Some Fundamental Premises for Strategy Formulation

1. Costs (and prices) always decline. Prices follow costs. Good managers know and apply the experience curve correctly. 2. Your competitive position largely determines your strategic options. Good managers know their strategic position and the possibilities and constraints it creates. 3. Customers, Competitors and Profits are always shifting. Good managers anticipate shifts and plan accordingly. 4. Simplicity is preferred over complexity. Too many products and options drive up costs.

The Benefits in Low costs

Original Price

New Price Cost 2 Cost1 New Margins

Company 2

Company 1
Note that because of Co. 1s lower costs, the drop in price affects Co. 1s margins proportionately less than co.2s (approximately 1/3 vs. in diagrams).

High R.O.I

Low Low Mkt. Share High Assumed causal relationships: High Market Share Causes

High Accumulated Volumes of Production Causes Low per Unit Costs

High Profits

An 85% Experience Curve

120 110 Deflated Direct cost per Unit 100 90 B 80 70 D C A

10th unit = $100 Then 20th unit = $100 * .85 =$85 Then 40th unit = $85*.85 = $72.25

60
50 40 30

20
10 0 10 20 30 40 50 60 70 80 90 100 120 130

Accumulated Vol. Of Production (units)

The Learning Effect Y = 2X n

Direct Labor hrs/unit

Where y = the no.(cost) of direct labor hrs required to produce the xth unit a = the no.(cost) of direct labor hrs required to produce the first unit x = the cumulative unit no. n = the learning index = (log 0)/(log 2) 0 = the learning rate 1-0 = the progress ration

1.0 .1 .01 .001 10 % progress (0 =90)

20% progress(0=80%)
30% progress (0=70%)

10 1000 100 Cumulative units as plotted logarithmetrically

 Break for experience curve simulation

Paper Airplane Exercise Results on Linear Scale

$5
Trial 1

Cost Per Airplane

4 3 2 1 9
Trial 2

Trial 3

12

Accumulative Experience (Number of Planes)

$10 5
Cost Per Airplane

Paper Airplane Exercise Results on Log Scale

Slope = 74% R2 = 1.00 Trial 1

Trial 2

Trial 3

2
1 0 2

5
Accumulative Experience (Number of Planes)

1 0

15

Example Using Traditional Linear Programming

Maximize : TT = $33X1 + $39X2 +$59X3 Subject to: 10X1 +15X2 +12X3 < or = 14,400 labor hours Production Constrain 24X1 + 20X2 + 14X3 < 0R = 5,900 machine hours Here, our optimal solution would be to produce: 0 units of X1 0 units of X2 361 units of X3 With resulting contribution margin of: $59 (361) = $21,299 This would yield optimal solution if there are no learning effects present. If, however, workers learn, machines are used more efficiently, and materials usage is optimized, then we would have to modify our linear programming formula. For example, that learning occurs such that there is a 90% experience curve effect. Then, if we were to only produce X the constraints on production change: Using logs 12X3.848 < or = 14,400 labor hrs 14X3.848 < or = 5,920 machine time We obtain 36X 3 .848 < or = 13,026 materials Yields an optimal solution of $59 (1,040X) = $61,360

Experience Curve for Price of Brokerage Services

30 20
EXECUTION REVENUE PER SHARE TRADED (intuitional: 1996 Dollars

1990

Slope = 64% R2 = 099

10

5 3

2003
300 500
1,000 2,000

5,000

10,000B

CUMMULATIVE SHARES TRADED

The Perils of a Price Cut

An innocent little 3% price cut by the average S&P 1000 knocks the profits down from 8.1% to 5.1% or a whopping 37%
Full Price $1.00 3% Off $0.97

Profit 8.1% Costs: 91.9%

Profit 5.1%

Costs: 91.9%

Incremental Breakeven Analysis

q= p (1-cm) c cm- p + (1-cm) c

Definitions: q---the breakeven sales increase in percentage; p---the magnitude of a price cut; Cm---the contribution margin in percentage (before the price cut); c---the reduction in marginal costs in percentage due to the price cut.

Incremental Breakeven Analysis

q= p (1-cm) c cm- p + (1-cm) c

Definitions: using Galanz example q---the breakeven sales increase in percentage = 90.5%; p---the magnitude of a price cut = 20%; Cm---the contribution margin in percentage (before the price cut) or (price marginal cost) = 40%; c---the reduction in marginal costs in percentage due to the price cut = 35%

Circumstances for a Price War

High growth markets Heterogeneous firms with a wide distribution of cost efficiencies New technologies with significant scale economies

Source of the Experience Effect

1. 2. 3. 4. 5. 6. Labor efficiency New processes and improved methods Product redesign Product standardization Scale effect Substitution in the product

Practical Considerations
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Cost-time relationship High-volume effect Shared experience Product Definition Cost data Marginal vs. average cost Inflation Planning horizon External influences Market instability

Steps in A Typical Value-Added Chain:

Product R & D Process R & D Purchasing of Raw Materials Transportation of Raw Materials Mfg. Of Parts and Components Assembly Testing and Quality Control Marketing Sales to intermediaries Wholesale Distribution Retailing After sales Service

The Generic Value Chain

Firm Infrastructure Human Resource Management Technology Development Procurement Inbound Logistics Operations Outbound Logistics Marketing & Sales

Service

Upstream Value Activities Economies of Scale Dominate

Primary Activities

Margin Downstream Value Activities Economies of Scope Dominate

Effects of accumulated experience over the cost accrued in different stages of value added
Deflated direct cost per unit R& D Purchasing and Mfg of parts & Components 75% Subassembly Marketing Distribution Retail

95%

70%

90%

85%

95%

Accumulated Volume of production in each stage (in units)

R& D Manufacture Assembly Marketing Distribution Retail

2%

20%

15%

30%

25%

8%

Accumulated Costs in

Mkt. Leader is A w/rel. mkt share of 4 to 1 over B. Conceptualize value-added in 2 stage mfg and dist. In mfg. Stage A has the 4 to 1 advantage over B but in dist. Stage B has 3 to 1 advantage in terms of mkt share, because this is just one of many others that share the same system of dist. If we assume that experience in both stages has the same impact over costs, and that each stage contributes half the final value of the product, we could use a normalized mkt share to determine the relative standing of the 2 firms in the business. Two firm ex. W/value added as manufacturing and distribution for firm A: Market Share = (Mfg. Share x Mfg. Value-Added) + (Distribution Market Share x Distribution Value-Added) = [(4 to 1 or 4/5)] + [(1 to 3 or I/4) x (0.5)] = 0.525 Similarly for firm B Market Share = 0.475 The relative market share of firm A over firm B using this weighted measure of experience in only 0.525/0.475 = 1.10 times, for smaller than the observed to 4 to 1 product ratio in the final market.

Gillette Razor Blades

Industry Life cycle Sales Business Life Cycle
Waves of Product life cycle
Wave of Profit

Blue Blades

Stainless Steel

Super Chromium

Platinum plus

Time

Location of product in: a less developed country a newly industrialized country a fully developed country
Sales

Time

Costs Sales Profit Relationships by Stages of life Cycle

Total Sales

Costs/Unit
Price/Unit

Profit

Loss

Introduction

Rapid Growth

Maturity

loss Decline

Growth Share Matrix

22% 20 %

Mkt. Growth Rate

18% 16% 14% 12% 10% 8%

6%
4% 2%

10X

4X

1.5X

1.0X

0.5X

0.1X

Relative Competitor Position

Industry growth Rate (2009) = Relative Industry Share = Circle Size =

(Total Ind. Sales 2009) (Total Ind. Sales 2008) Total Ind. Sales 2008 Your business units sales Leading competitors sales Your business units sales Total corp. sales

4 ways to separate high-low growth Avg. industry growth single industry Overall economic growth multiple industry Weighted average growth Corporate growth target

Ideal Movement of Products and cash in the Portfolio

Question Mark Star Modest + Cash Flow
Market Growth

Large Negative Cash Flow

Large Positive Cash Flow Cash Cow

Modes = or Cash flow Dog

Relative Competitive Position = Cash Movement = Product movement

Four Basic Types of Unbalanced Portfolios

Typical Symptoms
Inadequate cash flow Inadequate profits Inadequate growth Inadequate cash flows Inadequate profits Inadequate growth Excessive cash flow Excessive cash demands Excessive demands on Management Unstable growth & profits

Problems
Too Many losers

Corrective Actions
Divest/Liquidate/harvest losers Acquire profit producer Acquire Winners Divest/Harvest/liquidate selected question marks Acquire winners Nurture/Develop selected question marks Divest selected winners if Necessary Acquire profit producers

Too many question marks Too many profit producers Too many developing winners

Using the Matrix to Guide Strategy

The process consists of 3 steps: 1. Developing matrices for ones own firm. 2. Developing matrices for ones competitors. 3. Making strategic comparisons and generating strategies. Each step may be further subdivided: 1.a. Identify the products and the business sectors. 1.b. Selecting and ranking the criteria for assessing the Bus. Pos. and Ind. Attractiveness. 1.c. Gathering the data. 1.d. Quantifying each products position. 1.e. Drawing the matrices; past, present, and future. 1.f Assessing the implications of each products position in the matrix.