Strategy Dynamics Essentials

Strategy Dynamics
Essentials
Kim Warren
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STRATEGY DYNAMICS
ESSENTIALS
STRATEGY DYNAMICS
ESSENTIALS
Kim Warren
Strategy Dynamics Ltd

Copyright © 2010 Kim Warren
First edition published in electronic format only (PDF and Kindle)
Second Edition, print & Kindle, published 2015
Published by Strategy Dynamics Limited,
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This publication is designed to provide accurate and authoritative information
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recommendations for any specific circumstance, for which the advice of a
competent professional should be sought.
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Print versions ISBN:

Grayscale interior: ISBN-13 978-1505809053
ISBN-10 1505809053
Color interior: ISBN-13: 978-1512107753
ISBN-10: 1512107751
Cover image ©macrovector -Fotolia.com
To all the strategists, managers, educators and students
who, with determination and open minds,
have embraced the strategy dynamics method
and encouraged me to continue this work
This copy provided to Vienna University Student. Not for redistribution. © Kim Warren 2010
CONTENTS
A  A 10

P 11
The method 12
Who is this book for? 12
What prior knowledge do you need? 13
What "return on investment" can you expect? 13
Other resources 14
Acknowledgements 14
C 1 - B P O T 17
1.1 A Life-Cycle Example: Blockbuster® Inc. 18
1.2 Strategic Management: Positioning versus Delivery 21
1.3 What “Performance” Do We Want To Improve? 25
1.4 Building Future Performance 27
1.5 Nonfinancial Performance Objectives 31
1.6 Levels of Strategy 32
1.7 Example: Low-fare Airline Ryanair 33
C 2 - H R D P 35
2.1 Strategy Methods Focusing on External Factors 36
2.2 Strategy Methods Focusing on Firm-specific Factors 38
2.3 Limitations of Common Strategy Approaches 40
2.4 Tangible Resources and Profits 41
2.5 From Performance to Resources 43
2.6 Resources and Nonfinancial Performance 47
2.7 “Stocks” of Resources 48
2.8 When Resources Themselves Are the Objective 51
2.9 Specifying and Quantifying Resources 52
C 3 - R W  L 55
3.1 Quantifying the “Bathtub Behavior” of Resources 56
3.2 Accumulation over Time 59
3.3 Consequences of Resource Accumulation 61
3.4 Resources Won and Lost by Ryanair 62
3.5 “Accounting” for Resources 64
3.6 Control over the Building and Retaining of Resources 65
3.7 Generic Behaviors and Their Drivers 66
C 4 - I  
S A 71
4.1 Competition and Other External Factors 71
4.2 Existing Resources Drive Gains and Losses 72
4.3 How Resources Drive Their Own Growth and Loss 74
4.4 The Role of Potential Resources 76
4.5 The Strategic Architecture 77
4.6 Functional Issues and Other Objectives 83
C 5 - R Q 87
5.1 Size Is Not the Same as Quality 89
5.2 Attributes of Other Resources 90
5.3 When Resources Bring Access to Others 93
5.4 Using the Quality Curve to Beat Competitors 95
5.5 Other Uses for the Quality Curve and Resource Attributes 98
C 6 - D R 99
6.1 Developing Staff 99
6.2 The Customer Choice Pipeline 101
6.3 Product Development 105
6.4 Deteriorating Resources 106
6.5 How Resources Develop in Noncommercial Cases 108
6.6 Boundaries of the Firm 109
C 7 - C R 111
7.1 Type-1 Rivalry 112
7.4 Further Issues with the Three Types of Rivalry 118
7.5 Competing with Intermediaries 119
7.6 Competing for Other Resources 121
7.7 Rivalry in Noncommercial Cases 123
7.8 Dealing with Multiple Competitors 124
C 8 - S S  P 127
8.1 The Difference between Good and Poor Strategies 128
8.2 Steering Strategy and Performance 131
8.3 Policy to Guide Decisions 133
8.4 Controlling Indirect Decisions and Interference 136
8.5 Conflicting Objectives 137
8.6 Goals and Policy in Noncommercial Cases 138
C 9 - I R 141

9.1 State-of-Mind Intangibles 143
9.2 Information-based Intangible Resources 147
9.3 Quality-based Intangibles 150
C 10 - C 155
10.1 Dimensions of Capability 156
10.2 Learning Develops Capability 160
10.3 Capabilities Not Linked to Resource-building 161
10.4 The Balanced Scorecard 163
10.5 Capabilities in Public Sector and Voluntary Organizations 164
C  F S 167
Further resources 167
A 1: T S 168
A 2: P  C 170
ABOUT THE AUTHOR
A  A
Kim is an independent strategy writer and teacher, and a developer of

sophisticated dynamic enterprise models and "serious games" for MBA and
executive education. After 15 years in senior corporate strategy roles, Kim joined
the faculty at London Business School, teaching on MBA and Executive programs,
where he was introduced to the long-established and rigorous discipline of system
10 dynamics. Realizing serious limitations with the conventional strategy methods
offered in business schools, he developed the powerful strategy dynamics
frameworks, by translating system dynamics into simple managerial language.
S D E
He has devoted 20 years of effort to codifying and communicating this practical,

rigorous method, which enables organizations of any kind or size to make radical
improvements to their planning and implementation of strategy. In addition to
developing learning materials and publications, he continues to develop and
extend the method's power and relevance by helping businesses across all sectors
to deal with major strategic challenges. Most recently, the method has also proved
invaluable for dealing with issues in the public sector and in non-profit
organizations. He is author of the prize-winning Competitive Strategy Dynamics
(Wiley, 2002), and a major strategy textbook Strategic Management Dynamics
(Wiley, 2008). His work was recognized with the 2005 Jay W Forrester Award as
the most important contribution to the field of System Dynamics in the previous
five years, and he served as 2013 President of the International System Dynamics
Society.
PREFACE
While many of our largest corporations, as well as lesser-known enterprises, are
P
extremely well-managed by skilled, experienced and dedicated leaders, those
executives are ill-served in the critical task of developing and implementing
strategy by crude and unreliable methods that are not fit-for-purpose. The price
for this inadequacy is a heavy one. Poor strategy choices and implementation lead
to entirely avoidable business failures, ill-advised initiatives that have to be
11
abandoned, and a perpetual, grinding under-achievement of potential even for
those organizations that do not succumb to failure. In the grand scheme of things,
S D E

these failures sum up to the endless repetition of boom-and-bust cycles that afflict
most industries and the economic recessions that cause government and society
great hardship and cost.
In other fields of human endeavor, we have reduced the risk of serious failure
with two related approaches. First, we build models—at one time, physical models;
more often today, software models—of things we want to try, before creating the
real thing, whether that is a building, an aircraft, or a drug. Secondly, we codify
how things are supposed to work, to ensure reliable delivery of whatever it is we
are trying to do. Since we learn from what we do, we revise the models and update
the processes we have codified to improve performance further.
Both approaches are widespread in many fields of management. Manufacturing
companies build models of production facilities, distributors model their supply-
chains, retailers model the likely catchment of new stores, and organizations of
all kinds, of course, model their financial prospects. And businesses operate
reliably because they codify what they do, right from the most detailed operational
details that you will find, for example, in franchise systems, up to the procedures
for undertaking, repeatedly, successful product-launches, market entry, and
acquisitions of other companies.
Yet for the most important function of all—figuring out what we want an
enterprise to achieve and how that might be done—most organizations still rely
on qualitative judgement supported (at best!) by simplistic frameworks and
superficial analysis. This is unacceptable, not only to investors, but to employees,
customers and society at large.
The method
This book summarizes the strategy dynamics method for developing and
implementing strategy. The method is made possible by deploying the rigorous,
scientific method of system dynamics – well-established since the 1960s – to the
task of strategic management. In essence, system dynamics is the application of
engineering control theory principles to social systems, and since all enterprise
are "designed" systems, those principles are directly applicable to their design and
P
management. The challenge is to make those principles clearly understandable

in terms that make it possible for executives and analysts to use them reliably in
practice.
12 The end-result of this method is the creation of working, quantified models of
any enterprise, or any part thereof, of any scale, in any sector—or of any issue
that such an enterprise may face. But to get to that result requires, first, that we
S D E
establish the fundamentals of what an enterprise is—the things that make it up,
such as customers, staff, products and capacity—and the mechanisms by which
those elements actually function as an integrated system, both to generate
outcomes we want (such as sales and profits), and to enable the further growth
and development of that same system.
This book therefore focuses on defining the elements and mechanisms we need
for this task in clear, every-day language, and showing how these elements and
mechanisms can be assembled to create those working, quantified models we
need for developing and managing strategy.
Who is this book for?

The book is designed to help four main groups:
Ÿ Executives who have some responsibility, either alone or as part of a
team, for the performance of an organization, a business unit or a
function.
Ÿ Consultants and others who advise organizations on how to improve
performance, exploit opportunities effectively, or deal with substantial
challenges.
Ÿ Business students, at Undergraduate, Master’s and PhD levels.
Ÿ Business teachers, especially those teaching topics related to strategy.
Chapter 1 clarifies that “strategy” is a task for all levels of management, in all parts
of an organization—whether a profit-seeking business, or a Governmental or
non-profit entity—and explains why that task needs a rigorous, time-focused

approach. Chapters 2 to 4 set out the core principles of the strategy dynamics
method and how to apply them. Chapters 5-10 add important further frameworks
that are useful on their own, or as a part of a whole-enterprise model.
What prior knowledge do you need?

Fear not! You do not need advanced technical skills to learn and benefit from the
strategy dynamics method. A good general education is all that is required, but
P
you must be willing and able to think quantitatively about whatever enterprise
or function you may be involved in. This does not imply advanced mathematical
or statistical skills. Anyone capable of building simple spread-sheet models will
be able to grasp the strategy dynamics principles. Even those who are not so 13
comfortable with arithmetical analysis can still exploit the method by working
with colleagues or support staff who do have that capability.
S D E

What "return on investment" can you expect?
Even the earliest principles in this book can be applied right from the start. So
very little time (and almost no cost) is required before you can start to get value
from the method. This fast ROI can be repeated because components of the
method can be usefully deployed alone, to tackle strategic challenges in marketing,
staffing, and other functions. Of course, to apply the method to modeling the
whole of a complex enterprise will require more effort and practice, in
conjunction with others who are building the same understanding. However, this
is less difficult and costly than the alternative of trying to assemble a coherent
strategy and plans from the plethora of isolated and unreliable methods and
largely financial analysis that typically dominate organizations' attempts at
strategy and business planning.
Other resources
This book has been written to provide busy readers with the greatest amount of
useful understanding in the shortest possible time. But the principles it describes
are best-understood by seeing them in use, so extensive online materials are
available to support this book:
Ÿ An on-line course, that can be taken in summary form or in full, and
that may be taken in three separate parts. The course includes many
easy-to-use working models, including most of the examples in this
book. See http://sdl.re/sdcourse.1 (The course and models are free for
registered teachers).
Ÿ “Serious games” for training and education, http://sdl,re/microworlds.
Ÿ Powerful and easy-to-use Sysdea software for mapping and modelling
strategy and performance, http://sysdea.com. The software’s Help
system includes many worked examples—see http://docs.sysdea.com.
P
Ÿ A free fortnightly email briefing-note series at http://sdl.re/briefings.

The book deals with strategy for individual businesses or business units, and
functions or departments. The principles and frameworks also apply directly to
14 public service, voluntary and other not-for-profit organizations. Extensions to
cover additional issues of corporate strategy in multi-business firms are planned
for the future.
S D E
Acknowledgements
The list of people whose profound knowledge, experience and generosity of spirit
inspired the decade of effort that has gone into developing the ideas in this book
and the materials that support it, is a long one. It includes both outstanding
academics and exceptional practitioners—and many people who are both!
I must start by thanking the person who first introduced me to the concepts of
system dynamics, and who transformed my understanding of business and
strategy; John Morecroft of London Business School. And none of this would
have been possible without the rock-solid practical principles of the system
dynamics method developed by Jay Forrester of MIT Sloan School. Other
outstanding thinkers and teachers helped, inspired and encouraged my own
learning, including John Sterman (MIT/Sloan), David Lane (Henley Business
1 The main source for all materials is http://strategydynamics.com. http://sdl.re is a

shorthand redirect address for the main site.
School) and George Richardson (University of Albany). Many other academics
not only contributed to this learning but also showed how the knowledge could
be practically applied in challenging real-world business situations, including
Peter Milling (University of Mannheim), Markus Schwaninger (University of St
Gallen), Carmine Bianchi (University of Palermo), Bob Cavana (University of
Wellington), Jac Vennix and Etiënne Rouwette (Radboud University, Nijmegen)
and Jürgen Strohhecker (Frankfurt School of Finance).
A large number of practitioners continue to help organizations of all kinds and

sizes deal with large and complex challenges that no other concepts can help with.
I have been fortunate to work with just a few of these outstanding professionals,
including David Exelby, Steve Curram and Siôn Cave (DAS Ltd), Lars Finskud
(Vanguard Strategy) and Maurice Glucksman (McKinsey & Co). Hundreds of
students and executives have also contributed more than they will ever know.
Every class and every project-case they worked on has added to and consolidated
the ideas in this book and provided the extraordinary range of real-world
examples in this book and its related materials. Few, though, has done more in
P
this regard than Justin Lyon (Simudyne Ltd).
The production and delivery of the wide range of materials now available, and
the support for the many teachers who use them, has been entirely due to the
tireless efforts over nearly 20 years of my dear wife, Christina Spencer. Finally, 15
none of us could use—or teach others to use—strategy dynamics as easily, quickly
and reliably as is now possible without the brilliant Sysdea browser-based
S D E

software, developed by Chris Spencer.
S D E H R D P
16
CHAPTER 1
BUILDING PERFORMANCE
OVER TIME
Although definitions of strategy can get very detailed and sophisticated, a concise
statement will suffice for now:
An organization’s strategy is how it tries to reach its objectives.
This definition implies that the management of strategy consists of the following
tasks:
1 Choosing objectives for the organization. Objectives may be financial,
such as growth in cash flow, or non-financial, such as reaching a target
number of customers by a certain date. Objectives can also evolve as
conditions change.
2 Positioning the organization relative to other organizations. In

business cases, this involves deciding which customers to serve, which
products and/or services to provide, and how this will be done, usually
in comparison to positions chosen by competitors.1 The choice of
position implies that certain resources and capabilities will be needed.
Nonbusiness organizations also choose positions, deciding which
services to offer, for example, and to which beneficiaries.
3 Steering the organization’s progress over time. Having decided on a

position the organization believes will be successful, management has
the continuing challenge of developing effective policies and making
1 Constantinos C. Markides, All the Right Moves. (Boston: Harvard Business School Press,
2000), 27–112.
good decisions in order to build the resources and capabilities it needs
and to steer its strategy and performance.
These three elements of strategic management are most clearly visible in the case
of a business trying to make profits for investors, but strategy is also important
in public service, voluntary, and not-for-profit organizations.
1.1 A Life-Cycle Example: Blockbuster® Inc.

L-C E: B® I.
To see how these aspects of strategic management develop and adapt, consider
an organization that has lived through its entire life, from birth, through growth
and maturity, to decline and death - the video-rental business Blockbuster Inc.
Videocassette recorders (VCRs) were the first devices to allow consumers to both
time-shift live TV and to watch movies at home. By the mid-1980s, 30 percent of
US households owned a VCR, a fraction that was rapidly increasing. This was
before DVDs and Blu-ray, before Internet services such as Netflix enabled movie
rental from home (www.netflix.com), and long before it was possible to download
movies or TV shows online. Figure 1.1 shows the entire history of Blockbuster’s
store numbers, revenues, and operating profits, from its start in 1985 to 2008.
18 Blockbuster’s history can be divided into four main phases:

1 Start-up. In 1985 entrepreneur David Cook saw an opportunity to
rent videos from stores in residential neighborhoods to consumers
B P O T
with VCRs. The stores were large and offered a wider range of movies
than other rental outlets, which were mostly, small independently-run
businesses. IT systems based on a customer membership card enabled
control and ensured the most popular movies were available.
2 Growth. After just two years, Blockbuster was bought by another

successful entrepreneur, Wayne Huizenga, who set out to dominate
the market by opening hundreds of new stores each year. Eight years
of rapid growth gave Blockbuster strong buying power with movie
distributors, and hence low costs and early access to new titles. These
factors made the company highly profitable, generating over 30%
return on sales by 1995. Three big initiatives accelerated the company’s
growth:
○ A franchising scheme allowed independent operators to invest

their own capital in new stores, using Blockbuster’s systems and
marketing in return for a share of revenue.
○ Several acquisitions of other significant chains extended the
company’s market reach and buying power.
○ International expansion took place through acquisitions in the
United Kingdom, Australia, Japan, and other countries.
3 Maturity. After being acquired by Viacom in the mid-1990s,
Blockbuster’s profitability fell significantly, due to a combination of
turbulent market conditions, loss of focus on the management of
L-C E: B® I.

operational details, and a resulting high turnover of CEOs. Still, the

basic business remained attractive, boosted by a new product range—
software titles for videogame consoles, such as Nintendo, PlayStation,
and Xbox. Thanks to video game rentals, store numbers and revenues
continued to grow, if rather more slowly. The company also had to
respond to the new service provided by Netflix, which enabled
consumers to use the Internet to rent DVDs from home and return
them by post.
4 Decline. By 2005 the first signs of the final phase of strategy’s life
cycle—decline and ultimate closure—were evident. Netflix had
become a major force in the marketplace, making 2007 revenue of
$1.2bn, and similar services from Amazon.com and others led to 19
intense price competition, driving down profit margins. Blockbuster’s
vast store network, once a source of its dominance, became a large
B P O T

Figure 1.1: Blockbuster Inc.’s Performance History
10,000
Stores at year-end
8,000
6,000
4,000
2,000
0
1985 1990 1995 2000 2005
8,000 1000
Revenue Profit *
6,000
($millions) 800 ($millions)
600
4,000
400
2,000
200
0 0
1985 1990 1995 2000 2005 1985 1990 1995 2000 2005
* Profit before interest, tax, depreciation, and exceptional items

Source: Company reports
and costly liability. To these pressures would soon be added the threat
from video and TV download services as wider availability of fast
broadband services made this new distribution mechanism a practical
alternative. In November 2013, the business finally closed the high
street stores.
So how did the three key elements of strategic management change over
Blockbuster’s life?
L-C E: B® I.
Ÿ The most remarkable feature is that the basic positioning of the
business remained largely unchanged for over 20 years—providing a
wide range of family-oriented movies through neighborhood stores,
using a membership card system to ensure control and availability of
popular movies. The addition of gaming software merely built upon
that basic position. Nor did the resources and capabilities required to
succeed in that position alter—the stores, the brand, the types of
customers and staff, the systems, and the types of product remained
essentially unaltered in nature, although of course they changes
considerably in scale.
Ÿ Objectives clearly evolved as the market developed, and competitive
20 conditions and business performance changed. Cook’s aims during
the first year or two were to get Blockbuster established and start
generating profits. Huizenga raised the ambition considerably, aiming
B P O T
to open hundreds of stores each year, and drive rapid revenue growth,
as evidenced by the compound annual growth rate (CAGR) averaging
nearly 50 percent per year from 1987 to 1995. Growth in scale was key
to Huizenga’s aim to grow profits, which persuaded Viacom to pay
Figure 1.2: Generalized strategy life cycle, illustrating extensions and

strategic-change events
change the
Profit strategic
position
extend the
strategic position
add to the
strategic
position
choose the initial

strategic position
years
start-up growth maturity decline

if no change
handsomely for the business in 1995. From then on, choice of
objectives became less easy. The previously automatic link from store
openings to revenue growth was broken, and management had to
balance demands for delivering current-year profit targets with the
S M: P  D

need to invest in growth.
Ÿ Steering the strategy from year to year dominated the strategic
management of the company throughout its life. This required
continual decision-making on the range of movies to offer, price levels,
staff hiring and training, marketing spending and message, and—as

is critical as for any retailer—the rate, location, size, and design of new
store openings.
1.2 Strategic Management: Positioning versus Delivery

One observation stands out from the Blockbuster story:
Changing a strategic position is a very rare event.
It is not surprising that organizations rarely change their choice of who to serve,
with what, and how to do it. If you find a position that works today, something
quite substantial must change for it to stop working tomorrow. If your positioning
does not work, then you need to find one that does, quickly, before financial losses
21
put you out of business. We certainly do not observe businesses—or indeed
voluntary or public service organizations—constantly shifting their positions,
B P O T

despite what appears in business papers and journals about strategic innovation
and transformation. (Note that strategic innovation and transformation are not
to be confused with product innovation).
Most well-known businesses demonstrate great longevity of a successful
positioning. Low-fare airlines such as Southwest in the US and Ryanair in Europe
have maintained a strategic position unchanged for decades, as have IKEA
(furniture retailing), BMW (automotive), and Mittal Steel (steel production). The
resources and capabilities these firms require have also remained largely
unchanged over decades.
This stability of strategic position is not limited to old technology. In the internet
era, firms such as Amazon.com, eBay, and Expedia quickly found and exploited
a position that worked. They may have made small adjustments, such as Amazon’s
addition of affiliates into its business. They may also have added layer upon layer
of extensions to their basic proposition—for example, Amazon’s expansion into
CDs, DVDs, and other valuable, nonperishable products. Nevertheless, what these
and most successful businesses actually do is find a successful position, and then
relentlessly drive it forward. They do not keep changing their minds.
This is not to say that the positioning question never recurs. A strategic position
S M: P  D
may need to change for either positive or negative reasons.

Extending into new positions
Businesses often see new opportunities, whether to serve new customers, to
provide new products or services, or to deliver their goods and services in a new
way. Some such extensions of position make a big difference, as in the case of
Amazon’s Marketplace offering, which allows many other suppliers to offer their
products alongside Amazon’s own. More often, strategy extensions are small,
compared with the existing business. Europe’s easyJet has added more low-price
business models in car rental, cruise holidays, bus travel, and hotels, but all are
trivial compared to its vast airline business.
Extending into new positions can also be done by acquisition. In 2005 eBay
acquired Skype to strengthen its reach in the global marketplace and its payments
platform. Cisco Systems takes this mechanism much further, having acquired
over 100 companies1 in its strategy development. Not all such moves succeed—
Cisco has benefited strongly over many years from this stream of acquisitions,
22 while eBay’s purchase of Skype ended in break-up in 2009.
Avoiding threats to an existing position
B P O T
Blockbuster suffered from two big threats—the emergence of postal-service

substitutes to its store-based service and the increasing viability and availability
of online streamed delivery of movies and other media content. Management has
no choice in such cases but to review its established position and look for ways
to adapt or add to their original position, or even to move to a new strategic
position. Advances in technology are not the only source of threat. Powerful new
competitors can also force a rethink, withdrawal, or effort to replicate the
challenger. Established airlines, such as British Airways and American Airlines,
started up low-fare operations in response to the burgeoning growth of Southwest,
Ryanair, and the like. Others simply withdrew from the short-haul routes these
innovators threatened.
Occasionally, the threat may be so serious that the position ceases to be viable
and is abandoned. This has been the fate of many store-based travel agencies and
music stores, as it was for Blockbuster. In cases like these, investors will be best
1 http://en.wikipedia.org/wiki/List_of_acquisitions_by_Cisco_Systems
served by returning to them whatever cash can be generated during a gradual
winding-down of the store’s business.
Although switching to an entirely new strategic position is very rare, it is not
S M: P  D

completely unknown. Cell phone manufacturer Nokia for example, was founded
in 1865 as a paper producer before moving into rubber products around 1900,
and then cable manufacturing and a host of electrical products. Nokia’s first
electronics department started in 1960, leading to its move into
telecommunications, which only really started in the 1970s.

The Blockbuster story offers a general model for the strategy life cycle. Figure 1.2
illustrates the four broad phases of the strategy life cycle, starting with the initial
choice of strategic position, a period that is often unprofitable. The chart also
shows the impact of initiatives to add to the original strategic positioning, both
by acquisition and extension, and a change of that position when it becomes
unsustainable.
Given the extreme rarity of changes to strategic position, then, what does
“strategic management” actually do throughout the long intervening periods?
Most of management’s strategy work consists of delivering the strategy, also
known as implementation or execution.
23
Taking big initiatives, such as acquisitions or entering new markets, is sometimes
termed strategic decision-making, but seemingly small decisions can also have
B P O T

serious impacts on future performance. Hiring too few skilled staff, for example,
can hold back business performance for years afterwards.
Actions, choices and decisions by an organization, and changes in external
conditions are “strategic” if they significantly affect medium- to long-term
performance.
Making skilled choices that will steer strategy well from period to period is
therefore critical, but is often overlooked or even dismissed as mere “operational
effectiveness”.1 However, companies can massively outperform competitors on
this basis, rather than by choice of strategic position. Blockbuster delivered
revenue and cash-flow growth that was orders of magnitude larger than many of
their nearly identical rivals. The same is true of the dominant low-fare airlines
who have delivered performance that is orders of magnitude greater than weaker
competitors who chose precisely the same strategic position, let alone the large
number who have failed and gone out of business. Continuous strategic decision-
1 Michael E. Porter, What Is Strategy? Harvard Business Review, 74(6), 61–78.

making is equally critical in public service, voluntary, and not-for-profit
organizations.
The observation that strategically well-managed firms can radically outperform
S M: P  D
competitors has another important implication: performance prospects are not

dominated by external conditions.
In most cases, management has considerable scope to drive strong
performance.
Strategic issues are not exclusively long-term in nature, and the annual planning
processes common to many companies are not adequate. Two considerations
considerably reduce the timeframe over which both overall strategy and specific
issues or initiatives should be examined:
1 In some industries, conditions change very quickly. Consider how
often new cell phone handsets are launched or how quickly online
social networking services develop, and you will see that substantial
changes can occur from quarter to quarter or even month to month.
Strategic plans that offer only annual forecasts cannot be adequate in
such cases—it will be far too late to adjust strategy if you have to wait
twelve months before knowing how well it is working!
24
2 A focus on short timeframes is also needed when events occur that
will have long-term consequences. The success of a new product is
B P O T
often determined within a few months of its launch, so its impact on

overall performance needs to be tracked continually, not just in an
annual review. Such initiatives certainly have significant implications
for long-term performance and may also need the coordinated efforts
of several functional groups.
The start-up of a new rival is another event that may need a short-term focus.
Such threats require quicker responses and adaptation to strategy than an annual
perspective can handle. In one case, a division of GlaxoSmithKline saw its
dominant position in the market for travel vaccines under attack by a rival product
launch that would succeed or fail over just ten weeks, fundamentally threatening
the business’s entire future. There was no value in annual plans here—the episode
was unforeseen when the year’s budget was put together and was over before the
next planning round started!
1.3 What “Performance” Do We Want To Improve?
Strategy textbooks, being largely devoted to commercial businesses, generally
focus on some indicator of financial performance, so “profit” is a sensible place
to start. Two elements of profit must be distinguished. First is the normal profit
W “P” D W W T I?

that investors expect for the use of their capital, given the level of risk. This leaves
a second element, the “economic profit,” which is the surplus that remains after
the costs of all inputs (including capital) have been paid out. Economic profit, or
the closely related “economic value added” (EVA), has been widely adopted as a
management tool by many large corporations.1
Another performance measure that commonly gets attention is the profit return
on invested capital (ROIC) that a company generates. Different firms in an
industry typically exhibit a range of ROIC—a few suffer losses, others make a
modest return, and a few are exceptionally profitable. In Figure 1.3, Company X
and a few others are in this happy position and can be expected to achieve a
superior return as a result of their “competitive advantage.” This advantage is
said to be “sustainable” if we can continue making this superior return year after
year.
The distribution of ROIC varies widely among industries. Some industries feature
a large number of firms, many of which are very small, while others are more 25
concentrated with fewer, larger firms. Both the average profitability level and the
variance of that profitability also differ in a characteristic manner among
B P O T

industries. Cell phone service providers, for example, are few in number and
struggle to generate strong returns on the costly assets of their networks.
Pharmaceutical companies, in contrast, are still relatively numerous, in spite of
the many mergers that have
Figure 1.3: Illustrative profitability distribution taken place in the industry,
among firms in an industry and generate higher
Number and returns. Extremely diffuse
size of
companies and segmented markets,
such as a city’s restaurants,
Company X may feature hundreds of
competitors and a very wide
range of profitability.
-10 0 10 20 30
Profitability
Return on invested capital ROIC
1 Al Ehrbar. EVA: The Real Key to Creating Wealth. (Chichester: John Wiley & Sons, Inc.,
1998).
Although a focus on profit levels and profitability ratios is understandable, it
poses an obvious problem. We can nearly always boost profits now, by simple
changes such as raising prices or cutting expenditure, but we will regret these
actions if they damage future profits. In spite of this obvious conflict, it is common
for management—under pressure from investment analysts and their own
W “P” D W W T I?
performance incentives—to focus on delivering short-term results, even if it

damages prospects for the future. The banking crisis of 2008–2009 is an extreme
example of this problem.
Superior ROIC is not a good indicator of competitive advantage
or strong strategic management.
Investors’ interests are in fact best served by strong and sustained growth in the
future stream of profits, rather than the profits being made right now. Even if
investors sell their shares, the price they get will reflect what the buyers of those
shares expect future profit growth to be. A company’s share price increases when
it announces higher-than-expected profits, not because that profit is in itself worth
a great deal, but because it suggests that the company can continue delivering
increasing profits.
Investors don’t get their hands on all of a company’s profits. The actual money
26 available is the cash flow generated by the company’s operations minus any cash
needed to make the future growth of cash flow possible. Cash may also be needed
for more working capital, such as inventories, to support a growing business.
B P O T
What investors should really want, then, is growth in free cash flow: 1
Free cash flow = profit, after interest and tax are deducted
+ depreciation
− capital invested
− increase in working capital
It is not even necessarily bad for a company to generate negative profits and cash
flows for long periods, if the company is spending money now to exploit
opportunities to make strong future cash flows. Figure 1.4 illustrates the profits
and cash flow generated by Amazon.com from 1997 to 2008, both of which were
negative for several years. If ROIC were the appropriate indicator of strategic
success, we would have wanted to know why Amazon was so unsuccessful.
1 A clear explanation of why free cash flow is of critical importance to investors is in the
letter to shareholders from the founder and CEO of Amazon.com, Jeff Bezos, on pages 3–
5 of the Company’s 2004 Annual Report.
Figure 1.4: Amazon.com operating profits and To put a value on a firm’s
cash flow, 1997–2008 strategy, then, or to value an
investment or other
1,500
($millions
Cash flow initiative, we need an
Operating profit
1,000 estimate of the trajectory of
500
future cash flows, not just
the cash flows for a single
0
period of time. But that
-500 value is not simply the sum

of future free cash flows.
B F P

-1,000
People value cash that they
Source: Company reports
will receive soon more
highly than the cash they
may receive far in the future because it has alternative uses and because of the
uncertainty of long-term results. Each period’s cash flow is therefore discounted
by the firm’s cost of capital to arrive at its “present value.”1
1.4 Building Future Performance

The principles outlined to this point provide the main focus for the strategy
dynamics approach: 27
Strategic management is about building and sustaining performance
B P O T

into the future.
This is not a new idea in strategy. We have known since the 1950s2 that superior
profitability is neither interesting in itself, nor usually sustainable. A firm entering
a new market will spend money to do so and will therefore reduce its profitability
before making gains in the new market. Having successfully entered one new
market, it might do so again and again, and could therefore persist in making
lower returns than its stay-at-home rivals. Investors, though, would welcome its
efforts because of the increasing free cash flows.
From this point on, we will refer only to operating profit or cash flow when
discussing the financial performance of commercial firms.
Three distinct but related questions lie behind how organizations perform
through time (see Figure 1.5):
1 Tom Copeland, Tim Koller, and Jack Murrin. Valuation—Measuring and Managing the
Value of Companies, 4 ed. (Chichester: John Wiley & Sons, Inc., 2005).
2 Edith Penrose. The Theory of the Growth of the Firm, 4 ed. (Oxford: Oxford University
Press, 1959), 78–91.
Ÿ Why has past performance Figure 1.5: General questions of
followed the time path that it performance for strategic management
to address
has?
Performance
Ÿ Where will future
now How?
performance go if we carry
on as we are?
Why?
Ÿ How can we improve future
Where?
performance?
While the question of past time
B F P
performance won’t be applicable

to new ventures just starting out, in most cases, it is critical to address all three
questions in order to understand an organization’s past, present, and future
performance. Figure 1.6, illustrating the performance of coffee-store chain,
Starbucks, from 2002 projected to 2012, shows why these three questions are
important.
1 Why has past performance followed the time-path that it has? The
growth in profits up to 2007 resulted from a rapidly expanding
network of stores, which involved entering the markets of new
28 countries, built on an attractive profit model for each location. This
expansion was made possible by strong sales to a reliable customer
base, supported by excellent service from well-trained, loyal staff. 2008
B P O T
profits suffered from both difficult market conditions and from some
poor strategic decisions made earlier, notably the raising of prices and
over-expansion between 2002 and 2007. (The profits for 2008 were
actually lower than shown, at $504 million, but included a large
provision for the closure of stores).
2 Where will future

Figure 1.6: Starbucks’ profit history
performance go if we to 2008 and alternative futures
continue as we are? If 1,500
$ millions
Starbucks had failed to
act in 2008, profits in preferred
1,000
the following year history
would likely have been

lower than they were 500
(dashed blue line). feared

Continued loss of 0
2002 2004 2006 2008 2010 2012
customers and reduced
spending by those who
remained would have further depressed sales revenue. The stores’ fixed
costs would have caused even a small fall in revenue to drive a heavy
fall in profits. Further damage could then have set in. Customer loss
would have undermined Starbucks’ image as “the” place to go for a
great coffee experience, leading to still further loss of sales. Staff morale
could also have fallen, worsening the service experience, increasing
staff turnover, and raising the costs of hiring and training. In this
“feared” future, problems would have multiplied, and profits would
have declined steeply.
B F P

3 How can we improve future performance? Figure 1.6 shows a
“preferred” future (dashed green line), in which profits recover. Part
of this “how” was already in progress by the end of 2008, with cuts to
overhead costs. Unprofitable stores were closed in 2008 and 2009, and
it may be necessary to reduce prices to support sales volume, which
would hit margins. If the cost cuts do not damage service quality, store
closures effectively cut out loss-making branches, and consumer
spending recovers, the company may see profits grow again from 2010.
It could also continue opening branches in still-promising locations.
Taken together, these outcomes could lead to Starbucks’ preferred
future profits. 29
Starbucks’ story clearly shows that history is of more than academic interest. This
B P O T

company, like all organizations, is moving along a path through time whose
trajectory is already strongly determined by policies, decisions, and other events
from the past. Starbucks would not, for example, have had hundreds of loss-
making stores in 2008 if it had not previously opened them!
To appreciate the implications of history’s role in driving strategic performance,
imagine that Starbucks made exactly the same operating profits in 2008 as it
actually did, but had reached this
Figure 1.7: Starbucks—hypothetical profit point by a quite different path.
history and alternative futures
1,500
The answers to our three critical
$ millions preferred questions would be entirely
different (Figure 1.7).
1,000
history
1Why has past performance
feared followed the time-path that it
500
alternative has? The company could have
opened fewer, but high-
0 performing stores through
2002 2004 2006 2008 2010 2012
2002–2007. It might have raised
prices less to maintain customers’ perception of good value and set
higher staff levels to ensure good service. These choices would have
held down profits until 2007, but benefits could have shown up in 2008.
Profits would not have been depressed by loss-making stores, and the
company would have saved the heavy exceptional costs of closing them
(not included in Figure 1.6). With more attractive pricing and service,
customer numbers and purchase frequency may have fallen less
heavily. Profit growth may still have slowed, but may not have turned
negative.
B F P
2 Where will future performance go if we carry on as we are? With this

more healthy history, the likely future would have been entirely
different. Instead of collapsing as more stores became unprofitable
and customers left due to poor value and service, there could have
been a less severe decline, one due only to reduced consumer
spending (blue dashed line). This brighter future would still have come
at a cost, however. Up until 2007, the company would have made
nearly $700 million less profit but would have saved most of this
amount by not investing in stores that would have failed. Starbucks
would also be making back those lost profits twice over in the few
30 years following 2008.
3 How can we improve future performance? The preferred future

B P O T
presented in Figure 1.7 is still more attractive when starting from

Starbucks’ alternative (hypothetical) history. Sustained good-value
pricing and service levels could allow store profits to pick up again
in 2009, and enable continued store openings in under-served
territories. Without the crisis of 2008 to 2010, the company could
realistically aim for continued solid profit growth. (It turned out that
Starbucks improved profits much more than shown, even in this
preferred future, delivering profits of $1419 million in 2010).
The key message is that history matters—a lot! This has important implications
for what you do today, because “today” will be “history” when viewed from the
future, and past decisions will determine the path of the organization into that
future.
1.5 Nonfinancial Performance Objectives
and Not-for-profit Organizations
Management often sets targets for nonfinancial measures—customer growth,
market share, staff numbers, and so on. Some even set aims for intangible
measures, such as reputation. This does not mean they ignore financial
performance. Rather, they focus on these other factors because they are believed
to drive financial results. Investors and analysts also pay attention to such
N P O

 N-- O
measures—airlines report passenger journeys sold, cell phone companies report

on subscriber numbers, fast-moving consumer goods (FMCG) firms report
market shares, and so on.
At Skype, the voice-over-Internet phone (VoIP) service, attention has focused on
the growth in user numbers (Figure 1.8). Having users is not especially useful,
however, unless they are making calls, so a secondary indicator is usage, measured
as the number of call-minutes the business serves.
Figure 1.8: Growth in users and call traffic for Skype’s VoIP service
600
User accounts 30 Call traffic
millions billions of minutes
400 31
20
200 10
B P O T

0 0
Source: eBay Company reports

Note: Skype was owned by eBay Inc. between 2005 and 2009.
Nonfinancial performance aims are understandably common in public sector,

voluntary, and nongovernmental organizations (NGOs). Governments try to
decrease unemployment rates, police forces try to reduce crime rates, and
charitable organizations try to reduce or eliminate suffering among target groups.
For example, the World Health Organization’s Global Polio Eradication
Initiative1 aims “… to ensure that no child will ever again know the crippling effects
of polio.” As recently as 1980, there were thought to be approximately 400,000
cases worldwide. Here, the preferred and feared futures are reversed—the aim is
1 For more information on the Global Polio Eradication Initiative, see

http://www.who.int/topics/poliomyelitis/en/.
a decline in the Figure 1.9: History and alternative futures for
performance indicator, the number of cases of poliomyelitis worldwide
2500
preferably to zero (Figure
1.9). 2000 history
Objectives to reduce, previously
1500 4-7,000
rather than to increase, per year
feared
something also arise in 1000
corporate settings—many
500
businesses would prefer preferred
lower rates of staff 0
1995 2000 2005 2010 2015 2020 2025
turnover or shorter lead-
times for product development, for example. Targets of zero are also common,
such as for product failures or customer complaints.
L  S
1.6 Levels of Strategy

So far, we have focused on the overall performance of a self-contained
organization. Strategic management, though, applies in other contexts, as well.
Within an organization, each function or department may need a strategy—
32 marketing, research and development (R&D), human resources (HR), and so on.
Such departments commonly have their own objectives, such as capturing
customers or launching products. It is of course important for those aims to be
B P O T
consistent with those of other functions. Winning more customers is not helpful,
for example, if HR does not aim to develop the staff numbers to serve them.
Also, some businesses are not independent, but are part of a multi-business
corporation. In these cases, a business may also not be entirely self-contained,
but share support functions such as finance or R&D with other businesses owned
by the same group.
This means that strategic management is required at several levels (Figure 1.10).
For clarity:
Ÿ the term “business” will refer to organizations with one main purpose,
either a self-contained, independent business, or else a subsidiary, or
“business unit” of a larger group
the term “corporation” will refer to organizations consisting of several
such business units, and “corporate strategy” will refer to the particular
strategic challenges that arise in that context. (Note that this essentials
book will not cover these more complex corporate strategy issues.)
Public service and other not-for-profit entities also have functional departments
needing strategic management, and large organizations may consist of several
operating units with distinct purposes.
Figure 1.10: Functional, business-unit, and corporate levels of strategy
Corporate strategy
(the multi-business company)
E: L- A R

Business-unit Business-unit Business-unit Business-unit
strategy strategy strategy strategy
Human-resource Marketing Manufacturing Information- other function

strategy strategy strategy systems strategy strategies
1.7 Example: Low-fare Airline Ryanair

This chapter has explained the main tasks of strategic management and the kinds
of performance objectives that strategy is designed to deliver. It has also shown
that strategic management is fundamentally a “dynamic” issue—improving 33
performance continually over time. This is the challenge that the strategy
dynamics method has been specifically designed to address.
B P O T

To show the build-up of a strategy dynamic analysis, we will use Europe’s
successful low-fare airline, Ryanair. This case has the advantage of being focused
on a single business activity—providing low-cost air travel on short- to medium-
haul routes in a single region
Being a commercial firm, Ryanair certainly has financial aims, and as a publicly
quoted company, there is a focus on the profits it makes each year and each
quarter. We will focus on its earnings before interest, tax, depreciation, and
amortization (EBITDA). To increase its results, the company must grow revenues,
but since higher pricing contradicts Ryanair’s strategic positioning, revenue
growth must come from increasing sales of passenger-journeys.
The last item to address before setting out the quantitative history and aims of
Ryanair is time scale. Since conditions are not changing too quickly, we will look
at the company’s progress in annual terms, and over several years. Ryanair’s own
management undoubtedly looks at performance more frequently—to make plans
to open new routes, for example—but an annual perspective is adequate for our
purpose.
Figure 1.11 shows a five-year history of sales and profits and shows plausible
objectives for these two indicators—the preferred future—plus a less attractive
feared outcome. Ryanair’s recent past includes two strong external impacts—high
fuel prices during 2005–2007 and the severe recession of 2008–2009, which hit
demand for air travel especially hard. The company coped well with both of these
challenges, sustaining growth in demand and remaining profitable. Demand was
only sustained during 2009, however, with an 8 percent fall in prices, which led
to lower profits.
E: L- A R
In both the preferred and feared futures, market demand is assumed to recover
only after 2010. In the preferred outcome, demand recovers strongly, and Ryanair
is able to capture new demand by continuing to open many new routes. Economic
recovery also allows prices to recover and profit growth to resume. In the feared
outcome, market demand recovers more slowly, prices still cannot recover, and
the company is unable to find many new routes that will be profitable to serve.
The remaining chapters of this book will discuss the logic and key elements of
strategy dynamics analysis by building on the strategic performance indicators
illustrated in the Ryanair example1.
Figure 1.11: Five-year history and plausible objectives for low-fare airline
34 Ryanair
100
1,500 passenger journeys sold
profit (EBITDA)
B P O T
millions
€ millions preferred 80 preferred
1,000 60
history history feared
40
500
20
feared
0
0 2005 2007 2009 2011 2013
2005 2007 2009 2011 2013
1 This example will be developed further in later chapters All charts and figures
include data from the company’s Annual Reports and statutory returns, where
reported, up to and including the financial year ended March 2009. Other data
and projections to 2014 are illustrative estimates by the author
CHAPTER 2
HOW RESOURCES DRIVE
PERFORMANCE
Before we can understand how profits change over time, we need to clarify what
explains profits at any point in time. Strategy research seeks explanations of two
broad types:
1 How market features, competition, and the wider external
environment constrain profitability. Typically, these factors are used
to choose a strategic position that offers the potential to be sustainably
more profitable than average.
2 How characteristics of any specific firm, such as its resources and

capabilities relative to competitors, enable it to achieve and sustain
superior profitability.
The following discussion gives only a short summary of common approaches in

these categories. More detail on these and other methods can be found in popular
strategy textbooks.1
SWOT analysis. While now largely viewed as inadequate, SWOT remains the
first method most executives think of for developing strategy. SWOT is an
acronym for the four main issues that the method considers. “SW” refers to the
Strengths and Weaknesses of a business, relative to competitors, and to what is
needed to succeed— i.e., internal considerations. “OT” refers to Opportunities
and Threats that the organization might face—features of the external
environment.
1 See for example: Robert M. Grant. Contemporary Strategy Analysis, 5th ed.
(Oxford: Blackwell Publishing, 2005).
2.1 Strategy Methods Focusing on External Factors
Industry forces. The dominant model for assessing a firm’s business
environment is the so-called “5-forces” framework.1 This model helps explain
industry profitability and its variance (Figure 1.3), enabling management to find
S M F  E F
a strategic position where a sustainably high rate of profitability may be

possible—specific customer-segments to serve, distinctive products or services
to offer, or particular marketing channels to use, for example. The five “forces”
making up this framework are:
1 Activities of competitors who, in trying to capture sales, compete away
profitability through pricing, or by offering costly benefits to
customers—lower fares or better service by competing airlines for
example.
2 The potential for new entrants to start operating in the industry, if

they think they can make good profits, such as the start-up of new
airlines.
3 Availability and appeal of substitutes—i.e., goods and services that,

while not the same as those sold by the company, offer the customer
36 similar benefits. For example, trains are a substitute for many airline
routes, and videoconferencing is a viable alternative for some
business travel.
H R D P
4 The buying power of customers to drive prices down by switching

between competing suppliers. The ease with which customers can
switch between alternative airlines and the incentive to save money
on this high-cost purchase pushes down prices and profitability.
5 The power of suppliers to command high prices for critical inputs.

Major airports control access to a large fraction of the travel market
and so can command high prices from airlines who want to fly there.
In principle, the more intense the competitive pressures, the lower will be the
likely average profitability of an industry and the less the scope for any firm to
do better than this average. However, it is difficult to define and quantify each
force sufficiently to arrive at a robust analytical prediction of profitability and
its variance in any particular setting.
1 Michael E. Porter. Competitive Strategy. (New York: Free Press, 1980), 3–33.
PEST analysis Competitive forces are in turn affected by wider features of the
external environment, commonly assessed under four categories:1
1 Political factors include influences arising from the actions, policies,
and attitudes of governmental and nongovernmental entities. The
S M F  E F

influence may be explicit and direct, such as the 1980s legislation that
opened up competition in the US airline industry or more generalized,
such as trading agreements between countries.
2 Economic conditions have various effects on business prospects and

hence on strategy and performance. General economic growth of
course helps stimulate many markets, enabling the growth of
companies’ sales and profits. Economic conditions may, however,
have specific effects on particular industries, such as the severe drop
in business air travel in 2009 as companies in other industries sought
desperately to cut costs.
3 Social factors also influence how markets develop. The potential for
any product or service may change in size due simply to population
growth, age distribution, and other demographic effects. Other social
mechanisms reflect behavioral factors, such as the increasing
popularity of short-break vacations.
37
4 Technological developments cause two main effects. First, there is the
H R D P

improved functionality of products and services—the ever-increasing
capability of cell phones and other electronic devices, for example.
Secondly, technology can reduce unit costs. The extreme efficiency of
web-based sales compared with the slow and costly alternative of using
retail travel-agencies, for example, enabled new airlines to reach
customers at very low cost.
Environmental concerns and Legislative impacts are sometimes added to this list,
extending the acronym to PESTEL analysis. Once again, while a useful checklist,
these elements cannot be defined and quantified sufficiently well to provide more
than generalized conclusions regarding an industry’s attractiveness or future
prospects.
1 V. K. Narayanan and Liam Fahey. “Macroenvironmental analysis: Understanding

the environment outside the industry,” in The Portable MBA in Strategy, 2ⁿ ed.,
Liam Fahey and Robert M. Randall, eds. (Chichester: John Wiley & Sons, Inc.,
2001), 189–214.
Scenario planning.1 This important strategy method looks at how the external
environment may change. (Note that scenario planning should not be confused
with “forecasting.”) Scenarios are plausible alternative stories of how an industry’s
S M F  F- F
wider environment and competitive conditions might evolve into the future.
Management then assesses how demand, competitive conditions, and other
factors might change under these alternative versions of the future. These
conclusions are then used to develop a strategy that can both exploit opportunities
that may arise while at the same time being robust enough to account for any
dangers that may threaten those futures. While commonly used among very large
corporations, the principles of scenario planning are also valuable to smaller
companies and not-for-profit organizations. Scenario planning is a vital
component of strategic management but is frequently neglected—many firms
may have saved themselves considerable pain had they carried out this planning
prior to the recession of 2008–2009.
Competitor analysis.2 In addition to the above frameworks for thinking about
the wider external environment, several techniques exist for understanding one’s
competitors. Understanding how competitors’ strategies work, initiatives they
may pursue, and how they might respond to one’s own actions is a further critical
task of strategic management, but one that is rarely done well.
38
2.2 Strategy Methods Focusing on Firm-specific Factors
H R D P
Strategy research has now largely concluded that industry conditions are less
influential on firms' profitability than are the choices made by and the
characteristics of firms themselves-you can do well in intensely competitive
industries, and badly in more benign sectors. We have explained part of why this
might be the case in Section 1.2. The following are some common frameworks
for strategic assessment of the organization itself.
Value-chain analysis3 This approach looks at how a business adds value to the
inputs it uses in order to create products and services for which it can charge
more than the cost of those inputs and its operating costs. A restaurant, for
example, has to pay for the food and drink it buys, and hopes to sell the resulting
1 Kees van der Heijden. Scenarios: The Art of Strategic Conversation. (Chichester:
John Wiley & Sons, Inc., 1996).
2 Craig S. Fleisher and Babette E. Bensoussan. Strategic and Competitive Analysis:
Methods and Techniques for Analyzing Business Competition. (Upper Saddle
River, NJ: Prentice Hall, 2002).
3 Michael E. Porter. Competitive Advantage. (New York: Free Press, 1985), 33–52
meals for a higher price than the cost of the ingredients. That margin must also
be sufficient to pay for the real estate the restaurant occupies-another bought-in
input-and for staff, fuel, and other operating costs.
S M F  F- F

Internal costs are divided between "primary" costs-sourcing raw materials,
converting them to finished products, delivering them to customers, marketing
and selling to customers, and providing customers support-and "support" costs,
such as finance and IT support. Different industries vary widely in the mix
between these cost elements. Manufacturing companies may be dominated by

the cost of converting raw materials to finished products, wholesalers feature a
high proportion of logistics cost, and cosmetics companies spend heavily on
marketing.
Value-chain analysis can be used to identify opportunities for competitive
advantage in either of two ways-by eliminating costs or by seeking ways of raising
the price customers are willing to pay. It is also possible to combine the approach
with an analysis of customers' value chains in order to make savings or generate
more value, for example, by offering products that may be higher in price but
save customers more in other ways.
The value curve1 The value curve is a simple tool for finding a potentially strong
competitive position for a business by understanding the relative importance of 39
different customer benefits. This analysis can help identify new combinations
that are more attractive to customers than those offered by existing firms.
H R D P

Low-fare airlines first succeeded, for example, by offering exceptionally low prices,
and frequent point-to-point services, without offering many of the services of the
full-fare airlines who had previously dominated the market. If a powerful and
fundamentally new value-proposition can be found and implemented quickly,
then it can be difficult for competitors to copy, leading to a sustainable
competitive advantage and the profitability that this earns.
Resource and capability analysis2 Since we now know that a good strategic
position alone is not enough to guarantee success, research has tried to identify
1 W. Chan Kim and Renée Mauborgne, Creating new market space, Harvard
Business Review, 77(1), 83–93; W. Chan Kim and Renée Mauborgne. Blue Ocean
Strategy: How to Create Uncontested Market Space and Make the Competition
Irrelevant. (Boston: Harvard Business School Press, 2004).
2 Jay B. Barney. Gaining and Sustaining Competitive Advantage, 2ⁿ ed. (Upper
Saddle River, NJ: Prentice Hall, 2001), 127–169.; David J. Collis and Cynthia A.
Montgomery, Competing on resources: Strategy in the 1990s, Harvard Business
Review, 73(4), 118–128.
the internal factors that may provide sustainable advantage. That effort has
identified resources (things an organization possesses) and capabilities (activities
it is good at doing) as two internal factors leading to sustainable advantage. Note
that these factors are sometimes confusingly lumped together under the single
term "resources."
L  C S A
To provide competitive advantage, it is argued, a resource should be valuable,

rare, hard to imitate, and embedded in how the organization operates-the
so-called VRIO criteria. Tangible factors, such as cash, capacity, and staff, are
considered to be both obvious and easily copied or bought by rivals; therefore
only intangible factors can provide sustainable advantage. Examples of intangible
factors include a company's reputation and the strength of its customer
relationships. These principles now form the core of the so-called "resource-based
view" of strategy (RBV), a perspective that dominates current academic thinking.
Analysis of resources and capabilities, then, aims to: (1) specify the resources and
capabilities that could provide advantage; (2) assess these resources and
capabilities against what competitors possess; and (3) identify those resources
and capabilities that need to be developed in order to win and keep winning.
Unfortunately, like other strategy concepts, these factors are not easy to specify
or quantify, making it hard to work out how much, and of what, needs to be done,
40 or what impact any efforts may have on performance. Furthermore, there are
some fundamental problems that current RBV thinking does not adequately
address.
H R D P
As has long been known, even tangible resources are difficult, costly, and
time-consuming to accumulate, and so cannot be dismissed as irrelevant to
strategy and performance. Blockbuster's stores, for example, were fundamental
to its competitive advantage and market dominance for two decades.
Furthermore, resources are not independent of each other-a great sales force
cannot win customers without good products, and they cannot keep customers
if service capacity is inadequate. It is the entire system with all its
interdependencies that generates performance. As a result, no simple listing of
resources and capabilities can be adequate, even if these could be specified and
quantified
2.3 Limitations of Common Strategy Approaches

While useful to some degree, most of the principles and frameworks for strategy
analysis suffer from three important limitations:
1 They offer guidance on choice of strategic position—who to serve, with
what, and how. As explained in Section 1.1, such decisions are made
infrequently. Strategic management, being an ongoing task rather than
an occasional challenge, needs tools for steering strategy and
performance through time.
2 They are based on evidence for what might cause superior profitability
ratios, while management and investors should be more concerned
with improvements in cash flow over time and other absolute
performance indicators, such as customer numbers and sales volume.
3 Most rely on abstract and ambiguous terms that are hard to specify
T R  P

or quantify, and therefore offer little confidence as to their impact on
real performance.
2.4 Tangible Resources and Profits

Even if tangible resources are easy to copy, which is not always the case, they are
clearly involved in explaining an organization’s performance, so we start by
clarifying that connection. Figure 2.1 picks up the example of Ryanair from
Chapter 1, illustrating the firm’s income statement for the financial year ended
(y/e) March 2009 in causal form. Profits arise from its revenue minus costs, with
revenue arising from passenger fares and ancillary items, such as ground transport 41
and in-flight sales. Costs fall into major categories, such as staff, aircraft, operating
airports and routes, and marketing.
H R D P

Figure 2.1: Causal Structure of Ryanair Profits for Year Ended March 2009
Figure 2.1
Ancillary revenue
598.1
Fare revenue
Total revenue
2343.9
2942.0
Aircraft costs
Total operating Profit [EBITDA]
1402.1 costs €m p.a.
Route costs 2593.3 348.5
286.6
Other costs
Airport costs 139.1
443.3 Marketing costs
Staff costs 12.8
309.3
The causal relationships here are simple:
Profits = total revenue − operating costs

total revenue = fare revenue + ancillary revenue
operating costs = aircraft costs + route costs + airport costs + staff costs
+ marketing costs + other costs
If this causal explanation for profits was true for y/e March 2009, it was also true
for every previous year. It will also continue to be true in future, so long as the
firm conducts the same business. We can therefore connect the time charts of the
T R  P
above-listed items in the same layout (see Figure 2.2). Each chart in this figure
portrays the historic values for the items named and provides a plausible time
path for how they might develop in future. Although this may be an unfamiliar
view of a company’s income statement, it is simply illustrating in a graphical,
causal layout the same data we normally see in spreadsheet form.
The features of this diagram and others that will follow are important. Each item
includes a quantified scale on the vertical axis, and a specific timescale on the
Figure 2.2: Explanation of Ryanair Profits, 2005–2009, and plausible

future to 2014
42
H R D P
Source: Company Reports and author’s estimates.

horizontal axis. The current value “today” (the latest time for which data are
known) is highlighted in green, just above a vertical dashed line for the time at
which it applies. The time path of historical data is shown as a solid green line,
and forecasts are denoted by a dashed line.
Word-and-arrow diagrams are commonly used in management books to illustrate
a general relationship between connected items. Here, every such link has a more
precise meaning—if arrows link items A and B into C, then the numerical value
of C can be calculated or estimated from the values of A and B at each point in

time. Figure 2.2 follows this rule rigorously.
F P  R

2.5 From Performance to Resources
Next, we need to know what causes each of the revenue and cost items presented
in Figure 2.2. Conventionally, revenue would be explained in terms of market
size and market share:
revenue = size of air travel market × market share
Indeed, this is exactly how respected finance books recommend analysts to

forecast a company’s revenue and how many firms start developing their business
plans and budget forecasts. But while this equation is mathematically correct, it 43
is not a causal explanation of revenue. The equation could equally be stated the
other way round—i.e., market share = revenues ÷ market size. The reality, not just
H R D P

in this case but in virtually all others, is that revenue comes from sales volume
and price, and sales come from customers. This statement might seem obvious,
even simplistic, but that does not make it any less true! And since sales and profits
are not normally forecast in this way, it is worth pushing on to find out the
consequences of pursuing a more rigorous causal logic.
A true explanation for profit over time requires working back from the income
statement, through rigorous causal connections, until we get to factors that
management can influence. In Ryanair’s case, this works as follows:
annual fare revenue = passenger journeys sold × average fare paid
The number of passenger journeys sold is not given by market size

and market share, but instead by:
passenger journeys sold per year = number of customers

× journeys per passenger per year
Figure 2.3: How customers drive sales for Ryanair
F P  R
Source: Company Rep[orts and author’s estimates.
Journeys are taken by people! And it is the choices of those people—to become
customers, to cease being customers, and to buy more or less often—that a
company tries to influence with its choices of product offering, marketing, and
sales effort. Figure 2.3 shows these relationships, over time, for Ryanair, following
exactly the same principles as in Figure 2.2.
44
There is a critical reason for placing the “Estimated customers” graph at the far
left of Figure 2.3 in a box. All other items in Figures 2.2 and 2.3 are measures that
H R D P
describe what happened over each year as a whole—the fare revenue of €2,343.7m
was made over the period of April 2008 to March 2009, for example. In contrast,
“customers” are a quantity of something that exists at each point in time—like
the amount of water in a tank, which is what the box symbolizes. Typically, such
items are measured at the start and end of a reporting period—how much “stuff”
we have at the end of the financial year. This is well understood in the case of
cash. We start the year off with a quantity of cash, incur cash flows in and out
during the year, and end the year with a different quantity. This is simply the link
between the balance sheet and the cash flow statement, but equivalent
relationships apply to customers and other items, as well.
Generally, factors of this kind are known as “asset stocks” or simply “stocks.” In
the context of strategy, such items are called “resources,” and their behavior is
critical to how performance changes over time. This will be explained in Chapter
3.
Customers’ asset-stock character makes it necessary to calculate the average
number of customers during the year and their average travel frequency during
the year to accurately match the quantity of customers with the rate at which they
are delivering sales. If customer numbers were to change significantly over a
twelve-month period—as is likely in the case of Ryanair—taking a simple average
of year-start and year-end numbers may not accurately explain total sales over
the year. The more frequently this average is determined—each quarter or month,
for example—the more accurately it will explain the annual sales result.
Some additional details in Figure 2.3 are needed for completeness and accuracy:
Ÿ The company also gets additional, ancillary revenue from sales of food
and drink, ground transportation, and other services—also driven by
F P  R

customer numbers.
Ÿ Customers do not take all the journeys they buy—about 7% are
“no-shows,” so fewer journeys are flown than bought.
Ÿ The number of customers is not precisely knowable. Many people
habitually and repeatedly use this airline, perhaps because it is the only
one serving their desired routes, or simply because they prefer it.
Others use it only occasionally. These differing customers could be
split out into two or more segments, each of which has its own journey
frequency and fares. The structure in Figure 2.3 would therefore be
copied for each group, and total fare revenue calculated from the sum
of these segments. 45
Ÿ While this structure focuses on the firm itself, rather than being driven
by market size and market share, it is not immune from external
H R D P

factors. Customers’ average travel frequency is clearly affected by
economic conditions, as many airlines found when sales collapsed in
the 2008–2009 recession.
Exactly the same principles apply to the company’s costs. Costs are conventionally
explained in terms of the company’s success in reducing the percentage of revenue
expended on each item. So, for example:
staff cost = revenue × percentage of revenue spent on staff
Again, though, this equation can expressed the other way round: percentage of
revenue spent on staff = staff cost ÷ revenue × 100. And once again, this equation
does not provide a causal explanation. While we may want to limit such ratios,
the reality is that staff numbers drive the cost of staff, and we actually control
those costs by hiring and firing people and/or by changing their rate of pay. The
true causal explanation of staff cost is therefore:
staff cost = number of staff × cost per staff member

Similarly, aircraft numbers drive the costs of operating aircraft for any level of
utilization, the number of airports served drives airport-related costs, and the
number of routes drives the cost of operating those routes. Everything else being
equal, having more or less of each of these resources—staff, aircraft, airports, and
routes—will raise or lower the corresponding cost item accordingly. Figure 2.4
shows this analysis for Ryanair’s routes.
Figure 2.4: How resources drive Ryanair’s costs, e.g., routes
F P  R
Source: Company Reports
Again, some important details and adjustments are needed in practice:

46 Ÿ Some fraction of these costs is driven by adding or removing a resource,
as well as by simply having it. It costs money to open a new route.
Hiring and firing staff also costs money, as does starting or ending
H R D P
operations at an airport. Ryanair buys its own aircraft, rather than

leasing them, so the large cost of these purchases is a capital item and
does not appear on the income statement.
Ÿ Costs, too, are affected by external factors. The average aircraft cost,
for example, climbed sharply during in 2008, due to increases in the
prices of oil and jet fuel, then fell back once those conditions eased.
Ÿ We have the same problem here with point-of-time values for the
resources versus. whole-period values for the costs that they drive.
Aircraft numbers, staff, airport costs, and routes are reported as at the
end of each reporting period, but the costs are incurred in total during
those periods. As with customers, then, we again have to take the
average quantity of each resource during each period to explain the
total costs for the period, and the more frequently these values are
computed, the more accurate is the causal calculation.
The point of this discussion is to provide the tools to help management steer
strategy and performance over time. Figure 2.2 offers not only a causal
explanation of the company’s performance up to 2009, but also plausible targets
for future years out to 2014. This projection makes explicit three key assumptions:
4 Revenue growth is expected to come from increasing sales volume
(passenger journeys sold) plus slight price increases. It is not expected
that average prices will fall. The fares are still very low in comparison
to competitors, however, as this is fundamental to the firm’s strategic
R  N P

positioning.
5 Growth in journeys sold will come mostly from increased numbers of

customers—we will see later what is expected to cause that increase.
6 There is expected to be some increase in average customer demand—

journeys per passenger per year. In the early years, this will be helped
by recovery from economic recession and by continued, modest
growth in consumers’ general desire to travel.
2.6 Resources and Nonfinancial Performance

The same logic as we discussed above applies to other kinds of performance aims.
The quality of service for a telephone call center, for example, reflects a balance
between the incoming call volume and the capacity of the center’s staff to answer 47
those calls. Demand is driven by the population of people who might call, and
the rate at which they do; capacity is driven by the number of call center staff and
H R D P

the rate at which each can deal with calls.
This makes the resources-to-performance link directly applicable also to public
services, voluntary, and not-for-profit organizations. Figure 2.5 provides an
example of causal relationships between resources and performance that are
common in many charitable organizations. This particular organization recruits
volunteers to support people suffering from a serious, progressive, and ultimately
fatal disease. Volunteers provide advice and emotional support, for which they
need specialized training. There are currently (time = 0) 356 volunteers
supporting 2,511 patients, which is not enough to fulfill the required workload,
so calls on patients are sometimes rushed or missed.
Twelve quarters previously, volunteer capacity was only 60% of demand, but a
recruitment effort over the last eight quarters has increased volunteer numbers.
Planned future recruitment over the next four to six quarters is expected to raise
capacity to the point where all patient calls can be handled effectively, with
adequacy approaching 1.0. However, it is feared that the organization will face a
further rise in patient numbers, due to increasing prevalence of the disease, earlier
diagnosis, and longer life expectancy. By Quarter 16, then, the organization fears
that it will again be unable to provide fully adequate support for its patients.
Figure 2.5: Resources driving service performance in a voluntary

organization
“S”  R
48
H R D P
2.7 “Stocks” of Resources

The number of patients and volunteers in Figure 2.5, like Ryanair’s customers
and routes in Figures 2.3 and 2.4, are shown in boxes because these too are
resources, or asset stocks. The number of patients and volunteers are quantities
of items that drive demand and capacity, respectively, or are useful to the
organization, and are collected over time.
Resources are quantities of items or materials driving demand and
capacity—and hence income and costs— that are owned or reliably
available to the organization and are built up over time.
To clarify the distinction between resources and other items, imagine that time
is standing still. There would be no revenue or journeys, costs or profits for
Ryanair, and no workload for the charity from Figure 2.5, because time has to
pass for these items to exist. Indeed, they are actually measured in units per time
period—journeys per year, profits per year, workload per quarter, and so on.
Tangible Computer Law firm Airline Consumer Charity

resource chip-maker brand
Demand Final customers Computer Clients Customers Consumers Beneficiaries
side buyers
Intermediaries Computer Retailers
makers
remain loyal for years or decades.

Resellers
Supply Capacity Stores Professional Aircraft Production (Physical
side Staff plant assets)
Staff Production Service staff Sales force Volunteers
staff
Suppliers Airports
Table 2.1: Standard categories of tangible resources
Product range Chip types Legal services Routes offered Brands offered Services
offered
Cash Cash Cash Cash Cash Cash
McDonalds employee stays for only a matter of months, while customers may
than staff—fast food chains, banks, and sports teams, for example. The average
tomorrow. On this basis, many organizations find customers are more reliable
Resources need not be owned or directly controlled to be useful. They need only
be somewhat reliable—if they are available today, they are likely to be available
H R D P “S”  R
49
The resources displayed in Figures 2.3 and 2.4 are specific to the airline business
but are also examples of general types of resources to be found in most
organizations (see Table 2.1). Some resources drive demand for an organization’s
products or services, while others make up its ability to supply them.
Note that the table 2.1 specifies only a key staff group for each example, although
a complete analysis would need to cover all relevant staff groups. Table 2.1 is not
an exhaustive list of resource categories—intangible factors and capabilities are
also relevant, for example. However, the direct causal relationship between these
tangible items and performance leads to a critical observation:
It is not possible to explain performance without information on the
quantities of the tangible resources that drive it.
“S”  R
A few details to note about the items listed in this table:

Ÿ Not all kinds of firm have all types of resources. Companies that sell
directly to the final users of their product or service, such as a retailer,
do not have intermediaries (wholesalers, dealers, or agents).
Ÿ Some organizations depend on two quite different groups of
customers, either or both of which may generate revenue. For example,
media companies have viewers or readers but also serve advertisers,
50
and eBay depends on having both buyers and sellers.
Ÿ Where intermediaries are involved, they may well be the company’s
H R D P
true customers—that is, the organizations that actually buy from the
company. For example, Procter & Gamble (P&G) sells its products
primarily to retailers, rather than to consumers. Nevertheless, end-
customers are a critical resource, so are vitally important to strategy.
P&G certainly depends on, and needs to know how to influence the
end-consumers of its products.
Ÿ For many service organizations, staff are their capacity to provide their
service, rather than physical plant or equipment resources.
Ÿ Depending on the situation, not all resources need be made explicit,
even though they exist. Many companies have such easy access to
suppliers who want to serve them that there is little to be gained by
specifying those suppliers. (A publisher’s authors or an airline’s
airports, though, are both hard to obtain and critical to success.)
Investors, as suppliers of capital, may not usually need to be identified
but do need special attention in some cases, such as with fast-growing
new ventures.
Ÿ Specific cases may involve types of resource that are uniquely
important to those situations. Oil companies and other raw-material
producers, for example, are fundamentally dependent on their
reserves.
Public service, voluntary, and not-for-profit organizations feature very similar
W R T A  O

resource categories. They usually have a population that drives demand, even if
that population does not generate revenue. Criminals drive demand for policing,
patients drive demand for health care, malnourished people drive demand for
aid organizations, and so on. Not-for-profit organizations also feature staff, of
course, and very often those staff make up much of the capacity to deliver their
services—police officers, doctors, and aid workers for example. Finally, many
voluntary organizations require a special category of resource—the donors who
provide their funds.
2.8 When Resources Themselves Are the Objective

There is one case in which the rule that resources drive performance is not
relevant—when the objective that the organization is pursuing is itself a resource.
This can arise at different levels:
Ÿ A particular function or department may aim to build some quantity 51
of resource by some point in time—numbers of suitably qualified staff,
or numbers of products on the market, for example.
H R D P

Ÿ A whole business may have an objective to achieve some target
quantity of a resource. Many companies have goals to reach a certain
number of customers by some point in time. This may be more than
simply the responsibility of sales and marketing departments if, for
example, product performance, service quality, or other factors could
affect customer retention.
Objectives for intangible resources are also common—staff morale and market
reputation being common examples. Again, such aims may apply to the whole
organization or just to specific parts of them.
When an objective concerns a resource itself, rather than some other performance
outcome, we can forget about the principle that resources drive performance for
now, and go straight on to how such resources are won and lost, discussed in
Chapter 3.
2.9 Specifying and Quantifying Resources
To understand performance accurately enough to make good strategic choices,
it is not enough to simply note that certain resources are involved and move
on—the resources must be quantified, as in Figures 2.3 to 2.5. This requires them
to be properly specified.
For many resources, accurate specification is easy. There is no problem counting
S  Q R
Ryanair’s aircraft, for example! Staff and customers, too, are easy to define and
count. There is more to think about with both staff and customers, though.
It may be important to specify different groups of customers. We already noted
Ryanair’s regular passengers and other occasional customers. Distinct staff groups
may also need to be specified, such as production staff versus sales staff versus
service or support staff.
Defining and counting customers is not always easy. Counting customers when
there is a contractual relationship (e.g., for cell phone companies or electricity
suppliers) is easy, but how about a bank? Quantifying the total number of
account-holders may not be a problem, but some account-holders may have little
money in their bank accounts and conduct so few transactions that not
52 meaningful customers. This case would best be handled by segmenting customers
into the most important groups and, as with staff, leaving less-important
customers in an “other” category.
H R D P
Of the items listed in Table 2.1, capacity can be the most problematic. For an
airline, it is simple enough to count the number of aircraft, from which the
passenger-carrying capacity can be calculated, depending on the length of routes
that are offered. Often, though, it is not helpful to count the physical units of
capacity. A chemical plant’s capacity, for example, is not the sum of the number
of pipes and pumps of which it is made up. A simple solution is to express capacity
in terms of the physical output that can be produced—tons per hour, for example.
This also works in cases where capacity involves information technology. In
banking, a key capacity is the number of transactions that can be processed per
hour, not the number of servers or terminals.
Product range can also be tricky to define and measure. For an airline, this is the
number of routes it operates. Retailers count “stock-keeping units” (SKUs),
pharmaceutical firms have a number of drugs on the market, and car makers offer
a range of models. But is a single drug offered in adult and child formulations
one product or two? Are different variants of a single car model different
products?
So, it is not always an easy task to specify and measure resources, but there is
value from the very effort of trying to do so. Many companies benefit from
thinking carefully about the nature and number of customers they serve or about
the products they offer. New products, for example, are often added without
considering the impact on those already offered, leading to unhelpful and costly
proliferation. Management can make better decisions about what to do if they
have a clear and quantified specification of the resources that drive the sales,
S  Q R

capacity, revenue, costs, and profits of the business. Professional service firms,
for example, may struggle to agree on strategy because they have not clarified
exactly what “products” they offer or might develop. A law firm that treats each
client engagement as a unique service will often do better to define and specify a
clear set of services that it offers. This not only makes it easier to market and sell
those services, but helps control workloads and costs, increasing profitability.
The resource-based view (RBV). The discussion and specification of tangible
resources in this section is not the same as the textbook resource-based view of
strategy, discussed in Section 2.2. The strategy dynamics approach differs from
RBV in three principal ways:
1 Since tangible factors comprise the heart of any business or
organization, it is necessary to make them explicit, quantify them, and
53
connect them to the organization’s performance outcomes. Intangible
factors and capabilities will be added to the analysis if their influence
H R D P

operates through the impact they have on the tangible factors that
directly drive performance.
2 Strategy dynamics does not limit analysis to resources that are owned
or controlled by the organization, but includes any that are in any way
reliably accessible, customers being the main example.
3 Lastly, the approach makes explicit and quantifies the “complem-

entarity” amongst resources—how they work together as an
integrated, functioning system, to generate performance. This will be
explained further in Chapter 4.
.
54
CHAPTER 3
RESOURCES WON AND LOST
Chapter 2 explained that resources are useful items that have been built up over
time, and that there is a direct, quantitative relationship between the quantities
of those resources and performance at all times. The next logical question, then,
is what determines the quantity of resources at any point in time? The causal
relationships we have discussed so far have come in the following form:
If we know the value of A and B at any time, then we can calculate or

estimate the value of C at that time.
Resources and other asset stocks do not obey any such relationship. We explain
quantity of resources as follows:
The quantity of resource X today is the total amount of X that has ever
been added up to this time, minus the quantity that has ever been lost.
This is not an opinion, a theory, or a finding from statistical analysis of large

data-sets—it simply is how the world works. Nor is it an approximation. The
amount of cash in your bank account is precisely, to the cent, the sum of every
amount ever paid in minus every amount ever taken out. This is the critical feature
of resources, without which no sound understanding of strategy and performance
is possible.
Resources accumulate and deplete (fill and drain) over time.
The implications are profound. The number of customers you have today is not
explained by anything else—not by the prices charged, products offered,
marketing dollars spent, or sales effort expended. The number of customers is
precisely the sum of every customer ever won, minus every customer ever lost,
since the day the business started. And if we cannot explain the number of
customers in terms of anything but its own history, then neither can we explain
anything that depends on that number—such as sales and profits! So be very
Q  “B B”  R
skeptical of any business frameworks based on claims to have found that factor
X drives profitability.
Likewise, the number of staff today is not explained by salaries, career prospects,
or how well they are treated. It is precisely the sum of every person ever hired,
minus every person who ever left or was fired. The same logic applies to the
number of products offered, the amount of capacity in place, and the amount of
cash. Cash, of course, is the one resource that is explicitly reported in this way,
in a company’s balance sheet and cash flow statements.
Fortunately, we do not have to know all of a resource’s history to make use of
the concept. If we know how much of resource X there was at the start of any
period, and how much X was added or lost during the period, then we know
precisely how much X there will be at the end of the period—and that quantity
will then be how much there is to start the next period.
This principle can now be added to our emerging theory of performance:
56 1 Performance at any time depends on resources, and
2 Resources accumulate and deplete over time

R W  L
3.1 Quantifying the “Bathtub Behavior” of Resources

Although the calculation of resource quantities is quite different in nature from
most other causal relationships, we already know how to work out what happens
with accumulating stocks. If we are filling a bathtub and want to know how much
water it will contain at the end of the next minute, we measure how much there
is at the start of the minute, add the amount that flows in through the faucet and
subtract how much runs away down the drain. This is why the way resources
change over time is sometimes termed “bathtub behavior.” The quantity of
resources is built up by the flow of new resource into the stock—the inflow. And
resources are depleted by quantities of the resource flowing out of the stock—the
outflow—whether through misfortune, the actions of others, or by deliberate
intent. This applies to intangible factors as well as tangible resources, so:
Ÿ Winning customers adds to a customer base; recruiting new
employees increases our staff resource; marketing our products raises
awareness among potential customers; training our staff enhances
their level of skill.
Ÿ Customers are lost to competitors; resignations and firing reduce our
staff base; discontinuing a product reduces our product range; intense
pressure on staff reduces morale.
The mathematical behavior of this process is termed “integration,” and although
Q  “B B”  R

the term may not be familiar to you, you probably know how to do it. You likely
know more or less how much money was in your bank account at the end of last
month, and have some idea how much will be added to it during this month, and
how much you will pay out of it. You can therefore work out what will be left at
the end of the month.
Figure 3.1 quantifies this idea. Think of the box in the middle as a bathtub
containing your cash, and the wide arrows as pipes carrying cash into and out of
the tank. Think of the ovals as pumps that determine how fast that cash is flowing.
The ovals are highlighted in yellow because what they represent turns out to be
critically important.
If the numbers in Figure 3.1 continue through time, you will have $1,200 at the
end of next month, $1,400 at the end of the month after that, and so on. It is also
easy to work out what will happen if your rent goes up from $1,500 to $1,800 per
month.
The relationship between a resource stock and its flow rates shown in Figure 3.1, 57
known as a stock-and-flow diagram, is trivially simple, but just asking about
these basic numbers can transform strategy and performance. One popular
R W  L

Figure
Figure 3.1
3.1: Drivers of flows into and out of your bank account
Cash in bank
Cash in account Cash out
($ per month) ($ per month)
500 $1,000 450
Investment Clothes, fun …

income 150
150 Salary
350 Rent Food
200 100
A working model showing how changing flows of money into and out of a bank
account change its balance over time is at http://sdl.re/mmgs. This is an example
of working models included in the strategy dynamics course.
over-the-counter drug1, had been slowly losing sales and market share for many
years, and no marketing efforts had succeeded in changing this trend. About 22
million people now use the product, a number that is increasing by just under a
million each year (meaning average purchases per person are falling). This
Q  “B B”  R
information is not enough, however, and the example illustrates a critical issue:
It is important to know, separately, the inflow and outflow rates
for a resource.
Winning one million customers a year and losing none is not the same as winning
five million a year and losing four million, even though the resulting customer
base is the same. This mature pharmaceutical product might be expected to
feature little change in its customer base, but it turned out that 3.7 million new
consumers were won each year, and 2.9 million were lost! Marketing strategy
shifted from winning new consumers, which was already working well, to
retaining existing users, especially heavy buyers. The sales decline was halted, and
with a reduction in marketing spend. Similarly valuable insights have been found
in a wide variety of industries, from soft drink producer Coca-Cola to software,
car manufacturing, and consulting firms.
A common response to such examples is “That’s obvious.” Well, yes it is, but this
58 firm had been worrying about its sales and market share problem for many years,
and never found the solution because it never looked at these numbers. If you
don’t ask the question, you will not find the answer, no matter how obvious it
R W  L
seems afterward.
Surprisingly few organizations track these numbers or know what to do with
them. One large bank, for example, studied hundreds of pages of data about all
the different kinds of financial products each customer held, segmented by age,
income level, region, and just about every other criterion you might imagine. But
their analysis included not a single number on how many customers were won
and lost by each product each month. The data could be found, but no-one had
ever asked.
This stock-and-flow mechanism is not just critical for understanding customers
and sales. In some cases, especially for professional service firms and others that
rely on scarce, skilled employees, winning and retaining staff is vital to strategy
and performance. Infosys Technologies, a world leader in IT services based in
Bangalore, India, offers an interesting statement on the front of its 2007–2008
Annual report2.
1 The product cannot be named for competitive reasons.

“Our core corporate assets walk out every evening. It is our duty to make
sure that these assets return the next morning, mentally and physically
enthusiastic and energetic.”
The first eleven pages of that report go on to talk, not about market conditions,
customers, or financials, but exclusively about its people and what the company
is doing to develop and retain them.
3.2 Accumulation over Time

Chapter 2 pointed out that the direct relationship between performance and
resource quantities is true at all times in the past and future, so long as the same
activity continues. The same is true of the relationship between the inflows and
  T

outflows of a resource, and how its level changes over time.
In Figure 3.2, a business wins twenty customers per month, and initially loses
only twelve per month, but this loss rate rises in successive months to fourteen,
sixteen, eighteen, and so on, until by the end of month 12, customers are leaving
at the rate of thirty-six per month. There is a constant win rate and a straight-line
trend on customer losses. But the stock of customers does not follow a straight
line, but instead follows a curved path through time, peaking at 120 during month
5 (when twenty customers are won and another twenty are lost), and then 59
decreasing ever more rapidly until the year ends with only sixty-four customers
in place.
R W  L

Figure 3.2: How changing rates of customer losses affect customer
numbers and sales
2 http://www.infosys.com/investors/reports-filings/annual-
report/annual/Documents/Infosys-AR-08.pdf
This figure illustrates why it is difficult for the human mind to intuitively grasp
how resources will change over time. Even highly numerate people find it hard
to estimate what will happen to the level of a resource over time, given simple
changes to win and loss rates. Such misunderstandings can be serious. Cutting
your spending rate will not, for example, cut your borrowing unless the cut is so
large that spending falls below your income. Similarly, cuts to greenhouse gas
C  R A
emissions will not reduce atmospheric levels of these gases unless the cuts are so
deep as to bring emissions below the planet’s natural absorption rate.
Unfortunately, this absorption rate is a small fraction of the emission rate, which
is why climate change will not even start to be reversed unless emissions are cut
by at least 75% from 2009 rates.1
This non-intuitive behavior makes it vital to lay out the relationships between a
resource, its flow rates, and factors that depend on that resource in an
arithmetically accurate way. This structure must also be linked to performance
outcomes, such as the sales chart in Figure 3.2, if those too are to be understood.
Each item that changes over time needs to be displayed on a chart with a
quantitative scale and clear time frame. In Figure 3.2, the path of total monthly
sales shown by the dashed lines can only be understood if the rising sales per
month to the average customer are displayed alongside the changing customer
60 base.
While Figure 3.2 might be an unfamiliar way of looking at a situation, it is
perfectly easy to capture exactly the same relationships in a simple spreadsheet.
R W  L
However, diagrams provide a clearer image of what is happening than a page of

rows and columns. They provide a strong focus for a team to address what needs
to be done, and how much impact their choices will have, and by when. In this
case, discussion could focus on the same three critical questions highlighted at
the end of Chapter 1.
Ÿ why the loss rate has been rising at the rate it has
Ÿ where the future customer numbers and sales will go in future if the
loss rate (a) continues to rise, (b) stays at the same high rate, or (c) is
brought back to a lower rate once more
Ÿ how the company might reduce the loss rate, how quickly it might be
cut, and what will then happen to the number of customers and future
monthly sales.
1 See http://climateinteractive.org for extensive information on this case.

3.3 Consequences of Resource Accumulation
This defining characteristic of resources—called “asset stock accumulation”—has
long been known to be critical to strategic performance. A widely cited article
introduces the bathtub metaphor, and concludes that “a key dimension of strategy
formulation may be the task of making appropriate choices about strategic
expenditure … with a view to accumulating required resources and skills.”1 The
C  R A

article points out why a firm with already-developed resources has a substantial
competitive advantage—in our terms, the ability to deliver stronger sustained

growth in cash flows than competitors:
Ÿ Time compression diseconomies. This simply means that it takes time
to accumulate resources. For example, no matter how aggressively a
new competitor might try to copy the branch network of McDonald’s
or Starbucks, it will take years or decades to match the sheer scale of
that resource. Doubling the effort does not halve the time taken,
because of limits to how quickly things can be done. This means we
can readily explain the long-term leadership of firms, with no need to
rely on abstract “strategic” resources and capabilities claimed by RBV
to be critical. Such factors may add to that advantage, but are not
essential. 61
Ÿ Asset mass efficiencies, or, “the more you have, the more you get.” This
applies to many resources and will be explained in Chapter 4. For now,
R W  L

consider this. If you owned a great retail store location, would you
rent it to Starbucks or to a complete unknown in the coffee store
market? If you are a skilled young professional, would you be more
likely to join the leading global consultancy firm McKinsey &
Company, or an unknown consulting firm?
Ÿ Interconnectedness of asset stocks. In simple terms, building any
resource depends on other resources already in place. Taking
McKinsey as an example once more, major firms seek advice from
this firm because it has the brightest business analysis brains available,
and the brightest young business brains join the firm because it serves
the most important clients. This interconnectedness is crucial to the
performance of sector-beating firms, and will also be explained in
Chapter 4.
1 Ingemar Dierickx and Karel O. Cool, Asset stock accumulation and

sustainability of competitive advantage, Management Science, 35, 1504–1511.
Ÿ Asset erosion. Many tangible and intangible assets deteriorate unless
effort is made to maintain them—i.e., resources suffer outflows.
Physical plant wears out, staff skills become obsolete, products lose
their appeal, and customer loyalty to a brand decays. This
deterioration threatens the competitive advantage that a firm has from
its superior resources, a challenge that can vary widely for different
firms in the same industry.
Ÿ
Causal ambiguity. It can be hard, even for the firm itself, to know why
R W  L  R
exactly a resource accumulates and depletes at the rate it does. Some

changes, like adding capacity, simply reflect management’s decisions,
but it’s not so easy to know why customers are won and lost at a certain
rate. As Chapter 2 explained, much of what causes performance
outcomes is simply arithmetical, back to the point where resources
drive sales and costs. This chapter has shown that the current value
of each resource is not just influenced, but totally determined by
resource flows over time, so that that relationship is not ambiguous
either. Causal ambiguity must therefore lie in explaining what causes
resources to be won and lost at the rates observed.
These are powerful arguments for the critical importance of asset stock
62 accumulation to strategy and performance. It is remarkable, then, that no useful
models exploiting the mechanism have emerged from the strategy field in the last
twenty years. In addition, stock-accumulation has a particularly serious
R W  L
consequence – it destroys the validity of regression-based methods typically used

in the quest to explain business performance (see Appendix 2).
3.4 Resources Won and Lost by Ryanair

Ryanair explicitly reports some of the resources it adds—aircraft added and new
airports served each year, for example—but not others. We know how many staff
were employed at the end of each period, and so can work out the net increase.
However, we do not know separately how many employees were hired and lost.
Where staff turnover is modest and not a problem, as in this case, this unknown
may not be an issue, but it can be critical in other cases.
Figure 3.3 shows the history and a plausible future for the growth in Ryanair’s
customer base, fleet, and route network. The changing number of customers is
the most problematic item. Not only is the company not explicit about how many
distinct customers use its service—it may not even know—but we know nothing
at all about the number of new customers won each year or the number who
decide not to use the airline again. The values shown in these charts, then, are
Figure 3.3: Growth in Ryanair’s customer base, aircraft fleet,
and route network
R W  L  R

Source: Company Reports and author’s estimates
only illustrative. However, if accurate, they would imply that by year ended March
2010 there would be 14.4 million customers (13.3 + 3.2 – 2.1). 63
Although not shown separately in Figure 3.3, the company pays close attention
R W  L

to how many aircraft are acquired and disposed of each year, not just the net
addition. A faster renewal rate keeps down the average age of the fleet, with
benefits of customer comfort, reliability, and fuel efficiency.
For the route network, the separate issue of opening and closing routes is also
important. Opening a route is costly, so deciding to close it, due to disappointing
passenger volumes, is undesirable. The bigger the company becomes, the more
of the potential market it captures,
but the more problematic the Figure 3.4: Changes to the number of
issue of route openings and patients supported by a voluntary
closures becomes; it becomes organization
increasingly difficult to find viable
routes that are not already being
served. The difficulties of this
particular issue explain why the
company, though keen to boast of
the large number of new routes it
opens each year, is rather quieter
about how many it closes.
Similar analysis also applies to non-business cases. Figure 3.4 shows the reasons
why the number of patients who will need support from the charity in Figure 2.5
will grow to the scale feared by quarter 16. There is expected to be a strong increase
in the rate of new patients seeking support, with slower growth in the numbers
lost each quarter.
3.5 “Accounting” for Resources
Although we are not usually so explicit about the accumulation and depletion of
resources as described above, it is of course how we account for cash. So if it
important to control this critical resource by accounting for its changes in this
“A”  R
way, why do we not do the same for other key resources? Many companies state,
for example, that “people are our most important asset,” but include no accounting
whatever for what has happened to those assets during the period in question.
Table 3.1 shows how this would be done for the most common tangible resources.
Table 3.1: Accounting for resource movements
Cash Customers Staff Products Capacity

Opening Cash at start Customers at Staff at start Products at Capacity at
64 balance of year start of year of year start of year start of year
Added Cash in Customers Staff hired Products Capacity

R W  L
won launched added
Lost Cash out Customers lost Staff who left Product Capacity
dropped closed
Closing Cash at end Customers at Staff at end Products at Capacity at

balance of year end of year of year end of year end of year
While this table shows how to report changes that have occurred to a business
over a year-long reporting period, this time frame would not be adequate for
management control. Just as most companies look at cash flows every month or
week, it is equally important to look at other rapidly-changing resources, such as
customers and staff, on a more frequent basis. Remember also that it will be
necessary to examine such changes to subgroups of some resources, especially
customer segments and key staff groups.
3.6 Control over the Building and Retaining of Resources
Some resource flows are determined directly by management—Ryanair simply
C   B  R  R

decides how many aircraft to buy and sell, for example. Decisions to add other
resources are not so guaranteed.
A law firm might want to hire ten lawyers this month, but its success depends on
the availability of newly qualifying lawyers with the particular skills the firm is
looking for, on rivals’ efforts to hire those same people, and on the firm’s
reputation. It is not usually possible to be exactly certain of developing a target

number of new products in a given period. Winning customers, of course, is rarely
under accurate control at all. While management may want to add a certain
number of customers in any year, the actual result depends on the decisions of
customers themselves.
This range of controllability is shown in Figure 3.5. In each case, management
wishes to add fifty units during the period. When buying vehicles, that is exactly
Figure 3.5
Figure 3.5: Varying management control over resource flows

Direct Indirect
control influence
Vehicles Staff Customers
vehicles bought
new staff new customers
per year
per month per month 65
50 50 50
R W  L

perceived
jobs fraction value awareness
offered accepted
100 0.5 sales
effort
price marketing
spend
what they get. Staff hired may be more or less than the desired fifty, depending
on the number of job offers accepted. For customers, marketing may build
awareness, price changes may change customers’ perceptions of value, and sales
effort may be sized to target a number of leads. But whether these factors will
bring in ten, fifty, or one hundred new customers—or none at all—is rarely
knowable. Note that the actual decisions available in each case (in red text) become
increasingly remote from the vital flow rates as we move from direct to indirect
control.
Management should be concerned about resource losses as well as gains, and the
degree of control varies on these outflows, too. We can sell exactly the number
of vehicles we do not need, but may not be able to simply lose staff that we no
longer need. Customers, of course, are lost for all kinds of reasons, including the
actions of competitors, and our control over their loss is limited at best.
Note that if all resource flows were zero, then the firm’s resources would not
change from period to period. So under constant external conditions,
performance would be constant. The reason, then, that we are focusing so much
on the flow rates of resources and management’s control over those flow rates is
simple:
Management steers strategy and performance by influencing
resource flow rates.
G B  T D
3.7 Generic Behaviors and Their Drivers
The least controllable resource flows are those which are affected by the choices
of other people—employees and customers in particular. Therefore, it is helpful
to clarify those mechanisms and understand the forces that cause these flows to
change. Generically, there are three different things people choose to do that we
want to influence (see Table 3.2):
1 join us (e.g., become a customer; accept a job)
2 leave us (e.g., stop being a customer; resign from a job)
3 do more or less (e.g., buy more from us; work less hard)
66 We have already shown these three mechanisms, and their links to performance
in Figure 3.2.
R W  L
Ryanair’s business growth provides a good illustration of how these three

behaviors combine to determine sales. The volume of business (passenger journeys
booked) depends on the current number of active customers and their average
travel frequency, and the number of active customers depends on the history of
customers won and lost. Note that the same three mechanisms apply in non-
business cases, as well. People decide to become donors to a charity, to cease being
a donor, and to change their rate of giving.
The first two choices (joining and leaving) are switching decisions, to move from
one state to another—i.e., from not being a customer to being one (joining), or
from being an employee to being an ex-employee (leaving). They are also quite
significant but infrequent decisions. People do not keep changing their minds
about their favored products or services, nor about starting and leaving a
particular job. Even for the lowest-value products with the widest range of
alternatives, consumer choice remains remarkably stable over long periods.
The third choice—to do more or less of some activity—is fundamentally different.
This activity is done continually or rather frequently, so there is no change in the
basic state of mind, merely an increase or decrease in strength of feeling.
Management actions and choices may influence any or all of the three behaviors.
For example:
Ÿ A price increase may cut the customer win rate, increase the loss rate,
cut the average purchase rate.
Ÿ A marketing promotion could be designed to capture new customers,
rather than increase loyalty or the average purchase rate.
Ÿ Training service support staff may be aimed at cutting the customer
G B  T D

loss rate.
Ÿ Offering higher starting salaries aims to increase the hiring rate.
Ÿ Efforts to increase staff productivity could lead to higher staff turnover.
Ÿ Bonus schemes aim to raise the efforts of staff.
Ÿ Increasing the numbers of police on the streets may deter people from
taking to crime, encourage existing criminals to give up, and reduce
the rate at which criminals commit crimes.
The groups of people we are concerned with (customers and staff) are also subject
to other influences, of course, in particular those of competitors (or competing
choices) and other external factors beyond our control.
67
Lastly, we need to complete the link to performance arising from these behaviors.
How much total activity actually occurs depends on the number of people
R W  L

involved and the rate at which the average person is doing it That is:
Total sales = number of customers × purchases per customer

Total work output = number of employees × output per employee
Total crime rate = number of criminals × average crimes per criminal
We now need to go one stage further, and look at what might affect the three
critical behaviors of joining, leaving, and doing more or less. There are many
models of consumer choice in the marketing field, suited to different markets and
varying in complexity. Some models go further and deal with how customers
move between differing states—examining infrequent, regular, and loyal buying,
for example—an issue we will look at in Chapter 6. One popular framework in
strategy work is the value curve, discussed in Section 2.2.
Figure 3.6 shows how a mix factors may influence the whole structure of customer
acquisition, retention, and purchase frequency, and thus explain how Ryanair’s
sales may have developed over time. The items in red text are factors that Ryanair
management can directly decide upon.
The figure includes some additional items influencing the three behaviors
(dashed lines indicate that the causal relationship is not fully defined):
Ÿ The single largest factor winning new customers is simply opening
operations at additional airports to reach new potential customers
and offering routes from those new airports. The value-curve factors
then determine how much of that potential is captured.
Ÿ The mix of factors has quite different effects on the behaviors of
G B  T D
different customer segments. Ryanair’s offer is especially appealing
to leisure travelers, but less well-suited to the needs of business
professionals.
Source: Author’s estimates

Figure 3.6: Value-curve factors driving the three customer behaviors of Ryanair
68
R W  L
Ÿ The list of factors affecting behavior is not complete—quality of service
will affect both customer retention and journey frequency, for
example, and word-of-mouth recommendations will affect the win
rate.
Ÿ Each factor has a distinct influence on each behavior. Choice of
destinations may have a big impact on how frequently customers
travel, for example, but may not seriously affect whether a customer
G B  T D

is likely to switch airlines (leave) completely.

Ÿ In particular, certain factors cannot influence customer acquisition
because people who are not yet customers have no experience of
them—service quality, for example. Potential customers can only
respond to what they hear about such issues, i.e., through reputation.
Important Detail: Dealing with consumables and durables

Finally in this Chapter, we should explain that the rule ‘customers drive
sales’ operates differently for durable products, as compared with products 69
and services that are repeatedly consumed. In the cases of a consumer brand
and an airline, sales volume depends on the stock of current customers and
R W  L

their frequency of purchase. But that is only true because consumer brands
and air travel are both consumable products. For durable products, such as
televisions or cars, sales volume and revenue arise from winning customers,
i.e., the inflow to the customer resource. The stock of active customers is
then called an “installed base” of owners, who may not generate any
continuing sales revenue at all until the next time they replace the product.
Figure 3.7 (overleaf) shows how sales rates differ for a product serving the
same potential market, depending on whether it is durable, semi-durable,
or consumable. In contrast to very durable products, such as ovens, others
are semi-durable, items that are replaced relatively frequently, but not
repeatedly consumed, e.g., athletic shoes.
R W  L I D: D    
70
Figure 3.7
Figure 3.7 How durable, semi-durable, and consumable product sales depend on customers and the customer win rate
CONSUMABLE PRODUCT Owners SEMI-DURABLE PRODUCT

Total new Customers Total new ‘000
customers ‘000 customers
000/month Fraction of active 000/month
500 500
428 customers 428 Fraction of owners
repurchasing repurchasing
per month 20
per month
20 0.1
1.0
0 36 0 36
7.0 months 7.0 months
6.1 Sales volume 6.1 Sales volume
000 units per month 000 units per month
500 50
435 Sales revenue 49.8 Sales revenue
$million/month $million/month
10 6.1 10
0.61 4.98
4.35
Unit value Unit value
$10 0 36
$100
months
Owners DURABLE PRODUCT

Total new ‘000
customers
000/month
500
428 Fraction of owners
repurchasing
20
per month
0
0 36
7.0 months
6.1 Sales volume
000 units per month
50
Sales revenue
6.1 $million/month
7.0 20
7.0
Unit value 6.1
$1,000
CHAPTER 4
INTERDEPENDENCE AND THE
STRATEGIC ARCHITECTURE
So far, we have shown (a) that there is a rigorous, mostly arithmetical relationship
between performance and the tangible resources on which performance depends,
and (b) that those resources fill and drain—again following rigorous arithmetical
rules. We also started to explain what drives those resource gains and losses.
Continuing this logic leads to a simple but complete model of how an organization
actually functions and delivers performance. Three classes of factor drive the
inflows and outflows of resources:
1 Management decisions
2 External factors, including competitors’ decisions
3 Existing levels of resources
Section 3.5 showed that management simply chooses how much of certain
resources it wants to add or remove—by adding capacity, launching products, or
by hiring or firing staff—while flows of customers and staff are less easy to
influence. Chapter 8 will say more about how we might actually make those
choices.
4.1 Competition and Other External Factors

Whether management’s choices of price, marketing spend, service level, and so
on actually succeed in winning and retaining customers and persuading them to
buy also depends, of course, on what competitors choose to do. For example, if
all other factors are equal:
Ÿ A company spending more on marketing a particular brand than a
competitor will likely win customers faster.
Ÿ A company providing customers with a higher level of service support
than competitors will likely lose customers at a slower rate.
Ÿ A company selling products at a lower price will likely capture a higher
rate of sales to customers whom it shares with higher-priced rivals.
Chapter 7 will explain in detail how rivalry for resources operates. For now, we
need only note that competition also impacts our ability to win and retain other
C  O E F
resources, especially staff. This is a form of rivalry that primarily affects public
services and the voluntary sector. A public service organization competes against
other employers to hire school-leavers, while charities compete for donors, for
example.
We can now be much more specific about how such factors, mentioned briefly
in Section 2.1, actually work—by affecting both activity rates and the rates at
which resources are won and lost. For example, rising income levels lead to
increased numbers of people taking cruises for the first time and increase the
frequency with which people take cruises. The 2008–2009 recession, on the other
hand, slowed the flow of new car buyers dramatically. External factors affect staff
flows too—rising unemployment can reduce the rate of staff losses, for example.
Demographic and social factors can also be powerful. The rate at which new
72 viewers are won by a children’s television program reflects the number of children
entering the target age group each year. A more bizarre example of social-factor
impact concerns the increased entry into forensic science degrees, following the
I   S A
popularity of the television series CSI: Crime Scene Investigation. The increased
enrolment later led to a surplus of potential staff for the profession as newly
qualified specialists graduated and entered the job market.
4.2 Existing Resources Drive Gains and Losses

The third and most critical factor driving flows of resources is the quantities of
resources that already exist. More sales people will cause us to win customers
faster and slow the loss of existing customers. More research staff will speed
development of new products, and more maintenance people will slow the rate
at which failed equipment has to be replaced. Such linkages create the
interdependencies that make an organization a functioning system. Some such
relationships are clear and simple.
People are not the only resource that can drive the growth of other resources. A
wider product range helps win customers more quickly, for example. Note that
neither people nor product range are actually “used up” in helping other resources
grow. Cash, though, is a special case—it is usually consumed when used to grow
other resources—for example, buying more capacity, spending on marketing to
win customers, or raising salaries to slow staff losses. A faster inflow of
customers, then, might require a higher outflow of cash.
Ryanair offers one especially clear example of how the existing level of one
resource drives growth in another. Leisure travelers like to visit a variety of
places, so the number of routes an airline offers has a big impact on its ability to
win new customers. For example, if you want to travel from Paris to Barcelona,
E R D G  L

but a particular airline does not offer flights on that route, you will not become
a customer, but if it does, you may not only start using them, but consider them
for other journeys in future. The more routes in total that an airline offers, the
more people like you can be won as customers, and the faster its customer win
rate will grow. Figure 4.1 shows this relationship for Ryanair from 2004 to 2009
and provides plausible projections to 2014.
Figure 4.1: How routes drive customer growth for Ryanair
73
I   S A

Source: Company reports and author’s estimates.
Quantities of resources also affect the rate at which other resources are lost,
usually by failing in some way to support demands that those other resources
create. If Ryanair has too few staff for the passenger journeys sold, for example,
customers making those journeys will have a poor experience and may not use
the airline again. Too few aircraft for the routes and flight schedule will result
in delays and again increase the rate of customer losses (Figure 4.2).
Figure 4.2 summarizes the causal links between resource shortages and customer
loss for simplicity. For example, it is the number of passenger journeys flown,
rather than booked, that drives work for staff and hence service quality, and both
delays and levels of service quality need to be properly specified. Nevertheless,
the factors involved and the relationships between them can be rigorously
defined and used to calculate these two key causes of customer losses.
Figure 4.2: How shortages of staff or aircraft drive Ryanair’s
customer loss rate
H R D T O G  L
The next sections discuss two special cases of this kind of causal link—when
resources affect their own gains and losses, and when potential resources limit
74 growth.
4.3 How Resources Drive Their Own Growth and Loss

I   S A
The simplest case of a resource level influencing flow rates is when a resource
drives its own growth, leading to self-reinforcing feedback. An example of this is
when word of mouth wins new customers. If one hundred existing customers
win a company twenty new customers each month, then two hundred customers
will win forty (providing nothing else changes). When this arithmetical
relationship exists, we have truly exponential growth. Figure 4.3 demonstrates
this causal chain for Ryanair’s customer growth. Keep in mind that for this to
work, other factors must be satisfactory (e.g., maintaining low fares that are
attractive to customers).
The mechanism does not arise in all cases, so you need evidence that current
customers really do influence others to join. Rapid growth alone does not provide
that evidence, since other mechanisms could be at work.
Such self-dependency between resources and their own growth rate can apply to
other resources, too—for example, when people who enjoy their jobs recommend
their friends to apply to the same employer. Nor need such mechanisms rely on
active communication between existing participants and those who may be won.
Important Detail: How feedback drives and limits growth and decline
The fact that resources can drive their own growth and decline gives rise
to “feedback” in business systems, which comes in two varieties.
H R D T O G  L

Reinforcing feedback is at work at the right of Figure 4.3—an increase in
customers gives rise (everything else being equal) to more contacts per
year, more customers won, and therefore more customers in the next
period. If nothing were to stop this process, the customer base would grow
exponentially. Of course, something will stop it—e.g., the decreasing
number of potential customers.
So-called balancing feedback is at work at the left of Figure 4.3. Customers
leaving the potential population reduce the number remaining, and
therefore cut the number of contacts with active customers that can
happen each year. As a result, the number of customers who will leave the
potential population next period will be lower. Balancing feedback is also
at work in Figure 4.2, where any loss of customers reduces the number
who might then experience delays or service problems, and thus slows the
loss of customers in future periods.
Tracing out these feedback structures is a popular way for teams to try 75
and capture the big picture of the system they are trying to manage, so
they can quickly identify opportunities to improve performance, typically
I   S A

by removing balancing limits or enabling reinforcing feedback. However,
the method requires great care, because without supporting data,
participants are very likely to assume causal relationships and feedback
that, while perfectly plausible, do not in fact exist. A further problem is
that the behavior of interacting feedback loops is virtually impossible to
grasp intuitively from qualitative diagrams, risking the possibility of false
insights and erroneous decisions.
Instead, it is strongly recommended that the causal logic be built up
progressively, including data on how resources and other items are
changing over time, as described in this book. Since it can be time-
consuming to source all the required data (some of which may simply not
be available), a short-cut is to develop the architecture with estimated
sketches of how the team believes performance, resource levels, flow rates
and other items are changing. Any critically important causal relationship
can then be investigated by seeking confident supporting data.
Airport operators who Figure 4.3: How Ryanair’s customer win rate
is increased by word of mouth
welcome new services by
Ryanair can readily see
the passenger traffic the
airline brings to other
airports, with no need for
any discussion with them.
Resources also drive their
own loss rate. Figure 4.2
T R  P R
shows that an airline’s

loss of customers depends
on the number of staff
and on the current
quantity of customers
themselves. It is the Source: Author’s estimates
quantity of customers
that drives the number of
journeys flown, and hence the potential for poor service quality to arise if there
are too few staff. In this case and others, the more customers exist, the more will
76 be exposed to issues that may cause them to leave.
4.4 The Role of Potential Resources

I   S A
Growth often hits limits because organizations run out of potential customers
who are not already buying from them or their competitors. This fact has already
been captured in Figure 4.3, where the number of contacts between actual and
potential customers must fall when most of the potential has been captured—
enthusiastic customers simply have no-one new to persuade. The same factor
constrains the rate at which customers are won through other mechanisms.
Marketing, for example, will win new customers more slowly as the remaining
potential falls. This mechanism is well known as “diminishing returns” to
advertising, but our approach allows the scale and rate of change of the
mechanism to be quantified, and thus contributes to evidence-based strategic
management.
Eventually, the remaining potential is so small that advertising may seem to be
completely ineffective. But companies such as Coca-Cola or Heinz may still need
to advertize mature products for the following reasons:
Ÿ Customers can lose interest, slipping out of the active customer stock,
and will need to be recaptured.
Ÿ Demographic aging brings new potential customers each year who
must be won.
Ÿ Customers may also be loyal to competitors, so marketing seeks to
win them away from competitors.
Ÿ There may be potential to persuade active customers to purchase more
of the product.
In Ryanair’s case, growth is so rapid because it regularly opens new routes, each
of which brings with it new potential customers—the company is constantly

refilling the left-hand stock of Figure 4.3. If it were to stop adding new routes, it
T S A

would soon have captured just about every potential customer it can serve, and
its growth would be seriously limited. The pool of potential customers is also
being refilled by underlying growth in the number of customers wanting to fly
and being able to afford to do so. In some cases, growth in this potential can be
extremely rapid, even without any action by the business. Growth of cell phone
sales in China from 2000 to 2010, for example, was fueled by a rapid increase in
the number of potential subscribers, caused by rising incomes.
Limited numbers of potential staff can also cause difficulties. For example, a
company that locates a customer call center in a town with high unemployment
may easily be able to staff its operations until business growth requires more staff 77
than it can hire in that locality.
I   S A

4.5 The Strategic Architecture
Sections 4.2–4.4 have added the third element to the dynamic theory of
performance:
1 Performance at any time depends on resources, management
decisions, and external factors.
2 Resources are won and lost (accumulated and depleted) over time.
3 Resource win and loss rates also depend on existing resource levels,
management decisions, and external factors.
These three elements describe the fundamental structure of how any organization
functions and performs over time—its core “strategic architecture.” Chapters 5
through 10 will go on to add important extensions to these principles, but we can
demonstrate the power of this core architecture alone with a simple example—a
consumer brand, such as a premium coffee1. We will not include production or
distribution issues, but look only at the sale of products into stores and the capture
of consumers. Three resources are involved (Figure 4.4):
a consumers, of whom 3 million are potentially available
b retail stores, of which 5,000 are potentially available
c the sales force, initially zero
Management has three controls over this situation (in red):
1 advertising spend to capture consumers’ interest
2 sales force hiring

T S A
3 wholesale price (i.e., the price charged to stores, who add a percentage
mark-up when setting the price to consumers)
Here is the four-step process that produces the strategic architecture for this
business, with the rigorous causal logic of each connection described. It is possible
to trace out each sentence of the causal descriptions in the diagram.
1 Set out how the performance of concern is changing over time period of
interest. We want to launch the product and build sales and profits
78 over a four-year period. Profits will initially be negative, as we will
have to invest in the costs of advertising and the sales force before sales
and gross profit grow enough to cover those costs.
I   S A
2 Lay out how performance depends on tangible resources. In this case:
Brand profit per month = gross profit − sales force cost − advertising
cost
Gross profit per month = sales revenue − product cost
Sales revenue per month = sales volume × wholesale price
Sales volume per month = consumers who want the product
× fraction who can buy it
× volume bought per consumer
1 The challenge of building a consumer brand by steering the decisions in this

strategic architecture can be explored or taught with the Brand Management
Microworld business game (http://sdl.re/brands). Note, though, that the
numerical values and relationships differ significantly from the model in Figure
4.4, so outcomes will also differ.
The fraction of consumers who can buy the product depends on the
number of stores stocking it—the second resource.
Total costs are simply the sum of advertising spend (a management
decision) and sales force cost, given by sales staff—the third resource—
multiplied by the cost per employee.
3 Specify how resources depend, over time, on their flow rates. The
number of consumers wanting the product at the start of each month
is the number from the start of the previous month, plus any new
consumers won, minus any consumers lost during the month. The
number of stores stocking the product at the start of each month is
T S A

the number from the start of the previous month, plus any new stores
won, minus any stores lost during the month. The number of
salespeople at the start of each month is the number from the start of
the previous month, plus or minus any sales people added or lost
during the month.
Consumers at start of this month = consumers at start of last month

+ consumers won during last month
− consumers lost during last month
79
4 Identify how each resource flow rate depends at any time on existing
resource levels (including the resource itself and any potential,
I   S A

undeveloped quantity of that resource that may be available),
management decisions, and external factors. The number of consumers
won each month equals the number won by advertising, plus the
number won by seeing the product in stores and choosing to buy it.
In this case, there is no word-of-mouth effect, so this portion of the
consumer win rate does not depend on the current number of
consumers.
The number of consumers won by advertising depends on (a) advertising spend

(a management decision); (b) the fraction of potential consumers it reaches; (c)
the number of those potential consumers, and (d) the fraction of those reached
who become active consumers. The number won by seeing the product in stores
and deciding to buy the product depends on the product’s availability, which in
turn depends on the number of stores stocking the brand (a resource), and again
on the remaining number of potential consumers. The number of consumers lost
each month depends on the number who currently want the product, multiplied
by the fraction who lose interest each month.
I   S A T S A
80
Figure 4.4: The strategic architecture explaining the sales and profits of a new coffee brand
Figure 4.4
Consumers
a month.
200 New consumers 200
from advertising forgetting 1000 817
145 Final value
65 month 48
0 48
months
Fraction of potential Potential
consumers reached Net new Interested
0.61 consumers consumers consumers
(in thousands) (in thousands (in thousands)
per month) 3,000
3,000
Advertising spend 1,448
($ thousands per month) Store
500 mark-up
1,552 200 25%
0 48 0 months 48
months
13
New consumers Retail
from product Consumption price
Sales call 200
availability Sales volume per person $11.25
success fraction (in thousands of (in units per month)
93 units per month) 0.8
1.0
0.55 1,000 692
Product
Wholesale
availability price
1.0 (fraction) $9.00
Stores
Potential stocking 0.60 Revenue
10,000
Gross
stores Stores won the brand 6,224 profit
2,500
per month 5,000 Product 1,383
cost
10,000
3,579 1,421
250
5,714
Product cost
of stores, unless there is a drop in sales force at any time.

0 24 0 months 48
Salespeople per unit
months 42 needed on $7
existing stores
50
Total sales and
Sales force marketing cost
50 28 cost 1,000
Salespeople 22 250 750 Brand profit
available to ($ thousands per month)
win new stores 1,000 633
5
Salespeople Sales force
hired per month 2 ( Advertising spend )
50 - 1,000
0 50 0 48
500 months
Sales calls always prioritize visits to existing stores, so there will be no loss rate
salespeople (a resource) multiplied by the number of calls each person makes in
(a resource). The total number of calls per month equals the number of
total number of calls, minus the calls made on stores already stocking the product
(another resource). The number of sales calls each month to new stores is the
success rate depends on how many consumers want the product at that time
new stores, multiplied by the fraction of those calls that are successful. The
The number of stores won each month depends on the number of sales calls to
0 months 48
The number of sales people added each month is simply a management decision.
Figure 4.4 may be a novel way of looking at a situation, but this too could readily
be replicated in a spreadsheet. But pages of data in rows and columns can be quite
impenetrable, compared to a graphic explanation, which shows how everything
is connected. The time charts in this case clearly tell the story of how the launch
strategy led to the performance results:
Ÿ Steady advertising won consumers at a reasonable but declining rate
as the potential was used up. Spending more would have done so more
quickly, but at a higher cost, which would have led to bigger losses in
the early months. Reducing advertising spend in later months would
T S A

have boosted profits, but at the risk of a slower consumer win rate or
even a net loss of consumer.
Ÿ Stores were at first captured very slowly, both because of the small
sales force and the low success rate, reflecting the limited consumer
interest. After month 24, the larger sales force and increased consumer
interest won stores quickly, but that rate then slowed as more sales
calls were devoted to existing stores. A larger initial sales force would
have captured more stores sooner, but at greater cost and greater early
losses. However more stores would have increased product 81
availability, accelerating the capture of consumers and increasing sales
to those who already wanted the product but could not get it.
I   S A

Ÿ The constant wholesale price determined both the average
consumption rate and the profit margins made by stores and by the
company. A higher wholesale price (implying a more premium
product) may have either increased or decreased revenue, depending
on its impact on average consumption.
The strategic architecture for Ryanair is too large to be readily displayed
completely, but Figure 4.5 summarizes the core architecture resulting from
following the same four-step process used in our coffee example. It is simplified
for clarity, but nevertheless captures the critical features of the system driving
revenues and profits. The management decisions that steer strategy from period
to period are indicated in red. Note how many of those either concern flow rates
directly (aircraft to buy, staff to hire), or are closely linked to a flow rate (fares
affect customer win and loss rates).
Figures 4.4 and 4.5 are examples of strategic architectures for specific cases, but
each is also an example of a generic architecture for many similar kinds of
business. Any consumer brand will have consumers, stores, and sales force with
interdependencies similar to those in Figure 4.4, and any airline will have
I   S A T S A
82
Figure 4.5: The core strategic architecture of Ryanair
Figure 4.5
Worksheet 5.
Staff
Hiring Management
decisionsare
Service indicated in red.
quality
Marketing
Adding Aircraft Customers
Customers
aircraft won and lost
Average
fare
Passenger Total
journeys revenue
Aircraft Delays Journeys sold
utilisation per person
Choice of per year Profit
Flights destinations Aircraft (€ millions
per day (Aircraft) per year)
costs
Total
Opening Routes operating
Millionsof Fuel Route costs
routes kilometers costs costs
flown
Airport Other
costs costs
causal relationships, and the choices made by management.

Airports (Marketing
(Staff) Staff costs)
costs
Adding
airports
available in the Sysdea software help system at http://docs.sysdea.com – see

Figure 4.5. The wide variance of performance among businesses in various
A working model of the strategic architecture for a start-up restaurant business is

industries reflects vast differences among the values involved the strength of the
customers, staff, aircraft, routes, and airports organized in a structure like that in
4.6 Functional Issues and Other Objectives
This chapter has explained how the strategic architecture drives overall
performance in terms of financial outcomes for an entire commercial
organization. As explained in Chapter 1, this strategic architecture should focus
on delivering a strong trajectory of future profits, or more strictly, cash flows.
The strategic architecture principles also apply to nonfinancial objectives and to
F I  O O

functional issues with more localized aims. In Figure 4.6, a service department
struggles to sustain good service quality for rising numbers of customers. This
service quality should be expressed in terms that are relevant to the customers,
such as the frequency of problems they experience. The demand being served in
this case is calls per day, and is driven by the number of customers (a resource),
multiplied by the frequency with which they need service. The capacity to deliver
good service quality depends on the ability to deal with customer calls, which in
turn depends on the number of staff (another resource), multiplied by the number
of calls per day each can resolve.
Here, interdependency between the resources is not complicated. The customer
win rate is not something the service department can influence, but the loss rate
is affected by the level of service performance. Staff hiring is directly under their
control, while staff losses depend on the pressure the service staff are under. 83
Exactly the same principles can be used to develop a strategic architecture for
I   S A

public services, voluntary groups, or not-for-profit organizations. The example
in Figure 2.5 shows how the performance of a charity changes over time, as
indicated by the fraction of required calls it can fulfill. Figure 3.4 shows how to
add the inflows and outflows of patients who need the charity’s support, and, like
the service department discussed above, it is a simple matter to add the flows of
volunteers for this charity. This will allow the organization to anticipate
performance changes and make appropriate changes to its strategy.
Section 2.8 pointed out that some objectives concern achieving a certain level of
a resource by a certain time—capturing a target number of customers, or hiring
a certain number of employees, for example. These cases are much simpler than
those concerning performance outcomes, because analysis and activity need only
focus on the flow rates for the single resource of concern—how quickly customers
are being won and lost, or how quickly staff are being hired and leaving.
Nevertheless, the principles in this section still apply. Those flow rates depend on
management decisions (e.g., marketing spend or salaries offered), on external
factors (e.g., competitors’ prices or salaries), and on existing resource levels.
F I  O O
Figure 4.6: The strategic architecture of a functional issue
84
I   S A
Strategic plans versus strategic issues. Chapter 1 noted that strategic

management often needs to address specific issues, as well as develop
comprehensive plans for a whole organization. Figure 4.6 provides such an
example. It is important to remember this point when considering the frameworks
presented in Chapters 5 through 10; each can be valuable on its own or as part of
a strategy for an entire organization.
Important Detail: Tipping points and thresholds
Situations where modest changes trigger sudden rapid growth are popularly
known as tipping points, but we need to be clear about what exactly causes
such phenomena.
Reinforcing feedback itself does not indicate a tipping point, and if, for
F I  O O

example, customer numbers grow from 10 to 50 to 200 to 700 in successive
quarters, the growth rate is actually falling. A true tipping point happens
when a modest growth rate suddenly escalates. At least four mechanisms can
bring this about:
1 Segmentation. A market consisting of a large, low-growth segment and
an initially smaller, high-growth segment will take off when the
faster-growing segment overtakes the slower one.
2 Role models or opinion leaders. A market may grow quite slowly until
certain key individuals buy the product, making members of the general
population suddenly want to buy the product, as well. For example,
doctors use procedures they know to be reliable until they see experts
endorsing a new treatment, which leads to a sharp increase in the use
85
of the new treatment. The same clearly happens in fashion businesses,
which go to great lengths to gain celebrity endorsement for products.
I   S A

3 When win rates overtake losses. If a customer base of 100 is decreasing
by a rate of 20 per quarter, but is also growing at 20 per quarter, growth
is zero. A small increase in the win-= rate—which could be due to word
of mouth or other factors—results in rapid positive growth.
4 Thresholds. If a product is not especially appealing to potential

customers, growth may be slow, and remain so for some time, even
though it is being steadily improved. Flat-screen televisions, for
example, did not sell well for many years. When the products’ ratings
crossed a threshold of acceptability, though, the rate at which potential
customers bought them (and became actual customers) jumped sharply.
All these mechanisms can be identified in real cases, and quantified, enabling
important strategic choices to be made by management—whether they
should focus on developing promising market segments, capturing opinion
leaders, reducing customer losses, or improving the product.
86
CHAPTER 5
RESOURCE QUALITY
Chapters 1 to 4 assumed for simplicity that resources were uniform. Customers

all purchased at the same rate, staff had equal skills, products were equally
appealing. In reality, some customers buy more than others, staff have varying
skill levels, and products differ in their appeal. A sound explanation of
performance therefore requires these characteristics to be included in the analysis
and planning of strategy. Most tangible resources have one or more such
qualities—referred to as “attributes”—and these affect their impact on the
business system and its performance.
The way an attribute changes over time can be understood by extending the
bathtub analogy from Section 3.1. The resource itself is the quantity of water in
the bath, and the attribute of interest is its temperature. If you want a warmer
bath, you can add hot water. The initial temperature is the initial quantity of heat
divided by the amount of water that it warms, and the final temperature is the
new, greater quantity of heat divided by the now larger quantity of water.
An important difference between business resources and the bathtub example
is that, for businesses, the different qualities of resource remain separate. If a
firm with small customers wins larger ones, it ends up with some small and some
large, not a uniform population of mid-sized customers. Nevertheless, in many
cases it is possible to understand and improve performance by working with the
average quality of a resource. Figure 5.1 shows how the math works—a
company’s average customer size increases as it wins customers three times larger
than it started with:
Ÿ At the start, the company has 240 customers, each bringing sales of
35 units per month, so total sales = 8,400 units per month.
Ÿ After one month it has 245 customers, and total sales have been
increased by 5 × 105 = 525 units per month. Therefore, total sales =
8,925 units per month, and the average customer size is 8,925 ÷ 245
= 36.4 units per month.
Figure 4.6
Figure 5.1: How winning larger customers increases average customer size
Customers
New customers
per month 400
360
H R D P
5 240
Average sales per customer
New sales per new customer 0 Month 24 units per month
units per month
105 60
Total sales 58.33
units per month 35
25000 21000 0 Month 24
525
New sales 8400 Final value
each month
units per month Initial value
This mechanism is known as the “co-flow” structure, because the attribute flows
along with the resource that it describes. The same logic applies to working out
88 the impact of losing customers that are larger or smaller than average.
Instead of winning larger customers, the business in Figure 5.1 could improve
the quality of its customer base by closing smaller customers, say those with
R Q
average sales of only 10 units per month. It need not do so steadily over time, of
course. It could cease doing business with them all at one time, perhaps by passing
their accounts on to distributors. If it identified 100 such customers, then their
loss would cut direct sales by 1,000 units per month. After the change, it would
have 140 customers delivering total sales of 7,400 units per month, so the average
remaining customer would be generating 7,400 ÷ 140 = 52.8 units per month.
There is a third way to improve customer quality, of course, and that is to sell
more to the existing customers, either by capturing sales they would otherwise
have given to competitors or by helping them grow.
Improving a customer base then, as measured by average sales, has three generic
solutions:
1 Win bigger customers
2 Lose smaller customers
3 Increase the size of existing customers
Businesses of all kinds face questions about how they want their business to
develop. It is very common, for example, for companies to have too many small
customers who are too costly to serve, while others focus on the largest customers
only. Some companies, on the other hand, recognize that they cannot compete
for the largest customers, and develop ways of doing business that are well-suited
to the needs of mid-size to smaller customers.
5.1 Size Is Not the Same as Quality

Larger customers are not always more profitable than smaller ones. They may
demand lower prices or be more costly to serve, so it is important to understand

the relationship between size and profitability. This is best done with a device
S I N  S  Q

called the “quality curve,” which lays out the quality profile of individual
customers. In the top half of Figure 5.2, the revenue from a company’s largest
customer is shown at the left, and to this is added the revenue from the second
largest, the third largest, and so on. At the far right is the very small revenue
contributed from the company’s smallest customer. The average revenue per
customer is the total
Figure 5.2: The resource quality curve—customers’ revenue, A, divided
contribution to total revenue and profits by the total number
of customers, B.
Cumulative
revenue The lower part of 89
e 5.2
A Figure 5.2 shows the
Lowest-revenue differing customer
customer
R Q
profile in terms of
etc.
quality, rather than
sheer size. The same
curve is built, but
this time using the
B
profit contribution
Cumulative customers
from each customer,
Cumulative
profit
rather than their
contribution
Total profit contribution revenue. With this
E from all profitable customers
information, a
Total profit contribution
C from all customers management team
Most
unprofitable
customer
can make explicit
choices about how
they want their
Most profitable business to develop,
customer
D B such as:
Cumulative customers
Ÿ Just grow in total, by trying to win more customers across the entire
profile.
Ÿ Sort out the unprofitable tail, by shifting customers from right to left
(e.g., by raising prices or cutting support costs), or closing them where
this cannot be done.
Ÿ Focus on winning only larger new customers.
Ÿ Develop a lower-cost business model to improve the profitability of
mid-range customers.
A  O R
The message is to be deliberate about the choice of strategy, quantify its impact,
assess the time scale over which the impact of strategy will occur, and track its
progress using a combination of the methods used in Figures 5.1 and 5.2.
Important Detail: Take care with cost allocations

The analysis in Figure 5.2 can be sensitive to exactly how costs are allocated.
Note that the vertical axis is “profit contribution,” not simply “profit,” to
recognize that some costs are not driven by specific customers but are
incurred across the customer base (e.g., the cost of the sales vice-president’s
90 salary or the customer information systems). Closing customers between D
and B will not remove the need for such costs. It is therefore important to
know by how much total costs will actually be cut if such a rationalization
R Q
is to be carried out. Similar caution is needed if the curve is built for the
products in a product range. Many shared costs will not disappear if the
product range is reduced.
5.2 Attributes of Other Resources

Customers are a common example of resources whose quality is important to
understand and manage. Quality curves can be useful for other resources, as well,
such as the profit contribution from each product in a product range1. In one
confectionery market, for example, a competitor of Mars Inc. had a range of over
thirty products, but was much less successful, which offered a much smaller range
in the same market. For every dollar this company spent to advertise one of its
brands, Mars could spend double, leading to persistently stronger sales. The
1 See for example: Nikhil Bahadur, Edward Landry, and Steven Treppo, How to
slim down a brand portfolio, Strategy+Business, 44, 14–16. Also available at
http://www.strategy-business.com/article/06315 (registration required).
company with the wider range also found that each new product it launched only
captured sales by cannibalizing existing products.
A contrasting case concerns a commercial law firm whose services require specific
skills and experience. The firm responds to many client requests on a case-by-case
basis, although many of these requests are quite similar. These similar cases could
be codified as standard services, making each client contract more efficient,
reliable, and profitable. Furthermore, the defined service could be marketed more
explicitly and used to capture many new clients.

You can also adapt Figures 5.1 and 5.2 to understand and improve staff team
A  O R

performance. This can be valuable at all levels, from front-line operatives to senior
executives1. In Figure 5.3, a call center manager has 80 staff, each of whom needs
certain skills to deal adequately with customers’ enquiries. Ideally, each employee
should be able to respond to the full range of twenty issues, but that ideal is hard
to achieve because of staff turnover, which is running at five per month. Initially,
the average employee knows how to respond to twelve of the twenty issues. The
management decisions are shown in red—how many staff to hire and how much
training to do.
New staff have none of the necessary skills (we can only add cold water to this
particular bathtub!), so training gives new staff some basic skills, and increases 91
the skills of existing staff. Staff also forget some skills they were trained in, because
issues arise too seldom to be reinforced through practice. With no staff turnover
R Q
(dashed lines) and no hiring, training only builds skills among existing staff.
Improvement slows because learning is overtaken by the rate of forgetting (the
hotter the water in the bathtub becomes, the faster it cools down). Staff turnover
(solid line and bold text), raises the rate at which skills are lost (warm water is
lost, to be replaced by the cold water of unskilled staff).
One technical point to be aware of is that the resource attribute (the lower stock)
tracks the total skills of the team, rather than the average. Its units are “person
skills” which may seem an odd concept, but it is the only easy way to do the
necessary calculations. A closely related issue concerns staff experience, measures
of which may either be the number of years’ employment in an industry, or more
specifically, the time spent in a particular role or with a particular employer.
1 Linda Gratton. People processes as a source of competitive advantage, in

Strategic Human Resource Management, Linda Gratton, Veronica Hope Hailey,
Philip Stiles, and Catherine Truss, eds. (Oxford: Oxford University Press, 1999),
170–198. Laura Tovey, Competency assessment: A strategic approach—part II,
Executive Development, 7(1), 16–19.
A working model demonstrating the relationship between changing staff numbers and
experience (related to, but different from skills) can be explored at http://sdl.re/mhgs.
This is an example of working models included in the strategy dynamics course.
Figure 5.3: Skill building and losses in a call center with and without staff turnover
A  O R
92
R Q
Experience is a critical resource quality in a wide variety of cases.

Professional athletes commonly improve their skills with each season of
play1. Staff also carry experience with them as they move up through levels
of seniority, a mechanism we’ll examine in Chapter 6.
Staff skill is one example of a resource attribute declining if not constantly
reinforced. Another such case concerns equipment reliability, a concern for
organizations as diverse as water companies, whose pumps and other
equipment wear out, hotels and restaurants whose furnishings and fittings
1 The Football League Challenge is a fun and insightful class game in which the
dynamics of player experience features strongly—see http://sdl.re/football.
become damaged, and public infrastructure, such as roads and bridges. Some
firms depend so heavily on such assets that their upkeep is the dominant strategic
issue, where choice of maintenance, repair, and replacement are all critical. In
such cases, the tangible resource is the population of assets, and the co-flow
attribute is some measure of their state of repair, such as failure rate.
Similar analysis is useful in public service and voluntary sectors. Charitable
organizations receive varying contributions from individual donors and make
explicit choices about whether to target fewer, bigger donors or larger numbers
of smaller donors. The voluntary organization described in Figure 2.5 found that
A  O R

the activity of their volunteers was highly skewed. A small fraction of volunteers
were very active, supporting many patients, while most were making very few
visits. Training was costly, so the organization became more selective in accepting
volunteers and provided more intense encouragement and support to these
smaller numbers. The result was more care, of a consistently higher quality,
delivered by fewer volunteers, at much lower cost.
5.3 When Resources Bring Access to Others

An important category of attributes arises when one resource brings access to
another. Each of Starbucks’ new stores, for example, gives access to potential 93
customers, and the challenges described in Section 1.4 arose from misjudging this
issue. The company simply opened too many new stores with too few new
R Q
customers.
In Figure 5.4, an initially successful retailer is expanding its store network over
ten years1. Its first stores each reach 20,000 consumers who spend $500 per year
on its goods, so management believes much growth is possible. For the first five
years, plans go well, with sales and profits growing strongly. Unfortunately, these
top-line indicators hide a sharp fall in the true number of new consumers won
with each new store opening, and new stores increasingly succeed only by taking
sales away from established stores. Furthermore, the newer consumers turn out
to spend less at the stores than those captured around the initial locations. (This
spending rate is an attribute of the consumers, omitted here for simplicity). The
costs of operating these newer stores, despite being lower than the costs of the
earlier stores, are not covered by the incremental revenues and gross profit from
the sharply declining rate of new consumers, and profits go into decline.
1 The challenge of building a retail business while the quality of potential locations
changes can be explored or taught as one of the features in the Beefeater Restaurants
Microworld business game, see http://sdl.re/beefeater
R Q A  O R
94
Figure 5.4: Sales and profits of a retailer exceeding the viable potential for store numbers
Figure 5.4
Operating profit
Stores $m/year
New stores 50 32
per year Operating costs
500 476 $m/year
400
261 271 9
100
80 Gross profit
0 Year 10 $m/year
400
20
20
280
Potential new Gross margin
consumers per 0.8 Potential fraction .. 0.20
so they can reach smaller local markets.

new store ‘000 consumers
not yet won Active consumers Total sales
Total new potential (thousands) (thousands) $m/year
2000
consumers Consumers won 1400
‘000/year ‘000/year
2000 5000 4185
2690
1000
1000 450
0 Year 10 0 Year 10
profits at $32 million per year, and spent much less capital.
Sales per
consumer $/year
500
Fraction of new 335
potential consumers
won immediately .. 0.5
Fraction of remaining
[ Appeal and value potential consumers
of products offered ] won per year.. 0.3
This is not to say that management should give up at the first sign of having “used
new store dropped sharply ( as shown in gray text about half-way through its
units, offering limited product ranges with much lower operating costs precisely
up” a business opportunity. For example, some retailers develop slimmed-down
Had this company stopped expanding when the extra consumers won with each
expansion in year 6), it would have captured most of the potential market, kept
Ryanair’s airline business, which we have been following as we develop the
strategy dynamics frameworks, features a very similar mechanism—the opening
of new airports and routes brings access to new potential customers1. When the
airline starts services to a particular city, it gains access to the people in the region
of that city who might want to travel. Each new route it offers to and from that
airport attracts some more of that region’s potential travelers, as well as appealing
to a few more travelers from each of the regions at the other end of those routes.
In addition, closing routes removes access to some customers—an advisable
decision if a route has less potential than expected. Figure 5.5 shows a simplified
summary of these relationships, ignoring (a) the distinction between expanding
A  O R

the number of airports it serves and adding new routes, and (b) the conversion
of potential travelers to actual customers.
5.4 Using the Quality Curve to Beat Competitors

Competitive strategy is rarely done well, in spite of all the articles and books on
the topic. Mostly, firms try to capture little bits of market share by being generally
a bit better than rivals. This has several disadvantages:
Figure 5.5: How adding and closing routes adds and loses customers
for Ryanair 95
R Q
1 This mechanism is included in the LoFare Airline Microworld business game

mentioned in Chapter 4, see http://sdl.re/lofare.
Ÿ Effort spread across the whole will have less impact than if focused on
specific parts of the market or against specific competitors.
Ÿ Trying to under-price, out-sell, or out-service all competitors will
incur considerable cost.
Ÿ Industry-wide competitive efforts will be visible and will attract
U  Q C  B C
retaliation from all competitors.

Ÿ Such generalized efforts exacerbate the very competitive conditions
that damage profitability, for example by triggering price wars, or
escalating advertising commitments.
Selecting specific competitors to attack is more advisable than making
indiscriminate efforts. It is even possible, and often desirable, to seek the total
elimination of a competitor, but this requires a deep understanding of individual
rivals. A more rigorous approach to competitive strategy builds on two principles:
1 A close competitor will likely have both a similar set of resources and
a similar architecture to one’s own business.
2 Each competitor will, like one’s own business, have a range of

attributes (quality) for each resource—larger and smaller customers,
96 more and less popular products, stronger and weaker salespeople.
Investigation of these two elements makes it possible to evaluate any competitor’s

R Q
performance and to use that insight to inflict damage at little risk to ourselves.
One mid-market restaurant chain, growing fast in a promising market, was
number-two to a long-established market leader. Although operating only 120
restaurants compared with the leader’s more than 300, it was generating nearly
as much profit, due to a recent history of finding great locations and developing
better products. With a good understanding of the profit contribution profile of
its own restaurants, it was able to estimate the same profile for the competitor.
Revenue could be determined by counting the customers visiting each of the
rival’s restaurants, and costs could be estimated by comparison with the
company’s own units. The resulting estimation was not exact, of course, but close
enough to know roughly how much profit was coming from each of the
competitor’s units.
Selecting the point of attack was relatively simple (Figure 5.6). Trying to damage
their most profitable restaurants would be difficult—they were popular with their
local consumers, well-run, and received regular attention from senior
management. Any attack on these would have been noticed and vigorously
defended.
Attacking unprofitable restaurants was pointless, as the competitor would not be
concerned or damaged by their loss. The best targets were the restaurants
contributing profits in the mid-range. A random selection of these were chosen,
geographically dispersed and supervised by different regional managers, so that
attacks would not be noticed, provided that the tactics were subtle.
U  Q C  B C

The tactics were not led by
Figure 5.6: Damaging the profit contribution price cuts, since this would
gure 5.6 curve for a mid-market restaurant competitor
have hit profit margins hard

Competitor’s business and been highly visible to the
Cumulative under attack competitor. Instead,
profit
100 contribution marketing promotions were
$92m
$millions
$81m aimed at specific
neighborhoods from which
losing 11 profitable
restaurants (3%) each competing restaurant
hits competitor’s
profits by $11m (12%) drew its customers. Local
50
tactics also included
overstaffing their own
restaurants, deploying the best
unit managers, and providing
100 200 300 the best possible customer 97
Cumulative restaurants environment—décor,
lighting, and music.
R Q
These tactics took a large fraction of the revenue from the competitor’s targeted
units, at which point the competitor’s own policies started to act against them.
Management tried to sustain profits by cutting costs, especially staffing costs,
which damaged consumers’ experiences. With the targeted restaurants becoming
rather quiet, they lost still more consumers. Eventually, the targeted units moved
into losses or marginal profits, following which they were neglected by
management until they were closed.
Repeating these tactics across a selection of mid-profit outlets inflicted
disproportionate damage to the competitor’s overall profits, cutting sharply the
right-hand end of their profit curve (see Figure 5.6). The pressure to sustain profits
drove them into system-wide policies that did further damage, such as price
discounting and cuts in staffing, marketing budgets, product development, and
maintenance, all of which undermined critical resources in their strategic
architecture. Their management started to lose motivation and commitment, and
many left for better opportunities—often with the attacker! The competitor’s
corporate owners turned down requests for investment, making it impossible to
match the high-quality new units that were being added to the attacker’s business.
The competitor left the industry after just three years of the competitive strategy
O U   Q C  R A
being implemented, selling most of its remaining viable restaurants to the

one-time number-two, who was now in a dominant position.
This is just one illustration of how to use the quality curve to undermine
competitors by damaging the quality of its resources. In other cases, such tactics
have been deployed to hit the profit contribution of competitors’ mid-range
customers or products, or to capture key staff. In this case the chosen target was
the market leader, but often that is not feasible or is too risky, so in other cases it
may be preferable to target competitors who are large enough to be worth the
effort, but not so large as to threaten serious retaliation.
5.5 Other Uses for the Quality Curve and Resource

Attributes
This chapter has outlined some basic uses for the analysis of change to resource
attributes. Other uses include:
Ÿ assessing the development of product features; for example, to avoid
feature fatigue when consumers become overwhelmed with features
they can neither understand nor use
98 Ÿ strategic turn-round to rescue an organization in difficulty, commonly
due to having over-built low-quality resources, such as unprofitable
customers and products. (This was a widespread feature of troubled
R Q
companies following both the 2001 and 2009 recessions.)

These and other issues are developed extensively in Chapter 5 of Strategic
Management Dynamics.
CHAPTER 6
DEVELOPING RESOURCES
As with the attribute analysis in Chapter 5, the frameworks in this chapter can be
used on their own to improve business performance or as part of a complete
strategy. So far, we have assumed that resources are simply won or lost, in or out
of the business system. A more realistic picture of this process shows that
resources can develop through a series of states.
6.1 Developing Staff

Figure 6.1 shows how a law firm hires lawyers and promotes some to partner
through a simple two-stage chain. The problem here is the rising attrition of
lawyers at the bottom of the diagram, caused by the slow rate of promotion.
The same rigorous math we saw in Chapter 3 for how resources accumulate
applies equally to each state in this chain. The number of 180 lawyers is entirely
explained by the firm’s history of all lawyers who were ever hired, promoted, and
lost. Similarly, the number of twenty-eight partners at quarter 12 is precisely
explained by the sum of all lawyers ever promoted, minus all partners who ever
left. There could also be a third flow affecting partner numbers—experienced
lawyers hired directly into the partner grade from outside—but we will not be
including this possibility in this example.
Note once again that the flow rates highlighted in yellow totally explain the
number of lawyers and partners at each point in time. The red items indicate the
critical decisions of the firm’s leadership that have led to the current situation
and could lead to the plausible situation by quarter 20.
Figure 6.1: Two-level staff chain in a law firm 1
D S
This stage-wise development of resources has important implications, since it

extends the timescale over which strategic choices operate. In Figure 6.1, no more
than four percent of lawyers had ever been promoted in any quarter (and then,
only in quarter 3, when four out of 107 were promoted, or about one in
twenty-seven). A newly hired lawyer would therefore to have to wait on average
100 twenty-seven quarters, or nearly seven years, before being promoted. If the firm
had hired no new staff six years ago, then there would be no new partners now
with seven years’ experience. A resulting shortage of partners could cut the firm’s
D R
ability to win clients, so the resulting drop in performance would have been caused
by the firm’s hiring failure six years previously!
Such diagrams provide a powerful basis for assessing strategy, since they include
both management choices—in this example, rates of hiring and promotion (in
red)—and their consequences. Here, a rate of promotion that is too slow causes
lawyers to leave the firm too quickly. This picture can be readily integrated with
other parts of the business system, such as the winning of clients and delivery of
client work. It can also be linked to the resulting staff costs in order to work out
the resulting financial implications.
Note also that resources carry with them from stage to stage those same attributes
we looked at in Chapter 5. A lawyer with seven years’ experience in the first level
1 Strategic management of staff development in a consultancy business can be

explored or taught with the Professional Services Microworld business game, see
http://sdl.re/profserv.
here will add those years of experience to the partner group when she is promoted,
and a partner with twenty years’ experience will take that with her when she leaves.
If both events coincide, the average experience of the partner group will fall, but
will of course increase again each year as staff age.
6.2 The Customer Choice Pipeline

Customers are rarely switched from “potential” to “active” in the simple way
described in Section 4.4. Most often, they must be moved through a number of
stages. A simple model of customer development, often referred to as “AIDA,”
T C C P

has four stages: gaining customer attention, attracting their interest, stimulating
desire, and finally motivating them to act (i.e., to buy the product).
These pre-purchase states are important. First, marketing expenses may be quite
high in order to bring customers through those stages before you get any sales
from them. Second, interactions among not-yet-active customers can have
important effects on customer acquisition. Many people who admire BMW cars,
despite never having owned one, influence other potential owners positively.
Conversely, people with negative attitudes towards fuel-inefficient SUVs, again
without having owned one themselves, can have a negative impact on the attitudes
of other drivers.
101
Figure 6.2 shows a customer-development chain for the 36-month product launch
of a consumer product, such as the coffee brand discussed in Chapter 4. The
D R
marketing challenge is to move consumers through a series of stages until they
become buyers of the product. Marketing tries to influence their choice toward
the brand—hence the framework’s name, the “choice pipeline.”1
There are fifty million potential consumers who need to be won by marketing
and promotional spending. This particular chain combines the interest and desire
stages of the AIDA framework into a single population of interested consumers.
However, it divides active customers into two groups: “loyal” consumers, who
always purchase the brand when they need this kind of product, and “disloyal”
consumers, who divide their purchases between this brand and its competitors.
Management has a total marketing budget of $20 million per month to split across
four categories of spending: (1) advertising to build awareness; (2) advertising to
communicate the brand’s “values” and win consumers’ interest; (3) promotions
1 Lars Finskud. Developing Winning Brand Strategies. (Williston, VT: Business

Expert Press, 2009).
A working model of a consumer brand launch based on this structure is at http://sdl.re/mkcw.
This is an example of working models included in the strategy dynamics course.
Figure 6.2: Phasing marketing spend priorities to accelerate profit growth for a consumer
T C C P
102
D R
brand.
to persuade interested consumers to add the brand to those they purchase; and
(4) loyalty promotions to persuade consumers to purchase only this brand.
In the base case (dashed lines of graphs), the budget is allocated evenly, so $5
million is spent on each of the four activities in every month. It takes a long time
for the early advertising at the front end of the chain to bring consumers within
reach of the promotion spending that persuades them to actually buy the product.
In this case, sales are slow to take off, the brand does not break even until month
20, and by month 36, the brand has failed to pay back the spend on its own
marketing—cumulative profits are still negative.
In the better case (solid lines of graphs), awareness advertising is prioritized first,
followed by values advertising, in the first year. This pumps consumers more
quickly into the aware and interested states, so when spending switches to
promotion from month 12, it is much more effective. Spending at the front of the
chain can then be cut, since few people remain to be captured, and can be
increasingly focused on activating customers and winning their loyalty. Total
active consumers (disloyal plus loyal) climb to roughly the same number as in
the base case, 37 million, but a larger fraction are now loyal. Also, the total between
months 18 and 30 is much greater than in the base case, growing profits faster
during the same period and easily paying back the investment by month 36.
T C C P

This framework is not limited to consumer markets, or even to commercial cases.
New business-to-business (B2B) products and services must also pull potential
customers through stages, and have their own mechanisms for achieving these
flows, such as trade shows and direct sales calls. Similarly, charitable organizations
work hard to win attention and participation from potential donors.
The framework is so useful in a wide variety of cases because it captures how
people move between states of mind, a phenomenon that arises in numerous
situations, including politics and organizational change. A particularly important
case is the slow adoption of actions to reduce carbon dioxide emissions. Contrary
to popular belief, most emissions can be eliminated by existing known technology 103
that is simply not being deployed. Nor is it a costly endeavor—some twenty-five
percent of global emissions can be eliminated at a profit (i.e., savings exceed costs),
D R
and well over half of all emissions can be cut at no net cost to the economy1. The
problem is neither technology nor cost, but adoption—people and organizations
are unaware and uninformed about what can be done, which suggests that
governments wishing to make faster progress in reducing greenhouse gas
emissions should make advertising of information about the issue a priority.
Figure 6.2 simplifies greatly how marketing really works:
Ÿ It is unlikely that roughly comparable spending on four types of
marketing would be advisable in any real case.
Ÿ Each type of marketing will impact on more than a single flow of
customers—e.g., values advertising will help build both awareness and
interest.
1 For more information, see http://www.mckinsey.com/ Article : Greenhouse gas

abatement cost curves
Ÿ Multiple consumer segments may exist, each a different size, purchase
rate, and so on, and each will respond uniquely to marketing efforts.
This variability can be dealt with simply by replicating the consumer
chain with the relevant data for each segment and adding up the
resulting sales and profits.
Ÿ There may be word-of-mouth effects, where already-won customers
at the top of the pipeline pull others up through earlier stages, causing
faster growth than marketing alone can deliver.
Ÿ Potential customers may be divided among “early adopters,” who will
T C C P
try anything new, others who start buying the product after they see
its benefits, and late adopters, who only buy long after the majority
have done so. This is again dealt with by segmenting these groups, and
capturing any word-of-mouth effects both within each group and
among groups.
Ÿ The chain does not show all possible movements—e.g., the possibility
of consumers moving directly into upper levels of the chain with
spontaneous purchases.
Ÿ There may be different or additional states into which customers may
104 move, especially in terms of “rejectors,” who positively dislike the
product, and try to stop others liking and purchasing it.
Even so, this model illustrates important general issues.
D R
The difference between good and ineffective strategy is massive. In the example
from Figure 6.2, the brand does not just deliver a few percentage points of extra
margin in the better case, but hugely positive cash flows.
It may be best to change decisions substantially over time. A constant marketing
spend over many periods could never be the best answer. It is worse still to decide
spending amounts as a fraction of sales revenue—the company would spend
nothing at first, and overspend later on.
The missed potential may never be known. Had management followed the first
strategy (base case) for the brand, they may have been happy enough that it
eventually became profitable, never realizing that they could have made over $260
million more using a better strategy. Such massive strategic underachievement is
widespread.
Strategic management is all about the flow rates! Chapter 2 explained how
performance depends on resources; therefore (other things being equal) if
resource levels don’t change, performance will stay the same. Changing
performance must, then, mean managing flow rates.
Some minimum input is needed for the system to perform at all. Had the
company invested only, say, $5 million per month in the brand in total, rather
than $20 million, it would not have achieved one-quarter of the sales and profits.
It would have achieved very low sales and continued losing money indefinitely.
This is a common phenomenon in strategy—a perfectly attractive and feasible
opportunity fails to be taken because management will not commit what is needed.
There is some maximum performance that the system can deliver. There are
finite resources here, and increasingly powerful mechanisms preventing indefinite

growth. The brand might just generate $500 million per month in profit, but not
$1 billion or $2 billion. Only by adding to the resource potential could this limit
be raised. Lack of awareness regarding the finite nature of resources is a common
strategy error, as shown by the over-expansion of stores by Starbucks discussed
P D
in Chapter 1.
6.3 Product Development

Product development is another resource-development process, the typical stages
being:
1 idea generation, making use of basic R&D, competitors’ products,
customer focus groups or direct requests, employee suggestions, and 105
so on.
D R
2 initial screening, where the basic technological feasibility and market
potential are assessed.
3 technical development, which includes the product’s initial

specification and testing.
4 commercial evaluation, including market research, assessment of likely

sales, prices, and revenues, and estimation of production costs and
the capital investment needed.
5 final development, when the product takes the form that customers
will actually see, and the details of the production process are specified.
6 product launch, when marketing and sales activity start, sales are
generated and the product is shipped.
The exact stages involved and the activities in each vary considerably from
industry to industry. It is also common for companies to run stages in parallel in
order to collapse the time between initial idea creation and product launch—for
example, production engineering may run in parallel with final product design
and market testing1.
6.4 Deteriorating Resources

Staff and products are cases where we usually expect quality to increase as an item
(each person or product) moves from stage to stage. Some assets, though, degrade
over time, and it is not usually adequate to treat the asset base as a single
population, as we implied in Chapter 5. Instead, we need to distinguish units that
are in different stages of their life.
Figure 6.3 shows such a picture for a utility company’s assets. New units spend
D R
some time bedding in, then spend many years in a highly reliable state. They then
start to deteriorate, when failures become more frequent, until finally they become
very unreliable indeed. The company makes revenue for each unit of power it
transmits (assumed to remain stable over time), but the price it receives is
penalized by an industry regulator for each power failure that occurs.
The business starts with a poor asset base that continues to deteriorate for the
first five years. Maintenance spending on reliable assets is not sufficient to keep
the asset base at its initial level. Maintenance and refurbishment of degenerating
106 units are not enough to prevent a rapid flow of units into the unreliable state.
(“Refurbishment” means taking a unit out of service, replacing worn-out parts
and restoring it to an as-new state.) Spend on new equipment is too slow to
D R
prevent the number of unreliable units growing quickly, so total failures are
growing, which hits the company’s revenue. Falling revenue and rising operating
costs are causing a rapid decline in the company’s net cash flow.
The strategic question here is how spending rates should change over time, in
order to re-establish and sustain a lower failure rate and still produce a healthy,
sustainable cash flow. The strategy depicted in Figure 6.3 is as follows:
Ÿ In years 5 through 10, a big investment program replaces many of the
unreliable units and refurbishes most of the degenerating units. This
reduces the total failure rate and cuts drastically the pool of
degenerating units that will later become unreliable. So the number
of unreliable units continues to decline, even after the investment
program is cut back from year 10.
1 Karl T. Ulrich and Steven D. Eppinger. Product Design and Development, 4 ed. (New
York: McGraw-Hill/Irwin, 2007).
Figure 6.3: Recovery strategy for a power company’s deteriorating assets
Ÿ
Ÿ
Ÿ
Figure 6.3
Total new or Capital cost per:

as-new units - new unit $50,000
per year - refurbished unit $20,000 Total capital
10
spend
($millions per year)
400
Units
0 25 refurbished
Years
Units per year
5 0 25
bedding-in becoming Unreliable Years
(in thousands) reliable units
(thousands Reliable replaced
20 per year) units per year
starting to
(in thousands) degenerate 5
5 (thousands Degenerating
10 per year)
100 units
0 25 becoming
(in thousands)
Years 60 unreliable
10 (thousands Unreliable
50 per year) units
(in thousands) Net cash flow
30 ($millions per year)
10
20
150
0
5
number of degenerating units to increase.

0 25 -100
by the small increase in degenerating units.

100 Years
on reliable units 0 25
Maintenance Years
on degenerating
spend units Total
($millions per year) operating
Failures per year per 100: expenditure
- bedding-in units 1.0 per ($millions per year)
Total failures Cost
failure
per year Total cost fixing 200 Revenue
- reliable units 0.5 1,500 $20,000 failures ($millions per year)
- degenerating units 1.0 ($millions per year) 500
50
-unreliable units 2.0
0 25 Price, after
Years
penaltyfor 0 25
failures Years
maintenance is reallocated to reliable units, falling failure rates reduce

After the replacement and refurbishment programs are ended, and
units reduces failure rates still further, though this is partly countered
Over later years, the continuing decrease in the number of unreliable
place over all, but the degeneration rate does not rise enough for the
degenerate does rise, simply because there are more reliable units in
Maintenance of reliable units is increased. The rate that units start to
D R D R
107
the price penalty, allowing net cash flow to recover to a healthy and
sustainable rate.
(Note that this illustration does not include the cost of capital, but the result with
this cost included is still preferable to the original performance.)
H R D  N C
Important Detail: Developing resources must be “MECE”
Care is needed to lay out these resource chains accurately to ensure the math
works out correctly. The resource development chains in this chapter each
encompass the entire population of the resources involved. The law firm
chain includes all lawyers in the firm (partners and others); the product
chain covers all products undergoing development; and the utility company
model includes all of the company’s units of equipment. This illustrates an
important principle that is essential to making sure the performance
outcomes are numerically accurate—the stages in the chain must be
“MECE,” mutually exclusive and collectively exhaustive; that is, each unit of
resource must be in one, and only one, of the chain’s stages. For example:
Ÿ The law firm’s staff are either regular lawyers or partners, but not
both.
108
Ÿ The utility company’s assets are either bedding-in or reliable or
degenerating or unreliable.
D R
In the choice pipeline, any individual consumer must be in one, and only
one, of the stocks, so careful definition of each stage is needed. The second
stage is “aware but not interested,” for example, because “aware” alone
would describe consumers in all but the first stage.
6.5 How Resources Develop in Noncommercial Cases

Resources also “develop” in noncommercial situations. Staff chains work exactly
as those in business cases, but demand drivers also develop—for example when
political parties try to move voters from apathy to interest and then to support.
Not all developments are desirable, though, and some must be deterred rather
than encouraged. Today’s criminals previously moved through increasingly
serious levels of antisocial and illegal activity before becoming known to police.
One public policy case concerns type 2 (adult-onset) diabetes, the prevalence of
which is rising strongly in many countries. The disease does not just strike
overnight, but arises after individuals have spent some time in a pre-diabetes state,
where blood glucose levels exceed normal levels but do not climb high enough
to trigger a diagnosis. Genetic factors play a role in determining who develops
pre-diabetes, but obesity is also a risk factor. With weight loss, it is possible to
recover from pre-diabetes and move back to a situation where glucose levels are
H R D  N C

again in the normal range. Excess weight can also speed the progression from
pre-diabetes to the full disease.
A diagnosis of full diabetes marks the point at which the progression of the disease
becomes irreversible, and damage to small blood vessels starts to occur. Diabetes
can, though, be effectively managed with proper medication and monitoring, and
with improved diet and exercise. At some point it may become necessary to start
injecting insulin. Many of those with diabetes also develop secondary
complications, such as heart disease, kidney failure, blindness, or amputation.
Policy options include1:
Ÿ Improved treatment for those with complicated diabetes, resulting in
the immediate benefits of improved health and productivity, fewer
hospitalizations, and a net reduction in costs.
Ÿ Increased efforts to detect and manage patients with uncomplicated
diabetes. This implies immediate cost but no immediate benefit;
expenditure must be viewed as an investment with the pay-off coming 109
in later years, through reduced disease progression and thus lower
medical and productivity costs.
D R
Ÿ Increased efforts to detect and manage pre-diabetes, when simpler
and cheaper interventions emphasizing diet and exercise may prevent
the onset of diabetes and its associated costs. Again, this effort involves
immediate costs but later savings.
Ÿ Increased efforts to reduce the prevalence of obesity in society, and
thereby reduce the onset of both pre-diabetes and diabetes.
6.6 Boundaries of the Firm

Section 6.2 showed one particular resource—customers—being developed
through stages before actually becoming part of the business system. The same
process may apply to other resources. For example, potential staff need to be made
1 Andrew P. Jones et al., “Understanding diabetes population dynamics through

simulation modeling and experimentation,” American Journal of Public Health,
96(3), 488–494.
aware of a potential employer and then be made aware of the benefits of working
for a particular firm before they decide to apply for a job.
Some resources continue to be relevant even after they have left the system.
Former customers may no longer generate sales, but they may continue to
recommend a company to others—wedding services and property agents are
excellent examples of this. Former staff can also inform potential employees about
what it’s like to work for a given company. Both cases, of course, have a negative
alternative—unhappy former customers and staff can continue to damage your
business, even though they are no longer directly involved.
Figure 6.4 brings together the key resource-development chains, showing the
boundaries where resources are an active part of the system. Note that
B   F
management can often influence and make use of, those resources that are outside
of the system.
Figure 6.4: The multiple resource chains of the business system,

Figure 6.4 and the firm’s boundaries
Boundary
110 of the organization Former
customers
Loyal
Customers Disloyal
Informed lost
D R
Aware
Unaware developed
won
Current
In commercial products
In technical evaluation
Ideas in development
Products screening
launched
discontinued
Former
employees
Senior
Junior
Staff Informed leaving
Aware
Unaware promotion
hiring
Reliable
assets Deteriorating
On order assets
Capacity
coming degrading
Former on-stream disposal
initiation
Potential Active resources Cash
resources resources
Cash
income spending
CHAPTER 7
COMPETITIVE RIVALRY
Chapters 1 through 6 have explained the need to constantly build and retain
resources over time in order to deliver continually improving performance, but
we must remember that competitors are trying to do the same. All rivalry
situations can be captured by just three dynamic structures. Each can apply not
only to customers, but also to other resources that may be scarce, such as staff
and sources of supply. The three dynamic structures include:
a. Racing to capture potential resources: winning first-time buyers or hiring
newly qualified staff
b. Trying to steal resources away from competitors and prevent the reverse:
hiring rivals’ staff or keeping customers from switching to a competitor’s
product
c. Struggling for share of activity from resources shared with competitors:
consumer goods firms winning the largest share of retailers’ shelf space
or voluntary groups capturing a larger share of donors’ total giving.
These three mechanisms often operate together. In the case of fast-moving
consumer goods, competitors rush to win new consumers with a new type of
product, and strive to replace their rivals’ products in stores. Since neither
consumers nor stores buy exclusively any single product, companies must then
try to capture a larger share of purchases than their rivals.
Competition for some resources involves no interaction—we might term these
cases of “type-zero” rivalry. For example, my efforts to develop a new product do
not hinder your efforts to do the same. We may compete for some related
resources, such as the skilled scientists we both need, but the product development
race itself is not contestable.
These mechanisms of rivalry are most easily understood with a simple example,
so consider two coffee shops starting up in a town with 5,000 potential customers.
7.1 Type-1 Rivalry
Figure 7.1 shows the first year of each shop’s growth, when potential customers
are being captured either by our shop or by the competitor. Customers may move
back into the “potential” pool again if offered poor value by one or the other of
the coffee shops. Both shops start by charging $2.95 for their typical coffee product
and have captured about 2,000 customers each after six months. Then, our
competitor raises their price to $3.15, and we cut ours to $2.80:
Ÿ We start to win customers more quickly, while the competitor’s win
rate drops. Their customers also start going back into the potential
pool, so their customer base starts falling.
Ÿ Our customers visit more often, and spend more per visit, whereas
their customers visit less frequently, and spend less on each occasion.
Ÿ Our sales jump slightly at this point, with the higher number of
T-1 R
customer visits and spend, and then continue to rise as we continue

winning new customers. Their sales drop slightly, with less frequent
customer visits and lower spend, and start to decline.
Note that this result is specific to this case and is not a general rule about the
112 impact and advisability of price changes!
This case is an example of a “first-mover advantage,” since our successful capture
of a new customer removes that customer from the competitor’s potential pool.
C R
Unless we give that customer cause to leave us and once again become a potential
customer, we deny our rival the chance of winning that same new customer at
any future time.
When competition builds a market. This illustration assumes that potential
customers exist—i.e., people who know what a coffee shop is and why they might
like to visit one—and need only be captured. But as the choice pipeline in Figure
6.2 showed, this is not always the case. The marketing communications of all
competitors can therefore speed the development of the potential market itself.
For example, many companies advertising high-definition televisions (HDTVs)
in 2005 brought potential customers into stores to investigate HDTVs generally,
as well as to look at a particular model.
Such cases have further important implications. First, you can access potential
customers who have been alerted by competitors’ marketing. Conversely, you can
spend money to stimulate potential customers, only to see them be captured by
rivals! Therefore, great care is required in choosing what marketing and
promotion activities to deploy, at what rate and at what times, and what prices
Figure
Figure 7.1 7.1: How competing coffee shops capture potential customers in a previously unserved
town
Spend per visit External factors
Our price Our decisions
$2.95 à$2.80 Perceived value Visits per customer Our results
offered by per week Rival’s decisions/results
our store
1.0 à1.11 Our net
Our
Our quality 1.0 customers customers
won per week
200 3,000 2,654
21
Potential Store staff
-100 and overhead
customers
Store sales
($ thousands per week)
5,000
product differences between companies.

50
707 29.5
14.8 Store profit
0 52 Rival’s ($ thousands per week)
week
200 customers 10
4.2
3,000 0 0.7
-100 -14
1639
Rival’s net -10
Rival’s customers 0 week 52
quality 1.0 won per week
Perceived value
offered by Visits per customer
rival’s store
development and capture of new potential customers (Figure 7.2).

Rival’s price per week
$2.95 à$3.15 1.0 à0.9
Spend per visit
generation offers significant benefits over the previous one, it can accelerate the
potential customer base for the next generation. Also, if the new product
the existing population of customers or users becomes a major part of the
fraction of the potential market but were then replaced by the first digital services,
the case of cell phones, for example, early analogue services captured a small
Some industries repeatedly replace one generation of product with another. In
which in turn were replaced by 3G services. For every generation after the first,
to set. It is especially hard to be sure of the best choices when there are significant
C R T-1 R
113
Products that evolve Figure 7.2
Figure 7.2: The development and capture of
through several customers with new-generation products
generations bring new Potential customer base for
second-generation products
opportunities and nd
Our 2
challenges. It may be st
generation
customers
Our 1
easiest, for example, to Potential
generation
customers
customersfor
move all of your Ever-likely 1st generation
products 0 years 10
customers
not yet
existing first-generation reached 0 years 10
customers to your 0 years 10
second-generation 0 years 10
Rival’s 1
generation
st nd
Rival’s 2
generation
customers customers
offer. However, this Functionality and value
of 2nd generation products
risks cannibalizing sales vs. 1st generation
to those existing
customers, so you might focus first on stealing competitors’ first-generation
T-2 R
customers with your superior second-generation offer, or target potential

customers who did not find the first-generation sufficiently attractive to become
active customers.
7.2 Type-2 Rivalry

114 Let’s take the coffee shop example forward in time to a point where all potential
customers have been captured, but the two shops are still charging the same price
of $2.95 per coffee, and each has half of the 5,000 available customers. Halfway
C R
through the year, the two shops make the same decisions as above: we cut our
price to $2.80, and our competitor raises its price to $3.15.
Figure 7.3 shows the impact of these price changes on customers’ switching. Our
sales immediately jump a little, as customers’ visit frequency and average spend
increases, but this does not increase our profits because of the lower price. But
customers then start switching to our store at the rate of nearly 100 per week. Our
customer base grows while our competitor’s falls, leading to a rise in our weekly
sales and profits and a fall in theirs.
A key assumption here is that a constant fraction of the competitor’s customers
switches each week, which means that some customers tolerate the higher price
of the competitor for a longer time than others. This scenario implies customers
are very patient. After twenty-six weeks, less than half the rival’s customers have
switched, in spite of the $0.35 lower price at our shop. Different behavioral
assumptions would result in different dynamics. At the extreme, if all customers
respond to a price gap immediately, a pulse of customers would switch, rather
than the continuing flow shown in the center of Figure 7.3.
Figure 7.3: Type-2 rivalry: customer switching between rival coffee shops
Figure 7.3
Spend per visit

Our price External factors
$2.95 à$2.80 Perceived value Visits per customer Our decisions
offered by per week Our results
our store Rival’s decisions/results
1.0 à1.11
Our
Our quality 1.0
customers
4,000 3,522
2,500
Store staff
and overhead
Customers
switching to our Store sales
store per week (thousands per week)
Our relative 100 50
value for money 25 45.5
1.0 à1.24
Fraction of rival’s 8.2 Store profit
customers who (thousands per week)
switch per week
Rival’s 10
3.3
8.1
customers
0
4,000 -2.7
2,500 -10
Rival’s quality 1.0 1,478 0 52
week
Perceived value
offered by Visits per customer
Rival’s price rival’s store per week
$2.95 à$3.15 1.0 à0.9
Spend per visit
the competitor tries (unsuccessfully) to make more profit by raising their price.
second half of the year, we drop our price to try and recapture lost ground, and
losing to the competitor some of those customers we managed to win. In the
undeveloped potential and from each other. In this case, we start with a higher
price than the competitor, so win potential customers more slowly. We also start
shops opening at the same time and capturing customers both from the
Type-1 and type-2 rivalry can of course occur together. Figure 7.4 shows the two
C R T-2 R
115
C R T-2 R
116
Figure 7.4: The impact of changing price levels for type-1 and type-2 rivalry
between coffee shops
Figure 7.4
Our customers’
Prices visits per week External factors
$3.50 and spend per visit
$3.15 Our decisions
7.3 Type-3 Rivalry

Rival’s Our results
$3.00 $2.95
Our net
Our
customers Rival’s decisions/results
Ours customers
$2.80 $2.80 won per week
$2.50 200 4,000 3,638
18
Perceived 1,409
Potential -100 Store staff
value and overhead
1.5
1.11 1.11 Ours
customers 102
Store sales
1.0 5,000 ($ thousands per week)
1.0 Customers 50
0.9 Rival’s switching 31
to our store
40
0.5 539
per week
-29 7 Store profit
0 week 52
10
200 6.8
choice must be competed for on every purchase occasion.

4,000 0
2,618 -3.1
-100 -2
823 -10
Rival’s net 0 52
customers week
won per week Rival’s
customers
Rival’s customers’
visits per week
and spend per visit
disloyal at a later time. Disloyal customers present a challenge, because their

shop they use that they remain loyal to it for some months, only to become
that state from the beginning. Alternatively, they may be so satisfied with the first
Not all coffee shop customers use a single store exclusively—many use two or
to the three discussed thus far: disloyal customers. These customers may be in
more interchangeably. These customers constitute a fourth population in addition
In Figure 7.5, the two shops again follow the pricing policies in Figure 7.4, but
customers only become disloyal and do so at a rate that reflects the best value
offered by either of the two stores. For the first six months, the competitor offers
better value, so our price of $2.95 wins us only one-third of customer visits and
a low spend from each. Our rival enjoys two-thirds of customer visits and their
lower price of $2.80 drives sales of $5.27 per visit, so they break into profit after
just a few months.
The situation reverses in the second half of the year as our competitor raises its
price to $3.15 and we drop ours to $2.80, and we get a larger share of customer
visits and higher spend. Note that if we had gone along with the competitor from
-3.3
6.3
Rival’s decisions/results
Store profit
52
and overhead
Store staff
week
T-3 R
External factors
Our decisions
0
Figure 7.5: Type-3 rivalry for visits and spend by disloyal coffee shop customers
Our results
10
-10
37
7
Store sales
117
4,144
50
customers
Disloyal
52
C R
week
0
Customers’ spend
5,000
customers’ visits
Share of disloyal
Net new disloyal
29
0.81
0.19
won per week

per visit
5.27
4.74
customers
0.67
0.33
$5.50 5.27
5.00
$4.50
1.0
200
-100
$5
Potential
customers
52
856
week
0
5,000
Rival’s
0.9 Rival’s
Ours
1.11 Ours
$2.80
$3.15
Perceived
Prices
value
Figure 7.5
$2.95
$2.80
1.11
1.0
$3.50
$2.50
1.5
0.5
$3.00
1.0
week 26 and also charged $3.15, customer development would have stopped
completely, and any higher price would have seen many customers leave the
market altogether, flowing back into the potential pool.
F I   T T  R
Important Detail: The value curve and blue ocean strategy

For simplicity, these examples assumed that all aspects of what the two shops
offered—products, service, and so on—were equal, so competition
concerned only one factor—price. In competitive situations, assessing rivals’
products on the multiple dimensions of a value curve (Sections 2.2 and 3.6)
can give clearer answers to why customers and sales change over time. Many
people would prefer to operate in an environment in which competition is
limited or nonexistent. This is the essence of “blue ocean” strategy—the
discovery and exploitation of some novel proposition that is a leap in value
for customers, compared with existing alternatives.
Blue ocean strategies have always occurred, from the 19 century
introduction of mail-order retailing to Apple’s iPhone. Such
transformational strategies create a substantial new potential market, along
with a value proposition so compelling that it both exploits that potential
118 quickly and establishes a lead that competitors can only pursue after many
years of effort. Note, though, that finding blue ocean opportunities is not
always possible, and most businesses must continue competing in situations
C R
where only less clear-cut differentiation is possible.
7.4 Further Issues with the Three Types of Rivalry

Some further issues of competitive dynamics will need to be assessed in practice:
Ÿ Switching costs and adoption costs. Our examples have assumed that
customers change behavior when they perceive even the smallest
reason to change, but that is rarely the case. There can be costs, both
financial and nonfinancial, in starting to buy a product—taking on
your first mortgage for example. And there may be costs or effort in
switching between rival suppliers. Changing your car insurance
provider incurs time and effort, and switching mortgage provider costs
money. Customers must feel that any better value you offer exceeds
this cost threshold if they are to switch.
Ÿ Market segmentation again needs to be evaluated where significantly
different customer groups might exist. One competitor may lose out
in the largest part of a market, but totally dominate another segment.
Ÿ Limited rationality. We have also assumed customers are rational and
change behavior whenever it would make objective sense to do so.
This is rarely the case, and you may not know when, or to what extent
they do otherwise. People are not always honest, either with
themselves or interviewers, claiming their choice of car, for example,

reflected a careful appraisal of its performance and comfort, when in
C  I

fact its lovely shade of blue was just irresistible! Nevertheless, in most
cases people behave rationally enough for the kind of analysis
described here to be useful.
Ÿ Delays may arise between changes that should trigger behavior and
customers actually acting on those changes. For example, you may
need to hear from several friends before you actually decide to switch
to the new iPhone, even though you hear nothing new from each
successive person you talk to. This reflects the build-up of an
intangible state of mind, an issue covered in Chapter 9.
Ÿ Such factors can lead to path dependency, where outcomes reflect the
119
order of prior events. For example, you may buy the first model of a
new product, even though you know that better ones will be available
C R
later, resulting in the first supplier gaining a market lead, even if it
never offers a better product than later competitors.
7.5 Competing with Intermediaries

Intermediaries are businesses that sit between you and the end user of your
product, and they can create powerful type-3 rivalry, both in consumer and
business markets. Often, suppliers fight to get intermediaries to promote their
product more strongly than those of rivals. For example:
Ÿ A consumer-goods company wants retailers to allocate a larger share
of shelf space to its product than to rival products in the same category.
Ÿ Business-supply companies want their products to have more pages
in distributors’ catalogues than competitors’ products.
Ÿ Insurance companies want brokers to spend more time selling their
policies to customers than those of competitors.
Ÿ Intel would like PC manufacturers to feature Intel processors in more
of the models in their product ranges, rather than AMD processors.
C R C  I
120
Ÿ
Figure 7.6: A wholesale price reduction captures retailer shelf space from rival products
Figure 7.6
Store profit on
each product Consumers in
($ per shelf-foot) store locality
1,075 Normal
1,000 873 Ours
Shelf feet moved Shelf space for 5,000 purchases per
563 each month our product consumer
342 Rival’s to our product (in feet) (units per month)
5 3.0
6
0 Shelf space for 20 15.0
rival product
(in feet) 10
-5
20 0 24 Product sales
month (thousands of units per month)
10
products over their competitors.
5.0 50 40.3 Ours

0 24
month
Our share of 15 4.6 Rival’s
Retail prices shelf space
($ per unit)
$2 1.88 Impact of prices
on consumer
$1.60 1.63 purchases
Store profit on
each product $1.40
($ per unit) Gross profit
Store mark-up ($ thousands per month)
on wholesale
price 0.25 15 12.1 Ours
External factors Gross profit
($ per unit)
Our decisions 7.5
Our results Wholesale prices 2.3 Rival’s
Rival’s decisions/results $1.50
1.50 Rival’s
0 24
1.30 Product cost month
$1.30 Ours
per foot of shelf space. (There are small rounding differences in Figure 7.6.)
($ per unit) 1.00

Suppliers use Google Adwords to get advertising prominence for their
consumer products for a market of 5,000 entirely disloyal customers in the locality
units per month give the store a gross profit of $11,250 per month, or $562.50
this is initially allocated equally between the two products. Total sales of 30,000
The store has twenty feet (six meters) of shelf space for the product category, and
surrounding a store. We and our rival charge a wholesale price of $1.50 (bottom
left), to which the store adds a 25% mark-up, resulting in a retail price of $1.88.
In Figure 7.6, we and a single competitor have equally appealing fast-moving
To boost our sales and profitability, we cut the wholesale price to $1.30 from
month 6.
The store keeps the same percentage margin, so reduces the retail price by the
same fraction. The store thus makes less cash margin per unit. The lower retail
price immediately wins our product a larger share of consumers’ purchases. If
this were all that changed, the store would make less cash margin on the same
total sales, but the lower retail price also increases consumers’ total purchases.
With higher total sales, and a big increase in our product’s share, the store makes
C  O R

more profit per foot on our product than before, and rather less on the rival
product (graph in top left of Figure 7.6). The store therefore allocates three feet
more shelf space to our product, taking it away from the rival product.
The next month, the store still makes more cash per foot on our product, and
moves still more space from the competitor to us. We increase our sales volume
and profit, despite the lower price. In each subsequent month our product wins
still more shelf space, until it has gained five feet from the rival product. Although
the store could make still more profit with further reallocations, it is reluctant to
do so because it does not want to be dependent on a single supplier’s product.
The competitor could well respond with price reductions of its own, which could
raise total product sales again and cause the store to reallocate shelf space away 121
from our product. If rivals continued this tit-for-tat price cutting, there would be
a progressive reduction in the wholesale price toward the minimum that we and
C R
our competitor could tolerate and a considerable loss of total supplier gross profit.
7.6 Competing for Other Resources

Customers are the most obvious resource that competitors fight over, but rivalry
for staff is also widespread. This may even cross between different types of
employer, such as retail staff moving to work for an airline.
Figure 7.7 shows type-1 and type-2 rivalry for employees when two call centers
start up in a single town, with a total of 500 potential staff. We need to hire 250
people within twelve months, and offer a pay rate of $10 per hour. This encourages
people to consider working for us, first becoming potential staff, then joining us
so our staff numbers start to rise.
After three months, a competitor starts a similar call center, also wanting 250 staff
by the year-end. They need to grow faster and so offer $11 per hour. This has
three effects:
1 People start considering this employment opportunity at a faster rate
(top left graph).
2 In a type-1 process, the competitor starts hiring potential employees

who were already considering working for us but now have a better
offer (graph of Rival’s new staff per month)
3 In a type-2 process, the competitor starts taking people who already
work for us (graph of Staff switching per month).
C  O R
If this were to continue (dashed lines), the competitor would nearly reach their
goal, capturing 215 staff by the end of the year. Of these, about thirty will have
been stolen directly from us and the rest both stimulated and captured from the
ever-likely population. Halfway through the year, therefore, we raise our pay rates
to $12 (solid lines). This stimulates still-potential staff (the third peak of the “New
potential staff per month” graph) and nearly doubles the rate at which we can
hire. It also steals staff from our competitor, with the net flow of staff switching
each month(right) reversing in our favor.
Naturally, other factors feature in people’s choice of job, such as working
conditions and the recommendations of friends, but these other factors will also
122 operate by changing the flows of staff around this structure. Poor working
conditions in the rival’s call center, for example, will cause staff to switch more
quickly to our call center, and employees who tell their friends how much they
C R
enjoy working for our call center will increase the rate at which we win new staff
each month. Some people may also leave these organizations, returning to the
potential population.
Where staff develop through stages, competition may focus on particular groups.
There could be particular competitive effort on developing and retaining
supervisors, for example. In extreme cases, a “war for talent” can develop as
competitors fight to hold on to critical skilled staff1. In 2005, the Royal
Dutch/Shell oil company wanted to hire 1,000 experienced petroleum engineers.
Following years of under-recruitment across the industry, and young people
choosing other careers, all oil companies faced a shortage of such staff and an
aging workforce, so the company was unable to find so many experienced staff.
Other cases feature rivalry for certain industry-specific resources. Our coffee
shops from earlier, for example, compete for the best store locations. Low-fare
1 Ed Michaels, Helen Handfield-Jones, and Beth Axelrod. The War for Talent. (New York:
McKinsey & Co., 2001).
R  N C

Figure 7.7: Rivalry with pay rates for new call center staff
123
C R
airlines, such as Ryanair and Southwest, have grown aggressively by starting

operations on previously unserved routes. They may also make a rather different
choice—to start services on routes already being served by direct rivals.
7.7 Rivalry in Noncommercial Cases

Competition is widespread in public services and voluntary organizations and
is sometimes similar to the rivalry for business customers. Voluntary
organizations need to be seen to serve beneficiaries of their services if they are
to win donors, so may compete for such “customers.” Other customer-like
rivalry occurs with political parties competing for voters, and churches
competing for followers.
Rivalry for staff is ubiquitous among public service organizations, where the
framework in Figure 7.7 is directly applicable. Competition for staff can become
international in scope, such as when nursing staff are attracted from low-paying
economies to work in the health services of richer nations. Even terrorism is a
choice that those participating in it make, in preference to benign alternatives.
Recognizing that the groups concerned use tactics such as intimidation and the
kidnapping of children to feed their organizational structure allows for the
selection of counter-measures likely to be most effective. In Sierra Leone during
the 1990s, for example, children displaced by violence were specifically sought
R  N C
out and protected to prevent them falling into the hands of insurgents.
Voluntary organizations clearly compete for donors and for the giving they bring
in through the three standard rivalry mechanisms —capturing new donors,
winning donors from other organizations, and capturing more share of the giving
from donors who support more than one organization. As with businesses
competing for customers and sales, voluntary organizations need to understand
which form of competition they are engaged in, and where their efforts should
be focused.
7.8 Dealing with Multiple Competitors

124
Few companies are so fortunate as to have only one competitor to deal with, so
it is often necessary to extend the principles discussed in this chapter to handle
C R
multiple rivals. It is relatively straightforward to adapt the three standard rivalry

structures to a case of multiple competitors—we simply add an extra customer
stock for the second rival and the appropriate additional flows. However, this
approach soon gets unwieldy for larger numbers of competitors, so other solutions
are needed:
Ÿ To avoid the diagrams becoming too complex, several rivals’
customers can be shown in a single resource, using differing line styles
or colors for each, but this is only a presentational benefit and does
not simplify the analysis.
Ÿ It may be adequate to show only the key competitors to and from
whom you expect to see significant customer movement. Mercedes
might worry most about rivalry with BMW and Lexus, for example,
rather than other car makers.
Ÿ Treat large numbers of similar competitors as a “strategic group.” For
example, Mercedes might treat several luxury car makers as one
group1.
It will still be necessary to evaluate carefully the factors motivating customers to
switch between each pair of competitors or groups of competitors, but these
simplifications significantly ease the workload and the complexity of the strategy
debate the management team must have.
D  M C

125
C R
1 Discussion and examples of strategic groups can be found in: Robert M. Grant.
Contemporary Strategy Analysis, 5 ed. (Oxford: Blackwell Publishing, 2005), Chapter 4.
126
CHAPTER 8
STEERING STRATEGY AND
PERFORMANCE
Now that we have a rigorous picture of how an organization functions, performs,

and competes, we can use this understanding to make better decisions on several
questions:
1 Whether to take part. Following through the concept of the business
life cycle (Figure 1.2), the first question is whether it is a good idea to
get involved in a particular market at all.
2 Choosing a strategy for taking part. The decision to compete in a

market can only be made in the context of how that business might
actually work and how it might perform. The high failure rate among
new ventures—both independent and in large companies—suggests
there is much scope for a more effective evaluation of business ideas.
3 Designing a likely path to success. Beyond describing how a possible

business could operate, there is a big challenge to define a realistic
path by which that business could be started, developed, and grown
to create one’s ultimate vision.
4 Steering strategy through time. Having built a picture of how a business
could develop, we are then concerned with directing the enterprise as
it actually progresses. Competitive conditions are rarely stable, and
external factors also change. Strategic management must therefore
encompass the full range of decisions that significantly affect the
D  G  P S
organization’s internal development and interactions with outside

forces.
5 Whether to extend or revise the strategy. This is in essence a repeat of
the first two questions—whether to take part, and if so with what
strategy—except that we are now looking to add to an existing
enterprise. Should we enter a new market, extend our product range,
and/or develop a service offer alongside our product sales? This issue
covers all kinds of possible changes to the current business model, and
therefore any changes to the three principal elements of strategy
position—who to serve, with what products and services, and how.
The contribution of strategy dynamics to the first three questions lies in its ability
to lay out on paper a crystal-clear picture of how the prospective business should
work, including quantification of how all key numerical values of the business
should develop over time. The same method is just as appropriate when
128
considering whether to extend the strategy; simply show how doing so will add
to the resource levels likely to develop in the already-active strategy, and the
S S  P
resulting impact on revenues, costs, and profits.
8.1 The Difference between Good and Poor Strategies

We have noted before that, even when a good strategic position has been chosen
(who to serve, with what products, and how), the implementation decisions that
steer strategy can have a powerful impact on outcomes, and therefore on whether
it’s a good idea to pursue the plan. Those implementation decisions basically
involve choosing what to do, when, and how much, across all significant decision
items.
In the consumer brand example from Chapter 4 (Figure 4.4), we must decide
each month how much to spend on advertising, how much sales effort to deploy,
and what price to charge. The base case in Figure 8.1 (dashed lines) makes simple,
static choices on each decision—advertising of $0.5 million per month, a sales
effort of fifty salespeople, and a wholesale price of $9.00. But why is the outcome
so poor, and can it be improved with a better strategy?
D  G  P S
Figure 8.1: An improved strategy for a brand launch
129
S S  P
1 First, the advertising spend of $0.5 million per month reaches only a
small fraction of potential consumers, where “reach” implies that
people are not just exposed to the advertising, but notice it. Second,
salespeople will struggle to win stores until consumers are interested
in the brand. Last, since stores add a mark-up to the wholesale price,
a relatively higher price reduces consumption, while a lower price
increases it. Given these considerations, perhaps a better launch
strategy might look something like Table 8.1, which includes the
following steps:
2 Start by spending heavily to win consumer interest; delay selling to
stores until there is enough interest for stores to take the product; and
price low to grow volume and stores’ commitment. (In practice, a
lower launch price might reflect an introductory discount, rather than
a low-ticket price.)
D  G  P S
3 Next, keep advertising heavily to capture most of the potential market

as quickly as possible, and sell heavily to grow distribution.
4 Last, raise the price and cut sales and marketing to extract profitability.
Table 8.1: An improved launch strategy for a consumer brand

Month Advertising Salespeople Wholesale price
1–6 $1.2m 0 $8.00
7–12 $1.2m 100 $8.00
13–18 $1.2m 100 $10.00
19–48 $0.5m 50 $10.00
Figure 8.1 compares the result of this strategy (solid lines) with the simple, static
policies of the base case (dashed lines). This revised strategy is not just somewhat
130
better than the base case—it is considerably better, achieving much larger and
more rapid uptake by consumers and stores, breaking into profit after just twelve
S S  P
months, and driving high profits. This dramatic result would not, however, be
discovered from any discussion of the strategic positioning of the brand, nor from
qualitative debate among the management team. Even if the general shape of the
strategy, such as “advertise hard early on, then cut back,” was agreed on in
principle, the actual numbers and timing would still need to be worked out.
Of course, these outcomes can only be predicted for certain with perfect
information on all of the relationships in the strategic architecture of the situation,
which is never entirely possible. Nevertheless, much of the benefit can be
obtained, even with partial information:
Ÿ A similar episode has probably happened before. Either the company
itself or others will have launched similar products in a similar market,
so examine the data from similar cases.
Ÿ Even where the initiative is quite novel, well-reasoned estimates of the
performance trajectory can be made by adjusting from experience in
other cases.
Ÿ Remember that evaluation does not stop on launch date! As soon as
the initiative starts, it generates information on how the situation is
actually developing, so management need not make an all-or-nothing
choice immediately. Instead, they can start the initiative, then either
revise the implementation as data comes in, or kill it if it is clearly not
working.
In spite of the clear benefits, few firms carry out such fact-based analysis and
steering of strategic initiatives, with serious consequences:
S S  P

Ÿ Many initiatives are begun that could never deliver what management
hope for, because there is simply no plausible set of relationships
between the numerical values in the strategy’s architecture that could
ever lead to the desired result.
Ÿ Management persists with unfeasible strategies because there is no
understanding of why progress is disappointing or the likelihood that
it will continue to disappoint.
Ÿ Conversely, organizations also under-invest in strategic initiatives,
and remain unaware of how much stronger their performance could
have been had they chosen otherwise. Firms often kill perfectly
attractive initiatives before they reach the point at which they will 131
deliver good results. In Figure 8.1, management can be confident of
the strategy, even before strong sales and profits arise, because key
S S  P

flow rates are increasing quickly—consumers are becoming interested,
and stores are adopting the product.
8.2 Steering Strategy and Performance

What we have done in Figure 8.1—planning out in advance the decisions we think
will be best—is not enough. Although we have improved confidence in the likely
progress of the strategy, things will certainly turn out differently than expected.
This may seem to invalidate the task of planning, but does not in fact do so. The
strategy in Table 2.1 would still be vastly superior to the base case, even if it took
twice as long as expected to capture consumers. This slower progress would,
however, imply the need for adjustments to the strategy, such as persisting longer
with the high advertising rate or delaying somewhat the large sales force
commitment.
What we need, then, is a way to make such adjustments continually in response
to emerging information. Such means must include clear and well-chosen
indicators to be tracked, and equally clear procedures for using that information
to adjust each decision. The strategic architecture of interdependent resources
that we have developed effectively specifies the business “machine” and how it
functions and performs. Like any machine, this one too needs a control system
if it is to perform well.
The machine analogy is made more complex when human behaviors are involved,
because unlike the physics of mechanical systems, human responses are not
entirely predictable. However, that is no reason not to exploit the limited
predictability that exists. History shows an increasing penetration of organized
S S  P
control systems into more and more parts of the business system. For example,
we gave up long ago any attempt to control oil refineries by looking at meter
readings and using judgment to make decisions. Logistics systems, once managed
by the intuition of experienced managers, are now largely computer-controlled.
Systematic decision making is even encroaching on issues with substantial
behavioral dimensions, such as the lending decisions of banks that were once
made on the basis of individual managers’ personal assessment of each loan
applicant. Such applications now rely almost entirely on credit-scoring systems.
The subprime lending crisis of 2007 shows just how badly things can go wrong
when such disciplines are sidelined! Loans were granted to customers who would
never come close to reaching reasonable credit scores, and who came to be known
as “ninjas”: no income, no job, no assets. The risk that a larger fraction would
132
default on their loans was supposed to be covered by charging much higher
interest than normal, but the default risk became so high that no reasonable
S S  P
interest rate would be enough to cover that risk, and the whole scheme collapsed.
Systematic decision making systems do not magically tell management the best
decision to make in specific circumstances. Rather, managers follow long-
established procedures for working out the best decision under a variety of
conditions. Even when such procedures are not made explicit, the idea implies
some kind of “formula,” into which information about the situation is entered
and out of which a decision emerges. Various kinds of rule are common.
Fixed decision rules. Keeping the price fixed, regardless of the situation, is hardly
a decision rule at all, but although it may seem unlikely, such rules are sometimes
adopted. Some organizations operate a headcount limit for certain departments
regardless of circumstances. Financial versions of such rules are quite common;
a budget is effectively a rule defining how much can be spent on a given activity
in a given period of time. The brand example, however, shows how suboptimal
such fixed decisions can be.
Fixed fractional decision rules. This is another naïve, but common type of
decision rule—i.e., setting a fixed percentage of turnover on activities such as
marketing, training, and so on. The problem here is obvious. If you have no
revenue, you spend nothing, and therefore do nothing to improve disappointing
results, such as a low customer win rate or staff skill levels. Some organizations
use a version of this rule to control labor cost—e.g., managers requiring labor
cost to not exceed a specific percentage of weekly sales. Therefore, if sales fall for
some reason, staffing would be cut, which would then damage service, which
would in turn drive more customers away! It seems likely that such damaging
policies have become widespread because of the ill-advised performance focus
discussed in Chapter 1: the focus on profitability, return on sales (ROS), or on

invested capital (ROIC), rather than growth in cash flows.
Last year +/− x% rule. This is a common variation on the fixed decision rule and
P  G D

suffers from the same problems. It assumes last year’s spend was about right in
the first place, and that no significant change to that spending is necessary. This
is an example of a widely observed psychological phenomenon known as
“anchoring and adjustment.”1 To make an estimate, people start with an implied
reference point (the “anchor”) and adjust from there to reach their estimate.
People asked if they think the population of Shanghai is more or less than ten
million, for example, will on average make higher estimates than those asked if
it is more or less than five million. It is easy to see how this thought process gets
into decision making. Needing to work out the best decision for something today, 133
people reasonably anchor their thinking with recent decision values.
S S  P

8.3 Policy to Guide Decisions
Although the rules just described are seriously inadequate, they illustrate the key
elements involved in making decisions to control strategy:2
Ÿ Data about some measure or measures of the current state of the
system—e.g., profits
Ÿ A target for that measure or measures—e.g., target profits
Ÿ A rule or “policy” for adjusting a decision, in order to close the gap
between the measure and the target—e.g., raising the price by two
percent because profits are five percent below target.
1 Amos Tversky and Daniel Kahneman, Judgment under Uncertainty: Heuristics

and Biases, Science, 185, 4157.
2 More can be found on formulating policy for guiding decisions in: John Sterman.
Business Dynamics: Systems Thinking and Modeling for a Complex World. (New
York: McGraw-Hill/Irwin, 2000), Chapter 13.
The decision that emerges from the policy is expected to work by affecting other
items in the system. Here, the higher price is expected to increase profit margins
by more than may be lost through lower sales. Every policy is therefore an integral
part of the strategic architecture itself. Figure 8.1, for example, already shows in
red where policies are located in our brand launch, although it does not show the
measures that feed into each policy and does not specify the rule for each. So
what data should inform a policy?
Basing decisions on performance outcomes. Perhaps our policy for the
advertising spend for the brand from Figure 8.1 should be based on profit. None
of the simplistic policies above takes any account of profit, so they are not likely
to be especially effective.
P  G D
One possible policy to adjust advertising spend in response to profit might be:
Ÿ If a previous increase in advertising led to higher profits, repeat the
increase, and keep doing so until profits plateau. Increased advertising
might also seem best if a previous cut in advertising led to a fall in
profits.
Ÿ If, on the other hand, previous increases in advertising led to lower
profits, or a decrease in advertising led to higher profits, reduce
134 advertising spend.
The reduction in advertising spend today raises profit immediately, simply by
reducing the amount of advertising cost in the income statement. But this policy
S S  P
is ultimately ineffective because with a continued reduction in advertising spend,

we will never capture many consumers, and the brand will not take off.
Maybe we need to give advertising enough time to bring in new consumers and
sales before deciding whether the spending was useful, but how long should we
wait? If we look at the profit impact of higher spend after three months, it has
still not captured enough consumers to justify its cost, so the policy again results
in continued cuts, and sales and profits disappoint once again. If we adjust the
policy to allow six months of higher advertising spend, the results are quite
different—we gradually spend more, and eventually spend enough to bring in
customers, sales, and profits. This is an improvement but is still way off the much
better policy we worked out in Table 8.1.
Basing decisions on immediate effects. It is possible to improve policies
substantially by recalling a key principle of how a business system actually works.
It is resource flows that determine how performance changes, and those flows
depend, either directly or indirectly, on management decisions (as well as on
existing resources and other factors). It therefore makes sense to use information
on flow rates to inform the decision that influences them.
In this case, advertising spend could sensibly be decided upon based on its success
in winning potential consumers. Therefore, it would make sense to link the
decision to the consumer win rate itself. If more advertising wins customers faster,
increase advertising;, otherwise, decrease it. This promises to be a strong and
reliable policy, and illustrates a useful principle:
Policies should be informed by data on the factors, especially

resource flows, which they directly affect.
This principle can rarely be applied in isolation. Higher spending affects current
P  G D

profits, for example, and may simply be unaffordable. Nevertheless, this principle
should certainly be a key part of any policy. It may also be necessary to adjust a
policy or the data used to account for other factors that interfere with the policy.
In the case of the brand launch that we have been discussing, some active
consumers lose interest each month and flow back into the potential population,
while others are won simply by seeing the product in the stores.
Figure 8.2: Results of a policy to adjust advertising spend based on changes
in the consumer win rate
135
gure 8.2
DECISION: Spend
more or less
on advertising
S S  P

2000
Advertising 1900
$000/month Did consumers
500
won change in the
same direction as
advertising spend?
Potential Interested
consumers Net new consumers
‘000 consumers ‘000
000/month
3000 3000
2375
200
0 48 0 months 48
months
Sales force Sales volume
000 units
per month
50 2000
Stores 1532
Potential stocking
stores the brand
20000 Brand profit
9302 $000/month
1000 913
Wholesale
price - 1000
$9.00 0
months
48
A benefit of linking decisions to the resource flows they control is that we don’t
have to wait for their effects to work through the system, as we had to do when
using profit to inform the advertising decision. As soon as we know that more
advertising raises the consumer win rate, we can decide whether to increase
spending again.
C I D  I
Also, as the policy becomes more accurate in its predictions, we can adjust our
decisions—for example, increase our advertising spend by greater amounts.
Figure 8.2 shows our company starting with an advertising spend of $0.5 million
per month, and increasing or decreasing it by $100,000 each month depending
on whether it results in a faster or slower consumer win rate. Although this is the
net consumer win rate, including gains from product visibility and the backflow
of consumer losses, we want advertising to ensure a positive win rate overall, so
the policy should still work. And indeed, it does, with advertising spend increasing
rapidly to a rate at which the potential market is captured quickly.
What this policy has not done, however, is ensure that the cost of advertising is
justified by the additional gross profit made from sales to the additional
consumers the increased advertising has won us. The simplest way to do this is
to set a threshold for the number of consumers who need to be won for the higher
advertising spend to pay for itself. In this case, such an adjustment results in
136 advertising being reduced after the initial potential is captured, and profits
increase progressively to a sustainable rate of over $1.3 million per month.
S S  P
Finally, note that similar policies could be devised for setting the size of the sales
force, based on the store win rate. The pricing policy would be more complex,
since lower pricing works indirectly through increasing the consumers’ purchase
rate, store profitability, and hence the store win rate.
8.4 Controlling Indirect Decisions and Interference

Some critical decisions are so disconnected from tangible performance outcomes
that tracking their immediate impact is especially important.
Ÿ Where the resource concerned goes through development stages.
Marketing activities along the choice pipeline (Section 6.2) may result
in significant changes to the number of people who are aware and
informed about a product, long before they become active customers.
For example, The global drinks group Diageo PLC was about to kill a
product launch after spending tens of millions of dollars, because it
had seen few sales. Checking the research, though, showed that
advertising had made large numbers of consumers both aware and
interested in the product, so its sales were on the point of taking off.
Ÿ Where the resource concerned is intangible. Training is the classic
example of a factor linked to an intangible resource. Spending on
training today builds staff skills, that in due course impact on tangible
resource flows (e.g., winning customers), which eventually add up to
enough change that performance is improved. You may have to wait
months or years for the training benefit to show up, by which time
you may have decided to drop it, unless you are tracking its immediate
impact—e.g., on staff skills or effectiveness.
Ÿ Where inflows and outflows interact. As always, it’s the flow rates you
need to check, but the impact of any decision or policy can easily be
lost if other flows are affecting the same resource. You might respond
to a service quality problem by hiring more staff, but if work
C O
conditions are so poor that staff leave again, you will see no business
benefit from what is otherwise a good decision.
Ÿ When there are multiple drivers. Chapter 3 explained how multiple
factors—both within and beyond our control—affect many resource-
flows, especially where people are concerned (e.g., staff and
customers). You may therefore have a perfectly good policy toward
one factor (e.g., salary or price levels), but still see unfavorable flow
rates in other areas (e.g., staff losses or decreased customer win rate). 137
Where this happens, you need to be still more localized in tracking
the effect of your decision, for example by researching why people are
S S  P

not making the choices you would like. Doing so might lead you to
discover that there is no problem with the salaries you offer or with
your price, but that staff are leaving due to lack of promotion prospects
or customers are not being won because they prefer rivals’ products.
8.5 Conflicting Objectives

Management must often, of course, pursue a balance of two or more aims; growth
and profitability are a common pair. Consider an electricity supply company
trying to resist attack by a new competitor who enters the market by offering
lower prices. We will need a composite policy that both minimizes customer loss
while still protecting prices and margins.
Our rival initially has a simpler aim: they know they will not be profitable at first,
so they set prices sufficiently below ours to keep winning customers. This cannot
continue indefinitely, however, and at some point they must try and become
profitable, too. One possible outcome is shown in Figure 8.3.
Figure 8.3 8.3: Composite policies of rivals in electricity supply
Figure
Our decisions
Our results
Rival’s decisions/results
Our policy ...
Our
... to customers
maintain
profitability ... for 000
customer
switching 1000
669
Operating
Prices 0 quarters 12 profit
$ per quarter $m/quarter
200 100
400
392 Ours Ours
391 Rival’s -1
0
375
-200 -100 -77
Rival’s
Rival’s -200
Rival’s
C O
policy ... ... for

customer customers 331
... to switching 000
maintain
profitability 0 12
quarters
Both companies cut their price by $5 whenever they lose too many customers, or
fail to win enough. But in addition, we raise prices (or cut them by less than we
138
would otherwise have done) if our profit margin drops below ten percent, and
the lower the margin, the more we raise prices. Our rival starts with no objective
for profitability, but from quarter 6 they, too, seek to get their net margin up to
S S  P
ten percent by raising prices. The scenario in Figure 8.3 showing both companies
ending up with losses reflects the particular policy rules for each—other rules
would lead to quite different results.
8.6 Goals and Policy in Noncommercial Cases

The principles of developing policy to steer strategy are readily applicable to
voluntary and public service cases. A voluntary organization wanting to increase
fundraising, for example, would learn little to guide its efforts from simply
monitoring its flow of cash. It would be well advised to track instead the inflow
of new donors, the donation rate of donors, and the rate at which previously loyal
donors were lapsing. Another example concerns many cities’ efforts to deal with
homelessness. Voluntary organizations often responded to the issue by offering
meals to the homeless on the street. The unintended consequence is to discourage
the homeless from seeking help to escape from their situation, so the numbers
sleeping on the streets escalates rather than falling. Policy in many cities now
focuses instead on slowing the rate at which people become homeless, and
enabling people already in that situation to access services that move them out
of it, sustainably.
Non-business cases can, though, bring additional complications:
Ÿ Multiple agencies. Homelessness is affected by the wide range of
policies of a number of different agencies, such as social services, the
police, and charities, of which many will exist, offering a variety of
G  P  N C

services. It is hard enough for a single management team to design
coherent business policies, so it is hardly surprising that public-policy

cases are so complex.
Ÿ Zero-goals. A further feature of noncommercial cases, introduced in
Chapter 1, is that the goal is often to move an indicator toward
zero—e.g., no crime, no diabetes, no homelessness, and so on. Such
zero-targets can quite readily be built into the standard policy
frameworks discussed in this chapter.
Ÿ Conflicting goals. Public services and voluntary organizations will also
face the challenge of conflicting goals. Many countries want to stop
growth in the number of people with type 2 diabetes, for example, but
there is clearly a conflict between this goal and the need to limit the
costs involved. In addition to this conflict is the conflict between 139
seeking the greatest quality of life for people with the disease and the
wish to minimize the number of sufferers. Success in the first objective
S S  P

results in failure on the second, due to increased life expectancy.
140
CHAPTER 9
INTANGIBLE RESOURCES
Intangible, or soft, factors clearly have a big impact on performance—a damaged

reputation can destroy a business, strong staff motivation can drive powerful
growth, proprietary knowledge can generate market-leading products, and so
on1. But making practical use of these factors to steer strategy is difficult, because
terminology is often abstract, ambiguous, and inconsistent.2
Figure 9.1: A9.1

Figure classification of resources and capabilities
Tangible All classes of asset-stock

resources
Attributes of Intangible Capabilities
Customers tangible resources resources ... consisting of
Staff routines or
Tangible Intangible Informational procedures
Products +
Capacity Psychological skills and
knowledge
Cash Quality-related
Other: context- including
specific skills
plus operational
items, e.g. inventory,
orders
plus non-resource
quality items
1 See for example: Charles. J. Fombrun. Reputation: Realizing Value from the
Corporate Image. (Boston: Harvard Business School Press, 1996).
2 See for example: Jay B. Barney. Gaining and Sustaining Competitive Advantage,
3 ed. (Upper Saddle River, NJ: Prentice Hall, 2007), Chapter 5; Robert M.
Grant. Contemporary Strategy Analysis, 5 ed. (Oxford: Blackwell Publishing,
2005), Chapter 5.
Resolving these problems leads to a classification of “assets”—resources (both
tangible and intangible), and capabilities—that has proved reliable and practical
(Figure 9.1).
To expand on the table above:
Ÿ The tangible resources listed at left have dominated our discussion to
this point, and constitute the core of an organization’s strategic
architecture. Not all of these resources arise in every case, and some
cases may require additional resources, such as “projects” in contract-
based firms.
A C  R
Ÿ Other asset stocks exist but have little effect on strategic performance.
Inventory levels, for example, are rarely significant to overall
performance, even though they observe the bathtub behavior of all
asset stocks.
Ÿ The next category of asset stocks is the attributes of those tangible
resources, discussed in Chapter 5. Some of these attributes are actually
intangible, such as staff skills or product appeal.
Ÿ The three main categories of intangible resources are: (1) psychological;
(2) information-based; and (3) quality-related. Some quality items do
142 not accumulate, however.
Ÿ This leaves capabilities, which combine the skills of individuals and
I R
teams with knowledge that may have been captured, as well as routines
and procedures. Capabilities will be discussed in greater depth in
Chapter 10.
Once we have clearly defined intangible resources, their levels can be measured
and their impact on the rest of the system assessed. It is then possible to design
actions to improve matters and put in place procedures for ensuring they stay
that way.
Not “intangible assets.” The term “assets” is used indiscriminately in strategy to
define all types of resource and capability. All such factors do indeed fill and drain
over time, a process technically termed asset stock accumulation. But there are
two reasons for not using “assets” when assessing resources and capabilities. First,
a term encompassing such a wide variety of factors is confusing when also used
to define any particular category. Second, the term “assets” has a specific, accepted
meaning relating to items in a company’s accounting statements. The term
“intangible assets,” too, has a specific meaning in that context, referring to the
value of such items as patents and brands. Our concern, though, is with the
intangible elements themselves, not with their financial value, so to avoid
confusion with the use of the term in financial accounting, we will therefore refer
to intangible resources or intangibles, rather than “intangible assets” or “invisible
assets.”
The three most common categories of true intangible resources are:
1 Psychological factors, concerning the state of mind of key groups,
especially customers and staff, but also investors and other
stakeholders.
2 Information-based resources, such as data, technology, and knowledge.
3 Certain quality factors that must be built up and sustained over time,
S--M I
such as the reliability of new vehicle models or electronic equipment.
9.1 State-of-Mind Intangibles

The principle behind state-of-mind intangibles is the core concept of cognitive
psychology—that state of mind drives behavior—so detecting, measuring, and
managing state of mind is key. The case of the service department, introduced in
Section 4.6, includes two such factors that substantially worsen the company’s
problems. The department is the major unit of an IT service company, serving
medium-sized businesses. It recommends choice of hardware and software,
143
installs these for clients, and provides maintenance, support, upgrades, and
training.
I R
At the beginning, the company served approximately ninety clients who required
about seventy-five hours per month of service. Its founder and CEO was signing
up just under two new clients per month, and none were leaving. Each new client
also needed about 200 hours of initial work to get them set up on a sound basis.
The company was delivering good service to its clients, and had a solid reputation
that helped the CEO sign up more new clients.
The company employed seventy technical staff, of whom fifteen were relatively
new. It was taking on two or three new people per month to cope with growing
demand, and losing only about one person per month. Staff had 120 hours per
month to serve clients, after allowing for administration, holidays, and so on.
New staff were not so effective, taking about three times as long as experienced
staff to do typical tasks. In addition, each new employee needed about ten hours
per month of supervisory time from an experienced employee. It took three
months for new staff to become fully productive. Staff morale was high, reflecting
the company’s stable situation and the interesting work. Staff were busy, but not
overloaded, working at about ninety-five percent capacity to ensure good client
service.
The CEO found himself with too little time to continue his selling efforts, so
brought in an experienced business development executive. With the company’s
strong reputation, this new executive was soon bringing in more than double the
rate of new clients per month. All seemed well until about nine months later. Staff
were increasingly busy—payroll information suggested they were putting in
fifteen percent more time than normal—and there had also been an increase in
complaints from clients about service quality.
After a further three months, things really started to fall apart. Staff pressure got
still worse, even though staff numbers had grown to eighty-seven, and complaints
from clients, now numbering 143, escalated sharply. For the first time, some
S--M I
clients left the business to find support from other providers, and success in
winning new clients declined. Still worse, staff started to leave more quickly than
ever before, apparently due to the pressure they were under.
Figure 4.6 provided a simplified explanation of the problem, but it does not
adequately address the following questions:
Ÿ Staff were overloaded from month 9, so why was it not until month
15 that customers started complaining?
Ÿ Why was it a further few months before clients actually left?
144
Ÿ Why did staff losses only pick up some three months after the overload
started, and grow only slowly over the next few months?
I R
Ÿ If the worst point reached was an overload of about twenty percent,

how come the firm subsequently lost nearly fifty percent of its clients?
Figure 9.2 pulls apart one of the mechanisms at work. Starting from the bottom,
we see that the staff are just able to sustain good service quality until the pressure
gets too high—the ratio between the amount of work to be done and the capacity
to do the work. Service quality then falls. This is not easily measured, as it consists
of various issues, from delays in answering the phone, to incorrect advice, to faulty
installations. But one measurable consequence is the number of problems
reported by customers. This is not a nice, smooth data series, but nevertheless,
we can see that the problem rate clearly increased during the time that staff
pressure escalated.
The escalating service problems built up a level of dissatisfaction among clients
(the key “state-of-mind” intangible, and a negative one), but clients tolerated this
for a few months. It was only when dissatisfaction reached a threshold limit some
time later that it triggered actual client losses.
Figure 9.2
Figure 9.2: How staff pressure negatively affects service quality,
client satisfaction, and staff attrition
Client Increased
Forgiveness annoyance annoyance
rate per month
1.0
0.7
tolerance 0.5
limit
New clients Clients 0 months

24
Clientslost
per month per month
200 Fraction of
143
clients lost
79 0.25
10 25 0.17
19
4.5 0 months
24
0.04
S--M I
2.2 3
Problems per
client per month
2.0
[ Service
Pressure quality ] 1.0
on staff 1.0
1.5 0
0 24
months
1
0
0.5
0 24
months
Similar reasoning explains changes in staff morale and attrition1. The client losses 145
poisoned the positive intangible—the company’s reputation—that had enabled
more clients to be won in the first place.
I R
How might this firm have avoided these difficulties? Simply by increasing staff
numbers and continuing to hire ahead of increasing demand. How did it dig itself
out of the problem? This was not so simple and involved the rather shocking
tactic of terminating still more client contracts. This is not a general
recommendation on how to resolve service-quality problems, but was necessary
in this case because the difficulties were so serious. Only by radically cutting the
demands on the system could pressure be relieved and normal service resumed.
The cut had to be handled carefully, but had the additional benefit of improving
the quality of the firm’s client base (see Chapter 5).
Situations involving state-of-mind intangibles raise other common observations:
1 Strategic management of reputation and morale can be explored or taught with

the Professional Services Microworld business game, see http://sdl.re/profserv. The
Football League Challenge—an exercise for larger classes—also explores the
intangibles of team morale and cohesion; http://sdl.re/football.
Ÿ Intangibles can have very large-scale impacts on the tangible system
and performance and so should not be ignored.
Ÿ Negative issues are different from a lack of positives. Client
dissatisfaction in Figure 9.3 is not the same as low satisfaction, and
this difference matters.
Ÿ Intangibles are both influenced by and influence the tangible system.
Ÿ The client dissatisfaction and staff morale illustrated in Figure 9.2
were caused by changes to the tangible resources: clients and staff.
Ÿ Intangibles are manageable. Sometimes they can be influenced
S--M I
directly. UK bank Barclays PLC, for example, identifies “miserable

moments” that its customers experience, and always follows up such
incidents with a personal apology and symbolic gesture to the
offended customer.
Important Detail: Quality and reputation: A common structure

The connection between quality and reputation is very common. The
principle is that quality affects current customers, while reputation affects
146
potential customers (Figure 9.3). Since we are considering two different
groups, our concern differs in each case—we want potential customers to
I R
join us, and we want active customers to stay with us and buy more from
us. The factors that influence each group will also be different. Only current
customers can have real experience of product or service quality, and
therefore be motivated to leave if these are not good enough. Potential
customers, on the other hand, can only respond to what they hear about
product or service quality (i.e., the company’s reputation).
Figure 9.3: A common relationship between quality,
Figure 9.3: A common
reputation, and relationship between quality, reputation, and
customer movements
customer movements
Time needed
for reputation
Change in
Reputation reputation
to change
(Factors
per month affecting
Current quality)
quality
(Other factors
(Other factors causing loss
causing new of customers)
customers to be won) Current
New customers customers Customers lost
per month per month
indicates incomplete
causal links, simplified
for clarity
© Kim Warren, 2011

Ÿ Problems can fix themselves, though not always in an ideal way.
Losing customers relieves staff pressure, for example, but is not a
desired outcome.
Ÿ Intangibles can lead to persistent under-performance. This is a
common and serious failure of strategy, resulting from many
organizations’ obsession with tight cost control. They never have
I- I R

quite enough staff to get things done well, so are widely infected by
poor intangibles. They still push their employees to perform, but keep
hitting limits caused by damaged intangibles.
Ÿ Sporadic events are common drivers of intangibles. The failures that
the clients of the firm we have been discussing in this chapter
experienced were occasional incidents of varying seriousness. This
makes it important to capture incidents, not just continuous
measures, as the bank did with its miserable moments.
Ÿ Thresholds drive tipping points. People cannot possibly react to every
small change in how they feel about things, so it is extremely common
to see no significant reaction from a particular group until feelings,
whether positive or negative, have built up to some threshold level.
This makes it vital to track those feelings, if only by rough checking
147
and estimation, in order to anticipate discontinuities that may occur
at some future time.
I R
Ÿ Success on balanced scorecards can actually cause failure. All looked
good for the service firm we have been discussing in terms of
productivity, profitability, and business growth for many months,
during which time the seeds of its failure were taking root.
9.2 Information-based Intangible Resources

The simplest informational factor is data: specific information about something
important. This can be illustrated by extending the example from Chapter 5
concerning the performance of a call center.
In Figure 9.4, the call center started with 200,000 customers making on average
one call per month. The eighty staff could each take 125 calls per day, or 2,500
per month if fully trained, and so could just handle all the calls received. But to
answer customers’ enquiries, the staff need information about customers and
their activity—that is, data. Some data is long-lived, such as name, address, and
other personal details, while other data is transitory, such as recent transactions
or enquiries.
Here, twenty items of data are needed if every possible enquiry is to be answered,
but at first only sixty percent of that data is actually available, enough to deal with
ninety percent of customer enquiries. Missing data also increases the time needed
for staff to spend on each enquiry, so instead of being able to respond to 125 calls
per month, each employee can only handle ninety-nine. The call center therefore
has too few staff, simply because of the lack of easily accessible data. Over a quarter
of calls go unanswered, causing a loss of about five percent of customers each
I- I R
month. (This example does not include customer dissatisfaction, discussed above.)
Each month, more data becomes obsolete: old transactions become irrelevant,
customers’ details change without being updated, and so on. By month 12, the
Figure 9.4: Adding systems to capture data allows growth in call-center activity
148
I R
system comes into balance, but only because customer losses bring pressure back
to a level that staff can deal with. This is helped by the rising staff numbers, so
although each person can only respond to ninety-two calls per day, there are now
enough staff to manage all the incoming calls.
Realizing from the start that lack of data is damaging staff productivity and
customer service, the call center invests in improved systems to collect data. This
I- I R

takes the first twelve months to complete, but when those systems come online,
the flow of up-to-date data increases rapidly, and the database starts to fill. Staff
productivity rises strongly over months 12 to 18, so the center’s capacity is easily
able to handle the larger number of calls from the increasing customer base. Note,
incidentally, that the total quantity of data to be captured is itself rising, due to
the growing number of customers.
A working model of a similar situation in which data supports

customers service is at http://sdl.re/mpdg. This is an example of
working models included in the strategy dynamics course.
This is a simple case of an investment in information systems (IS) that clearly

makes sense. It is not always so easy to define or portray the information itself,
its impact on the rest of the system, or the impact of actions taken to manage it.
Further issues include: 149
Ÿ Interdependence between systems. Managers find it hard to assess the
I R
value of IS investments, because the combined benefit of multiple
investments is not a simple addition of the individual benefit of each
investment. The value of improved call-handling, for example, will be
reduced if not accompanied by improved data quality. This makes it
meaningless to try, as most organizations do, to work out the financial
case for each IS initiative. It is the program of investments that
improves performance, not the individual systems.
Ÿ The contribution of IS degrades. Here, there is a problem with the
obsolescence of data. But decay arises for other reasons, as well. The
business processes that IS supports will change, so the system becomes
increasingly ineffective at supporting those processes. The
organization’s needs may change in scope and complexity, so an
unchanging set of systems again becomes less effective.
Ÿ IS investments are not just about processing data. IS investments often
change the business processes themselves and affect the skills of the
people using them. A bank’s credit-scoring system relieves executives
of the need to be skilled at assessing a customer’s risk, while
sophisticated support systems enable service staff to handle enquiries
they would previously have needed to refer to others.
“Knowledge” is a less well-defined form of information-related resource, since it
can refer to knowing what as well as knowing how. Knowledge management is
especially relevant in consultancies and other professional firms, but also features
in other organizations1. Collecting and organizing such knowledge is of course
costly, but doing so leads to a number of potential benefits. As Figure 9.1 indicates,
knowledge frequently operates by contributing to an organization’s capability at
getting things done, an issue we will deal with in Chapter 10.
Q- I
9.3 Quality-based Intangibles

The focus on quality over recent decades has been of much more importance than
merely making business operations cost-efficient and reliable. As the case of the
computer service company introduced in Section 4.6 and discussed above shows,
quality issues are of critical importance to strategy—quality has a significant
impact on the medium- to long-term development of performance2.
Certain quality measures can move immediately, in response to the factors on
150 which they depend. If for example a retail store finds that five of its usual twenty
staff do not show up for work one day, its service quality will instantly suffer. If
those same employees show up again on the following day, service quality will
I R
jump back to its normal level. A law firm winning a major engagement that pushes
workloads well above the capacity of its staff will deliver poor work, either to this
project or others, but quality will recover when that engagement ends
Quality is key to strategic performance, so should feature in the
business architecture if its certainty is not assured.
Many firms manage quality so well that it has become utterly reliable, and so can
be safely ignored when assessing its strategic prospects. However, quality is not
always assured, and there are various elements of quality that need to be tracked:
Ÿ Quantification is important. There is a big difference for the customers
of the retail store if its staff shortage leads to queues of five minutes
1 Georg von Krogh, Kazuo Ichijo, and Ikujiro Nonaka. Enabling Knowledge
Creation: How to Unlock the Mystery of Tacit Knowledge and Release the Power of
Innovation. (Oxford: Oxford University Press, 2000).
2 Barrie G. Dale. Managing Quality, 4 ed. (Oxford: Blackwell Publishing, 2003),
51–65.
or fifteen minutes; the law firm’s overload will be more serious if it
leads to clients losing cases, rather than just experiencing delays.
Ÿ Track the correct quality indicator. Consider an office furniture
supplier who is experiencing delivery problems after expanding its
product range. Delivery lead-time, measured in days, is an obvious
measure of service quality, but is not actually the most important
factor, since office refits are mostly planned well in advance. On-time
delivery—delivering on the day and time promised—is more
important to customers and therefore a better measure of service

quality. Delivery completeness is also important, since missing items
cause inconvenience.
Q- I
Ÿ Track the quality drivers, not just the quality itself. The computer
service case we have been discussing shows how situations can
progress toward a crisis, while exhibiting no actual problems until the
factors driving it have moved into critical territory. Tracking workload
and staff capacity would have shown the quality problem approaching.
Ÿ Focus on the customer. The office furniture example illustrates a case
where several quality issues arise, but some are more important than
others. This is why quality initiatives place heavy emphasis on the
151
“voice of the customer” (VoC)1.
Ÿ Internal quality matters, too. Many activities are carried out by one
I R
department or unit in an organization for the benefit of other
departments or units (“internal customers”), so poor quality can
undermine the ability of other units to perform well.
Although many quality measures respond more or less instantly to the factors
that drive them, others clearly accumulate. Product development efforts, for
example, progressively increase product performance or functionality. In essence,
we are assessing how much of the users’ requirement the product fulfills, assuming
it is produced entirely to specification.
Other positive quality indicators that accumulate include various forms of
efficiency, for example the fuel-efficiency of motor vehicles or aircraft, or the
fraction of incident energy captured by solar cells. Some important indicators are
not so much quality as “lack of quality.” Examples include the manufactured
1 Michael L. George, John Maxey, David Rowlands, and Malcolm Upton. The Lean
Six Sigma Pocket Toolbook: A Quick Reference Guide to 70 Tools for Improving
Quality and Speed. (New York: McGraw-Hill, 2004), 55–68.
quality of electronic components, which shows up in the reject fraction; the
quality of chemicals, measured in terms of purity; and the quality of manufactured
products that shows up in the fraction of subsequent warranty claims.
In Figure 9.5, a piece of software developed for 1,000 users is released with 100
unknown bugs. As users start using the software, they find the bugs and report
them. The bugs are gradually fixed by a small team, but users continue to
experience bugs until the fix is made and deployed.
The initially high discovery rate of unknown bugs falls sharply because so many
users are working with the software and therefore discovering the bugs. However,
not all bugs are quickly discovered because, even after many months, there is a
Q- I
low probability that any particular feature is used in exactly the way that will result
in a bug event.
Figure 9.5: Fixing bugs discovered in a software application
152
I R
In the first case (dashed lines and light text), a team of five people have failed to
fix all known bugs, even after twelve months. In the second case (solid lines and
bold text), a larger team fixes the known bugs more quickly. Surprisingly, though,
this quick elimination of known bugs is not enough to make much reduction in
the total number of bug events users experience over the entire two-year episode.
The majority of bug events were experienced by users in the early months, filling
the stock of known bugs not yet fixed to a high level. Even with a larger team, it
takes some time to fix those bugs—too late to undo the problems users
experienced early on.
This example illustrates features that arise in other cases of fault-based quality:
Ÿ The problem experienced by the customer or user is different in nature
from the fault itself. For example, the experienced problem could be
a numerical error, a messy screen format, or a complete system crash.
A problem with the physical manufacture of a car could show up as
excess noise, high fuel consumption, or a road-side breakdown.
Ÿ There is a trade-off between the desire to release a product as soon as
possible, and the aim to release it with the fewest number of problems.
Ÿ Many problems persist, unknown either to the producer or the
customer, simply because the occurrence of the combination of events
Q- I
needed for the problem to arise is rare.
Ÿ Discovered problems require time and effort to be fixed, so a balance
has to be made between the cost of resources needed to fix all
discovered problems as soon as possible, and the costs associated with
allowing problems to persist.
153
I R
154
CHAPTER 10
CAPABILITIES
Capabilities have received considerable attention in strategy research and

popular writing1. However, making use of capabilities to design and deliver
performance faces the same difficulty that arises with intangible resources:
terminology that is inconsistent and abstract. We start with a firm distinction:
Resources are things we have (or can access);
capabilities are activities we are good at doing.
In simple grammatical terms, since a capability is about doing something, it can
be expressed as the present participle of a verb—marketing, hiring, serving
customers, developing products—or the noun describing such a process—
product development, recruitment, and so on.
Ÿ Capabilities, like resources, are asset stocks. Capabilities accumulate
and deplete, and exhibit the characteristics of asset stocks established
in Chapter 3.
Ÿ Capabilities differ from skills. Skills are attributes of individuals, and
move with the people who hold them, but teams need more than the
sum of those skills if they are to be capable.
Ÿ Capabilities are composite factors. Capabilities consist of people’s
skills, knowledge, and procedures for getting things done (see Figure
9.1). Nevertheless, it is possible and helpful to formulate a capability
as a single factor.
1 See for example: George Stalk, Philip Evans, and Lawrence Shulman,
“Competing on Capabilities,” Harvard Business Review, 70(2), 57–69.
The terms “capability” and “competence” are interchangeable.
Ÿ Core competences are different from capabilities1. The catchy phrase
“core competence” is used widely and indiscriminately in articles,
books, and discussions among executives. The phrase originally
described the powerful underlying technologies in multi-business
firms. Honda’s four-stroke engine technology enabled them to
compete in motor-cycles, cars, and snowmobiles, and Canon’s laser
technology lay at the heart of its scanners and printers. But a core
competence alone is not enough if we lack basic capabilities in other
functions. Honda, for example, struggled in the car industry during
the 1990s, because of weaknesses in design, marketing, and production
D  C
engineering.
Ÿ Capability building is best done deliberately. Well managed
organizations do not merely hope that capabilities will emerge by trial
and error—they know what they need to be good at doing, and
deliberately work out how best to do those things. They then continue
relentlessly to keep improving what they do.
156 Important Detail: Keep it simple with Ockham’s Razor

Ockham’s razor is a principle attributed to the 14th-century friar William
of Ockham. It states that the simplest explanation for any phenomenon is
C
likely to be the best. This implies that, in the search for scientific theories, it
is advisable to seek explanations that are “parsimonious” (requiring the
minimum number of factors), and do not involve ambiguous or abstract
factors and mechanisms. This principle is worth bearing in mind when
considering the likely usefulness and reliability of strategy theories and
frameworks.
10.1 Dimensions of Capability

To specify capabilities requires that we be clear what being “good at” something
actually means. There are three elements to consider: (1)is the activity done
quickly; (2) is it done well; (3) and is it done at low cost?
1 C. K. Prahalad and Gary Hamel, The Core Competence of the Corporation,

Harvard Business Review, 68(3), 79–91.
Figure 10.1 looks again at the retailer discussed in Section 5.3. As the retailer gains
confidence, it wants to open stores quickly in order to capture the market before
competitors have a chance to move in. As the retailer uses up the potential market,
it slows its store-opening rate. At this point, the fastest it could possibly open any
new store, after deciding to do so, is over three quarters (dashed lines and light
text). However, with a low capability of finding locations and then acquiring and
developing stores, the best it can do is open each new store after a process taking
six quarters.
Figure 10.1: Impact of store-opening lead time capability for a retailer
D  C
157
C
Opening stores quickly is not enough to ensure that sales and profits grow
strongly, however. The retailer wants high-quality stores, which means finding
locations that can attract as many potential customers as possible in each area. It
also wants to acquire each store for a low cost. Figure 10.2 adds these two
capabilities. The business spends twenty-five percent more on each store than it
has to, so its cost capability is 1 ÷ 1.25, which is 0.8. The average store’s location
reaches only about seventy percent of the potential customers that the best
locations could access, so its quality capability for opening stores is 0.7.
In Figure 10.2, other capabilities are assumed to be adequate. For example, the
retailer offers appealing products, hires and deploys enough staff to meet demand
and keeps them well-trained. It is remarkable, then, to see the dramatic impact
of a single strong capability concerning the opening of new stores. The difference
would have been still greater with a higher capability at merchandising: the choice
of products to offer and their positioning in stores. If this led to the capture of
the nearly one million potential customers still remaining at quarter 20, the
company’s sales would have been nearly $300 million per quarter and operating
profits would have exceeded $8 million per quarter. It is not surprising, then, to
find that organizations with even small capability advantages across the many
key activities—staffing, product development, marketing, sales and so on—deliver
orders-of-magnitude more performance than less capable rivals.
Note too that the measures of capability are neither abstract nor impractical. It
is perfectly possible for a retailer to track how long it takes to get a new store
opened, to compare its costs with the best that others can achieve, and to assess
each store’s reach into its local market. It is equally possible for most firms to
evaluate their capability of doing certain key tasks quickly, well, and economically,
and, armed with this information, set plans and targets for improving each
D  C
capability.
158
Figure 10.2: Impact of multiple store-opening capabilities for a retailer
C
Figure 10.2 also illustrates a further common observation:
Most capabilities are concerned with building and retaining resources.
There are exceptions, but most important capabilities are clearly connected to
the flow rates in the strategic architecture—winning customers, developing
products, retaining staff, and so on.
Capabilities in low-fare airlines. Ryanair and similar low-fare airlines
demonstrate many of the principles regarding capabilities, following the principle
that capabilities will be found in the major resource flows of the strategic
architecture, as well as with certain non-resource performance measures.
The opening of operations at new airports is a particularly close match for the
D  C
site-acquisition capability of the retail store chain. Ryanair has by now developed
a strong capability to identify and add new travel routes and to market those
services in order to build customer numbers and capture the journeys they wish
to make.
Capabilities and business processes. Strong capabilities depend on having
effective business processes, so it is helpful to understand the connection between
these concepts1. In simple terms, business process design identifies the set of
activities required to make something happen in the most efficient way. Since our
159
strategic focus is on resource flow rates, these are the processes that are of most
concern. Figure 10.3 expands the store-opening resource flow into key stages of
C
the process. If these are optimally designed, and if the staff involved are skilled
and have the information they need to do their tasks well, then the retailer be able
to find and open quality stores, quickly and inexpensively.
Figure 10.3:
Figure 10.3The processes of store opening for a retailer
Stores opened
per quarter Stores
operating
BUSINESS PROCESS STEPS
YES Negotiate YES

Receive Meets our Acquire Develop Fit out Open store
opportunity needs? opportunity Success? site site store
NO NO
Rejected Lost
1 An accessible explanation of business process design can be found in: Daniel V.

Hunt. Process Mapping: How to Reengineer your Business Processes. (New York:
John Wiley & Sons, Inc., 1996).
10.2 Learning Develops Capability
At the founding of the retail business above, management would likely know that
finding locations for new stores would be an important capability and therefore
hire someone with relevant experience for the task. Since capabilities, like
resources, are asset stocks, they accumulate and deplete, which in this context
means learning and forgetting. To complete the picture of how capabilities arise
and help grow resources, then, we need a model for how learning occurs.
The retailer might reasonably hope that the employees who find and open stores
will gradually learn to do the job better across three dimensions; opening better
L D C
stores, more quickly, and at lower cost. The following events describe this
capability development for UK restaurant and hotel group Whitbread PLC over
approximately five years:
Ÿ Their first expert had some initial success in finding good locations
for new restaurants, but was soon very busy, traveling long distances
to visit promising locations, assess them, reject many as unsuitable,
negotiate to acquire good opportunities (many of which failed), and
follow through with purchases.
Ÿ The company’s ambitions required faster site acquisition, so the
160 company hired more experts, but its capability was still no more than
the sum of these experts’ skills. By this time, the group was getting
information on which factors were most important to store
C
performance—visibility, passing traffic, ease of access, and so on. So

they wrote out these specification and issued them to real-estate agents
in their search areas. They started to receive fewer opportunities, but
much better ones. They also discussed how successful they were with
each purchase negotiation, and shared with each other tips for
achieving the lowest possible price.
Ÿ The analysis required for new opportunities was now better
understood, so the team hired an analyst. They had computer systems
set up to automate parts of the assessment, such as the socio-
demographic profile of a locality’s population. This allowed a quick
desktop appraisal of each new opportunity, cutting the number of
locations that had to be visited still further.
Ÿ Meanwhile, more staff were added, but now the retailer could bring
in people with less experience, quickly train them in their processes,
and support them with the information and systems that had been
developed.
As a result of these events, the company was soon acquiring much better locations,
more quickly, and at lower prices than any competitor in its sector—an advantage
that remains with the business to this day, some 20 years on.
Taking a high-level view of this story offers a simple architecture for capturing
how a capability develops. The small initial capability (acquiring effective
C N L  R-

locations for their restaurant) drives an inflow of the target resource (the
locations),and that flow itself drives an increase in capability. The next period’s
higher capability drives a faster, better, less expensive inflow of further resource,
leading to the generic architecture for learning mechanisms described in Figure
10.4. This powerful self-reinforcing feedback between resource acquisition and
the growing capability can be observed in many companies who emerge rapidly
to dominate their markets, such as Starbucks, Amazon, and Google.
Figure 10.4: Generic structure for the dynamics of learning to build

capability
161
C
If even modestly effective learning is added to the initially poor site-finding
capability of the retail business shown by the solid lines of Figure 10.2,
performance can improve sufficiently quickly for the organization to achieve very
similar results to the best achievable outcome, shown by the dashed lines of Figure
10.2.
10.3 Capabilities Not Linked to Resource-building

Although most strategically critical capabilities are linked to the acquisition,
development, and retention of an organization’s tangible resources, certain
capabilities operate on factors other than resources.
One example concerns the teams of sales people that some newspapers and
magazines employ to sell advertising space by phone to known advertisers. Other
sales staff are responsible for winning those advertisers in the first place. This is
Figure 10.5: Distinct capabilities linked to winning, retaining,
and selling to customers
Figure 10.5: Distinct capabilities linked to
winning, retaining, and selling to customers
Customer Customer
acquisition Customer Customers Customer retention
capability win rate loss rate capability
C N L  R-
Total sales
Ongoing per period
sales Sales per
capability customer
per period
a common practice in other organizations, too, where winning and retaining

© Kim Warren, 2011
customers is the main responsibility of sales people who call on customers, leaving
continuing sales capture to telephone-based sales groups.
Chapter 3 showed how sales performance in many situations depends on winning
and keeping customers, and on growing sales to existing customers. We therefore
commonly find a capability associated with each of these three elements (Figure
10.5).
Other examples of capabilities not directly related to resource flows include
distribution capabilities to ensure on-time delivery to customers, engineers’
162 capability to repair failed equipment, and the capability to select a product range
likely to maximize customer purchase rates.
Measuring capabilities. If capabilities are to be usable for strategy analysis and
C
planning, it is important to give them measures that are accurately expressed and
unambiguous. As for intangible resources, it is often helpful to start with the
extremes of a zero-to-one scale:
Ÿ Zero capability implies that, no matter how much of other useful
resources a team is given, it would not succeed in building the resource
for which it is responsible. If the team’s task is to retain a resource
against loss, then the outflow of this resource continues at the rapid
rate that would occur if the team did not exist.
Ÿ A capability of 1.0 is the maximum performance that can be imagined,
or that is possible, given absolute limits.
This zero-to-one range often leads to capability levels that are nearer the 1.0 end
of the scale, since organizations with especially low capabilities on important
processes will likely not survive. Three common reference points lend some
precision to these measures:
Ÿ A maximum rate of resource-build customer awareness if they had
our product and marketing budgets to work with.
A team’s capability is then defined as the ratio between the rate at which they are
actually building the resource, and the best rate that can be imagined, given one
of the benchmarks above.
10.4 The Balanced Scorecard

Ÿ The balanced scorecard has transformed the way in which
organizations track and steer their performance and is now a popular
performance assessment tool among large companies1. The method

recognizes that management needs to track a range of measures if it
is to sustain strong performance and so includes measures in four
categories:
T B S

Ÿ financial: e.g., revenue growth, margins, profitability, return on capital
Ÿ customers: e.g., satisfaction, retention, market share and share of
business
Ÿ internal processes: e.g., delivery systems, service response and new
product introductions
Ÿ learning and growth: e.g., employee expertise and staff development
The balanced scorecard process recognizes the interconnectedness between the 163
different activities of the business and the importance of measuring and managing
soft factors, such as staff skills and quality. Increased training of support staff
C
about a company’s products, for example, will improve sales effectiveness, which
will, in turn, improve sales and margins. However, a particular challenge arises
in choosing exactly which factors are important in each of the four domains and
which measures to adopt to monitor and control them. A strategic architecture
can help identify metrics for the four domains.
Figure 10.6 shows a strategic architecture for a consulting firm. It makes one big
simplification in treating all professional staff as a single resource, rather than the
several distinct levels of experience and seniority that exist in reality. It also adds
an intangible factor—staff expertise. Populating this architecture with time chart
data provides the rigorous, integrated numerical measures that a sound balanced
scorecard requires. Measures for the financial domain can be extracted from the
revenue, cost, and profit region of the architecture, plus others not shown in this
1 Robert S. Kaplan and David P. Norton. The Balanced Scorecard. (Boston: Harvard
Business School Press, 1996); Robert S. Kaplan and David P. Norton. Strategy Maps.
(Boston: Harvard Business School Press, 2004).
See also http://www.balancedscorecard.org.
limited picture, such as the salary rates of different groups of staff and the costs
C  P S  V O
of information systems. Data and movements in customer-related measures can

be extracted from the customer region at the top of the architecture, and we can
be safe in the knowledge that these measures are entirely coherent in their causal
relationships.
A full strategic architecture would make clear exactly which internal processes
are key and enable relevant measures for each to be identified. Finally, learning
and growth measures should be tracking the organization’s capabilities rigorously,
as defined in this chapter.
10.5 Capabilities in Public Sector and Voluntary

Organizations
The frameworks linking capabilities to resource development are directly
applicable to noncommercial organizations. Voluntary organization wanting to
win new donors, retain existing donors, and raise more money from current
donors will likely get better at each of these tasks as it grows in experience. As for
the retailer’s location-finding team, this will not simply involve increasing the
skills of the individuals involved, but also the development of better procedures
and the capture of useful information, such as the socio-demographic profile of
164
donors who are most easily won or who give more often.
The charity supporting patients with terminal illnesses, described in Sections 2.6
C
and 3.3, also shows how problems can arise as a result of ineffective learning. The
Figure 10.6:
Figure 10.5Extracting balanced scorecard measures for a consulting firm
Clients
Client
win rate
Client loss
rate Customer
Workload
Projects per project
per year
Services
Add/cease offered Fee rate
services Sales charged
effort Project
workload
Quality
of work
Financial
Workload
to build
and develop Fee
services income
Total
workload Operating
Internal Pressure
profit
$m/year
processes Total
professional
capacity
on staff
Total costs
Staff
expertise
Professional
Hiring
staff Professional
staff cost Training Learning
[ Other staff,
and
coaching and
Staff loss
rate
premises and
other costs ] growth
low frequency of calls made by volunteers to the patients they support undermines
C  P S  V O

important mechanisms. Not only do individual volunteers have little opportunity
to improve their own skills, but they can also make little contribution to
developing the procedures and information required to help the whole team
improve.
165
C
166
CONCLUSIONS AND FURTHER STEPS
This book provides only a brief explanation of how the strategy dynamics
approach works and contributes to radically improved strategic management in
all kinds of organization. A more extensive reference is Strategic Management
Dynamics by Kim Warren (John Wiley & Sons., Inc., 2008).
Further resources
Ÿ An online course on strategy dynamics is available at
http://sdl.re/sdcourse. The full course consists of 10 classes each
corresponding to a chapter in this book, each with 3-5 video segments.
The videos include embedded quizzes to help check your
understanding. Being quite substantial, this course can be taken in 3
parts. Alternatively, an introductory course can be chosen, consisting
only of the summary video segments for each class.
Ÿ The easy-to-use Sysdea online software for building and sharing
working dynamic business models is at http://.sysdea.com. Numerous
examples feature in its Help system at http://docs.sysdea.com.
Ÿ For education and training purposes, some “serious games”, built on
the principles in this book are available at http://sdl.re/microworlds.
These games each provide several strategic challenges, plus simple
tools for instructors to manage and assess learners’ use of the games.
Discussion and questions concerning the method can be raised through the
Strategy Dynamics Network on LinkedIn.
APPENDIX 1:
TECHNICAL SPECIFICATION
T S
The relationships making up the strategic architecture of an organization and

driving its performance over time, developed in Chapters 1 through 4, can be
formalized as follows:
Performance P at time t is a function of the quantity of resources R₁ to Rn,

discretionary management choices, M, and exogenous factors, E, at that time.
168 P(t) = f [R₁(t), …Rn(t), M(t), E(t)] (1)
The current quantity of each resource Ri at time t is its level at time t−1 plus
A 1
or minus any resource flows that have occurred between t-1 and t.
Ri(t) = Ri (t−1) +/− ΔRi(t−1…t) (2)
The change in quantity of Ri between time t-1 and time t is a function of the
quantity of resources R₁ to Rn at time t-1, including that of resource Ri itself,
on management choices M and on exogenous factors E at that time.
ΔRi(t−1…t) = f [R₁(t−1),…Rn(t−1), M(t−1), E(t−1)] (3)
For these equations to be accurate, the time period must be short enough for the
change ΔRi(t-1. . t) to be small relative to the scale of resource Ri. It is equally true
that resource quantities tomorrow will be equal to the quantities today plus or
minus the rate at which they are currently changing, i.e., Ri(t+1) = Ri (t)
+/−ΔRi(t…t+1).
No additional equations are needed to capture the frameworks discussed in
Chapters 5 through 9. The only extension required is to distinguish resources
held by different competitors, as discussed in Chapter 7. Intangible resources
(Chapter 9) and their relationship with the strategic architecture are already
captured by equations (1) to (3).
Capabilities (Chapter 10) can also be encompassed by equations (1) to (3).
However, as explained in the text, it is helpful to distinguish capabilities from
resources, which results in equation 3 being extended as follows:
The change in quantity of resource Ri between time t–1 and time t is a

function of the quantity of resources R₁ to Rn at time t–1, including that
of resource Ri itself, on management choices M on exogenous factors E at

that time, and on the related capability Ci.
ΔRi(t−1…t) = f [R₁(t−1),…Rn(t−1),
T S
M(t−1) , E(t−1), Ci (t−1)] (3a)
The current quantity of capability Ci at time t is its level at time t–1 plus
or minus any flows into or out of that capability that have occurred
between t–1 and t.
Ci(t) = Ci (t−1) +/− ΔCi(t−1…t) (4)
The change in quantity of capability Ci between time t–1 and time t is a 169
function of the change that occurs to the quantity of the associated resource
Ri during that same period.
A 1
ΔCi(t−1… t) = f[ΔRi(t−1…t)] (5)
APPENDIX 2:
PROBLEMS WITH CORRELATION
A big and important consequence arising from the behavior of accumulating
stocks is that it messes up our ability to learn much from statistical analysis –
P  C
especially the simple correlation methods often used to find “explanations” for
business performance. The reason for this is that the math of accumulation
prevents any possibility of a linear relationship between cause and effect in any
situation where an accumulating resource sits between the two.
To illustrate this problem and how it arises, consider a simple manufacturing
company that wants to understand whether it should spend more or less money
on marketing. Management looks at the company’s recent history and sees the
patterns for marketing and operating profit shown below.
170 Marketing spend and operating profit history for a company

A 2
The charts reflect the following history:

Ÿ The company was originally dissatisfied with its low and stagnant
profits up to month 6.
Ÿ A new head of marketing arrived, who persuaded the company to
increase its marketing spend from month 7. This increase in
expenditure immediately led to lower profits, as the increase in sales
was insufficient to cover the extra cost, although profits started to
recover over the following nine months.
Ÿ In month 15, the head of finance lost patience with the situation,
pointing out that the company had seen a total loss of profits over
those nine months of more than $500,000, compared with what they
could have expected from just pursuing the original low rate of
marketing. He even doubted that the previous rate of marketing was
necessary.
Ÿ The CEO agreed, so the company cut its marketing spend sharply
from month 16. Sure enough, profits jumped as the savings in

marketing spend were far greater than the value of lost sales. The head
of finance was clearly correct and pointed out to his colleagues that
P  C

he had made the company over $1.5 million of additional profit over
the twelve months since his recommendation, compared with the
original low profit rate.
The head of marketing was feeling somewhat dejected about this. Convinced that
she was right to increase marketing spend, she commissioned some industry
research. The company was one of fifty near-identical firms, and luckily,
information on monthly marketing spend and profits was available for all of its
competitors.
The next figure shows two results from comparing operating profit with
171
marketing spend for this large sample of companies.
A 2
The left-hand graph shows how operating profits in any month compare with
marketing spend in that month. The head of marketing was not at all happy with
this finding, which suggested that profits were negatively correlated with
marketing spend. On reflection, she was not too surprised, since marketing would
surely take some time to have its effect, and its immediate impact would of course
be an increase in cost.
Perhaps operating profits would increase some months after is the increase in
marketing spend? The head of marketing then looked at how competitors’
marketing spend compared with operating profits three months later (right-hand
chart, above). Disappointingly, there still seemed to be no positive correlation
between marketing spend and profits—but at least the negative relationship had
disappeared.
In spite of these apparently approximate and perplexing relationships between
marketing spend and profit, the business model at work here is totally
deterministic, with no uncertainty whatsoever:
operating profit = revenue – production costs – marketing spend – overhead
sales revenue = customers * sales per customer * unit price
production cost = sales in units * variable cost per unit + fixed production cost
P  C
customers today = customers last month + customers won – customers lost
sales per customer = base sales per customer + marketing spend * sales increase
per marketing dollar
customers lost = five per month
customers won per month = marketing spend * customers won per marketing
dollar
172
Moreover, the cost of acquiring a customer is $50,000. On average, each customer
stays for 20 months before being lost to competitors. During that time, the
A 2
customer generates 2,000 units of sales per month, on which the gross profit is
$40, making a total profit contribution of $80,000. There is no ambiguity
whatsoever that every marketing dollar generates $1.60 of value in less than two
years.
The next figure portrays these relationships diagrammatically.
If the business structure is very simple, why could the head of marketing not
discover any correlation between marketing spend and profits? The problem lies
at the flow-to-stock boundary. There is no obvious relationship between the
number of customers in any month and the win rate of customers in that same
month—nor should we be particularly surprised at the lack of such a relationship,
since today’s number of customers reflects the entire history of customer gains
and losses.
This has profound implications for any effort to explain performance outcomes:
Ÿ It is unsafe to seek correlation between any possible causal factor and
performance outcomes if any accumulating stock exists between the
P  C

cause and the outcome.
Ÿ It is meaningless to seek correlation between asset stocks and the flow
rates that determine them—their relationship is precisely defined by
the math of integration.
Now consider that a real business consists of many accumulating resources, that
those resources move through multiple stages, and that the rate at which any is
changing reflects other resource quantities, which themselves are subject to the
same difficulty. No wonder correlation analysis rarely discovers anything useful
about strategy! 173
A 2
While many businesses may be well-managed, poor strategy choices and
implementation lead to a perpetual, grinding under-achievement of potential,
ill-advised initiatives, or avoidable failures. In other fields of human endeavor,
we reduce the risk of serious failure by building models of what we want to do
before trying it for real, and codifying how things are supposed to work.
Learning from what we do, we revise the models and update those codified
processes to improve performance further. But for the most important function
of all—figuring out what the enterprise could achieve and how that might be
done—most organizations still rely on qualitative judgement and superficial
analysis. This is unacceptable.
The strategy dynamics method— in essence, the application of engineering

control theory principles to enterprise systems—solves this problem. Strategy
Dynamics Essentials explains the frameworks that accomplish this aim and
shows how they are applied. The method can be used to build working,
quantified models of any enterprise, or any part thereof, of any scale, in any
sector—or of any issue that an enterprise may face. The book is written for
executives responsible for any aspect of business performance, consultants and
other advisors, business students at all levels, and business teachers. No
advanced technical skills are needed—just the will and ability to think
quantitatively about whatever enterprise or function you are concerned about.
Even the earliest principles can be applied right from the start, and this fast ROI
can be repeated because key structures can be usefully deployed to tackle
strategic challenges in marketing, staffing, and other functions—which is less
difficult and costly than trying to assemble coherent strategy and plans from
current alternative approaches.
The book is supported by a full, Masters' level on-line course, “serious games”
for training and education, and the powerful and easy-to-use Sysdea software
for modelling strategy and performance.

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2 Positioning the organization relative to other organizations. In

3 Steering the organization’s progress over time. Having decided on a

1.1 A Life-Cycle Example: Blockbuster® Inc.

18 Blockbuster’s history can be divided into four main phases:

2 Growth. After just two years, Blockbuster was bought by another

○ A franchising scheme allowed independent operators to invest

L-C E: B® I.

operational details, and a resulting high turnover of CEOs. Still, the

B P O T

* Profit before interest, tax, depreciation, and exceptional items

Figure 1.2: Generalized strategy life cycle, illustrating extensions and

choose the initial

start-up growth maturity decline

S M: P  D

staff hiring and training, marketing spending and message, and—as

1.2 Strategic Management: Positioning versus Delivery

B P O T

may need to change for either positive or negative reasons.

Blockbuster suffered from two big threats—the emergence of postal-service

S M: P  D

telecommunications, which only really started in the 1970s.

B P O T

1 Michael E. Porter, What Is Strategy? Harvard Business Review, 74(6), 61–78.

competitors has another important implication: performance prospects are not

often determined within a few months of its launch, so its impact on

W “P” D W W T I?

B P O T

performance incentives—to focus on delivering short-term results, even if it

-500 value is not simply the sum

B F P

1.4 Building Future Performance

B P O T

performance won’t be applicable

2 Where will future

would likely have been

(dashed blue line). feared

have declined steeply.

B F P

B P O T

2 Where will future performance go if we carry on as we are? With this

3 How can we improve future performance? The preferred future

presented in Figure 1.7 is still more attractive when starting from

N P O

measures—airlines report passenger journeys sold, cell phone companies report

B P O T