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Chapter Two:Strategy Analysis

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Strategy Analysis

Definition: It is a qualitative analysis that identifies the firm’s profit drivers and key risks. It makes the subsequent accounting and financial analysis mare practicable. This, in turn, enables the analyst to assess the sustainability of the firm’s current performance and make realistic forecast of future performances. A firm’s value is determined by its ability to earn a return on its capital in excess of its cost of capital (NPV). While a firm’s cost of capital is largely determined by the capital markets, its profit potential is determined by its own strategic choice.

TCTRprofitNet

onDepreciatiprofitNetNCF

jRRRkwhere

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NCFNPV

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Strategic choice depends on:

• A. Industry choice: The choice of industry or a set of industries in which the firm operates.

• B. Competitive positioning: The manner in which the firm intends to compete with other firms in its chosen industry or industries.

• C. Corporate strategy: The way in which the firm expects to create and exploit synergies across the range of businesses in which it operates.

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A. Industry Analysis

• Average profit of the market varies considerably based on different industries. The differences imply the associated risk factor as well. The risk and return preference of each firm is best demonstrated by the choice of its industry. Profit of each industry depends on “five forces”.

1. Rivalry among existing firms

2. Threat of new entrants.

3. Threat of substitute products

4. Bargaining power of buyers

5. Bargaining power of suppliers

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A. Industry Structure and Profitability

1. Rivalry Among Existing Firms

Industry growth

Concentration

Differentiation

Switching costs

Scale/learning economies

Fixed variable costs

Excess capacity

Exit barriers

3. Threat of Substitute Products

Relative price and performance

Buyers willingness to switch

4. Bargaining Power of Buyers

Switching costs

Differentiation

Importance of product for cost and quality

Number of buyers

Volume per buyers

Industry Profitability

5. Bargaining Power of Suppliers

Switching costs

Differentiation

Importance of product for cost and quality

Number of suppliers

Volume of suppliers

2. Threat of New Entrants

Scale economies

First mover advantage

Distribution access

Relationships

Legal barriers

DEGREE OF ACTUAL AND POTENTIAL COMPETITION

BARGAINING POWER OF INPUT AND OUTPUT MARKETS

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1. Rivalry among existing firmsdepends on:

• i. Industry Growth rate: The competitive behavior of a firm with high growth industry and stagnant industry is different.

• ii. Concentration and balance of competitors: Concentration of the number of firms in the industry shapes the competitive behavior of the firm. (Example: IBM in mainframe computer formulates the rules of industry, Coke-Pepsi restrict price cut)

• iii. Degree of Differentiation and switching costs: If the products are very similar the switching cost of customers is low and price competition is common. If the products are differentiated switching cost is high and rivalry is less acute.

• iv. Scale or Learning Economies and Ratio of Fixed Cost to Variable Cost: For steep learning curve and large economies of scale there are incentives for aggressive competition. Similarly, for high fixed cost to variable cost ratio there is incentive to reduce price to utilize the installed capacity. (example: airline industry)

• v. Excess Capacity and exit barriers: Specialized assets with excess capacity makes a firm aggressive in price cut. Exit becomes then difficult. There may be regulations restricting the exit.

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2. Threat of New Entrantsdepends on:

• i. Economies of Scale: Large scale economies is a constraint for new entrants. The existing firm is motivated to handle this risk by a large investment in research and development (pharmaceutical or jet engines), in brand advertising (soft-drink), or in physical plant and equipment (telecommunication)

• ii. First Mover Advantage: The first mover might be able to set industry standard, to enter into exclusive arrangements with suppliers of cheap raw materials, or to acquire scarce government licenses. He may capitalize learning economies or significant switching costs. This makes new entrance difficult. (example: switching cost of Microsoft’s DOS operating system is quite high)

• iii. Access to channels of Distribution and Relationship: Limited capacity of distribution channels and high costs of developing new channels can act as powerful barriers to new entry. Existing relationship between firms and customers in an industry also make it difficult for new firms to enter an industry.

• iv. Legal Barriers: Patents, copyrights limit new entries. Similarly, licensing regulations limit entry into taxi services, medical services, broadcasting, telecommunications industries, etc.

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3. Threat of substitute products

• Substitute products are not necessarily similar products rather the products that perform the same function. For example, car rental and air lines may be substitutes, Jute and synthetics are substitutes. Technological innovation may introduce substitute like computer for type writers. It depends on:

• i. Relative price and performance• Ii. Customers’ willingness to switch

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Relative Bargaining Power in Input and Output Markets

• While degree on competition in an industry determines whether or not there is potential to earn abnormal profits, the actual profits are influenced by the industry's bargaining power with its suppliers and customers. On the input side there is labor, raw materials and components, and finances. On the output side firm may either sell directly to the final customers, or enter into contract with intermediaries in the distribution chain. There is a competition among all these factors called relative bargaining

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4. Bargaining Power of buyersDepends on:

• 1. Price sensitivity: Buyers are more price sensitive when the products are undifferentiated and switching cost is low.

• 2. Relative bargaining power: In a monopoly market there is low bargaining power of the buyers and in a perfect market there is high bargaining power of the buyers. This in turn, depends on number of buyers relative to number of sellers, as well as the volume per buyer.

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5. Bargaining Power of Suppliers

• Suppliers’ bargaining power is the opposite to the bargaining power of the buyers. In a monopolistic and oligopolistic market the supplier or suppliers have strong bargaining power. (Example: Power of Coke-Pepsi on bottlers) On the other hand, in a perfect market they do not have a bargaining power as they have to accept the market price. (Example: can producers lack power). Market of intermediate goods also determines the bargaining power when they are the exclusive suppliers for the next sequence of producers. (IBM’s unique position as mainframe suppliers dominates computer leasing business)

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Industry Analysis: Case StudyPersonal Computer Industry

• Introduction: Computer industry introduced in 1981 when IBM announced its PC with Intel’s microprocessor and Microsoft’s DOS operating system. With tremendous growth, in 1997 there was 100 million PC installed capacity, 30 million PC overseas sales with 21% annual growth rate. Since then the profitability went down. Despite the spectacular growth in 1998 the industry experienced low profitability. Why?

• Concentrated market: Top 5 firms sharing 60% so price cut was common. The industry began in 1981 by the IBM with Intel microprocessor and Microsoft’s DOS operating system.

• Undifferentiated products: Many firms producing identical products and acute competition experienced price cut.

• Large scale economies: Components share 60% of the price, so large procurement needed.

• Low switching cost as different brands use same Intel microprocessor and Microsoft Windows operating system

• Easy access to distribution channel • Easy entry due to easy availability of spare parts. (Michael Dell

started Dell computers with mare assembling at his dormitory room)

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Industry Analysis: Case Study (Contd.)Personal Computer Industry

• Substitute products like Apple’s Macintosh computers offered competition• Power of suppliers and buyers: Intel (microprocessor) and Microsoft

(DOS) hold strong bargaining power as suppliers. From 1983 to 1993 corporate buyers became price sensitive as computer procurement cost was very significant for successes, and once being aware of the technology brand names mattered little to them.

• Tremendous pressure on firms to spend large sums of money to introduce new products rapidly, maintain high quality, and provide excellent customer support contributed to low profit potentials.

• Prospective issue: Dominance of Intel and Microsoft in input market is going to continue which indicates little change of the structure of the industry in future as well

• Limitation of the analysis: Industry may not have clear boundaries (Shadow zones: workstation, manufacturers abroad, for Dell’s industry analysis IBM compatible PCs vs. all PCs)

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B. Competitive Strategy Analysis

• This is the strategy of positioning a firm in the industry. It refers to the strategy of the competitive advantage of the firm over other firms of the same industry. Commonly it is either (i) Cost Leadership or (ii) Product Differentiation.

• (i) Cost Leadership refers to the firm’s advantage in the cost of production. This depends on the production system.

• (ii) Product Differentiation refers to the advantage of the firm regarding the specification of the product. This depends on the acceptability of customers on the marketing point.

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Strategies for Creating Competitive Advantage

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Competitive Strategy 1:Cost Leadership

• Cost Leadership means to create sustainable cost advantage over rivals with regard to same product or service. It arises from:– Economies of scale: To explore the optimum scale– Economies of learning: Complication of technology of production.

Both short run and long run– Efficient production: constrained optimization– Simpler product design: Alter value chain to bypass cost-

producing activities.– Lower input cost: procure or produce?– Low cost distribution: owning or hiring?– Little research and development or brand advertisement. Industry

standard? Cost-benefit of low R&D?– Tight Cost Control system: To ascertain the cost centre,

standardize costs and identify the agent responsible for variation

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Cost Leadership in case of identical commodity

Industry Firm

Quantity in million

D (MU)

Si

(MC)

Quantity in thousands

Pric

e

Tk.50 D=AR=MR

Qf1

Sf1

Qi

Pric

e

Sf2

Qf2

AC1

AC2

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Competitive Strategy 2: Product Differentiation

• Product differentiation strategy seeks to be unique in industry along some lines highly valued by customers. It implies to identify such attributes, and meet that in a unique and cost-efficient way. It involves:– Superior product quality– Superior product variety– Superior customer service– More flexible delivery– Investment in brand image– Investment in R&D, engineering skills and marketing

capabilities– More focus on creativity and innovation.

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Advantage of product differentiation

MC

AC

AR=MR

MCAC

D=AR

MR

Without differentiation:Elastic demand curve

With differentiation:Relatively Inelastic demand curve

Pric

e

Quantity Quantity

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Competitive Strategy Analysis (Contd.)

• Competitive Advantages involves the identification of either cost leadership or product differentiation. It requires:– 1. Match between firm’s competence and key success factors to

execute strategy.– 2. Match between firm’s value chain and activities required to

execute the strategy– 3. Sustainability of competitive strategy.

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Case Analysis: Personal Computer Industry (Contd.)Success of Dell Computers

• Despite the constraints Dell was quite successful. Why?1. Direct selling (through internet web site). Utility of retailer went down

as computer became standardized on the Windows-Intel platform. Dell was pioneer in direct selling. It saves the markup of retailers.

2. Made-to-order manufacturing. This allowed to concentrate more on quick assembling and shipping. It saved the cost of inventory pileup, working capital and obsolete inventories.

3. Expertise third party after sale services & very effective telephone based servicing.

4. Lowest accounts receivable days of the industry by encouraging the customers to pay on credit card.

5. Dynamic R&D investment: Dell recognized that Intel and Microsoft are key suppliers and they invested huge amounts in developing new generation processors and software. So Dell R&D concentrated in the organizational aspect that respond quickly to these changes.

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C. Corporate Strategy Analysis

• This refers to the corporate decision whether to concentrate on single line of business or to diversify the business among different lines. It relates to the goal of wealth-maximization of shareholders. Conflicting views have been observed. The portfolio theory says that diversification is more economic on the part of the investors rather than the firm. Unlike 1970s, recent trend of US companies is to reduce diversity. On the other hand, the global trend of group of companies or multibusiness organization still continues with some successes. Example: General Electric is successful in creating significant values by managing highly diversified business ranging from aircraft engines to light bulb. Sears has not been successful in retailing together with financial services.

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Effectiveness of Diversification

ClimateProbability Return of

UmbrellaReturn

Ice-creamPortfolioReturn

Rainy 0.25 25 -5 10

Moderate 0.5 14 10 12

Dry 0.25 0 15 7.5

Return E(R) = 

13.3% 7.5% 10%

Risk 

8.9% 7.5% 1.8%

Risk (Coeff. of variance) 67% 100% 13.5%

ii PR *

ii PRR 2)(

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U.S. Industry Profitability, 1971-90ROE ROA

Pharmaceuticals 21.4% 11.8%Printing and publishing 15.5 7.1Food products 15.2 6.6Chemicals and allied products 15.1 7.5Petroleum and coal products 13.1 6.5Instruments and related products 12.9 7.2Industrial chemicals and synthetics 12.9 6.2Paper and allied products 12.5 6.0Aircraft, guided missiles, and parts 12.4 4.1Fabricated metal products 12.3 5.7Motor vehicles and equipment 11.6 5.6Rubber and misc. plastic products 11.6 5.1Electric and electronic equipment 11.5 5.4Machinery, except electrical 11.1 5.8Stone, clay, and glass products 10.4 4.8Textile mill products 9.3 4.3Nonferrous metals 8.3 3.9Iron and steel 3.9 1.5

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Value creation at corporate level

• This depends on the transaction cost of performing a set of activities inside the firm versus using the market mechanism. Transaction cost economics implies that the multiproduct firm is an efficient choice of organizational form when coordination among independent, focused firms is costly due to market transaction cost.

• Transaction cost increases if the production process needs specialized assets, such as human capital skills, proprietary technology or other organizational know-how that is not easily available in the market place.

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Corporate Strategy Analysis (Contd.)

Advantage of value creation at corporate level (disadvantages of introducing a new business)

1. Significant information gap between investors and entrepreneurs. (lemon’s problem)

2. Significant information gap between buyers and producers. Besides, due to poor legal infrastructure buyers may not enforce warranties

3. Unavailability of quality people. When employer fails to assess the quality of applicant for new position, he would like to stick to the old people and give them promotion.

4. Communication cost within the organization goes down regarding confidentiality of customers.

5. Head office can significantly reduce cost of enforcing agreements between organizational subunits.

6. Organizational subunits can share valuable nontradable assets such as organizational skills, systems and processes.

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Corporate Strategy Analysis (Contd.)

• Disadvantages of value creation at corporate level:• When transaction cost increases?1. Lack of specialization. Top management may lack information, skills

and expertise related to different industries.2. Lack of economies of scale.3. Diversification is motivated more by higher investment rather than

higher profit. 4. Creates agency problem.5. Becomes difficult to assess the performances of each unit of the

firm. Sometimes even poorly performing units are subsidized by the organizational head office that fails to ensure the justice expected by the investors.

• Remedies: 1. Decentralization of organization2. Hiring specialist managers for each business unit

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For corporate strategy analysis: An analyst should ask..

• Are there significant imperfection in product, labor or financial market? Market imperfection increases transaction cost.

• Does the organization have special resources such as brand names, proprietary know-how, access to scarce distribution channels to create economies?

• Is there a good fit between the company’s specialized resources and the portfolio of businesses?

• Does the company make appropriate distribution of decision making across the different units?

• How does the company handle the agency cost and coordination problem?

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Applying corporate strategy analysisAmazon.com

• Amazon.com, a pioneer in electronic commerce sector, started operation as online bookseller in 1995 and went public 1997. Successes led an increase in share price. Market capitalization was $36 billion in 1999. Expansion strategy included acquisition of other online businesses, and selling online CD, videos, gift, pharmaceutical drugs, pet supplies, and groceries.

• Advantages:

1. valuable brand name on the internet. Since electronic commerce is a new phenomena, customers valued it quite high.

2. Amazon acquired critical expertise in flawless execution of electronic retailing that can be exploited in many areas.

3. Amazon has been able to create a tremendous amount of loyalty among its customers through superior marketing and execution.

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Applying corporate strategy analysisAmazon.com (Contd.)

• Constraints:• Amazon was expanding too rapidly. Expansion beyond

book retailing must fail.• Competitors like Wal-Mart, Barnes & Noble are also

having valuable brand names execution capabilities, and customer loyalty. Which must offer formidable competition in retail business.

• Expanding rapidly in so many areas may confuse customers, dilute Amazon’s brand value, and increase chance of poor execution.

• Effect:• Sales increases but profitability goes down and more

importantly share price goes down from $221 in April 1999 to $118 in May 1999.