6 billion, of which more than one third was at-
tributable to Fokker.
Mr Schrempp’s Track Record

Mr Schrempp was previously chairman of DASA, Daimler’s aerospace division, from
1989. During this time many of DASA’s problems worsened. In 1993 Mr Schrempp
bought Fokker, which was a chronically loss making regional Dutch aircraft maker;
Fokker made large numbers of unwanted aircraft and was forced to lease them to
customers on unprofitable short-term deals. He formed an alliance with Aerospatiale,
the French state owned company, to produce helicopters and missiles in the shrinking
arms market.
His rationale for buying Fokker was that Daimler needed to develop into medium
sized aircraft (80–100 seats) while Fokker had a strong market position but needed a

partner to develop new models. At the time there was a great deal of criticism of the
deal by German analysts and fund managers: ‘It was the wrong policy and the wrong
company. Fokker had a lot of structural problems. It was just like Reuter’s mistake with
AEG. How was it going to compete with Siemens?’
It may seem a little strange to observers in other countries that Mr Schrempp is
being allowed to perform the task of dismantling what he put together, and to carry on
after admitting that he has made serious mistakes. But some German commentators
reckon that this makes him just the man for the job. One indication of the competitive
strength of the company is that Mercedes landed a $1 billion dollar joint venture deal
with China to build multi-purpose vehicles in the face of strong competition from
Chrysler.
1 Set out the strategic rationale for Mr Reuter’s programme of diversification, and the
reasons for its failure.
2 Compare the strategic approaches of Mr Reuter and Mr Schrempp.

Case 8.3: Eurotunnel: A Financial Hole in the Ground (1996)

The Eurotunnel links the South of England with France; it was completed in 1994 after
seven years of work; it was one of the biggest construction projects in history and was
financed entirely by the private sector.
‘Eurotunnel has exceeded the City’s worst expectations and unveiled a loss of £925
million for 1995, its first full year of operation, one of the biggest single-year deficits
ever by a UK company’ (the Times, April 23, 1996).
Cash flow for 1995

£m
Income
Le Shuttle (cars and trucks) 299
Eurostar (Passenger train) 80
Total 379
Expenditure
Operating cost 341
Operating surplus 38
Overheads
Depreciation 136
Interest 768
Bank fees 59
Loss 925
Capital structure
Debt 8900
Equity 2200
Market share on the cross channel traffic was about 45 per cent, so even if traffic
continued to grow at about 10 per cent per year it was difficult to see how Eurotunnel
would ever be able to meet its interest obligations. Furthermore, soon after the
announcement the rival ferry operators were announcing discounts of up to 40 per cent
in an attempt to arrest the decline in their market share. The statements from both
ferry operators and Eurotunnel suggested that a prolonged price war was in prospect.
In fact, these losses were widely expected. When Eurotunnel was formally opened by
Queen Elizabeth and President Mitterrand on 5 May 1994, it was due to start paying
interest charges of £500 million per year, which until that time had been rolled up into
its debt. But the first year’s revenue was predicted to be no more than £100 million, so
it was going to run out of cash soon after it opened. It was estimated that before making
profit a further £1500 million would have to be raised. It was the magnitude of the first
year’s loss which caused surprise and horror amongst shareholders.
How Could All This Have Come About?

The finance position was caused by overruns and delays which had increased the original
estimated cost of £4700 million to £11 100 million. In fact many investors were worried
that the company’s projection of revenues would turn out to be as over-estimated as
costs were under-estimated. The original projections, in broad terms, were that
Eurotunnel would quickly gain one third of the passenger and one fifth of the freight

traffic on the cross channel route. While these estimates might have been accurate, by
1994 the total value of traffic was £600 million per year, including the London to Paris
airline routes. Thus the total market size was probably not much greater than Eurotun-
nel’s interest charges plus operating expenses. Eurotunnel also expected fares and
freight rates to rise in line with the inflation rate. But ferry prices had risen by 2.5 per
cent less than the inflation rate in the 10 years to 1994, and air fares by 4.5 per cent
less. Furthermore, prices were pitched at the same level as those of the ferry operators.
A combination of over-estimated traffic and prices would have led to a substantially
lower revenue than predicted, with the consequent implications for running out of cash.
Even Eurotunnel’s own revenue predictions had fallen over time:
Eurotunnel’s revenue forecasts (£million)

Year to which forecast applied
Date of forecast 1993 1994 1995 1996
1987 488 762 835 908
1990 393 764 833 904
1993 0 224 554 691
Actual 31 379
A further complication was that severe doubts about the safety of the tunnel were
raised at a late stage, and the market’s nervousness about the deal is evidenced by the
fall in the share price from £5.10 at the beginning of March 1994 to £3.20 in May, when
a rights issue was launched to raise £750 million.
Meantime the ferry operators had not been idle. The two main operators had spent a
total of £500 million on upgrading short-trip facilities, for example by bringing McDon-
ald’s on to the ships and turning the journeys into entertainment. The ferry companies
pointed out that they could adjust their capacity on the route to match demand, while
Eurotunnel was to a large extent inflexible.
An indication of the competitive position just before opening can be obtained from
the following:
Projected cross channel market in 1996: date of estimate 1994

Journey time Market share Market share Price
Company minutes 1996 1994
% % £
Stena 75 15 30 126–320
P&O 75 32 64 139–320
Hoverspeed 75 3 6 142–338
Eurotunnel 35 50 0 220–310
By October 1994 further delays to running full capacity services had resulted in the
coffers emptying once more, while Eurotunnel’s image was severely dented by a number
of high profile break downs. By this time the share price had fallen to less than £2.00.
The chief executive who got Eurotunnel going was Sir Alastair Morton who started
work in February 1987 and said he found ‘a start-up company in danger of dying in its
infancy’. He is renowned for his combative and confrontational nature, and spent years

battling head on with contractors and bankers. He has called the contractors names
such as schoolboys, blackmailers and chronic depressives, while bankers have grown weary
of his temper. On the other hand, the CEO of the main contractor said ‘There aren’t
many people who have his physical and mental strength and stamina.’ Indeed, on 10
April 1995 Morton was forced to apologise to shareholders for the shortfall between
predicted 1994 revenue (£224 million) and actual revenue (£31 million) leading to a loss
for 1994 of £387 million.
There seems to be no end in sight. By late 1995 Eurotunnel’s share price had reached
a new low of £1.20. The emphasis had shifted from short-term predictions of market
shares to the idea that by the year 2005 or so Eurotunnel would be the ‘natural’ way to
travel between Britain and France, and that the ferry operators would have long gone.
This would enable the debt to be repaid and after that those shareholders who had held
out would be in for a dividend bonanza.
Extract from a letter to the Times 25 June 1996

The Tunnel is one of this century’s greatest contributions to the future of Europe and I
am proud to be associated with it as a shareholder. I do not want to see the achieve-
ment handed to others at a discount for them to reap the rewards in the future. We
the shareholders need to take a long-term view and set aside short-term expediencies.
… the banks will acquire a very valuable asset at a knockdown price.
1 Explain the situation which arose in 1996 using strategy models.
2 Given the obviously poor chance of making a return, how do you account for the
willingness of banks to lend so much money for the project?
3 What future strategy do you suggest for Eurotunnel?
Case 8.4: The Balanced Scorecard

The Balanced Scorecard was developed by Robert S Kaplan and David P Norton38 and is
a tool for implementing strategy which has been adopted by a large number of organisa-
tions and many have reported that it has greatly contributed to understanding and
implementing strategy; on the other hand some organisations have reported difficulty in
fully implementing the approach, but this is to be expected with a technique which
requires a significant investment in time and effort and a reconsideration of existing
organisational procedures. At the outset it needs to be stressed that the Scorecard is
not a mechanistic tool as its name might suggest; rather, it is a process which the
organisation can adapt to its own particular needs and characteristics therefore the
precise definition of the Scorecard can vary significantly depending on the circumstanc-
es.
The Balanced Scorecard uses four perspectives on the company’s vision and strategy
to identify value creating activities at the SBU level:
 Financial
 Internal Business Processes
 Customer
 Learning and Growth

And for each of these sets out:

 Objectives
 Measures
 Targets
 Initiatives
By being explicit about value creating activities and how to develop and measure
them the approach provides a framework for translating a strategy into operational
terms and contributes to the development of a strategic management system. The
objectives and measures used in the scorecard are derived from a top-down process
based on the mission and strategy which have already been specified for the SBU; the
Scorecard is therefore not concerned with the determination of objectives but with
how to achieve them. The given SBU mission and strategy are expressed as tangible
objectives and measures and the targets and initiatives are then derived from these
explicitly understood objectives and measures.
The concept of balance reflects the fact that clear and final answers to business
issues do not exist and that it is necessary to employ informed judgement. Since trade-
offs have to be made in the allocation of scarce resources to meet the needs of
customers there are two classes of measurement:
 external measures for shareholders and customers;
 internal measures of critical business processes, innovation, and learning and growth.
It is not a simple matter to relate measures of internal effectiveness to external
outcomes because measures are not always available in unambiguous numerical forms
thus there is also a balance to be struck between:
 objective and hence quantifiable outcome measures;
 subjective performance drivers of the outcome measures.
It needs to be pointed out that most organisations will already have performance
measurement systems and a decision has to be made whether the Scorecard should
complement these or replace them. This is an important issue, because if the Scorecard
is seen as just another set of measurements amongst many then the chances of fully
implementing the Scorecard process are likely to be diminished.
In a practical setting the scorecard is used for a series of specific tasks as follows.
1. Clarify and translate vision and strategy
2. Communicate and link strategic objectives and measures
3. Plan, set targets and align strategic initiatives
4. Enhance feedback and learning
A discussion of each of these tasks helps show how the Scorecard might work in
practice.
1. Clarify and translate vision and strategy
The SBU senior management team works together to translate the SBU strategy
into specific strategic objectives. This is often easier said than done, because at the
financial level it is first of all necessary to agree on the balance between revenue and
market growth, profitability and cash flow. At the customer level it is necessary to
agree on the segments in which to compete; this will require a degree of consensus
to resolve differences of opinion on the composition of the segments.
Once the financial and customer objectives have been determined the objectives and

measures for internal business processes can be tackled. This has the advantage of
breaking away from the typical cost, quality and cycle times of existing processes and
highlights the processes that are most critical for achieving high levels of perfor-
mance for customers and shareholders. The Balanced Scorecard may reveal entirely
new processes that the organisation needs to excel at for the strategy to succeed.
The final step, learning and growth objectives, identifies the rationale for investing in
retraining, IT systems and new organisational procedures.
It is the process of building the Balanced Scorecard which clarifies strategic objec-
tives and identifies the critical drivers of these objectives. In practice consensus on
strategic objectives is rarely found initially, with individuals’ views being determined
by factors such as experience and functional background. It is almost impossible to
go on and build complete consensus, but the Balanced Scorecard makes disagree-
ments and their rationales more visible; it helps to accommodate incomplete
consensus because the management team adopts joint responsibility for the shared
model of the entire business, to which each has contributed.
2. Communicate and link strategic objectives and measures
The details of how communication is carried out are much less important than the
fact that it signals to all employees the critical objectives that must be accomplished.
Once all employees understand high level objectives they can establish local objec-
tives that support the overall SBU strategy.
3. Plan, set targets and align strategic initiatives
The scorecard is an instrument for driving organisational change. To achieve ambi-
tious objectives it is necessary to set ‘stretch targets’ and on the basis of these
determine resource requirements. This enables strategic planning to be integrated
with the annual budgeting process. As a result the organisation is enabled to
 quantify the long-term desired outcome;
 identify mechanisms and resources to achieve these outcomes;
 establish short-term milestones for the Scorecard measures.
4. Enhance feedback and learning
The Scorecard information enables management to review and update with a view
to learning about the future rather than dwelling on the past. Strategic learning starts
with the clarification of the shared vision and the use of measures, whether objective
or subjective, and elevates the discussion beyond ill-defined and nebulous ideas. The
way in which the pieces fit together can be visualised, and the comparison between
desired and current performance identifies performance gaps.
A Final Word
The Balanced Scorecard fills a gap which exists in most management systems – the lack
of a systematic process to implement and obtain feedback about strategy. Management
processes built around the scorecard enable the organisation to align itself with the
long-term strategy and focus on implementing it. The balance aspect emerges from a
framework which makes it possible to make explicit trade-offs among a number of
objectives. At the same time the authors stress that the Scorecard is about management
first and measurement second and as such has a major role to play in generating
1 What is the relationship between the Process Model and the Balanced Scorecard?


Telecom and MCI
1 Compare BT’s strategic process with WorldCom’s in relation to the takeover attempts.
2 What are the strategic prospects for the new WorldCom/MCI company?
Case 8.6: Vuitton: Expensive Success (2007)

Have you ever seen a Louis Vuitton bag marked down in price in a sale? The answer is
no, and you never will. Have you ever had to pay for the repair of a Vuitton product?
The answer is no, and you never will because repairs are free. Was Vuitton hit by the
global downturn in the early 2000s like other luxury producers? The answer is no. In
fact, Vuitton increased both profits and margins during that period and the share price
almost doubled in 2003/04. So does having one of the world’s most famous brands
guarantee success? The answer is no, because other equally famous brands have suffered
during the recession. So perhaps there is something special about Vuitton’s manage-
ment.
Market Position
Vuitton has the biggest market share in the luxury goods sector:
Brand Sales Operating Market Share

($billion) Margin (%) (%)
Vuitton 3.80 45 37
Prada 1.95 13 19
Gucci 1.85 27 18
Hermes 1.57 25 15
Coach 1.20 30 12
The calculated market share is a rough indicator that takes the big five as the total
market in prestige consumer goods. Vuitton probably has less than one-third of the
total luxury goods market but in relative terms, it is twice as big as its nearest competi-
tor.
Vuitton has focused on establishing brand loyalty and many customers have started
with relatively cheap items and moved up to lines such as Suhali, a goatskin bag costing
about $2000.
On the other hand, Vuitton is heavily dependent on certain markets: for example, 55
per cent of sales are to Japanese customers. This dates back to before 1989 when
Vuitton was owned by the Racamier family, which had targeted Japan, and by the time
Vuitton was acquired by Bernhard Arnault, Japanese sales accounted for 75 per cent of
the total. The CEO of Louis Vuitton since 1990, Mr Yves Carcelle, is credited with
masterminding Vuitton’s growth and takes the view that as living standards grow
internationally there is no constraint to Vuitton’s continuing expansion. Growth under
Mr Carcelle has been extraordinary: sales multiplied six times up to 2004, margins

increased from 9 to 45 per cent, and by 2004 the company was clocking up an annual
growth rate of 16 per cent.
Vuitton has not been afraid to take chances, for example by employing the ‘grunge’
designer Jacobs, who has increased Vuitton’s attraction to a younger clientele and now
accounts for 15 per cent of sales.
Making the Goods

On the manufacturing side, Emmanuel Mathieu was appointed in 2000 to head the
industrial operations and has increased productivity by 5 per cent per year by introduc-
ing many efficiency improvements ranging from new leather cutting machines to quality-
circles type teams. The launch time for a new product has been reduced from one year
to six months in the space of five years. This type of managerial input has transformed
Vuitton from being a large-scale cottage industry to a modern business. But it is still
highly labour intensive and the average bag output is five per day per employee.
It is clearly important to achieve the right balance between mechanisation and hand-
made production. One observer compared Vuitton with Hermes, where at Hermes it
was like stepping back in time with rows of employees doing nothing but stitching. A
Hermes bag is, in fact, more expensive than Vuitton but, as can be seen from the table,
Hermes’s operating margin is much lower.
An example of how a new product launch can work is the Boulogne Multicolor, a
shoulder bag costing about $1500. When following up on the success of the Murakami
line, marketing executives surveyed store managers and found that many customers
were asking for a Murakami shoulder bag. Technicians in the marketing workshop took
the classic Boulogne shoulder bag, reworked it and then had the prototype approved by
the senior management team; this bypassed the normal design procedures. The bag then
went straight into production using existing templates.
In Vuitton factories, teams are between 20 and 30 strong and take on one product at
a time; members are encouraged to make suggestions and are kept informed about sales
performance. The goal is for individuals to be multi-skilled and for teams to be autono-
mous. This has contributed to fast problem solving so that products such as the
Boulogne Multicolor can pass through the system quickly in response to marketing
needs. One result is that production has remained in France rather than in countries
where labour costs are lower. Mr Mathieu states that French production is a guarantee
of quality.
Going for Growth

During the recession after 2000, Vuitton increased advertising by about 20 per cent at a
time when competitors were cutting advertising budgets; not only that, but a new global
campaign was initiated featuring Jennifer Lopez and a series of supermodels. This has
resulted in a higher brand profile, but because of Vuitton’s size advertising spend is still
only 5 per cent of sales compared with the industry average of 10 per cent.
During the course of 10 years, Vuitton has expanded internationally and doubled its
retail network to 318 stores in 51 countries by 2004. Vuitton was the first luxury group
to open a store in Shanghai in 1992, and mainland China accounted for 8 per cent of
sales by 2004. The first store in India was opened in 2004. Entering new markets is not
taken lightly. Planning for the Indian enterprise, for example, started in 1999 when a
Vuitton team visited India with a view to determining how the rich spent their money.

International expansion is about more than establishing stores in new locations. The
worldwide brand awareness generated by presence in countries such as India and China
means that when international travellers journey abroad they will be aware of the
existence of the brand, and its cachet is introduced to the segment in new countries.
So is Vuitton Unstoppable?
A serious threat is counterfeiting, mainly from China. Oddly enough, the Chinese do not
buy counterfeits, preferring the real thing, and most copies are sold to tourists or
exported.
The drive for growth poses risks. In 2003, for example, Vuitton opened 18 new
stores, double the number of openings 10 years ago. This poses strains on the distribu-
tion network and means that the company has to increase its vigilance to ensure that
quality standards are not compromised. It is imperative that discipline is maintained.
Louis Vuitton is only part of the LVMH holding company which extends over wines
and spirits, perfumes and cosmetics, watches and jewellery and selective retailing, and
includes such brands as the duty free retail chain DFS, Christian Lacroix and Givenchy. It
is estimated that 80 per cent of LVMH profits come from Vuitton. This has been noted
by analysts and in 2004 LVMH won a court ruling against a Morgan Stanley analyst on
the basis that he had downgraded LVMH shares unfairly; in his view Vuitton was a
mature business.
1 The fashion industry is usually regarded as highly competitive. How did Vuitton tackle
this competitive environment? (Use the five forces.)
2 Explain Vuitton’s success using the process model.
Case 8.7: Implementation: The Missing Link (2006)

From its foundation the CEO of Hewlett-Packard (HP) had been recruited internally but
in July 1999 Carly Fiorina took over as the first outsider. She made significant changes in
the structure of the giant company and forced through a merger with Compaq in 2002;
but in February 2005 the HP board asked her to resign and she agreed. It is a big step to
fire such a high profile chief executive so something important must have gone wrong.
The chairman, Patricia Dunn, said in a statement, ‘This is not a change related to
strategy; this is a change to accelerate strategy.’ When the interim chief executive,
Robert Wayman, was asked to explain exactly what this strategy was he responded that
there were a variety of strategies related to HP’s unique portfolio of businesses. Both
chairman and chief executive claimed that Ms Fiorina’s weaknesses were in execution
and not in setting a mistaken overall direction. In fact, the board made it clear that Ms
Fiorina’s replacement would be expected to pursue the existing plan.
Ms Fiorina’s Strategy
Ms Fiorina’s strategy can be described in general terms as follows. By the late 1990s, the
computer industry had become highly competitive. Therefore, combining two large
rivals – HP and Compaq – would provide the opportunity to produce a huge but lean
operation. This would result in a profitable computer business to complement HP’s
printer business, where it was the unchallenged world leader. She used to express her

strategy as ‘high tech, low cost’.
Competition Reaction
The attempt to become market leader in computers did not work out. Against a
backdrop of overcapacity in the industry that was driving down prices and that resulted
in a sales margin of about 1 per cent in 2004, Dell was able to undercut HP at the cheap
end of the market because of its already lean supply chain. By the end of 2003, Dell was
shipping more computers than HP, with a global market of 18 per cent compared with
HP’s 16 per cent. To counter this, HP would have to enter the direct sales market and
by the time of the merger Compaq had attempted to imitate Dell’s direct sales model;
but this did not meet with support within HP because of the retailer connections and
HP continued with its old industry model when competing with Dell.
Dell also entered the printer market in 2003, threatening HP’s dominance. Other
focused rivals were also entering HP’s territory (for example, EMC in corporate data
storage systems). In IT corporate computing services HP, with an operating margin of
only 1.1 per cent, was uncompetitive compared with IBM, Accenture and EDS. HP had
failed to buy PricewaterhouseCoopers in 2001 because it felt the price was too high so
IBM stepped in; some observers felt that if the purchase was going to be profitable for
IBM then HP must have lost out. HP also had difficulty competing against Kodak and
Sony in the consumer electronics business.
The software market was also changing with the advent of open source software
products, which are low cost alternatives to branded products; cheaper ways to
produce and distribute software emerged such as web-based delivery and reusable
software ‘components’. This presented firms like HP with a stark choice: attempt to
produce high-tech products that command a high price or compete with low cost
products from a much lower cost base. Ms Fiorina had acquired some half-dozen small
software companies, but in corporate computing HP actually lost money in 2004 despite
this being a highly profitable market for competitors.
One problem was that high tech still seemed to be associated with high cost. HP had
an annual R&D budget of $3.5 billion and a relatively large sales force. This R&D
expenditure should have led to innovative new products, but, although Ms Fiorina
claimed that HP had come up with 200 new consumer technology products, none of
them seemed to catch the public imagination; in fact, HP decided to sell a rebranded
version of the Apple iPod. Dell, by comparison, does relatively little R&D and sells direct
to customers rather than through independent distributors; as a result its overheads are
about 10 per cent on sales compared with 18 per cent for HP. The demand from
customers has increasingly come for interchangeable components, thus giving greater
freedom to change suppliers. This means that in spite of its ‘high-tech’ focus HP was
under increasing pressure to produce standardised products rather than the individualis-
tic high tech.
Financials
In the third quarter of 2004, HP badly missed profit expectations and in 2004 the share
price fell by 8 per cent and performed worse than nearly all its competitors. In fact,
after the merger with Compaq, HP’s market value was about equal to the value of its
printer business alone. From this perspective, HP was a printer company and the other
businesses were distractions. This situation led to calls for HP to be broken up and,

although this move was resisted by Ms Fiorina, it was reported that the option had been
discussed by the board several times. At the announcement of Ms Fiorina’s departure,
the share price rose by 10 per cent and some analysts claimed that this was because of
the now increased chance of a break-up.
Ms Fiorina’s Style
Shortly after her arrival Ms Fiorina restructured HP from 80 autonomous business units
to four divisions, and centralised operations such as branding and advertising. She
eventually reduced the workforce by over 20 000. She had to combat inertia and had to
force through her plans to streamline the business. She demonstrated decisiveness and
was a great communicator.
But her tough management style was at odds with the old collegiate culture that HP
was famous for. When earnings dipped in 2004 Ms Fiorina fired three senior executives
on the spot. She carried through the merger with Compaq despite serious disagreement
with members of the board, and insisted that synergies would eventually make HP a
market leader in all its businesses. She did not appoint a chief operating officer to take
care of the details of making her initiatives work but instead relied on long serving
executives. She lost several top executives, who went to positions such as president of
Eastman Kodak and senior executive at Nokia.
1 Do you think that firing the boss was the cure for HP’s problems and that it was just an
implementation problem? Tackle this by analysing the strategic process in HP over the
period covered in the case.

1 Use the process model to assess the likelihood of Tesco being successful in the US.
Case 8.9: Revisit The Timeless Story of Entertainment

1 Assess whether the entertainment business is ‘such an odd business that no one can
define what good management actually is’. Use the process model and HBO’s actions.
Case 8.10: Revisit Driving Straight

1 On reading this account an MBA graduate remarked that Mr Marchionne really
understood the strategic process and the role of strategic models. Explain what the
graduate meant.

1 Analyse the impact of Mr Knudstorp using the process model and show how his actions
contributed to Lego’s turnaround.

Appendix 1
Strategy Report
The Problem of Communication
One of the major challenges that you will be faced with when discussing strategy
issues is that few managers will have your comprehension of strategic models and
understanding of the structure within which strategic decisions are made. MBA
graduates often report that they may as well be talking a foreign language and often
find it difficult to conduct meaningful discussions with managers who have not
been exposed to formal business education. It can often be worse than that:
graduates are sometimes accused of using meaningless jargon in an attempt to
impress. This is frustrating for the graduate who has spent a great deal of time
acquiring the knowledge of how models work, their importance for business
decisions and practice in applying them to a wide range of issues. So how can you
get other managers to ‘see’ the relevance and importance of strategic models and
structure? The answer to that, from my experience, is with difficulty. I have run
many ‘Strategic Awareness’ seminars (from one to six days in length) that attempt to
shift managers into the ‘Strategic Thinking’ box in Figure 1.2 without starting from
the base of the ‘Core MBA Subjects’ box. This is clearly a difficult undertaking.
The Strategy Report is intended to help you to produce a report that presents a
clear picture of a strategy problem, the analysis and recommendations in a form that
is hopefully accessible to management. The report demonstrates the relevance of
strategic models, shows how they are applied to the specific problem and arrives at a
plan of action supported by some means of evaluating strategic performance. It is
not a definitive template, but many graduates have reported that the Strategy Report
has provided a valuable starting point.
State the Subject

Although by their nature strategic problems are complex, the essence of the
problem can be communicated quite briefly. The difficulties confronting a company
can often be traced to a few underlying causes, such as the growth of a new compet-
ing technology, escalation of costs, greatly reduced product life cycles or
government intervention. But it has to be borne in mind that the identification of
the root cause, in the Rittel sense, may be difficult and is open to interpretation.
A bland statement such as ‘The company has run losses for the past three years
and will go out of business unless this is reversed’ is unsatisfactory. The alternative
is much more revealing. ‘Four years ago the company decided on a modernisation
programme and an associated marketing drive to capture a larger share of the
market. The investment programme utilised all retained earnings and resulted in a
high gearing level. Unfortunately, the main competitors reacted strongly to the
marketing drive, and there has been little increase in sales revenue. The company is
Strategic Planning Edinburgh Business School A1/1

Appendix 1 / Strategy Report
now operating with substantial excess capacity and a higher level of costs than
before. The net effect is continuing losses and high debt, and no competitive
advantage has been achieved.’
Summary of Recommendations
The strategic analysis can be summarised in a series of recommendations which are
clearly set out at the beginning. The combination of a brief statement of the
problem together with the recommendations provides the reader with an orientation
making it possible to follow the various strands in the argument and see where they
are leading.
Taken together, the subject and recommendations are often included in the ‘ex-
ecutive summary’ and is as far as many managers will get. Unless the strategic issue
and the recommendations are expressed in a plausible and readable form it is
unlikely that the Report will be read further.
Introduction
This section sets the scene for the later analysis. It deals with the main characteris-
tics of the organisation, the economic environment within which it operates, the
market and competitors, and the reasons why a strategic move is necessary.
Objectives
The strategy will hinge on the achievement of objectives, even if these can be
specified only in the most general way. It is therefore necessary to clarify the
business definition and to identify any new company objectives using ideas such as
Gap Analysis, Shareholder Wealth analysis, the separation of means and ends, and
the role of non-monetary objectives.
Analysis and Diagnosis

The analytical section rationalises data and information, systemises it by the applica-
tion of concepts and theories and explains these as necessary.
Use of Data
Do not allow your analysis to be undermined by an incompetent approach to
numbers. The objective of data communication is to turn data into information.
There are a number of rules which can be applied as follows.
A1/2 Edinburgh Business School Strategic Planning

Use only relevant numbers There is nothing to be gained by swamping the

reader with vast amounts of peripheral infor-
mation.
Simplify the raw numbers Remove irrelevant numbers.
Round numbers where possible.
Avoid spurious accuracy.
Make tables simple Make tables as small as possible.
Round to sensible digits.
Use meaningful labels.
Include row and column averages.
Use graphs Graphs are useful when simple patterns are
involved.
Avoid graphs with complex patterns.
Use summary measures Describe the main points of a table.
Do not leave the reader to draw conclusions.
The presentation of quantitative data requires intellectual discipline; inclusion of

irrelevant data and poor presentation undermine the analysis.
Analysis
This is when you have to be able to see what ideas can be applied to the four
boxes in the process model. The Augmented Process Model can be used as a guide,
but each case is likely to be different. The core disciplines can be used to address
issues as follows.
Organisational What are the relationships within the organisation in terms

Behaviour of authority, power communications and management style?
Are these likely to be conducive to change?
Economics What is the economic climate in the markets the company is
operating in?
What is the direction of government policy, and what
opportunities or threats will this present?
Are there economies of scale in the industry?
What are the barriers to entry?
Marketing What are the market characteristics of the products, and
what opportunities exist for segmentation and differentia-
tion?
Finance Which areas of company activity currently contribute to
value creation?
Accounting How well has the company been allocating its resources?
What areas of strength and weakness does this reveal?
Project What trade-offs have been made regarding time, cost and
Management quality and have these been effective?

Explain briefly any models you apply. Do not assume that the reader is familiar
with ideas, but at the same time do not become technical and ‘lose’ your audience.
Since the objective of using the core disciplines is to impose a structure on real
world events it is usually necessary to make assumptions about unknown factors;
these assumptions must be made explicit, and if relaxing them is likely to make a
significant difference to the analysis, this should be investigated by sensitivity
analysis.
The analysis provides the basis for assessing the competitive position of the
company and identifies its competitive advantage. Apply models such as Porter’s
five forces, the value chain, portfolio analysis, and any others you consider relevant.
Diagnosis
The individual strands of analysis are incorporated into frameworks for identify-
ing strategic options.
1. Environmental threat and opportunity profile (ETOP): focuses on the
economy and the market external to the company.
2. Strategic advantage profile (SAP): concentrates on the internal characteristics
of the company.
3. Strengths, weaknesses, opportunities and threats (SWOT) analysis:
provides a comprehensive view of the strategic position of the company, and
identifies the fit between the company’s potential and market opportunities to-
gether with the fit between company weaknesses and market threats.
Choice
This is the stage at which, having collected information and performed the analysis,
the question of what to do next is faced. The analysis will reveal potential generic
strategies based on alignments in the SWOT analysis.
Analysing Options
The application of core concepts to each option identifies characteristics such as
expected cash flow, relative net present values and risk. Different perspectives can
be obtained by applying sensitivity analysis, break-even analysis and the pay back
criterion. Constraints such as the availability of funds and the mobility of resources
must be identified.
No strategy can exist in a vacuum, and the likely reaction of competitors must be
made explicit, together with projected strategic responses to the most likely out-
comes.
The thrust of the analysis of choice is to identify the areas in which the strategy
will contribute towards achieving, or improving on, competitive advantage.
Selecting Options
Options are framed in generic terms at corporate and business levels for clarity
and to avoid becoming ‘stuck in the middle’ by default.
The selection of an option involves making trade-offs among potential costs,
benefits and risks. There will not be a correct answer because of the uncertain
nature of strategy problems, so you must make explicit the reasons for the choice,

the values awarded to different trade-offs and the attitude adopted towards risk. A
choice can really only be justified in relation to other potential choices since the
company has to adopt some course of action.
Implementation
Can the strategy be made to work? What company structure is most suited to the
strategy? How will you know if it is working or not?
Resource Allocation
Compare the current allocation of resources with that which will be required to
achieve the strategy. Where the strategy implies significant organisational change
identify the approach to introducing and managing the change process.
The labour implications include organisational structure, incentive systems, pro-
motion and training. The capital implications include capacity utilisation,
obsolescence, new technologies and labour substitution.
At the same time, flexibility needs to be built in so that other courses of action
can be pursued if predictions are wrong. There is no point to developing a totally
inflexible structure which cannot be deviated from without invalidating the whole
strategy. Flexibility enables contingencies to be outlined.
Evaluation and Control
A system of control which includes the production of performance measures
relating to profitability, activity, efficiency, cash flow and debt is an essential
component of implementation. Intermediate targets are also useful so that individu-
al managers know what they are meant to achieve. Taken together, these goals and
performance measures should have the potential to provide a perspective on the
overall development of the strategy as time proceeds. They should also serve as an
early warning system for detecting differences between expected and actual out-
comes.
Feedback
Identify whether the organisation is likely to adapt and learn as change proceeds.
Recommendations
A summary of the recommendations appears at the beginning, and this section is a
fuller version with the various strands of the strategy explained in some detail,
potential problems discussed, and contingencies identified which may be adopted in
the event of unfavourable outcomes. Often at this stage you will realise that the
recommendations do not really relate to the analysis and it is necessary to revisit the
report to ensure that it all hangs together and supports the final conclusions.

Appendix 2
Practice Final Examinations

This section contains two practice final examinations which are indicative of the
type and level of material which appears in the Final MBA degree examination. The
duration of the examination is three hours. Within the time of three hours you may
allocate time among sections as you see fit. There is no choice in the selection of
questions to be answered.
For each question a guide is provided in Appendix 3 which will allow you to
assess your performance. The practice examination serves two purposes: to test
understanding of the course and to provide information on the standards required
to pass the University Final degree examination.
Some Tips on Analysing Cases and Questions

In business three types of strategic problem are typically encountered and these are
reflected in the composition of the examination.
1. Detailed internal and environmental information on a particular company,
together with some indication of current thinking in the company.
2. A story of a company typically spanning several years in which there is less
detailed information on the company but more information on changing com-
petitive circumstances.
3. You are asked a question about strategic ideas.
These broad categories are encountered again and again in real life. Examples of
each are as follows.
1. A company is carrying out a strategic review on the appointment of a new CEO
and is attempting to determine why it is in its current position and what it should
do in the future. Members of the management team express different points of
view on how to interpret the present position and deal with perceived problems.
2. A company has failed to capitalise on previous competitive advantage, and from
being an industry leader has lost market share and is no longer highly profitable.
3. The CEO asks for advice on how risk and uncertainty should be incorporated
into strategic decision making.
While there are no hard and fast rules on how to tackle each type of question,
here are a few general pointers.
Numerical Cases
The data typically refer to one or two years of accounting information, some data on
internal operations and market information on sales, market size and so on. In real
life much more data would be available, but the principles involved are the same.

Appendix 2 / Practice Final Examinations
Before addressing the specific question asked it is necessary to determine what the
data are telling us. This then raises the basic question: where do I start? The answer
is: anywhere! Here are two approaches.
1. Start from the inside of the company and work out and ‘follow your nose’. For
example, start with assessing if the company is profitable overall because this
both reveals overall levels of efficiency and identifies potential constraints on
future action. Consider the operating surpluses, both before and after overheads,
and the cash flow; look at the capital tied up in the company and work out ratios
such as return on investment and gearing. Then look at the individual products
and start thinking about applying some models. For example, where the products
are located on the BCG matrix, whether they are related and the prospects for
product life cycles. Then consider any information about external events, such as
new entrants; this may be the opportunity to apply the five forces model, or
identify market structures and consider drawing up profiles and developing a
SWOT framework. This provides you with the basis for interpreting the product
costs and revenues. You are then in a position to answer just about any question.
2. Work through the process model. Start by asking what business the company is
in and where it sees its markets and the approach of the decision makers. Then
analyse the environment, the industry and internal operations (this was the start-
ing point for the first approach). This takes you on to considering the choices
made in the past and the choices which might be made in the future. Some of
the analysis will be relevant to assessing how strategy has been implemented and
finally there might be some information on how the company has reacted to
changes in the past. This thought process will result in a similar set of analyses to
the first approach, but it is rather more structured and you can use the augment-
ed process model as a rough check list for ideas.
Case Questions
The case is typically a two to three page narrative and may be supplemented with a
few tables and diagrams. As in the numerical case there is less information available
than in real life, but again the principles are the same. While one or two of the
questions in the case may focus on specific aspects of the story, the real challenge is
to rationalise what happened using strategy models. Once more this comes down to
the basic issue: where do I start? There are several approaches of which two are as
follows.
1. Ignore the question and ask what has really been happening. This can be done by
following the steps in the process model: did the organisation have clear objec-
tives? did it understand its markets? did it make a rational choice? did it
implement effectively and did it learn from its mistakes? Once you have derived
a few rough answers to the questions raised by the process model you should
understand enough about what has happened to answer the question and to
flesh out your answer by applying relevant models.
2. Focus on the question asked and identify relevant models to generate an answer.
The question itself can act as the stimulus for applying strategic models, and in

fact one reason that specific questions are posed is to help candidates focus on
relevant issues.
Bear in mind that you cannot answer the question by simply reproducing the
contents of the case. For example, the answer to a question on what went wrong
may focus on the characteristics of the strategist and the lack of clear objectives,
coupled with inadequate market analysis; this provides insight into the strategic
process which a description of events does not. Many candidates confuse narrative
with analysis and simply restate the case in a slightly different way.
Essay Questions
The essay places you in the position of formulating an answer to a question which
raises an issue of principle and cannot really be answered on the basis of infor-
mation. Typically you will be expected to talk about strategy issues and provide
clarification. For example, you might be asked by a colleague ‘What is the point of
trying to plan for the future?’ You cannot answer this by recourse to the successes
of planning (remember the difficulty of attempting to prove a hypothesis) but you
can set out the concept of the process model and the costs and benefits of a
planning approach. The important point is to identify what the question is really
about and then consider the arguments for and against.
Some General Issues

Whether answering a strategic planning examination question or writing a strategy
report there are some issues you should bear in mind.
Make sure you understand what is being asked: in real life the issue at stake is often not
obvious. Remember the Rittel characteristic that understanding many questions is
the same as answering them. So ask yourself questions such as: is this about
competitive analysis, corporate versus business strategy, the value chain and so on.
Whatever you decide can lead you into a different set of models and analysis.
Always think in terms of models: this may appear to be superfluous advice given the
nature of the course but just about anything you consider should trigger a model or
an idea. For example, inventory accumulation should trigger management over the
product life cycle. Also, when applying the process model keep the augmented
model in mind and apply models to supplement the discussion; a process model
analysis that does not deploy supplementary models or ideas is usually superficial.
Follow through on your analysis: you may construct an excellent SWOT matrix but
without considering its implications it is of little value. The same goes for a five
forces analysis: you may develop a well thought out profile but you need to inform
the reader about what it means; can it be concluded that the industry is intensely
competitive or not?
Do not be afraid to express opinions: by its nature a strategic analysis is likely to be
complex and contain conflicting results. That means you have to balance up the
pros and cons of the argument. You may have conducted an exhaustive process
model analysis but you have to decide whether the overall process is robust or not.
It is how you bring the arguments together and arrive at a personal conclusion that

gives life to the strategic analysis. But beware: an unsupported opinion is of no

value.
This could happen to you: the three types of question are representative of what
happens in real life. But you don’t get much time in real life so you have to be able
to think effectively ‘on your feet’. Therefore look at the examination as training for
dealing with real life situations. If you fail the examination it is not a disaster but a
message that you have not convinced me that you are thinking like a strategist; in
other words, have you managed to move into the ‘Strategic Thinking’ box in
Figure 1.2? The real disaster, of course, is that you fail in real life and that is what
the examination is intended to help avoid.
Practice Final Examination 1

All three sections should be attempted; the sections carry equal marks. The pass
mark is 50 per cent.
Section 1
The accounts and product information below refer to a hypothetical company,
Stratco plc.
THE FINANCIAL TIMES: COMPETING IN A RECESSION

The opinion of most forecasters is that the recession is now starting to bite
and companies in the electrical and related sectors can expect their markets to
be hit for the next two years. However, this does not mean that there are no
opportunities for companies who are willing to look to longer term prospects
both in terms of productivity and product diversification. The changing nature
of communications has led to market openings for a variety of new products;
companies with resources and expertise in place will be ready to step into
profitable markets when the business cycle begins its inevitable improvement.
Experts vary on their opinion of when this may be, the most optimistic being
18 months and the most pessimistic being three years.
Memo
From: Marketing Director
To: Board of Directors
There has been a substantial increase in the number of small companies entering
our market area where we are producing Links and Cutters. This has posed
problems with some of our customers because these new entrants are able to
offer products more closely tailored to their requirements. While the impact on
the market shares of our existing products is likely to be marginal, it looks like
we are going to face increasing difficulties in establishing market shares with new
products from now on, and perhaps we should be reviewing the development
potential of the Grinder.

On the basis of the information on Stratco plc in Exhibits 1 and 2, and the in-
formation above, assess the strategic prospects for the company by carrying out the
following tasks.
1. Set up a profile of the company and its environment on which you would base
recommendations for a strategic thrust. Pay particular attention to the incorpora-
tion of risk.
2. Suggest additional information which you would find useful. How might this
information be obtained?
3. Assess your recommendations from the shareholder viewpoint.
4. The current operating surplus could have been increased from $1 409 000 to
$2 454 000 by cutting research expenditure, development expenditure and com-
pany marketing by 50 per cent. What effect is this likely to have on company
value in the short and long term?
Exhibit 1: Stratco plc

Operating Account at End Year: Production Cost and Revenue ($000)
COST OF GOODS 5 055 SALES REVENUE 8 954
SOLD
GROSS PROFIT 3 899
Operating Account at End Year: Overheads and Operating Surplus ($000)
Factory rents 300
Owned factory overheads 100
Development expendi- 590
ture
Company marketing 800
OPERATING 1 409
SURPLUS
Cash Flow Account at End Year ($000)
OUTLAY INCOME
Material purchase costs 1 650
Interest on assets 42
Wage costs 2 592
Assembly line costs 1 120
Total overheads 2 490 Sales revenue 8 954
TOTAL OUTLAY 8 852 TOTAL INCOME 8 996
NET CASH FLOW 144

Balance Sheet at End Year ($000)

FIXED ASSETS
Factory 2 000
TOTAL FIXED 2 000
ASSETS
CURRENT ASSETS
Raw materials 1 000
Cash 3 500
TOTAL CURRENT 8 124
ASSETS
TOTAL ASSETS 10 124
OWNERS’ EQUITY 10 124
DEBT
Loan 0
TOTAL DEBT 0
Exhibit 1 (continued)
Company Value at End Year ($000)
CASH 3 500 TOTAL DEBT 0
NET LIQUID ASSETS 3 500
Operating surplus value* 9 545
COMPANY VALUE 13 045
POTENTIAL PRODUCT VALUES
Production models** 42 200
Development models** 7 300
* Capitalised value of operating surplus ** Based on shareholder value analysis
Exhibit 2: Report on products for year

Status: Production Link Cutter Link Cutter
Models
Remaining life (years) 9 5
Composition of demand Composition of supply
Orders 2 715 4 437 Output 3 095 6 457
Warranty demand 79 115 Previous inventory 1 643 1 453
TOTAL DEMAND 2 794 4 552 TOTAL SUPPLY 4 738 7 910
Resource productivity Distribution of supply
Output/Line 515 645 Warranty replacements 79 115

Status: Production Link Cutter Link Cutter

Models
Output/Worker 10 18 Sales to backlog 0 0
Output/Unit material 0.97 1.96 Sales to orders 2 715 4 437
Working time (%) 100 101 Actual market share (%) 12.7 8.4
Labour attrition rate (%) 2.16 3.10 Excess supply (inventory) 1 944 3 359
Price ($/unit) 1 778 930
Competing price ($/unit) 1 778 1 000
Account at end year
Wage cost ($000) 1 200 1 392
Assembly line cost ($000) 420 700
TOTAL COST ($000) 2 749 3 649 SALES REVENUE ($000) 4 827 4 127
Unit cost ($/unit) 888 565 GROSS PROFIT ($000) 2 345 1 555
Cost of goods sold ($000) 2 482 2 572
Labour experience*
1 quarter 10 20
4 quarters 150
7 quarters 290 65
9 quarters 133
Exhibit 2 (continued)
Report on Grinder for Year 5
Status: Buying in Technology
Remaining life (years) 10
Estimated market peak 50 000 Current market size 35 238
Competing price ($/unit) 921 Forecast warranty returns (%) 3
Production cost ($/unit) 712
Forecast market share (%) 9.3 Remaining development (years) 1
Development expenditure
Spending this year ($000) 590
Total to date ($000) 1 180
* Number of quarters employees have worked on this product
Section 2 The British Satellite Broadcasting Disaster
Background
In the late 1980s the British television system comprises four terrestrial stations: two
run on the basis of an annual licence fee (which everyone who owns a TV set must

pay); these were the British Broadcasting Corporation channels 1 and 2, and the
commercial stations ITV and Channel 4. The first satellite TV licence was awarded
to British Satellite Broadcasting (BSB) in December 1986; BSB had a number of
apparent advantages. First, it was first in this new field serving the British market; its
only rival Sky did not announce its satellite service until the middle of 1988. Second,
BSB had the backing of some of Britain’s richest media companies; on the other
hand, Sky was owned and run by Rupert Murdoch, the proprietor of News Corpo-
ration, which at the time was labouring under the burden of an $8 billion debt.
Third, BSB had what it considered to be a superior technology in D-MAC, which
was supposed to provide clearer pictures and better sound than the PAL system
used by Sky.
But by November 1990, after only three months of BSB transmissions, it had
become clear that both satellite stations could not survive. Sky was making losses of
about $8 million per week, while BSB was making losses of about $16 million per
week. BSB was virtually taken over by Sky, which assumed complete management
control of the combined company BSkyB. What went wrong with a company which
was apparently in a situation with all the preconditions for success?
Getting to the Market Too Slow

Despite BSB’s 18-month lead in terms of licensing, Sky went on the air 15 months
ahead of BSB. This was important because the two systems were incompatible, and
the first to install a satellite dish and receiver was likely to keep the customer; it cost
about $450 to install or change system. By the time BSB started broadcasting in
April 1990 Sky had installed 750 000 dishes.
Defining the Product

The reason BSB was so late in actually starting broadcasting was that the superior
technology could not be put into practice, and it was estimated that this delayed the
BSB launch by eight months. Furthermore, BSB overrated the selling power of the
D-MAC system, whose superior performance was only apparent on the newest TV
sets and recorders. Viewers who had not committed themselves to Sky were
therefore waiting for a product with a characteristic which they could not assess;
once word started to get around that the difference between the two systems was
minimal the advantage of D-MAC was lost.
Getting the Market Wrong

The market for Sky TV was largely the C1/C2 socioeconomic classes, which is not
the higher spending middle and upper classes which appeal to advertisers. BSB
could have aimed at the market niche which Sky had not exploited with ‘quality’
programming, but it chose to fight Sky in the C1/C2 market where Sky was already
well ahead. While, of course, it is impossible to know what lay in the minds of BSB
executives, it seemed that they considered their competitor to be Sky, whereas in
fact they also had to compete with the range of quality and popular programmes
available free on the four terrestrial stations. Their problem was not just to attract a
potential satellite customer from Sky, but to attract a satellite customer in the first

place. Since Sky had already decided on the market and the level of programming,
BSB was now competing for part of the market which had already been generated
by Sky rather than adding to the total market by virtue of its unique characteristics.
Getting the Costs Wrong

On the cost side, BSB had various disadvantages. First, the D-MAC technology was
more costly than PAL, which was already in existence and proven. Second, BSB
bought and launched its own two Marco Polo satellites, while Sky rented time on
the Astra satellite which was already in orbit. Third, BSB housed itself in lavish
studios and offices in expensive central London; Sky was located in less ostentatious
facilities in the cheaper suburbs. Fourth, it was well known that BSB had used
relatively high salaries to attract executives from the terrestrial stations; Sky had not.
Fifth, BSB was determined to outbid Sky for American films, and sent prices to
unheard of levels. One explanation for the runaway costs at BSB was that it was a
consortium, whose owners could not collectively act to control expenditure in the
way which Rupert Murdoch could.
1. Could BSB have been competitive if a different strategy had been adopted? Set
out an argument which, on balance, suggests either YES or NO.
2. If YES – Suggest reasons why the company followed the course which it did.
3. If NO – Suggest reasons why the enterprise was pursued to the disastrous extent
which it reached.
Section 3
Imagine you have been hired to introduce strategic planning into a medium sized
company. The difficulty is that only the CEO believes that on balance there will be a
payoff. The directors for Finance, Marketing and Production are sceptical because
of the constantly changing environment within which the company operates. Set out
the arguments you would use to justify your case for strategic planning, and do not
ignore the potential drawbacks of the approach which are likely to be in the minds
of your opponents.
Practice Final Examination 2

Section 1
HIGH LEVEL INVESTMENT FUND
ACME PLC: ANALYST’S PRELIMINARY REPORT (CONFIDENTIAL)
This company is not living up to expectations. It has had four years of continuous
growth and, despite adverse economic conditions, last year reported an operating
surplus of $2.2 million. But this year the surplus has dropped back to $1.3 million.
Now that general economic conditions have started to improve, with a GNP
increase of 2.5 per cent in the first quarter of this year alone and booming export
markets, it should have been positioned to take advantage of the recovery. Not only
does Acme seem to be missing the boat, it seems to be unaware of changing

competitive conditions. To my knowledge, three major companies in the industry

have already increased capacity significantly, and two of them have high inventory
levels. There are also signs that stronger international markets are leading to an
increased number of entrants, and competitive pressures generally are likely to
become even more severe.
1. Analyse the current competitive position of Acme Plc using the Report above
and the information in Exhibits 1 and 2.
Exhibit 1: Acme plc
Operating Account at End Year: Production Cost and Revenue ($000)
COST OF GOODS SOLD 6 789 SALES REVENUE 10 848
GROSS PROFIT 4 059
Operating Account at End Year: Overheads and Operating Surplus ($000)
Factory rents 300
Hiring and redundancy cost 300
Line installation cost 200
Development expenditure 1 000
Company marketing 200
OPERATING SURPLUS 1 309
Cash Flow for Year ($000)
OUTLAY INCOME
Factory purchase Factory sale 1 800
Material purchase 2 500
Loan interest 500 Interests on assets 250
Wage cost 2 280
Line cost 1 190
Product marketing 900
Total overhead 2 750 Sales revenue 10 848
Total outlay 10 120 Total income 12 898
Net cash flow 2 778
Exhibit 1: (continued)
Balance Sheet at End Year ($000)
FIXED ASSETS
Factory 4 000
TOTAL FIXED ASSETS 4 000
CURRENT ASSETS
Raw materials 1 000


Cash 3 000
TOTAL CURRENT ASSETS 5 269
TOTAL ASSETS 9 269
OWNERS’ EQUITY DEBT 5 269
Loan 4 000
TOTAL DEBT 4 000
Exhibit 2: Report on products

Switch Laser Switch Laser
Composition of demand Composition of supply
Orders 5 250 6 120 Output 3 550 6 600
Warranty demand 100 63 Inventory 1 000 1 500
TOTAL DEMAND 5 350 6 183 TOTAL SUPPLY 4 550 8 100
Distribution of supply
Warranty replacements 100 63
Sales to orders 4 450 6 120
Working time (%) 117 100 Actual market share (%) 17.8 21.0
Labour attrition rate (%) 8 2 Excess supply (inventory) 0 1 917
Price ($/unit) 1 200 900
Competing price ($/unit) 1 500 900
Account at end year
Wage cost ($000) 600 1 680
Assembly line cost ($000) 350 840
Cost of material used ($000) 453 1 650
TOTAL COST ($000) 2 103 4 370 SALES REVENUE ($000) 5 340 5 508
Unit cost ($/unit) 592 662 GROSS PROFIT ($000) 2 645 1 414
Cost of goods sold 2 695 4 094
Exhibit 2: (continued)
Report on Development
Tube Socket
Estimated market peak 50 000 30 000 Current market size 25 000 20 000
Estimated market at launch 35 000 25 000
Competing price ($/unit) 1 000 1 500
Production cost ($/unit) 800 900

Report on Development
Tube Socket
Forecast market share (%) 10.0 15.0 Remaining development (years) 1 2
Development expenditure
Spending this year ($000) 700 300
Total to date ($000) 1 500 800
2. The new strategy analyst makes the following statement:

‘It does not matter what the difference between Unit Cost and Competing
Price is. What is important is cash flow, i.e. that the Cost of Goods Sold is
less than the revenue from sales.’
Compose an argument expressing the opposite point of view, making use of the
company information.
Section 2 Euro Disney Has a Slow Start

By the end of 1992 reservations were being expressed about the future of Euro
Disney. The following describes what happened up to the beginning of 1993.
The Disney theme parks are by far the most successful theme parks in the world.
Europeans take trips to the US with the primary intention of visiting a Disney
theme park. They are acknowledged to be highly efficient at delivering entertain-
ment to a consistently high standard. The group also runs hotels near each theme
park. Transplanting the concept to Europe was obviously an attractive proposition,
and in April 1992 Euro Disney was opened outside Paris with a great fanfare of
publicity, which was subsequently maintained at a high level.
The initial objective was to attract 11 million visitors per year, and for the first
seven weeks of operation it had daily attendance figures averaging about 30 000,
which would have given exactly 11 million visitors in the first full year of operation.
But it was to be expected that in the winter months attendances would fall as low as
10 000 per day, and therefore the attendance for the first year was unlikely to exceed
9 million. The Asterix theme park, which is 20 miles from Euro Disney and has
been in operation for some time, closes down from the end of October to April.
The implications of a 2 million shortfall are potentially severe: each visitor spends
about $40 (including the entrance fee), suggesting that revenue might be about $80
million below expectations. The problem, oddly enough, was not the international
appeal of Euro Disney, but its French appeal. The numbers of British, Dutch and
German visitors were as predicted, but the French were unwilling to patronise Euro
Disney. Reasons given were bad publicity about traffic jams, the hour long waits for
rides inside the park, and the apparent French dislike of American culture.
In September came news of a top management reshuffle, with the crucial job of
running the theme park and merchandising going to an American. By this time the
share price had tumbled from a peak of Ff160 to Ff75. The results for the year to
end September 1992 revealed a loss of $23 million. A total of 6.8 million had

attended in the 24 weeks to the first half year, and the occupancy rates of the hotels
was 74 per cent. The company stated that the losses were primarily due to the fact
that the infrastructure had been designed to deal with higher numbers, hence costs
would not have increased greatly had attendances been higher. These figures were in
line with the earlier information on attendances, and if these fall to 10 000 per day
for the winter half year the total for the year will be just over 9 million.
In 1993 it was concluded that the future of Euro Disney was highly uncertain
because of the alignment between its internal weaknesses and external threats. By
September 1993, Euro Disney had lost almost a billion dollars.
The park was rechristened Disneyland Paris in 1995 (and Disneyland Resort Paris
in 2002) and new attractions, such as Space Mountain, were installed. This resulted
in a visitor increase of about one fifth and the first operating profit was announced
in 1995. But financial performance has been volatile, for example there was a loss of
63 million euros in 2009.
In 2015 it was the most visited tourist attraction in Europe but it still has a debt
of about $2 billion. In that respect it has similarities to the Channel Tunnel: it is
regarded as a successful technological investment, it is very popular with customers
but it has not been financially viable. It is a prime example of the potential pitfalls of
international expansion; PEST analysis suggests that the social differences between
the US and France are such that transplanting US culture to France is a doubtful
economic proposition.
1. From the viewpoint of January 1993, would you regard the strategy of trans-
planting a successful operation from the US as a failure?
2. Based on performance up to January 1993, would you expect Euro Disney to be
successful in the long term?
Section 3
The company strategic planner argued that the setting of company objectives is
central to formulating a strategic plan. The CEO disputed this, saying that in a
changing world it is not possible to be definite about objectives and, in any case,
employees pay little attention to them. Discuss how objectives are set and how to
ensure that the organisation acts in accordance with them.

Appendix 3
Guide to Strategic Planning Practice

Final Examinations
The assessment is based on the application of relevant concepts and analyses to the
problems. Answers comprised of a series of unconnected observations will receive
little credit. However, attempts to rationalise complex issues using ideas from the
strategic planning course, or any of the core courses, will be handsomely rewarded.
This guide suggests how ideas can be applied; the sample answers are not models to
be slavishly followed, and candidates are encouraged to be inventive in their
approach to the issues.
While it is essential that you attempt all three questions in the examination the
papers are graded on a holistic basis; for example, an outstanding analysis of the
case could compensate for deficiencies in the answers to the other questions. But
bear in mind that if you do not attempt one of the questions the grade awarded for
that question will be zero; part of the test is that you make a sensible effort to tackle
all three diverse questions. The role of the examiner is to assess whether you have
demonstrated an adequate knowledge of the subject and the ability to apply
strategic ideas.
Guide to Practice Final Examination 1

Section 1
Set Up a Profile of the Company and its Environment on Which You
Would Base Recommendations for a Strategic Thrust. Pay Particular
Attention to the Incorporation of Risk.
ETOP
Environmental factors relating to the economy as a whole and the market in which
the company is operating can be gleaned from the newspaper article and observa-
tions in the company memo.
Threats
The recession is expected to last for up to three years; the newspaper refers to the
‘inevitable’ improvement in conditions when the business cycle starts its upward
trend. However, no one can predict the duration of the business cycle with any
degree of accuracy. In the absence of any change in strategy by the company, the
continuing recession will lead to

Appendix 3 / Guide to Strategic Planning Practice Final Examinations
 reduced total market, depending on income elasticity for the products sold;
 relatively low gross profit because of reduced sales and depressed prices;
 potential action by competitors to attempt to protect existing sales; these actions
might threaten the company’s market share.
There appears to have been a reduction in entry barriers, resulting in increased
competition from small companies. These increased competitive pressures could
result in reduced profits.
The company is therefore faced with threats on two fronts: those due to the
recession and those due to changed market conditions.
Opportunities
One view is that the upturn will eventually lead to an increase in market size. But to
take full advantage of this it is necessary to get the timing right: this could be the
right time to start building up market share in anticipation of the increased total
market. On the other hand, because of the increased differentiation of products
and segmentation of the market no company can afford to wait passively for better
economic conditions to produce higher profitability. Specific action will have to be
undertaken to exploit the changing characteristics of the market.
Ranking of Threats and Opportunities

The relative importance of the factors is open to interpretation. For example, in the
short run the most important threat appears to be the recession and its potential
impact on cash flows; in the long run the threat is in the form of a change in
competitive circumstances. The most important opportunity seems to be in posi-
tioning the company to take advantage of the eventual end to the recession.
SAP
Starting with an overall view of profitability the operating surplus is 36 per cent of
gross profit; this suggests that overheads may be unduly high. The cash flow is
negligible, and it must be a cause for concern that the gross profit of nearly $4
million is not being translated into cash inflows. This raises the question of how
effectively resources as a whole are being allocated.
Ratio analysis provides information on the efficiency with which resources are
being deployed. Operating surplus as a percentage of total assets shows that return
on total assets is 14 per cent; it is a matter for debate whether this is an adequate
return given the operating characteristics of the company and returns within the
industry. The gearing ratio is zero because the company has no debt. This can be
interpreted as a sound management approach, or it might suggest that the company
has not pursued opportunities unless they can be financed internally.
Products
Comparisons between products reveal differences in the returns on the products.
The Link is currently generating a gross profit of $864 (i.e. $2.345 million divided by
2715) per unit sold, while the Cutter is generating $350 (i.e. $1.555 million divided

by 4437). On the cost side there are some differences in the cost structures of the
two products, but there is not enough information to assess relative efficiency. On
the market side the Cutter has a smaller market share and is currently priced below
the competing level. If the unit cost of the Cutter were 5 per cent lower, and the
price set to the competing level, then the difference between unit cost and price
would be increased by about $100; at the current level of sales this would have
added about $0.44 million to gross profit. This would have increased the gross
profit per unit sold to about $450. Whether this is achievable depends on the
elasticity of demand.
You can attempt to position the two products in the BCG portfolio matrix; for
example, the Link has a higher market share, is on the market at the competing
price, has a lower expenditure on product marketing and has a much higher gross
profit than the Cutter. This suggests that the Link has characteristics of a Cash Cow,
and that the Cutter may be a Star or Question Mark. The conclusion you reach on
the position of the products has implications for the interpretation of the account-
ing cash flows and the future allocation of resources to the two products. For
example, gross profit as a percentage of sales revenue is 49 per cent for the Link and
38 per cent for the Cutter. This accounting ratio might be taken to suggest that
more resources should be devoted to the Link and fewer to the Cutter; however, the
marketing department could argue that the difference between the two is a result of
their position in the product life cycle and in the BCG portfolio matrix.
Development Products
The product under development – the Grinder – can be analysed using break-even,
pay back and return on investment. The projected difference between unit cost
and competing price is currently $209; total development expenditure is likely to be
about $2 million by launch date which suggests break-even sales in the region of
10 000 units. The forecast market share and market peak suggest maximum sales of
about 4500 per year; the break-even point is therefore well within the potential level
of sales. However, the pay back period is likely to be at least two years, given that
the market is still growing and is currently at about 35 000 compared to the peak of
50 000, and a lot of things can happen during that time.
The return on investment for the Grinder can be approximated to by comparing
the initial investment and the projected net cash flows. For example, selling 4500
per year with a net contribution of $200 per unit would yield a cash flow of about
$0.9 million per year; this results in over 40 per cent return on investment on the
development costs of about $2 million.
The prospects for the Grinder can be assessed by using scenarios as a basis for
investigating the sensitivity of cash flows to changes in assumptions; the infor-
mation in the newspaper report and the internal memo can be used to derive a
scenario. For example, the projected unit cost for the Grinder is currently $712, and
the competing price is $921, while the Marketing Director’s memo suggested that
there are likely to be changes in competitive conditions. If the unit cost turned out
to be 10 per cent higher and the competing price 10 per cent lower after launch,
then the unit cost and competing price would be about $783 and $829 respectively,

resulting in a net contribution of $46 per unit. This would reduce cash flows to less
than a quarter of the estimate above, with severe effects on break-even, pay back
and rate of return. The Marketing Director also stated that market share will be
harder to win in the future. The combination of higher cost, lower price and lower
market share could be fatal for the Grinder.
These projections may not fully reflect the potential returns from the Grinder
because it adds a related product to the portfolio; this enables the company to
further exploit its core competence. Furthermore, the Grinder may help to
increase the brand image associated with StratCo and contribute to the development
of a sustainable competitive advantage.
Advantages
 The company has built up expertise in existing product markets, and has already
climbed well up the experience curve for the Link.
 The gross profit figure suggests that the company is effective at making money
in existing markets.
 Currently there is no debt and the company is cash rich.
 The potential product values suggest that the company has a sound basis for
long-term survival.
Weaknesses
 The high gross profit is not translated into a high positive cash flow because of
the level of overheads and production to inventory.
 Resource management could be improved; inventories of the Cutter increased by
over 100 per cent.
 The Grinder does not seem to be well positioned for stiff competition.
Ranking of Advantages and Weaknesses

Again it is necessary to exercise judgement to assess the relative importance of
different factors. For example, it appears that the company has been good at selling
products and establishing market shares, but poor at resource management and cost
control.
SWOT
The objective is to find a match between the market potential and the strengths of
the company, as well as identifying where the company is likely to be under threat.

Existing products and expertise Deploy cash: boost existing market shares,
spend more on Grinder
Unused cash Use spare capacity when Grinder launched
and sell Cutter from inventory
Potential cash flow Use spare capacity when Grinder launched
and sell Cutter from inventory
Weaknesses Threats
Cost control Increased competition in declining total
market
Potential competitive position of
Grinder
Strategic Options
Potential generic possibilities are listed below, together with the risks associated
with each.
Stability: based on the alignment between existing products and expertise and the
potential market upturn. Carry on and hope that upturn will compensate for
increased competition.
 Risk: market share may decline further.
 Contingency: be ready to protect market share by price reductions and/or
increased marketing effort.
Retrench: based on the alignment between the weak prospects for the Grinder and
increased competition. Abandon the Grinder, increase cash as a buffer, reduce
overheads such as research, and devote some more resources to the Cutter and
Link; reduce capacity.
 Risk: competitive advantage will pass to other companies who may eventually
compete us out of the market. Lower research expenditure may lead to a lack of
prototypes in the long run.
 Contingency: be ready to use cash aggressively in the light of competitive
reaction.
Expand: based on alignment between cash reserves, potential cash flow, excess
capacity and potential for market development. Position company for expected
upturn; meet competition head on and use cash to consolidate position.
 Risk: the company may run out of cash before returns accrue.
 Contingency: ensure that sources of credit are available.
General Risk Considerations
 Length of recession unknown.
 Emerging competitive pressures may be stronger than predicted.

 Getting the timing right is crucial.
Choice
It is necessary to come down in favour of one of the options. In arriving at a choice
indicate the trade-offs you are willing to make in terms of threats, opportunities and
risks.
Suggest Additional Information Which You Would Find Useful. How

Might This Information Be Obtained?
By this stage you have identified potential opportunities and threats, and additional
information on these would enable a more informed choice of strategy.
The likely timing of the changes in economic activity is clearly important, and
additional insights can be obtained from published forecasts, stockbrokers and
consultants. A constant watch needs to be kept on the unemployment rate, the
inflation rate, changes in consumer expenditure and the general state of the world
economy.
Additional market research into product life cycles would help in refining the
composition of the product portfolio. For example, it looks as if the Cutter will
require a higher market share in order to generate a competitive advantage which
will enable higher profits to be made; if the market has reached maturity it will be
difficult to achieve this.
The new entrants are segmenting the market, therefore more market research on
the characteristics of these segments would be valuable.
It is not clear whether the Grinder is viable, given the likelihood of increased
competition, so a rigorous financial appraisal is required, together with additional
research into its market potential.
It is actually difficult and expensive to improve on the information available so
the collection of additional information may not be worthwhile.
Assess Your Recommendations from the Shareholder Viewpoint.

The impact on shareholders depends on the market view of the risks and the
potential returns. Put yourself into the position of a shareholder and consider
whether the strategy you have proposed would cause you to sell your shares.
Currently, the market value of the company is greater than the total asset value
suggested in the balance sheet. However, the values of the individual products come
to a total of $49 500 000, which is far in excess of the current company value. This
suggests that the company value could be increased by splitting it up into the SBUs
represented by the individual products, although this may not be possible in
practice. The gross profit is, in fact, nearly three times the operating surplus, on
which the company value is largely based. If the overheads were reduced and the
gross profit increased as a result of the proposed strategy, operating surplus could
well be doubled; this alone would have the effect of increasing company value by
about $10 million.

Another way of looking at this is that a strategy based on stability would leave the
share value largely unchanged in the short run, but with little chance of long-term
growth; a strategy based on retrenchment could increase share value in the short
run, with less certain long-term prospects; a strategy based on expansion might
reduce value in the short run, depending on the view the market takes of risk.
The Current Operating Surplus Could Have Been Increased from

$1 409 000 to $2 454 000 by Cutting Research Expenditure,
Development Expenditure and Company Marketing by 50 Per Cent.
What Effect is This Likely to Have on Company Value in the Short
and Long term?
There is likely to be a significant difference between short and long run effects and
this is a source of conflict. In the short run operating surplus would be increased, as
would the operating surplus value; however, the market may take a dim view of the
long-term consequences. The Grinder would be launched as a marginal product in a
competitive market, market shares would fall, and fewer prototypes would be
generated in the long run.
Section 2
Could BSB Have Been Competitive?

The events leading up to November 1990 suggest that both companies had made a
major strategic blunder, because the market which they targeted was not large
enough to support two major satellite stations. It looks unlikely that controlling
costs on its own would have been sufficient to generate success for BSB, because
even the much leaner Sky was losing heavily by the time of the take over. However,
it is possible that BSB might have been successful if it had controlled its costs and
developed a different segment of the market; for example, BSB had not exploited
the A and B socioeconomic groups.
The BSB experience can be expressed in terms of the process model.
Strategists
The strategists were apparently not a cohesive group because of the consortium
structure; there was a clear principal–agent problem.
Objectives
A clear set of objectives in terms of intended market, type of programming and so
on does not seem to have been spelt out.
Overall who Decides to Do What

The combination of a consortium approach and unspecified objectives resulted in
an organisation that lacked direction.

Industry Analysis
Once perceived differentiation disappeared BSB dropped into the failure likely part
of the perceived price differentiation matrix. In terms of the familiarity matrix
BSB was moving into new familiar markets with new unfamiliar technology but did
not appear to realise it. Competition between the two companies led to a zero sum
game, where one could benefit only at the expense of the other; the problem for
BSB was that Sky already held a strong position by the time BSB started playing.
The claimed superiority of the BSB product can be analysed in terms of the dimen-
sions of quality; while there was a great deal of emphasis laid on quality, it looks
like the dimensions of quality which BSB management considered important were
not so considered by customers.
Internal Analysis
BSB was inevitably going to be a high cost producer: the relatively expensive and
untried D-Mac technology, the high salaries and the lavish offices meant that unless
it could generate very high revenues (much greater than Sky already had) it was not
going to be profitable. BSB had little insight into how an effective value chain might
be constructed.
Competitive Position
The combination of poor market analysis together with a high cost structure
suggests that BSB started out with little prospect of achieving a competitive
advantage.
Overall Analysis and Diagnosis

The company was weak on analysis and diagnosis, and did not appear to under-
stand the competitive environment well.
Generic Strategy Alternatives

BSB tried to compete on the basis of differentiation. But the basis of differentiation
became unclear and, coupled with high costs, BSB ended up stuck in the middle.
Strategy Variations
BSB was determined to operate independently despite the fact that it was not clear
there was room for another broadcaster in the market; no attempt was made to
consider alliances or partnerships with existing broadcasters.
Choice
The prevailing view appeared to be that money was not a constraint; this was not
conducive to systematic analysis and decision making.
Overall Choice
There appeared to be no appreciation of the basis on which BSB would compete.

Resources and Structure

BSB laid a great deal of emphasis on management and the trappings of a large HQ
without considering whether it added value.
Resource Allocation
The notion of bidding for programmes without any analysis of whether they would
be worth the price paid suggests no understanding of efficiency principles.

The service was launched late and there appeared to be no cost controls. BSB is
possibly unique in that it cannot really be located in the planning and control matrix,
because it appeared to exercise no planning or control. It cannot be characterised as
‘flexible’ because this would imply some degree of intention.
Overall Implementation
It is doubtful if BSB could have remained in business for long.
Feedback
The executives appeared to have learned nothing from their experience in other
broadcasting companies and they appeared to be unwilling to change their behav-
iour.
Overall Strategic Process

It can be concluded that the underlying problem facing BSB was the weakness in its
strategic process; while a strategic process will never be perfect the BSB process
lacked robustness in any dimension.
Having weighed up the process you can judge whether BSB could have achieved
a competitive advantage over its rivals.
If YES
If the conclusion is reached that a viable success strategy existed, then it is interest-
ing to ascertain why BSB did not recognise it. This is probably to do with
managerial perceptions, and the conviction that the BSB product had the quality
to overcome Sky competition. The lack of an analysis of the company’s own
strengths and weaknesses (SWOT) compared to Sky probably led to managers being
unaware of how precarious their position really was.
Because of poor resource allocation BSB was unable to exploit potentially profit-
able avenues, such as product differentiation and market segmentation.
If NO
Once the course of action had been decided on then no individual seemed to be
able to stop it. There seems to have been a lack of feedback from the control and
monitoring stage which would have led to a re-evaluation of the strategy choice.

It is possible that the BSB management was not risk averse, and was willing to
push ahead despite the lack of any immediate indications of success.
The View from Now

BSkyB has prospered since the merger and in 2010 was the first subscription service
to reach 10 million homes. It has introduced High Definition and broadband
services and increased the number of channels offered thus maintaining its differen-
tiation compared to BBC, Freeview and internet providers.
Section 3
The central issue is that Strategic Planning has been promoted by the general
manager (CEO) but opposed by the specialists, each of whom is likely to be
concerned with protecting his or her own interests (the principal–agent problem).
There are many arguments which can be advanced both for and against strategic
planning systems. The question is concerned with the potential benefits and costs
to:
Individual Specialists
Benefits:
 Opportunity to contribute within a recognised structure
 More information on other areas in the company
 Constraints on resources made explicit
 Opportunity to contribute to objective setting
Costs:
 Potential loss of control
 More accountability
The Company
Benefits:
 The strategic process itself can be a positive factor on performance with the
explicit recognition of objectives, rigorous analysis of the environment, competi-
tion and the company, selection of generic options, the allocation of resources
consistent with these, and the development of control and feedback systems.
 The process provides a structure within which decisions can be made.
 The attempt to identify performance gaps, pursue a general strategic thrust and
consider contingencies can help provide the company as a whole with a sense of
involvement and common purpose.
Costs:
 Formal strategic planning can introduce rigidity and rob the company of the
ability to react to changing circumstances.
 It may impart a mechanistic impression to the process which is mistaken.
 There is no empirical evidence from real life studies that planning itself will
increase profitability.

Do the benefits outweigh the costs? First, can be argued that the strategic plan-
ning approach is a process rather than a formalised planning structure therefore
some of the objections are irrelevant. Second, the strategic process provides an
understanding of what the company is trying to achieve in relation to its resources
and it is difficult to see how this is inferior to haphazard decision making.
Guide to Practice Final Examination 2
Section 1
Question 1: Analyse the Current Competitive Position of Acme Plc

Using the Report Above and the Information in Exhibits 1 and 2.
Economic and Competitive Environment

The impact of the recent increase in economic activity on the demand for the
company’s two products depends on their GNP elasticity. It is possible that the
GNP elasticity of the Switch is relatively high, which could account for the underes-
timate of demand for the Switch, with consequent under-production. The over-
production of the Laser could have been due to an over-estimate of its GNP
elasticity. However, it is unlikely that changes in demand conditions account for the
fact that supply of Switches was about 20 per cent lower than demand, while supply
of Lasers was 30 per cent greater than demand.
Further increased sales as a result of continued improvement in economic condi-
tions cannot be guaranteed because competitive pressures are expected to
increase. The Analyst’s concerns about increased foreign competition depends on
barriers to entry, but he provides no information on these. The problem confront-
ing the company is that demand is increasing, but supply is likely to increase by
even more; the result would be a reduction in the equilibrium, or competing
price. Even if the company were to achieve increased sales, the impact of increased
competition is likely to be a reduction in profit margins as any monopoly profits
are bid away. Apart from this the fact that competitors have been building up
capacity has some ominous implications. Once the investment in production
capacity and inventory has been made, competitors may start basing their prices on
marginal cost thus increasing competitive pressure.
The Company
The overall financial performance of the company was one of the Analyst’s con-
cerns. A factor contributing towards the fact that operating surplus is much lower
than gross profit is hiring and line installation costs; if these had increased from last
year this could account for up to $0.5 million of the observed drop of $0.6 million
in operating surplus. The cash flow position is distorted by the sale of a factory,
which is simply a switch in the company’s portfolio of assets. The net cash flow
would have been about $1 million, which is similar to the current operating surplus.

Ratio analysis shows that return on total assets was 14 per cent and return on
owner equity was 25 per cent. It is worthwhile to consider different scenarios, for
example the return on total assets would have been 20 per cent if the hiring, firing
and line installation costs had not been incurred. The gearing ratio can be assessed
from the balance sheet and it emerges that debt comprises over 40 per cent of total
assets and 75 per cent of owner equity. The fact that debt is so high in relation to
owner equity might pose constraints on future borrowing.
The fact that company supply is so far out of line with product demand suggests
that there are some planning and control deficiencies. Overall profitability could
well be increased by improved resource management.
In summary the company could be making a much higher operating surplus, and
has the potential to generate a substantial return on assets; but the debt position
may have an effect on the ability of the company to develop its products further.
Products
Ratio analysis reveals that the Switch is making 49 per cent profit on sales value,
while the Laser is making only 25 per cent. This is reflected in the gross profit per
unit: the Switch is making about $610 gross profit per unit, while the Laser is
making only about $230. This difference could be due to cost factors, market
conditions, or a combination of both. On the cost side, the labour force on the
Switch is working 17 per cent overtime, and the attrition rate is 8 per cent compared
to 2 per cent on the Laser. This suggests that the labour force on the Switch is not
so far up the experience curve as it might be, and hence the Switch is being pro-
duced less efficiently than the Laser. On the market side the Switch has even more
problems: it did not meet all of potential demand. Thus from both cost and market
viewpoints the Switch could have been more profitable in relation to the Laser. A
scenario could be used to estimate the potential profitability of the Switch if
sufficient numbers had been produced to meet all demand and unit cost had been
significantly lower; the scenario could include price being set equal to competing
price and lower product marketing expenditure (with appropriate assumptions about
the impact on market share). A case could be made for reallocating resources from
the Laser to the Switch.
An attempt to locate the Switch and the Laser within the BCG matrix to inter-
pret their likely potential in terms of the product life cycle meets with some
difficulty. The problem is that the two products have virtually identical market
shares, but otherwise they are completely different. The price of the Switch was
below the competing level, and product marketing expenditure was over twice that
on the Laser; despite this the Switch’s gross profit was almost twice that of the
Laser. This could be due to the Laser being a Star or Question Mark, i.e. it is
struggling to maintain its relative position in a growing market, while the Switch is a
Cash Cow, i.e. it has a relatively large market share in a mature market; in that case,
you would perhaps question the aggressive pricing and marketing policy adopted for
the Switch.

Development Products
The Tube is close to being launched in a highly competitive environment while
projected unit cost is only $200 less than the competing price. Without being
precise, the return on the Tube can be calculated roughly by first of all estimating
gross profit; this is done by multiplying market share by estimated market peak by
the difference between competing price and unit cost. This comes to about $1
million per annum. At first sight this appears to be a high rate of return on the
projected development expenditure of $2.2 million. The problem is that the
profitability of this product is highly sensitive to relatively small changes in market
share, unit cost and competing price. Furthermore, there is no guarantee that the
estimated market peak will be achieved, while the product life cycle may be relatively
short. Given that the estimated market size at launch will be only 35 000 units, the
minimum pay back period for the Tube looks like being three years. It may be worth
undertaking a ‘crash’ development programme of, say, $2 million, on the Tube in
the last year of its development to buy more market share and start off with a lower
production cost. On the other hand, since past expenditure is sunk, the best course
of action may be to abandon the Tube and allocate development expenditure to the
Socket.
The Socket, on the other hand, has the potential to generate about $2.7 million
per year in gross profit, and the total investment in development at the current rate
of expenditure will be about $1.4 million. The problem is that it will be another two
years before the Socket comes on the market, and competitive conditions may well
have changed significantly by then. It may be worth accelerating expenditure on the
Socket to get it on the market sooner.
Managing the Portfolio

The company is currently spending about 10 per cent of sales revenue on the
development of the two products; the company is already deeply in debt, and unless
it can increase its operating surplus a large increase in development expenditure may
cause it to start making losses. Furthermore, with only two products in the devel-
opment stage, and with uncertain product life cycles for the two products currently
on the market, the company should be thinking about where new products are
going to emerge from in the longer term, and how these will be financed.
The conclusions drawn in the preceding discussion are set out in a SWOT analysis.
Healthy return on assets and return on Possibility of economic upturn
owner equity Laser is a Question Mark or Star
Costs temporarily high due to hiring and Invest in Tube and Socket to
line installation improve characteristics and launch
Socket early
Switch is a cash cow

Weaknesses Threats
High gearing, which may constrain Increased competition from abroad
additional product development Competitors building capacity
Resource allocation: Switch not meeting
demand while Laser building inventories
High attrition rate on Switch
Tube sensitive to adverse outcome
Socket two years from launch
The alignments among strengths and opportunities, weaknesses and threats are
used to evaluate Acme’s competitive position.
 The opportunities of developing the Laser into a Cash Cow and investing in the
development projects require finance and are aligned with the healthy cash flow
and the current Cash Cow characteristics of the Switch; but the weakness of the
existing high gearing ratio may pose a constraint on pursuing these opportuni-
ties.
 The threat of increased competition is aligned with weaknesses in resource
allocation: unless resource allocation is improved the price pressures will cause
further reductions in profitability and Acme will find it difficult to diversify into
the new product range.
Is there a generic strategy choice which will enable Acme to improve its competi-
tive position in the future? It could be concluded that Acme should pursue a
corporate strategy of stability and focus on improving resource allocation and
ensuring that the Cash Cow characteristics of the Switch are capitalised on while
managing the Laser through the Star stage.
Question 2: Compose an Argument Expressing the Opposite Point of

View, Making Use of the Company Information.
This question is deliberately vague, and presents a rather confused argument.
The issue can be tackled using the basic model of costs and revenues:
Profit Quantity Price — Unit cost
It is obvious from this that high volume products with a relatively small differ-
ence between unit cost and price can be more profitable than low volume products
with a large difference. The Laser has higher sales than the Switch buts its gross
profit is lower.
The performance of the company as a whole is not simply the sum of the indi-
vidual products because some costs, such as R&D, cannot be allocated to
individual products. It is therefore important to control overheads as well as to
produce and sell individual products efficiently. Acme appears to have incurred
significant debts in developing its new products. There is a trade-off between
making profits and investing for the future.
Taking gross profit figures for individual products at one point in time may not
reflect longer term marketing objectives, such as pricing low in order to maintain

or gain market share for a Star; costs may not be representative of long-term
prospects because the product may still be relatively low on the experience curve.
The gross profit for each product may not be an accurate indicator of efficiency
because accounting procedures can disguise how resources are being used, for
example when selling from inventory on a historic cost basis current gross profit
may not reflect current costs and revenues. The Switch sold from inventory and the
Laser increased inventories and this was not captured by the individual gross profit
figures.
However, when assessing what actually determines a company’s cash flow, it is
necessary to ascertain where revenue is being generated, and at the end of the day
this is due to the difference between unit cost and price. The behaviour of unit cost
compared to competing price provides an indicator of the efficiency of resource
allocation compared with competitors. Cash flow is not necessarily a good indica-
tor of competitive advantage.
Why would a strategy analyst make such a statement? He may have been trying to
focus attention on the revenue generating potential of the company which is, in
simple terms, the difference between what the company spends and what it earns.
In the long run it stands to reason that cash flow must be positive.
Section 2
From the Viewpoint of January 1993, Would You Regard the Strategy
of Transplanting a Successful Operation From the US as a Failure?
The Disney theme parks are often used as an example of excellence in manage-
ment, with particular emphasis being placed on the ability of Disney employees to
deliver high-quality service consistently. It is therefore of considerable importance
to determine if and why Euro Disney is in fact a failure in a different market.
The first step is to decide on appropriate performance measures. One measure
is simply the number of visitors; the park attracted 6.8 million visitors in its first 24
weeks of operation, so in that sense it could be regarded as a fantastic success.
However, despite the large number, the costs incurred were greater than revenues
and a loss of $23 million was made. But since costs do not vary much with numbers
at the margin, this loss would have disappeared with another 0.5 million attendances
(ignoring the hotel profits), which is about 7 per cent. The difficulty with all market
research is that it is subject to some margin of error, and to be wrong by 7 per cent
in the start-up phase of a very large project is not unknown. The problem is the high
sensitivity of profits to relatively small variations in attendance. If attendances had
been 10 per cent higher the enterprise would have been in profit. In fact, the
predictions about non-French visitors appeared to have been broadly correct. A
further performance measure is hotel occupancy, which was 74 per cent; whether
this was a good or bad figure depends on the break-even level of hotel occupancy.
It is possible that there was a weakness in the value chain which resulted in a
lower quality product being delivered at a higher cost. The fact that Euro Disney
attracted millions of visitors, and was subject to the scrutiny of US executives,

suggests that the delivered quality was similar to that elsewhere; the trouble was how
that quality was perceived by Europeans.
Another way of looking at Euro Disney is that it is a new product in Europe and
as such is near the start of its product life cycle. The shape of product life cycles is
notoriously difficult to predict, and it may well be that the ‘growth’ stage is proving
to be lengthier than predicted. It may be that the problem is the rate of growth of
the market rather than its ultimate size.
The financial loss is a performance measure, but it needs to be interpreted to put
the figures in context. The loss is an outcome of the scale of the enterprise: to make
the park attractive initially it was necessary to build it and provide the quantity of
entertainment services which would make it worthwhile for people to come a long
way to visit, therefore it had to be able to accommodate at least 11 million. The
company could not do anything about the consequent running costs to operate this
scale of theme park. But if Euro Disney had been built to a scale consistent with,
say, 8 million attendance the theme park might not have been able to produce the
required appeal.
Euro Disney performance can also be assessed by using the process model.
Objectives
The initial objective was quite clear: to transplant the Disney concept to Europe and
attract 11 million visitors in the first year.
Strategist
Subsequently there was some evidence of lack of direction at the top, with the
reshuffle of top management in the face of what might have been short-term
financial problems.

The efficiency of the analysis and diagnosis aspect has been discussed above, and it
is a matter of judgement as to whether it could have been done any better.
Choice
The strategy choice – to go with a theme park more or less identical with its
American counterparts – was subsequently adhered to with the appointment of the
American executive in charge of running and merchandising.
Euro Disney is an example of international expansion which did not transfer
competitive advantage from one country to another. The fact that demand condi-
tions were so different between the US and France resulted in the highly
sophisticated quality delivery system delivering the wrong product.
Implementation
Resource allocation was constrained because of the need to build the total Euro
Disney infrastructure, and the low marginal cost of additional visitors; whether
increased resources devoted to marketing will achieve better results cannot be

predicted – this depends on the marginal cost of additional marketing (and mer-
chandising) and the marginal revenues which it generates.
Feedback
The management was slow to act on the feedback that the characteristics of Euro
Disney did not entirely meet with approval from the French.

The strategy process had a number of weaknesses which contributed to its relative
lack of success compared with the US Disney parks. There were problems with the
strategists, doubts about the quality of the analysis, reliance on transferring competi-
tive advantage internationally, resource allocation problems and slow feedback.
Based on Performance up to January 1993, Would You Expect Euro

Disney to be Successful in the Long Term?
The long-term prospects of the market as reflected in the share price are not very
promising: by September the share price had fallen by half. Is the market justified in
its pessimistic prediction? It is likely that the market initially valued the company on
the basis of its success in America, but in the light of events expectations have
dropped to a lower level.
An analysis of internal factors can reveal the potential for long-term profitability
by changing the way the company is currently run. The first year’s results suggested
that total cost was:
$272 million 6.8 40 $23 million loss $295 million
A conservative estimate suggests that Euro Disney already has a full year market
of about 9 million visitors, generating revenues in the park of about $360 million;
whether this will generate a profit depends on the marginal cost of the additional 2.2
million visitors. The marginal cost per visitor is probably very low, so it is difficult to
conclude that it would be impossible eventually to generate at least some profit on
such an enterprise. But whether that profit would generate an adequate return on
capital invested depends on the set up costs. One crucial issue is whether it will be
possible to reduce operating costs without damaging the quality of the product.
The adverse publicity suggests that Euro Disney had not performed as well as it
might in terms of quality. The misgivings about the time spent queuing and the
‘American’ image are things the company can do something about; in fact, Euro
Disney will probably have to take action not only to improve the delivery of the
product, but to improve its perceived quality. The approach adopted was to put an
American in charge of merchandising; this suggests that Euro Disney did not
consider the quality problem to be due to the French dislike of American culture,
but that the marketing effort was not efficient. It certainly seems that a significant
contribution to long-term success could be made by operating on internal factors.
There are many external imponderables: is the current situation related to the
product life cycle, i.e. is the growth in visitors merely slower than predicted, rather
than the total market being lower than predicted? Will the ‘resistance’ of French

consumers be overcome? Will there be an economic upturn in Europe, and what is

the income elasticity of demand? Will the management find a way of improving
winter attendances? Will the existing theme parks, such as Asterix, react in an
aggressive fashion?
The discussion is summarised in a SWOT analysis.
Has already generated a market of Improve marketing and image
about 9 million visitors annually Improve winter attendances
Low marginal cost High income elasticity of demand
Weaknesses Threats
Low share price American image: resistance of French
Long queuing times consumers
Existing theme parks: Asterix
The task facing Euro Disney is to generate a long-term competitive advantage,

and it is clear from the alignment in the SWOT analysis that the internal weaknesses
need to be tackled and a response mounted to the external threats before the
opportunities can be taken advantage of. Whether this is attainable is difficult to
determine, so it can only be concluded that the longer term success of Euro Disney
is highly uncertain.
The View from Now

In 1993 it was concluded that the future of Euro Disney was highly uncertain
because of the alignment between its internal weaknesses and external threats. By
September 1993, Euro Disney had lost almost a billion dollars.
The park was rechristened Disneyland Paris in 1995 (and Disneyland Resort Paris
in 2002) and new attractions, such as Space Mountain, were installed. This resulted
in a visitor increase of about one fifth and the first operating profit was announced
in 1995. But financial performance has been volatile, for example there was a loss of
63 million euros in 2009.
In 2015 it was the most visited tourist attraction in Europe but it still has a debt
of about $2 billion. In that respect it has similarities to the Channel Tunnel: it is
regarded as a successful technological investment, it is very popular with customers
but it has not been financially viable. It is a prime example of the potential pitfalls of
international expansion; PEST analysis suggests that the social differences between
the US and France are such that transplanting US culture to France is a doubtful
economic proposition.
Section 3
There is a logical sequence from vision to mission to objectives although it may not
always be explicit.

The overall vision of what the organisation is about is translated into a mission
statement which gives a general direction to the allocation of resources; the mission
statement then leads to the specification of objectives which are disaggregated to
SBU and functional levels and can be understood and acted on by management.
While it is not possible to be precise, as the CEO says, there is a big difference
between a travel agency that aims at being a major player in the corporate business
travel market and one that aims to have a chain of holiday agencies in large cities.
Objectives can be expressed in many ways including financial, economic, social
and behavioural objectives; they are not necessarily measurable, although the
SMART framework can be useful.
Objectives are not necessarily immutable once they have been determined, but
can be adjusted in the light of changing circumstances as a result of feedback in the
strategic process.
Factors that affect the setting of objectives include:
 The characteristics of decision makers, for example prospectors as opposed to
analysers
 Shareholder wealth
 Gap analysis
 The size of company
 Corporate versus SBU objectives
 Risk aversion
 Ethical considerations
The benefits of setting objectives include:
 Objectives provide explicit direction; otherwise there is no basis for consistent
decision making over time.
 The business definition provides a focus for determining relevant skill sets.
 Setting objectives ensures that a distinction is made between means and ends.
All organisations face the problem of ensuring that individuals act in accordance
with objectives; this is the principal–agent problem and if it is not addressed the
CEO’s concern will become reality: employees will pay little attention to objectives.
It is necessary to align the incentive system with objectives to ensure that employees
act in accordance with them.
To sum up, objective setting is an integral part of the strategic process and a
process that does not contain a clear set of objectives is unlikely to be robust. The
difficulties associated with objective setting pointed out by the CEO are not
sufficiently compelling to ignore objective setting.

Appendix 4
Answers to Review Questions

Contents
Module 1 .............................................................................................................4/1
Module 2 .............................................................................................................4/7
Module 3 .......................................................................................................... 4/23
Module 4 .......................................................................................................... 4/31
Module 5 .......................................................................................................... 4/36
Module 6 .......................................................................................................... 4/59
Module 7 .......................................................................................................... 4/79
Module 8 .......................................................................................................... 4/97
Module 1
Review Questions
1.1 The CEO is actually implementing a strategic planning approach possibly based on
his knowledge of military strategy: he has established a set of objectives, which is to
keep shareholders happy, to achieve about 12 per cent return on investment, and
not to grow the business other than to follow trends in the market; this can be
deduced from the fact that market share has remained constant for several years; he
carries out (unspecified) analyses of the market place, and has decided on a planning
time horizon, i.e. about one year ahead; he has a control process in the sense that he
watches costs and tries to keep them under control. The real issue is whether the
skills he has transferred from the military environment are likely to be effective in
business.
In order to probe rather more deeply into the process and arrive at a series of
questions, you can use the elements of Strategic Planning. Under each of the
headings you should generate a series of relevant questions such as:
Structure
 How do you decide what prices to charge for your products?
 What criteria do you use for allocating resources among competing alternatives?
 What methods do you use to determine whether potential investments are likely
to be worthwhile?

Appendix 4 / Answers to Review Questions
Analysis
 You criticise the scientific method of strategic planning, but your own conclu-
sions are based on one observation; how do you know you are right?
 Why do you consider 12 per cent to be a good rate of return in your industry?
 How do you assess competitive pressures in your industry?
Integration
 What would be your reaction to the entry of a major aggressive competitor?
 What is your contingency to deal with the worst potential outcome which you
think is reasonably likely in the next year?
 What would be the likely costs and benefits of attempting to increase market
share?
 How does the company cope with change?
Evaluation
 What procedures do you use in the company to ensure that you obtain relevant
information in time to make use of it?
 What techniques do you use to ensure that your costs are at least comparable
with competitors?
 What incentive systems do you use to ensure that your employees are ‘happy’,
and how do you determine whether they are ‘happy’?
Feedback
 How do you keep your employees in touch with the overall objectives and
direction of the company? Do you think it is necessary?
 How often do your functional managers meet with you to discuss the future of
the company?
You could also pose a series of questions about corporate versus SBU issues: for
example, what criteria are used to select products, and how resources are allocated
among SBUs.
The CEO seems to think that his military background gives him an advantage in the
business environment. However, none of his statements about how he runs the
company are obviously related to conducting military campaigns. You could ask a
question relating to the carry over from military to business strategy; for example, in
a competitive market there are many ‘enemies’, so how does this relate to the
military case where typically a single, clearly defined, enemy is engaged?
You will probably have had some difficulty in formulating sensible questions at this
stage. By the end of the course the types of question listed above will be almost
automatic. However, it is unlikely that you could unsettle this CEO, because people
who have been moderately successful are usually convinced that they are doing the
right things.

The View from Now

This generic issue emerged from experience in executive programmes where senior
executives were put in the unfamiliar situation of running a simulation. Despite
having been exposed to top-class business faculty members teaching their specialist
subjects, executives tended to revert to ‘This is what has worked for me in the past’
rather than think in terms of applying models in order to understand the environ-
ment and the competitive advantage of the company. The complacency of the CEO
is actually not the outcome of laziness but of ignorance of how to apply an analytical
strategic approach. The whole of this course is devoted to overcoming this hurdle.
1.2 It is a matter of judgement whether the five point plan is regarded as being
prescriptive. While it was fairly specific it did not specify a time scale nor specific
targets in terms of market share, sales revenue, cost reduction nor how increases in
market intelligence would be measured.
The Planning Approach
 The future can be predicted accurately enough to make rational choices. The various crises
which occurred as soon as the plan was decided on are consistent with the ar-
gument that the future cannot be predicted accurately. However, the CEO was
not so much predicting the future in terms of events as the future of the compa-
ny in terms of three scenarios: carry on as before, be more aggressive in existing
markets or combine increased aggression with an acquisition. He then asked for
recommendations from each functional specialist and on the basis of that had
them put together a five point plan. This course of action was a rational choice
in terms of what could be divined about the future; it has to be appreciated that
even the ‘do nothing’ option is a choice in its own right. Therefore the fact that
the future was unpredictable is not a valid argument for making no change at all.
 It is possible to detach strategy formulation from everyday management. The information
presented by the functional managers was slanted towards their own interest,
and each felt that his perspective was the most important. The information cer-
tainly did not reach the CEO in a ‘tidy bundle’ and he had to integrate and
interpret it; it is quite possible that a different CEO would have come to a differ-
ent set of conclusions with exactly the same information. At the same time the
CEO was dependent on the functional managers to present all relevant infor-
mation, and he had no guarantee that this was actually done. For example, the
marketing projections might have been pure speculation and the ‘detailed finan-
cial appraisal’ carried out by the finance department might have used
questionable accounting conventions. As it turned out almost all of the infor-
mation presented, whether it was accurate or not, went out of date very quickly.
 It is possible to forego short-term benefit in order to gain long term advantage. The CEO
made it clear that the attempt to attain a higher degree of competitive advantage
would result in reduced profits in the short run, although an attempt would be
made to mitigate this by introducing a JIT programme. The fact that the returns
would be reaped in the longer term when combined with the subsequent crises
resulted in the unanimous conclusion that no changes should be made. The im-

mediate crises focused attention on the fact that the change programme would
not deliver immediate benefits.
 The strategies proposed are capable of being managed in the way proposed. There is no
doubt that the strategy could not be implemented in the way proposed given the
reaction of the labour force. It would appear that no consideration had been
given to how the proposed changes would appear to the very people who would
have to put them into effect.
 The chief executive has the knowledge and power to choose among options. While the five
point plan had been developed for the CEO by the functional managers they did
not exhibit much commitment to it. All of them were happy to suggest shelving
it as soon as circumstances changed; none of them produced a suggestion as to
how the general thrust of the plan might be maintained while accommodating
the difficulties they faced.
 After careful analysis, strategy decisions can be clearly specified, summarised and presented; they
do not need to be altered because circumstances outside the company have changed. There is no
doubt that some adjustments to the five point plan would have to be made in the
light of ongoing events. In fact the five point plan did not have a time scale at-
tached and it was not set out in a precise fashion.
 Implementation is a separate and distinctive phase that only comes after a strategy has been
agreed. This was certainly one of the drawbacks of the whole process. The five
point plan was constructed in isolation from any consideration of how it might
be implemented, and as soon as an attempt was made to put it into effect it be-
gan to founder.
In summary it can be noted that while the strategic process can be criticised in these
terms, the five point plan did not really amount to a prescriptive plan and the
criticisms, while valid in their own right, do not invalidate what the CEO was trying
to achieve.
Emergent Strategy
The general approach adopted by the CEO accorded with the emergent approach in
that each day he considered the three questions and tried to take the answers into
account in running the company. He spent as much time as he considered useful in
generating information, and then operated in satisficing mode by identifying three
courses of action out of many possibilities and then deciding to go with the expan-
sionary diversification option which led to the development of the five point plan.
It is important not to confuse the five point plan with the CEO’s strategic choice;
the five point plan was a means of achieving the overall objective and was likely to
be subjected to detailed changes as time progressed. As market conditions changed
(for example the Japanese invasion) the CEO’s perception of market possibilities
would probably change; but it would presumably take a series of fundamental
changes to alter his overall vision of where the company should be going.
Resource Based Strategy
The CEO’s summary highlighted some distinctive competencies: a productive
research department and a sound internal structure. However, the main focus was

on external market pressures in the form of intensifying competition in established

markets. The five point plan did not identify the unique competencies of the
company which could be aligned with market opportunities.
The View from Now

The three notions of planning, emergent strategy and resource based strategy are as
relevant now as they were a quarter of a century ago. Executives are still confused
by the world around them and some feel that planning can point the way forward,
some feel that events are completely outside their control (emergent) while others
feel that the answer lies in the internal resources of the organisation (resource
based). Of, course, the fact is that real life is a mixture of the three and personal
commitment to one approach is a serious strategic error.
1.3 At first sight the five point plan has a certain logic and comprises a fairly specific set
of recommendations for future action. But does it really provide a focus for future
deployment of resources?
The salient point is that there does not appear to be a clear distinction between
corporate and business unit concerns. The role of the corporate CEO lies in
managing corporate cash flows, deciding which markets to be in, allocating re-
sources among the business units and acquiring or divesting business units. Detailed
actions for business unit efficiency are suggested (such as JIT), but no consideration
is given to the optimal allocation of resources among business units. Instead, the
first four points are directed at all three business units independent of their individ-
ual operations and they essentially boil down to increasing competitive advantage
and reducing costs.
The fifth point refers to corporate communications and the need to develop a
company culture; this is left totally vague and the issue of whether the same culture
is appropriate for the individual business units is not addressed. The role of the
corporate headquarters in the company is not discussed; while the current three
products are related in terms of production techniques and markets served there is
no indication of what the parenting contribution of the corporate centre is likely to
be in the future.
Thus when viewed from the business versus corporate perspective the five point
plan emerges as being incomplete and unstructured. While all of the issues raised in
the plan are important they do not identify where the company is headed as a
corporation and what the role of the individual business units are within this grand
design.
The View from Now

The problem of business versus corporate strategy has been the downfall of many a
company and it is still not often recognised. The skill set of a corporate CEO differs
significantly from that of a business CEO and it is often not recognised that the
effective product manager will not necessarily have the skills required at the corpo-
rate level.
1.4 Rittel’s Tame and Wicked Properties: see Table 1.1

1. The CEO attempted to formulate the problem by asking three questions every
day. When he decided he needed a full answer to the first question he was con-
fronted with a number of reports about current performance which he had to
interpret and integrate. In this case it was clear that there was no such thing as a
definitive formulation of company performance. When it came to identifying
what should be done in the future the options multiplied, while specifying what
would achieve successful change was only partially addressed.
2. The CEO’s summary of current performance immediately identified what would
have to be done in many respects: the internal weaknesses in coordination and
the external threat of increased competition implied action to increase efficiency
and improve marketing.
3. The CEO came up with three broad strategies each of which had its own costs
and benefits. The third option, which he appeared to favour, was not supported
in its entirety by the subsequent information provided in the various reports (the
acquisition of Easy Turbines was not pursued). The course of action finally un-
dertaken was the best the team could come up with but it could not be claimed
that it was the best possible.
4. Once a start was made to putting the plan into action it immediately merged into
market dynamics, and it is an open question whether the same conclusion would
have been reached the following week.
5. The CEO did not have a check list of techniques which he could apply. Instead
he depended on the skills of the individuals who happened to be on his team at
the time.
6. The fact that competition was increasing may have been due to market entrants
or it may have been a symptom of the fact that not enough resources had been
devoted to maintaining product quality and after sales service.
7. Far from being able to undertake the same course of action again, it was imme-
diately doubtful if the five point plan itself could be implemented at all.
8. The chance of the particular combination of circumstances confronting the
CEO having occurred before is practically zero. As a result there was no prece-
dent which could provide him with the answers he was looking for. He may have
had experience of a company in a similar competitive situation but whether it
could be similar enough to provide real guidance on what to do in this situation
is an open question.
The View from Now

The fact that real life is indeterminate was Rittel’s contribution and it still causes
many students concern to the extent that some complain their strategy professors
do not ‘teach them’ how to deal with the real world. The learning point is to
recognise the world for what it is.
1.5 The CEO and the operations manager were advocating the strategic planning
approach in which the company can be managed by applying analysis and logic to
existing information. Their view of the world was that they had just not been good
enough at doing this in the past. They were also committed to a resource based
view, that profitability could be improved by making the company more efficient in

the technical sense. They were backed up in this by the finance director, who saw
the issue in terms of efficient resource allocation.
On the other hand, the marketing manager felt that the emergent approach would
be more effective and that the company needed a greater degree of flexibility. He
felt that strategy could emerge as the company developed and as the environment
changed and that it was pointless to plan for the unknowable. He was concerned
with the dynamics of the market and felt that the way forward was to be continually
proactive.
The strategy consultant could see that they were disagreeing about the fundamental
approach to decision making. He pointed out that the first step was to recognise
these perspectives and then it was up to them to decide on a course of action
instead of arguing about how they see the world individually.
One of the fundamental tasks of business education is to enable managers to
understand what it is they are actually arguing about. In this case declining profit
was a symptom of the wider problem that the company was not equipped to deal
with changing market conditions.
The View from Now

One of the important outcomes of studying strategic planning is self-realisation, i.e.
being aware of the stance you are taking. The identification of symptoms rather than
the underlying problem is a major intellectual problem. This scenario is an applica-
tion of the ideas in Exercise 1.2.
Module 2
Review Questions
2.1 At this stage you do not have command of the many models necessary to analyse
fully the contents of the boxes but it is still possible to make significant progress in
assessing the strategic process.
Strategists
The CEO clearly saw himself in the role of ultimate strategist while asking his
subordinates to provide information, analysis and opinions. The company itself
was at the diversified stage but it was not clear that product and marketing deci-
sions had been fully delegated to the SBU chiefs. In fact, the SBU chiefs did not
appear to figure in the decision-making process. The CEO may have been averse
to risk, bearing in mind his comments on the risks associated with moving into
new markets and acquiring Easy Turbines.
Objectives
The CEO did not explicitly state the mission and objectives of the company. He
did say that it was time to shed the image of conservatism and that resources
should be devoted to exploiting existing markets more vigorously and diversify-

ing. These general statements of intent were not translated into measurable ob-
jectives even in the five point plan.
WHO DECIDES TO DO WHAT
In this stage of the process the strategist demonstrated the ability to bring to-
gether information and come to clear conclusions. While a strategic direction for
the company was identified this was not associated with the formulation of spe-
cific objectives.
The General Environment
The first Economic Report related general economic conditions to company
performance.
The Industry Environment
The first Marketing Report dealt with competitive pressures in relation to prod-
uct life cycles and market entrants.
Internal Factors
A great deal of information on the internal situation was provided in the first
Accounting, R&D, Finance, Production and Manpower Reports. Each focused
on a particular aspect of the company and as a result it was difficult to determine
from the Reports what the company was particularly good at.
The first CEO’s Summary drew together the individual Reports and focused
attention on the fact that competitive pressures were such that the company
could not carry on as before.
ANALYSIS AND DIAGNOSIS
The CEO was clearly determined not to undertake any action without a clear
understanding of the current situation of the company in the general and market
environments and its competitive standing. It would have been possible, of
course, to spend even more time on examining the behaviour of competitors and
analysing the internal operations of the company. However, given that time was
moving on and the CEO recognised the need to maintain competitiveness there
is a limit to how much time can be spent on this stage of the process.
The CEO identified three generic strategy alternatives: carry on as before, be
more aggressive in existing markets, and combine increased aggression with
diversification. These three options can be regarded as generic because they
imply fundamentally different future resource allocation.
Strategy Variations
The second set of Reports introduced some variations on the generic approach-
es; for example, there was a great deal of discussion of expansion by acquisition,
and the R&D Report suggested how much should be spent on new products.

Strategy Choice
There was a good deal of comment on the generic alternatives and the strategy
variations in the second set of Reports. The final choice made by the CEO was
for an expansionist diversified approach but not to pursue the acquisitions route.
While the CEO consulted his colleagues and achieved a degree of consensus he
took responsibility for the final decision.
CHOICE
The CEO did not simply ask for information but actively canvassed his col-
leagues for their views on different courses of action. It is, of course, not known
whether he had already decided what to do, but the weight of opinion was cer-
tainly against diversification by acquisition and the CEO did appear to have
taken these views into account. Thus the process for making choice was quite
exhaustive and the final decision was certainly not taken in isolation.
The five point plan did not specify the structure within which changes would be
implemented, and it was not clear whether responsibilities would be allocated on
a functional or divisional basis.
Resource Allocation
Specific action was to be undertaken to improve resource use, including the
introduction of JIT, improved coordination and improved communications
The intention was to introduce more rigorous controls for monitoring company
performance. However, what form these would take was not specified.
IMPLEMENTATION
The five point plan was concerned with the implementation of change. While the
plan dealt with a range of issues it is worth considering what additional actions
might be undertaken. For example, there is no mention of whether the incentive
system was aligned with the proposed changes; it has been noted that little atten-
tion was paid to company structure; there was no discussion of how the changes
would be sequenced nor of critical success factors. While a great deal of thought
had gone into the identification of company position and definition of strategy it
is an open question as to whether the changes could be implemented. The sub-
sequent reaction of the workforce suggested that there were formidable
problems in store.
FEEDBACK
There was a great deal of feedback by the following week. The reaction of the
functional managers was that the change programme should be abandoned.
What the CEO would decide to do is another story.

It will be noted that when setting out the events in this way the actual sequence was
ignored. According to the story in the first stage the CEO became concerned about
what was happening and started with analysis and diagnosis, which was dealt with
in the first set of reports and the CEO’s summary. The general environment was
dealt with in the Economic Report, the competitive position was the concern of
the Marketing Report, while the Accounting, R&D, Finance, Production and
Manpower Reports dealt with internal factors.
The second stage was concerned with choice, and the CEO identified three
generic strategy alternatives and asked his functional managers for suggested
courses of action, i.e. strategy variations. It was also during this stage that the
CEO took the Market Analyst’s Report into account and specified general objec-
tives: he stated that the company should shed its conservative image and emerge as
a real contender in the market. The CEO’s final strategy choice was to pursue an
expansionist, diversified approach.
The third stage was concerned with implementation and the management of
change; however, no attempt was made to address resources and structure,
improved resource allocation was to be achieved by improved internal coordina-
tion and ‘just in time’ techniques, better internal communications and use of
information, and more effective evaluation and control procedures were to be
installed.
The subsequent crises caused the functional managers to suggest going back up the
process (feedback) to the choice level and reverting to the original strategy. This
highlights some of the internal conflicts in the CEO’s role that he had to resolve:
on the one hand he had identified objectives that he wished to adhere to but on the
other there were immediate problems that had to be dealt with which might result in
compromising his original intention; at the same time he had to ensure that his
functional managers maintained their commitment to the broad vision. This is not
an easy game to play.
The reason for ignoring the actual sequence of events when applying the process
model is that the intention is to evaluate the process itself. In any case, real life
events are typically complex and it is often difficult to determine what is actually
happening. But it is usually possible to relate events to different parts of the process
model, therefore having assessed the details of the process it is possible to identify
where strategy is likely to come unstuck. In the Mythical company the main weak-
ness appears to lie in the implementation stage of the process. The application of
the process model to different companies will reveal different strengths and
weaknesses in processes and goes a long way towards explaining what actually
happens.

You should now be able to select at random any of the Reports generated by
Mythical Company managers and have a fair idea of what aspect of the strategy
process it was directed towards. There is always going to be scope for discussion on
where individual aspects should be located; for example, the second of the Account-
ing Reports can be classified as a comment on strategy variations as a contribution
to strategy choice. But you may have a different view on this Report, and there is
nothing wrong with that so long as you can provide a reasoned argument in favour
of your view.
So is the overall strategy process in the Mythical Company robust? Evaluation is a
matter of weighing up the strengths and weaknesses and that is something you have
to do.
The View from Now

This is the first exercise in applying the process model and it takes into account all
aspects of the company’s operations and the external environment. The process
model was an innovative feature of the EBS strategic approach from the start and
has achieved what so many strategy courses fail to do: integrate the MBA courses
into a cohesive whole.
Case 2.1: Rover Accelerates into the Fast Lane (1994)

1 This question is intended to start you thinking about value creation and the
determinants of company value. This issue will be developed as the course proceeds.
The following are the types of underlying weakness which might be identified by a
predator and, once they have been rectified, lead to a once for all increase in value.
The rationale for takeovers at Section 7.4.3 will deal with these issues in more detail.
 Development expenditure: this had possibly been inefficiently allocated, given
that the company was still waiting for a replacement for the Metro. Its main
access to advanced technology appeared to be through its alliance with Honda
rather than through internal development.
 Marketing strategy: Simpson had suggested redefining Rover as a niche produc-
er. The fact that the company had performed better than the total market
suggests that this approach may have met with success. Pischetsrieder’s view that
the German market could be increased by a factor of up to 9 suggested that in
his view the marketing strategy had been completely ineffective.
 Resource management: costs were still relatively high in that the break-even
output was still high in relation to current sales. But significant progress had
been made in the past, and there was certainly potential for continuing im-
provement.
 Expected increase in demand: the 5 per cent UK growth may be a leading
indicator for European demand which had declined by 20 per cent during the
same period. It was possible, for example, that an increase in European demand
might have increased sales well beyond the break-even level without any need to
alter the current marketing strategy.

 Weak products: Rover had already divested well-known model names; it was
acknowledged that the Metro needed replacement; it is possible that the Honda
small batch production technology was inappropriate for the niche that the
company was targeting, and that the BMW approach of building to individual
specification would strengthen the product offerings.
2 The financial aspects of the takeover can be assessed using ideas from the finance
and accounting courses. In 1993 the company assets were valued at £1.4 billion less
debts of £0.4 billion, so it looks as if BMW bought Rover for about ‘half price’.
However, the real issue is whether a sensible rate of return could be obtained on the
£529 million spent plus the £400 million of debt which had to be repaid. If the
current profit of £100 million were to continue, the rate of return comes out at
about 10 per cent. Thus in financial terms the attractiveness of the purchase
depends on how BMW regards this return on capital.
The prospects of Rover continuing to make profits depend on factors such as
reducing the break-even output and/or increasing sales. The productivity graph
shows that the UK still had a long way to go to equal Japan and the US; further-
more, Germany was a relatively high cost producer, so it is not clear that the merger
would result in significantly lower costs. The aspirations voiced by Pischetsrieder
regarding the potential for increased sales did not appear to be based on any
evidence. It appears that BMW had purchased a profitable Land Rover model and
cars with no track record of profitability.
There are many non-financial aspects of the takeover and these ideas will be
developed later in the course; these include:
 Synergy: Rover’s activities may have been a good fit with those of BMW in their
sector of the quality car market.
 Economies of scale: the combination of Rover and BMW may have contributed
to economies of scale; however, at the time Rover produced only a fraction of
BMW’s output.
 Think global act local: instead of trying to increase BMW sales in the UK, the
purchase of Rover’s market share provided BMW with immediate market pene-
tration.
 Competitive action: the takeover could be interpreted as an indirect attack on
Honda, which was a major competitor and had been achieving significant market
gains in the quality sector. The takeover also gave BMW access to Honda tech-
nology; however, given the differences in their approach this was probably not
significant. The move also eliminated the direct competition between Rover and
BMW.
Some of the non-financial aspects have a potentially negative impact.
 Company culture: the management culture of Rover and BMW may not turn out
to be compatible.
 Managing change: the achievement of BMW’s ambitions for Rover would incur
significant change costs; BMW’s plans in fact amounted to reversing the trend
towards Rover becoming a niche producer.

 Honda constraint: the existing 20 per cent ownership of Rover by Honda might
have constrained future BMW plans.
There are clearly a number of arguments both for and against the takeover. Having
identified these it is necessary to assign some form of ranking to each in order to
arrive at a balanced judgement on whether the takeover was worthwhile. This is a
subjective process, but it is important that you give some thought to the trade-offs
and come to a reasoned conclusion on the takeover given the available information.
Another way of looking at the takeover is that BMW would bring some parenting
benefits to Rover; from the information available it appears that the only feasible
advantage is synergy, as discussed above. One danger is that the parenting impact
will lead to value destruction as the link with Honda is removed. At the end of the
day the acquisition of Rover will have to add more than £529 million to BMW’s
worth to make the takeover worthwhile. From the information available it is not at
all clear how this might be achieved.
3 The following is an example of how the classification might be carried out, but you
will no doubt have your own opinions.
Objectives
 Edwardes: improve labour relations and modernise technology.
 Day: redefine Rover as a niche producer.
 Pischetsrieder: make Rover a volume producer.
 Edwardes: totally concerned with the cost side.
 Day: Rover had lost ability to compete against the big players; product life cycle
notion used to get rid of Austin and Morris.
 Pischetsrieder: international alliance was the key to competitiveness.
Strategy Choice
 Edwardes: initially was concerned with stability and defence of market share.
 Day: recognised that the company had to retrench and redefine itself as a niche
producer.
 Pischetsrieder: adopted an expansionist approach which was a totally different
strategy to both previous CEOs.
Implementation
 Edwardes: concentrated on improving labour relations and forging the Honda
link.
 Day: emphasise reducing break-even and developing backward integration.
 Pischetsrieder: a vision was founded on new technology, synergy and horizontal
integration.

Feedback
 Pischetsrieder: did not appear to have learned anything from the experience of
Edwardes and Day.
You should be able to see how the process model makes it possible to discuss the
strategic approaches of the three CEOs in a structured fashion; it focuses on the
differences in objectives, choice and implementation which are the main elements of
their strategies. Without a process model you would find yourself flitting among
objectives, analysis, choice, implementation and so on in a haphazard fashion. While
there is much that can be said about what the CEOs did, it is visualising it in a
structure which is important.
The View from Now

The process model analysis of Edwardes, Day and Pischetsrieder revealed totally
different visions of how Rover could be developed. Pischetsrieder’s vision of a mass
market industry leader led to the subsequent investment of billions of marks and it
has been estimated that by 2000, when it was sold, BMW had lost today’s equivalent
of about $8 billion on Rover Group. What caused such a disaster? It was noted in
the strategic process analysis that Pischetsrieder appeared to have learned nothing
from the experiences of Edwardes and Day: his vision of transforming a niche
producer into a mass market producer was inherently unworkable. Pischetsrieder
was fired in 1998 mainly because of the losses caused by the acquisition of Rover.
As you might expect, Land Rover was an attractive proposition and was spun off
and sold to Ford. The remainder was bought by Phoenix Consortium for a symbolic
£10 but failed to make a profit, going bankrupt in 2005. In the original case it was
noted that car production was loss making so this should come as no surprise: if
BMW had failed to transform Rover then re-badging Rover as MG Rover was
unlikely to be successful.
In 2008 Land Rover and Jaguar were bought by the Indian conglomerate Tata and
joined together as one company in 2013. The combination of these two high profile
luxury brands has proved highly profitable although they are still niche products.
Returning to the process analysis of the three leaders it is interesting to conjecture
how the company would have developed under Day; perhaps he would have carried
through his niche approach and abandoned car production and focused on Land
Rover.
Case 2.2: The Millennium Dome: How to Lose Money in the Twenty-First
Century (2001)
1 The Dome had an artificially determined product life cycle of one year. This meant
that if the visitor projections were not achieved there was no second chance. The
operating costs of the Dome were largely fixed, but given the relatively short
operating time there was no opportunity to move up the experience curve. It was
therefore a very risky project from the start and its financial viability was extremely
uncertain.

On the basis of the first year’s experience it is quite possible that the Dome could
generate £100 million per annum in revenue, assuming about six million paying
customers per year. The operations and running costs in the year of operation came
to £201 million. This suggests that it would be necessary to cut the operating costs
by more than half to generate a viable concern. Inspection of these accounts
suggests that there are items, such as Central Contingency, which may not really
refer to the variable costs of operations, so it is possible that £201 million is not a
representative figure. It is likely that costs could be significantly reduced as experi-
ence builds up, while it is also possible that the Dome could be made to appeal to a
wider audience. If it were to be a success in the longer term it is clear that action is
necessary on both the cost and revenue sides.
2
Who Decides to Do What
Strategists
These were initially politicians who were much more concerned with their personal
reputations than financial viability. Mr Ayling was a successful businessman but had
many interests and may not have been able to focus adequately on the Dome; Jenny
Page had no experience of running a profit making business.
Objectives
The mission focused on the impact on individuals, and the objectives made no
mention of balancing the accounts. The mention of ‘value for money’ for the
Millennium Commission was vague – it did not necessarily imply that the Dome
would end up with a financial surplus.
The overall objective was to produce ‘the greatest show on earth’, which would last
for only one year, while attempting to balance the accounts. These objectives were
incompatible.
It was not clear what business the Dome was in – education or entertainment.
Overall who decides to do what
There was plenty of will to produce the greatest show on earth, but little under-
standing of what would be required to generate a profitable business concern. There
appears to have been significant principal–agent problems.
The general environment
The millennium was a unique time to launch the venture, and the UK itself had
been enjoying prosperity for three years under the Labour government.
The industry environment
There is a great deal of competition among attractions, and a high proportion of
visitors would have to make the trip to London adding to the cost. The market
research suggested 11 million paying visitors but this turned out to be wrong by a
factor of two; there was little information on elasticity of demand to provide
guidance on pricing. The subsequent government report suggested that the Dome
was not sufficiently differentiated (the wow factor) to attract visitors.

Internal analysis
The Dome was never expected to make a profit, but there was no understanding of
what the ultimate costs were likely to be.
Overall analysis and diagnosis
As might be expected the management received the blame for not succeeding in a
task which was probably impossible from the outset.
Choice
Generic strategy
A strategy of differentiation was obviously selected, but given the difficulty of
defining the objectives it appears that the basis of differentiation was not clear: what
would make the Dome the experience of a lifetime?
Strategy variations
The Dome was effectively an alliance with businesses who provided sponsorship. It
is debatable whether this was workable given that the businesses wanted advertising
and the government wanted a prestige project.
Strategy choice
The process of selecting the strategy was muddled because of the change in gov-
ernment and interference by politicians.
Overall choice
It is not certain that the end product was based on analysis or whether it simply
evolved.
Implementation
Resources and structure
The senior management may not have had the characteristics required to run the
Dome efficiently. Firing the chairman and CEO was unlikely to solve the funda-
mental problems.
Resource allocation
The lack of operational experience was evident in the queues and the lack of
financial controls. The Dome management had expended so much energy in
delivering the Dome on time for the Millennium that they probably had not had
time to develop sound operational procedures.
Evaluation and control
It was impossible to construct a balance sheet so clearly the financial control system
was inadequate.
Overall implementation
There seemed to be no understanding of how to run the Dome efficiently.
Feedback
It became apparent quite early on that things were not turning out as planned (or
hoped). But it was difficult to react to events because of the relatively short time
period.

Overall strategic process

Given the weaknesses in the strategic process it could be argued that the individuals
concerned did a good job in making it as good as it was; after all it did attract
millions of visitors. The real weakness lay in the objective setting area which set an
almost impossible task.
The View from Now

It transpired that things were even worse than portrayed in the Case. Papers released
by the National Archives in 2010 revealed that the Dome's original operating
company struggled to pay its bills from the week the attraction opened its doors and
it ran out of money by 28 January 2000 – four weeks after its opening night. So the
exhibitions and events together were a disaster. This is consistent with the weak-
nesses found throughout the strategic process.
All that remains of the original Dome is the shell. The contents were auctioned off
in 2001 and the Dome itself sold for a token £1 to Meridian Delta and in 2005 it
was renamed The O2 and redeveloped as part of an entertainment district at a cost
of £600 million. It is now a 20,000 seater stadium which sold 2 million tickets in
2014 for various types of show. All this is a far cry from the original concept and
remains a salutary lesson to governments investing in vanity projects. By their very
nature such projects have unclear objectives and are hampered by principal–agent
issues.
Case 2.3: The Rise and Fall and Rise of Starbucks: How the Leader Makes a
Difference (2012)
1 In order to visualise the impact that the return of Schultz had on Starbucks, identify
what he did in each part of the process model in turn. The analysis below uses
concepts from later in the course to demonstrate the type of thinking required to
carry out a full strategic analysis.
Objectives
Before
Starbucks had lost sight of the business it was in. The original vision had been
discarded in favour of growth at all costs. The continuous growth over many years
had given top management a feeling of invincibility.
After
Schultz provided a vision, which he termed an ‘aspiration’, and focused on Star-
bucks’s role as a provider of high-quality coffee in a friendly setting.
Strategists
Before
Jim Donald had been remarkably successful in other retail businesses but could not
transfer his capabilities to Starbucks.

After
Starbucks was Schultz’s life (apart from his family). He had created the business and
its philosophy and did not see it merely in terms of profitability and growth. His
vision was long-term.
Overall Who Decides to Do What
Before
The combination of a high-powered CEO and the objective of growth at all costs
led to the core values of the organisation being eroded.
After
Schultz brought a proven track record of innovation together with a clear under-
standing of the business Starbucks should be in. Schultz’s interest was aligned with
Starbucks’; the principal–agent problem created by employing an ‘outsider’ was
overcome.
The Macro Environment
PEST Before
Economic: The global economy was booming up to 2007 and Starbucks benefited
from the resulting increase in consumer expenditure.
Social: Lifestyles were changing and Starbucks’s environment fitted.
Technological: Starbucks had fallen behind in terms of the coffee-making machines
(too tall), computer systems and hardware.
PEST After
Economic: While Schultz had started to detect problems before the crisis, the
recession made the many problems more apparent.
Social: It was no longer novel to drink coffee in a Starbucks; the environment had
been copied to the extent that it was the normal way of doing things.
Technological: New coffee machines and computer systems were required to bring
Starbucks up to date in terms of both delivering a high-quality product and being
efficient behind the scenes.
Environmental Scanning
Schultz had carried out an environmental scan (possibly along the lines of the
PEST), which no one else in the organisation appeared able to undertake.
The Industry Environment
Five Forces
Force Strength Reason Action before Action after
Bargaining High Imitators appearing None Reward card;
power of buyers mystar-
bucksidea.com
Bargaining High Need to maintain None Improve supply
power of quality chain
suppliers

Force Strength Reason Action before Action after

Threat of new High Easy to set up a coffee None Improve relations
entrants shop with customers
Threat of High New drinks being None New products
substitutes developed
Rivalry High Homogeneous product None Carve out a niche
The five forces perspective reveals that Donald had taken no action to combat
changing competitive conditions. The effect on margins that Schultz detected was a
result og the squeeze caused by the increased five forces.
Price Differentiation Matrix Before
Starbucks had drifted from success likely to success uncertain. The difficulty was
that Donald did not appear to have noticed.
Price Differentiation Matrix After
Improve the store environment, for example by getting rid of the warm sandwiches.
Introduce new machines – Mastrena and Cloverl; introduce new blends such as Pike
Place; improve the relationship with customers.
Product Life Cycle Before
Starbucks had created a new market, gained first mover advantage and managed the
growth era efficiently. When the transition came to a mature market it was not
recognised that this required a change in the approach: consolidation, efficiency,
defence, etc. But instead of growing with the market the objective became growth at
all costs. This resulted in expansion into areas where marginal cost exceeded
marginal revenue, cannibalisation of local markets, overextended supply chains,
reduction in product quality and diversification into anything that could be sold.
Product Life After
Stop growth for its own sake and focus on improving the business, eliminating
unprofitable stores and consolidating operations.
BCG Matrix Before
Starbucks was managed as a star after it had moved into the cash cow segment. The
entry of competitors meant that it was moving in the dog direction, which was
potentially fatal. It was not realised that, despite its global size, Starbucks could be a
dog in local markets.
BCG Matrix After
Schultz implicitly recognised the danger of becoming a dog. His focus was to shift
Starbucks back into the cash cow quadrant.
Internal Analysis
The Value Chain
Value chain Before After
Primary activities
Inbound Inventories not aligned with Rigorous supply chain developed
logistics demand

Value chain Before After

Operations Scheduling shifts inefficient; dirty Install more efficient machines;
stores; lack of freshness improve incentives
Outbound Losing customers Improve store atmosphere
logistics
Marketing and Losing unique brand identify Social networking
sales
Service
Support activities
Procurement Ethical sourcing Maintain branding factor
Technology Out of date computers and tills New computer systems, new
development coffee machines and instant
coffee
Human Perverse incentives Less focus on comps; give
resource managers sense of ownership
management
Management Senior management out of touch Replace senior management
systems
Schultz took action throughout the value chain to design an organisation that was
not only more efficient but was also aligned with customer preferences.
Core Competence Before
The core competence of producing good coffee in pleasant stores was undermined
by imitation and diversification.
Core Competence After
Schultz realised that once the core competence was lost it would be impossible to
recover. Much of his effort was devoted to reinforcement of the original core
competence.
Competitive Position Before
Despite its continuing growth and comps, Schultz could see that Starbucks was
losing its competitive position. The problem was that this was not apparent to other
senior managers and so it was necessary to replace them.
Competitive Position After
Schultz identified those aspects of the business that needed to be improved in order
to regain its competitive position. His actions had a positive impact on all the
models.
Before
The Starbucks management had been blinded by growth and continuing financial
success.
After
Schultz’s analysis was intuitive and qualitative rather than quantitative.


Before
Corporate: expansion.
Business: stuck in the middle.
After
Corporate: retrenchment and stability.
Business: differentiation.
Strategy Variations
Before
Organic growth.
After
Organic growth and some acquisitions with a strategic fit, such as Clover.
Choice
Before
The senior team made decisions on the basis of growth opportunities, given that the
‘comps’ had grown for many years. No attempt was made to analyse the impact of
growth at the margin.
After
Schultz wished to consult but some decisions were made unilaterally. He was forced
to implement a power culture in order to realise his vision.
Overall Strategic Choice
Before
Starbucks was mainly carried along by general economic conditions and unplanned
expansion.
After
Schultz recognised the importance of pursuing the generic strategy of focused
differentiation to prevent Starbucks falling further into ‘stuck in the middle’.
Before
Starbucks was decentralised and exercised little control over the individual stores;
many stores diversified according to their own ideas of what would sell.
After
While still being decentralised, Schultz insisted on a uniform approach consistent
with his vision of how the stores should appear to the customer.
Resource Allocation
Before
Decisions on store openings were not made on strict financial grounds.

After
Marginal analysis was applied and the build criterion in terms of cost and revenue
was strictly applied.
Before
The focus on ‘comps’ concealed the underlying problems, which were masked
because of expansion in a favourable economic climate.
After
The focus on ‘comps’ was eliminated in favour of a sustainable economic model,
which took other factors into account.
Before
The lack of investment criteria and control measures other than ‘comps’ meant that
Starbucks could drift into disaster without realising.
After
Schultz shifted Starbucks from financial planning to strategic control.
Feedback
Before
Communication was mainly from the top down and little attention was paid to store
managers on the ground.
After
Schultz made a point of going into the field, finding out what was happening, and
communicating with the company on a personal level. He attempted to make
Starbucks a learning organisation.
Before
Given the weaknesses identified in each component of the process, it is not
surprising that Starbucks began to fail.
After
While many of Schultz’s statements and actions might appear to be aspirational and
guided by instinct rather than analysis, he implicitly understood that the strategic
process was weak and needed to be strengthened in almost all dimensions. In such a
large and decentralised company, it was therefore necessary to take decisive action
to make the changes required. Analysing the strategic process demonstrates the
difference that a leader can make.
The View from Now

In the years since Howard Schultz took back control, Starbucks has continued to
expand internationally and now operates in over 60 countries. There have been
many product innovations, for example the introduction of the Trenta – the largest
cup size – in 2011. Schultz has made a number of acquisitions, for example Evolu-

tion Fresh in 2012, with the intention of launching a chain of juice bars. The
strategic process analysis shows how Schultz reinvigorated Starbucks, but the next
strategic issue is whether the massive international expansion together with diversi-
fication will lead to loss of control and a return to the situation where Schultz
stepped back in.
Module 3
Review Questions
3.1 The business travel skill set includes the ability to
 put together customised plans with minimal travel time;
 respond quickly with options as business plans change;
 be precise in communicating alternatives where choices have to be made;
 respond to general instructions.
The holiday travel skill set includes the ability to
 understand different holiday packages;
 align family needs with package offerings;
 minimise costs;
 make suggestions based on vague preferences.
You can probably think of many more under each heading, but the important point
is that the skill sets are different and there are likely to be differences in the personal
attributes of the individuals most suited to each.
Whether you think that it would be easy for the business travel agent to make the
move depends on the fit between the two lists you produced. The list above
suggests that the skill sets are so different that the business travel agent would have
to undergo a significant amount of retraining. If this were not recognised then the
business travel agent may well fail in the holiday business despite being successful
previously.
The View from Now

The skill sets of different types of travel agent have been extended by the advent of
the internet; on-line booking by hotels and airlines has had a significant impact on
the demand for conventional travel agent services. New web-based travel agent
‘superstars’ such as Virtuoso and Travel Leaders have emerged providing tailored
travel services. The travel customer is no longer constrained by the working day
now that travel agents work virtually. Travel agents whose skills sets have developed
in line with technology have demonstrated that the capability of consumers to book
on-line has not meant the end of the travel agent.
3.2 The main skills for each would be the following:
1. Surveillance and combat skills.
2. Computer application skills.
3. Research and interviewing skills.

Clearly these are completely different types of skill although the three types of
company are in the same industry. It would be a rare individual who developed the
three skill sets to a professional level simultaneously, but it is possible that over time
an individual could move from one skill set to another.
The View from Now

The problem of computer security has reached levels of sophistication which were
not envisaged even a decade ago. The skills differences between the three types of
companies are much more pronounced now than they were twenty years ago. The
changes in technology which have taken place reinforce the need to match skills
with the business definition.
3.3 When tackling this problem you have to try to identify clearly defined objectives
which are measurable and attainable; the SMART framework could provide a
starting point. For example, phrases such as ‘best possible’ provide no real basis for
action because people may think that they are already achieving this; furthermore, it
is necessary to identify a standard against which the ‘best possible’ can be assessed.
A revised statement might read like this:
To ensure that sick persons in the following categories (not listed here) do not
have to wait more than 10 days for treatment; to ensure that the infirm (who
are unable to leave their homes and care for themselves) have at least two days
of nursing assistance per week; to spend resources on the education of 10 to
15 year olds on the principles of healthy living as a preventative measure; to
divert resources wherever feasible from cure to prevention.
This statement attempts to identify the target groups and provides the basis for
measurable performance. It is still vague about the reallocation of resources, but it
has to be recognised that some aspects of the mission statement can be no more
than a statement of intent.
Turning to your own statement, identify the parts of it which are
 Non-measureable
 ambiguous
 infeasible
The View from Now

A perennial problem with mission statements is that they do not provide a defini-
tion of the organisation to which employees can relate. As a further exercise you can
look up the websites of major companies and consider their published visions and
missions using the headings in 3.2.
3.4
1. The first step is to construct a profile of the current position. For example, the
company is currently profitable with relatively low labour costs. But its cash flow
is poor; it has three products in its portfolio, and there has been a history of
resource allocation problems. The company has several new products in the
pipeline, but doubts have been expressed about their potential viability.

To estimate what is likely to occur if no change to current strategy is made, you

can start by considering what is happening to competitive pressures; the consen-
sus is that these will increase. The combination of increased competition, shorter
product life cycles, and resource allocation problems strongly suggest that the
company will be less profitable in the future and will certainly not be much big-
ger than at the present. The increase in profits which can be expected in the
short run because of a more favourable economic climate cannot be relied on to
continue.
The desired outcome, as stated by the CEO, is to capture larger market shares,
diversify into related markets, and ensure that profits do not decrease in the long
run.
From the subsequent reaction of the management team to the various crises you
could infer that they do not consider that the difference between the current
position and the desired position is all that great. However, the CEO has con-
cluded that the gap between expected and desired outcomes is substantial. It is
the CEO’s perception of this gap which justifies the five point plan for change.
The gap is due to both external and internal factors. The main external factor is
the changing competitive position; the main internal factor is the inefficient use
of resources.
2. Credible objectives: at first sight the objective does not appear to be unattainable; in
fact, it seems essential for the future prosperity of the company. However, the
subsequent reaction of the management team suggests that they did not really
believe that reformulation of company objectives was necessary.
Quantifiable objectives: the CEO was primarily concerned with share price, profita-
bility, market shares and productivity. He was concerned with the intangible
‘company culture’ only to the extent that it was likely to contribute towards high-
er productivity and achievement of the overall objectives.
Aggregate objectives: the CEO had his eye firmly fixed on the prospects for the
share price, and was obviously concerned about the Market Analyst’s report.
Disaggregated objectives: the five point plan for change can be seen as a series of
disaggregated objectives; however, responsibility for achieving individual objec-
tives was not allocated among functional specialists or SBUs.
Principal–agent problem: the individual reports reveal that each functional manager
had different objectives, but there was nothing in the five point plan about a new
incentive system. Perhaps that is why they came up with so many reasons for
subsequently abandoning the new strategy.
Means and ends: the CEO had no illusions about the role of the five point plan; it
was clearly a means towards the overall end of maintaining the company’s value.
Economic objectives: the CEO was a profit maximiser in that he focused on the
likely pattern of profits; he saw increased competitive advantage as being a
means of maximising profit rather than being an end in itself.
Financial objectives: the CEO was aware of the good ROI for the current year, but
did not consider this to be a good predictor of future financial viability. He did
not carry out a formal shareholder wealth analysis, but he was well aware of the
direction the company had to take to ensure that wealth would be created.
Social objectives: these did not figure in any of the discussions.

Stakeholders: the five point plan gives some indication of the implicit stakeholder
map visualised by the management team. For example, it could be deduced that
the team positioned employees as high priority but low influence. It then came
as a surprise to discover that employees in fact had high influence. Because he
promoted an expansionary approach the CEO probably felt that he did not have
to make any trade-off between the interests of shareholders and the interests of
employees other than to obtain their cooperation in the process. However, the
reaction of employees suggested that they felt they would be made worse off as a
result of the proposed changes.
Ethical considerations: the CEO was apparently not confronted with any ethical
dilemmas other than his responsibility to ensure the success of the company.
The View from Now

There has been a marked increase in the role of corporate social responsibility in the
conduct of companies. In the case of the Mythical Company no attention was paid
to social objectives; nowadays it is typical to find an expression of commitment to
social objectives on company websites, under the guise of corporate social responsi-
bility. It is worth considering whether published social objectives have any
operational meaning.
3.5 This is an example of the principal–agent problem. The details of the discussion are
not so important as recognition of the fact that they will all approach the issue from
different perspectives, and that maximisation of company profit is unlikely to be the
most important consideration for any of them. For example
CEO: turnover is not necessarily a good indicator of profitability, and I need to
ensure that profitability from the three SBUs is as high as possible because I am
answerable to shareholders. The suggested system would give SBU managers the
incentive to increase turnover at the expense of profitability.
Accounting: it is a good idea from the viewpoint of efficiency because it means we
have a simple and unambiguous rule to apply when deciding on remuneration.
Human resources: the implication that one manager is three times more valuable than
another can have a serious impact on motivation and cooperation among the SBUs.
Competitive conditions could worsen for one of the products, for example if a
strong competitor entered the market, and the resulting reduction in revenue would
be outside the control of the SBU manager.
SBU3 manager: it is not equitable, because I have to spend a lot of time travelling and
work more hours than the other two.
SBU2 manager: the only reason we have SBU1 producing equipment at all is because
of the specialised work we do, so SBU1’s sales really depend on our production of
cleaning compounds and SBU3’s ability to generate new customers.
SBU1 manager: why is it that only the accounting manager is in favour of my idea? It
stands to reason that the bigger your sales are the bigger your responsibility and that
is what you should be paid for.
The fundamental issue which emerges from this discussion is that individual
members of the organisation interpret the issue from their own perspective and this

leads to conflicts; one of the challenges in strategy is to recognise the principal–

agent problem and devise methods of overcoming it.
The View from Now

The principal–agent problem refuses to go away. In economics the primary objec-
tive of the firm is profit maximisation and this is not necessarily consistent with
sales maximisation. Sales maximisation is a perverse incentive because it is not
necessarily in the interests of shareholders or employees. Rewarding CEOs for
company growth rather than profitability remains one of the major problems in
corporate governance today.
Case 3.1: Porsche: Glamour at a Price (1993)

1 This question is presented at this stage to distract you from the immediate issues
relating to objectives and reinforce the complexity of strategy. The issue of competi-
tive advantage is a recurrent one, and it is important not to lose sight of this
fundamental strategic issue. Issues raised by the case include international competi-
tive advantage, return on sales, risk, supply and demand factors and ratio analysis.
You will find it instructive to return to this case after Module 7.
External Analysis
The case highlights some of the problems of competing internationally. It is
important to appreciate the impact of fluctuating exchange rates on relative prices,
costs and competitiveness. It is likely that some of Porsche’s problems were due to
the appreciating mark during the periods 1985–1987 and 1989–1990, which gave
Porsche a price disadvantage in the US, one of its major markets. However, the
1985–1987 period saw the highest sales in the US. Exchange rate fluctuations often
have a lagged effect, and it may have taken some time for the price increases to
work through; by 1989 US sales had fallen to less than one third of their 1986 peak.
Sales in Western Europe had been much less volatile than US sales, and held more
or less steady since 1987. The net effect was that world sales declined over a period
of seven years, suggesting that something more fundamental than the exchange rate
must be wrong. Even if it is assumed that the total market for luxury sports cars had
been constant for the seven years to 1992, the fact that Porsche sales had fallen by
nearly 50 per cent suggests a very significant loss in market share. Competition had
in fact been increasing from makes such as Lexus. From this it can be deduced that
Porsche had lost some of its competitive advantage.
But even at its ‘peak’, Porsche’s competitive position was in question: profits were
only 2.4 per cent of turnover. A relatively small increase in cost coupled with a small
reduction in revenues (for example caused by a fall in the mark against the dollar)
would lead to losses.
The competitive position of Porsche, and other makers of cars in this segment, is
always under threat: the tendency is to rely on the brand image, but with the
technology which is now available there is plenty of scope for cars with similar, or
even better, characteristics to enter the market; in this sense the relative quality

advantage of Porsche cars has been undermined. Consumers will to some extent be
willing to substitute better technological features for the image associated with the
Porsche name.
Porsche cars are susceptible to two main risks. First, the market seems to have a
high GNP elasticity (see Section 4.8.1). Second, because of fluctuating exchange
rates the prices in different markets, particularly the US, are highly volatile. For
example, if a recession coincides with a fall in the dollar, both price in DM and sales
will fall, with a severe impact on revenues. There may therefore be a case for
shifting production to the location of sales (think global, act local). Alternatively,
Porsche could have hedged its exposure to currency fluctuations.
The impact of new suppliers, such as the Japanese, is to increase supply; this can be
expected to reduce the price if demand is constant. If demand falls at the same time
then the impact on equilibrium price could be quite substantial. One reason for a
reduction in demand could be a change in consumer preferences.
Internal Analysis
Can Porsche only survive if it becomes part of a large manufacturer? It is difficult to
see what scale economies might be exploited if it were taken over; in fact, Porsche
made profits right up until 1991. The problem seems to have been that the company
was geared up to produce 50 000 cars with the associated cost structure, and was
therefore bound to make losses if it only sold half that number without rationalising
its production. Ratio analysis can help to put the recent history into perspective:
losses are currently 2 per cent of turnover, so relatively modest cost reductions
would keep the company in profit. The cash mountain would keep the company
afloat for another 8 years at the current rate of losses.
The fluctuating exchange rate would also have had an effect on revenues, making
them difficult to predict; for example, in 1991 the devaluation of the mark against
the dollar could have contributed to the losses because of the lower revenues earned
from US sales.
There seems to have been a lack of an effective strategic control mechanism which
would enable the company to adapt to changing circumstances. The fact that sales
have been falling for seven years, finally resulting in losses, together with the fact
that a new model range is not expected until 1995, suggests that the company was
unwilling to accept that its market position had changed fundamentally. By 1988
sales were down by 30 per cent, and it should have been clear that action should be
taken; however, on the basis of the sales figures it seems that nothing effective was
actually done.
2 There are no shareholders, therefore the family is not accountable in terms of value
creation. The company objective does not therefore need to be consistent with the
maximisation of shareholder wealth; in fact, the family does not seem to be preoc-
cupied with profit maximisation objectives and that is a serious issue in terms of
Section 3.11. The family might have found it difficult to generate incentives which
would result in value maximisation. A poorly motivated management could account
for the slow response to new competition, for example the fact that a new car range
will not be ready for several years.

A stakeholder map drawn from the perspective of the owners would reveal the
family having high priority and high influence. This is to be expected, but it seems
that from the owners’ perspective consumers have high influence but low priority;
this can be deduced because of the low priority given to producing a new generation
of Porsche cars. It would appear that the owners either did not pay much attention
to the interests of stakeholders or their implicit stakeholder map gave a low
weighting in terms of influence to stakeholders other than themselves.
Objective Setting
The company seemed to lack a sense of overall direction and the owners appeared
to be unwilling to change their mindset from the past. An elementary application of
the gap approach would have revealed a significant difference in where the company
was headed and where the owners would like it to be. It is clear that Porsche needed
to arrest the decline in market share and/or break into new markets. There were a
number of approaches which might be followed, given that the company has a
substantial family cash asset which could be converted into a profit generating asset.
These include
 updating the models
 further differentiating and segmenting the market
 looking for new markets in the rapidly growing Far Eastern economies
 investigating partnership arrangements with a major manufacturer
All of these would involve a change in the business definition to some extent and
the formulation of revised aggregate and disaggregated objectives. But it is unlikely
that such fundamental changes can be easily achieved by a management which is
unwilling to relinquish personal control and has allowed the company to lose its
markets.
Case 3.2: Fresh, But Not So Easy (2013)

1
From Vision to Mission to Objectives

We do not know Sir Terry’s vision or mission but it can be inferred that his vision
was for Tesco to be the biggest retailer in the world. He was not content to domi-
nate the UK market. His mission was to deliver groceries and related products to
UK consumers using the Tesco stores format, but to enter the US market he would
have to adopt a different format and target a different type of consumer. So the
objective of entering the US market follows from the vision but does not follow
from the mission.
The Gap Concept

The expected outcome in the UK was saturation and an end to growth. The gap
between that and the desired outcome of continual growth could only be filled by
international expansion. Two of the questions which need to be answered are:
 Does the company have potential resources to close the gap?

 Can a strategy be developed which will close the gap?

Tesco certainly had the resources to close the gap but it was unclear whether it had
the strategy to enter a new market successfully.
Credible Objectives
Given the outcome of other international ventures both in grocery and other
industries Sir Terry’s colleagues may well have doubted the credibility of entering
the US market.
Quantifiable and Non-Quantifiable Objectives

Any attempt to quantify the return on investment could only be speculative. That
means the objective was actually non-quantifiable. Executives may have deluded
themselves with scenarios which, of course, are not forecasts.
Aggregate Objectives
The objective of shareholder value maximisation no doubt drove Sir Terry, but he
did seem more concerned with growth for its own sake.
Disaggregated Objectives
It looks like executives were told that US entry was a disaggregated part of the
aggregate objective of sales maximisation.
The Principal–Agent Problem

Sir Terry’s record of success and his personal standing meant that he was not
accountable. But his previous success was no guarantee of success in a different
market.
Means and Ends

This can be regarded as a classic example of confusion between means and ends:
expansion had become an end instead of being a means to achieve profit maximisa-
tion.
Economic Objectives
Was US entry consistent with profit maximisation? That is doubtful given the point
made above about it being a non-quantifiable objective. It may have accorded with
Sir Terry’s view of what would maximise profit.
Financial Objectives
It has been pointed out above that any attempt to quantify the return is impossible.
In fact, there was a real risk of value destruction rather than value creation.
Social Objectives
There was no social dimension to the investment, other than the name Fresh &
Easy, which could have healthy implications.

Stakeholders
The most important stakeholder in market entry is the potential customer; Tesco
executives went to great pains to find out what the customers wanted.
Ethical Issues
There did not appear to be any ethical issues involved other than that it was a risky
project which might leave shareholders worse off.
Are Objectives SMART?

Specific: there was a clear statement of expected outcome.
Measurable: the investment was not measurable in profitability terms but it was in
terms of number of stores opened.
Achievable: it is not known whether it was achievable in the eyes of Tesco employ-
ees.
Relevant: it was aligned with the goal of sales maximisation.
Time-bound: There was a well worked-out plan of store openings, although this was
not achieved in practice.
Overall the objective was not completely SMART and this may have contributed to
eventual failure.
Overall Assessment
When viewed from these various perspectives there appear to be many flaws in the
objective of entering the US market.
Module 4
Review Questions
4.1
1. The economy seems to have taken something of a ‘nose dive’ during the year,
and you can locate the situation in Figure 4.1: actual output is now much lower
than potential output and there is a substantial output gap. On the basis of past
cyclical experience it will be some time before the economy comes out of the
recession, so it looks as though the correct decision would have been to wait.
2. The first effect of the higher unemployment rate has been to move down the
Phillips curve in Figure 4.2. This will lead to lower expectations of inflation in
the future, with a downward shift of the Phillips curve (Figure 4.3). The combi-
nation of these two events should lead to a continuing reduction in both the
inflation rate and the wage inflation rate next year. Furthermore, cost push infla-
tion next year will be reduced as the lower level of wage increases feeds through.
Thus demand pull inflation is eliminated by the fact that actual output fell below
potential output, cost push inflation would be reduced by the fall in the wage
inflation rate, and expectations of future inflation would be reduced as the infla-

tion rate itself fell. While the inflation rate, and the wage inflation rate, would be
expected to decrease during the recession, the continuing effects of cost push
and expectations would ensure that the rates would not fall to zero in the short
term.
3. You can base the scenario on Table 4.5, which shows how volatile revenues can
be in the face of recession and competitive action. The Investment sector has
shrunk by 5 per cent, and this is shown in the reduction in the Total Market in
Table A4.1 from 100 to 95.
Table A4.1 Scenario

Period Total Market Price Total % Change
market share (%) revenue
Last Year 100 10 10 100
This Year a 95 10 8 76 −24
This Year b 95 8 8 61 −39
It is not necessary to have precise numbers on prices and market size to estimate
the relative effects for the purpose of the scenario. Two assumptions are made in
this example:
1. that the company protects its market share by a price reduction of 20 per
cent;
2. the price reduction is matched by competitors and both market share and
price fall by 20 per cent.
You can use any combination of outcomes which you think likely in order to
assess the potential effect on revenues. The point is that the combination of
relatively small changes can have a catastrophic impact on revenue.
Case 4.1: Revisit Porsche: Glamour at a Price

1 The various environmental tools can be used to construct the profile as follows.
 PEST analysis: the political situation in Europe was changing, with trade
restrictions disappearing as the EU developed; given the importance of the US
market it will be important that trade relations between Germany and the US
remain good. The main economic factor is that luxury goods (particularly cars)
depend on healthy and growing economies. Changes in social attitudes, for ex-
ample in respect of safety on the roads, could act against sports cars generally.
Porsche may not have been keeping up technologically and the gap between
Porsche and competitors may be difficult to close in the short term.
 Macroeconomic analysis: a significant upturn in the economies of the US and
Western Europe would greatly help sales. However, no information is provided
on the prospects for these economies.
 International analysis: the fluctuating exchange rate with the US is significant and
unpredictable. It is difficult to see how Porsche can cope with this without pro-
ducing locally in the US. There are worrying signs that the transfer of
competitive advantage up to 1986 has not been maintained.

 Environmental scanning: competition with sports cars seems to be emerging

from new style luxury cars. Perhaps the whole concept of the sports car market
needs to be reconsidered.
 Scenarios: perhaps the new range of cars should be targeted at a different
segment.
Going from these perspectives to the ETOP, it is difficult to find positive entries as
set out in Table A4.2.
Table A4.2 Environmental threat (−) and opportunity (+) profile

International − Expected appreciation of exchange rate
− New Japanese models
− Decreasing appeal in Europe and US
− Success at home not transferred abroad
− National advantage in luxury cars shifting to Japan
Macroeconomic − GNP elasticity (unless there is an economic recov-
ery)
Socioeconomic − Change in tastes
The View from Now

The principal–agent issue associated with family ownership was resolved in 2009
when an agreement with Volkswagen was reached to merge the car manufacturing
operations to form an integrated automotive group. Porsche has a majority holding
in the integrated company although management is in the hands of Volkswagen.
The principal–agent issue outlined in 1993 has not apparently affected subsequent
development of Porsche because the company has gone from strength to strength.
Sales in 2014 were about three times that in 2002 and the company claims to be the
most profitable car company in terms of profit per car sold.
The four potential courses of action in the original analysis turned out to be
remarkably prescient.
Updating the models: Porsche has remained at the forefront of sports car technology
and models such as the 911 and the Boxster are industry icons. Hybrids of the
Cayenne and the 916 have been launched.
Further differentiating and segmenting the market: the Cayenne SUV has been a spectacular
success and the luxury Panamera filled another gap in the portfolio. Porsche has
succeeded in attracting non-sports car drivers and most of the 60 per cent increase
in sales since 2010 can be accounted for by the Cayenne and the Panamera; this has
raised questions in the motoring press as to whether Porsche is in danger of
undermining its brand image. After all, is there any real difference between the
Cayenne and the Range Rover?

Looking for new markets in the rapidly growing Far Eastern economies: the United States has
traditionally been Porsche’s biggest foreign market but by 2014 it was being
overtaken by China.
Investigating partnership arrangements with a major manufacturer: the partnership with
Volkswagen is outlined above.
It was pointed out in the original analysis that these actions would involve a change
in the business definition which could be hindered by the principal–agent issue. It
could be that the agreement with Volkswagen made the subsequent changes in
business definition possible.
The components of PEST can be compared in 2015 with what they were in 1993.
Political: while trade barriers within the EU had long been abolished the situation
was far from stable with the economic problems of Greece and the prospect of
British withdrawal depending on the referendum due in 2017.
Economic: the demand for luxury sports cars is still dependent on GNP, as could
be seen from the reduction in demand following the financial crisis in 2008.
Social: the desire for higher safety levels led to major improvements in the safety
characteristics of all cars; a major change has been the green movement and the
development of hybrids and plug-in electric cars.
Technological: Porsche recognised the need for continual technological improve-
ment and has remained on the forefront of sports car design.
Porsche has responded to changes in the PEST profile and has converted emerging
threats into opportunities.
International analysis: Porsche did not find it necessary to produce locally within the
US and maintained its country based competitive advantage.
Environmental scanning: the underlying concept of the sports car does not appear to
have changed.
Scenarios: the success of Porsche has been based on its new niche markets rather
than the sports car market.
Overall the 1993 ETOP profile does not apply to 2015. The international threats
identified did not transpire.
Case 4.2: An International Romance that Failed: British Telecom and MCI
(1998)
1
Political
 The US government is clearly intent on introducing as much competition as
possible into the telecoms market by deregulation. But if monopolies start to
appear it is quite possible that anti-trust legislation might be introduced.
Economic
 Competition is increasing from both small and large suppliers.

 The Baby Bells might be more competitively responsive than the giant semi-
monopolies.
 While the demand for telecoms services is increasing, the price is falling leading
to static revenues.
 There are significant barriers to entry because of the need to build infrastructure.
Social
 Telephony is becoming an accepted part of life and the overall market is set to
increase significantly as consumers, both business and social, become ‘telephone
literate’.
Technological
 The Baby Bells control the technology which provides access to local markets,
but there may be alternatives.
 The internet could be an important future base for many telephony services.
The profile that emerges from the PEST analysis is of a highly volatile environment
in all dimensions.
2 The environmental scan would extend beyond the boundaries of America and
would be particularly concerned with the future of technology. For example, since
the American market has been deregulated, are there other major international
suppliers who might potentially enter the market? On the technological front,
questions such as the impact of satellite links and possible advances in computer
technology which might radically alter internet capacity need to be considered. The
PEST analysis indicates that there is so much going on that it will be difficult to
identify trends.
3 Scenarios are by their nature speculative but need to focus on what are identified as
important variables. For example:
 WorldCom might be totally excluded from the Baby Bell interconnection system
and may have to invest billions of dollars to make the system operational.
 The demand for long distance calls might continue to increase but the price may
fall by an even greater amount: potential profitability under these circumstances
needs to be investigated.
 AT&T might enter the market in a big way: what will this do to potential prices
and market shares?
Each of these scenarios provides the basis for extensive investigation to offer
insights into the risks confronting the company and whether it is likely to be
adaptable enough to deal with the possibilities. One scenario that would not have
been imagined in the late 1990s was that the CEO, Bernie Ebbers, had built
WorldCom on extremely shaky financial foundations and was eventually convicted
for securities fraud, conspiracy and filing false documents with regulators. Often the
future lies beyond imagination.

Case 4.3: Lego Rebuilds the Business (2008)

1
The following table summarises the main influences and Lego’s reaction.
PEST factor Impact Action taken
Political None
Economic Lack of growth in the toy market Diversification
Relatively high costs of production Transfer production to
Eastern Europe
Social Demographic changes: fewer boys in 5–9 Attract girls
age group
Technological High-tech gadgets aimed at children and Develop new products
new production methods
Part of the answer to the delayed response lies in Mr Knudstorp’s statement, ‘We
had become arrogant – we didn’t listen to customers any more.’ This is an example
of the fact that the function of environmental scanning is not given a high priority
in most companies and its importance is not realised. The world had changed in
economic, social and technological dimensions but no one noticed, despite the fact
that, ‘These factors did not appear overnight.’ It would appear that it was not
declining profits which precipitated the desire to change but recognition of the crisis
in 2003.
Module 5
Review Questions
5.1 The structural analysis of the industry can be set out as follows.
Buyers – Bargaining Power: HIGH

Since buyers are individual consumers they have no bargaining power. But there are
plenty of alternative providers of health products.
Suppliers – Bargaining Power: HIGH

The current supplier is the only one within reasonable geographical reach; this
supplier is likely to be affected by a labour dispute. While a takeover may increase
supplier efficiency it would possibly increase supplier bargaining power.
New Entrants – Threat:HIGH

There are few barriers to entry, and the number of health food products is continu-
ally increasing.
Substitutes – Threat: HIGH

This depends on how the market is defined. There are a large number of luxury
goods competing for consumer expenditure, such as alcohol and consumer durables

which are indirect substitutes. To some extent health foods are homogeneous, and
the manufacturer will be increasingly faced with substitutes for his particular
product.
Industry Competitors – Rivalry: HIGH

The lack of barriers to entry and the existence of a large number of competing firms
suggest that the industry is closer to perfect competition than monopoly. The
prospects for making monopoly profits in the long run are poor. Competitive
pressures may appear from unexpected quarters as strategic groups change.
The five forces profile is as follows
Competitive force Degree

Buyers’ bargaining power High
Suppliers’ bargaining power High
Threat of new entrants High
Threat of substitutes High
Rivalry High
The analysis reveals that the company is exposed to a high degree of competition in
all dimensions. The ETOP identified a number of threats and opportunities and
now the five forces profile poses the question of whether this is a desirable industry
to be in. Looking ahead there is little prospect that the profile is likely to change
significantly and the medium term prospect is of exposure to threats, a relatively
weak bargaining position and intense competition.
Case 5.1: Apple Computer (1991)

1 Each of the market related models can throw light on different aspects of the Apple
experience.
 Product Differentiation
At launch Apple attempted to locate the Macintosh in the top right hand corner
of the perceived price differentiation model in Figure 5.7. The limited success
after launch suggests that the Macintosh fell into the ‘highly uncertain’ area. The
perceived differentiation was never sufficient to generate a high market share,
and when Windows was introduced the Macintosh fell sharply into the ‘failure’
area. This made it necessary to cut the price in order to bring the Macintosh back
towards the ‘success’ area. That did not seem to work either.
 Segmentation
It looks like the Apple segment did not satisfy the segmentation criterion of
adequate size.
 Industry Supply and Demand
The industry supply was shifting to the right throughout the 1980s; the supply
increase was greater than increases in demand, causing the price of IBM compat-
ible computers to fall. In the face of falling prices it became progressively more
difficult for Apple to charge its original prices.

 Market Structure
As the computer market became more ‘perfect’ and monopoly profits were bid-
ded away it became impossible for Apple to aim for a gross margin of 50 per
cent, with the objective of ploughing back the profits into R&D.
 Price Elasticity
The elasticity of demand for the Macintosh seems to have been quite high, since
a 40 per cent price cut led to about 80 per cent increase in sales. However, Apple
may have been correct in its original assessment of the price elasticity for its
higher range computers, since most of the sales increase occurred for the lower
range machines. In terms of the basic model:
Original Revenue Price Quantity Sold
New Revenue 0.6 Price 1.8 Quantity Sold
1.08 Original Revenue
The net result was that Apple had to incur the costs of almost doubling produc-
tion, but this had only about 8 per cent impact on revenues. It was not surprising
that the company found that its gross margins fell sharply and it became neces-
sary to shed some of its labour force.
 Pricing in Segments
Apple attempted to set a relatively high price to a group of consumers who were
‘locked into’ its unique technology; the hope was that this group had a low price
elasticity.
 Product Quality
The notion of quality focused on the graphics interface between the computer
and the user. However, this notion of quality did not appeal to everyone.
 Product Life Cycles
The slow monochrome type computers were largely obsolete by 1988, and the
Macintosh II launched in 1987 merely kept up with technological progress. The
fast colour computers can be interpreted as a substitute for slow monochrome
computers.
 Portfolio Analysis
The Macintosh never quite became a Cash Cow; it seemed stuck in the Question
Mark part of the BCG matrix, with its low market share in a growing market.
 Five Forces Analysis
The profile depends on whether the perspective is taken from within the Macin-
tosh niche or from the personal computer market generally. From the niche
viewpoint the threat of new entrants is low, as is the threat of substitutes; suppli-
er bargaining power is low because there are many suppliers of computer parts
and buyer bargaining power is low because once a commitment to a Macintosh
has been made it seems almost addictive; rivalry is low because the Macintosh
monopolised the niche. But from the industry viewpoint the profile is totally
different. The IBM is a direct substitute and there are improvements appearing
all the time, so the threat is high. The market was relatively easy to enter so long
as supplies were available; while supplier bargaining power is still low buyer bar-
gaining power is high because there is a range of choice at the point of purchase;
finally, rivalry is intense with some strong competitors such as IBM. The two
perspectives are summarised below.

Competitive force Apple view Industry view

Threat of new entrants Low High
Threat of substitutes Low High
Buyers’ bargaining power Low High
Suppliers’ bargaining power Low Low
Rivalry Low High
This demonstrates the importance of applying the five forces from the appropri-
ate perspective, otherwise you can end up with a mistaken view of the
competition facing a company.
 Strategic Groups
The grouping depends greatly on which variables are used to plot the relative
positions. For example, if Macintosh had used the axes perceived quality and
relative price the positions of Macintosh and IBM would have been quite sepa-
rate. But if computing speed and capacity were used the two would have been
very close. As in the case of the five forces it seems that Apple did not realise the
real nature of its competitive environment.
2 At the time described, the future for Apple was bleak. The Macintosh was now an
undifferentiated product competing directly on price with the IBM and compatibles
in a market where monopoly profits had largely been bid away. To tempt existing
users from IBM is difficult because of switching cost to a non-compatible technolo-
gy and the prospect of a limited range of software being available. To sell
Macintoshes to new users involves high marketing and advertising outlays. Perhaps
the only real possibility for Apple is to return to its high technology roots and
identify areas where it can generate an innovative lead, such as in multi-media,
which might again lead to a high degree of differentiation. The cooperative venture
with IBM may have benefits in terms of spreading R&D costs, but they are still
competitors where it matters, i.e. in selling personal computers.
The View from Now

Competitive environment
By 2014 the Apple Mac had about 14 per cent of the PC market. The Apple
portfolio has changed greatly since 1991 with the advent of the iPad and the iPhone
so the models analysed in 1991 are reviewed below.
Production differentiation
It was not until the return of the late Steve Jobs in 1998 that the Mac (as it was
branded) and the launch of the iMacG3 that sales increased. A significant step was
the adoption of the Intel processor in 2006 followed by a series of innovative
products based on the Macbook. The innovations introduced by Jobs moved the
Mac back into the ‘success likely’ area of the price differentiation matrix.
Segmentation
The Mac remained focused on the premium end of the market where it is dominant
with about 90 per cent market share.

Industry supply and demand

The market for PCs started to decline with the advent of tablets and smartphones.
The future of this product substitution is unknown but it is a significant threat.
Market structure
The move towards a ‘perfect’ market did not continue after 1991 with the five
biggest producers currently taking 75 per cent of the market. It has remained an
oligopoly and therefore there is scope for a degree of monopoly profits.
Price elasticity
The Mac still commands a price premium – the average Mac price is about twice
that of the average PC. Despite this sales have about doubled since 2007.
Product quality
The Mac is still regarded as a high-quality product; the notion of quality is difficult
to pin down but it apparently still has that reputation among users. It has remained
in the ‘success likely’ sector of the price differentiation matrix.
Product life cycles
The product life cycle is determined by changes in technology and Apple has
consistently been at the forefront of developments; as a result it has not been
subject to falling sales as the life cycle of current products has come to an end.
Portfolio analysis
The Mac is a Cash Cow in the premium PC segment.
Five forces analysis
The 1991 analysis demonstrated how important it is not to be fooled by an internal
view of the five forces profile. With its domination of the premium segment all five
forces are probably ‘low’ by 2015.
The future of Apple
The conclusion drawn in 1991 was remarkably prescient.
Perhaps the only real possibility for Apple is to return to its high technology roots and identify areas
where it can generate an innovative lead, such as in multi-media, which might again lead to a high
degree of differentiation. The cooperative venture with IBM may have benefits in terms of spreading
R&D costs, but they are still competitors where it matters, i.e. in selling personal computers.
With the return of Steve Jobs Apple did just that: it returned to its high technology
roots and not only innovated with the Macbook series but subsequently launched
the iPhone and the iPad series.
This is an outstanding example of the difference a leader can make to an organisa-
tion. The concept of the iPhone and the iPad incorporated the suggestion of multi-
media and created a new market. So the future for Apple in 1991 was looking bleak
and it did not start to succeed until the innovations introduced by Steve Jobs were
launched.

Case 5.2: Salmon Farming (1992)

1
Subject of Strategy Analysis

A large number of investments has been undertaken in the salmon farming busi-
ness, particularly in Scotland and Norway, and farms now find themselves in a
highly volatile environment where losses appear to be the norm and there seems
little prospect for improvement in profitability. In retrospect salmon farming looks
like a poor investment. The rationale for ‘going back in time’ is to determine
whether the problems are temporary or endemic to the industry, and what courses
of action salmon farmers, acting individually or together, might take in the future to
improve the return on their investment.
Summary of Recommendations
Further investment in the salmon farming industry is to be avoided. The outlook for
existing farmers is poor, and there is little scope for cost savings based on econo-
mies of scale arising from integration of existing salmon farms. Protection from
foreign competition on its own is unlikely to return profitability to past levels; it
would also be necessary to regulate new entrants to the industry.
Introduction
The salmon industry is comprised of a large number of small firms and as a result is
highly competitive; this high degree of competition will lead to low profits in the
long run. There is an endemic tendency for prices to be volatile which adds a
considerable degree of uncertainty to cash flows. As the general movement towards
free trade continues, producers can expect little assistance from government in the
form of tariff protection from foreign competitors.
Objectives
The immediate objective is to restore the industry to profitability from its current
loss making situation. What is the gap likely to be, say, five years from now, between
the desired position (making profits) and the likely actual position? It seems clear
that if no changes to the current strategy of individual companies are undertaken,
during the next five years the gap between the desired position and the current loss-
making position is unlikely to close.
Analysis
Prior to any major investment it is essential to develop an overall view of the
potential size and growth of the market for the product, its likely responsiveness to
the overall level of economic activity, and competitive conditions. Without this
framework it is impossible for individual companies to interpret factors such as
falling profits and fluctuating prices.

Characteristics of the Product

The first step is to define what the industry is selling. Farmed salmon was originally
conceived of as being a close substitute for wild salmon. But as the supply of
farmed salmon has increased consumers have become more knowledgeable about
the difference between farmed and wild salmon. Hence the quality of farmed
salmon was causing problems. Farmed salmon is now generally regarded as being
inferior to wild salmon and does not command the same price. In other words, it is
no longer regarded as a close substitute.
The quality difference between farmed and wild salmon is not its only important
characteristic: one farmed salmon is identical to another, i.e. the good is homoge-
neous. In other words, all salmon farms are competing directly with each other to
sell the same good.
Another important characteristic is that the product is perishable. This means that
it can be stored only for a short period. To all intents and purposes current produc-
tion has to be disposed of immediately. It is not possible to keep excess production
in inventory if prices are relatively low. It is possible that investment in freezing
facilities would eventually enable farmed salmon to be stored for extended periods,
and this would lengthen the market clearing time period, but this is not a feasible
option at the moment. Some salmon is tinned, but there is no mention of this
market in the article and it is therefore likely to be unimportant.
Demand for Farmed Salmon

What is the price elasticity of demand likely to be? In the market clearing period,
which is very short because of the perishable characteristic, the response of demand
to lower prices is likely to be small. This is because there is a limit to the amount of
salmon which people can, or wish to, eat in a short period. Thus the short-term
industry demand curve is likely to be highly inelastic. This is shown in Figure A4.1.
2.14
1.50
Price
Demand
Quantity
Figure A4.1 The demand for farmed salmon

The two prices shown in Figure A4.1 are the price of the 250 tonnes sold in France,
i.e. £1.50, and the original market price which was 30 per cent higher. If the demand
curve is highly inelastic the price reduction will not result in a significant increase in
consumption.
Fish is normally bought in shops where the price of salmon can be compared with
that of other fish, and anyone who consumes fish on a regular basis will be well
aware of the approximate relative price of different types of fish. Therefore,
consumers can be regarded as being reasonably well informed on prices and the
quality of salmon compared to other fish.
What are the prospects for increasing the demand for salmon over a longer period?
Can the demand curve be shifted significantly to the right? There is no doubt that
there has been a substantial increase in demand for farmed salmon in the last 10
years, as a result of increases in domestic consumption and the exploitation of
markets such as airlines. Thus in the early 1980s it was to be expected that the
demand curve would shift to the right as the product penetrated the market.
However, once markets are more or less saturated any increase in demand will
depend on income elasticity. One definition of a luxury is that the quantity
purchased increases by a greater percentage than the increase in average income; for
example, the amount of potatoes purchased does not increase very much as income
increases, but the demand for wild salmon does. It is likely that the demand for
farmed salmon will increase by no more than the average increase in real incomes.
Analysing the Competitive Environment

The salmon farming industry is characterised by a large number of relatively small
productive units. There are various difficulties involved in starting new farms, such
as finding a site, obtaining necessary permits, and so on, but on the whole the entry
cost is not particularly high. The technology is widely known and understood.
Therefore there are few barriers to entry.
The pieces are by this time starting to fall into place: an industry comprised of a
large number of small producers making a homogeneous product for a market
comprised of well-informed consumers and with low entry barriers, sounds very
much like perfect competition. Certainly, salmon firms are price takers, i.e. they
have no control individually over the market price of salmon. This means that each
firm faces a horizontal demand curve for its product: if it attempts to charge above
the market price it will sell nothing, but it can sell as much as it can produce at the
going price.
It is well known that no market is perfect in the textbook sense. But a very im-
portant conclusion can be drawn about a market which has many of the features of
perfect competition: in perfect competition no profits above the opportunity cost
of capital are made in the long run. By definition, there are no monopoly profits.
Therefore, the outlook for making profits in the long run, which could be defined as
the time beyond the point at which competition reacts to the profits which are being
made in the early stages, is virtually non-existent. In the language of finance, the
prospective return would be the opportunity cost of capital plus the equity risk
premium, i.e. the return attributable to the risk associated with salmon farming. This

is a very serious issue because, from the viewpoint of the early 1980s, it suggests
strongly that the only way of making a return on salmon farming would be to enter
at an early stage of market development, make monopoly profit while it lasted, then
convert the asset back into cash.
One interpretation of strategy is that it is largely a search for market imperfec-
tions. In other words, you look for the ways in which the market may vary from the
‘perfect’ case; this could be because of factors such as barriers to entry, lack of
consumer knowledge, economies of scale and monopoly power. In this case it could
be predicted from an early stage that imperfections were unlikely to persist for long.
From the present time onwards the prospects for exploiting market imperfections
are limited.
Another perspective on competitive position can be derived from portfolio
analysis. In terms of the BCG matrix, fish farms have some characteristics of
‘Dogs’, in that individually they have a small market share in a potentially low
growth market, coupled with a history of losses. What are the prospects for shifting
an individual fish farm from the ‘Dog’ to the ‘Cash Cow’ portion of the matrix?
The Price of Salmon

The general trend of salmon prices, which have halved in the past three years, can
be explained in terms of relative movements in the supply and demand curves; the
net impact on prices and quantities will depend on how far the demand curve shifts
as the market is developed, compared to the shift in the supply curve as the number
of producers increases. This is shown in Figure A4.2.
Supply (t–3)
Pt–3
Supply (t)
Price
Pt
Demand (t)
Demand (t–3)
Quantity
Figure A4.2 The long run price of salmon

This shows that the price has fallen in half between three years ago (Pt−3) and now.
Any shift in the demand curve due to income elasticity and increased preference for
salmon has been more than compensated for by the shift in the supply curve as
more firms have entered the industry.

The volatility of salmon prices can be explained by the combination of the inelastic
demand curve and the temporary shifts in supply in the market clearing period
shown in Figure A4.3.
Supply Supply(N)
Price
P(N)
Demand
Quantity
Figure A4.3 Volatile salmon prices

In Figure A4.3 Supply(N) refers to the supply with the 250 tonnes from Norway.
The price has fallen to P(N), which is 30 per cent lower than P, the original price.
Production Cost
Production costs are of two types: fixed and variable. Without knowing the details,
it was obvious that the fixed costs were relatively high: setting up the farm, purchas-
ing cages, buying stock, paying labour. These can be regarded as fixed because of
the very short market period. The marginal cost of a salmon then drops to the cost
of taking it to market. The combination of high fixed costs and very low marginal
cost for a perishable good is troublesome, because it opens the possibility of
markets clearing at very low prices (marginal cost) when there is an unexpected
increase in supply.
Data
The data in the article confirm the general picture. One farmer claimed that the
price halved in three years. The industry as a whole has already lost £15 million
during the year, and the big producer, Marine Harvest, lost £19 million last year.
The ‘latest dumping’ led to a price fall of 30 per cent down to £1.50, where farmers
are ‘losing £0.40 per lb’. Table A4.3 shows what this suggests.

Table A4.3 Salmon price and profit

Price 3 years ago £4.28
Price this year £2.14
Production Cost (implied) £1.90
Profit (Price − Production Cost) £0.24
‘Dumping’ Price £1.50
There are many definitions of production cost depending on accounting conven-

tions; assume for the moment that Production Cost is similar to long run average
cost, which would be arrived at by using accounting methods of depreciation of
fixed assets. This leaves a profit of £0.24 per lb, which comes to about £500 per
tonne in equilibrium.
The article states that the industry as a whole has been making a loss at the current
price level, and it was claimed that a ‘price recovery’ was necessary to ensure their
survival. This suggests that the situation may even be worse than can be implied
from the data shown above.
All of this is consistent with the prediction that profits would ultimately decline as
competition increased.
General Economic Environment

The industry serves an international market, and is subject to competition from
salmon farms in countries such as Norway which are likely to have natural ad-
vantages operating in their favour. Thus it was likely that the Scottish producers
would be confronted by at least equal cost competition from an early stage. A
potential advantage for Scottish farmers might appear to be their location near to
local markets: it is possible that transport costs would compensate for any potential
natural advantage which Norwegian producers might have. However, in real terms
this advantage is limited, since the major market for farmed salmon is in the large
EU countries which have no indigenous salmon farming potential. The 55 million
population of the UK is small compared to the 350 million in the rest of the EC;
however, Norway is at no transport disadvantage compared to Scotland when
supplying major centres such as Paris, as can be seen from the article.
A major concern of producers is ‘dumping’; it is difficult to define exactly what is
meant by ‘dumping’, but it usually means selling products at less than their produc-
tion cost. Dumping was ‘proved’ in 1989, but what form the proof took is difficult
to determine. For example, companies may sell at less than ‘production cost’ in
foreign markets in order to generate market share, and in the process may force
local companies out of business. However, this could be regarded as being no
different to a price war waged by local companies among themselves, i.e. as part of
the normal competitive process.
In any case it is to be expected that firms will sell at different prices in different
markets to take account of varying market conditions; this can be concluded from
the theory of the discriminating monopolist. It would be illogical for producers to
sell in any market at a price lower than the marginal production cost for any length

of time. The situation is complicated in the salmon farming case because the
marginal cost of production is simply the transport cost of getting the fish to
market; this is relatively low compared to average cost. Once the fish have been
produced it is worthwhile to send them to market so long as there is an expectation
of generating a price higher than the marginal transport cost.
The combination of relatively low marginal cost and an inelastic demand curve in
the market clearing period makes price volatility almost inevitable. The only way of
countering this is to impose a relatively high tariff, as in the US. But given the
general trend towards free trade in the European area the possibility of protection in
the long run is remote.
A further consideration is that salmon farming imposes externalities on the
amenity of the surroundings. Because of its nature, salmon farming tends to be
carried out in areas of scenic beauty, and the possibility exists that public opinion
may ultimately result in moves to limit the impact of the industry on the environ-
ment. This could take the form of entry barriers, but it could also result in increased
costs to the salmon farmers as they are forced to take amenity considerations into
account.
Case 5.3: Lymeswold Cheese (1991)

1 Application of the process model makes it possible to identify factors which
contributed to failure. As in most cases of company failure there is no single cause.
Objectives
The general objective was clear enough, i.e. to diversify Dairy Crest and break into
the high-quality cheese market. The series of blunders could be explained by the
lack of profit maximising behaviour on the part of Dairy Crest; it had more experi-
ence in buying and selling milk, which is a homogeneous product, and because of its
monopoly power did not have the incentives of a competitive firm.
Dairy Crest had the corporate objective of selling milk and related products in a
monopolistic market, while Lymeswold had the SBU objective of breaking into the
high-quality cheese market. The corporate and the business objectives did not seem
well aligned.

Since so much went wrong, it is reasonable to conclude that the company had not
carried out an adequate analysis of the competitive environment and its potential
competitive advantage. But even an exhaustive analysis might have been wrong.

Table A4.4 Scenarios

Year Market Market Sales Change in
growth (%) share (%) sales (%)
1984 10 2 000
Scenario A
1985 30 11 2 860 43
1986 30 12 4 056 42
Scenario B
1985 10 9 1 980 −1
1986 10 8 1 936 −2
For example, the prediction of market size and/or market share was wrong by a
factor of 2. At first sight this might appear to be a completely incompetent forecast.
However, imagine that the assumption was made that the 30 per cent growth rate
would continue for at least a few more years; it is a rational strategy to build capacity
ahead of expected increases in demand. If the market is growing by 30 per cent, it
doubles every two and a half years, but if the growth rate falls to 10 per cent it will
double only every seven years. Add to this that market share probably declined due
to the lack of market development and poor quality control. The scenarios in
Table A4.4 show how divergent predictions can be. Start from a hypothetical base
of 1984, with 10 per cent market share and a total market of 20 000, giving sales of
2000 tonnes. If the market grew by 30 per cent in 1985 and 1986 (Scenario A), and
market share increased by 1 per cent per year, Dairy Crest would have been working
to full capacity by 1986.
However, if the market grew by only 10 per cent, and market share fell slightly each
year, then Scenario B shows the drop in sales from 1986. It seems likely that Dairy
Crest did not carry out a sensitivity analysis before investing in new capacity. This
would have helped identify the conditions under which sales would double, and the
dangers of allowing market share to fall.
Choice
Lymeswold was launched into a market containing long established market leaders,
and the basic strategy was to win a significant proportion of the market as quickly as
possible; this probably accounts for the fanfare with which the product was
launched.
In the UK, high-quality cheese was a rapidly growing market, and Lymeswold
started off its life as a Question Mark or Star. As such it would not have generated
significant positive net cash flows during the early part of its product life, and the
strategic thrust at that stage should have been to achieve as high a market share as
possible. However, when shortages occurred Dairy Crest did not attempt to increase
the customer base, but simply kept supplying existing customers.

Implementation
Once it had committed itself to the new factory, Lymeswold was burdened with
excess capacity and therefore high costs.
One of the reasons for falling sales seems to have been the quality of the cheese. It
does not appear to have been attractive enough compared to the French and
German cheeses, and customers could not count on its consistency over time.
Insufficient attention was paid to the characteristics of the product. Lymeswold
could be located in the perceived price differentiation matrix. Nothing is known
about the perceived relative price, but it did not have a high level of differentiation,
therefore the chances are that it falls into the failure or highly uncertain areas.
It is possible that the outcome was inevitable because the product life cycle of
Lymeswold may have been relatively short. This could have been because
Lymeswold was not really a substitute for the stronger French and German soft
blue cheeses but merely introduced consumers to this market.
There seems to have been little scope for synergy between the original Dairy Crest
product portfolio and Lymeswold cheese.
Feedback
While there may have been plenty of information flow within the company there
was a distinct lack of learning and responsiveness. There was little or no attempt
made to improve quality and consistency, increase the market base and control costs
in the light of what was happening.
Overall Process
This analysis suggests that the strategic process was not robust: weak objectives,
poor analysis, mistaken choice, inadequate implementation and lack of feedback. See
from this perspective, it is not surprising that Lymeswold failed.
Case 5.4: Cigarette Price Wars (1994)

1 The argument on destroying the brand can be interpreted in terms of the perceived
price differentiation model. The Kravis and Davidson arguments suggest that
Marlboro was located in the high price high differentiation segment and that the
price reduction undermined its perceived differentiation, thus shifting its position
towards the failure likely segment. However, it is just as likely that the perceived
price had been pushed up by the advent of the discount brands while the fact that
the discount brands were so much cheaper undermined perceived differentiation: is
a Marlboro really three times as good as a discount cigarette? Thus Marlboro may
have been shifting in the matrix already and the price cut can be interpreted as an
attempt to regain its original position. While the situation was complicated by the
success of Camel the continuing loss of market share corroborates this perspective.
The big picture can be analysed by the application of industry demand and supply
curves. The demand curve was slowly moving leftwards as the consumption of
cigarettes decreased, while the supply curve was moving to the right as technological
progress reduced costs; the lack of entry barriers was apparent from the penetration

of the market by the discount producers. This means that the equilibrium price for
cigarettes was declining, and it was this downward pressure on prices which affected
the competitors.
Marlboro had been pursuing a strategy based on differentiation, but it had steadily
been losing competitive advantage. A price war had been waged for some consider-
able time, and Marlboro were already losing it. The discount cigarettes had slashed
prices dramatically and grabbed about 30 per cent of the market, and Marlboro’s
share had dropped from over 30 per cent to 22 per cent. The observers quoted did
not appear to have noticed this. Perhaps they were confusing the behaviour of
profitability with market position. It would appear that costs had fallen by as much
as revenues in the past few years, with the result that profits had remained buoyant.
Consider the basic model of revenue and costs:
Cost Unit cost Output
The joint effect of a falling total market and decreasing market share can be
compensated for by cost reductions only up to a point. For example, assume that
unit cost had fallen by 50 per cent along with the doubling in productivity; this is
probably an overestimate of the cost reduction. Marlboro’s market share had fallen
from 30 per cent to about 20 per cent; assume that the market had fallen by 10 per
cent. This gives the following in index form:
Revenue1 1.0 0.3 1.0 0.3
Revenue2 0.9 0.2 1.0 0.18, i.e. a reduction of 40%
Cost1 1.0 1.0 1
Cost2 0.5 0.9 0.45, i.e. a reduction of 55%
There was thus plenty of scope for profits to be maintained in the short term.
However, if further reductions in market share and market size occurred, it was
likely that profits would fall substantially because further productivity increases were
unlikely to be as pronounced as those in the past few years. It looks as though the
Marlboro management were much more aware of the potential problems facing
them than the industry observers.
One reason that the price cut may have seemed particularly attractive was the
competitive position of KKR. Since it was more highly geared than Philip Morris,
the price cut could be seen as an attack on the KKR Cash Cow which KKR had
limited resources to withstand. The two sectors – premium and discount – can be
viewed as separate, the real struggle being between the premium producers, not the
premium versus discount producers.
Therefore it can be argued that Philip Morris was not completely mistaken. Howev-
er, there were various options open to Philip Morris which may have been much
more effective.
1. Do nothing: accept that market share would continue to decline, perhaps
because any attempt to arrest it would cause a price war from which there would
be no net gain, or that further marketing expenditure could not improve on the

Marlboro image further. It could be that Marlboro was in the decline stage of the
product life cycle.
2. Differentiate further: this would require additional marketing expenditure and
the strength of the brand was clearly weakening anyway.
3. Segmentation: target Marlboro at other sectors of the market. This would take
considerable time to have any significant impact.
2 There are two factors:
1. Elasticity of Demand: The total market demand is inelastic but this clearly does not
apply to individual firms. The price reduction of 20 per cent reduced the differ-
ential between Marlboro and the cheapest discount cigarettes from about 210
per cent to 150 per cent. Whether this would be sufficient to halt the decline in
market share, never mind increase market share, is rather doubtful.
2. Competitive Reaction: The market shares in Figure 5.23 reveal that the industry is
characterised by oligopoly, or competition among the few, leading to a kinked
demand curve for the individual firm. When one company ‘breaks rank’ and
reduces prices, its competitors will tend to follow. If the main target of Marl-
boro’s price cut is the other premium producers, the outcome will depend on
their reaction. To some extent it is a zero sum game, since one firm can only gain
at the expense of competitors. If there is a price war it will be less than zero sum
so far as the producers are concerned: the only gainers will be the consumers.
3 A great deal depends on the similarities between the US and the UK markets. While
Benson & Hedges has the largest market share in the UK, it is not relatively so
dominant as Marlboro in the US. In fact, there is a relatively large number of small
competitive producers: the top ten companies account for just over 60 per cent of
the market. The market structure suggests that monopoly profits are unlikely to be
as high as in the US, and hence there is less scope for price cutting. While there are
no discount brands on the British market, the same demand and supply factors
operate.
As market leader, Benson & Hedges has various options, for example:
1. watch market share being whittled away as happened to Marlboro;
2. pre-empt the opposition by reducing prices now;
3. takeover competitors;
4. accept that in the long term the cigarette market is doomed, and diversify into
other areas as soon as possible;
5. segment the market;
6. introduce flanker discount brand.
The View from Now

Was the Price Cut a Mistake?
It was concluded in 1994 that the outlook for Marlboro was bleak and that the price
reduction was unlikely to work in a declining market. But by 2014 the Marlboro
market share was 44 per cent, far higher than the 26 per cent in 1994. It is still the
number one cigarette brand and stands at 27th in the world with a brand value of
about $20 billion. The danger of Marlboro sliding down the price differentiation
matrix did not transpire so it turned out that the price reduction was not ‘suicide’

after all and had virtually no impact on the Marlboro brand perception. The total
market, of course, has continued to decline: in 1994 25 per cent of adults smoked,
reducing to 19 per cent by 2015; total consumption has fallen by over 25 per cent
over the period.
How Effective Will the Price Cut be?
It now costs about $6 for a pack of Marlboro, three times what it was in 1994 and
twice as much in real terms. This increase has largely been due to the increase in
sales tax and makes it difficult to disentangle the subsequent impact of the one-off
price change in 1993.
Lessons for the UK
There are new threats in 2015 to the cigarette market affecting both.
1. Increased awareness of health effects leading to long-term decline in consump-
tion.
2. The growth of e-cigarettes as a substitute.
In terms of the five forces, this amounts to an increase in the bargaining power of
buyers and an increase in the threat of substitutes. By now the challenges facing US
and UK cigarette markets are similar.
Case 5.5: A Prestigious Price War (1996)

1 An obvious first step in assessing competition is to set out the five forces. But
before tackling this issue it is necessary to consider the market definition. If the
newspaper market is defined as selling news in print form the threat of substitutes,
for example, is probably low; but if the market is defined as selling advertising the
possibilities are much greater because the newspaper is competing against other
media for advertising revenue. It is instructive to set up the five forces from the
viewpoint of a news vendor and an advertising vendor. A complication is that the
five forces derived for a segment of the market, such as the quality newspapers, will
differ from that of the newspaper market in general.
Market News Advert

Threat of new entrants Low High
Threat of substitutes Low High
Bargaining power of suppliers ? ?
Bargaining power of buyers Medium High
Industry rivalry High High
The threat of new entrants is probably low given the history of the Independent since
1986. The threat of substitutes to newspapers is low, although it is possible that in
the future internet delivery of newspapers might become popular; but for advertis-
ing newspapers face substitutes in the form of television, cinema, magazines, etc.
The bargaining power of buyers for existing newspapers is medium, given the brand
loyalty associated with particular newspapers, but for advertising it is very high.
Industry rivalry is high in both cases but for different reasons. In the advertising

industry there are a large number of suppliers leading to intense competition. In the
quality newspaper market there are only five main players leading to oligopoly.
Competition in the quality sector in the past had taken the form of differentiation
and segmentation, hence the newspapers targeted different market niches with
different degrees of focus. A rough classification of the segments is as follows:
 Financial Times: financial readers with an international focus
 Guardian: left wing and liberal
 Daily Telegraph: professional and business classes with some tabloid characteris-
tics
 Times: professional and business classes
 Independent: yuppies (young upwardly mobile professionals)
In the daily newspaper business the quality newspapers comprise a strategic group
which is distinct from the tabloids. The groups can be located in a matrix which has
a measure of quality on one axis and price on the other: the quality newspapers are
located in the high quality-high price area, while the tabloids are clustered in the low
quality-low price area. There were some overlaps before the price reduction, for
example the Daily Telegraph has some tabloid characteristics. But as the Times
reduced its price and differentiated itself in the direction of the tabloids the overlaps
will increase and it is likely that the quality newspapers and the tabloids will in the
future compete more directly.
Murdoch was intent on shifting the position of the Times in the perceived price
perceived differentiation matrix. The Times was increasing its differentiation relative
to other quality newspapers, while at the same time reducing its relative price;
whether this might ultimately alienate the Times’s traditional readership remains to
be seen.
Given the different characteristics of the quality newspapers it is therefore to be
expected that the impact of the price reduction on the sales of competitors would
not be uniform. Table A4.5 demonstrates this.
Table A4.5 Change in daily sales – September 1993 to June 1994

No(000s) %
Times 163 46.0
Daily Telegraph −15 −1.5
Financial Times 13 4.5
Guardian −2 −0.5
Independent −55 −16.6
Total Quality Market 104 4.4
Between 1993 and 1994 the Times price reduction led to some substitution, but this
was mainly from the Independent; the impact on Daily Telegraph sales was relatively
minor. In fact, the size of the quality market grew significantly over the year, and
this may have been partly due to the Times price reduction. If the Financial Times is
removed from the calculation, over half of the increase in Times sales (i.e.

104−13=91) is accounted for by the increase in the total market size. Market
conditions were therefore not totally a zero sum game, although the slow growth in
market size meant that significant increases in sales could only take place at the
expense of competitors.
In an oligopolistic market each company faces a kinked demand curve because of
the reaction of competitors. There is always the threat of a price war in this type of
market, but in this case the main competitor – the Daily Telegraph – was slow to
respond and the other players either did not react (Guardian) or reacted in a half-
hearted fashion (Independent). Because of the lack of reaction the price elasticity of
demand for the Times turned out to be greater than unity: the initial price reduction
of 33 per cent led to an increase in sales of 46 per cent; as a result the total revenue
from sales increased over the period. While not all of the increase in sales can be
attributed to the price reduction, as the Times differentiated itself in the form of
increased sports coverage, it is likely that an immediate reaction by the Daily
Telegraph would have reduced the impact of the Times’s strategic move.
The effect on profits is difficult to predict because it is not known what happened
to costs, although they would have presumably increased with the size of the
newspaper. The sales figure multiplied by the price does not give the full story on
revenues because the increased circulation would have increased advertising
revenue. In fact a reduction in total revenue even in the long term due to demand
elasticity is not necessarily inconsistent with profit maximisation because of the
direct relationship between advertising revenue and circulation.
Prior to the price cut it was generally considered that the quality newspaper market
was in the mature stage of the product life cycle. However, the 4.4 per cent growth
in the market in the course of one year suggests that it may have entered a second-
ary growth stage. The change in market share over the period is shown in
Table A4.6:
Table A4.6 Market shares

Sep 93 Jun 94
Times 15 21
Daily Telegraph 42 40
Financial Times 12 12
Guardian 17 16
Independent 14 11
Before the price reduction the Times was probably verging on the Dog area of the
BCG matrix. By June 1994 the ratio between the Times’s and Daily Telegraph’s market
share had changed from 2.8 to 1.9, so the relative market share advantage enjoyed
by the Daily Telegraph had greatly diminished. If the market had entered a growth
stage the Times could be classified as a rising Star, and hence it is to be expected that
it would not be making significant profits.
2 The 38 per cent reduction in the price of the Daily Telegraph was accompanied by a
39 per cent fall in the share price. This suggests that the market thought that price

reductions would have little impact on the size of the total market, hence the net
effect on revenues would be negative. The fact that the share price of the Times fell
by much less than that of the Daily Telegraph or the Independent suggests that the
market felt that by reducing price the Daily Telegraph would halt the loss in market
share but would have little impact on the position that the Times had built up. This
was backed up by the developments up to 1996, by which time Daily Telegraph sales
had not increased.
Thus one interpretation is that the financial market predicted that the newspaper
market would reach equilibrium at a much lower price than previously. While there
will always be a degree of overshooting in financial markets, the stock market
reaction was generally in line with reasonable expectations about future profitability.
Case 5.6: Revisit An International Romance that Failed: British Telecom and
MCI
1 Telephone prices had fallen by 50 per cent in the US in the three years to 1997; this
suggested that supply had been increasing at a much higher rate than demand and
that BT would require significant cost advantages if it were to succeed. Its track
record of reducing costs in the UK was impressive, but this was starting from the
high base of a government monopoly. At the same time international call prices had
fallen by 60 per cent so the supply and demand changes were not confined to the
US.
There are three distinct segments in the US telephone market: corporate, long
distance and local. BT may not have realised that competition was quite different in
each and therefore that different competitive approaches would be required.
The extent to which BT understood the five forces can be inferred as follows.
Threat of new entrants
 Local segment: low: while deregulation had lowered entry barriers in principle, in
practice it turned out to be very difficult to win market share and after a year
MCI had only $80 million of local business.
 Long distance segment: high: the market was mature and, given MCI’s market
position, it might have been expected that this sector was safe. But it turned out
that the Baby Bells were able to enter this market.
 Corporate segment: high: the fact that international call prices had fallen suggests
that there had been entry into the market for multinational one stop services.
MCI was not equipped for this market, and BT lacked experience in the US.
It is possible that BT did not appreciate the threat of new entrants, both from the
viewpoint of entrants to the segments in which it wished to operate and its own
ability (with MCI) to enter segments such as local markets.
Threat of substitutes
With the advent of internet technology the threat was high in all three segments.
However, the threat was not immediate so it had probably had little impact on the
market by 1997.

Buyer bargaining power

The objective of deregulation was to increase buyer power in all three segments, and
this was bound to increase as new cables were installed, the technology changed and
new entrants appeared.
Supplier bargaining power
No information.
Competitive rivalry
Competitive conditions were changing in all three segments with deregulation.
While direct competition may not have appeared to be increasing in terms of
number of competitors, the increased threat of new entrants resulted in all three
becoming increasingly contestable. The long distance segment was mature and
monopoly power had been eroded. The corporate segment was being contested by
major international alliances. The local segment was already highly competitive and
was become increasingly so. Competitive rivalry in all three segments was high so
none of them provided an easy entry which would provide a platform from which
to attack the others.
There were three key forces which were becoming increasingly competitive and BT
did not appear to have recognised this: the increasing threat of new entrants in the
corporate and long distance segments and its own difficulty in entering the local
market, the increased power of buyers and the increased rivalry. Together these had
contributed to the imbalance between supply and demand and the falling prices in
the previous three years. The problem confronting BT was not so much that these
competitive forces had been changing but that BT did not appear to understand
their implications.
Case 5.7: The Timeless Story of Entertainment (2005)

1
Competitive force
Threat of new entrants High Few barriers to entry
Threat of substitutes High Good ideas tend to be imitated
Bargaining power of buyers High There is endless choice
Bargaining power of suppliers High Creative individuals are rare
Rivalry High There are many companies competing for the
same audience and good ratings
The highly competitive nature of the business results in low profits in the long term.
But, because successes are intermittent, at any one time some companies make high
profits.

2
Competitive force
Threat of new entrants HBO established a niche of cutting-edge drama
Threat of substitutes Cutting-edge drama is difficult to imitate
Bargaining power of buyers HBO was the only producer of cutting-edge
drama
Bargaining power of suppliers Creative people were eager to join
Rivalry HBO became a monopolist in its niche
By taking action to counter the competitive forces HBO set the scene for long-term
competitive advantage where profitability was not determined by random successes.

1 The US grocery market was mature and the existence of local scale economies
meant that new entrants would be faced with low margins. There was likely to be
competitive reaction from the incumbents.
Competitive Force Be- Rationale
fore
Threat of new entrants High Low barriers to entry
Threat of substitutes High Innovations easily imitated
Bargaining power of buyers High Tesco has no established brand image
Bargaining power of suppliers High Tesco has to sets up a distribution
system
Rivalry High Knowledgeable consumers; low
switching costs; low margins
The market is clearly highly competitive if the intention is to compete on the same
basis as the incumbents. The previous experience of Sainsbury’s et al. demonstrates
the difficulty of entering a mature and competitive market.
2 Incumbents such as Kroger and Safeway were stuck in the middle. Tesco’s challenge
was to enter the middle sector without suffering the same fate.
Segmentation analysis
The segmentation matrix had identified a hole in the market for convenience stores
and ready meals. Each can be assessed in terms of the four characteristics a segment
requires if it is to be exploited successfully. The key was to combine convenience
and quality.

Segmentation variable Convenience Ready meals

Identifiable Shoppers had to visit several stores Exists in the UK
Demand related Confidence that relevant quality goods UK experience
would be available
Adequate size Focus on cities Uncertain if it would appeal
Attainable Database and UK type supply chain UK type supply chain
On the basis of its detailed market research, Tesco had:
 identified the key product characteristics: quality food and variety of ready meals;
 derived the characteristics of the target segment: those who wished to minimise
shopping time;
 identified the location of the target segment: the middle market.
Product Life Cycle
Tesco introduced a new product, which meant a new PLC and the potential for first
mover advantage.
Price Differentiation Matrix
Tesco was offering a highly differentiated product which was hopefully located in
the success likely sector of the price differentiation matrix.
Portfolio
It was essential that Tesco did not enter the market as a Dog – this was the fate that
had befallen Sainsbury’s et al. The creation of a new product meant that it entered as
a Star.
Value Chain
Tesco had a core competence in terms of the logistical aspects of the value chain.
Impact on the Five Forces
The intended impact on the five forces was as follows.
Competitive Force After Rationale
Threat of new entrants Low First mover advantage and local econo-
mies of scale
Threat of substitutes Low Focused stores and large choice of ready
meals
Bargaining power of buyers Low Segment not well served
Bargaining power of suppliers ? Dependent on the efficiency of supply
chain
Rivalry Low First mover advantage
Thus in the short run Tesco intended to reduce competitive pressures. Whether this
would be sustainable is unknown but Sir Terry felt that unless a significant early
market impact was made the prospects were poor.


1
Change Action
Threat of entrants Low cost High Strengthen brand
copycats
Threat of substitutes High tech High Websites, virtual factory
gadgets
Bargaining power of More choice of High Bind customers to company
buyers toys
Bargaining power of High cost Low Relocate production
suppliers
Rivalry The big five High Divest and focus on core
There are various ways of looking at the five forces, but the example above shows
that four of the five forces constituted serious threats to Lego and that Mr Knud-
storp had taken specific actions to mitigate them. He had also taken advantage of
the low bargaining power of suppliers to reduce costs and relocate production.
Module 6
Review Questions
Case 6.1: Analysing Company Accounts

1 Starting from the corporate perspective the ratios are as follows.
Year 1 Year 2
Ratio % %
Return on total assets Operating surplus/Total assets 8 15
Return on equity Operating surplus/Owners’ equity 11 28
Return on investment Operating surplus/Total fixed 11 16
assets
This evidence suggests that company performance improved significantly between

the two years. This was primarily due to the fact that the operating surplus increased
from £1.3 million to £3.8 million, an increase of about three times, while the value
of assets increased by only two thirds. The reason that ROE and ROI were equal in
Year 1 was that the values of owners’ equity and fixed investment were approxi-
mately equal; by Year 2 fixed assets had almost doubled, while owners’ equity had
remained almost unchanged, leading to the very large increase in ROE. This arose
from the fact that the increase in fixed assets had been financed almost entirely by
loans, as can be seen from the increase in long-term debt from £2 million to £12

million. The company structure changed from Year 1 to Year 2 in that Total
overheads increased from 39 per cent of COGS to 42 per cent of COGS; this
suggests that the increase in size, as measured by the increase in sales of 42 per cent
was not accompanied by economies of scale in support activities. The major change
in overheads was the doubling of Corporate HQ costs to 19 per cent of COGS in
Year 2 and the question needs to be addressed as to whether this increase was
necessary.
The net cash flow position improved greatly, from a net outgoing of £0.2 million to
a net inflow of £2.3 million. The fact that the net cash flow in Year 2 was £1.5
million less than the operating surplus needs to be explained; it is obvious that a
major part of the difference is that the company now has a very large long-term loan
interest commitment of £1.3 million per year. This raises the question of whether
operating surplus is the appropriate measure of profitability for this company.
Substituting net cash flow for operating surplus in Year 2 gives the following result.
Ratio Year 1 Year 2 Year 2

% % %
Operating surplus Net cash flow
Return on total assets 8 15 9
Return on equity 11 28 17
Return on investment 11 16 10
Using net cash flow for Year 2 reveals that both ROTA and ROI were virtually
unchanged between the two years. This demonstrates how accounting conventions
can greatly affect measured performance and raises doubts as to whether the
underlying profitability of the company actually increased.
The gearing ratio and the quick ratio changed as follows.
Year 1 Year 2
Ratio % %
Gearing Debt/Total assets 25 47
Gearing Debt/Owners’ equity 34 89
The Quick ratio (Current assets − Inventories)/Liabilities 25 8
The Quick ratio fell from 0.25 to 0.08 suggesting a significant increase in exposure
to risk. The gearing ratio increased from 25 per cent to 47 per cent using Total
assets and from 34 per cent to 89 per cent using Owners’ equity; this higher gearing
ratio, combined with the level of risk exposure, may lead to future lending being
more expensive and perhaps being difficult to obtain.
The conclusions on company profitability are therefore mixed: on a like for like
basis company performance improved significantly, but the longer term prospects
are uncertain given the reservations on underlying profitability and risk exposure.
2 AcmeSpend’s operational cost structure changed between the two years:

Year 1 Year 2
Percentage of COGS % %
Wages 37 29
Production lines 24 28
These ratios reveal that the company has become more capital intensive, to be
expected as a result of the large investments in equipment made during the period.
In fact, the absolute wage cost fell in Year 2 despite the increase in sales.
The impact of the investment programme on profitability is uncertain, given the
doubts raised above on the appropriate measure of profit but for consistency we
shall use operating surplus. The contribution of the investment can be to increase
sales revenue, reduce costs or some combination of the two. Sales revenue increased
from £8.1 million to £11.5 million between the two years but it is difficult to see
what effect an internal reorganisation of capital and labour inputs could make to the
value of final sales – this is more likely to be related to general demand for Ac-
meSpend’s product, marketing expenditure and pricing. The investment resulted in
higher productivity, in the sense that the ratio of COGS to sales revenue fell from
61 per cent in Year 2 to 47% in Year 2; in other words, the direct per unit costs of
production and sales were reduced. The real issue, then, is the impact of the
investment on costs, i.e. what would have happened to profitability if sales had
increased and no investment programme had been undertaken.
An answer to this can be obtained by estimating the cost saving resulting from the
investment. This can be calculated in several steps.
1. The COGS in Year 1 is grossed up by the increase in sales revenue (as an
approximation to the actual increase in physical output):
$4.9 million $11.5 million/$8.1 million $6.9 million
2. The difference between the actual COGS in Year 2 and what it would have been
is calculated:
$6.9 million $5.4 million $1.5 million
3. The increase in Total Fixed Assets is calculated:
$23 million $12 million $11 million
4. The return on the investment is approximately:
$1.5 million/$11 million 14%
The cost of capital is $1.32 million/$12 million = 11%.
It is clearly an approximation to assume that the COGS would have increased in
proportion to sales but it does appear that the investment generated a return greater
than the cost of capital. The returns above the cost of capital are a contribution to
increase in profitability. It is likely that unit cost would have increased at the margin
using the Year 1 capital structure so the return on the investment may have been
higher. Therefore using these assumptions it can be concluded that the investment
did contribute to the increase in profitability.
It is possible that the investment was originally appraised along the lines of potential
cost saving and justified on the basis of the NPV. This is an illustration of how
difficult it is to determine after the event if things are turning out as planned. For
example, the ‘what if’ calculation of costs depends on the sales level in Year 2, but it

is not known what estimates of future sales were made at the time of the investment
appraisal.
3 This depends on the impact of the investment on the SAP, i.e. the effect on
AcmeSpend’s strengths and weaknesses. AcmeSpend has taken steps to rationalise
and modernise its productive processes and value chain. It has reduced costs
(according to our rough calculation) and should be in a position to compete
effectively with other efficient producers in the future. While there are some
concerns about what has really happened to profitability between the two years, it is
open to question whether AcmeSpend would have been able to accommodate
significant increases in demand with its Year 1 capital structure. It looks like the
investment has made AcmeSpend more competitive but at the cost of increased risk
exposure. The impact on the SAP can be summarised as follows.
Internal area Impact on competitive strength (+) or

weakness (−)
Production and value chain + Streamlined operations
Marketing + Increased capacity to support increased sales
Finance − Increased exposure
− Higher gearing
On balance it can be concluded that AcmeSpend has strengthened its long-term

competitive position. But it is possible to interpret the analysis differently; for
example, you may consider that the finance position has been so weakened that the
prospects for further expansion of capacity will be severely curtailed in the event of
continuing increase in demand.
The View from Now

Accounting concepts do not change over time but accounting standards do. For
example, International Accounting Standards publishes voluminous amendments
and updates each year. It is important not to get confused by details and focus on
what can be deduced from the accounting data.
Case 6.2: Analysing Company Information

1 The first step is to use accounting ratios to assess overall company profitability in
terms of the return on capital (Table A4.7).
Table A4.7
Top line divided by Bottom line Ratio as %
Operating surplus Total assets 8
Operating surplus Owners’ equity 13
Gross profit Total assets 42
Cash flow Total assets 28

Acme as a whole is making between 8 per cent and 13 per cent rate of return using
operating surplus as the profit measure. But there is a large difference between gross
profit and operating surplus, and this suggests that two things have to be looked at:
the amount spent on overheads and the performance of the individual products.
Some of the questions which need to be addressed include the following.
1. Are the overheads under control? Total overheads are 34 per cent of COGS; this
suggests a top heavy organisation.
2. Can overheads be reduced without long-term damage in order to increase
operating surplus? Corporate HQ is 13 per cent of COGS; another way of look-
ing at it is that corporate HQ costs 35 per cent of direct wage cost.
3. Are the individual products performing as well as they could? Return on sales for
the three products are different: 59 per cent for the Box, 15 per cent for the Lid
and 7 per cent for the Hinge. There could be scope for reallocating resources.
Acme’s net cash flow position is $2.8 million, so it is generating much more cash
than suggested by the operating surplus of $0.8 million. But it is necessary to
compare like with like so adjust the net cash flow by the income of $1.8 million
from selling a factory; the resulting net cash flow of $1.0 million is still much greater
than the operating surplus. You have to address the question of why a company
which can generate a large positive net cash flow does not return a similar operating
surplus. A contributing factor is the accounting conventions. For example, the
calculation of COGS matches historic costs with sales, so the costs incurred in the
current period could be significantly different from historic costs if Acme is selling
some products from inventory. This is in fact the case, as both Box and Lid ran
down inventories during the year. (see start year and end year inventories).
Acme has a gearing ratio of 67 per cent, using the ratio of debt to owner equity,
caused by the long-term loan of $4 million. While there is no absolute benchmark
for assessing whether this gearing ratio is excessive, if Acme’s track record to date
has been sound there is probably scope for further borrowing to finance expansion.
The quick ratio is 1, suggesting low exposure to risk, and the interest payment on
the long-term loan is less than 4 per cent of total outlays so Acme is not unduly
exposed to interest rate movements.
Some conclusions about the effectiveness of management at the corporate level can
be drawn.
 While Acme is making a positive return on assets the fact that cash flow is
greater than operating surplus suggests that the return could be improved.
 Acme could be handling its cash better; at the moment it is holding $3 million in
cash, presumably for working capital, while servicing a debt of $4 million.
 There is a clear need to investigate corporate overheads.
Thus while Acme embarked on an ambitious programme of investment and
expansion two years ago the benefits are not being fully realised as yet.
2 Having analysed the corporate financial position the products can be analysed by
interpreting the management discussion and the data in terms of strategic models.

Product Life Cycle

According to the marketing manager the Box is the staple product, so it is probably
in the mature stage. The Lid is in the growth stage, which attracted the entry of
AceComponents. The Hinge was launched two years ago and is probably in the
early growth stage. Are the three products being managed consistently with their
product life cycle position?
The attempt to equate production of the Box with demand has not been successful
in that not enough is being produced to meet current demand with the result that
inventories have dropped to zero; that means that some customers are not being
satisfied.
The Lid should be building inventories in the expectation of further market growth
but instead has been running inventories down. If the current level of demand
remains constant next year there will be just sufficient supply to fill all orders, but if
there is an increase in demand, say 5 per cent, then some orders will not be filled.
The price has been kept at the competing level and marketing expenditure is 15 per
cent of COGS, which is much the same as for the Box, so it does not look like
action has been taken to meet the competition posed by AceComponents.
The Hinge is building inventory and is priced about one third lower than the
competition. Marketing expenditure, however, is only 16 per cent of COGS. The
similarity in marketing expenditure among the three products suggests that the
marketing budget is determined by a formula rather than by reference to market
conditions.
It appears that no explicit attention has been paid to the product life cycle for the
Box and the Lid; the Hinge appears to be managed consistently with its life cycle
position although there is scope for increasing marketing expenditure.
Portfolio
The market share held by competitors is not known so it is only possible to position
the three products approximately.
The Box has 18 per cent market share in a mature market so it is can be positioned
as a Cash Cow. In fact, it is responsible for generating 75 per cent of gross profit. It
has a high market share and a low unit cost compared to the competing price. But
the product upgrade has disrupted production and overtime is being worked and the
attrition rate is relatively high at 11 per cent. This suggests that unit cost could be
even lower with a stable labour force which was not working overtime. It was
argued above that the Box is not being managed consistently with its position in the
product life cycle. Therefore, instead of defending the Cash Cow Acme was
allowing it to be overtaken by competitors and was not controlling costs effectively.
This is likely to lead to loss of competitive advantage.
The Lid has 12 per cent share in a growth market so can be positioned as a Star,
possibly approaching a Question Mark because of the increased competition from
AceComponents. But it does not look like the Lid is being managed as a Star as
noted in the product life cycle analysis: inventories are being run down, marketing
expenditure is 15 per cent of COGS and price has been set at the competing level.

The attrition rate is also relatively high at 10 per cent. If action is not taken the Lid
will almost certainly end up as a Question Mark in danger of becoming a Dog.
The Hinge has 8 per cent market share and is most likely a Question Mark. It was
launched into a competitive market and the difference between the price charged
and the unit cost is very small. The accountant is quite right that the Hinge does not
look very promising from his perspective. But that is to be expected from a Ques-
tion Mark. The real issue is whether it can be transformed into a Star in the near
future and that depends on the impact of the relatively low price.
In one sense the portfolio is balanced with a Cash Cow, a Star and a Question Mark.
But the actions of management suggest that they have little insight into how to
manage a portfolio: the Box is being weakened both in terms of market share and
cost, the Lid is in danger of becoming a Question Mark and the Hinge is in danger
of being abandoned simply because it exhibits Question Mark characteristics.
Perceived Price and Differentiation

The upgrade of the Box has probably shifted it further up in the ‘success likely’
sector; but this advantage has not been consolidated by adequate production,
increased marketing and cost control. The Lid and Hinge are probably in the
‘success uncertain’ sector and require significant increases in marketing expenditure
to shift them towards ‘success likely’. But this will be a waste of time for the Lid
unless production is increased.
Value Chain
It can be deduced from the discussion that there are weaknesses in the value chain.
On support activities, human resource management has been weak in the introduc-
tion of new work practices and attrition is high; management systems are weak in
that the management team seems to have little insight into the competitive envi-
ronment. On the operations side production is relatively inefficient due to the high
attrition. The linkage between marketing and production is weak leading to unsatis-
fied orders. The team needs to take a close look at the value chain but the team
itself is part of the problem.
Recommendations
From the strategic viewpoint the conclusions are clear: start managing the three
products consistently with their product life cycle and BCG positions: allocate more
production resources to the Box and Lid; increase marketing on the Lid and perhaps
reduce the price; monitor the Hinge to see if it can achieve Star status. But these
actions are likely to be constrained by the deficiencies in the value chain. The
proposals will probably find favour with the CEO and the marketing manager but
the accountant and the production manager may be difficult to convince.
3 The first step is to look at the difference between the predicted unit cost and
competing price at launch (Table A4.8). This varies quite substantially by product.
There is another two years until the launch of the Holder, so its estimates are likely
to have a higher margin of error than for the other two products.

Table A4.8
Product Price Unit cost Price minus Price minus 5%
Unit cost minus Unit cost +
5%
Pin 800 700 100 25
Holder 1000 750 250 163
Ratchet 1500 800 700 585
Sensitivity analysis reveals that the Pin is highly exposed to relatively small errors in
cost and price estimates.
The break-even output for each product can be estimated by using the formula
fixed cost divided by net contribution per unit. Assuming that development
expenditure will continue at the same rate as the present for each of the products
gives the following results (Table A4.9).
Table A4.9
Product Years to Spending Spending to Total spending Break-even
launch per year launch ($thousand) output
($thousand) ($thousand)
Pin 1 500 500 1700 17 000
Holder 2 500 1000 2400 9 600
Ratchet 1 300 300 1800 2 571
This calculation includes sunk costs and it can be argued that these should be
ignored when making decisions about whether to continue or abandon any of the
products. The trouble is that all you have to do is to wait until sunk costs have been
incurred and then any investment can be made to look worthwhile. So this analysis
tells us whether the investments should have been undertaken rather than whether
they should be continued. The marketing manager did not understand the notion of
sunk costs in his discussion about the future of the Pin.
You can use the break-even analysis to estimate the pay back period; the assump-
tion made in the following is that the market does not grow after launch.
Product Market size Market Sales Pay back Product

share (%) life
Pin 35 000 9 3 150 5 5
Holder 40 000 10 4 000 2 6
Ratchet 50 000 14 7 000 0.4 7
The pay back calculation reveals that if the market does not grow the Pin will just
repay the original investment; both the Holder and the Ratchet have the potential to
make high returns. Again the calculations are greatly affected by whether sunk costs
are included. You can repeat the pay back calculation taking into account only the
expected expenditures for the remainder of the development period for each

product, and attempt to calculate a more accurate series of cash flows by extrapolat-
ing the growth in the market between the expected market at launch and the
maximum market size which is expected during the product life. But it is not clear
that more detailed calculations would affect the general conclusions.
The pay back calculation does not provide a proper calculation of the worth of a
product. This can be obtained by carrying out a discounted cash flow analysis of
the expected cash flows, and this would take into account possible reductions in
unit cost after launch due to the experience effect. You could attempt to identify
the opportunity cost of development expenditure, for example, by considering
whether development expenditure should be switched to marketing expenditure on
the products which are currently being sold. In particular, as discussed above there
is a need to increase marketing expenditure and production resources on both Lid
and Hinge.
In summary, the Pin is unlikely to make significant profits over its short life cycle;
the Holder is high risk because of the time that will elapse before launch, when
many things can change. The Ratchet is least sensitive to errors in cost and price
predictions; with a predicted 14 per cent market share it is the most likely to be
launched as a Star; the Pin is likely to be a Dog and the Holder is uncertain. The
Ratchet thus appears to be potentially the most viable of the three.
4 The following is an example of how the profile can be constructed, and no doubt
you will have your own views on its final form.

Internal Competitive strength (+) or weakness (−)
area
Research + Three potentially profitable products in last two years
− No new products since then
Develop- + Three products proceeding according to plan
ment
− Doubts regarding potential of Pin
Production − Poor product management
− High labour turnover rate for Box and Lid
− High corporate overheads
Marketing + Balanced portfolio
− Lid and Hinge under competitive pressure
Finance + Positive cash flow
− Doubt as to underlying profitability
What does this tell us about Acme’s competitive position? Acme seems to be
making profits in spite of poor product management, weak human resource
management and spending a great deal on a Question Mark (Pin); there is some
doubt regarding underlying profitability and the value chain has various weaknesses.
Unless Acme changes its management approach it is likely to run into serious

problems soon in that both the Box and Lid will lose competitive position and the
Pin may be launched as a Dog.
The View from Now

The management team discussion relating to the numbers adds significantly to the
interpretation. Over time such discussions change in detail regarding products,
technology, economic conditions and so on, but in strategic terms they do not
change: issues relating to what the numbers mean, market entry, value chain and
monitoring emerge with regularity. But typically the discussions flit from one issue
to another and it is only when managers become familiar with the strategic process
that they become structured.
Case 6.3: Lufthansa Has a Rough Landing (1993)

1 From 1988, in terms of fleet size, Lufthansa embarked on an expansionary
strategy, and in 1992 it was in the process of retrenchment with its intention to
take 26 aircraft out of service; its overall strategy appeared to be dictated by the
business cycle and Lufthansa seemed to be reactive rather than proactive. The
expansion in its capacity between 1987 and 1991 was substantial: 31 per cent
increase in employees, 82 per cent increase in aircraft, and 43 per cent increase in
seat kilometres offered. Unfortunately the expansion on the supply side was not
matched by increase in the volume of sales, which went up by 30 per cent. This
meant that each employee was still selling the same number of seat miles, while the
aircraft were running at 36 per cent empty, compared with 30 per cent empty in
1987.
Macro Environment
Lufthansa continued expanding when the market entered a recession in 1991. It is
always difficult to predict changes in the market accurately and it may have been felt
that a temporary recession should not cause a change in the long-term expansion
strategy.
Product Life Cycle

The demand for air travel grew at over 5 per cent per year until 1991; did the
reduction in 1991 signal entry to the decline stage in the product life cycle? The
demand for air travel is highly GNP elastic therefore it is to be expected that growth
would slow with the onset of the recession in 1990, so it is safe to assume that
growth would resume once the international economy recovered. It might be
concluded that the demand for airline travel was entering the transition to maturity
but this is unlikely: the demand for holiday travel is GNP elastic partly because it is a
luxury good. Lufthansa had been managed consistently with the growth stage of the
product life cycle: capacity had been increased ahead of demand. The problem was
that capacity had been increased at a far greater rate than the increase in demand
and the company was exposed to the temporary reduction in demand due to
economic conditions.

Portfolio Analysis
Lufthansa had a relatively low market share in a growth market so can be classed as
a Question Mark. From that perspective it is not surprising that it did not make high
returns due to the combination of 30 per cent unused capacity, high levels of
advertising and competitive pricing (Table A4.10).
Table A4.10
1987 1988 1989 1990 1991
Market share (%) 2.5 2.5 2.5 2.7 2.9
There seemed little prospect of converting the Question Mark to a Star given that
market share had increased by only 0.4 per cent as a result of the investment. This
may have been why Lufthansa was looking for a partner to develop the US market:
the only way to increase market share significantly was to merge with or acquire
another company.
The five forces profile was as follows.
Competitive force Intensity Reason

Threat of entrants High Airlines are continually expanding their route
structures; many budget airlines have entered
the market.
Threat of High Faster rail links such as the Channel Tunnel
substitutes linking the UK with France comprise a real
substitute for air travel.
Bargaining power High Few airlines have a monopoly of take-off slots
of from a particular airport so there is usually
buyers plenty of choice.
Bargaining power Low While there are few aircraft producers there is
of intense competition among them
suppliers
Rivalry High Many competitors selling a homogeneous
product
The highly competitive profile resulted in low margins for all companies. In fact, the
low entry barriers, homogeneous product and informed travellers are characteristics
of perfect competition which means that it was difficult to make returns greater
than the opportunity cost of capital.
Ratio Analysis
The ratio of pre-tax profit to turnover was as follows.

Table A4.11
1987 1988 1989 1990 1991
1.9% 2.0% 2.0% 1.0% –1.9%
With such low margins Lufthansa was highly sensitive to changes to costs and/or
revenue. The margin dropped to 1 per cent in 1990 and despite the fact that revenue
increased by 11 per cent in 1991 the additional fleet cost led to a loss. But Lufthansa
was not alone in making losses: it performed better than the industry (-0.8 per cent)
in 1990 but much worse than the industry in 1991 (–0.5 per cent). This was proba-
bly caused by its high level of excess capacity and may have been the justification for
removing 26 aircraft from service in 1992.
The low returns on sales are consistent with the competitive analysis that revealed
an industry with perfectly competitive characteristics.
Value Chain
It is easy to conclude that there must be something wrong with the value chain
when a company makes losses. But the combination of the recession and the almost
perfectly competitive market combined to make the industry as a whole a loss
maker. Lufthansa did attempt to strengthen the value chain by purchasing new
aircraft and introduced systems that improved labour productivity. So it is possible
that Lufthansa did have an effective value chain ready to take advantage of the next
upturn in demand.
Reasons for Losses

There were a number of contributory factors.
 Managing the growth stage of the product life cycle and running into a recession.
 Excess capacity.
 Attempting to convert a Question Mark into a Star.
 Highly competitive environment.
Clearly not all of these were within Lufthansa’s control.
Future Prospects
External and internal profiles can be constructed as follows.

Environmental threat and opportunity profile

International − Recession
+ Potential for growth after end of recession
Macroeconomic + Increasing incomes: long-term increase in demand
Microeconomic − Homogeneous product
− Characteristics of perfect competition
Market − Low entry barriers
− Slow growth in product life cycle

Internal
area Competitive strength (+) or weakness (−)
Operations − Relatively small: no scale economies
? Excess capacity: filling only two thirds of
seats
+ Efficient work force
Marketing + Brand name
Finance − Loss making
+ Airline industry in general making losses
There is a conflict between the short-term need to eliminate losses and the long run
need to create competitive advantage. Therefore should Lufthansa continue to
reduce capacity or should it take advantage of its more efficient value chain and wait
out the recession?
Since the future cannot be predicted with accuracy the decision is bound to be a
gamble. Therefore a good case can be made for both. Whichever decision is made
the judgement on whether it was ‘right’ or ‘wrong’ will depend on general market
conditions over which Lufthansa has no control.
The View from Now

After the ‘rough landing’ in 1993 Lufthansa was saved by entering into alliances,
principally the Star Alliance. It was fully privatised by 1997.
History repeats itself and Lufthansa had another rough landing in 2010 during the
economic recession when it lost 380 million euros followed by another loss of 13
million euros in 2011; some of the losses were incurred for restructuring when 20
per cent of administrative jobs were cut. Despite these losses Lufthansa had been
highly successful, growing to be the largest airline in Europe in terms of passengers
and aircraft, when combined with its subsidiaries. In 2015 Lufthansa was experienc-
ing yet another rough landing and was retrenching yet again by closing down its long
haul operations from Düsseldorf.

Lufthansa made significant changes to its value chain in 1993 and continued to do
so in 2010 and 2015. These changes suggest that Lufthansa was having difficulty in
aligning its value chain with market conditions.
The five forces profile in 1993 is reproduced below and it is similar to today with
the same influences at work.
Competitive force Intensity Reason
Airlines are continually expanding their route
Threat of entrants High structures (see * below); many budget airlines
have entered the market.
Faster rail links such as the Channel Tunnel
Threat of
High linking the UK with France comprise a real
substitutes
substitute for air travel.
Few airlines have a monopoly of take-off slots
Bargaining power of
High from a particular airport so there is usually
buyers
plenty of choice.
Bargaining power of While there are few aircraft producers there is
Low
suppliers intense competition among them.
Many competitors selling a homogeneous
Rivalry High
product.
The conclusion drawn in 1993 can equally be applied to today:
The highly competitive profile resulted in low margins for all companies. In fact, the low entry
barriers, homogeneous product and informed travellers are characteristics of perfect competition which
means that it was difficult to make returns greater than the opportunity cost of capital.
*A major threat to Lufthansa and other long established airlines has emerged in the
past decade: the super-connectors who now dominate Europe to Asia routes. These
are the Gulf States airlines Emirates, Qatar Airways and Etihad, recently joined by
Turkish Airlines. Most international airlines depend on travellers to and from their
home countries but these entrants carry passengers who change at their hub
airports. Between 2008 and 2015 these four more than doubled passenger numbers;
Emirates is now the world’s biggest international carrier, flying 200 billion passenger
kilometres per year compared to Lufthansa’s 140 billion. The super-connectors are
now turning their attention to North America and Africa which is an even more
direct challenge to the incumbent airlines. Things are going to get increasingly
difficult for the national carriers, so watch this space.
Case 6.4: General Motors: The Story of an Empire (1998)

1 As the competitive environment changed various actions were undertaken and in
1998 Jack Smith embarked on six major initiatives to tackle GM’s problems;
strategic models can be used to assess how the actions and initiatives are likely to
impact on GM’s operations and the extent to which they will enable GM to recover
its market position. Broadly speaking there was a change in the competitive condi-

tions which had existed up to the 1980s and the discussion will focus on the
differences before and after that time.
Strategists
Before 1980s: A strong management background which was pathbreaking at the time.
After 1980s: There was a principal–agent problem as senior executives competed
with each other hence the characteristics of the CEO may have been related more
to political rather than business ability. The size of GM seemed to have led to
inertia. The interests of shareholders were not pursued so far as the industrial
operation of the company was concerned: the share price had fallen 70% under the
Dow Jones. There is no evidence that the process of choosing a new CEO was
related to the changing demands which had arisen since the 1980s.
Objectives
Before 1980s: No clear objective; it had diversified into parts, electronics and finance.
After 1980s: Return to the core business of producing cars. However, it is difficult to
know if changing objectives were the outcome of executives jockeying for position
or the result of a rational analysis. For example the marketing changes and globalisa-
tion initiatives can be interpreted as personal victories rather than being part of an
overall strategic thrust. After the 1980s it was not clear if GM intended to maintain
the position of Cadillac as a luxury brand.
After the 1980s GM lacked a leader with vision; there did not seem to be a clear idea
of where its competitive advantage lay and how this was changing. None of the
changes had improved this significantly.
Analysis
International Environment
Before 1980s: The international environment had not affected GM significantly.
After 1980s: GM was faced with international competition in the US market, and did
not seem to be aware of whether its competitive advantage was country or company
specific. GM had not capitalised on the potential to think global and act local.
However, for an operation of this size this was going to be difficult, as Ford had
discovered. The notion of global consolidation was designed to result in a more
design responsive company which could compete cost effectively in different
markets.
Industry Environment
The car market had two distinct segments: the market for high-quality, highly
differentiated cars and the mass-produced market where price is a dominant
characteristic.
The first step is to determine the characteristics of the changing competitive
environment and then determine the extent to which GM’s reactions were aligned
with these changes. The five forces analysis provides a starting point.

Market Before 1980s After 1980s Reaction

force
Buyers’ Restricted choice M More makers H Build smaller Cadillacs;
bargaining reduce showrooms
power
Suppliers’ Vertically integrated H Buy rather than make L Sell Delphi; reduce
bargaining platforms
power
Labour ? Labour: strikes H Poor HR management
Threat of new Dominant in US L Globalisation H Global consolidation
entrants market: high entry
barriers
Threat of Brand name L Sport-utilities H None
substitutes
Rivalry Market leader ? Move towards perfect H Restructure and cut cost
competition
Market force Alignment

Buyers’ bargaining power New products not aligned with new demands: sports utility L
opportunity lost, smaller Cadillac not focused on new
market preferences.
Suppliers’ bargaining power Some rationalisation of supply chain, but labour relations poor. M
Threat of new entrants Did not respond directly to Lexus, etc. and was unable to L
erect barriers.
Threat of substitutes Kept to its old model range L
Rivalry Internal focus L
There was no clear systematic response to the changes in market conditions. The
reactions tended to focus on short-term problems and were not consistent with
building competitive advantage.
Perceived Differentiation
There are various dimensions to perceived differentiation and in this case two
aspects of perceived quality were central: reliability and luxury. A separate perceived
price differentiation matrix can be constructed for each.
 Because of the improvement in reliability of competitors GM was shifting across
the perceived differentiation and price matrix towards the failure likely sector.
 By building smaller Cadillacs and standardising components the perception of
the luxury brand was undermined and also shifted towards the failure likely sec-
tor.
The net result was that GM was rapidly losing its advantageous product positioning.

There was no identifiable market response to the problem of product positioning:

GM was not a first mover in new products such as SUVs. None of the actions of
1998 address this issue.
Product Life Cycle
It is possible that the GM range, particularly in the luxury sector, was in the decline
stage.
Product Portfolio
Although GM still had significant market shares the erosion in market share due to
competition and poor product development was shifting at least the luxury bracket
in the direction of a Dog. If the product life cycle for some models was in decline
the strategic future was poor.
Segmentation
The marketing approach for a highly differentiated luxury product differs from that
of a relatively homogeneous low price product.
Before 1980s: Clear distinction between the luxury and mass market cars. The 1984
restructure was based on this difference.
After 1980s: Centralising sales and marketing systems might have resulted in a
misaligned marketing approach for both segments individually. The pursuit of a
modular approach to car construction might have further undermined the perceived
differentiation between the two segments.
Internal Factors
Most of the changes had an internal focus and can be interpreted as attempts to
improve the components of the value chain which were not performing adequately.
Procurement
Vertical integration meant that it was not utilising its buying power nor benefiting
from market discipline on suppliers.
Action: Delphi was sold.
Impact: strengthen.
Technology Development
New approaches were being used by competitors, such as devising common
platforms, and GM’s reliability was not keeping up with the competition.
Action: new smaller type of car plant focused on modular construction; but this
amounted to following competitors rather than leading it by innovative technologi-
cal advances.
Impact: strengthen.
Human Resource Management
Poor record on strikes. There appeared to be no proactive response to labour
problems and the confrontational style continued.
Action: none
Impact: weaken.

Management Systems
The divisional structure and layered management had contributed to GM’s lack of
response to changing conditions.
Action: a combination of centralising functions and relating managers more closely
to their responsibilities.
Impact: strengthen.
In-bound Logistics
Operations: the man days per car suggests that operations were relatively inefficient.
Poor reliability was having a negative impact on brand.
Action: reduce labour force by 25 000.
Impact: weaken.
Out-bound Logistics
Large costly (20 per cent of all costs) showroom presence.
Action: reduce the number of showrooms. However, this cost based measure could
have significant implications for brand awareness and product positioning.
Impact: weaken.
Marketing and Sales, Service
Different sales, service and marketing systems.
Action: centralisation.
Impact: reduce perceived differentiation of car types: weaken.
Overall impact on the value chain: there were weaknesses in the value chain some of
which were addressed by the initiatives but these were primarily directed at reducing
costs and improving management processes rather than generating value for the
customer, i.e. ensuring that the right cars were produced. Some of the initiatives may
have contributed to improving the links through the value chain, for example the
attempt to relate managers more closely to responsibilities; but there is no evidence
that the overall value chain was considered explicitly.
GM had lost competitive advantage and did not demonstrate a clear notion of how
this might be regained. The initiatives were mostly reactive.
Choice
Generic Strategy
The company had undertaken a corporate generic strategy of expansion into
unrelated markets such as financing and electronics. However, there appeared to be
little synergy from either vertical integration or financial services. This was high-
lighted by the values of the component parts of the company; none of the
acquisitions appeared to have imparted value to the core business of making cars.
The expansion trajectory was not based on existing resources or routines and
resulted in unrelated diversification.
Action: the corporate strategy of retrenchment to core activities.

GM had to some extent changed its business strategy from high price differentiation
to low cost.
Action: adopt global production to achieve economies of scale. Despite its size it
was in danger of becoming stuck in the middle.
Implementation
The divisional structure had become very costly because of duplication. Vertical
integration was generating no benefits. Layered management was leading to stagna-
tion.
Action: centralisation
Resource Allocation
Costs were relatively high.
Action: build smaller plants; reduce number of showrooms.
The financial background of many existing managers suggests that the company lay
towards the ‘tight financial’ sector of the planning and control matrix; this was
consistent with the lack of response to market changes and the focus of the 1998
initiatives on cost reduction.
Action: none.
The high costs were clearly seen as a major priority and attempts were made to
address this.
Feedback
The bureaucratic structure was still a drawback. The behaviour of senior executives
suggests that the organisation was not geared to learning but was introspective and
dominated by political manoeuvring.
Action: none.
Overall Response
After the 1980s the strategic process was weak in most respects and the actions and
initiatives strengthened internal operations in several ways but may have weakened
competitive advantage; whether the process was now sufficiently robust to enable
GM to recover its competitive advantage in the long term was open to question.
An indication of GM’s future prospects can be obtained by summarising the main
conclusions from the analysis of the elements of the strategic process.
Strategic process Main issue Future
Strategists In conflict Weakness
Objectives Outcome of rivalries Weakness
Macro environment Global consolidation Strength
Industry environment Lost perceived differentiation Weakness

Strategic process Main issue Future

Internal factors Value chain initiatives Strength
Generic strategy Stuck in the middle Weakness
Resources and structure Centralisation Uncertain
Resource allocation Reduce costs Uncertain
Evaluation and control Finance bias Weakness
Feedback Weakness
The analysis suggests that the GM strategic process was dominated by weaknesses
and uncertainties. Unless action was taken to remedy the weaknesses the prospects
for GM were bleak: it would continue to react to unfavourable events and tinker at
the margin with its structure and systems. Of course, the conclusions could be
wrong and you might have taken a different view of the case; but you are now in a
position to see what has happened to GM since 1998 and make your own judge-
ment.
Case 6.5: Driving Straight (2011)

1
Culture
Mr Marchionne changed the management culture within a short time by getting rid
of the existing management structure immediately, firing many existing managers
and giving precedence to young, design-minded executives. He changed a power
culture into a task culture.
Finance
In order to deal with the financial problems, Mr Marchionne had to convince the
market that he had a chance of success ( i.e. he had to change market expectations).
Once he had the confidence of investors, he was able to float a rights issue.
Value Chain
The Porter version can be used to illustrate Mr Marchionne’s impact.
Activity Before After
Primary
In-bound logistics
Operations Slow to market Speed up development
Out-bound logistics
Marketing and sales Out of date models Improve brand image
Secondary
Procurement Too many different Rationalise platforms
components
Technology develop- Too financially weak to Simulations and Multiair
ment exploit
Human resource Hierarchical Flat management, new

Activity Before After

management blood
Management systems Inflexible Committed to success
Mr Marchionne restructured the value chain. Many of his actions can be interpreted
as specifically directed at the weak links, for example linking innovative design with
existing platforms.
Core Competence
The previous regime appeared to have lost sight of the fact that Fiat Group was
primarily a car maker. Mr Marchionne refocused back to what he saw as the core
competence of making cars with a specific competence in design.
Research and development
Mr Marchionne improved the innovation process for new models.
Innovation step Before After
Invention No direction Focus on style
Prototype Build and test Simulations
Patent Licence out ideas Keep ideas in house
Development Total 26 months Total 18 months
Launch No great impact Much excitement
Market exploitation Models out of phase with Fast to market
market
Overall
Mr Marchionne was faced with a dysfunctional organisation and he saw that the
only way to get to the market the products that customers would buy was to fix the
internal weaknesses. This was a precondition for success.
Module 7
Review Questions
Case 7.1: Revisit Salmon Farming

1
Salmon Farming SWOT Analysis

You will have your own opinion on how to classify the factors confronting individ-
ual farmers, and the match between strengths and opportunities, weaknesses and
threats. Table A4.12 is a SWOT example.

Table A4.12
Scotland as a brand name Diversification
Segmentation
Storage investment
Income elasticity
Tariff protection
Regulation
Weaknesses Threats
Poor substitute for wild salmon Low entry barriers
Loss making Efficient foreign producers
No economies of scale Potential environmental issues
Price volatility (‘dumping’)
Long-term declining price
There is some degree of alignment between the Scotland brand name and the
potential for diversification and segmentation. But there is a strong alignment
between the weaknesses and threats.
Generic Strategy Options
In the face of oversupply, the generic option is clearly one of retrenchment or
stability. Expansion is out of the question at the moment, and there is little scope
for increased investment in the industry. It is within the context of the general
need to stabilise or retrench that specific options can be identified.
Reduce Production Costs
The evidence in the article suggests that there are few economies of scale; the
economies of scale which Marine Harvest has been able to achieve appear to be
insignificant in relation to the impact of competitive pressures.
Producers currently claim that the ‘dumping’ price is 20 per cent below produc-
tion costs. It is unlikely that scale economies, or attempts at more efficient
operation, could eliminate this gap. Technological advances will give at best a
temporary cost advantage because of the ease of imitation.
Invest in Freezing Facilities
As far as the individual producer is concerned, investment in storage facilities
would enable advantage to be taken of periods of high prices, if these do occur.
At an industry level it could help to reduce the volatility of prices. But the en-
demic problems of overcapacity and low profits would still remain. Given the
difficulties faced by farmers at the moment, it is unlikely that they will contem-
plate additional investment in their farms.

Market Development
There is virtually no scope for differentiating the product; indeed, the price
reduction has probably eroded the notion of salmon being a luxury good and
may have undermined further its position as a substitute for wild salmon.
There may be possibilities for identifying market niches, and segmenting the
market to further exploit markets for salmon in different forms, such as smoked
and tinned salmon. These will require a fairly substantial marketing effort, and
are unlikely to generate market increases of the dimensions required to overcome
the problems of excess supply.
Given the ease of entry and existence of excess capacity, any market advantages
are likely to be competed away quickly.
Diversification
The only real possibility appears to be the tourist related development men-
tioned in the article. However, a fish centre is unlikely to create more than about
30 jobs, which is insignificant compared to the 6300 employed in the industry as
a whole.
Lobby for Protection
The reaction of industry representatives has been to lobby the government to
introduce tariff barriers as was done in the US to eliminate what they see as un-
fair competition. But the ease of entry means that profits are likely to remain
low. The erection of entry barriers by government, in the form of regulating the
number of farms in the industry, may be necessary.
Strategic Choice
A feasible strategic option for farmers wishing to stay in the industry is to cam-
paign for an import tariff and barriers to entry in the form of regulating the
number of fish farms. This may be a case where there is a legitimate argument
for government intervention because of market volatility. But given the move-
ment towards free trade, and the increased government desire worldwide to
pursue non-interventionist policies, there seems little chance of long-term suc-
cess in this respect.
The View from Now

The analysis carried out in 1992 demonstrated the difficulty of making profit in an
industry tending towards perfect competition. The SWOT analysis predicted a
difficult future for small producers and as a result the past two decades have seen
increased concentration in the industry, for example there were 48 producers in
2004 and 27 by 2014. Total production has increased from about 50000 tonnes in
1992 to 160000 tonnes in 2014. The number of direct employees has remained static
since 2004 at about 1000. As expected, with increased concentration the industry
now has oligopolistic characteristics, with the biggest company – The Scottish
Salmon Company (Norwegian owned) – having 20 per cent market share. About 80
per cent of total output is owned by foreign firms – two thirds of output is con-

trolled by Norway. As predicted in 1992 there is little scope for the small independ-
ent producer.
The problem of ‘dumping’ still remains. Anti-dumping regulations were introduced
by the European Union in 2006; this took the form of a minimum import price. In
2007 the WTO ruled that the MIP was not consistent with its rules. The MIP was
abolished in 2008. So fifteen years after the 1992 analysis the definition of dumping
was still a source of argument and has yet to be resolved.
Case 7.2: Revisit Lymeswold Cheese

1 There are no guarantees of success, even if the obvious blunders made by Dairy
Crest were avoided. Lymeswold was confronting established market leaders who
had been there for decades in a sector where consumers were becoming increasingly
knowledgeable. Their product had been refined and improved over many years, and
had a proven track record. To break into such a market may have been an impossi-
ble task from the start.
Possible success strategies can be analysed at the business level in terms of cost
leadership, product differentiation and focus. To achieve cost leadership, the
enterprise would have to be large enough to generate economies of scale. The
differentiation approach depends on whether a segment of the market could be
identified at which Lymeswold could be targeted and which would generate long-
term sales. This would be based on properly differentiating the product, but if
consumers regarded French and German cheese as the ‘real thing’ then Lymeswold
had no real future. The focus approach would involve Dairy Crest in making sure
that Lymeswold was run as an identifiable company within Dairy Crest with its own
strategy.
At the corporate level it might be possible to consider vertical integration,
expanding into a related market, and adopting a prospector rather than defender
stance. But these possibilities can only be speculative given the information availa-
ble.
A contributing factor was the weakness in implementation, and it is possible that a
proper system of incentives for Lymeswold employees might have improved their
performance, and caused managers to focus more on the implications of their
behaviour, their approach to the market, and their investments. In order to achieve
this managerial perceptions in the company would probably have to be changed.
The View from Now

The process model analysis carried out in 1991 revealed weaknesses in every part of
the strategic process and it was a classic case of how not to launch a new product
into an existing mature market. The strategic lessons of Lymeswold are as relevant
today as they were at the time. There are some speciality British cheeses on the
market, such as Stichelton, Stinking Bishop and Cornish Yarg but they have a
minute share of the market. These small producers have succeeded by not attempt-
ing to take the incumbents head on. The main brands such as Stilton, Brie and
Camembert are so powerful that small producers have to find a niche within which

to operate. In fact, these small brands have met the criteria for segmentation set out
in 5.4.
Case 7.3: Revisit A Prestigious Price War

1 Up to June 1995 Murdoch had acted as a prospector and Black as a reactor. If Black
is going to regain the Daily Telegraph’s competitive advantage he will have to adopt a
proactive stance.
The situation facing the Daily Telegraph can be summarised as follows:
High market share Telegraph already has some tabloid characteristics
Economies of scale Growing market
Weaknesses Threats
Limited financial Price war: further price reduction by Times
resources Times continues to differentiate
Recent price reduction Tabloids attack market where they overlap
The alignment of strengths and opportunities suggests that the Daily Telegraph could
attempt to capitalise on its market dominance and economies of scale and aim for
expansion in both quality and tabloid markets through cost leadership. Possibly it
could make up for the loss of its relative market share in the quality sector by
increasing sales in the tabloid sector. But the alignment of weaknesses and threats
show that there are significant risks in both quality and tabloid markets, and that
retrenchment and the avoidance of market confrontation might be more advisable.
The prospects for the Daily Telegraph depend on how its long-term competitive
advantage develops. If prices have adjusted to a lower equilibrium level the Daily
Telegraph may be able to achieve cost leadership if it maintains its relatively high
market share; but there is plenty of evidence that the competition will not ease up,
and because of its financial situation it is unlikely that the Daily Telegraph will be able
to continue the price war indefinitely. It could be that the optimum strategy is to
accept that the price war has been lost, retrench and concentrate on containing
costs.
The View from Now

The conclusion drawn in the case was that the reduction in share prices was in line
with expectations rather than being a ‘ludicrous over-reaction’. Conrad Black was
dismissed in 2004 for financial wrongdoing and sued by the company. You can draw
your own conclusions from that.
In 2006 the Telegraph was re-launched with a tabloid sports section. So the conclu-
sion from the SWOT analysis was borne out: the Telegraph continued to operate in
both the quality and tabloid markets.
Newspapers share with cigarettes the prospect of a declining market, although for
different reasons. Newspapers are faced with competition from internet news

services and sales of the Times have fallen by about 50 per cent between 1994 and
now. The Telegraph has seen a similar reduction, and even the venerable Financial
Times, which did not join the price war, has seen a reduction of about one third. In
the early 1990s the quality newspapers visualised competitive threats from each
other but now the multi-media news platforms are a much greater threat. That
means the five forces profile has changed in much the same way as for cigarettes,
i.e. the threat of substitutes has increased along with the bargaining power of buyers.
Now that newspapers are available on a tablet app it is doubtful if printed newspa-
pers have any future so newspapers will have to figure out how to compete in the
digital world. The Telegraph has been working on that for years and in 2014 appoint-
ed a Head of Interactive Journalism.
Case 7.4: Revisit General Motors: The Story of an Empire

1 The first step is to structure the many strands of the analysis in a SWOT framework.
The precise structure of the analysis is a matter of judgement.
Brand names New product markets
Global reach
Economies of scale after restructuring
Weaknesses Threats
High costs New entrants
Principal–agent problems
Diversified structure
Declining product positioning
Labour relations
Reliability
There is an alignment between GM’s strengths and the opportunities in new

product markets. But the alignment between its weaknesses and the threat of new
entrants into these markets makes it doubtful if GM can capitalise on the potential.
The short-term generic corporate strategy needs to continue to focus on providing a
framework within which the organisational problems can be resolved. The company
needs to identify and retrench to its core activities so that it can focus on the
business of making and selling cars. At the business level it needs to consider where
each range of cars falls in the BCG portfolio and decide what action would result in
a balanced portfolio for the future.
The long-term generic corporate strategy should be to capitalise on lower costs and
expand back in the markets where it has lost position, such as Cadillac, and enter the
new segments of the market such as sports utility vehicles. The new organisational
structure needs to provide the ability to innovate and be flexible enough to react as
quickly as competitors to changing market demands. It may well be that the net
impact of short-term retrenchment and long-term expansion will result in GM being

smaller than it is now. It is impossible to say what the optimum size should be for a
global car company but unless it manages to reallocate resources in such a way that
it becomes market rather than cost focused it will not have a profitable future.
The View from Now

The rather gloomy prophecy for GM in 1998 was that it was unlikely that GM
would be able to capitalise on its strengths. This was borne out by events and in
2008 both GM and Chrysler went into Chapter 11 bankruptcy and had to be
rescued by the government; the situation was made worse by the recession but
bankruptcy was not inevitable because Ford, under Alan Mulcally, managed to avoid
this fate. It has been estimated that the cost to the taxpayer of bailing out GM was
$12 billion. This can be compared to the $40 billion cost to UK taxpayers of bailing
out the Royal Bank of Scotland.
GM’s market share has continued to decline in the US, from about 35 per cent in
the late 1990s to 18 per cent in 2014. GM has not been able to cope with the
changing competitive environment over the years, particularly the threat of new
entrants in the form of foreign competitors such as Toyota which now has about 15
per cent market share. It would appear that the weaknesses identified in the GM
strategic process have not been overcome to this day.
Case 7.5: The Rise and Fall of Amstrad (1993)

1
Corporate Generic Strategy

Amstrad adopted a generic strategy of expansion from the outset. This was
achieved by diversifying the product portfolio into related products by selecting
products for which the technology already existed and which could be produced and
sold in large volumes. Amstrad exploited core competencies in consumer electron-
ics. When the market turned down in the late 1980s, and competition became
severe, Amstrad was forced to stabilise.
Amstrad has always chosen a policy of internal expansion, and after the difficulties
of the early 1990s opted to go back to being a private company rather than seeking
an external partner. The market opportunities pursued have always been related, in
the sense that they have all been in the electronics sector and the objective has been
to sell new ideas to the individual and domestic sector rather than to the corporate
market. The company has not been vertically integrated; it has concentrated on
assembling components and has not invested a substantial budget in R&D. It has
also adopted an active posture in the past, and has tended to act in a pre-emptive
fashion rather than waiting until events forced it to take action.
The selection of new products can be located in the familiarity matrix, and it
seems reasonable to conclude on the evidence that Amstrad did not stray beyond
new familiar market factors, and new familiar technologies. It appears that
Amstrad attempted to remain in the ‘high’ area of the matrix, and did not attempt to

move into new unfamiliar markets and technologies where the risks would be largely
unknown.
Business Level Generic Strategies

The generic strategy was overall cost leadership, which involved getting first to the
market with a high volume product and significantly undercutting competitors.
There was no attempt to focus on specific market niches and avoid confrontation.
Amstrad saw significant market opportunities which could have been exploited by
any existing computer manufacturer.
Sugar was clearly a prospector, and the combination of being a prospector and cost
leader led to a heavy emphasis on new product-market growth and an aggressive
pursuit of new products and markets. What happens to a prospector when
opportunities dry up and markets turn down? There is no evidence that Sugar has
turned into a defender, who stops looking for new products and adopts a strategy
of maintaining cost advantages. Amstrad still had new products on the market and
was apparently waiting for the end of the recession in the early 1990s.
The organisational culture was greatly dependent on Mr Sugar, and until 1990 the
organisation fitted the power culture model quite closely, with Mr Sugar acting in
the role of entrepreneurial leader in a fast growing innovative company. However,
when the company’s innovative lead was threatened Mr Sugar’s cultural style ceased
to be so effective.
Effectiveness of Strategy Options

The assessment of how effective a strategy approach has been depends to a large
extent on when the observation was made. For example, up to 1985 Amstrad’s
approach had been successful in that profits had grown to about £20 million, but
they would hardly have been classified as exceptional. By 1987, when profits were
over £150 million, the Amstrad approach would have been hailed as an outstanding
example of the aggressive, innovative, prospector approach. But by 1992 doubts
would have been expressed as to whether this approach really provides the founda-
tion for sound, long-term success.
Marketing Strategy
Amstrad’s strategy can be located on the perceived price differentiation matrix:
the combination of a differentiated product and a low price locates the products
towards the top left sector of the matrix, which is the area in which success looks
likely. But in the personal computer case Amstrad did not exit quickly enough when
its differentiation was eroded. It looks like not enough attention was paid to the
product life cycle in personal computers and Amstrad did not react quickly enough
to technological obsolescence.
Competitive Advantage
One of the intriguing aspects of Amstrad’s strategy is that there were few barriers
to entry in the markets which were tackled: after all, if Amstrad could exploit these
markets so could other companies. How did Amstrad make profits in these highly

competitive markets? The apparent answer was to be first in, mount a large advertis-
ing campaign, set prices low enough to deter competitors for as long as possible,
and then move on to another market when competitive pressures caused further
reductions in price. So Amstrad did not attempt to generate a sustainable compet-
itive advantage in any of its markets, but tried to capitalise on its first mover
advantage.
One of the main characteristics of Amstrad was a highly effective value chain, but
it is instructive to note how quickly the advantage conferred by the value chain can
be undermined by market changes.
The View from Now

Amstrad now only produces set top boxes for Sky, which it in fact did from the
time it was established. The 1993 analysis demonstrated that a strategic choice can
be rendered obsolete by fast changing technological and market factors.
While the name Amstrad has continued the original company was wound up in
1997 and one of its shareholder companies was renamed Amstrad. The lessons of
1993 for the consumer electronics business are as relevant today with the continued
march of technological progress. Some notable technology failures were the
operating system Windows Vista, the LaserDisc, The Apple Newton and the Sony
eVilla. If you have not heard of these products there is a very good reason: they
were utter disasters
Case 7.6: What Is a Jaguar Worth? (1992)

1
Recognising Unrealised Value

DEVELOPMENT EXPENDITURE HAS BEEN INEFFICIENTLY
SPENT
A new model was on the drawing board, but was quickly cancelled after the
takeover. It was generally felt that the J-type project was not going to deliver the
type of car required in the late 1990s, being relatively heavy and underpowered;
this was a severe indictment of the market vision of the development team.
There was some scope for improving current models, and this was done by face-
lifting both the XJS and XJ6 models; however, this probably had little real im-
pact on sales and was certainly not a foundation for future success.
MARKETING STRATEGY HAS NOT PURSUED OPPORTUNITIES
It was generally recognised that Sir John Egan had done a brilliant marketing job
in increasing Jaguar’s image and sales during the 1980s. Given the increasing
competition from the Japanese in this sector, it was not clear that major increas-
es in demand could be generated by changes in marketing strategy.

RESOURCE MANAGEMENT HAS BEEN POOR

There is no doubt that Jaguar costs were higher than they need to have been, and
that not enough attention had been paid to quality control. By the end of 1991
the workforce had been cut by 30 per cent. Despite the publicity surrounding the
reactions of the Ford executives to the Jaguar factory it seems unlikely that Ford
was unaware of the potential for improving productivity and reducing unit costs.
EXPECTED INCREASE IN DEMAND
The takeover took place when the UK was in the middle of a boom and expecta-
tions were high. While this factor may have contributed to the decision in the
short run, by the end of 1991 the international economy was faltering, and the
Japanese had made a significant impact on the market.
WEAK PRODUCTS
The F-type project was discontinued, but apart from this Jaguar had a limited
product range. The company was now wholly reliant on a resurgence in demand
for the traditional type of Jaguar car. The problem was that the Jaguar portfolio
overall was weak, not just one or two products. The entry of competitors such as
the Lexus was likely to have a major impact on the positioning of Jaguar in the
perceived price differentiation matrix.
Buying Market Share

The purchase of Jaguar enabled Ford to enter the luxury car market without
incurring the cost of developing a new car and launching it against the established
competitors. The interpretation of the high price paid as a pre-emptive bid to
achieve this raises the issue of whether Ford would have been better off to develop
a new car rather than purchase an inefficient producer.
Reducing Competitive Pressures

At the time of purchase Ford was not in the luxury car market therefore this reason
does not apply.
Synergy
Given the outdated production methods it is difficult to see where synergy might
arise. The integration of Jaguar into the Ford value chain was going to be difficult.
Balancing the portfolio

Jaguar had several Question Mark characteristics: reduced market share in a growth
market, particularly in the US where the new entrant Lexus had made a successful
entry, possibly at the expense of Jaguar. Jaguar may have been perceived as a star.
Core Competencies
Perhaps a Jaguar core competence was the ability to maintain the brand image and
reputation in spite of being overtaken technologically by other makers. But there
was no apparent core competence on the production side.

Justifying the Acquisition

The acquisition of Jaguar does not appear attractive on any of the criteria. At the
time of the takeover the price paid was so high in relation to Jaguar’s records and
immediate prospects that it is possible that the potential value creation was bid away
in the offer. What are the chances that Ford would ever make a reasonable rate of
return on its investment? For example, to make a 10 per cent rate of return the
Jaguar losses will have to be converted to a profit of at least £160 million per year.
To achieve this would require significant unit cost reductions, higher sales volumes
and a successful counter to the increasing Japanese competition. Perhaps the main
motivation was managerial perception: it was considered essential that Ford entered
the luxury sector and here was a ready-made opportunity.
The View from Now

One of the major mistakes made in acquisitions is to overvalue the target. This can
be due to the excitement of a bidding war, over-optimism on the part of manage-
ment, lack of adequate due diligence or simply no understanding of how to estimate
value. The history of acquisitions continues to be marked by major failures and the
analysis of this case can help you to understand why. You will wonder why nobody
appears to learn from the mistakes of the past. This is a general issue which comes
into the domain of behavioural finance; you could read Daniel Kahneman Thinking
Fast and Slow and Richard Thaler Misbehaving: The Making of Behavioural Economics for
insights into the irrationality of decision makers.
Case 7.7: Good Morning Television Has a Bad Day (1993)

1 When a company achieves monopoly power it makes profits in excess of the
opportunity cost of capital, i.e. normal profit, and therefore there is some price
which the potential monopolist is willing to pay in order to be awarded monopoly
power. At the auction stage competition hinged on how much monopoly profit
bidders reckoned they would be able to earn. Individual companies varied widely in
their estimates of how high this would be.
The bids were greatly influenced by the number of bidders (see Scottish) – if it was
known that there was at least one other bidder then the participants were faced with
a blind auction. Clearly there would be no point to bidding away the entire expected
monopoly profit, so the question was how high to go – the outcome for any
individual bidder was completely unpredictable given that undefined quality was
being taken into account. So the auction itself was designed to extract at least some
of the monopoly profits from suppliers. The five forces model set out below shows
the situation when the bidding took place compared to some time later.
Bargaining Power of Buyers: Before LOW, After HIGH
The bids were made in the expectation that there would be a captive audience
due to the fact that there was only one breakfast channel.

Bargaining Power of Suppliers: Before LOW, After LOW

While there was a limited supply of presenters and programme makers, the Big
Breakfast departed from the previous model.
Threat of New Entrants: Before LOW, After HIGH
This is a question of perception: the bidders clearly did not see the threats facing
them. Because of changing technology, for example in the form of satellites,
there were no real barriers to entry. The fact of winning the bid did not guaran-
tee a monopoly.
Threat of Substitutes: Before LOW, After HIGH
The remedy to problems in the past had been to tinker with the established for-
mat. It had not occurred to the bidders that the viewing public might want
something completely different.
Intensity of Rivalry: Before LOW After HIGH
Not only did GMTV not recognise the potential for competition, they were
unable to mount a positive response and reverted to the previously proven tech-
niques of Mr Greg Dyke. GMTV was confronted by an oligopoly and if the
audience size remained much the same was playing in a zero sum game. In this
situation it was highly likely that monopoly profits would be quickly bidded
away.
The threats identified by the five forces analysis did not appear to be perceived by
many of the bidders. If the bidders had had even an inkling of what might happen
then was a major role for scenario and sensitivity analysis to determine break-even
points for different assumptions and bids, but such elementary analyses appeared to
have been ignored by GMTV.
From the relatively small surplus bid which GMTV submitted, it would appear that
in the case of breakfast TV there was at least one other company which had the
same estimate of monopoly profit. However, the incumbent (TV-am) put in a much
lower bid – £20 million per year – despite the fact that it would have no start-up
costs and had already developed a product which could win market share. This was
an ominous sign.
After the bid had been won, the new supplier had no guarantee that in the year
before handing over the franchise the incumbent would have any incentive to
maintain the market share.
2 Applying the elements of the process model helps identify the main errors.
Strategists and Objectives
GMTV intended to acquire a monopoly. The fact that they continued with much
the same format suggests that they had no vision of altering the product or cap-
turing new markets. This mentality was later shown to be inappropriate to deal
with changing market conditions.


GMTV was faced with an oligopoly instead of its predicted monopoly. But it did
not appear to recognise this, and appears to have carried out little analysis and
diagnosis of its competitive position.
GMTV altered the product (presenters) but did not appear to have done any
market research.
Strategic Choice
GMTV did not have a generic strategic thrust of its own, but was content to
more or less follow the pattern developed by TV-am.
Implementation
GMTV did not appear to have any contingency plans.
Little attempt appears to have been made to control costs.
Feedback
Although GMTV was faced with a reduced market share and high fixed costs
(due to its very high franchise bid) it did not react quickly.
When GMTV did react, it reverted to the original product (presenters); there was
some attempt to differentiate by screening Super Nintendo, but this had little im-
pact in comparison to the type of differentiation and targeting which The Big
Breakfast had pioneered.
3
Table A4.13
Strengths Weaknesses
Brand name Costs
Product life cycle
Opportunities Threats
New products Low entry barriers
Technology
From the alignment between strengths and opportunities it appears that the
appropriate generic strategy is differentiation rather than low cost. Greg Dyke was
an acknowledged prospector who had proved in the past that he could successfully
differentiate a TV programme. But differentiation needs to be accompanied by cost
controls because of the low entry barriers.
The View from Now

The life cycle dealt The Big Breakfast a deadly blow: consumer preferences changed
and the last show aired in 2002.
The successor to GMTV, Daybreak, was launched in 2010 but it was not successful
and was replaced by Good Morning Britain in 2014; this version featured some well-

known breakfast TV personalities (poached from its rival BBC) but failed to
overtake BBC Breakfast and has consistently had about half as many viewers.
What lessons can be carried over from the early 1990s? The market has changed in
that there is a duopoly with significant entry barriers. Why do viewers prefer BBC
Breakfast to Good Morning Britain? The answer would appear to lie in the type of
differentiation each pursues. BBC Breakfast has had a largely unchanged format for
at least a decade and understands its target audience. On the other hand Good
Morning Britain, and its predecessor Daybreak, have frequently changed the format
and attempted to draw in viewers with personalities, just as The Big Breakfast did
years ago. The fact that the programme has not been a spectacular success after
years of trying could be due to the mindset of its executives; they have not been
innovative but have tried variations of the same old formula.
Case 7.8: The Rise and Fall of Brands (1996)

1 The general principle is that the value of a share depends on the expectation of
future returns. To some extent these future returns are dependent on the brand
image; therefore any change in the perception of the brand image will affect the
share price. If this were not the case then the brand image would be worthless.
There are a number of ways in which a brand helps sustain competitive advantage.
It serves as a signal of quality, contributes to consumers’ perceived value and can
have spillover effects on other products in the company’s portfolio. A strong brand
can generate a degree of monopoly power because it is a form of entry barrier. If
any of these general characteristics are undermined then the expected cash flow
attributable to all brands are likely to be adversely affected.
Rather than proving that the market is illogical, it could be argued that the reverse is
true, i.e. that the market is highly efficient and reacts swiftly when information
emerges which could affect future cash flows. The short-term impact on share
prices can be exaggerated because of the way financial markets operate: there will
always be a degree of over and under shooting before an equilibrium is established.
2 Market situations are typically complex, and models drawn from the core disciplines
can provide perspectives on different aspects. Porter’s five forces can be used to
identify the main forces at work, and the models can be used to explore their
implications.
Threat of Substitutes: Increasing

This is probably the main threat facing brands, and leads to a loss of differentiation.
 Perceived price quality differentiation model. Successful brands can be positioned in the
high perceived quality and medium-high perceived price area of the matrix. The
appearance of low price own brand substitutes could cause an increase in the
perceived price and a reduction in perceived quality, causing uncertainty regard-
ing long-term success.
 Product life cycle model. It is possible that some brands had passed through the
maturity stage into decline and the emergence of substitutes was inevitable. It is

important to disentangle the product life cycle effect from the reduction in brand
appeal due to other reasons.
Threat of New Entrants: Increasing

Entry barriers were being progressively reduced primarily because of the impact of
new technologies.
Suppliers’ Bargaining Power: Decreasing

As the range of products increased the market power of individual suppliers would
fall.
Buyers’ Bargaining Power: Increasing

The more choice on the market, and the more information available to consumers,
the greater is the opportunity for buyers to switch among products and this leads to
a reduction in brand loyalty. The power of retailers as buyers emerged as competi-
tion for shelf space became more intense.
Industry Rivalry: Increasing

The threat of new entrants, emergence of substitutes and increased bargaining
power of buyers discussed above combined to affect competitive forces.
 Market models: competition and monopoly. The reduction in differentiation, lowering
of entry barriers and increased consumer power can be interpreted as a shift in
the direction of perfect competition, with the result that monopoly profits were
largely bid away
 Demand and supply model. The entry of new brands can be characterised as a shift
to the right of the supply curve. With a given demand this would result in a fall
in price. Because of the recession in the early 1990s the demand curve was mov-
ing to the left, causing an additional downward influence on price.
The combined effect of these influences meant that competitive pressure in the
markets for branded consumer goods had increased greatly, and the incumbents
were confronted with a new situation where the profits associated with even a
strong brand could not be relied upon.
3
Objectives
 Procter & Gamble started with the objective of maintaining market share in
existing brands.
 Pepsi intended to maintain the brand image.
 Unilever set out to integrate marketing with other functions.
Analysis
 Procter and Gamble’s analysis focused on identifying which of its 2300 brand
varieties were worthwhile. The company had been complacent in the past, and

had not seen the need to rationalise its portfolio until market pressures forced it
to come to a better understanding of which products generated profits.
 Unilever’s analysis concentrated on internal systems and meeting customer needs
rather than on changes in the market place.
Strategy Choice
 Procter & Gamble retrenched its product range, and adopted low cost leadership
in the remainder.
 Pepsi adopted a reactive defender stance, and reinforced its differentiation.
 Unilever concentrated on stability, rationalised its marketing function and
focused on specific markets.
Implementation
 Unilever was the only case where there was a significant internal reallocation of
resources among functions. Unilever had taken a hard look at its value chain, and
had come to the conclusion that the separation of marketing as a primary opera-
tion was not working: marketing was being redefined as a support operation and
integrated to some extent with development. In the other two cases the focus
was on rationalisation of product lines and increased differentiation to meet the
challenge.
 There were significant differences among the three companies in their strategic
reaction to the brand problem. It is not, of course, possible to predict which
approach will be most successful but the construction of a well thought out and
robust strategic process is a sound foundation.
The View from Now

How wrong can you be? Far from the value of brands falling because of the reasons
identified in 1996 the value of brands has accelerated. But the value of brands is not
stable; for example, compare the top five valued brands in 2001 with 2014 from The
Interbrand/Business Week Rankings.
Brand rank 2009 Brand name Brand value ($billion)
1 Coca-Cola 69
2 IBM 60
3 Microsoft 57
4 GE 48
5 Nokia 45
Brand rank 2014 Brand name Brand value ($billion)
1 Apple 145
2 Microsoft 69

3 Google 66
4 Coca-Cola 56
5 IBM 50
The notable changes in the rankings are the emergence of Google and Apple (which
was 20th in 2009). The value of these brands emerged on the basis of the success of
products such as the Google search engine and the iPhone and iPad; subsequently
the brands have been carefully managed but the creation of the brand in the first
place appears to be the outcome of serendipity.
Case 7.9: The Veteran Returns (2007)

1 In order to conduct a SWOT it is necessary to work through the analysis.
Strategist
Mr Isdell had wide experience of Coca-Cola internationally but he had never been a
CEO and had no experience in other industries. This could have restricted his
vision to what Coca-Cola had been rather than what it might become.
Objectives
Mr Isdell did not change the definition of the business but focused on reinforcing
the Coca-Cola brand as it was.
Who decides to do what?
The Board had decided to make a trade-off between Coca-Cola experience and
CEO experience. The result appears to have been that Mr Isdell focused on internal
rather than external issues.
Macro-environment
A partial PEST analysis can be carried out.
 Economic: the growth potential lay in developing countries.
 Social: the main social change was the obesity issue. Mr Isdell decided to add
other drinks to the portfolio rather than address the perception of Coca-Cola
itself in terms of health.
 Technological: there seemed to be little change, with bottling contracts dating
back for many years.
There was no macro-factor that required insights from a veteran.
Industry environment
It is doubtful whether Mr Isdell needed to travel all over the world to identify the
problems. All he had to do was address the following issues.
Price differentiation
The fact that Coca-Cola had been losing global market share for several years
suggested that it was shifting down the matrix towards ‘failure likely’. The criteria
for spending an additional $400 million were not clear and it may not have been
sufficient to arrest the shifting perception.

Portfolio
The core Coca-Cola product is a ‘cash cow’ in a static (lost their vigour) or long-
term declining market in developed countries because of changing tastes (obesity)
and substitutes. There was a clear need to introduce ‘stars’ which were growing
seven times faster. But Mr Isdell had not been particularly aggressive in adding to
the portfolio by losing out in bidding competitions.
Five forces
Threat Rationale
Threat of new entrants Low Established brand
Threat of substitutes High Changing tastes
Bargaining power of buyers High Plenty of options and falling global share
Bargaining power of suppliers High Dependence on bottlers
Rivalry High Large competitors such as Pepsi
Coca-Cola has always operated in a highly competitive market and the force of
substitutes has increased significantly lately.
Internal factors
Mr Isdell appeared to focus on the bottling aspect of the value chain.
Primary activities
 Operations: dealt with relationships with bottlers rather than their efficiency.
 Marketing and sales: increased the marketing budget.
Support activities
 Human resource management: did not attempt to improve productivity or trim
the labour force.
 Management systems: senior management appeared to be ignorant of the
situation and he initiated a ‘cathartic’ process. He focused on relationships with
bottlers rather than efficiency.
 Technology development: as a bottler, he made no changes.
From this viewpoint, Mr Isdell actually did very little to change the internal opera-
tions of Coca-Cola.
Competitive position
It is not clear that Mr Isdell did enough to significantly affect Coca-Cola’s competi-
tive advantage. The fact that sales increased by 17 per cent and profits increased by
only 14 per cent suggests that costs increased by more than revenues.
Mr Isdell did not bring any insight from being a veteran. In fact, as a senior execu-
tive he had contributed to the problems originally.
Brand name Health drinks
Market share Sports drinks
Developing economies

Weaknesses Threats
Complex value chain Adverse five forces profile
Losing differentiation Obesity
Cash cow in declining market
Mr Isdell did not appear to consider alignment in the SWOT; he made choices
based on what he knew about.
Generic strategy choice
At the corporate level Mr Isdell chose growth, but his rationale was unclear. If the
company was over-extended retrenchment in some markets might have been
preferable. He did achieve growth quite quickly but decided against diversification.
At the business level he pursued differentiation by increasing the marketing budget.
The product itself remained unchanged.
Strategy variations
Mr Isdell pursued international expansion and diversification by acquisition. But the
acquisitions were relatively small and did not make much impact on total sales. The
bottling deals were a form of diversification but were efficiency rather than market-
ing measures.
Choice
Mr Isdell was constrained by his own background. He introduced changes but none
of them were radical.
Overall Choice
Mr Isdell more or less maintained the status quo, as the industry analysts expected.
The causal connection between Mr Isdell’s actions and the increase in sales is not
clear, other than the marketing spend; it could be that improving economic condi-
tions resulted in higher sales rather than his actions.
The View from Now

Coca-Cola has continued to prosper since Mr Isdell with an increase of about 25 per
cent in revenue and by 2011 was Interbrand’s most valuable brand in the world. It
has slipped since due to the rise of Google and Apple but that is not as a result of a
decline in its performance.
Module 8
Review Questions
8.1
1. In a competitive environment this is precisely what you have to watch out for.
Changes in technology and consumer preferences are happening all the time and
there are few businesses which operate in a static environment. This relates to a
weakness in the analysis and control aspects of the process model.

2. This is symptomatic of a power culture where there is not sufficient delegation

of authority. A serious analysis of what is unique about a particular manager’s
knowledge and attributes will usually reveal that he is by no means irreplaceable.
This is an issue of managerial perceptions.
3. It is astonishing how many managers feel that they are insulated from competi-
tive pressures and do not understand their competitive position. Posing simple
questions like ‘Why do we charge the prices we do?’, ‘Why don’t we have a big-
ger market share?’, and ‘Why do we bother to control costs?’ will quickly reveal
the type of competitive pressures acting on the company.
4. It depends on how overheads are defined, and whether the company is currently
operating efficiently. For example, if marketing and research were cut the medi-
um term impact could well be catastrophic. If overheads could be cut, they
should already have been. This suggests a weakness in internal analysis.
5. This is probably due to a preference for using retained earnings rather than loans
to finance investments and short-term cash flow problems. A properly struc-
tured portfolio is preferable to drifting into overdraft without any clear idea of
why it is happening. Is undertaking an investment using borrowed money more
risky than using retained earnings? This indicates that management does not
really understand the role of financial structure and issues such as gearing.
6. This myth makes an assumption about the price elasticity of demand, and the
responsiveness of sales to perceived differences in quality. The Apple Computer
case in Module 5 demonstrates how facile this statement is. An understanding of
product positioning within the perceived price differentiation matrix is cen-
tral to an analysis of competitive positioning.
7. This is a variation on the first myth, but it is even more dangerous because it
totally discounts the potential value of additional information. How you cope
with a changing competitive environment without information on consumers
and competitors is a mystery. This is an area where marginal analysis can be
brought to bear.
The View from Now

If there ever was an example of the timeless nature of strategy this is it. A quarter of
a century later the seven myths are just as prevalent and the original answer argued
that lack of understanding of the strategic process and models explains many
business failures. One of the driving forces behind the development of the strategic
planning course was experience in the 1970s and 1980s with senior managers who
were in thrall to these myths. Year after year the same issues emerged in manage-
ment programmes and it is likely that they will continue to emerge as each new
cohort of uneducated managers gets promoted.
Case 8.1: The Body Shop (1992)

1 At first sight the Roddick approach to strategic management might appear to be
haphazard. There are at least three interpretations of what happened.
1. Haphazard management is a successful formula for this type of business. Since
there is no scientific evidence which proves that a haphazard approach cannot

work this possibility cannot be dismissed. It is possible that opportunities have

been seized as they have arisen without any attention being paid to planning and
control. The reactive approach can be successful for a time, and does not depend
on a structured approach to the deployment of resources.
2. Roddick may have just been lucky so far. It is also possible that Roddick had the
right idea at the right time, and has merely been carried along by the success of
her original product line.
3. Roddick’s public utterances are at variance with the way the company is actually
run, and she has a specified strategic plan.
Whichever view is taken of the reasons for The Body Shop’s success so far, the
argument can be analysed using the process model.
The objective of the company seems to be to expand into markets in a logical
sequence; the sequence starts with the major centres of population and then exploits
smaller centres so long as these are potentially viable. International markets have
been tackled in a similar fashion. The less financially orientated objectives contained
in ‘The Body Shop charter’ add further dimensions in terms of a statement of
objectives which individuals can relate to. There is nothing unusual about attempt-
ing to care for customers, and the image of a happy workforce is something which
most companies would like to project. In general terms the ‘charter’ as described
does not conflict with the notion of profit maximisation.
Anita Roddick is a charismatic leader who provides clear direction for employees.
The approach of targeting major population centres first, followed by towns with
fewer than 50 000 people, suggests a structured and analytical approach, and the
concentration on ‘small ticket’ items strongly suggests that a great deal of systematic
analysis has been carried out.
An Environmental Threat and Opportunity Profile identifies the market opportuni-
ties, such as the potential for consecutive penetration of domestic markets and the
potential for international expansion, and the threats, such as the potential impact of
the economic cycle. A Strategic Advantage Profile identifies where the real strengths
of the company lay, i.e. as a manufacturer and wholesaler rather than as a retailer.
Attention had been paid to the construction of the value chain and care appeared to
have been taken not to overstretch resources and ensure that there were effective
linkages.
Strategy Choice
If the company simply reacted to events as they unfolded, or relied on luck to
ensure success, it is unlikely that there would be so much emphasis placed on long-
term growth prospects and how these could be achieved. In other words, the choice
of strategy seems to have been explicit. The corporate generic strategy was expan-
sion, and the business generic strategy was differentiation based on no animal
testing backed up by the powerful image of Roddick herself.
There is plenty of evidence of specific choices being made concerning the strategic
thrust in terms of the segment of the market addressed and the productive process.

For example, The Body Shop is not a retailer, despite how the chain might appear to
customers. It could be argued that the marketing approach is designed to avoid
areas of risk.
Implementing and Monitoring
The implementation of the strategy has been anything but haphazard. There is
evidence of highly effective cost control, for example by using franchises to limit the
growth of overheads. Growth is not based on following developments in the
general economic environment but on exploiting new market opportunities which
are carefully identified in advance.
Performance and profits are monitored; Gordon Roddick warned that the company
was not immune from recession, demonstrating an awareness of general economic
constraints.
The control approach can be located in the Strategic Control matrix. The Body
Shop has a well-defined set of objectives and exercises a degree of financial control
but does not rely purely on financial measures of achievement (see Roddick’s
opinion of City people). This suggests that The Body Shop lies in the Strategic
Control part of the matrix.
Feedback
The involvement of customers and employees together with causes such as Amnes-
ty International suggest that Roddick laid great stress on keeping in touch with the
market and interest groups. The piecemeal development probably created an
adaptable organisation; the image of being different could have helped create an
organisation that was not opposed to change.
The Roddick Strategy Process
All the evidence points to the fact that the company has a clear idea of what it
wishes to achieve, has allocated resources in a rational way, and keeps track of
exactly what is happening. The ‘naivety’ attributed to Roddick could be interpreted
as entrepreneurial behaviour, which to some extent is concerned with doing the
unexpected. In short, it can be concluded that there is very little ‘magic’ involved:
The Body Shop’s success is based on a hard headed set of business principles.
2 The price/earnings ratio is Share Price divided by Dividend per share. The stock
market average is about 10, which suggests a return of about 10 per cent on shares.
Why are owners of Body Shop shares willing to accept a return of less than 4 per
cent (i.e. 100 divided by 28) on their shares?
The answer lies in the determinants of the share price. The current price of a share
depends on the market’s expectation of future returns. Assume that The Body
Shop’s cost of capital is 10 per cent. If profits were expected to remain at their
present £20 million the company value would be:
20
200
0.1
This gives a value of £200 million for the company.
Analysts expect profits to grow by between 30 per cent and 40 per cent for at least
another year. For the purpose of illustration, imagine the market expects the growth

in profits to carry on for three years (the planning period), and then stabilise (in
perpetuity). This would give a shareholder value pattern as follows:
Year 1 … 2 … 3 … Perpetuity
20 1 20 1 20 1 20 1
1 1 1 1
where g is the growth rate and r is the interest rate.
This expression lets the current profit grow at g per cent per annum for three years,
and then works out the residual value of the profit remaining at the Year 3 level into
perpetuity.
Assuming an interest rate of 10 per cent, a growth rate of 30 per cent per annum
produces a current company value of £414 million, and a growth rate of 40 per cent
per annum gives a company value of £511 million, which is fairly close to the
current figure of £470 million.
It is now clear that the high price earnings/ratio depends entirely on the market’s
expectation of high profit growth rates. Are these likely to continue? The Body
Shop has had a history of significant profit increases in the past, but profit forecasts
have recently been marginally downgraded.
There are arguments both for and against expecting further growth in profits based
on the characteristics of the goods sold, their income elasticity, the continued
prospects for expanding markets internationally and the possibility of competition
and changing tastes.
The shares are really only ‘screaming cheap’ if the market considers that the growth
rate will be higher than 40 per cent, and/or expects this growth to continue beyond
the planning period of three years.
This analysis reveals a potential weakness in the company’s valuation. If the pro-
spects for further profit growth were for any reason removed, for example because
of the entry of a major competitor or a change in consumer preferences, the share
price would probably fall by half immediately, i.e. the company value would fall
towards £200 million.
Postscript
In September 1992 it was announced that the half yearly profits for The Body Shop
would be £8 million, compared to £9 million for the same period in 1991. The
growth in profits had ground to a halt, and the market at that point revised its
estimate for future profit growth. The share price immediately fell by 40 per cent,
which is close to the prediction made above using the information available one year
previously. The Roddicks tried to maintain expectations by pointing to the continu-
ing expansion of shops abroad, and arguing that the recession was much more
pronounced in the UK than in other countries. However, until a resumption of
profit growth occurs it is unlikely that the share price will recover. After the share
price fall the price/earnings ratio stood at about 20, which was similar to the
performance of other top stores such as Marks & Spencer. There is therefore no
question of The Body Shop being a financial disaster; it was really just a question of

when the growth prospects would diminish and bring the share price back into line
with other successful companies.
The View from Now

The Body Shop is an example of how the share price is determined by growth
prospects and expectations rather than by hard facts. In 2015 the Body Shop is still
in operation although it is now owned by L’Oréal. Dame Anita died in 2007 but the
brand image of The Body Shop has lived on, despite many reservations as to its
commitment to a ‘green’ way of life (whatever that may be taken to mean). For
example, in 2013 it emerged that prices in Ireland were up to 50 per cent more than
in the UK. It was also questionable why Roddick sold the business to L’Oréal, the
largest cosmetics company in the world. It was reported at the time that Dame
Anita reckoned that her inputs to decision making in L’Oréal, a huge company,
would be more beneficial because she would affect more people.
The case has stood the test of time as an example of how an outstanding individual
can create an effective organisation and motivate its employees.
Case 8.2: Daimler in a Spin (1996)

1 The strategic rationale was to diversify to become a major international player; Mr
Reuter felt that Daimler could not compete with the major US and Japanese
companies with its current scale of operations. Such a programme of expansion
could only be achieved by acquisition, as internal growth in new markets would not
be possible on the scale he desired. The acquisition rationale was originally based on
the synergy, or economies of scope, which could be generated by an ‘integrated
technology group’ loosely based round the transport industry, but some of the
acquisitions (such as white goods) were unrelated to the core business. There may
have been a desire to diversify risk, but this was not explicitly part of the strategy.
The strategic mistakes Mr Reuter made can be identified within the structure of the
process model.
Objectives
Historically the interests of German shareholders had not been accorded a high
priority as a stakeholder; being insulated from the market led to the principal–agent
problem: Mr Reuter’s objective was to develop his strategic objective and not to
maximise profits, and this meant that he did not separate the means (the strategy)
from the ends (value creation). Consequently, the signals from capital markets (in
the form of share prices) were ignored, and the programme of expansion continued
despite the fact that it was not adding value.
Analysis
Mr Reuter made mistakes at three levels. First, at the macro level, he expanded into
defence industries at a time when the cold war was winding down. It would be
unfair to suggest that Mr Reuter should have been able to predict when the cold war
would end, but the events during the late 1980s should have been taken into
account; there appeared to have been a lack of environmental scanning and PEST
analysis. Second, at the market level, Mr Reuter did not seem to appreciate that

many of the products added to the portfolio, for example by its purchase of AEG,
were not dominant enough to add to the company’s competitive advantage; he did
not add Cash Cows to the portfolio. This was particularly important at a time when
the car making business itself was coming under increasing competitive pressure.
Taken together these factors suggest that the strategy choice was not founded on a
strong analysis of the environment. Third, at the company level he did not appear to
have identified the competencies upon which diversification ought to be based. He
was unable to create value by utilising resources and routines currently residing
within the company, and he did not appear to be aware of how far the diversifica-
tion process was taking the company from its core activities.
Choice
The intended corporate strategy was expansion by related diversification, but in the
end a significant part of the expansion was unrelated. This meant that the company
was venturing into markets where markets and products were unfamiliar; the
clustering of products in the ‘unfamiliar’ sector of the familiarity matrix was clearly a
problem. The notion that acquisitions should have a strategic fit with Daimler
became less and less important as the acquisitions programme progressed.
Implementation and Control
The problem of coordinating many businesses was dealt with by a decentralised
structure; this led to a lack of adequate control, and with this structure it is difficult
to see how the potential synergies or economies of scope could be realised. There
appeared to be no contingency planning, and the end of the cold war caused the
company insurmountable difficulties. There also seemed to have been little account
taken of the problems of integrating different corporate cultures; given the diverse
nature of the acquisitions programme Daimler had to accommodate a variety of
management styles.
Daimler is in fact an example of how the potential advantages from parenting were
not realised:
 The individual companies might have performed better if they were not subject
to interference from the corporate centre.
 Linkages among companies to foster synergy were not achieved.
 There was little scope for provision of common services given the diversity of
the portfolio and the lack of vertical integration.
 The corporate centre was inefficient in developing a manageable portfolio.
Feedback
Although Mr Reuter had started to divest unrelated businesses by the time he left
this seemed to be more of a response to the problem of value destruction rather
than a result of learning from past mistakes.
Overall Process
It could be argued that Mr Reuter was simply unfortunate, and was caught out by
unforeseeable events. However, there were weaknesses in all stages of the strategic
process: Mr Reuter could be accused of wishing to expand Daimler at all costs,

paying little attention to the macro and competitive environments, being haphazard
in his choice of strategy, and failing to control the monster he had created.
2 In the wide sense they were both corporate expansionists who ended up divesting
and retrenching.
Objectives and Strategists
It is tempting to categorise Mr Reuter as a prospector and Mr Schrempp as a
defender, but in fact their behaviour was largely dictated by the circumstances in
which they found themselves. Mr Reuter was a prospector when he was not subject
to serious constraint up to about 1994, when he became a defender; he changed
from being proactive to reactive. Mr Schrempp started as a prospector when he was
in charge of DASA, but by the time he took over Daimler he had become an
analyser and defender. Mr Schrempp started off proactively by explicitly setting the
objective as profit maximisation, and for the first time admitted that Daimler was
making a loss.
Their use of information was different. Mr Reuter pursued his personal goals under
the protection of ‘stakeholder capitalism’ and appeared to assume that everything
would work out in the long term. Mr Schrempp appeared to be more aware of
Daimler’s precarious situation, for example, by making the loss public knowledge.
He recognised that the grand strategy had to be monitored and that decisions had to
be made in the light of both external and internal factors.
Choice
Mr Reuter followed a corporate strategy of expansion by diversification, some of
which was unrelated, through acquisition. He then retrenched by selling off the
more obvious of the unrelated activities – the AEG white goods business. Mr
Schrempp attempted to identify the core business and set about divesting large parts
of the business. This is a good example of how retrenchment can lead to value
creation. But he still wished to expand internationally, this time through the joint
venture in China. An interesting aspect of the Daimler experience is that the
German economy had been insulated against the type of takeover which had been
common in the UK and US because of the way the capital market worked; thus in
the space of 10 years or so Daimler went through stages of corporate strategy which
had taken several decades to work out in other countries.
Daimler set out on the quest for growth using a devolved divisional structure, but it
then ran into problems with its portfolio; this led to the recognition that the
company should get back to its core activities, and this in turn led to restructuring.
Daimler had to define its core business, but the notion of the ‘integrated technology
group’ was quite nebulous. The focus then turned to the creation of value by
managing and closely monitoring the portfolio from the centre. So another interpre-
tation is that Mr Reuter and Mr Schrempp were carried along by economic and
organisational forces over which they had little control.
Implementation and Control
Their approach to management control was different: Mr Reuter simply set guide-
lines for the main businesses, while Mr Schrempp set up a tight financial control

system. He also introduced a hurdle rate below which a business would be divested.
In terms of the planning and control matrix, Mr Reuter’s approach lay in the
Strategic Planning sector, while Mr Schrempp had moved into the Financial Control
sector.
Feedback
Mr Reuter finally started to learn from his mistakes by 1995; it was felt that Mr
Schrempp had learned from his own mistakes and was the right person to sort out
the mess he had created.
Mr Schrempp caused a significant change in how the company was run, and no
doubt raised many issues relating to management culture.
Many commentators had asserted that Mr Schrempp was a good choice to lead
Daimler, despite his failures in the past. However, this is open to question, and it is
an important issue because of the impact which the CEO has on the direction of the
company. Both strategists started off as prospectors who followed an expansionist
course regardless of the costs, but it was claimed that Mr Schrempp had learned his
lesson and would therefore be able to lead Daimler into profit. It does not require a
great deal of imagination to impose tight financial controls on an organisation; but
Mr Schrempp had not demonstrated much capacity to learn in the past: he failed to
see the problems associated with Fokker and subsequently tried to expand the
defence business after the end of the cold war when the market was shrinking. It is
one thing to learn a hard lesson; it is quite another to demonstrate the entrepreneur-
ial vision which a highly complex and ailing corporation requires.
The View from Now

In 1998 Daimler and Chrysler merged to become DaimlerChrysler AG, but when
the Chrysler part was sold to Cerberus Capital Management in 2007 it became
Daimler AG. It was supposed to be a ‘merger of equals’ but this was hotly contested
in a series of court cases. Certainly the scope for synergies was limited as the
company did not adopt a single car platform.
Many of the weaknesses identified in the original analysis appear to have recurred in
subsequent years. Decision making was haphazard, for example, the Chrysler merger
was subsequently divested because it could not be made to work.
Case 8.3: Eurotunnel: A Financial Hole in the Ground (1996)

1 Given the long history of the project, the scrutiny to which it had been subjected in
the media, the importance of Eurotunnel to both Britain and France and the huge
levels of investment, at first sight it seems inexplicable that such losses would be
incurred and that there was little prospect for improvement. But working through
the process model reveals that the strategic process had significant flaws.


Objectives
These were initially framed in terms of building a tunnel rather than maximising
shareholder profit; the fact that profit maximisation was not the primary objective
did not bode well for future economic viability. Issues of national pride were
involved, with the result that cost overruns were accepted as inevitable.
Strategist
Mr Morton was capable of maintaining momentum in spite of the construction
problems and the financial prospects; he was able to keep investors’ confidence by
his sheer force of personality beyond the point which the investment made sense. In
fact, there was a significant principal–agent problem, in that he pursued the tunnel
building objective without reference to shareholders. Mr Morton was a prospector
in the sense that he got things done in a highly individual manner; but an analyser
approach was required to consider the implications of what was being achieved.
The culture of Eurotunnel could be classified as power type, where not only did Mr
Morton dominate decision making but he was personally responsible for ensuring
that they were implemented. In the power culture it is likely that any plan will reflect
the interests of the dominant leader.
Overall who decides to do what
The non-profit maximising objective and the power culture created by Mr Morton
was an ominous combination.
Macro environment
Political With both French and British governments behind it the

project was largely insulated from commercial pressures.
Economic The demand for passenger and freight travel was expected to
grow in line with rising incomes.
Social Assumptions were made about the willingness of people to
travel underground rather than on a ferry.
Technological Technological projects are high risk. It was well known from
previous cases (Concorde, motorway construction etc.) that
cost overruns on technologically based projects were highly
likely; the project was undertaken with a lack of foresight based
on relevant experience.
The PEST analysis highlights the fact that many things were being taken on trust
and that there was a high degree of risk.
The outcome was a combination of over-estimated revenues and under-estimated
costs; this suggests that the analysis was inadequate, and this is consistent with the
observations made about Mr Morton above. The primary defect in the analysis can
be seen by considering the basic model of cash flow generation:

Market size Market share Price

The early estimates were that Eurotunnel would quickly capture 33 per cent market
share (less on the freight trade). Given this, the estimates of market size and price
were crucial if a reasonably accurate prediction of cash flows were to be made. The
projected growth in price was well out of line, with ferry prices falling by 2.5 per
cent per year in real terms over a 10 year period instead of remaining constant. For
sensitivity analysis assume that the growth in the market had been over-estimated by
a similar amount over the 10 years; the result is that the market turned out to be
about 60 per cent of the size (in revenue terms) originally anticipated. On the cost
side, the operational costs could be predicted reasonably well, but it is not possible
to programme capacity so closely to demand as the ferries can, therefore until
Eurotunnel can reach full capacity utilisation it is likely to suffer relatively high unit
cost.
These mistakes were closely related to the competitive position of Eurotunnel, as
revealed by an examination of the five forces.
 Bargaining Power of Suppliers: HIGH: the contractors had a strong bargain-
ing position and which contributed to the overruns and cost escalation. The only
bargaining counter which Morton had was to withhold payment, but this would
have resulted in no tunnel being built.
 Bargaining Power of Buyers: HIGH: there was plenty of choice of ferries and
hovercraft and it was relatively easy to switch among them.
 Threat of New Entrants: HIGH: as a new entrant to the market Eurotunnel
comprised a threat to the incumbents; however, they had plenty of time in which
to work out and implement a competitive response. The airlines were also com-
peting for part of the cross channel market, and had reduced their prices even
more than the ferry operators over the decade; budget airlines were all set to take
a substantial slice of the market.
 Threat of Substitutes: HIGH: while the product is homogeneous in the sense
that it is simply a journey, the characteristics of Eurotunnel and the ferries mean
that to some extent they are substitutes. For example, the differentiating tactics
of the ferries had converted the travel experience to being part of the holiday.
 Industry Rivalry: HIGH: Eurotunnel did not turn out to be a monopoly.
Instead it was in a relatively mature oligopolistic market which plunged into a
price war; given the slow growth in market size it was a zero sum game in the
short run. Supply and demand analysis leads to the conclusion that a significant
increase in supply in a mature, competitive market would be expected to lead to
a fall in price. The ferry operators’ long experience in the market and high mar-
ket share had conferred a competitive advantage in terms of first mover
advantage. Furthermore, they adopted a proactive competitive response by dif-
ferentiating their products (by improving the quality of the ferry crossing) and
reducing the price. The mistake made by Eurotunnel was not to predict that the
ferries would take such action, and as a result had an over-optimistic expectation
of initial market impact.
The profile is of a highly competitive market in all dimensions with the implication
that it would be difficult to make profits above the opportunity cost of capital. But

it was assumed that these competitive pressures would cease to exist when Euro-
tunnel opened.
The characteristics of cross channel travel include price, speed, reliability, comfort
and additional services; thus differentiation is not only based on speed, which was
Eurotunnel’s single selling point. Since Eurotunnel was charging about the same as
the ferries (with fewer special offers), for many travellers Eurotunnel would lie
further down the perceived price differentiation matrix than the ferries. No doubt
the Eurotunnel breakdowns had some impact on this positioning.
Internal analysis
A great deal was known about the demand for cross channel travel, but nothing was
known about how to operate a cross channel tunnel effectively. Thus in terms of the
familiarity matrix Eurotunnel entered a familiar market with an unfamiliar product.
Another dimension to the circumstances facing Mr Morton can be obtained by
mapping how he perceived the various stakeholders given his actions.
Stakeholder Influence Priority

Shareholders High Low
Managers Low Low
Employees High Low
Potential customers Low Low
Suppliers High High
As the project proceeded the interests of shareholders were virtually ignored; given
Mr Morton’s style it is likely that the priority given to managers was relatively low
given that he made most decisions. A high priority was given to suppliers, who were
in fact unable to deliver as desired by Mr Morton. The fact that so little competitive
analysis appeared to have been done suggests that customers were given a low
priority and their potential influence was disregarded. It is interesting to speculate
how things might have turned out if Mr Morton had a different conceptual map; for
example, if customers had been given high priority more attention might have been
paid to countering the strategic moves of the ferry operators.
Eurotunnel costs were bound to be relatively high because the capital cost turned
out to be more than twice the original estimate resulting in the high interest pay-
ments.
It was assumed that Eurotunnel would have a competitive advantage such that the
ferry operators would have no option but to exit the market. But the analysis above
suggests that Eurotunnel did not have a cost advantage and the perceived differenti-
ation was not necessarily all that pronounced, being based only on speed. Thus
whatever Eurotunnel’s comparative advantages were they were certainly not such as
to dominate the market.


The whole operation was characterised by assumptions that could easily have been
shown to be faulty by the application of PEST, the basic model of revenue, five
forces and perceived price and differentiation. It is possible that some of the analysis
was carried out but that the conclusions were disregarded because of the political
imperative.
Choice
Generic strategy
Eurotunnel selected differentiation, while low cost leadership might have been more
appropriate; this was probably not attractive because of the high cost structure. The
fact that the ferries could differentiate on variables other than speed resulted in
Eurotunnel being stuck in the middle.
Strategy variations
The construction phase was undertaken by contractors rather than by forming
partnerships or alliances. The result was endless confrontation that contributed to
the delays and cost overruns.
Strategy choice
It appears that Mr Morton did not think in terms of strategy but in getting the job
done. The scale of the job to be accomplished meant that little attention was paid to
strategy.
Overall choice
Eurotunnel ended up stuck in the middle by default.
Implementation
The construction stage was characterised by delays and technical problems. Once
Eurotunnel was operating there was a lack of competitive response to the ferry
companies’ actions, and there were operational breakdowns. As the losses mounted
there appeared to have been no contingency planning. It could be concluded that
the trade-offs between time, cost and quality were such that quality was given a low
priority and that this led to the subsequent breakdowns.
Feedback
Each new round of projections was subsequently shown to be false, but the lessons
did not seem to be learned. In 1995 Mr Morton apologised for the unexpected
shortfall, and a year later astonishment was expressed at the size of the losses. Given
the simplicity of the revenue calculation using the basic model, it seems incredible
that no one was able to advise the board of the true position. However, this did not
appear to be a learning organisation.
There were significant flaws in all dimensions of the strategic process. No single
factor led to the failure of Eurotunnel as a commercial enterprise: the strategic
process was not robust.
2 This is an important strategic issue because it suggests that the banks had not
applied strategic models to Eurotunnel.

The original estimate of £4700 million would not have incurred such high interest
charges since most of it would have been raised by equity. There are various
possible explanations why the banks carried on injecting cash.
 Loans take priority over equity, so if it was anticipated that operating surpluses
would be made the banks would receive at least some interest payments; the
account for 1995 shows that an operating surplus was actually made (before
deducting depreciation). There was also the possibility of capitalising interest
payments so that they would not be lost.
 The fallacy of sunk costs: since so much had been spent it was considered
necessary to continue. While sunk costs should be ignored in any calculation of
future investment, the magnitude of sunk costs is a poor reason for continua-
tion.
 Marginal analysis: since cash already committed was sunk, the appropriate
calculation is the rate of return on additional investment; typically the calculation
is favourable each time it is carried out, and this approach has been a contributo-
ry factor in most major examples of cost overrun, such as Concorde.
 The banks may have been convinced that in the relatively near future Eurotunnel
would achieve monopoly power – the ‘natural’ way to travel.
 The perception of risk may have been affected by the assumption that the two
governments would eventually bail out this high profile investment.
The banks seem to have been convinced by false arguments that could have been
exposed by strategic analysis and the application of strategic models.
3 The first step is to identify the likely positive and negative factors which will bear on
Eurotunnel.
Environmental Threat and Opportunity Profile

International • European integration
• Recovery of Euro economies after integration
• Increased demand for travel generally
Microeconomic • Reduced competition from ferries
• Real price of travel falling
Market • Continued growth expected
• There is not much more competitors can do
Strategic Advantage Profile

Market • Continued growth expected
• Segments can be separated: holidays, business, haulage
• Already has 50 per cent share
Production • Costs will fall as full capacity reached
• Significant experience effects likely

Despite the poor showing of Eurotunnel to date, the profiles suggest that the
problems are largely financial: the integration of Europe offers great opportunities
and competitive pressures are probably not going to increase significantly.
Potential low costs Growing market
Potential further economies of scale Ferries on defence
Integrated service
Market segmentation
Weaknesses Threats
Limited financial resources Bankers will take over company
Niches: airlines, better ferries
Ferry companies merge
There is strong alignment between the potential strengths and opportunities, and
between the weakness and the threats.
Several generic possibilities can be derived from the SWOT analysis:
 write off the sunk costs and then embark on a low cost leadership approach; but
it is unlikely that the banks would agree;
 segmentation, such as special contracts with haulage firms;
 differentiation for business travellers and holiday traffic;
 vertical integration to provide door to door services.
The enormous debt is likely to act as a major constraint on business development
because there is little prospect of paying it off given the potential revenue. It is likely
that Eurotunnel will exist in a permanent state of crisis management.
Note: over a decade later attempts were still being made to ‘refinance’ Eurotunnel and the ferry
operators were still in business.
The View from Now

The pessimistic analysis in 1994 was borne out by what happened over the next two
decades. In 2006 the company was placed in bankruptcy protection by the French
courts and ‘financial restructuring’ was undertaken to wipe 5 billion euros from its
books. This was necessary because the interest payments on the debt meant that it
could never be a viable proposition. The situation was exacerbated by the fact that
even by 2015 it was still not carrying the original estimate of passengers from 20
years ago. It finally made an operating profit in 2011.
Despite its financial woes it is still regarded as a major engineering feat. But that was
part of the original problem of objectives identified in 1996: the objective was to
build a tunnel and not to maximise profit.

Case 8.4: The Balanced Scorecard

1 The precise mapping of the Scorecard against the process model is a matter of
judgement but it is unlikely that the two will fit exactly. This is because the Score-
card is a top-down concept and takes the SBU objectives as given and focuses on
translating these into disaggregated and measurable objectives which can be acted
on by the individuals working within the SBU. The Scorecard is not concerned with
the formulation of the mission and objectives of the organisation as a whole, and
there is therefore little emphasis on macroeconomic environmental scanning; rather,
the focus is on the market and the customer and the internal actions which must be
taken to ensure that a competitive advantage in service provision is achieved.
Value creating
activities Actions Use
Who decides to do what
Strategists Plan, set targets and align
Objectives Clarify and translate
Disaggregated Objectives
Credible Targets
Quantifiable Measures
Behavioural
Economic
Financial Financial
Social
Analysis and diagnosis
Macro environment
Industry environment Customer
Internal factors Internal business
processes
Choice
Generic strategy
alternatives
Strategy variations
Strategy choice Objectives
Implementation Communicate and link
Resources and Internal business
structure processes
Resource allocation Internal business
processes
Evaluation and Internal business Targets and measures
control processes

Value creating
activities Actions Use
Feedback Enhance feedback and
learning
Communication Learning and growth
Management style
Adaptability
Learning organisation Learning and growth
The Scorecard places a great deal of emphasis on implementation and the develop-
ment of management systems which are aligned with organisational objectives. In
that respect it touches on many aspects of the strategic process, and can contribute
significantly to eliminating weaknesses within the process in the areas where it is
particularly relevant. But it is an inward looking technique which is designed to
make the organisation more effective at what it is doing, rather than being con-
cerned with the identification of market opportunities and long-term strategic focus.
A major criticism of the Scorecard is that it takes the world largely as given and
attempts to optimise the allocation of resources accordingly and consequently it
introduces a degree of inflexibility. Organisations which are faced with rapid change
and fierce competition may find that the Scorecard inhibits fast strategic response.
The major difference between the Balanced Scorecard and the process model is that
it is prescriptive in nature while the process model is concerned with strategy
making as a whole in a dynamic setting. The Balanced Scorecard may be a highly
effective tool for the Implementation stage of the process model in certain circum-
stances, but it is the job of the strategist to assess its relevance as the competitive
environment changes.
The View from Now

The version analysed here became known as the first generation Scorecard. The
second generation Scorecard introduced the idea of causal chains; it was discovered
that the development of causal chains was too abstract for practising managers and
the second generation was superseded by the third generation, which introduced the
idea of a Vision or Destination Statement which, it was claimed, made it more
straightforward to select appropriate strategic moves and outcome objectives. The
Scorecard has continued to evolve in response to the needs of different types of
organisation in different settings. A significant number of organisations still adhere
to the first generation design because it is relatively simple to understand and
implement.
It is worth restating that the Balanced Scorecard is prescriptive whereas the strategy
process model is an analytical framework.

Case 8.5: Revisit An International Romance that Failed: British Telecom and
MCI
1
Objectives
BT wished to enter the US market with the intention of developing one stop
services for multinational companies and in this respect had a narrow focus.
However, MCI appeared to have ambitions in all three market segments and had a
wider focus. It is likely that the objectives of the two companies were not aligned,
which in turn would lead to conflicts of interest.
WorldCom had already decided to focus on carrying data for business calls and had
concentrated on building its infrastructure to support this. WorldCom had a clear
view of how it would use MCI’s brand name and billing systems.
Strategists
BT and MCI were headed by two powerful characters and it was not clear who was
ultimately going to be in charge; the outcome would have a significant impact on
which set of objectives was pursued. BT did not have a track record in acquisitions
and had not long emerged from being a monopoly. On the other hand WorldCom
had built up a reputation for success in generating value from acquisitions.
The fact that questions can be raised about the alignment of business objectives
between BT and MCI and the possible differences between the two CEOs raises
doubts on the strength of this part of the BT strategic process.
Macro Environment
The BT strategy of international expansion was intended to transfer its competitive
advantage from Britain to the US. However, BT’s success in the UK was not based
on meeting competitive forces but was primarily based on making an existing
monopoly more efficient. BT’s competitive advantage in the UK was based on
country specific rather than company specific factors. WorldCom was ready to take
advantage of deregulation in a market in which it was already highly competitive.
The basis of competitive advantage for the two companies was totally different, and
BT did not recognise that it would have difficulty transferring competitive ad-
vantage to the highly competitive market profiled in Module 5.
The objective of deregulation was to increase buyer power in all three segments, and
this was bound to increase as new cables were installed, the technology changed and
new entrants appeared.
Product life cycle – The corporate segment was on the growth stage while both long
distance and local segments appeared to be in the mature stage. Different strategic
approaches are required at different stages in the product life cycle, and it was not
clear that BT recognised this. WorldCom had a clearer view of competitive condi-
tions and did not attempt to break into these markets using conventional technology
but focused on gaining its foothold through the internet.

Portfolio – MCI’s existing markets could be positioned in the Cash Cow sector, but
were coming under attack from the Baby Bells. The corporate segment had the
characteristics of a Question Mark and therefore would require a great deal of
investment before significant returns could be generated. WorldCom tackled the
segments as Stars and acted accordingly.
Relative price and differentiation – Telephone services are largely homogeneous, and it is
not clear how services could be differentiated in any of the segments. Consequently
success depended on being able to price lower than competitors, and there was no
reason to conclude that BT and MCI could adopt the role of cost leaders. World-
Com had already demonstrated the ability to cut costs, and its intention was to cut
costs by up to $5 billion; it might also be able to differentiate using the internet and
coupling telephony with a range of other services.
Internal Factors
Competence – It was not clear what unique competence BT was bringing to the US.
WorldCom had already demonstrated competence in change management and had a
track record in the industry.
Value chain – There was no obvious fit between the value chains of BT and MCI and
no clear linkages which would lead to enhanced value creation; there was no
obvious match of skills in the two organisations. WorldCom seemed confident that
the value chains were compatible and could lead to cost savings of $2.5 to $5 billion.
Economies of scale – It was not clear that the combination of BT and MCI would lead
to lower unit cost. On the other hand, WorldCom appeared to have thought
through those areas where costs could be reduced by combining activities.
BT seemed to be intent on becoming a major international player in the telecoms
market but did not seem to be clear on what form this business would ultimately
take. It was not clear how the joint company would be positioned. WorldCom
appeared to be focusing on innovative approaches to the market.
BT appeared to lack an understanding of the differences between the US and British
markets and seemed unclear on how it would generate competitive advantage. The
fact that the fit between BT and MCI was suspect suggests that this part of the
strategic process was also weak. WorldCom was specific about how it would
integrate the two organisations and the implications for the joint value chain.
Generic Strategy
BT undertook a generic corporate strategy of international expansion by acquisition.
WorldCom focused on national expansion by acquisition.
At the business level BT was a low cost leader in Britain, and attempted to transfer
that to US. However, low cost in Britain might not translate to low cost in the US,
while MCI did not appear to be a low-cost producer.
Strategy Variations
BT and MCI were already in an alliance; it is not clear that actually merging the two
companies would achieve a great deal more than the alliance. On the other hand, the

merger would provide BT with more control and there would be less risk of
conflicts of interest and cheating due to the prisoner’s dilemma.
Strategy Choice
A significant difference between BT and WorldCom was in the process of making
choice. While BT appeared to have searched for a weak target WorldCom had a
record of searching for an appropriate strategic fit.
Overall Choice
In the analysis section it was concluded that BT was uncertain about the basis for its
competitive advantage and this is consistent with a choice process which lacked
focus.
There were potential culture problems in integrating major US and British compa-
nies. WorldCom already had experience in dealing with these successfully in the US.
Resource Allocation
WorldCom had a plan for more efficient use of resources which would result in cost
savings, but BT and MCI did not clarify how their joint resources would be put to
better use.
BT did not know that MCI was heading for losses. This demonstrated that there
was little control at this early stage. It would appear that BT was in the low financial
control and low planning sector of the planning and control matrix. This is not a
good place to be because it suggests a lack of both strategic planning and financial
controls. WorldCom appeared to be strong in both financial and planning aspects
and was thus in a different part of the planning and control matrix.
Even before it began the BT MCI partnership had no clear direction for implemen-
tation, and something would have to be done to introduce a proper control system.
On the other hand implementation was one of WorldCom’s core competences.
It is an open question whether the BT MCI merger could have been successful
given the weaknesses in the process which can be inferred even from this brief
account. At the time of the takeover battle it looked like WorldCom had a much
more robust strategic process. (In the light of what happened later to Bernie Ebbers
it transpired that the WorldCom strategic process was not robust, being based on
unsound financial practices; but that information was not available at the time.)
2 The strategic future of the WorldCom MCI company will be based on relatively
strong elements in the combined value chain. Some of these can be inferred from
the case.
Support Activities
Human resource management: record of aligning management in diverse companies.
Technology development: total fibre optic coverage, satellite coverage and internet
developments.

Procurement: had already purchased MFS, Compuserve and America Online.

Primary Activities
Logistics: integrated billing.
Operations: set to take advantage of potential cost savings, based on synergy, shared
resources, etc.
Marketing: intended to capitalise on MCI’s brand name.
The evidence suggests that WorldCom had a clearer notion than BT how the
linkages between the different value chains could be capitalised on.
A SWOT analysis reveals alignments between company strengths and market
opportunities, but there are significant threats which are aligned with weaknesses.
Innovative and dynamic Take local business from Baby Bells
Largest internet services provider in the Growing internet market
world
MCI’s brand name and expertise
Skill in realigning companies
Fibre optic and satellite coverage
Weaknesses Threats
Probably highly geared after takeovers Other global alliances
MCI experiencing low growth and losses Mature local market
Falling prices
WorldCom could use its strengths to overpower the Baby Bells and dominate the
growing internet market; but its financial position is likely be weakened by MCI and
that would make it difficult to counter powerful new entrants to the mature local
market.
Possible generic choices are:
 exploit first mover advantage to achieve low cost leadership in the market with
undifferentiated products;
 attempt to differentiate in a manner which cannot be easily imitated, and this
might be achieved by using innovative internet technology.
The View from Now

When WorldCom went bankrupt in 2002 it was the biggest bankruptcy in US
history, but was surpassed by Lehman Brothers and Washington Mutual in 2008.
The remains of WorldCom and MCI now trade as MCI and offer a similar range of
telephony services as before. The SWOT analysis suggested that WorldCom MCI
would have to be proactive and pursue price leadership or differentiation rather
than being caught ‘in the middle’. The subsequent bankruptcy and the fact that it is
still in the same business suggests that it did neither.

The world of telecommunications has changed, of course, with G4 and G5 mobile

networks and internet services such as Skype. The mobile market is dominated by
huge companies with world rankings as below.
Company Subscribers (millions)
China Mobile 860
Bridge Alliance & Singtel 560
Vodaphone 450
Airtel 330
A further six companies lie between 200 and 300 million subscribers. There are
constant threats of takeovers such as that of O2 by Three in 2015.
The PEST analysis in 2015 can be compared with that developed in 1998.
1998 2015
Political The US government is clearly It is not just US regulators
intent on introducing as much who are taking anti-trust
competition as possible into action. For example, in 2014
the telecoms market by Chinese regulators levied a
deregulation. But if monopo- series of fines on Qual-
lies start to appear it is quite comm.
possible that anti-trust legisla-
tion might be introduced.
Economic Competition is increasing from This is probably even more
both small and large suppliers. important in 2015 given that
the barriers to entry are
continually falling; for
example, Skype took a
significant market share in a
very short time.
The Baby Bells might be more
competitively responsive than
the giant semi-monopolies.
While the demand for tele- While there is a great deal of
coms services is increasing, the competition the proliferation
price is falling leading to static of bundled packages makes it
revenues. difficult to compare prices.
Regulators are increasingly
taking action on the relatively
high price for ‘roaming’.
There are significant barriers See above.
to entry because of the need to
build infrastructure.
Social Telephony is becoming an What was not foreseen in
accepted part of life and the 1998 was that the telephone
overall market is set to would become a multi-media

1998 2015
increase significantly as device.
consumers, both business and
social, become ‘telephone
literate’.
Technological The Baby Bells control the The notion of local markets
technology which provides has ceased to exist.
access to local markets, but
there may be alternatives.
The internet could be an Again innovations such as
important future base for Skype have changed the
many telephony services. market.
The profile that emerges from The technology has changed
the PEST analysis is of a but the PEST still reveals a
highly volatile environment in highly volatile environment.
all dimensions.
One of the risks in international expansion is that local competitive conditions are
not well understood. The giant UK retailer Tesco fell into this trap when attempting
to enter the US market in 2007. Despite spending a great deal of time in prepara-
tion, to the extent of living with US families, Tesco’s aim of ‘redefining the US
grocery market’ was a failure and it abandoned the US in 2013. If the risks are so
pronounced why do companies keep on attempting to expand internationally? One
reason is the principal–agent problem: the CEO is rewarded for company growth
and when the local market is saturated or has reached maturity the only option is
international expansion.
Case 8.6: Vuitton: Expensive Success (2007)

1 The fashion industry is typically regarded as highly competitive, and the following
five forces analysis of the industry is consistent with this.
Competitive force
Threat of new High Companies such as Coach; the main barrier to
entrants entry is reputation.
Threat of substitutes High Vuitton makes a determined effort to generate
customer loyalty. But there are several equally
prestigious competitors. Counterfeits are not a
serious issue because the target market does not
purchase them.
Buyer power High There are no switching costs.
Supplier power Low Skilled craft people employed by Vuitton.
Rivalry High Although competition is not based on price,
there is a constant struggle for market position.

But there is a paradox because such a highly competitive environment is not

consistent with Vuitton’s high margins; Vuitton may have mitigated the impact of
the five forces.
Competitive force
Threat of new entrants Low It is virtually impossible for a new ‘name’ to be
established in a short time.
Threat of substitutes Low There is actually no substitute for a Vuitton item.
Buyer power Low Customer loyalty is very high.
Supplier power Low Skilled craft people employed by Vuitton.
It may have been Mr Carcelle’s insight that the issue was not direct competition but
the establishment of perceived market position.
2 The reasons for the success of Louis Vuitton in such a competitive market may be
revealed by analysing the strategic process.
Strategists
Both Mr Arnault and Mr Carcelle are committed to growth and clearly act in
accordance. Although Vuitton is part of the LVMH group, Vuitton is not subject to
principal–agent issues and Mr Carcelle has been given the opportunity to pursue
efficiency and exploit markets.
Objectives
There is a clear objective to pursue organic growth both in terms of new product
lines and developing emerging markets. The objective is supported by the flexible
methods embedded in the supply chain.
Strong and consistent leadership combined with realistic objectives result in a
focused organisation.
Macro Environment
The dangers of being highly dependent on one market – Japan – are well under-
stood. The identification of target segments (rich consumers) in developing
countries is a key strategic element. The downturn in economic activity has not been
taken as a signal to retrench.
Product life cycle
The luxury goods sector is a growing market globally. Vuitton has acted consistently
with this: it has identified and entered emerging segments, such as India, and has
opened stores ahead of demand in order to establish first mover market position, as
in Shanghai. It has continually invested in new products to satisfy the needs of
developing luxury sectors.
The product life cycle for fashion products tends to be short; Vuitton has produced
a range of classics that have stood the test of time and has managed to avoid many
of the problems associated with the fashion product life cycle.

Perceived price and differentiation

Everything Vuitton does is aimed at maintaining its position in the highest price and
differentiation sector of the success likely area.
 There are no price reductions for sales
 Workmanship is impeccable
 Quality standards are emphasised by the free lifetime repair guarantee
 The use of high profile supermodels
 Taking chances with innovative designers
The Vuitton brand name extends to all products under its umbrella.
Portfolio
Vuitton has the dominant market share with sales double that of its nearest compet-
itors. This places it firmly in the Star quadrant of the BCG. On the evidence of
relative margins, it appears that Vuitton is benefiting from scale economies. For
example, despite its relatively low marketing spend, Vuitton is spending the same in
absolute terms as its competitors.
Internal Factors
Value chain
Vuitton appears to have a particularly effective value chain and supply chain,
although there is no guarantee that it will accommodate future growth plans.
The support activities are geared towards an innovative approach:
 Technology development: New products are derived from the existing portfolio
and developed quickly, in some cases bypassing the established procedures.
 Human resource management: The team structure and involvement of employ-
ees – coupled with the attention paid to their suggestions – appears to have led
to high levels of productivity.
 Management systems: The labour intensive cottage industry has been trans-
formed into a modern factory business without compromising the ‘handmade’
image.
The primary activities appeared to be well designed:
 Operations: The relatively high margins suggest a high level of overall productiv-
ity despite being a labour-intensive industry; it is possible to get products to
market in a relatively short time. Mr Mathieu has progressively modernised pro-
duction and the cumulative impact of a 5 per cent per annum productivity
increase has become apparent in the relatively high operating margin.
 Marketing and sales: Marketing was proactive; however, the distribution network
is becoming increasingly strained as the number of outlets increases.
 Service: The free lifetime repair service was designed to ensure that customers
were retained.
Vuitton benefits from an integrated value chain where there are clear linkages
between the support and primary activities.
Core competence
Vuitton’s core competence lies in the production of value associated with the brand.

While the range of products has been increased, there has been no attempt to
diversify and extend the brand image outside the luxury goods sector. This is a
classic case of ‘sticking to the knitting.’
Vuitton has taken active steps to ensure that its market position is protected and its
production system delivers what consumers want in a cost-effective manner.
There is a sound understanding of the macro and industry environment and the
internal organisation necessary to support the luxury brand.
Vuitton has had a clear corporate strategy of expansion since the appointment of Mr
Carcelle and it has acted consistently with this strategy. The international expansion
has been pursued in a methodical fashion and competitive advantage has been
transferred to foreign markets.
At the business level, Vuitton has pursued a strategy of differentiation and has
pursued the rich market segment wherever it appeared. Growth has not been
pursued at the expense of differentiation and there is no danger that Vuitton will
end up stuck in the middle.
Strategy Variations
Vuitton has pursued organic growth and has not made acquisitions or gone into
alliances.
Choice
While Mr Carcelle is clearly in control, there is significant input from executives
such as Mr Mathieu, the marketing team and shop floor employees. There is a
feeling that everyone is involved in the strategic process.
There was a clear view of the basis of competitive advantage and the role of
employees in formulating options.
A SWOT analysis provides an indication of where Vuitton should go next.
Brand name Emergent economies
Efficient and flexible organisation Growth in incomes
New products
Weaknesses Threats
Parent LVMH may have cash problems Counterfeiting
Overextended distribution system Big names such as Prada and Gucci
Vuitton does not appear to derive benefit from being part of LVMH either in
reputation or financial terms. While Vuitton needs to maintain first mover ad-
vantage in new markets, it must protect its reputation. There is a good case for
stabilisation and consolidation rather than pursuing growth for its own sake. There
is a danger that further pursuit of growth will lead to reduction in margins and, if
the supply chain becomes too stretched, it may lead to problems with quality and
delivery.


Vuitton is a division of the holding company LVMH. It does not fall naturally into
the divisional structure classification, nor does it have a matrix structure. It is a flat
decentralised organisation.
Resource Allocation
There is a clear recognition of the need for efficient resource allocation and it is
significant how the production processes have been developed in a more sophisti-
cated fashion than at Hermes.
Vuitton can be characterised as ‘tight strategic’ in the planning and control matrix:
relatively low spend on marketing and the care with which it approaches new
markets.
Despite its glamorous image, Vuitton is focused on efficiency and has made a
determined effort to convert the company into a modern business enterprise.
Feedback
The company can be defined as a learning organisation. The Boulogne Multicolor
bag is an example of how company information – as expressed by store managers –
was acted on. The grouping into specialised work teams and the willingness to
decentralise problem solving to the lowest possible level made it possible to get the
new bag to the market in a very short time.
Vuitton’s success was based on a robust strategic process initiated by Mr Carcelle
and carried through by enthusiastic executives such as Mr Mathieu.
The View from Now

In 2007 it was demonstrated that Vuitton had a robust strategic process which
helped account for its success up till then. The robust strategic process provided the
basis for long-term success which Vuitton has continued to enjoy. In 2014 it was
ranked as the 29th brand worldwide with a brand value estimated at $16 billion. This
is an example of explaining success rather than failure using the strategic process
and demonstrates that success can be maintained on the foundation of a robust
process.
Case 8.7: Implementation: The Missing Link (2006)

1
Strategists
Carly Fiorina was a prospector who pursued opportunities, but her statement of
‘high tech, low cost’ contained a potential contradiction. Her unwillingness to recruit
and her firing of executives on the basis of a single financial result suggests a power
culture. The opinion of her replacements was that she was deficient in the imple-
mentation dimension of the strategic process.

There were disagreements at board level on strategy and the statements after her
departure suggest continuing lack of agreement on or understanding of what she
was trying to do.
Objectives
HP’s profitability was largely dependent on a single product – printers – and it
appeared that the intention was to enlarge the product portfolio and benefit from
economies of scale and synergy, but economies of scale are often difficult to achieve
and synergy is elusive. The computer market was becoming increasingly fragmented
and Ms Fiorina seemed to be having trouble identifying what business it was in.
The combination of a power culture, serious top-level disagreements, and potential-
ly contradictory objectives made it difficult to weld such a large organisation into a
cohesive whole. The conflict between Ms Fiorina’s style and the existing collegiate
culture led to principal–agent problems.
Macro Environment
PEST
 Economic: Computing in the wide sense was increasingly becoming a consumer
product.
 Social: Expectations were ease of use, standardisation, and low cost.
 Technological: Corporate installations and software services were becoming
increasingly specialised.
These all presented challenges to which HP was slow to react.
Industry structure
The PC market was an oligopoly and Dell had initiated a classic price war based on
its low cost structure.
The printer market was almost a monopoly, but it was certainly a contestable
market. Once Dell entered with what is essentially a homogeneous product, HP
would have to invest heavily and innovate to compete on anything but price.
The corporate computing market was segmented and HP found it difficult to
compete with specialised providers.
There were few barriers to entry in the PC or printer markets so HP was always at
risk from competitive moves.
Five forces
The five forces vary to some extent among products but the following profile
applies to the high-technology sector.
Competitive force
Bargaining power of Standardisation and the growth of High Increasing
buyers specialist suppliers
Bargaining power of HP was large enough to have Low Not expected to
suppliers considerable purchasing power increase

Competitive force
Threat of new entrants Appearing in all markets High Increasing in both
standardised and
specialist markets
Threat of substitutes Technical advances happening all High High investment
the time required to stay
ahead
Rivalry Cut-throat competition leading to High Some companies
low margins prepared to wage a
war of attrition
HP was operating in an increasingly competitive environment where quality
differences counted for less and less.
Price differentiation matrix
HP had traditionally operated in the high-differentiation, high-price sector, but with
the advent of low cost competitors and its own moves into homogeneous products
it had shifted into the success uncertain area. The ‘high tech, low cost’ position was
by definition in success uncertain.
Product life cycle
The PC market was in or approaching maturity and it would be difficult to achieve a
higher market share – a zero-sum game. The lack of new products or real differenti-
ation, coupled with the management focus on internal issues, meant that market
share would be continuously under pressure.
Portfolio
The printer was HP’s Cash Cow, but as the product became homogeneous it was
increasingly subjected to competition.
Since Dell had a higher PC market share – 18 per cent versus 16 per cent – than
HP, it is doubtful whether HP would be able to achieve Cash Cow status.
The corporate sector was growing but it seemed as if HP was at the Question Mark
stage at best.
The software market was also growing but HP was finding it difficult to expand into
the market and to make a profit. There was a real danger of software becoming a
Dog.
Thus, despite its size, HP had a weak portfolio; it had no Stars because of the lack
of innovation.
Internal analysis
Value chain
Ms Fiorina attempted to streamline the value chain but encountered a great deal of
resistance. The value chain was not capable of competing either with standardised
products or in corporate computing. Weaknesses in the value chain include R&D,
management in support activities and marketing in primary activities. There were no
obvious linkages among the value chains of the different businesses.

Innovation and R&D

HP is highly dependent on innovation, and the process by which innovations are
developed for the market is crucial. But few of the recent innovations had been
successful and the fact that HP had licensed the iPod indicated that its innovation
process was inefficient. There appeared to be major barriers in the innovation
process.
Economies of scale
The rationale for the Compaq merger had not borne fruit. HP’s low margins in its
non-printer businesses demonstrate that sheer size does not necessarily lead to low
unit cost compared to competitors.
Human resource management
The combination of the need for change, a power orientated CEO and the colle-
giate culture that had served HP well for several decades led to internal disruption.
Synergy
The notion that the acquisition of another computer company would produce
synergies is difficult to follow. There is little apparent linkage between printer and
PC production and corporate computing and software. HP had arrived at a situation
of unrelated diversification without apparently realising it.
Core competence
The pressure on HP to break up is indicative of the fact that there was no unique
competence that generated value and that the parenting influence of the corporate
centre was unclear.
Finance
HP was unable to meet its own profit targets, and it was exposed by its reliance on
the printer business. Any advances made by Dell, for example, could lead to a
sudden slump in the share value. HP’s share price volatility is demonstrated by the
10 per cent increase in value in response to Ms Fiorina’s resignation.
The source of HP’s competitive advantage is difficult to identify. It did not appear
to have an advantage in PCs or corporate computing, while its domination of the
printer market was contestable. Whatever competitive advantage HP had did not
appear to be sustainable.
HP was faced with changing consumer preferences, increased competition in all
markets and an internal structure that was not conducive to change. Ms Fiorina’s
actions had not really addressed these issues.
At the corporate level Ms Fiorina pursued diversification and growth. The rationale
for both was low cost to compete with more focused rivals.
At the business level HP was in danger of being stuck in the middle – ‘high tech,
low cost’. The sales model continued to be based on differentiation (high tech) but

the danger was that the differentiation made no difference to the consumer, who
tended to make decisions based on price.
Strategy Variations
Given its position in mature markets, Ms Fiorina undertook expansion by acquisi-
tion. The major merger with Compaq was a doubtful success, while the smaller
acquisitions (such as PWC) were pursued in a half-hearted fashion.
Choice
The choice process was centred on Ms Fiorina, who pursued her choices in the
teeth of opposition both from the board and from senior colleagues. This led to a
lack of management commitment to her strategies.
Overall Choice
Ms Fiorina did not appear to have a systematic approach to choices, the basic
motivation being to dominate markets at all costs. Because of the intense competi-
tion market domination was impossible.
Ms Fiorina made major changes to the supply chain but did not win the support of
employees.
Resource Allocation
In terms of value creation, HP was a printer company. Whether it should channel
resources to the other businesses depends on whether they are classed as Stars or
Dogs. But resources appeared to be allocated without reference to value creation.
Ms Fiorina could be classified as ‘tight financial’, given her reaction to one poor
quarter. Variations in returns are a symptom of deeper causes and are unlikely to be
the ‘blame’ of particular executives.
The major criticism of Ms Fiorina was that her implementation of the strategy was
at fault. Given the imprecise nature of objectives and the shaky foundations of
choice, it is not surprising that implementation appeared to be weak: implementing
for what? The lack of a chief operating officer indicates the low priority that
implementation had for Ms Fiorina.
Feedback
It appears that Ms Fiorina pressed through with her changes in spite of negative
feedback from colleagues and the board. Whether she was right to do so is a matter
of judgement since it is possible that HP would have been even less able to react to
changing circumstances had the old regime remained in control.
So was firing the boss the answer? The conclusions from applying models within
the process can be brought together into a SWOT analysis.

HP brand Acquire software companies
Domination of printer market Exploit high-tech servers
Reduce costs
Weaknesses Threats
Power culture Oligopoly
Disagreements on objectives Homogeneous markets
Weak value chain New entrants
Ineffective R&D Changing customer preferences
Reliance on synergy Stuck in the middle
Reliance on printers
Weak profitability
Employee dissatisfaction
Loss of senior executives
In the light of the SWOT analysis, it could be argued that HP had nowhere to go in
its current structure. From this viewpoint, HP started from a weak competitive
position and Ms Fiorina attempted to address it by fundamental change that she was
actually unable to carry through. In this sense her failure can be attributed to
implementation, but as always there were many other determining factors; the
strategic process was not robust.
Concentration on a charismatic leader can obscure the extent of underlying prob-
lems. Ms Fiorina took over an ailing giant with a strong management culture. By the
time she left, the business was greatly changed – it included Compaq and many
employees had been shed – and it may have lost the uniqueness that gave HP its
competitive edge. It could be argued that only she was capable of dealing with the
new giant she had created; the right time to fire her could have been before the
Compaq merger to prevent it happening, as several board members had wanted.
The View from Now

After Ms Fiorina, HP went through several CEOs; Mark Hurd was an aggressive
cost-cutter, Leo Apotheker bought Autonomy, which turned out to be a disaster
and led to $30 billion being wiped off the company value. Both left with severance
packages of about $25 million. Meg Whitman has set in motion major changes
including splitting the company into two parts – the PC and printer business and
technology services. It has been reported that she is in line for a severance package
of $50 million – twice that of her predecessors. The history of HP demonstrates the
impact that leaders have on a major organisation; it seems that the leaders have had
difficulty deciding what business HP is in and with the potential split of the compa-
ny that still seems to be the case.


1
Objectives
Clear and well specified, based on extensive research.
Strategist
Sir Terry had a track record and was well aware of the risks both to himself and the
company. He had the attributes of an analyser and prospector.
The combination of clear objectives and a strong leader who was aware of princi-
pal–agent issues was a positive factor.
Macro Environment
Political Market domination at home led to international expansion
Economic The US has one of the highest per capita incomes in the world
Social Consumer habits in the US were conducive to convenience shopping and ready
meals; trend to healthy eating; green marketing
Technological US lagged in logistical efficiency; compartmentalised trucks; database analysis
Tesco took advantage of all aspects of the PEST. They also had an effective
environmental scanning process to identify opportunities.
Discussed above: the attempt to mitigate the five forces might not be successful.
Internal Factors
Discussed above: there was belief in core competence, but whether that core
competence was aligned with US preferences was open to question.
The central issue is whether the UK competitive advantage is country or company
based and can be transferred successfully.
The move was based on detailed market research and a sound understanding of the
basis of Tesco’s competitive advantage. But the intangible issue of transfer of
competitive advantage was uncertain.
Generic strategy
At the corporate level expansion and at the business level differentiation; this had
been the basis for Tesco’s previous expansion.
Strategy variations
Tesco pursued organic growth and was forced into international expansion because
of the dominant UK market share.

Choice
The choice process was based on data collection and analysis; growth was not
pursued for its own sake but in the pursuit of value added – ‘transformational’.
Once the decision had been made a major commitment was undertaken. The
dangers of becoming stuck in the middle were understood.
Resources and structure
The database enabled decisions to be taken at the local level.
Resource allocation
The database approach enabled fine-tuning of resources at all levels.
Evaluation and control
Sir Terry was willing to accept the possibility of financial loss; Tesco can be classi-
fied as ‘strategic control’ in the planning and control matrix.
Tesco was highly efficient in the UK and intended to transfer that efficiency to the
US.
Feedback
Sir Terry was not a remote figure and Tesco could be classified as a learning
organisation.
Tesco’s strategic process was highly robust and is the foundation of its success in
the UK. If failure occurs it is more likely to be due to exogenous shocks than to
weaknesses in the process. Warren Buffet was in favour of the move and committed
his own money to it.
The various strands can be captured in a SWOT.
Clear objectives New approach: quality based on
Understanding of market convenience
UK value chain New product: ready meals
Financial security
Willing to take risk
Weaknesses Threats
Unknown reaction of US shoppers Imitable
Logistics still to be constructed Fast reaction of incumbents
Financial power of Wal-Mart
It emerges from the SWOT that the strengths and opportunities are aligned, which
is to be expected given the explicit and informed decision to go ahead. But it also
emerges that the weaknesses are aligned with the main threats of being imitable and
fast competitive reaction. In particular, Wal-Mart is well placed to take up the
challenge. Although Tesco was entering the market in a big way in some localities,

the US is a very large market and it may end up confined to its original entry sites.
Whether that would be economic is open to question.
The paradox emerges that while Tesco’s strategic process is robust and is a founda-
tion for success, the SWOT analysis suggests that prospects are highly uncertain.
The View from Now

Tesco did pull out of the US in 2013. But the drive for expansion both at home and
abroad appears to have led to a lack of focus. Executives appeared to be blind to the
threat from low cost rivals Aldi and Lidl, and Tesco’s market share in the UK fell
from 30.6 per cent in 2011 to 28.7 per cent in 2014. As a result the share price
halved between 2012 and 2014. But worse was to come: eight senior executives were
suspended when it was found that profits had been overstated by £250 million and
the Serious Fraud Office initiated a criminal investigation. In 2015 Tesco announced
a loss of £6.4 billion, one of the biggest corporate losses in UK history. It also
announced that 49 planned stores would be abandoned and that its stores portfolio
would be reviewed. How could these failings occur? They stemmed from weakness-
es in environmental scanning and in the Evaluation and Control sector of the
process model. So at one time the rise of Tesco appeared unstoppable but these
weaknesses in the strategic process led to catastrophic outcomes.
Case 8.9: Revisit The Timeless Story of Entertainment

1
Strategists
The prospectors had been replaced by non-entertainment industry CEOs (possibly
analysts) when they ran into trouble. Lack of continuity of leadership had been
avoided by HBO. Possibly the strategists in other companies had confused their role
with that of the creators of the products.
Objectives
HBO had established clear objectives which provided a focus for the business.
Disney’s objective was to produce a major animation, rather than identifying what
kind of animation would be successful.
It does not appear that any one type of strategist is most appropriate for the
entertainment business. Clear objectives appeared to be a major factor in HBO’s
success. This is the same as other industries.
Macro Environment
It is very difficult to predict what consumers will like. This is the same as other
industries such as fashion and electronics.
Five forces
The high level of competition was demonstrated in Question 1 of Case Study 5.7,
and this occurs in many other industries.

Product life cycle

Product life cycles for individual products are extremely short, although the life
cycle can be extended by variations on past success, such as the Rocky, Die Hard and
Matrix movies. The product life cycle of a generic product, such as cutting-edge
drama, is much longer.
Short product life cycles occur in many industries, such as fashion. In such cases,
the brand has a much longer life cycle than individual products.
Portfolio
HBO could be characterised as a profitable Dog. It has a low share in a low growth
market. Profitable Dogs can be found in other industries.
Price and differentiation
Differentiation in entertainment is hard to achieve because of the ease of imitation;
for example, the many Rocky-type movies. But original cutting-edge TV drama is
difficult to copy and once the company has generated a reputation or brand and has
attracted creative people, it is hard to dislodge it from its market position. HBO had
positioned itself in the ‘success likely’ sector and was likely to stay there.
As in other industries, it is the position in the matrix which contributes to success or
failure.
Internal Analysis
Culture
Entertainment companies tend to have a power culture, but HBO appeared to have
avoided that. In other industries many companies are dominated by a charismatic
leader (who sometimes has a sudden fall as in entertainment).
Core competence
The HBO core competence is difficult to imitate and gave it a competitive ad-
vantage. This is the case with any core competence; the fact that it was based on
creative people posed particular management issues but again that is not unusual.
Value chain
The value chain in big entertainment companies tends to focus on primary activities
in boom times, but the support (finance) activities take over when times are hard
and stifle creativity. HBO avoided this by focusing on the linkages in the value
chain. This type of response is found in most industries.
The basis for HBO’s lasting competitive advantage lies in doing well what other
entertainment companies do not do. This is the usual basis for competitive ad-
vantage.
Choice
At the corporate level HBO did not attempt to grow in competition with the major
companies.
At the business level the natural generic choice in entertainment is differentiation,
but large companies often end up stuck in the middle because they are high cost but

not sufficiently differentiated. HBO aimed at a differentiated niche. This is found in

many industries.
There appear to be few economies of scale or scope. In fact, the success of HBO
suggests that the conglomerates have little cost advantage. Many industries do not
have significant economies of scale.
Resource Allocation
There seems to be a tendency to justify expenditure on the basis of past success and
there are few efficiency criteria. Lack of rational resource allocation is not unique to
the entertainment business.
In the big companies cost control appears to have been relaxed when times are
good, thus giving rise to the pendulum effect. The big companies operated in the
‘loose control’ sector of the planning and control matrix, while HBO operated in
the ‘strategic control’ sector. One of the main reasons for failure in any industry is
the lack of appropriate controls.
Feedback
The extravagant media moguls never seemed to learn from the past. They appeared
to lose sight of the fact that much of the success is random and is not due to their
own foresight (see Mr Goldman’s remark). HBO had learned a success formula and
stuck with it.
The application of the process model and HBO’s actions suggests that the enter-
tainment business does not differ from other industries. The risks are high and the
people are difficult to manage, but this is all a matter of degree.
The View from Now

HBO has continued to be innovative and successful as analysed in the case. A
recent major success was Game of Thrones. Need one say more?
Case 8.10: Revisit Driving Straight

1
Strategist
The Fiat situation clearly required someone to reconfigure the company. Mr
Marchionne had a track record of success, had other options and could pursue his
own agenda. There did not appear to be any principal–agent problems, given that he
had the backing of the Agnelli family.
Objectives
Mr Marchionne set out the clear objective of fixing the car business and focusing on
styling.


Mr Marchionne had identified the core business of Fiat Group as the cars and that
the future of the company depended on the success of that division. There was thus
a strong leader with a clear vision.
The car industry is an oligopoly where it is necessary to compete on differentiation
rather than price. The problem was that Fiat was neither low cost nor sufficiently
differentiated so it had become stuck in the middle.
Five forces
Competitive force
Threat of new en- The international majors were liable to break High
trants into local markets at any time
Threat of substitutes New technologies were continually being High
applied to upgrade the product
Bargaining power of There is plenty of choice of models High
buyers
Bargaining power of The unionised workforce reduced flexibility High
suppliers
Rivalry Oligopoly High
The profile suggests a highly competitive industry in which it is difficult to generate
significant margins. In this situation, once Fiat had lost its competitive edge it was
going to be difficult to win it back.
Perceived price differentiation
Fiat had shifted into the success uncertain area and was heading towards failure
likely. Mr Marchionne tackled this by focusing on design (perceived differentiation)
plus the premium brands which added to Fiat’s reputation.
Product life cycle
The existing models had reached the end of the product life cycle and the lack of
centralised design meant that replacements were not forthcoming. Mr Marchionne
ensured that new models were in the pipeline.
BCG matrix
Fiat could be characterised as a Dog – having lost market share in a stable market.
By shifting Fiat up in the perceived price differentiation matrix, Mr Marchionne
won back market share and Fiat began exhibiting Cash Cow characteristics, which
made it possible to generate profit.
Mr Marchionne improved Fiat’s position in several dimensions: market positioning,
financial strength, and value chain.
The clarity with which Mr Marchionne perceived Fiat’s problems and solutions is
striking.

Strategic Variations
The GM partnership was not successful, probably because of the principal–agent
problems it created. Mr Marchionne reckoned that Fiat must grow organically and
fall back on its own resources.
Subsequently he pursued a strategic alliance with Chrysler, where he had identified a
strategic fit.
Generic Choice
 Corporate level: Mr Marchionne initially pursued retrenchment by getting out of
the GM partnership and scrapping models. He then went for expansion based
on a portfolio of new models.
 Business level: Fiat was stuck in the middle and Mr Marchionne re-established its
cost leadership base while pursuing effective differentiation.
Choice
The new flat leadership structure meant that managers could identify with strategic
choice as it was not dictated from a remote hierarchy.
Mr Marchionne made major choices that determined the future of Fiat in such a
way that he carried the workforce with him.
He decentralised by devolving responsibility.
Resource Allocation
His focus was on efficiency, particularly in relation to the elements of the value
chain.
Fiat cannot really be placed in the planning and control matrix prior to Mr Mar-
chionne because it seemed to be totally lacking in planning and control systems. Mr
Marchionne positioned Fiat in the strategic control sector: medium degree of
devolved planning and clear strategic aims.
Mr Marchionne ensured that the structure existed to put his strategic choices into
action effectively. He ensured that ineffective implementation did not constrain his
vision.
Feedback
Mr Marchionne not only changed the management order; he also listened to the
‘kids’. By getting rid of the hierarchy he made it possible for Fiat to develop into a
learning organisation.
The MBA student reckoned that Mr Marchionne had worked through the elements
of the process model systematically. By strengthening all elements of the strategic
process, he set the scene for Fiat’s success. The fact that he was able to transfer
success to Chrysler supports the view that he understands the strategic process.

The View from Now

Mr Marchionne went on to be CEO of Chrysler and worked the same magic,
returning it to profit two years after bankruptcy. Mr Marchionne is an example of a
CEO who understands how to implement strategy in its widest sense and is able to
transfer that knowledge from one company to another. Fiat Chrysler Automobiles is
now a major global carmaker.

1
Strategists
Family ownership and executive control led to a principal–agent problem: there
were no shareholders to express concern when things started to go wrong. Mr
Knudstorp was willing to undertake radical change and was clearly an analyser. He
did not have prospector characteristics in that he decided to take the firm back to its
core rather than continue to innovate. His CFO background meant that he would
probably focus on getting the finances right as a first priority.
Objectives
Lego is a world-famous toy-maker. The management of theme parks and ‘lifestyle’
products requires a different skill set. The lack of a clear business definition meant
that Lego lost its focus on the core business.
The lack of accountability and shifting business definition went hand in hand.
Five forces
Discussed above: the family management had not recognised the change in com-
petitive conditions, just as they appear to have missed many of the PEST issues. The
increased threats from new entrants and substitutes reduced margins, as did the
increased power of buyers and rivalry. But management did not appear to have
identified the need to control costs.
Product life cycle
The toy market is mature in developed countries, although it is income elastic so a
certain amount of growth can be expected from time to time. But the strategic
implication is that Lego should have defended its position in the mature stage, but it
lost its focus on the target customer.
Portfolio
Lego had differentiated into a number of question mark products and was unable to
develop them into cash cows. Once they were divested, the company moved back
into profit because the core building brick product was clearly a cash cow.
Price differentiation
By diversifying into a range of products, Lego was in danger of losing the perceived
differentiation of its core product.

Internal Analysis
Financial
The financial situation arrived as a surprise, although the signs had all been there for
some time: increased competition, falling profitability and increasing debt.
Human resources
The power culture that had developed under family control was replaced by a task
culture by Mr Knudstorp.
Value chain
Mr Knudstorp took steps to improve the elements of the value chain as follows:
Primary activities Action
Operations Improved efficiency and reduced workforce
Out-bound logistics Relocated production facilities
Marketing and sales Improved relations with customers
Support activities Action
Technology Reduced development time for new products
Human resource management Improved communications
Management systems Incentive system
His objective was to create a unified value chain with strong linkages among the
elements. For example, the film tie-in products such as Star Wars and Harry Potter
fitted into the value chain.
Core competence
Lego’s core competence was the production and marketing of bricks and closely
related products. Theme parks and lifestyle products did not share the routines or
the resources and were instances of unrelated diversification. Lego management had
not realised how far they had strayed from their core competence.
It turned out to be impossible to extend the Lego brand into other areas profitably.
This was a classic case where the management did not understand the basis of the
company’s competitive advantage.
By the early 2000s Lego had lost sight of its competitive advantage and it took the
strong leadership and clear vision of Mr Knudstorp to restore it.
Generic Strategy
The corporate strategy was to expand into unrelated markets, given that the core
business was mature. This was changed to retrenchment and stabilisation in
response to the financial crisis.
The business level strategy was differentiation, but because of the scale involved and
the high degree of competition, it was essential to keep costs under control. It was
not recognised that the degree of differentiation could no longer insulate Lego
against high costs and it ended up stuck in the middle.

Strategy Variations
Lego developed by internal growth and did not attempt to acquire other companies
or enter into joint ventures. The sale of the Legoland parks resulted in a minority
shareholding where there was no decision-making power.
Choice
Choices had previously been made by the Christiansen family, who were probably
greatly influenced by the past experience of success without realising that times had
changed. The professional, Mr Knudstorp, introduced an objective approach based
on relevant information and consultation.
Overall Choice
A random and reactive approach was replaced by choice based on a clear vision of
the company and its core competence.
Lego was highly centralised and little power was devolved to the divisions. As a
result, top management dealt directly with a wide-ranging portfolio that it did not
understand.
Resource Allocation
Under family control the principles of resource allocation were not systematic, given
the rapid descent into loss. Mr Knudstorp improved the elements of the value
chain.
Under family control there appeared to be no systematic controls and Lego slipped
into crisis without anyone noticing. Mr Knudstorp shifted Lego from Loose
Planning to Tight Financial control.
Lego was an organisation that could have fallen into crisis at any time because it had
no systematic understanding of its performance in the financial and competitive
senses. Mr Knudstorp’s contribution was to bring an awareness of business reality.
Feedback
The lack of willingness to ‘speak about money’ was symptomatic of the lack of
appreciation of business issues at all levels. Mr Knudstorp attempted to change
Lego into a learning organisation.
The process was weak in most dimensions prior to Mr Knudstorp assuming control.
He took action in most dimensions and that is the reason for the turnaround in the
financial and competitive positions. Whether Mr Knudstorp developed a long-term
competitive advantage remains to be seen.
The View from Now

The strategic improvements introduced by Mr Knudstorp appear to have been the
basis for long-term competitive advantage. Initiatives such as licenses for Indiana
Jones and Star Wars led to a global increase of 20 per cent in sales. So successful has

the company become that in 2014 Warner Brothers and Lego released an animated
movie – The Lego Movie – to universal acclaim. It was concluded in the case that Mr
Knudstorp had strengthened most dimensions of the strategic process and this was
the foundation for later success; Lego has been able to identify and take advantage
of opportunities as opposed to being reactive in the years leading up to the crisis.

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19. Porter, M.E. (1990) The Competitive Advantage of Nations, New York: Free Press.
20. Garvin, D.A. (1986) ‘What does product quality really mean?’, Sloan Management Review,
Vol. 26, No. 1.
21. Powell, T.C. (1995) ‘Total Quality Management as competitive advantage’, Strategic
Management Journal, Vol. 16, pp. 15–37.
22. Boston Consulting Group (1970) The Product Portfolio Concept: Perspective No 66. Boston,
MA: Boston Consulting Group.
23. Porter, M.E. (1980) Competitive Strategy: Techniques for Analyzing Industries and Competitors,
New York: Free Press.
24. ‘Dumping crisis threatens salmon farming’, The Scotsman, 10 July 1991.
25. Ansoff, I. (1987) Corporate Strategy, New York: McGraw Hill.
26. Cooper, R. and Kaplan, R.S. (1987) ‘How cost accounting systematically distorts product
costs’, in Bruns, W.J. and Kaplan, R.S. (eds) Accounting and Management: Field Study Perspec-
tives, Boston, MA: HBR Press.
Strategic Planning Edinburgh Business School R/1

References
27. Kaplan, R.S. (1984) ‘Yesterday’s accounting undermines production’, Harvard Business
Review, July–August.
28. Kaplan, R.S. (1988) ‘One cost system isn’t enough’, Harvard Business Review, January–
February.
29. Smith, T. (1996) Accounting for Growth, 2nd Edition, New York: Random House Business
30. Mansfield, E. et al. (1977) ‘Social and private rates of return from industrial innovations’,
Quarterly Journal of Economics, Vol. 19.
31. Handy, C. (1993) Understanding Organisations, 4th edition, London: Penguin.
32. Porter, M.E. (1985) Competitive Advantage: Creating and Sustaining Superior Performance. New
York: Free Press.
33. Chiesa, V. and Manzini, R. (1997) ‘Competence Based Diversification’, Long Range
Planning, Vol 30, No 2, pp. 209–17.
34. Porter, M.E. (1985) Competitive Advantage, New York: The Free Press.
35. Miles, R.E. and Snow, C.C. (1978) Organizational Strategy, Structure and Process, New York:
McGraw-Hill.
36. Porter, M.E. (1987) ‘From competitive advantage to corporate strategy’, Harvard Business
Review, May–June, pp. 43–59.
37. Wilson, P. (1991) ‘Myths which can sink you’, Financial Times, 9 March.
38. Kaplan R.S. and Norton D.P. (1996) The Balanced Scorecard, Boston, MA: Harvard
Business School Press.
R/2 Edinburgh Business School Strategic Planning

Index
accounting practices 6/11 competitive price 4/31
accounting ratios 6/17–6/22 competitive reaction
accounting report 1/28, 1/32 kinked demand curve 5/15–5/17
accounting techniques 6/14 competitive threat 7/9
acquisition 7/24 consensus decisions 7/48–7/50
advance capacity 7/10 consumption expenditure 4/31
alliances 5/14, 7/29 contingency planning 7/45
Amstrad case study 7/52, 4/85–4/87 control, and evaluation 8/15–8/18
analyser (manager type) 7/17–7/19 core business 1/46
Apple computer case study 5/75 core competence 6/43–6/46
balanced scorecard 8/35 corporate management 7/38–7/40
barriers and synergy 6/36
strategic 5/54 corporate strategy 1/42–1/47
structural 5/54 portfolio models and 5/42–5/43
barriers to entry 5/50–5/56 cost leadership 7/13
BCG relative share growth matrix 5/36– costs
5/40 and economic activity 4/32
benchmarking 6/22–6/23 and revenue 4/2–4/4
Beta coefficient 3/23 fixed 6/4
Body Shop case study 8/29–8/30, 8/30 production 6/11–6/14
bounded rationality 1/11, 3/19, 6/39 sunk 6/4
break-even analysis 6/14–6/15 variable 6/4
budgets 8/13–8/15 crises 1/34–1/35
business cycles 4/22–4/24 critical success factors 2/3, 8/11
capacity utilisation culture
and synergy 6/36 personal 6/30
capital asset pricing 3/23 power 6/29
capital, cost of 3/22–3/23 role 6/30
capitalised value 3/21–3/22 task 6/30
Cash Cow (product type) 5/38, 5/39– defender (manager type) 7/17–7/19
5/42, 7/39 demand
cash flow 1/34, 3/20–3/21, 3/23–3/25, and supply 4/10–4/12
3/26, 5/42 factors 5/6–5/7
causal ambiguity 6/51 demand curve 5/2–5/13, 5/40, 5/48
CEO’s statement 1/28, 1/30, 1/32 and market share 5/7–5/9
change, management of 8/9–8/11 and marketing expenditure 5/9–5/12
combination strategies 7/12 and revenue 5/3–5/5
companies, evolution of 2/10 elasticity 5/3
competences 6/43–6/46 estimating 5/12–5/13
competition 5/61 kinked 5/15–5/17
analysis of 8/23–8/28 shift of and shift along 5/10
oligopoly 5/57 demand related unemployment 4/11
perfect 5/50–5/52 development 6/26–6/29, 6/55
competitive advantage 6/50 cost overruns 1/34
competitive advantage of nations 4/18– report 1/29, 1/31
4/20 development engineer 6/27
competitive position 8/23–8/28 discounting 3/20
Strategic Planning Edinburgh Business School I/1

Index
distinctive capabilities 6/43–6/46 external action 7/24

diversification 1/44, 5/45 external dependence 7/46
replication based 6/48 externalities 5/59
resource based 6/48 familiarity matrix 7/39
routine based 6/48 feedback 2/2
trajectory 6/49 finance report 1/29, 1/31
unrelated 6/49 financial controls 6/27, 8/17
divisional structure 8/4 first mover advantage 5/68–5/70, 6/27
divisionalisation 1/44 five forces 5/60
Dog (product type) 5/38, 5/41–5/42, fixed cost 6/4
7/11, 7/38 focus strategy 7/14
dominant management logic 1/46 forecasting, economic 4/20–4/24
durability 5/35 foreign GNP 4/15
dynamical systems 1/27 frictional unemployment 4/11
ecological concern 3/28 functional structure 8/3
economic indicators 4/7, 4/35 game theory 5/13–5/15
economic report 1/29, 1/31 competitive reaction 5/13–5/15
economics 4/2 gap concept 3/7–3/9
economies of scale 5/69–5/71, 7/10 gearing ratio 6/20
and synergy 6/36 generic strategies 7/7–7/19
economies of scope 6/32–6/35 and company performance 7/19
economy assessing 7/12
and profitability 4/29–4/33 product-based 7/13–7/15
forecasting 4/20–4/24 SBUs 7/17–7/19
international 4/15–4/20 globalisation 1/47
workings of 4/4–4/20 government
elasticity and allocating 5/60
demand curve 5/3 and market failure 5/57
GNP 4/30 and regulating 5/59
supply 5/47 and rule making 5/58
emergent strategy 1/11 expenditure 3/2
environment, economic 4/2 gross national product (GNP) 4/10–4/12
environmental scanning 4/26 elasticity 4/30–4/31
environmental threat and opportunity foreign 4/15
profile 4/2, 4/33–4/35, 5/73–5/74, full employment 4/10
7/3 potential 4/10
environmental threats and opportunities growth vector 5/43
3/1–3/2 hedonic price index 5/29
ethics 3/36 historical cost 6/11
evaluation human resource management 6/29
and control 8/15–8/18 imports 4/6
exchange rate fluctuations 4/16–4/18, incentives
4/34 and performance gaps 3/9
exogenous shocks 4/22, 5/69, 6/13 inflation rate 4/5, 4/6, 4/8
expansion 7/10 and unemployment 4/12–4/15
international 7/29–7/31 relative 4/15
expectations 4/14 information, qualitative and quantitative
expected utility maximisation 7/44 1/38
expected value 7/42 innovative stimulus, and synergy 6/37
experience effects 5/69–5/71, 7/10 input prices, and economic activity 4/32
exports 4/6 integration 1/40, 6/36, 6/37–6/40
I/2 Edinburgh Business School Strategic Planning

Index
interest rate 3/20, 3/21, 3/22 military strategy 1/17

internal action 7/24 minimax 7/46
internal analysis 6/1–6/63 model(ling) 2/1–2/8
company characteristics 6/22–6/23 benefits and costs 2/4
international economy 4/15–4/20 components 2/2–2/4
international expansion 7/29–7/31 monopoly 5/53–5/54
inventories 6/7–6/8 moral issues 3/36
investment appraisal 6/16, 6/17 net present value (NPV) 3/20–3/21, 6/3,
investment expenditure 4/7 6/16
Jaguar case study 7/53, 4/87–4/89 new entrants 5/62
joint production objectives 3/42
and synergy 6/37 aggregate 3/12
joint ventures 7/29 and plans 3/2
labour relations 1/35 behavioural 3/17
labour turnover 6/55 credible 3/9
launch strategy 5/23 disaggregate 3/13
leading indicator 4/21 economic 3/17–3/19
learning effect 6/13 financial 3/17, 3/19–3/28
limit pricing 5/17 non-quantifiable 3/10–3/12
logical incrementalism 2/3 quantifiable 3/10–3/12
Lymeswold Cheese case study 5/77, 4/82 social 3/28–3/29
macroeconomics 4/7 oligopoly 5/57
management style 8/12 opportunity cost 6/2–6/4, 7/12
managerial perceptions 7/45–7/50 overtime 6/13
managerial power relationships 7/48 paradox of voting 7/48
managers parenting advantage 1/47
classification 7/17 pay back period 6/15
roles of 2/12 penetration 5/43
manpower report 1/30, 1/32 performance
marginal analysis 6/5–6/8 assessment 1/28–1/30
marginal cost 6/5–6/8 projections 3/7
marginal product, diminishing 6/8–6/10 performance gaps 3/7–3/9, 7/8, 7/38
market 5/2 and incentives 3/9
and prices 5/47–5/50 external v internal 3/8
definition 5/34–5/35 PEST 4/2, 4/24
failure 5/57 Phillips curve 4/12–4/14
mature 7/8 plans, and objectives 3/2
overextended 7/11 portfolio models 5/35–5/45
perfect 5/50 and corporate strategy 5/42–5/43
structures 5/50–5/57 BCG model 5/36–5/45
market analyst’s report 1/33 limitations 5/41
market share 4/31, 5/8 portfolio planning 1/45
and demand curve 5/7–5/9 predatory pricing 5/17
Market Value Added (MVA) technique present value 3/20
3/27 net 3/20
marketing expenditure, and demand price leadership 5/17
curve 5/9–5/12 price war 5/13
marketing manager 6/27 price(s)
marketing report 1/29, 1/31 and markets 5/47–5/50
maximisation 3/17–3/19 determination 5/48
means and ends 3/16, 3/36 fluctuations 5/48

Index
in segments 5/21–5/22 and economy 4/30–4/32

principal–agent problem 3/14–3/16, and GNP elasticity 4/30
3/32, 5/58 risk
probability analysis 7/42–7/45
subjective 7/43 attitudes to 7/46–7/47
product differentiation 5/22–5/25, 7/13 aversion 7/44
product information 5/45 diversifying 7/10
product life cycle 5/31–5/35, 7/11 non-diversifiable 3/23
growth stage 5/37 sales
static stage 5/37 and economy 4/30–4/31
product portfolio 7/12 salmon farming case study 5/76, 4/79
product quality 5/25–5/31 satisficing 3/19
product replacement 5/44 scenario 3/7–3/8, 4/27, 4/32, 7/41
production costs 6/11–6/14 segmentation 5/18–5/22
production report 1/30, 1/32 pricing 5/21–5/22
profit selling product inventory 6/7–6/8
maximisation 3/17–3/19, 6/10 sensitivity analysis 6/16–6/17
profitability series decomposition 4/23
and economy 4/29–4/33 shareholder value 3/12
prospector (manager type) 7/17–7/19 shareholder wealth 3/12, 3/25–3/28,
quality 5/25–5/31 7/35–7/38
and strategy 5/29–5/31 and resource allocation 7/37
dimensions of 5/28–5/29 and strategy options 7/34
product-based 5/25 estimating 3/25
production-based 5/27 skill set 3/4
transcendent 5/25 stakeholders 3/25, 3/29
user-based 5/26 Star (product type) 5/38, 5/39, 5/42,
value-based 5/27–5/28 7/39
Question Mark (product type) 5/38, strategic advantage profile (SAP) 6/54–
5/39, 5/42, 7/39 6/56, 7/3, 1/4
rational choice 7/2 strategic architecture 6/50
reactor (manager type) 7/17–7/19 strategic barriers 5/56
replacement demand 5/35 strategic business units (SBUs) 6/10
reputation 6/50 and corporate strategy 1/42
research 6/55 generic strategies 7/7–7/19
indicative factors 6/25 management 7/40
report 1/29, 1/31 strategic groups 5/67–5/68
research and development 6/23–6/29 strategic options
research and innovation 6/23 identifying 7/20–7/31
resource allocation 8/8 related and unrelated 7/20–7/23
and shareholder wealth 7/35–7/38 strategic planning
and value creation 7/37 analysis 1/37–1/40
resource based strategy 1/13 and crises 1/34–1/35
restructuring 1/45 and evolution of company 2/10
retrenchment 7/11 and quality 5/29–5/31
return on capital employed (ROCE) 6/18 and shareholder wealth 7/35–7/38
return on investment (ROI) 6/18 choice 7/34–7/50
return on net assets (RONA) 6/18 company benefits of 1/48
return on total assets (ROTA) 6/18 control 1/40
revenue decision-making process 1/26–1/42
and costs 4/2–4/4 dynamics 1/27–1/28
I/4 Edinburgh Business School Strategic Planning

Index
elements of 1/36 strategy and 5/46

individual benefits of 1/49 synergy 1/44
integration 1/40 tactics 1/18
models 2/1–2/8 takeovers 7/24–7/27
nature of 1/7 tame problems 1/14
origins of 1/17 top management 1/48–1/50
payment for 1/49 total quality management (TQM) 5/30–
research 1/21 5/31
scientific approach 1/19–1/23 transfer payments 4/5
structure 1/36 uncertain imitability 6/51
strategists 2/11–2/14 uncertainty analysis 7/42–7/45
strategy makers 2/8–2/14 unemployment
strategy report 1/1–1/5 and inflation 4/12–4/15
strengths, weaknesses, opportunities and unemployment rate 4/7, 4/10, 4/12
threats (SWOT) 7/3–7/4, 3/4–3/6 value chain 6/40–6/43
structural analysis 5/60–5/64 value creation, and resource allocation
structural barriers 5/54, 5/56 7/37
structural unemployment 4/11 variable cost 6/4
substitute products 5/62 vertical integration 6/37–6/40
sunk cost 6/4 and synergy 6/36
supply 5/46 voting paradox 7/48–7/50
and demand 4/10–4/12 wage inflation rate 4/12–4/15
supply curve 5/45 wage rate 4/3
elasticity 5/46 wicked problems 1/14
shifts 5/47 zero sum game 5/13

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Strategic

SP-A4-engb 1/2018 (1007)

Edinburgh Business School

Tel + 44 (0) 131 451 3090

Using the Course Package xi

Module 1 Introduction to Strategy, Planning and Structure 1/1

1.1 Strategic Planning: The Context 1/1

Module 2 Modelling the Strategic Planning Process 2/1

2.1 The Modelling Approach 2/1

Module 3 Company Objectives 3/1

3.1 Setting Objectives 3/2

Strategic Planning Edinburgh Business School v

3.13 Social Objectives 3/28

Module 4 The Company and the Economy 4/1

4.1 The Company in the Economic Environment 4/2

Module 5 The Company and the Market 5/1

5.1 The Market 5/2

vi Edinburgh Business School Strategic Planning

Review Questions 5/75

Module 6 Internal Analysis of the Company 6/1

6.1 Opportunity Cost 6/2

Module 7 Making Choices among Strategies 7/1

7.1 A Structure for Rational Choice 7/2

Strategic Planning Edinburgh Business School vii

Review Questions 7/52

Module 8 Implementing and Evaluating Strategy 8/1

8.1 Implementing Strategy 8/2

Appendix 1 Strategy Report A1/1

Appendix 3 Guide to Strategic Planning Practice Final Examinations A3/1

viii Edinburgh Business School Strategic Planning

Appendix 4 Answers to Review Questions A4/1

Strategic Planning Edinburgh Business School ix

Strategic Planning Edinburgh Business School xi

The Timeless Nature of Strategy: The View from Now

xii Edinburgh Business School Strategic Planning

Your Learning Style

Strategic Planning Edinburgh Business School xiii

xiv Edinburgh Business School Strategic Planning

Introduction to Strategy, Planning and

1.1 Strategic Planning: The Context

Strategic Planning Edinburgh Business School 1/1

there is little chance of the product launch succeeding. Organisational change is

1/2 Edinburgh Business School Strategic Planning

revamping an existing product or launching a new product; the projected cash

1.2 What Is Strategic Planning?

Strategic Planning Edinburgh Business School 1/3

planning is concerned with running a company and economic policy is concerned

Issue Government action

Issue Question Core discipline

1/4 Edinburgh Business School Strategic Planning

Issue Question Core discipline

Strategic Planning Edinburgh Business School 1/5

Core discipline Contribution to Madonna Inc

1/6 Edinburgh Business School Strategic Planning

1.2.1 Managers’ Definitions of Strategy

1.2.2 Academic Definitions of Strategy

Strategic Planning Edinburgh Business School 1/7

A pattern in a stream of decisions; the pattern may not be comprehensive, uni-

This raises the question as to whether strategic planning is a conceptually valid

What determines the framework of a firm’s business activities and provides

The point of reproducing these definitions is to demonstrate that there is no

1/8 Edinburgh Business School Strategic Planning

A different perspective on strategy can be derived from economics: the forces of