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Heriot-Watt Management Programme

Strategic Management

Alex Scott

School of Management and Languages Heriot-Watt University Edinburgh EH14 4AS, United Kingdom. Version 2010.1

Heriot-Watt Management Programme School of Management and Languages Heriot-Watt University Edinburgh Scotland UK EH14 4AS Telephone Fax E-Mail +44(0) 131 451 3864 +44(0) 131 451 3865 external@sml.hw.ac.uk

http://www.sml.hw.ac.uk/external First published 2000 by Heriot-Watt Management Programme (ISBN: 0-273-64534-X). Republished 2009 (ISBN: 978-1-907291-23-4). This edition published in 2010 by Heriot-Watt Management Programme. Copyright Heriot-Watt Management Programme. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior written permission of the Publishers. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers.

Distributed by Heriot-Watt University. Heriot-Watt Management Programme : Strategic Management ISBN 978-1-907291-35-7 Printed and bound in Great Britain by Graphic and Printing Services, Heriot-Watt University, Edinburgh.

Acknowledgements
Academic Director of Edinburgh Business School, Heriot-Watt University, Alex Scott is an economist and has published over thirty research papers into efciency in education, efcient use of energy, energy and the environment and the cost to the taxpayer of government industrial aid programmes. He has written several textbooks and is a pioneer in developing and carrying out research into new educational techniques, particularly in the eld of economic and business simulations. Professor Scotts executive teaching includes running strategic planning sessions for groups of senior managers, widening the perspectives of functional managers, and teaching nancial specialists the principles of how economies function in todays highly complex and interdependent world. Among the companies for which he has run management programmes are American Express, British Rail, British Telecom, Cathay Pacic, Fiskars, Hewlett-Packard, National Health Service, ScottishPower, Scottish Widows, Swiss Bank Corporation.

Contents
1 Introduction to strategic management 1.1 Studying strategic management . . . . . . . . . . . . . . . . 1.2 The scope of strategic management . . . . . . . . . . . . . 1.3 Effectiveness of strategic management: the evidence . . . . 1.4 strategic management at corporate and business unit levels 1.5 The meaning of strategic management . . . . . . . . . . . . 1.6 Strategy as a process . . . . . . . . . . . . . . . . . . . . . 1.7 The role of the CEO . . . . . . . . . . . . . . . . . . . . . . 1.8 Principal agent problem . . . . . . . . . . . . . . . . . . . . 1.9 References . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Mission and objectives 2.1 Mission and objectives in the process 2.2 Vision and mission . . . . . . . . . . . 2.3 Setting objectives . . . . . . . . . . . . 2.4 Who sets objectives . . . . . . . . . . 2.5 Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 2 3 6 7 19 24 25 26 27 28 28 32 35 39 41 42 42 43 45 46 47 48 49 53 62 63 65 65 71 74 78 82 94 97 105 107 113 115

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3 Analysing the macro environment 3.1 The macro environment in the process . . . . . . . . . . . . . . . . 3.2 Dening the scope of the environment . . . . . . . . . . . . . . . . 3.3 Implications for company sales and revenues . . . . . . . . . . . . 3.4 The environment as a threat to costs . . . . . . . . . . . . . . . . . 3.5 Gaining competitive advantage by understanding the environment 3.6 Long term competitive effects of environmental changes . . . . . . 3.7 Macroeconomic environmental variables . . . . . . . . . . . . . . . 3.8 The international economy . . . . . . . . . . . . . . . . . . . . . . 3.9 Looking ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.10 Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Analysing the market environment 4.1 The market environment in the process . . 4.2 The market . . . . . . . . . . . . . . . . . . 4.3 Barriers to entry: structural and strategic . . 4.4 Market structures . . . . . . . . . . . . . . . 4.5 Competitive behaviour . . . . . . . . . . . . 4.6 Segmentation . . . . . . . . . . . . . . . . . 4.7 The life cycle . . . . . . . . . . . . . . . . . 4.8 Portfolio models . . . . . . . . . . . . . . . 4.9 Strategic groups . . . . . . . . . . . . . . . 4.10 The structural analysis of industries . . . . 4.11 Environmental threat and opportunity prole 4.12 References . . . . . . . . . . . . . . . . . .

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ii

CONTENTS

5 Analysing resources and strategic capability 5.1 Resource analysis in the process . . . . . . . . . . . . . . . . 5.2 Accounting ratios . . . . . . . . . . . . . . . . . . . . . . . . . 5.3 Financial structure . . . . . . . . . . . . . . . . . . . . . . . . 5.4 Break even analysis . . . . . . . . . . . . . . . . . . . . . . . 5.5 Pay Back period . . . . . . . . . . . . . . . . . . . . . . . . . 5.6 Net Present Value . . . . . . . . . . . . . . . . . . . . . . . . 5.7 Sensitivity analysis . . . . . . . . . . . . . . . . . . . . . . . . 5.8 Human resources . . . . . . . . . . . . . . . . . . . . . . . . . 5.9 Benchmarking . . . . . . . . . . . . . . . . . . . . . . . . . . 5.10 Economies of scale and the experience curve . . . . . . . . . 5.11 The scope of the company . . . . . . . . . . . . . . . . . . . . 5.12 Creating value from the production process . . . . . . . . . . 5.13 The denition of competitive advantage . . . . . . . . . . . . 5.14 Assessing strategic capability: the strategic advantage prole 5.15 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Culture and stakeholder expectations 6.1 Stakeholders in the process . . . . . . . . 6.2 Stakeholder interest . . . . . . . . . . . . 6.3 Stakeholder interests: the priorities . . . . 6.4 Stakeholder inuence . . . . . . . . . . . 6.5 Mapping shareholders and their inuence

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117 119 120 124 126 127 128 129 131 133 134 136 143 153 154 156 157 158 158 159 161 164 167 169 169 170 171 178 182 193 203 204 205 206 207 216 226 231 232 233 234 235 237 238 241 241

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7 Strategic options and strategic choice 7.1 Strategy choice in the process . . . . . . . . . . 7.2 The importance of structure . . . . . . . . . . . . 7.3 Strengths, weaknesses, opportunities and threats 7.4 Generic strategies . . . . . . . . . . . . . . . . . 7.5 Business level generic options . . . . . . . . . . 7.6 Identifying strategic options . . . . . . . . . . . . 7.7 Strategy choice . . . . . . . . . . . . . . . . . . . 7.8 Choice: is it rational? . . . . . . . . . . . . . . . . 7.9 Reference . . . . . . . . . . . . . . . . . . . . . . 8 Implementation 8.1 Strategy implementation in the process 8.2 Organisational structure . . . . . . . . . 8.3 Management of change . . . . . . . . . 8.4 Resource allocation . . . . . . . . . . . 8.5 Effective implementation is difcult . . . 8.6 Reference . . . . . . . . . . . . . . . . .

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9 Strategic Control 9.1 Strategy control in the process . . . . . . . . . . . . . . . . . . . . . 9.2 Degree of planning and type of control . . . . . . . . . . . . . . . . . 9.3 Feedback . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.4 Analysing the ongoing competitive position: using the process model 9.5 Finally . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Heriot-Watt University Strategic Management

CONTENTS

iii

Answers to questions and activities 1 Introduction to strategic management . . . . 2 Mission and objectives . . . . . . . . . . . . 3 Analysing the macro environment . . . . . . 4 Analysing the market environment . . . . . . 5 Analysing resources and strategic capability 6 Culture and stakeholder expectations . . . . 7 Strategic options and strategic choice . . . . 8 Implementation . . . . . . . . . . . . . . . . 9 Strategic Control . . . . . . . . . . . . . . . .

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242 242 245 250 254 262 273 276 280 282

Heriot-Watt University Strategic Management

Chapter 1

Introduction to strategic management


Contents
1.1 1.2 1.3 1.4 1.5 Studying strategic management . . . . . . . . . . . . . . . . . . . . . . . . The scope of strategic management . . . . . . . . . . . . . . . . . . . . . Effectiveness of strategic management: the evidence . . . . . . . . . . . . strategic management at corporate and business unit levels . . . . . . . . The meaning of strategic management . . . . . . . . . . . . . . . . . . . . 1.5.1 The history of strategic management . . . . . . . . . . . . . . . . 1.5.2 The planning approach . . . . . . . . . . . . . . . . . . . . . . . 1.5.3 Emergent Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . 1.5.4 Resource based strategy . . . . . . . . . . . . . . . . . . . . . . 1.5.5 Have we decided what strategic management is? . . . . . . . . . 1.6 1.7 1.8 1.9 Strategy as a process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The role of the CEO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Principal agent problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 2 3 6 7 8 13 15 17 18 19 24 25 26

Learning Objectives To understand the strategic management approach the main differences between corporate and business level strategy why there is a lack of empirical evidence on the effectiveness of strategy different approaches to strategy policy making strategy as a process

Chapter 1. Introduction to strategic management

1.1

Studying strategic management

Strategic management is a synthesis of ideas from many business disciplines and its emphasis is on understanding the operation of business in the real world. There are many exercises in the Module, and these serve several purposes: to give you practice in applying ideas, to demonstrate why they are important in real life applications, and to develop ideas through application in a way which is not possible through explanation. These exercises should be regarded as an integral part of the text and conceptual development. You will nd that some important points emerge in the discussion of the exercises rather than in the text, and therefore you ignore them at your peril.

1.2

The scope of strategic management

Strategic management is in many ways similar to economic policy, in that strategic management is concerned with running a company and economic policy is concerned with running the economy of a country. Anyone who has studied macroeconomics will have some understanding of the complexity of scal and monetary policy, and the many ideas and theories which are involved. However, although the scale of a company is very much less than that of a country such as the UK or Japan, the job is probably just as complex. That is why effective CEOs are as rare as effective Central Bank Governors; in fact, effective CEOs are typically paid much more than government ministers. The complexity of economic policy becomes apparent when an attempt is made to list the issues involved which includes growth of GNP, unemployment, ination, the budget balance, the role of markets, the trade balance, the rate of interest, the exchange rate, income redistribution, pollution, government expenditure and business investment; in fact, the list could be extended to ll this page. When we turn to strategic management it is not difcult to generate a list of equal length: protability, growth in sales, market share, relative costs, competitive position, pricing, environmental scanning, human resource management, accounting ratios, investment appraisal, shareholder value and dividend policy. The theories of microeconomics and macroeconomics are used to make sense of the relationships among the many variables involved in the economy and to provide an understanding of how economies operate; this provides the basis for interpreting government economic policy making. The objective of strategic management is to bring together business concepts and ideas in order to understand how companies (and other organisations) operate in a competitive environment, develop an understanding of the inter-relationships involved, and hence provide the basis for arriving at conclusions regarding why companies have succeeded or failed in the past and how they might operate successfully in the future. Put this way, strategic management emerges as an ambitious undertaking; for example, it is necessary to have some understanding of how people work effectively in companies (organisational behaviour and human resource management), how companies set about selling effectively in markets (marketing management), the competitive environment within which companies operate (economics), the meaning of accounting numbers (nancial and management accounting), the techniques used to identify the most protable investments (nancial appraisal), the implementation of plans taking account of time, quality and cost trade offs (project management); the ideas from these subjects need to be integrated to make sense of company histories and derive potential courses

Heriot-Watt University Strategic Management

1.3. Effectiveness of strategic management: the evidence

of action. This is clearly a complex task, and because of its complexity there are many ways of tackling it, and this is reected in the variety of names which relate to the eld of strategic management including corporate strategy, business strategy, corporate planning, business policy, strategic planning, long range planning and competitive strategy. Different authors have different preferences for their choice of name, usually based on their preferred denition of the boundaries of the subject. The term strategic management is used here precisely because it has no particular connotation and makes it possible to develop the various themes without having to worry about their relation to the denition. Incidentally, the word strategy is often used as a general term which includes strategic management and the names listed above; the rather looser term strategy will often be used in discussions. But there is one message which must be clear from the beginning: just as there is no one denition of what strategic management is about, there are no simple answers to strategic management issues. You are continually confronted with glib commentators and so called business experts on TV and in newspapers who attribute success or failure to a single factor, for example that Microsoft is a success because Bill Gates just happened to be in the right place at the right time, or the superstar Madonna is a success because she sings and dances better than anyone else. Neither of these assertions stands up to close examination: Microsoft has adapted to new technologies and to a rapidly changing competitive environment and has still maintained its lead, while there are plenty of performers who can sing and dance better than Madonna. So we must probe deeper to understand why it is that some organisations prosper while others fail.

Exercise 1.1
Madonna is an entertainment phenomenon: she is recognised world wide and has been the worlds highest paid female entertainer; but it is generally accepted that her singing does not compare well with a properly trained voice, her dancing does not appear to be signicantly better than the dancers in her chorus line, and her lms have not been particularly successful, suggesting that her acting is not of the highest calibre; she does not play a musical instrument. What things do you think she did do particularly well to generate success?

1.3

Effectiveness of strategic management: the evidence

Before embarking on the specics of strategic management it is necessary to face up to one somewhat unpalatable fact: there is no empirical evidence that the approaches which will be developed under this heading, nor indeed under any of the denitions, are statistically related to success. It is important to bear this in mind at all times, because we live in a world of great uncertainty and the claims of business experts, professors and gurus must all be taken with a pinch of salt. For example, one of the most famous attempts to identify the causes of success was the book In Search of Excellence1 published in 1982. Based on a survey of 43 companies the factors common to excellent companies were identied and, by implication, a prescription for success was developed. This included such ideas as stick to the knitting, i.e. keep to what you know, and the importance of liberal and friendly management practices. But within a Heriot-Watt University Strategic Management

Chapter 1. Introduction to strategic management

decade several of the excellent companies had fallen on hard times, and in particular IBM had by 1993 posted the largest losses in corporate history. This suggests that what might be a factor related to success at one time is not necessarily so at another; success and failure are the result of many factors, and it is misleading to look for a single answer to complex issues. The point of developing an overall strategic management framework is therefore not to develop prescriptions for success but to be able to assess individual factors in the wider context and arrive at some understanding of their combined impact. Those who have studied statistics might suggest that some indication of how effective strategic management is could be found by carrying out a survey of companies and comparing the performance of those which have used a particular strategic management approach and those which have not; this approximates to the classical test and control group approach in scientic studies. But there are a number of reasons why it is almost impossible to produce convincing statistical results by this approach. There are different views on what strategic management actually is; for example, many studies attempted to measure the impact of planning systems on company performance, but planning systems are only one aspect of strategic management. The types of company, the environments in which they operate, and the problems facing them, are so different that it is difcult to do more than draw general similarities among companies and situations. In other words, the range of variables which would have to be controlled for is enormous. There may be signicant interactions among variables; for example, economies of scale may only occur in certain circumstances, and the use of company size on its own as an indicator of potential economies of scale may be misleading. Another way of expressing this is that the company as a whole is more than the sum of its individual parts, and undue emphasis on disaggregating the functions and characteristics of a company can obscure the overall picture. Companies and their markets change with the passage of time and, combined with the inevitable lags between actions and outcomes, it becomes impossible to disentangle cause and effect. In other words, it cannot be inferred with certainty that a company succeeded either because it made the right decisions or because circumstances turned out to be favourable in relation to what it did. Research into strategy is dominated by the case study approach, which means that any prescription for best practice strategy can only be corroborated by reference to relatively few cases. A feature of the strategy literature is that it is heavily spiced with anecdotes, and evidence in favour of hypotheses comes in the form of what is sometimes known as casual empiricism. But if there is no scientic proof in favour of different courses of action, how is it that experts in strategy command very high fees for telling companies what they should be doing? In the past experts have offered different prescriptions for strategy approaches including that consistency of delivery is the key issue striving for higher quality is a major success factor in its own right diversication is an essential aspect of company growth Heriot-Watt University Strategic Management

1.3. Effectiveness of strategic management: the evidence

company success depends on the identication and exploitation of core competencies internationalisation is the engine of growth a strong home base is a prerequisite for international success. The scientically trained may nd it puzzling that so much credibility is attached to prescriptions which have no empirical foundation. On the other hand, managers point out that they have to operate in an environment in which the scientic approach cannot be applied, that the anecdotal approach is better than nothing, and it is necessary to use what we do know in order to introduce rationality into decision making. An attempt to determine whether strategy making processes rather than other company characteristics make a difference to company performance was carried out by Hall and Banbury 2 . This was a large scale study which obtained responses from over 300 companies, and it is interesting for the light which it sheds on the problems of carrying out research in the area rather than in the statistical ndings themselves (which are hedged with qualications because of the limitations of the study). The objective of the study was to concentrate on whether a strategy process was followed rather than on its content. What the authors considered important was the accumulation of strategy skills over time, or the development of a strategy making process capability; this is clearly a subjective variable and is open to interpretation based on the information provided by the respondents. They pointed out that the one variable which cannot be used as a performance measure is current protability, because of lagged effects; this means it is necessary to use measures such as new product development, innovation, social responsiveness and growth, all of may also be considered subjective and may be irrelevant in certain cases. By and large, it was found that strategic process capability counts: that the more rms in the study were able to develop competence in multiple modes of strategy making processes then the higher their performance. But the authors make a telling point which makes it impossible to draw specic lessons from the study: the direction of causation may be the other way round, and it may be that successful rms adopt processes which accord with the denitions of strategic process capability. This is a particular problem when looking at a cross section of companies at one time, where it is not possible to pursue the dynamics of strategy making and performance. So even a well specied and conducted study which produces statistically signicant ndings may contain little more than a description of the way the world is. At this stage you might say But if there is no empirical evidence that companies which adopt courses of action suggested by the study of strategic management do no better than others, what is the point of carrying on with this course?. This is exactly the same argument as saying that since economists are no better than anyone else at predicting the future of the economy then there is no point to studying economics. The real reason for studying economics is to attempt to understand the world better and the same applies to strategic management. If you try to run a company without the benet of ideas, concepts and theories you might as well act randomly; in fact, CEOs who do not have a formal business education (and may even claim to be proud of it) are implicitly applying rules derived from their experience. These rules may have worked in the past, but they are difcult to verbalise and their transferability from one situation to another is open to question. This is the important outcome of studying strategic management: it will enable you to look at any business issue using a common intellectual framework; it may Heriot-Watt University Strategic Management

Chapter 1. Introduction to strategic management

not generate the answers which will lead to success in the future, but you will at least have a pretty good idea of why things are as they are. This may seem to be special pleading to lend importance to a subject which is not deserving of it. For those of you who take that view, perhaps exposure to the subject matter itself will persuade you otherwise.

Exercise 1.2
If Madonnas success is related to the factors identied in dening Madonna as a business, why dont all singers use this approach and guarantee themselves success?

1.4

strategic management at corporate and business unit levels

Many of the terms used in this Module have a meaning which is not shared by other authors. For example, the term corporate strategy will be used to refer to the strategic concerns of the CEO, who could be in control of a small company employing ve people and producing one product, or a very large company employing many thousands of individuals and producing hundreds of different products; these concerns are differentiated from business strategy, which is concerned with the efcient operation of an identiable part of the company, normally referred to as a strategic business unit (SBU). Some authors use the term corporate strategy to refer to all aspects of company strategy at whatever level. There is no right or wrong here, but it is important to be aware of such differences when you read other sources. An SBU is normally thought of as being a division of a company, with its own internal structure which mirrors that of the parent company; the parent company devolves most responsibility to the chief executive of the SBU, who reports back to the centre in terms of overall SBU performance. However, the SBU can take a number of forms: it can be a grouping of business subsidiaries which have some common strategic elements such as similar competitors, closely related supply chain activities, similar type of product, contained within a geographical area and so on. The SBU is particularly important to diversied companies, because it provides a method of rationalising the organisation of many different types of business whereby resources can be aligned with individual market requirements. Thus the corporate concerns are with determining the scope of the company and resource allocation among SBUs, while the SBU concerns are with the exploitation of their particular markets.

Exercise 1.3
A decentralised gardening business might look something like the following:

Heriot-Watt University Strategic Management

1.5. The meaning of strategic management

The SBUs deal with garden machinery, selling plants from a number of market gardens, and constructing garden buildings such as sheds, gazebos and conservatories. The sales turnover of SBU1: SBU2: SBU3 is 3: 2: 1. The SBU1 manager has suggested that the salaries of the three SBU managers should also be in the ratio 3: 2: 1. This proposal has not met with the approval of everyone. Set out a discussion on this between the CEO, the two corporate services ofcers and the three SBU managers showing why they agree or disagree with the proposal.

1.5

The meaning of strategic management

Many of the terms listed under the broad heading of strategic management contain the term strategy. This is clearly a key element of strategic management so it is important to develop a clear idea of what it means at the outset. However, there is more to this than simply setting out a denition which can be used in practice. Commonly encountered denitions include the following 1. Knowing where you are going and how you are going to get there 2. Setting clear objectives and mobilising resources to achieve them 3. Thinking in the long rather than the short term 4. Working out how to do better in the market place than your competitors 5. Deriving and selecting a course of action There are some common threads running through these denitions, but individually they could lead to different courses of action. For example, denition 2 focuses on objectives, but makes no difference between short term and long term as in denition 3; denition 4 is the only one explicitly concerned with markets. It is natural to conclude that one way of resolving this confusion is to refer to the academic literature on the topic to see what business theoreticians have to say on the matter. But the literature itself does not provide an unambiguous denition. Since the early 1950s, when business schools began to examine the factors which are associated with company failure and success, there has been an ongoing debate about what is meant by strategy. It is useful at this Heriot-Watt University Strategic Management

Chapter 1. Introduction to strategic management

stage to consider the main themes of this discussion before setting out how strategy is dened and utilised in this Module. The idea of strategy was originally developed in a military context and extends back at least as far as 360 B.C. to Sun Tzus The Art of Strategy. The very word strategy comes from the Greek strategio meaning a general, stratos meaning an army, and agein meaning to lead. Broadly speaking, military strategy deals with objectives, understanding the military environment, deploying resources and implementing tactics. There is some doubt as to how far the concepts of military strategy can be transferred to business, and partly this is due to the difference between the objectives in war, which are to destroy the enemy, and the objectives in business, which are largely to sell effectively in markets. There is a signicant difference between attempting to destroy an enemys resources and operating in a market in competition with other sellers. However, there are similarities in the military and business situations, in that both armies and businesses need objectives, both need to have an understanding of their environments, both have resources and have to implement courses of action. From these ideas, and from the development of business in the 20th century, various approaches to business strategy have developed. It is important to stress from the outset that strategy problems cannot be analysed and resolved and then more or less forgotten about. In real life the day never comes when strategy decisions are made and all problems are solved. This is because the environment within which the company competes is constantly changing: products move through the life cycle; new companies enter the market; consumer preferences change; government regulations change; major political events alter markets both domestically and internationally. The functional view of management, i.e. the view that there is a set number of objectives to be tackled by individual managers which, taken together, determine the effectiveness of the company, is a limited interpretation of the strategy problems which companies face; in the real world there is no such thing as a set number of objectives relating to a future time period. Strategy can only be properly understood in a dynamic rather than a static setting. To some extent different views on strategy are dependent on how it is felt that dynamics ought to be taken into account.

1.5.1

The history of strategic management

During the course of the 20th century the business environment has changed in several ways, and at the same time strategic ideas have developed; one of the intriguing aspects of these developments is that strategic ideas appear to have developed as a means of describing what has happened as business changed, and these ideas have then been used as the basis for prescribing how companies should behave. For example, as companies grew in the 1950s and became increasingly difcult to manage from the centre, the notion of decentralising control to divisional level developed, and this was associated with the development of control techniques such as nancial budgeting and investment appraisal. In subsequent decades attention focused on diversication, portfolio management, the search for competence and so on. An outline of the main developments and the associated ideas is contained in Table 1.1, which is roughly based on the decades since the 1950s and draws on the work of Goold, Campbell and Alexander3 . This classication is very approximate, but it shows how the development of the business environment and strategic ideas were closely connected. The terms used in Table 1.1 have become part of the language of strategy, and

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discussions typically use terms such as portfolio, diversication and synergy in a sense which is particular to the subject, and often such discussions give the impression that strategy is a discipline which has a well developed theory and approach. But it is important to appreciate that these ideas developed by observing the reactions of companies to changing circumstances after the event; while the analysis of company operations is based on the application of these ideas, they were rarely applied explicitly at the time by CEOs. The ideas behind the terms in Table 1.1 will be developed in later chapters, but a brief review of the historical background will help to put the ideas in perspective. Table 1.1: Historical development of strategic management

1950s After about the mid 1930s companies such as GM, Du Pont and Standard Oil had grown too large and complex to be managed with their previous functional organisation. The decentralisation of activities into divisions which characterised the 1950s highlighted the distinction between business and corporate strategy: the divisions were responsible for exploiting their markets, while the corporate centre was responsible for nancial control and resource allocation among the different elements of the corporation. This was the beginning of the process of disaggregating companies into SBUs. Many of the ideas of corporate nance were developed and applied on an increasing scale, including the notions of discounting, investment appraisal and capital budgeting. 1960s By the 1960s the established markets of many large companies had ceased to grow, and opportunities for company growth were now perceived to lie in diversication of activities. This built on the established divisionalisation, and new companies were brought under the corporate umbrella as additional divisions. A compelling argument during this period was that the assimilation of different, but related, businesses under the corporate umbrella would lead to synergy. The quest for synergy provided a powerful rationale for diversication through acquisition, because it offered the promise of creating value beyond that which the business would have were it left on its own. Synergy in fact turned out to be elusive, but this ought not to have been surprising because the potential Heriot-Watt University Strategic Management

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benets were based more on hope than on evidence. It was not appreciated at the time that the quest for synergy often led to value destruction rather than value creation, and this sowed the seeds for later corporate strategies based on the perceived weakness of many diversied companies. It was about this time that the role of the manager with transferable skills began to be recognised, because the management of diversity could not be accomplished by specialists. It is not surprising that this is the period when business schools began to identify what these general management skills were comprised of and to teach them to practising managers. 1970s During the 1970s there were several major changes in economic and competitive conditions. National growth rates fell, and there was a period of great instability as world energy prices soared and the balance of economic power shifted for a time to the OPEC countries. At the same time that competitive pressures increased with advances in technology trade barriers were reduced and the Pacic rim economies grew enormously. It became widely recognised that the company environment was much more complex and unpredictable than in the 1960s. In addition, the management of diversity as pursued in the 1960s was increasingly recognised as a problem, and the search for a balanced portfolio of products led to the development of the portfolio approach to product management. 1980s The inability of many companies to manage and add value to diverse portfolios led to take-overs by corporate raiders who saw opportunities for releasing value from failed corporate diversications. This development was largely conned to the US and the UK partly because of their more developed capital markets and the independence of corporations from banks. The scale of the take-over strategy was staggering: in the US in 1988 over 2000 companies were acquired with a total market value of over $850 billion. The take-over battles made the specialists into household names: Goldsmith, Milken, Kravis and Boesky in the US, Hanson and White in the UK. The search for value creation focused on cash ows and led to the development of techniques known as value based planning, which include discounted cash ows and net present values. It was during this time that Peters and Waterman published In Search of Excellence, (mentioned at 1.4) which pointed out that one of the success factors of excellent companies lay in identifying what they were good at and avoiding diversifying out of their area of competence. This led to concern over the activities of professional managers who knew little about the businesses they were running other than the nancial outcomes. Early 1990s As it became increasingly apparent that diversication of itself had not led to signicant increases in value in many cases, attention turned to how the company itself created value and competitive advantage, i.e. the resource based view of the company. There are several strands to this. First, it was argued that the company could diversify, but such moves had to be based on companies in strategically similar industries which would share a dominant general management logic. This abstracted from the type of industry and product, and focused on the way managers conceptualised the industry and how

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they made important decisions. The problem with this approach is that it is difcult to dene what the dominant management logic is actually comprised of, and it is not very helpful to take the view that you will know it when you see it. A second strand is to identify the competencies which the company possesses and which are the basis for non-imitable competitive advantage; this led to the notion of core competence. This was of particular importance at a time when companies were involved in downsizing and rationalisation, because it was important that the company realised what it was downsizing back to; on the other hand, a company which was considering expansion through diversication could think in terms of the competences it was bringing to the new business that were common to those which already provided the basis for competitive advantage. Both these notions led to the idea of linked portfolios rather than the balanced portfolios of an earlier time. However, the degree to which the components of the portfolio were linked was not always clear, nor was the basis on which the linkages were based. A third strand was to argue that a conglomerate had the potential to bring certain advantages to the individual businesses which was unrelated to synergy, economies of scale: the parenting advantage. Broadly speaking, there are four areas in which parenting advantage might be generated, but as discussed below there is no guarantee that any advantage will result. Stand-alone inuence: while the individual SBU is encouraged to act independently to meet its goals as set by the parent, there is actually a major problem in deciding how far the parenting inuence ought to extend. The parenting activities include agreeing and monitoring performance targets, approving major capital expenditures and selecting business unit managing directors; the parenting inuence may extend to product-market strategies, pricing and human resource management. But it can be argued that the more the parent extends its inuence into the affairs of the individual businesses, the more likely it is that it will destroy value; why should a parent manager working part time do better than a business manager working full time? Linkage inuence: a major role which the parent should undertake is to encourage relationships among SBUs to capitalise on synergy. But in the absence of a parent, if companies are not in competition their managers would be free to establish linkages by alliances, joint ventures and informal agreements without parental involvement; so it is an open question as to why the parent should do any better than managers acting in their own self-interest. Functional and services inuence: the parent can provide functional services whose cost can be spread across the SBUs. But this creates a degree of vertical integration whereby the supplier is insulated from outside competition; it is difcult to guarantee that internal suppliers will be as efcient as the market. Corporate development activities: the main role of the parent is usually seen as buying and selling businesses, creating new businesses, and redening businesses. This amounts to changing the businesses in the corporate portfolio. But since the weight of research indicates that the majority of corporately sponsored acquisitions, new ventures and business redenitions fail to create value, the odds against success are long; there is thus no particular benet to the individual SBU of being part of the conglomerate for this reason. Heriot-Watt University Strategic Management

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A fourth strand was to tie in these ideas with analysis of the value chain, which came to be viewed as a series of activities linked together in such a way that it capitalised on the competences of the company. Underlying all this was a serious attempt to come to grips with the determinants of competitive advantage, and it became apparent that in a rapidly changing competitive environment it was very difcult to identify these components of competitive advantage and capitalise on them.

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Late 1990s As trade barriers continued to fall, through the work of the World Trade Organisation and the formation of trading blocks such as the European Union, and capital markets transcended national frontiers, companies increasingly found themselves competing in an international market place. Companies in many industries began to fear that nationally based operations would stand little chance against powerful multi nationals. Thus the late 1990s witnessed huge international mergers in industries such as nancial institutions, telecommunications, energy supply, car production and pharmaceuticals. While the arguments in favour of mega mergers are clearly persuasive enough to provide companies with the incentive to embark on these ventures, it is an open question whether the outcome in the longer term will be viable, value generating operations. There is no guarantee that scale economies will be realised, nor is there any guarantee that size will confer a real competitive advantage in servicing distinctive local markets for goods and services. Early 2000s It has always been difcult to build sustainable competitive advantage because eventually anything can be imitated. In an environment of fast technological change companies started to realise that part of their advantage lay in the knowledge and unique skills of their experienced employees. It became a priority to identify and classify knowledge so that it could be maintained and disseminated as required. But it soon became apparent that the really important bits of knowledge were extremely difcult to identify because they resided within specic individuals and were largely learned on the job; this became known as tacit knowledge. This presented organisations with a real problem: competitive advantage and innovation depend on a resource that cannot readily be identied or controlled. Techniques of knowledge management began to be developed to tackle these imponderables but progress has been slow. This description of strategic ideas and the circumstances in which they developed does not really tell us much about how companies arrived at particular courses of action. For example, did the CEO of a large company announce one day We shall now pursue a policy of decentralisation and divisionalisation or It is now time for us to embark on a series of acquisitions? It is not only necessary to understand what was done and why, but it is just as important to understand how companies make such decisions in real life. Thus this turns out to be surprisingly difcult to do, and there are several schools of thought on how strategy is arrived at. These can be grouped into three broad approaches: planning, emergent and resource based.

1.5.2

The planning approach

This approach is based on the notion that once a set of objectives has been determined, the business environment analysed and forecasts made, a plan can be worked out by senior management which is then passed down for implementation; this plan is then adhered to over the planning time scale. This is usually thought of as the strategic planning approach, and it has been claimed by its supporters that this prescriptive form of strategy is rational and objective; but as Mintzberg 4 and many others have pointed out, it makes a number of assumptions about the world which are highly questionable. The future can be predicted accurately enough to make rational discussion and choice realistic. It is in fact a widespread fallacy that the future can be predicted Heriot-Watt University Strategic Management

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with any realistic degree of accuracy. At the macro level economists disagree quite markedly on the economic prospects for any given country during the course of the next year; such forecasts can never take into account unforeseeable events such as the Asian economic crisis in 1997 or the collapse of the Russian nancial system in 1998. At the micro level market innovations and the actions of competitors can have fundamental effects which are also impossible to predict, such as the introduction of telephone insurance selling in the UK in the early 1990s. One reason that such market changes are impossible to predict is that that they are dependent on the unique vision of individuals; if such unique vision did not exist there would be virtually no scope for competitive action in the rst place. It is possible to detach strategy formulation from everyday management. In arriving at a strategy it is necessary to have a full set of data which can be subjected to analysis and from which conclusions can be drawn. But this assumes that there is some technique whereby the relevant information is extracted from the organisation, and from individual managers, and presented to strategy makers in a tidy bundle. This dodges the question of who is to decide on which information is relevant, and indeed whether the information is readily available. Furthermore, as events unfold information is continually evolving and can go out of date very quickly. It is possible and better to forego short-term benet in order to obtain long-term good. In a situation of uncertainty, and lack of knowledge about the future because of the difculties of forecasting mentioned above, it may often appear preferable to reap short-term benets; it is also extremely difcult to convince those who lose in the short term that the trade-off is worthwhile. The strategies proposed are logical and capable of being managed in the way proposed. Any strategic initiative which involves change is dependent on company personnel adapting and working in alignment with company objectives. Change management is one of the most problematical areas of strategy implementation, and it can not be taken for granted. Time and again it is found in practice that prescriptive actions simply do not take the human dimension adequately into account. The Chief Executive has the knowledge and power to choose among options. He does not need to persuade anyone, nor compromise his decisions. This takes a naive view about leadership and how it is exercised. In reality, very few business leaders can behave like dictators, and certainly not for very long. It is necessary to achieve consensus and agreement at all levels of the organisation, otherwise a prescriptive plan simply cannot be made to work. After careful analysis, strategy decisions can be clearly specied, summarised and presented; they do not require further development, nor do they need to be altered because circumstances outside the company have changed. This is perhaps one of the greatest and most potent fallacies: it is never possible to avoid ambiguity completely, and it is potentially lethal to ignore changing competitive circumstances. One of the most important reasons for company failure is the lack of a feedback mechanism and the channels of communication that make it possible for decision makers to adapt to changing circumstances.

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Implementation is a separate and distinctive phase that only comes after a strategy has been agreed; for example, a strategy to close a factory merely requires a management decision and then it just happens. This is possibly a reection of the fact that the implementation stage of strategy has always received much less attention than the more glamorous and exciting areas of objective setting and strategy choice. In reality nothing just happens, and an essential part of strategy making is to evaluate the feasibility of different courses of action. It may well be desirable, on nancial grounds, to close a factory, but the actual process of achieving this may have widespread and damaging effects on the company as a whole. During the early 1960s the notion of prescriptive planning was quite popular and many corporations set up corporate strategic planning departments. However, experience has revealed that the attempt to drive corporate strategy in this restrictive fashion is unproductive. A major problem arises when individuals become committed to the strategic plan itself, and not to the success of the company; this can occur when performance measures have been expressed in nancial terms, and the pursuit of favourable nancial reports takes precedence.

1.5.3

Emergent Strategy

This approach starts from a different premise: that people are not totally rational and logical. The extent of this irrationality has been the subject of research, and the general ndings accord with common sense. Managers can only handle a relatively small number of options. Managers are biased in their interpretation of data - in fact any data set can be interpreted in a number of legitimate ways, and it is not surprising that managers often select the interpretation which backs up their previously determined views. Managers are likely to seek a satisfactory solution rather than maximise prots. Organisations consist of coalitions of interest groups. The implementation of decisions depends on negotiation and compromise between those groups, leading to unpredictable outcomes. When making decisions, managers pay as much attention to a companys culture and politics as to factors such as resource availability and external factors. Thus, far from strategy being planned before the event, it emerges over time in an unpredictable manner. The strategy emerges from a chaotic environment and hence may appear to have little structure as a result; it is therefore argued that the claim of a cause and effect relationship between analysis and strategy choice and implementation is fundamentally awed. There is another very good reason why there is a limited use of information in decision making: the world is actually too complex to be understood by the human brain. Rationality has to be seen in the context of what is possible in the real world, rather than what might be done in an ideal world. The term used to describe rationality when it is impossible to take into account the complexity of real life is bounded rationality; Heriot-Watt University Strategic Management

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the decision maker is rational given the information at his or her disposal, but is quite aware that more information is likely to be available. In economics it is argued that broadly speaking decision makers act in accordance with prot maximisation, but it is impossible to reconcile prot maximisation with bounded rationality. This means that a different view of decision making has to be taken and the term satiscing was invented to reect the fact that decision makers collect information and defer selecting a course of action until the costs of further delay and information collection are considered to be greater than the potential benets of searching out a better option. Thus rather than simply attempting to maximise prot, the decision maker satises himself or herself that there is nothing more to be gained from further delay. This helps to explain why decision makers are so eager to nd out what management gurus have said and are continually searching for ways of making sense of the real world. To decision makers any information is better than no information, and it does not matter very much to them that the information they are acting on does not accord with accepted views of what is proper scientic enquiry. Another way of looking at this is to make up a list of things which the company does not know with any certainty when about to launch a new product; for example How customers will perceive quality How far it will be possible to meet production cost targets How competitors will react When a substitute will appear on the market The impact on sales of a one year delay in launch It is certainly possible to collect some information on such issues, but it will not be complete and is likely to be unreliable. In fact, it turns out that you can not actually get hold of the really important information and it is always necessary to make assumptions and to take many things on trust. However, it can be argued that just because the world is a complex and changing place does not mean that decision makers should simply sit back and let things happen and that there is still a role for the proactive approach. While there are bound to be adjustments to corporate objectives as time goes on, the company can still be directed along the general lines of a broad mission. The Board needs to do more than simply react to changing circumstances. There is a need for efcient resource allocation; if this is not tackled resources might as well be allocated randomly. While compromises need to be made with interest groups within the organisation, this is more of a constraint than a barrier to action. Decisions still have to be taken, and it is nonsense to avoid this simply because people are difcult to manage. In many cases investments take a considerable time to reach fruition, therefore a degree of long term planning is inevitable. Satiscing is in itself a rational basis for choice, since it is better to make an Heriot-Watt University Strategic Management

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informed judgement on the basis of some information than no information at all, or to ignore information altogether. The act of attempting to plan at least makes the basis for management action clear. Therefore there is some middle ground between trying to plan for all eventualities and simply reacting to events as they occur.

1.5.4

Resource based strategy

This approach lays emphasis on the internal resources available to the company. While it does not overlook the importance of the competitive environment, it starts from the basic premise that strategy is primarily concerned with the search for competitive advantage, and to a large extent the source of competitive advantage rests within the companys resources. The resource based view does not focus so much on the actual labour and capital deployed by the company, but rather on the way in which these resources are utilised. A successful company is not a passive collection of resources which reacts to changes in the competitive environment, but develops the ability to take advantage of opportunities as they arise, and to create the opportunities themselves by innovative behaviour. The resource based approach uses various terms for different types of resources. Without going into detail at this stage it is important to distinguish among them. Resources include physical resources, human resources, nancial resources and intellectual resources. Competences arise from the continual deployment and integration of resources over time and across activities. Core competences are necessary for successful performance. Distinctive capabilities are competences superior to competitors. Taken together these can be regarded as the companys strategic capabilities. The role of strategic capabilities in creating sustainable competitive advantage depends on several characteristics, including the following. Rarity: some resources and competences are so scarce that only a few rms have access to them. This raises the question of how companies acquire such resources and competences when they are rare; they would clearly command a high price on the open market. Complexity: competences are nurtured from many linkages among resources and activities that are mostly impossible to identify and replicate. Causal ambiguity: because of the difculty of attributing cause and effect the causes of superior performance are unclear, even to company insiders. Culture: competences may be embedded in the organizational culture and cannot be replicated outside the context of the particular company. A major problem with the resource based approach is that it shrouds success in mystery. It would appear that competences are so rare and difcult to imitate that sustainable competitive advantage is unique to every company that possesses it. The question that then arises is how sustainable competitive advantage arises in the rst place. It may Heriot-Watt University Strategic Management

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be the case that successful companies are not necessarily there because anyone has superior insight in organisational design or strategic t. Instead there are typically many views in the company regarding the capabilities a particular activity requires and it is the market, rather than the visionary executive, that selects the most effective match. It can be argued that strategic capabilities are established by market forces rather than being designed. The implication is that, by denition, there is nothing to be gained from analysing successful (or unsuccessful) companies. That is not the view taken in this course; there are, of course, many things that cannot be fully explained. But there is a great deal that can be explained by the application of appropriate strategic concepts and tools.

1.5.5

Have we decided what strategic management is?

First it is necessary to tidy up the terminology. Strategy relates to many aspects of life, including war, playing games and business. strategic management is the application of strategy to business, and in the rest of this Module the two terms will be used interchangeably. There is little doubt what strategic management is about: it is the running of an organisation effectively, however effectively may be dened. But if you go back to the commonly encountered denitions, you will see that they are in fact no more confused about what strategy is than the scholars who have considered the issue in depth. The fact is that there are a number of ways of approaching strategy and none of them provides a full answer which is operationally useful in all circumstances.

Exercise 1.4
The following discussion took place among a senior management team in response to the prospect of reduced prots for the current operating year. CEO: I dont think our prot problem is simply due to external events such as the recent problems with the economy. It seems to me that it is more to do with the way we do things - I am not certain that we are acting as efciently as we could be. Operations manager: we have actually invested heavily in more productive assets and in training programmes in the last two years. I am not sure there is much more we can do in that respect. Marketing manager: I dont think we exploited the market opportunities for our new range of products as well as we could have done. When we didnt capture market share early on last year we should have channelled a lot more resources into the marketing effort. We cant take market conditions as given. Finance director: but we had already decided how to bring these products to the market and we had no spare resources. CEO: yes, we put a lot of effort into the plan, and it was a great disappointment when it didnt work out. Maybe we need to spend even more time planning in the future. Marketing manager: what is the point of planning in ever more detail when we cant seem to react to the unexpected?

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Operations manager: that is a defeatist attitude. We just dont spend enough time collecting and analysing information. Human resources manager: youre all right in your analysis and youre all wrong about what we should do. As with most taped conversations, even after heavy editing it does not seem to make much sense at rst sight. In particular, the human resources manager did not appear to contribute anything. Your job is to interpret what was said in terms of the three strategic approaches.

1.6

Strategy as a process

It should be clear from the preceding discussions that strategic management, or strategy, is a complicated subject. If you think of strategy as being a problem to solve, say for a particular company, it does not take long to realise that it is incredibly complex; one way of thinking about complexity is to categorise problems as tame or wicked in the sense used by Rittel5 . In this scheme, wicked means much more than incredibly complex. For example, consider Fermats Last Theorem; in about 1637 the mathematician Fermat noted that he had a proof for the proposition that there were no three numbers which would t the expression xn + yn = zn where n 2

The trouble was that he claimed not to have sufcient room in the margin to elaborate the proof. The search for the proof occupied many mathematicians for the next three hundred years, and it was not until 1993 that Andrew Wiles, after many years of effort, found the solution using highly rened and abstract mathematical concepts. There is no doubt that Fermats Last Theorem is an incredibly complex problem, but consider it in the light of Rittels distinction between tame and wicked characterised in Table 1.2. Table 1.2: Tame and Wicked problems

Is Fermats Last Theorem a tame or wicked problem? If you study Table 1.2 you will see

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that it falls into the Tame category on every criterion. Now consider the discussion of strategy so far, and see where it falls. 1. It is difcult to formulate the problem 2. The process of formulating and understanding the problem goes a long way towards solving it 3. The scientic approach cannot be used to test solutions 4. It is not clear where the problem ends because of real world dynamics 5. There are many techniques which can be applied, and no agreement on which is most effective in which circumstances 6. The cause is usually not clear, and symptoms are often confused with problems 7. Companies operating in the real world are far away from the laboratory 8. Each business problem is unique, although it may share common features with other situations The fact that strategy has many of the characteristics of a wicked problem probably helps account for the fact that there are several different ways of approaching strategy, and that strategic ideas have evolved over a number of years. This then poses an intellectual dilemma: which approach to strategy should be selected and why? The answer to this is none of them. Instead, strategy will be dealt with as a process, which makes it possible to incorporate all different approaches and ideas as variations on the process itself. At rst this idea might seem a little perplexing, so it is necessary to start by clarifying what is meant by a process. The simplest way of thinking about this is to consider a typical business situation where the production department has not produced enough units to satisfy demand, i.e. the marketing department has sold more than the company can make. At a management meeting in AcmeGrow the following discussion took place. CEO: As a result of our production shortfalls we have a lot of unsatised customers, and I reckon that this year our turnover could have been $10 million greater than otherwise. So I want to nd out what went wrong. Production Manager: We were taken completely by surprise when an additional 25 per cent orders came in. We were not carrying much inventory, so I put everyone on overtime. But this caused increased machine breakdowns, which cost a small fortune in maintenance, and we only managed to increase output by 15 per cent. CEO: Why were you working so close to capacity with no slack in the system? Production Manager: Because you and the nance department decided we should reduce costs by introducing a Just in Time system. Finance Manager: When the JIT system was introduced you didnt tell us that you were likely to be faced with such variations in demand. Production Manager: Talk to the Marketing Manager about that. Marketing Manager: My job is to sell, not worry about productive capacity. Anyway, I warned the nance department that we were launching a new marketing campaign but Heriot-Watt University Strategic Management

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no-one seemed interested. I must admit that the campaign was far more successful than I had thought it might be. CEO: Lets x this problem. We cut costs and became more efcient on the one hand, but this has ended up costing us far more in lost sales and additional maintenance. We have to make sure that this doesnt happen again. We need to implement a less rigorous JIT system and carry more inventories. The CEO has certainly identied a solution to the particular problem which confronted AcmeGrow. But you need to stop here and think about what has really happened. Before proceeding leave the text and write down what you would say to the managers about this problem as an external consultant. In trying to assess what has really happened the rst step is to decide whether the JIT system, which the CEO identied as the cause of the problem, is really the sickness or merely a symptom. Does the JIT x guarantee a solution to other potential problems, such as the entry of a new competitor, the emergence of substitutes, a price war, the loss of key personnel, to name but a few? It is likely that the CEOs solution will have little impact on the outcome of these events, and they could cause disruption and losses on a similar or greater scale than the current issue. Therefore, what has really happened is that AcmeGrow is unable to respond to events before they happen, or to take account of events as they unfold. For example, the implications of the new marketing campaign should have been discussed at the outset; at that stage decisions about productive capacity and the JIT system could have been made. But there is no process in the company to ensure that this happened. Instead, we have a group of task orientated managers who do not perceive the operation of the company beyond the bounds of their own immediate responsibility; the fact that the nance department did not respond to the marketing manager at an early stage shows that while communication can take place, it does not do so in a way which leads to relevant action. Thus the real solution is for the CEO to set up a process by which managers consider the full implications of changes on the overall operation of the company. This would provide a solution to the immediate problem, but would also result in a framework within which a range of unforeseeable events could be handled. For example, in the event of a price war the marketing manager can provide an assessment of how much price cutting is required to maintain market share, and for how long; this enables the nance manager to assess the impact on company cash ows and viability; at the same time the production manager can assess whether there are short term cost savings which can be made in the identied time scale. The precise details of the solutions arrived at are not really the issue: the point is that none of this would happen in the absence of a management process which enables the management team to work together. This simple example highlights the importance of the process as opposed to the task. At the strategic level the focus is often on the task, and questions such as, Have we selected the appropriate strategy? Are we implementing effectively? are frequently addressed. In particular circumstances these questions have to be answered, but from the wider viewpoint the real issue is whether these questions are being asked in the context of a process which will ensure that they will be addressed and answered at the appropriate time whatever else is happening. The notion of a strategy process is in fact quite simple and is set out in Figure 1.1; once you have seen it, it accords with common sense. The examples refer to the case above.

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Figure 1.1: The strategy process model Setting objectives Unless there is some direction to a companys actions they may as well be random.

Example The objective of AcmeGrow is to make prots, which is why so much concern was expressed over the loss of sales and the increase in costs. If the objective had been to keep sales constant, the marketing manager would not have launched the new campaign.

Analysis It is necessary to know as much as possible about the external and internal environments. It is impossible to make logical decisions in the absence of relevant information, and one of the great challenges is to identify what information (from the vast amount available) is relevant and to use that information to draw conclusions.

Example The marketing manager seemed to have little idea of the impact of the marketing campaign, nor indeed if the increase in sales was due to that factor alone; it may have been due to an increase in the market demand that was independent of the actions of the company. There was little understanding of how susceptible AcmeGrows resource structure was to unanticipated changes. Thus the company had little strategic understanding of its external or internal environment.

Strategy choice The course of action selected must be consistent with the analysis and diagnosis stage.

Example On the one hand AcmeGrow was expanding, by undertaking a marketing campaign to increase sales; on the other hand it had organised its resources internally in a manner consistent with stable sales. Both sets of actions were consistent with the overall aim of protability, i.e. to increase sales and reduce costs, but the strategic choice did not align resources with marketing. Heriot-Watt University Strategic Management

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Implementation It is necessary to set up an appropriate organisational structure, allocate resources efciently and manage the process of change.

Example AcmeGrow had introduced a JIT system in the pursuit of higher prots. Where it failed was in the management of the change itself. Each manager was concerned only with his own area of responsibility and no attempt had been made to ensure that the workforce supported the new system.

Control It is necessary to track whether the chosen strategy does actually happen.

Example In AcmeGrow it was only after the full scale of the disaster became apparent that management met to remedy the situation. An early warning system would have alerted the team that things were starting to go wrong at an early stage.

Feedback Strategy is dynamic. This is one of the most fundamental issues in strategy, but it is often disregarded because of the preoccupation with the search for strategic options and the difculties of implementation and control. The point needs to be hammered home at the outset: there are no complete answers to strategy problems because the world keeps on changing. The ve steps above are in a rough order which corresponds to common sense, but feedback occurs all the time and the loop must be continually revisited.

Example The management team meeting illustrates slow feedback, where it is realised that the implementation and control stage needs to be revised, i.e. reconsider the JIT system. There is also feedback into the analysis and diagnosis stage, i.e. the marketing manager clearly needs to gather more information about markets and have a clearer idea of what marketing actions are likely to be successful.

Even at this early stage the power of the process approach becomes apparent. It provides an overview of strategy which is impossible to achieve by considering individual aspects of company problems. In the example it was identied that the real problem confronting the company was the lack of a management process; the precise details of how this process would operate is up to the CEO. In the strategy case we identify an overall process which is not prescriptive but is a model of reality. Thus very quickly Heriot-Watt University Strategic Management

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we arrive at the conclusion that the goal of prot maximisation was not translated into coherent actions as a result of sound analysis and diagnosis, while implementation is weak and there is a lack of effective feedback. Looked at this way, how long can this company be expected to survive if it is defective in so many dimensions of the process? This application of the process model does not enter into analytical detail. The next step is to build a set of powerful tools which will enable us to tackle the various components of the process model in a structured fashion. Each of the chapters deals with a part of the process model, culminating in a full integration of the underlying ideas within the process structure.

1.7

The role of the CEO

The denition of strategy as a process provides insights into the role of the CEO. People often wonder why CEOs are paid so much and what it is that makes them special. The answer to this is that the job of the CEO is to manage the strategy process and few individuals possess the attributes to perform this role effectively. Referring back to strategy as process it emerges that the CEO must be able to perform the following roles. Strategist, entrepreneur and goal setter. The CEO must be able to make decisions about potential investments, react to changing circumstances, identify new courses of action and provide leadership for the organization as a whole. Analyser and competitor. The CEO needs to be constantly aware of changes in the economic environment, the efciency of the rm, and its competitive position. The process of information collection and analysis is time consuming, and it is necessary for the CEO to lter out what is unimportant and focus on factors which are likely to impact signicantly on the rm. Strategy choice maker. Options must be identied and different points of view taken into account in order to assess the costs and benets associated with each. Implementer and controller. Once decisions have been taken the CEO has a major role to play in making them happen. As well as allocating resources, the CEO has to set up systems to monitor how effectively resources are being utilized and whether strategic goals are being achieved. Communicator. As new information becomes available and competitive conditions change the CEO has to ensure that everyone is kept aware of changes in direction as far as possible. There is more to the CEOs role than handling complexity, there is also a degree of conict inherent in the different roles. For example, the CEO needs to set up systems which ensure resources are used efciently; but these very systems may introduce inexibility and resistance to the changes which the CEO considers necessary in the role of competitor. The objectives and mission of the rm may be expressed in general and non-measurable terms, while the control systems tend to be based on nancial measurements; the two approaches may be difcult to reconcile. Thus as well as being charged with the task of resolving conicts of interest in the company, the CEO must Heriot-Watt University Strategic Management

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also deal with the internal conicts caused by the roles which he or she is required to adopt.

1.8

Principal agent problem

A central problem of management is the need for the principal to establish a contract with an agent or agents that ensures the principals objectives are met. The underlying problem is one of asymmetric information: it is not possible for the principal to monitor all aspects of the agents performance. The individual agent has an incentive to conceal the fact that objectives have not been achieved, and will possibly attempt to ascribe an unsuccessful outcome to other factors, such as supply problems lying outside the agents control. It is therefore extremely difcult to arrive at an efcient contract because of the complexity of aligning the objectives of the agent with those of the principal. For example, the personal objectives of an individual manager may include maximisation of wealth, ambition, desire for a quiet life, desire to avoid confrontation, and so on. There is no guarantee that the manager will place the companys objectives high in this personal set of priorities. The problem extends to the contract between the CEO and shareholders; the CEO may have a remuneration package which includes a bonus for growth in current prots; to ensure that current prots continue to grow the CEO may reduce expenditure on R&D, which has the effect of increasing current prot at the expense of long term competitiveness. The misallocation of resources can be compounded by involving accountants and other specialists in attempting to nd out what has gone wrong, while the problem really lies with the contract and incentive system. An example of the difculty of ensuring that the agent acts in the interests of the principal emerges when one company mounts a take-over bid for another. This always has the effect of initially increasing the share price of the target company. If the managers running the company had acted in the best interests of the shareholders then this could not happen, because they would have run the company efciently and exploited opportunities, all of which would have been reected in the current share price. In these circumstances it would appear that the outsider actually knows more about the company than the incumbent management, and has spotted opportunities for increasing shareholder wealth which these managers have not. The trouble is that there is no effective mechanism by which shareholders can ensure that their managers act efciently; this is because the ownership of the company is spread among many shareholders while the running of the company is concentrated in the hands of relatively few senior managers and board members. An example of the lack of control on the part of shareholders occurred in the UK in the years following the privatisation of huge nationalised industries including gas and water utilities. In all cases the existing management received enormous increases in remuneration, and the argument that it was necessary to pay such large salaries in order to attract the best talent appeared spurious to most shareholders because they had been in the job prior to privatisation. In the case of British Gas this coincided with a high degree of dissatisfaction with the provision of gas as measured by the number of ofcial complaints received by the gas regulator, and one British Gas Annual General Meeting was attended by a pig by the name of Cedric (the unfortunate CEO of British Gas was called Cedric Brown) brought by a group of dissatised small shareholders. In

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the event it proved impossible for the small shareholders to censure the management board because the large institutional investors supported the existing management. The privatised Water Companies caused similar dissatisfaction; for example, the people of Yorkshire (one of the rainiest areas in Europe) had to suffer restricted supplies because of water shortages at a time when management freely admitted that about one third of all water was being lost through leaks in the pipes. Once more it proved impossible for the small shareholders to oust what they perceived as incompetent and greedy top management. No position is taken here on whether the top management of these organisations were in fact greedy and incompetent; the point is that a signicant minority of shareholders felt that they were but were unable to do anything about it. So in addition to the roles of the CEO that can be identied in the strategy process in the previous section the CEO has to deal with the principal agent problem at all levels of the organisation. Every manager who has subordinates has to deal with the principal agent problem and the resulting conicts of interest.

Exercise 1.5
Use the process model to discuss 1. the reasons advanced by Mintzberg and others that prescriptive planning is impossible 2. emergent strategy 3. the case study approach to strategic analysis (with reference to the AcmeGrow discussion).

1.9

References

1. Peters, T.J. and Waterman, R.H. (1982) In Search of Excellence, Harper & Row. 2. Hall, S. and Banbury, C. (1994) How strategy making processes can make a difference, Strategic Management Journal, Vol. 15, pp. 251-63. 3. Goold, M., Campbell, A. and Alexander, M. (1994) Corporate Level Strategy: Creating Value in the Multi-Business Company, New York: John Wiley & Sons Ltd. 4. Mintzberg, H. (1994) The Rise and Fall of Strategic Planning, New York: Free Press. 5. Rittel, H. (1972) On the planning crisis: systems analysis of the rst and second generations, Bedriftsokonomen No 8, pp. 390-396.

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Chapter 2

Mission and objectives


Contents
2.1 2.2 Mission and objectives in the process . . . . . . . . . . . . . . . . . . . . Vision and mission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.1 Understanding the business . . . . . . . . . . . . . . . . . . . . . 2.2.2 Deriving the mission statement . . . . . . . . . . . . . . . . . . . 2.2.3 Disaggregating the mission . . . . . . . . . . . . . . . . . . . . . 2.3 Setting objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.1 Strategic objectives . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.2 Financial objectives . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.3 Priority and conict . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.4 Characteristics of objectives . . . . . . . . . . . . . . . . . . . . . 2.4 Who sets objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4.1 Who is the strategist . . . . . . . . . . . . . . . . . . . . . . . . . 2.4.2 Characteristics of strategists . . . . . . . . . . . . . . . . . . . . 2.4.3 Company evolution and strategists . . . . . . . . . . . . . . . . . 2.5 Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 28 28 30 31 32 32 33 33 34 35 36 37 38 39

Learning Objectives To understand the connection between the mission and the scope of the company To be able to translate a mission statement into a set of objectives To understand the importance of objective setting at all levels of the organisation To appreciate the role of the strategy maker in determining the broad thrust of the company

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2.1

Mission and objectives in the process


Setting objectives

Vision Mission Objectives Strategists Feedback

Analysis Strategy choice Implementation Control

2.2

Vision and mission

It might seem obvious to state that the senior executives in a company need to have a clear idea of which business the company is in and the way in which it is going to pursue protability in that business. One of the roles of the CEO is to develop a vision within which the resources of the company can be mobilised. In general terms this is usually thought of in terms of setting out a mission statement which serves as a denition of the company which is clearly understood by employees and provides a focus for their activities. However, this is difcult to observe in practice and the process of identifying the business and expressing the companys approach in a mission statement is full of pitfalls.

2.2.1

Understanding the business

The reaction of many managers to the question What business are you in? is often incredulity that such an obvious question needs to be asked. When pressed, the response might take the form Its obvious - we make soft drinks. A few supplementary questions will reveal that this response is not just inadequate, but it can lead the company into serious errors. Do you control all stages of production or do you purchase all ingredients and merely mix and bottle? Do you control distribution and marketing channels? Are you competing in the soft drinks or beverage market? Is your drink a stand alone or is it also intended as a mixer? The rst question relates to the productive scope of the company, i.e. the extent to which it buys in its inputs and hence how it perceives its own supply chain. For example, Heriot-Watt University Strategic Management

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a soft drinks company which makes its own bottles has a whole series of concerns which are absent from a company which buys its bottles from a bottle making company. In particular, it has to be concerned with the efciency of its own bottle making plant, rather than relying on the forces of the market to enable it to purchase bottles at the lowest cost. The scope of the company also impacts on the skill set the company needs to develop, and has an effect on how the company focuses its resources. For example, the company which buys in bottles needs a negotiator who can work out deals with bottle manufacturers which generate a competitive price and a guarantee of supplies; the company which makes its own bottles needs to recruit individuals with productive expertise in this function. These are clearly quite different skill sets. The second question relates to the market positioning of the product; for example, the company may produce soft drinks for own brand supermarket products, and have little need for marketing the product in its own right. This is of fundamental importance for company expansion, because the own brand producer can only expand if its customers grow or by nding more large customers to supply, while the company which markets directly to consumers can increase its sales by marketing more aggressively. The third question relates to the breadth and focus of the business denition; for example, soft drinks are sold alongside alcoholic drinks in restaurants and public houses, and could be promoted as an alternative to alcoholic drinks. Or it might be possible to present the soft drink as an alternative to coffee, which contains caffeine and is a mild stimulant. Or it might be possible to present the drink as an aid to athletic performance. The fourth question relates to the different markets which might be targeted; for example, tonic water is relatively rarely consumed on its own and is usually mixed with gin. It is unlikely that tonic water could be aimed at both this market and the health market. Taken together, answers to these questions can identify companies of totally different types: A one stage producer which bottles the product and sells it on to supermarkets. An integrated producer which projects the brand image of a healthy drink which has an appeal to sports orientated consumers. There are many examples of how a clear denition of the business can change the company focus. For example, a travel agent can focus on business travel or holidays, and these are two quite distinct segments of the travel market. Furthermore, many travel agents who focus on holidays consider that they are in the business of selling holidays. But if they regard themselves as in the entertainment business and the holiday as an entertainment package the business can focus on selling any entertainment which people have to travel for. The rst step, then, in arriving at a vision for the company and its future is to understand properly what business the company is in. Unless this is clearly dened the company vision is likely to be meaningless at best, and misleading at worst.

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Exercise 2.1
Set out the skill sets relevant to travel agents specialising in business and holidays. Do you think it would be easy for an experienced business travel agent to move to a holiday company? Here are three different denitions of the business of a specialist security company which produce a different business focus. Providing bodyguards for VIPs Protection against electronic invasion of computer systems Screening individuals applying for high level appointments What are the main skills which you would associate with each?

2.2.2

Deriving the mission statement

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

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Exercise 2.2
The public body responsible for the health services of a city of approximately 5 million inhabitants produced the following mission statement: To provide the best possible standards of care for the sick and inrm, and to generate a high level of awareness of health issues with the emphasis on prevention rather than cure. Rewrite this mission statement in an operational fashion, and justify your version.

2.2.3

Disaggregating the mission

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

Exercise 2.3
You are in charge of an international courier business which has two divisions: 1. fast and secure delivery of sensitive company information 2. guaranteed overnight delivery of anything as long as the origin and destination are both within a given country. Set out the objectives for the marketing and operation functions in each division.

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2.3

Setting objectives

Once the general vision of the company has been established, and the mission identied, it is necessary to determine what has to be achieved for the mission to be successful. While the mission can be expressed in general terms, it is necessary to state the objectives in terms of specic performance targets; in the absence of such identiable targets the mission can have little operational signicance and will probably be acknowledged but largely ignored by managers at all levels. Objective setting introduces accountability into the business of pursuing the company vision, so it is not productive to use vague terms such as increase market share or increase the return on assets employed. Before turning to the denition of specic objectives, it is useful to differentiate between two types of objective: strategic objectives, which are related to the generation of competitive advantage, and nancial objectives, which are mainly concerned with prot maximisation.

2.3.1

Strategic objectives

The pursuit of competitive advantage involves many choices and actions and at this stage it is not possible to do more than identify the type of objective which comes under this heading; the specic rationale is not discussed, for example, the objective to increase market share by 10 per cent would be based on considerations of economies of scale, price leadership, barriers to entry, product life cycle and various other factors, all of which are discussed later. The point about the following list is that it is possible to quantify each, at least in rough terms, to serve as a specic objective for managers. Some strategic objectives: Increase market share by 10 per cent Reduce unit cost to 5 per cent less than that of major competitors Develop a strong reputation for reliability by reducing defect rates to 1 per cent Develop the image of a technological leader by launching at least two new products each year Expand internationally by exporting 20 per cent of output Some of these objectives are aligned with a mission which is a statement of where the company would like to be, although no target time scale is provided. For example, increasing market share by 10 per cent is aligned with a mission statement concerned with developing the company into a market leader, rather than with a mission concerned with maintaining the companys current success. Thus the strategic objectives must be aligned with the mission, be measurable and be perceived as attainable by the managers charged with achieving them. It should now be apparent that for the mission statement and strategic objective setting process to be useful it needs to be performed in a step down fashion. Dene the business Derive the mission statement Disaggregate the mission to individual functional departments Heriot-Watt University Strategic Management

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Set measurable and achievable strategic objectives Each of these steps requires an increasing degree of familiarity with the company, its markets and its competitors. It is therefore a mistake to regard the objective setting process as isolated from the other elements of the strategy process; by considering objective setting on its own, its role in clarifying what the company is about and the role of managers within the overall vision, becomes clear.

2.3.2

Financial objectives

It can be strongly argued that all objectives are subordinate to prot maximisation, or shareholder wealth maximisation, which comes to much the same thing. Unless the company makes a rate of return which is capable of attracting investment it has no reason to exist. However, the notions of prot maximisation and shareholder wealth maximisation are not unambiguous; for example, the time period over which prot is to be maximised will depend on factors such as the product life cycle and risks. Although prot maximisation cannot be dened unambiguously, there are various aspects of nancial performance which are stepping stones to prot maximisation and some of these are listed below. Again the precise rationale for each is not explored. Some nancial objectives Increase share price by 15 per cent Reduce gearing ratio from 65 per cent to 40 per cent Increase the return on capital (ROI) from 8 per cent to 12 per cent Increase net cash ow from $5 million per year to $10 million per year As in the case of strategic objectives, these are measurable but have not been as tightly dened as they might be, for example no time scales are given within which each must be achieved. But what is important is that once more the nancial objectives must be aligned with strategic objectives and with the overall company mission. For example, the mission might be to become market leader, and this translates into an objective to increase market share by 10 per cent; this would be aligned with a nancial objective of increasing the share price by 15 per cent over a period of two years, accepting that the share price may remain static or may even fall as expenses are incurred in the early stages of attempting to increase market share.

2.3.3

Priority and conict

Managers often worry about whether nancial objectives should take priority over strategic objectives. While there is no absolute right or wrong answer to this issue, an undue focus on one or other of the two types of objectives can have important consequences. For example, the company might be pursuing the strategic objective of attaining the reputation of highest quality and most reliable producer in the industry. This is aligned with the achievement of the nancial objective of increasing ROI by 5 per cent. However, after a year of pursuing the strategic objective it may well be found that the ROI has decreased by 1 per cent; if the focus changes to deal with the short term reduction in ROI, the strategic objective might well be abandoned. At any given time Heriot-Watt University Strategic Management

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Chapter 2. Mission and objectives

there is likely to be a conict among different objectives, primarily because some relate to the short run (such as maintaining an adequate cash ow) and others to the long run (such as achieving market leadership). It is therefore essential to recognise that trade-offs have to be made which take into account factors such as the time scales involved in achieving the different types of objective. Some objectives cannot be achieved within a short term period, and an undue focus on short term nancial measures can lead to a reactive approach which is inconsistent with achieving longer term strategic objectives which are aligned with the company vision.

2.3.4

Characteristics of objectives

While a great deal of care may have been devoted to the denition of objectives and their alignment with the company mission, it is still possible to end up with a set of objectives which employees feel has little to do with their own roles in the company. The following are some characteristics of objectives which are a necessary, although not sufcient, conditions to ensure that they are seen as operationally valid. Related to employees: the language in which an objective is phrased must be in terms that are readily understood and have some meaning in the context within which people work. For example, the objective of increasing market share can mean different things to different people: the share of market volume sales, the share of total market revenues, the share of a particular segment and so on. The objective therefore needs to be spelled out in some detail otherwise it will appear to be vague and irrelevant. Credible: employees have to believe that the objective is achievable, otherwise it will likely be disregarded. In practice, there is little to be gained from setting objectives which are clearly impossible. This is different from setting challenging objectives (sometimes known as stretch objectives), where employees can recognise that their achievement will involve signicant effort and perhaps change, but that they are not outside the realms of possibility. Achievable: this is related to credibility, but it is quite possible for management to set objectives which are credible but which are known to be beyond the capabilities of the organisation. Not only is this pointless, but when the objectives are found to be non-achievable there are potentially important implications for morale, and the willingness to accept objectives in the future. Disaggregated: it is necessary to establish objectives at all levels in the organisation which are aligned with the overall objective and mission, and which make sense to the individuals whose job it is to achieve them. For example, the following shows how an overall strategic objective can be cascaded into a series of nancial, business, sales and production objectives.

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Level Strategic Financial SBU Sales Production

Objective Achieve market leadership Increase turnover by 25 per cent Increase market shares Penetrate new market segments Increase productivity

It is not uncommon for employees to feel disaffected by the objectives which have been set for them, and for management to misunderstand that this is not because the objectives are non-aligned with the business vision but that they are unrelated to the perception of employees.

Exercise 2.4
The following objectives have been set out for a vehicle accessory company which has branches in ve major cities. Over the next three years we intend to increase market share in each city by 5 per cent, to increase our net cash ow to 15 per cent of assets, and to reduce our borrowing in order to remove the burden of interest payments. As a consultant you are asked to comment on the objectives before their release, and assess whether they will add signicantly to performance.

2.4

Who sets objectives

In principle, within a company there exists a strategy maker, or team of strategy makers, who identify the company mission, translate it into objectives, and then ensure that these objectives are disaggregated and disseminated to managers who are responsible for implementing them. However, the process view of strategy lays stress on the fact that there is continual feedback from employees and the environment, and that hence the notion that objectives are set at some point in time and are then treated as permanent is far from the truth. Objectives may well be the outcome of a long period of trial and error and may be based on extensive consultations with employees at various levels. This approach amalgamates the rationalist view that objective setting is undertaken in a totally logical fashion with the emergent view that objectives are derived from the experience of the company over time. Individuals, not companies, make decisions, but the decisions taken by individuals are constrained by the organisation and its traditions. The relative importance of individuals versus organisations has always been a topic of debate; the emphasis varies among companies depending on their age, the personalities of individual managers and many other factors. An important outcome of the Peters and Waterman research into company excellence was that a strong leader, who made the company excellent in the rst place, was a recurring factor in almost every case. In fact, you will observe in everyday life that one of the rst things which companies do when they encounter severe problems is Heriot-Watt University Strategic Management

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to change the leader. There is no doubt that the leader can set the style for the whole organisation. Perhaps the most extreme cases occur in sports management where unsuccessful teams typically react by ring the manager. The success of the Asda chain of superstores in the UK between 1992 and 1996, when the Asda share price grew at twice the rate of the stock exchange index, was largely attributed to Archie Norman; during his ve years he not only changed the company culture and rescued it from collapse, but also fought a wider battle against price xing and had a signicant effect on competition in the retail industry. When Norman decided to become chairman in 1996, with the avowed intention of ultimately going into politics, the market took fright and articles appeared in the nancial press which revealed that many commentators felt that the future success of the company was dependent on Norman and very little else. In the event his successor, Allan Leighton, was equally successful and Asda went from strength to strength after Normans departure. As a politician Norman subsequently had no impact whatsoever. Asda was acquired by Wal-Mart in 1999 for 6.7 billion and has since maintained its position as one of the leading retailers in the UK. We know from everyday experience that different individuals have different objectives, view the same information in different ways, and often act differently depending on the decision making environment. Those who sit on boards or committees often feel that decisions arrived at would have been different had the decisions been taken by any individual member of the group. Thus the setting of the companys objectives may appear to be arbitrary to the extent that it is dependent on who is involved at the time.

2.4.1

Who is the strategist

To some extent the question of who sets objectives and who determines the strategy is the same thing. It is often difcult to identify the ultimate strategic planner in companies which have developed beyond the stage of owner-manager control. The functions carried out by managers are complex and are continuously changing. While managers tend to feel that they understand their own function, there is relatively little systematic information available on how managers actually spend their time. Some research has been carried out into managerial styles and approaches; but it is extremely difcult to carry out research in this area because it is necessary to observe what managers actually do on the job. Because of the labour intensive nature of the research, it is virtually impossible to generate information on a large sample and the information produced has to be interpreted by the observer as events occur, resulting in a high degree of subjectivity. While the research has produced some information about what managers actually do, it has been unable to identify causal relationships between behaviour and outcomes. In general terms, it has not been possible to identify which characteristics contribute in what degree to being a good manager in real life; in particular, very little has been found out about what comprises an effective strategic planner. Examples of the difculty involved in identifying the characteristics of an effective strategic planner can be seen in the books written by successful managers. The accounts are typically idiosyncratic and it is virtually impossible to identify the key characteristics which contributed to success rather than to failure. This is partly because few professional managers are trained in the scientic approach, and this is compounded by the fact that their accounts are at least partially concerned with portraying themselves in a favourable light.

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Most research ndings conclude that there is a signicant difference between what general managers actually do and what theory suggests that they ought to do. For example, when seeking out information, theorists suggest that the general manager should think in terms of obtaining data which will enable thorough organisational and environmental analysis to be carried out, which in turn will assist the manager in arriving at effective strategies. However, research suggests that general managers prefer verbal sources and that they avoid documented information; their approach is impressionistic rather than detailed. Added to this is the widely known fact, which does not require research to verify it, that there are signicant differences in management style: some general managers are naturally reective while others tend to be doers. There is therefore no particular reason to expect that observed management behaviour will be identical for different individuals; what is not known is whether such variation has an impact on effectiveness. The observer-based research has not uncovered signicant connections between management style and effectiveness. Since the activities of managers cannot be readily classied and tted into a model of behaviour, the precise role of different managers in the strategic planning process is not subject to hard and fast rules. The roles which managers play depend on many factors unique to the individual company; for example, in companies with a rigid hierarchical structure the process may be concentrated on one person, such as the managing director. For many managers the identity of the strategic planner in their own company is obscure and many may not be able to identify any one person with responsibility for the function. Strategic planning can be regarded as a multidimensional role which is undertaken by many individuals working at different levels. For example, there are corporate level strategists, typically the Board of Directors and the CEO; below these are the SBU strategists who comprise executives, planning departments and consultants. In some cases the pinnacle of the strategic planning process is occupied by the CEO who sits at the top of the decision making process. Control of the strategic planning process can thus rest in the hands of different people. This does not mean that the process itself cannot be identied and analysed, but it does suggest that companies should give some thought to how the function is undertaken in their organisations. If no one is very sure about who is carrying out the strategic planning function, it could well be that the process itself could be greatly improved.

2.4.2

Characteristics of strategists

The approach to strategy is partly dependent on the characteristics of the decision maker; where decisions are made by a number of individuals, for example in a board of directors, it is the overall or dominant characteristic of the group which is important. The following characteristics provide insights into how decision makers are likely to behave in different circumstances1 : Prospector Analyser Defender Reactor

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The Prospector is primarily concerned with the identication of new market opportunities, and issues relating to internal organisation take second place. The Analyser is characterised by sophisticated internal information systems and detailed investigation of options, but this is unlikely to be followed up by the type of action undertaken by the Prospector. The Defender is concerned with maintaining the current market position without exhibiting a great deal of initiative in developing new market opportunities. Finally, the Reactor simply deals with circumstances as they arise. These dominant characteristics may be relevant only to a specic period and will obviously change as managers are replaced. They may also be determined by market conditions; for example, a Prospector may be forced to become a Defender in the face of unexpectedly erce competition. The classication is not prescriptive, in the sense of recommending that a company should strive to change from one classication to another in order to improve performance, but does help understand how the company has reached the position it is in and the type of strategy which might win general support. For example, there is little prospect of support for an aggressive approach to new markets in a company dominated by Defenders. At the corporate level the dominant characteristic of the chief executive can be a fundamental determinant of the course which the company will take. For example, Lord King of British Airways was a prospector who saw a future for a defunct airline; his successors had the characteristics of analysers and defenders and have had difculty realising Lord Kings vision. Corporate raiders such as Goldsmith and Hanson were prospectors of a different type, in that their vision of opportunities lay in identifying the failures of other managers.

Exercise 2.5
Use the process model developed in Chapter 1 to 1. map out the roles of general management 2. identify conicts in the role.

2.4.3

Company evolution and strategists

The typical company is continuously evolving so the roles undertaken by decision makers are to some extent dependent on the stage of the companys evolution, which can be classied in three stages: the small single-product company, the integrated company and the large diversied company. Only a very small minority of companies actually evolve in the sense that they end up as large diversied companies. However, the classication makes it possible to characterise the role of the strategy maker as follows: Small or Entrepreneurial Single-product company with little formal structure controlled by the owner-manager. Integrated Single product-line company with a degree of vertical integration and specialised functional organisation. The owner-manager still retains control over strategic decisions, but most operating decisions are delegated through policy. Diversied Multi-product company with formalised managerial systems which are evaluated by objective criteria such as return on investment. Product and market Heriot-Watt University Strategic Management

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decisions are delegated to the heads of SBUs. In smaller companies the individual owner plays a dominant role in determining strategy, but in the larger, diversied company it may be difcult to identify strategists. The latter is the type of company in which ownership and control tend to be separated, with managers answerable to shareholders rather than to individual owners. In fact, many aspects of the companys operations depend on the stage of evolution of the company. For example, the ability of a company to undertake radical innovation varies from the small entrepreneurial company which is constantly evolving to the large diversied company facing the problem of how to stimulate innovative activity within the companys structure. When a company reaches a certain size there is a tendency for bureaucratic procedures to become dominant, with the result that a signicant proportion of resources is devoted to maintaining the status quo, and innovation is seen as a costly and disruptive form of behaviour.

Exercise 2.6
Use the process model to map out the general strategic approach of companies at the three levels of evolution. Bear in mind that the elements of the process model will be dealt with in considerable detail in later chapters, so your answer can only be general at this stage.

2.5

Reference

1. Miles, R.E. and Snow, C.C. (1978) Organisational Strategy, Structure and Process, McGraw-Hill.

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Chapter 3

Analysing the macro environment


Contents
3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 The macro environment in the process . . . . . . . . . . . . . . . . . . . . Dening the scope of the environment . . . . . . . . . . . . . . . . . . . . Implications for company sales and revenues . . . . . . . . . . . . . . . . The environment as a threat to costs . . . . . . . . . . . . . . . . . . . . . Gaining competitive advantage by understanding the environment . . . . Long term competitive effects of environmental changes . . . . . . . . . . Macroeconomic environmental variables . . . . . . . . . . . . . . . . . . . The international economy . . . . . . . . . . . . . . . . . . . . . . . . . . 3.8.1 Exchange rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.8.2 Think global act local . . . . . . . . . . . . . . . . . . . . . . . . . 3.8.3 The competitive advantage of nations . . . . . . . . . . . . . . . 3.9 Looking ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.9.1 Forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.9.2 PEST Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.9.3 Environmental scanning . . . . . . . . . . . . . . . . . . . . . . . 3.9.4 Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.10 Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 42 43 45 46 47 48 49 49 51 51 53 53 56 58 59 62

Learning Objectives To understand how the economy wide environment affects company operations To understand how competitive forces are affected by economy wide events To develop frameworks incorporating environmental threats and opportunities To understand how a companys competitive advantage can be affected by its national setting To develop approaches to broad economic inuences which can be used as a basis for company responses

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3.1

The macro environment in the process

3.2

Dening the scope of the environment

The term environment has been increasingly used in recent years as referring to physical surroundings, which include the air, water, sea, trees, farmland etc; the protection of the environment is now high on the political agenda, with measures being taken to reduce the level of carbon dioxide in the atmosphere in the hope of avoiding global warming, to reduce CSFs in order to save the ozone layer because it is essential for life, and so on. The term environment has become so emotive that it is difcult to use it in any other context; however, in the business sense the environment refers to all those external factors which may have an impact on the operation of the organisation. These factors vary from the most general such as the East Asia economic crisis, the behaviour of the US and Japanese economies and the introduction of the common Euro currency in Europe, to changes at the industry level and competitive conditions in local markets. The problem is that there are so many variables and factors in the world which might affect the operation of the company that it is virtually impossible to track them all and relate them to the company. Think of the quantity of information you could encounter in one day contained in the Financial Times, the Wall Street Journal, Business Week and the Economist; then there are specialist reports on individual countries and industries available from various sources, stockbroker reports and so on. It is impossible even to read everything published, never mind subject it to analysis. Many managers feel that attempting to understand the environment outside the industry is counter productive because it simply creates information overload. However, the impact of overall environmental factors on the operation of individual companies can be so signicant that it is essential at least to make explicit what decision makers think is going to happen in that environment. The companys strategy can then be determined within the constraints of the overall environment, and serious mistakes, such as mounting a major expansion just when all the indications are that the economy is entering a recession, can be avoided. The fact that the environment is almost impossible to understand fully and to predict with any degree of certainty is not a valid argument for ignoring it; what is important is that company decisions are aligned with whatever Heriot-Watt University Strategic Management

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changes decision makers think are likely to occur. A useful starting point is with the economic ideas of macroeconomics and microeconomics. Macroeconomics deals with the state of the global and national economies. At the global level it is concerned with exchange rates, trade ows, relative growth rates of different countries and business cycles. At the country level it deals with growth in Gross National Product, and variables such as unemployment rates, interest rates, ination rates and government scal and monetary policy. It could be argued that a company or organisation is so insignicant in comparison to the global economy, or to the economy of a country, that macroeconomic changes are only marginally related to company performance. But this can be completely mistaken because changes in the economy, whether at the global or national level, can have direct consequences for the industry in which a company operates and on the company itself. There are three main reasons for analysing and attempting to understand the economy as a component of strategic analysis. It is necessary to distinguish between events and inuences which are outside the control of the company and those which are the results of its own decisions. For example, if sales revenue unexpectedly declines, it is essential to determine whether this has been caused by a downturn in total demand in the economy rather than being the result of an inadequate marketing response to strategic moves by competitors. It is important to be aware of changes in the economy which may present opportunities or pose threats. For example, economic conditions and government policies likely to lead to a rise in interest rates could pose a threat to to consumer durables companies whose sales are largely funded through hire purchase, such as TVs and videos. In the UK there was a house price boom in the early 2000s that led to much discussion regarding whether the interest rate was too low; while it was impossible to predict when interest rates might increase there was certainly a high probability that this would occur, so consumer durables companies should have had contingency plans to cater for this event. An understanding of how the economy operates makes it possible to interpret predictions. It is impossible to switch on a current affairs programme on TV without being confronted by an expert giving an opinion on the prospects for the economy or for particular industries, and these can often appear to be contradictory. But it is very difcult for a person not acquainted with macroeconomic principles to judge whether predictions are based on personal opinion or sensible analysis.

3.3

Implications for company sales and revenues

The impact of changes in economic activity on the sales of a product depends on the responsiveness of the demand for that product to changes in GNP. For example, the demand for potatoes is not likely to be affected by changes in GNP as much as the demand for hi- sets. The degree of responsiveness is known as GNP elasticity, and a product is elastic with respect to GNP when a 1 per cent change in GNP leads to a greater than 1 per cent change in the demand for the product; it is inelastic when a 1 Heriot-Watt University Strategic Management

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per cent change in GNP leads to a less than 1 per cent change in demand. While it is impossible to estimate GNP elasticity with accuracy, a rough idea of the magnitude is still useful. In fact managers are likely to have a general idea of how responsive industry sales are to changes in economic conditions; you dont need to sell either potatoes or hi- sets to realise that the difference in the elasticities is quite signicant; for example, the GNP elasticity for hi- sets might be 1.5, i.e. a 1 per cent change in GNP would result in a 1.5 per cent change in the demand for the product, while that for potatoes might be zero. It would be folly to assume that the elasticity of demand for hi- sets was the same as for potatoes. To show this explicitly, take the case where, due to a world-wide recession, GNP for the country is expected to fall by 4 per cent next year, and the company currently has 15 per cent market share of the hi- market. The GNP elasticity is 1.5, and the following shows the difference between assuming GNP elasticity to be zero rather than 1.5. The calculation is based on the fact each 1 per cent reduction in GNP leads to a 1.5 per cent reduction in market size, thus a 4 per cent reduction in GNP leads to a 6 per cent reduction in market size. Table 3.1: Revenue and GNP elasticity GNP elasticity 0.0 1.5 1.5 Total market 1000 940 940 Market share 15 15 16 Total sales 150 141 150 -6.0 0 % change

If GNP elasticity were assumed to be zero when it is actually 1.5, sales would turn out to be 6 per cent lower than expected. By taking a realistic view of the likely elasticity the company could decide on the response to adopt in the face of a declining total market: for example, a strategy designed to maintain sales volume would involve attempting to increase market share from 15 per cent to 16 per cent. The GNP elasticity does not tell the whole story about the connection between GNP and demand for a product. It is not only the size of GNP which is important, but also the distribution of national expenditure among its components. For example, a reduction in income tax, which leads to an increase in disposable incomes and hence to consumption expenditure, may be accompanied by a reduction in government expenditure due to the end of the Cold War, the net effect of which is to leave GNP unchanged. Consequently, those industries which rely on government expenditure on defence, such as the electronics industry, may nd market size reduced, while those in consumer goods industries, such as TV sets, may nd market size increased. At the same time, the government may have increased the rate of interest, which would affect the demand for investment goods. It is therefore possible for individual sectors of the economy to have a falling market size despite a relatively high level of growth in the economy as a whole. Again, these are factors which management ignores at its peril.

Exercise 3.1
In the example shown in Table 3.1 it was predicted that GNP was expected to fall by 6 per cent. Instead of this, imagine that GNP is expected to grow next year by 5 per cent due to expansionist scal and monetary policies. What would be the impact be on total sales if market share 1 remained at 15 per cent. 2 increased to 16 per cent. What Heriot-Watt University Strategic Management

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conclusion would you draw for marketing strategy if the economy were growing?

3.4

The environment as a threat to costs

Input prices are likely to vary with the level of economic activity; wage rates in particular have a tendency to increase when the unemployment rate is low, but not to decrease when the unemployment rate is high. Consider a company which has anticipated a 10 per cent increase in demand due to GNP growth; it intends to respond by increasing purchase of inputs by 10 per cent. There are two views in the company on what will happen to input prices: 1. They will all be unchanged. 2. They will all increase by 5 per cent. The implications of the two scenarios for total cost are as follows: Table 3.2: Cost scenarios

In Scenario 2, the actual increase in total cost is 16 per cent rather than the 10 per cent which would be expected if factor prices were unchanged, because of marginal increases in the prices of inputs. Since it is unlikely that signicant changes in GNP will occur without changes in the prices of inputs, it would be naive to ignore these potential price changes. Calculations of the viability and cash ow implications of increasing sales by 10 per cent in this case could be totally misleading if no attention is paid to the likely impact of wider economic inuences. It must be recognised that the impact of a change in GNP is not conned to the sales and revenue side, and it may well turn out that anticipated increases in cost may cancel out the potential revenue benets of a marketing strategy designed to take advantage of an increased market size caused by an increase in GNP. From the cash ow point of view at least it is important to be aware of macroeconomic impacts.

Exercise 3.2
Using the information in Table 3.2, assume that Labour and Materials prices will increase by 15 per cent, and the price of Capital by 10 per cent. What would be the impact on total cost compared with the base case? What implication does this have for net cash ow?

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3.5

Gaining competitive advantage by understanding the environment

Having identied the various relationships between change in GNP, demand for the product and the likely consequences for the company, attention can then be turned to how competitors will behave in the light of the changing circumstances. If competitors have not carried out an analysis of GNP trends and have little understanding of GNP elasticities, the company may have an advantage by being the rst to take defensive action in the face of a potentially decreasing market, or by being the rst to take the initiative to take advantage of a predicted increase in market size. However, if competitors do have the same kind of information at their disposal, will they not react in the same way as our company? For example, in the declining market case shown above, competitors may attempt to protect their sales by reducing price in order to increase market share. Since it is impossible for all companies to increase market share, some company is bound to suffer as a result. It seems likely that the outcome would be a general reduction in the price of the product. Consider what happens to the company which had not attempted to make predictions and found itself in a declining market in which competitors are acting aggressively in order to protect their total sales volume. The company would then have a falling market share in a declining market with a decreasing competitive price. The combined effect of these inuences could be extremely serious for revenues despite the fact that the reductions in total market, market share and price were relatively small individually. This can be illustrated as follows: Table 3.3: Volatile revenues Period 1 2 Total market 100 95 Market share (%) 20 18 Price 10 9 Total revenue 200 154 -23 % change

It is assumed that the company simply follows general price changes rather than being proactive, so that in Period 2, despite the fact that the total market fell by only 5 per cent, market share by 2 per cent and price by 10 per cent, the cumulative effect on total revenue was a reduction of 23 per cent. Thus a set of changes in market and competitive conditions originating in a reduction in GNP could have signicant implications for cash ow and protability. Companies which consider that the state of the economy has only a marginal impact on their performance and their strategy may well be living in a fools paradise.

Exercise 3.3
Imagine that the situation depicted by Table 3.3 has happened to your company, and as marketing manager you predict that next year total market will fall by a further 5 per cent, that market share will decline by another 3 per cent, and that price will fall from 9 to 8. 1. What will be the impact on total revenue? 2. What courses of action would you suggest to the CEO for the short run and the long run? Heriot-Watt University Strategic Management

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3.6

Long term competitive effects of environmental changes

Although managers may not be aware of it, their attitudes and styles can be greatly affected by general economic conditions. A brief outline of UK economic history illustrates this. During the 1950s and 1960s the UK experienced relatively stable prices, growth rates, unemployment rates and ination rates. To some extent this was a world wide phenomenon, and rapid change was something which companies were not on the whole exposed to; this set of conditions contributed to the attitudes of a complacent generation of UK management which seemed incapable of dealing with the increasing pace of change which started about the beginning of the 1970s; in fact, because of the lack of change, management was regarded as an activity for which training was irrelevant, and the idea that management ideas could be formalised was an alien concept. By the mid 1970s the stable scenario had been destroyed when global recession, which was partly caused by the trebling of oil prices, caused substantial economic upheavals. This period also saw the end of stable international exchange rates with the collapse of the Bretton Woods agreement in 1973, and the emergence of powerful competition from the Far East economies. It is no secret that UK managers were ill equipped to deal with these changes, and the economic traumas of the 1970s, which included 25 per cent ination rates, poor productivity growth, the loss of important markets and endless labour disputes, were at least partly caused by lack of foresight and adaptability on the part of managers. This period also saw a signicant increase in the extent to which governments attempted to regulate the level of economic activity. The share of government in the economy (measured by the sum of government expenditures on goods and services and transfer payments) increased to well over 40 per cent of national income by 1979, and the notorious stop-go policies which were utilised in response to economic uctuations seemed at times to make the situation worse rather than better. In fact, the incomes policy introduced in the mid 1970s, coupled with very high marginal tax rates, led to a signicant reduction in incentives for managers generally. By the end of the 1970s the prevailing view was that government would continue to increase its involvement in the economy, and managers should be able to function in a government dominated economy. This turned out to be a totally mistaken view. A totally different economic philosophy was introduced by the Thatcher government, which was elected in 1979. At the same time the pace of change and the volatility of economic activity and related factors increased in the 1980s. In the UK there were substantial changes in unemployment rates, industrial output, ination rates, interest rates, productivity, exports, imports, capital ows, and exchange rates. At the same time there was a conscious effort on the part of government to disengage from the economy and allow market forces to operate more freely; this in turn led to deregulation, selling state owned companies, and lower marginal tax rates. All these economic changes have affected individual company performance in one way or another. For example, by the late 1980s the UK was experiencing a boom, with record growth rates and the lowest unemployment rate for 10 years; in particular, asset prices spiralled, and many successful large companies started to diversify into property, while those already in the property business began to extend themselves. To many observers it seemed that the pinnacle of credit and unfettered expectations on which this boom depended was unstable, but developers pressed on regardless. After the economic downturn in 1991 the bubble burst and there were many disasters, the best known being the Canary Wharf development - the largest building in London - which went Heriot-Watt University Strategic Management

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bankrupt before it was even occupied. Economic circumstances had led yet again to a gold rush outlook on the part of otherwise sensible managers, who did not seem to appreciate that they were gambling entirely on the continuation of boom time conditions. A rudimentary understanding of economics might have given cause for concern about the inationary pressures being generated during the boom and the possibility that the government might be forced to take deationary measures. In the 2000s the UK entered a period of relatively high economic growth, low unemployment and ination. This provided a degree of economic stability that had not been seen for decades; this was rudely shattered by the nancial crisis which started in 2007 and led a an even greater economic downturn than 20 years previously. Once again companies were unprepared for such volatility and appeared to have learned nothing from the past.

3.7

Macroeconomic environmental variables

Managers who have not been educated in general economic principles can be excused for nding it difcult, or impossible, to explain the various changes observed in the economy, which is subject to a seemingly perplexing variety of inuences of the type described above. It has already been pointed out that managers are bombarded with information of all kinds; information on economic conditions arrives in the form of news reports, national and international statistics, news commentaries by experts, and reports prepared by specialists who may be independent economic consultants, stockbrokers, or employed by the company. The problem facing the manager is to decide which information is relevant, and interpret it in order to form a view on what is happening in the economy as a whole; this is a prerequisite to deriving implications for the industry and the company itself. Managers therefore often ask if it is possible to make sense of factors, and whether anything can be done to accommodate them. This is in fact the area of study known as macroeconomics. A sample of what macroeconomic theories cover is: The determination of GNP through the interaction of demand and supply in the economy as a whole, and the effect of changes in both demand and supply factors full employment output, actual output, the unemployment rate and the ination rate the role of expectations money supply and the rate of interest the rate of interest and investment expenditure factors affecting the demand for and supply of imports and exports the determination of the exchange rate and international nancial ows Armed with an understanding of macroeconomic principles it is possible to use information on current government economic policy, changes in the international economy, trends in consumer expenditure and company investment, and other variables to derive scenarios which can be used as a backdrop to company strategy formulation. The important issue is that just because the operation of the economy is a complex Heriot-Watt University Strategic Management

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and confusing subject it can not be ignored, because economy wide changes have implications for companies and individuals. For example, changes in the interest rate affect companies who borrow, changes in consumer expenditure affect companies producing consumer goods, an increase in ination will affect company costs, changes in the exchange rate affect companies which import and export. When the economy enters a recession it is quite normal for companies to report reduced prots and to blame this on the slowdown in general economic activity. However, it is an open question as to how far such reductions in prot could have been avoided and, in fact, it is usually found that some companies are not affected to a signicant extent; perhaps this is partly due to a general understanding of what was happening in the economy at large and the willingness to take appropriate action.

3.8

The international economy

Few companies are immune from international factors. Those which sell directly in foreign markets are continuously exposed to changes in trading conditions; under conditions of relatively free trade even those companies which sell only in domestic markets are open to competition from imports. Consequently, many companies are concerned with factors such as variable exchange rates, differences between local and foreign ination rates and differences in the growth rates of different economies. At rst this might appear to be an impenetrable jungle of conicting inuences.

3.8.1

Exchange rates

The most important problem confronting companies in international markets is the unpredictable behaviour of exchange rates, and Table 3.4 gives an indication of the extent to which the exchange rate of the UK pound against the US dollar varied in the recent past. Table 3.4: The pound to dollar exchange rate approximate year on year change (%) Year 1 2 3 4 5 6 7 8 9 10 11 Exchange rate 0.52 0.62 0.69 0.86 0.69 0.68 0.53 0.55 0.62 0.53 0.57 12 4 13 15 Deation% 24 19 11 25 20 1 22 Reation%

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These uctuations have signicant implications for predicting the cash ows from foreign markets. For example, a company making plans two years ahead in Year 9 in the UK would not have known that the pound would be reated by 15 per cent the following year. In the light of these factors, the company stands to benet by taking a view on what is expected to happen to the exchange rate when trading internationally. For example, if the company is convinced that a particular currency is undervalued in relation to the domestic currency, a potential strategy is to break into the market now and establish market share in the knowledge that losses will be incurred until a reation takes place. Or if a company is evaluating a potential investment in a country, the prospect of a reation of that countrys currency could have major implications for the timing of the cash ows necessary to carry out the investment. Many companies argue that they are in the business of making and selling their products and are not in the business of foreign exchange dealing. Others justify ignoring possible future changes on the grounds that they do not see what they can do about them. However, a decision to ignore the problem of uncertain exchange rates is equivalent to adopting the view that there will be no changes in the future; this is as much an act of response as a forecast that changes will occur. There are various methods of hedging bets in relation to exchange rates, for example buying currency forward; this makes it possible to predict some future cash ows, but it means that the company will not gain from any favourable movements in the exchange rate. It is not possible for a company to cover future exchange rates entirely because cash ows will extend for years in the future and these cash ows are difcult to predict with any degree of certainty. There is no reason to view exchange rate risks as being different from the other uncertainties facing the company, and in the current volatile state of the international economy it makes sense to attempt to identify risks and incorporate them into decision making. Apart from these economic inuences on markets, governments often favour local industry. For example, the notion of local content restricts companies freedom to purchase supplies and components; import duties can add signicantly to nal prices; subsidies to companies in shipbuilding and sunshine industries can endow competitive advantage. One strategy is to produce goods in the country where they are to be sold, thus avoiding the impact of different ination rates, exchange rate uctuations and government intervention. It is often asserted that the world is becoming a global village and that international locations matter less and less for companies; the opposite view is that successful companies in the international arena build on the strengths which they have created in their home market. Certainly, each country presents a different mix of factors such as cultures, markets, trading conditions and competitive conditions.

Exercise 3.4
Using the information on exchange rates in Table 3.4, consider the case of a company which expected to sell 5000 units per year at $1000 each giving a revenue of $5 million in Year 9. What would the revenue be in in years 9 through 11?

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3.8.2

Think global act local

One way of avoiding exchange rate risks and signicant differences in production costs is to expand within the market rather than exporting to it. The world can be considered as a single market, and local markets as segments of the broader global market. Many global companies produce locally using different brand names for domestic markets. This approach enables exibility in relation to local conditions and allows management to focus on the all important factors of differentiation to t local preferences, while avoiding the problems of centralised control from the remote corporate head ofce located in a foreign country. However, it can be argued that national preferences are continually being eroded by the standardising forces of the mass media and international travel. This can account for the world wide acceptance of Coca Cola and McDonalds hamburgers. Furthermore, it can be argued that global companies are able to reap economies of scale and that consumers will, at the end of the day, opt for the lowest price products and overlook supercial differences. While this is to some extent true, there are still signicant differences in many of the products sold in different countries and companies would be foolish to ignore this. While there is global acceptance of some products, such as Coca Cola, many others vary greatly among countries: the French drink wine, the Germans drink beer and so on. While there are arguments on both sides of this issue, any company which is considering an investment to service a particular geographic market needs to consider seriously whether it should invest in its country of origin or invest in the country where its market will be. Other factors which bear on this issue are discussed in the following sections.

3.8.3

The competitive advantage of nations

The role which national location can play in inuencing the competitive position of companies was developed by Michael Porter 1 who pointed out that competitive advantage is often strongly concentrated in a few locations; for example, the clustering of electrical distribution equipment in Sweden, tunnelling equipment in Switzerland, large diesel trucks in the USA and microwaves in Japan. Porter identied several ways in which a nation can affect the competitive advantage of individual companies. A rms home nation plays a critical role in shaping managers perceptions about the opportunities that can be exploited by supporting the accumulation of valuable resources and capabilities and creating pressures on the rm to innovate, invest and improve over time. The impact of the history and environment of a country is often obvious. Scotland has had a long history of industrial decline and the development of a dependence ethos fostered by many years of misguided government aid policies. As a result the rate of new business start ups is roughly half the rate in England; this is in marked contrast to a small state such as Singapore, where the government has been at least as interventionist but in a totally different way. It is the existence of conditions which contribute to sustaining competitive advantage in a dynamic sense which is important. A country can offer favourable factor conditions, in particular those that are highly specialised to the needs of particular industries. But this is only part of the story; it can also offer favourable demand conditions in the form of sophisticated home consumers who continually force rms to produce the right things. Up to the late 1970s the willingness of British governments to bail out lame ducks in

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manufacturing industries contributed to the lack of incentive to invest in the innovations which would sustain competitive advantage for individual companies. One of the dangers of protectionism is that local companies have little incentive to retain competitive advantage. For example, British cars and motorcycles of 1970s vintage were still being produced and sold in India up to 2000 because of protectionism that was not relaxed until the mid 1990s; after that the Ambassador cars and Royal Eneld motorcycles were quickly replaced by Japanese and Korean makes. This is an illustration of how consumers as well as companies stand to lose from a lack of international competition. The most extreme example of all was the plight of companies in the Eastern Bloc economies which had been so conditioned by their national environment that the notions of protability and cost control were unknown. When the Berlin Wall came down and Eastern Bloc companies were subject to competition from Western companies the inevitable result was large scale bankruptcies and high unemployment rates. According to Porter, the impact of the national environment on the competitiveness of individual companies is largely determined by the following inuences. Factor conditions: highly specialised resources develop in different countries over time; the development of computer businesses in Silicon Valley in California meant that there was a large pool of highly skilled manpower. Related and supporting industries: a company is only one part of an integrated production process, and depends on the availability of companies which can supply it with products and related companies which supply the local labour market with relevant skills. Demand conditions: sophisticated consumers force companies to innovate and shape their market orientation. The dominance of Japanese cameras is partly explained by the popularity of amateur photography in Japan; the success of German motor manufacturers in producing quality cars as opposed to mass produced cheap cars is partly due to the German respect for quality engineering. Strategy, structure and rivalry: a country which fosters competition at home potentially breeds a strong core of companies which are capable of competing in the international arena. There are few instances of powerful international companies emerging from protected or subsidised home markets. The highly protected British car industry was unable to compete in the 1970s and virtually ceased to exist. Japanese companies, which had been subject to intense home competition, invested heavily in new car plants in Britain in the 1980s. When assessing its competitive position, a company needs to determine whether its competitive advantage is due to company specic or country specic attributes. If the advantage is country specic then it can exploit foreign markets by exporting; if it is company specic it can invest in the country concerned. This partly explains why Japanese car makers invested in Britain: their management skills and production techniques were company specic and hence transferable. However, in a world of exchange rate uncertainty, as discussed above, companies may also make locational decisions because producing in the country where they sell their products insulates them against potentially unfavourable exchange rate movements. Decision makers thus have to trade off perceived competitive advantages against exchange rate risks.

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Exercise 3.5
Imagine you own a computer hardware company in France and wish to break into the US market. What factors would you take into account when deciding to export from France or set up a factory in Silicon Valley?

3.9

Looking ahead

All decisions are about the future and there are various approaches to assessing what the future might have in store. These include forecasting key economic indicators, taking a range of possible factors into account (PEST) and considering a range of possible futures and their implications for the company (scenarios).

3.9.1

Forecasting

From the strategy viewpoint, the main reason for trying to understand what is happening in the economy is to provide a basis for predicting the future course of events. Since no one can look into the future with any degree of certainty, this amounts to trying to ascertain what is likely to happen and acting accordingly. A cynical manager might ask, if it is impossible to predict the future with accuracy, is there really any point to making forecasts? The answer to this is that even vague predictions can be valuable. For example, for many companies it makes a difference if national income is likely to increase or decrease; it follows that it would be useful to predict whether national income is likely to increase or decrease next year. In other words, the direction of change is important in its own right; it may be possible to go further and predict the dimension of change, but often the very fact of predicting an increase or a decrease is the major determinant of strategy. Any action which has future consequences takes a view of future events, if only by default; therefore it is better to be explicit about what is thought likely to happen. One problem facing managers is the number of forecasts available. Practically every day professional forecasters issue predictions of what is going to happen next week, month or year: some are academically prestigious, such as the London Business School, some are issued by well known stockbrokers and can affect the behaviour of the stock market, and many are ignored. Can any use be made of these forecasts? The simple answer is no, because all forecasters share the same poor track record. Some are right in some cases, others are right in others, and there is always someone ready to claim that their institution successfully predicted current events. To the cynical observer, there is a market in predictions, and the various producers attempt to present their forecasting product in the best light. In fact, forecasters seem to share the ability to miss really big changes. One of the consistent failures of economic forecasters is the inability to predict the performance of the UK economy. Table 3.5 shows some of the predictions for GDP growth made before the beginning of a typical year by some of the most prestigious forecasters around, compared with what actually happened.

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Table 3.5: Forecasting UK GNP for a typical year GNP % growth Actual Confederation of British Industry James Capel Morgan Grenfell UK Treasury National Institute for Economic and Social Research London Business School -2.2 -0.8 -0.4 0.4 0.5 0.8 1.4

No forecaster even came close to predicting what would happen. The difference between the highest of the predictions for GNP growth (+1.4 per cent) and the actual outcome (-2.2 per cent) is not trivial for those companies whose product has a high income elasticity. A company which acted on the basis of the London Business School forecast and increased its output in the expectation of a signicant increase in demand would have found itself with substantial unsold inventories by the end of 1991. A manager might reasonably ask whether the disparity in the forecasts was due to the way they were carried out, i.e. that some methods are likely to be more successful than others. In fact, there are a number of approaches to forecasting, ranging from the intuitive to the highly quantitative. For example, the London Business School model, which performed worst in this year, is highly sophisticated and is operated by economists of considerable experience; the UK Treasury bases its forecasts on one of the most complex models of any economy in existence (known as the Treasury Model). There is virtually no connection between the statistical complexity of the forecasting models and their accuracy. The simplest approach to forecasting is to discover one statistic which serves as a reasonable indicator of what is likely to happen next, and this statistic is known as a leading indicator. A leading indicator is a statistic which signals when changes are about to happen in the economy, or in a particular industry. For example, the number of housing starts would be an obvious leading indicator to use for a business in the glazing industry, because a prospective reduction in the number of houses completed would have an impact on the number of windows required. Most leading indicators are chosen because they have served as predictors in the past, and there is no guarantee that they will perform effectively in the future. This is an example of using statistical association as the basis for prediction rather than causal relationships; the trouble is that no one can predict when a leading indicator is likely to lose its predictive power. There is in fact a very good reason for forecasts being wrong: unpredictable events occur which cannot themselves be foreseen. The forecasting procedure must assume that no major events occur to disrupt the orderly operation of the economy; unforeseeable events such as the oil price increases of the early 1970s and reductions in the mid 1980s, the ending of Communism and war in the Middle East, can combine to rob forecasts of any accuracy they might have had. The characteristic of exogenous shocks is that they cannot be predicted in the statistical sense, i.e. the use of past data and the extrapolation of trends are of no help. Many forecasts might have been correct if Heriot-Watt University Strategic Management

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exogenous shocks had not occurred, but it is virtually impossible to nd this out after the event because of the problem of isolating the various inuences. So is it possible to make any sense of what is happening in the economy, given that highly sophisticated teams of economic forecasters have such obvious difculty? One approach is to think in terms of the business cycle. In most countries periods of boom tend to be followed by periods of depression, which in turn tend to be followed by periods of boom, resulting in a cyclical pattern which is repeated over and over again. Economic growth is by no means uniform. Economists have made many attempts to measure the duration of the business cycle, and there is some evidence of the existence of long term, medium term and short term cycles which have a certain degree of regularity. If managers could identify the stage of the business cycle even approximately, it would clearly help in planning generally. However, inspection of historical data reveals that although cycles are often clear in retrospect, it is extremely difcult to predict when the next stage of the cycle will occur; in fact managers nd that economic activity generally is so variable that it is difcult enough to determine which stage of the cycle they are currently operating in, never mind attempting to predict future changes. One method of approaching the problem is to think of the business cycle as being comprised of three main components: the general trend over time, the underlying smooth cycle, and random uctuations. The statistical technique which corrects for cyclical and trend effects is known as series decomposition. It is not necessary to understand how this technique works, but it is important to be able to ask the correct questions when assessing cyclical data. These questions are: 1. What is the trend? 2. What is the underlying cyclical pattern? 3. How large are random disturbances? In the case of an economy, the trend is the long term growth rate in potential output; this varies signicantly between countries. Some indication of the underlying cyclical pattern can be obtained by nding the time between previous peaks and troughs of unemployment rates. Random inuences include changes in government economic policy and exchange rate uctuations. It needs to be stressed that no one is able to predict the business cycle with any degree of accuracy, but it is possible to form a rational view as to whether the economy is in the upswing or the downswing. The example shown in Figure 3.1 is illustrative of how to think of the problem.

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Figure 3.1: It is important to visualise the business cycle in such broad terms. This is because managers have to make at least an implicit assumption about where the economy is in the cycle (unless they ignore the issue altogether and hope for the best).

Exercise 3.6
What will be the difference in the attitude of a CEO to a major investment if he thinks that the economy is about half way towards the peak of the cycle compared to being at the top and ready to fall back down again?

3.9.2

PEST Analysis

It is now clear that trends and events in the national and international economy need to be monitored because of their impact on the company. It is also necessary to be able to interpret forecasts, because every decision undertaken implies some assumptions about the future, so it is as well to make them explicit. But the macroeconomy is only one dimension of the overall environment; others are social changes, changes in tastes and preferences, technological changes, ecological, political and so on. The checklist of Political Economic Social Technological factors provides a useful framework for assessing these inuences; at one level the PEST analysis is nothing more than four lists, and as such is of little value. But the identication of a range of relevant factors, and an analysis of the relationships among them, can provide important insights into the companys prospects. The types of inuence that need to be considered are as follows. Political: a change of government can lead to fundamental changes in taxation, regulation and intervention in the labour market, all of which have far reaching implications for company operations. For example, the change from a right wing to left wing government may herald the emergence of stricter laws on monopoly behaviour and relaxation of labour laws in favour of employees. A company that is considering expanding internationally needs to be aware of differences in the political situation because what it can do in its home country may not be allowed elsewhere. Economic: the importance of macroeconomic issues has been discussed in this chapter; industry structure and its implications for competitive pressure will be discussed in Chapter 4. Heriot-Watt University Strategic Management

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Social: Changes in attitudes, tastes, fashions and age structure have effects on individual companies; for example, changes in the demographic composition of the population have implications for manufacturers of baby products and nancial organisations providing pensions. Changes in social norms, such as attitudes to marriage, divorce and to the number of children in a family, have implications for the demand for housing. Social information tends to be qualitative rather than quantitative, and there is no specic analytical approach that can be applied; an awareness of societal changes, however, is central to wide strategy issues, and the identication of potential opportunities and threats. The fact that information is qualitative does not mean that it cannot be used in an analytical fashion. For example, social analysis is complementary to economic analysis because economic factors operate within the given social structure; predicting social changes can help to explain why demand curves are likely to shift in the future. Qualitative information will usually indicate whether something is likely to increase, decrease, or remain unchanged; knowing about the direction of change can be extremely valuable on its own, independent of the expected dimension of change. Technological: technological change happens all the time, but it can speed up in individual sectors; for example, in less than a decade mobile telephones and the internet altered communication patterns and how goods are bought and sold. In 1995 it was inconceivable that people would be able to make a living trading on eBay. But while it is necessary to keep abreast of such developments it is also important to pay attention to background technological change: unless new methods and techniques are incorporated into company systems and the company is willing to invest in new approaches, competitive advantage can disappear with alarming speed even in the absence of dramatic change. As an example of how a PEST analysis can be applied, consider the case of a monopolistic electricity utility which has been recently privatised. It runs several coal red power stations, two of which are 25 years old, and one 15 year old nuclear power station. Political Recent elections resulted in a new government which is more inclined to stricter regulation and opening up the market. The new government is committed to subsidising domestic house insulation. There is increasing international political agreement to cut pollution. Economic New gas elds are being opened up with implications for the price of gas. There are several indications of a slow down in economic activity which will have a signicant effect on industrial demand for energy of all types. The price of coal on international markets has started to increase. Social There is a rising public awareness of the need to conserve energy. Heriot-Watt University Strategic Management

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The aversion to nuclear energy is increasing. The number of single occupancy households is predicted to increase by 25 per cent over the next two decades. Technological Improved techniques for insulating houses are being developed. Studies have shown that alternative energy sources such as wind, water and solar power are now cost effective. If the company had conned its environmental analysis to the economic dimension alone, it would have been concerned about the imminent economic slow down, competition from gas and higher costs of coal. But the PEST analysis analysis identies a wider prole of potential threats. Factor Political Issues the company is likely to be constrained by the new government, exposed to increased, competition and possibly lower demand than expected the imminent economic slow down, competition from gas and higher costs of coal. attitudes to conservation which are possibly going to lead to improved insulation and alternative power sources Research into alternative energy sources starting to pay off Threat High

Economic Social Technological

High High High

The PEST analysis reveals that the company has a great deal to worry about other than adapting to the demands of privatisation.

3.9.3

Environmental scanning

A PEST analysis deals with what is known about the environment at a particular time and is usually carried out when an important decision has to be made, for example investing in a new product or entering a new market. What is typically overlooked is that it is necessary to monitor continuously all of the PEST type variables. The reason that companies are often caught unawares by changes in consumer preferences, or by changes in government policy, is not that such events could not be predicted but because no one in the company has responsibility for monitoring what is happening in the environment and bringing important issues to the attention of decision makers. A classic example was the advent of microcomputers: many mainframe computer manufacturers, including IBM, did not appear to recognise a major change was under way and several went out of business; another was the rise in popularity of SUVs at the expense of standard cars, and major manufacturers such as GM and BMW took years to recognise that a new market segment had developed. There is also the danger of imagining that changes are occurring when they are not. For example, telephony companies bid astronomical sums for third generation mobile phone licences without apparently giving serious consideration to whether consumers would be willing to pay for the additional services nor, indeed, whether the technology could be developed such that an acceptable rate of return could be made on the investment; companies were Heriot-Watt University Strategic Management

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caught up in a bidding frenzy because they saw that everyone else was doing it. Environmental scanning is the process of keeping in touch with changes in the environment and is an important component of the feedback part of the strategic process. But in practice it is an extremely difcult activity to undertake; for example, what are the characteristics of the person to be given responsibility for environmental scanning? What specic direction can be given regarding what to look for? Many CEOs would be unconvinced of the productivity of such a role. But it is not just the identication of potential opportunities and threats that is the problem, it is communicating these to decision makers. Managers typically do not wish to read detailed reports and analyses and usually regard discussions of what might happen as a distraction from getting on with the job. This is when away days become important, when senior managers leave the organisation as a group to focus on the future of the business. Again, the trouble with most away days is that they tend to become focused on current problems and environmental scanning is pushed into the background. Anyone who has run strategy sessions for companies knows how difcult it is to get senior executives to focus on such issues, and in fact the level of ignorance about the competitive environment is surprising to observers who are not familiar with the problems inherent in effective environmental scanning.

3.9.4

Scenarios

Once some projections of possible futures have been made they can be used as the basis of scenarios; this term has already been used in a loose sense in the discussion about the impact of changes in GNP on revenues and costs. It must be made clear that a scenario is not a forecast, but it is an attempt to investigate the implications of possible futures for the company. In some instances it may be based on a short run issue, such as the likely impact of a price reduction by a major competitor; the potential impact on market share and the cash ow implications can be mapped out, or the implications for the companys protability of matching the price reduction. A long term scenario is much more speculative, and many managers doubt their value. However, put yourself in the position of a European nancial services company in 2000 and visualise the implications of a zero ination in the year 2010; nancial products such as insurance policies are typically sold on the basis of nominal interest rates. But if ination disappears the interest rate will tend to fall to its real long term level of about 3 per cent. When the ination rate in the UK fell to almost zero by 1998 most insurance companies were unprepared for the impact on expected payouts. The PEST analysis carried out in 3.9.2 can be used to illustrate the construction of different scenarios. In Scenarios A and B one factor has been selected from each of the PEST headings and extrapolated three years from now.

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PEST Political

Scenario A All householders are eligible for subsidies of 75% of the cost of insulation Four new gas elds in the North Sea have been brought on line increasing supply by 30% Because of voter hostility the government has decided not to restart the nuclear power station building programme and to decommission existing nuclear power stations A new cavity wall insulation material has been developed that is 30% cheaper than alternatives and can be installed by the householder

Economic

Social

Scenario B The government has ruled that all coal red power stations must reduce their emissions by 50% within ve years Because of a series of natural disasters the price of coal has doubled on international markets The number of single occupancy homes has increased much more quickly than expected and is now expected to increase by 30% in the next ve years Economic studies have now shown that alternative energy sources are never going to be cost effective

Technological

The implications of these changes would be broadly as follows: PEST Political Scenario A Householders who install insulation will use less energy therefore demand will fall The price of gas, a competing fuel, will fall; it will probably be necessary to reduce the price of electricity to remain competitive Investment plans will have to be brought forward As householders install cheaper insulation demand for energy will fall Scenario B High costs will be incurred in installing pollution extraction equipment The cost of the main input, coal, is increasing therefore the cost of producing electricity will increase The demand for energy will increase as the number of households increases No more customers will be lost for this reason therefore demand will be unaffected

Economic

Social

Technological

The two scenarios present different possibilities for the future not only because of the magnitude of the changes but because of their combination. The potential impact of the scenarios on the company are completely different. Scenario A portrays a future of falling demand because of the combination of political actions and technological change; prices will also probably fall and so a signicant fall in revenue (price x quantity sold) can be expected. At the same time investment will have to be undertaken to replace the nuclear power station. The combination of lower revenues and the investment cost may lead to cash ow problems. But it is possible that the falling demand may make it feasible to decommission the nuclear power station without building a replacement immediately. Scenario B has two major inuences on the cost side: pollution control and Heriot-Watt University Strategic Management

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increased input costs. The demand side is, however, quite positive. In this case the focus could be on controlling costs to maintain competitiveness while taking advantage of the buoyant demand. As a result the need to invest in pollution control equipment is not likely to cause major cash ow problems. The PEST analysis identies the potential threats and opportunities in the environment. The scenarios consider what might happen if various threats and opportunities materialise. It is clearly impossible to take action now that will enable both divergent futures to be accommodated in three years time, but since these futures are feasible it is important to determine how exible the organisation is and how well it is equipped to face the types of uncertainty identied.

Exercise 3.7
In 1996 British Telecom (BT), which is the giant supplier of UK telephone services, made a bid for MCI, which was then Americas second largest internal long distance telecoms carrier. The deal was called off when WorldCom stepped in with a higher bid. Here are some facts about the US market which BT was attempting to enter. During the period up to 1995 there had been a signicant liberalisation of the US telecoms market and it was to take advantage of this that MCI was trying to enter the local markets. But in order to enter the local markets MCI would have to build the local network itself or interconnect with the circuits of Baby Bell operators. In fact, US law allows the Baby Bells a great deal of freedom to challenge the terms of interconnection in the courts and with state regulators, with the result that after a year of deregulation it was still almost impossible to challenge the Baby Bells. MCI did announce that it was going to build its own exchanges and circuits, but nobody knew how much this was likely to cost. Deregulation works both ways, and the mature long distance internal market was, in its turn, opening to competition from the Baby Bells; indeed, because of existing local competition, the Baby Bells do not have many of the characteristics of semi monopolists like MCI who had been operating in a mature market for quite some time. Furthermore, Internet telephony now seemed a real possibility; therefore there were no guarantees that alliances based on existing technology would dominate the telecoms market in the future. There were severe competitive challenges ahead. Total revenues from local calls were likely to grow only slowly during the next few years, while the cost of long distance calls in the US fell by 50 per cent between 1994 and 1997; international prices fell by 60 per cent in the same period. Furthermore, other global alliances involving companies such as AT& T were also competing for the same business. 1. Draw up a PEST analysis using the limited information available. 2. What would you be looking for when conducting environmental scanning? 3. Derive two scenarios for the future of WorldCom after the take over of MCI.

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3.10

Reference

1. Porter, M.E. (1998) The Competitive Advantage of Nations, New York: Free Press.

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Contents
4.1 4.2 The market environment in the process . . . . . . . . . . . . . . . . . . . The market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.1 Demand factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.2 Supply factors 4.3 4.4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.3 Price determination . . . . . . . . . . . . . . . . . . . . . . . . . Barriers to entry: structural and strategic . . . . . . . . . . . . . . . . . . . Market structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.4.1 Perfect competition . . . . . . . . . . . . . . . . . . . . . . . . . . 4.4.2 Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.4.3 Oligopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.5 Competitive behaviour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.5.1 Game theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.5.2 Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.5.3 Contestable markets . . . . . . . . . . . . . . . . . . . . . . . . . 4.6 Segmentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.6.1 Product differentiation . . . . . . . . . . . . . . . . . . . . . . . . 4.6.2 Product quality . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.6.3 Pricing in segments . . . . . . . . . . . . . . . . . . . . . . . . . 4.7 4.8 The life cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Portfolio models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.8.1 The BCG relative share growth matrix . . . . . . . . . . . . . . . 4.8.2 Other portfolio models . . . . . . . . . . . . . . . . . . . . . . . . 4.8.3 Portfolio models and corporate strategy . . . . . . . . . . . . . . 4.9 4.10 4.11 4.12 Strategic groups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The structural analysis of industries . . . . . . . . . . . . . . . . . . . . . Environmental threat and opportunity prole . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 65 65 68 69 71 74 74 75 76 78 78 80 81 82 85 86 90 94 97 98 101 101 105 107 113 115

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To develop an awareness of demand and supply factors To understand the importance of barriers to entry To appreciate the link between market structures and competitive behaviour To understand the strategic importance of segmentation and differentiation To develop the product life cycle concept and relate it to portfolio theory To expand the scope of competitive analysis to include competitive groups To analyse the competitive forces acting within an industry To develop an environmental threat and opportunity prole

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4.1

The market environment in the process

While the general environment impacts on the company in a variety of ways, the most immediate effects come from the markets in which it operates: the type of market, the degree of competition, the growth prospects, the threat of new entrants, and so on. This can be thought of as the immediate environment of the company and it can be subjected to much closer and more detailed analysis than the general environment.

4.2

The market

All organisations have to pay prices for what they buy and sell; these prices are determined by the market (except for charitable organisations and those whose output is provided free by the state), and it is therefore important for managers to have some understanding of how prices are determined in markets and what causes them to change. In fact, changes in market prices are important signals which managers should be able to interpret because they have important implications for strategy formulation.

4.2.1

Demand factors

There must be few managers who have not wondered from time to time what would happen to sales if the price of their product were increased or decreased. Typically it is felt that this is an impossible question to answer because the world is a highly complex place with many changes happening at any given time. However, imagine that a company selling shoes were to decrease the price of their shoe range by, say 10 per cent, and nothing else changed; would sales increase by 1 per cent, 10 per cent or 20 per cent? The marketing manager should be able to make an educated guess based on knowledge of consumers, the behaviour of competitors, the characteristics of competing

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goods and so on. This is, of course, a question about the shape of the demand curve, an example of which is shown in Figure 4.1.

Figure 4.1: Demand curve If the price of a shoe were currently P and selling quantity Q, a price reduction might result in very little more being sold (a vertical demand curve) or a great deal more being sold (a more horizontal demand curve). This clearly has important implications for strategic choice, because if it is believed that the demand curve is almost vertical there is little to be gained by reducing price. On the other hand, if it is believed that a substantial increase in sales will result, it would be worthwhile reducing the price signicantly. If the company is pursuing an increase in market share it is clearly important to be explicit about the shape of the demand curve. It is also important to realise that while the precise shape of the demand curve cannot be determined, any decision on pricing (which includes the decision to leave price unchanged) implicitly makes an assumption on the shape of the demand curve. Therefore there is no getting away from the concept of price elasticity and it should be brought to the forefront of all discussions about pricing policy. The basic assumption made in order to draw a demand curve is that nothing else changes. But this is never the case in real life, and from one time period to the next signicant changes in market conditions take place. For example, consumer incomes change all the time; it was discussed in Chapter 3 Section 4 how some goods are highly income elastic, i.e. when incomes increase, individuals wish to purchase more of that good. This can be interpreted in terms of the demand curve: when incomes increase the demand curve shifts to the right, because at every price individuals are willing to purchase more. In the case of shoes it is possible that an increase in incomes affects the demand for leisure footwear, such as trainers and walking boots, much more than the demand for standard shoes. The general effect is illustrated in Figure 4.2.

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Figure 4.2: Demand curve shift Now consider a change in market conditions which a company can instigate on its own, namely an increase in marketing expenditure. The purpose of such a move is to persuade individual consumers to purchase more at every given price, i.e. to shift the demand curve to the right in exactly the same way as occurs when there is an increase in income. The question which then needs to be addressed is how far the demand curve will be shifted, and over what time period. Apart from shifting the demand curve, another reason for embarking on a marketing campaign is to increase consumer loyalty to the brand, and this can be interpreted as reducing the elasticity of demand; over the longer term the intention may be to position the product as relatively high priced and high quality. This approach is similar to the use of scenarios discussed at Chapter 3 Section 3.9.4. The hypothetical question is posed: What would happen if price or marketing were changed? This provides the basis for assessing alternative futures; it is impossible to be precise about the shape of the demand curve, or the shifts which might result from a marketing campaign, but an approximation based on what is known about the market is a great deal better than acting randomly. The idea of the demand curve can be generalised to the industry level: if the demand curve referred to all units of the product sold and P was the average price charged, what would be the effect of a reduction or increase in the price charged by all companies? If the demand curve were elastic then all companies could benet by reducing their prices. But in reality this is unlikely to be the case, and companies have to be aware of the fact that if they reduce their prices in order to increase their sales, then at least part of the increase is going to come from the sales of other companies. This is likely to stimulate competitive reaction, and this will be pursued at Chapter 4 Section 6. Besides the actions of the company itself, there are many factors which affect the size of the total market including the following. Determinants of market size: Product Life Cycle Business Cycle Heriot-Watt University Strategic Management

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Exogenous shocks GNP Elasticity Exchange Rates These factors which inuence the total market size are outside the control of the company, but because the company cannot control them it does not follow that they can be ignored. In fact it is essential to try to understand the likely impact of these factors, several of which were discussed in Chapter 3, on market size One important reason for keeping the notion of the demand curve in mind is that it helps distinguish the impact of factors outside the control of the company from those pricing and marketing decisions which affect the market share which the company achieves out of the given total market. Thus, when total sales fall it is necessary to identify whether it is because of some pricing or marketing reason, or because there has been a change in the size of the total market. For example, a fall in sales may be unrelated to marketing activity, because it was due to an unpredictable change in total demand for the product. It is therefore necessary to disentangle the impact of changes in the determinants of market size from those which affect market share. The practical problem in doing this is that the world is continually changing with the factors changing by different amounts at the same time.

4.2.2

Supply factors

Prices determine not just how much is sold on the market, but the quantity which companies are willing to sell. At low prices companies will be willing to sell fewer units than at high prices, leading to an upward sloping curve (1) as shown in Figure 4.3

Figure 4.3: Supply curve Exactly the same questions can be asked about the industry supply curve as about the demand curve: will a given increase in price lead to a relatively small or large change in output? Furthermore, the supply curve can shift too; for example, if costs increase then companies will be willing to sell fewer units at any given price and the curve will shift to the left (2). As in the demand case, supply conditions have important strategic Heriot-Watt University Strategic Management

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implications. For example, if prices have recently risen due to a sudden increase in demand in a particular industry, some understanding of the supply curve can help the company estimate what the reaction of the industry as a whole is likely to be.

4.2.3

Price determination

Up to this point prices have been allowed to vary to demonstrate the characteristics of both demand and supply. However, prices in the market are not free to vary on their own but are determined by the interaction of demand and supply. On the one hand the production of goods and services depends on the costs which companies incur in supplying different quantities, while on the other the demand for goods and services depends on what people are willing to pay for different quantities. The interaction of demand and supply produces prices. An understanding of price determination makes it possible to make predictions about the outcome of changes in both demand and supply conditions.

Figure 4.4: Demand, supply and price determination The idea of price determination is simple. In Figure 4.4 the price will tend to move towards P, known as the equilibrium price. If the price is higher than P then companies will produce more than consumers are willing to buy, and the price will fall. If it is lower than P then consumers will attempt to buy more than companies are willing to produce, hence bidding up prices. Managers may feel that the idea of equilibrium price is of limited use because in real life prices are continually changing, and nobody knows what the equilibrium price is for any particular product. However, demand and supply analysis is a powerful tool both for understanding market conditions and predicting what is likely to happen in the future. Any factor which alters the position of the industry demand or supply curves will have an impact on market prices. The extent of this impact depends on the shape of the demand and supply curves. If the demand curve is inelastic then changes in supply will be reected in price rather than quantity changes, and vice versa. The important issue for managers is to attempt to visualise the shape of the demand and supply curves in their industry in order to provide insights into the likely outcome of both demand and supply changes. In fact a relatively limited amount of information on demand and supply conditions for an industry can enable managers to assess the impact of events such as Heriot-Watt University Strategic Management

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the entry of competitors (increase in supply) and the emergence of substitutes (reduction in demand). Demand and supply analysis can be used to portray the outcomes of Scenarios A and B developed in 3.9.4. Scenario A depicted a combination of political and technological factors that would lead to a reduction in demand, so the demand curve would shift to the left as in Figure 4.5 because consumers would be willing to buy less at each price.

Figure 4.5: Scenario A Using the demand and supply curves as drawn the price would fall from P1 to P2 and the quantity from Q1 to Q2. By presenting the outcomes in this way the strategic discussion can focus on how much shift can be expected in the demand curve and the likely shape of the industry supply curve. For example, if the supply curve were much more inelastic (steeper) than drawn the impact would be mainly on the price. Scenario B was concerned with supply side factors and can be represented as in Figure 4.6.

Figure 4.6: Scenario B Because of the higher price of coal the industry supply curve would shift to the left, i.e. electricity companies would be willing to produce less at each price. Again, the effect

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depends on how the curves are drawn, for example if the demand curve were much more elastic (atter) the effect would be mainly on the quantity rather than the price. Detailed industry knowledge could be used to estimate the supply curve and the how far it is likely to shift. An important outcome of presenting scenarios in this way is that it makes assumptions explicit and makes use of available information in a structured manner. For example, it may be concluded that the market impact of Scenario B is insignicant because of the characteristics of the demand and supply curves; such a conclusion may not be obvious from a descriptive account. What happens if both demand and supply factors were to change simultaneously? In that case the analysis becomes more complicated because both demand and supply curves have to be shifted at the same time. But the same principles apply: make an informed estimate of the shapes of the demand and supply curves and then estimate the likely shifts that would arise from the various inuences.

Exercise 4.1
The shipping industry is characterised by very large variations from year to year in the price of vessels. 1. Explain this in terms of the shape of the demand and supply curves in the industry. 2. What strategic implication would you draw from the analysis? 3. Would your answer be improved by having detailed data on the shipping business available?

4.3

Barriers to entry: structural and strategic

Once a company has established its competitive advantage in an industry or geographical location it cannot afford to relax. This is because competitive pressure will not only arise from existing competitors in the industry, but these pressures are likely to be much greater when new companies can enter the market. In a competitive economy there is in fact a signicant degree of movement into and out of particular markets and research suggests that, on average, there is a 30 to 40 per cent turnover in companies every ve years. Since all markets are open to the threat of entrants, a company enjoying monopoly prots will always be concerned about the threat from potential entrants. The incumbent monopolist not already protected by barriers which make entry difcult or impossible will be motivated to nd out if there are ways in which barriers to entry can be erected, Broadly speaking, there are two types of barrier, the structural and the strategic: structural barriers are outside the control of the rm while strategic barriers depend on specic actions undertaken by the rm to deter entry. Structural barriers include: Capital requirements: it is typically necessary to undertake signicant investment expenditure in order to enter a new market, and some industries require amounts Heriot-Watt University Strategic Management

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which can be difcult to raise unless the company already has a secure track record; the capital requirement itself can pose a major threat to the entrant should the enterprise fail and the investment costs cannot be recovered. Sunk costs: it is not only the costs of entry which are important, but the costs of exit. It is usually assumed that a high capital entry cost deters entrants, but this is not necessarily the case. Certainly a high investment requirement limits the number of potential entrants, but the fact is that there are many large companies in the world. Consider the case of an airline: it costs a great deal to obtain an aeroplane and set up a route, but the aeroplane can always be sold. However, the route set up costs are also high and are sunk because they cannot be recovered on exit; this is the real nancial barrier to entry. At rst it might seem a paradox, but in fact the barrier to exit is just as important as the barrier to entry. Size of the market: because of investment and infrastructure costs it may not be feasible for more than one company to operate in the industry; while this argument is attractive in principle, it is rare in practice to nd such a market. A well known example is electricity generation and supply, where duplication of electricity lines would clearly be wasteful. This is known as a natural monopoly, and was the rationale for nationalisation because it was felt that competition would be wasteful; but the experience of privatisation has demonstrated that infrastructure can be shared among competing rms in a variety of ways. Control by legislation or tacit agreement: these agreements can last for a surprisingly long time. For example, De Beers has controlled supply in the diamond market for over fty years and xes the world price of diamonds; inventions are provided with patent protection for a xed period so that inventors can gain a benet from their activities. But it is difcult to predict how long tacit agreements will last; for example, the most powerful cartel in the world at one time, OPEC, was for many years unable to maintain high oil prices in the face of the development of supply from non-OPEC countries. Economies of scale: the idea of economies of scale is based on the long run average cost curve of the rm. The long run average cost curve shows how unit costs vary with different scales of output. If the incumbent rm is well down the long run average cost curve entrants have to come in at a large scale, or they will be at a signicant cost disadvantage. Experience effect: reductions in unit cost occur as the labour force learns by doing, more effective practices are adopted, materials wastage is reduced and so on; but it becomes progressively more difcult to achieve experience gains and after some time there is no further benet at the margin. If the experience effect is signicant, it will convey a signicant rst mover advantage to the incumbent rms in an industry and new entrants start off at a cost disadvantage. The difference between the experience effect and economies of scale is that new entrants will start to move up the experience curve, whereas scale economies can only be captured by increasing the size of the rm. The fact that competitors will accumulate their own experience means that it cannot provide an incumbent rm with a permanent entry barrier in the form of a cost advantage. Strategic barriers arise from competitive actions undertaken by the company, and include: Heriot-Watt University Strategic Management

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Reputation: the company can aim at building up a high degree of brand loyalty by emphasising characteristics such as quality and reliability; this is particularly important in industries where it is difcult for consumers to obtain comparable information on different products, for example products which are purchased only rarely like expensive white goods. Pricing: when the threat of entry emerges the company can reduce price as a deterrent (limit pricing is discussed in detail at Chapter 4 Section 4.5.2); however, this can really only work where the company is a monopolist; otherwise the price reduction might be seen as a competitive move against other incumbents. Furthermore, there is a real danger in many countries of breaching anticompetitive legislation. Access to distribution channels: while the new entrant may have a product which compares in quality and cost to the incumbents, this can be of little avail if the incumbent controls distribution. When the UK electricity and gas monopolies were privatised one of the major changes in the attempt to introduce competition was to separate production and distribution. While at rst sight it might appear attractive to attempt to erect strategic barriers, it turns out that these are very difcult to generate and maintain without resorting to illegal activities. There is, in fact, very little research evidence on the effectiveness of strategic barriers or entry deterrent behaviour, particularly using pricing. However, managers report that they frequently engage in such strategies, especially to protect new products. This is most likely because of the lack of information on the part of potential entrants as to underlying protability. It takes time to generate information on the likely returns from competitive action and setting a low price can serve as a misleading signal to potential entrants. While competition usually cannot be avoided in the long run, entry deterring strategies may provide sufcient time for the company to build up market share and achieve scale economies which might not have been possible had entrants been enticed into the market earlier.

Exercise 4.2
The grocery business in the UK was dominated for years during the 1990s by the major chains including Tesco, Sainsbury, Asda and Safeway. There were complaints by consumer groups that supermarket prices in the UK were higher than in the rest of Europe and that supermarket protability was higher in the UK. For some time there was a threat of entry by WalMart, which is by far the biggest US discount retailer. WalMart offers a very wide range of products at relatively low prices. It has achieved this by building up a highly efcient world wide distribution network and it focuses entirely on attracting shoppers by offering low prices. The UK incumbent companies offered a range of additional services, such as loyalty cards, fresh food, nancial services and in-store customer services. There are high start up costs for new supermarkets in the UK, starting with the process of obtaining planning permission, through constructing large out of town premises, car parks and access roads. Furthermore, UK shoppers were all familiar with the existing supermarket names, very few, however, having heard of WalMart. In June 1999 WalMart made a bid for Asda, the UKs third largest food retailer. Assess the extent of the barriers to entering the UK facing WalMart prior to its take over Heriot-Watt University Strategic Management

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of Asda.

4.4

Market structures

The demand and supply model is extremely useful in analysing the potential impact of changes on prices and can lead to important strategic conclusions. But it is not the whole story because it does not tell us much about competitive forces within the industry. The type and degree of competitive forces depends on factors such as the number and size of competitors, ease of entry into the industry and the type of product; taken together, different combinations of these factors lead to quite distinct market structures. It is obvious that market structures vary considerably among industries. The market for wheat is comprised of many relatively small producers, none of which can individually affect the price; on the other hand telephone services are supplied by a few very large companies In the UK British Telecom had a government monopoly until it was privatised, at which time it was exposed to competition from cable and mobile telephone companies. Knowledge about market structure can tell managers a great deal about potential protability and can be central to identifying strategic options and arriving at strategic conclusions.

4.4.1

Perfect competition

The term perfect competition is used because it refers to a market which has the most extreme form of competition. Managers typically react to the idea of perfect competition with the response that it does not exist in real life and that it is therefore completely irrelevant to real life decision making. This attitude is largely caused by the unrealistic assumptions made to dene perfect competition, that the product is homogeneous there are no barriers to entry no economies of scale exist there is universal availability of information on prices and quantities there is a large number of competitors The outcome of these assumptions is that no rm can charge more than the market price and the demand curve is horizontal: if any rm attempts to sell above the market price it will lose all its customers; if it attempts to sell below the market price it will go out of business because it will not cover its costs. An important aspect of perfect competition is that no monopoly prots are made, i.e. rms make only the opportunity cost of capital. Managers are usually uneasy about perfect competition because it does not accord with common experience; this is not surprising given the complexity of real life compared with the restrictive world of perfect competition. But despite the fact that it is difcult to observe in real life, this market model provides a powerful tool for interpreting real life events. Consider what happened in the market for personal computers during the late 1980s and early 1990s. The personal computer market was originally characterised by very high start up costs because of the R&D Heriot-Watt University Strategic Management

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required prior to production. As the technology was disseminated, the need to undertake expenditure on R&D was reduced. Entry to the industry was almost impossible before 1980 because of the lead and market share built up by the main players such as IBM; for companies inside the industry their position looked relatively secure. However, when the technology was disseminated and clones could be built and sold virtually at marginal cost, the situation was reversed. By 1990 many people who used personal computers did not care what make it was because personal computers became homogeneous goods, all doing much the same thing. Once the initial developments had been made it became relatively simple to enter the market: the components could be purchased and assembled; this meant that barriers to entry had largely disappeared and many rms entered the industry producing IBM clones. Most of these entrants were producing volumes which enabled them to capture at least part of any potential scale economies so they did not appear to be at any particular cost disadvantage. At the same time users became much more educated, and information on personal computers became widely available through the many computer magazines which appeared. Now consider again the conditions for perfect competition: homogenous product no barriers to entry no economies of scale universal information large number of competitors computers identical computer parts freely available pure assembly operations have limited scale effects computer magazines etc many brands of personal computers appeared

It seemed fairly clear that the conditions for perfect competition had appeared by the late 1980s. It was a simple matter to predict that computer companies would stop making prot on the production of personal computers and would merely make at best the opportunity cost of capital. This was precisely what happened by the early 1990s when it became widely acknowledged that making personal computers was not protable, one of the factors which contributed to the difculties experienced by major computer companies at this time and which led in 1993 to IBM reporting the largest corporate losses of any company in history. Far from being a remote concept best assigned to economics text books, the idea of perfect competition is thus of central importance in strategic analysis. For example, one approach is to identify where markets are not perfect and attempt to capitalise on the reason: it could be because of any one or more factors in the list of conditions. So rather than keeping on selling the same thing as everyone else (the assumption of homogeneous products), a possible course of action is to differentiate the product and target a specic sector of the market. In the personal computers case such differentiation included selling a package of services which included maintenance and software support, and introducing new features such as colour, more memory, portability and high speed processors. Unfortunately, none of these features could provide companies with more than a transitory advantage because of the speed with which the technology can be disseminated and the fact that new ideas can be easily imitated. For those reasons the basis of competition kept returning to the relative price charged.

4.4.2

Monopoly

At the other extreme from perfect competition is the situation where the industry is comprised of only one producer, the monopolist, whose demand curve is the industry Heriot-Watt University Strategic Management

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demand curve for the product. This demand curve slopes from left to right because the company is not a price taker, i.e. it can sell more by lowering the price. One way of visualising the competitive pressures on a monopolist is to imagine what happens to the position of the demand curve if a competitor enters the industry. This would cause the demand curve to be forced down to the left; this is known as monopolistic competition, which sounds like a contradiction in terms. If all rms had the same cost curves it would be worthwhile for competitors to enter the industry until all monopoly prots were bidded away. To counteract this, companies attempt to maintain their monopoly prots by capitalising on market imperfections such as barriers to entry and product differentiation. The effects of competition do not act only on the demand side. On the cost side, you could imagine the average cost curve moving from left to right as competition for inputs increases and the prices of labour, capital and materials increase. This would also have the effect of reducing monopoly prots. Sometimes companies are able to affect competitive conditions in factor markets, for example by entering into agreements with trade unions. But again, this typically confers only a transitory advantage because other companies can copy these arrangements.

4.4.3

Oligopoly

When there are relatively few competitors in a market the likely reaction of competitors to changes in pricing and marketing strategy must be taken into account. When there are relatively few competitors it could be argued that the notion of a measurable demand curve for an individual company has little operational meaning because its shape and position depends on competitive reaction, which in turn cannot be predicted. Does this mean that the concept of the demand curve cannot be used in this situation? In fact, the demand curve provides a useful method of incorporating knowledge about competitive conditions with the idea of price elasticity. Take the case where a company has not changed the price of its product for some time; this price is also charged by competitors. If the company were to increase its price it knows that none of its competitors would follow suit and that many customers would be lost when they realised that the product could be obtained more cheaply elsewhere. If the company were to lower its price, it knows that its competitors would follow suit and that there would be very little increase in demand. The idea of a sharp reduction in demand resulting from a price increase, and very little increase in demand resulting from a price reduction, is illustrated by the kinked demand curve shown in Figure 4.7.

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Figure 4.7: The kinked demand curve The current price is P; above that point the demand curve is virtually horizontal, based on the assumption that competitors do not follow suit. Below P the demand curve is almost vertical, based on the assumption that competitors do follow the price reduction. This has important strategic implications for the company. If the company is not making prot on a product, it is unlikely to be possible to improve net contribution by increasing the price because any price increase would lead to a substantial loss in sales. On the other hand, if the company wishes to increase market share by reducing the price, it follows that when the price is reduced total revenue will be smaller than it otherwise would have been and hence so will net contribution. When competitive conditions suggest that the demand curve is kinked, the attempt to increase market share by reducing price can only be justied if future net contribution will be signicantly higher than it otherwise would have been to compensate for the revenue forgone in creating the higher market share. This means that there is a trade-off between giving up revenues now in order to increase market share and the expectation of higher revenues in the future when price can be returned to its original level at the higher market share. As market conditions change the extent to which the demand curve is kinked may also change. For example, if two or three competitors take-over a number of small companies in the industry, it is to be expected that the part of the demand curve below the kink will steepen. Thus when discussing competitive reaction, it is useful to frame the issue in terms of whether the demand curve is likely to have a signicant kink and what the slope of the demand curve both above and below the kink is likely to be. The idea of the kinked demand curve has an important strategic implication for pricing: if it is thought that the demand curve is kinked, it follows that it is necessary to make a signicant price change and stick with it. Otherwise the price change will have virtually no effect because of competitor reaction. But the danger is that a competitive pricing move may lead to a price war the outcome of which is unpredictable because it depends on the reactions of the individual competitors; for example, a price increase by one company as a result of higher costs may result in all other competitors raising their prices by a similar amount, or one of the companies may see an opportunity to grab a larger market share and may therefore reduce price. The indeterminate outcomes in this

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situation can result in a price war in which the monopoly prots which could be earned because of market imperfections are bidded away.

Exercise 4.3
In Exercise 4.2 the barriers to entry to the supermarket business were assessed. The grocery business in the UK has evolved from fty years ago, when there were many thousands of small shops, to about twenty years ago when town centre supermarkets grew up, to now when the market is dominated by the huge out of town mega stores. Track these changes over time using the different forms of market structure.

4.5

Competitive behaviour

While the notions of market structure provide important insights into how competitive conditions affect protability, it is rare that a company is a pure price taker with little scope for competitive action. All competitive action has to take into account the potential reaction of competitors and it is clearly important to identify how far these reactions can be anticipated. Some light can be thrown on this by applying the concepts of game theory and investigating how competitors are likely to react to different types of pricing.

4.5.1

Game theory

A well known example is the zero sum game, where any gain made by one party is at the expense of the other. This occurs in a mature market where sales are not increasing, so where there are only two competitors they may nd it of mutual benet to have a tacit agreement on prices. In this way they can carve up the market between them and make a prot acceptable to both. However, each company is faced with the possibility that if it were suddenly to cut prices dramatically it might put the other out of business, or attract a substantial part of the others business. But if the other company reacted very fast, and had the resources to cope with further price reductions, the net outcome might be lower prices with both companies being worse off. This is a typical pattern of events in a price war, the net effect being to benet consumers. When attempting to frame a game strategy companies are faced with potential costs and benets, all associated with a high degree of uncertainty. Managers can use what information they have about competitors to assess their possible reactions and perhaps identify a course of action which appears to have a good chance of success. Such competitor information might include estimates of nancial reserves, attitudes to uncertainty, company morale, the strength of the marketing department and previous successes and failures in new ventures. This prole of competitors strengths and weaknesses can help indicate the likely response to different courses of action. However, the dominant characteristic of competitor reaction is unpredictability; the company must always be prepared for a variety of responses to any competitive action. Even with full information on competitors, however, it can be impossible to arrive at an optimum strategy. A game which illustrates this and has important implications for business behaviour is the prisoners dilemma. Imagine the police are trying to make two suspects confess to a major crime, but they have no evidence; the police tell each prisoner privately that Heriot-Watt University Strategic Management

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if he confesses he will go free if the other remains silent but he will go to prison for 7 years if the other also confesses if he remains silent he will be sent to prison for 1 year on a minor charge if the other remains silent but he will go to prison for 10 years if the other confesses. Imagine you are one of the prisoners: what is your best course of action? The rst step in arriving at a conclusion is to draw up a decision matrix which shows the number of years you will spend in prison for each possible action depending on what your partner in crime does. Partner You Silent Confess Silent 1 0 Confess 10 7

The answer is clear: if you stay silent the best you can hope for is 1 year in prison, and the worst is 10 years, whereas by confessing you either go free or spend 7 years in prison. In this case your best option is to confess, independent of what your partner in crime does. This one-off event is articial, but it does contain important lessons for cooperative behaviour, for example when businesses enter into joint enterprises or strategic alliances. Imagine what might happen if you have gone to prison and served 7 years. Given that research into criminals has shown that prison has very little effect on behaviour, assume that you and your partner commit the same crime and end up in exactly the same position once more. Both of you know very well by this time that if both of you do stay silent then you will spend only 1 year in prison, so will your experience affect your behaviour this time round? If you are convinced that your partner sees the virtue of not confessing then it is in your interest to confess, because that way you go free. But the same logic applies to your partner, so once again you will both end up confessing and going back to prison for 7 years. The point of the dilemma is that not only does the situation lead to an outcome which is not in the best interests of either party, but experience does not lead to a different outcome. Turning to the parallel with the business world, you would immediately point out that the two parties are free to discuss what they should do and as a result of their collusion would agree to stay silent, hence serving only 1 year. But this is a true dilemma: once you have reached the agreement then you have even more incentive to confess, because you will go free. The only way out of this dilemma is to introduce another variable which gives an incentive to stick to the agreement. This variable is the knowledge that the situation will be repeated an unknown number of times. Why an unknown number of times? Because after each 1 year sentence it is worthwhile to enter into the agreement, but if it is known that this is the last time then both of you will have an incentive to break it. A great deal of stress is laid on trust and commitment in cooperative business ventures. For example, both parties have an incentive to conceal information on true costs and prots and both have to be sure that the other will not break ranks and make a prot at the expense of the other. But if agreements are not legally binding, both parties are

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continually faced with the equivalent of the prisoners dilemma. One way of building trust is to make a commitment to the venture which would make it costly to break ranks. In the absence of signicant nancial commitments it is not difcult to see why cooperation in a competitive environment is so fragile and difcult to maintain. You may feel that this devalues the concept of trustworthiness as a moral virtue. But in the business setting it is necessary to be realistic about the likely actions of business partners and interpret them in terms of the incentives involved. As you might imagine game theory is a complex subject, but while it is highly mathematical it provides important insights into behaviour. The prisoners dilemma has what is known as a dominant strategy equilibrium because the best strategy is independent of the choice of the other party. If there is not a dominant strategy then it is necessary to estimate the other partys likely response. The logic then becomes rather involved, but it is worth noting that an equilibrium strategy can be achieved in a variety of situations; the mathematician Nash demonstrated the circumstances under which each party makes the best response given what the other has chosen to do. But the fundamental point of the original dilemma is unaltered: unless there is trust and commitment to a course of action there is always an incentive for one party to break ranks.

4.5.2

Pricing

Price setting can be used as a competitive tool and short term revenue ows may be sacriced as the result of cutting price in the pursuit of wider strategic objectives. The three main forms of competitive pricing are price leadership, limit pricing and predatory pricing. Price leadership: the dominant rm in the industry announces its price changes before all other rms, which then match the leaders price. The problem for the price leader is that it has to retaliate against defectors to maintain credibility, but it is difcult to see how the price leader can penalise a defector without penalising all of the smaller companies in the industry. The smaller rms will only cooperate if they gain some benet from the arrangement; the benet is that they do not need to worry that rivals will secretly reduce price to steal market share; hence it is in their interest to adopt a passive pricing role. But in a continually changing competitive environment price leadership is bound to be a fragile situation. Limit pricing: this is an attempt by a rm to erect an entry barrier by charging a low price in order to deter potential entrants; this is only worthwhile if it has a cost advantage and can set the price low enough to deter entry but still make a prot. In reality, there is no point to incumbent rms setting a limit price because potential entrants will recognise that any price reductions prior to entry are articial. Once entry occurs, it would make no sense for the incumbent to continue to suppress price. This is because the lost prot opportunities from having previously set the limit price are sunk and, once the entrant is in the market, the incumbent should attempt to maximise future prots. On the other hand, the potential entrant cannot be certain that the incumbent will in fact attempt to maximise prots after his entry, so it then becomes a game where the incumbent attempts to affect the potential entrants expectations about his subsequent behaviour. It is obviously too simple to think of limit pricing simply as a method of keeping out potential competitors by making returns appear low; it is really an issue of expectations.

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Predatory pricing: in this case a rm sets a price with the objective of driving new entrants or existing rms out of business. In order to make this strategy work it is necessary for the predator to have some strength, such as a large cash reserve or relatively low costs, which other rms in the industry do not share. This approach could work where a competitor is known to be nancially unstable, but otherwise it is likely to lead to competitive reaction, and we are back to the zero sum game. These approaches to competitive pricing are typically encountered in textbooks, but they are rarely found in practice. Probably this is because they characterise extreme forms of competitive behaviour which do not occur much in real life. So far as price leadership is concerned, it is unrealistic to expect one rm to set prices in a competitive market, where changes are occurring all the time; in the case of limit pricing, rms rarely expect to be able to deter competitors from entry by engaging in a price war, and recognise that their real future lies in competing effectively rather than trying to destroy competition; the same applies to eliminating existing competition by predatory pricing - it is one thing to try to win market share by pricing competitively, but it is quite another to set out deliberately to ruin a competitor. The point is that competition cannot be avoided, and a price change which deters or eliminates one competitor is unlikely to have a permanent effect on competitive pressures. Another consideration is that the chance of setting off a price war is particularly high in conditions of oligopoly, outlined at Chapter 4 Section 4.4.3, where it was pointed out that there may be no benet from competitive pricing due to competitive reaction. This does not mean that pricing is irrelevant for strategic purposes, but it does suggest that an attempt to achieve long term competitive advantage using pricing alone is unlikely to be successful.

4.5.3

Contestable markets

Another reason for the lack of empirical evidence on the effectiveness of pricing as a competitive tool is that it is unlikely to have much impact in the absence of structural barriers of the type discussed at Chapter 4 Section 4. This is because, when structural barriers are low, entry deterring strategies would be ineffective because the cost to the incumbent would exceed the benet. In this case entry is so attractive that the incumbent should not waste time trying to prevent it. An extreme case is where entry costs are not sunk and exit can be achieved costlessly, and this is known as a perfectly contestable market. If sunk costs are zero, would-be entrants do not have to worry about the kinds of retaliatory measures that incumbents might implement, because if the entrants nd they cannot make a prot they can simply exit. If incumbents realise this, then they will set their prices so as to stop the entrants from wanting to enter in the rst place. Hence, whether there is one rm or several rms actually operating in it at any time, a perfectly contestable market never offers the incumbent more than the normal rate of prot. This explains why many companies which apparently have a monopoly do not actually make monopoly prots; this is a different situation from a true monopoly which does not make prots because it is relatively inefcient as a result of the absence of direct competition. For a rm contemplating entry to a particular market it is clearly important to differentiate between the two cases.

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Exercise 4.4
It is probably impossible to observe a game in practice, in the form outlined by the prisoners dilemma, and it is unlikely that the three forms of pricing described occur in practice; furthermore, while contestable markets are probably real enough, it is difcult to point to a particular market and describe it as contestable in the theoretical sense. Despite these reservations, attempt to apply the above ideas to the example outlined in Exercise 4.2.

4.6

Segmentation

From the strategy viewpoint, it is often misleading to think in terms of a product which is sold to a homogeneous group of consumers. The theory of competition in markets starts with the assumption that consumers have identical characteristics and have full information about the prices charged for the product; this leads to the notion of a single demand curve for the product, and implies a marketing strategy which concentrates on the average consumer. However, an appraisal of the potential worth of a product may be radically altered by relaxing these assumptions and investigating potential market segments based on variations from the average consumer, and the marketing strategies which might be able to exploit them. For example, it may be found that a 5 per cent price reduction may lead to a 1 per cent increase in sales volume, suggesting that the product is price inelastic. However, the additional sales due to lower prices may be concentrated among consumers in the lowest income group; rather than offering a price reduction to everyone in the market, it would be more effective to offer the price reduction only to those in the group who are likely to respond. In this case the lowest income group is a segment of the market which is a group of consumers within a broader market who possess a common set of characteristics, and these consumers in a segment respond to market mix variables in broadly the same way. An example of a company which focuses on a particular segment is Cray Research, which manufactures super computers for organisations which require massive data analysis capabilities, such as weather forecasting. The economic idea underlying segmentation is that the market demand curve is the summation of the demand curves for market segments; these segment demand curves can vary signicantly in their characteristics. The objective in segmentation is to identify different groups according to their characteristics, estimate how they are likely to react to different selling approaches directed at them, and allocate marketing effort accordingly. There are many characteristics on the basis of which the market can be segmented, such as income, social class, geographical location, age, sex, family size, educational background, etc. When the segments are not separated geographically it may not be feasible to charge different prices among segments, and in this case the marketing thrust would accentuate product characteristics which have a particular appeal to individuals in the different segments. There are in fact four main characteristics which a segment needs to have if it is to be potentially exploitable: Identiable: there must be sufcient common features that enable the segment to Heriot-Watt University Strategic Management

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be identied in the market place. Demand related: the identied segment must have at least one characteristic which translates into demand terms, such as the willingness to pay more for a high quality product. Adequate size: the segment needs to be large enough to generate a potentially attractive return on the investment required to exploit it; this is where techniques such as break even analysis are particularly important. Attainable: if the segment cannot be reached by available marketing and advertising approaches there is no point to embarking on the investment For example, before launching the Lexus motor car the makers had to be convinced that they could reach high income individuals in sufcient numbers; given the erce competition which already existed among high prole brands such as Jaguar, Mercedes and BMW in the segment this was a formidable undertaking. From this a number of key steps can be identied for carrying out a segmentation analysis. Identify the most important segmentation variables An important issue here is whether there are general criteria which can be used in determining which variables are likely to be most important and in what circumstance. The problem is that markets are individual in nature, and it is not possible to derive general criteria. The best that can be done is to approach the issue in a structured fashion, for example: Identify the key product characteristics Derive the characteristics of the target segment Identify the location of the target segment; location can be in the physical sense or by income, social class etc. While it is not possible to provide more than a set of general rules for such a structure, it is essential that this stage is pursued quite deeply so that the company understands where the basis for competitive advantage is likely to lie. Construct a segmentation matrix The identied variables can be combined with other information about the industry to produce a matrix which can identify where segmentation gaps potentially exist. A simple example is to construct a matrix of restaurant ethnic types and quality in a particular city; this could take the following form.

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Quality Type Chinese Japanese Indian Mexican Italian 6 High 3 1 2 Medium 7 3 10 10 4 15 5 9 Low 5

This classication suggests that there is a gap in the market for high quality Mexican and low quality Japanese restaurants. This is merely the rst step and more detailed analysis would look at the potential market size in relation to the number of restaurants of a particular type. For example, comparison with a city of a similar size might reveal that there is potential for at least another three medium Italian restaurants. Analyse segment attractiveness Simply because the fact that these gaps have been identied does not mean that they can be protably lled. The four main characteristics of attractiveness need to be evaluated. Characteristic Identiable Demand related Analysis The criteria of quality and ethnic type are distinctive It is unlikely that people would frequent a low quality Japanese restaurant because of its emphasis on fresh produce. UK consumers have no experience of high quality Mexican food City centre property prices are very high: the start up cost is a major investment in both cases There is no evidence from other cities that anyone wants either type of restaurant Attractiveness High Low

Adequate size Attainable

Low Low

On balance it does not look as through either of these segments is attractive. It is always necessary to bear in mind that in a competitive economy there is usually a very good reason for gaps existing: they have already been tested and found to be unprotable. Identify the key success factors The key success factors are the necessary, but not sufcient, conditions for success. It is possible to identify those activities which must be completed as a precondition for success. Unless close attention is paid to the identication of these factors there is little chance that the segment will be effectively exploited. For example, from the matrix above it might be concluded that there is a gap for another high quality Japanese restaurant. Some key success factors involved in exploiting this segment are identify a source of totally fresh sea food obtain the services of a highly qualied Japanese cook (these are very rare) nd and decorate premises which provide a Japanese look and feel

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4.6.1

Product differentiation

For some products it may be virtually impossible to differentiate among consumers on the basis of product characteristics because the product does not lend itself to this approach; for example, there is little difference between one grain of wheat and another. But it may be possible to change the characteristics of a product in ways which will have particular appeal to different types of segment. An obvious example is a car; for the low income family with young children the optimum car is certainly not a two seater high performance sports car which is relatively expensive both to purchase and run. The potential product can be thought of as a bundle of characteristics which appeal to different consumers in different ways. Product differentiation extends the concept of segmentation to the determination of which bundle of characteristics should be incorporated in the version of the product targeted at each group. There are times when differentiation may be more apparent than real. Differentiation may simply be a perception on the part of potential buyers, for example aspirin is sold under many brand names and all of them simply cure headaches. However, real or perceived differentiation has implications for marketing strategy and pricing policy. Consumer characteristics can be matched with potential product characteristics to identify those market segments where it is likely to be worthwhile to differentiate the product. The two most important determinants of a products success are likely to be the price of the product compared to similar products, and the degree to which consumers perceive the product as a different offering. Data on consumer perceptions of relative price and differentiation can be generated by market research, and the approximate position of the product in Figure 4.8 can be identied.

Figure 4.8: Perceived price/differentiation The model tells some rather obvious things: a product with low perceived differentiation and high perceived relative price is likely to fail; a product with high perceived differentiation and low perceived relative price is likely to succeed. Despite the apparent simplicity of the approach, the model is remarkably powerful in identifying potential courses of action. For example, if current development and pricing plans suggest that a Heriot-Watt University Strategic Management

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product will fall into the uncertain area, a possible strategy response is to reduce price and/or mount an advertising campaign designed to increase perceived differentiation to get into the success likely area. There is little point to pursuing plans which seemed destined to produce a product in the failure likely area. The model can also be used to arrive at a launch strategy. A product which has high perceived differentiation can be put on the market at a relatively high price at rst and then abandoned, or the price reduced when competitors react and the perceived difference is eroded. In the electronics industry, some companies consistently enter new markets with a high priced differentiated product in the knowledge that their competitive advantage will be relatively short lived. This is because the technology can usually be copied; for example, when pocket calculators were rst introduced with many nancial and mathematical features, the subsequent entry of new competitors soon reduced the perceived differentiation because every new calculator had these functions.

4.6.2

Product quality

One of the most frequently encountered approaches to product differentiation is reference to the superior quality of a companys product or service. While managers in many companies believe that part of their appeal to customers is attributable to the superior quality of their products, they are often vague about exactly what the quality difference comprises. The consumer magazines, such as Which? in the UK, which carry out comparative studies of products made by different companies often nd that products differ only marginally, and that their denition of a best buy often bears little relation to manufacturers advertising claims. This confusion is not restricted to consumers; disagreement is often encountered among employees within a given company on what constitutes quality. Some take the view that quality depends on the production process, in other words it depends on how the product is made, while others feel that quality depends on reliability in use. There are several approaches to the denition and measurement of quality, and it is important that managers are clear about what they mean by quality prior to allocating resources either to increasing quality or exploiting it in the market place. However, given the difculties in dening quality shown below, it is not surprising that the role of quality is shrouded in uncertainty. Transcendent quality The philosophical approach to quality is based on a form of circular reasoning which robs the concept of operational use for decision making purposes. Essentially, the Platonic denition relates quality to high standards of excellence and achievement which can only be recognised in the light of experience. Thus a painting by a great master appeals to an art critic who has devoted a large part of his life to the study of art, but will be little more than a pretty picture to a sixteen year old who has had no art education. The pursuit of transcendent standards by managers is unlikely to be related to commercial criteria given the difculty of dening what comprises these standards. Product based quality A product can be viewed as a bundle of characteristics, most of which are susceptible to some form of measurement. For example, compare ying from London to New York rst class on a scheduled ight with ying Concorde before it was withdrawn from service. Concorde took less time, and this can be measured. However, rst class is more comfortable than the rather cramped Concorde, and different passengers will have

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different views on how great the difference in comfort actually is. There is therefore no guarantee that passengers would agree on which was the higher quality ight. It could be argued that the market tells us because those who actually chose to pay the higher price and y Concorde had decided that it provided a higher quality service taking all things into consideration. The characteristics approach has considerable power in classifying products and identifying what it is that consumers are willing to pay for, but product characteristics are not necessarily determinants of product quality; this is because quality may be dependent on how well the characteristics are produced or combined together. Sometimes manufacturers incorporate characteristics which have little relevance to consumers, but which are thought to enhance the quality image of the product. For example, it does not matter much to the average consumer that a particular make of watch will function at 100 metres below water. While the resulting image of dependability may help sales of the watch, the cost of building a case which can withstand high pressure may far outweigh the return from the additional sales. In that sense it could be claimed that the watch had too much quality. This notion of quality also applies to service industries, where quality and consistency are closely linked; most people have had the experience of recommending a restaurant which failed to deliver the same quality for someone else. The consistency characteristic is important, because if it has not been achieved the consumer can have no condence that he will be able to buy the same product each time. But consistency is not actually part of the quality itself, which in the restaurant case depends on the raw materials and the ability of the chef. User based quality This approach departs from the functionally based product characteristic differentiation, and enters the conceptual mineeld of what it is that contributes to quality in the eyes of the consumer. An economic interpretation is that product quality variations cause differences in the position of the demand curve for products which are otherwise identical. But it is difcult to determine what these quality variations might be. For example, take the case of two products which have identical functional characteristics; what is left to vary? One might look better than the other to many consumers, or have what is typically referred to as a better design. For example, this is a feature ascribed to different makes of electric kettle, where the appearance can be changed but it is virtually impossible to alter the functional characteristics. Almost every user based denition of quality can be reinterpreted as a functional, measurable characteristic. For example, durability, exibility, strength and speed are all denable as functional characteristics. One marketing approach is to attempt to identify ideal points, which are precise combinations of characteristics which provide maximum satisfaction to consumers. This takes into account that the interaction of different quality dimensions can produce more utility than the sum of the individual parts. Production based quality This approach relates to production in conformance with specications, independent of what these specications may be in the rst place. Notions such as getting it right rst time, statistical quality control, and designs intended to reduce the scope for manufacturing mistakes, all have the objective of producing the same product each

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time. To some extent the manufacturing based approach can be interpreted as a cost reduction exercise, with the objective of producing a set of product characteristics at the lowest average cost. While there is no doubt that a component of the concept of quality is that each unit performs to the design standards, it begs the question of what comprises the quality standard in the rst place, and why the particular array of characteristics was originally chosen. Value based quality This is a hybrid notion which combines the price, or production cost, with the quality. According to this denition, a running shoe costing $600 is not a quality product, since no one would buy it. This denition can be interpreted in terms of the economic ideas of marginal and total utility. The value based denition of the running shoe hinges on the fact that at the margin consumers would be unwilling to pay the high marginal cost associated with virtually undetectable marginal differences in product characteristics. The marginal cost associated with improving aspects of the running shoes characteristics becomes progressively higher, while the additional utility which the consumer obtains from increments to these characteristics continually declines. Thus while the total utility which the consumer would obtain from the $600 running shoe would be much higher than for a shoe costing $120, consumers do not value the difference at $480. Many cases do exist, however, where seemingly marginal differences in characteristics are translated into very large price differences which consumers are willing to pay. An obvious example is the willingness to pay three times as much for a Rolls-Royce as a Jaguar; it might be argued that in objective terms the marginal utility of the additional $150 000 is less than the perceived additional comfort and performance of the RollsRoyce. Indeed, it may be that the quality difference has been established by prolonged advertising campaigns, which have stressed the quality aspects of the product process without being clear what the quality difference amounts to for the consumer. Rolls-Royce advertising campaigns have stressed the care taken over the production standard of every single component, but whether this can be translated to the consumer in terms of an identiable difference in utility in use is left open. Whether it matters to the consumer that a particular part of the car is hand built is another matter; producers are often confused about the difference between the production process and the nal characteristics of the product. Managers should attempt to determine when a particular production process merely adds to costs rather than to market appeal. The Morgan car company, a British company which makes a range of old style sports cars, refused for many years to alter its production processes in line with technology, and insisted that the whole car be built by hand; while this helped to foster the image of a unique product, the costs associated with this form of quality were such that the rm ran into serious nancial problems. The Morgan car company could not translate the hand built image into a price which consumers were willing to pay. Quality and strategy A considerable amount of research has been carried out into the relationship between different dimensions and market performance; the ndings provide some pointers which are helpful for strategy formulation. Some quality related issues which might appear to be self evident are not necessarily true. For example, quality and price may be expected to be positively related, other things being equal, because of the additional production costs associated with higher quality. However, when different dimensions of quality are Heriot-Watt University Strategic Management

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taken into account, the price-quality relationship is obscure. This means that a company cannot assume that it will be able to charge a higher price after having improved the physical quality of its product. Another nding relates to quality and advertising; it might be expected that quality and advertising expenditure are positively related, given the higher returns to advertising for higher quality products. Again, the evidence is ambivalent. It may be the case that investment in higher perceived quality is a substitute for advertising expenditure. There is some evidence that quality is positively related to market share, suggesting that investment in perceived quality has paid off in the past in marketing terms. There is also some evidence that quality and protability (as measured by ROI) are correlated. Thus on balance, there is some evidence that the pursuit of quality may generate returns in terms of competitive advantage and prots. However, while the empirical evidence suggests that important inuences are at work, it is not clear cut, and the pay-off from quality may vary substantially depending on the circumstances. The idea that quality is a fundamental determinant of success has generated an approach known as total quality management (TQM). As its name suggests, quality in all its dimensions is pursued with a high degree of rigour and commitment. Notions of quality are brought to the forefront of awareness, and include all aspects of company performance through production processes and customer service. Some countries have introduced formal quality standards against which companies can be appraised; for example, in the UK the BS5750 award signals that a company has met various quality criteria relating to production processes. But the pursuit of TQM is by no means an exact science because of the difculty of dening quality and providing the incentives which will make quality initiatives work. TQM took on the characteristics of a philosophy rather than a particular business technique, and is greatly dependent for its success on the energy and commitment of the approach in particular circumstances. TQM is a relatively recent development and gained its momentum during the 1980s, but by the mid 1990s scepticism had set in. This occurred because, while there were some well publicised instances where TQM appeared to have been successful (for example Rank Xerox and Motorola), surveys revealed that up to 80 per cent of TQM initiatives failed. Research on the issue suggests that the features most generally associated with TQM, such as quality training, process improvement and benchmarking, do not in themselves produce competitive advantage; this is probably because these can be imitated by competitors without necessarily being associated with a TQM programme. However, some tacit and behavioural features such as an open culture, employee empowerment and executive commitment do appear to be associated with advantage. In other words these tacit characteristics, and not TQM tools and techniques, drive TQM successes, and organisations that acquire them can perform relatively better than competitors without the accompanying TQM ideology. Discussions on quality can benet from attempting to identify specically which areas of revenue and cost different dimensions are likely to affect, and in which market segments. One of the effects of TQM was to demonstrate that there was not necessarily a tradeoff between quality and cost, and many companies which successfully implemented TQM programmes reported simultaneous increases in productivity and quality. However, it may be that successful TQM programmes have merely eliminated inefciencies in companies and after this has been achieved there is no such thing as a costless improvement in quality. Table 4.1 shows how it might be possible to relate variations in different quality dimensions to potential implications for market share and production Heriot-Watt University Strategic Management

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cost in a particular market segment; the entries would depend on the circumstances facing the individual company. Table 4.1: Quality and competitive advantage Impact on Dimension performance reliability conformance aesthetics Market share High High Low Medium Production cost High Low Medium Low

For this company a relatively low production cost incurred to improve reliability would lead to a potentially high impact on market share. While improvements in performance are also likely to lead to a high impact on market share, the high cost associated with performance may make it a less attractive option than improving aesthetics. This cost based approach is at odds with TQM, which holds that all aspects of quality are important because of the interdependence of the various functions in the company.

4.6.3

Pricing in segments

It goes without saying that market conditions differ among segments, and that different prices can be charged in each. However, it may well be the case that there are virtually no differences in the cost of products sold in different segments; for example, where segments are based on geographical location rather than product differentiation there may be no difference in the production cost in each. What is the optimum price to charge in each segment? This topic has been extensively treated in economics, and is known as discriminating monopoly. The economic theory is relevant here because the effect of segmentation is to confer some degree of monopoly power to the company in the different segments; it also stresses the importance of market rather than cost conditions when setting prices. Without elaborating the theory (which can be found in any intermediate level economics textbook), it will come as no surprise that the conclusion arrived at is that, in pursuit of prot maximisation, a monopolist will charge different prices in different markets depending on demand conditions. This follows despite the fact that the marginal cost of production is identical in each market. In terms of the basic model, the theory is concerned with nding the price in each market for which revenue minus cost is maximised. The monopolist will charge a higher price in a market with a low demand elasticity than in a market with a high demand elasticity. The implication for pricing is clear: if different demand conditions exist in different parts of the market different prices should be charged, even though costs are the same in each. There is a real pay off from nding out what the different demand conditions are, rather than setting a uniform price in all parts of the market. This is because total prot from the uniform price is lower than the sum of prots obtained from differential pricing. This arises from selling much more of the product at a lower price in the segments where demand is relatively responsive to price, and less of the product at a higher Heriot-Watt University Strategic Management

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price in segments where demand is relatively unresponsive to price. Segmentation is therefore a potentially powerful tool for transforming a loss-making product into a protable product without changing anything but the price charged to different groups of consumers. In many market situations the potential for segmentation exists, but it has not been exploited as a source of additional revenue because managers are unaware of the notions of segmentation and differential pricing. Marketing practitioners have turned segmentation into an operational tool for exploiting markets. The rst step is to carry out research to determine the characteristics of different segments of the market, and the product characteristics which might best match with them. The second step is to derive estimates of price and income elasticities; in marketing terminology, this is often expressed as price and income responsiveness. The additional feature added by marketing strategy is that the product itself is adjusted to match as closely as possible the demand characteristics of the different segments, or advertising campaigns are mounted to convince potential consumers that differences exist in different brands of the same product. Because resources are required to differentiate products, marginal cost may not be identical in the different market segments; however, the principle of differential pricing based on market conditions still applies despite the fact that production costs are different. The theory of price discrimination, on which differentiation is based, can be developed further to demonstrate that there are limits to the extent of segmentation depending on the impact of segmentation on costs. The potentially higher revenues from segmenting the market, differentiating the product and setting different prices can be balanced against the additional costs incurred in each segment in order to obtain an approximation to the limits imposed by cost differences. Market segmentation is a good example of how economic, accounting and marketing approaches can be integrated to provide a conceptual structure to deal with the diverse information occurring in real life. For example, marketing ideas identify a product where segmentation is potentially viable, economic ideas are used to measure demand characteristics, and emphasise the role of marginal cost in decision making, accounting ideas are applied to identify marginal cost. It can be noted that relevant accounting information on marginal costs is essential for making rational segmenting decisions: unless the marginal costs relating to product differentiation are properly estimated, the result may be what appears to be a successful marketing strategy in terms of capturing market share, but poor prots because the use of average costs led to a misallocation of resources.

Exercise 4.5
One of the signicant marketing events of 1992 was the sudden decision to reduce the price of Marlboro cigarettes. The background to this event was It was the dumbest decision in corporate history. They have ruined one of the best brand names in the world and have created permanent damage. Henry Kravis, famous Wall Street buyout specialist, addressing Harvard Business School students. It is commercial suicide. All that investment in the brand, then you tell people that you can now buy for less than $2 what was worth $2.15 until yesterday. The buyer is never going to believe you again. Bruce Davidson, tobacco analyst at the broker Smith New Court. Heriot-Watt University Strategic Management

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Kravis was referring to the decision by Philip Morris to cut the price of Marlboro cigarettes by 20 per cent. He was not, however, an unbiased observer, having been responsible in 1989 for a take-over of RJR Nabisco which had responded by cutting the prices on their Camel and Winston brands. Financial markets expected the price war will have a signicant impact on the protability of cigarette companies - Philip Morris share price fell from $64 to $51 (23 per cent) within minutes of the announcement of the price reduction, and fell further to $46 the following week. Wall Street itself took fright and fell by 50 points. However, the notion that Philip Morris had simply ruined a brand name must be seen against the wider economic forces against which the Marlboro brand had been struggling for a considerable time. The total market for cigarettes The total market for cigarettes had been declining for some years, although it was growing in the Far East and east Europe. In the context of a declining market, the total US market was price inelastic; advertising campaigns were primarily aimed at increasing or maintaining the market share of individual brands. There was no expectation that the Marlboro price cut would increase total cigarette sales. However, despite the declining market the major companies had been able to increase prots because of technological progress. Productivity increased dramatically; in 5 years daily production increased from 7500 per minute to 15 000, with accompanying cost reductions. Changing competitive conditions Technological progress and falling costs played a part in the introduction of cheaper discount cigarettes. Figure 4.9 shows the growth in the market share of discounted cigarettes.

Figure 4.9: Discounted cigarettes as % of US market At the same time Marlboros market share was in decline, as shown in Figure 4.10.

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Figure 4.10: Marlboro market share Sales dropped by 366 million packs in 1992, costing $200m in prot. It is not surprising that the discounted brands made such inroads into the premium brands market share given the disparity in price between the two; for example Price of cheapest discount brand: $0.69 Price of Marlboro: $2.15 Consumers have probably asked themselves what it is about a particular cigarette that makes it worth 3 times as much as another. The Marlboro advertising strategy was targeted at 18-24 year old men, on the basis that smokers tend to stay with the same brand for years. The cowboy based advertising campaign has been familiar since the mid 1950s, and many observers considered that Marlboro was the worlds best marketed product. However, in 1988 Camel introduced a campaign using a camel image called Joe. By 1991 Camels market share was 4 per cent, and it was generally felt that Camel was taking market share from Marlboro. Market position The dominance of Marlboro in the cigarette market is illustrated in Figure 4.11, which shows market shares by volume.

Figure 4.11: US cigarette market shares But the ability of the main competitors to wage a price war depends on more than the Heriot-Watt University Strategic Management

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success of the individual brands. The overall market shares of the two main competitors were: Premium Discount Philip Morris (Marlboro etc) RJR Nabisco (Camel etc) 34 19 8 10

In 1989 Kravis partnership fund KKR took over RJR Nabisco for $25 billion, of which only $3 billion was from the KKR buyout fund; KKR was much more heavily in debt than Philip Morris. Rationale for price cuts On the basis of the price differential, it follows that the margins on discount cigarettes were relatively small, and there was little scope for the discount producers to reduce their prices signicantly in response to the Marlboro cuts. This means that the differential between Marlboro and the premium brands would be signicantly reduced, and it was hoped that this would be sufcient to entice smokers back to the premium brand. Use all the segmentation ideas to analyse what was happening to Marlboro.

4.7

The life cycle

The tools of competitive analysis discussed in this chapter are extremely powerful, but they all suffer from the fact that they have no dynamic dimension. The analysis is carried out at a particular time and place, and it is difcult to take account of longer term changes in the market place. The analysis of industry dynamics is based on the life cycle model: introduction: the product is invented and introduced to the market; it can take some time for information about the product to be disseminated growth: the product becomes increasingly well known, markets are penetrated and it possibly replaces other products maturity: all markets are exploited and there is no further increase in sales decline: the product is superseded by technological progress, or substitutes appear The product life cycle is depicted in Figure 4.12, which is a general representation rather than referring to any particular product.

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Figure 4.12: Since industries are composed of products the idea of the life cycle can be generalised to the industry level, and Figure 4.12 can be regarded as either referring to a product or to the industry. Everyone is familiar with industry life cycles in broad terms, for example, the very high rates of growth in the personal computer market, which have now slackened off as the industry approaches maturity, or the decline of the cigarette industry in Western countries as information on the health risk of smoking reduces the number of consumers. While the idea of the life cycle is a very general one, and varies according to the product and the country, it is an essential tool of strategic analysis because the companys estimate of where the industry is on the life cycle greatly determines its choice of strategy. The idea provides a structure within which market information can be interpreted rather than being an absolute representation of reality. As the pace of technological change has increased in the past few decades, it is generally felt that product life cycles have also shortened. The implication of this is that companies in high technology industries must continually strive to improve their existing products and invent new ones simply to stay in the game. For example, every new mobile phone launched on the market has to have a host of new features to stand any chance of success; features now regarded as standard would not have been dreamt of in the 1990s, including photographic, email and internet browsing facilities. The importance of the life cycle idea becomes apparent when considering the type of strategic approach which companies need to adopt in the different stages. Introduction The company invests in new productive capacity and spends relatively high amounts on marketing to bring the product to the notice of consumers. Cash ows are likely to be negative, and during this period the company has little idea of how the market will develop, what competitors will appear, and in fact whether its investments are likely to be justied. Growth As sales start to increase the company has to invest further in productive capacity ahead of market demand, and has to meet the challenge of new entrants; despite the costs involved in entering a new and growing market, there are potentially very high returns from the rst mover advantage. However, if the company wishes to maintain its market share in a growth market, it is necessary to increase sales; this is because market share equals sales divided by the market size, so if market Heriot-Watt University Strategic Management

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size increases market share will fall unless sales increase by at least the same percentage as the market. To achieve increased sales it is necessary to adopt aggressive marketing and offer competitive prices. If the company wishes to increase market share during this stage, with the aim of being one of the market leaders when the product cycle reaches maturity, it is necessary to be even more aggressive. During this period it is unlikely that the product will produce signicant prots because marketing expenditure is relatively high prices are set relatively low capacity is underutilised in the expectation of increased orders Maturity During this stage the company is able to gear its productive capacity to demand, and attention is turned to protecting market share. If the company has not gained a signicant market share by the time the market matures it will nd it very difcult to do so because do to so means taking customers away from competitors. Price does not need to be set below that of the competition to keep the existing market share, and marketing expenditure can be reduced. Thus once revenues have stabilised, selling costs can be reduced which generate the potential for substantial positive net cash ows. Decline The company has to decide whether to exit the industry, or phase out its productive capacity. This is not the time to be undertaking new investments, which is why it is important that companies recognise the threat posed by the advent of this stage of the life cycle. The transition from growth to maturity A crucial stage in the product life cycle occurs when the transition occurs from growth to maturity. Given that the management of products in the two stages is so different it is necessary for the company to make changes during the transition. Many companies do not recognise in time that the transition has occurred and lose their competitive advantage. In the growth stage it is to be expected that prots will be relatively low because of the high costs incurred in marketing aggressively and maintaining excess capacity. When the market ceases to grow carrying on with these policies can lead to losses and company failures. That is why the transition is sometimes known as the shakeout. In practice it is not a simple matter to avoid the problems of transition because it is very difcult to identify when the market is approaching maturity. It is difcult to detect when the market growth rate has started to reduce; forecasting is notoriously difcult and if the company moves too soon it will lose sales because of lack of capacity. Apart from the difculty of identifying the transition companies often adopt a mind set during the growth stage that is unwilling to recognise that conditions are different and it is time to adopt a new approach. The product life cycle model occurs in the context of the business cycle, which makes it difcult to identify the transition stage because it is easy to confuse a slow down in Heriot-Watt University Strategic Management

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demand due to macroeconomic factors with a slowdown due to the transition phase. Furthermore, a downturn in the business cycle may cause a reduction in market size during the mature part of the life cycle, at a time when signicant reductions would not normally be expected. This may lead companies to think the market has entered a the decline stage rather than the decrease being temporary. Real product life cycles are not smooth but have an uneven pattern depending on the extent to which the product is affected by economic circumstances. It is obviously difcult to differentiate business cycle effects from the underlying product life cycle. It is, however, important be explicit about what is thought to be happening, because the strategy implications of a fall in sales due to a temporary reduction in consumer incomes differ from those due to the onset of the end of the product life cycle. The main differences in approach over the course of the product life cycle can be summarised as follows. Decision Price Marketing Capacity Investment Introduction Low High High High Growth Low High High High Transition Increase Reduce Reduce Reduce Maturity Market Low JIT Decline Market Low Reduce

Replacement Zero

This interpretation is not a prescription for success but is indicative of the changes in emphasis that companies have to consider as the product moves through the life cycle; there is plenty of scope for strategic moves as opportunities are identied, for example a competitor may go out of business during the mature stage and action can be taken to attract more customers. It emerges clearly that Just in Time (JIT) techniques are applicable only during the maturity stage. There is a signicant benet to be gained from focusing on inventory control when demand is fairly stable, but when the market is growing the primary requirement is to ensure that there is sufcient capacity to meet increased orders. Application of JIT during this stage can lead to lost orders and ultimately to the loss of competitive advantage because market share will be lower than it otherwise would have been.

Exercise 4.6
Add the effect of the product life cycle to the discussion of Marlboro in the previous section.

4.8

Portfolio models

The concepts of demand analysis, differentiation, segmentation and life cycles are important ideas that contribute to the formulation of strategy. Many of these concepts can be incorporated into models which generate important insights into the strategic potential of individual products. But it is the dynamic development of markets and competition over time which makes strategy so complex, and an important dimension of portfolio models is that they take the passage of time explicitly into account through the incorporation of the life cycle idea. Heriot-Watt University Strategic Management

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4.8.1

The BCG relative share growth matrix

The best known of the portfolio models was developed by the Boston Consulting Group (BCG)1 which focuses on two factors: relative market share, and the stage of the product life cycle. It was discussed at Chapter 4 Section 8 how the companys strategic approach is affected by the stage of the product life cycle. Another important factor is the relative market share, which is dened in terms of the companys market share compared to that of its leading competitors. The implications of relative market share for competitive advantage arise from two inuences. 1. Economies of scale: result in lower average cost as the productive capacity of the company increases. The higher a companys market share the larger must be its productive capacity compared to its competitors. This is because a sale made by one company is by denition a sale not made by another company, thus the higher the market share of one company, the smaller must be competing companies on average, and the less their opportunities to capture economies of scale. When economies of scale exist, it follows that the higher the market share of a company compared to that of competitors, the lower will be its relative unit cost. 2. The experience effect: a company with the highest market share to date must have a higher cumulative output to date than its competitors, and hence its labour force has the potential to be higher up the learning curve, resulting in lower per unit labour costs. As a company produces additional units of output, other factors also contribute to continuing cost reductions; these include fewer rejects and better designed production lines. The combination of the effect of the learning curve and these inuences results in what is known as the experience curve; research suggests that each doubling of output leads to a 20 per cent reduction in unit cost because of experience effects. The two variables of market growth rate and relative market share are plotted against each other as shown in Figure 4.13.

Figure 4.13: The BCG matrix Individual products are positioned in the matrix depending on their relative market share and the current market growth rate and are classied according to which quadrant they Heriot-Watt University Strategic Management

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fall into. In order to determine a products position in the matrix it is necessary to decide on its position in the product life cycle. This is bound to be imprecise, as already discussed, but the importance of identifying the transition from growth to maturity now becomes more apparent because of the products potential for generating positive cash ows as it develops from the Star to the Cash Cow position. While the classications are approximate they provide a powerful tool for identifying important characteristics relating to the performance of products. The Dog A product which has a low market share in a stable market, and which is not making prots currently, stands little chance of making prots in the future. This is because the costs of increasing market share are likely to outweigh the potential gains. The costs of attempting to increase market share will be high because the market has stabilised and it will be necessary to attract customers from competing companies; this can only be done by increased marketing expenditure and/or price reductions, and this is likely to lead to competitive reaction, the prospect of which adds considerably to the uncertainty of the exercise. A Dog may have already cost the company a considerable amount in development and marketing, and managers may feel averse to abandoning a product which has already cost so much. This reasoning is false because costs incurred in the past (sunk costs) have no bearing on the future. Abandoning the Dog will release scarce resources which could be put to more protable use. It does not follow that because a product lies in this part of the matrix that it cannot make prots. It may occupy a niche, or there may be no economies of scale that give larger competitors a cost advantage. In this case it is the relatively efcient company which makes the most prot. If a product is not currently making prots and is being produced as efciently as possible, it has little future. Cash Cow This product achieves higher economies of scale and is further up the experience curve than competitors. It has low marketing costs because of brand loyalty, the price is set at the same level as competitors and capacity is aligned with demand. The Star The Star will incur relatively high costs for the following reasons Marketing costs will be high because of the competition for new customers as market size increases. Production costs will be relatively high because as the company increases output it will be introducing cohorts of workers at lower levels on the experience curve. Capital costs will be high because of the need to install capacity ahead of demand: there is no point in spending resources on marketing and being unable to handle the demand. Inventory costs are likely to be high because it will be difcult to align output with demand. In addition, price has to be set below that of competitors to attract new customers, with the result that the margin on sales is likely to be low or even negative; the net Heriot-Watt University Strategic Management

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result is that the Star is likely to make a loss. It is not possible to be precise about the magnitude of the loss because some Stars may achieve an early mover advantage and make signicant prots. The objective in managing a Star is to maintain or increase market share until market growth ceases and it becomes a cash generating Cash Cow. The Question Mark The product in this sector is called a Question Mark because it will become a Dog if the market matures before market share can be increased, while it is uncertain whether it can be converted into a Star in time. The Question Mark will incur relatively high costs for the same reason as the Star, but it will have to put even more resources into marketing and set even lower prices. It is therefore likely that the Question Mark will incur heavy losses in the attempt to convert it to a Star. There is no real option in this, because if no attempt is made to convert it to a Star it will inevitably become a Dog. Applying the BCG matrix In order to use the BCG matrix effectively it is necessary to recognise that the classication is based on two variables only: market growth and market share. It should not be applied in a mechanistic way, for example it cannot be concluded that all Dogs will make losses and all Cash Cows will generate high prots. This is because market conditions may result in a protable Dog and poor management in a loss making Cash Cow. By and large it is to be expected that cash is generated by the Cash Cows and is used to invest in the Stars and Question Marks. The strategy implications of different BCG classications combined with product characteristics are outlined below. The strategy implications are not necessarily denitive and are open to discussion, but they are indicative of the type of conclusion that can be reached on the basis of portfolio analysis. BCG Classication Characteristic Cash Cow Protable Loss making Cash Cow Strategy implication Defend Missed transition: review capacity, investigate JIT, consider pricing and elasticity Entering decline stage; reduce capacity, marketing and investment

Cash Cow

Dog Dog Star Star Question Mark Question Mark

Probably no economies of scale; potentially vulnerable so monitor closely Loss making Divest Large losses Possibly entering transition to maturity: cut back on capacity and marketing. Losing market share Increase marketing and reduce price Severe losses Determine if there is sufcient time to develop into star Maintain resource allocation to develop into Gaining market Star share

Declining sales, market share unchanged Protable

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Back to the demand curve At this stage we should not lose sight of the relevance of demand curve analysis which related revenue changes to changes in price and market share in terms of movements along, and movements of, the demand curve. In the growth stage of the cycle, demand analysis can be used to provide an indication of the price that would maintain or increase market share. At this stage the objective is not to maximise prot in the short run but to lay the foundation for a cash cow. Once the market has stabilised, i.e. the total market has stopped growing, the question of prot maximisation and the optimum market share can be addressed. One of the advantages of portfolio analysis is that it focuses attention on a longer run view of costs, and the possible implications of a lower market share for competitors costs. Demand analysis is one step in the determination of competitive advantage and prot maximisation.

4.8.2

Other portfolio models

The salient characteristic of other portfolio models is that they are more complex than the BCG matrix, and take into account many more variables. This means that they cannot be fully displayed in matrix form because they have too many dimensions. For example, the Mackinsey portfolio model has two general dimensions of business strength and industry attractiveness. Business strength takes into account such variables as capacity utilisation and relative costs, and industry attractiveness takes into account variables such as growth rate, protability, cost trends and industry structure. The variables are weighted in terms of relative importance, and scored to give an overall rating for the two dimensions. It is not clear whether the additional complexity adds signicantly to the strategic analysis which emerges from the BCG model.

4.8.3

Portfolio models and corporate strategy

The product portfolio is an important tool in the management of individual products through the life cycle. It also provides a useful perspective on the mix of products which comprise a corporation. Is there such a thing as an optimum portfolio? A company which is comprised only of Cash Cows will remain static by denition, and is liable to suffer substantial reductions in cash ows as products come to the end of their life cycles. However, too many Question Marks and Stars may drain company resources. An optimum portfolio could be dened as one in which the Cash Cows generate sufcient cash ows to produce adequate returns to shareholders and the cash necessary to develop the potential of Question Marks and Stars to replace the Cash Cows in time. If the company had ambitions to grow, the balance between Cash Cows, Stars and Question Marks would be adjusted accordingly. Portfolio selection is not a mechanistic process based on the selection of products as they appear in the BCG matrix. There are many difculties involved in identifying which Question Marks and Stars are likely to succeed. The portfolio decision will depend on the various risks involved, and the companys attitude to risk bearing. Furthermore, the variables in the matrix do not capture all relevant product characteristics. A company may have a balanced portfolio in the sense that it has no loss-making Dogs, and several Stars and Question Marks which will replace ageing Cash Cows. But products are not conceptual entities to be guided through the stages of the product life cycle; managers have to know a lot about their products, including how to make them at the lowest cost and sell them effectively against competitors. A balanced portfolio which is comprised Heriot-Watt University Strategic Management

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of totally unrelated products in a diversied company may be virtually unmanageable, and there is no guarantee that the corporation is adding value by including all of them in the portfolio. Consideration needs to be given to developing a portfolio in which products are linked in such a way as to benet from the competencies of the corporation. Diversications which are aimed solely at balancing the portfolio may be totally misguided; the company can end up with an unmanageable portfolio, and this has been a contributing factor to the failure of many diversications in the past. A competitor may decide to undertake a change of direction through diversication into new markets; if this leads to a preponderance of Stars and Question Marks it may reduce the resources available to maintain competitiveness in existing markets. The portfolio model can enable SBU managers to visualise competition at the corporate level, where it is not so much the product itself which is of importance, but its contribution to the product portfolio. The SBU manager may be unwilling to dispose of a Star which he sees as having considerable future potential; from the corporate viewpoint the product may not t with the companys competencies and more value could be created by selling it and devoting the resources elsewhere. The process of selecting the optimal portfolio can be envisaged in terms of the markets and products in which the company is currently or potentially operating. A systematic approach to identifying the components of the portfolio strategy was developed by Ansoff 2 and he dened what he called the growth vector which interpreted the direction in which the company intended to develop its portfolio. The growth portfolio was originally specied in terms of the company mission in relation to its product; rather than explore the growth vector in terms of company mission, which Ansoff dened in a particular way, Figure 4.14 builds on Ansoffs approach and develops a growth vector in terms of markets and products.

Figure 4.14: Components of a growth vs sector Penetration If the company wishes to grow relative to competitors on the basis of the products which it sells in existing markets it can only do so by increased penetration, and hence by an increase in market share. If the market is mature it follows that sales can only be gained at the expense of incumbents, while if the market is growing the company must continuously acquire a larger share of market growth than competitors. For the mature market, this can be interpreted as developing a dog into a cash cow, and for a growth market as developing a question mark into a star. Either way, growth depends

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

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markets with a new set of products and is therefore akin to the notion of unrelated diversication discussed at Chapter 5 Section 5.12.4. In this case there is no direct experience of marketing strategy which can be applied, while the company has no experience of production. Car makers often have a wide portfolio of car types, and often have interests in lorries (or trucks) and buses; but few have productive capacity in earth moving equipment, for example. An interesting exercise is to try to identify car companies which have moved into the diversication part of the matrix. No growth strategy will ever t exactly into a particular segment of the matrix, but this simple classication helps to interpret the impact of a particular course of action on the product portfolio, and the extent to which it ts with the current knowledge of markets and products. The matrix can be greatly elaborated to incorporate dimensions such as geographical location and product technologies, but the fundamental message is the same: make explicit the direction of change in which the growth strategy will take the company, and incorporate this into the design of the portfolio.

Exercise 4.7
The following advertisement and related discussion took place in a hypothetical company (which is actually based on a real life situation). ADVERTISEMENT SUPERTOOLS PLC THE TOOL COMPANY YOU CAN TRUST If you want an individually crafted hand plane which cuts evenly through all types of wood and is individually tailored to your needs, then the StylePlane is for you. Our traditional workmanship and use of the best materials ensure that you will be buying a unique instrument which will last for at least 10 years. Continual product renement ensures that your StylePlane will be admired and respected, while our after sales service is second to none. If your needs are less modest, try our electric PowerPlane: what it lacks in individuality and precision it makes up for in speed. MINUTES OF THE SUPERTOOLS MANAGEMENT MEETING Accountant: I am concerned about the low protability on sales of the Power- Plane. We make a lot more on our traditional product, and servicing the debt incurred in retooling for the PowerPlane is quite a burden. Furthermore, I dont understand why we are selling the PowerPlane at such a low price compared with similar makes. After all, the StylePlane is the most expensive hand plane on the market. Production manager: I ran the StylePlane for 25 years without problems, but this new fangled PowerPlane is more difcult to manage. I take a hands-off approach and generally leave the supervisors to get on with it, but I should point out that we have enormous productive capacity, and we are holding a lot of inventories. But we never have to hold much inventory for the StylePlane because it tends to be made for individual orders. Human resource manager: we are now employing a different kind of person for the PowerPlane, and our old and trustworthy skilled people who have been producing the StylePlane for two generations are almost impossible to replace. I also have a problem with morale, in that these workers reckon that StylePlane prots are draining away in Heriot-Watt University Strategic Management

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nancing the PowerPlane. CEO: it looks like we made a mistake going into the new technology; maybe we should have simply kept on with what we were good at. We control at least 80 per cent of the market in StylePlanes, and look at the latest improvement to the StylePlane: brass inlaid edging which adds hugely to the look of the instrument. What does our new marketing manager have to say? Marketing manager: the market has changed a great deal in the past 10 years. Although we have about 80 per cent of the market, StylePlane customers are getting as rare as the people who make them. We are now trying to service a growing population of relatively young home-owners who wish to tackle general home improvements rather than experts who produce ne cabinets. And you have to bear in mind that the PowerPlane market is subject to fast technological change; at the moment PowerPlane has about 15 per cent market share, which has increased from 10 per cent two years ago; we are by no means the biggest in the market. CEO: youll be telling us we should be going into powered sanding machines next. We never needed a marketing manager in the old days, when the StylePlane sold itself by its reputation. It is displayed prominently in every major toolshop in the country, but no one seems to be interested in pushing sales of the PowerPlane. I dont want us to get into the situation where we are selling one product against another. Lets discuss this again at our next meeting, by which time I hope that our production manager has done something about getting PowerPlane costs down. 1. Locate the two products in the BCG matrix and give your reasons. 2. Apply other models to SuperTools products. 3. Assess SuperTools portfolio in corporate strategy terms.

4.9

Strategic groups

It may not be immediately obvious where in an industry competitive forces actually arise; there may be many rms in an industry but not all of them may be direct competitors. One approach is to identify strategic groups, which are sets of rms in an industry similar to one another and different from rms outside the group on one or more key dimensions of their characteristics and strategy. Identifying the groups makes it possible for the rm to nd close and distant competitors and analyse the likely competitive implications of changes in strategy. But while this sounds ne in principle it is difcult to apply in practice because of the many variables which could be used to classify competitors; these include organisation: scale, degree of vertical integration or diversication, distribution channels product characteristics: quality, image, level of technology nancial structure: return on assets, gearing

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It is necessary to use a degree of imagination to obtain insights into the strategic groupings within the industry. For example, two important variables might be identied and mapped against each other to see how rms in the industry cluster together. An example is in the restaurant business in a cosmopolitan city where there are many ethnic restaurants, all of which offer different styles of cooking. Take the three most numerous types of ethnic restaurant: Indian, Chinese and Thai. At rst sight it might appear that these three styles of restaurant are not in direct competition; however, they compete on more than cooking style. There are at least two dimensions besides cooking style: quality and degree of specialisation. There is no question that restaurants target different levels of quality within the same ethnic group; within their broad style restaurants specialise in different ways, for example, in sh, seafood, vegetarian and region. It is instructive to think of a number of ethnic restaurants and plot them on a graph as shown in Figure 4.15.

Figure 4.15: I have carried this out for my own city of Edinburgh, and nd that the clusters are quite pronounced as shown. Basically, there are four clusters, and it is within these that a great deal of competition arises rather than between, say, high quality and low quality Indian restaurants. This example uses two characteristics of product differentiation to identify the strategic group. Another dimension could be the number of restaurants under one owner: there may be signicant economies in purchasing and minimising excess capacity with increasing numbers of restaurants. Since the denition of the industry group is dependent on the selection of relevant variables it is far from being an exact science. But attempting to dene the strategic group can provide a perspective on competitive pressures which is not apparent from aggregate data.

Exercise 4.8
Using SuperTools as a basis, draw the axes within which you would plot strategic groups within the tool industry and locate the two products.

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4.10

The structural analysis of industries

The economic models of market structure demonstrate that the degree of competition in an industry is the result of structural factors over which individual companies have little control. A rm in a highly competitive market has no option but to be a price taker; a rm in a monopoly position may be able to limit competition, but entry deterring strategies are often constrained by contestability; oligopolists have to exercise restraint because of potential retaliation from major competitors. In an attempt to make explicit the various factors which determine competitive conditions within an industry, Porter3 identied what became known as the ve forces. The basic idea is that competition arises from several features of the market and if companies recognise these competitive forces they will be better equipped to achieve competitive advantage. The ve forces are Threat of new entrants Threat of substitutes Suppliers bargaining power Buyers bargaining power Industry competitors rivalry Porters view is that the collective strength of these competitive forces determines the ability of rms in an industry to earn rates of return on investment above the cost of capital. Another way of looking at the ve forces is that they identify the areas in which the conditions for perfect competition do not apply; it has already been pointed out that while the conditions for perfect competition are rarely found, in those instances where they are approximated to then companies tend to make the opportunity cost of their capital, i.e. there are no monopoly prots. Industry competitors rivalry In order to assess the intensity of rivalry, start by considering the number of competitors in the industry: Number of rms Many Few One Type of market Perfect Oligopoly Monopoly Basis for competition Price Differentiation Price (to deter entrants)

In one sense the intensity of rivalry decreases from perfect competition to monopoly. In comparative static terms a company in a perfect market in equilibrium earns the opportunity cost of capital (normal prot) while a monopolist earns more than normal prot. But in a dynamic sense rivalry might appear to be different. Consider the following three cases. A market that is moving towards perfect competition (because the product is becoming homogeneous and barriers to entry are falling) may contain many companies that are acting in an aggressively competitive manner by cutting prices Heriot-Watt University Strategic Management

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and increasing marketing; but a market that has reached a situation approximating to equilibrium may not show much evidence of competitive activity. It is possible for oligopolists to exist in tacit harmony for considerable periods but suddenly to embark on a price war where competition is overt. A monopolist may be in a highly contestable market that makes it impossible to earn signicantly higher than normal prot. The market structure (perfect competition, oligopoly or monopoly) largely determines the prot that can be made. But competitive pressures may not be evident to the observer, as in the case of contestability which is based on potential competitors. Therefore the intensity of rivalry cannot be assessed merely by observing the behaviour of competitors. Additional insights into rivalry can be gained from taking the product life cycle into account as the following scenarios demonstrate. Life Cycle Stage Introduction Growth Transition Maturity Decline Competitive actions First mover Competing for increased market share Competing to establish cash cow Companies defend position Attempt to protect sales rather than market share Rivalry Low High High Low High

Establishing the intensity of rivalry therefore requires several inuences to be taken into account, including market structure, the product life cycle and recent competitive activity. The strategic implication of intense rivalry is that the company has to be careful about any action that will be interpreted as an attempt to win market share from competitors. Product improvements, a new marketing campaign or a new pricing structure are all likely to lead to immediate competitive response. Therefore it is of prime importance to assess the intensity of rivalry. Threat of new entrants The threat posed by new entrants depends on the barriers to entry, which in turn depend on the following: Economies of scale: incumbents may have an advantage because of their size because entrants would have higher costs, at least initially. Regulation: there may be laws or legal requirements which inhibit potential competitors. But these may be relaxed in the future as, for example, the government adopts a less direct role in the economy. Entry price: there is a price at which entry will appear attractive to rms outside the industry. Technological factors: where entry has previously been made difcult because of high R&D investment, the incumbent may become at risk because the technology is copied. It is not a simple matter to identify and assess the risk of entry. In the examples above the threats may lie in the future rather than the present and could be identied by a Heriot-Watt University Strategic Management

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PEST analysis. Once the potential risk has been identied a response can be worked out to maintain the barrier to entry. If no response is feasible a strategy to respond to the impact of entry needs to be determined. The danger for many companies is that they do not recognise the potential threat from new entrants until it is too late because they focus on what competitors are actually doing rather than the conditions that make entry attractive. Threat of substitutes To a large extent the emergence of substitutes depends on technological progress. This is a continuous threat and highlights the importance of environmental scanning to keep track of ongoing developments. Because of the wide ranging and unpredictable pattern of technological progress it is very difcult to predict under what circumstances substitutes are likely to appear. In fact it may be difcult to recognise a substitute when it does appear because it may be accompanied by a change in consumer preferences or prices. For example, air travel was not regarded as a close substitute for rail travel until the advent of cut price airlines and the realisation by people who had never own that it was a viable alternative. The rail link between London and Paris has suffered greatly from the impact of cheap airlines. At times it may be difcult to distinguish between a new entrant and the emergence of a substitute product. A new entrant will have a similar product and will compete mainly on price. The substitute has characteristics that full the same consumer needs and effectively reduces the market size for the existing product. It is important to distinguish between them because the strategic response is different: a new entrant can be met with reduced prices and an increase in marketing but this will not work for a substitute because consumers no longer wish to buy the original product. Suppliers bargaining power This depends on the degree of competition in supplier markets and the number of companies in the industry. For example, there are many thousands of farmers in the UK while retailing is dominated by four supermarket chains; farmers claim that the supermarkets have excessive buying power and that they are unable to obtain a price that provides a reasonable return on farming. The two extreme cases are where the company is the sole purchaser of an input (monopsony), and where the supplier is the sole provider for the industry (monopoly). In the case of monopsony the supplier has low bargaining power and in the case of monopoly the supplier has high bargaining power; the typical situation will be somewhere in between the two and the balance of bargaining power is often difcult to identify. In the case of the supermarkets versus farmers the balance lies in favour of the supermarkets hence suppliers have low bargaining power. But this extends only to the big supermarkets and it is probable that small retailers pay signicantly higher prices and hence are at a cost disadvantage. A well known example of high bargaining power is when labour unions are powerful enough to negotiate more favourable remuneration than would be possible for an unorganised work force. What is less obvious is the bargaining power of workers with scarce skills, for example in nancial markets some investment specialists command very high salaries because they are perceived to be able to beat the market. It is important for companies to identify as far as possible where the balance of bargaining power lies with different suppliers so that they do not end up paying more for inputs than competitors.

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

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Buyer power Branded Low Many competing brands Brand identity High Many buyers rely on brand reputation Find out Switching cost Part of everyday High characteristics of purchases other makes High A particular Number of buyers Very large segment Income elasticity Regarded as Low Regarded as necessity luxury Perceived None High The segment differentiation thinks it has certain desirable features Satised buyers Information Can be gained by High experience have no incentive to collect information on other makes Own Brand The only one in the shop Unknown to buyers

Factor Monopoly power

Buyer power High Low

Low

Low High Low

Low

Each factor has been classied as high or low to demonstrate that the own brand is subject to relatively higher buyer bargaining power than the branded make. You may well interpret the buyer power differently depending on your own experience but it is possible to arrive at an estimate of the buyer power in a fairly objective manner. The conclusion from this analysis is that buyer bargaining power is high for the own brand shampoo and low for the branded shampoo. The ve forces prole Once an estimate has been made of each of the competitive forces a prole can be constructed to identify the type of competitive forces acting on the company. Take the case of two companies with the following proles. Competitive force Threat of new entrants Threat of substitutes Bargaining power of suppliers Bargaining power of buyers Industry rivalry Company 1 High High Low Low Low Company 2 Low Low High High High

This classication identies two totally different competitive situations with important implications for strategic action. Company 1 will focus on potential competitors and technological change. Company 2 will focus on trying to get better deals from suppliers, marketing Heriot-Watt University Strategic Management

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aggressively to buyers, and on its cost position relative to competitors. Now consider the two proles in a different way: the rst prole refers to the company now and the second is an estimate for three years in the future. The company will have to change its strategic focus as above to accommodate the changes in competitive conditions. These are clearly important conclusions, but in real life it is a fact that very few companies understand the competitive forces operating on them and are unaware that these are changing over time. Companies often fail to react to changing competitive conditions because they simply did not know they were occurring. One of the big changes that occurred in the UK grocery business was the closure of many small city centre groceries because of the arrival of the edge of town supermarkets. But now the major supermarket chains are opening in town stores in an apparent reversal of the trend. Can this be explained in terms of the ve forces? The situation before the supermarkets appeared and after supermarkets had set up in town stores is shown below. Competitive force Threat of new entrants Threat of substitutes Bargaining power of suppliers Bargaining power of buyers Industry rivalry Before Supermarkets Local monopolies: Low barriers to entry Out of town shopping High Small scale Lack of choice Local monopolies High Low Low After Supermarkets Filled vacant niche Low

Out of town shopping Low now exists Large scale buyers Low Low Desire for convenience Still local monopolies Low

According to this analysis the competitive pressures acting on the small retailers were the threat of substitutes from out of town shopping centres and their lack of buying power resulting in relatively high prices. This combination drove them out of business; subsequently the supermarkets lled the vacant niches but were not now faced with the threat of substitutes and had the buying power to ensure that in town prices were competitive with the edge of town centres. Thus they were able to capitalise on the desire for convenience. The forces are, of course, open to a different interpretation but it does appear that the supermarkets were able to alter the balance of the forces and hence opened up an opportunity. Criticisms of the ve forces model While the ve forces model is an extremely effective technique for analysing competitive forces, it does have some potential drawbacks and it does not provide the answers to all issues relating to competitive analysis. It gives the impression that all forces are equally important in the determination of competitive position. It has been argued that the customer, or buyer, is the most important dimension of competitive advantage and that the ve forces approach disguises this. However, this criticism misses the point about a framework of analysis; the ve forces is merely a structure within which various inuences can be examined, and while it is probably true that most of the time buyers are important, in some circumstances other inuences might be just as important. Heriot-Watt University Strategic Management

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It focuses on threats, whereas many companies engage in cooperation and alliances. This approach may be excluded if, for example, all suppliers are regarded as threats. But again this misses the point: if suppliers are identied as a potential threat it could be that one method of eliminating this threat is to enter into an alliance. The function of the model is to help identify competitive pressures rather than provide a prescriptive solution. The model does not deal with internal issues such as human resources and efciency. This being the case, the model must be regarded as one important component when building up an overall view of protability. The ve forces model sits squarely in the analysis and diagnoses part of the process model of strategy. It is important for analysing competitive inuences and deriving an understanding of the companys competitive advantage; it is an essential tool for deriving appropriate strategies at the choice stage, but it does not do the work for you.

Exercise 4.9
Use Porters ve forces to categorise the competitive conditions confronting SuperTools.

4.11

Environmental threat and opportunity prole

Over the course of this chapter and the previous chapter a large number of models have been discussed which throw light on different aspects of the economic and competitive environment. The fact that each model focuses on different aspects of the environment means that no single model can be relied on to derive an overall view of the threats and opportunities presented by the environment and it is necessary to integrate them into an overall framework. The following scheme sets out the main models discussed and their area of focus.

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Model Macroeconomics

Competitive advantage of nations Forecasting Predicting changes in key factors PEST Checklist of all potential factors Environmental scanning Tracking changes and speculating about the future Scenarios Implications of speculation Demand and supply How markets operate Market structures Forms of competition Deriving rational competitive response Game theory Segmentation Identifying markets Product positioning Differentiation Dynamics Life cycle Product positioning Portfolio models Product positioning Strategic groups Structural analysis Competitive forces

Focus Determination of GNP growth, consumer expenditure, interest rates, ination, unemployment etc Specic national competitive factors

These models can be applied to available information to generate an environmental threat and opportunity prole (ETOP). The prole can be constructed under the heading of each of the models and the relevant threats and opportunities identied.

Exercise 4.10
Just after the SuperTools discussion reported at Chapter 4 Section 9.5, the following newspaper reports appeared. PERSONAL INCOMES AND HOUSE PURCHASES UP THIS YEAR Data released by the National Statistical Ofce today reveal that in the rst six months of the year personal incomes increased by 4% in real terms, and it looks like a lot of this increase is being invested in housing. New house starts increased by 3%. EXCHANGE RATE FALLS FURTHER The value of the pound on foreign markets rose during the last week by a further 1 per cent, putting additional pressure on home suppliers of manufactured goods such as TVs, freezers, tools and computers. These sectors have been under increasing threat from cheap imports for the past year or so. Combining this information with that in Chapter 4 Section 9.5, derive an ETOP for SuperTools. Much of this will be based on the analysis already carried out.

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4.12

References

1. Hedley, B.D. (1977) Strategy and the business portfolio, Long Range Planning, Vol. 10 2. Ansoff, I. (1987) Corporate Strategy, McGraw Hill 3. Porter, M.E. (1985) Competitive Advantage: Creating and Sustaining Superior Performance, The Free Press.

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Chapter 5

Analysing resources and strategic capability


Contents
5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10 5.11 Resource analysis in the process . . . . . . . . . . . . . . . . . . . . . . . Accounting ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Break even analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pay Back period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Present Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sensitivity analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Human resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Benchmarking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Economies of scale and the experience curve . . . . . . . . . . . . . . . . The scope of the company . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.11.1 Economies of scope . . . . . . . . . . . . . . . . . . . . . . . . . 5.11.2 Synergy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.11.3 Diversication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.11.4 Vertical integration . . . . . . . . . . . . . . . . . . . . . . . . . . 5.12 Creating value from the production process . . . . . . . . . . . . . . . . . 5.12.1 The value chain . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.12.2 The value system . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.12.3 Competence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.12.4 Competence and diversication . . . . . . . . . . . . . . . . . . . 5.12.5 Strategic architecture . . . . . . . . . . . . . . . . . . . . . . . . 5.13 5.14 5.15 The denition of competitive advantage . . . . . . . . . . . . . . . . . . . Assessing strategic capability: the strategic advantage prole . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119 120 124 126 127 128 129 131 133 134 136 136 137 138 139 143 143 146 147 150 152 153 154 156

Learning Objectives To use accounting techniques to assess company efciency

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To identify the sources of synergy To assess the impact of vertical integration and diversication To recognise the basis of competence and the potential of strategic architecture To analyse the value chain To identify the factors contributing to competitive advantage To construct a strategic advantage prole

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5.1

Resource analysis in the process

While it is clearly important to understand the external macro and competitive environment within which the company operates, it is also important to identify the match between a companys resources and capabilities and the opportunities which that external environment presents; understanding the competitive environment is a necessary but not sufcient condition for formulating strategy. The idea that company resources and capabilities are the foundation for protability has become known as the resource based view of the company, as discussed at Chapter 1 Section 5.4. The central theme is to determine how value is added by the various activities of the company and how the value creating framework might be developed in the future. Thus the thrust of company analysis is to assess the effectiveness with which resources have been allocated in the past, demonstrate principles which can be used for allocating resources in the future and estimate the strengths and weaknesses of the company with a view to identifying how threats may be countered and opportunities may be pursued. There are two extreme views on the analysis of resources. One is that the companys resources can be manipulated in an efcient manner in the pursuit of a particular course of action. Another is that organisational change is very difcult to achieve and the notion that resources can be adjusted in line with changes in strategy is far too nave; furthermore, it can be argued, changes in the external environment occur so quickly, and are so unpredictable, that over time exibility of resources is the important issue and, consequently, strategy and resources are closely related. As with most things in life, the

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reality lies somewhere between the two extremes and, in individual cases, exibility and efciency can assume different levels of importance.

5.2

Accounting ratios

The rst step in analysing the company is to secure a sound understanding of its nancial position. The main constraints on future company development are protability and debt structure. Because there are many dimensions to protability, it is necessary to have some understanding of accounting methods in order to be able to extract protability measures from company data. The company has at its disposal a great deal of information which it can use in identifying the effectiveness with which resources are being, or have been, allocated. It is at this point that an apparent disagreement between the practitioners of nance and those of accounting needs to be claried. It is widely accepted that Return on Investment (ROI) is not a reliable measure for assessing potential investments; instead it is necessary to use the formal tools of investment appraisal. While these tools are extremely powerful, they do not indicate how well resources are actually being deployed in the company; this is a highly complex issue which the analysis of effectiveness must deal with. Questions to be asked include the following. Are we moving up the learning curve? Are we producing the level of sales value per person employed which we originally thought possible? Are we making effective use of our capital? Are we keeping inventories under control? These questions can be tackled by using historical accounting information relating to costs and revenues. While the theory of nance provides the tools for allocating resources in the future, accounting procedures are designed to reveal the efciency with which resources have been allocated to date. Because there are many dimensions to company efciency there is a variety of accounting ratios, the following selection providing an indication of the range of measures which might be used. Return on Investment ROI Return on Net Assets RONA Return on Capital Employed ROCE Return on Total Assets ROTA Earnings per Share These ratios are not dened in detail here; the important point is that they measure slightly different aspects of company performance. The ratios are useful tools for Heriot-Watt University Strategic Management

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analysing accounts because they help to reduce the amount of information in the accounts which require analysis and they can identify potential weaknesses in company management. Since the objective of ratios is to simplify the complexity of accounting information, it would be pointless to use a vast number of ratios. However, there is no denitive set of ratios which will provide the correct information for managers; not only are there many ratios to choose among, individual ratios can also be dened in different ways. It is therefore necessary to select a number of potentially useful ratios which can be employed over a period of time to ensure the consistency of the information from which the ratios are derived. A problem which confronts many companies is that the accounting information collected does not relate directly to the activities of the company, or to the individual products. The activity based costing approach is intended to generate close estimates of the costs associated with activities which are much more relevant for decision making. The difference between a set of traditional cost accounting categories and activity based analysis is shown in Table 5.1. Table 5.1: Traditional cost accounting and activity based cost accounting Traditional categories ($) Wages and salaries Supplies Travel Rental Operating expenses Total 500000 100000 50000 150000 100000

Cost of performing specic activities ($) Liaison with suppliers 150000 Process orders 120000 Handle deliveries 50000 Internal processing 250000 200000 Quality assurance Trouble shooting 130000 Total

Using the traditional categories it is impossible to say whether the wages and salaries cost is high or low from one year to the next because the costs are not associated with specic activities; however, the activity based approach reveals that over one third of total cost is attributable to quality assurance and trouble shooting. This provides a different perspective on where the company is incurring all types of cost. Besides focusing attention on activities rather than cost categories, the activity based approach draws attention to the notion of value added; in this case the issue of whether quality assurance and trouble shooting together add more than $330000 of value can be addressed. It may be concluded that these activities indeed generate a value in excess of the cost, but it is important to recognise the potential for misallocation of resources which can arise because the cost structure is not understood. To ensure that ratios produce performance measures which relate to the efciency with which resources are allocated, appropriate measures of revenues, costs and assets must be used. While it may appear obvious, it needs to be stressed that revenues and costs must not include changes in the portfolio of assets; the buying and selling of assets is not directly related to the efciency with which inputs are being converted to outputs. However, inspection of published company accounts reveals that the sale or acquisition of assets is often slipped into the accounts, perhaps to disguise a particularly good or bad year.

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The way in which accounting information is calculated can have far reaching implications. A successful British stockbroker named Smith1 asked the seemingly simple question: how can it be that companies which appear to be nancially sound can suddenly go bankrupt? He pointed out that the signs of nancial malaise were detectable if you knew what to look for in the published accounts. He identied 11 practices which could be misleading, although they were not illegal, and constructed a table which simply listed major companies and how many of these dubious practices they pursued; the blobs which he used in the table became notorious as a measure of the reliability of company accounts. Although the information was in the public domain, Smiths analysis touched a sensitive nerve with the companies concerned, and many felt that their reputations had been adversely affected. From the strategic viewpoint, this story has some important implications. First, it reinforces the fact that protability is not totally objective because it depends on the accounting conventions and assumptions used. Second, it is very difcult to obtain accurate information on the performance of competitors from published information. Since assets appear in the bottom line of most of the measures, it is important that they are calculated in a manner which is consistent with the opportunity cost of the resources tied up in the company. In practice, it is extremely difcult to assign a value to assets. In the rst instance, many assets were purchased in the past and have depreciated through use and obsolescence. The book value attributed to them by accounting procedures may bear little relation to what the asset would realise on the market, nor to the replacement cost of the asset. Two companies may have identical performance in terms of RONA, but because of different accounting methods one may appear to be performing more protably. The notion of replacement value raises another issue, i.e. that of ination. For example, the book value may be based on a price paid several years ago, but since then ination could have led to all round price increases of 50 per cent. Since revenues are in current price terms, it would seem to make sense to adjust the asset value to current price terms. In practice this could be virtually impossible, given that the company may have hundreds of assets of different vintages. It would be an impossible task to generate data on replacement value of all assets each time the RONA was calculated. Take the case of an asset costing $100 purchased 4 years ago, during which time ination has been 50 per cent, and the asset has been depreciated at 20 per cent per year using the straight line method. Table 5.2 shows possible calculations of asset value. Table 5.2: Different asset values Current book value Current book value ination adjusted Historical cost Replacement cost $20 $30 $100 $150

A further problem concerns the selection of assets to include in the calculation. All rms are faced with the problem of lease or buy with respect to the acquisition of assets, and the choice can have a signicant impact on the ratio because a change from owning to leasing moves the entry from the bottom to the top line. Consider the case of a company shown in Table 5.3 which has the revenues, costs and assets shown in Year 1. Heriot-Watt University Strategic Management

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Table 5.3: RONA and asset ownership Year 1 $M Revenue Cost Assets RONA 20 10 100 10% 2 $M 20 12 100 8%

In the following year the company decides to sell an asset for $10M, and lease a replacement for $2M per annum; nothing else changes. The result is shown in Year 2; the cash received from the sale is now treated as part of company assets instead of the asset value, so the net effect on company assets is zero. The operational efciency of the company has not changed, but the RONA has fallen. Has the company become less efcient? While ratio analysis is an indispensable aspect of evaluating company performance, ratios clearly do not provide a complete picture. But they are the only information available so it is necessary to have an understanding of the information which they do convey.

Exercise 5.1
The problems confronting SuperTools have already been discussed at some length. The following accounts refer to two separate years of SuperTools operations; between the two years SuperTools had undertaken a large investment programme to nance tooling up for the PowerPlane.

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1. Use nancial ratios to compare company performance in the two years paying particular attention to the appropriate measure of protability. 2. Can it be deduced that the investment programme was responsible for any increase in protability? 3. What strategic implications can be drawn from the analysis?

5.3

Financial structure

Companies have three sources of nance: retained prots, equity issues and loans. Over a period of time the company will nance its activities by various combinations of these three and the availability of nance will ultimately constrain its strategic Heriot-Watt University Strategic Management

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capabilities. Companies typically start their lives by raising nance from shareholders and, as time goes on, prots are generated and some are distributed to these shareholders. The total shareholder equity is thus the original equity nance plus the retained prots. The company can fund expansion by issuing more shares (equity) or by incurring debt; this type of debt is typically in the form of long term loans for specic investment projects rather than the short term loans which are necessary for covering variations in short term cash ow. The main difference between debt nance and equity nance is that the interest on debt takes priority over payments of dividends to shareholders and must be paid no matter how prots uctuate; the more debt there is in relation to equity then the more dividends will uctuate with protability. If the interest cannot be paid then the company goes bankrupt. This means that the shareholders bear the risk of uctuations in prot and therefore look for a higher return on their funds than the providers of loan nance. As a result it is cheaper to nance investments by debt, but each time this is undertaken the risks to existing shareholders increase. A measure of the risk associated with debt nancing is the gearing ratio, dened as
Debt nance Shareholder equity

which is usually expressed as a percentage. It is a simple matter to calculate a companys gearing ratio, but the real question is: what is the optimal gearing ratio for a particular company? There are a number of factors which have to be taken into account. A company which has a sound track record will be regarded as a good loan prospect by banks and should have little difculty raising debt for growth. A company which has not taken advantage of this, and has constrained its growth to nance by retained earnings, may not be taking advantage of opportunities. This could be an indication of a cautious and risk averse management, or perhaps of a management with little strategic vision. The higher the gearing ratio, say around 100 per cent, the more reliant it is on steady and non uctuating prots over time. This is likely to make banks nervous and, beyond some point, it will be difcult or impossible to raise additional nance no matter how attractive the investment might appear to be. The company needs to balance dividend payments against the loss of exibility which may result from a high gearing ratio. There is therefore no optimal gearing ratio which applies to all companies, or even to a given company over a period. A company which has embarked on a strategic initiative may have a high gearing ratio, while a company which has established itself as a market leader and has little room for expansion in existing markets may have a low gearing ratio. But on a protability basis they may be considered equally successful.

Exercise 5.2
1. What has happened to the gearing ratio for SuperTools? 2. What impact does the change in the ratio have for SuperToolss strategic capability? Heriot-Watt University Strategic Management

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5.4

Break even analysis

It is possible to use information on xed cost, variable cost and selling price to obtain a perspective on the desirability of proceeding with a new project. A relatively straightforward question is: How many units would have to be sold before the product starts making a net contribution? This is known as break-even analysis. A simple version of break-even analysis, which assumes that unit cost and price will not vary with output, is as follows. On the cost side, total cost incurred as output is increased is: Total cost = Sales Variable unit cost + Fixed cost On the revenue side, the total revenue generated by the product is: Total revenue = Sales Price It is then a simple matter to solve for the Sales at which Total cost = Total revenue: Sales Sales Variable unit cost) = Fixed cost Fixed cost Break even = Net contribution per unit

Price = (Price -

Sales

Variable unit cost + Fixed cost

You simply take the xed cost and divide that by the difference between price and unit cost. The break even chart is shown in Figure 5.1

Figure 5.1: Break-even chart This type of calculation is central for developing strategy. The most obvious question which can be addressed with this information is whether the total sales requirement before the product makes a positive cash contribution is attainable. This focuses attention on the factors affecting potential total sales over time. Estimates of cumulative sales are based on the marketing information available on market size and market share, and can be expressed as Cumulative sales = + + + where 1, 2 t = (Total market Market share)2 (Total market Market share)t time periods. (Total market Market share)1

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Break-even analysis adds a dimension to the appraisal of a course of action which is missing from the discounting approach. Sensitivity analysis can be used to identify conditions under which the product will not even cover its production costs. The calculation can be made more sophisticated by allowing unit cost to change with output, for example by taking potential experience effects into account; it can then help identify possible courses of action, such as aiming at efciency improvements which could transform the prospects for a product. Break-even analysis is obviously limited in that it concentrates only on the volume of output and sales and does not take into account the passage of time; however, it does provide a useful picture of potential costs and revenues. Its main strategic contribution is to relate the costs incurred in the development of a product to its market setting, since revenues cannot be generated without incurring costs.

Exercise 5.3
Imagine a company which is considering a new product launch into the glue market, where market research suggests that the total annual market sales are about 400 000. The company reckons that it can enter the market with a high quality product (NozzleGlue) priced at $10, or a lower quality product (BlueGlue) at $7; the distinguishing feature of the NozzleGlue is a non drip nozzle, which does not affect the glue itself. However, it is felt that the BlueGlue would appeal to a wider market because it is cheaper. The BlueGlue was expected to have a variable unit cost of $4 compared to the variable unit cost of $5 for the NozzleGlue. The set up investment cost of the NozzleGlue at 200 000 is expected to be signicantly higher than that of the BlueGlue at 180 000 expressed in annual terms. 1. Work out the annual break even output 2. What are the strategic implications of the break even analysis? Use a model which might help in determining the likely impact of the differentiation between the NozzleGlue and the BlueGlue.

5.5

Pay Back period

A question often asked by managers is: How long will it be before the project pays back its start up costs? This is important from the viewpoint of anticipated corporate cash ows and is not revealed by break-even analysis which concentrates on sales volume. The calculation of Pay Back is identical to that of net present value except that the annual cash ows are not discounted; instead, they are summed until the total becomes positive. Cash Flow Pay Back - A1 - A1 A2 A3 An A 2 + A 3 - A1 A 2 + A3 + A n - A1

A 2 - A1

where A1 = expenditure in Year 1 A2 An = income in Years 2 to n The Pay Back period is the length of time before the running total becomes positive.

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There is some dispute as to whether the Pay Back period adds to the information produced by a properly executed Net Present Value analysis. The discounting approach takes into account both the incidence of cash ows over time and risk factors; in theoretical terms the argument that the company needs to predict its net cash position is irrelevant because a bank which used the same NPV criterion as the company would be willing to lend money against the security of the expected future income stream. This suggests that there is no such thing as running out of cash for an investment which has a positive NPV. However, from the corporate strategic viewpoint there are situations in which the Pay Back criterion may have implications for the selection of the product portfolio. For example, the prospect of increasing the gearing ratio may be unacceptable, even for a short period. Whether the notions of Break-Even and Pay Back appeal to the nancial purist is irrelevant; what is important is to generate information on different aspects of investments so that corporate decision makers can arrive at a well balanced view of the strategic implications of different courses of action.

Exercise 5.4
Using the example of the glue company, the investment costs of the two products are as follows: NozzleGlue 1000000 BlueGlue 810000 The management has carried out some market research and has concluded that the market share requirements of the break even calculations for both products would be met. 1. Calculate the payback period for both products. 2. Does this calculation provide additional insights into the strategic potential of the two products?

5.6

Net Present Value

These tools of nancial appraisal are extremely useful in assessing the merits of an investment, but it is also necessary to subject any investment to the rigorous approach of discounted cash ow. This involves discounting the future cash ow streams back to the present using the company cost of capital and subtracting the sum of these present values from the investment cost. This gives the Net Present Value which provides the basis for determining whether an investment is worthwhile in the rst place and for making choices among competing investments. It is important to be clear about the importance of the net present value calculation. The cost of capital takes into account the market view of the risks associated with the company and therefore, to some extent, the cost of capital can be regarded as a method of taking risk into account in analysing an investment. The discounting approach gives much higher weighting to cash ows which occur sooner rather than later and to this extent it takes account of the natural concerns associated with projecting cash ows Heriot-Watt University Strategic Management

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into the future. However, while formal nancial appraisal techniques provide an objective interpretation of cash ow data, the following reservations must be borne in mind. The raw data may be suspect because it is necessary to use information about the past, which may be suspect if it is based on accounting conventions. Formal appraisal techniques can evaluate what might happen, but they cannot take into account the unknowable; the assumptions about the future may be wrong. Different projects may have completely different implications for personnel management through their impact on job satisfaction and incentives. Although it is important to quantify the options confronting the company as far as possible, decisions are often based on qualitative rather than quantitative factors. Despite these reservations, all investments should be subjected to a proper calculation of the net present value in arriving at the nal decision.

Exercise 5.5
In the glue company example the management have decided that both products are likely to maintain their market share for ten years and that, during this time, the net revenues will remain more or less constant. The company cost of capital is 15 per cent. 1. Calculate the NPV for both products. 2. What additional insight does the result produce from the strategic viewpoint?

5.7

Sensitivity analysis

When making predictions about the future it is not possible to be precise, but it is possible to have some idea of the range of values likely to be associated with important variables. At the very least, the best possible and worst possible scenario for each important variable can be projected. Sensitivity analysis is related to scenario analysis but is conducted at a more detailed level. One approach is to use an appraisal framework as shown in Table 5.4. Table 5.4: Calculating contribution Revenue = minus Outlay = Number of workers Wage rate + Units of capital Price + Units of material Price equals contribution in each period Having carried out an appraisal of the prospects for a new product, it may become Heriot-Watt University Strategic Management Total market Market share Price

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apparent on closer investigation that a high proportion of cost will be incurred by labour, but that some managers have reservations about the prospects for the labour market due to predictions that the economy is likely to be entering a new period of sustained growth. This could result in wage rates being 20 per cent higher than would otherwise be the case. The framework can be adjusted to take this possibility into account as shown in Table 5.5. Table 5.5: Adjusted contribution Revenue = minus Outlay = Number of workers Wage rate 1.2 + Units of capital Price + Units of material Price equals contribution in each period Because wage costs are a relatively high proportion of total cost, a 20 per cent higher wage rate would have a signicant impact on the protability of the investment. This could cause managers to take a rather different view of the desirability of undertaking this investment rather than alternatives. Sensitivity analysis can be carried out in relation to different dimensions of performance. For example, the impact of the potentially higher wage rate on NPV, Break-Even, Pay Back and cash ow can be investigated. Sensitivity analysis is therefore a powerful technique for generating a perspective on the potential returns from a course of action. It identies which are the crucial variables and where unexpected threats may exist. It can pin-point issues to which attention should be directed before a decision is taken. A somewhat less obvious aspect of sensitivity analysis is to identify the combination of circumstances which is necessary to ensure success. In the example above, sensitivity analysis might have revealed that a 10 per cent higher price for either labour or capital would lead to failure, as would a market share of 14 per cent or less. Managers must then seriously address the issue of whether it is likely that the following will actually occur. Market share Wage rate Capital price Greater than 14% No more than 10% greater No more than 10% greater and and Total market Market share Price

Put in this way, this might appear to be an unlikely combination of circumstances but it will undoubtedly lead to failure. But looking at it from the opposite viewpoint it might be discovered that success depends on Achieving 15% market share reducing labour cost by 2% per year keeping equipment costs constant When looked at this way such a combination may emerge as just as unlikely as the combination which would generate certain failure. The reason that some projects fail is the lack of recognition that their success was actually dependent on the simultaneous and and

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occurrence of several favourable circumstances, a fact which was not made explicit.

Exercise 5.6
Apply sensitivity analysis to the glue company to identify how the risks associated with the investment could be reduced with respect to: 1. cost reduction. 2. market share.

5.8

Human resources

Human resource management is important for strategy for two reasons. First, the people in a company are a resource like any other and the determinants of how effectively that resource operates can be affected by strategic change. Second, when strategic changes are introduced they have to be implemented by people and resistance to change can exert a powerful constraint on success. The development of adaptability and the ability to cope with strategic change is a major objective of human resource management. One of the main characteristics of an organisation is its culture, which comprises its set of beliefs, values and managerial approaches; this culture is reected in its structures, systems and approach to the development of strategy. The culture itself is derived from the companys past history, type of leadership, the people involved and its use of technology and resources. But since each company has a different history and different combinations of people and other resources the culture of each is likely to be unique. However, four2 broad types of culture which provide a basis for understanding how the workforce is likely to react to change can be identied. Power culture The organisation tends to revolve around one individual (or small group), who dominates decision making and determines how things are done. This culture usually occurs in a relatively new or small company which is entrepreneurial in nature. However, as this type of organisation grows it becomes increasingly difcult to maintain central control and there is a tendency for smaller groups to form who are, in their turn, dominated by their own leaders. In this type of organisation there is unlikely to be a strategic plan, but if there is one it will tend to reect the interests of the dominant leader rather than being based on analysis of the environment and explicit strategy choice. An example of this type of culture is in the newspaper industry, where the old style proprietors dictated editorial approach and newspaper layout. Role culture This is a distinctive type of organisation which relies on committees, structures, analysis and the application of logic. While a few senior managers make nal decisions, they rely on procedures and systems and clearly dened rules of communication. This bureaucratic type of structure works well when the environment is stable, but the fact that it relies on rules and procedures means that external changes are not typically recognised at an early stage and the company is not well equipped to deal with them Heriot-Watt University Strategic Management

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because it is relatively inexible. Major changes tend to be dealt with by a change in the top management team. This type of culture is prevalent in the civil service and the old style retail banks where strategic changes tend to be slow and methodical. Task culture This type of culture arises in organisations which are geared to tackle specic tasks which tend to be of limited duration. The organisation is based on exible teams who tackle assignments, these teams being typically multidisciplinary, and power rests within the team structures. As a result, control relies largely on the efciency of the individual teams which top management must allow a great deal of autonomy. This culture is apparent in advertising agencies and consultancies; it is less appropriate for factory style operations, although the team approach is being used increasingly in all work environments. Personal culture While this culture does not occur often in business, it is as well to be aware of it. In this case the individual pays little attention to the organisation and is most concerned with self gratication. All strategic responses depend on the inclination of the individual and hence are unpredictable. Voluntary workers are a good example, but individual professionals such as architects or consultants working as lone people within larger organisations can fall into this category. But this form of culture itself is unlikely to permeate an entire organisation. The type of culture prevalent in the company will have a major impact on how the organisation reacts to strategic change. Table 5.6 indicates how the cultural composition relates to competitive advantage and the ability to cope with strategic change. Table 5.6: Culture Power Role Task Personal Achieve competitive advantage Lacks analysis Slow Flexible Lack focus Cope with strategic change Unpredictable Resistant Change is norm Unpredictable

These broad classications therefore provide some insight into the alignment of strategy with culture and where problems are likely to arise. But it is necessary to invoke a warning here. When problems arise in implementing strategy they are often ascribed to cultural problems, because these are actually difcult to identify and it is virtually impossible to do anything about them in the short term. Thus the failure can be ascribed to cultural problems which are outside anyones control. But what might appear to be a cultural problem may in fact be due to the more general principal agent problem; for example the incentive system may not be aligned with the revised strategic objectives.

Exercise 5.7
Classify each of the managers in SuperTools (described at Chapter 4 Section 9.5) in terms of their culture and interpret the Marketing managers dilemma in these terms.

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5.9

Benchmarking

A companys competitive position can only really be assessed in relation to other companies in the industry. One way of achieving a perspective on this is to develop quantiable measures of performance which can be compared with other rms. The performance of major competitors can be ascertained from the information contained in their annual reports which contain indicators such as ROI. But given the problems of interpretation revealed by Smith, these cannot be taken at their face value and it is necessary to ensure that like is being compared with like. This means that it is necessary to interpret published information, and hence comparisons are bound to be approximate. Whether they are accurate enough to provide real information on competitive advantage is a problem which must be confronted by the individual analyst. In fact, this kind of information may not be of any real use for strategic purposes. While it is important to develop a picture of the companys relative nancial strength in relation to competitors, the objective of doing so is to provide information for strategic purposes rather than to emulate the performance of other companies. This is because there is no guarantee that competitors are pursuing best practice and, in any case, competitive advantage is rarely achieved by simply copying the behaviour of others. Instead, information on competitors can be used as a method of diagnosing the companys own performance by asking questions such as the following. Why is a competitors ROI higher than ours and what does this tell us about our own use of resources? How does our competitors nancial strength (in terms of gearing, cash reserves and cash ow) compare with ours and what exibility does this give them? There are many dimensions of company performance and benchmarking can be applied to just about anything: delivery times, inventory ratios, payroll processing, manpower turnover and so on. Benchmarking is clearly an important diagnostic tool because it indicates where resources might be deployed more efciently. It may be possible to obtain the cooperation of other companies to carry out a detailed comparison of how efciently specic parts of the organisation are functioning; the companies need not be in the same industry, but need to be world leaders in the function, such as distribution systems. A benchmarking exercise involves the following stages. 1. Identify the activities or functions which may require improvement. 2. Identify companies which are world leaders in these activities or functions. 3. Contact the companies and talk to managers and workers in order to identify why their performance is superior. 4. Use the results to redesign processes and, if possible, to change expectations within the company as to what comprises good performance.

Exercise 5.8
Given the pros and cons of benchmarking outlined above, what do you think are likely to be the main outcomes of a benchmarking exercise? Heriot-Watt University Strategic Management

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5.10

Economies of scale and the experience curve

It is well known that costs can vary greatly among companies in the same industry. This is not necessarily the outcome of chance or poor management of resources on the part of some companies compared with others. There are at least two very good reasons for such differences: economies of scale, which relate to the size of the company, and experience effects, which relate to the total output of the company to date. The concept of economies of scale relates to what the unit cost of production would be at different scales of operation. It is concerned with the average cost of production in relation to the productive capacity of a company; for example, if the productive capacity of a company were doubled, it would benet from economies of scale if the cost per unit fell. Economies of scale can emerge for a number of reasons. Indivisibilities: this is usually associated with machinery, where there is a minimum size for most machines, such as in a steel plant, and each addition either to size or capacity comes in discrete amounts. For example, it may not be possible to increase the size of a steel plant by, say, 5 per cent, because an additional line may be 40 per cent of the existing plant size, and the capacity of the next largest machinery is 30 per cent higher than the existing plant. The idea also applies to human resources, for example a company may need an additional accountant but hiring one will generate excess capacity in the accounting department. Technical relationships: in most capital intensive industries there is a declining relationship between capacity and unit cost; for example, it does not cost twice as much to build an oil tanker of twice the capacity because capacity is determined by length times height times width. Specialisation: originally this idea related to breaking down mass production processes into their component parts, so that individual workers became extremely adept at a small number of tasks. This mechanistic view of how employees work effectively has been largely discredited and it has been recognised that specialist work teams (quality circles) generate a more efcient and motivated workforce; but the same underlying idea of specialisation still operates as work groups become more adept at handling their particular part of the production process. In a wider sense, specialisation is more feasible as the size of the company increases in areas such as knowledge workers, where large companies have their own IT departments, specialist nancial analysts and so on. The empirical evidence on economies of scale is mixed: in some industries it is signicant and in others it hardly exists. The difculty in attempting to measure the impact of scale economies in real life is that it is not merely the increase in productive capacity which is relevant, but whether the higher productive capacity is based on a more efcient combination of labour and capital. It may be that some larger companies have not selected the optimum combination of inputs and hence do not benet from potential scale economies; this does not mean to say that they do not exist and that they might not be exploited by some companies in an industry. It may also be the case that the difculties of managerial coordination beyond some company size make it impossible to benet from potential scale economies. Newspaper reports of mergers and acquisitions usually focus on the scale economies which will be generated which are typically realised by shedding employees; but it is often difcult to differentiate between Heriot-Watt University Strategic Management

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efciency gains, which occur when a more effective management team is installed, and genuine scale economies, which are realised when capacity and output are more closely aligned. The incidence of scale economies helps explain why some industries are dominated by a few monopolistic companies while others are characterised by a large number of small companies. There are pronounced scale economies in industries such as electricity production and car manufacturing; however, in industries such as specialised machine tool production there may be considerably less scope for economies of scale. One of the problems faced by state regulators is to ensure that competitive pressures can be brought to bear in an industry dominated by a monopolist without sacricing scale economies. Economies of scale are sometimes confused with the experience curve, which relates to the reduction in unit costs resulting from the total volume of output to date. For example, one of the factors contributing to the experience curve is the degree to which employees learn to do their job more efciently over time. Experience is a dynamic notion which, while being related to economies of scale in that the larger a company the more output it will have produced, is conceptually independent of economies of scale. The research carried out on this issue reveals that the effect of experience varies among companies and industries; it is to be expected that the evidence on experience will be mixed because of factors such as variations in production techniques by industry, differences in managerial ability to take advantage of its potential effects and exogenous shocks. A general review of the empirical evidence suggests that a doubling of output has the potential to lead to a 20 per cent reduction in average cost. Whether this can be used as a benchmark for individual companies is a matter for managers to resolve, but there seems little doubt that there is a potential for experience effects in most areas of activities. An important aspect of the empirical ndings is that the effect is not linear, i.e. it takes successive doubling of output to achieve the same proportional cost reduction. This would produce a relationship between experience and unit cost of the shape shown in Figure 5.2

Figure 5.2: The experience curve and unit cost As cumulative output increases movement up the experience curve (down the unit cost curve) becomes slower, because each additional 20 per cent cost reduction requires a doubling of output. The advantage conferred by experience is continually being eroded. In Figure 5.2 company Y has a substantial unit cost advantage over company X at the Heriot-Watt University Strategic Management

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rst point, when cumulative output to date was Y 1 and X1 respectively. By the second point company Y has increased its cumulative lead in output terms, i.e. output Y 2 is now much greater than output X 2 , but the unit cost advantage has almost disappeared. But it is necessary to impart a word of caution regarding the experience effect. While it is a well established statistical nding, it does not imply causation. In other words, just because it has been found in the past it does not follow that every company will benet from it; experience has to be managed before the potential gains can be realised. This has important strategic implications because a company might be tempted into pursuing a higher market share (which by denition will increase its output relative to competitors) by aggressive pricing, advertising and marketing in the hope that experience effects will lead to lower costs and higher prots. There are two dangers here. First, the experience effects may not be realised because the company has expanded in size and has had to increase its workforce who, in turn, take time to learn. Second, if knowledge about potential experience effects is freely available in an industry competitors will quickly react for exactly the same reason. The overall effect is likely to be lower prices in the industry with no net benet to any individual company.

Exercise 5.9
There is a clear difference between economies of scale and the experience curve. What do you think are the strategic implications of the two effects?

5.11

The scope of the company

It was discussed in Chapter 2 how the company needs to identify its business and direction in order to arrive at a sensible mission statement and objectives. In the modern world not all companies focus exclusively on the production of one output and many have to make fundamental decisions about what range of products to include in the portfolio. In a broad sense this is a decision on diversication, which can take both horizontal and vertical forms. The issues addressed here are economies of scope, synergy, diversication and vertical integration.

5.11.1

Economies of scope

Economies of scope are similar to economies of scale, in that both ideas refer to the size of the company; however, economies of scope relate to a reduction in unit cost as the number of products is increased rather than the number of units produced. The scale economies argument is that if two companies were merged which produce the same product then the resulting unit cost would be lower. The scope economies argument is that if two companies were merged which produce different (but related) products the unit cost of both would be reduced. There are a number of reasons why this might occur. Some inputs can be shared among a number of different outputs; these inputs can take the form of physical resources or specic skills and competencies. For example, banks have greatly increased the number of nancial products which they offer in the past decade because some of the skills involved in managing banking accounts, providing insurance and selling home mortgages are similar. Heriot-Watt University Strategic Management

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The investment cost of entering new markets can be greatly reduced if technical know-how is common. The reputation associated with some products can have a positive impact on others. For example, the Virgin brand has been extended from its base in music recording to airlines and nancial services. The corporate R & D effort can support several product divisions. For example, in the British aerospace industry companies have been able to utilise the same R & D departments for both defence and civilian products. This rationale for the potential of economies of scope begs an important question when analysing the internal operation of a company which produces more than one product: is total cost lower than it would be if the company were split up into its component product parts? The fact is that economies of scope are by no means the automatic outcome of diversication, although they are typically used as the justication for diversication in the rst place. A company whose products compete in unrelated markets using different resources and different management skills might be faced with diseconomies of scope. It is therefore necessary to take a hard look at the portfolio of products to assess what contribution the portfolio actually makes to competitive advantage in individual markets.

Exercise 5.10
Why is it difcult to identify economies of scope? What issues need to be resolved in identifying the benets of economies of scope?

5.11.2

Synergy

Synergy appears to have rst been mentioned by Ansoff 3 , and relates to the benets from diversication. The notion differs from economies of scale and the experience effect in that it is independent of the size of the company or its total output to date; in this respect it is similar to economies of scope and, in fact, some observers have claimed that there is no difference between the two. In the following discussion there are overlaps with the discussion on economies of scope given that neither has ever been strictly dened. The existence of synergy should lead to the situation where a corporation is valued at more than the sum of the value of its individual parts if they could be separated. The problem arises in attempting to pin down exactly what synergy is; for example, Fuller denes it as the behaviour of integral, aggregate, whole systems caused by the unpredictable behaviour of any of their components or subassemblies of their components taken separately from the whole 4. The problem with this denition is that it focuses on the unpredictable outcomes; if the benets of synergy are unpredictable then it is not clear how the effects can be used as a justication for expanding the product portfolio. However, some successful companies attribute at least part of their success to synergy, therefore it is important to determine whether synergy can be predicted and capitalised on in formulating strategy. For example, no one would expect a synergistic effect from a company which produces ball bearings taking over a company producing ice cream; but is it possible to use the concept as an operational tool to tell the ball bearing company which type of company to take over? While the idea of synergy has an intuitive appeal it turns out to be difcult Heriot-Watt University Strategic Management

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to pin it down in practice. There are two problems in attempting to benet from synergy as a consequence of company actions. The rst is to identify where the benets of synergy are likely to be generated. The second is that there is little empirical evidence which can guide the company in individual situations; in other words, synergy may be little more than wishful thinking on the part of companies engaged in expansion who have heard that synergy is an outcome of diversication. To put the potential benets from synergy into context, bear in mind that some of the most successful companies in history (such as Coca Cola, Pepsi, and McDonalds) have stayed with their original product.

Exercise 5.11
If synergy is not a magical effect it must arise from identiable factors which become apparent in cost and marketing advantages. Identify the aspects of company operations from which the effects of synergy are likely to originate.

5.11.3

Diversication

Diversication is often regarded as the normal state of affairs for a company; many companies consider it unremarkable that they produce a wide range of products of both similar and dissimilar characteristics. The evidence available on the relative performance of diversied companies demonstrates that it is not an automatic recipe for success, with most studies concluding that there is virtually no benet from many diversications. Some accounting studies have been carried out on the degree of diversication and performance, using measures such as return on investment. There is no obvious connection between the two and it seems that prots are more likely to be determined by industry protability than by diversication itself. Given this lack of positive evidence that there is much real gain from diversication, why has it been such a popular corporate pastime? There are several potential incentives to diversify. To minimise risk: it is now recognised that diversifying is a means of minimising management risk but not shareholder risk. The objective of stabilising cash ows over time is a weak rationale for diversifying, and certainly provides no basis for expecting any value production. To capture synergy and economies of scope: there is some potential for this with respect to related diversications, but the rationale is difcult to justify when the diversication is unrelated. To add value through the parenting function: the value creation potential of parenting was discussed at Chapter 1 Section 6.1, and was found to be on the whole unconvincing. To apply the dominant management logic: Managers of diversied rms may see themselves as deriving economies of scope through their prociency in spreading scarce top management skills across apparently unrelated business areas through the application of their dominant management logic; this is the way in which managers conceptualise the business and make critical resource allocations, Heriot-Watt University Strategic Management

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be it in technologies, product development, distribution, advertising or human resource management. The dominant management logic has a direct effect when managers develop specic skills, e.g. information systems, and seemingly unrelated businesses rely on these skills for success. There is a danger that the dominant management logic rationale can be mistakenly applied by managers who perceive themselves as possessing above average general management skills. Furthermore, without detailed knowledge about a particular business it is impossible to know at the time of the diversication whether the new business ts the dominant management logic or whether the managerial skill is above average. In the absence of obvious relationships between businesses, claims that economies of scope derive from a dominant management logic are difcult to defend. To share reputation: it is possible to extend the brand image of a successful company to unrelated products. An example of this is in retailing, where many products are sold under the umbrella of Tesco or WalMart. Diversication is discussed further at Chapter 5 Section 5.12.4 in relation to competence.

Exercise 5.12
Richard Bransons Virgin business empire is a good example of a highly diversied portfolio. There were at one time 27 companies in the group arranged in six divisions: Travel and tourism, including Virgin Atlantic Airways, Virgin Clubs and Hotels and Virgin Airships and Balloons; Retail and Cinema; Media and Entertainment, with companies in publishing, television and radio; Consumer Products, including Virgin Cola, Virgin Jeans and Virgin Cosmetics; Design and Modelling; Financial Services, which is a major venture in the direct selling by telephone of nancial products What do you think is the rationale for this conglomerate?

5.11.4

Vertical integration

Every company is part of a vertical chain in that it purchases inputs from other companies and sells its output to other companies or nal consumers. Intuitively it may appear attractive to gain control of both upstream and downstream activities and integrate all aspects of the productive process. But this raises an important strategic question: what is the rationale for vertical integration? This in fact comes down to the question of whether a company should make something itself or buy it from some other company; in other words can the market provide inputs more cheaply than internal production? In this case more cheaply does not refer simply to the price paid for the input in question, but has to be seen in the wider context of the costs and benets of using the market rather than producing internally. Heriot-Watt University Strategic Management

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There are various degrees of vertical integration: a company can control all levels of the process from extraction of raw material to sales to the nal customer, or it may only cover a part of the process. In the clothing industry, for example, complete vertical integration does not exist, as farmers who produce wool are not owned by cloth producers. Another dimension is that integration between stages is not always complete. A vertically integrated steel making company may sell some of its pig iron to other steel makers. A fully integrated company which produces just enough to supply each stage of its own productive process is relatively rare. The case for vertical integration depends on the transaction costs associated with markets compared with the administrative costs of internal organisation; it is therefore necessary to investigate the potential costs and benets of markets versus internal production. The benets of using the market include the following. Market rms can achieve economies of scale which the companys purchases would be insufcient to generate on their own. Market rms are subject to the discipline of the market, hence it is unnecessary to implement rigorous internal controls to ensure efciency. In fact, these arguments in favour of using the market rather than producing internally are quite powerful; there needs therefore to be a strong justication for embarking on vertical integration. The potential costs of using the market are the following. The coordination of production ows may be compromised because the supplier may have other priorities from time to time. Private information may be leaked to competitors who use the same suppliers. Thus a company has to balance up the efciency benets of using the market against the fact that using the market can expose it to risk. But there are also some specic costs associated with internal production which have to be brought into the equation. There can be a mismatch in the optimal scale of production between stages of production. It is unlikely that scale economies will be achieved at the same output for the different products. Business at different stages can be radically different and present different strategic problems. If the company is constrained by its own supply it will not be able to act quickly and exibly in response to changes in the market. The risk inherent at each stage ceases to be independent and risks which affect one stage will have an effect on other stages of production. This compounding of risk is an often overlooked cost of vertical integration. As with most strategic issues there is no single answer which applies to all companies; in some cases vertical integration may appear to be justied, and in others it may not. But what is important is to avoid the erroneous arguments which are commonly used to justify buying in from the market and which can lead to serious strategic error. Heriot-Watt University Strategic Management

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To avoid paying the costs necessary to make the product. This is wrong even if the company currently has excess capacity because the costs have to be borne by someone. To avoid paying a prot margin to other companies. This is wrong because it is not whether the supplier makes a prot that is important but whether the prot made is higher than could be made by the company were it to undertake the activity itself. Given a lack of experience and scale economies this is doubtful. To avoid paying higher prices during periods of peak demand or scarce supply. This is wrong because again it is relative protability which is relevant; if the supplier operates in a competitive market the company could not make the product any more cheaply because the higher price reects higher input costs. A company may have come to the conclusion, based on an analysis of costs and benets, that vertical integration is undesirable, and it may recognise the erroneous arguments above, but it may still feel that vertical integration is worthwhile because it is not possible to achieve a complete and enforceable contract with a market supplier in the same way that is possible with internal production. There are at least three reasons for this. Life is too complex to draw up a contract which can take all eventualities into account. There are severe difculties involved in specifying and measuring performance with any accuracy; for example, it is impossible to dene the thrust of an engine exactly and then predict its wear and tear over time. Neither party is willing to reveal all information to the other in the bargaining process; this may end up by putting the buyer at a disadvantage which might have been avoided by internal production. Apart from the problem of achieving a complete contract, companies are aware of the holdup problem, when a party in a contractual relationship may be able to exploit the other partys weaknesses once the contract has been agreed. This cannot be evaluated in nancial terms before the event, and is of course difcult to predict or avoiding action would be taken during the bargaining stage. It is argued that there are a number of ways by which internal production can resolve the holdup problem better than recourse to arms length market contracting. First, vertical integration can give access to more powerful governance in the sense that disputes can be settled by internal administrative procedures such as recourse to rules or informal mediation. Second, because of the guarantee that internal relationships will be continued and must be lived with, there is more incentive to get things right. Third, depending on the company culture, vertically integrated divisions may be more likely to behave in a cooperative fashion because they see themselves bound together by a common purpose. It may well be that there are potential avenues for discouraging opportunistic behaviour and for achieving cooperative outcomes that are not available in a market contract setting. But there is no guarantee that these inuences will lead to a more efcient resolution of the holdup problem; it may well be that the holdup problem is something that has to be lived with. In principle, to remove the holdup problem implies controlling all inputs Heriot-Watt University Strategic Management

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to the process, and even vertical integration does not resolve that because inputs have to be purchased no matter how far backwards the integration goes. Furthermore, if the company decides to make rather than buy in competitive markets, it will face additional principal agent problems and more management resources will be devoted to resolving these. Another major problem is that the internal pricing system must perform the same function which the market would have performed, otherwise it becomes impossible to monitor the performance of the sections of the vertical chain and identify where value is being created. For example, internal prices which are based on accounting conventions rather than market conditions are likely to provide misleading cost signals. One method of resolving the problem is to allow managers the option of buying from outside suppliers if their price is lower. This has the effect of applying the discipline of the market to the components of the vertical chain, while hopefully enabling the company to achieve the potential benets of vertical integration outlined above. The prospect of vertical integration has always been a source of concern to those who felt that companies would grow so big that they would dominate markets and would then be in a position to hold consumers to ransom. In practice this does not occur because, as discussed above, the rationale for vertical integration is not always strong, and in any case vertically integrated companies are unlikely to enjoy monopoly power at all stages of the productive process.

Exercise 5.13
An example of a vertically integrated company with signicant monopoly power is British Gas which controlled the process from discovery of gas supplies through distribution to the nal consumer. The stockbroker Kleinwort Benson produced an analysis of the break up value of British Gas compared to its current total share price value. The analysis is shown in Table 5.7. Table 5.7: Break up value of British Gas Division Exploration/production Pipelines Distribution Other Net debt Total Asset value (bn) 5.3 11.5 3.1 1.7 2.5 19.1 Source: Kleinwort Benson. 1. Should British Gas do its own exploration, production and distribution? 2. If not, what factors might explain why it should cease to exist as a vertically integrated company? 13.9 Trading value (bn) 3.4 13.9 2.9

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5.12

Creating value from the production process

Value is created by the production process through the effectiveness with which resources are deployed and combined together, and in relative terms value is created by the competence which the company contains and which is embedded in both processes and products. These aspects of value creation cannot be easily measured, and in fact are often difcult to identify. But there are ideas which can be applied to help reveal how a company creates value in a competitive market - the notion of a chain of value creating activities which are based on supply linkages, the underlying competence which drives the company and the appropriate expansion trajectory derived from the value creating core of company activities.

5.12.1

The value chain

A company can be visualised as a chain of value producing activities which starts with inputs at one end and sales at the other; the overall value is represented by protability, but it is difcult to disaggregate company activities in such a way that the contribution of each to value production can be identied. Porter 5 tackled this problem by breaking the value chain down into two main components: primary activities, which are basically the logistics of production and sales, and support activities, which are necessary for the effective functioning of the company, but which are not directly related to production and sales. While this is not the only way of breaking down the value creating dimensions of an organisation, it is useful to follow the Porter approach. The primary activities are the following. In-bound logistics: process. receiving, storing and handling inputs to the production

Operations: transforming inputs into output; this is the physical process of making, testing and packing the product. Out-bound logistics: moving the product from operations to buyer in the case of a tangible product, and bringing the buyer to the product in the case of many services. Marketing and sales: analysing customers and bringing to the attention of customers the products and services which the company is selling; this includes the functions of advertising and marketing. Service: maintaining the value of the product by after sales service. These activities contribute to competitive advantage to the extent that they are performed better than those of competitors. What is not typically appreciated is that it is not just the effectiveness with which these individual primary activities are performed that is important, but the linkages among them and the support activities. Procurement: the process by which resources are acquired; this function is concerned with obtaining resources at the lowest price and highest quality. Technological development: the technology associated with each of the value activities, including learning by doing, product design and process development. Heriot-Watt University Strategic Management

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Human resource management: the business of managing the work-force. Management systems: this includes quality control, nance and operational planning. These support activities add value, just as the primary activities do, but are not direct functional parts of the production process The concept of value which Porter uses in value chain analysis is not protability but how the ultimate consumer views the product in relation to competing products. Unfortunately, this is almost impossible to measure, and it is usually necessary to use other measures such as operating margin, prot or shareholder value. Once some measure of competitive difference has been established, the value chain can be analysed to identify how value is created by its components. The following example shows how a value chain that can confer competitive advantage may be constructed. The potential for competitive advantage does not lie in effective performance of each activity because that can always be imitated. It lies in the fact that the activities are integrated and that the chain is capable of responding effectively to change. The Reaction to increased competition column shows the type of changes that the value chain must be capable of to provide an effective response to a competitor who has launched a higher quality product.

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Value chain Primary activities In-bound logistics

Effective operation

Reaction to increased competition

Efcient warehousing and inventory control Benet from experience effect

Adapt warehouses and adjust inventory control techniques Redirect labour force without reducing productivity; improve quality control Identify new ways to market Establish high quality product position Demonstrate attractiveness of improved product

Operations

Out-bound logistics Marketing and sales Service Support activities Procurement Technological development

Develop distribution channels Position product in the right segment Aim for repeat orders

Negotiate effectively Improve and differentiate product Provide incentives aligned with objectives Develop competences

Focus on high quality inputs Move fast to identify and implement specic improvements Develop a commitment to higher quality Identify new competences

Human resource management Management systems

A weakness in any one of the Effective operations can have a serious impact on the operation of the value chain as a whole. For example, poor inventory control can lead to high costs and inability to meet the orders produced by the marketing effort. But it is also clear that if any activity is incapable of change in the face of competitive action the resulting value chain will be equally ineffective. For example, if it is not possible to identify the required product improvements the company will lack the right product to meet the challenge. The basis for sustainable competitive advantage rests in the creation of an organisation that can achieve excellence in each activity and keep on doing so. That depends on the changes in each activity being in harmony, for example there is little point to implementing the new marketing strategy before the improved product is ready for production. It is the uniqueness of such a value chain and the difculty of imitating it that results in sustainable competitive advantage. The question then arises of how to create such an organisation. That requires management of the value chain as a whole and an understanding of the linkages among the components. The value chain is not a set of consecutive actions that have to be executed in turn; it must be visualised as a holistic system and that, needless to say, is Heriot-Watt University Strategic Management

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very difcult to achieve. There is no doubt that the idea of constructing a competitive value chain is a difcult area both conceptually and operationally. It is not surprising that very few companies fully understand their value chains and CEOs are continually perplexed by the inability of their organisations to recognise and react to competitive challenges.

5.12.2

The value system

Unless it is completely vertically integrated, every company buys inputs and in many cases does not actually sell to nal customers. Thus every company is part of a value system which is made up of the individual value chains of suppliers, distributors and nal customers. Opportunities for increasing competitive advantage can be identied by understanding the value chains of both suppliers and buyers. Anything a company can do to reduce its suppliers costs or improve suppliers effectiveness can enhance its own competitiveness. At the same time down stream value chains are important because the costs and margins of down stream companies are part of the price the end user pays and the activities down stream users perform affect end users satisfaction. A company can enhance its competitiveness by undertaking activities that have a benecial effect on its customers value chains. For example, some aluminium can producers constructed plants next to breweries and delivered cans on conveyors directly to brewers can lling lines; this resulted in signicant savings for both can producers and breweries and had a positive impact on both value chains. It has been demonstrated that a complete understanding of the companys own value chain is difcult to arrive at, and is really only an approximation. To extend the analysis to other companies about which it has little real information is clearly an almost impossible undertaking. But even a vague understanding of suppliers and buyers value chains can open up potentially important strategic options, as in the case of the aluminium can producers. It was recognised that locating their plants next to the breweries increased the effectiveness of both the in-bound logistics and procurement elements of the brewers value chains; it also improved their own out-going logistics element. As a result both sets of companies were able to benet from the improvement in the value system.

Exercise 5.14
Marks & Spencer, the British retailer, used to be famous for its relationships with UK suppliers and the resulting guarantee of high quality; it was also a leader in human resource management which was linked to a high standard of customer service. While many characteristics of Marks & Spencer could be imitated, it turned out to be almost impossible for other retailers to emulate the companys success and Marks & Spencer retained its place as one of the most protable retailers in the world for several decades. However, by 1998 some serious problems had emerged. For example, there was a build up of unwanted stocks amounting to about 150 million; the image of quality and value which had been built up by purchasing from British suppliers was undermined by switching to foreign suppliers because British suppliers were relatively expensive; to cap it all, a series of board room battles undermined the companys image as a leader in human resource management. By the beginning of 1999 it came as no surprise that Marks & Spencer prots fell dramatically. After a boardroom reorganisation, a restructuring process was undertaken which started with the sacking of many middle managers. The stock build up was attributed to the fact that there was no marketing Heriot-Watt University Strategic Management

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department and this was also remedied. Analyse the success of Marks and Spencer and its subsequent failure in terms of the value chain and value system.

5.12.3

Competence

The aspects of competitive performance which a company is relatively good at are its capabilities, or competencies (both terms are widely used). The notion of distinctive competencies relates to all of the characteristics of a company which give it a competitive edge. It has been illustrated in the value chain analysis that it is not being particularly good at one thing that generates sustainable competitive advantage, but the integration of activities into a value-generating chain. This is also the case with competencies because if they can be identied then they can be imitated. While technique based competence is a necessary condition for competitive advantage it is not a sufcient condition: competencies have to be combined in such a way that the resulting organisation cannot be readily imitated. Prahalad and Hamel 6 developed the concept of core competence primarily to understand the basis of competitive advantage for large diversied corporations; as a rst step they argue that the collective learning in the organisation must be able to coordinate diverse production skills integrate multiple streams of technologies organise work to deliver value This can be visualised as the effective management of a complex value chain that has many products and processes at each stage; organisational learning is the ability built up over a period to perform these functions better than competitors. To achieve this it is necessary to develop an ethos within the company that promotes communication involvement commitment A workforce that is well informed, where individuals feel part of the process and are committed to organisational objectives is clearly a precondition for the implementation of an effective value chain. Large companies are typically organised into strategic business units (SBUs) as the outcome of historical development discussed in Chapter 1 Section 5.1. While the SBU approach has led to major improvements in effectiveness compared with centralisation Prahalad and Hamel argue that a hidden cost is that it leads to a mind set within SBUs that runs counter to the development of company wide core competences. They contend that the conventional SBU mentality leads to under-investment in developing core competencies. This is because the SBUs concentrate on their own effectiveness without taking a wider view of their linkages with the rest of the company. Heriot-Watt University Strategic Management

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imprisoned resources within the SBU. While the principles of capital budgeting are understood as a method of allocating resources there is no comparable mechanism for allocating human skills that embody core competencies. bounded innovation. Individual SBU managers will pursue only those innovations which relate to their own operations and will ignore, or not recognise the importance of, hybrid opportunities. The message which comes across is that SBU autonomy can stand in the way of developing a long term competitive advantage. Furthermore, the capital budgeting approach to resource allocation may be inappropriate because it is not possible to relate future cash ows to core competencies. But this does not answer the question of what comprises core competence. Because of the difculty of identifying core competence in a conceptual sense, it is easier to say what it is not, for example: outspending others on R & D shared costs, for example, SBUs sharing excess capacity vertical integration. Core competences are not the outcome of R & D expenditures, in fact the pursuit of new products may dilute existing competences; shared costs are one of the potential dimensions of synergy and vertical integration raises fundamental issues regarding the business denition. To identify a core competence there are three tests which can be applied. It gives potential access to a wide array of markets makes a signicant contribution to perceived customer benets of the end product is difcult to imitate. The key test is that it is difcult to imitate. Because they are so difcult to generate core competencies are likely to be relatively rare, and Prahalad and Hamel reckon that there are probably no more than ve or six per company. If they are difcult to imitate they are also probably difcult to recognise but if they are not recognised, companies can unwittingly surrender core competencies when substituting outside suppliers for internal services. It is therefore essential to distinguish between divesting a business and losing a core competence. This adds a different dimension to the issue of vertical integration and make versus buy (Chapter 5 Section 11.4). By its nature, the cost of losing a core competence cannot be calculated in advance, but it may lead to a signicant reduction in company performance. Prahalad and Hamel originally used the example of two large companies in the evolving information technology business to demonstrate the impact of core competences; these were NEC which, they contended, adopted a core product approach, and GTE which maintained an SBU mentality. Prahalad and Hamel attribute the success of NEC compared with GTE to the core competence approach it adopted. But with the passage of time their conclusions appear to be a little less secure. While NEC performed better than GTE, during the ten years up to 1996 NECs shares subsequently lagged behind Heriot-Watt University Strategic Management

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the average of the stock market by 28 per cent; in fact, it can be argued that much of its nancial success was due to its semiconductor business which was related to the world shortage in memory chips rather than the deployment of core competences. Critics have also argued that until 1991 NEC was organised in ten vertically integrated divisions which were controlled by powerful and independent leaders in a manner which was not conducive to synergy. It was only in 1991 that the company was reorganised into three horizontal groups, which was one year after Prahalad and Hamel completed their study. Whether the critics are correct is not really the issue - the fact that the evidence is so mixed demonstrates just how difcult it is to use the notions of competence as a source of competitive advantage. The discussion so far has focussed on the difculty of dening and identifying a core competence, so it might be concluded that it is an intangible and unique attribute of certain successful companies. But from the discussion the main characteristics of core competences can be identied; the following list shows how these relate to the core competence of effectively managing the value chain in a company as discussed in Chapter 5 Section 12.1. Core competence characteristic Difcult to identify Difcult to imitate Value chain management The competence is spread across several managers The management group is comprised of a particular set of individuals with their own incentives and commitment Each SBU is only part of the value chain Even this one core competence has the potential to generate competitive advantage

Do not reside within SBUs Relatively rare

Thus core competence is embedded within the company and it is doubtful if the individuals involved could replicate it in a different set of circumstances. Compare this with the statement by the CEO of a high tech start up company Our core competence is innovation: we invent and deliver new products to the market. On reection, this interpretation of innovation suggests two core competences: inventiveness and delivery to the market. These measure up against the characteristics as follows.

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Core competence characteristic Difcult to identify

Inventiveness Certain individuals are known to possess the ability to invent No one has a monopoly on inventiveness Inventions usually emerge from the R&D department, which can be regarded as an SBU New ideas and inventions appear all the time

Deliver The route to market involves development, marketing etc Venture capitalists specialise in bringing new products to the market It is the job of SBUs to deliver to the market

Difcult to imitate

Do not reside within SBUs

Relatively rare

New products are brought to the market all the time

Neither has the characteristics of a core competence; the CEO may feel that the combination of both is a unique attribute that amounts to a core competence; but while the combination may be relatively rare it is certainly not unique. This approach possibly reveals one reason that so many high tech start up companies fail: they thought they had a core competence when in fact they did not.

5.12.4

Competence and diversication

A technique for using the concept of competencies using categories of competence which can be utilised in diversication, rather than attempting to dene competencies precisely, has been developed by Chiesa and Manzini 7 . They reckoned that competencies can be dened in terms of routines and resources; for example, distinctive capabilities are the outcome of routines and a trained workforce is a resource. The form of diversication can then be classied depending on whether it is based on routines that the company has developed and resources that it currently possesses or whether it has to acquire or develop either or both. The classication of diversication in Figure 5.3 is based on their original idea.

Figure 5.3: Competence based diversication While the classication is bound to be imprecise in real life, each class of diversication

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has identiable characteristics. Replication based diversication This should be the least risky form of diversication because it is based on an expansion rather than a change in the form of the organisation. A major change in the British nancial market in the 1990s was the diversication of building societies (which are mutually owned organisations) into providers of the full range of banking services. Previously building societies had specialised in provided mortgages for house purchase, and typically charged relatively low rates to borrowers and paid low interest rates to savers. Up till then, when they were the only providers of housing nance, there was an imbalance between supply and demand in the market for housing nance and building societies rationed available funds; for example, only individuals who had been saving signicant amounts for several years in a building societys account were eligible for a loan. When banks started competing in this market, the building societies found that a substantial part of their business was lost and they reacted by diversifying into activities previously undertaken only by banks. The building societies utilised their existing resources, in the form of a network of branches and experienced personnel, and applied the routines which they already had for the management of house nance to a wider range of services. Replication based diversication was probably the underlying reason for the success of building societies in the highly competitive personal nancial sector. Subsequently most building societies were oated on the stock exchange; this resulted in large windfall gains for mutual shareholders, reecting the enormous value added which their replication based diversication had produced. Routine based diversication In this case new resources need to be added to those currently available in the company, but the same routines can be used to manage them. The biggest company in Scotland was ScottishPower which diversied from being an electricity utility company into water, gas and telecommunications. New resources were required for several of these new products, and the top management claimed that the same competences (or routines) were relevant for the management of different types of utility. In addition, the customer could be provided with a package deal covering electricity, gas, water and telecommunications. Thus not only would a particularly efcient set of routines be transferred to these activities but synergy among the outputs could be built up. Resource based diversication This occurs when a company starts producing outputs which utilise existing resources but which require different routines. The British university system is world renowned for the excellence of its education, and Edinburgh Business School (EBS) set about delivering this education in the form of the MBA by distance learning. But the conventional routines which deliver class-based educational outputs were incompatible with distance learning, and it was necessary for EBS to develop a totally new set of routines to deliver business. The existing routines included regular studentteacher contact, periodic graded assignments, student peer group interaction and academic counselling. The new routines included self contained teaching packages, self assessment and the use of sophisticated examinations to measure performance. To change current routines and introduce new routines can involve much more fundamental organisational change than the routine based diversication undertaken by ScottishPower.

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Unrelated diversication The extreme form of unrelated diversication occurs where the only resource shared is the nancial structure and control system. There are, of course, numerous examples of companies which have diversied into areas unrelated in terms of resources and routines; the Virgin business portfolio outlined in Chapter 5 Section 11.3 is an example. Diversication is particularly risky when the rm has to acquire new types of resources and manage them using routines with which it is unfamiliar. It could be argued that much of the Virgin portfolio is in the entertainment business and these businesses are therefore related. But it is worth considering in detail the resources and routines required to produce such diverse outputs as tourism, cinema, TV and publishing; this would probably give a different answer on relatedness. Diversication trajectory It is probable that few boards consider possible diversication strategies using this type of classication; hence they tend to embark on the process without a clear notion of how far from the core activities of the company a particular diversication is taking them. Consider the ScottishPower example in more detail and plot the trajectory, or direction in the matrix, of its diversication over time. The ScottishPower board had described its diversication as being primarily routine based. A closer examination of each acquisition suggests that this was not actually the case. The rst acquisition was replication based: ManWeb was another electricity company in England that needed to be made more efcient. The next step was routine based: Southern Water was a medium sized water company in the south of England. It then moved into the unrelated area by the development of a telecommunications business. Finally, ScottishPower moved back to replication based diversication by taking over PacicCorp, a US electricity company. Was the Board correct in its view that the diversication was routine based? ScottishPower then divested its telecommunications business and its water utility. It therefore ended up with only its replication based diversications, i.e. other electricity companies. (PacicCorp was also sold but this was because of problems specic to the US energy market). The withdrawal from water and electricity could have been due to the fact that the Board did not recognise just how far away from their core activities the diversication trajectory was taking the company and the risks involved.

5.12.5

Strategic architecture

The way in which the companys collection of unique attributes is combined together is known as strategic architecture. The strategic architecture of the company is derived from the ideas of the value chain, the value system and the core competencies upon which competitive advantage is based. It is a network of relational contracts within or around the rm. Firms establish relationships with their employees (internal architecture), with their suppliers or customers (external architecture), or among a group of rms engaged in related activities (networks). The value of architecture lies in the capacity of organisations to create organisational knowledge and routines, to respond exibly to changing circumstances and to achieve easy and open exchanges of information. Each of these is capable of creating an asset for the rm, for example, organisational knowledge - which is more valuable than the sum of individual knowledge. Strategic architecture is unique to every company; if it were not so, then it could be imitated and would not contribute to sustainable competitive advantage. It has already been discussed how value chain analysis does not fully describe Marks & Spencer Heriot-Watt University Strategic Management

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because of the linkages between elements in the value chain and the value system. In principle an understanding of its strategic architecture might help the company identify which core competencies to build. But the architecture has typically developed over a considerable period in an unplanned manner and as a result is so complex and unique to an individual company that it is doubtful whether it can be described in operational detail. But it is a useful idea because it highlights the fact that value is not just created by the internal efciency of the company.

Exercise 5.15
Analyse AcmeTools competence based diversication from the StylePlane to the PowerPlane.

5.13

The denition of competitive advantage

The discussions of issues such as the value chain and core competence have referred to sustainable competitive advantage without being precise about what it is. One measure is the ability to maintain a higher rate of return on assets than competitors over a long period. In practice it is difcult to identify what factors contribute to sustainable competitive advantage; the factors that are typically cited by companies, including superior quality, lowest price, best customer service and occupying a cash cow position in the BCG matrix, are usually irrelevant. This is because there are at least two conceptual problems involved in attempting to identify the source of competitive advantage. Causal ambiguity: it is difcult to establish exactly what characteristics of the company contribute to its success because of the difculty of identifying cause and effect relationships. Uncertain imitability: because of the causal ambiguity, potential competitors are faced with uncertainty as to whether their attempt at imitation will work. In view of this is it possible to say anything meaningful about the factors responsible for competitive advantage? There is, but only in a limited way. There are two broad sources of competitive advantage: those based on market conditions and those based on the internal characteristics of the company. The former can be termed strategic assets and the latter distinctive capabilities. Strategic assets arise mainly from the structural barriers to entry discussed at Chapter 4 Section 4.3 and include the following. Sunk costs Relative size of the market Economies of scale Legislation Distinctive capabilities include Heriot-Watt University Strategic Management

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Architecture Reputation Innovation Core competencies Consider the characteristics of a Cash Cow, classied according to strategic assets and distinctive capabilities, which contribute to competitive advantage set out in Table 5.8. Table 5.8: Competitive advantage of a cash cow Characteristic High market share Stable market Customer loyalty Fixed plant capacity Stable labour force Advantage Economies of scale First mover Reputation Full utilisation Experience Source Strategic asset Distinctive capability Distinctive capability Strategic asset Strategic asset

The point that emerges is that the competitive advantage of a cash cow is based on a combination of strategic assets and distinctive capabilities. This has implications for the debate regarding the resource based view of strategy: competitive advantage cannot be attributed to a single factor. Does being a cash cow guarantee sustainable competitive advantage? Only to the extent that any of the sources of competitive advantage cannot be imitated and/or improved on. There are many instances of companies losing their cash cow position because attention was not paid to the sources of competitive Finally, this example is limited because it is concerned with the maintenance of sustainable competitive advantage; the question of how the company achieved the cash cow position in the rst place is another question and is due to the fundamental distinctive competence: the ability to innovate, seize rst mover advantage, mobilise resources, construct the value chain and so on.

Exercise 5.16
What characteristics of Marks & Spencer do you think contributed to its competitive advantage which was sustained over a long period?

5.14

Assessing strategic capability: the strategic advantage prole

The internal analysis of the company has ranged over a variety of concepts and ideas. The nal step is to integrate these ideas to produce an overview of the companys strengths and weaknesses, or in other words its strategic capability. This can be done by constructing a prole of the company using the concepts in this chapter to identify relative strengths and weaknesses. The difculty is to construct a prole which captures Heriot-Watt University Strategic Management

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all strategically important aspects of the company; one approach is to use the value chain as a starting point and add in other dimensions to t the individual case. There is no single correct way of doing this, and Table 5.9 contains a suggested structure. Table 5.9: Assessing strategic capability Dimension Value chain Primary activities In-bound logistics Operations: Concepts Strength (+)

Out-bound logistics Marketing and sales:

Service Support activities Procurement

Warehousing and inventory control Benchmarking Experience Synergy Distribution channels Market share Bargaining power of buyers Pricing Quality Repeat orders

Technological development Human resource management Management systems

Vertical integration Bargaining power of suppliers Economies of scope Competence Culture Leadership Dominant logic Competence Network Core competences Barriers to entry Accounting ratios Cash ow Financial structure Economies of scale Linkages

Value system Distinctive capabilities Strategic assets Protability

Architecture

This classication is by no means complete but it illustrates the complexity involved in attempting to arrive at a full picture of a companys strategic capability.

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5.15

References

1. Smith, T. (1996) Accounting for Growth Random House. 2. Handy, C. (1993) Understanding Organisations, 4th edition, Penguin. 3. Ansoff, H.I. (1968) Corporate Strategy, Harmondsworth: Penguin. 4. Fuller, R.B. (1975) Synergistics, Macmillan. 5. Porter, M.E. (1985) Competitive Advantage: Creating and Sustaining Superior Performance, The Free Press. 6. Prahalad, C.K. and Hamel, G. (1990) The core competence of the corporation, Harvard Business Review, May-June, pp. 79-91. 7. Chiesa, V. and Manzini, R. (1997) Competence based Diversication, Long Range Planning, Vol 30, No 2, pp. 209-217.

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Chapter 6

Culture and stakeholder expectations


Contents
6.1 6.2 6.3 6.4 6.5 Stakeholders in the process . . . . . . . . . . . . . . . . . . . . . . . . . . Stakeholder interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stakeholder interests: the priorities . . . . . . . . . . . . . . . . . . . . . . Stakeholder inuence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mapping shareholders and their inuence . . . . . . . . . . . . . . . . . . 158 158 159 161 164

Learning Objectives To identify the main stakeholders To assess their inuence To identify stakeholder priorities To carry out stakeholder proling and mapping

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6.1

Stakeholders in the process

6.2

Stakeholder interest

A variety of individuals and groups have an interest in the organisation and the way in which it is managed, those individuals and groups being categorised as the stakeholders. The notion of stakeholder extends well beyond the shareholders, or owners of the company, to include managers, employees, customers, suppliers, creditors, the local community and the government. Each stakeholder has a different type of interest in the company; for example, the shareholders are concerned with the return on their investment, and the safety of their capital, while customers are concerned with the quality of the product they purchase and after sales service. Thus each stakeholder has an expectation of some return from the company which is not necessarily expressed in nancial terms. An outline of the various stakeholders and their interest is shown in Table 6.1. The main characteristic of this classication is that the interests of the different stakeholders are completely different. This raises the possibility of conicts of interest, therefore the issue of stakeholder inuence needs to be pursued in some detail. There are in fact two distinct issues to be addressed when analysing stakeholder interests and expectations. These are:

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Table 6.1: Stakeholders and their interests Stakeholder Shareholders Managers Employees Interest Return on investment Risk Salary Advancement Salary Advancement Security Fair treatment Prompt payment Repeat orders Relative value for money Quality Availability Cash ow Financial stability Lack of negative externalities Employment prospects Payment of taxes Lawful operation

Suppliers Customers

Creditors Local community Government

which interests are most important the inuence which stakeholders have on the operation of the company The rst of these largely relates to how stakeholders feel the company should be run, while the second relates to how the company is actually run.

6.3

Stakeholder interests: the priorities

It could be argued that this is really a discussion about how society should be run, for example, in a general sense should employees or shareholders be regarded as more important? An individuals judgement on this is likely to be affected by which group he or she is in. It is quite natural for an employee to consider that his day to day involvement with the company is more important than that of the shareholder who may never have been inside the door. It is important to be explicit about the issue of stakeholder priorities because it has implications for the efciency with which the company can be operated. The following are the types of argument you will encounter on stakeholder priorities, but it is important that you keep an open mind on the issue. Shareholders The shareholders can be regarded as the most important because they provide the capital for the company and if it does not operate efciently shareholders can withdraw their funds and invest in something more protable. In this respect the shareholders Heriot-Watt University Strategic Management

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provide a service to the rest of the economy in that they direct resources to those operations which provide the highest nancial returns; in that sense everyone benets from the freedom of choice to pursue the best return on the money invested. On the other hand it can be argued that shareholders tend to take a short term view of company prospects and it is not safe to leave the destiny of companies to their discretion. This in turn becomes an argument about how efciently capital markets work, and the fact is that no method has yet been discovered which is as effective as capital markets in directing the allocation of resources in the economy as a whole. Central planning was exposed as a failure with the fall of communism; variations on free market operations have been tried, but these amount to attempts at inuencing the way the market works rather than replacing it. So far as the company is concerned, it needs to be recognised that shareholders control the supply of capital, and if their interests are not met in the form of a rate of return which is comparable to other investment opportunities, then the company will most likely cease to exist. It is because of this that it is often concluded that shareholders are the highest priority stakeholders and companies ignore this at their peril. Managers Managers comprise the group which is charged with determining the direction, scope and effectiveness of the business. They are responsible for the allocation of resources, and it is largely upon them that the stakeholders depend for their returns. In addition, if managers make the wrong decisions, the employees lose their jobs and customers are deprived of the companys products. It can thus be argued that managers are the most important stakeholders and therefore should be rewarded accordingly. While this is true, there is also a market in managers, and so long as the company treats them at least as well as companies which might compete for their services, then they do not need to be singled out for special treatment. Their stakeholder priority is high, but it need not be at the expense of shareholder or employee returns. Employees It is on the productive effort of employees that the success of the company depends. But exactly the same argument applies in the case of managers: there is a market in employees which determines the conditions under which they are employed, and again it is unnecessary to single them out for special stakeholder treatment above and beyond that dictated by the market. Suppliers The stakeholder priority depends on the number of suppliers which the company uses. The ve forces model discussed at Chapter 4 Section 10 highlighted the bargaining power of suppliers. When the company is greatly dependent on one supplier it follows that its stakeholder priority is relatively high. But before assigning too high a priority to suppliers it is necessary to determine whether the company can substitute for other suppliers, or increase the number of suppliers. If there is a high degree of dependence on a supplier then this may be a case for vertical integration, but typically recourse to the market will reveal that there are plenty of other suppliers. It may be that a long term relationship has been developed with certain suppliers which provides security of supplies, exibility and so on. But it has to be recognised that there

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are costs as well as benets in such a relationship, and if dependence on particular suppliers is found to have a signicant inuence on the management and direction of the company, then the stakeholder priority must be reconsidered. Customers It is clearly important to provide customers with what they want, but this is because they can take their custom elsewhere in competitive markets. Other than the obvious fact that the company sells to customers, it is difcult to see what priority should be accorded to customers as stakeholders. Creditors As capital markets have become increasingly competitive the interests of individual creditors has diminished. If the creditor has made a realistic estimate of the client then it will be reasonably condent that its debts will be serviced and need have no other interest in the company. Local community Companies depend on their local community for employees, services, land, planning permission and so on; the local community depends on the company for employment and the creation of wealth. Both sides benet from the arrangement and in this respect it is important for the company to live in harmony with the local community There is no doubt that the local community has a valid stakeholder interest which needs to be taken into account in company decision making. Government So long as the company pays its taxes and acts according to the law there is no need for the government to gure in its decision making. In a market economy the role of the government is to set the rules of the game and monitor that they are being adhered to. The government really has no stakeholder interest beyond this for market companies. In government run organisations such as the civil service this is not the case, but here the government acts as a shareholder and it is in that sense that it has a high stakeholder priority.

Exercise 6.1
1. In a purely market economy which stakeholder do you think has the highest priority? 2. What effect does this priority have on the way a large limited liability company is run?

6.4

Stakeholder inuence

While it can be argued that, in principle, some stakeholders should have little interest in the company, the existence of legislative, institutional and historical factors can imbue stakeholders with a signicant degree of inuence; for example, a strong trade union can result in employees having a signicant impact on major company decisions.

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It is not only the degree of inuence which is important, but the fact that the interests of stakeholders are often in conict; this leads to the principal agent problem. While the prole of stakeholder inuence varies among different companies, the following indicates the factors which determine how important that inuence is likely to be. Shareholders Despite their importance, shareholders usually exert little inuence on major company decisions or how the company is run from day to day. Large companies typically have many shareholders and they are geographically isolated, coming together, if at all, only for the annual general meeting. Power rests with the executives, and it is only in exceptional circumstances that CEOs are censured or dismissed at the AGM. In some cases large nancial institutions, which manage portfolios for pension funds and investment trusts, may have a signicant shareholding in a particular company; if the institutional shareholders together take a similar view on a particular issue they may wield some power over company executives at the AGM. However, it must be recognised that these nancial institutions are really the representatives of the individuals whose money they manage, and there is no guarantee that they will act in accordance with these individuals wishes. In smaller companies, which are family owned or have a few partners, the shareholders wield a direct inuence on company operations. But in this case they typically play the dual role of shareholders and managers and this negates the principal agent problem. Managers By and large the inuence of managers increases with the size of the company as the inuence of the shareholders diminishes. The independence of managers also depends on the type of remuneration package - whether it is related to absolute prots, growth in sales, successful acquisitions, or whatever. Ideally, the management incentive structure would be aligned with shareholder interests, which are largely prot maximisation, but this is notoriously difcult to achieve. There are many examples of CEOs receiving huge salary increases at the same time as company fortunes are falling - this is usually because remuneration is lagged and is related not to current but to past performance. One method of attempting to align the two is to make the CEO a shareholder by giving stock options instead of direct remuneration. While the outcome of this should be the maximisation of shareholder wealth, the CEO has an incentive to cash in the options at the most opportune time, and this may not be consistent with long term prot maximisation. In principle, the role of the non executive board members, and an independent chairman, is to provide the countervailing power which will balance up the interests of managers and stakeholders, but given the limited time which the nonexecutives spend in the company, and the fact that directorships are often interlocking, the non executives often wield little real power.

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Employees There was a time in the UK when trade unions had sufcient numerical strength, and the backing of legislation, to ensure that employees had a signicant impact on company decision making. The changes in the legislation in the 1980s, coupled with an absolute decline in trade union membership, led to a signicant reduction in this form of employee inuence. In some countries, such as Germany, employee inuence is much higher because of labour legislation which is more favourable to employees than is the case in the UK. Thus much depends on the individual country and its legislation. However, employees wield inuence in a different way. At the simplest level, it is not feasible for a company to replace its entire workforce at a stroke. Even if it were, the new employees would start off far down the experience curve and productivity and competitiveness would be severely undermined. Thus the company is to a great extent dependent on the skills and attributes of the current employees. In this case it is not so much the direct inuence of employees on company decision making which is important, but the extent to which they are able and willing to collaborate in the changes which strategic decision making involves. This in turn depends on the company culture, organisational structure, incentives and so on. The more specic are the employee skill sets to the individual company, the more important this factor is likely to be. Suppliers As discussed above, the important considerations are the number of suppliers and the availability of substitutes. Customers Again, the ve forces model reveals that the number of customers or customer groups largely determines customer inuence. On the other hand, if there are few substitutes for the companys products this power will be greatly diminished. Creditors Companies tend to build relationships with sources of credit, such as banks, so that they can rely on a fast and fairly sympathetic reaction to credit requirements. Some companies have representatives of creditors on the board; this is usually the outcome of venture capital being provided for high risk start ups by banks which wish to monitor their investments. But typically this involvement diminishes as the management establishes a track record. Companies have the option of nancing investments from retained earnings, obtaining loans, or a combination of both. It could be argued that a company which has become so dependent on a particular bank that it exerts inuence on company operations only has itself to blame. In principle, the inuence wielded by the bank is to decide whether to provide a loan, and it does this in competition with other banks. Where a relationship has been established it can be costly to change creditor, but this is an issue of costs and benets rather than creditor inuence. The fact that the company is highly geared (as discussed at Chapter 5 Section 3) may constrain its activities, but it is difcult to see how the creditor can exert direct inuence on the company unless it has put the creditors funds at risk. Local community The inuence of the local community may take a variety of forms. Heriot-Watt University Strategic Management

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If the company develops a reputation as a good employer, it will typically have little difculty in recruiting at the going wage rate; however the opposite is likely to apply if its reputation is suspect. If the company pollutes the locality it will probably have difculty obtaining permission for expansion. Government Apart from regulation, the government can inuence companies by its role as a purchaser and through its policies on subsidies and trade. The purchasing inuence affects companies in the defence industry; subsidies affect companies in the sectors which the government is attempting to encourage; trade policy affects importers and exporters. Again the extent of shareholder inuence depends on the individual case.

Exercise 6.2
From the discussion identify the factors which determine each stakeholders inuence. Set this out in the form of a table with the stakeholders listed on the left and the relevant factors listed on the right.

6.5

Mapping shareholders and their inuence

In order to understand why a company operates in the way it does, or to assess its potential for change, the inuence of the individual stakeholders needs to be identied and prioritised. The general principles of stakeholder inuence discussed above will not necessarily apply to every case. In most instances it is pointed out that there are likely to he signicantly different levels of inuence in individual cases. The nal step in the process is to map out the perceived inuences and this can take the following form. Consider a company which is family owned and the family maintains a close control on the business, uses mostly unionised labour and supplies a single customer; one of the owners is currently considering moving into new markets. The stakeholder map would look like: Stakeholder Shareholders (family) Managers Employees Customers Suppliers Inuence High Low High High Low

The potential move into new markets can then be considered in the light of the inuence wielded by stakeholders; it could emerge that the change would be constrained by the attitudes of the other shareholders willingness of the employees to accept change Heriot-Watt University Strategic Management

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While current customers have a high inuence they will not affect the decision to move into new markets and the part-owner must convince his partners rather than management about the desirability of the move. Any organisational change which is not accompanied with some form of stakeholder mapping is likely to run into constraints which could have been identied well in advance.

Exercise 6.3
Consider the situation of the marketing manager in SuperTools; if he wishes to pursue the development of the PowerTool and perhaps enlarge the company portfolio what can he learn from a stakeholder mapping exercise?

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Chapter 7

Strategic options and strategic choice


Contents
7.1 7.2 7.3 7.4 Strategy choice in the process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169 169 170 171 171 172 172 174 175 176 176 177 177 178 178 179 180 180 181 182 182 183 185 186 189 190 192 193

The importance of structure . . . . . . . . . . . . . . . . . . . . . . . . . . Strengths, weaknesses, opportunities and threats Generic strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.4.1 Corporate strategy concerns . . . . . . . . . . . . . . . . . . . . 7.4.2 Corporate decisions on company size . . . . . . . . . . . . . . . 7.4.3 Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.4.4 Expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.4.5 Retrenchment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.4.6 Combination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.4.7 Assessing corporate size strategies . . . . . . . . . . . . . . . . 7.4.8 Allocating resources among SBUs . . . . . . . . . . . . . . . . . 7.4.9 Monitoring and controlling performance . . . . . . . . . . . . . .

7.5

Business level generic options . . . . . . . . . . . . . . . . . . . . . . . . 7.5.1 Low cost leadership . . . . . . . . . . . . . . . . . . . . . . . . . 7.5.2 Differentiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.5.3 Focus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.5.4 Stuck in the middle . . . . . . . . . . . . . . . . . . . . . . . . . . 7.5.5 Generic strategies and company concerns . . . . . . . . . . . . . . . . . . . . . . 7.5.6 Generic strategies and company performance

7.6

Identifying strategic options . . . . . . . . . . . . . . . . . . . . . . . . . . 7.6.1 Related and unrelated options . . . . . . . . . . . . . . . . . . . 7.6.2 Vertical integration . . . . . . . . . . . . . . . . . . . . . . . . . . 7.6.3 Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.6.4 Alliances and joint ventures . . . . . . . . . . . . . . . . . . . . . 7.6.5 International expansion . . . . . . . . . . . . . . . . . . . . . . . 7.6.6 Corporate generics to business generics to options . . . . . . . .

7.7

Strategy choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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7.7.1 Shareholder wealth

. . . . . . . . . . . . . . . . . . . . . . . . .

194 197 198 198 199 201 202 202 203 204

7.7.2 Performance gaps . . . . . . . . . . . . . . . . . . . . . . . . . . 7.7.3 The portfolio choice . . . . . . . . . . . . . . . . . . . . . . . . . 7.7.4 Product and market familiarity . . . . . . . . . . . . . . . . . . . . 7.7.5 Risk and risk aversion . . . . . . . . . . . . . . . . . . . . . . . . 7.7.6 Contingency planning . . . . . . . . . . . . . . . . . . . . . . . . 7.7.7 Managerial perceptions . . . . . . . . . . . . . . . . . . . . . . . 7.7.7.1 7.8 7.9 Attitude to external dependence . . . . . . . . . . . . . Choice: is it rational? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Learning Objectives To develop a structure within which rational choice can be made To apply the SWOT framework in a strategic setting To dene generic strategies To identify strategic options To relate managerial perceptions to strategy choice

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7.1

Strategy choice in the process

7.2

The importance of structure

The objective of an analysis of strategic choice is to attempt to rationalise the way in which choices are made among competing alternatives. In real life it might appear that, in many instances, no choice was actually made and that the company was simply carried along by the force of events, perhaps ending up with a dominant market position as the result of good fortune upon which it then capitalised; this is consistent with the emergent view of strategy, or logical incrementalism. In other instances choices were made but on such a non structured basis that no general lessons can be drawn from the experience. The difculty of applying the scientic approach to strategy was discussed at Chapter 1 Section 3; a related issue is that the problem of drawing lessons from the experience of companies is compounded by the fact that different perspectives on the same choice can come to the conclusion either that the outcome was fortuitous or that it was the result of a structured choice approach. This is partly due to the difculty of determining after the event what actually happened during the choice making process. Managers are as prone as anyone else to justifying their actions and have a tendency to superimpose a structure on a series of events which, at the time they took place, were unstructured. By this stage of the strategy process a great deal of analysis has been carried out: The company objectives have been scrutinised, and the desired state of the company formulated. The macroeconomic environment has been evaluated to determine the likely course of business conditions. The markets within which the company operates, or intends to operate, have been analysed. The internal operation of the company has been examined. Heriot-Watt University Strategic Management

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However, no matter how detailed and sophisticated the analysis has been, it has not generated an automatic course of action; what the analysis has done is to identify many relevant factors and estimate their relative importance, thus providing the basis on which an informed choice can be made. The next step is to develop a structure within which the outcome of the analysis can be utilised in order to arrive at that informed choice.

7.3

Strengths, weaknesses, opportunities and threats

The proles of environmental threats and opportunities (ETOP), and company strengths and weaknesses (SAP), contain a great deal of information which is relevant to strategy choice, and the rst step is to combine the proles to identify where matches occur between the two. This is the crucial step in linking the analysis of the environment with the analysis of the company: can we identify where company strengths are aligned with market opportunities and where environmental threats are aligned with company weaknesses? This is known as an analysis of strengths, weaknesses, opportunities and threats (SWOT). For example, a company might have identied a threat arising from the entry of foreign competition due to the relaxation of trade barriers; corresponding to this might be a weakness in company marketing, where the sales force has recently been depleted and the distribution system is already having difculty in delivering orders on time. On their own the threat and the weakness are of great concern to the company, but the fact that they are aligned means that the company does not have the capacity to counter the threat at the moment. The combination of internal and external analysis revealed that strengthening company marketing is an issue of crucial and immediate importance. SWOT analysis is an essential rst step in assessing what the company needs to do to protect its current market position, and in identifying potential strategic thrusts which can capitalise on company strengths and market opportunities. A SWOT analysis might look like the following for a large city centre retail store Strengths City centre location Reputation Weaknesses No scope for physical expansion High level of gearing Opportunities Increasing personal expenditures Increase product range Threats Out of town shopping centres City centre transport restrictions

The SWOT analysis illustrates the dilemma facing many city centre department stores at a time when shopping habits are changing. The strengths of location and reputation are aligned with the fact that people are spending more on shopping, and the range of products on the market is increasing. However, the weaknesses identify a set of constraints on capitalising on this alignment, because in the city centre there is no room for expansion while the company will nd it difcult to nance additional investment because of previous borrowings. Furthermore, the threat of out of town shopping centres, which have arisen because of increased car ownership and mobility, coupled with increasing restrictions on car use in city centres, means that not only will it be Heriot-Watt University Strategic Management

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almost impossible to capitalise on the opportunities, but the company itself is under serious competitive threat. To some extent the deductions which are drawn from the SWOT analysis will depend on how decision makers rank the various entries in the matrix. But one option appears particularly attractive: sell up and take the reputation out of town where the market is heading. The reputation is the only really valuable asset the company has and the revenue from the sale would enable it to invest where the market is.

Exercise 7.1
Set out a SWOT analysis for SuperTools using the information contained in Exercise 4.7 and Exercise 5.1 for Year 2. Assess what action the analysis suggests the company should take.

7.4

Generic strategies

A dictionary denition of generic is applicable to any member of a group or class. Generic strategies are therefore associated with broad classications of strategy; in military terms this would involve being an aggressor or defender, or perhaps choosing to be neutral. The business generic strategy options are represented differently at corporate and business levels. At the corporate level the generic options are related to the scope of the company and the directions it will pursue, for example the development of new products or the acquisition of companies to increase the product portfolio. It is at this level that the overall denition of what business the company is in is made. At the business level, generic choice relates to competing in product markets. These generic strategies are the basis on which the company attempts to build its competitive advantage; without a clear idea of the generic strategy which it is pursuing, a company is likely to end up with no identiable strategy with the result that it will lack direction and strategic intent.

7.4.1

Corporate strategy concerns

The concerns of corporate strategy vary among companies depending on their degree of diversication, their geographical scope, their number of products and so on. The main concerns are deciding whether they should be expanding, contracting or remaining stable managing the corporate portfolio allocating resources among SBUs contributing to the formulation of business level strategy coordinating diverse activities Heriot-Watt University Strategic Management

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monitoring and controlling performance In a single product company there will clearly be little stress on managing the corporate portfolio, while in a large multi product company business level strategy will tend to be left largely to managers of strategic business units. Some of these concerns are discussed below.

7.4.2

Corporate decisions on company size

Reverting to the military analogy, the ultimate generic option is whether to go to war or not; having gone to war, generic options include whether to attack or defend, to wage war in one theatre or several and when to allocate resources to land, air or sea forces. The generic choice determines the framework within which subsequent actions will be undertaken. In the case of business, generic strategies are concerned with issues such as what business the company is in, how diversied it should be and whether it should aim for horizontal and/or vertical integration; within the framework of these choices it is useful to think in terms of stability, expansion, retrenchment, or combinations. At rst sight, these three strategy options might appear to be nothing more than common sense, in that there is nothing else a company can do but stay the same, get smaller, expand, or change the mix of its activities. However, in strategy terms the choice should have been determined by the outcome of comprehensive analyses of the economic environment, the market and the company itself, with managers being explicit about which generic alternative they are pursuing and why. The denition of the generic options of stability, expansion and retrenchment raises a number of problems because there are so many dimensions of company performance. By and large, these ideas relate to the scale and scope of a companys operations. For example, for a single product company expansion can be dened as attempting to increase market share and, hence, total revenue; a more ambiguous case would be the attempt to increase total revenue by increasing the quality and the price of the product, which could lead to a lower volume of output and hence lower market share. For a multiple product company expansion relates to the revenues from the individual products, together with the introduction of new products. It is important to be clear about what the strategy options are NOT. For example, an expansion strategy cannot be dened as increasing protability, which can be the outcome of the efciency with which the company has achieved its objectives. Increased protability could be achieved by contracting the companys activities, and therefore could be associated with a retrenchment generic strategy. The generic strategy is one of the means by which the end of protability may be achieved.

7.4.3

Stability

The initial inclination is to regard this as being no change; however, the fact that managers do not perceive objectives in terms of increasing markets, introducing new products or acquiring new businesses, does not mean that the company is in a steady state. An analysis of external and internal factors may have revealed one or more of the following. Relatively small performance gap An analysis of where the company is now and where it is hoped to be in, say, three years

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time may have revealed that the actual and desired states would converge without any signicant change in the companys strategy. Markets are mature Portfolio analysis may have revealed that current markets are no longer in their growth stage and that further expansion of market share is unlikely to pay dividends. Analysis of product life cycles may have revealed that current products have relatively long life cycles; in the meantime there is no need to invest in new products to take their place. Internal weaknesses An analysis of the efciency with which the company allocates its resources may have revealed that production processes are based on out of date equipment, that inventories could be reduced, that inadequate training is being undertaken and that labour productivity is falling. As a result unit costs are higher than they need be, and if the company were to embark on expansion it would rapidly nd itself at a cost disadvantage compared with its competitors. The stability strategy is therefore primarily concerned with increasing efciency, investment in labour-saving capital, the introduction of just-intime procedures and other actions which will bring costs under control. Unstable nancial history The previous record of the company may have been characterised by marked swings in protability and dividends paid to shareholders. As a result managers may feel that the share price is not a proper reection of the true value of the company and that there is a danger of hostile take-over. One way to generate a stable track record may be to make no signicant investments. Poor economic prospects Analysis of the national and international economy may have revealed that the business cycle is on the downturn, that markets are likely to decrease, and the company should prepare itself for increased competitive pressure as competitors attempt to maintain their competitive position. Competitive threat The elimination of trade barriers may have opened up the prospect of increased competition from foreign companies who are known to be more efcient at marketing and producing quality goods on time. Managers may consider that the company has to marshal its resources in order to meet this perceived threat, rather than dissipating them on relatively unknown prospects. Perceived costs of change Expansion is usually associated with change and individuals are often averse to change in organisations. One way of attempting to avoid the painful effects of change is to pursue a strategy of stability. The trouble is that stability does not guarantee a static organisation, many companies having found that they must initiate signicant changes merely to maintain their market position. The generic strategy may be pursued for the wrong reason; the longer such a philosophy survives in a company the more difcult it will become to introduce the changes which will ultimately be forced on it.

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Managers averse to risk Managers may feel that the prospect of loss greatly outweighs potential gains from expansion. If the company is already perceived as being successful, there is a decided attraction to carrying on with what has been done in the past rather than embarking on new enterprises. Even to maintain their market position is an achievement for many companies in a rapidly changing competitive environment. In fact, at any one time the great majority of companies are likely to be pursuing a generic strategy of stability. This might well be accompanied by substantial internal changes which are necessary in order to maintain market position. The list demonstrates that stability is not a passive option.

7.4.4

Expansion

Expansion can take many forms and it is important to have some understanding of the underlying forces which lead to expansion at the corporate level. There are several reasons why a company may actively pursue a strategy of generic expansion. Portfolio management Portfolio analysis may have revealed that markets for most products are still in the growth stage and that it is necessary to expand in order to maintain market shares. Diversifying risk It may be felt that an increased portfolio of products reduces the risk for the company as a whole. Whether diversication actually does reduce the risks facing the company is another matter; some of the issues relating to diversication of risk were discussed at Chapter 5 Section 11.3. Whatever the rights and wrongs of this method of dealing with risk, there is no doubt that the desire to diversify risk gives management a strong motivation to expand. Searching for competencies A line of business may t with the perceived competencies of the company, and although the expansion does not meet normal investment criteria, in the eyes of corporate management it may contribute to the companys long run competitive advantage. Economies of scale Investigation of the cost structure of the company and its competitors may suggest that there are signicant economies of scale to be exploited. In a mature industry the additional sales can only be achieved by increasing market share at the expense of competitors; in a growing market it is necessary to grow faster than competitors if a dominant market position is to be achieved. Experience effects This is similar to the economies of scale case, with the qualication that the potential advantage is only available for a limited period. Building advance capacity It would not be surprising to nd many companies following an expansion strategy when general economic conditions are improving. However, by the time that economic conditions start to improve, it may be too late to expand because of shortages of Heriot-Watt University Strategic Management

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capital and labour. Some companies take the opportunity of a recession to expand their operations in order to be ready for the next upswing. Managerial motivation In some companies the remuneration of top management is related to total revenue rather than protability. This naturally leads to a preference for expansion over stability. Managers who are not rewarded on this basis may still regard their personal long term success as largely dependent on being responsible for a growing company. It is expanding companies which catch the headlines; the managers associated with expansion benet from the aura of success. Managerial perception There is a widespread feeling among managers that if a company is growing it must be basically healthy, but a company which is pursuing an expansion strategy for the wrong reasons could be weakening its long term competitive potential.

7.4.5

Retrenchment

Under this heading come the notions of downsizing, delayering and restructuring. These initiatives are undertaken in the quest for a more efcient organisation either in terms of shedding businesses which are not seen as part of the companys core competence or in terms of enhancing labour productivity. This is the strategy which many managers often do not want to be associated with because it implies that mistakes have been made in the past. This is why many companies nd it necessary to appoint a new CEO when retrenchment is necessary, or to use independent consultants to advise on retrenchment policies. But if the notion of retrenchment can be divorced from that of protability, and the emotive objections overcome, it can be demonstrated that retrenchment is not necessarily brought about by incompetence and can be a perfectly logical strategy. Product life cycles Some products may be nearing the end of their life cycles and there are no replacements available to which the company can divert resources. Managers may decide it is better to wait and see whether new products can be developed in the areas in which the company has expertise, rather than diversifying into areas of high uncertainty. Unbalanced portfolio It is not unknown for companies which are cash rich to diversify into numerous areas in which they have little experience. Subsequently, it may transpire that some of the acquisitions are dogs, using the BCG denition. Since such products are almost impossible to salvage because the costs of increasing their competitive advantage far outweigh the potential returns, the appropriate strategy is to divest. Overextended markets Internal analysis may have revealed that, at the margin, the company is losing money on some customers. This can arise from maintaining a production, sales and distribution network which incurs very high marginal costs, while the revenue from many customers is relatively low due to competitive pressures. If, in economic terms, it is found that the marginal cost exceeds the marginal revenue, the remedy is to cut back on the scale of operations. Companies are often able to identify customers not worth having because, for example, the delivery cost may be high, because extremely favourable terms had to Heriot-Watt University Strategic Management

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be offered to get the order in the rst place, or because resources were already working at full capacity and lling the order caused disruption. Retrenchment for this reason will typically increase protability because losses at the margin are eliminated. Retrenchment can therefore be associated with rationalisation and a drive to greater efciency. These positive reasons need to be distinguished from retrenchment caused by a series of poor decisions which managers attempt to counter by selling productive assets to boost short term cash ow, or imposing economies on the organisation which provide no more than a temporary solution to cash ow problems.

7.4.6

Combination

There are two ways of looking at combination strategies. First, they occur when a multiple SBU company is pursuing different generic strategies in relation to individual SBUs, making it is impossible to characterise the generic strategy for the company as a whole as stability, expansion or retrenchment. Second, the company can pursue a different generic policy sequentially, so that the current generic policy can only be interpreted in the context of the grand overall strategy design. Opportunity cost The real cost of a course of action is the best alternative forgone. Analysis of markets may reveal that some resources could be put to better use and that they should be redeployed. However, in order to release these resources it may be necessary to reduce some current activities by way of a retrenchment strategy. The period of retrenchment may be protracted, depending on the circumstances. The overall generic strategy may be stability or expansion, depending on the markets into which the company is diverting resources. Product portfolio Because of the unpredictability of product successes and failures, and the objective of maintaining a portfolio, the company may have no alternative but to go through periods of expansion and retrenchment. Furthermore, at any time the multiple SBU company is likely to nd that some SBUs are expanding and others are in retrenchment simply because of their individual product portfolios. If a sufciently long term view is taken, it could be argued that all companies pursue a combination generic strategy because that is the way things are likely to turn out.

7.4.7

Assessing corporate size strategies

It is clear that different generic strategies are appropriate in different circumstances. The inuences outlined above will partly determine which generic strategy a company will follow in the pursuit of its objectives. The question naturally arises of what criteria ought to be employed in deciding which generic strategy to pursue, given that in any circumstance there will be inuences acting in different directions. The question which should be asked is Which generic strategy will add most value to the company? This focuses attention on the ultimate objective of the company rather than on the means by which the objective might be achieved. It is illogical to opt for expansion if it is likely to reduce the value of the company, or if retrenchment would add value. In spite of the emotive implications of the generic alternatives, the distinction between means and ends must be maintained; otherwise the company will nd itself embarking on a course Heriot-Watt University Strategic Management

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of action which, in reality, has nothing to commend it other than its appeal to managers.

7.4.8

Allocating resources among SBUs

The allocation of resources among businesses is not only an important activity, but it distinguishes a divisionalised company from one which is merely a nancial entity, or a holding company. The subsidiaries of a holding company usually determine their own nancial policy, and use retained prots for investment and pay the residual to the parent company for distribution as dividends. In the divisional company the head ofce determines nancial policy, all prots being returned to corporate headquarters which in turn makes decisions on investments and the sources of nance. Important roles of the centre are to ensure that the individual spending plans of the divisions are within the overall borrowing limit of the company and to allocate investments among divisions where there are budgetary constraints; this is known as capital budgeting. The problem confronting the centre is to devise capital budgeting rules for allocating resources which are efcient and consistent. This is by no means an easy task because arbitrary rules can produce inconsistent outcomes. The problem is unlikely to be resolved by adopting a formally correct method such as allocating resources on the basis of the Net Present Value because, in cases where there is capital rationing, the formally correct answer can lead to the selection of a group of investments which do not necessarily include those with the highest NPVs; it is difcult to convince managers that their excellent investment proposals are unacceptable because of the application of a mathematical technique. The problem is complicated by the principal agent problem: each SBU CEO will attempt to portray his business in the best light and it is very difcult to disentangle an accurate picture of what is happening at SBU level.

7.4.9

Monitoring and controlling performance

The performance of the individual businesses needs to be monitored in various dimensions. While protability is clearly very important, other measures include growth of sales revenue, operating margin, market share and customer perceptions of value for money. Furthermore, performance targets can be set on a short term basis, say every month or every quarter, or on a longer term basis such as annually or three yearly; however, the further ahead targets are set the less meaningful they are; it is, therefore, important that the corporate measures and targets are seen as being relevant. Controlling performance is dependent on the incentive structure. It is important that the incentive system is aligned with the performance measures: there is little point to setting medium term market share targets when remuneration is based on short term protability. In fact, in markets where change is rapid and technology is developing fast it is important that the incentive system does not stie innovative behaviour; this can arise when the measures used refer primarily to the past when what is required is a forward looking set of targets; unfortunately, these can be extremely difcult to quantify in such conditions, and the best that may be possible is to identify a series of milestones which establish dates for particular stages in the development of a product life cycle.

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Exercise 7.2
Assess SuperToolss corporate activities under each of the headings in this section. Treat the CEO as the corporate head and the Marketing Manager as head of the two SBUs producing the two products.

7.5

Business level generic options

The focus here is on the effective exploitation of individual product markets as opposed to the overall resource allocation problem facing corporate level strategists. This is the responsibility of the SBU, which may have a product portfolio of its own to consider. The generic approaches can be classied according to the strategy adopted towards individual products, or the strategy approach adopted by the SBU towards the exploitation of a group of products. At the product level, the focus is on achieving competitive advantage in a given market. Porter 1 identied three main generic strategies: overall cost leadership, differentiation and focus.

7.5.1

Low cost leadership

The objective is to achieve a situation where unit costs are signicantly lower than those of other companies in the industry, thus producing higher prots than competitors and the ability to mount a defence against competitive threats. This strategy is partly based on the BCG concept of the advantage conferred by relatively high market share; this cost advantage derives from those economies of scale and experience effects which, by denition, are not available to smaller companies. The strategy implies two specic preoccupations. First, the company must attempt to gain the market share which has the potential to generate the cost advantages desired. This market share must, of course, be achievable; there is no point to adopting a strategy of cost leadership when existing industry giants control 80 per cent of the market. Second, the company must be continually concerned with efcient resource allocation and be at the forefront of technological developments which have the potential to reduce costs. Once it has achieved a cost advantage the company will be continually concerned with its maintenance; it would be a serious mistake to assume that economies of scale and experience effects will automatically confer low cost advantage on the company for ever. For example, it has already been stressed that experience effects are transitory, that competitive conditions continually change with the result that economies of scale are always under threat and that international developments can lead to the entry of previously excluded efcient producers. The cost leadership strategy can be seen as an investment process. Costs are incurred initially in winning market share and setting up efcient production techniques. Subsequently the net cash ows will be higher than they otherwise would have been because of the unit cost advantage. Although a company successfully implements a low cost leadership strategy and produces a cash cow there is no guarantee that this will result in a sustainable competitive advantage. While the company will benet from economies of scale and experience effects technology is continually developing and cost advantages can be

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quickly eroded. Laptop computers, for example, are sold on the basis of differentiation, according to advertisements, which stress various features such as memory, speed, quality of graphics and so on. But in fact all laptops made at a particular time do much the same things and the main difference between them is price. Over the years market dominance has shifted from one company to another as the ability to produce these complex machines has changed in relative terms.

7.5.2

Differentiation

The effect of product differentiation was discussed at Chapter 4 Section 4.6.1, where differentiation made it possible to generate prots by segmenting the market and enabling different prices to be charged in different segments. In this case there is less preoccupation with market share because the company is continually redening the market; it may in fact have 100 per cent market share in the segment for the particular combination of differentiated characteristics which it has produced. Therefore, since the product is not homogeneous, less attention is paid to relative costs. Obviously, the company must be able to charge a price differential which will compensate it for the additional costs incurred in differentiation and it would be irrational to ignore cost behaviour altogether; however, the overriding objective is not to produce at a lower cost than competitors, but to produce something which is seen as being different from competitors. The strategic process involves searching for and adding some characteristic such as superior quality or service associated with the product; it may not be a real effect, but may be an image consciously created by the company. The salient characteristic of the strategy is that the company is primarily concerned with capitalising on the perceived characteristics of the product. This approach can be adapted to identify product position by plotting the main differentiating variables against each other and locating both the companys and competing brands within it. For example, brands of Scottish malt whisky are usually described in terms of their smoothness and peatiness (if you dont drink whisky you just have to take this on trust). Some of the eighty or so brands of malt whisky are plotted in Figure 7.1.

Figure 7.1: There is plenty of scope for discussion about where precisely each brand should be located; the important point is that there are clear differences among brands when their

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characteristics are plotted in this way. In the eyes of consumers there are signicant differences between brands, but this positioning picture does not tell one important item of information: how much more are people prepared to pay for more peatiness or more smoothness or some combination of the two? Market research may provide some insights into the optimum price, but it is largely a matter of judgement. This amounts to selecting the preferred position in the perceived price and quality matrix; but there may well be a signicant difference between the companys preferred position and how the product is regarded by consumers.

7.5.3

Focus

The previous generic strategies involved different ways of meeting competition and achieving an advantage: in the rst case this was by lower costs; in the second, by altering product characteristics. The focus strategy is different in that it typically involves the identication of market niches where it is possible to avoid confrontation with competitors. Within the niche the company can focus on cost or differentiation. The focus approach is not a high volume alternative and it pays little attention to market share. The niche may be a part of the market which requires specialised attention, very fast guaranteed delivery, or some other characteristic which high volume producers cannot provide because of the homogeneous nature of their product. Once a company has established itself in a niche it can potentially make a high rate of return because it is able to avoid direct competition with large companies and in effect act like a monopolist; this lack of direct competition can lead to inefciencies in production and what might appear to be a bizarre marketing strategy. The Morgan car company in the UK makes somewhat eccentric sports cars that appeal to a minority of enthusiastic drivers. For many years the cars were partly hand built and the factory was antiquated with virtually no attention paid to time and motion. There was a waiting list of three or four years for delivery. Consultants suggested that Morgan should invest in a more efcient factory and increase production to reduce the waiting list. The directors were not convinced because they felt that changing the build approach would undermine the perception of differentiation, while increasing production and sales could bring them into direct competition with the larger sports car makers, against whom they certainly could not compete. In the event Morgan invested in some production improvements but did not signicantly increase output. This is a case where the company appeared to be highly aware of its competitive advantage and the limits imposed by the focus strategy.

7.5.4

Stuck in the middle

A salient feature of the three generic strategies is that the companies specialise in a particular approach to the market; they specialise in production processes, individualised products or identifying unsatised consumers. A company which does not specialise is likely to be continuously adjusting its competitive focus in response to changes in the market, with the result that it is stuck in the middle; such an undened strategy is likely to be associated with relatively poor performance because the marketing effort of such a company is likely to be confused: at any one time it may not be clear whether marketing managers are attempting to achieve market share, differentiate the product in the eyes of the consumer, or nd unexploited opportunities. The Morgan car company could well have ended up stuck in the middle if it had Heriot-Watt University Strategic Management

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introduced modern production methods and aimed at a wider market: it would have lost much of its differentiation which was partly based on the eccentric approach to production while it would have been far too small to compete effectively at the price of roughly comparable mass produced sports cars. It does not always follow that low cost leadership and differentiation are mutually exclusive. Some companies have apparently successfully combined low cost leadership and differentiation; Benetton manufactures highly differentiated clothes and runs an international production and retail chain that is highly efcient and charges relatively low prices. The underlying reason for success is that Benetton understood what it was trying to do whereas many companies end up being stuck in the middle because they have not understood the basis of their competitive advantage.

7.5.5

Generic strategies and company concerns

While there will always be difculty in classifying companies between differentiation, cost leadership and focus at the margin, companies which have explicitly adopted one of the three will have different concerns as outlined in Table 7.1. Table 7.1: Cost leadership, differentiation and focus: concerns Generic strategy Cost leadership Concerns Optimum plant size Process engineering skills Simple product design Quantitative incentives Tight resource controls Tight nancial reporting system Differentiation Branding Design Marketing Advertising Service Quality Creativity in R&D Focus Matching products with customers After sales service Dedicated work force Unless company structure and generic strategy are aligned there is a real danger that it will lose either its cost leadership or differentiation and end up in that unwelcoming Heriot-Watt University Strategic Management

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place: stuck in the middle.

7.5.6

Generic strategies and company performance

It is reasonable to ask what the most appropriate generic strategy might be, given the circumstances of the company, the positioning of its products and the past behaviour of managers. There are three main issues to bear in mind when attempting to relate generic strategies to company performance. First, the point has already been made that the generic strategy is a means, while company performance is the end. Therefore a stability strategy is not necessarily less protable than an expansionist strategy and the cost leader is not necessarily less protable than the differentiator. Second, it has been argued that the underlying measure of protability relates to the value added by alternative courses of action which is not necessarily reected in changes in short term cash ows. However, in some cases, value added may not be the immediate concern of decision makers; for example, a family may wish to maintain control of a company despite the fact that its value would be increased by expansion. Third, the data do not exist on which to apply the scientic method of hypothesis testing. Therefore, any conclusions drawn on the most appropriate strategy are likely to be heavily conditioned by the experience of the individual strategist.

Exercise 7.3
1. Combine the generic strategies of differentiation and cost leadership with the Miles and Snow categories of prospector, analyser, defender and reactor to identify the likely emphasis of a company on new product market growth. You will have to set up a matrix with generic strategy on one axis and type of strategist on the other. 2. What benets do you think would be gained in real life from classifying organisations in this way?

7.6

Identifying strategic options

The generic strategies provide the framework within which the company formulates its individual strategy. By the time the company arrives at this stage it will have amassed a considerable quantity of information on itself and its markets, on any performance gaps and on the t between its own potential and market opportunities. It will have identied whether it is expanding or contracting at the corporate level and the strategic emphasis which it has exhibited in the past at the SBU level. The next step is to identify which courses of action might be undertaken in order to achieve the identied objectives. This is a formidable task because the range of options from which real choices can be made is virtually limitless. But the whole strategy process would fall apart if the decision maker were presented with such a wide range of potential courses of action that comparisons could not be made. There is clearly a need to set out some general principles so that the most relevant strategy options can be identied. Within the context of a given generic strategy some broad classications can serve to reduce the options which have to be evaluated. For example, a company which wishes to pursue a generic expansion strategy can consider internal versus external market development, horizontal versus vertical integration and being innovative rather Heriot-Watt University Strategic Management

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than imitative. The decision to pursue one of these options immediately reduces the strategic options. It is at this point that SWOT analysis, where the alignment of strengths and opportunities helps to identify the appropriate generic strategy, is brought to bear.

7.6.1

Related and unrelated options

The problem of diversication, and the difculty of generating value from diversications, has been discussed at some length. Given this, it might seem that a related diversication is preferable to an unrelated diversication. There are many compelling arguments in favour of staying in the business that you know most about; for example, marketing and selling techniques are known, production processes are similar, many administrative and distributive overheads can be shared among similar products and the nature of the competition is well known (or it should be). But there are some reasons why it may not be possible to expand in existing markets; for example, competitive legislation may make any further increases in market share illegal, or the company is cash rich and has already exploited existing markets as far as it is considered economic to do so. Take the case of a company currently producing baby food which is faced with a declining demand for its product because of demographic changes. It has the option of moving into the production of tinned food with a special appeal to young children, or diversifying into the production of toys; diversifying into a different type of food product appears to be a more closely related diversication than getting involved in producing toys. The factor which makes both related is that they are both in markets involving children. The trouble is that this ranking of relatedness may focus on the wrong variables. In fact, the research carried out during the past thirty years has established little agreement on the contribution of related diversication to competitive advantage. The case has been strongly made that this is because traditional measures of relatedness look only at the industry or market level whereas what really matters is relatedness among strategic assets. Research suggests that the factors which contribute to long run returns are: the potential to reap economies of scope across SBUs that can share the same strategic asset; this could be a common distribution system, and in the case of the baby food manufacturer diversifying into toys would mean setting up a distribution system with toy shops instead of food stores. the potential to use a core competence in the new SBU; this could be an understanding of marketing child products and it may be equally relevant to both options. the potential to utilise a core competence to create a new strategic asset in a new business faster; thus while the existing distribution system is common for both types of food product, the knowledge of how to build up the system may still confer a competitive advantage in the toy market. the potential for related diversication to expand the companys pool of core competencies as it learns new skills; the lessons learned in building a toy distribution system may be relevant to the existing food distribution system. The usual arguments in favour of related options, which are based on costs, efciency and market knowledge, may generate only a short term advantage because these attributes can be replicated. The four types of relatedness above are less obvious and could provide a totally different perspective on what appears to be an unrelated Heriot-Watt University Strategic Management

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diversication, so dened because the products involved are physically different. The arguments in favour of unrelated options have tended to be less precise and more difcult to quantify than those for apparently related options. For example, managers may feel that diversication reduces the risk of the company failing, or that there is positive synergy to be gained from unrelated activities, or there may be peak load capacity problems which can be evened out by branching into products with a different seasonal demand. There is clearly much more to the issue of relatedness than meets the eye; companies need to take a serious introspective look prior to adopting a stance on the relationship between a possible new course of action and the companys current capabilities. To illustrate the benets of not taking the situation at its face value consider the case of a company that produces industrial ofce cleaning equipment. It is now the market leader in its market segment - city centre ofce high technology blocks - and the new CEO feels that the time is right to expand from this secure base. He has identied two options: to acquire an ofce cleaning company that mainly uses the companys equipment or to acquire a producer of domestic vacuum cleaners. The CEO argues in favour of the former option because, as he says We know the ofce cleaning business and this will increase the market for our own cleaners. Some executives agree, some disagree, while the strategic planner argues that both options are totally misguided. The strategist argues as follows. Domestic appliance The production process of heavy duty industrial components for a specialised market differs from that for light weight units for a mass market. Use an existing core The skill sets are different This only applies if there is competence for producing and marketing some activity that the a product and a service company already excels in that can be used more effectively in the domestic appliance company Use an existing core The acquisition amounts to The industrial and domestic competence to create a new vertical integration with all markets are so different that strategic asset the problems of beneting there is little prospect of from make versus buy increasing entry barriers in either by combining the two companies There may be production Expand the pool of core It is difcult to visualise competencies which competencies could and product marketing skills that are complementary be shared Four factors Economies of scale across SBUs Cleaning service There is no scale potential combining a production operation with a service provider The strategist has recognised that the rst option is an attempt to integrate production and service companies and the fact that they are in the same market segment is irrelevant; the second can be visualised as expansion into a position of unfamiliar product and market. As a result there is likely to be very little benet from merging the companies in either case. Thus in terms of the competence based expansion Heriot-Watt University Strategic Management

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trajectory of Chapter 5 Section 12.4 there is little commonality between either routines or resources with the result that both options lie in the Diversication sector. This is probably not a popular conclusion for the CEO and is an example of how a strategist is often the bearer of news that conicts with common sense conclusions which are not based on recognition of the elusive nature of competitive advantage.

7.6.2

Vertical integration

Vertical integration involves movement into other parts of the production chain by which raw materials are converted into nal products; some of these activities may be related, others totally unrelated. The potential costs and benets associated with vertical integration were discussed at Chapter 5 Section 11.4, where the question of the optimal degree of integration was discussed. The car company which takes over a steel rolling business is an example of backward integration, but it is unlikely that the steel company will only produce steel for the car company itself; the further into other parts of the production chain the company moves the less likely it will be to produce only for, or buy only from, itself and it may nd it owns a series of companies each supplying a different market of which the supply to the company itself at each stage may only be a relatively small part. The vertical integration thus starts to present similar types of problem as related and unrelated options; the company may benet in some ways from the integration, but the benets may be swamped by the costs of unrelated diversication. Forward integration involves the company carrying out the functions of its customers; a typical example is when a company distributes its output instead of using contractors, or opens its own retail outlets. Much the same considerations apply as in backward integration. For example, it is unlikely that the company is currently the only supplier for the forward customer, and integration can again have the characteristics of an unrelated diversication. A variation on this strategy is to adopt the role of a captive company, where a large proportion of output is purchased by a single customer, and that customer actually performs some of the functions which would normally be carried out by the company itself. Whether the captive company is an economically sound organisation, or whether being captive is a sign of weak management, depends on the circumstances; for example, in the car components industry many protable captive companies have existed for a long time. The crucial question which must always be borne in mind is whether, taking everything into consideration, the company would add value by controlling other parts of the productive chain. The case of British Gas, discussed at Chapter 5 Section 11.4, demonstrates that vertical integration may not be an efcient option. In the previous example the CEO had included an argument in favour of the rst option based on vertical integration ( this will increase the market for our own cleaners) without appearing to recognise what this implied. The strategist had recognised that this option amounted to a form of vertical integration with all its inherent problems. This is an additional reason for doubting the potential viability of the rst option.

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7.6.3

Acquisitions

Instead of undertaking internal growth through the mobilisation of the companys own resources, the company can grow by taking over or merging with other companies. Some of the more important reasons for considering acquisition are unrealised value potential, buying into markets, reducing competitive pressures, the quest for synergy, balancing the portfolio and developing core competence.

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Recognising unrealised value Some chief executives have a skill in identifying companies which have not fully exploited their value opportunities. The activities of such a company may be unrelated to the current business of the potential acquirer, whose competence is perceived to be in adding value independent of the type of business. It is instructive to try to identify the areas in which the companys performance might be inadequate, because unless these can be identied it is difcult to understand the rationale for a takeover in the rst place. At its simplest level, the rationale for a takeover depends on whether the current share value of the company could be increased by a reallocation of resources. Reasons for a company being undervalued include the following. DEVELOPMENT EXPENDITURE HAS BEEN INEFFICIENT The predator may feel that because of inadequate expenditure on product development, the potential market share is lower and unit cost higher than they should be. MARKETING STRATEGY HAS NOT PURSUED OPPORTUNITIES The predator may spot opportunities for product differentiation and market segmentation which he considers will transform the protability of products which are currently poor cash generators. RESOURCE MANAGEMENT HAS BEEN POOR The predator may conclude that unit costs are higher than in similar companies and that opportunities exist to reduce costs simply by improving resource management. EXPECTED INCREASE IN DEMAND The predator may expect an upturn in the demand for the companys products because of an improvement in general economic conditions. The predator may feel that the target company is particularly weak in the analysis dimension of the strategy process. WEAK PRODUCTS The predator may identify products, for example Dogs, which do not contribute to shareholder wealth; divesting them will release resources for more productive purposes. This is not an exhaustive list of factors which may contribute to an undervalued share price, but it illustrates that to a large extent a predators motivation is based on a perception of the company which is not reected in the market valuation. The predator may, of course, be wrong. All the research studies in this eld come to the conclusion that takeovers rarely create value. In the majority of cases it has been found that the value of the bidders shares falls after the takeover, while many studies point to longer term negative effects on the protability of the acquired business units. Even in Japan, where takeovers and mergers have only become important since the mid 1980s, there is no evidence that the activity has improved protability or growth. In fact it is not sufcient in itself to conclude that a company has not realised its value potential; certain other conditions also need to be satised. First, it is important that no other potential acquirer has arrived at the same conclusion; if a competitive bidding situation results then it is likely that all potential gains will be captured in the purchase price. Second, it is necessary to realise the potential gains. The four potential benets of parenting were discussed in Chapter 1 Section 1.5.1 each of these being associated with a paradox which raised serious doubts about the ability of a parent corporate Heriot-Watt University Strategic Management

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organisation to add value in the long run. It may be possible to add value on a once for all basis by remedying managerial weaknesses; but whether there is any gain to be had beyond that from retaining ownership of the company is open to question. One of the most spectacular examples of value destruction was the takeover of NCR, a US computer company, by AT&T, the US telecoms company. In 1991 AT & T paid $7.5 billion for NCR; during the next ve years it ran up losses of $2 billion before spinning NCR off, at which time it was worth about $4 billion. That cost AT & Ts shareholders about $5.5 billion. The CEO was not red. Buying market share Take the case of a company which currently has 20 per cent market share in a mature market and has decided, on the basis of the analysis of costs and competitive conditions, that its long term prospects would be greatly enhanced by increasing market share to 30 per cent. At the moment it is operating at full capacity; therefore, in order to increase market share, it has to invest in new plant and mount a marketing strategy which will take customers away from its competitors. The outcome of the marketing strategy is unknown because the reaction of competitors cannot be predicted with any degree of certainty; the company may simply nd itself involved in a price war without any permanent increase in market share. Not only does a takeover make it possible to avoid the costs of the competitive thrust required to achieve the increase in market share, but the labour force in the acquisition will be relatively high on the experience curve. Reducing competitive pressures Governments are continually on the lookout for companies which attempt to achieve monopoly power. In the US there is a formidable set of anti trust laws and, in Britain, the Monopolies Commission has the power to veto takeovers which it considers are not in the public interest. In any case, monopoly power does not automatically mean that monopoly prots will be earned, due to the inuence of contestable markets discussed in Chapter 4 Section 5.3. Synergy There may be potential gains from sharing resources and making better use of capacity. The difculties of capitalising on synergy were discussed in Chapter 5 Section 11.2, and the history of acquisitions which attempted to take advantage of synergy has not been encouraging. There are no guarantees that economies of scope will automatically ensue.

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

Exercise 7.4
In the industrial ofce cleaning manufacturer example in Section 7.6.1 the CEO argued in favour of acquisition. How would the strategist assess this option using each of the reasons for acquisition?

7.6.4

Alliances and joint ventures

Alliances and joint ventures take many forms, including licensing agreements, franchise agreements, relational contracting, relational management, consortia, virtual corporations, virtual functions and joint ventures. It is not the details of these which are important so much as the underlying rationale for strategic alliances in the rst place. It has already been noted that the success rate of mergers and takeovers has been low; it is therefore important to determine whether or not this form of cooperative action leads to better results. Research has found no signicant long term effects of joint venture activity on protability in any industrial sector. Given this, the real issue is why companies should choose an arms length contract rather than entering into a full merger. Any form of collaboration raises the issue of game theory, and the prisoners dilemma discussed in Chapter 4 Section 5.1 is particularly relevant. No contract can cover all eventualities, with one or both sides always having an incentive to cheat in some way. That is probably one reason why the research has found no connection

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between this form of collaboration and protability. Alliances and joint ventures have a supercial attractiveness that masks the underlying problems that arise as the parties pursue their own interests.

7.6.5

International expansion

There is no difference in principle in moving into a foreign market compared with opening up new domestic markets. The same considerations of strategic opportunities and threats and competitive advantage must be taken into account. But it has to be recognised that competitive conditions may be signicantly different in another country. The competitive advantage of a company relates to its strengths relative to the competition in the market where it currently operates. The fact that a company has a competitive advantage in one location does not mean that it can be readily transferred abroad. An example is the Japanese car maker Honda: in Japan it had about 10 per cent market share and was dwarfed by Nissan with about one fth of the market and Toyota with about one third; but for years Honda sold many more cars in the US than either of its big domestic competitors. The explanation is that in Japan both Toyota and Nissan were much stronger in terms of marketing and control of the distribution system, but these advantages could not be transferred to the US. Honda used its competencies in car engines and receptiveness to US marketing ideas to give it a clear lead in the US. Another instance relates to the attempts by Hong Kong hotel groups to capitalise on their reputations, which were earned in Hong Kong, for being the best hotels in the world. The leading hoteliers, such as the Mandarin Oriental and the Peninsula, successfully established operations in other parts of Asia. But it proved far more difcult to do so in the US and Britain because the essential ingredient of high quality service is a relatively high ratio of service staff per room; since wage rates are much higher in the US and Britain, it proved impossible to maintain the same ratio without making the hotel impossibly expensive. These hotels are thus at no advantage compared with established chains when attempting to differentiate through excellence of service. It is therefore necessary to focus on the elements of competitive advantage which can be transferred. In the case of Nissan and Toyota it was not the strength of their distribution systems in Japan which was potentially transferable, but their knowledge of how to build and efciently operate large distribution systems; but because of the differences between Japan and the US it is doubtful if even the knowledge was transferable. Successful hotels are more than buildings and physical features, since all hotel designers and builders are trying to produce an attractive environment; unless the service offered is signicantly different, and is perceived to be so by customers, then no transfer of advantage has taken place. Besides the problem of transferring advantages, there are several variables which complicate operations on the international scene. Volatile exchange rates present serious problems; some of these were discussed at Chapter 3 Section 8.1 under Exchange Rate Fluctuations. The fact that exchange rates cannot be predicted with any certainty, and the fact that relatively signicant changes can take place in a short period, can make nonsense of cost and revenue predictions in foreign markets. One way of hedging against exchange rate movements as part of an expansionist strategy is to produce as closely as possible to consumers. This means setting up productive units in the countries where the markets are. For example, in the late 1980s Fiskars, a Heriot-Watt University Strategic Management

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company producing knives in Finland, had the option of attempting to enter the UK market by exporting to the UK. The purchasing power parity of the UK pound against the Markka at the time suggested that the Markka was about 20 per cent overvalued; unless the Finnish knives were reduced in price by 20 per cent they would be relatively highly priced in the UK. Another way of looking at this is that the overvaluation caused relative production costs in Finland to be 20 per cent higher than they would have been in the UK. An alternative strategy was for Fiskars to acquire a UK knife producer, or set up a production unit in the UK, thus insulating itself against variations in the exchange value of the pound. In the event, Fiskars purchased Wilkinson Sword, a famous company of razor blade makers in the UK, and Gerber, a successful knife maker, in the US. Relative factor costs vary by country. For example, the ratio of the cost of labour to the cost of capital is lower in the US than in Europe, leading to more capital intensive production in Europe. It may be more efcient to shift the production of labour intensive goods to the US to take advantage of the relatively cheap labour Productivity varies widely among countries. For example, for many years the UK had a lower output per worker in the manufacturing sector than any other major country in the European Community. To some extent this was overcome in the 1990s, when the UK experienced the highest growth in productivity in Europe. This increase in productivity was spearheaded by new Japanese car plants which were able to overcome restrictive labour practices. But in those industries in which productivity is still relatively low companies may nd it more efcient to produce goods outside the UK. Governments often protect home production. This takes many forms, including the minimum domestic content requirement. Protectionism can make it necessary to set up productive units in a country which would otherwise not be attractive. Cultural norms can vary fundamentally by country and are ignored at the companys peril. For many years the Ford Motor Company in the UK attempted to manage its factories using the management philosophy and approach (and many managers) of the US. This contributed signicantly to a decade of labour problems. The economies of different countries rarely move exactly in step, and therefore the information gathering and interpreting function is greatly increased with each additional foreign market. This issue should not be underestimated, given the importance of relevant information to the identication of opportunities and threats and the formulation of strategy. This is a formidable list of risk factors, any one of which has the potential to undermine the viability of the international move. The ScottishPower entry to the US energy market was discussed at Chapter 5 Section 12.4, and explicit treatment of the international aspects adds another dimension to the strategic context.

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Risk factor Volatile exchange rates

Relative factor costs

Productivity differences

Government

Cultural norms

Different economies

Observation Both production and sales were in the US so variable exchange rates had no impact on protability While relative factor costs vary between the US and UK the issue is whether PaciCorp was locally efcient So long as productivity in PaciCorp was as high as its competitors there was no disadvantage The regulatory framework in the US was totally different and ScottishPower had little experience of this environment ScottishPower sent management teams to the US to improve working practices and increase operating efciency In the event there was an energy crisis in California that led to signicant losses

Risk level Low

Low

Low

Medium

High

High

PaciCorp was eventually sold for about 400 million less than had been paid for it and the ScottishPower share price increased signicantly when the sale was announced. While this is not the whole story it emerges that there were at least two high risk factors, one of which had a major impact on viability.

7.6.6

Corporate generics to business generics to options

The progression of options from the selection of the corporate generic choice to business generics and options is illustrated in Table 7.2.

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Table 7.2: From generics to options Generic strategy Corporate Expansion Stability Retrenchment Business Cost leadership Differentiation Options

Investment Cost control Downsize

Merger Defend Divest

Alliance Restructure Rationalise

Economies of scale Branding

Technology Segmentation

This does not cover all cases, but shows how the hierarchy of decision making can be constructed.

Exercise 7.5
Imagine you are the CEO of a successful machine tool business which is currently located in the UK. You have amassed a large cash reserve, and you have to decide for the next AGM of shareholders whether to recommend paying the cash out in dividends or expanding the business. What are the main pros and cons of pursuing each of the ve strategic options discussed above? Set out your argument in the form of a matrix which identies the main arguments for and against each option.

7.7

Strategy choice

At one level it can be argued that strategy choice is primarily concerned with the identication and selection of the strategy option which maximises shareholder wealth. Since a full analysis of expected future cash ows would have taken into account risks and uncertainties, the selection of the optimum strategy could be regarded as more or less automatic; it would be, after all, irrational to select a strategy which does not produce the highest possible shareholder wealth. In principle, therefore, all steps in the process of strategy choice should be directed towards identifying this option. Unfortunately, while shareholder wealth is an important conceptual benchmark to use in evaluating strategies, the real world is too complex to be expressed in the form of a single value which represents the optimum strategy; there are at least two reasons for this. 1. The future is too uncertain to be captured in a cash ow projection. Thus while most strategy writers concern themselves with the idea of value creation, there is no agreement on how it can be measured in an uncertain future. 2. The strategy is concerned with the means as well as the ends. The shareholder wealth analysis can quantify a well dened course of action, while strategy must be Heriot-Watt University Strategic Management

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framed in such a way as to be feasible for those carrying it out and must take into account the many intangible factors which affect decision making. Many factors which intervene make the connection between proposed courses of action and the impact on shareholder wealth difcult to identify. Since maximisation of shareholder value is simply the outcome of delivering long term competitive advantage a strategic option which is to perform this function must satisfy a number of selection criteria. Consistency with objectives: an option may appear to be attractive, but it may not t with the companys stated objectives. For example, the objective may be to achieve market dominance in the domestic market, hence international expansion would not be consistent. Suitability in terms of company resources: SWOT analysis is of crucial importance in determining suitability, because the point of the SWOT analysis is to identify the alignment between company strengths and market opportunities. For example, a company may have a particular strength in cost control systems, but this may not t with the market opportunities for differentiated products. Feasibility: to some extent this is a matter of alignment, but even if the organisation has the resources the changes required to implement the option may be impossible to achieve; in addition, the commitment of key personnel must be obtained. Even if an option appears to be consistent and suitable, the intangible dimensions of organisational development may make it unworkable. The following discussion focuses on the factors which bear on the actual process of arriving at a choice of strategy.

7.7.1

Shareholder wealth

It is instructive to consider how shareholder wealth can be determined by the choice of strategy, and why it is important to bear in mind the potential implications of a choice for shareholder wealth despite the problems inherent in its calculation described above. For example, it is often assumed that expansion will deliver higher shareholder value than retrenchment in the medium term, but this is by no means the case. Consider the following example which shows the net cash ows generated by three corporate generic alternatives: the cash ows vary up to the end of the planning horizon and are then assumed to be constant in perpetuity. This makes it possible to calculate the NPV of each cash ow stream at 15 per cent cost of capital. Table 7.3: Strategy options and shareholder wealth ($million) Net cash ows for year Strategy Stability Expansion Retrenchment Shareholder wealth (NPV) 857 1041 973 1 100 -100 500 2 110 50 70 3 120 210 80 4 130 200 90 5 140 220 100 +6 140 220 100

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The potential net cash ows from the three options have been derived from analyses of markets, competition, opportunities, threats, environmental factors and so on. Taking each generic alternative in turn: Stability is based on carrying on as at present, and exhibits a constant growth in cash ow over the period because of slight sales growth and anticipated cost savings, generating shareholder wealth of $857 million. Expansion is based on investment in new capacity, the development and introduction of new products, and a marketing strategy designed to achieve signicant market shares by Year 3. By that time cash ow will be almost twice as high as in the stability option. Despite the substantial cash outow in the rst year, and the low cash ow in the second year, the expansion option produces an increase of $184 million in shareholder wealth over the stability option. While it may be concluded that the expansion option is an automatic choice over stability, managers may be unwilling to face the prospect of two years of cash ow problems, with its adverse short term protability reports. Retrenchment might arise because the company has discovered that by disinvesting it can concentrate resources on the longer term development of its core business. Therefore, although cash ows will lag behind those of the other two options from Years 3 to 5, the large positive cash ow in Year 1 from divesting part of the business contributes to shareholder wealth of $973 million which, while lower than the expansion option, is $116 million greater than the stability option. If managers are unwilling to face the implications of the expansion option, then retrenchment has decided value advantages over the stability option. One of the conceptual difculties of the shareholder wealth approach is that it collapses all future expectations to the present. It may appear odd that the different long term prospects of the expansion and retrenchment options beyond Year 5 are associated with much the same shareholder wealth at the present; the expansion option implies a company with a portfolio of products with relatively high market shares and an equilibrium long term cash ow more than double that of the retrenchment option. This arises because of the discounting process which takes into account the opportunity cost of capital and the fact that no further growth in cash ows is assumed after the end of the planning period. If managers conclude that the planning period does not adequately take into account the longer term implications of the different strategies then the planning period itself can be amended accordingly; however, this does not alter the principles on which the analysis is based. A further powerful application of shareholder wealth analysis is to break down the activities of the company and estimate the contribution which each makes to the total value of the company. For example, in the retrenchment example a part of the company had been identied which was subtracting from shareholder wealth; by getting rid of it shareholder wealth was increased. Take the case of a company which has three SBUs, the largest of which produces washing machines, the second largest provides maintenance services and the smallest is engaged in contract cleaning services. This company may regard the production of equipment as being the core business on which the others are built. However, as often happens, the maintenance and contract cleaning SBUs develop markets which are independent of the equipment which the company produces and start to behave as independent entities. The question then arises of identifying which SBUs are

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contributing most to the value of the company as a guide to future resource allocation. This type of situation is represented by the example in Table 7.4, which uses the stability option in the previous example disaggregated into three SBUs. Obviously there are problems associated with allocating costs to the SBUs, but for the purposes of the analysis this is assumed to be relatively unimportant. Table 7.4: Resource allocation and shareholder wealth ($million) Year SBU 1 Revenue Cost Cash ow 2 Revenue Cost Cash ow 3 Revenue Cost Cash ow Total Cash ow 360 857 271 227 1 Shareholder wealth 500 480 20 200 165 35 75 30 45 100 2 530 495 35 205 170 35 85 45 40 110 3 540 520 20 220 170 50 110 60 50 120 4 560 530 30 225 275 50 110 60 50 130 5 580 540 40 230 190 40 120 60 60 140 60 140 40 40 +6

The current and future revenues from selling products and services are dominated by the core business of SBU 1; it generates about two thirds of company revenue and incurs about two thirds of total cost. However, it has the lowest shareholder wealth of the three SBUs, while the smallest SBU of the three in terms of total revenue has the highest shareholder wealth. Taking the costs in Year 1 as an indication of the total allocation of resources, the mismatch shown in Table 7.5 emerges between resources deployed and value created. Table 7.5: Resource allocation and value creation (%) SBU1 Shareholder wealth Resource allocation 26 71 SBU2 32 24 SBU3 42 45

This indicates that the core business consumes 71 per cent of company resources, while producing 26 per cent of shareholder wealth; the smallest SBU consumes 45 per cent of resources and produces 42 per cent of shareholder wealth. Because SBU 1 is seen as the core business, it is likely that managers devote more than 71 per cent of total management time to trying to make it pay. In choosing among strategy options, management ought to address the following questions. First, are the activities

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of SBUs 2 and 3 really dependent on the production of washing machines? If no clear linkages among products can be identied it is unlikely that producing them in the same company produces value over and above what could be achieved if they were produced independently. Second, if not, should resources be reallocated from SBU 1 to SBUs 2 and 3? It could turn out that the long term future of the company lies in providing maintenance for a range of manufacturers and pursuing further contract cleaning possibilities. However, at the moment, it is likely that these SBUs are starved of resources and managerial inputs because of preoccupation with the core business. It must be stressed that shareholder wealth analysis at this aggregate level can only be indicative of the value creation activities of the company because of the need to make arbitrary assumptions about the allocation of joint costs and predictions of future costs and revenues. However, even if costs were incorrect by 10 per cent for SBU 3, the same general result would emerge. This approach can throw into sharp relief the fact that a company may be oblivious to the evolving nature of its business and may be encumbered with a management which developed the company through its initial stages but cannot now see beyond that. While Shareholder Wealth analysis is clearly an important tool in those cases where the future can be estimated with some degree of certainty, focusing attention on the potential of different courses of action to generate value, there is still a need for tools which can be applied to what are essentially leaps into the unknown.

7.7.2

Performance gaps

The performance gap is the difference between the expected outcome if the company carried on as at present and the desired outcome. The desired outcome itself would be an amalgamation of company characteristics designed to meet overall company objectives; for example, in the shareholder wealth analysis there may be several strategies which would accomplish the expansion option. In this case the company would wish to have additional products and higher market shares by Year 5 than would occur if no changes were made to current policies. The identication of this desired future state greatly narrows the range of feasible strategic options. The application of gap analysis therefore has immediate benets by identifying the appropriate options from which the strategy choice ought to be made. The gap identies whether the company should be pursuing a generic strategy of stability, expansion or retrenchment. The extent of the gap indicates whether the company has to undertake a signicant reallocation of resources in order to close the gap; for example, the company may have specied an ambitious objective in terms of market share, but it may turn out that the gap is relatively small and that closing the gap does not involve a signicant change in direction. Within the generic strategy the ways of closing the gap can be identied; for example, whether strategy should be concentrated on external or internal factors, such as marketing effort as opposed to cost control. By structuring the question of where the company is actually going compared to where managers would like it to go, the gap approach reduces the array of strategy alternatives to those which have direct relevance to the companys objectives and to its potential Heriot-Watt University Strategic Management

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capacity. What might appear to be a painfully obvious process requires managers to step back from the actual running of the company and identify in an objective manner options which might not be intuitively obvious were the gap not identied in the rst place.

7.7.3

The portfolio choice

When the company is comprised of a portfolio of products, the problem facing corporate management is to decide on the components of the portfolio while SBU management is concerned with the management of the products selected. The portfolio approach developed at Chapter 4 Section 8 is fundamental to this issue, the role of corporate management being to attempt to select the optimum portfolio of products for the company. There are many criteria which can be applied to the selection process, depending on the circumstances and the objectives of the company. Taking the BCG matrix of market share and market growth as an example, the most obvious strategy option is to eliminate the unprotable Dogs. Beyond this it becomes difcult to lay down hard and fast rules for using the BCG matrix. The company needs to have Stars to replace the Cash Cows when they come to the end of the product life cycle; but how many and of what type depend on their t with the existing portfolio and how it is likely to develop. The Question Marks can pose an intractable problem; while the company can wait for the Stars to become Cash Cows as the market matures and ceases to grow, the Question Marks cannot be transformed into Stars without a substantial investment in resources. Projections of the product life cycle and the reaction of competitors are necessary before making a choice of which Question Marks to pursue and which to abandon. A complicating factor is that the company may have to make a strategic response to other companies which are developing their portfolios. For example, everything might depend on who is rst to transform a Question Mark into a Star; a potentially attractive Question Mark may have no future because of the early action of a competitor; or the company may have to abandon a Question Mark because a Cash Cow is coming under competitive threat and resources are required to maintain its competitive advantage.

7.7.4

Product and market familiarity

When arriving at a decision it is important to be explicit on what the choice is about. For example, what is known about the product markets and the technology involved in the choice? An increase in the number of products which involves entry into new markets poses an array of new uncertainties for the company because it is venturing out of its established markets and products, and typically into new technologies. The resulting portfolio may be balanced in the BCG sense, but be comprised of a number of unlinked products. The risks involved can be claried by estimating the degree of familiarity with markets and technologies as shown in Figure 7.2.

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Figure 7.2: Familiarity matrix It is important for management to be aware of the extent to which the choice is likely involve the company in situations about which it has a limited amount of information and experience. A choice in the top right quadrant ought not to be undertaken without consideration of the extent to which company resources are likely to be able to deliver prots in an unfamiliar environment.

7.7.5

Risk and risk aversion

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

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it more likely that sales will increase rather than decrease. By asking the salesman what the chances are, we are really asking him to assign probabilities to possible future outcomes, and the pattern of responses is termed a probability distribution. The salesmans responses might be as shown in Table 7.6. Table 7.6: Expected value Change in sales (000s) -20 -10 0 +10 +20 Average 0 Probability 0.05 0.10 0.20 0.40 0.25 Expected value (000s) -1.0 -1.0 0.0 4.0 5.0 Expected value 7.0

Assume that the salesman has identied ve possibilities: that sales will fall by 20 000 or 10 000, remain the same, or increase by 10 000 or 20 000; the reasons for arriving at these estimates are unimportant. The average of these expectations is zero, i.e. adding the possibilities of change and dividing by 5 gives zero. However, in the second column the salesman has expressed his subjective probabilities of these outcomes: for example, he reckons that there is only one chance in 20 that sales will fall by 20 000, but 4 chances in 10 that they will increase by 10 000. The third column is obtained by multiplying the probability by the possible outcome. For example, the probability of a 20 000 increase is .25, giving an expected increase of 5000. The summation of these expected outcomes comes to 7000, i.e. taking the salesmans subjective probabilities into account he expects sales to increase by 7000 next year rather than the zero suggested by the simple average. Since the 7000 estimate takes into account what the salesman feels he knows about the future, it can be argued that it is a better basis for decision making than concluding that there will be no change in sales. The table of possible outcomes and probabilities ignores an important issue, namely the attitude of managers to risk. A particular manager may feel that even though the probability of losing $100 million is only one in ten, this is still an unacceptable risk because it would result in the company going bankrupt. This is known as risk aversion and it would result in the manager preferring an investment with a lower expected value which did not contain the risk of bankruptcy in the probability distribution. The expected value approach can conceal the fact that risks are not symmetrical; therefore it would be folly to base decisions on the expected values alone no matter what the law of large numbers states because the company may end up with a portfolio of projects each of which contained the potential to bankrupt it. It is a well established fact that individuals do not always act in accordance with expected utility maximisation, i.e. do not always choose an alternative with the highest expected outcome. A practical technique for taking risk aversion into account is to use the minimax criterion. This involves selecting the option with the lowest potential loss independent of the probabilities associated with predicted returns. An example of how this might work in practice is illustrated by the potential outcomes from the two investments shown in

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Table 7.7 Table 7.7: Minimax decision making Investment A NPV ($m) 140 50 -20 Expected NPV 120 Probability 0.8 0.2 0.1 Investment B NPV ($m) 100 80 -10 85 Probability 0.7 0.2 0.1

Investment A gives a higher expected NPV of $120 million compared to $85 million for investment B; however, investment B would be chosen because it has a lower potential loss. Strong arguments in favour of investment A could be suggested; for example, it has a higher probability of a higher NPV. However, whether investment A is preferable to investment B cannot be resolved on the basis of the numbers alone. There is another type of risk which cannot be quantied because the future event itself cannot be foreseen. For example, no one knows whether an earthquake will occur next week, or whether a carefully planned just-in-time organisation is going to fall apart because of human error. What is known is that something, sometime, is going to go wrong with plans and expectations. This type of risk is often referred to as uncertainty, and dees any attempt at quantication. But, given that it does exist, it is necessary to make some allowance for it; for example, how much additional inventory is it worth holding just in case there is an unexpected materials shortage? Despite the fact that the chances of a shortage occurring seem remote, a manager may feel inclined to hold a substantial inventory because the very existence of the company would be placed in jeopardy if orders could not be met in time. Because of the existence of uncertainty, it is essential that strategies are constructed which have the potential to adapt to circumstances which turn out to be radically different to those anticipated. If the strategy is inexible, it will be impossible to respond to events as they unfold with the result that the strategy would have to be abandoned at an early stage. One way of tackling this is through contingency planning, which involves making sure that the strategy is capable of responding to a wide variety of scenarios and keeping options open as long as possible.

7.7.6

Contingency planning

One of the difculties in formulating strategy is the need to take into account the unknowable as well as the likelihood of events not turning out as predicted. In the second case it is possible to take a reasoned view on the position to adopt in the event of adverse circumstances and take action to provide insurance against loss, such as holding high inventories and identifying second best market opportunities. But the rst case poses a set of problems to which previously calculated solutions cannot be applied because managers cannot foresee what the event might be, never mind the likelihood of its occurrence; for example, much of the outcome of strategy depends on the actions of competitors, which are usually unforeseeable, and exogenous events can occur which completely alter the characteristics of the market. The notion of contingency planning can be applied to the second case by identifying alternative courses of action Heriot-Watt University Strategic Management

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to undertake should certain events transpire. In the rst case it makes little sense to develop a contingency plan because the range of possible events is limitless. But this does not alter the fact that managers need to have some alternative course of action in mind if future events make the pursuit of the current strategy impossible. There are therefore two types of contingency planning: rst is the technical process of attempting to minimise the probability of loss due to risk and identifying alternative courses of action in the event of potential outcomes; second is the strategic response to major unpredictable events. The rst of these can be tackled by the application of ideas from the business disciplines, but the second poses more intractable problems. Some insights into potential events and how the company might react to them are provided by the scenario approach discussed at Chapter 3 Section 9.4, but responses to this type of problem are almost wholly determined by managerial attitudes and perceptions.

7.7.7

Managerial perceptions

The application of sophisticated information gathering and analytical techniques does not of itself generate a strategy choice. At the end of the day someone has to weigh up the arguments for and against different courses of action and arrive at a decision on strategy. This someone may be the CEO, or it may be a group of decision makers, and the process by which the decision is nally arrived at may be obscure; after the event it may be identied as logical incrementalism or emergent strategies. Those who carried out the analyses may feel that little attention was paid to their conclusions; or the CEO may draw opposite conclusions to the analysts from precisely the same information; analysts themselves may feel that the CEO does not fully comprehend the implications of their ndings. It is in fact very difcult for outside observers to assess the rationality of decision making processes in a particular organisation; this is because the personal objectives of decision makers may not be known and, therefore, the weighting which they attribute to different factors cannot be taken into account when attempting to explain their decisions. However, there are a number of factors which bear on decision makers and which might help to explain observed behaviour.

7.7.7.1 Attitude to external dependence All companies depend on other companies to some extent: many companies concentrate on relatively few customers and some companies are dependent on relatively few suppliers. Some managers may see a particular degree of external dependence as a potential threat, while others may see it as a strength. There is no hard and fast rule, but the CEO who dislikes the idea of increasing the level of dependence is unlikely to consider seriously a strategy which relies on such a change, no matter how attractive it may appear in terms of adding value. Another form of external dependence is when a majority shareholder exerts inuence on decision making; in such a situation some managers may be unwilling to take strategy decisions because they feel that they do not really control the company. Adherence to previous strategies The process of strategy is continually evolving and, because of changing circumstances, no particular strategy can be regarded as sacrosanct. The time may come when a major strategy decision which involves a signicant change from previous strategies needs to Heriot-Watt University Strategic Management

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be taken. However, managers may have invested substantial personal resources in the identication and implementation of strategy to date, and the current strategy may be regarded as a component of the corporate culture. In such circumstances, managers may be unwilling to make signicant changes until external factors force a response; this can cause a company to adopt a passive stance to strategy. Indeed, the very success of the previous strategy may contain the seeds of future disaster because of the natural tendency to take refuge in a tried and tested approach. Managerial power relationships All organisations have their own internal politics. The process of decision making has innite variety, from the friendly compromise reached between brothers running a family business, to the autocratic dictates of a powerful CEO in charge of a large multinational. The aversion to external dependence on the part of the powerful CEO might dominate decision making, despite the fact that all of the analyses carried out support a greater degree of external dependence and that most managers in the company are in favour of it. The issue of managerial perceptions is related to the principal agent issue where the objectives of managers are not necessarily consistent with those of shareholders. For example, an SBU manager may be opposed to a strategy which involves retrenchment of his SBU despite the fact that it is in the interests of the company as a whole; he may have a strong inuence on strategy choice if he is a long serving respected employee. He will probably not present his opposition in terms of his personal feelings, but will doubtless come up with convincing arguments against the move; however, those knowing his attachment to the SBU could probably predict that he would oppose the strategy without necessarily knowing on what grounds he would do so.

Exercise 7.6
Set out the approach to strategy choice of the CEO and the marketing manager of SuperTools under each of the headings. What do you think would happen if the COE were replaced by the marketing manager?

7.8

Choice: is it rational?

The process of arriving at a strategy choice can be set out as a highly logical process: SWOT Generics Options Choice and People a SWOT analysis provides insights into the market potential in relation to the companys assets and the market threats which the company is not equipped to meet. From this analysis the corporate generic strategy can be derived and then the product strategies of the individual SBUs. The strategic variations in each case can be identied and the most appropriate alternatives arrived at. But at the end of this process the choice has to be made by individuals and, as a result, the choice itself will be affected by many inuences which may not be directly related to the strategy issue itself. Furthermore, managerial traits as identied by Miles and Snow will also inuence how attractive different approaches appear to different individuals. It cannot be guaranteed that a choice will be made on the basis of an impeccable strategic argument. Heriot-Watt University Strategic Management

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7.9

Reference

1. Porter, M.E. (1985) Competitive Advantage, New York: The Free Press.

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Chapter 8

Implementation
Contents
8.1 8.2 Strategy implementation in the process 8.2.1 Structural forms . . . . . . . . . . . . . . . . . . . 206 207 208 213 214 215 216 216 218 219 221 224 225 226 227 228 229 230 231 232

Organisational structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.2.2 Functional silos . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.2.3 Integrating mechanisms . . . . . . . . . . . . . . . . . . . . . . . 8.2.4 Is there an optimal structure? . . . . . . . . . . . . . . . . . . . .

8.3

Management of change . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.3.1 Types of strategic change . . . . . . . . . . . . . . . . . . . . . . 8.3.2 Barriers to change . . . . . . . . . . . . . . . . . . . . . . . . . . 8.3.3 Force eld analysis . . . . . . . . . . . . . . . . . . . . . . . . . . 8.3.4 Cultural web . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.3.5 Styles of managing strategic change . . . . . . . . . . . . . . . . 8.3.6 The complexity of managing strategic change . . . . . . . . . . .

8.4

Resource allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.4.1 Critical success factors . . . . . . . . . . . . . . . . . . . . . . . 8.4.2 Budgets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.4.3 Incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.4.4 Resource planning . . . . . . . . . . . . . . . . . . . . . . . . . .

8.5 8.6

Effective implementation is difcult . . . . . . . . . . . . . . . . . . . . . . Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Learning Objectives To understand the role of organisational structure in strategic implementation To identify the problems of managing strategic change To assess the problems of effective resource allocation To be able to structure the complexity of implementing strategic change

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8.1

Strategy implementation in the process

In the strategic planning process model the implementation stage is visualised as starting after the choice of strategy has been made. Once implementation gets under way it is to be expected that there will be a constant process of feedback to earlier stages. For example, as resources are mobilised it may become apparent that the original objectives are unattainable, that predicted costs were too low and that competitive response had been over-estimated. By treating implementation as an identiable part of the strategy process, the manager is forced to recognise that no matter what sophisticated analysis has been undertaken to arrive at a strategic choice, choosing strategy is not an end in itself; unless there is a mechanism for making it happen it is a pointless activity. At this stage it needs to be reiterated that strategic planning is really a process and is not necessarily accompanied by a detailed set of plans. The strategy may have been arrived at in an incremental manner, or it may have emerged in response to changing circumstances; the generic strategy, perhaps of expansion through cost leadership, might be perceived only in general terms. In fact, the temptation to translate a generic strategy into a set of procedures and well dened goals may be counter-productive because it robs the company of the ability to adapt to changing circumstances; feedback and continuous adaptation are important elements of the process model. But even a vague concept of where the company is headed and the strategy it has selected to achieve its objective has implications for how resources are allocated and their use monitored. In what follows the use of the term plan therefore refers to managements perception of the strategic plan rather than to a plan in the formal sense. Strategy implementation occurs within an organisational structure, which may or may not be appropriate for the selected strategy, it requires the management of change and it depends on effective resource allocation; as a result successful implementation is difcult. These issues are dealt with in turn.

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8.2

Organisational structure

It was discussed in Chapter 1 Section 1.5 how strategic approaches evolved in response to changing market demands and this was accompanied by changes in organisational structure. In historical terms the original functional form was followed by divisional, matrix and networks; as different structures were developed and adopted the existing structures did not disappear because no one structure is superior to others in all circumstances with the result that many different structures are used today. Resources are allocated within an organisational structure and companies are aware that the structure needs to be aligned to the company objectives, the competitive environment and strategy choice; but selecting the appropriate structure is not an easy matter. It is complicated by the fact that variables such as size, views on the appropriate span of control and technology affect organisational design. There is a common tendency to introspective behaviour resulting in the emergence of functional silos leading to the need to develop integrating mechanisms to ensure alignment with overall company objectives. As a result of this complexity companies may have a structure which has evolved over time and, although the existing structure is due largely to chance, the fact that the company functions and competes effectively suggests that it is t for purpose so there is no incentive for the company to change it. Company structure can inuence company operations fundamentally to the extent that the structure dictates strategic choice, i.e. that strategy can follow structure. The structure can inuence many aspects of the organisation including the following. Reinforce the power structure Determine who allocates resources Identify responsibilities Inuence the effectiveness with which resources are deployed. There are many ways of organising a company and companies often have a structure which exists as the consequence of historical inuences; little explicit consideration may have been given to whether the company structure is suited to meeting the companys objectives. This can be a major oversight because the company structure can inuence company operations in such a fundamental fashion that it may dictate the strategic direction; many managers consider that company structure and planning cannot be treated separately. Among other things the organisational structure affects the power structure, determines who allocates resources, identies responsibilities for undertaking action and affects the effectiveness with which resources are deployed. This means that a change in organisational structure can lead to changes in company performance, both in the short and long term, as different views on strategy assume importance and resources are redeployed. The difculty is to establish criteria on the basis of which the most appropriate structure for individual companies can be determined. A change in organisational structure can lead to fundamental changes within the company which signicantly affect performance, both in the short and long term. When a company changes its structure there is no guarantee that the effect on performance will be positive.

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8.2.1

Structural forms

The main types of company structure are functional (U form) divisional (M form) holding company matrix networks The functional structure groups individuals according to their specialities rather than around products. Functional Structure Research & Development Production Marketing Finance & Accounting This does not mean that the functions are situated in the same location but that a production supervisor, say, reports to the Director of Production rather than to the manager responsible for a particular product. The principle underlying the functional structure is that efciency is generated by the specialisation in the functions rather than specialisation in product lines. The divisional structure splits the company into a series of divisions; the division can be based on products or geographical boundaries and, typically, each division will have its own functional structure. It contributes to resolving the principal agent problem in that divisional protability can be more easily measured than functional returns. A divisional structure might look something like the following, where each division has its own functional structure. Divisional Structure Corporate SBU1 SBU2 SBU3 SBU4 Resource allocation etc Household electrical Industry electrical Electronic Software

The divisional structure is more likely to be encountered when the company has a differentiated product portfolio; however, a single product company which operates in different countries, or services distinctly different types of customer in a given country, can have a divisional structure. The underlying principle is that efciency is generated by focusing functional specialists on specic products and markets. The role of the corporate centre is to select the portfolio of SBUs, allocate resources and provide strategic direction. The control exerted by the corporate centre over SBUs varies Heriot-Watt University Strategic Management

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signicantly; some corporate CEOs monitor SBUs closely down to the level of approving individual investment decisions, while others adopt a lighter touch. The holding company structure is one where the conglomerate has no particular logic to the incorporation of the individual businesses and the centre plays a less direct role in the determination of strategy than in the divisional company. The role of the centre is mainly in allocating resources among the businesses and exploiting opportunities through investment, acquisitions, mergers, joint ventures and alliances. The holding company structure is much looser than the divisional structure, although the nancial controls which it imposes on the individual businesses may be extremely strict. A holding company might take the following form: Holding Structure Financial consultancy: Grain distribution: Turbine importing: Sugar beet rening: wholly owned subsidiary wholly owned subsidiary 60% ownership in joint venture 20% minority shareholding

The matrix structure operates when economies of scope provide a rationale for organising along more than one dimension. The idea can be difcult to visualise but it looks something like the following. Matrix Structure Functional divisions Product divisions Household electrical Industry electrical Electronic Software Employee X is engaged in marketing electronic products; the CEO of electronics instructs her to scale down marketing of the combined remote control (CRC) because it is becoming obsolete and there is no replacement available. But the marketing director instructs X to maintain marketing because the CRC is an important element in the portfolio. The marketing director approaches the CEO of electronics with a request that employee Y devote time to upgrading the CRC; but the R & D director refuses to divert resources from what he considers to be much more promising prototypes. The CEO of electronics instructs employee Z to request additional funds to nance employee Y, and on and on. What organisation would adopt a structure in which it is virtually impossible to arrive at a decision when there are conicts of interest? The fact is that the plaintive cry Who is in charge here? is often heard because organisations are in the grips of a matrix structure without being aware of it. In the network structure work groups may be organised by function, geography or customer base. Relationships among groups are governed more often by changing implicit and explicit requirements of common tasks than by formal lines of authority. It is difcult to map out how such an organisation would appear in practice because it Heriot-Watt University Strategic Management Y X Z R&D Production Marketing Finance

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depends on the circumstances; as in the case of the matrix the network structure raises problems of direction and control. Table 8.1: Structure: advantages and disadvantages Functional structure Advantages Specialisation Division of labour Simplies training Preserves strategic control Divisional Structure Advantages Divisional performance expressed Coordination among functions Develops broadly trained managers Disadvantages Coordination among functions Focus on functional rather than company objectives Coordination among departments Lack of broadly trained managers

Disadvantages Coordination among specialists in prot terms Communication among functional specialists Duplication of functional services Loss of some strategic control to divisional managers

Holding Structure Advantages Risk spreading Financial strength for new market entry

Disadvantages Probably lack of synergy Game theory problems Little control at centre other than nancial

Matrix Structure Advantages Flexibility and adaptability Less bureacratic Close coordination

Disadvantages Slow decision making - general agreement required Specic responsibility often unclear Highly dependent on effective teams

These are not exhaustive and in some cases what is listed as an advantage could be regarded as a disadvantage from a different perspective. For example, the advantage of risk spreading for the Holding Structure may be a disadvantage from the efciency perspective because it insulates the CEOs of the individual businesses from the consequences of foolhardy investments. So individual companies have to weigh up the advantages and disadvantages and arrive at a reasoned conclusion on which structure is most appropriate; while it is not possible to identify hard and fast rules for the decision it is important that the potential advantages and disadvantages are recognised. Within the organisational structures the design can vary; for example, there can be differences in the levels of hierarchy, the span of control of individual managers and the deployment of technology. The importance of organisational design is in identifying which structure ts different tasks. The variables which have to be taken into account in

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organisational design include size, span of control and technology. Size As organisations grow there is a need to retain the coordination that was accomplished informally in a small group; this is complicated by the division of labour into specialisms and departments. To maintain coordination, layers of management tend to be added creating hierarchy. As hierarchy increases power becomes increasingly difcult to concentrate at the top and there is typically a distribution of power to lower managers. Decentralization occurs as lower level managers assume decision-making powers, therefore to retain standard operational procedures the organisation increasingly relies on written policies and procedures. This formalisation of organisational rules helps to maintain order across the growing organisation and ensures conformity and continuity in practices. Size can limit the exibility of individuals, affect how much authority can be delegated, and lead to an emphasis on results rather than how work is actually performed (because results are easier to monitor). Historically, increased size tended to result in divisional structure because of the difculties of control. But this has not always been the case and it is an open question whether retaining the functional structure, or adopting matrix or networks as an alternative to divisional is more efcient. Span of Control How many employees can or should a manager oversee? implications for organisational structure. Span of control has

Narrow span of control has a low number of workers under a manager creating a tall pyramid structure because of the layering required to maintain a low managerto-employee ratio. The tight supervision inherent in the tall structure leads to a bureaucracy where work is performed under tight controls, little variability of tasks is permitted, and there is a high degree of specialisation. High span of control has a higher number of employees under a manager, creating a at organisation that has a lower level of hierarchy. This leads to workers having more autonomy and freedom to perform tasks. The sacrice of control may be compensated for by higher levels of creativity and job satisfaction. Thus an apparently trivial difference in view regarding the appropriate span of control in an organisation can have a fundamental impact on structure and culture: the hierarchical structure emerging from a narrow span of control creates a different working environment to the at organisation under a high span of control. If an organisation wishes to delayer (i.e. reduce the number of levels of management) it must recognise that the inevitable outcome is an increase in the span of control. This may constitute a signicant cultural change for managers on its own.

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Technology The technology of how work is performed affects how it is organised. If the work requires tight controls and few mistakes can be tolerated, such as processing cheques at a bank, it requires high formalisation, specialisation, and division of labour. If the work is creative, such as Research and Development, the organisation is not formalised, division of labour is not clear, and decision-making is decentralised. Technology can be classied as: Custom (small batch or job order) where production is in small quantities or one of a kind. Because the product is novel or designed for a specic buyer or use there is no standard method of production. Custom technology relies on the skill, craftsmanship and ability of the worker therefore close work supervision is not effective and there is no economy of scale. Examples include: tailored suits, private yachts and artistic creations. Mass Production (large batch) where production for a mass market requires controls to ensure a standardised product. Assembly line production results in high xed costs which are spread over large volumes of output to achieve low unit costs. The skill level of the large labour force is low and requires tight supervision to minimise variations in output. Examples include: Ford car factories in the 1920s, meat and poultry processing. Continuous (process) where technology is controlled by the manufacturing process itself and requires little worker involvement. For example, oil rening takes in a continuous supply of crude oil for transformation into petroleum products and the main worker involvement is maintaining the manufacturing process. The technology of the task therefore requires different organisational designs. The problem facing the organisation is whether these designs are best organised into functional, divisional or other structures. The ultimate criterion for selecting organisational structure is to assess how each is likely to contribute to the creation of value. For example, a large corporate centre in a holding company may have little impact other than to increase costs and in this sense would have a negative impact on company value. It also depends on whether the structure is likely to be exible enough to deal with change; for example, a company organised on functional lines may nd the structure incapable of delivering a planned increase in market share in selected segments of the market because more product specialists are required with the appropriate production back-up but the marketing and production departments are not closely co-ordinated. Companies often appear to be preoccupied with their structure rather than their business denition. Every day in the business sections of newspapers there are reports of company re-structuring exercises; often the rst action of a new CEO is to restructure the company. This may be due to the perception that if you get the structure right then everything else will fall into place; this rests on the implicit belief that strategy follows structure rather than the other way round. But organisational structure is only part of the strategic process and focusing on structure at the expense of the other stages in the process is clearly a mistake.

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8.2.2

Functional silos

Typically organisations are structured into divisions and departments each of which perform their own specic function and determine their own competency. This includes hiring people who are expert in doing that specic function. A functional silo comes about when the business processes of a functional unit focus inwardly on their functional objectives instead of on company objectives. This can create barriers which impact negatively on the units ability to contribute to its role in the broader mission of the organisation. This functionally oriented organisation structure tends to create silo thinking where each department stands alone with little interaction with other departments within the same organisation. Common experiences foster growth of expertise within the functional area and efciency through repetitively focussing knowledgeable individuals on familiar problems. This leads to a principal agent problem of considerable complexity because decision-makers have to compare the needs and priorities of one silo versus another. It is very difcult to foster communication among silos to ensure that employees understand the larger picture and that the function is not optimised at the expense of the overall system. Business processes cut across these functional silos. Where different activities in a process require different skills, the process involves a number of people and departments. Even though the process ows internally through several departments, from the customer point of view only a single process has taken place. For example, consider the marketing business process that extends from nding customers to lling their orders. Throughout this process, each department performs its own function: the sales department nds customers and gets their orders, the distribution department delivers the nished product to customer and nally the nance department collects revenue once the customer has received the product. These activities make up one business process of selling to customers but it may not appear like that to the departments. The marketing department wishes to maximise the number of orders, the distribution department wishes to minimise the time taken to full orders and the nance department wishes to collect money as soon as possible. The marketing department does not care that it is overloading the distribution department with orders; the nance department does not care that it might be alienating good customers by demanding early payment; the distribution department does not care that it is slow in providing information to the nance department; and so it goes on. Moving nancial resources among functional areas may encounter legal, administrative, and other institutional barriers. Even if the workforce is willing to be shifted, moving human resources from one functional area to another reduces the ability to build expertise and efciencies. Thus, it is often difcult to shift human and nancial resources to functional areas where the most benets will be earned. The rigidity of the system makes it difcult to allocate resources from a holistic perspective From the functional perspective control and responsibility changes according to the specicity of each department, therefore reallocating resources away from the silos are seen as involving risks of task duplication, delay and different perceptions of quality. These are real concerns and makes it difcult for the organisation to shift its view from who does what? to what needs to be done? As processes ow through the functional silos, the emphasis needs to be on making sure that the process ows effectively and efciently without signicant obstacles caused by lack of communication. Thus the functional silos need to coordinate and communicate continuously to ensure the process achieves completion.

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But this is difcult to achieve because of the underlying principal agent problem. From the managers viewpoint it is necessary to recognise that functional silos can emerge at any time; if they are allowed to emerge unchecked and unrecognised for what they are the result can be that the organisation ceases to function effectively without anyone being sure of why.

8.2.3

Integrating mechanisms

One way to resolve the principal agent problems that arise between different functional areas and divisions, resulting in functional silos, is to encourage integrating mechanisms. Some integrating approaches are as follows. Direct contact: assemble teams of managers from different divisions or functions to solve mutual problems. The problem here is that the mutual problems must have sufcient in common to foster collaboration, while the normal processes of team building need to be effectively implemented to make the effort worth while; this takes time and it cannot be assumed that the mere fact of bringing managers together will actually increase integration. Liaison Roles: one manager in each area is made responsible for communication with other areas. The problem here is that the liaison role is crucially dependent on the abilities of the selected manager. There is a danger that liaison managers end up liaising with each other and make little real impact. Task Forces: temporary committees are formed across divisions to solve a specic problem. The problem is to ensure that the integration does not end with the particular project. Individuals can display a high degree of commitment in such project orientated teams (such as hot groups) but they can quickly shift their focus to another interesting task. These teams also have to go through the processes of team building in order to be effective. Cross-functional teams: these work like a permanent task force that deals with problems as they occur. The problem here is that the problems may not always be suited to the aptitudes of the permanent task force. Matrix structure: it has the appearance of an integrating mechanism because it involves multiple reporting but it suffers from the disadvantages identied in Section 8.2.1. The matrix structure involves a trade-off: are the integration benets sufcient to outweigh the problems inherent in the matrix structure? These are actions that the organisation can take to foster integration, but there are other approaches which rely more on individual relationships rather than formal structures. Informal relationships. Coordination can occur through informal relationships but such relationships are usually serendipitous. The relationships are likely to be initiated by shared problems but once these have been resolved it is again open to chance whether the relationship is maintained. Shared values. This depends on the extent to which individuals see themselves as working towards a common goal and having the same perceptions as to how this Heriot-Watt University Strategic Management

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should be achieved. The development of a company culture that promotes shared values, such as corporate social responsibility, may contribute to integration but the outcome is likely to be highly unpredictable. It could backre if individuals gain the impression that they are being manipulated and therefore respond in a negative fashion. It was argued above that the emergence of functional silos is an ever present problem. It is difcult to initiate integrative mechanisms which will neutralise them; probably the most effective solution is to watch out for them emerging and deal with them before they get embedded.

8.2.4

Is there an optimal structure?

Organisational structures are necessary in order to make organisations operate effectively; a random association of workers is unlikely to achieve much. An organisational structure exists for a number of reasons and is always subject to change in a dynamic competitive environment. Each structural form has its own advantages and disadvantages and every organisation struggles with the need to make it operate as effectively as possible. While there are no solutions to the problems of strategy and structure an awareness of the issues is the rst step in doing the best job possible in the circumstances. Take the case of Larry, the head of HRM in Smallco who had a reputation for getting things done; he was headhunted by Largeco whose CEO felt that the organisation was not functioning as effectively as it could. Two years later Larry was red, having achieved nothing in Largeco. What prevented Larry transferring his success from Smallco to Largeco? The following organisational proles show that it was not just on the dimension of size that they differed. Organisational characteristic Structural form Size Span of control Technology Functional silos Integrative mechanisms Smallco Functional 500 High Custom 3: production, marketing, nance Shared values Largeco Divisional 5000 Low Continuous 15: each division Cross functional teams

None of Larrys experience from Smallco was relevant to Largeco. He spent the whole year trying to come to terms with the differences so achieved nothing.

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8.3

Management of change

Any change in an organisation requires reallocation of resources and therefore alters what people do. A company which has been operating in mature markets for some time is likely to nd signicant change more difcult to achieve than prospector type companies which have a history of innovation, growth and diversication. For example, for a long time the British workforce was associated with resistance to change; from the mid 1960s miners, shipbuilders and steelworkers wished to remain in jobs which were becoming progressively uneconomic and were not only unwilling to change to other jobs but wanted to carry on doing their existing jobs in the same way as they had always done. The notion that a job belonged to an employee led to decades of job demarcation disputes and strikes aimed at saving jobs which were in direct opposition to market forces. Every company which attempts to undertake change faces the problem of change implementation. In order to cope with change many companies attempt to develop a corporate culture which rewards adaptability, innovation and exibility and thus create an atmosphere conducive to the introduction of changes which save costs, increase productivity, and get people to do things better and think of better things to do. This is difcult to achieve and is certainly not attainable in a short space of time. The important point for managers to bear in mind is that reallocation of resources is not simply a matter of investing, retooling, and hiring new people. Even a relatively modest reallocation may present insuperable problems for companies which have fostered a no change mentality amongst their workforce. There are a number of approaches which facilitate strategic change including identifying barriers to change , force eld analysis, application of cultural web concepts and aligning management style to the type of change.

8.3.1

Types of strategic change

It is virtually impossible to imagine an organisation which remains in an unchanging equilibrium for any length of time. This is because the world is complex and dynamic. The problem of environmental scanning was discussed in Section 3.9.3; while changes in the environment can be usefully categorised in the PEST framework it is not a simple matter to identify which events are likely to impact signicantly on the organisation. The PEST example in Section 3.9.2 demonstrated that a newly privatised monopoly had much more to worry about than simply adapting to a new competitive situation because an examination of the environment revealed several high risks that were independent of the fact of privatisation. There is a difference between strategic change and other types of change within an organisation. It may be thought that strategic changes are large while others are relatively small but this is not necessarily the case. A strategic change is dened as a change that impacts signicantly on at least one part of the strategic process. It could be an innovation that makes it necessary to change the business denition, or an invention that affects the production process, or the emergence of a substitute that affects the prole of the ve forces. This initial impact will then have knock on effects throughout the strategic process. Any resulting change in business denition will require the formulation of new objectives and may require restructuring the supply chain; new production process may require retraining and new control systems; emergence of a substitute may require increased R&D and a new marketing strategy. Despite the fact that events initially impact on different parts of the strategic process there is one common

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element: people have to change what they are doing. Consequently changes can not be introduced in a mechanistic manner and it is necessary to manage the people affected. The types of event that trigger strategic change can be classied to anticipate the management problems that the resulting change will present. The following list is by no means exhaustive but it does highlight the general inuences that are likely to emerge from environmental scanning; the impact on the strategic process helps to identify the type of change which can take the following forms. Crisis: immediate action required to prevent the company going bankrupt Short term: rapid change required to meet a new competitive threat Long term: slow adjustment to meet predicted end of product life cycle Incremental: many changes to the strategic process required but most are marginal Transformational: new business denition leading to radical change in strategic process It will be seen later that these are classications of change are crucial when it comes to the style of management required for different types of change. Change driver New leadership Increasing size and complexity Acquisition Technological obsolescence Political events Strategic drift Life cycle differences among products Impact on strategic process New business objectives Introduce new control system Extend value chain New primary functions in value chain Changed competitive position Generic strategy choice New portfolio Change response Long term Transformational Incremental Transformational Short term Crisis Long term Incremental Long term Transformational

These drivers are largely the result of changes in the environment over which the company has no control but to which it must make some response. Some change drivers that originate internally are as follows.

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Change driver Innovation Identify untapped market Identify inefcient work practices Concern over job satisfaction Deterioration in working conditions Banks withdraw credit

Impact on strategic process New product launch Market expansion Resource allocation Value chain High attrition rate Cash ow problem

Change response Short term Short term Incremental Long term Incremental Incremental Short term Crisis

It is clearly useful to identify the change driver and its likely impact on the strategic process and hence the rst round of change responses. But in real life it is unlikely that only one of the drivers will be operating at a time; for example, strategic drift may be identied at the same time as concern over job satisfaction, so not only is it necessary to re-focus individuals but at the same time set up an appraisal system that ensures employees are properly rewarded for their efforts. Thus the strategic change process is likely to be multi-dimensional which makes the job of change management complex.

8.3.2

Barriers to change

There are barriers to change in all organisations due to organisational and personal reasons. There are several reasons why some individuals will always be resistant to change: 1. Self interest: this is the principal agent problem which it may not be possible to resolve because company objectives cannot be aligned with some individuals objectives. 2. Misunderstanding: this arises because of communications problems and inadequate information being available. It is a particular problem in large organisations; further, a strategic change will impact on people in different ways as it works through the strategic process and many implications for the organisation may be unpredictable. 3. Low tolerance of change: individuals often do not like the sense of insecurity that accompanies change. There is not much that can be done about this because reassurances are likely to be treated with a degree of scepticism, particularly if colleagues lost their jobs in previous changes. 4. Disagreement over the need for change: there can be genuine disagreement over the advantages and disadvantages of a change and it is difcult to resolve these differences because they are subjective. If it is accepted that there is not much that can be done about these individual attitudes it is necessary to accept the way the world is and work round them. These barriers will not stop change completely but they certainly make it difcult. There are also several organisational factors that act as barriers. Heriot-Watt University Strategic Management

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1. Structural inertia: reorganisation can be complex because it is necessary to ensure that production and delivery functions keep operating efciently and this is particularly difcult to achieve during the transition period. It is easy to conclude that it is simpler just to leave things as they are. 2. Existing power structures: changes reduce some managers span of control and are therefore bound to meet with resistance. Sometimes the only way to deal with this is a radical solution, such as delayering, where a whole management layer is removed. 3. Resistance from work groups: teams which have operated successfully up to now will see little point to changing. It may be feared that team output will be reduced, at least in the short term, with adverse consequences for rewards. Disbanding a tightly knit group can have disastrous effects on morale so there is no easy way out of this dilemma. 4. Failure of previous change initiatives: in a dynamic environment it is inevitable that there will be failures as well as successes. The problem arises when failure is looked upon as a reason for resisting change rather than a lesson for the future. Taken together these personal and organisational barriers to change can present formidable obstacles; the challenge for change management is to identify them and ensure that they are accommodated in the change process.

8.3.3

Force eld analysis

The principal agent problem demonstrates that conicts of interest occur at all levels within an organisation. When strategic change occurs conicts of interest are likely to be exacerbated because strategic changes are typically carried out in response to incomplete information (forecasts of the future or likely actions of competitors) and individuals interpret them in different ways, while the magnitude of the strategic impact means that individuals may see their own interest being threatened. It is therefore inevitable that some individuals or groups will be in favour of a particular strategic change and others will be opposed. It then becomes a matter of identifying the forces for and against the change, assessing the balance between them, and guring out whether the balance can be altered in order to make the change possible. This is illustrated in the force eld diagram.

Figure 8.1: Force eld Heriot-Watt University Strategic Management

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The forces acting for a change are the driving forces and those against are the restraining forces. The following are the main steps in applying a force eld analysis. Clarify what change is required to achieve the strategic objective. For example, entering a new market segment may require withdrawal from an existing segment and diverting resources from R&D to marketing. The impact of a change on other parts of the strategic process generates forces for and against the change. Identify the driving and restraining forces in relation to each aspect of change and estimate their relative size. For example, the CEO and the marketing director are in favour of the new market entry because it is seen as a major opportunity (High driving force) while the nance director has some concerns about the impact on short term cash ow (Low restraining force); The marketing department as a whole is in favour of more resources (High driving force) but some members may be opposed to abandoning an existing segment (Low restraining force); the R&D department is opposed to losing resources because an innovative new product is within six months of launch (High restraining force). Assess the balance of forces; if the balance is clearly in favour of the change it may not be necessary to take action other than to start implementing the change. If the balance is clearly against change a decision needs to be made on whether to attempt to alter the balance or abandon the change. In the example the R&D director threatens that there will be no signicant product development possible for the next three years and this is such a serious threat to the long term viability of the company that it tips the balance against the change. Decide how to alter the balance of forces. There are two distinct options: reduce the strength of the forces restraining the change or increase the forces driving the change. The latter could be achieved by promising the members of the marketing department a bonus if the segment entry is successful but this is likely to heighten the R&D directors opposition. It is more effective to reduce the R&D directors opposition by promising an increase in the R&D budget in a years time. The force eld is a powerful tool in identifying how to implement strategic change. The concept was originally developed by Kurt Lewin for managing organisational change. Lewin developed a model for change with three phases: 1. unfreezing - reducing the strength of forces which maintain current equilibrium 2. moving - developing new organisational values, attitudes and behaviours 3. refreezing - stabilising after the changes to generate a new equilibrium. While the three stage model is useful for changes in procedures and processes it is arguably not applicable to strategic change. The establishment of a new equilibrium is not relevant because in a dynamic competitive environment there is no such thing - if anything, a new equilibrium would breed resistance to change in the future. The objective of developing a robust strategic process is that the organisation is capable of change and that is not consistent with refreezing.

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8.3.4

Cultural web

A different approach to change management is to embed the willingness to adapt to strategic change in the culture of the organisation. The focus is not on specic strategic changes but on the general attitude of the workforce which, in the force eld case, would signicantly reduce the restraining forces although it would not entirely eradicate them because of principal agent issues. It is well known that organisational culture is almost impossible to dene and it is difcult to change. Despite the fact that culture cannot be dened it is usually argued that you know it when you see it. Take the contrasting examples of a family owned retail business (Smiths) and a small creative advertising partnership (Adwell). Smiths is run on strictly hierarchical principles with the patriarchal owner at the top of a pyramid that extends down through departmental heads, supervisors and counter assistants; it is virtually unknown for a counter assistant to speak to the owner and no one is on rst name terms with their superiors. There are accepted codes of behaviour and dress and time keeping is strict. In Adwell it is difcult initially to identify the three senior partners, everyone is on rst name terms, including non-creative staff such as administrators and secretaries, and there is a relaxed and collaborative atmosphere. There is a erce commitment to results and the creative partners are well aware that if they fail to perform they will be red; but this is accepted as a normal aspect of such businesses. Imagine what would happen if Smiths bought Adwell and tried to run it like a shop, or if an Adwell senior partner were head-hunted to replace the ageing owner of Smiths. The outcomes are indeterminate but there is no doubt that there would be a clash of cultures. Now consider the likely reaction of the two businesses to strategic change; it is reasonable to conclude that Smiths would be far less conducive to change than Adwell. If that was your conclusion you have walked straight into the cultural trap: you have been taken in by appearances rather than nding out about the culture. Smiths has decided to make a strategic change by acquiring a boutique selling upmarket ladies outts. The counter assistants have always been circulated around departments and regard themselves as professional sales people and they would all relish the challenge and opportunity presented by taking a spell in the boutique. The departmental managers and the buyers see the boutique as a prestigious addition to the portfolio; in fact, everyone is comfortable with their place in the hierarchy and they are loyal to the organisation and to old Mr Smith. Adwell has focused up to now on the sports clothing sector but the senior partners have decided to tender for a major account in the motor trade; they see this as being a crucial strategic expansion of the scope of the company; they feel that diversication is essential in the long run because of increasing competition in the sports clothing sector. The trouble is that the creative partners are fully committed to their current clients and they feel they do not have the time to learn about a new business sector. If new partners are brought in they feel this will not benet them personally; in any case, each of them feels capable of winning new accounts in the sports clothing sector. Their skills are highly transferable and all of them could move to another organisation and probably take most of their accounts with them. They are loyal to their creative colleagues rather than to Adwell. The non creative members see the move as simply adding to their workloads and some of them start looking at the situations vacant columns. What were the underlying causes of such a profound difference in the culture that led to easy acceptance of strategic change in one organisation and hostility in the other? Heriot-Watt University Strategic Management

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It would clearly be useful to be able to identify the main cultural characteristics of an organisation to assess its likely reaction to strategic change and identify, if possible, actions which could be undertaken to change the culture so that it was more aligned with change. If nothing else, it would help to avoid the trap of confusing organisational structure with culture. One approach is the cultural web 1 , which is used to classify cultural assumptions and practices. Elements of the cultural web The cultural web identies six interrelated elements that help to make up what Johnson and Scholes call the "paradigm" of the work environment. The six elements are: 1. Stories - The past events and people talked about inside and outside the company. For example, who and what the company chooses to immortalise says a great deal about what employees value. 2. Rituals and Routines - The daily actions of people that signal acceptable behaviour. For example, the routines determine what reaction is expected in given situations, and what is valued by management. 3. Symbols - The visual representations of the company including logos, the standard of the working environment and formal or informal dress codes. 4. Organisational Structure - This is not so much the structure dened by the organisation chart but the unwritten lines of power and inuence. 5. Control Systems - These include nancial systems, quality systems and rewards, particularly the way they are measured and distributed within the organisation. 6. Power Structures - The location of real power in the company. This may involve one or two key senior executives, a whole group of executives, or even a department. These people have the greatest amount of inuence on decisions, operations, and strategic direction. Using the cultural web The cultural web is used to assess culture as it is now, then to dene the desired culture and identify the differences between the two. These differences are the changes required. Each element is examined in relation to the example of Smiths and Adwells to see how the underlying cultural differences relating to strategic change might be uncovered. 1. Analysing Culture As It Is Now Stories Smiths: most of the stories involve old Mr Smith: how he built the company up from a street stall, how he deals personally with customer complaints, how he spent a fortune on redesigning the food hall then tore it apart and started again because it didnt seem right to him. Adwell: stories about winning accounts with a sudden brilliant idea, saving a clients business with a novel advertising campaign and meeting publishing deadlines against impossible odds. Heriot-Watt University Strategic Management

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The issue here is whether the rituals and routines are potentially barriers to strategic change. In Smiths all rituals and routines are directed towards customer satisfaction while in Adwell the focus is on creative freedom. In Smiths the rituals and routines can be directed to customer satisfaction in any environment but in Adwell operations are dependent on individual preferences. Symbols Smiths: the imposing faade of the old building and the peculiar logo make employees proud to be part of the business. Employees take a pride in appearing smartly dressed. Adwell: The prestigious client list denes the business. The Smiths symbol contributes to the corporate identity while in Adwell the logo is a reection of the achievements of individuals. In Adwell employees do not adhere to a corporate image. Control Systems Smiths: the remuneration system is designed to reward individuals and departments; it is not perfect but employees accept that it is by and large fair. The computerised stock system means that lines are continually being added or abandoned. Adwell: there is no system to identify whether accounts are actually protable. Some accounts are jealously guarded by their owners. The nance director has repeatedly pointed out that overall prots vary alarmingly but no one seems particularly interested. Smiths controls are designed to encourage employees and to track the outcome of new ventures, such as the new boutique. Adwells lack of controls encourages the maintenance of the status quo. Power Structures Smiths: while the counter assistants wield considerable inuence the real power rests in Mr Smith. It is a power based on loyalty, respect, fair dealing and many other things. Adwell: real power resides in the individual creative partners; the three senior partners wield very little power in the strategic sense. There is a marked difference in the elements of the cultural web in the two organisations. Taken together they provide insights into the organisation that is not apparent from simply looking at the organisational structures. It emerges clearly that Smiths culture is almost purpose built for strategic change while Adwells culture contributes to a static organisation. 2. Dene the desired culture Each element of the cultural web is examined in detail to identify what would be required to generate a web which would be conducive to strategic change. The following shows how this might work out. Heriot-Watt University Strategic Management

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Cultural Web component Smiths Find stories about Stories successes achieved by counter assistants Rituals and routines Design new company uniforms Symbols Repair the faade Organisational structures Improve communication between department managers and Mr Smith Improve payment by results system Give supervisors more responsibility

Adwell Find stories about team successes Draw up code of practice for dealing with clients Dene the company mission Assign clear roles to the creative partners Make creative partners accountable Set up a clear chain of command

Control systems Power structures

3. Identify the differences It emerges that the desired culture for Smiths involves changes in the elements of the cultural web at the margin while those for Adwell are radical. It appears that the Smiths cultural web is already closely aligned with strategic change while the changes required in the Adwell cultural web are unlikely to be achievable. Thus the cultural web analysis suggests that there are some improvements that can be made in Smiths culture but Adwell is likely to remain locked in its cultural prison. This is a negative conclusion so far as Adwell is concerned but it does identify the fact that attempting to change the culture is not going to improve the prospects for the suggested strategic change. If the senior partners focus on issues such as stories and team working for a considerable time this might generate sufcient cultural change to enable strategic changes in the future. Whatever is done in Adwell, it is not going to be easy or immediate. Despite the difculties in dening and identifying culture the cultural web provides a framework for analysing at least some of the elements that contribute to culture and identifying where they can be adjusted to facilitate strategic change.

8.3.5

Styles of managing strategic change

There are various styles of managing strategic change ranging from educational and participative to coercion and edict. Roughly speaking this means close involvement with those affected at one end of the scale and simply telling people to get on with it at the other. There are costs and benets associated with each style but it is not possible to conclude that one style is superior to another because much depends on the circumstances and the organisational culture. The different types of strategic change were identied in Section 8.3.1; for example, when it is suddenly announced that a new out-of-town shopping centre is to open within a year then Smiths would need to react quickly to this crisis and there may not be time for a participative approach; on the other hand, Smiths may have decided that the long term future lies with the specialised boutique approach and there is time to involve employees in this long term transformational change. The table below shows how different styles, their potential benets and problems and the type of strategic change for which they could be most effective. Heriot-Watt University Strategic Management

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Style

Means

Benets

Problems

Mutual trust and Education and Overcome lack respect Small communication group meetings of information Increased ownership of direction or process Guided process enables involvement

Labour intensive and costly Solutions constrained by existing cultural paradigm Reaction to perceived manipulation Risk of adverse reaction Only successful in crisis

Type of strategic change Incremental change Transformational Long time horizon Transformational Long time horizon Nontransformational Crisis Crisis Rapid change

Participation

Small group task forces Change agent takes control

Intervention Manipulation Direction Coercion Edict

Use of authority Clarity Exploit existing State of crisis power structure

Although the classication is approximate it does provide pointers to the most appropriate management style. For example, if coercion were applied for long term transformational change there will be time for resentment to build up because employees may feel that given time and involvement they would be willing to make the necessary changes by mutual agreement; at the other extreme, if a participative style were adopted in a time of crisis there would be no time to resolve different points of view and conicts of interest. From this perspective it can be judged in broad terms which style is likely to be most effective but whether it works out in practice depends on the skill of management.

8.3.6

The complexity of managing strategic change

An issue which is often overlooked in the management of change is that the management team is itself part of the change process and may not be well equipped to implement a strategy which involves signicant change. For example, a company which decides to diversify will require the senior management team to become more concerned with corporate level decision making rather than running a single product line. The current nance ofcer may not have the experience and skills required to handle nancial planning in a diversied company; the personnel ofcer may have no experience in integrating new and existing activities. At the SBU level, the type of manager who has successfully run a Cash Cow may not have the innovative approach to market development and risk taking required to transform a Star into a moneymaking proposition. The concepts and models developed so far, taken together, provide a basis on which to tackle the seemingly intractable problem of changing an organisation.

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Change model Type of strategic change

Barriers to change

Decide whether a change is feasible Devise tactics to alter forces Redirect culture towards Cultural web Identify the elements of culture as they relate to the change change Styles of managing change Identify relevant style Align style with type of change Force eld analysis While change management is complex it is possible to tackle it in a structured and logical manner. But it is important that each model is applied in context and is seen as part of the change process rather than as a complete answer in itself. The problem of functional silos extends to managers involved in the change management process.

Role of model Identify the change driver and its impact on the strategic process Identify the in-built institutional factors causing resistance to change Identify forces acting for and against change

Outcome Clarify the change

Clarify principal agent problems

8.4

Resource allocation

All companies are continually faced with the problem of allocating resources. Typically a company will have procedures for allocating resources among competing uses; these include setting budgets, using pre-determined accounting rules, bargaining among SBU CEOs and so on. Whatever approach is adopted it is essential to bear in mind two considerations. 1. How well aligned with the strategic thrust is the resource allocation procedure? 2. How are resources allocated when a major strategic change of direction has been selected? Take the case where a company is attempting to develop a star product into a cash cow and where the resource allocation rule is that the budget for the SBU this year must be within 10 per cent of last years. In order to develop increased sales and market share it is necessary to build advance capacity and probably produce for inventory; this will most likely require much more than a 10 per cent increase in resources for a year or two and the additional input of resources will not be accompanied by an increase in protability. Unless the strategic decision to develop the product is accompanied by a change in the resource allocation rule it will simply not happen. Thus at any one time it is necessary to consider the alignment between what the company is attempting to achieve and the current methods of resource allocation and recognise that when a strategic change is undertaken, it may be necessary to change the whole approach to budgeting. It is not really a case of the resources being unavailable which leads to a failure to achieve objectives, but inappropriate methods for ensuring that resources Heriot-Watt University Strategic Management

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are directed towards efcient uses. This may seem to be almost alarmingly obvious to an observer, but resource allocation procedures within organisations are typically well embedded and can be very difcult to change. The value chain is a powerful tool for helping to focus on the alignment between strategic objectives and resource allocation. Instead of attempting to ensure that the functional parts of the company are provided with adequate resources, attention can be turned to the extent to which the activities which generate value are able to function, and that the linkages among them are not overlooked. For example, a company which is about to undertake expansion into new markets may need to increase its sales force; in the rst instance attention needs to be focused on the human resource support activity and various questions can be asked. Does the HR department have sufcient resources to mount a recruitment programme? Does the HR department have experience in this type of recruitment? Has a prole of the desired type of sales person been identied? Is there an adequate communication channel between SBU and HR? The difculty of attributing value added to different parts of the value chain has already been discussed, but it is probably not too difcult to identify when there is a weak link in the chain which will constrain the extent to which appropriate resources can be deployed. On the other hand, it is all too easy to assume that a previously effective HR department can deliver a new set of outputs.

8.4.1

Critical success factors

The notion of critical success factors has its roots in network and critical path analyses originally developed for use in military planning. In principle the idea is simple: a project is set out as a sequential network of events with the objective of identifying the critical path, which is the minimum time for the project. Inspection of the network reveals that there are some things which must happen before others. The same general approach can be adopted in strategy implementation, but because of the complexity of the process, and the fact that so much is unknown about the future, it is really only possible to identify events which must occur, or things which must be done, in order to ensure that the strategy has a chance of coming to fruition. It is not a straightforward matter to identify critical success factors. It is necessary to have a detailed understanding of available resources, the resources which will be required, the sequence of events and how individuals are likely to react to the changes which they will experience. A critical success factor can be the acquisition of a capital asset or it could be the installation of an appropriate incentive structure. When it is found that a strategy is not being implemented as effectively as originally expected it is more than likely that a critical factor has been overlooked; the reason that the whole process has ground to a halt is because that is the nature of a critical success factor. The rst step in identifying critical success factors is to determine what must denitely be achieved to ensure success. The resulting list sets the scene for the actual implementation process because it identies the immediate priorities. An example Heriot-Watt University Strategic Management

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of how critical success factors can be identied is to consider what is critical when attempting to convert a Question Mark to a Star compared with turning a Star into a Cash Cow. A list of potential actions has been identied and the criticality of each can be assessed in the two situations. Factor Capacity Marketing Star to Cash Cow Eliminate excess capacity Be prepared to reduce as market matures Reduce Set to competitive level Critical? Yes Yes Question Mark to Critical? Star Maintain excess Yes capacity Maintain at high level Yes

R&D Price

Yes Yes

Maintain at high level Yes Yes Set lower than competitors

There are at least four common factors critical to success, but the action associated with each is different in the two situations.

8.4.2

Budgets

The problem of allocating budgets is encountered at many levels, but for strategy purposes these can be reduced to two: the corporate and SBU or functional levels. At the corporate level the overall budget is rationed among competing alternatives, typically on the basis of proposals submitted by SBUs. At the SBU or functional level it is necessary to allocate funds to individual managers so that they can carry out the tasks which are required to achieve the objectives of each investment; the investment appraisal which revealed that the net cash ows generate a positive NPV does not usually take into account uncertainty as to how costs will actually be incurred and resources deployed. At the corporate level it could be argued that no budget constraint exists because any investment which generates a positive NPV ought to attract funds from the market; by denition, this is a project which generates a return greater than the companys cost of capital. However, there are many reasons why a company may be unable to raise money on the market to nance investments. The most obvious one is when the market does not agree with the companys estimate of future returns; the track record of the companys managers may be such that the market views their plans with considerable reserve. Another reason is that the company may be unwilling to reveal its intentions to competitors. The desirability of an investment may depend on achieving a competitive advantage which would be impossible if competitors knew what the companys strategy was likely to be. In fact, strategic options are often difcult to dene with the precision which will attract investors. It is one thing to use investment appraisal to attempt to estimate the relative value implications of alternative strategies, but it is quite another to translate this into a convincing investment plan. It was discussed at Chapter 7 Section 4.9 how the application of sophisticated capital rationing techniques does not necessarily resolve the budget allocation problem. One way to avoid the difculties associated with capital rationing is to set across-the-board budget limits; this has the advantage that all SBUs are treated in the same way, and in turn the SBUs can set across-the-board limits since this is consistent with corporate policy. However, such an approach is inconsistent with principles of efcient Heriot-Watt University Strategic Management

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resource allocation. The whole emphasis of the strategic planning process has been on the identication of activities with different potential pay-offs and directing resources accordingly. For example, if the objective were to increase the market shares of products currently being produced, it would make little sense to increase the research budget at the same time simply because the marketing budget was to be increased. On the other hand, if there is no sensible budgetary control, when companies are faced with adverse market conditions and decide to follow a retrenchment strategy the rst thing that is usually done is to cut back on those budgets which can be manipulated without affecting current performance. Training, research and maintenance budgets are often pruned to achieve an immediate increase in ROI without proper consideration of the overall resource allocation implications. This is often justied by senior management on the grounds that survival is the primary concern and renements can come later. This reaction is probably inevitable when senior management concentrates attention on short term cash ows rather than on the concept of shareholder wealth which puts short term cash ows into context. The SBU CEO is confronted with many imponderables. If a new market is being entered he has to decide how much to allocate to marketing and over what period. The marketing manager has to decide how much to allocate to market research, advertising, promotions and so on. By the time the original funds have been parcelled up and allocated to the various functions it may be difcult to identify specic expenditure with the original project. The original investment appraisal assumed that the cash would be used efciently at the functional level. The management problem is to ensure that this happens, but there may be relatively few guidelines to assist managers who are in the front line. A potentially effective strategy may never actually happen because budgets are disseminated throughout the organisation in a haphazard fashion.

8.4.3

Incentives

Ideally, incentives should be related to the value creating activities of the company and in this way contribute to resolving the principal agent problem. But, given the difculty of determining value for the company as a whole, it is clearly impossible to parcel out the components of added value to managers and employees. On the other hand, it should be possible to recognise when the incentive system is at odds with the value creation objective. For example, a production manager who is rewarded for minimising inventories can cause havoc with a marketing strategy aimed at achieving an increased market share. It is important for managers to recognise that the incentive system may be at fault when the performance of individuals does not match expectations. In fact, one of the barriers to change is that incentive systems are not reviewed to ensure that they are consistent with revised company and individual objectives; what is perceived as being unwillingness to change may be partly due to the fact that individuals can see that a proposed change is not to their advantage given the existing system of incentives. It is a basic fact of life that managers and employees will be unwilling to change their behaviour if the benets of doing so are perceived as being lower than the costs to themselves. A change in the incentive system can go a long way towards easing the implementation of change. It also needs to be recognised that the incentive system is not entirely nancial; other dimensions include promotion prospects, recognition and job satisfaction. It can be

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very difcult to align all elements of the incentive system to company objectives, but it is necessary to attempt to ensure that both nancial and non-nancial incentives are operating in the same direction. Imagine a large multinational company that has decided on the following set of objectives for its SBUs. 1. Achieve a minimum of 20 per cent return on sales 2. Reduce direct unit cost by 3 per cent per annum 3. Achieve at least third place in terms of market share in all 10 international markets 4. Develop a reputation for product quality and top class after sales service As an incentive each SBU CEO would be rewarded for every 1 per cent increase in return on sales above 20 per cent and would be penalised for each 1 per cent below the 3 per cent cost reduction target. There are several problems here. First, the objectives conict with each other. It is doubtful if it is possible to achieve a reputation for quality while reducing unit cost; it is also difcult to see how market share can be increased while costs are reduced. Second, an across the board reduction in costs will penalise those SBUs that were relatively efcient and who will therefore nd it difcult to reduce costs further. Third, the return on sales objective does not have a specic incentive associated with it. Fourth, the incentives are a mixture of reward and punishment. Individuals do not respond well to negative incentives. So the incentives do not serve as an effective method of dealing with the principal agent problem in this case; but at the same time it has to be recognised that the objectives are probably unattainable.

8.4.4

Resource planning

If the company is ever going to achieve a competitive advantage, it must set up procedures to ensure that resources are used efciently. A fundamental requirement in effective resource planning is that the production department knows what it is meant to produce; this means setting up communications between marketing and production so that each can understand the others viewpoint. For example, it is often found that the production department is frustrated by continuously changing volumes of orders, and as a result cannot always react with fast delivery times; the marketing department may feel that reasonable notice of orders is always given, that the production department is inefcient and is not really interested in fullling the needs of hard won customers. Effective communication between marketing and production would reveal the likely incidence of bulk orders, provide guidance to production on how much inventory the marketing department feels that it can reasonably live with, and enable the marketing department to appreciate the difculties of capacity utilisation and inventory control and the benets of a relatively stable production schedule. A service company faces different problems because services cannot be stored hence there are no inventories. Sufcient resources need to be employed to meet uctuations in demand but if supply exceeds demand for any length of time then unnecessary costs will be incurred. There is a balancing act involved in aligning resources with expected demand in a cost effective manner bearing in mind the trade-offs. Resource planning has implications for all aspects of the companys performance. The application of sophisticated just-in-time approaches can reduce inventory costs Heriot-Watt University Strategic Management

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signicantly, the smoothing of peaks and troughs in production schedules can create the stable environment necessary to develop a company culture, the introduction of new technology at appropriate times enables the company to make use of new skills and techniques, and a systematic approach to resource planning is the foundation for monitoring costs.

8.5

Effective implementation is difcult

One of the most common observations made by senior executives is that they know what their business denition is, they understand the competitive environment and their internal capabilities, they have a clear idea of the strategic approach BUT it just seems impossible to actually make it all work. It will be clear by this stage why implementation is difcult; but it is by no means impossible if the various factors affecting implementation are understood and a structured approach is taken to resolving them. Implementation factor Organisational structure Structural forms Functional silos Identify the t between strategic objectives and structure Watch out for units which are not contributing effectively to business processes Foster cooperation What to do

Integrating mechanisms The management of change Types of strategic change Barriers to change Force eld analysis Cultural web Styles of managing change Resource allocation Critical success factors Budgets Incentives Resource planning

Clarify the nature of the change Identify institutional resistance to change Deal with the balance of forces acting for and against change Align cultural elements with new objectives Align style with type of strategic change

Identify what must be achieved to avoid failure Align allocation of nance with objectives Align incentive structure with objectives Ensure that the right resources are available at the right time

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That is a lot to get right. But if you get just one of them badly wrong there is a good chance that implementation will fail. In that sense all of these are critical success factors. As a thought experiment you can select any of the factors and think through what would happened if you got it wrong. For example, if the force eld is not used to identify the forces acting for and against change the balance against change will not be recognised therefore no action to correct the balance will be taken; if the management style is not aligned to the type of strategic change nothing will be achieved; if the budgeting system is wrong it will be impossible for managers to reallocate resources. If managers do not understand these change issues they will be unable to comprehend why the implementation process is failing; there is then a tendency to conclude that it is all too difcult and things should be kept as they are.

Exercise 8.1
1. Consider the implementation of SuperTools decision to develop and produce the PowerPlane in the light of the topics dealt with in this section. 2. On the basis of your analysis, what do you think the prospects are for developing and launching the PowerPlane?

8.6
1

Reference

G Johnson and K Scholes (2005) Exploring Corporate Strategy Prentice Hall

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Chapter 9

Strategic Control
Contents
9.1 9.2 9.3 9.4 9.5 9.6 Strategy control in the process . . . . . . . . . . . . . . . . . . . . . . . . Degree of planning and type of control . . . . . . . . . . . . . . . . . . . . Feedback . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Analysing the ongoing competitive position: using the process model . . . Finally . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234 235 237 238 241 241

Learning Objectives To understand the principles of strategic control To use the process model for evaluating strategic performance To incorporate feedback mechanisms into the strategic process To assess the changing competitive position

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9.1

Strategy control in the process

The strategic planning approach is initially based on expectations, for example of the outcome of a new product launch, of gaining market share, of generating revenues and so on. When decisions have been made and actions are implemented it is necessary to measure and evaluate actual performance to nd out if the expectations are being fullled. When the component parts of the plan have been made explicit, the plan provides a benchmark against which actual outcomes can be compared, so that when variations between expected and actual outcomes occur their causes can be investigated. For example, it may be found that the net contribution from a particular product is lower than anticipated; this could occur for a variety of reasons, for example because the selling price turned out to be lower than predicted, or because productivity was lower, or because market share turned out to be harder to win. The reason for the shortfall will suggest whether action should be taken to achieve the original objectives, or whether the plan itself needs revision in the light of events; it is essential to identify whether the deviation from the plan is due to causes within the control of the company. This process contributes to the conversion of the plan from wishful thinking to a means by which the company can exert control over its performance. The well-known case of Barings bank and the losses generated by Leeson revealed a lack of strategic control on the part of Barings. The same lack of control was apparent at Daiwa, whose trader Toshihide Iguchi lost even more than Nick Leeson - 900 million in the foreign exchange market. These two cases generated losses in a relatively short time, but this was not the case for Yasua Hamanaka of Sumitumo, who controlled so much of the copper market that he was known as Mr Five Percent; he lost 1300 million over a ten year period and managed to conceal what he was doing for most of that time. The Royal Bank of Scotland changed from one of the most successful banks in the world to being nationalised and posting the biggest losses in UK corporate history within a year; this was the result of a disastrous drive for expansion culminating in the acquisition of AB Ambro, possibly the most misguided take-over ever. While these are extreme examples, a lack of strategic control can clearly have severe repercussions.

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9.2

Degree of planning and type of control

Companies vary greatly in the way in which they attempt to control planning outcomes. Some companies rely largely on nancial indicators, while others take into account a wider range of measures which reect competitive positioning. The attempt to control and evaluate planning outcomes is complicated by the degree to which planning has been undertaken in the rst case; when the planning process is vague, for example, the only measures which might be seen as relevant are nancial ratios. This issue was pursued in a study carried out by Goold and Campbell, 1 and Figure 9.1 attempts to capture the main thrust of their approach by categorising companies according to their degree of planning and their approach to control.

Figure 9.1: Degree of planning/ and type of control Loose control companies, in the sense of the classication, have a high planning inuence but adopt a exible approach to evaluation and control; the process may be informal in nature without predetermined milestones, benchmarks or measures. This could have the effect that managers are not provided with incentives which consistently relate their actions to the overall purposes of the strategy. At the other extreme, Financial Control companies rely largely on nancial measures of performance which can miss many of the aspects of strategic control which are necessary to ensure that plans are actually being achieved; this type of company uses tight nancial control as a substitute for a planning approach. In the middle of the range is the company which uses a variety of control methods and gives a balanced weighting to strategic and nancial inuences. Clearly this classication is by no means precise; Goold and Campbell attempted to classify companies but ran into difculties in trying to be exact, leading to disagreement about the classication depending on the viewpoint of the person within the organisation. But companies can usefully be entered into the matrix in a rough fashion; for example, a company which is run by a nancially minded CEO who insists on the development of detailed plans backed up with clear nancial targets, but with no attention paid to factors such as market share, sales growth and competitor performance, could be classied as Financial Control. The point of the classication is not to imply that some companies are better or worse than others, but to provide insight into the approach to evaluation and control. For example when markets are subject to rapidly changing technological development, the approach characterised by Financial Control may be inappropriate. In this situation the company needs to be able to meet rapidly changing conditions and not be diverted from its purpose by nancial measures that may well be irrelevant. Heriot-Watt University Strategic Management

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In a subsequent study of major British companies, Goold and Campbell attempted to identify potentially effective control methods.2 The general conclusions were as follows. The rst stage in the control process should involve the selection of relatively few appropriate objectives. From these objectives suitable targets can be derived so that pressure can be created for effective strategic performance, but without setting up a bureaucracy to achieve it. A series of milestones can be identied which are tracked over time; these serve as benchmarks for evaluating strategic performance and provide early warning of deviations from expected outcomes. A narrow set of nancial measures cannot provide the overall strategic view which is necessary; on the other hand, many of the objectives and targets cannot be measured with accuracy, and a great deal of subjective evaluation is necessary. To see how this might work in practice take the case of a company that is about to launch an innovative toaster that automatically adjusts the heating elements for the type of bread inserted; this is an already crowded market and there is some doubt as to whether the new features will lead to success. The four control criteria are related to the four types of planning control identied in Figure 9.1. Criteria Few objectives Loose Vague: high quality, high tech prole Imprecise notions None No real understanding of what has been achieved so likely to be irrelevant Planning Achieve 15% market share within 3 years 8% Market share Year 1, 12% Year 2 Actual versus desired market share Financial Generate 15% ROI within 3 years Strategic Achieve competitive advantage

Derive targets

5% ROI Year 1, Relative market 10% ROI Year 2 share Allow 1% variation each year Performance relative to competitors Does it look like competitive advantage has been achieved?

Milestones

Subjective evaluation

None

None

There are signicant differences of their use of the criteria among the four classes. This interpretation suggests that the Loose control approach is too vague to control the process in any dimension. The Planning control class sets specic market criteria but judges the outcome purely on the basis of whether these have been achieved rather than taking other variables into account, even subjectively. The Financial control class is much the same, except that it is even more constrained by nancial measures. The Strategic control class uses a combination of measurable and subjective criteria that enable judgement to be exercised in the light of changing circumstances. If this interpretation is more or less correct, it suggests that the Loose, Planning and Financial classes are likely to have considerable difculty in determining what is really happening to the strategy. Heriot-Watt University Strategic Management

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Exercise 9.1
Assess SuperTools evaluation and control approach.

9.3

Feedback

Companies typically do not pay much explicit attention to feedback as a key factor in the strategy process. This might seem surprising, given that strategy occurs in a dynamically changing environment; the scope of these environmental changes is enormous, ranging from the way the economy is performing to unexpected competitive moves on the part of competitors. The difculty of carrying out continuous environmental scanning and communicating the results was discussed in Chapter 3.9.3; it is not sufcient to scan the environment and monitor company performance; it is necessary to be able to act on information and changes as they occur. There are at least three dimensions to feedback. 1. Communication channels: how is information disseminated both upwards and downwards in the organisation? It is difcult in practice to set up procedures which recognise the unexpected and ensure that the information is communicated to the individuals who can take appropriate action. The real problem is to determine what is the most appropriate communication structure for a given organisation. For example, compare how information might be disseminated in a company organised along functional lines with one organised divisionally. In the functional organisation the marketing department may identify a change in market trends for a particular product, but is likely to have difculty communicating the implications to other departments. In the divisional company the SBU can react to the market change, but there may be no means of communication with the corporate centre which needs to know what is happening to the company product portfolio. 2. Ability to adapt: the fact that communication channels exist does not guarantee that appropriate action will be taken. A great deal depends on the individuals concerned and their attitude to change. To a great extent this depends on the willingness of individuals to listen to information which may often not be to their liking, be prepared to admit mistakes, and be proactive. These characteristics are typically part of the company culture and cannot be adjusted in the short term. 3. Learning organisation: Anyone with experience of education knows how difcult it can be to develop learning abilities in individuals. The challenge is even greater for organisations. The crucial issue is whether the organisation is able to learn from and build on experience. Taking the example of a change in market trends, can the organisation look back to a similar event and use that as a starting point, or is it necessary to re-invent the wheel each time? It is not whether the individuals concerned learn how to react to events, but whether the organisation as a whole capitalises on the learning of the individuals. It is tempting to set up a system of formalised meetings at departmental, interdepartmental and divisional levels and hope that the structure will take care of feedback requirements. But setting up a formalized procedure is not even a necessary precondition for ensuring that feedback will be integrated into the strategic process. Heriot-Watt University Strategic Management

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Exercise 9.2
Assess feedback in SuperTools.

9.4

Analysing the ongoing competitive position: using the process model

Competitive conditions continually change depending on the performance of the company and the reactions of competitors. A key aspect of implementing strategy is to be aware at all times of the companys competitive position; it cannot be assumed that the initial market conditions identied at the analysis stage will continue unchanged as events unfold. It is from this point in the strategy process that a great deal of the feedback to previous steps occurs as new opportunities and threats arise. An overall view of the companys competitive position can be obtained by integrating the models and approaches developed. This requires the application of a battery of concepts and models as shown in Table 9.1 structured under the headings of the process model. Table 9.1: The process model synthesis

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To some extent it is a matter of discretion where a particular idea appears; for example, many accounting techniques are used for both internal analysis and evaluation and control, and competence is an internal factor which may also guide strategic choice. While this is a forbidding list it is actually not exhaustive as there are many concepts from other disciplines which could be applied to specic strategy issues but which are not included; a strategy analysis could, in principle, include every idea from the business disciplines, but it is up to the individual analyst to determine which ideas are relevant to the particular case and integrate them into a structure. It is clear from this display that it is only by the consistent application of a wide range of tools that a companys competitiveness can be properly assessed. It is the integration of the process model with analytical ideas and models which provides a structure within which competitiveness can be assessed in the wide sense. It will rarely be found that a company is perfect in terms of every single idea and model: the trick is to identify the areas in which a company is particularly strong or weak and which factors have contributed to its success or failure. This is not an easy thing to do and it is a typical misconception that success or failure can be attributed to a single factor. Perhaps the most demanding intellectual challenge of all is to apply the ideas to a company and identify the seeds of success or failure before either actually occurs. Strategy problems vary widely and not all models are applicable to all cases. One of the skills in strategic analysis is to identify which models and ideas are applicable to a particular case and to derive insights from these models. But the sheer variability of real life and the range of potentially applicable concepts mean that different analysts may focus on different aspects of the problem and, as a result, two valid analyses may produce different outcomes. This does not necessarily mean that partial analyses are wrong because, even if all models and concepts were applied, there is still the problem of attributing relative importance to each in arriving at conclusions. While the integrated approach in Table 9.1 provides a basis for evaluating overall competitive position, the individual ideas and concepts can be applied to a variety of Heriot-Watt University Strategic Management

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strategic issues including new product development and launch, investment appraisal, entering new markets, the rationale for takeovers, make versus buy and many others. Because all such issues typically have implications throughout the strategic process, the framework should always be kept in mind as a means of setting individual issues within the overall strategic context. Without going into a great deal of detail, the following outlines the sorts of question which continually need to be addressed when monitoring and evaluating strategy. Strategists and objectives Initially, objectives are set on the basis of a vision of the companys future which, in turn would have been derived from a view of how the company might grow. The appropriateness of these objectives is affected by the principal agent issue (where the shareholders might not have the same objectives as the CEO) and the characteristics of the chief decision makers in the company. Ongoing questions to ask include whether the perceived performance gap is being closed, whether the objectives are still consistent with current competitive conditions and perhaps whether the strategy selected is now seen to have been largely determined by the prospector qualities of the CEO rather than as the outcome of serious strategy appraisal. Analysis and diagnoses It is a mistake to treat the analysis and diagnosis stage as a once for all activity. The general environment must be continuously scanned for changes which are likely to affect the market and the type of competitive market within which the company operates can be subject to sudden change. The way in which value is produced by the internal operations of the company is not static because changes in cost structure are inevitable as the company moves up the experience curve, benets from economies of scale can emerge, new products are launched and investments are made in R&D. Bringing these internal and external factors together to assess the ongoing competitive position is a rst step which requires to be supplemented by a further set of questions relating to the stage in the product life cycle, the positioning of the portfolio, product differentiation and the identication of the companys strengths and weaknesses in relation to potential opportunities and threats; again, all of these are subject to change, often at short notice, and companies which appear to be unresponsive to changes in competitive conditions may be oblivious to what is actually happening. Choice While the main strategic choice will have been made in the past it is essential to question whether the choice is being pursued as originally intended and whether the choice is still appropriate. For example, the choice may have been to pursue a highly differentiated niche and grow by acquisition; the passage of time may reveal that the niche has been poorly dened, that the market is wider than anticipated and companies are competing mainly on the basis of price rather than quality, while the acquisition process has delivered higher productive capacity but with increased costs and poor company morale. It is the alignment of the chosen strategy with subsequent events which will greatly determine future success, but as time goes by the company may lack a mechanism for ensuring that the strategy does not drift. Implementation Is the organisational structure ideal from the viewpoint of company size, products, and

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geographical location? Are steps taken to ensure that functional silos do not develop? Is the management of change structured and guided by models such as the force eld and the cultural web? Are resources allocated according to rational criteria rather than being randomly allocated on the basis of an outmoded budgeting system? Control and feedback Again the issue of alignment arises: are company structure and resource allocation consistent with the strategy? Does the company have procedures in place which provide relevant information on competitive performance? Is company structure exible enough to respond to changes in competitive conditions?

9.5

Finally

Complexity is what makes strategic analysis such an intellectually demanding subject. But if you bear in mind that a structured approach coupled with the identication and application of relevant models is the key to strategic insight you will have learned the most important strategic lesson of all.

9.6
1 2

References

Goold, M. and Campbell, A. (1987) Strategies and Styles, Blackwell: Oxford.

Goold, M. and Campbell, A. (1990) Strategic Control: Milestones for Long-Term Performance, Hutchinson Business Books.

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Answers to questions and activities


1 Introduction to strategic management
Exercise 1.1 (page 3) You need to think of Madonna as a business enterprise rather than an individual performing on stage or screen. The overall objective of the Madonna business was to achieve stardom, and resources were mobilised to achieve this. It might be surmised that in order to compensate for her lack of relative advantage in the performing arts Madonna gathered highly competent personnel around her in terms of musicians, songwriters, dancers, producers and so on. The Madonna business understood marketing, in the sense that the images which she projected coincided with what her public wanted. But to do this she needed to have an understanding of her market, and her frequent changes of image probably reected changing market preferences. Prerequisites for the Madonna business to thrive for over two decades include sensible nancial controls and market based criteria for which investments to make, whether in road tours, books, lms or a new image. So it can be concluded that what she did particularly well was to exercise business skills rather than performing skills.

Exercise 1.2 (page 6) The interpretation of Madonnas success was just that: an interpretation and explanation. But while another singer who behaved in the same business fashion as Madonna might be successful, there are many other factors at work. These include the business ability of the singer, the effectiveness of the business team built up, the selection of the correct marketing approach in relation to the singers characteristics and the ability to adapt to changing preferences. Thus while behaving like Madonna may increase the chances of success for a particular singer, there is no guarantee that it will do so. In addition, relatively few singers (and this applies to the population generally) have the vision to conceive of themselves as a business and to apply business principles to what they do. So to a large extent most singers would not be able to act in the same way as Madonna even if it was pointed out to them that this was the route to success.

Exercise 1.3 (page 6) The details of the discussion are not so important as recognition of the fact that they will all approach the issue from different perspectives. For example CEO: turnover is not necessarily a good indicator of protability, and I need to ensure that protability from the three SBUs is as high as possible. The suggested system would give SBU managers the incentive to increase turnover at the expense of protability. Finance and accounting: it is a good idea because it means we have a simple rule to apply when deciding on remuneration.

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Human resources: the implication that one manager is three times more valuable than another can have a serious impact on motivation and cooperation among the SBUs. SBU3 manager: it is not equitable, because I work the same number of hours as the other two. SBU2 manager: the only reason we have SBU1 producing machinery at all is because of the gardening business we generate, so SBU1s sales really depend on ours. SBU1 manager: why is it that only Finance and Accounting are in favour of my idea? It stands to reason that the bigger your sales are the bigger your responsibility and that is what you should be paid for. This is your rst experience of the fact that all the members of the organisation regard issues from their own perspective and this leads to conicts; this is a subject which will come up again and again in the course and is a fundamental problem of management.

Exercise 1.4 (page 18) The CEO and the operations manager were advocating the strategic planning approach in which the company can be managed by applying analysis and logic to existing information. Their view of the world was that they had just not been good enough at doing this in the past. They were also committed to a resource based view, that protability could be improved by making the company more efcient in the technical sense. They were backed up in this by the nance director, who saw the issue in terms of efcient resource allocation. On the other hand, the marketing manager felt that the emergent approach would be more effective and that the company needed a greater degree of exibility. He felt that strategy could emerge as the company developed and as the environment changed and that it was pointless to plan for the unknowable. He was concerned with the dynamics of the market and felt that the way forward was to be continually proactive. The human resources manager could see that they were disagreeing not so much about the way the problem should be tackled, but about the fundamental approach to decision making generally. He was saying that there is some middle ground which could accommodate both approaches, but given the entrenched attitudes of the managers it is unlikely that they would arrive at a compromise on their own. One of the fundamental tasks of business education is to enable managers to understand what it is they are actually arguing about. In this case the prot problem was a symptom of a wider problem, i.e. the lack of a robust strategic process, which to some extent the CEO recognised.

Exercise 1.5 (page 26) 1. The reasons advanced by Mintzberg and others that prescriptive planning is impossible The points can be inserted into the process model as follows, bearing in mind that you can have different opinions on where each entry should occur.

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Setting objectives Formulation and everyday management CEO can choose and implement The idea that those responsible for setting objectives and deriving the strategy sit outside the process is clearly mistaken. By setting this issue within the process it becomes even more apparent how articial the notion of separation is. Analysis and diagnosis Prediction It is impossible to undertake strategic decision making without some form of prediction, but the analysis should be able to throw light on how accurate predictions are likely to be and the type of contingencies which will be necessary to insure against adverse but unpredictable outcomes. Strategy choice Short term costs and long term benet logical and applicable There will always be a trade off between the long and short run in making strategic choices. But given the importance of the choice element in the process, it is important that some rationality is imparted into choosing and implementing a course of action. Implementation Implementation is separate The implementation stage is an integral part of the process and is in fact the part of the process where most managers spend most of their time. Feedback Analysis leads to a prescribed course of action which need not be altered Once it is recognised that the environment can change, the dynamic aspect of strategy assumes equal importance to other considerations. 2. Emergent strategy This is entirely consistent with the process approach, and gives particular importance to the feedback element. The company constantly revisits its objectives, and does not regard a particular course of action as cast in stone. 3. The case study approach to strategic analysis The case study approach enables the process model to be applied, and the strengths and weaknesses of a particular companys process can be identied at a particular time. Application of the process model to a case enables a degree of generalisation by extracting those elements of the process which are common to different situations. The application of the process model to the management team conversation shows how the common elements of what appears to be a one-off situation can be extracted.

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2 Mission and objectives


Exercise 2.1 (page 30) 1. Set out the skill sets relevant to travel agents specialising in business and holidays. The business travel skill set includes the ability to put together customised plans with minimal travel time respond quickly with options as business plans change be precise in communicating alternatives where choices have to be made respond to general instructions The holiday travel skill set includes the ability to understand different holiday packages align family needs with package offerings minimise costs make suggestions based on vague preferences You can probably think of many more under each heading, but the important point is that the skill sets are different and there are likely to be differences in the personal attributes of the individuals most suited to each. Whether you think that it would be easy for the business travel agent to make the move depends on the t between the two lists you produced. The list above suggests that the skill sets are so different that the business travel agent would have to undergo a signicant amount of re-training. If this were not recognised then the business travel agent may well fail in the holiday business despite being successful previously. 2. The main skills for different security companies would be the following 1. Surveillance and combat skills 2. Computer application skills 3. Research and interviewing skills Clearly these are completely different types of skill, but without knowing the scope of the security company it is impossible to predict what they might be, although all three types of company are in the same industry.

Exercise 2.2 (page 31) When tackling this problem you have to try to identify clearly dened objectives which are measurable and attainable. For example, phrases such as best possible provide no real basis for action because people may think that they are already doing this; furthermore, it is necessary to provide some form of standard against which the best possible can be assessed. A revised statement might read like this

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To ensure that sick persons in the following categories enumerated do not have to wait more than 10 days for treatment; to ensure that the inrm (who are unable to leave their homes and care for themselves) have at least two days of nursing assistance per week; to spend resources on the education of 10 to 15 year olds on the principles of healthy living as a preventative measure; to divert resources wherever feasible from cure to prevention. This statement attempts to identify the target groups and provides the basis for measurable performance. It is still vague about the reallocation of resources, but it has to be recognised that some aspects of the mission statement can be no more than a statement of intent at this stage. Turning to your own statement, identify the parts of it which are non measureable ambiguous infeasible

Exercise 2.3 (page 31) The precise answer to this problem depends on individual interpretation, but it is important to communicate the different types of business involved by the denition of the objectives. 1. The marketing objective is to target decentralised companies and convince them of the integrity and efciency of the company; the emphasis is on the quality of the operation rather than the price. The operational objective is to develop systems which guarantee a high degree of security and tried and tested international communication networks. 2. The marketing objective is to advertise widely to bring in as many customers as possible and offer competitive rates, so long as the company does not incur a loss. The operational objective is to use whatever methods are available to deliver whatever turns up. Since the data carrying operation is highly specialised, it is pointless to advertise widely and the emphasis will probably be on a highly personalised individual process. On the other hand, the national carrier is in direct competition with others who are doing exactly the same thing and will nd it very difcult to establish a brand image and reputation.

Exercise 2.4 (page 35) The objective of increasing market share in ve different markets is unlikely to be achieved without incurring additional marketing expenses and probably reducing prices. Thus the strategic and nancial objectives are not compatible in the short term. These objectives are more of a statement of the position the company would like to be in than a statement of operational priorities. Since the strategic and nancial objectives are Heriot-Watt University Strategic Management

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not aligned in the time frame specied it is difcult to see that the impact on company performance will be signicantly positive. The statement of objectives may in fact lead to conicts between nance and marketing which are counter-productive.

Exercise 2.5 (page 38) You will nd that the issues facing general managers are similar to those discussed at Chapter 1 Section 1.7 regarding the role of the CEO. 1. map out the roles of general management Objective setting. This stage of the process relies upon the skills of the manager as strategist, entrepreneur and goal setter. Even in large companies these functions are not the sole domain of the chief executive and some aspects are typically devolved to managers. While managers are to some extent constrained by existing plans and commitments, they have a role to play in making decisions about potential investments, reacting to changing circumstances, identifying new courses of action and so on. The objectives set will be a function of the outlook of the strategists: prospector, analyser and so on. Analysis. In order to ensure that the company is competitive the manager needs to be constantly aware of changes in the economic environment, the efciency of the rm, and its competitive position. The process of information collection and analysis is time consuming, and it is necessary for managers to lter out what is unimportant and focus on factors which are likely to impact signicantly on the rm. Managers are typically keenly aware that time spent on analysing is at the expense of more immediate concerns and this role tends to be given a low priority because of its lack of immediate pay-off. Choice. It is rare that major strategy decisions are taken without wide managerial consultation. Options must be identied and different points of view brought to bear in order to assess the costs and benets associated with each. At times the manager will be involved in higher level strategy assessment and at others he will be making devolved strategy type decisions at his own level. Implemention, control and feedback. Once decisions have been taken, the manager has a major role to play in making them happen. This involves allocating resources in the rst instance. Organising resources is typically thought of as being the major role a manager has to perform, but in fact it is only one of several and it may not consume most time. As well as allocating resources, the manager has to monitor how effectively the resources are being utilised; this means that systems must be set up which adequately measure performance. It is also necessary to ensure that communications are such that changes in the environment and the internal operation of the company are incorporated into the dynamic decision making process. 2. identify conicts in the role. The problem of management does not end with complexity and competing demands on the managers time and intellectual resources. There is also a degree of conict inherent in the different roles. For example, the manager needs to set up systems which ensure that resources are used efciently; but these very systems may introduce inexibility and resistance to the changes which the manager sees Heriot-Watt University Strategic Management

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are necessary in his role as competitor. The objectives and mission of the rm may be expressed in general and non-measurable terms, while the control systems tend to be based on nancial measurements; the two approaches may be difcult to reconcile. Thus as well as being charged with the task of resolving conicts of interest in the rm, the manager must also deal with the internal conicts caused by the roles which he is required to adopt.

Exercise 2.6 (page 39) The following observations on the general strategic approach of the three kinds of organisation are by no means denitive; the important issue is that you are able to identify the basis of different approaches at each stage of the process dependent on the broad characteristics of the companies Objectives Small Integrated Diversied Informal and probably not communicated by owner Specic to the product Expressed in terms of mission and disaggregated to SBUs, products and functions

Analysis Small Integrated Non-systematic and probably based largely on intuition Detailed analysis of known markets, but without the application of sophisticated techniques Continuous environmental scanning, construction of scenarios and investigation of competencies

Diversied

Choice Small Integrated Diversied Reactive Proactive and focused Complex, with differences between corporate concerns and SBU concerns

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Implementation and Control Small Integrated Haphazard and dependent on the disposition of the owner Focused on production of the product and subject to informal or formal nancial controls Divisionalised, and supported by a battery of nancial and strategic controls

Diversied Feedback Small Integrated Diversied

No real distinction because of multiple roles Dependent on the willingness of managers to adapt to new information May be seen as a threat to the status quo

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3 Analysing the macro environment


Exercise 3.1 (page 44) Revenue and GNP elasticity GNP elasticity 0.0 1.5 1.5 Total market 1000 1075 1075 Market share 15 15 16 Total sales 150 161 172 7.5 14.7 % change

Using the 1.5 estimate of GNP elasticity, it could be predicted that sales would be 7.5 per cent higher than if the elasticity were assumed to be zero; this is a signicant quantity and to ignore it could have serious consequences; for example, if the company were already producing at full capacity, it would not be able to meet the additional demand. While total sales would not be affected market share would necessarily fall. The opportunity which presents itself is to grab a slightly larger market share in the growing market, and in this case a 1 per cent increase in market share to 16 per cent results in a 14.7 per cent growth in sales. When the economy starts to grow strongly, an effective marketing strategy response would be to concentrate resources on those products with a relatively high GNP elasticity.

Exercise 3.2 (page 45) The effect would be to increase total cost by 25 per cent, as shown below.

If the 10 per cent increase in sales does not lead to an increase in revenue of 25 per cent or more, the impact of the change in economic conditions will be to worsen net cash ow.

Exercise 3.3 (page 46) 1. The impact of the combined changes would be a total fall in revenues by 46 per cent of the revenues in period 1; in other words, the company is now faced with revenues about half of that two years before. Market Total Total % change Period Price share (%) market revenue 3 90 15 8 108 -46

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of the company, there is little that can be done in the short term to increase total revenue. For example, if the price were reduced in an attempt to increase market share the resulting revenue might well be lower still. The only response which can be made in the short run is to operate on the cost base. This would involve scaling down the use of resources in line with demand and searching for efciency measures which could reduce costs. In the long run the objective would be to recover at least some of the market share lost so that, if the economy improves, the company will benet.

Exercise 3.4 (page 50) The reation would have affected potential revenue as follows. Year 9 10 11 Exchange rate 0.62 0.53 0.57 Revenue in (million) 3.1 2.7 2.8

It is clearly difcult to plan ahead in such an unstable economic environment. However, a company which incorporated potential exchange rate movements in its planning would have had some idea whether this type of uctuation was potentially disastrous and have developed a contingency plan to activate in the event of a reation of the magnitude which occurred between Year 9 and Year 10.

Exercise 3.5 (page 53) Using Porters framework, the following factors can be identied, although you might not agree with the interpretation. Factor conditions: there is a plentiful supply of educated and productive labour in Silicon Valley Related and supporting industries: all types of computer related industries are to be found in Silicon Valley Demand conditions: consumers are unlikely to be more sophisticated in the US, as computer literacy is pretty universal in industrialised countries Strategy, structure and rivalry: a production unit based in the US would be at least able to react quickly to changes in competitive conditions. The great unknown is what will happen to exchange rates and it could be that, if the dollar were to strengthen against the Euro, relative production costs would be much lower in France; this could compensate for the advantages of locating in the US.

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Exercise 3.6 (page 56) If the CEO thinks it is half way towards the peak he will probably be in favour of the investment. But if he believes that the economy has reached the peak and is ready to fall back into recession he may well conclude that this is the wrong time to invest. If managers are not explicit about their expectations then such decisions will be taken by default. Naturally enough, managers feel confused about what is likely to happen next because of the many views expressed by economists and politicians; but the question can still be posed: is this a sensible course of action given our particular expectation of what is going to happen to GNP in the next two years?

Exercise 3.7 (page 61) 1. Draw up a PEST analysis using the limited information available. Political The US government is clearly intent on introducing as much competition as possible into the telecoms market by deregulation. But if monopolies start to appear it is quite possible that anti-trust legislation might be introduced. Economic Competition is increasing from both small and large suppliers. The Baby Bells might be more competitively agile than the giant semimonopolies. While the demand for telecoms services is increasing, the price is falling leading to static revenues. There are signicant barriers to entry because of the need to build infrastructure. Social Telephony is becoming an accepted part of life and the overall market is set to increase signicantly as consumers, both business and social, become telephone literate. Technological The Baby Bells control the technology which provides access to local markets, but there may be alternatives. The internet could be an important future base for many telephony services. 2. What would you be looking for when conducting environmental scanning? The environmental scan would extend beyond the boundaries of America and would be particularly concerned with the future of technology. For example, since the American market has been deregulated, are there other major international suppliers who might potentially enter the market? On the technological front, questions such as the impact of satellite links and possible advances in computer technology which might radically alter internet capacity need to be considered. 3. Derive two scenarios for the future of WorldCom after the take over of MCI. Heriot-Watt University Strategic Management

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The scenarios are speculative, but need to focus on what are considered to be important variables. For example: WorldCom might be totally excluded from the Baby Bell interconnection system and may have to invest billions of dollars to make the system operational. The demand for long distance calls might continue to increase but the price may fall by an even greater amount: potential protability under these circumstances needs to be investigated. AT & T might enter the market in a big way: what will this do to potential prices and market shares? Each of these scenarios provides the basis for extensive investigation to provide some notion of the risks confronting the company. One scenario that would not have been imagined in the late 1990s was that the CEO, Bernie Ebbers, had built WorldCom on extremely shaky nancial foundations and was eventually convicted for securities fraud, conspiracy and ling false documents with regulators. Often the future lies beyond imagination.

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4 Analysing the market environment


Exercise 4.1 (page 71) 1. In the short term the supply of vessels is almost xed because of the time it takes to build new ones. This results in an almost vertical supply curve and is the key to explaining why there are such large short term variations in vessel prices. The situation is summarised in the gure.

We can now track what happens from the time there is a sudden increase in demand which has the effect of shifting the demand curve to the right. The shift to the right of the demand curve in period 2 is not associated with an immediate large proportionate increase in supply and the price rises to P2. By the later time period 3, shipyards have reacted to the higher price and increased the stock of vessels. This has the effect of reducing the price to P3. In period 4 the demand falls back to its original level, and since the supply is now higher than in the rst time period, this has the effect of causing the price to fall to P4. A rudimentary knowledge of supply, demand and price determination predicts exactly what happens in the shipping business and also reveals that price uctuations are likely to be a permanent feature of the shipping market. This is an example of what is known as the cobweb theory in economics. 2. There are several strategic implications If a manager is convinced that the demand for shipping services is likely to increase, he should buy vessels now because the price is bound to increase by a large amount when the demand makes itself felt. Conversely, if prices start falling there is a good chance that they will go into freefall and this is therefore the time to dispose of any unwanted assets.

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Because of the interaction of supply and demand prices in the shipping business are always going to uctuate and there is no point in waiting for a period of stability. Bear in mind that even if managers learn how to react in this environment the cyclical behaviour of the market will still continue. 3. Any factor which alters the position of the industry demand or supply curves will have an impact on market prices. The extent of this impact depends on the shape of the demand and supply curves. In the shipping industry the effects are large because of the inelastic supply curve. If the supply curve had been elastic the impact on prices would have been much less. The analysis was not expressed in terms of actual prices, nor was there any attempt to be accurate. This is because demand and supply analysis uses the concept of equilibrium price which does not exist in real life because transactions are taking place all the time around the equilibrium point; all buyers and sellers would have to have complete information about each other for all transactions to take place at the equilibrium point and that is clearly impossible. However, the analysis does enable us to make predictions about the direction and rough magnitude of change, taking account of what is known about the slopes of the demand and supply curves, We can then base our actions on the knowledge that, in the absence of other changes, this is how things will generally work out. More detailed information would not have told us much more about the relative demand and supply elasticities.

Exercise 4.2 (page 73) The rst step is to identify the structural and the strategic barriers. Structural Capital requirements: expenditure can be controlled because the market can be entered incrementally by building one store at a time. In any case, as a global player, WalMart has huge nancial resources. Sunk costs: it may be possible to sell supermarkets together with their goodwill to the incumbents in the event of failure. Size of the market: consumer expenditure is growing in the UK; however, there is a possibility that some local markets might become saturated. Tacit agreement: the incumbents who currently share the market have had little incentive to reduce prices up to now; it may be that they will react quite strongly to the WalMart threat. Economies of scale: WalMart depends on its world wide operations to generate scale economies. By building supermarkets on an even larger scale than the incumbents they should not be at a disadvantage. Experience effect: WalMart can draw on the experience gained in the US to drive costs down. Strategic Reputation: the act of shopping itself is not differentiated; unless the incumbents Heriot-Watt University Strategic Management

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can offer a shopping experience which is superior to WalMart, it is difcult to see that the name of the store can make much difference. Pricing: if the consumer groups are right then WalMart might be faced with signicant price reductions by the incumbents, making it that much more difcult to attract shoppers. But this depends on whether competition really has been absent from the market. Access to distribution channels: this is one of WalMarts strengths and is one of the main reasons for entering the market in the rst place. Assessment According to this analysis there were in fact no real barriers, either structural or strategic, which would stop WalMart entering the UK market. However, the analysis could be carried out differently with emphasis being placed on certain aspects: Sunk costs: the incumbents may prefer to watch an entrant fail and then attract the mobile consumers rather than enter a price war. Consequently, sunk costs may be relatively high. Size of the market: the major retailers have in fact been increasing capacity faster than the growth in the market. Therefore there is really no room for an entrant. Reputation: the major retailers have already been differentiating by offering nancial services and attempting to align themselves with local communities. The reputation barrier may be much greater than WalMart thinks. Thus the strategic decision cannot be classied as either right or wrong on the basis of the available information.

Exercise 4.3 (page 78) When there were many small stores serving local markets it could be argued that many of the conditions for perfect competition existed. However, it could also be argued that each of the small stores served its own local monopoly and in fact had a good deal of market power. This monopoly power was not based on scale economies but on the fact that consumers were not highly mobile. Later the larger self service supermarkets led to the decline of the small shopkeeper and at this point the stores tried to compete by differentiating their shops and services mainly by stocking a very large number of lines. This was a form of imperfect competition, where real economies of scale had not been exploited. Then came the mega stores and the relatively few retail chains now constitute an oligopoly. In the modern car owning society it is quite possible for consumers to switch from one to the other and there is a marked reluctance to engage in a price war.

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Exercise 4.4 (page 82) The answer to this difcult question depends on how much information is available, and you may have gathered more information than is contained in the case by reading the business press. Thus the following comments are not denitive but are intended to show how the ideas can provide a particular perspective on the issue. Prisoners dilemma: the incumbent retail chains have often been accused of colluding to keep prices high. The dilemma suggests that such an agreement would be difcult to arrive at and that it would be unlikely to have remained in place for a long time. Price leadership: it is possible that price leadership may occur once WalMart becomes established. However, this is dependent on its gaining a dominant market share and that is by no means inevitable. Limit pricing: the incumbents probably cannot use limit pricing because it is well known that WalMart has a lower cost structure. Predatory pricing: WalMart has always had a policy of low prices and no instance has been discovered of WalMart using temporary price cuts to put competitors out of business. Contestable markets: there is a slight logical problem here, in that if all markets were contestable there is no incentive for entry because prices have already been set at the level which makes entry uneconomic. The only reason that the incumbents might have had for setting prices higher than the contestable level is that they did not consider the market to be contestable because of the high sunk costs.

Exercise 4.5 (page 91) Segmentation The segment of the market which Marlboro was aimed at was the status conscious smoker who was happy to pay a premium price for being associated with the brand. There was an association with free outdoor living, which related to the American ideal. The key segmentation variables were packaging, tobacco quality and advertising. A segmentation matrix relating to the period before the premium cigarettes entered the market would have revealed something like the following, using price and quality as the segmentation variables. High Price Low Low x High Quality x x

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There was a gap in the Low/Low category and this was subsequently lled by the premium suppliers. Quality Marlboro seemed to rely on the notion of user based quality, but given the characteristics of a cigarette it is difcult to see how the dimensions of quality could be used to maintain sales when discounted cigarettes became available at one third of the price. While the discount cigarettes were perhaps inferior in quality in terms of the tobacco used, it is unlikely that this difference was a factor of three to one. In any case, the notion of quality for cigarettes had come under attack from the anti smoking lobby where the quality of all cigarettes was exposed to criticism because of the associated health hazard. Perceived price and differentiation Marlboro was moving in the perceived price differentiation matrix towards the failure likely region. Pricing in segments The original rationale for charging a high price in the segment was that the demand was relatively inelastic because of the strength of the brand. However, this was changing and the relatively high price could have been one of the reasons why Marlboro had been losing market share.

Exercise 4.6 (page 97) The Marlboro cowboy had been around for over three decades and it is possible that the brand was reaching the decline stage in the product life cycle. This has to be distinguished from the fact that the cigarette market itself in the US had entered the decline stage: you can probably think of other products which have undergone a facelift by an advertising campaign while the product characteristics remained unchanged.

Exercise 4.7 (page 104) It is necessary to disentangle the relevant information from the advertisement and the discussions. 1. StylePlane: It is on the mature to decline stage of the life cycle and has the dominant market share at about 80 per cent. This places it securely in the Cash Cow sector. This is corroborated by the fact that it is the product which is making prots and nancing the development of the PowerPlane. PowerPlane: It is on the growth part of the cycle but is unlikely to be the largest in the market. This makes it somewhere between a Question Mark and a Star. The fact that it is losing money and is building up inventories corroborates this. 2. Barriers to entry StylePlane has established a strategic barrier by its reputation and can Heriot-Watt University Strategic Management

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therefore charge a premium price. There are no barriers to the PowerPlane market and in fact Super- Tools themselves are a market entrant. Monopoly StylePlane has monopolistic power and is not in a contestable market. PowerPlane is in a highly competitive market and is not a dominant player; there are some features of perfect competition which are driving down prots. Pricing StylePlane competition is a zero sum game because the market is static or declining. PowerPlane is priced below competition, and this is unlikely to be an attempt at predatory or limit pricing, but is probably intended to help increase market share in a growing market. Segments The two products are in different market segments and they are not competing against each other. The CEO does not see this and is concerned that the products are competing against each other. This highlights the importance of dening the market in which the company is competing. Perceived price differentiation model The StylePlane is already in the high price high quality part of the matrix; it is not clear whether the type of cosmetic improvement discussed will move it signicantly. The PowerPlane is not differentiated, but is priced lower than other makes; it is probably located in the success uncertain area. 3. In BCG corporate terms the portfolio is unbalanced because it is comprised of a declining cash cow and an uncertain star. There is some room for discussion on the corporate growth vector; at rst sight it is an existing product into an existing market, but in fact the PowerPlane is a new product using completely different workforce and technology and the market it is entering is new to the company. This actually places it in the diversication quadrant. Part of the companys problem is that the CEO has failed to recognise that it has moved into an unrelated diversication. If the company followed the CEOs joke about powered sanders, the growth vector would be even more focused on new products and markets.

Exercise 4.8 (page 106) The two obvious axes are the degree of technology embedded in the product and the skill required to use it. The StylePlane would be plotted as low technology and high skill Heriot-Watt University Strategic Management

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and the PowerPlane as high technology and low skill. From this perspective the two products are in two quite different strategic groups with different competitive inuences. Another possible axis relates to the type of end use: professional cabinet making for the StylePlane and home DIY for the PowerPlane. However, the skill variable can be regarded as a proxy for the type of end use and changing the axis would not alter the relative positions much. It is virtually impossible to think of axes which would result in the two products being classied in the same strategic group.

Exercise 4.9 (page 113) The model is applied to the two products individually because they are in different segments of the market for tools. Threat of entrants Threat of substitutes Power of suppliers Power of buyers Rivalry StylePlane Low: monopoly power Low: unique High: skilled labour Low: specialised market Low: virtual monopoly PowerPlane High: homogeneous product High: technological change Low: uses standard parts and unskilled labour High: switching costs low High: many competitors

The two products are a mirror image in terms of the classication. It emerges quite clearly that the competitive conditions facing the two products are quite different and that the Powerplane will need a different marketing approach.

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Exercise 4.10 (page 114)

The rank order of threats and opportunities depends on how important the various factors are considered to be. For example, while the market for PowerPlane is growing, the ve forces analysis reveals that it is faced with serious threats.

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5 Analysing resources and strategic capability


Exercise 5.1 (page 123) 1. The aggregate ratios are as follows Ratio Return on total assets Return on equity Return on investment Year 1 % 8 11 11 Year 2 % 15 28 16

There seems little doubt that company performance has improved signicantly between the two years. This is primarily due to the fact that the operating surplus increased from 1.3 million to 3.8 million, an increase of about three times, while the value of assets increased by only two thirds. The reason that ROE and ROI were equal in Year 1 was that the values of owners equity and xed investment were approximately equal; by Year 2 xed assets had almost doubled, while owners equity had remained almost unchanged, leading to the very large increase in ROE. This arose from the fact that the increase in xed assets had been nanced almost entirely by loans, as can be seen from the increase in long term debt from 2 million to 12 million. The net cash ow position has improved greatly, from a net outgoing of 1.8 million to a net inow of 2.2 million. The fact that the net cash ow in Year 2 is 1.6 million less than the operating surplus needs to be explained; it is obvious that a major part of the difference is that the company now has a very large long term loan commitment of 1.3 million per year. This in fact raises the question of whether operating surplus is the appropriate measure of protability for this company. Substituting net cash ow for operating surplus in Year 2 gives the following result. Operating surplus Ratio Net cash ow Year 1 % Return on total assets Return on equity Return on investment 8 11 11 Year 2 % 15 28 16 Year 2 % 9 17 10

Using net cash ow for Year 2 reveals that both ROTA and ROI were virtually unchanged between the two years. This demonstrates how accounting conventions can greatly affect measured performance and raises doubts as to whether the underlying protability of the company has actually been increased. 2. The companys cost structure itself changed between the two years:

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Percentage of total cost

Year 1 %

Year 2 % 29 28

Wages Production lines

33 22

These ratios reveal that the company has become more capital intensive, to be expected as a result of the large investments in equipment made during the period. But whether this cost structure is actually more efcient would require more detailed gures on unit costs. The impact of the investment programme on protability is uncertain, given the doubts raised above on the appropriate measure of prot. In fact, sales revenue increased from 8.1 million to 11.5 million between the two years and it is difcult to see what effect an internal reorganisation of capital and labour inputs could make to the value of nal sales - this is more likely to be related to general demand for the companys product, marketing expenditure and pricing. The real issue, then, is what would have happened to protability if sales had increased by that amount and no investment programme had been undertaken. One answer to this can be obtained by simply grossing up the cost of goods sold in Year 1 by the increase in sales revenue: 4.8 million 11.5/8.1 = 6.8 million The actual cost of goods sold was 5.4 million, so one way of looking at the return on the investment of 11 million (the difference between the Fixed Assets between the two years) is that it resulted in a cost reduction of 1.4 million. This gives an ROI of 13 per cent, which suggests that the investment was worthwhile. It needs to be stressed that the information available cannot provide a denitive answer to these questions. It may be possible to arrive at different conclusions by conducting the analysis in a different way. The important issue is not to take the numbers at their face value but to try to interpret them in a variety of ways. 3. The company appears to be in a growing market and it has taken steps to rationalise and modernise its productive processes. It has reduced its costs in the sense that COGS is 1.4 million less than it otherwise would have been so it should be in a position to compete effectively with other efcient producers in the future. While there are some concerns about what has really happened to protability between the two years, it is open to question whether the company would have been able to accommodate signicant increases in demand with its Year 1 capital structure.

Exercise 5.2 (page 125) 1. The ratio of debt to owners equity has increased from 34 per cent to 89 per cent. 2. The gearing ratio is still less than 100 per cent, and the debt interest payments are currently about one third of operating surplus. Would nancial institutions be willing to lend more? This largely depends on whether protability is now regarded as stable and the fact that sales revenue grew by about 40 per cent between Year 1 and Year 2 suggests that the market is not stable - a great deal depends on whether the increase in sales is regarded as temporary. As the perceived risk Heriot-Watt University Strategic Management

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associated with SuperTools is now much higher than in Year 1, it is likely that banks would require a higher return to reect this. If SuperTools had nanced the original investment by equity issue it would perhaps now be in a stronger position to consider further expansion.

Exercise 5.3 (page 127) 1. The calculation itself is quite simple being based on the formula Fixed Cost divided by Contribution per unit, generating the break even numbers below. NozzleGlue BlueGlue Price ($) Unit cost ($) Contribution ($) Fixed cost ($) Break even (units) Market share (%) 10 5 5 200000 40000 10 7 4 3 180000 60000 15

2. The break even calculation demonstrates that both possibilities depend upon capturing a signicant market share in a highly competitive market. It is necessary to decide whether 15 per cent market share for a non-differentiated product is feasible, or whether the company should opt for the more conservative 10 per cent, where the higher price is partly balanced by the higher quality. It is therefore necessary to be explicit about the price to quality trade off and this can be tackled using the perceived price and differentiation matrix. Using information on competing products both can be positioned and assessed whether they are likely to lie within the success or failure areas. The model provides additional insight on whether the required market shares of 10 per cent and 15 per cent are feasible.

Exercise 5.4 (page 128) 1. The calculation is set out below. NozzleGlue Market size ($) Market share (%) Contribution ($) Annual revenue ($) (multiply above three together) Investment cost ($) Payback (divide investment cost by annual revenue) 400000 10 5 200000 1000000 5 years BlueGlue 400000 15 3 180000 810000 4.5 years

2. The calculation makes a number of assumptions, for example that the market share requirement of the break even analysis would be achieved, that the market Heriot-Watt University Strategic Management

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would remain at about the same level for several years and that the selling price and costs would be unchanged. Given the length of time to payback in both cases it is unlikely that these assumptions would be valid in four or ve years time. The fact that the payback period for the BlueGlue is six months less than that for the NozzleGlue is probably not signicant given the time scales involved. What the payback analysis shows is that both products are exposed to a relatively high degree of risk.

Exercise 5.5 (page 129) 1. The calculation assumes that you are familiar with the concept of NPV and how to work it out. BlueGlue NozzleGlue 10 years of annual net revenue Sum of 10 years discounted (Present Value)@15% Investment Net Present Value (Present Value minus Investment) 2. The break even analysis showed the market share required for the products to recover their investment cost, while the payback calculation showed that the NozzleGlue was more risky because of the longer payback period. The NPV calculation shows that the BlueGlue is a better investment in the formal sense and backs up the ndings of the payback analysis. This is another item of information in favour of the BlueGlue; however, it is dependent on the basic assumptions on market shares and costs; if these are wrong the calculation is meaningless. $180000 $903378 $81000 $93378 $20000 $1003754 $1000000 $3754

Exercise 5.6 (page 131) 1. There are a number of risk factors associated with any product launch, for example the assumption that both products would capture a signicant market share after launch; it is questionable whether the high quality product would in fact be more appealing to potential customers. While the potential market share is a matter of conjecture the company does have some control over costs and it is useful to examine what might happen to the risk prole if costs were reduced by a reasonable amount, say by 10 per cent. The scenario derived from the payback calculation is as follows.

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After reducing the unit cost by 10 per cent in each case the scenario is

The impact of a relatively small reduction in costs on cash ows is quite marked, with the pay back period for the BlueGlue being reduced to less than four years. Since the payback period is quite sensitive to relatively small reductions in unit costs the company should consider what determines cost in more detail. 2. It is up to you to carry out sensitivities on the impact of different market shares. You have to decide what variations in market share are likely; for example should the sensitivity consider plus or minus 1 per cent, or plus and minus 5 per cent? If you nd that the NPV becomes negative for both products with only a 1 per cent smaller market share, this will suggest that attention should be focused on the market side as well as on costs. However, if you nd that the break even, payback and NPV are relatively unaffected by such small variations, then you can recommend focusing on the cost side. There are no unambiguous answers to this issue because it is an attempt to look into the future, but it is important to be aware of the possibilities.

Exercise 5.7 (page 132) While the culture classications are meant to reect organisations, it is instructive to classify each manager. You might, of course, arrive at different conclusions to the following.

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Manager Accountant Production Human resource CEO Marketing

Culture role role role power or personal task

This classication throws the predicament of the Marketing manager into sharp relief. He is faced with a CEO who exhibits either a power or personal cultural trait which leads to unpredictable responses based either on a lack of analysis or lack of focus. At the same time his three colleagues are dominated by their role and tend to be slow to react to competitive challenges and are resistant to change.

Exercise 5.8 (page 133) A major outcome of the benchmarking approach is that it may reveal things about the company about which it is ignorant and provide some insight into what comprises best practice. For example, a company simply may not know that distribution systems used by retailers can be adapted efciently to a manufacturing setting. But a note of warning is necessary: measurable dimensions of company performance are unlikely to reveal how competitive advantage is achieved, otherwise the characteristics would already have been imitated. It is how performance is achieved, rather than the fact that it is being achieved, which is difcult to identify and is something which competitors are unlikely to divulge.

Exercise 5.9 (page 136) If there are signicant experience effects to be exploited, the company has a limited time to take advantage of them because of the reducing percentage effect as cumulative output is increased. If there are also signicant economies of scale in the industry, the company which is rst in and is bigger than competitors has the potential for an early cost advantage. A company which feels it has a cost advantage over rivals should attempt to identify where the advantage is derived. If it is from experience effects, the advantage can be expected to decline over time; if it is from economies of scale the advantage will be retained so long as competing companies do not increase in size.

Exercise 5.10 (page 137) It is in fact extremely difcult to determine whether economies of scope are being realised because to do so the company would need to know what production costs would be if the products were produced separately. Because many costs are shared, an accurate picture of existing costs cannot be produced through the need to allocate costs on an arbitrary basis. Some of the issues which need to be identied are Heriot-Watt University Strategic Management

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how can potential economies of scope be recognised? how can the costs and benets of economies of scope be measured? what are the limits to economies of scope, i.e. where does relatedness end? should the company focus on increasing market share in existing markets (to benet from scale economies) or on increasing the portfolio of products (to benet from scope economies)? These issues are intended to stimulate further consideration on this issue; no doubt you can come up with additional suggestions.

Exercise 5.11 (page 138) Corporate management There may be possibilities for individual SBUs to share common indivisible resources and to eliminate excess capacity. However, this is not a case of 2+2=5, but simply making the optimum use of capacity. This benet is more properly related to production management. A different corporate management issue is that similarity among SBUs may make them more amenable to management than a series of SBUs in unconnected markets. This begs the question of what is meant by similar. An SBU which has recently been added to the company may produce similar products, but may have inherited a management structure and ethos which is totally alien to the corporation. Synergy at the corporate level may be identiable after the event, but whether the addition of any given SBU to an existing company would generate a positive synergistic impact is impossible to predict. Economies of scale While synergy is different from economies of scale, it is possible that some dimensions of scale economies can be captured by diversication into similar products. This is related to the notion that there is a carry over from experience in similar production and selling environments; operating in a series of similar markets has elements of doing more of the same thing which is the notion underlying both economies of scale and experience effects. This argument is not very compelling to the economist whose rigorous denition of economies of scale takes into account the optimum deployment of labour and capital. The mere fact of expanding some functions is no guarantee that scale economies will result. Vertical integration The potential for economies is discussed at 5.11.4. These economies are related to capacity utilisation, transport costs and so on. They are usually related to more efcient use of resources and do not really accord with the notion of 2 + 2 = 5. Capacity utilisation A company may have concealed excess capacity, in the sense that its labour force could undertake additional tasks without signicant increases in wages or numbers employed, factory space may not be fully utilised, and so on. This potential benet resembles that of similar SBUs making use of each others spare capacity from time to time. Heriot-Watt University Strategic Management

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Joint production Many inputs are shared among different products; management itself is shared at the corporate level. For example, take the case of two sheep farmers, one of whom produced only wool and the other produced only meat. If they were to merge their operations there would obviously be scope for sheep producing both wool and meat. There are likely to be many instances of much more subtle benets from joint production in modern companies. Innovative stimulus The mere fact of incorporating another area of activity may spark off new ideas and approaches. While this is an undoubted possibility, it is unlikely to be predictable. Even a rudimentary examination of the sources of synergy throws up an important point: while synergy may exist it is unlikely to be predictable. From the strategy viewpoint there is no basis on which to conclude that a particular course of action would lead to a predictable reduction in costs due to synergy. It is likely that synergy is the outcome of complex interaction effects and linkages specic to individual companies, with the contributing factors varying from case to case.

Exercise 5.12 (page 139) Taking the four arguments in favour of diversication in turn: Risk minimisation: the risk prole of the six divisions is certainly different; for example travel and tourism and nancial services are affected by different variables. However, it is difcult to conclude that the business portfolio was put together on the basis of a risk analysis; it is more likely to have been constructed on the basis of identiable business opportunities. Synergy and economies of scope: it could be argued that all six divisions are directed towards consumer services and as such are generally related. There are certainly linkages between retail and cinema and media and entertainment; however, the linkage between these and nancial services is less certain. Parenting: the role of the centre in adding value to these diverse activities is not obvious. Dominant management logic: Richard Branson is one of the most well known businessmen in the world, and brings his own logic of dynamism, enthusiasm and high prole to everything he touches. But whether this particular management approach is the most appropriate for all 27 companies is impossible to say. Reputation: Branson initiated the Virgin brand in the music business and successfully transferred it to air travel. Whether the extension to nancial services is due to the contribution of the brand name, rather than the innovative genius of Branson himself, is a matter of conjecture.

Exercise 5.13 (page 142) 1. First of all, it is necessary to decide which business British Gas sees itself as being in. If its business is as supplier to nal consumers it can purchase gas from any Heriot-Watt University Strategic Management

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source and distribute it. This means it could concentrate on distribution and let other companies explore and set up pipeline systems. If it denes its business as exploration it could focus on nding new elds and selling the production rights. If the analysis was correct the break up value was about 25 per cent greater than the corporate value. In this case the market clearly did not think that the benets of vertical integration were being realised. While it is not possible to derive specic conclusions from the data, the following problems are likely to arise. A mismatch in the optimal scale of production between stages of production. While it may be possible to link the capacity of pipelines and distribution, the exploration stage is likely to generate unpredictable capacity. It is highly unlikely that just enough reserves would be discovered to satisfy current demand. Business at different stages can be radically different and present different strategic problems. The management of exploration is different, to say the least, from the problems of marketing gas to nal consumers. In between there are also different problems involving efcient production and distribution. If the company is constrained by its own supply it will not be able to act quickly and exibly in response to changes in the market. Unless the company conducted exploration in anticipation of increases in demand it would certainly be constrained by its own reserves. If it were constrained it would have to go on the open market to purchase supplies and this throws into doubt the rationale for undertaking exploration on its own account in the rst place. The risk inherent at each stage ceases to be independent and risks which affect one stage will have an effect on other stages of production. Exploration is an extremely expensive business, as is the maintenance of unused reserves. Rather than take the risk of satisfying future (unproved) demand the company may well be better to concentrate on the distribution and marketing of gas which it purchases from suppliers. 2. It is possible to set up arguments based on British Gas concentrating on exploration and selling its reserves on the open market to purchasers. The reason that the break up value of British Gas was greater than the corporate value does not rest on the fact that any one part of the vertical chain is necessarily unprotable but that the vertical chain itself does not make economic sense.

Exercise 5.14 (page 146) The foundations of Marks & Spencers original success lay in a strong value chain. Taking the primary functions rst. In-bound logistics: M & S had a set of strong relationships with suppliers which it used to its advantage. Operations: M & S was very efcient at the process of retailing. Heriot-Watt University Strategic Management

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Out-bound logistics: M & S was perceived as providing a high level of service. Marketing and sales: M & S was very good at satisfying local demand conditions. Service: with its no questions asked policy on returns, for example, it was perceived as caring about customers. The support activities were considered by many to be the real foundation for success: Procurement: M & S seemed to have the knack of stocking exactly what people wanted to buy. Technological development: applications of IT. the company was at the forefront of modern

Human resource management: M & S was regarded as being a top class employer offering excellent careers for its employees. Management systems: the stores were regarded as being among the best run in the world. The linkages which had been established between the primary and support activities were very difcult to imitate and together they enabled Marks & Spencer to position itself as a highly differentiated retailer. The problems which arose can be located primarily within the support aspects of the value chain. Procurement: the unsold stocks suggest that the company had lost its ability to match its purchases with consumer demand. Human resource management: the boardroom battles and the subsequent sacking of middle managers suggest that for some time its policies had been less than optimal. At the primary activities level the main failure was in the marketing function. While the individual managers had been good at responding to local demand conditions, they could only do so as long as the centralised stocks available to them were generally aligned with taste and fashion. Once this link had been lost it was impossible for local managers to market effectively. Many of the elements of the primary components of the value chain continued to be effective but the crucial links between primary and support activities were broken. Because Marks and Spencer did not understand its own value chain it allowed its nonimitable competitive advantage to disappear. The main value system linkage was between the company and its British suppliers which generated the reputation for quality. When it switched to foreign suppliers it became part of the same value system as other retailers. The result was that it lost its differentiation based on perceived quality. The fact that seven years later Marks and Spencer had still not recovered its market position demonstrates how difcult it is to repair the value system. Heriot-Watt University Strategic Management

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Exercise 5.15 (page 153) One interpretation of SuperTools diversication is that it was related because the company was merely entering a different segment of the existing market. However, the competence based approach generates a different conclusion. The routines adopted for the production of the PowerPlane were quite different: they were based on unskilled labour and high levels of output, with little attention being paid to the type of quality which was important for the StylePlane. The resources were also quite different, being highly skilled craftsmen who required a long period of apprenticeship. This means that SuperTools had undertaken an unrelated diversication in the competence based sense and this probably contributed to the reservations expressed by the marketing managers colleagues.

Exercise 5.16 (page 154) Marks and Spencer had a signicant market share in the relatively stable retail market and could be classied as a cash cow. As such it beneted from some of the strategic assets. But it was famous for its reputation and this distinctive capability was key to its competitive advantage. The importance of this distinctive capability became apparent after it lost its reputation through mismanagement of the value chain: it had to fall back on the strategic assets which were not strong enough to maintain its overall competitive advantage and the company went into long term decline.

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6 Culture and stakeholder expectations


Exercise 6.1 (page 161) There are no absolutely correct answers to the questions, but they can be discussed in the following way. 1. In a purely market economy capital will be directed to the uses which generate the highest rate of return. As a result a company which does not make the market rate of return (adjusted for risk) will be starved of capital and will go out of business. This is not an ethical issue, i.e. it is not a question of which stakeholder should have the highest priority because that is a matter for subjective judgement. Other stakeholders will receive their rewards on the basis of the operation of the market and there is no particular hierarchy of stakeholders such as managers, employees, suppliers, customers or creditors. The local community may have some degree of priority depending on the circumstances, while in a purely market economy the government has by denition virtually no role to play in business decision making. 2. This is a principal agent problem. The executives are aware that they must make at least as much return as comparable companies in order to attract capital. However, they have no incentive to increase the rate of return beyond that unless their remuneration package is aligned with the maximisation of shareholder returns. Thus the implication of this priority is that shareholders must attempt to align the interests of the executives with their own.

Exercise 6.2 (page 164) There are no hard and fast answers to this question, but the type of factors determining stakeholder inuence include

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Stakeholder Shareholders Managers

Factor Number Size of company Number of shareholders Non-executive directors

Employees

Unionisation Labour legislation Culture Transferable skills

Suppliers

Number Substitutes

Customers

Number Substitute products

Creditors

Gearing Board representation Relationship

Community

Reputation Pollution Employee conditions

Government

Legislation Purchaser Trade policies: subsidies and tariffs

Exercise 6.3 (page 165) The stakeholder map from the marketing managers point of view will look like the following:

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In order to implement his ideas the marketing manager would have to convince the CEO and make sure that the StylePlane employees did not oppose him; he would also have to ensure that the reputation of the StylePlane was not undermined and hence alienate the StylePlane customers.

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7 Strategic options and strategic choice


Exercise 7.1 (page 171) The construction of the SWOT analysis depends on your own interpretation of the information, and you might disagree with the following. Strengths StylePlane is a cash cow StylePlane reputation Up to date plant and equipment Plenty of productive capacity Weaknesses StylePlane in decline stage Gearing is 47 per cent PowerPlane production problems Moribund management team Low morale The strengths of the company are aligned with the opportunities for the PowerPlane and the development of new products, although the gearing ratio might present problems if new product development requires investment. The main weakness for the future is that the management team (with the exception of the marketing manager) is unwilling to face up to the threats. It emerges from the SWOT analysis that reliance on the behaviour which generated success in the past will not work in the future. The logical course of action is to utilise the revenues from the StylePlane, as long as they last, to nance the development of the PowerPlane as it moves up the product life cycle, and generate potential new stars for the future such as the PowerSander. Threats New entrants Technological change Opportunities PowerPlane is a star New product development

Exercise 7.2 (page 178) Company size generic decisions The CEO had for many years pursued a strategy of stability and then opted for a generic strategy of expansion. However, he has now regretted this and his attitude seems to be to retrench. Managing the portfolio A major problem is that there are few production synergies between the two products, and the production manager is out of his depth in managing a high volume low quality product. Little regard is paid to the overall efciency of resource use. Allocating resources The CEO paid little attention to the accountants concerns and simply issued instructions to the production manager to reduce costs. The inventory problem was not even

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discussed. Contributing to the formulation of business level strategy The CEO has no understanding of the marketing managers approach; his notion of differentiation is to add more of the same to the Style- Plane and he has little appreciation of product positioning. So far as extending the portfolio with further product development is concerned, he treated the issue with disdain. Monitoring and controlling performance There seemed to be little in the way of regular reporting.

Exercise 7.3 (page 182) 1. This is a difcult question; the following matrix sets out one solution. Heavy emphasis Prospector Analyser Aggressive Seek pursuit of new expansion in products and related markets products and markets Ignore Seek lower cost options No emphasis Reactor Defender Maintain Wait for advantage competitive moves

Differentiation

Cost leadership

Cost control systems

Wait for poor results

The Prospector is primarily concerned with pursuing growth by differentiated or low cost products and is probably indifferent to which characteristic generates potential competitive opportunities; a potential weakness is lack of attention to details such as cost control. The Analyser will tend to start from the base of a strong core business and will expand into related areas; this is because the Analyser is unwilling to enter markets on which there is little information and no experience. The Defender will tend to be operating in mature markets and is likely to be concerned with maintaining the position of cash cows; the Defenders attitude may be largely conditioned by the fact of operating in mature markets. The Reactor, as might be expected, simply waits until the pressure of events forces some course of action upon it; at times the Reactor will behave like one of the other three types, but there will be no consistency in the approach over time. This illustration might at rst appear to be painfully obvious; however, experience suggests that many managers do not have a clear idea of which classication their company falls within. Many managers would like to be characterised as Prospectors, but in fact they are Reactors; managers who feel that they do not always seize opportunities should ask themselves whether this is because of an aversion to risk or because they are basically Analysers. 2. This type of classication has a potential payoff in real life. When the opportunity for product market growth arises, an SBU CEO can start by identifying the main Heriot-Watt University Strategic Management

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behavioural characteristics of the organisation, identify whether the SBU is a Prospector or a Reactor and see from the matrix how it is likely to behave in the circumstances. The important issue is whether the previous orientation of the company is likely to be effective in the circumstances which will face it in the future; the Defender, for example, can consider whether it is worth attempting to introduce organisational change to instil elements of Analyser and Prospector into the organisation in order to encourage the investigation and pursuit of new opportunities.

Exercise 7.4 (page 189) The strategist would work through each of the reasons for acquisition methodically and try to determine whether any of them was convincing. Reason for acquisition Recognised unrealised value Buying market share Reducing competitive pressures Synergy Strategists response The CEO does not mention that either company is badly managed at the moment The market segments are different so market share in the original market will be unaffected No attempt appears to have been made to assess competition pressures in either new market; competitive pressures may actually increase Although not mentioned synergy is an implicit argument in both cases, but the differences in markets and skill sets makes it unlikely It is not known where any of the products are positioned in the BCG matrix while there are no apparent linkages among the value chains This was dealt with above Convincing reason No No No

No

Balancing the portfolio Core competences

No

No

Again the strategist is the bearer of unpopular news: there is no obvious case for either acquisition as a means of creating value.

Exercise 7.5 (page 193) Against Difcult to dene relatedness Vertical integration Direct control over supplier Lose market discipline Acquisitions Potential of unrealised value May bid away potential benets Joint ventures and alliances Avoid implementation Prisoners dilemma problems International expansion Exchange rate volatility Transfer competitive advantage Strategic option Related and unrelated Heriot-Watt University Strategic Management For Potential for synergy

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You probably came up with a different list of arguments for and against each option; the important point is to realise that there are always going to be arguments for and against the adoption of any strategic option and that these have to be balanced against each other. With the limited information provided in the question it would be impossible to arrive at the best strategic option; an important issue then is how much additional information would be necessary to arrive at a rational choice. How do these options compare with simply distributing the cash to shareholders in the form of dividends? This depends on whether the CEO thinks he can generate a better return for shareholders than they would have obtained elsewhere; at the very least he would have to be condent of generating a higher rate of return than the market average.

Exercise 7.6 (page 203) There is plenty of room for discretion here and the following interpretation is by no means denitive. Shareholder wealth Performance gaps Marketing Manager CEO Concerned with the product Seems to be aware of value creation Does not look forward Sees that the company is not equipped to meet future market conditions Does not think in these Is concerned about the terms balance of the portfolio Is willing to enter the Sees unfamiliar markets unfamiliar sector and products as high risk Risk averse Risk taker No need in a static Does not consider it StylePlane world No mention of mergers or Same as CEO alliances Greatly affected by past Wishes to get away from the success past Has no power base and is Sees choice as an expression of his dominant unlikely to persuade colleagues position

Portfolio choice Familiarity Risk Contingency External dependence Previous strategies Power relationships

The marketing manager is more of an analyser than the CEO, but at the same time he would be willing to take more risks. The approach to decision making would change to become more market orientated. This is an example of how changing the CEO could have a signicant impact on the way the company is managed and future strategy.

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8 Implementation
Exercise 8.1 (page 232) 1. At this stage we are moving into areas where judgement and interpretation can lead to different views; however, the important point is that in a situation such as this you recognise the importance of considering these elements of the implementation process. Structural forms: there was no recognition by the CEO of the need for specic product based responsibilities; the company was organised along functional lines almost by default. The two technologies differe: the StylePlane is custom and the PowerPlane is mass production. In the custom case there is no need for close supervision and there is no economy of scale; the opposite applies to mass production. That is probably why the PowerPlane was regarded by the production manager as an almost unwelcome distraction. Functional silos: there is very little reason for communication between the two production lines; the skilled StylePlane workers are unlikely to have much in common with the unskilled PowerPlane production line workers. While the two lines may not be formally organised as divisions that will not prevent silos developing. Integrating mechanisms: at the moment there appear to be none and it is difcult to see what form an integrating mechanism might take between totally different production lines. Type of strategic change: this is a major strategic change that impacts on every component of the strategic process; the very business denition has been altered. Unfortunately, at the moment the CEO appears unaware of this. Barriers to change: there are some obvious barriers, such as the unwillingness of craftspeople to become involved in mass production and Production Managers sympathy for the StylePlane. Force eld analysis: everyone appears to be against the change; the StylePlane workers feel resentment. The CEO has made no attempt to clarify, identify, assess the balance of forces or decide how to alter the forces. Cultural web: the elements of the cultural web, i.e. the stories, routines etc. are all about custom production. It is difcult to see how the elements could be generated for mass production in a way that would appeal to the custom build workers. There was a tendency on the part of the CEO and the production manager to refer back to the old days as a time when things were much better. Styles of managing strategic change: the change is transformational with a long time horizon, suggesting participative management style. The CEO does not appear to wish participation by members of his management team so it is unlikely he will promote a participative approach for employees. Critical success factors: there is an unstructured discussion referring to some important factors, such as nance, but no mention of criticality. The company seemed to blunder on and deal with problems as they arose rather than thinking through what would be required to ensure that the PowerPlane was a success. Budgets: the Accountant does not appear to have control over spending. He appeared to have no understanding of such issues as the implications of Heriot-Watt University Strategic Management

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developing a star product in the market. Overall, the discussion suggested that the company had little real perspective on cost structure and return on investment. Incentives: the low morale mentioned by the HRM Manager suggests the incentive system is not aligned with business objectives. The CEO seemed to focus on failure rather than success: his attitude to the PowerPlane was x it or else, and he was scathing about the prospects of further product development. Resource planning: the Production Manager does not wish to get involved in details; little attention appeared to be paid to aligning the supply of the PowerPlane with the demand; the Production manager had to be told to turn his attention to this by the CEO. With no overall control over resources it is difcult to see how the company can operate efciently. 2. The structured approach reveals implementation failures at every turn. There is no recognition of the need to optimise the organisational structure, no recognition of the complexity of managing strategic change and an undisciplined approach to resource allocation. With such an unstructured approach to implementation the chances of success are remote. If it all goes wrong the management team will have no idea why.

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9 Strategic Control
Exercise 9.1 (page 237) SuperTools uses a variety of control approaches but they are all ad hoc and at the discretion of the individual manager and other managers pay little attention. There is no overriding approach so it can be classied as a Loose control company. Their actions can be assessed according to the four criteria. Criteria Few objectives Derive targets Milestones Loose No clear objectives provided by CEO: discuss again at the next meeting No specic target is agreed on Market share was noted - it had increased from 10% to 15% but nothing was made of this No attempt was made to arrive at an evaluation of the current situation which reects the confusion that prevailed in the overall strategic approach

Subjective evaluation

This is consistent with the lack of focus on implementation and shows the company is simply following events as they transpire without making proactive use of information in any constructive way, even subjectively, as it becomes available.

Exercise 9.2 (page 238) Communication channels: on the evidence of the meeting, it seemed that a great deal could happen without anyone becoming aware of it. There seemed to be no process where everyone was kept up to date with events. Ability to adapt: some issues raised in the discussion were not pursued, such as the morale problem with StylePlane workers. There was no recognition of the fact that the organisation as a whole was not coping well with the changing pattern of demand and the introduction of new product types. Learning organisation: this is perhaps the biggest problem, in that the CEO and the production manager did not appear to want to know about organisational change. The marketing manager was certainly in learning mode, but overall the organisation was not. In the previous discussions it emerged that SuperTools had problems in relation to implementation and evaluation and control. This analysis suggests that there is little chance that SuperTools will improve on its performance because there is no process for ensuring that information will be disseminated and acted upon.

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