2010 s Man 290610

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 +44(0) 131 451 3864

Fax +44(0) 131 451 3865

E-Mail [email protected]

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 otherthan 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.

AcknowledgementsAcademic Director of Edinburgh Business School, Heriot-Watt University, Alex Scott is aneconomist and has published over thirty research papers into efficiency in education, efficientuse of energy, energy and the environment and the cost to the taxpayer of government industrialaid programmes. He has written several textbooks and is a pioneer in developing and carryingout research into new educational techniques, particularly in the field of economic and businesssimulations.

Professor ScottŠs executive teaching includes running strategic planning sessions for groupsof senior managers, widening the perspectives of functional managers, and teachingfinancial specialists the principles of how economies function in todayŠs highly complex andinterdependent world. Among the companies for which he has run management programmesare American Express, British Rail, British Telecom, Cathay Pacific, Fiskars, Hewlett-Packard,National Health Service, ScottishPower, Scottish Widows, Swiss Bank Corporation.

i

Contents

1 Introduction to strategic management 11.1 Studying strategic management . . . . . . . . . . . . . . . . . . . . . . . . 21.2 The scope of strategic management . . . . . . . . . . . . . . . . . . . . . 21.3 Effectiveness of strategic management: the evidence . . . . . . . . . . . . 31.4 strategic management at corporate and business unit levels . . . . . . . . 61.5 The meaning of strategic management . . . . . . . . . . . . . . . . . . . . 71.6 Strategy as a process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191.7 The role of the CEO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241.8 Principal agent problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251.9 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

2 Mission and objectives 272.1 Mission and objectives in the process . . . . . . . . . . . . . . . . . . . . 282.2 Vision and mission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282.3 Setting objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322.4 Who sets objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352.5 Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

3 Analysing the macro environment 413.1 The macro environment in the process . . . . . . . . . . . . . . . . . . . . 423.2 Defining the scope of the environment . . . . . . . . . . . . . . . . . . . . 423.3 Implications for company sales and revenues . . . . . . . . . . . . . . . . 433.4 The environment as a threat to costs . . . . . . . . . . . . . . . . . . . . . 453.5 Gaining competitive advantage by understanding the environment . . . . 463.6 Long term competitive effects of environmental changes . . . . . . . . . . 473.7 Macroeconomic environmental variables . . . . . . . . . . . . . . . . . . . 483.8 The international economy . . . . . . . . . . . . . . . . . . . . . . . . . . 493.9 Looking ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533.10 Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

4 Analysing the market environment 634.1 The market environment in the process . . . . . . . . . . . . . . . . . . . 654.2 The market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 654.3 Barriers to entry: structural and strategic . . . . . . . . . . . . . . . . . . . 714.4 Market structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 744.5 Competitive behaviour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 784.6 Segmentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 824.7 The life cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 944.8 Portfolio models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 974.9 Strategic groups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1054.10 The structural analysis of industries . . . . . . . . . . . . . . . . . . . . . 1074.11 Environmental threat and opportunity profile . . . . . . . . . . . . . . . . . 1134.12 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

ii CONTENTS

5 Analysing resources and strategic capability 1175.1 Resource analysis in the process . . . . . . . . . . . . . . . . . . . . . . . 1195.2 Accounting ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1205.3 Financial structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1245.4 Break even analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1265.5 Pay Back period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1275.6 Net Present Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1285.7 Sensitivity analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1295.8 Human resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1315.9 Benchmarking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1335.10 Economies of scale and the experience curve . . . . . . . . . . . . . . . . 1345.11 The scope of the company . . . . . . . . . . . . . . . . . . . . . . . . . . . 1365.12 Creating value from the production process . . . . . . . . . . . . . . . . . 1435.13 The definition of competitive advantage . . . . . . . . . . . . . . . . . . . 1535.14 Assessing strategic capability: the strategic advantage profile . . . . . . . 1545.15 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156

6 Culture and stakeholder expectations 1576.1 Stakeholders in the process . . . . . . . . . . . . . . . . . . . . . . . . . . 1586.2 Stakeholder interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1586.3 Stakeholder interests: the priorities . . . . . . . . . . . . . . . . . . . . . . 1596.4 Stakeholder influence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1616.5 Mapping shareholders and their influence . . . . . . . . . . . . . . . . . . 164

7 Strategic options and strategic choice 1677.1 Strategy choice in the process . . . . . . . . . . . . . . . . . . . . . . . . 1697.2 The importance of structure . . . . . . . . . . . . . . . . . . . . . . . . . . 1697.3 Strengths, weaknesses, opportunities and threats . . . . . . . . . . . . . 1707.4 Generic strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1717.5 Business level generic options . . . . . . . . . . . . . . . . . . . . . . . . 1787.6 Identifying strategic options . . . . . . . . . . . . . . . . . . . . . . . . . . 1827.7 Strategy choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1937.8 Choice: is it rational? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2037.9 Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204

8 Implementation 2058.1 Strategy implementation in the process . . . . . . . . . . . . . . . . . . . 2068.2 Organisational structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2078.3 Management of change . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2168.4 Resource allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2268.5 Effective implementation is difficult . . . . . . . . . . . . . . . . . . . . . . 2318.6 Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232

9 Strategic Control 2339.1 Strategy control in the process . . . . . . . . . . . . . . . . . . . . . . . . 2349.2 Degree of planning and type of control . . . . . . . . . . . . . . . . . . . . 2359.3 Feedback . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2379.4 Analysing the ongoing competitive position: using the process model . . . 2389.5 Finally . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2419.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

© Heriot-Watt UniversityStrategic Management

CONTENTS iii

Answers to questions and activities 2421 Introduction to strategic management . . . . . . . . . . . . . . . . . . . . 2422 Mission and objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2453 Analysing the macro environment . . . . . . . . . . . . . . . . . . . . . . 2504 Analysing the market environment . . . . . . . . . . . . . . . . . . . . . . 2545 Analysing resources and strategic capability . . . . . . . . . . . . . . . . 2626 Culture and stakeholder expectations . . . . . . . . . . . . . . . . . . . . 2737 Strategic options and strategic choice . . . . . . . . . . . . . . . . . . . . 2768 Implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2809 Strategic Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282


1

Chapter 1

Introduction to strategicmanagement

Contents

1.1 Studying strategic management . . . . . . . . . . . . . . . . . . . . . . . . 2

1.2 The scope of strategic management . . . . . . . . . . . . . . . . . . . . . 2

1.3 Effectiveness of strategic management: the evidence . . . . . . . . . . . . 3

1.4 strategic management at corporate and business unit levels . . . . . . . . 6

1.5 The meaning of strategic management . . . . . . . . . . . . . . . . . . . . 7

1.5.1 The history of strategic management . . . . . . . . . . . . . . . . 8

1.5.2 The planning approach . . . . . . . . . . . . . . . . . . . . . . . 13

1.5.3 Emergent Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . 15

1.5.4 Resource based strategy . . . . . . . . . . . . . . . . . . . . . . 17

1.5.5 Have we decided what strategic management is? . . . . . . . . . 18

1.6 Strategy as a process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

1.7 The role of the CEO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

1.8 Principal agent problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

1.9 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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

2 Chapter 1. Introduction to strategic management

1.1 Studying strategic management

Strategic management is a synthesis of ideas from many business disciplines and itsemphasis is on understanding the operation of business in the real world. There aremany exercises in the Module, and these serve several purposes: to give you practicein applying ideas, to demonstrate why they are important in real life applications, and todevelop 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 conceptualdevelopment. You will find that some important points emerge in the discussion of theexercises 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 strategicmanagement is concerned with running a company and economic policy is concernedwith running the economy of a country. Anyone who has studied macroeconomicswill have some understanding of the complexity of fiscal and monetary policy, andthe many ideas and theories which are involved. However, although the scale of acompany is very much less than that of a country such as the UK or Japan, thejob is probably just as complex. That is why effective CEOs are as rare as effectiveCentral Bank Governors; in fact, effective CEOs are typically paid much more thangovernment ministers. The complexity of economic policy becomes apparent when anattempt is made to list the issues involved which includes growth of GNP, unemployment,inflation, the budget balance, the role of markets, the trade balance, the rate ofinterest, the exchange rate, income redistribution, pollution, government expenditureand business investment; in fact, the list could be extended to fill this page. Whenwe turn to strategic management it is not difficult to generate a list of equal length:profitability, growth in sales, market share, relative costs, competitive position, pricing,environmental scanning, human resource management, accounting ratios, investmentappraisal, shareholder value and dividend policy. The theories of microeconomicsand macroeconomics are used to make sense of the relationships among the manyvariables involved in the economy and to provide an understanding of how economiesoperate; this provides the basis for interpreting government economic policy making.The objective of strategic management is to bring together business concepts and ideasin order to understand how companies (and other organisations) operate in a competitiveenvironment, develop an understanding of the inter-relationships involved, and henceprovide the basis for arriving at conclusions regarding why companies have succeededor 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 aboutselling effectively in markets (marketing management), the competitive environmentwithin which companies operate (economics), the meaning of accounting numbers(financial and management accounting), the techniques used to identify the mostprofitable investments (financial appraisal), the implementation of plans taking accountof time, quality and cost trade offs (project management); the ideas from these subjectsneed to be integrated to make sense of company histories and derive potential courses


1.3. Effectiveness of strategic management: the evidence 3

of action. This is clearly a complex task, and because of its complexity there are manyways of tackling it, and this is reflected in the variety of names which relate to thefield of strategic management including corporate strategy, business strategy, corporateplanning, business policy, strategic planning, long range planning and competitivestrategy. Different authors have different preferences for their choice of name, usuallybased on their preferred definition of the boundaries of the subject. The term strategicmanagement is used here precisely because it has no particular connotation and makesit possible to develop the various themes without having to worry about their relation tothe definition. Incidentally, the word ‘strategy’ is often used as a general term whichincludes 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 noone definition of what strategic management is about, there are no simple answers tostrategic management issues. You are continually confronted with glib commentatorsand so called business experts on TV and in newspapers who attribute success orfailure to a single factor, for example that Microsoft is a success because Bill Gatesjust happened to be in the right place at the right time, or the superstar Madonna isa success because she sings and dances better than anyone else. Neither of theseassertions stands up to close examination: Microsoft has adapted to new technologiesand 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. Sowe must probe deeper to understand why it is that some organisations prosper whileothers fail.

Exercise 1.1

Madonna is an entertainment phenomenon: she is recognised world wide and has beenthe world’s highest paid female entertainer; but it is generally accepted that her singingdoes not compare well with a properly trained voice, her dancing does not appear tobe significantly better than the dancers in her chorus line, and her films have not beenparticularly successful, suggesting that her acting is not of the highest calibre; she doesnot 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 specifics of strategic management it is necessary to face upto one somewhat unpalatable fact: there is no empirical evidence that the approacheswhich will be developed under this heading, nor indeed under any of the definitions,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 themost famous attempts to identify the causes of success was the book In Search ofExcellence1 published in 1982. Based on a survey of 43 companies the factors commonto ‘excellent’ companies were identified and, by implication, a prescription for successwas developed. This included such ideas as ‘stick to the knitting’, i.e. keep to what youknow, and the importance of liberal and friendly management practices. But within a



decade several of the ‘excellent’ companies had fallen on hard times, and in particularIBM had by 1993 posted the largest losses in corporate history. This suggests that whatmight be a factor related to success at one time is not necessarily so at another; successand failure are the result of many factors, and it is misleading to look for a single answerto complex issues. The point of developing an overall strategic management frameworkis therefore not to develop prescriptions for success but to be able to assess individualfactors 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 effectivestrategic management is could be found by carrying out a survey of companies andcomparing the performance of those which have used a particular strategic managementapproach and those which have not; this approximates to the classical test and controlgroup approach in scientific studies. But there are a number of reasons why it is almostimpossible 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 companyperformance, but planning systems are only one aspect of strategic management.

• The types of company, the environments in which they operate, and the problemsfacing them, are so different that it is difficult to do more than draw generalsimilarities among companies and situations. In other words, the range ofvariables which would have to be controlled for is enormous.

• There may be significant interactions among variables; for example, economiesof scale may only occur in certain circumstances, and the use of company sizeon 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 thesum of its individual parts, and undue emphasis on disaggregating the functionsand characteristics of a company can obscure the overall picture.

• Companies and their markets change with the passage of time and, combinedwith the inevitable lags between actions and outcomes, it becomes impossible todisentangle cause and effect. In other words, it cannot be inferred with certaintythat a company succeeded either because it made the right decisions or becausecircumstances turned out to be favourable in relation to what it did.

Research into strategy is dominated by the case study approach, which means that anyprescription for ‘best practice’ strategy can only be corroborated by reference to relativelyfew 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 knownas ‘casual empiricism’. But if there is no scientific proof in favour of different courses ofaction, how is it that experts in strategy command very high fees for telling companieswhat they should be doing? In the past experts have offered different prescriptions forstrategy approaches including that

• consistency of delivery is the key issue

• striving for higher quality is a major success factor in its own right

• diversification is an essential aspect of company growth


1.3. Effectiveness of strategic management: the evidence 5

• company success depends on the identification and exploitation of corecompetencies

• internationalisation is the engine of growth

• a strong home base is a prerequisite for international success.

The scientifically trained may find it puzzling that so much credibility is attached toprescriptions which have no empirical foundation. On the other hand, managers pointout that they have to operate in an environment in which the scientific approach cannotbe applied, that the anecdotal approach is better than nothing, and it is necessary touse what we do know in order to introduce rationality into decision making.

An attempt to determine whether strategy making processes rather than other companycharacteristics make a difference to company performance was carried out by Halland Banbury2. This was a large scale study which obtained responses from over 300companies, and it is interesting for the light which it sheds on the problems of carryingout research in the area rather than in the statistical findings themselves (which arehedged with qualifications because of the limitations of the study). The objective of thestudy was to concentrate on whether a strategy process was followed rather than onits content. What the authors considered important was the accumulation of strategyskills over time, or the development of a strategy making process capability; this isclearly a subjective variable and is open to interpretation based on the informationprovided by the respondents. They pointed out that the one variable which cannot beused as a performance measure is current profitability, because of lagged effects; thismeans 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 beirrelevant in certain cases. By and large, it was found that strategic process capabilitycounts: that the more firms in the study were able to develop competence in multiplemodes of strategy making processes then the higher their performance. But the authorsmake a telling point which makes it impossible to draw specific lessons from the study:the direction of causation may be the other way round, and it may be that successfulfirms adopt processes which accord with the definitions of strategic process capability.This is a particular problem when looking at a cross section of companies at one time,where it is not possible to pursue the dynamics of strategy making and performance.So even a well specified and conducted study which produces statistically significantfindings 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 whichadopt courses of action suggested by the study of strategic management do no betterthan others, what is the point of carrying on with this course?’. This is exactly the sameargument as saying that since economists are no better than anyone else at predictingthe future of the economy then there is no point to studying economics. The real reasonfor studying economics is to attempt to understand the world better and the same appliesto strategic management. If you try to run a company without the benefit of ideas,concepts and theories you might as well act randomly; in fact, CEOs who do not have aformal business education (and may even claim to be proud of it) are implicitly applyingrules derived from their experience. These rules may have worked in the past, but theyare difficult to verbalise and their transferability from one situation to another is opento question. This is the important outcome of studying strategic management: it willenable you to look at any business issue using a common intellectual framework; it may



not generate the answers which will lead to success in the future, but you will at leasthave 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 notdeserving of it. For those of you who take that view, perhaps exposure to the subjectmatter itself will persuade you otherwise.

Exercise 1.2

If Madonna’s success is related to the factors identified in defining Madonna as abusiness, why don’t all singers use this approach and guarantee themselves success?

1.4 strategic management at corporate and business unitlevels

Many of the terms used in this Module have a meaning which is not shared byother authors. For example, the term corporate strategy will be used to refer to thestrategic concerns of the CEO, who could be in control of a small company employingfive people and producing one product, or a very large company employing manythousands of individuals and producing hundreds of different products; these concernsare differentiated from business strategy, which is concerned with the efficient operationof an identifiable 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 companystrategy at whatever level. There is no right or wrong here, but it is important to be awareof such differences when you read other sources.

An SBU is normally thought of as being a division of a company, with its own internalstructure which mirrors that of the parent company; the parent company devolves mostresponsibility to the chief executive of the SBU, who reports back to the centre in termsof overall SBU performance. However, the SBU can take a number of forms: it can bea grouping of business subsidiaries which have some common strategic elements suchas similar competitors, closely related supply chain activities, similar type of product,contained within a geographical area and so on. The SBU is particularly important todiversified companies, because it provides a method of rationalising the organisationof many different types of business whereby resources can be aligned with individualmarket requirements. Thus the corporate concerns are with determining the scope ofthe company and resource allocation among SBUs, while the SBU concerns are withthe exploitation of their particular markets.

Exercise 1.3

A decentralised gardening business might look something like the following:


1.5. The meaning of strategic management 7

The SBUs deal with garden machinery, selling plants from a number of market gardens,and constructing garden buildings such as sheds, gazebos and conservatories. Thesales turnover of SBU1: SBU2: SBU3 is 3: 2: 1. The SBU1 manager has suggestedthat the salaries of the three SBU managers should also be in the ratio 3: 2: 1. Thisproposal has not met with the approval of everyone.

Set out a discussion on this between the CEO, the two corporate services officers andthe 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 theterm ‘strategy’. This is clearly a key element of strategic management so it is importantto develop a clear idea of what it means at the outset. However, there is more to this thansimply setting out a definition which can be used in practice. Commonly encountereddefinitions 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 definitions, but individually theycould lead to different courses of action. For example, definition 2 focuses on objectives,but makes no difference between short term and long term as in definition 3; definition4 is the only one explicitly concerned with markets. It is natural to conclude that oneway of resolving this confusion is to refer to the academic literature on the topic to seewhat business theoreticians have to say on the matter. But the literature itself doesnot provide an unambiguous definition. Since the early 1950s, when business schoolsbegan 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



stage to consider the main themes of this discussion before setting out how strategy isdefined and utilised in this Module.

The idea of strategy was originally developed in a military context and extends backat least as far as 360 B.C. to Sun Tzu’s The Art of Strategy. The very word strategycomes from the Greek strategio meaning a general, stratos meaning an army, andagein 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 tobusiness, and partly this is due to the difference between the objectives in war, which areto destroy the enemy, and the objectives in business, which are largely to sell effectivelyin markets. There is a significant difference between attempting to destroy an enemy’sresources and operating in a market in competition with other sellers. However, there aresimilarities in the military and business situations, in that both armies and businessesneed objectives, both need to have an understanding of their environments, both haveresources and have to implement courses of action. From these ideas, and from thedevelopment of business in the 20th century, various approaches to business strategyhave developed.

It is important to stress from the outset that strategy problems cannot be analysedand resolved and then more or less forgotten about. In real life the day never comeswhen strategy decisions are made and all problems are solved. This is because theenvironment within which the company competes is constantly changing: products movethrough the life cycle; new companies enter the market; consumer preferences change;government regulations change; major political events alter markets both domesticallyand internationally. The functional view of management, i.e. the view that there is aset number of objectives to be tackled by individual managers which, taken together,determine the effectiveness of the company, is a limited interpretation of the strategyproblems which companies face; in the real world there is no such thing as a set numberof objectives relating to a future time period. Strategy can only be properly understoodin a dynamic rather than a static setting. To some extent different views on strategy aredependent 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 severalways, and at the same time strategic ideas have developed; one of the intriguing aspectsof these developments is that strategic ideas appear to have developed as a meansof describing what has happened as business changed, and these ideas have thenbeen used as the basis for prescribing how companies should behave. For example,as companies grew in the 1950s and became increasingly difficult to manage fromthe centre, the notion of decentralising control to divisional level developed, and thiswas associated with the development of control techniques such as financial budgetingand investment appraisal. In subsequent decades attention focused on diversification,portfolio management, the search for competence and so on. An outline of the maindevelopments and the associated ideas is contained in Table 1.1, which is roughlybased on the decades since the 1950s and draws on the work of Goold, Campbell andAlexander3. This classification is very approximate, but it shows how the developmentof 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



discussions typically use terms such as ‘portfolio’, ‘diversification’ and ‘synergy’ in asense which is particular to the subject, and often such discussions give the impressionthat strategy is a discipline which has a well developed theory and approach. But itis important to appreciate that these ideas developed by observing the reactions ofcompanies to changing circumstances after the event; while the analysis of companyoperations is based on the application of these ideas, they were rarely applied explicitlyat the time by CEOs. The ideas behind the terms in Table 1.1 will be developed in laterchapters, but a brief review of the historical background will help to put the ideas inperspective.

Table 1.1: Historical development of strategic management

1950s

After about the mid 1930s companies such as GM, Du Pont and Standard Oil had growntoo large and complex to be managed with their previous functional organisation. Thedecentralisation of activities into divisions which characterised the 1950s highlighted thedistinction between business and corporate strategy: the divisions were responsible forexploiting their markets, while the corporate centre was responsible for financial controland resource allocation among the different elements of the corporation. This was thebeginning of the process of disaggregating companies into SBUs. Many of the ideasof corporate finance were developed and applied on an increasing scale, including thenotions 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 diversification ofactivities. This built on the established divisionalisation, and new companies werebrought under the corporate umbrella as additional divisions. A compelling argumentduring this period was that the assimilation of different, but related, businesses underthe corporate umbrella would lead to synergy. The quest for synergy provided a powerfulrationale for diversification through acquisition, because it offered the promise of creatingvalue beyond that which the business would have were it left on its own. Synergy in factturned out to be elusive, but this ought not to have been surprising because the potential



benefits were based more on hope than on evidence. It was not appreciated at the timethat the quest for synergy often led to value destruction rather than value creation, andthis sowed the seeds for later corporate strategies based on the perceived weakness ofmany diversified companies.

It was about this time that the role of the manager with transferable skills began tobe recognised, because the management of diversity could not be accomplished byspecialists. It is not surprising that this is the period when business schools began toidentify what these general management skills were comprised of and to teach them topractising managers.

1970s

During the 1970s there were several major changes in economic and competitiveconditions. National growth rates fell, and there was a period of great instability asworld energy prices soared and the balance of economic power shifted for a timeto the OPEC countries. At the same time that competitive pressures increased withadvances in technology trade barriers were reduced and the Pacific rim economiesgrew enormously. It became widely recognised that the company environment wasmuch more complex and unpredictable than in the 1960s. In addition, the managementof diversity as pursued in the 1960s was increasingly recognised as a problem, andthe search for a balanced portfolio of products led to the development of the portfolioapproach to product management.

1980s

The inability of many companies to manage and add value to diverse portfolios led totake-overs by corporate raiders who saw opportunities for releasing value from failedcorporate diversifications. This development was largely confined to the US and theUK partly because of their more developed capital markets and the independence ofcorporations from banks. The scale of the take-over strategy was staggering: in theUS in 1988 over 2000 companies were acquired with a total market value of over $850billion. 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 valuecreation focused on cash flows and led to the development of techniques known asvalue based planning, which include discounted cash flows 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 excellentcompanies lay in identifying what they were good at and avoiding diversifying outof their area of competence. This led to concern over the activities of professionalmanagers who knew little about the businesses they were running other than thefinancial outcomes.

Early 1990s

As it became increasingly apparent that diversification of itself had not led to significantincreases in value in many cases, attention turned to how the company itself createdvalue and competitive advantage, i.e. the resource based view of the company. Thereare several strands to this. First, it was argued that the company could diversify, but suchmoves had to be based on companies in strategically similar industries which wouldshare a dominant general management logic. This abstracted from the type of industryand product, and focused on the way managers conceptualised the industry and how



they made important decisions. The problem with this approach is that it is difficult todefine what the dominant management logic is actually comprised of, and it is not veryhelpful 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 andwhich are the basis for non-imitable competitive advantage; this led to the notion of corecompetence. This was of particular importance at a time when companies were involvedin downsizing and rationalisation, because it was important that the company realisedwhat it was downsizing back to; on the other hand, a company which was consideringexpansion through diversification could think in terms of the competences it was bringingto the new business that were common to those which already provided the basis forcompetitive advantage. Both these notions led to the idea of linked portfolios rather thanthe balanced portfolios of an earlier time. However, the degree to which the componentsof the portfolio were linked was not always clear, nor was the basis on which the linkageswere based.

A third strand was to argue that a conglomerate had the potential to bring certainadvantages to the individual businesses which was unrelated to synergy, economiesof scale: the parenting advantage. Broadly speaking, there are four areas in whichparenting advantage might be generated, but as discussed below there is no guaranteethat any advantage will result.

• Stand-alone influence: while the individual SBU is encouraged to actindependently to meet its goals as set by the parent, there is actually a majorproblem in deciding how far the parenting influence ought to extend. The parentingactivities include agreeing and monitoring performance targets, approving majorcapital expenditures and selecting business unit managing directors; the parentinginfluence may extend to product-market strategies, pricing and human resourcemanagement. But it can be argued that the more the parent extends its influenceinto the affairs of the individual businesses, the more likely it is that it will destroyvalue; why should a parent manager working part time do better than a businessmanager working full time?

• Linkage influence: a major role which the parent should undertake is to encouragerelationships 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 establishlinkages by alliances, joint ventures and informal agreements without parentalinvolvement; so it is an open question as to why the parent should do any betterthan managers acting in their own self-interest.

• Functional and services influence: the parent can provide functional serviceswhose cost can be spread across the SBUs. But this creates a degree of verticalintegration whereby the supplier is insulated from outside competition; it is difficultto guarantee that internal suppliers will be as efficient as the market.

• Corporate development activities: the main role of the parent is usually seenas buying and selling businesses, creating new businesses, and redefiningbusinesses. This amounts to changing the businesses in the corporate portfolio.But since the weight of research indicates that the majority of corporatelysponsored acquisitions, new ventures and business redefinitions fail to createvalue, the odds against success are long; there is thus no particular benefit tothe individual SBU of being part of the conglomerate for this reason.



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



Late 1990s

As trade barriers continued to fall, through the work of the World Trade Organisationand the formation of trading blocks such as the European Union, and capital marketstranscended national frontiers, companies increasingly found themselves competingin an international market place. Companies in many industries began to fear thatnationally based operations would stand little chance against powerful multi nationals.Thus the late 1990s witnessed huge international mergers in industries such as financialinstitutions, telecommunications, energy supply, car production and pharmaceuticals.While the arguments in favour of mega mergers are clearly persuasive enough to providecompanies with the incentive to embark on these ventures, it is an open questionwhether 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 guaranteethat size will confer a real competitive advantage in servicing distinctive local marketsfor goods and services.

Early 2000s

It has always been difficult to build sustainable competitive advantage becauseeventually anything can be imitated. In an environment of fast technological changecompanies started to realise that part of their advantage lay in the knowledge andunique skills of their experienced employees. It became a priority to identify and classifyknowledge so that it could be maintained and disseminated as required. But it soonbecame apparent that the really important bits of knowledge were extremely difficult toidentify because they resided within specific individuals and were largely learned onthe job; this became known as ‘tacit’ knowledge. This presented organisations with areal problem: competitive advantage and innovation depend on a resource that cannotreadily be identified or controlled. Techniques of knowledge management began to bedeveloped to tackle these imponderables but progress has been slow.

This description of strategic ideas and the circumstances in which they developed doesnot really tell us much about how companies arrived at particular courses of action. Forexample, did the CEO of a large company announce one day ‘We shall now pursue apolicy of decentralisation and divisionalisation’ or ‘It is now time for us to embark ona series of acquisitions’? It is not only necessary to understand what was done andwhy, but it is just as important to understand how companies make such decisions inreal life. Thus this turns out to be surprisingly difficult to do, and there are severalschools of thought on how strategy is arrived at. These can be grouped into three broadapproaches: 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 bysenior management which is then passed down for implementation; this plan is thenadhered to over the planning time scale. This is usually thought of as the strategicplanning approach, and it has been claimed by its supporters that this prescriptive formof strategy is rational and objective; but as Mintzberg4 and many others have pointedout, it makes a number of assumptions about the world which are highly questionable.

• The future can be predicted accurately enough to make rational discussion andchoice realistic. It is in fact a widespread fallacy that the future can be predicted



with any realistic degree of accuracy. At the macro level economists disagreequite markedly on the economic prospects for any given country during thecourse of the next year; such forecasts can never take into account unforeseeableevents such as the Asian economic crisis in 1997 or the collapse of the Russianfinancial system in 1998. At the micro level market innovations and the actions ofcompetitors can have fundamental effects which are also impossible to predict,such as the introduction of telephone insurance selling in the UK in the early1990s. One reason that such market changes are impossible to predict is thatthat they are dependent on the unique vision of individuals; if such unique visiondid not exist there would be virtually no scope for competitive action in the firstplace.

• It is possible to detach strategy formulation from everyday management. In arrivingat a strategy it is necessary to have a full set of data which can be subjectedto analysis and from which conclusions can be drawn. But this assumes thatthere is some technique whereby the relevant information is extracted from theorganisation, and from individual managers, and presented to strategy makers ina tidy bundle. This dodges the question of who is to decide on which informationis relevant, and indeed whether the information is readily available. Furthermore,as events unfold information is continually evolving and can go out of date veryquickly.

• It is possible and better to forego short-term benefit in order to obtain long-termgood. In a situation of uncertainty, and lack of knowledge about the future becauseof the difficulties of forecasting mentioned above, it may often appear preferable toreap short-term benefits; it is also extremely difficult to convince those who lose inthe short term that the trade-off is worthwhile.

• The strategies proposed are logical and capable of being managed in the wayproposed. Any strategic initiative which involves change is dependent on companypersonnel adapting and working in alignment with company objectives. Changemanagement 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 thatprescriptive actions simply do not take the human dimension adequately intoaccount.

• The Chief Executive has the knowledge and power to choose among options. Hedoes not need to persuade anyone, nor compromise his decisions. This takes anaive view about leadership and how it is exercised. In reality, very few businessleaders can behave like dictators, and certainly not for very long. It is necessaryto achieve consensus and agreement at all levels of the organisation, otherwise aprescriptive plan simply cannot be made to work.

• After careful analysis, strategy decisions can be clearly specified, summarisedand presented; they do not require further development, nor do they need tobe altered because circumstances outside the company have changed. This isperhaps one of the greatest and most potent fallacies: it is never possible to avoidambiguity completely, and it is potentially lethal to ignore changing competitivecircumstances. One of the most important reasons for company failure is the lackof a feedback mechanism and the channels of communication that make it possiblefor decision makers to adapt to changing circumstances.



• Implementation is a separate and distinctive phase that only comes after a strategyhas been agreed; for example, a strategy to close a factory merely requires amanagement decision and then it just happens. This is possibly a reflection ofthe fact that the implementation stage of strategy has always received much lessattention than the more glamorous and exciting areas of objective setting andstrategy choice. In reality nothing ‘just happens’, and an essential part of strategymaking is to evaluate the feasibility of different courses of action. It may wellbe desirable, on financial grounds, to close a factory, but the actual process ofachieving this may have widespread and damaging effects on the company as awhole.

During the early 1960s the notion of prescriptive planning was quite popular and manycorporations set up corporate strategic planning departments. However, experiencehas revealed that the attempt to drive corporate strategy in this restrictive fashion isunproductive. A major problem arises when individuals become committed to thestrategic plan itself, and not to the success of the company; this can occur whenperformance measures have been expressed in financial terms, and the pursuit offavourable financial reports takes precedence.

1.5.3 Emergent Strategy

This approach starts from a different premise: that people are not totally rational andlogical. The extent of this irrationality has been the subject of research, and the generalfindings 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 beinterpreted in a number of legitimate ways, and it is not surprising that managersoften select the interpretation which backs up their previously determined views.

• Managers are likely to seek a satisfactory solution rather than maximise profits.

• Organisations consist of coalitions of interest groups. The implementation ofdecisions depends on negotiation and compromise between those groups, leadingto unpredictable outcomes.

• When making decisions, managers pay as much attention to a company’s cultureand 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 anunpredictable manner. The strategy emerges from a chaotic environment and hencemay appear to have little structure as a result; it is therefore argued that the claim of acause and effect relationship between analysis and strategy choice and implementationis fundamentally flawed.

There is another very good reason why there is a limited use of information in decisionmaking: 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, ratherthan what might be done in an ideal world. The term used to describe rationality whenit is impossible to take into account the complexity of real life is ‘bounded rationality’;



the decision maker is rational given the information at his or her disposal, but is quiteaware that more information is likely to be available. In economics it is argued thatbroadly speaking decision makers act in accordance with profit maximisation, but it isimpossible to reconcile profit maximisation with bounded rationality. This means that adifferent view of decision making has to be taken and the term ‘satisficing’ was inventedto reflect the fact that decision makers collect information and defer selecting a courseof action until the costs of further delay and information collection are considered to begreater than the potential benefits of searching out a better option. Thus rather thansimply attempting to maximise profit, the decision maker satisfies himself or herselfthat there is nothing more to be gained from further delay. This helps to explain whydecision makers are so eager to find out what management gurus have said and arecontinually searching for ways of making sense of the real world. To decision makersany information is better than no information, and it does not matter very much to themthat the information they are acting on does not accord with accepted views of what isproper scientific enquiry.

Another way of looking at this is to make up a list of things which the company does notknow 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 becomplete and is likely to be unreliable. In fact, it turns out that you can not actually gethold of the really important information and it is always necessary to make assumptionsand to take many things on trust.

However, it can be argued that just because the world is a complex and changing placedoes not mean that decision makers should simply sit back and let things happen andthat 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. TheBoard needs to do more than simply react to changing circumstances.

• There is a need for efficient resource allocation; if this is not tackled resourcesmight 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 difficult to manage.

• In many cases investments take a considerable time to reach fruition, therefore adegree of long term planning is inevitable.

• Satisficing is in itself a rational basis for choice, since it is better to make an



informed judgement on the basis of some information than no information at all, orto ignore information altogether.

• The act of attempting to plan at least makes the basis for management actionclear.

Therefore there is some middle ground between trying to plan for all eventualities andsimply reacting to events as they occur.

1.5.4 Resource based strategy

This approach lays emphasis on the internal resources available to the company. Whileit does not overlook the importance of the competitive environment, it starts fromthe basic premise that strategy is primarily concerned with the search for competitiveadvantage, and to a large extent the source of competitive advantage rests within thecompany’s resources. The resource based view does not focus so much on the actuallabour and capital deployed by the company, but rather on the way in which theseresources are utilised. A successful company is not a passive collection of resourceswhich reacts to changes in the competitive environment, but develops the ability to takeadvantage of opportunities as they arise, and to create the opportunities themselves byinnovative behaviour.

The resource based approach uses various terms for different types of resources.Without going into detail at this stage it is important to distinguish among them.Resources include physical resources, human resources, financial resources andintellectual resources. Competences arise from the continual deployment andintegration of resources over time and across activities. Core competences arenecessary for successful performance. Distinctive capabilities are competencessuperior to competitors. Taken together these can be regarded as the company’sstrategic capabilities.

The role of strategic capabilities in creating sustainable competitive advantage dependson several characteristics, including the following.

• Rarity: some resources and competences are so scarce that only a few firmshave access to them. This raises the question of how companies acquire suchresources and competences when they are rare; they would clearly command ahigh price on the open market.

• Complexity: competences are nurtured from many linkages among resources andactivities that are mostly impossible to identify and replicate.

• Causal ambiguity: because of the difficulty of attributing cause and effect thecauses of superior performance are unclear, even to company insiders.

• Culture: competences may be embedded in the organizational culture and cannotbe 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 difficult to imitate that sustainablecompetitive advantage is unique to every company that possesses it. The question thatthen arises is how sustainable competitive advantage arises in the first place. It may



be the case that successful companies are not necessarily there because anyone hassuperior insight in organisational design or strategic fit. Instead there are typically manyviews in the company regarding the capabilities a particular activity requires and it is themarket, rather than the visionary executive, that selects the most effective match. It canbe argued that strategic capabilities are established by market forces rather than beingdesigned.

The implication is that, by definition, there is nothing to be gained from analysingsuccessful (or unsuccessful) companies. That is not the view taken in this course; thereare, of course, many things that cannot be fully explained. But there is a great deal thatcan 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 applicationof strategy to business, and in the rest of this Module the two terms will be usedinterchangeably.

There is little doubt what strategic management is about: it is the running of anorganisation effectively, however effectively may be defined. But if you go back to thecommonly encountered definitions, you will see that they are in fact no more confusedabout what strategy is than the scholars who have considered the issue in depth. Thefact is that there are a number of ways of approaching strategy and none of themprovides 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 tothe prospect of reduced profits for the current operating year.

CEO: I don’t think our profit problem is simply due to external events such as the recentproblems with the economy. It seems to me that it is more to do with the way we dothings - I am not certain that we are acting as efficiently as we could be.

Operations manager: we have actually invested heavily in more productive assets andin training programmes in the last two years. I am not sure there is much more we cando in that respect.

Marketing manager: I don’t think we exploited the market opportunities for our new rangeof products as well as we could have done. When we didn’t capture market share earlyon last year we should have channelled a lot more resources into the marketing effort.We can’t take market conditions as given.

Finance director: but we had already decided how to bring these products to the marketand we had no spare resources.

CEO: yes, we put a lot of effort into the plan, and it was a great disappointment when itdidn’t work out. Maybe we need to spend even more time planning in the future.

Marketing manager: what is the point of planning in ever more detail when we can’tseem to react to the unexpected?


1.6. Strategy as a process 19

Operations manager: that is a defeatist attitude. We just don’t spend enough timecollecting and analysing information.

Human resources manager: you’re all right in your analysis and you’re all wrong aboutwhat we should do.

As with most taped conversations, even after heavy editing it does not seem to makemuch sense at first sight. In particular, the human resources manager did not appear tocontribute anything. Your job is to interpret what was said in terms of the three strategicapproaches.

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 aparticular company, it does not take long to realise that it is incredibly complex; one wayof thinking about complexity is to categorise problems as ‘tame’ or ‘wicked’ in the senseused by Rittel5. In this scheme, wicked means much more than incredibly complex. Forexample, consider Fermat’s Last Theorem; in about 1637 the mathematician Fermatnoted that he had a proof for the proposition that there were no three numbers whichwould fit the expression

xn + yn = zn where n � 2

The trouble was that he claimed not to have sufficient room in the margin to elaboratethe proof. The search for the proof occupied many mathematicians for the next threehundred years, and it was not until 1993 that Andrew Wiles, after many years of effort,found the solution using highly refined and abstract mathematical concepts. There is nodoubt that Fermat’s Last Theorem is an incredibly complex problem, but consider it inthe light of Rittel’s distinction between tame and wicked characterised in Table 1.2.

Table 1.2: Tame and Wicked problems

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



that it falls into the Tame category on every criterion. Now consider the discussion ofstrategy so far, and see where it falls.

1. It is difficult to formulate the problem

2. The process of formulating and understanding the problem goes a long waytowards solving it

3. The scientific 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 ismost 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 withother situations

The fact that strategy has many of the characteristics of a wicked problem probablyhelps 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 anintellectual dilemma: which approach to strategy should be selected and why? Theanswer to this is ‘none of them’. Instead, strategy will be dealt with as a process, whichmakes it possible to incorporate all different approaches and ideas as variations on theprocess itself. At first this idea might seem a little perplexing, so it is necessary to startby clarifying what is meant by a process. The simplest way of thinking about this is toconsider a typical business situation where the production department has not producedenough units to satisfy demand, i.e. the marketing department has sold more than thecompany can make. At a management meeting in AcmeGrow the following discussiontook place.

CEO: As a result of our production shortfalls we have a lot of unsatisfied customers, andI reckon that this year our turnover could have been $10 million greater than otherwise.So I want to find out what went wrong.

Production Manager: We were taken completely by surprise when an additional 25per cent orders came in. We were not carrying much inventory, so I put everyone onovertime. But this caused increased machine breakdowns, which cost a small fortune inmaintenance, 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 finance department decided we shouldreduce costs by introducing a Just in Time system.

Finance Manager: When the JIT system was introduced you didn’t tell us that you werelikely 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, Iwarned the finance department that we were launching a new marketing campaign but



no-one seemed interested. I must admit that the campaign was far more successfulthan I had thought it might be.

CEO: Let’s fix this problem. We cut costs and became more efficient on the one hand,but this has ended up costing us far more in lost sales and additional maintenance. Wehave to make sure that this doesn’t happen again. We need to implement a less rigorousJIT system and carry more inventories.

The CEO has certainly identified a solution to the particular problem which confrontedAcmeGrow. But you need to stop here and think about what has really happened. Beforeproceeding leave the text and write down what you would say to the managers aboutthis problem as an external consultant.

In trying to assess ‘what has really happened’ the first step is to decide whether the JITsystem, which the CEO identified as the cause of the problem, is really the sickness ormerely a symptom. Does the JIT fix guarantee a solution to other potential problems,such as the entry of a new competitor, the emergence of substitutes, a price war, theloss of key personnel, to name but a few? It is likely that the CEO’s solution will have littleimpact on the outcome of these events, and they could cause disruption and losses ona 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 accountof events as they unfold. For example, the implications of the new marketing campaignshould have been discussed at the outset; at that stage decisions about productivecapacity and the JIT system could have been made. But there is no process in thecompany to ensure that this happened. Instead, we have a group of task orientatedmanagers who do not perceive the operation of the company beyond the bounds oftheir own immediate responsibility; the fact that the finance department did not respondto the marketing manager at an early stage shows that while communication can takeplace, 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 considerthe full implications of changes on the overall operation of the company. This wouldprovide a solution to the immediate problem, but would also result in a framework withinwhich a range of unforeseeable events could be handled. For example, in the eventof a price war the marketing manager can provide an assessment of how much pricecutting is required to maintain market share, and for how long; this enables the financemanager to assess the impact on company cash flows and viability; at the same timethe production manager can assess whether there are short term cost savings whichcan be made in the identified time scale. The precise details of the solutions arrived atare not really the issue: the point is that none of this would happen in the absence of amanagement 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 weselected the appropriate strategy? Are we implementing effectively? are frequentlyaddressed. In particular circumstances these questions have to be answered, but fromthe wider viewpoint the real issue is whether these questions are being asked in thecontext of a process which will ensure that they will be addressed and answered at theappropriate time whatever else is happening. The notion of a strategy process is in factquite simple and is set out in Figure 1.1; once you have seen it, it accords with commonsense. The examples refer to the case above.



Figure 1.1: The strategy process model

Setting objectives

Unless there is some direction to a company’s actions they may as well be random.

Example The objective of AcmeGrow is to make profits, which is why so much concernwas expressed over the loss of sales and the increase in costs. If the objective hadbeen to keep sales constant, the marketing manager would not have launched the newcampaign.

Analysis

It is necessary to know as much as possible about the external and internalenvironments. It is impossible to make logical decisions in the absence of relevantinformation, and one of the great challenges is to identify what information (from thevast 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 themarketing 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 theactions of the company. There was little understanding of how susceptible AcmeGrow’sresource structure was to unanticipated changes. Thus the company had little strategicunderstanding 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 marketingcampaign to increase sales; on the other hand it had organised its resources internallyin a manner consistent with stable sales. Both sets of actions were consistent withthe overall aim of profitability, i.e. to increase sales and reduce costs, but the strategicchoice did not align resources with marketing.



Implementation

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

Example AcmeGrow had introduced a JIT system in the pursuit of higher profits. Whereit failed was in the management of the change itself. Each manager was concerned onlywith his own area of responsibility and no attempt had been made to ensure that theworkforce 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 apparentthat management met to remedy the situation. An early warning system would havealerted 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 oftendisregarded because of the preoccupation with the search for strategic options and thedifficulties of implementation and control. The point needs to be hammered home atthe outset: there are no complete answers to strategy problems because the worldkeeps on changing. The five steps above are in a rough order which correspondsto common sense, but feedback occurs all the time and the loop must be continuallyrevisited.

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

Even at this early stage the power of the process approach becomes apparent. Itprovides an overview of strategy which is impossible to achieve by considering individualaspects of company problems. In the example it was identified that the real problemconfronting the company was the lack of a management process; the precise details ofhow this process would operate is up to the CEO. In the strategy case we identify anoverall process which is not prescriptive but is a model of reality. Thus very quickly



we arrive at the conclusion that the goal of profit maximisation was not translated intocoherent actions as a result of sound analysis and diagnosis, while implementation isweak and there is a lack of effective feedback. Looked at this way, how long can thiscompany 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 stepis to build a set of powerful tools which will enable us to tackle the various componentsof the process model in a structured fashion. Each of the chapters deals with a partof the process model, culminating in a full integration of the underlying ideas within theprocess structure.

1.7 The role of the CEO

The definition of strategy as a process provides insights into the role of the CEO. Peopleoften 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 andfew individuals possess the attributes to perform this role effectively. Referring back tostrategy 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 makedecisions about potential investments, react to changing circumstances, identifynew courses of action and provide leadership for the organization as a whole.

• Analyser and competitor. The CEO needs to be constantly aware of changes inthe economic environment, the efficiency of the firm, and its competitive position.The process of information collection and analysis is time consuming, and it isnecessary for the CEO to filter out what is unimportant and focus on factors whichare likely to impact significantly on the firm.

• Strategy choice maker. Options must be identified and different points of viewtaken into account in order to assess the costs and benefits associated with each.

• Implementer and controller. Once decisions have been taken the CEO has a majorrole to play in making them happen. As well as allocating resources, the CEOhas to set up systems to monitor how effectively resources are being utilized andwhether strategic goals are being achieved.

• Communicator. As new information becomes available and competitive conditionschange the CEO has to ensure that everyone is kept aware of changes in directionas far as possible.

There is more to the CEO’s role than handling complexity, there is also a degree ofconflict inherent in the different roles. For example, the CEO needs to set up systemswhich ensure resources are used efficiently; but these very systems may introduceinflexibility and resistance to the changes which the CEO considers necessary in therole of competitor. The objectives and mission of the firm may be expressed in generaland non-measurable terms, while the control systems tend to be based on financialmeasurements; the two approaches may be difficult to reconcile. Thus as well as beingcharged with the task of resolving conflicts of interest in the company, the CEO must


1.8. Principal agent problem 25

also deal with the internal conflicts caused by the roles which he or she is required toadopt.

1.8 Principal agent problem

A central problem of management is the need for the principal to establish a contractwith an agent or agents that ensures the principal’s objectives are met. The underlyingproblem is one of asymmetric information: it is not possible for the principal to monitorall aspects of the agent’s performance. The individual agent has an incentive to concealthe fact that objectives have not been achieved, and will possibly attempt to ascribean unsuccessful outcome to other factors, such as supply problems lying outside theagent’s control. It is therefore extremely difficult to arrive at an efficient contract becauseof the complexity of aligning the objectives of the agent with those of the principal. Forexample, the personal objectives of an individual manager may include maximisationof wealth, ambition, desire for a quiet life, desire to avoid confrontation, and so on.There is no guarantee that the manager will place the company’s objectives high inthis personal set of priorities. The problem extends to the contract between the CEOand shareholders; the CEO may have a remuneration package which includes a bonusfor growth in current profits; to ensure that current profits continue to grow the CEOmay reduce expenditure on R&D, which has the effect of increasing current profit at theexpense of long term competitiveness.

The misallocation of resources can be compounded by involving accountants and otherspecialists in attempting to find out what has gone wrong, while the problem really lieswith the contract and incentive system. An example of the difficulty of ensuring thatthe agent acts in the interests of the principal emerges when one company mounts atake-over bid for another. This always has the effect of initially increasing the shareprice of the target company. If the managers running the company had acted in thebest interests of the shareholders then this could not happen, because they would haverun the company efficiently and exploited opportunities, all of which would have beenreflected in the current share price. In these circumstances it would appear that theoutsider actually knows more about the company than the incumbent management,and has spotted opportunities for increasing shareholder wealth which these managershave not. The trouble is that there is no effective mechanism by which shareholders canensure that their managers act efficiently; this is because the ownership of the companyis spread among many shareholders while the running of the company is concentratedin 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 inthe years following the privatisation of huge nationalised industries including gas andwater utilities. In all cases the existing management received enormous increases inremuneration, and the argument that it was necessary to pay such large salaries inorder to attract the best talent appeared spurious to most shareholders because theyhad been in the job prior to privatisation. In the case of British Gas this coincided witha high degree of dissatisfaction with the provision of gas as measured by the numberof official complaints received by the gas regulator, and one British Gas Annual GeneralMeeting was attended by a pig by the name of Cedric (the unfortunate CEO of BritishGas was called Cedric Brown) brought by a group of dissatisfied small shareholders. In



the event it proved impossible for the small shareholders to censure the managementboard because the large institutional investors supported the existing management. Theprivatised Water Companies caused similar dissatisfaction; for example, the people ofYorkshire (one of the rainiest areas in Europe) had to suffer restricted supplies becauseof water shortages at a time when management freely admitted that about one third ofall water was being lost through leaks in the pipes. Once more it proved impossiblefor the small shareholders to oust what they perceived as incompetent and greedytop management. No position is taken here on whether the top management of theseorganisations were in fact greedy and incompetent; the point is that a significant minorityof 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 identified in the strategy process inthe previous section the CEO has to deal with the principal agent problem at all levelsof the organisation. Every manager who has subordinates has to deal with the principalagent problem and the resulting conflicts of interest.

Exercise 1.5

Use the process model to discuss

1. the reasons advanced by Mintzberg and others that prescriptive planning isimpossible

2. emergent strategy

3. the case study approach to strategic analysis (with reference to the AcmeGrowdiscussion).

1.9 References1. 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 adifference’, 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 & SonsLtd.

4. Mintzberg, H. (1994) The Rise and Fall of Strategic Planning, New York: FreePress.

5. Rittel, H. (1972) ‘On the planning crisis: systems analysis of the first and secondgenerations’, Bedriftsokonomen No 8, pp. 390-396.


27

Chapter 2

Mission and objectives

Contents

2.1 Mission and objectives in the process . . . . . . . . . . . . . . . . . . . . 28

2.2 Vision and mission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

2.2.1 Understanding the business . . . . . . . . . . . . . . . . . . . . . 28

2.2.2 Deriving the mission statement . . . . . . . . . . . . . . . . . . . 30

2.2.3 Disaggregating the mission . . . . . . . . . . . . . . . . . . . . . 31

2.3 Setting objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

2.3.1 Strategic objectives . . . . . . . . . . . . . . . . . . . . . . . . . 32

2.3.2 Financial objectives . . . . . . . . . . . . . . . . . . . . . . . . . 33

2.3.3 Priority and conflict . . . . . . . . . . . . . . . . . . . . . . . . . . 33

2.3.4 Characteristics of objectives . . . . . . . . . . . . . . . . . . . . . 34

2.4 Who sets objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

2.4.1 Who is the strategist . . . . . . . . . . . . . . . . . . . . . . . . . 36

2.4.2 Characteristics of strategists . . . . . . . . . . . . . . . . . . . . 37

2.4.3 Company evolution and strategists . . . . . . . . . . . . . . . . . 38

2.5 Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 thecompany

28 Chapter 2. Mission and objectives

2.1 Mission and objectives in the process

Setting objectives Vision Mission Objectives Strategists ⇓ Analysis ⇓ ⇑ Strategy choice Feedback ⇓ Implementation ⇓

Control

2.2 Vision and mission

It might seem obvious to state that the senior executives in a company need to have aclear idea of which business the company is in and the way in which it is going to pursueprofitability in that business. One of the roles of the CEO is to develop a vision withinwhich the resources of the company can be mobilised. In general terms this is usuallythought of in terms of setting out a mission statement which serves as a definition ofthe company which is clearly understood by employees and provides a focus for theiractivities. However, this is difficult to observe in practice and the process of identifyingthe business and expressing the company’s approach in a mission statement is full ofpitfalls.

2.2.1 Understanding the business

The reaction of many managers to the question ‘What business are you in?’ is oftenincredulity that such an obvious question needs to be asked. When pressed, theresponse might take the form ‘It’s obvious - we make soft drinks’. A few supplementaryquestions will reveal that this response is not just inadequate, but it can lead thecompany into serious errors.

• Do you control all stages of production or do you purchase all ingredients andmerely 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 first question relates to the productive scope of the company, i.e. the extent towhich it buys in its inputs and hence how it perceives its own supply chain. For example,


2.2. Vision and mission 29

a soft drinks company which makes its own bottles has a whole series of concernswhich are absent from a company which buys its bottles from a bottle making company.In particular, it has to be concerned with the efficiency of its own bottle making plant,rather than relying on the forces of the market to enable it to purchase bottles at thelowest cost. The scope of the company also impacts on the skill set the company needsto 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 withbottle manufacturers which generate a competitive price and a guarantee of supplies;the company which makes its own bottles needs to recruit individuals with productiveexpertise in this function. These are clearly quite different skill sets.

The second question relates to the market positioning of the product; for example, thecompany may produce soft drinks for ‘own brand’ supermarket products, and have littleneed for marketing the product in its own right. This is of fundamental importance forcompany expansion, because the own brand producer can only expand if its customersgrow or by finding more large customers to supply, while the company which marketsdirectly to consumers can increase its sales by marketing more aggressively.

The third question relates to the breadth and focus of the business definition; forexample, soft drinks are sold alongside alcoholic drinks in restaurants and publichouses, and could be promoted as an alternative to alcoholic drinks. Or it might bepossible to present the soft drink as an alternative to coffee, which contains caffeineand is a mild stimulant. Or it might be possible to present the drink as an aid to athleticperformance.

The fourth question relates to the different markets which might be targeted; forexample, tonic water is relatively rarely consumed on its own and is usually mixed withgin. It is unlikely that tonic water could be aimed at both this market and the healthmarket.

Taken together, answers to these questions can identify companies of totally differenttypes:

• 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 whichhas an appeal to sports orientated consumers.

There are many examples of how a clear definition of the business can change thecompany 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, manytravel agents who focus on holidays consider that they are in the business of sellingholidays. But if they regard themselves as in the entertainment business and the holidayas an entertainment package the business can focus on selling any entertainment whichpeople have to travel for.

The first step, then, in arriving at a vision for the company and its future is to understandproperly what business the company is in. Unless this is clearly defined the companyvision is likely to be meaningless at best, and misleading at worst.



Exercise 2.1

Set out the skill sets relevant to travel agents specialising in business and holidays. Doyou think it would be easy for an experienced business travel agent to move to a holidaycompany?

Here are three different definitions of the business of a specialist security company whichproduce 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 identified it is possible to derive a statement ofhow the company intends to operate within that business area. The statement maybe related to the quality of the company’s products, the degree of differentiation, thegeographical 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, themission statement could take the following forms depending on how the business isvisualised.

• 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 qualitydependable product to market under their umbrella brand.

• To target teenage consumers who want a brightly coloured effervescent drink inan 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 theoperational usefulness of the mission statement can be exaggerated, and it can oftenbe argued that the mission statement is merely a description of what the company israther than providing any new direction to employees. For example, the company mayhave been producing own brand drinks to supermarkets since it began business, so theintroduction of a mission statement has virtually no impact on employees.

Sometimes the mission is a statement of where senior management wish theorganisation to be at some point in the future. For example, a company might aspireto be the market leader in terms of market share, and therefore the mission statementis based not only on what business the company is in, but where it would like to bepositioned within the relevant market. But in these cases it is important not to producea mission which employees see as being unattainable and to which they cannot relate.The consequences could be quite far reaching, as middle managers and employeesmay develop a cynical view of senior management and their aspirations.


2.2. Vision and mission 31

Exercise 2.2

The public body responsible for the health services of a city of approximately 5 millioninhabitants produced the following mission statement:

To provide the best possible standards of care for the sick and infirm, and to generatea high level of awareness of health issues with the emphasis on prevention rather thancure.

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 bemodified and applied to individual parts of the organisation to ensure, as far as possible,that the focus of functional departments is aligned with the vision of the senior managers.The missions of functional departments could be expressed as follows.

• Corporate security’s mission is to protect corporate personnel in an unobtrusivefashion by preventative measures whenever possible.

• Human resources’ mission is to identify and develop effective leaders, create highperformance teams and enable individuals to maximise their potential.

While such mission statements might appear to be banal and obvious, in their turn theycan have a major influence on the focus of the functional departments. For example,compare the following mission statements with those above.

• Corporate security’s mission is to provide a feeling of corporate security by a highprofile stance of uniformed patrols and fast response.

• Human resources’ mission is to focus on the development of the individual ratherthan that of groups and foster the benevolent culture created by its founder.

The type of security personnel required for the first mission statement would, of course,be totally different to those required for the second. The focus of human resources ondeveloping leaders and effective teams rather than actively pursuing the development ofindividuals 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 areboth within a given country.

Set out the objectives for the marketing and operation functions in each division.



2.3 Setting objectives

Once the general vision of the company has been established, and the missionidentified, it is necessary to determine what has to be achieved for the mission to besuccessful. While the mission can be expressed in general terms, it is necessary tostate the objectives in terms of specific performance targets; in the absence of suchidentifiable targets the mission can have little operational significance and will probablybe acknowledged but largely ignored by managers at all levels. Objective settingintroduces accountability into the business of pursuing the company vision, so it is notproductive to use vague terms such as ‘increase market share’ or ‘increase the returnon assets employed’. Before turning to the definition of specific objectives, it is usefulto differentiate between two types of objective: strategic objectives, which are relatedto the generation of competitive advantage, and financial objectives, which are mainlyconcerned with profit maximisation.

2.3.1 Strategic objectives

The pursuit of competitive advantage involves many choices and actions and at thisstage it is not possible to do more than identify the type of objective which comesunder this heading; the specific rationale is not discussed, for example, the objective toincrease market share by 10 per cent would be based on considerations of economiesof 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 toquantify each, at least in rough terms, to serve as a specific 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 productseach year

• Expand internationally by exporting 20 per cent of output

Some of these objectives are aligned with a mission which is a statement of wherethe 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 concernedwith developing the company into a market leader, rather than with a mission concernedwith maintaining the company’s current success. Thus the strategic objectives mustbe aligned with the mission, be measurable and be perceived as attainable by themanagers charged with achieving them.

It should now be apparent that for the mission statement and strategic objective settingprocess to be useful it needs to be performed in a step down fashion.

• Define the business

• Derive the mission statement

• Disaggregate the mission to individual functional departments


2.3. Setting objectives 33

• Set measurable and achievable strategic objectives

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

2.3.2 Financial objectives

It can be strongly argued that all objectives are subordinate to profit maximisation, orshareholder wealth maximisation, which comes to much the same thing. Unless thecompany makes a rate of return which is capable of attracting investment it has noreason to exist. However, the notions of profit maximisation and shareholder wealthmaximisation are not unambiguous; for example, the time period over which profit is tobe maximised will depend on factors such as the product life cycle and risks. Althoughprofit maximisation cannot be defined unambiguously, there are various aspects offinancial performance which are stepping stones to profit maximisation and some ofthese are listed below. Again the precise rationale for each is not explored.

Some financial 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 flow 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 tightlydefined as they might be, for example no time scales are given within which each mustbe achieved. But what is important is that once more the financial objectives must bealigned 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 toincrease market share by 10 per cent; this would be aligned with a financial objectiveof increasing the share price by 15 per cent over a period of two years, accepting thatthe share price may remain static or may even fall as expenses are incurred in the earlystages of attempting to increase market share.

2.3.3 Priority and conflict

Managers often worry about whether financial objectives should take priority overstrategic 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 importantconsequences. For example, the company might be pursuing the strategic objectiveof attaining the reputation of highest quality and most reliable producer in the industry.This is aligned with the achievement of the financial objective of increasing ROI by 5 percent. However, after a year of pursuing the strategic objective it may well be found thatthe ROI has decreased by 1 per cent; if the focus changes to deal with the short termreduction in ROI, the strategic objective might well be abandoned. At any given time



there is likely to be a conflict among different objectives, primarily because some relateto the short run (such as maintaining an adequate cash flow) 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 intoaccount factors such as the time scales involved in achieving the different types ofobjective. Some objectives cannot be achieved within a short term period, and anundue focus on short term financial measures can lead to a reactive approach whichis inconsistent with achieving longer term strategic objectives which are aligned with thecompany vision.

2.3.4 Characteristics of objectives

While a great deal of care may have been devoted to the definition of objectives and theiralignment with the company mission, it is still possible to end up with a set of objectiveswhich employees feel has little to do with their own roles in the company. The followingare some characteristics of objectives which are a necessary, although not sufficient,conditions to ensure that they are seen as operationally valid.

• Related to employees: the language in which an objective is phrased must be interms that are readily understood and have some meaning in the context withinwhich people work. For example, the objective of increasing market share canmean different things to different people: the share of market volume sales, theshare of total market revenues, the share of a particular segment and so on. Theobjective therefore needs to be spelled out in some detail otherwise it will appearto be vague and irrelevant.

• Credible: employees have to believe that the objective is achievable, otherwiseit will likely be disregarded. In practice, there is little to be gained fromsetting objectives which are clearly impossible. This is different from settingchallenging objectives (sometimes known as stretch objectives), where employeescan recognise that their achievement will involve significant effort and perhapschange, but that they are not outside the realms of possibility.

• Achievable: this is related to credibility, but it is quite possible for management toset objectives which are credible but which are known to be beyond the capabilitiesof the organisation. Not only is this pointless, but when the objectives are found tobe non-achievable there are potentially important implications for morale, and thewillingness to accept objectives in the future.

• Disaggregated: it is necessary to establish objectives at all levels in theorganisation which are aligned with the overall objective and mission, and whichmake sense to the individuals whose job it is to achieve them. For example, thefollowing shows how an overall strategic objective can be ‘cascaded’ into a seriesof financial, business, sales and production objectives.


2.4. Who sets objectives 35

Level Objective

Strategic Achieve market leadership

Financial Increase turnover by 25 per cent

SBU Increase market shares

Sales Penetrate new market segments

Production Increase productivity

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

Exercise 2.4

The following objectives have been set out for a vehicle accessory company which hasbranches in five major cities.

Over the next three years we intend to increase market share in each city by 5 percent, to increase our net cash flow to 15 per cent of assets, and to reduce ourborrowing in order to remove the burden of interest payments.

As a consultant you are asked to comment on the objectives before their release, andassess whether they will add significantly 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 theseobjectives are disaggregated and disseminated to managers who are responsible forimplementing them. However, the process view of strategy lays stress on the fact thatthere is continual feedback from employees and the environment, and that hence thenotion that objectives are set at some point in time and are then treated as permanentis far from the truth. Objectives may well be the outcome of a long period of trial anderror and may be based on extensive consultations with employees at various levels.This approach amalgamates the rationalist view that objective setting is undertaken ina totally logical fashion with the emergent view that objectives are derived from theexperience of the company over time.

Individuals, not companies, make decisions, but the decisions taken by individuals areconstrained by the organisation and its traditions. The relative importance of individualsversus organisations has always been a topic of debate; the emphasis varies amongcompanies depending on their age, the personalities of individual managers and manyother factors. An important outcome of the Peters and Waterman research into companyexcellence was that a strong leader, who made the company excellent in the first place,was a recurring factor in almost every case. In fact, you will observe in everyday lifethat one of the first things which companies do when they encounter severe problems is



to change the leader. There is no doubt that the leader can set the style for the wholeorganisation. Perhaps the most extreme cases occur in sports management whereunsuccessful teams typically react by firing the manager. The success of the Asdachain of superstores in the UK between 1992 and 1996, when the Asda share pricegrew at twice the rate of the stock exchange index, was largely attributed to ArchieNorman; during his five years he not only changed the company culture and rescuedit from collapse, but also fought a wider battle against price fixing and had a significanteffect on competition in the retail industry. When Norman decided to become chairmanin 1996, with the avowed intention of ultimately going into politics, the market took frightand articles appeared in the financial press which revealed that many commentators feltthat 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 fromstrength to strength after Norman’s departure. As a politician Norman subsequently hadno impact whatsoever. Asda was acquired by Wal-Mart in 1999 for £6.7 billion and hassince 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 thedecision making environment. Those who sit on boards or committees often feel thatdecisions arrived at would have been different had the decisions been taken by anyindividual member of the group. Thus the setting of the company’s objectives mayappear 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 isthe same thing.

It is often difficult to identify the ‘ultimate’ strategic planner in companies which havedeveloped beyond the stage of owner-manager control. The functions carried out bymanagers are complex and are continuously changing. While managers tend to feelthat they understand their own function, there is relatively little systematic informationavailable on how managers actually spend their time. Some research has been carriedout into managerial styles and approaches; but it is extremely difficult to carry outresearch in this area because it is necessary to observe what managers actually do onthe job. Because of the labour intensive nature of the research, it is virtually impossibleto generate information on a large sample and the information produced has to beinterpreted 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 inwhat degree to being a good manager in real life; in particular, very little has been foundout about what comprises an effective strategic planner.

Examples of the difficulty involved in identifying the characteristics of an effectivestrategic planner can be seen in the books written by successful managers. Theaccounts are typically idiosyncratic and it is virtually impossible to identify the keycharacteristics which contributed to success rather than to failure. This is partlybecause few professional managers are trained in the scientific approach, and thisis compounded by the fact that their accounts are at least partially concerned withportraying themselves in a favourable light.


2.4. Who sets objectives 37

Most research findings conclude that there is a significant difference between whatgeneral managers actually do and what theory suggests that they ought to do. Forexample, when seeking out information, theorists suggest that the general managershould think in terms of obtaining data which will enable thorough organisational andenvironmental analysis to be carried out, which in turn will assist the manager in arrivingat effective strategies. However, research suggests that general managers prefer verbalsources and that they avoid documented information; their approach is impressionisticrather than detailed. Added to this is the widely known fact, which does not requireresearch to verify it, that there are significant differences in management style: somegeneral managers are naturally reflective while others tend to be doers. There istherefore no particular reason to expect that observed management behaviour will beidentical for different individuals; what is not known is whether such variation has animpact on effectiveness. The observer-based research has not uncovered significantconnections between management style and effectiveness.

Since the activities of managers cannot be readily classified and fitted into a model ofbehaviour, the precise role of different managers in the strategic planning process is notsubject to hard and fast rules. The roles which managers play depend on many factorsunique to the individual company; for example, in companies with a rigid hierarchicalstructure the process may be concentrated on one person, such as the managingdirector. For many managers the identity of the strategic planner in their own companyis obscure and many may not be able to identify any one person with responsibility forthe function.

Strategic planning can be regarded as a multidimensional role which is undertaken bymany individuals working at different levels. For example, there are corporate levelstrategists, typically the Board of Directors and the CEO; below these are the SBUstrategists who comprise executives, planning departments and consultants. In somecases the pinnacle of the strategic planning process is occupied by the CEO who sitsat the top of the decision making process. Control of the strategic planning processcan thus rest in the hands of different people. This does not mean that the processitself cannot be identified and analysed, but it does suggest that companies should givesome thought to how the function is undertaken in their organisations. If no one is verysure about who is carrying out the strategic planning function, it could well be that theprocess itself could be greatly improved.

2.4.2 Characteristics of strategists

The approach to strategy is partly dependent on the characteristics of the decisionmaker; where decisions are made by a number of individuals, for example in a board ofdirectors, it is the overall or dominant characteristic of the group which is important. Thefollowing characteristics provide insights into how decision makers are likely to behavein different circumstances1:

• Prospector

• Analyser

• Defender

• Reactor



The Prospector is primarily concerned with the identification of new marketopportunities, and issues relating to internal organisation take second place. TheAnalyser is characterised by sophisticated internal information systems and detailedinvestigation of options, but this is unlikely to be followed up by the type of actionundertaken by the Prospector. The Defender is concerned with maintaining the currentmarket position without exhibiting a great deal of initiative in developing new marketopportunities. Finally, the Reactor simply deals with circumstances as they arise.

These dominant characteristics may be relevant only to a specific period and willobviously change as managers are replaced. They may also be determined by marketconditions; for example, a Prospector may be forced to become a Defender in the faceof unexpectedly fierce competition. The classification is not prescriptive, in the senseof recommending that a company should strive to change from one classification toanother in order to improve performance, but does help understand how the companyhas reached the position it is in and the type of strategy which might win generalsupport. For example, there is little prospect of support for an aggressive approachto new markets in a company dominated by Defenders.

At the corporate level the dominant characteristic of the chief executive can be afundamental determinant of the course which the company will take. For example, LordKing of British Airways was a prospector who saw a future for a defunct airline; hissuccessors had the characteristics of analysers and defenders and have had difficultyrealising Lord King’s vision. Corporate raiders such as Goldsmith and Hanson wereprospectors of a different type, in that their vision of opportunities lay in identifying thefailures 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 conflicts in the role.

2.4.3 Company evolution and strategists

The typical company is continuously evolving so the roles undertaken by decisionmakers are to some extent dependent on the stage of the company’s evolution, whichcan be classified in three stages: the small single-product company, the integratedcompany and the large diversified company. Only a very small minority of companiesactually evolve in the sense that they end up as large diversified companies. However,the classification makes it possible to characterise the role of the strategy maker asfollows:

Small or Entrepreneurial Single-product company with little formal structure controlledby the owner-manager.

Integrated Single product-line company with a degree of vertical integration andspecialised functional organisation. The owner-manager still retains control overstrategic decisions, but most operating decisions are delegated through policy.

Diversified Multi-product company with formalised managerial systems which areevaluated by objective criteria such as return on investment. Product and market


2.5. Reference 39

decisions are delegated to the heads of SBUs.

In smaller companies the individual owner plays a dominant role in determining strategy,but in the larger, diversified company it may be difficult to identify strategists. Thelatter 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 company’s operations depend on the stage of evolution of thecompany. For example, the ability of a company to undertake radical innovationvaries from the small entrepreneurial company which is constantly evolving to the largediversified company facing the problem of how to stimulate innovative activity within thecompany’s structure. When a company reaches a certain size there is a tendency forbureaucratic procedures to become dominant, with the result that a significant proportionof resources is devoted to maintaining the status quo, and innovation is seen as a costlyand disruptive form of behaviour.

Exercise 2.6

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

2.5 Reference1. Miles, R.E. and Snow, C.C. (1978) Organisational Strategy, Structure and Process,

McGraw-Hill.


41

Chapter 3

Analysing the macro environment

Contents

3.1 The macro environment in the process . . . . . . . . . . . . . . . . . . . . 42

3.2 Defining the scope of the environment . . . . . . . . . . . . . . . . . . . . 42

3.3 Implications for company sales and revenues . . . . . . . . . . . . . . . . 43

3.4 The environment as a threat to costs . . . . . . . . . . . . . . . . . . . . . 45

3.5 Gaining competitive advantage by understanding the environment . . . . 46

3.6 Long term competitive effects of environmental changes . . . . . . . . . . 47

3.7 Macroeconomic environmental variables . . . . . . . . . . . . . . . . . . . 48

3.8 The international economy . . . . . . . . . . . . . . . . . . . . . . . . . . 49

3.8.1 Exchange rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

3.8.2 Think global act local . . . . . . . . . . . . . . . . . . . . . . . . . 51

3.8.3 The competitive advantage of nations . . . . . . . . . . . . . . . 51

3.9 Looking ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

3.9.1 Forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

3.9.2 PEST Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

3.9.3 Environmental scanning . . . . . . . . . . . . . . . . . . . . . . . 58

3.9.4 Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

3.10 Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 company’s competitive advantage can be affected by itsnational setting

• To develop approaches to broad economic influences which can be used as abasis for company responses

42 Chapter 3. Analysing the macro environment

3.1 The macro environment in the process

3.2 Defining the scope of the environment

The term ‘environment’ has been increasingly used in recent years as referring tophysical surroundings, which include the air, water, sea, trees, farmland etc; theprotection of the environment is now high on the political agenda, with measures beingtaken to reduce the level of carbon dioxide in the atmosphere in the hope of avoidingglobal warming, to reduce CSFs in order to save the ozone layer because it is essentialfor life, and so on. The term environment has become so emotive that it is difficult to useit in any other context; however, in the business sense the environment refers to all thoseexternal factors which may have an impact on the operation of the organisation. Thesefactors vary from the most general such as the East Asia economic crisis, the behaviourof the US and Japanese economies and the introduction of the common Euro currencyin 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 mightaffect the operation of the company that it is virtually impossible to track them all andrelate them to the company. Think of the quantity of information you could encounter inone day contained in the Financial Times, the Wall Street Journal, Business Week andthe Economist; then there are specialist reports on individual countries and industriesavailable from various sources, stockbroker reports and so on. It is impossible even toread everything published, never mind subject it to analysis. Many managers feel thatattempting to understand the environment outside the industry is counter productivebecause it simply creates information overload.

However, the impact of overall environmental factors on the operation of individualcompanies can be so significant that it is essential at least to make explicit what decisionmakers think is going to happen in that environment. The company’s strategy can thenbe 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 isentering a recession, can be avoided. The fact that the environment is almost impossibleto understand fully and to predict with any degree of certainty is not a valid argumentfor ignoring it; what is important is that company decisions are aligned with whatever


3.3. Implications for company sales and revenues 43

changes decision makers think are likely to occur.

A useful starting point is with the economic ideas of macroeconomics andmicroeconomics. Macroeconomics deals with the state of the global and nationaleconomies. At the global level it is concerned with exchange rates, trade flows, relativegrowth rates of different countries and business cycles. At the country level it deals withgrowth in Gross National Product, and variables such as unemployment rates, interestrates, inflation rates and government fiscal and monetary policy. It could be argued thata company or organisation is so insignificant in comparison to the global economy, orto the economy of a country, that macroeconomic changes are only marginally relatedto company performance. But this can be completely mistaken because changes in theeconomy, whether at the global or national level, can have direct consequences for theindustry in which a company operates and on the company itself.

There are three main reasons for analysing and attempting to understand the economyas a component of strategic analysis.

• It is necessary to distinguish between events and influences which are outsidethe 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 determinewhether this has been caused by a downturn in total demand in the economy ratherthan being the result of an inadequate marketing response to strategic moves bycompetitors.

• It is important to be aware of changes in the economy which may presentopportunities or pose threats. For example, economic conditions and governmentpolicies likely to lead to a rise in interest rates could pose a threat to to consumerdurables companies whose sales are largely funded through hire purchase, suchas TVs and videos. In the UK there was a house price boom in the early 2000sthat led to much discussion regarding whether the interest rate was too low; whileit was impossible to predict when interest rates might increase there was certainlya high probability that this would occur, so consumer durables companies shouldhave had contingency plans to cater for this event.

• An understanding of how the economy operates makes it possible to interpretpredictions. It is impossible to switch on a current affairs programme on TV withoutbeing confronted by an ‘expert’ giving an opinion on the prospects for the economyor for particular industries, and these can often appear to be contradictory. But it isvery difficult for a person not acquainted with macroeconomic principles to judgewhether 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 theresponsiveness of the demand for that product to changes in GNP. For example, thedemand for potatoes is not likely to be affected by changes in GNP as much as thedemand for hi-fi sets. The degree of responsiveness is known as GNP elasticity, anda product is elastic with respect to GNP when a 1 per cent change in GNP leads to agreater than 1 per cent change in the demand for the product; it is inelastic when a 1



per cent change in GNP leads to a less than 1 per cent change in demand. While it isimpossible to estimate GNP elasticity with accuracy, a rough idea of the magnitude isstill useful. In fact managers are likely to have a general idea of how responsive industrysales are to changes in economic conditions; you don’t need to sell either potatoes orhi-fi sets to realise that the difference in the elasticities is quite significant; for example,the GNP elasticity for hi-fi sets might be 1.5, i.e. a 1 per cent change in GNP wouldresult in a 1.5 per cent change in the demand for the product, while that for potatoesmight be zero. It would be folly to assume that the elasticity of demand for hi-fi sets wasthe same as for potatoes.

To show this explicitly, take the case where, due to a world-wide recession, GNP for thecountry is expected to fall by 4 per cent next year, and the company currently has 15per cent market share of the hi-fi market. The GNP elasticity is 1.5, and the followingshows the difference between assuming GNP elasticity to be zero rather than 1.5. Thecalculation is based on the fact each 1 per cent reduction in GNP leads to a 1.5 percent reduction in market size, thus a 4 per cent reduction in GNP leads to a 6 per centreduction in market size.

Table 3.1: Revenue and GNP elasticity

GNP elasticity Total market Market share Total sales % change

0.0 1000 15 150

1.5 940 15 141 -6.0

1.5 940 16 150 0

If GNP elasticity were assumed to be zero when it is actually 1.5, sales would turn outto be 6 per cent lower than expected. By taking a realistic view of the likely elasticity thecompany 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 toincrease market share from 15 per cent to 16 per cent.

The GNP elasticity does not tell the whole story about the connection between GNPand demand for a product. It is not only the size of GNP which is important, butalso the distribution of national expenditure among its components. For example,a reduction in income tax, which leads to an increase in disposable incomes andhence to consumption expenditure, may be accompanied by a reduction in governmentexpenditure due to the end of the Cold War, the net effect of which is to leave GNPunchanged. Consequently, those industries which rely on government expenditure ondefence, such as the electronics industry, may find market size reduced, while those inconsumer goods industries, such as TV sets, may find market size increased. At thesame time, the government may have increased the rate of interest, which would affectthe demand for investment goods. It is therefore possible for individual sectors of theeconomy to have a falling market size despite a relatively high level of growth in theeconomy 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 by6 per cent. Instead of this, imagine that GNP is expected to grow next year by 5 percent due to expansionist fiscal and monetary policies. What would be the impact be ontotal sales if market share 1 remained at 15 per cent. 2 increased to 16 per cent. What


3.4. The environment as a threat to costs 45

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 particularhave a tendency to increase when the unemployment rate is low, but not to decreasewhen the unemployment rate is high. Consider a company which has anticipated a 10per cent increase in demand due to GNP growth; it intends to respond by increasingpurchase of inputs by 10 per cent. There are two views in the company on what willhappen 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 percent which would be expected if factor prices were unchanged, because of marginalincreases in the prices of inputs. Since it is unlikely that significant changes in GNP willoccur without changes in the prices of inputs, it would be naive to ignore these potentialprice changes. Calculations of the viability and cash flow implications of increasing salesby 10 per cent in this case could be totally misleading if no attention is paid to the likelyimpact of wider economic influences.

It must be recognised that the impact of a change in GNP is not confined to the salesand revenue side, and it may well turn out that anticipated increases in cost may cancelout the potential revenue benefits of a marketing strategy designed to take advantageof an increased market size caused by an increase in GNP. From the cash flow point ofview 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 increaseby 15 per cent, and the price of Capital by 10 per cent. What would be the impact ontotal cost compared with the base case? What implication does this have for net cashflow?



3.5 Gaining competitive advantage by understanding theenvironment

Having identified the various relationships between change in GNP, demand for theproduct and the likely consequences for the company, attention can then be turnedto how competitors will behave in the light of the changing circumstances. If competitorshave not carried out an analysis of GNP trends and have little understanding of GNPelasticities, the company may have an advantage by being the first to take defensiveaction in the face of a potentially decreasing market, or by being the first to takethe initiative to take advantage of a predicted increase in market size. However, ifcompetitors do have the same kind of information at their disposal, will they not react inthe 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 increasemarket share. Since it is impossible for all companies to increase market share, somecompany is bound to suffer as a result. It seems likely that the outcome would be ageneral reduction in the price of the product.

Consider what happens to the company which had not attempted to make predictionsand found itself in a declining market in which competitors are acting aggressively inorder to protect their total sales volume. The company would then have a falling marketshare in a declining market with a decreasing competitive price. The combinedeffect of these influences could be extremely serious for revenues despite the fact thatthe reductions in total market, market share and price were relatively small individually.This can be illustrated as follows:

Table 3.3: Volatile revenues

Period Total market Marketshare (%)

Price Totalrevenue

% change

1 100 20 10 200

2 95 18 9 154 -23

It is assumed that the company simply follows general price changes rather than beingproactive, so that in Period 2, despite the fact that the total market fell by only 5 percent, market share by 2 per cent and price by 10 per cent, the cumulative effect on totalrevenue was a reduction of 23 per cent. Thus a set of changes in market and competitiveconditions originating in a reduction in GNP could have significant implications for cashflow and profitability. Companies which consider that the state of the economy has onlya marginal impact on their performance and their strategy may well be living in a fool’sparadise.

Exercise 3.3

Imagine that the situation depicted by Table 3.3 has happened to your company, and asmarketing 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 thelong run?


3.6. Long term competitive effects of environmental changes 47

3.6 Long term competitive effects of environmental changes

Although managers may not be aware of it, their attitudes and styles can be greatlyaffected by general economic conditions. A brief outline of UK economic historyillustrates this. During the 1950s and 1960s the UK experienced relatively stableprices, growth rates, unemployment rates and inflation rates. To some extent this wasa world wide phenomenon, and rapid change was something which companies werenot on the whole exposed to; this set of conditions contributed to the attitudes of acomplacent generation of UK management which seemed incapable of dealing withthe 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 whichtraining was irrelevant, and the idea that management ideas could be formalised was analien concept. By the mid 1970s the stable scenario had been destroyed when globalrecession, which was partly caused by the trebling of oil prices, caused substantialeconomic upheavals. This period also saw the end of stable international exchangerates with the collapse of the Bretton Woods agreement in 1973, and the emergenceof powerful competition from the Far East economies. It is no secret that UK managerswere ill equipped to deal with these changes, and the economic traumas of the 1970s,which included 25 per cent inflation rates, poor productivity growth, the loss of importantmarkets and endless labour disputes, were at least partly caused by lack of foresightand adaptability on the part of managers.

This period also saw a significant increase in the extent to which governments attemptedto 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 transferpayments) increased to well over 40 per cent of national income by 1979, and thenotorious ‘stop-go’ policies which were utilised in response to economic fluctuationsseemed at times to make the situation worse rather than better. In fact, the incomespolicy introduced in the mid 1970s, coupled with very high marginal tax rates, led toa significant reduction in incentives for managers generally. By the end of the 1970sthe prevailing view was that government would continue to increase its involvement inthe economy, and managers should be able to function in a government dominatedeconomy. 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 volatilityof economic activity and related factors increased in the 1980s. In the UK there weresubstantial changes in unemployment rates, industrial output, inflation rates, interestrates, productivity, exports, imports, capital flows, and exchange rates. At the sametime there was a conscious effort on the part of government to disengage from theeconomy 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 economicchanges have affected individual company performance in one way or another. Forexample, by the late 1980s the UK was experiencing a boom, with record growth ratesand the lowest unemployment rate for 10 years; in particular, asset prices spiralled,and many successful large companies started to diversify into property, while thosealready in the property business began to extend themselves. To many observers itseemed that the pinnacle of credit and unfettered expectations on which this boomdepended was unstable, but developers pressed on regardless. After the economicdownturn in 1991 the bubble burst and there were many disasters, the best knownbeing the Canary Wharf development - the largest building in London - which went



bankrupt before it was even occupied. Economic circumstances had led yet again toa ‘gold rush’ outlook on the part of otherwise sensible managers, who did not seem toappreciate that they were gambling entirely on the continuation of boom time conditions.A rudimentary understanding of economics might have given cause for concern aboutthe inflationary pressures being generated during the boom and the possibility that thegovernment might be forced to take deflationary measures. In the 2000s the UK entereda period of relatively high economic growth, low unemployment and inflation. Thisprovided a degree of economic stability that had not been seen for decades; this wasrudely shattered by the financial crisis which started in 2007 and led a an even greatereconomic downturn than 20 years previously. Once again companies were unpreparedfor 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 excusedfor finding it difficult, or impossible, to explain the various changes observed in theeconomy, which is subject to a seemingly perplexing variety of influences of the typedescribed above. It has already been pointed out that managers are bombarded withinformation of all kinds; information on economic conditions arrives in the form of newsreports, national and international statistics, news commentaries by experts, and reportsprepared by specialists who may be independent economic consultants, stockbrokers,or employed by the company. The problem facing the manager is to decide whichinformation is relevant, and interpret it in order to form a view on what is happeningin the economy as a whole; this is a prerequisite to deriving implications for the industryand the company itself. Managers therefore often ask if it is possible to make sense offactors, and whether anything can be done to accommodate them. This is in fact thearea of study known as macroeconomics. A sample of what macroeconomic theoriescover is:

• The determination of GNP through the interaction of demand and supply in theeconomy as a whole, and the effect of changes in both demand and supply factors

• full employment output, actual output, the unemployment rate and the inflation rate

• the role of expectations

• money supply and the rate of interest

• the rate of interest and investment expenditure

• factors affecting the demand for and supply of imports and exports

• the determination of the exchange rate and international financial flows

Armed with an understanding of macroeconomic principles it is possible to useinformation on current government economic policy, changes in the internationaleconomy, trends in consumer expenditure and company investment, and other variablesto 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


3.8. The international economy 49

and confusing subject it can not be ignored, because economy wide changes haveimplications for companies and individuals. For example, changes in the interest rateaffect companies who borrow, changes in consumer expenditure affect companiesproducing consumer goods, an increase in inflation will affect company costs, changesin the exchange rate affect companies which import and export. When the economyenters a recession it is quite normal for companies to report reduced profits and to blamethis on the slowdown in general economic activity. However, it is an open question asto how far such reductions in profit could have been avoided and, in fact, it is usuallyfound that some companies are not affected to a significant extent; perhaps this is partlydue to a general understanding of what was happening in the economy at large and thewillingness to take appropriate action.

3.8 The international economy

Few companies are immune from international factors. Those which sell directly inforeign markets are continuously exposed to changes in trading conditions; underconditions of relatively free trade even those companies which sell only in domesticmarkets are open to competition from imports. Consequently, many companies areconcerned with factors such as variable exchange rates, differences between local andforeign inflation rates and differences in the growth rates of different economies. At firstthis might appear to be an impenetrable jungle of conflicting influences.

3.8.1 Exchange rates

The most important problem confronting companies in international markets is theunpredictable behaviour of exchange rates, and Table 3.4 gives an indication of theextent to which the exchange rate of the UK pound against the US dollar varied in therecent past.

Table 3.4: The pound to dollar exchange rate approximate year on year change (%)

Year Exchange rate Deflation% Reflation%

1 0.52 24

2 0.62 19

3 0.69 11

4 0.86 25

5 0.69 20

6 0.68 1

7 0.53 22

8 0.55 4

9 0.62 13

10 0.53 15

11 0.57 12



These fluctuations have significant implications for predicting the cash flows from foreignmarkets. For example, a company making plans two years ahead in Year 9 in the UKwould not have known that the pound would be reflated by 15 per cent the followingyear.

In the light of these factors, the company stands to benefit by taking a view on whatis 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 thedomestic currency, a potential strategy is to break into the market now and establishmarket share in the knowledge that losses will be incurred until a reflation takes place.Or if a company is evaluating a potential investment in a country, the prospect of areflation of that country’s currency could have major implications for the timing of thecash flows necessary to carry out the investment.

Many companies argue that they are in the business of making and selling their productsand are not in the business of foreign exchange dealing. Others justify ignoring possiblefuture 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 toadopting the view that there will be no changes in the future; this is as much an act ofresponse as a forecast that changes will occur.

There are various methods of hedging bets in relation to exchange rates, for examplebuying currency forward; this makes it possible to predict some future cash flows, but itmeans that the company will not gain from any favourable movements in the exchangerate. It is not possible for a company to cover future exchange rates entirely becausecash flows will extend for years in the future and these cash flows are difficult to predictwith any degree of certainty. There is no reason to view exchange rate risks as beingdifferent from the other uncertainties facing the company, and in the current volatile stateof the international economy it makes sense to attempt to identify risks and incorporatethem into decision making.

Apart from these economic influences on markets, governments often favour localindustry. For example, the notion of ‘local content’ restricts companies’ freedom topurchase supplies and components; import duties can add significantly to final prices;subsidies to companies in shipbuilding and ‘sunshine’ industries can endow competitiveadvantage. One strategy is to produce goods in the country where they are to besold, thus avoiding the impact of different inflation rates, exchange rate fluctuations andgovernment intervention.

It is often asserted that the world is becoming a ‘global village’ and that internationallocations matter less and less for companies; the opposite view is that successfulcompanies in the international arena build on the strengths which they have createdin their home market. Certainly, each country presents a different mix of factors such ascultures, markets, trading conditions and competitive conditions.

Exercise 3.4

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


3.8. The international economy 51

3.8.2 Think global act local

One way of avoiding exchange rate risks and significant differences in production costsis to expand within the market rather than exporting to it. The world can be consideredas a single market, and local markets as segments of the broader global market. Manyglobal companies produce locally using different brand names for domestic markets.This approach enables flexibility in relation to local conditions and allows management tofocus on the all important factors of differentiation to fit local preferences, while avoidingthe problems of centralised control from the remote corporate head office located in aforeign country.

However, it can be argued that national preferences are continually being eroded by thestandardising forces of the mass media and international travel. This can account forthe world wide acceptance of Coca Cola and McDonald’s hamburgers. Furthermore,it can be argued that global companies are able to reap economies of scale and thatconsumers will, at the end of the day, opt for the lowest price products and overlooksuperficial differences. While this is to some extent true, there are still significantdifferences in many of the products sold in different countries and companies would befoolish to ignore this. While there is global acceptance of some products, such as CocaCola, many others vary greatly among countries: the French drink wine, the Germansdrink beer and so on.

While there are arguments on both sides of this issue, any company which is consideringan investment to service a particular geographic market needs to consider seriouslywhether it should invest in its country of origin or invest in the country where its marketwill 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 influencing the competitive positionof companies was developed by Michael Porter1 who pointed out that competitiveadvantage is often strongly concentrated in a few locations; for example, the clustering ofelectrical distribution equipment in Sweden, tunnelling equipment in Switzerland, largediesel trucks in the USA and microwaves in Japan. Porter identified several ways inwhich a nation can affect the competitive advantage of individual companies.

A firm’s home nation plays a critical role in shaping managers’ perceptions about theopportunities that can be exploited by supporting the accumulation of valuable resourcesand capabilities and creating pressures on the firm to innovate, invest and improve overtime. The impact of the history and environment of a country is often obvious. Scotlandhas had a long history of industrial decline and the development of a dependence ethosfostered by many years of misguided government aid policies. As a result the rate of newbusiness start ups is roughly half the rate in England; this is in marked contrast to a smallstate such as Singapore, where the government has been at least as interventionist butin a totally different way.

It is the existence of conditions which contribute to sustaining competitive advantage ina 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. Butthis is only part of the story; it can also offer favourable demand conditions in the form ofsophisticated home consumers who continually force firms to produce the right things.Up to the late 1970s the willingness of British governments to bail out ‘lame ducks’ in



manufacturing industries contributed to the lack of incentive to invest in the innovationswhich would sustain competitive advantage for individual companies. One of thedangers of protectionism is that local companies have little incentive to retain competitiveadvantage. For example, British cars and motorcycles of 1970s vintage were still beingproduced and sold in India up to 2000 because of protectionism that was not relaxeduntil the mid 1990s; after that the ‘Ambassador’ cars and ‘Royal Enfield’ motorcycleswere quickly replaced by Japanese and Korean makes. This is an illustration of howconsumers 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 Bloceconomies which had been so conditioned by their national environment that the notionsof profitability and cost control were unknown. When the Berlin Wall came down andEastern Bloc companies were subject to competition from Western companies theinevitable result was large scale bankruptcies and high unemployment rates.

According to Porter, the impact of the national environment on the competitiveness ofindividual companies is largely determined by the following influences.

• Factor conditions: highly specialised resources develop in different countries overtime; the development of computer businesses in Silicon Valley in California meantthat there was a large pool of highly skilled manpower.

• Related and supporting industries: a company is only one part of an integratedproduction process, and depends on the availability of companies which cansupply it with products and related companies which supply the local labour marketwith relevant skills.

• Demand conditions: sophisticated consumers force companies to innovate andshape their market orientation. The dominance of Japanese cameras is partlyexplained by the popularity of amateur photography in Japan; the success ofGerman motor manufacturers in producing quality cars as opposed to massproduced cheap cars is partly due to the German respect for quality engineering.

• Strategy, structure and rivalry: a country which fosters competition at homepotentially breeds a strong core of companies which are capable of competingin the international arena. There are few instances of powerful internationalcompanies emerging from protected or subsidised home markets. The highlyprotected British car industry was unable to compete in the 1970s and virtuallyceased to exist. Japanese companies, which had been subject to intense homecompetition, invested heavily in new car plants in Britain in the 1980s.

When assessing its competitive position, a company needs to determine whether itscompetitive advantage is due to company specific or country specific attributes. Ifthe advantage is country specific then it can exploit foreign markets by exporting; ifit is company specific it can invest in the country concerned. This partly explainswhy Japanese car makers invested in Britain: their management skills and productiontechniques were company specific and hence transferable. However, in a world ofexchange rate uncertainty, as discussed above, companies may also make locationaldecisions because producing in the country where they sell their products insulatesthem against potentially unfavourable exchange rate movements. Decision makers thushave to trade off perceived competitive advantages against exchange rate risks.


3.9. Looking ahead 53

Exercise 3.5

Imagine you own a computer hardware company in France and wish to break into theUS market. What factors would you take into account when deciding to export fromFrance 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 whatthe future might have in store. These include forecasting key economic indicators, takinga range of possible factors into account (PEST) and considering a range of possiblefutures and their implications for the company (scenarios).

3.9.1 Forecasting

From the strategy viewpoint, the main reason for trying to understand what is happeningin the economy is to provide a basis for predicting the future course of events. Sinceno one can look into the future with any degree of certainty, this amounts to trying toascertain what is likely to happen and acting accordingly. A cynical manager mightask, if it is impossible to predict the future with accuracy, is there really any point tomaking 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 toincrease or decrease; it follows that it would be useful to predict whether national incomeis likely to increase or decrease next year. In other words, the direction of change isimportant in its own right; it may be possible to go further and predict the dimensionof change, but often the very fact of predicting an increase or a decrease is the majordeterminant of strategy. Any action which has future consequences takes a view offuture events, if only by default; therefore it is better to be explicit about what is thoughtlikely to happen.

One problem facing managers is the number of forecasts available. Practically every dayprofessional forecasters issue predictions of what is going to happen next week, monthor year: some are academically prestigious, such as the London Business School, someare 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 answeris no, because all forecasters share the same poor track record. Some are right insome cases, others are right in others, and there is always someone ready to claim thattheir institution successfully predicted current events. To the cynical observer, there isa market in predictions, and the various producers attempt to present their forecastingproduct in the best light. In fact, forecasters seem to share the ability to miss really bigchanges.

One of the consistent failures of economic forecasters is the inability to predict theperformance of the UK economy. Table 3.5 shows some of the predictions for GDPgrowth made before the beginning of a typical year by some of the most prestigiousforecasters around, compared with what actually happened.



Table 3.5: Forecasting UK GNP for a typical year

GNP % growth

Actual -2.2

Confederation of British Industry -0.8

James Capel -0.4

Morgan Grenfell 0.4

UK Treasury 0.5

National Institute for Economic and Social Research 0.8

London Business School 1.4

No forecaster even came close to predicting what would happen. The differencebetween the highest of the predictions for GNP growth (+1.4 per cent) and the actualoutcome (-2.2 per cent) is not trivial for those companies whose product has a highincome elasticity. A company which acted on the basis of the London Business Schoolforecast and increased its output in the expectation of a significant increase in demandwould 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 theway they were carried out, i.e. that some methods are likely to be more successfulthan others. In fact, there are a number of approaches to forecasting, ranging fromthe 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 economistsof considerable experience; the UK Treasury bases its forecasts on one of the mostcomplex models of any economy in existence (known as the Treasury Model). There isvirtually no connection between the statistical complexity of the forecasting models andtheir accuracy.

The simplest approach to forecasting is to discover one statistic which serves as areasonable indicator of what is likely to happen next, and this statistic is known as aleading indicator. A leading indicator is a statistic which signals when changes areabout to happen in the economy, or in a particular industry. For example, the number ofhousing starts would be an obvious leading indicator to use for a business in the glazingindustry, because a prospective reduction in the number of houses completed wouldhave an impact on the number of windows required. Most leading indicators are chosenbecause they have served as predictors in the past, and there is no guarantee that theywill perform effectively in the future. This is an example of using statistical associationas the basis for prediction rather than causal relationships; the trouble is that no one canpredict 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 occurwhich cannot themselves be foreseen. The forecasting procedure must assume thatno major events occur to disrupt the orderly operation of the economy; unforeseeableevents such as the oil price increases of the early 1970s and reductions in the mid1980s, the ending of Communism and war in the Middle East, can combine to robforecasts of any accuracy they might have had. The characteristic of exogenous shocksis that they cannot be predicted in the statistical sense, i.e. the use of past data andthe extrapolation of trends are of no help. Many forecasts might have been correct if



exogenous shocks had not occurred, but it is virtually impossible to find this out after theevent because of the problem of isolating the various influences.

So is it possible to make any sense of what is happening in the economy, given thathighly sophisticated teams of economic forecasters have such obvious difficulty? Oneapproach is to think in terms of the business cycle. In most countries periods of boomtend to be followed by periods of depression, which in turn tend to be followed by periodsof boom, resulting in a cyclical pattern which is repeated over and over again. Economicgrowth is by no means uniform. Economists have made many attempts to measurethe duration of the business cycle, and there is some evidence of the existence of longterm, medium term and short term cycles which have a certain degree of regularity. Ifmanagers could identify the stage of the business cycle even approximately, it wouldclearly help in planning generally. However, inspection of historical data reveals thatalthough cycles are often clear in retrospect, it is extremely difficult to predict when thenext stage of the cycle will occur; in fact managers find that economic activity generallyis so variable that it is difficult enough to determine which stage of the cycle they arecurrently operating in, never mind attempting to predict future changes.

One method of approaching the problem is to think of the business cycle as beingcomprised of three main components: the general trend over time, the underlyingsmooth cycle, and random fluctuations. The statistical technique which corrects forcyclical and trend effects is known as series decomposition. It is not necessary tounderstand how this technique works, but it is important to be able to ask the correctquestions 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 significantly between countries. Some indication of the underlying cyclicalpattern can be obtained by finding the time between previous peaks and troughs ofunemployment rates. Random influences include changes in government economicpolicy and exchange rate fluctuations. It needs to be stressed that no one is able topredict the business cycle with any degree of accuracy, but it is possible to form a rationalview as to whether the economy is in the upswing or the downswing. The exampleshown in Figure 3.1 is illustrative of how to think of the problem.



Figure 3.1:

It is important to visualise the business cycle in such broad terms. This is becausemanagers have to make at least an implicit assumption about where the economy is inthe 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 thinksthat the economy is about half way towards the peak of the cycle compared to being atthe 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 tobe monitored because of their impact on the company. It is also necessary to be ableto interpret forecasts, because every decision undertaken implies some assumptionsabout the future, so it is as well to make them explicit. But the macroeconomy isonly one dimension of the overall environment; others are social changes, changesin tastes and preferences, technological changes, ecological, political and so on. Thechecklist of Political Economic Social Technological factors provides a useful frameworkfor assessing these influences; at one level the PEST analysis is nothing more than fourlists, and as such is of little value. But the identification of a range of relevant factors,and an analysis of the relationships among them, can provide important insights into thecompany’s prospects. The types of influence 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 reachingimplications for company operations. For example, the change from a right wing toleft wing government may herald the emergence of stricter laws on monopoly behaviourand relaxation of labour laws in favour of employees. A company that is consideringexpanding internationally needs to be aware of differences in the political situationbecause what it can do in its home country may not be allowed elsewhere.

Economic: the importance of macroeconomic issues has been discussed in thischapter; industry structure and its implications for competitive pressure will be discussedin Chapter 4.



Social: Changes in attitudes, tastes, fashions and age structure have effects onindividual companies; for example, changes in the demographic composition ofthe population have implications for manufacturers of baby products and financialorganisations providing pensions. Changes in social norms, such as attitudes tomarriage, divorce and to the number of children in a family, have implications for thedemand for housing. Social information tends to be qualitative rather than quantitative,and there is no specific analytical approach that can be applied; an awareness ofsocietal changes, however, is central to wide strategy issues, and the identification ofpotential opportunities and threats. The fact that information is qualitative does notmean that it cannot be used in an analytical fashion. For example, social analysis iscomplementary to economic analysis because economic factors operate within the givensocial structure; predicting social changes can help to explain why demand curves arelikely to shift in the future. Qualitative information will usually indicate whether somethingis likely to increase, decrease, or remain unchanged; knowing about the direction ofchange can be extremely valuable on its own, independent of the expected dimensionof change.

Technological: technological change happens all the time, but it can speed up inindividual sectors; for example, in less than a decade mobile telephones and theinternet altered communication patterns and how goods are bought and sold. In 1995it was inconceivable that people would be able to make a living trading on eBay. Butwhile it is necessary to keep abreast of such developments it is also important to payattention to background technological change: unless new methods and techniquesare incorporated into company systems and the company is willing to invest in newapproaches, competitive advantage can disappear with alarming speed even in theabsence of dramatic change.

As an example of how a PEST analysis can be applied, consider the case of amonopolistic electricity utility which has been recently privatised. It runs several coalfired power stations, two of which are 25 years old, and one 15 year old nuclear powerstation.

Political

• Recent elections resulted in a new government which is more inclined to stricterregulation and opening up the market.

• The new government is committed to subsidising domestic house insulation.

• There is increasing international political agreement to cut pollution.

Economic

• New gas fields are being opened up with implications for the price of gas.

• There are several indications of a slow down in economic activity which will havea significant effect on industrial demand for energy of all types.

• The price of coal on international markets has started to increase.

Social

• There is a rising public awareness of the need to conserve energy.



• The aversion to nuclear energy is increasing.

• The number of single occupancy households is predicted to increase by 25 percent 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 solarpower are now cost effective.

If the company had confined its environmental analysis to the economic dimensionalone, it would have been concerned about the imminent economic slow down,competition from gas and higher costs of coal. But the PEST analysis analysis identifiesa wider profile of potential threats.

Factor Issues ThreatPolitical the company is likely to be constrained by the new

government, exposed to increased, competition andpossibly lower demand than expected

High

Economic the imminent economic slow down, competition from gasand higher costs of coal.

High

Social attitudes to conservation which are possibly going to leadto improved insulation and alternative power sources

High

Technological Research into alternative energy sources starting to payoff

High

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

3.9.3 Environmental scanning

A PEST analysis deals with what is known about the environment at a particular timeand is usually carried out when an important decision has to be made, for exampleinvesting in a new product or entering a new market. What is typically overlooked isthat it is necessary to monitor continuously all of the PEST type variables. The reasonthat companies are often caught unawares by changes in consumer preferences, orby changes in government policy, is not that such events could not be predicted butbecause no one in the company has responsibility for monitoring what is happeningin the environment and bringing important issues to the attention of decision makers.A classic example was the advent of microcomputers: many mainframe computermanufacturers, including IBM, did not appear to recognise a major change was underway and several went out of business; another was the rise in popularity of SUVs atthe expense of standard cars, and major manufacturers such as GM and BMW tookyears to recognise that a new market segment had developed. There is also the dangerof imagining that changes are occurring when they are not. For example, telephonycompanies bid astronomical sums for third generation mobile phone licences withoutapparently giving serious consideration to whether consumers would be willing to payfor the additional services nor, indeed, whether the technology could be developed suchthat an acceptable rate of return could be made on the investment; companies were



caught up in a bidding frenzy because they saw that everyone else was doing it.

Environmental scanning is the process of keeping in touch with changes in theenvironment and is an important component of the feedback part of the strategicprocess. But in practice it is an extremely difficult activity to undertake; for example,what are the characteristics of the person to be given responsibility for environmentalscanning? What specific direction can be given regarding what to look for? Many CEOswould be unconvinced of the productivity of such a role.

But it is not just the identification of potential opportunities and threats that is theproblem, it is communicating these to decision makers. Managers typically do not wishto read detailed reports and analyses and usually regard discussions of what mighthappen as a distraction from getting on with the job. This is when ‘away days’ becomeimportant, when senior managers leave the organisation as a group to focus on thefuture of the business. Again, the trouble with most ‘away days’ is that they tend tobecome focused on current problems and environmental scanning is pushed into thebackground. Anyone who has run strategy sessions for companies knows how difficultit is to get senior executives to focus on such issues, and in fact the level of ignoranceabout the competitive environment is surprising to observers who are not familiar withthe problems inherent in effective environmental scanning.

3.9.4 Scenarios

Once some projections of possible futures have been made they can be used as thebasis of scenarios; this term has already been used in a loose sense in the discussionabout the impact of changes in GNP on revenues and costs. It must be made clear thata scenario is not a forecast, but it is an attempt to investigate the implications of possiblefutures for the company. In some instances it may be based on a short run issue, suchas the likely impact of a price reduction by a major competitor; the potential impact onmarket share and the cash flow implications can be mapped out, or the implications forthe company’s profitability of matching the price reduction. A long term scenario is muchmore speculative, and many managers doubt their value. However, put yourself in theposition of a European financial services company in 2000 and visualise the implicationsof a zero inflation in the year 2010; financial products such as insurance policies aretypically sold on the basis of nominal interest rates. But if inflation disappears the interestrate will tend to fall to its real long term level of about 3 per cent. When the inflation ratein the UK fell to almost zero by 1998 most insurance companies were unprepared forthe impact on expected payouts.

The PEST analysis carried out in 3.9.2 can be used to illustrate the construction ofdifferent scenarios. In Scenarios A and B one factor has been selected from each of thePEST headings and extrapolated three years from now.



PEST Scenario A Scenario BPolitical All householders are eligible for

subsidies of 75% of the cost ofinsulation

The government has ruled that allcoal fired power stations mustreduce their emissions by 50%within five years

Economic Four new gas fields in the NorthSea have been brought on lineincreasing supply by 30%

Because of a series of naturaldisasters the price of coal hasdoubled on international markets

Social Because of voter hostility thegovernment has decided not torestart the nuclear power stationbuilding programme and todecommission existing nuclearpower stations

The number of single occupancyhomes has increased much morequickly than expected and is nowexpected to increase by 30% inthe next five years

Technological A new cavity wall insulationmaterial has been developed thatis 30% cheaper than alternativesand can be installed by thehouseholder

Economic studies have nowshown that alternative energysources are never going to be costeffective

The implications of these changes would be broadly as follows:

PEST Scenario A Scenario BPolitical Householders who install

insulation will use less energytherefore demand will fall

High costs will be incurred ininstalling pollution extractionequipment

Economic The price of gas, a competing fuel,will fall; it will probably benecessary to reduce the price ofelectricity to remain competitive

The cost of the main input, coal, isincreasing therefore the cost ofproducing electricity will increase

Social Investment plans will have to bebrought forward

The demand for energy willincrease as the number ofhouseholds increases

Technological As householders install cheaperinsulation demand for energy willfall

No more customers will be lost forthis reason therefore demand willbe unaffected

The two scenarios present different possibilities for the future not only because of themagnitude of the changes but because of their combination. The potential impact of thescenarios on the company are completely different.

• Scenario A portrays a future of falling demand because of the combination ofpolitical actions and technological change; prices will also probably fall and soa significant fall in revenue (price x quantity sold) can be expected. At thesame time investment will have to be undertaken to replace the nuclear powerstation. The combination of lower revenues and the investment cost may leadto cash flow problems. But it is possible that the falling demand may make itfeasible to decommission the nuclear power station without building a replacementimmediately.

• Scenario B has two major influences on the cost side: pollution control and



increased input costs. The demand side is, however, quite positive. In this casethe focus could be on controlling costs to maintain competitiveness while takingadvantage of the buoyant demand. As a result the need to invest in pollutioncontrol equipment is not likely to cause major cash flow problems.

The PEST analysis identifies the potential threats and opportunities in the environment.The scenarios consider what might happen if various threats and opportunitiesmaterialise. It is clearly impossible to take action now that will enable both divergentfutures to be accommodated in three years time, but since these futures are feasible itis important to determine how flexible the organisation is and how well it is equipped toface the types of uncertainty identified.

Exercise 3.7

In 1996 British Telecom (BT), which is the giant supplier of UK telephone services, madea bid for MCI, which was then America’s second largest internal long distance telecomscarrier. The deal was called off when WorldCom stepped in with a higher bid. Here aresome facts about the US market which BT was attempting to enter.

During the period up to 1995 there had been a significant liberalisation of the UStelecoms market and it was to take advantage of this that MCI was trying to enter thelocal markets. But in order to enter the local markets MCI would have to build the localnetwork itself or interconnect with the circuits of ‘Baby Bell’ operators. In fact, US lawallows the ‘Baby Bells’ a great deal of freedom to challenge the terms of interconnectionin the courts and with state regulators, with the result that after a year of deregulation itwas still almost impossible to challenge the ‘Baby Bells’. MCI did announce that it wasgoing to build its own exchanges and circuits, but nobody knew how much this was likelyto cost.

Deregulation works both ways, and the mature long distance internal market was, inits turn, opening to competition from the ‘Baby Bells’; indeed, because of existing localcompetition, the ‘Baby Bells’ do not have many of the characteristics of semi monopolistslike 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 guaranteesthat alliances based on existing technology would dominate the telecoms market in thefuture.

There were severe competitive challenges ahead. Total revenues from local calls werelikely to grow only slowly during the next few years, while the cost of long distance callsin the US fell by 50 per cent between 1994 and 1997; international prices fell by 60 percent in the same period. Furthermore, other global alliances involving companies suchas 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.



3.10 Reference1. Porter, M.E. (1998) The Competitive Advantage of Nations, New York: Free Press.


63

Chapter 4

Analysing the market environment

Contents

4.1 The market environment in the process . . . . . . . . . . . . . . . . . . . 65

4.2 The market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

4.2.1 Demand factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

4.2.2 Supply factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68

4.2.3 Price determination . . . . . . . . . . . . . . . . . . . . . . . . . 69

4.3 Barriers to entry: structural and strategic . . . . . . . . . . . . . . . . . . . 71

4.4 Market structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

4.4.1 Perfect competition . . . . . . . . . . . . . . . . . . . . . . . . . . 74

4.4.2 Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

4.4.3 Oligopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

4.5 Competitive behaviour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

4.5.1 Game theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

4.5.2 Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

4.5.3 Contestable markets . . . . . . . . . . . . . . . . . . . . . . . . . 81

4.6 Segmentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82

4.6.1 Product differentiation . . . . . . . . . . . . . . . . . . . . . . . . 85

4.6.2 Product quality . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

4.6.3 Pricing in segments . . . . . . . . . . . . . . . . . . . . . . . . . 90

4.7 The life cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94

4.8 Portfolio models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

4.8.1 The BCG relative share growth matrix . . . . . . . . . . . . . . . 98

4.8.2 Other portfolio models . . . . . . . . . . . . . . . . . . . . . . . . 101

4.8.3 Portfolio models and corporate strategy . . . . . . . . . . . . . . 101

4.9 Strategic groups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

4.10 The structural analysis of industries . . . . . . . . . . . . . . . . . . . . . 107

4.11 Environmental threat and opportunity profile . . . . . . . . . . . . . . . . . 113

4.12 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

Learning Objectives

64 Chapter 4. Analysing the market environment

• 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 profile


4.1. The market environment in the process 65

4.1 The market environment in the process

While the general environment impacts on the company in a variety of ways, the mostimmediate effects come from the markets in which it operates: the type of market, thedegree of competition, the growth prospects, the threat of new entrants, and so on. Thiscan be thought of as the immediate environment of the company and it can be subjectedto 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 aredetermined by the market (except for charitable organisations and those whose outputis provided free by the state), and it is therefore important for managers to have someunderstanding of how prices are determined in markets and what causes them tochange. In fact, changes in market prices are important signals which managers shouldbe 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 wouldhappen to sales if the price of their product were increased or decreased. Typicallyit is felt that this is an impossible question to answer because the world is a highlycomplex place with many changes happening at any given time. However, imagine thata company selling shoes were to decrease the price of their shoe range by, say 10 percent, and nothing else changed; would sales increase by 1 per cent, 10 per cent or 20per cent? The marketing manager should be able to make an educated guess based onknowledge of consumers, the behaviour of competitors, the characteristics of competing



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 mightresult in very little more being sold (a vertical demand curve) or a great deal morebeing sold (a more horizontal demand curve). This clearly has important implications forstrategic choice, because if it is believed that the demand curve is almost vertical there islittle to be gained by reducing price. On the other hand, if it is believed that a substantialincrease in sales will result, it would be worthwhile reducing the price significantly. Ifthe company is pursuing an increase in market share it is clearly important to be explicitabout the shape of the demand curve. It is also important to realise that while theprecise shape of the demand curve cannot be determined, any decision on pricing(which includes the decision to leave price unchanged) implicitly makes an assumptionon the shape of the demand curve. Therefore there is no getting away from the conceptof price elasticity and it should be brought to the forefront of all discussions about pricingpolicy.

The basic assumption made in order to draw a demand curve is that nothing elsechanges. But this is never the case in real life, and from one time period to the nextsignificant changes in market conditions take place. For example, consumer incomeschange all the time; it was discussed in Chapter 3 Section 4 how some goods are highlyincome elastic, i.e. when incomes increase, individuals wish to purchase more of thatgood. This can be interpreted in terms of the demand curve: when incomes increasethe demand curve shifts to the right, because at every price individuals are willing topurchase more. In the case of shoes it is possible that an increase in incomes affectsthe demand for leisure footwear, such as trainers and walking boots, much more thanthe demand for standard shoes. The general effect is illustrated in Figure 4.2.


4.2. The market 67

Figure 4.2: Demand curve shift

Now consider a change in market conditions which a company can instigate on itsown, namely an increase in marketing expenditure. The purpose of such a move isto persuade individual consumers to purchase more at every given price, i.e. to shift thedemand curve to the right in exactly the same way as occurs when there is an increasein income. The question which then needs to be addressed is how far the demandcurve 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 loyaltyto the brand, and this can be interpreted as reducing the elasticity of demand; over thelonger term the intention may be to position the product as relatively high priced andhigh 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 werechanged?’ This provides the basis for assessing alternative futures; it is impossible tobe precise about the shape of the demand curve, or the shifts which might result from amarketing campaign, but an approximation based on what is known about the market isa great deal better than acting randomly.

The idea of the demand curve can be generalised to the industry level: if the demandcurve referred to all units of the product sold and P was the average price charged, whatwould be the effect of a reduction or increase in the price charged by all companies? Ifthe demand curve were elastic then all companies could benefit by reducing their prices.But in reality this is unlikely to be the case, and companies have to be aware of the factthat if they reduce their prices in order to increase their sales, then at least part of theincrease is going to come from the sales of other companies. This is likely to stimulatecompetitive 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 sizeof the total market including the following.

Determinants of market size:

• Product Life Cycle

• Business Cycle



• Exogenous shocks

• GNP Elasticity

• Exchange Rates

These factors which influence the total market size are outside the control of thecompany, but because the company cannot control them it does not follow that theycan be ignored. In fact it is essential to try to understand the likely impact of thesefactors, 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 helpsdistinguish the impact of factors outside the control of the company from those pricingand marketing decisions which affect the market share which the company achieves outof the given total market. Thus, when total sales fall it is necessary to identify whetherit is because of some pricing or marketing reason, or because there has been a changein the size of the total market. For example, a fall in sales may be unrelated to marketingactivity, 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 ofmarket size from those which affect market share. The practical problem in doing this isthat the world is continually changing with the factors changing by different amounts atthe same time.

4.2.2 Supply factors

Prices determine not just how much is sold on the market, but the quantity whichcompanies are willing to sell. At low prices companies will be willing to sell fewer unitsthan 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 thedemand curve: will a given increase in price lead to a relatively small or large changein output? Furthermore, the supply curve can shift too; for example, if costs increasethen companies will be willing to sell fewer units at any given price and the curve willshift to the left (2). As in the demand case, supply conditions have important strategic


4.2. The market 69

implications. For example, if prices have recently risen due to a sudden increase indemand in a particular industry, some understanding of the supply curve can help thecompany 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 ofboth demand and supply. However, prices in the market are not free to vary on theirown but are determined by the interaction of demand and supply. On the one handthe production of goods and services depends on the costs which companies incur insupplying different quantities, while on the other the demand for goods and servicesdepends on what people are willing to pay for different quantities. The interaction ofdemand and supply produces prices. An understanding of price determination makes itpossible to make predictions about the outcome of changes in both demand and supplyconditions.

Figure 4.4: Demand, supply and price determination

The idea of price determination is simple. In Figure 4.4 the price will tend to movetowards P, known as the equilibrium price. If the price is higher than P then companieswill produce more than consumers are willing to buy, and the price will fall. If it is lowerthan 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 oflimited use because in real life prices are continually changing, and nobody knows whatthe equilibrium price is for any particular product. However, demand and supply analysisis a powerful tool both for understanding market conditions and predicting what is likelyto happen in the future.

Any factor which alters the position of the industry demand or supply curves will havean impact on market prices. The extent of this impact depends on the shape of thedemand and supply curves. If the demand curve is inelastic then changes in supply willbe reflected in price rather than quantity changes, and vice versa. The important issuefor managers is to attempt to visualise the shape of the demand and supply curves intheir industry in order to provide insights into the likely outcome of both demand andsupply changes. In fact a relatively limited amount of information on demand and supplyconditions for an industry can enable managers to assess the impact of events such as



the entry of competitors (increase in supply) and the emergence of substitutes (reductionin demand).

Demand and supply analysis can be used to portray the outcomes of Scenarios A andB developed in 3.9.4. Scenario A depicted a combination of political and technologicalfactors that would lead to a reduction in demand, so the demand curve would shift to theleft 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 P2and the quantity from Q1 to Q2. By presenting the outcomes in this way the strategicdiscussion can focus on how much shift can be expected in the demand curve and thelikely shape of the industry supply curve. For example, if the supply curve were muchmore inelastic (steeper) than drawn the impact would be mainly on the price. ScenarioB 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


4.3. Barriers to entry: structural and strategic 71

depends on how the curves are drawn, for example if the demand curve were muchmore elastic (flatter) 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 farit is likely to shift.

An important outcome of presenting scenarios in this way is that it makes assumptionsexplicit and makes use of available information in a structured manner. For example, itmay be concluded that the market impact of Scenario B is insignificant because of thecharacteristics of the demand and supply curves; such a conclusion may not be obviousfrom a descriptive account.

What happens if both demand and supply factors were to change simultaneously? Inthat case the analysis becomes more complicated because both demand and supplycurves have to be shifted at the same time. But the same principles apply: make aninformed estimate of the shapes of the demand and supply curves and then estimatethe likely shifts that would arise from the various influences.

Exercise 4.1

The shipping industry is characterised by very large variations from year to year in theprice 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 businessavailable?

4.3 Barriers to entry: structural and strategic

Once a company has established its competitive advantage in an industry orgeographical location it cannot afford to relax. This is because competitive pressure willnot only arise from existing competitors in the industry, but these pressures are likely tobe much greater when new companies can enter the market. In a competitive economythere is in fact a significant degree of movement into and out of particular markets andresearch suggests that, on average, there is a 30 to 40 per cent turnover in companiesevery five years.

Since all markets are open to the threat of entrants, a company enjoying monopolyprofits will always be concerned about the threat from potential entrants. The incumbentmonopolist not already protected by barriers which make entry difficult or impossible willbe motivated to find 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 firm while strategic barriers dependon specific actions undertaken by the firm to deter entry. Structural barriers include:

• Capital requirements: it is typically necessary to undertake significant investmentexpenditure in order to enter a new market, and some industries require amounts



which can be difficult to raise unless the company already has a secure trackrecord; the capital requirement itself can pose a major threat to the entrant shouldthe 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 ofexit. It is usually assumed that a high capital entry cost deters entrants, but thisis not necessarily the case. Certainly a high investment requirement limits thenumber of potential entrants, but the fact is that there are many large companiesin the world. Consider the case of an airline: it costs a great deal to obtain anaeroplane and set up a route, but the aeroplane can always be sold. However, theroute set up costs are also high and are sunk because they cannot be recoveredon exit; this is the real financial barrier to entry. At first it might seem a paradox,but in fact the barrier to exit is just as important as the barrier to entry.

• Size of the market: because of investment and infrastructure costs it may not befeasible for more than one company to operate in the industry; while this argumentis attractive in principle, it is rare in practice to find such a market. A well knownexample is electricity generation and supply, where duplication of electricity lineswould clearly be wasteful. This is known as a natural monopoly, and was therationale for nationalisation because it was felt that competition would be wasteful;but the experience of privatisation has demonstrated that infrastructure can beshared among competing firms in a variety of ways.

• Control by legislation or tacit agreement: these agreements can last for asurprisingly long time. For example, De Beers has controlled supply in thediamond market for over fifty years and fixes the world price of diamonds;inventions are provided with patent protection for a fixed period so that inventorscan gain a benefit from their activities. But it is difficult to predict how long tacitagreements will last; for example, the most powerful cartel in the world at onetime, OPEC, was for many years unable to maintain high oil prices in the face ofthe development of supply from non-OPEC countries.

• Economies of scale: the idea of economies of scale is based on the long runaverage cost curve of the firm. The long run average cost curve shows how unitcosts vary with different scales of output. If the incumbent firm is well down thelong run average cost curve entrants have to come in at a large scale, or they willbe at a significant 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; butit becomes progressively more difficult to achieve experience gains and after sometime there is no further benefit at the margin. If the experience effect is significant,it will convey a significant first mover advantage to the incumbent firms in anindustry and new entrants start off at a cost disadvantage. The difference betweenthe experience effect and economies of scale is that new entrants will start tomove up the experience curve, whereas scale economies can only be capturedby increasing the size of the firm. The fact that competitors will accumulate theirown experience means that it cannot provide an incumbent firm with a permanententry barrier in the form of a cost advantage.

Strategic barriers arise from competitive actions undertaken by the company, andinclude:


4.3. Barriers to entry: structural and strategic 73

• Reputation: the company can aim at building up a high degree of brand loyaltyby emphasising characteristics such as quality and reliability; this is particularlyimportant in industries where it is difficult for consumers to obtain comparableinformation on different products, for example products which are purchased onlyrarely like expensive white goods.

• Pricing: when the threat of entry emerges the company can reduce price as adeterrent (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 theprice reduction might be seen as a competitive move against other incumbents.Furthermore, there is a real danger in many countries of breaching anti-competitive legislation.

• Access to distribution channels: while the new entrant may have a product whichcompares in quality and cost to the incumbent’s, this can be of little avail if theincumbent controls distribution. When the UK electricity and gas monopolies wereprivatised one of the major changes in the attempt to introduce competition was toseparate production and distribution.

While at first sight it might appear attractive to attempt to erect strategic barriers, itturns out that these are very difficult to generate and maintain without resorting to illegalactivities. There is, in fact, very little research evidence on the effectiveness of strategicbarriers or entry deterrent behaviour, particularly using pricing. However, managersreport 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 asto underlying profitability. It takes time to generate information on the likely returns fromcompetitive action and setting a low price can serve as a misleading signal to potentialentrants. While competition usually cannot be avoided in the long run, entry deterringstrategies may provide sufficient time for the company to build up market share andachieve scale economies which might not have been possible had entrants been enticedinto the market earlier.

Exercise 4.2

The grocery business in the UK was dominated for years during the 1990s by themajor chains including Tesco, Sainsbury, Asda and Safeway. There were complaintsby consumer groups that supermarket prices in the UK were higher than in the rest ofEurope and that supermarket profitability was higher in the UK. For some time there wasa threat of entry by WalMart, which is by far the biggest US discount retailer. WalMartoffers a very wide range of products at relatively low prices. It has achieved this bybuilding up a highly efficient world wide distribution network and it focuses entirely onattracting shoppers by offering low prices. The UK incumbent companies offered arange of additional services, such as loyalty cards, fresh food, financial services andin-store customer services. There are high start up costs for new supermarkets in theUK, starting with the process of obtaining planning permission, through constructinglarge out of town premises, car parks and access roads. Furthermore, UK shopperswere all familiar with the existing supermarket names, very few, however, having heardof WalMart.

In June 1999 WalMart made a bid for Asda, the UK’s third largest food retailer.

Assess the extent of the barriers to entering the UK facing WalMart prior to its take over



of Asda.

4.4 Market structures

The demand and supply model is extremely useful in analysing the potential impactof changes on prices and can lead to important strategic conclusions. But it is notthe whole story because it does not tell us much about competitive forces within theindustry. The type and degree of competitive forces depends on factors such as thenumber 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 marketstructures. It is obvious that market structures vary considerably among industries. Themarket for wheat is comprised of many relatively small producers, none of which canindividually affect the price; on the other hand telephone services are supplied by a fewvery large companies In the UK British Telecom had a government monopoly until it wasprivatised, at which time it was exposed to competition from cable and mobile telephonecompanies. Knowledge about market structure can tell managers a great deal aboutpotential profitability and can be central to identifying strategic options and arriving atstrategic conclusions.

4.4.1 Perfect competition

The term perfect competition is used because it refers to a market which has the mostextreme form of competition. Managers typically react to the idea of perfect competitionwith the response that it does not exist in real life and that it is therefore completelyirrelevant to real life decision making. This attitude is largely caused by the unrealisticassumptions made to define 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 firm can charge more than the market priceand the demand curve is horizontal: if any firm attempts to sell above the market priceit will lose all its customers; if it attempts to sell below the market price it will go out ofbusiness because it will not cover its costs. An important aspect of ‘perfect’ competitionis that no monopoly profits are made, i.e. firms make only the opportunity cost of capital.Managers are usually uneasy about perfect competition because it does not accord withcommon experience; this is not surprising given the complexity of real life comparedwith the restrictive world of perfect competition.

But despite the fact that it is difficult to observe in real life, this market model providesa powerful tool for interpreting real life events. Consider what happened in the marketfor personal computers during the late 1980s and early 1990s. The personal computermarket was originally characterised by very high start up costs because of the R&D


4.4. Market structures 75

required prior to production. As the technology was disseminated, the need to undertakeexpenditure on R&D was reduced. Entry to the industry was almost impossible before1980 because of the lead and market share built up by the main players such as IBM; forcompanies inside the industry their position looked relatively secure. However, when thetechnology was disseminated and ‘clones’ could be built and sold virtually at marginalcost, the situation was reversed. By 1990 many people who used personal computersdid not care what make it was because personal computers became homogeneousgoods, all doing much the same thing. Once the initial developments had been made itbecame relatively simple to enter the market: the components could be purchased andassembled; this meant that barriers to entry had largely disappeared and many firmsentered the industry producing ‘IBM clones’. Most of these entrants were producingvolumes which enabled them to capture at least part of any potential scale economiesso they did not appear to be at any particular cost disadvantage. At the same time usersbecame much more educated, and information on personal computers became widelyavailable through the many computer magazines which appeared. Now consider againthe conditions for perfect competition:

homogenous product computers identicalno barriers to entry computer parts freely availableno economies of scale pure assembly operations have limited scale

effectsuniversal information computer magazines etclarge number of competitors many brands of personal computers appeared

It seemed fairly clear that the conditions for perfect competition had appeared by thelate 1980s. It was a simple matter to predict that computer companies would stopmaking profit on the production of personal computers and would merely make atbest the opportunity cost of capital. This was precisely what happened by the early1990s when it became widely acknowledged that making personal computers was notprofitable, one of the factors which contributed to the difficulties experienced by majorcomputer companies at this time and which led in 1993 to IBM reporting the largestcorporate losses of any company in history.

Far from being a remote concept best assigned to economics text books, the idea ofperfect 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 onthe 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 assumptionof homogeneous products), a possible course of action is to differentiate the productand target a specific sector of the market. In the personal computers case suchdifferentiation included selling a package of services which included maintenance andsoftware support, and introducing new features such as colour, more memory, portabilityand high speed processors. Unfortunately, none of these features could providecompanies with more than a transitory advantage because of the speed with whichthe 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 iscomprised of only one producer, the monopolist, whose demand curve is the industry



demand curve for the product. This demand curve slopes from left to right because thecompany 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 whathappens 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 asmonopolistic competition, which sounds like a contradiction in terms. If all firms had thesame cost curves it would be worthwhile for competitors to enter the industry until allmonopoly profits were bidded away. To counteract this, companies attempt to maintaintheir monopoly profits by capitalising on market imperfections such as barriers to entryand product differentiation.

The effects of competition do not act only on the demand side. On the cost side, youcould imagine the average cost curve moving from left to right as competition for inputsincreases and the prices of labour, capital and materials increase. This would alsohave the effect of reducing monopoly profits. Sometimes companies are able to affectcompetitive conditions in factor markets, for example by entering into agreements withtrade unions. But again, this typically confers only a transitory advantage because othercompanies can copy these arrangements.

4.4.3 Oligopoly

When there are relatively few competitors in a market the likely reaction of competitorsto changes in pricing and marketing strategy must be taken into account. When thereare relatively few competitors it could be argued that the notion of a measurable demandcurve for an individual company has little operational meaning because its shape andposition depends on competitive reaction, which in turn cannot be predicted. Does thismean that the concept of the demand curve cannot be used in this situation? In fact, thedemand curve provides a useful method of incorporating knowledge about competitiveconditions 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 itknows that none of its competitors would follow suit and that many customers wouldbe 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 suitand that there would be very little increase in demand. The idea of a sharp reductionin demand resulting from a price increase, and very little increase in demand resultingfrom a price reduction, is illustrated by the kinked demand curve shown in Figure 4.7.


4.4. Market structures 77

Figure 4.7: The kinked demand curve

The current price is P; above that point the demand curve is virtually horizontal, basedon the assumption that competitors do not follow suit. Below P the demand curve isalmost 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 makingprofit on a product, it is unlikely to be possible to improve net contribution by increasingthe price because any price increase would lead to a substantial loss in sales. On theother hand, if the company wishes to increase market share by reducing the price, itfollows that when the price is reduced total revenue will be smaller than it otherwisewould have been and hence so will net contribution. When competitive conditionssuggest that the demand curve is kinked, the attempt to increase market share byreducing price can only be justified if future net contribution will be significantly higherthan it otherwise would have been to compensate for the revenue forgone in creating thehigher market share. This means that there is a trade-off between giving up revenuesnow in order to increase market share and the expectation of higher revenues in thefuture when price can be returned to its original level at the higher market share. Asmarket conditions change the extent to which the demand curve is kinked may alsochange. For example, if two or three competitors take-over a number of small companiesin the industry, it is to be expected that the part of the demand curve below the kink willsteepen. Thus when discussing competitive reaction, it is useful to frame the issue interms of whether the demand curve is likely to have a significant kink and what the slopeof 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 asignificant price change and stick with it. Otherwise the price change will have virtuallyno effect because of competitor reaction. But the danger is that a competitive pricingmove may lead to a price war the outcome of which is unpredictable because it dependson the reactions of the individual competitors; for example, a price increase by onecompany as a result of higher costs may result in all other competitors raising theirprices by a similar amount, or one of the companies may see an opportunity to grab alarger market share and may therefore reduce price. The indeterminate outcomes in this



situation can result in a price war in which the monopoly profits which could be earnedbecause of market imperfections are bidded away.

Exercise 4.3

In Exercise 4.2 the barriers to entry to the supermarket business were assessed. Thegrocery business in the UK has evolved from fifty years ago, when there were manythousands of small shops, to about twenty years ago when town centre supermarketsgrew 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 competitiveconditions affect profitability, it is rare that a company is a pure price taker with littlescope for competitive action. All competitive action has to take into account the potentialreaction of competitors and it is clearly important to identify how far these reactions canbe anticipated. Some light can be thrown on this by applying the concepts of gametheory 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 theexpense of the other. This occurs in a mature market where sales are not increasing,so where there are only two competitors they may find it of mutual benefit to have atacit agreement on prices. In this way they can carve up the market between them andmake a profit acceptable to both. However, each company is faced with the possibilitythat if it were suddenly to cut prices dramatically it might put the other out of business,or attract a substantial part of the other’s business. But if the other company reactedvery fast, and had the resources to cope with further price reductions, the net outcomemight be lower prices with both companies being worse off. This is a typical patternof events in a price war, the net effect being to benefit consumers. When attemptingto frame a game strategy companies are faced with potential costs and benefits, allassociated with a high degree of uncertainty. Managers can use what information theyhave about competitors to assess their possible reactions and perhaps identify a courseof action which appears to have a good chance of success. Such competitor informationmight include estimates of financial reserves, attitudes to uncertainty, company morale,the strength of the marketing department and previous successes and failures in newventures. This profile of competitors’ strengths and weaknesses can help indicate thelikely response to different courses of action. However, the dominant characteristicof competitor reaction is unpredictability; the company must always be prepared fora variety of responses to any competitive action.

Even with full information on competitors, however, it can be impossible to arrive atan optimum strategy. A game which illustrates this and has important implications forbusiness behaviour is the prisoner’s dilemma. Imagine the police are trying to maketwo suspects confess to a major crime, but they have no evidence; the police tell eachprisoner privately that


4.5. Competitive behaviour 79

if he confesses he will go free if the other remains silentbuthe 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 otherremains silentbuthe 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 first stepin arriving at a conclusion is to draw up a decision matrix which shows the number ofyears you will spend in prison for each possible action depending on what your partnerin crime does.

Partner

You Silent Confess

Silent 1 10

Confess 0 7

The answer is clear: if you stay silent the best you can hope for is 1 year in prison,and the worst is 10 years, whereas by confessing you either go free or spend 7 yearsin prison. In this case your best option is to confess, independent of what your partnerin crime does. This one-off event is artificial, but it does contain important lessonsfor cooperative behaviour, for example when businesses enter into joint enterprises orstrategic alliances. Imagine what might happen if you have gone to prison and served7 years. Given that research into criminals has shown that prison has very little effecton behaviour, assume that you and your partner commit the same crime and end up inexactly the same position once more. Both of you know very well by this time that if bothof you do stay silent then you will spend only 1 year in prison, so will your experienceaffect your behaviour this time round? If you are convinced that your partner sees thevirtue of not confessing then it is in your interest to confess, because that way you gofree. But the same logic applies to your partner, so once again you will both end upconfessing and going back to prison for 7 years. The point of the dilemma is that notonly does the situation lead to an outcome which is not in the best interests of eitherparty, but experience does not lead to a different outcome.

Turning to the parallel with the business world, you would immediately point out that thetwo parties are free to discuss what they should do and as a result of their collusionwould 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 anothervariable which gives an incentive to stick to the agreement. This variable is theknowledge that the situation will be repeated an unknown number of times. Why anunknown number of times? Because after each 1 year sentence it is worthwhile to enterinto the agreement, but if it is known that this is the last time then both of you will havean 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 andprofits and both have to be sure that the other will not break ranks and make a profitat the expense of the other. But if agreements are not legally binding, both parties are



continually faced with the equivalent of the prisoner’s dilemma. One way of building trustis to make a commitment to the venture which would make it costly to break ranks. Inthe absence of significant financial commitments it is not difficult to see why cooperationin a competitive environment is so fragile and difficult to maintain. You may feel that thisdevalues the concept of trustworthiness as a moral virtue. But in the business settingit is necessary to be realistic about the likely actions of business partners and interpretthem in terms of the incentives involved.

As you might imagine game theory is a complex subject, but while it is highlymathematical it provides important insights into behaviour. The prisoner’s dilemmahas what is known as a dominant strategy equilibrium because the best strategy isindependent of the choice of the other party. If there is not a dominant strategy thenit is necessary to estimate the other party’s likely response. The logic then becomesrather involved, but it is worth noting that an equilibrium strategy can be achieved in avariety of situations; the mathematician Nash demonstrated the circumstances underwhich each party makes the best response given what the other has chosen to do. Butthe fundamental point of the original dilemma is unaltered: unless there is trust andcommitment to a course of action there is always an incentive for one party to breakranks.

4.5.2 Pricing

Price setting can be used as a competitive tool and short term revenue flows may besacrificed as the result of cutting price in the pursuit of wider strategic objectives. Thethree main forms of competitive pricing are price leadership, limit pricing and predatorypricing.

Price leadership: the dominant firm in the industry announces its price changes beforeall other firms, which then match the leader’s price. The problem for the price leader isthat it has to retaliate against defectors to maintain credibility, but it is difficult to see howthe price leader can penalise a defector without penalising all of the smaller companiesin the industry. The smaller firms will only cooperate if they gain some benefit from thearrangement; the benefit is that they do not need to worry that rivals will secretly reduceprice 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 afragile situation.

Limit pricing: this is an attempt by a firm to erect an entry barrier by charging a low pricein order to deter potential entrants; this is only worthwhile if it has a cost advantage andcan set the price low enough to deter entry but still make a profit. In reality, there is nopoint to incumbent firms setting a limit price because potential entrants will recognisethat any price reductions prior to entry are artificial. Once entry occurs, it would makeno sense for the incumbent to continue to suppress price. This is because the lostprofit opportunities from having previously set the limit price are sunk and, once theentrant is in the market, the incumbent should attempt to maximise future profits. On theother hand, the potential entrant cannot be certain that the incumbent will in fact attemptto maximise profits after his entry, so it then becomes a game where the incumbentattempts to affect the potential entrant’s expectations about his subsequent behaviour.It is obviously too simple to think of limit pricing simply as a method of keeping outpotential competitors by making returns appear low; it is really an issue of expectations.


4.5. Competitive behaviour 81

Predatory pricing: in this case a firm sets a price with the objective of driving newentrants or existing firms out of business. In order to make this strategy work it isnecessary for the predator to have some strength, such as a large cash reserve orrelatively low costs, which other firms in the industry do not share. This approach couldwork where a competitor is known to be financially unstable, but otherwise it is likely tolead to competitive reaction, and we are back to the zero sum game.

These approaches to competitive pricing are typically encountered in textbooks, but theyare rarely found in practice. Probably this is because they characterise extreme formsof competitive behaviour which do not occur much in real life. So far as price leadershipis concerned, it is unrealistic to expect one firm to set prices in a competitive market,where changes are occurring all the time; in the case of limit pricing, firms rarely expectto be able to deter competitors from entry by engaging in a price war, and recognise thattheir 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 thingto try to win market share by pricing competitively, but it is quite another to set outdeliberately to ruin a competitor. The point is that competition cannot be avoided, and aprice change which deters or eliminates one competitor is unlikely to have a permanenteffect on competitive pressures.

Another consideration is that the chance of setting off a price war is particularly highin conditions of oligopoly, outlined at Chapter 4 Section 4.4.3, where it was pointed outthat there may be no benefit from competitive pricing due to competitive reaction. Thisdoes not mean that pricing is irrelevant for strategic purposes, but it does suggest thatan attempt to achieve long term competitive advantage using pricing alone is unlikely tobe successful.

4.5.3 Contestable markets

Another reason for the lack of empirical evidence on the effectiveness of pricing as acompetitive tool is that it is unlikely to have much impact in the absence of structuralbarriers of the type discussed at Chapter 4 Section 4. This is because, when structuralbarriers are low, entry deterring strategies would be ineffective because the cost to theincumbent would exceed the benefit. In this case entry is so attractive that the incumbentshould not waste time trying to prevent it. An extreme case is where entry costs are notsunk and exit can be achieved costlessly, and this is known as a perfectly contestablemarket.

If sunk costs are zero, would-be entrants do not have to worry about the kinds ofretaliatory measures that incumbents might implement, because if the entrants find theycannot make a profit they can simply exit. If incumbents realise this, then they will settheir prices so as to stop the entrants from wanting to enter in the first place. Hence,whether there is one firm or several firms actually operating in it at any time, a perfectlycontestable market never offers the incumbent more than the normal rate of profit. Thisexplains why many companies which apparently have a monopoly do not actually makemonopoly profits; this is a different situation from a true monopoly which does not makeprofits because it is relatively inefficient as a result of the absence of direct competition.For a firm contemplating entry to a particular market it is clearly important to differentiatebetween the two cases.



Exercise 4.4

It is probably impossible to observe a game in practice, in the form outlined by theprisoner’s dilemma, and it is unlikely that the three forms of pricing described occur inpractice; furthermore, while contestable markets are probably real enough, it is difficultto 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 inExercise 4.2.

4.6 Segmentation

From the strategy viewpoint, it is often misleading to think in terms of a product whichis sold to a homogeneous group of consumers. The theory of competition in marketsstarts with the assumption that consumers have identical characteristics and have fullinformation about the prices charged for the product; this leads to the notion of a singledemand curve for the product, and implies a marketing strategy which concentrates onthe average consumer. However, an appraisal of the potential worth of a product maybe radically altered by relaxing these assumptions and investigating potential marketsegments based on variations from the average consumer, and the marketing strategieswhich might be able to exploit them. For example, it may be found that a 5 per cent pricereduction may lead to a 1 per cent increase in sales volume, suggesting that the productis price inelastic. However, the additional sales due to lower prices may be concentratedamong consumers in the lowest income group; rather than offering a price reduction toeveryone in the market, it would be more effective to offer the price reduction only tothose in the group who are likely to respond. In this case the lowest income groupis a segment of the market which is a group of consumers within a broader marketwho possess a common set of characteristics, and these consumers in a segmentrespond to market mix variables in broadly the same way. An example of a companywhich focuses on a particular segment is Cray Research, which manufactures supercomputers for organisations which require massive data analysis capabilities, such asweather forecasting.

The economic idea underlying segmentation is that the market demand curve is thesummation of the demand curves for market segments; these segment demand curvescan vary significantly in their characteristics. The objective in segmentation is to identifydifferent groups according to their characteristics, estimate how they are likely to react todifferent 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, educationalbackground, etc. When the segments are not separated geographically it may not befeasible to charge different prices among segments, and in this case the marketing thrustwould accentuate product characteristics which have a particular appeal to individualsin the different segments.

There are in fact four main characteristics which a segment needs to have if it is to bepotentially exploitable:

• Identifiable: there must be sufficient common features that enable the segment to


4.6. Segmentation 83

be identified in the market place.

• Demand related: the identified segment must have at least one characteristicwhich translates into demand terms, such as the willingness to pay more for ahigh quality product.

• Adequate size: the segment needs to be large enough to generate a potentiallyattractive return on the investment required to exploit it; this is where techniquessuch as break even analysis are particularly important.

• Attainable: if the segment cannot be reached by available marketing andadvertising approaches there is no point to embarking on the investment Forexample, before launching the Lexus motor car the makers had to be convincedthat they could reach high income individuals in sufficient numbers; given the fiercecompetition which already existed among high profile brands such as Jaguar,Mercedes and BMW in the segment this was a formidable undertaking.

From this a number of key steps can be identified for carrying out a segmentationanalysis.

Identify the most important segmentation variables

An important issue here is whether there are general criteria which can be used indetermining 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 derivegeneral criteria. The best that can be done is to approach the issue in a structuredfashion, 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 senseor 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 understandswhere the basis for competitive advantage is likely to lie.

Construct a segmentation matrix

The identified variables can be combined with other information about the industry toproduce 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 aparticular city; this could take the following form.



Quality

Type High Medium Low

Chinese 3 7 5

Japanese 1 3

Indian 2 10 15

Mexican 10 5

Italian 6 4 9

This classification suggests that there is a gap in the market for high quality Mexicanand low quality Japanese restaurants. This is merely the first step and more detailedanalysis would look at the potential market size in relation to the number of restaurantsof a particular type. For example, comparison with a city of a similar size might revealthat there is potential for at least another three medium Italian restaurants.

Analyse segment attractiveness

Simply because the fact that these gaps have been identified does not mean that theycan be profitably filled. The four main characteristics of attractiveness need to beevaluated.

Characteristic Analysis Attractiveness

Identifiable The criteria of quality and ethnic type are distinctive HighDemandrelated

It is unlikely that people would frequent a low qualityJapanese restaurant because of its emphasis on freshproduce. UK consumers have no experience of highquality Mexican food

Low

Adequatesize

City centre property prices are very high: the start up costis a major investment in both cases

Low

Attainable There is no evidence from other cities that anyone wantseither type of restaurant

Low

On balance it does not look as through either of these segments is attractive. It is alwaysnecessary to bear in mind that in a competitive economy there is usually a very goodreason for gaps existing: they have already been tested and found to be unprofitable.

Identify the key success factors

The key success factors are the necessary, but not sufficient, conditions for success.It is possible to identify those activities which must be completed as a precondition forsuccess. Unless close attention is paid to the identification of these factors there is littlechance that the segment will be effectively exploited. For example, from the matrix aboveit might be concluded that there is a gap for another high quality Japanese restaurant.Some key success factors involved in exploiting this segment are

• identify a source of totally fresh sea food

• obtain the services of a highly qualified Japanese cook (these are very rare)

• find and decorate premises which provide a Japanese ‘look and feel’



4.6.1 Product differentiation

For some products it may be virtually impossible to differentiate among consumers onthe basis of product characteristics because the product does not lend itself to thisapproach; 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 willhave 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 twoseater high performance sports car which is relatively expensive both to purchase andrun. The potential product can be thought of as a bundle of characteristics whichappeal to different consumers in different ways. Product differentiation extends theconcept of segmentation to the determination of which bundle of characteristics shouldbe incorporated in the version of the product targeted at each group.

There are times when differentiation may be more apparent than real. Differentiationmay simply be a perception on the part of potential buyers, for example aspirin issold under many brand names and all of them simply cure headaches. However,real or perceived differentiation has implications for marketing strategy and pricingpolicy. Consumer characteristics can be matched with potential product characteristicsto identify those market segments where it is likely to be worthwhile to differentiate theproduct.

The two most important determinants of a product’s success are likely to be the price ofthe product compared to similar products, and the degree to which consumers perceivethe product as a different offering. Data on consumer perceptions of relative price anddifferentiation can be generated by market research, and the approximate position ofthe product in Figure 4.8 can be identified.

Figure 4.8: Perceived price/differentiation

The model tells some rather obvious things: a product with low perceived differentiationand high perceived relative price is likely to fail; a product with high perceiveddifferentiation and low perceived relative price is likely to succeed. Despite the apparentsimplicity of the approach, the model is remarkably powerful in identifying potentialcourses of action. For example, if current development and pricing plans suggest that a



product will fall into the ‘uncertain’ area, a possible strategy response is to reduce priceand/or mount an advertising campaign designed to increase perceived differentiation toget into the ‘success likely’ area. There is little point to pursuing plans which seemeddestined 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 highperceived differentiation can be put on the market at a relatively high price at firstand then abandoned, or the price reduced when competitors react and the perceiveddifference is eroded. In the electronics industry, some companies consistently enter newmarkets with a high priced differentiated product in the knowledge that their competitiveadvantage will be relatively short lived. This is because the technology can usually becopied; for example, when pocket calculators were first introduced with many financialand mathematical features, the subsequent entry of new competitors soon reduced theperceived differentiation because every new calculator had these functions.

4.6.2 Product quality

One of the most frequently encountered approaches to product differentiation isreference to the superior quality of a company’s product or service. While managersin many companies believe that part of their appeal to customers is attributable tothe superior quality of their products, they are often vague about exactly what thequality difference comprises. The consumer magazines, such as Which? in the UK,which carry out comparative studies of products made by different companies oftenfind that products differ only marginally, and that their definition of a ‘best buy’ oftenbears little relation to manufacturers’ advertising claims. This confusion is not restrictedto consumers; disagreement is often encountered among employees within a givencompany on what constitutes quality. Some take the view that quality depends on theproduction process, in other words it depends on how the product is made, while othersfeel that quality depends on reliability in use. There are several approaches to thedefinition and measurement of quality, and it is important that managers are clear aboutwhat they mean by quality prior to allocating resources either to increasing quality orexploiting it in the market place. However, given the difficulties in defining quality shownbelow, 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 robsthe concept of operational use for decision making purposes. Essentially, the Platonicdefinition relates quality to high standards of excellence and achievement which canonly be recognised in the light of experience. Thus a painting by a great master appealsto an art critic who has devoted a large part of his life to the study of art, but will belittle more than a pretty picture to a sixteen year old who has had no art education. Thepursuit of transcendent standards by managers is unlikely to be related to commercialcriteria given the difficulty of defining what comprises these standards.

Product based quality

A product can be viewed as a bundle of characteristics, most of which are susceptible tosome form of measurement. For example, compare flying from London to New Yorkfirst class on a scheduled flight with flying Concorde before it was withdrawn fromservice. Concorde took less time, and this can be measured. However, first class ismore comfortable than the rather cramped Concorde, and different passengers will have



different views on how great the difference in comfort actually is. There is therefore noguarantee that passengers would agree on which was the higher quality flight. It couldbe argued that the market tells us because those who actually chose to pay the higherprice and fly Concorde had decided that it provided a higher quality service taking allthings into consideration.

The characteristics approach has considerable power in classifying products andidentifying what it is that consumers are willing to pay for, but product characteristicsare not necessarily determinants of product quality; this is because quality may bedependent on how well the characteristics are produced or combined together.

Sometimes manufacturers incorporate characteristics which have little relevance toconsumers, but which are thought to enhance the quality image of the product. Forexample, it does not matter much to the average consumer that a particular make ofwatch will function at 100 metres below water. While the resulting image of dependabilitymay help sales of the watch, the cost of building a case which can withstand highpressure may far outweigh the return from the additional sales. In that sense it could beclaimed that the watch had ‘too much’ quality.

This notion of quality also applies to service industries, where quality and consistencyare closely linked; most people have had the experience of recommending a restaurantwhich failed to deliver the same quality for someone else. The consistency characteristicis important, because if it has not been achieved the consumer can have no confidencethat he will be able to buy the same product each time. But consistency is not actuallypart of the quality itself, which in the restaurant case depends on the raw materials andthe ability of the chef.

User based quality

This approach departs from the functionally based product characteristic differentiation,and enters the conceptual minefield of what it is that contributes to quality in theeyes of the consumer. An economic interpretation is that product quality variationscause differences in the position of the demand curve for products which are otherwiseidentical. But it is difficult to determine what these quality variations might be. Forexample, 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 havewhat is typically referred to as a ‘better design’. For example, this is a feature ascribed todifferent makes of electric kettle, where the appearance can be changed but it is virtuallyimpossible to alter the functional characteristics.

Almost every user based definition of quality can be reinterpreted as a functional,measurable characteristic. For example, durability, flexibility, strength and speed are alldefinable as functional characteristics. One marketing approach is to attempt to identifyideal points, which are precise combinations of characteristics which provide maximumsatisfaction to consumers. This takes into account that the interaction of different qualitydimensions can produce more utility than the sum of the individual parts.

Production based quality

This approach relates to production in conformance with specifications, independentof what these specifications may be in the first place. Notions such as getting itright first time, statistical quality control, and designs intended to reduce the scopefor manufacturing mistakes, all have the objective of producing the same product each



time. To some extent the manufacturing based approach can be interpreted as a costreduction exercise, with the objective of producing a set of product characteristics at thelowest average cost. While there is no doubt that a component of the concept of quality isthat each unit performs to the design standards, it begs the question of what comprisesthe quality standard in the first place, and why the particular array of characteristics wasoriginally chosen.

Value based quality

This is a hybrid notion which combines the price, or production cost, with the quality.According to this definition, a running shoe costing $600 is not a quality product, sinceno one would buy it. This definition can be interpreted in terms of the economicideas of marginal and total utility. The value based definition of the running shoehinges on the fact that at the margin consumers would be unwilling to pay the highmarginal cost associated with virtually undetectable marginal differences in productcharacteristics. The marginal cost associated with improving aspects of the runningshoe’s characteristics becomes progressively higher, while the additional utility whichthe consumer obtains from increments to these characteristics continually declines.Thus while the total utility which the consumer would obtain from the $600 runningshoe would be much higher than for a shoe costing $120, consumers do not valuethe difference at $480.

Many cases do exist, however, where seemingly marginal differences in characteristicsare translated into very large price differences which consumers are willing to pay. Anobvious example is the willingness to pay three times as much for a Rolls-Royce as aJaguar; 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 Rolls-Royce. Indeed, it may be that the quality difference has been established by prolongedadvertising campaigns, which have stressed the quality aspects of the product processwithout being clear what the quality difference amounts to for the consumer. Rolls-Royceadvertising campaigns have stressed the care taken over the production standard ofevery single component, but whether this can be translated to the consumer in termsof an identifiable difference in utility in use is left open. Whether it matters to theconsumer that a particular part of the car is ‘hand built’ is another matter; producersare often confused about the difference between the production process and the finalcharacteristics of the product. Managers should attempt to determine when a particularproduction process merely adds to costs rather than to market appeal. The Morgan carcompany, a British company which makes a range of old style sports cars, refused formany years to alter its production processes in line with technology, and insisted that thewhole car be built ‘by hand’; while this helped to foster the image of a unique product,the costs associated with this form of quality were such that the firm ran into seriousfinancial problems. The Morgan car company could not translate the hand built imageinto a price which consumers were willing to pay.

Quality and strategy

A considerable amount of research has been carried out into the relationship betweendifferent dimensions and market performance; the findings provide some pointers whichare helpful for strategy formulation. Some quality related issues which might appear tobe self evident are not necessarily true. For example, quality and price may be expectedto be positively related, other things being equal, because of the additional productioncosts associated with higher quality. However, when different dimensions of quality are



taken into account, the price-quality relationship is obscure. This means that a companycannot assume that it will be able to charge a higher price after having improved thephysical quality of its product. Another finding relates to quality and advertising; itmight be expected that quality and advertising expenditure are positively related, giventhe higher returns to advertising for higher quality products. Again, the evidence isambivalent. It may be the case that investment in higher perceived quality is a substitutefor advertising expenditure.

There is some evidence that quality is positively related to market share, suggesting thatinvestment in perceived quality has paid off in the past in marketing terms. There is alsosome evidence that quality and profitability (as measured by ROI) are correlated. Thuson balance, there is some evidence that the pursuit of quality may generate returnsin terms of competitive advantage and profits. However, while the empirical evidencesuggests that important influences are at work, it is not clear cut, and the pay-off fromquality may vary substantially depending on the circumstances.

The idea that quality is a fundamental determinant of success has generated anapproach known as total quality management (TQM). As its name suggests, qualityin all its dimensions is pursued with a high degree of rigour and commitment. Notionsof quality are brought to the forefront of awareness, and include all aspects of companyperformance through production processes and customer service. Some countries haveintroduced formal quality standards against which companies can be appraised; forexample, in the UK the BS5750 award signals that a company has met various qualitycriteria relating to production processes. But the pursuit of TQM is by no means anexact science because of the difficulty of defining quality and providing the incentiveswhich will make quality initiatives work. TQM took on the characteristics of a philosophyrather than a particular business technique, and is greatly dependent for its successon the energy and commitment of the approach in particular circumstances. TQM is arelatively recent development and gained its momentum during the 1980s, but by themid 1990s scepticism had set in. This occurred because, while there were some wellpublicised instances where TQM appeared to have been successful (for example RankXerox 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 themselvesproduce competitive advantage; this is probably because these can be imitated bycompetitors without necessarily being associated with a TQM programme. However,some tacit and behavioural features such as an open culture, employee empowermentand executive commitment do appear to be associated with advantage. In other wordsthese tacit characteristics, and not TQM tools and techniques, drive TQM successes,and organisations that acquire them can perform relatively better than competitorswithout the accompanying TQM ideology.

Discussions on quality can benefit from attempting to identify specifically which areas ofrevenue 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 trade-off between quality and cost, and many companies which successfully implementedTQM programmes reported simultaneous increases in productivity and quality. However,it may be that successful TQM programmes have merely eliminated inefficiencies incompanies and after this has been achieved there is no such thing as a costlessimprovement in quality. Table 4.1 shows how it might be possible to relate variationsin different quality dimensions to potential implications for market share and production



cost in a particular market segment; the entries would depend on the circumstancesfacing the individual company.

Table 4.1: Quality and competitive advantage

Impact on

Dimension Market share Production cost

performance High High

reliability High Low

conformance Low Medium

aesthetics Medium Low

For this company a relatively low production cost incurred to improve reliability wouldlead to a potentially high impact on market share. While improvements in performanceare also likely to lead to a high impact on market share, the high cost associatedwith performance may make it a less attractive option than improving aesthetics. Thiscost based approach is at odds with TQM, which holds that all aspects of quality areimportant 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 differentprices can be charged in each. However, it may well be the case that there are virtuallyno differences in the cost of products sold in different segments; for example, wheresegments are based on geographical location rather than product differentiation theremay be no difference in the production cost in each. What is the optimum price to chargein each segment? This topic has been extensively treated in economics, and is knownas discriminating monopoly. The economic theory is relevant here because the effectof segmentation is to confer some degree of monopoly power to the company in thedifferent segments; it also stresses the importance of market rather than cost conditionswhen setting prices.

Without elaborating the theory (which can be found in any intermediate level economicstextbook), it will come as no surprise that the conclusion arrived at is that, in pursuitof profit maximisation, a monopolist will charge different prices in different marketsdepending on demand conditions. This follows despite the fact that the marginal costof production is identical in each market. In terms of the basic model, the theoryis concerned with finding the price in each market for which revenue minus cost ismaximised.

The monopolist will charge a higher price in a market with a low demand elasticitythan in a market with a high demand elasticity.

The implication for pricing is clear: if different demand conditions exist in different partsof the market different prices should be charged, even though costs are the same ineach. There is a real pay off from finding out what the different demand conditions are,rather than setting a uniform price in all parts of the market. This is because total profitfrom the uniform price is lower than the sum of profits obtained from differential pricing.This arises from selling much more of the product at a lower price in the segmentswhere demand is relatively responsive to price, and less of the product at a higher



price in segments where demand is relatively unresponsive to price. Segmentationis therefore a potentially powerful tool for transforming a loss-making product into aprofitable product without changing anything but the price charged to different groups ofconsumers. In many market situations the potential for segmentation exists, but it hasnot been exploited as a source of additional revenue because managers are unaware ofthe notions of segmentation and differential pricing.

Marketing practitioners have turned segmentation into an operational tool for exploitingmarkets. The first step is to carry out research to determine the characteristics ofdifferent segments of the market, and the product characteristics which might best matchwith them. The second step is to derive estimates of price and income elasticities; inmarketing terminology, this is often expressed as price and income responsiveness.The additional feature added by marketing strategy is that the product itself is adjustedto match as closely as possible the demand characteristics of the different segments,or advertising campaigns are mounted to convince potential consumers that differencesexist in different brands of the same product.

Because resources are required to differentiate products, marginal cost may not beidentical in the different market segments; however, the principle of differential pricingbased on market conditions still applies despite the fact that production costs aredifferent. The theory of price discrimination, on which differentiation is based, can bedeveloped further to demonstrate that there are limits to the extent of segmentationdepending on the impact of segmentation on costs. The potentially higher revenuesfrom segmenting the market, differentiating the product and setting different prices canbe balanced against the additional costs incurred in each segment in order to obtain anapproximation to the limits imposed by cost differences.

Market segmentation is a good example of how economic, accounting and marketingapproaches can be integrated to provide a conceptual structure to deal with the diverseinformation occurring in real life. For example, marketing ideas identify a productwhere segmentation is potentially viable, economic ideas are used to measure demandcharacteristics, and emphasise the role of marginal cost in decision making, accountingideas are applied to identify marginal cost. It can be noted that relevant accountinginformation on marginal costs is essential for making rational segmenting decisions:unless the marginal costs relating to product differentiation are properly estimated, theresult may be what appears to be a successful marketing strategy in terms of capturingmarket share, but poor profits because the use of average costs led to a misallocationof resources.

Exercise 4.5

One of the significant marketing events of 1992 was the sudden decision to reduce theprice of Marlboro cigarettes. The background to this event was

‘It was the dumbest decision in corporate history. They have ruined one of the bestbrand names in the world and have created permanent damage’. Henry Kravis,famous Wall Street buyout specialist, addressing Harvard Business Schoolstudents.‘It is commercial suicide. All that investment in the brand, then you tell people thatyou can now buy for less than $2 what was worth $2.15 until yesterday. The buyeris never going to believe you again’. Bruce Davidson, tobacco analyst at the brokerSmith New Court.



Kravis was referring to the decision by Philip Morris to cut the price of Marlborocigarettes by 20 per cent. He was not, however, an unbiased observer, having beenresponsible in 1989 for a take-over of RJR Nabisco which had responded by cutting theprices on their Camel and Winston brands. Financial markets expected the price warwill have a significant impact on the profitability of cigarette companies - Philip Morris’share price fell from $64 to $51 (23 per cent) within minutes of the announcement ofthe price reduction, and fell further to $46 the following week. Wall Street itself tookfright and fell by 50 points. However, the notion that Philip Morris had simply ruined abrand name must be seen against the wider economic forces against which theMarlboro 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 wasgrowing in the Far East and east Europe. In the context of a declining market, the totalUS market was price inelastic; advertising campaigns were primarily aimed at increasingor maintaining the market share of individual brands. There was no expectation that theMarlboro price cut would increase total cigarette sales. However, despite the decliningmarket the major companies had been able to increase profits because of technologicalprogress. Productivity increased dramatically; in 5 years daily production increased from7500 per minute to 15 000, with accompanying cost reductions.

Changing competitive conditions

Technological progress and falling costs played a part in the introduction of cheaperdiscount cigarettes. Figure 4.9 shows the growth in the market share of discountedcigarettes.

Figure 4.9: Discounted cigarettes as % of US market

At the same time Marlboro’s market share was in decline, as shown in Figure 4.10.



Figure 4.10: Marlboro market share

Sales dropped by 366 million packs in 1992, costing $200m in profit.

It is not surprising that the discounted brands made such inroads into the premiumbrands’ market share given the disparity in price between the two; for example

Price of cheapest discount brand: $0.69Price of Marlboro: $2.15

Consumers have probably asked themselves what it is about a particular cigarette thatmakes it worth 3 times as much as another. The Marlboro advertising strategy wastargeted at 18-24 year old men, on the basis that smokers tend to stay with the samebrand for years. The cowboy based advertising campaign has been familiar since themid 1950s, and many observers considered that Marlboro was the world’s best marketedproduct. However, in 1988 Camel introduced a campaign using a camel image calledJoe. By 1991 Camel’s market share was 4 per cent, and it was generally felt that Camelwas taking market share from Marlboro.

Market position

The dominance of Marlboro in the cigarette market is illustrated in Figure 4.11, whichshows 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



success of the individual brands. The overall market shares of the two main competitorswere:

Premium Discount

Philip Morris (Marlboro etc) 34 8

RJR Nabisco (Camel etc) 19 10

In 1989 Kravis’ partnership fund KKR took over RJR Nabisco for $25 billion, of whichonly $3 billion was from the KKR buyout fund; KKR was much more heavily in debt thanPhilip Morris.

Rationale for price cuts

On the basis of the price differential, it follows that the margins on discount cigaretteswere relatively small, and there was little scope for the discount producers to reducetheir prices significantly in response to the Marlboro cuts. This means that the differentialbetween Marlboro and the premium brands would be significantly reduced, and it washoped that this would be sufficient 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, butthey all suffer from the fact that they have no dynamic dimension. The analysis is carriedout at a particular time and place, and it is difficult to take account of longer term changesin 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 sometime for information about the product to be disseminated

• growth: the product becomes increasingly well known, markets are penetrated andit 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 substitutesappear

The product life cycle is depicted in Figure 4.12, which is a general representation ratherthan referring to any particular product.


4.7. The life cycle 95

Figure 4.12:

Since industries are composed of products the idea of the life cycle can be generalisedto the industry level, and Figure 4.12 can be regarded as either referring to a productor to the industry. Everyone is familiar with industry life cycles in broad terms, forexample, the very high rates of growth in the personal computer market, which have nowslackened off as the industry approaches maturity, or the decline of the cigarette industryin Western countries as information on the health risk of smoking reduces the number ofconsumers. While the idea of the life cycle is a very general one, and varies accordingto the product and the country, it is an essential tool of strategic analysis because thecompany’s estimate of where the industry is on the life cycle greatly determines itschoice of strategy. The idea provides a structure within which market information can beinterpreted rather than being an absolute representation of reality.

As the pace of technological change has increased in the past few decades, it isgenerally felt that product life cycles have also shortened. The implication of this isthat companies in high technology industries must continually strive to improve theirexisting products and invent new ones simply to stay in the game. For example, everynew mobile phone launched on the market has to have a host of new features to standany chance of success; features now regarded as standard would not have been dreamtof in the 1990s, including photographic, email and internet browsing facilities.

The importance of the life cycle idea becomes apparent when considering the type ofstrategic approach which companies need to adopt in the different stages.

• Introduction

The company invests in new productive capacity and spends relatively highamounts on marketing to bring the product to the notice of consumers. Cashflows are likely to be negative, and during this period the company has little ideaof how the market will develop, what competitors will appear, and in fact whetherits investments are likely to be justified.

• Growth

As sales start to increase the company has to invest further in productive capacityahead of market demand, and has to meet the challenge of new entrants; despitethe costs involved in entering a new and growing market, there are potentially veryhigh returns from the first mover advantage. However, if the company wishes tomaintain 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



size increases market share will fall unless sales increase by at least the samepercentage as the market. To achieve increased sales it is necessary to adoptaggressive marketing and offer competitive prices. If the company wishes toincrease market share during this stage, with the aim of being one of the marketleaders when the product cycle reaches maturity, it is necessary to be even moreaggressive.

During this period it is unlikely that the product will produce significant profitsbecause

– 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 gaineda significant market share by the time the market matures it will find it very difficultto do so because do to so means taking customers away from competitors. Pricedoes not need to be set below that of the competition to keep the existing marketshare, and marketing expenditure can be reduced. Thus once revenues havestabilised, selling costs can be reduced which generate the potential for substantialpositive net cash flows.

• Decline

The company has to decide whether to exit the industry, or phase out its productivecapacity. This is not the time to be undertaking new investments, which is why it isimportant that companies recognise the threat posed by the advent of this stageof the life cycle.

• The transition from growth to maturity

A crucial stage in the product life cycle occurs when the transition occurs fromgrowth to maturity. Given that the management of products in the two stages isso 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 losetheir competitive advantage. In the growth stage it is to be expected that profits willbe relatively low because of the high costs incurred in marketing aggressively andmaintaining excess capacity. When the market ceases to grow carrying on withthese policies can lead to losses and company failures. That is why the transitionis sometimes known as the ‘shakeout’. In practice it is not a simple matter to avoidthe problems of transition because it is very difficult to identify when the marketis approaching maturity. It is difficult to detect when the market growth rate hasstarted to reduce; forecasting is notoriously difficult and if the company movestoo soon it will lose sales because of lack of capacity. Apart from the difficulty ofidentifying the transition companies often adopt a mind set during the growth stagethat is unwilling to recognise that conditions are different and it is time to adopt anew approach.

The product life cycle model occurs in the context of the business cycle, which makesit difficult to identify the transition stage because it is easy to confuse a slow down in


4.8. Portfolio models 97

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 sizeduring the mature part of the life cycle, at a time when significant reductions would notnormally be expected. This may lead companies to think the market has entered a thedecline stage rather than the decrease being temporary. Real product life cycles arenot smooth but have an uneven pattern depending on the extent to which the productis affected by economic circumstances. It is obviously difficult to differentiate businesscycle effects from the underlying product life cycle. It is, however, important be explicitabout what is thought to be happening, because the strategy implications of a fall insales due to a temporary reduction in consumer incomes differ from those due to theonset of the end of the product life cycle.

The main differences in approach over the course of the product life cycle can besummarised as follows.

Decision Introduction Growth Transition Maturity Decline

Price Low Low Increase Market Market

Marketing High High Reduce Low Low

Capacity High High Reduce JIT Reduce

Investment High High Reduce Replacement Zero

This interpretation is not a prescription for success but is indicative of the changes inemphasis that companies have to consider as the product moves through the life cycle;there is plenty of scope for strategic moves as opportunities are identified, for examplea competitor may go out of business during the mature stage and action can be takento attract more customers. It emerges clearly that Just in Time (JIT) techniques areapplicable only during the maturity stage. There is a significant benefit to be gainedfrom focusing on inventory control when demand is fairly stable, but when the market isgrowing the primary requirement is to ensure that there is sufficient capacity to meetincreased orders. Application of JIT during this stage can lead to lost orders andultimately to the loss of competitive advantage because market share will be lower thanit otherwise would have been.

Exercise 4.6

Add the effect of the product life cycle to the discussion of Marlboro in the previoussection.

4.8 Portfolio models

The concepts of demand analysis, differentiation, segmentation and life cycles areimportant ideas that contribute to the formulation of strategy. Many of these conceptscan be incorporated into models which generate important insights into the strategicpotential of individual products. But it is the dynamic development of markets andcompetition over time which makes strategy so complex, and an important dimension ofportfolio models is that they take the passage of time explicitly into account through theincorporation of the life cycle idea.



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 productlife cycle. It was discussed at Chapter 4 Section 8 how the company’s strategic approachis affected by the stage of the product life cycle. Another important factor is the relativemarket share, which is defined in terms of the company’s market share compared tothat of its leading competitors. The implications of relative market share for competitiveadvantage arise from two influences.

1. Economies of scale: result in lower average cost as the productive capacity of thecompany increases. The higher a company’s market share the larger must be itsproductive capacity compared to its competitors. This is because a sale made byone company is by definition a sale not made by another company, thus the higherthe market share of one company, the smaller must be competing companies onaverage, and the less their opportunities to capture economies of scale. Wheneconomies of scale exist, it follows that the higher the market share of a companycompared 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 havea higher cumulative output to date than its competitors, and hence its labour forcehas the potential to be higher up the learning curve, resulting in lower per unitlabour costs. As a company produces additional units of output, other factors alsocontribute to continuing cost reductions; these include fewer rejects and betterdesigned production lines. The combination of the effect of the learning curveand these influences results in what is known as the experience curve; researchsuggests that each doubling of output leads to a 20 per cent reduction in unit costbecause of experience effects.

The two variables of market growth rate and relative market share are plotted againsteach 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 shareand the current market growth rate and are classified according to which quadrant they



fall into. In order to determine a product’s position in the matrix it is necessary todecide on its position in the product life cycle. This is bound to be imprecise, as alreadydiscussed, but the importance of identifying the transition from growth to maturity nowbecomes more apparent because of the product’s potential for generating positive cashflows as it develops from the Star to the Cash Cow position. While the classifications areapproximate they provide a powerful tool for identifying important characteristics relatingto the performance of products.

The Dog

A product which has a low market share in a stable market, and which is not makingprofits currently, stands little chance of making profits in the future. This is because thecosts of increasing market share are likely to outweigh the potential gains. The costsof attempting to increase market share will be high because the market has stabilisedand it will be necessary to attract customers from competing companies; this can onlybe done by increased marketing expenditure and/or price reductions, and this is likely tolead to competitive reaction, the prospect of which adds considerably to the uncertaintyof the exercise. A Dog may have already cost the company a considerable amount indevelopment and marketing, and managers may feel averse to abandoning a productwhich has already cost so much. This reasoning is false because costs incurred in thepast (sunk costs) have no bearing on the future. Abandoning the Dog will release scarceresources which could be put to more profitable use.

It does not follow that because a product lies in this part of the matrix that it cannot makeprofits. It may occupy a niche, or there may be no economies of scale that give largercompetitors a cost advantage. In this case it is the relatively efficient company whichmakes the most profit. If a product is not currently making profits and is being producedas efficiently as possible, it has little future.

Cash Cow

This product achieves higher economies of scale and is further up the experience curvethan competitors. It has low marketing costs because of brand loyalty, the price is set atthe 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 asmarket size increases.

• Production costs will be relatively high because as the company increases outputit 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 handlethe demand.

• Inventory costs are likely to be high because it will be difficult to align output withdemand.

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



result is that the Star is likely to make a loss. It is not possible to be precise about themagnitude of the loss because some Stars may achieve an early mover advantage andmake significant profits.

The objective in managing a Star is to maintain or increase market share until marketgrowth 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 themarket matures before market share can be increased, while it is uncertain whether itcan be converted into a Star in time. The Question Mark will incur relatively high costs forthe same reason as the Star, but it will have to put even more resources into marketingand set even lower prices. It is therefore likely that the Question Mark will incur heavylosses in the attempt to convert it to a Star. There is no real option in this, because if noattempt 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 theclassification is based on two variables only: market growth and market share. It shouldnot be applied in a mechanistic way, for example it cannot be concluded that all Dogswill make losses and all Cash Cows will generate high profits. This is because marketconditions may result in a profitable Dog and poor management in a loss making CashCow.

By and large it is to be expected that cash is generated by the Cash Cows and is usedto invest in the Stars and Question Marks. The strategy implications of different BCGclassifications combined with product characteristics are outlined below. The strategyimplications are not necessarily definitive and are open to discussion, but they areindicative of the type of conclusion that can be reached on the basis of portfolio analysis.

BCG Classification Characteristic Strategy implicationCash Cow Profitable DefendCash Cow Loss making Missed transition: review capacity,

investigate JIT, consider pricing andelasticity

Cash Cow Declining sales,market shareunchanged

Entering decline stage; reduce capacity,marketing and investment

Dog Profitable Probably no economies of scale; potentiallyvulnerable so monitor closely

Dog Loss making DivestStar Large losses Possibly entering transition to maturity: cut

back on capacity and marketing.Star Losing market share Increase marketing and reduce priceQuestion Mark Severe losses Determine if there is sufficient time to

develop into starQuestion Mark Gaining market

shareMaintain resource allocation to develop intoStar



Back to the demand curve

At this stage we should not lose sight of the relevance of demand curve analysis whichrelated revenue changes to changes in price and market share in terms of movementsalong, and movements of, the demand curve. In the growth stage of the cycle, demandanalysis can be used to provide an indication of the price that would maintain or increasemarket share. At this stage the objective is not to maximise profit in the short run but tolay the foundation for a cash cow. Once the market has stabilised, i.e. the total markethas stopped growing, the question of profit maximisation and the optimum market sharecan be addressed. One of the advantages of portfolio analysis is that it focuses attentionon a longer run view of costs, and the possible implications of a lower market share forcompetitors’ costs. Demand analysis is one step in the determination of competitiveadvantage and profit maximisation.

4.8.2 Other portfolio models

The salient characteristic of other portfolio models is that they are more complex than theBCG matrix, and take into account many more variables. This means that they cannotbe fully displayed in matrix form because they have too many dimensions. For example,the Mackinsey portfolio model has two general dimensions of business strength andindustry attractiveness. Business strength takes into account such variables as capacityutilisation and relative costs, and industry attractiveness takes into account variablessuch as growth rate, profitability, cost trends and industry structure. The variables areweighted in terms of relative importance, and scored to give an overall rating for the twodimensions. It is not clear whether the additional complexity adds significantly to thestrategic 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 productsthrough the life cycle. It also provides a useful perspective on the mix of productswhich comprise a corporation. Is there such a thing as an optimum portfolio? Acompany which is comprised only of Cash Cows will remain static by definition, andis liable to suffer substantial reductions in cash flows as products come to the end oftheir life cycles. However, too many Question Marks and Stars may drain companyresources. An optimum portfolio could be defined as one in which the Cash Cowsgenerate sufficient cash flows to produce adequate returns to shareholders and thecash necessary to develop the potential of Question Marks and Stars to replace theCash Cows in time. If the company had ambitions to grow, the balance between CashCows, Stars and Question Marks would be adjusted accordingly.

Portfolio selection is not a mechanistic process based on the selection of products asthey appear in the BCG matrix. There are many difficulties involved in identifying whichQuestion Marks and Stars are likely to succeed. The portfolio decision will depend onthe various risks involved, and the company’s attitude to risk bearing. Furthermore, thevariables in the matrix do not capture all relevant product characteristics. A companymay have a balanced portfolio in the sense that it has no loss-making Dogs, and severalStars and Question Marks which will replace ageing Cash Cows. But products are notconceptual entities to be guided through the stages of the product life cycle; managershave to know a lot about their products, including how to make them at the lowest costand sell them effectively against competitors. A balanced portfolio which is comprised



of totally unrelated products in a diversified company may be virtually unmanageable,and there is no guarantee that the corporation is adding value by including all ofthem in the portfolio. Consideration needs to be given to developing a portfolio inwhich products are linked in such a way as to benefit from the competencies of thecorporation. Diversifications which are aimed solely at balancing the portfolio may betotally misguided; the company can end up with an unmanageable portfolio, and thishas been a contributing factor to the failure of many diversifications in the past.

A competitor may decide to undertake a change of direction through diversification intonew markets; if this leads to a preponderance of Stars and Question Marks it may reducethe resources available to maintain competitiveness in existing markets.

The portfolio model can enable SBU managers to visualise competition at the corporatelevel, where it is not so much the product itself which is of importance, but its contributionto the product portfolio. The SBU manager may be unwilling to dispose of a Starwhich he sees as having considerable future potential; from the corporate viewpoint theproduct may not fit with the company’s competencies and more value could be createdby selling it and devoting the resources elsewhere.

The process of selecting the optimal portfolio can be envisaged in terms of the marketsand products in which the company is currently or potentially operating. A systematicapproach to identifying the components of the portfolio strategy was developed by Ansoff2 and he defined what he called the growth vector which interpreted the direction inwhich the company intended to develop its portfolio. The growth portfolio was originallyspecified in terms of the company mission in relation to its product; rather than explorethe growth vector in terms of company mission, which Ansoff defined in a particularway, Figure 4.14 builds on Ansoff’s approach and develops a growth vector in terms ofmarkets 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 whichit sells in existing markets it can only do so by increased penetration, and hence byan increase in market share. If the market is mature it follows that sales can onlybe gained at the expense of incumbents, while if the market is growing the companymust continuously acquire a larger share of market growth than competitors. For themature market, this can be interpreted as developing a dog into a cash cow, and for agrowth market as developing a question mark into a star. Either way, growth depends



on pricing and marketing strategies relating to the company’s current operations, whilebenefiting from the company’s accumulated experience in production. During the late1990s European car makers were faced with a mature market but there was massiveover capacity in car production world wide. The scale of some European car makers wastoo small to compete with the main global players, and many car companies attemptedto increase their market penetration by acquiring established and prestigious makes.BMW acquired Britain’s Rover and Rolls Royce, while VW acquired Bentley.

Product replacement

It may be concluded that no further penetration by the current version of the productcan be achieved, and it is necessary to add characteristics and perhaps abandon someexisting characteristics; it could also be due to the product approaching the end of theproduct life cycle. The replacement can be an enhancement of an existing product ora totally revised version with a different set of characteristics, but it is important thatit at least fulfils the requirements of the replaced product, and/or satisfies changingconsumer preferences.

This type of growth involves the company in investment in product development anda shift away from the set of products in which it has built up expertise in the areasof producing efficiently and marketing effectively. However, the company is able tocapitalise on its knowledge of the market, its brand name and its existing distributionsystems. One of the most significant product enhancements in the car business duringthe 1990s was the advent of the off-road vehicle. Instead of purchasing a standard roadcar, 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 yearsevery major car maker had such a vehicle in its portfolio. It was not a new concept,as Britain’s Rover car company had been producing the world famous Range Rover forseveral decades; but the new entrants went for more luxury, better handling and state ofthe 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 asfinding markets in new geographical locations and identifying unexploited segments orniches. This means that new techniques need to be developed for selling products withknown characteristics, and this requires effective strategies for market entry. This in turnraises issues relating to the product life cycle, as entry into a growth market requires adifferent approach to entry into a mature market. But as with market penetration, thesuccess of the growth strategy depends on pricing and marketing approaches. TheKorean car maker Daewoo entered the British market in the early 1990s with a standardrange of cars, but used a fixed price selling approach which market research suggestedwould appeal to many car buyers. The idea was that there were no salespeople inthe showroom and that no negotiation would take place on the price. Despite the factthat the Daewoo cars were no better than other makes in their range, the company madesignificant inroads into the British market. While it might have been a marketing successin the short term, by the early 2000s Daewoo had gone bankrupt and been acquired byGeneral Motors who rebranded the range as Chevrolet and abandoned the fixed priceapproach.

Diversification

In this model diversification has a particular meaning, in that the company enters new



markets with a new set of products and is therefore akin to the notion of unrelateddiversification discussed at Chapter 5 Section 5.12.4. In this case there is no directexperience of marketing strategy which can be applied, while the company has noexperience of production. Car makers often have a wide portfolio of car types, andoften have interests in lorries (or trucks) and buses; but few have productive capacityin earth moving equipment, for example. An interesting exercise is to try to identify carcompanies which have moved into the diversification part of the matrix.

No growth strategy will ever fit exactly into a particular segment of the matrix, but thissimple classification helps to interpret the impact of a particular course of action on theproduct portfolio, and the extent to which it fits with the current knowledge of marketsand products. The matrix can be greatly elaborated to incorporate dimensions such asgeographical location and product technologies, but the fundamental message is thesame: make explicit the direction of change in which the growth strategy will take thecompany, and incorporate this into the design of the portfolio.

Exercise 4.7

The following advertisement and related discussion took place in a hypotheticalcompany (which is actually based on a real life situation).

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SUPERTOOLS PLC THE TOOL COMPANY YOU CAN TRUST

If you want an individually crafted hand plane which cuts evenly through all typesof 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 bebuying a unique instrument which will last for at least 10 years. Continual productrefinement ensures that your StylePlane will be admired and respected, while ourafter sales service is second to none. If your needs are less modest, try our electricPowerPlane: 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 profitability on sales of the Power- Plane.We make a lot more on our traditional product, and servicing the debt incurred inretooling for the PowerPlane is quite a burden. Furthermore, I don’t understand whywe are selling the PowerPlane at such a low price compared with similar makes. Afterall, the StylePlane is the most expensive hand plane on the market.

Production manager: I ran the StylePlane for 25 years without problems, but thisnew fangled PowerPlane is more difficult to manage. I take a hands-off approach andgenerally leave the supervisors to get on with it, but I should point out that we haveenormous productive capacity, and we are holding a lot of inventories. But we neverhave to hold much inventory for the StylePlane because it tends to be made for individualorders.

Human resource manager: we are now employing a different kind of person for thePowerPlane, and our old and trustworthy skilled people who have been producing theStylePlane for two generations are almost impossible to replace. I also have a problemwith morale, in that these workers reckon that StylePlane profits are draining away in


4.9. Strategic groups 105

financing the PowerPlane.

CEO: it looks like we made a mistake going into the new technology; maybe we shouldhave simply kept on with what we were good at. We control at least 80 per cent of themarket in StylePlanes, and look at the latest improvement to the StylePlane: brass inlaidedging which adds hugely to the look of the instrument. What does our new marketingmanager 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 asrare as the people who make them. We are now trying to service a growing populationof relatively young home-owners who wish to tackle general home improvements ratherthan experts who produce fine cabinets. And you have to bear in mind that thePowerPlane market is subject to fast technological change; at the moment PowerPlanehas about 15 per cent market share, which has increased from 10 per cent two yearsago; we are by no means the biggest in the market.

CEO: you’ll be telling us we should be going into powered sanding machines next. Wenever needed a marketing manager in the old days, when the StylePlane sold itself byits reputation. It is displayed prominently in every major toolshop in the country, but noone seems to be interested in pushing sales of the PowerPlane. I don’t want us to getinto the situation where we are selling one product against another. Let’s discuss thisagain at our next meeting, by which time I hope that our production manager has donesomething 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 firms in an industry but not all of them may be direct competitors.One approach is to identify strategic groups, which are sets of firms in an industry similarto one another and different from firms outside the group on one or more key dimensionsof their characteristics and strategy. Identifying the groups makes it possible for thefirm to find close and distant competitors and analyse the likely competitive implicationsof changes in strategy. But while this sounds fine in principle it is difficult to apply inpractice because of the many variables which could be used to classify competitors;these include

• organisation: scale, degree of vertical integration or diversification, distributionchannels

• product characteristics: quality, image, level of technology

• financial structure: return on assets, gearing



It is necessary to use a degree of imagination to obtain insights into the strategicgroupings within the industry. For example, two important variables might be identifiedand mapped against each other to see how firms in the industry cluster together. Anexample is in the restaurant business in a cosmopolitan city where there are manyethnic restaurants, all of which offer different styles of cooking. Take the three mostnumerous types of ethnic restaurant: Indian, Chinese and Thai. At first sight it mightappear 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 besidescooking style: quality and degree of specialisation. There is no question that restaurantstarget different levels of quality within the same ethnic group; within their broad stylerestaurants specialise in different ways, for example, in fish, seafood, vegetarian andregion. It is instructive to think of a number of ethnic restaurants and plot them on agraph as shown in Figure 4.15.

Figure 4.15:

I have carried this out for my own city of Edinburgh, and find that the clusters are quitepronounced as shown. Basically, there are four clusters, and it is within these that agreat deal of competition arises rather than between, say, high quality and low qualityIndian restaurants.

This example uses two characteristics of product differentiation to identify the strategicgroup. Another dimension could be the number of restaurants under one owner:there may be significant economies in purchasing and minimising excess capacitywith increasing numbers of restaurants. Since the definition of the industry group isdependent on the selection of relevant variables it is far from being an exact science.But attempting to define the strategic group can provide a perspective on competitivepressures which is not apparent from aggregate data.

Exercise 4.8

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


4.10. The structural analysis of industries 107

4.10 The structural analysis of industries

The economic models of market structure demonstrate that the degree of competition inan industry is the result of structural factors over which individual companies have littlecontrol. A firm in a highly competitive market has no option but to be a price taker; a firmin a monopoly position may be able to limit competition, but entry deterring strategiesare often constrained by contestability; oligopolists have to exercise restraint because ofpotential retaliation from major competitors.

In an attempt to make explicit the various factors which determine competitive conditionswithin an industry, Porter3 identified what became known as the five forces. The basicidea is that competition arises from several features of the market and if companiesrecognise these competitive forces they will be better equipped to achieve competitiveadvantage. The five forces are

• Threat of new entrants

• Threat of substitutes

• Suppliers’ bargaining power

• Buyers’ bargaining power

• Industry competitors’ rivalry

Porter’s view is that the collective strength of these competitive forces determines theability of firms in an industry to earn rates of return on investment above the cost ofcapital. Another way of looking at the five forces is that they identify the areas in whichthe conditions for perfect competition do not apply; it has already been pointed out thatwhile the conditions for perfect competition are rarely found, in those instances wherethey are approximated to then companies tend to make the opportunity cost of theircapital, i.e. there are no monopoly profits.

Industry competitors’ rivalry

In order to assess the intensity of rivalry, start by considering the number of competitorsin the industry:

Number of firms Type of market Basis for competition

Many Perfect Price

Few Oligopoly Differentiation

One Monopoly Price (to deter entrants)

In one sense the intensity of rivalry decreases from perfect competition to monopoly.In comparative static terms a company in a perfect market in equilibrium earns theopportunity cost of capital (normal profit) while a monopolist earns more than normalprofit. But in a dynamic sense rivalry might appear to be different. Consider the followingthree cases.

• A market that is moving towards perfect competition (because the product isbecoming homogeneous and barriers to entry are falling) may contain manycompanies that are acting in an aggressively competitive manner by cutting prices



and increasing marketing; but a market that has reached a situation approximatingto equilibrium may not show much evidence of competitive activity.

• It is possible for oligopolists to exist in tacit harmony for considerable periods butsuddenly to embark on a price war where competition is overt.

• A monopolist may be in a highly contestable market that makes it impossible toearn significantly higher than normal profit.

The market structure (perfect competition, oligopoly or monopoly) largely determinesthe profit that can be made. But competitive pressures may not be evident to theobserver, as in the case of contestability which is based on potential competitors.Therefore the intensity of rivalry cannot be assessed merely by observing the behaviourof competitors. Additional insights into rivalry can be gained from taking the product lifecycle into account as the following scenarios demonstrate.

Life CycleStage

Competitive actions Rivalry

Introduction First mover LowGrowth Competing for increased market share HighTransition Competing to establish cash cow HighMaturity Companies defend position LowDecline Attempt to protect sales rather than market share High

Establishing the intensity of rivalry therefore requires several influences to be taken intoaccount, 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 aboutany 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 alllikely to lead to immediate competitive response. Therefore it is of prime importance toassess the intensity of rivalry.

Threat of new entrants

The threat posed by new entrants depends on the barriers to entry, which in turn dependon the following:

• Economies of scale: incumbents may have an advantage because of their sizebecause entrants would have higher costs, at least initially.

• Regulation: there may be laws or legal requirements which inhibit potentialcompetitors. But these may be relaxed in the future as, for example, thegovernment adopts a less direct role in the economy.

• Entry price: there is a price at which entry will appear attractive to firms outsidethe industry.

• Technological factors: where entry has previously been made difficult because ofhigh R&D investment, the incumbent may become at risk because the technologyis copied.

It is not a simple matter to identify and assess the risk of entry. In the examples abovethe threats may lie in the future rather than the present and could be identified by a



PEST analysis. Once the potential risk has been identified a response can be workedout to maintain the barrier to entry. If no response is feasible a strategy to respond to theimpact of entry needs to be determined. The danger for many companies is that theydo not recognise the potential threat from new entrants until it is too late because theyfocus on what competitors are actually doing rather than the conditions that make entryattractive.

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 scanningto keep track of ongoing developments. Because of the wide ranging and unpredictablepattern of technological progress it is very difficult to predict under what circumstancessubstitutes are likely to appear. In fact it may be difficult to recognise a substitute when itdoes appear because it may be accompanied by a change in consumer preferences orprices. For example, air travel was not regarded as a close substitute for rail travel untilthe advent of cut price airlines and the realisation by people who had never flown thatit was a viable alternative. The rail link between London and Paris has suffered greatlyfrom the impact of cheap airlines.

At times it may be difficult to distinguish between a new entrant and the emergence ofa substitute product. A new entrant will have a similar product and will compete mainlyon price. The substitute has characteristics that fulfil the same consumer needs andeffectively reduces the market size for the existing product. It is important to distinguishbetween them because the strategic response is different: a new entrant can be metwith reduced prices and an increase in marketing but this will not work for a substitutebecause 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 ofcompanies in the industry. For example, there are many thousands of farmers in theUK while retailing is dominated by four supermarket chains; farmers claim that thesupermarkets have excessive buying power and that they are unable to obtain a pricethat provides a reasonable return on farming. The two extreme cases are where thecompany is the sole purchaser of an input (monopsony), and where the supplier is thesole provider for the industry (monopoly). In the case of monopsony the supplier has lowbargaining 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 bargainingpower is often difficult to identify. In the case of the supermarkets versus farmers thebalance 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 paysignificantly higher prices and hence are at a cost disadvantage.

A well known example of high bargaining power is when labour unions are powerfulenough to negotiate more favourable remuneration than would be possible for anunorganised work force. What is less obvious is the bargaining power of workers withscarce skills, for example in financial markets some investment specialists commandvery high salaries because they are perceived to be able to ‘beat the market’. It isimportant for companies to identify as far as possible where the balance of bargainingpower lies with different suppliers so that they do not end up paying more for inputs thancompetitors.



Buyers’ bargaining power

The bargaining power of buyers depends on a number of factors, including the extent towhich a product is a necessity, the availability of competing sellers and substitutes. It canbe argued that this is all captured in the elasticity of demand for the company’s product,but the difficulty facing companies is that it is very difficult to estimate the elasticity ofdemand so it is necessary to use a variety of information to estimate where the balanceof bargaining power lies. The factors to take into account include the following.

• Monopoly power: this depends on the number of competitors in the market; butthe number of companies in the market may not be a good guide because thecompany may have a local monopoly.

• Brand identity: a strong brand such as Gucchi results in a degree of loyalty amongbuyers.

• Switching costs: for many products there are no costs to the buyer in switchingfrom one seller to another because the products are homogeneous and widelyavailable. There may be a significant switching cost for consumer durablesbecause it is necessary to gather information about other makes. Retail stores andair lines attempt to increase switching costs by their loyalty cards, where switchingfrom one retailer to another results in losing the accumulated credit points.

• Number of buyers: many companies in the defence industry only sell to thegovernment; in this case prices are set by negotiation.

• Income elasticity: this is partly determined by the extent to which a product is anecessity; people buy more of luxury goods as incomes increase, but typicallyconsumers have plenty of choice of luxury goods. The higher the income elasticitythe higher is buyer bargaining power.

• Perceived differentiation: some buyers may be convinced that the product hasbetter characteristics than competitors, for example it may have the reputation ofreliability or high quality.

• Information: this depends on the extent to which consumers are well informedabout the characteristics of competing products. Freely available information isone of the conditions for perfect competition, and the more educated consumersare the more difficult it is to establish brand loyalty.

Any estimate of buyer power is bound to be approximate, but it is usually possible toidentify 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 ahigher price, and assess them in terms of the above factors.



Factor Own Brand Buyer power Branded Buyer powerMonopoly power The only one in

the shopLow Many competing

brandsHigh

Brand identity Unknown tobuyers

High Many buyers relyon brandreputation

Low

Switching cost Part of everydaypurchases

High Find outcharacteristics ofother makes

Low

Number of buyers Very large High A particularsegment

Low

Income elasticity Regarded asnecessity

Low Regarded asluxury

High

Perceiveddifferentiation

None High The segmentthinks it hascertain desirablefeatures

Low

Information Can be gained byexperience

High Satisfied buyershave no incentiveto collectinformation onother makes

Low

Each factor has been classified as ‘high’ or ‘low’ to demonstrate that the own brand issubject to relatively higher buyer bargaining power than the branded make. You maywell interpret the buyer power differently depending on your own experience but it ispossible to arrive at an estimate of the buyer power in a fairly objective manner. Theconclusion from this analysis is that buyer bargaining power is high for the own brandshampoo and low for the branded shampoo.

The five forces profile

Once an estimate has been made of each of the competitive forces a profile can beconstructed to identify the type of competitive forces acting on the company. Take thecase of two companies with the following profiles.

Competitive force Company 1 Company 2

Threat of new entrants High Low

Threat of substitutes High Low

Bargaining power of suppliers Low High

Bargaining power of buyers Low High

Industry rivalry Low High

This classification identifies two totally different competitive situations with importantimplications for strategic action.

• Company 1 will focus on potential competitors and technological change.

• Company 2 will focus on trying to get better deals from suppliers, marketing



aggressively to buyers, and on its cost position relative to competitors.

Now consider the two profiles in a different way: the first profile refers to the companynow and the second is an estimate for three years in the future. The company willhave to change its strategic focus as above to accommodate the changes in competitiveconditions. These are clearly important conclusions, but in real life it is a fact that veryfew companies understand the competitive forces operating on them and are unawarethat these are changing over time. Companies often fail to react to changing competitiveconditions because they simply did not know they were occurring.

One of the big changes that occurred in the UK grocery business was the closureof many small city centre groceries because of the arrival of the edge of townsupermarkets. But now the major supermarket chains are opening ‘in town’ stores inan apparent reversal of the trend. Can this be explained in terms of the five forces? Thesituation before the supermarkets appeared and after supermarkets had set up ‘in town’stores is shown below.

Competitive force Before Supermarkets After SupermarketsThreat of newentrants

Local monopolies:barriers to entry

Low Filled vacant niche Low

Threat of substitutes Out of town shopping High Out of town shoppingnow exists

Low

Bargaining power ofsuppliers

Small scale High Large scale buyers Low

Bargaining power ofbuyers

Lack of choice Low Desire forconvenience

Low

Industry rivalry Local monopolies Low Still local monopolies Low

According to this analysis the competitive pressures acting on the small retailers werethe threat of substitutes from out of town shopping centres and their lack of buyingpower resulting in relatively high prices. This combination drove them out of business;subsequently the supermarkets filled the vacant niches but were not now faced withthe threat of substitutes and had the buying power to ensure that ‘in town’ prices werecompetitive with the edge of town centres. Thus they were able to capitalise on thedesire for convenience. The forces are, of course, open to a different interpretation butit does appear that the supermarkets were able to alter the balance of the forces andhence opened up an opportunity.

Criticisms of the five forces model

While the five forces model is an extremely effective technique for analysing competitiveforces, it does have some potential drawbacks and it does not provide the answers to allissues relating to competitive analysis.

• It gives the impression that all forces are equally important in the determination ofcompetitive position. It has been argued that the customer, or buyer, is the mostimportant dimension of competitive advantage and that the five forces approachdisguises this. However, this criticism misses the point about a framework ofanalysis; the five forces is merely a structure within which various influencescan be examined, and while it is probably true that most of the time buyers areimportant, in some circumstances other influences might be just as important.


4.11. Environmental threat and opportunity profile 113

• It focuses on threats, whereas many companies engage in cooperation andalliances. This approach may be excluded if, for example, all suppliers areregarded as threats. But again this misses the point: if suppliers are identifiedas a potential threat it could be that one method of eliminating this threat is toenter into an alliance. The function of the model is to help identify competitivepressures rather than provide a prescriptive solution.

• The model does not deal with internal issues such as human resources andefficiency. This being the case, the model must be regarded as one importantcomponent when building up an overall view of profitability.

The five forces model sits squarely in the analysis and diagnoses part of the processmodel of strategy. It is important for analysing competitive influences and deriving anunderstanding of the company’s competitive advantage; it is an essential tool for derivingappropriate strategies at the choice stage, but it does not do the work for you.

Exercise 4.9

Use Porter’s five forces to categorise the competitive conditions confronting SuperTools.

4.11 Environmental threat and opportunity profile

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



Model FocusMacroeconomics Determination of GNP growth, consumer expenditure,

interest rates, inflation, unemployment etcCompetitive advantage ofnations

Specific national competitive factors

Forecasting Predicting changes in key factorsPEST Checklist of all potential factorsEnvironmental scanning Tracking changes and speculating about the futureScenarios Implications of speculationDemand and supply How markets operateMarket structures Forms of competitionGame theory Deriving rational competitive responseSegmentation Identifying marketsDifferentiation Product positioningLife cycle DynamicsPortfolio models Product positioningStrategic groups Product positioningStructural analysis Competitive forces

These models can be applied to available information to generate an environmentalthreat and opportunity profile (ETOP). The profile can be constructed under the headingof each of the models and the relevant threats and opportunities identified.

Exercise 4.10

Just after the SuperTools discussion reported at Chapter 4 Section 9.5, the followingnewspaper reports appeared.

PERSONAL INCOMES AND HOUSE PURCHASES UP THIS YEAR

Data released by the National Statistical Office today reveal that in the first sixmonths of the year personal incomes increased by 4% in real terms, and it lookslike a lot of this increase is being invested in housing. New house starts increasedby 3%.

EXCHANGE RATE FALLS FURTHER

The value of the pound on foreign markets rose during the last week by a further 1per cent, putting additional pressure on home suppliers of manufactured goodssuch as TVs, freezers, tools and computers. These sectors have been underincreasing threat from cheap imports for the past year or so.

Combining this information with that in Chapter 4 Section 9.5, derive an ETOP forSuperTools. Much of this will be based on the analysis already carried out.


4.12. References 115

4.12 References1. 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 SuperiorPerformance, The Free Press.


117

Chapter 5

Analysing resources and strategiccapability

Contents

5.1 Resource analysis in the process . . . . . . . . . . . . . . . . . . . . . . . 119

5.2 Accounting ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

5.3 Financial structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124

5.4 Break even analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

5.5 Pay Back period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127

5.6 Net Present Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128

5.7 Sensitivity analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129

5.8 Human resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

5.9 Benchmarking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133

5.10 Economies of scale and the experience curve . . . . . . . . . . . . . . . . 134

5.11 The scope of the company . . . . . . . . . . . . . . . . . . . . . . . . . . . 136

5.11.1 Economies of scope . . . . . . . . . . . . . . . . . . . . . . . . . 136

5.11.2 Synergy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

5.11.3 Diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138

5.11.4 Vertical integration . . . . . . . . . . . . . . . . . . . . . . . . . . 139

5.12 Creating value from the production process . . . . . . . . . . . . . . . . . 143

5.12.1 The value chain . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

5.12.2 The value system . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

5.12.3 Competence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

5.12.4 Competence and diversification . . . . . . . . . . . . . . . . . . . 150

5.12.5 Strategic architecture . . . . . . . . . . . . . . . . . . . . . . . . 152

5.13 The definition of competitive advantage . . . . . . . . . . . . . . . . . . . 153

5.14 Assessing strategic capability: the strategic advantage profile . . . . . . . 154

5.15 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156

Learning Objectives

• To use accounting techniques to assess company efficiency

118 Chapter 5. Analysing resources and strategic capability

• To identify the sources of synergy

• To assess the impact of vertical integration and diversification

• 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 profile


5.1. Resource analysis in the process 119

5.1 Resource analysis in the process

While it is clearly important to understand the external macro and competitiveenvironment within which the company operates, it is also important to identify thematch between a company’s resources and capabilities and the opportunities whichthat external environment presents; understanding the competitive environment is anecessary but not sufficient condition for formulating strategy. The idea that companyresources and capabilities are the foundation for profitability has become known as theresource based view of the company, as discussed at Chapter 1 Section 5.4. The centraltheme is to determine how value is added by the various activities of the company andhow the value creating framework might be developed in the future. Thus the thrustof company analysis is to assess the effectiveness with which resources have beenallocated in the past, demonstrate principles which can be used for allocating resourcesin the future and estimate the strengths and weaknesses of the company with a view toidentifying how threats may be countered and opportunities may be pursued.

There are two extreme views on the analysis of resources. One is that the company’sresources can be manipulated in an efficient manner in the pursuit of a particular courseof action. Another is that organisational change is very difficult to achieve and thenotion that resources can be adjusted in line with changes in strategy is far too naïve;furthermore, it can be argued, changes in the external environment occur so quickly, andare so unpredictable, that over time flexibility of resources is the important issue and,consequently, strategy and resources are closely related. As with most things in life, the



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

5.2 Accounting ratios

The first step in analysing the company is to secure a sound understanding of itsfinancial position. The main constraints on future company development are profitabilityand debt structure. Because there are many dimensions to profitability, it is necessaryto have some understanding of accounting methods in order to be able to extractprofitability measures from company data.

The company has at its disposal a great deal of information which it can use in identifyingthe effectiveness with which resources are being, or have been, allocated. It is at thispoint that an apparent disagreement between the practitioners of finance and those ofaccounting needs to be clarified. It is widely accepted that Return on Investment (ROI)is not a reliable measure for assessing potential investments; instead it is necessary touse 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; thisis a highly complex issue which the analysis of effectiveness must deal with. Questionsto 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 originallythought 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 relatingto costs and revenues. While the theory of finance provides the tools for allocatingresources in the future, accounting procedures are designed to reveal the efficiencywith which resources have been allocated to date.

Because there are many dimensions to company efficiency there is a variety ofaccounting ratios, the following selection providing an indication of the range ofmeasures 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 defined in detail here; the important point is that they measureslightly different aspects of company performance. The ratios are useful tools for


5.2. Accounting ratios 121

analysing accounts because they help to reduce the amount of information in theaccounts which require analysis and they can identify potential weaknesses in companymanagement. Since the objective of ratios is to simplify the complexity of accountinginformation, it would be pointless to use a vast number of ratios. However, there is nodefinitive set of ratios which will provide the correct information for managers; not onlyare there many ratios to choose among, individual ratios can also be defined in differentways. It is therefore necessary to select a number of potentially useful ratios which canbe employed over a period of time to ensure the consistency of the information fromwhich the ratios are derived.

A problem which confronts many companies is that the accounting information collecteddoes 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 thecosts associated with activities which are much more relevant for decision making. Thedifference between a set of traditional cost accounting categories and activity basedanalysis is shown in Table 5.1.

Table 5.1: Traditional cost accounting and activity based cost accounting

Traditional categories ($) Cost of performing specific activities ($)Wages and salaries 500000 Liaison with suppliers 150000Supplies 100000 Process orders 120000Travel 50000 Handle deliveries 50000Rental 150000 Internal processing 250000Operating expenses 100000 Quality assurance 200000

Trouble shooting 130000Total �� Total ��

Using the traditional categories it is impossible to say whether the wages and salariescost is high or low from one year to the next because the costs are not associatedwith specific activities; however, the activity based approach reveals that over one thirdof total cost is attributable to quality assurance and trouble shooting. This providesa different perspective on where the company is incurring all types of cost. Besidesfocusing attention on activities rather than cost categories, the activity based approachdraws attention to the notion of value added; in this case the issue of whether qualityassurance and trouble shooting together add more than $330000 of value can beaddressed. It may be concluded that these activities indeed generate a value in excessof the cost, but it is important to recognise the potential for misallocation of resourceswhich can arise because the cost structure is not understood.

To ensure that ratios produce performance measures which relate to the efficiency withwhich resources are allocated, appropriate measures of revenues, costs and assetsmust be used. While it may appear obvious, it needs to be stressed that revenues andcosts must not include changes in the portfolio of assets; the buying and selling of assetsis not directly related to the efficiency with which inputs are being converted to outputs.However, inspection of published company accounts reveals that the sale or acquisitionof assets is often slipped into the accounts, perhaps to disguise a particularly good orbad year.



The way in which accounting information is calculated can have far reachingimplications. A successful British stockbroker named Smith1 asked the seeminglysimple question: how can it be that companies which appear to be financially soundcan suddenly go bankrupt? He pointed out that the signs of financial malaise weredetectable if you knew what to look for in the published accounts. He identified 11practices which could be misleading, although they were not illegal, and constructed atable which simply listed major companies and how many of these dubious practicesthey pursued; the ‘blobs’ which he used in the table became notorious as a measure ofthe reliability of company accounts. Although the information was in the public domain,Smith’s analysis touched a sensitive nerve with the companies concerned, and manyfelt that their reputations had been adversely affected. From the strategic viewpoint, thisstory has some important implications. First, it reinforces the fact that profitability is nottotally objective because it depends on the accounting conventions and assumptionsused. Second, it is very difficult to obtain accurate information on the performance ofcompetitors from published information.

Since assets appear in the bottom line of most of the measures, it is important thatthey are calculated in a manner which is consistent with the opportunity cost of theresources tied up in the company. In practice, it is extremely difficult to assign a valueto assets. In the first instance, many assets were purchased in the past and havedepreciated through use and obsolescence. The book value attributed to them byaccounting procedures may bear little relation to what the asset would realise on themarket, nor to the replacement cost of the asset. Two companies may have identicalperformance in terms of RONA, but because of different accounting methods one mayappear to be performing more profitably.

The notion of replacement value raises another issue, i.e. that of inflation. For example,the book value may be based on a price paid several years ago, but since then inflationcould have led to all round price increases of 50 per cent. Since revenues are in currentprice terms, it would seem to make sense to adjust the asset value to current priceterms. In practice this could be virtually impossible, given that the company may havehundreds of assets of different vintages. It would be an impossible task to generate dataon 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 timeinflation has been 50 per cent, and the asset has been depreciated at 20 per centper year using the straight line method. Table 5.2 shows possible calculations of assetvalue.

Table 5.2: Different asset values

Current book value $20

Current book value inflation adjusted $30

Historical cost $100

Replacement cost $150

A further problem concerns the selection of assets to include in the calculation. All firmsare faced with the problem of lease or buy with respect to the acquisition of assets, andthe choice can have a significant impact on the ratio because a change from owning toleasing moves the entry from the bottom to the top line. Consider the case of a companyshown in Table 5.3 which has the revenues, costs and assets shown in Year 1.


5.2. Accounting ratios 123

Table 5.3: RONA and asset ownership

Year 1 2

$M $M

Revenue 20 20

Cost 10 12

Assets 100 100

RONA 10% 8%

In the following year the company decides to sell an asset for $10M, and lease areplacement for $2M per annum; nothing else changes. The result is shown in Year2; the cash received from the sale is now treated as part of company assets instead ofthe asset value, so the net effect on company assets is zero. The operational efficiencyof the company has not changed, but the RONA has fallen. Has the company becomeless efficient?

While ratio analysis is an indispensable aspect of evaluating company performance,ratios clearly do not provide a complete picture. But they are the only informationavailable so it is necessary to have an understanding of the information which they doconvey.

Exercise 5.1

The problems confronting SuperTools have already been discussed at some length. Thefollowing accounts refer to two separate years of SuperTools’ operations; between thetwo years SuperTools had undertaken a large investment programme to finance toolingup for the PowerPlane.



1. Use financial ratios to compare company performance in the two years payingparticular attention to the appropriate measure of profitability.

2. Can it be deduced that the investment programme was responsible for anyincrease in profitability?

3. What strategic implications can be drawn from the analysis?

5.3 Financial structure

Companies have three sources of finance: retained profits, equity issues and loans.Over a period of time the company will finance its activities by various combinationsof these three and the availability of finance will ultimately constrain its strategic


5.3. Financial structure 125

capabilities. Companies typically start their lives by raising finance from shareholdersand, as time goes on, profits are generated and some are distributed to theseshareholders. The total shareholder equity is thus the original equity finance plus theretained profits. The company can fund expansion by issuing more shares (equity) orby incurring debt; this type of debt is typically in the form of long term loans for specificinvestment projects rather than the short term loans which are necessary for coveringvariations in short term cash flow.

The main difference between debt finance and equity finance is that the interest on debttakes priority over payments of dividends to shareholders and must be paid no matterhow profits fluctuate; the more debt there is in relation to equity then the more dividendswill fluctuate with profitability. If the interest cannot be paid then the company goesbankrupt. This means that the shareholders bear the risk of fluctuations in profit andtherefore look for a higher return on their funds than the providers of loan finance. As aresult it is cheaper to finance investments by debt, but each time this is undertaken therisks to existing shareholders increase.

A measure of the risk associated with debt financing is the gearing ratio, defined as

Debt financeShareholder equity

which is usually expressed as a percentage.

It is a simple matter to calculate a company’s gearing ratio, but the real question is: whatis the optimal gearing ratio for a particular company? There are a number of factorswhich have to be taken into account.

• A company which has a sound track record will be regarded as a good loanprospect by banks and should have little difficulty raising debt for growth. Acompany which has not taken advantage of this, and has constrained its growth tofinance by retained earnings, may not be taking advantage of opportunities. Thiscould be an indication of a cautious and risk averse management, or perhaps of amanagement with little strategic vision.

• The higher the gearing ratio, say around 100 per cent, the more reliant it is onsteady and non fluctuating profits over time. This is likely to make banks nervousand, beyond some point, it will be difficult or impossible to raise additional financeno matter how attractive the investment might appear to be. The company needsto balance dividend payments against the loss of flexibility which may result froma high gearing ratio.

There is therefore no optimal gearing ratio which applies to all companies, or even to agiven company over a period. A company which has embarked on a strategic initiativemay have a high gearing ratio, while a company which has established itself as a marketleader and has little room for expansion in existing markets may have a low gearing ratio.But on a profitability basis they may be considered equally successful.

Exercise 5.2

1. What has happened to the gearing ratio for SuperTools?

2. What impact does the change in the ratio have for SuperTools’s strategiccapability?



5.4 Break even analysis

It is possible to use information on fixed cost, variable cost and selling price toobtain a perspective on the desirability of proceeding with a new project. A relativelystraightforward question is: ‘How many units would have to be sold before the productstarts making a net contribution?’ This is known as break-even analysis. A simpleversion of break-even analysis, which assumes that unit cost and price will not vary withoutput, 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 � Price = Sales � Variable unit cost + Fixed cost

Sales � (Price - Variable unit cost) = Fixed cost

Break even =Fixed cost

Net contribution per unit

You simply take the fixed cost and divide that by the difference between price and unitcost. 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 questionwhich can be addressed with this information is whether the total sales requirementbefore the product makes a positive cash contribution is attainable. This focusesattention on the factors affecting potential total sales over time.

Estimates of cumulative sales are based on the marketing information available onmarket size and market share, and can be expressed as

Cumulative sales = (Total market � Market share)1

+ (Total market � Market share)2

+ � � �

+ (Total market � Market share)t

where 1, 2 � � � t = time periods.


5.5. Pay Back period 127

Break-even analysis adds a dimension to the appraisal of a course of action which ismissing from the discounting approach. Sensitivity analysis can be used to identifyconditions under which the product will not even cover its production costs. Thecalculation 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 identifypossible courses of action, such as aiming at efficiency improvements which couldtransform the prospects for a product. Break-even analysis is obviously limited inthat it concentrates only on the volume of output and sales and does not take intoaccount the passage of time; however, it does provide a useful picture of potentialcosts and revenues. Its main strategic contribution is to relate the costs incurred inthe development of a product to its market setting, since revenues cannot be generatedwithout 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 400000. The company reckons that it can enter the market with a high qualityproduct (NozzleGlue) priced at $10, or a lower quality product (BlueGlue) at $7; thedistinguishing feature of the NozzleGlue is a non drip nozzle, which does not affect theglue itself. However, it is felt that the BlueGlue would appeal to a wider market becauseit is cheaper. The BlueGlue was expected to have a variable unit cost of $4 comparedto the variable unit cost of $5 for the NozzleGlue. The set up investment cost of theNozzleGlue at £200 000 is expected to be significantly higher than that of the BlueGlueat £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 modelwhich might help in determining the likely impact of the differentiation betweenthe 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 backits start up costs?’ This is important from the viewpoint of anticipated corporate cashflows 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 theannual cash flows are not discounted; instead, they are summed until the total becomespositive.

Cash Flow - A1 A2 A3 � � � An

Pay Back - A1 A2 - A1 A 2 + A3 - A1 � � � A2 + A3 + � � � An - A1

where A1 = expenditure in Year 1A2� � � An = income in Years 2 to n

The Pay Back period is the length of time before the running total becomes positive.



There is some dispute as to whether the Pay Back period adds to the informationproduced by a properly executed Net Present Value analysis. The discounting approachtakes into account both the incidence of cash flows over time and risk factors; intheoretical terms the argument that the company needs to predict its net cash positionis irrelevant because a bank which used the same NPV criterion as the company wouldbe willing to lend money against the security of the expected future income stream. Thissuggests that there is no such thing as ‘running out of cash’ for an investment which hasa positive NPV.

However, from the corporate strategic viewpoint there are situations in which the PayBack criterion may have implications for the selection of the product portfolio. Forexample, the prospect of increasing the gearing ratio may be unacceptable, even fora short period. Whether the notions of Break-Even and Pay Back appeal to the financialpurist is irrelevant; what is important is to generate information on different aspects ofinvestments so that corporate decision makers can arrive at a well balanced view of thestrategic implications of different courses of action.

Exercise 5.4

Using the example of the glue company, the investment costs of the two products are asfollows:

NozzleGlue £1000000BlueGlue £810000

The management has carried out some market research and has concluded that themarket share requirements of the break even calculations for both products would bemet.

1. Calculate the payback period for both products.

2. Does this calculation provide additional insights into the strategic potential of thetwo products?

5.6 Net Present Value

These tools of financial appraisal are extremely useful in assessing the merits of aninvestment, but it is also necessary to subject any investment to the rigorous approachof discounted cash flow. This involves discounting the future cash flow streams back tothe present using the company cost of capital and subtracting the sum of these presentvalues from the investment cost. This gives the Net Present Value which provides thebasis for determining whether an investment is worthwhile in the first place and formaking 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 thecompany and therefore, to some extent, the cost of capital can be regarded as a methodof taking risk into account in analysing an investment. The discounting approach givesmuch higher weighting to cash flows which occur sooner rather than later and to thisextent it takes account of the natural concerns associated with projecting cash flows


5.7. Sensitivity analysis 129

into the future.

However, while formal financial appraisal techniques provide an objective interpretationof cash flow data, the following reservations must be borne in mind.

• The raw data may be suspect because it is necessary to use information about thepast, which may be suspect if it is based on accounting conventions.

• Formal appraisal techniques can evaluate what might happen, but they cannot takeinto account the unknowable; the assumptions about the future may be wrong.

• Different projects may have completely different implications for personnelmanagement through their impact on job satisfaction and incentives.

• Although it is important to quantify the options confronting the company as far aspossible, decisions are often based on qualitative rather than quantitative factors.

Despite these reservations, all investments should be subjected to a proper calculationof the net present value in arriving at the final decision.

Exercise 5.5

In the glue company example the management have decided that both products arelikely to maintain their market share for ten years and that, during this time, the netrevenues 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 possibleto 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 importantvariable can be projected. Sensitivity analysis is related to scenario analysis but isconducted 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 = Total market � Market share � Price

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



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 marketdue to predictions that the economy is likely to be entering a new period of sustainedgrowth. This could result in wage rates being 20 per cent higher than would otherwisebe the case. The framework can be adjusted to take this possibility into account asshown in Table 5.5.

Table 5.5: Adjusted contribution

Revenue = Total market � Market share � Price

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 higherwage rate would have a significant impact on the profitability of the investment. Thiscould cause managers to take a rather different view of the desirability of undertakingthis 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, PayBack and cash flow can be investigated. Sensitivity analysis is therefore a powerfultechnique for generating a perspective on the potential returns from a course of action.It identifies which are the crucial variables and where unexpected threats may exist. Itcan pin-point issues to which attention should be directed before a decision is taken. Asomewhat less obvious aspect of sensitivity analysis is to identify the combination ofcircumstances which is necessary to ensure success. In the example above, sensitivityanalysis might have revealed that a 10 per cent higher price for either labour or capitalwould lead to failure, as would a market share of 14 per cent or less. Managers mustthen seriously address the issue of whether it is likely that the following will actuallyoccur.

Market share Greater than 14% and

Wage rate No more than 10% greater and

Capital price No more than 10% greater

Put in this way, this might appear to be an unlikely combination of circumstances but itwill undoubtedly lead to failure. But looking at it from the opposite viewpoint it might bediscovered that success depends on

Achieving 15% market share and

reducing labour cost by 2% per year and

keeping equipment costs constant

When looked at this way such a combination may emerge as just as unlikely as thecombination which would generate certain failure. The reason that some projects fail isthe lack of recognition that their success was actually dependent on the simultaneous


5.8. Human resources 131

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 withthe 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 peoplein a company are a resource like any other and the determinants of how effectively thatresource operates can be affected by strategic change. Second, when strategic changesare introduced they have to be implemented by people and resistance to change canexert a powerful constraint on success. The development of adaptability and the abilityto 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 setof beliefs, values and managerial approaches; this culture is reflected in its structures,systems and approach to the development of strategy. The culture itself is derivedfrom the company’s past history, type of leadership, the people involved and its use oftechnology and resources. But since each company has a different history and differentcombinations 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 theworkforce is likely to react to change can be identified.

Power culture

The organisation tends to revolve around one individual (or small group), who dominatesdecision making and determines how things are done. This culture usually occurs in arelatively new or small company which is entrepreneurial in nature. However, as thistype of organisation grows it becomes increasingly difficult to maintain central controland there is a tendency for smaller groups to form who are, in their turn, dominated bytheir own leaders. In this type of organisation there is unlikely to be a strategic plan,but if there is one it will tend to reflect the interests of the dominant leader rather thanbeing based on analysis of the environment and explicit strategy choice. An example ofthis type of culture is in the newspaper industry, where the old style proprietors dictatededitorial approach and newspaper layout.

Role culture

This is a distinctive type of organisation which relies on committees, structures, analysisand the application of logic. While a few senior managers make final decisions, theyrely on procedures and systems and clearly defined rules of communication. Thisbureaucratic type of structure works well when the environment is stable, but the factthat it relies on rules and procedures means that external changes are not typicallyrecognised at an early stage and the company is not well equipped to deal with them



because it is relatively inflexible. Major changes tend to be dealt with by a change in thetop management team. This type of culture is prevalent in the civil service and the oldstyle 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 specific taskswhich tend to be of limited duration. The organisation is based on flexible teams whotackle assignments, these teams being typically multidisciplinary, and power rests withinthe team structures. As a result, control relies largely on the efficiency of the individualteams which top management must allow a great deal of autonomy. This culture isapparent in advertising agencies and consultancies; it is less appropriate for factorystyle operations, although the team approach is being used increasingly in all workenvironments.

Personal culture

While this culture does not occur often in business, it is as well to be aware of it. Inthis case the individual pays little attention to the organisation and is most concernedwith self gratification. All strategic responses depend on the inclination of the individualand hence are unpredictable. Voluntary workers are a good example, but individualprofessionals such as architects or consultants working as lone people within largerorganisations can fall into this category. But this form of culture itself is unlikely topermeate an entire organisation.

The type of culture prevalent in the company will have a major impact on how theorganisation reacts to strategic change. Table 5.6 indicates how the cultural compositionrelates to competitive advantage and the ability to cope with strategic change.

Table 5.6:

Culture Achieve competitive advantage Cope with strategic changePower Lacks analysis UnpredictableRole Slow ResistantTask Flexible Change is normPersonal Lack focus Unpredictable

These broad classifications therefore provide some insight into the alignment of strategywith culture and where problems are likely to arise. But it is necessary to invoke awarning here. When problems arise in implementing strategy they are often ascribedto cultural problems, because these are actually difficult to identify and it is virtuallyimpossible to do anything about them in the short term. Thus the failure can be ascribedto ‘cultural problems’ which are outside anyone’s control. But what might appear to bea cultural problem may in fact be due to the more general principal agent problem; forexample 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) interms of their culture and interpret the Marketing manager’s dilemma in these terms.


5.9. Benchmarking 133

5.9 Benchmarking

A company’s competitive position can only really be assessed in relation to othercompanies in the industry. One way of achieving a perspective on this is to developquantifiable measures of performance which can be compared with other firms. Theperformance of major competitors can be ascertained from the information containedin their annual reports which contain indicators such as ROI. But given the problemsof interpretation revealed by Smith, these cannot be taken at their face value and it isnecessary to ensure that like is being compared with like. This means that it is necessaryto interpret published information, and hence comparisons are bound to be approximate.Whether they are accurate enough to provide real information on competitive advantageis 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. Whileit is important to develop a picture of the company’s relative financial strength in relationto competitors, the objective of doing so is to provide information for strategic purposesrather than to emulate the performance of other companies. This is because there is noguarantee that competitors are pursuing best practice and, in any case, competitiveadvantage is rarely achieved by simply copying the behaviour of others. Instead,information on competitors can be used as a method of diagnosing the company’s ownperformance by asking questions such as the following.

• Why is a competitor’s ROI higher than ours and what does this tell us about ourown use of resources?

• How does our competitors’ financial strength (in terms of gearing, cash reservesand cash flow) compare with ours and what flexibility does this give them?

There are many dimensions of company performance and benchmarking can be appliedto just about anything: delivery times, inventory ratios, payroll processing, manpowerturnover and so on. Benchmarking is clearly an important diagnostic tool because itindicates where resources might be deployed more efficiently. It may be possible toobtain the cooperation of other companies to carry out a detailed comparison of howefficiently specific parts of the organisation are functioning; the companies need not bein the same industry, but need to be world leaders in the function, such as distributionsystems. 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 whytheir performance is superior.

4. Use the results to redesign processes and, if possible, to change expectationswithin 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 likelyto be the main outcomes of a benchmarking exercise?



5.10 Economies of scale and the experience curve

It is well known that costs can vary greatly among companies in the same industry. Thisis not necessarily the outcome of chance or poor management of resources on the partof some companies compared with others. There are at least two very good reasonsfor such differences: economies of scale, which relate to the size of the company, andexperience 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 beat different scales of operation. It is concerned with the average cost of production inrelation to the productive capacity of a company; for example, if the productive capacityof a company were doubled, it would benefit from economies of scale if the cost per unitfell. Economies of scale can emerge for a number of reasons.

• Indivisibilities: this is usually associated with machinery, where there is a minimumsize for most machines, such as in a steel plant, and each addition either to sizeor capacity comes in discrete amounts. For example, it may not be possible toincrease the size of a steel plant by, say, 5 per cent, because an additional linemay be 40 per cent of the existing plant size, and the capacity of the next largestmachinery is 30 per cent higher than the existing plant. The idea also applies tohuman resources, for example a company may need an additional accountant buthiring one will generate excess capacity in the accounting department.

• Technical relationships: in most capital intensive industries there is a decliningrelationship between capacity and unit cost; for example, it does not cost twice asmuch to build an oil tanker of twice the capacity because capacity is determinedby length times height times width.

• Specialisation: originally this idea related to breaking down mass productionprocesses into their component parts, so that individual workers becameextremely adept at a small number of tasks. This mechanistic view ofhow employees work effectively has been largely discredited and it has beenrecognised that specialist work teams (quality circles) generate a more efficientand motivated workforce; but the same underlying idea of specialisation stilloperates as work groups become more adept at handling their particular part ofthe production process. In a wider sense, specialisation is more feasible as thesize of the company increases in areas such as ‘knowledge’ workers, where largecompanies have their own IT departments, specialist financial analysts and so on.

The empirical evidence on economies of scale is mixed: in some industries it issignificant and in others it hardly exists. The difficulty in attempting to measure theimpact of scale economies in real life is that it is not merely the increase in productivecapacity which is relevant, but whether the higher productive capacity is based on amore efficient combination of labour and capital. It may be that some larger companieshave not selected the optimum combination of inputs and hence do not benefit frompotential scale economies; this does not mean to say that they do not exist and thatthey might not be exploited by some companies in an industry. It may also be thecase that the difficulties of managerial coordination beyond some company size makeit impossible to benefit from potential scale economies. Newspaper reports of mergersand acquisitions usually focus on the scale economies which will be generated which aretypically realised by shedding employees; but it is often difficult to differentiate between


5.10. Economies of scale and the experience curve 135

efficiency gains, which occur when a more effective management team is installed, andgenuine scale economies, which are realised when capacity and output are more closelyaligned.

The incidence of scale economies helps explain why some industries are dominated by afew monopolistic companies while others are characterised by a large number of smallcompanies. There are pronounced scale economies in industries such as electricityproduction and car manufacturing; however, in industries such as specialised machinetool production there may be considerably less scope for economies of scale. Oneof the problems faced by state regulators is to ensure that competitive pressures canbe brought to bear in an industry dominated by a monopolist without sacrificing scaleeconomies.

Economies of scale are sometimes confused with the experience curve, which relates tothe 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 employeeslearn to do their job more efficiently over time. Experience is a dynamic notion which,while being related to economies of scale in that the larger a company the more outputit will have produced, is conceptually independent of economies of scale.

The research carried out on this issue reveals that the effect of experience varies amongcompanies and industries; it is to be expected that the evidence on experience willbe mixed because of factors such as variations in production techniques by industry,differences in managerial ability to take advantage of its potential effects and exogenousshocks. A general review of the empirical evidence suggests that a doubling of outputhas the potential to lead to a 20 per cent reduction in average cost. Whether this can beused as a benchmark for individual companies is a matter for managers to resolve, butthere seems little doubt that there is a potential for experience effects in most areas ofactivities. An important aspect of the empirical findings is that the effect is not linear, i.e.it takes successive doubling of output to achieve the same proportional cost reduction.This would produce a relationship between experience and unit cost of the shape shownin Figure 5.2

Figure 5.2: The experience curve and unit cost

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



first point, when cumulative output to date was Y1 and X1 respectively. By the secondpoint company Y has increased its cumulative lead in output terms, i.e. output Y2 is nowmuch greater than output X2, but the unit cost advantage has almost disappeared.

But it is necessary to impart a word of caution regarding the experience effect. While itis a well established statistical finding, it does not imply causation. In other words, justbecause it has been found in the past it does not follow that every company will benefitfrom it; experience has to be managed before the potential gains can be realised. Thishas important strategic implications because a company might be tempted into pursuinga higher market share (which by definition will increase its output relative to competitors)by aggressive pricing, advertising and marketing in the hope that experience effects willlead to lower costs and higher profits. There are two dangers here. First, the experienceeffects may not be realised because the company has expanded in size and has hadto increase its workforce who, in turn, take time to learn. Second, if knowledge aboutpotential experience effects is freely available in an industry competitors will quickly reactfor exactly the same reason. The overall effect is likely to be lower prices in the industrywith no net benefit to any individual company.

Exercise 5.9

There is a clear difference between economies of scale and the experience curve. Whatdo 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 anddirection in order to arrive at a sensible mission statement and objectives. In the modernworld not all companies focus exclusively on the production of one output and manyhave to make fundamental decisions about what range of products to include in theportfolio. In a broad sense this is a decision on diversification, which can take bothhorizontal and vertical forms. The issues addressed here are economies of scope,synergy, diversification 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 sizeof the company; however, economies of scope relate to a reduction in unit cost as thenumber of products is increased rather than the number of units produced. The scaleeconomies argument is that if two companies were merged which produce the sameproduct then the resulting unit cost would be lower. The scope economies argument isthat if two companies were merged which produce different (but related) products theunit 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 inputscan take the form of physical resources or specific skills and competencies. Forexample, banks have greatly increased the number of financial products whichthey offer in the past decade because some of the skills involved in managingbanking accounts, providing insurance and selling home mortgages are similar.


5.11. The scope of the company 137

• The investment cost of entering new markets can be greatly reduced if technicalknow-how is common.

• The reputation associated with some products can have a positive impact onothers. For example, the Virgin brand has been extended from its base in musicrecording to airlines and financial services.

• The corporate R & D effort can support several product divisions. For example, inthe 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 whenanalysing the internal operation of a company which produces more than one product: istotal cost lower than it would be if the company were split up into its component productparts? The fact is that economies of scope are by no means the automatic outcome ofdiversification, although they are typically used as the justification for diversification inthe first place. A company whose products compete in unrelated markets using differentresources 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 whatcontribution the portfolio actually makes to competitive advantage in individual markets.

Exercise 5.10

Why is it difficult to identify economies of scope? What issues need to be resolved inidentifying the benefits of economies of scope?

5.11.2 Synergy

Synergy appears to have first been mentioned by Ansoff3, and relates to the benefitsfrom diversification. The notion differs from economies of scale and the experienceeffect 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 haveclaimed that there is no difference between the two. In the following discussion thereare overlaps with the discussion on economies of scope given that neither has ever beenstrictly defined.

The existence of synergy should lead to the situation where a corporation is valuedat 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 defines it as the behaviour of integral, aggregate, whole systems caused bythe unpredictable behaviour of any of their components or subassemblies of theircomponents taken separately from the whole4.

The problem with this definition is that it focuses on the unpredictable outcomes; ifthe benefits of synergy are unpredictable then it is not clear how the effects can beused as a justification for expanding the product portfolio. However, some successfulcompanies attribute at least part of their success to synergy, therefore it is important todetermine whether synergy can be predicted and capitalised on in formulating strategy.For example, no one would expect a synergistic effect from a company which producesball bearings taking over a company producing ice cream; but is it possible to use theconcept as an operational tool to tell the ball bearing company which type of companyto take over? While the idea of synergy has an intuitive appeal it turns out to be difficult



to pin it down in practice.

There are two problems in attempting to benefit from synergy as a consequence ofcompany actions. The first is to identify where the benefits of synergy are likely to begenerated. The second is that there is little empirical evidence which can guide thecompany in individual situations; in other words, synergy may be little more than wishfulthinking on the part of companies engaged in expansion who have heard that synergyis an outcome of diversification.

To put the potential benefits from synergy into context, bear in mind that some of themost successful companies in history (such as Coca Cola, Pepsi, and McDonald’s) havestayed with their original product.

Exercise 5.11

If synergy is not a magical effect it must arise from identifiable factors which becomeapparent in cost and marketing advantages. Identify the aspects of company operationsfrom which the effects of synergy are likely to originate.

5.11.3 Diversification

Diversification is often regarded as the normal state of affairs for a company; manycompanies consider it unremarkable that they produce a wide range of products ofboth similar and dissimilar characteristics. The evidence available on the relativeperformance of diversified companies demonstrates that it is not an automatic recipefor success, with most studies concluding that there is virtually no benefit from manydiversifications. Some accounting studies have been carried out on the degree ofdiversification and performance, using measures such as return on investment. Thereis no obvious connection between the two and it seems that profits are more likely to bedetermined by industry profitability than by diversification itself.

Given this lack of positive evidence that there is much real gain from diversification, whyhas it been such a popular corporate pastime? There are several potential incentives todiversify.

• To minimise risk: it is now recognised that diversifying is a means of minimisingmanagement risk but not shareholder risk. The objective of stabilising cash flowsover time is a weak rationale for diversifying, and certainly provides no basis forexpecting any value production.

• To capture synergy and economies of scope: there is some potential for this withrespect to related diversifications, but the rationale is difficult to justify when thediversification is unrelated.

• To add value through the parenting function: the value creation potential ofparenting was discussed at Chapter 1 Section 6.1, and was found to be on thewhole unconvincing.

• To apply the dominant management logic: Managers of diversified firms may seethemselves as deriving economies of scope through their proficiency in spreadingscarce top management skills across apparently unrelated business areas throughthe application of their dominant management logic; this is the way in whichmanagers conceptualise the business and make critical resource allocations,



be it in technologies, product development, distribution, advertising or humanresource management. The dominant management logic has a direct effectwhen managers develop specific skills, e.g. information systems, and seeminglyunrelated businesses rely on these skills for success. There is a danger that thedominant management logic rationale can be mistakenly applied by managerswho perceive themselves as possessing above average general managementskills. Furthermore, without detailed knowledge about a particular business it isimpossible to know at the time of the diversification whether the new businessfits the dominant management logic or whether the managerial skill is aboveaverage. In the absence of obvious relationships between businesses, claimsthat economies of scope derive from a dominant management logic are difficult todefend.

• To share reputation: it is possible to extend the brand image of a successfulcompany to unrelated products. An example of this is in retailing, where manyproducts are sold under the umbrella of Tesco or WalMart.

Diversification is discussed further at Chapter 5 Section 5.12.4 in relation tocompetence.

Exercise 5.12

Richard Branson’s Virgin business empire is a good example of a highly diversifiedportfolio. 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 andVirgin 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 offinancial 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 othercompanies and sells its output to other companies or final consumers. Intuitively itmay appear attractive to gain control of both upstream and downstream activities andintegrate all aspects of the productive process. But this raises an important strategicquestion: what is the rationale for vertical integration? This in fact comes down tothe question of whether a company should make something itself or buy it from someother company; in other words can the market provide inputs more cheaply than internalproduction? In this case ‘more cheaply’ does not refer simply to the price paid for theinput in question, but has to be seen in the wider context of the costs and benefits ofusing the market rather than producing internally.



There are various degrees of vertical integration: a company can control all levels of theprocess from extraction of raw material to sales to the final customer, or it may only covera part of the process. In the clothing industry, for example, complete vertical integrationdoes not exist, as farmers who produce wool are not owned by cloth producers. Anotherdimension is that integration between stages is not always complete. A verticallyintegrated 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 ownproductive process is relatively rare.

The case for vertical integration depends on the transaction costs associated withmarkets compared with the administrative costs of internal organisation; it is thereforenecessary to investigate the potential costs and benefits of markets versus internalproduction. The benefits of using the market include the following.

• Market firms can achieve economies of scale which the company’s purchaseswould be insufficient to generate on their own.

• Market firms are subject to the discipline of the market, hence it is unnecessary toimplement rigorous internal controls to ensure efficiency.

In fact, these arguments in favour of using the market rather than producing internallyare quite powerful; there needs therefore to be a strong justification for embarking onvertical integration. The potential costs of using the market are the following.

• The coordination of production flows may be compromised because the suppliermay 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 efficiency benefits of using the market againstthe fact that using the market can expose it to risk. But there are also some specificcosts 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 ofproduction. It is unlikely that scale economies will be achieved at the same outputfor the different products.

• Business at different stages can be radically different and present differentstrategic problems.

• If the company is constrained by its own supply it will not be able to act quickly andflexibly in response to changes in the market.

• The risk inherent at each stage ceases to be independent and risks which affectone stage will have an effect on other stages of production. This compounding ofrisk 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 justified, and in others it may not.But what is important is to avoid the erroneous arguments which are commonly used tojustify buying in from the market and which can lead to serious strategic error.



• To avoid paying the costs necessary to make the product. This is wrong even ifthe company currently has excess capacity because the costs have to be borneby someone.

• To avoid paying a profit margin to other companies. This is wrong because it is notwhether the supplier makes a profit that is important but whether the profit made ishigher 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 profitability which is relevant; if thesupplier operates in a competitive market the company could not make the productany more cheaply because the higher price reflects higher input costs.

A company may have come to the conclusion, based on an analysis of costs andbenefits, that vertical integration is undesirable, and it may recognise the erroneousarguments above, but it may still feel that vertical integration is worthwhile because it isnot possible to achieve a complete and enforceable contract with a market supplier inthe same way that is possible with internal production. There are at least three reasonsfor this.

• Life is too complex to draw up a contract which can take all eventualities intoaccount.

• There are severe difficulties involved in specifying and measuring performancewith any accuracy; for example, it is impossible to define the thrust of an engineexactly and then predict its wear and tear over time.

• Neither party is willing to reveal all information to the other in the bargainingprocess; this may end up by putting the buyer at a disadvantage which mighthave 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 theother party’s weaknesses once the contract has been agreed. This cannot be evaluatedin financial terms before the event, and is of course difficult to predict or avoiding actionwould be taken during the bargaining stage. It is argued that there are a number ofways by which internal production can resolve the holdup problem better than recourseto arm’s length market contracting. First, vertical integration can give access to morepowerful governance in the sense that disputes can be settled by internal administrativeprocedures such as recourse to rules or informal mediation. Second, because of theguarantee that internal relationships will be continued and must be lived with, there ismore incentive to get things right. Third, depending on the company culture, verticallyintegrated divisions may be more likely to behave in a cooperative fashion because theysee themselves bound together by a common purpose. It may well be that there arepotential avenues for discouraging opportunistic behaviour and for achieving cooperativeoutcomes that are not available in a market contract setting.

But there is no guarantee that these influences will lead to a more efficient resolutionof the holdup problem; it may well be that the holdup problem is something that has tobe lived with. In principle, to remove the holdup problem implies controlling all inputs



to the process, and even vertical integration does not resolve that because inputs haveto be purchased no matter how far backwards the integration goes. Furthermore, if thecompany decides to make rather than buy in competitive markets, it will face additionalprincipal agent problems and more management resources will be devoted to resolvingthese. Another major problem is that the internal pricing system must perform the samefunction which the market would have performed, otherwise it becomes impossible tomonitor the performance of the sections of the vertical chain and identify where value isbeing created. For example, internal prices which are based on accounting conventionsrather than market conditions are likely to provide misleading cost signals. One methodof resolving the problem is to allow managers the option of buying from outside suppliersif their price is lower. This has the effect of applying the discipline of the market to thecomponents of the vertical chain, while hopefully enabling the company to achieve thepotential benefits of vertical integration outlined above.

The prospect of vertical integration has always been a source of concern to those whofelt that companies would grow so big that they would dominate markets and would thenbe 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 anycase vertically integrated companies are unlikely to enjoy monopoly power at all stagesof the productive process.

Exercise 5.13

An example of a vertically integrated company with significant monopoly power is BritishGas which controlled the process from discovery of gas supplies through distribution tothe final consumer. The stockbroker Kleinwort Benson produced an analysis of thebreak up value of British Gas compared to its current total share price value. Theanalysis is shown in Table 5.7.

Table 5.7: Break up value of British Gas

Division Asset value (£bn) Trading value (£bn)

Exploration/production 5.3 3.4

Pipelines 11.5 13.9

Distribution 3.1 2.9

Other 1.7

Net debt 2.5

Total 19.1 13.9

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 verticallyintegrated company?


5.12. Creating value from the production process 143

5.12 Creating value from the production process

Value is created by the production process through the effectiveness with whichresources are deployed and combined together, and in relative terms value is created bythe competence which the company contains and which is embedded in both processesand products. These aspects of value creation cannot be easily measured, and in factare often difficult to identify. But there are ideas which can be applied to help reveal howa company creates value in a competitive market - the notion of a chain of value creatingactivities which are based on supply linkages, the underlying competence which drivesthe company and the appropriate expansion trajectory derived from the value creatingcore of company activities.

5.12.1 The value chain

A company can be visualised as a chain of value producing activities which starts withinputs at one end and sales at the other; the overall value is represented by profitability,but it is difficult to disaggregate company activities in such a way that the contributionof each to value production can be identified. Porter5 tackled this problem by breakingthe value chain down into two main components: primary activities, which are basicallythe logistics of production and sales, and support activities, which are necessary for theeffective functioning of the company, but which are not directly related to production andsales.

While this is not the only way of breaking down the value creating dimensions of anorganisation, it is useful to follow the Porter approach. The primary activities are thefollowing.

• In-bound logistics: receiving, storing and handling inputs to the productionprocess.

• 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 ofa tangible product, and bringing the buyer to the product in the case of manyservices.

• Marketing and sales: analysing customers and bringing to the attention ofcustomers the products and services which the company is selling; this includesthe 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 areperformed better than those of competitors. What is not typically appreciated is that itis not just the effectiveness with which these individual primary activities are performedthat is important, but the linkages among them and the support activities.

• Procurement: the process by which resources are acquired; this function isconcerned with obtaining resources at the lowest price and highest quality.

• Technological development: the technology associated with each of the valueactivities, including learning by doing, product design and process development.



• Human resource management: the business of managing the work-force.

• Management systems: this includes quality control, finance and operationalplanning.

These support activities add value, just as the primary activities do, but are not directfunctional parts of the production process

The concept of value which Porter uses in value chain analysis is not profitabilitybut how the ultimate consumer views the product in relation to competing products.Unfortunately, this is almost impossible to measure, and it is usually necessary touse other measures such as operating margin, profit or shareholder value. Oncesome measure of competitive difference has been established, the value chain can beanalysed to identify how value is created by its components. The following exampleshows how a value chain that can confer competitive advantage may be constructed.The potential for competitive advantage does not lie in effective performance of eachactivity because that can always be imitated. It lies in the fact that the activities areintegrated and that the chain is capable of responding effectively to change. The‘Reaction to increased competition’ column shows the type of changes that the valuechain must be capable of to provide an effective response to a competitor who haslaunched a higher quality product.



Value chain Effective operation Reaction to increasedcompetition

Primary activities

In-bound logistics Efficient warehousing andinventory control

Adapt warehouses andadjust inventory controltechniques

Operations Benefit from experienceeffect

Redirect labour forcewithout reducingproductivity; improvequality control

Out-bound logistics Develop distributionchannels

Identify new ways to market

Marketing and sales Position product in the rightsegment

Establish high qualityproduct position

Service Aim for repeat orders Demonstrate attractivenessof improved product

Support activities

Procurement Negotiate effectively Focus on high qualityinputs

Technological development Improve and differentiateproduct

Move fast to identify andimplement specificimprovements

Human resourcemanagement

Provide incentives alignedwith objectives

Develop a commitment tohigher quality

Management systems Develop competences Identify new competences

A weakness in any one of the ‘Effective operations’ can have a serious impact on theoperation of the value chain as a whole. For example, poor inventory control can leadto high costs and inability to meet the orders produced by the marketing effort. But itis also clear that if any activity is incapable of change in the face of competitive actionthe resulting value chain will be equally ineffective. For example, if it is not possible toidentify the required product improvements the company will lack the right product tomeet the challenge.

The basis for sustainable competitive advantage rests in the creation of an organisationthat can achieve excellence in each activity and keep on doing so. That dependson the changes in each activity being in harmony, for example there is little point toimplementing the new marketing strategy before the improved product is ready forproduction. It is the uniqueness of such a value chain and the difficulty of imitating itthat results in sustainable competitive advantage.

The question then arises of how to create such an organisation. That requiresmanagement of the value chain as a whole and an understanding of the linkages amongthe components. The value chain is not a set of consecutive actions that have to beexecuted in turn; it must be visualised as a holistic system and that, needless to say, is



very difficult to achieve. There is no doubt that the idea of constructing a competitivevalue chain is a difficult area both conceptually and operationally. It is not surprisingthat very few companies fully understand their value chains and CEOs are continuallyperplexed by the inability of their organisations to recognise and react to competitivechallenges.

5.12.2 The value system

Unless it is completely vertically integrated, every company buys inputs and in manycases does not actually sell to final customers. Thus every company is part of a valuesystem which is made up of the individual value chains of suppliers, distributors andfinal customers. Opportunities for increasing competitive advantage can be identified byunderstanding the value chains of both suppliers and buyers. Anything a company cando to reduce its suppliers’ costs or improve suppliers’ effectiveness can enhance its owncompetitiveness. At the same time down stream value chains are important because thecosts and margins of down stream companies are part of the price the end user paysand the activities down stream users perform affect end users’ satisfaction. A companycan enhance its competitiveness by undertaking activities that have a beneficial effect onits customers’ value chains. For example, some aluminium can producers constructedplants next to breweries and delivered cans on conveyors directly to brewers’ can fillinglines; this resulted in significant savings for both can producers and breweries and hada positive impact on both value chains.

It has been demonstrated that a complete understanding of the company’s own valuechain is difficult to arrive at, and is really only an approximation. To extend the analysis toother companies about which it has little real information is clearly an almost impossibleundertaking. But even a vague understanding of suppliers’ and buyers’ value chainscan open up potentially important strategic options, as in the case of the aluminiumcan producers. It was recognised that locating their plants next to the breweriesincreased the effectiveness of both the in-bound logistics and procurement elementsof the brewers’ value chains; it also improved their own out-going logistics element. Asa result both sets of companies were able to benefit from the improvement in the valuesystem.

Exercise 5.14

Marks & Spencer, the British retailer, used to be famous for its relationships with UKsuppliers and the resulting guarantee of high quality; it was also a leader in humanresource management which was linked to a high standard of customer service. Whilemany characteristics of Marks & Spencer could be imitated, it turned out to be almostimpossible for other retailers to emulate the company’s success and Marks & Spencerretained its place as one of the most profitable retailers in the world for several decades.However, by 1998 some serious problems had emerged. For example, there was abuild up of unwanted stocks amounting to about £150 million; the image of quality andvalue which had been built up by purchasing from British suppliers was underminedby switching to foreign suppliers because British suppliers were relatively expensive; tocap it all, a series of board room battles undermined the company’s image as a leaderin human resource management. By the beginning of 1999 it came as no surprisethat Marks & Spencer profits fell dramatically. After a boardroom reorganisation, arestructuring process was undertaken which started with the sacking of many middlemanagers. The stock build up was attributed to the fact that there was no marketing



department and this was also remedied.

Analyse the success of Marks and Spencer and its subsequent failure in terms of thevalue chain and value system.

5.12.3 Competence

The aspects of competitive performance which a company is relatively good at are itscapabilities, or competencies (both terms are widely used). The notion of distinctivecompetencies relates to all of the characteristics of a company which give it acompetitive edge. It has been illustrated in the value chain analysis that it is not beingparticularly good at one thing that generates sustainable competitive advantage, butthe integration of activities into a value-generating chain. This is also the case withcompetencies because if they can be identified then they can be imitated. Whiletechnique based competence is a necessary condition for competitive advantage it isnot a sufficient condition: competencies have to be combined in such a way that theresulting organisation cannot be readily imitated.

Prahalad and Hamel6 developed the concept of core competence primarily tounderstand the basis of competitive advantage for large diversified corporations; as afirst 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 hasmany products and processes at each stage; organisational learning is the ability builtup over a period to perform these functions better than competitors. To achieve this it isnecessary 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 arecommitted to organisational objectives is clearly a precondition for the implementationof an effective value chain.

Large companies are typically organised into strategic business units (SBUs) as theoutcome of historical development discussed in Chapter 1 Section 5.1. While the SBUapproach has led to major improvements in effectiveness compared with centralisationPrahalad and Hamel argue that a hidden cost is that it leads to a mind set within SBUsthat runs counter to the development of company wide core competences. They contendthat the conventional SBU mentality leads to

• under-investment in developing core competencies. This is because the SBUsconcentrate on their own effectiveness without taking a wider view of their linkageswith the rest of the company.



• imprisoned resources within the SBU. While the principles of capital budgetingare understood as a method of allocating resources there is no comparablemechanism for allocating human skills that embody core competencies.

• bounded innovation. Individual SBU managers will pursue only those innovationswhich relate to their own operations and will ignore, or not recognise theimportance of, hybrid opportunities.

The message which comes across is that SBU autonomy can stand in the way ofdeveloping a long term competitive advantage. Furthermore, the capital budgetingapproach to resource allocation may be inappropriate because it is not possible to relatefuture cash flows to core competencies. But this does not answer the question of whatcomprises core competence. Because of the difficulty of identifying core competence ina 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 ofnew products may dilute existing competences; shared costs are one of the potentialdimensions of synergy and vertical integration raises fundamental issues regarding thebusiness definition. To identify a core competence there are three tests which can beapplied. It

• gives potential access to a wide array of markets

• makes a significant contribution to perceived customer benefits of the end product

• is difficult to imitate.

The key test is that it is difficult to imitate. Because they are so difficult to generate corecompetencies are likely to be relatively rare, and Prahalad and Hamel reckon that thereare probably no more than five or six per company. If they are difficult to imitate theyare also probably difficult to recognise but if they are not recognised, companies canunwittingly surrender core competencies when substituting outside suppliers for internalservices. It is therefore essential to distinguish between divesting a business and losinga core competence. This adds a different dimension to the issue of vertical integrationand make versus buy (Chapter 5 Section 11.4). By its nature, the cost of losing a corecompetence cannot be calculated in advance, but it may lead to a significant reductionin company performance.

Prahalad and Hamel originally used the example of two large companies in the evolvinginformation technology business to demonstrate the impact of core competences; thesewere NEC which, they contended, adopted a core product approach, and GTE whichmaintained an SBU mentality. Prahalad and Hamel attribute the success of NECcompared with GTE to the core competence approach it adopted. But with the passageof time their conclusions appear to be a little less secure. While NEC performed betterthan GTE, during the ten years up to 1996 NEC’s shares subsequently lagged behind



the average of the stock market by 28 per cent; in fact, it can be argued that muchof its financial success was due to its semiconductor business which was related tothe 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 integrateddivisions which were controlled by powerful and independent leaders in a manner whichwas not conducive to synergy. It was only in 1991 that the company was reorganised intothree horizontal groups, which was one year after Prahalad and Hamel completed theirstudy. Whether the critics are correct is not really the issue - the fact that the evidenceis so mixed demonstrates just how difficult it is to use the notions of competence as asource of competitive advantage.

The discussion so far has focussed on the difficulty of defining and identifying a corecompetence, so it might be concluded that it is an intangible and unique attribute ofcertain successful companies. But from the discussion the main characteristics of corecompetences can be identified; the following list shows how these relate to the corecompetence of effectively managing the value chain in a company as discussed inChapter 5 Section 12.1.

Core competence characteristic Value chain management

Difficult to identify The competence is spread across severalmanagers

Difficult to imitate The management group is comprised of aparticular set of individuals with their ownincentives and commitment

Do not reside within SBUs Each SBU is only part of the value chain

Relatively rare Even this one core competence has thepotential to generate competitiveadvantage

Thus core competence is embedded within the company and it is doubtful if theindividuals involved could replicate it in a different set of circumstances. Compare thiswith the statement by the CEO of a high tech start up company ‘Our core competenceis innovation: we invent and deliver new products to the market’. On reflection, thisinterpretation of innovation suggests two core competences: inventiveness and deliveryto the market. These measure up against the characteristics as follows.



Core competencecharacteristic

Inventiveness Deliver

Difficult to identify Certain individuals areknown to possess theability to invent

The route to marketinvolves development,marketing etc

Difficult to imitate No one has a monopoly oninventiveness

Venture capitalistsspecialise in bringing newproducts to the market

Do not reside within SBUs Inventions usually emergefrom the R&D department,which can be regarded asan SBU

It is the job of SBUs todeliver to the market

Relatively rare New ideas and inventionsappear all the time

New products are broughtto the market all the time

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

5.12.4 Competence and diversification

A technique for using the concept of competencies using categories of competencewhich can be utilised in diversification, rather than attempting to define competenciesprecisely, has been developed by Chiesa and Manzini7.

They reckoned that competencies can be defined in terms of routines and resources;for example, distinctive capabilities are the outcome of routines and a trained workforceis a resource. The form of diversification can then be classified depending on whetherit is based on routines that the company has developed and resources that it currentlypossesses or whether it has to acquire or develop either or both. The classification ofdiversification in Figure 5.3 is based on their original idea.

Figure 5.3: Competence based diversification

While the classification is bound to be imprecise in real life, each class of diversification



has identifiable characteristics.

Replication based diversification

This should be the least risky form of diversification because it is based on an expansionrather than a change in the form of the organisation. A major change in the Britishfinancial market in the 1990s was the diversification of building societies (which aremutually 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 tosavers. Up till then, when they were the only providers of housing finance, there was animbalance between supply and demand in the market for housing finance and buildingsocieties rationed available funds; for example, only individuals who had been savingsignificant amounts for several years in a building society’s account were eligible fora loan. When banks started competing in this market, the building societies foundthat a substantial part of their business was lost and they reacted by diversifying intoactivities previously undertaken only by banks. The building societies utilised theirexisting resources, in the form of a network of branches and experienced personnel, andapplied the routines which they already had for the management of house finance to awider range of services. Replication based diversification was probably the underlyingreason for the success of building societies in the highly competitive personal financialsector. Subsequently most building societies were floated on the stock exchange; thisresulted in large windfall gains for mutual shareholders, reflecting the enormous valueadded which their replication based diversification had produced.

Routine based diversification

In this case new resources need to be added to those currently available in thecompany, but the same routines can be used to manage them. The biggest company inScotland was ScottishPower which diversified from being an electricity utility companyinto water, gas and telecommunications. New resources were required for several ofthese 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, waterand telecommunications. Thus not only would a particularly efficient set of routines betransferred to these activities but synergy among the outputs could be built up.

Resource based diversification

This occurs when a company starts producing outputs which utilise existing resourcesbut which require different routines. The British university system is world renownedfor the excellence of its education, and Edinburgh Business School (EBS) set aboutdelivering this education in the form of the MBA by distance learning. But theconventional routines which deliver class-based educational outputs were incompatiblewith distance learning, and it was necessary for EBS to develop a totally newset of routines to deliver business. The existing routines included regular student-teacher contact, periodic graded assignments, student peer group interaction andacademic 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 morefundamental organisational change than the routine based diversification undertakenby ScottishPower.



Unrelated diversification

The extreme form of unrelated diversification occurs where the only resource shared isthe financial structure and control system. There are, of course, numerous examplesof companies which have diversified into areas unrelated in terms of resources androutines; the Virgin business portfolio outlined in Chapter 5 Section 11.3 is an example.Diversification is particularly risky when the firm has to acquire new types of resourcesand manage them using routines with which it is unfamiliar. It could be argued thatmuch of the Virgin portfolio is in the entertainment business and these businesses aretherefore related. But it is worth considering in detail the resources and routines requiredto produce such diverse outputs as tourism, cinema, TV and publishing; this wouldprobably give a different answer on relatedness.

Diversification trajectory

It is probable that few boards consider possible diversification strategies using this typeof classification; hence they tend to embark on the process without a clear notion ofhow far from the core activities of the company a particular diversification is taking them.Consider the ScottishPower example in more detail and plot the trajectory, or directionin the matrix, of its diversification over time. The ScottishPower board had described itsdiversification as being primarily routine based. A closer examination of each acquisitionsuggests that this was not actually the case. The first acquisition was replicationbased: ManWeb was another electricity company in England that needed to be mademore efficient. The next step was routine based: Southern Water was a mediumsized water company in the south of England. It then moved into the unrelated areaby the development of a telecommunications business. Finally, ScottishPower movedback to replication based diversification by taking over PacificCorp, a US electricitycompany. Was the Board correct in its view that the diversification was routine based?ScottishPower then divested its telecommunications business and its water utility. Ittherefore ended up with only its replication based diversifications, i.e. other electricitycompanies. (PacificCorp was also sold but this was because of problems specific to theUS energy market). The withdrawal from water and electricity could have been due tothe fact that the Board did not recognise just how far away from their core activities thediversification trajectory was taking the company and the risks involved.

5.12.5 Strategic architecture

The way in which the company’s collection of unique attributes is combined together isknown as strategic architecture. The strategic architecture of the company is derivedfrom the ideas of the value chain, the value system and the core competenciesupon which competitive advantage is based. It is a network of relational contractswithin or around the firm. Firms establish relationships with their employees (internalarchitecture), with their suppliers or customers (external architecture), or among agroup of firms engaged in related activities (networks). The value of architecture liesin the capacity of organisations to create organisational knowledge and routines, torespond flexibly to changing circumstances and to achieve easy and open exchangesof information. Each of these is capable of creating an asset for the firm, 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 beimitated and would not contribute to sustainable competitive advantage. It has alreadybeen discussed how value chain analysis does not fully describe Marks & Spencer


5.13. The definition of competitive advantage 153

because of the linkages between elements in the value chain and the value system. Inprinciple an understanding of its strategic architecture might help the company identifywhich core competencies to build. But the architecture has typically developed over aconsiderable period in an unplanned manner and as a result is so complex and uniqueto an individual company that it is doubtful whether it can be described in operationaldetail. But it is a useful idea because it highlights the fact that value is not just createdby the internal efficiency of the company.

Exercise 5.15

Analyse AcmeTool’s competence based diversification from the StylePlane to thePowerPlane.

5.13 The definition of competitive advantage

The discussions of issues such as the value chain and core competence have referredto sustainable competitive advantage without being precise about what it is. Onemeasure is the ability to maintain a higher rate of return on assets than competitorsover a long period. In practice it is difficult to identify what factors contribute tosustainable competitive advantage; the factors that are typically cited by companies,including superior quality, lowest price, best customer service and occupying a cashcow position in the BCG matrix, are usually irrelevant. This is because there are at leasttwo conceptual problems involved in attempting to identify the source of competitiveadvantage.

• Causal ambiguity: it is difficult to establish exactly what characteristics of thecompany contribute to its success because of the difficulty of identifying causeand effect relationships.

• Uncertain imitability: because of the causal ambiguity, potential competitors arefaced 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 forcompetitive advantage? There is, but only in a limited way. There are two broad sourcesof competitive advantage: those based on market conditions and those based on theinternal characteristics of the company. The former can be termed strategic assetsand the latter distinctive capabilities. Strategic assets arise mainly from the structuralbarriers 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



• Architecture

• Reputation

• Innovation

• Core competencies

Consider the characteristics of a Cash Cow, classified according to strategic assets anddistinctive capabilities, which contribute to competitive advantage set out in Table 5.8.

Table 5.8: Competitive advantage of a cash cow

Characteristic Advantage Source

High market share Economies of scale Strategic asset

Stable market First mover Distinctive capability

Customer loyalty Reputation Distinctive capability

Fixed plant capacity Full utilisation Strategic asset

Stable labour force Experience Strategic asset

The point that emerges is that the competitive advantage of a cash cow is based on acombination of strategic assets and distinctive capabilities. This has implications for thedebate regarding the resource based view of strategy: competitive advantage cannot beattributed to a single factor. Does being a cash cow guarantee sustainable competitiveadvantage? Only to the extent that any of the sources of competitive advantage cannotbe imitated and/or improved on. There are many instances of companies losing theircash cow position because attention was not paid to the sources of competitive

Finally, this example is limited because it is concerned with the maintenance ofsustainable competitive advantage; the question of how the company achieved thecash cow position in the first place is another question and is due to the fundamentaldistinctive competence: the ability to innovate, seize first mover advantage, mobiliseresources, construct the value chain� � � and so on.

Exercise 5.16

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

5.14 Assessing strategic capability: the strategic advantageprofile

The internal analysis of the company has ranged over a variety of concepts and ideas.The final step is to integrate these ideas to produce an overview of the company’sstrengths and weaknesses, or in other words its strategic capability. This can be doneby constructing a profile of the company using the concepts in this chapter to identifyrelative strengths and weaknesses. The difficulty is to construct a profile which captures


5.14. Assessing strategic capability: the strategic advantage profile 155

all strategically important aspects of the company; one approach is to use the valuechain as a starting point and add in other dimensions to fit the individual case. There isno single correct way of doing this, and Table 5.9 contains a suggested structure.

Table 5.9: Assessing strategic capability

Dimension Concepts Strength (+)

Value chainPrimary activitiesIn-bound logistics Warehousing and inventory controlOperations: Benchmarking

ExperienceSynergy

Out-bound logistics Distribution channelsMarketing and sales: Market share

Bargaining power of buyersPricingQuality

Service Repeat orders

Support activitiesProcurement Vertical integration

Bargaining power of suppliersEconomies of scope

Technological development CompetenceHuman resource management Culture

LeadershipManagement systems Dominant logic

Competence

Value system NetworkDistinctive capabilities Core competencesStrategic assets Barriers to entryProfitability Accounting ratios

Cash flowFinancial structureEconomies of scale

Architecture Linkages

This classification is by no means complete but it illustrates the complexity involved inattempting to arrive at a full picture of a company’s strategic capability.



5.15 References1. 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 SuperiorPerformance, 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 Diversification’, LongRange Planning, Vol 30, No 2, pp. 209-217.


157

Chapter 6

Culture and stakeholderexpectations

Contents

6.1 Stakeholders in the process . . . . . . . . . . . . . . . . . . . . . . . . . . 158

6.2 Stakeholder interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158

6.3 Stakeholder interests: the priorities . . . . . . . . . . . . . . . . . . . . . . 159

6.4 Stakeholder influence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161

6.5 Mapping shareholders and their influence . . . . . . . . . . . . . . . . . . 164

Learning Objectives

• To identify the main stakeholders

• To assess their influence

• To identify stakeholder priorities

• To carry out stakeholder profiling and mapping

158 Chapter 6. Culture and stakeholder expectations

6.1 Stakeholders in the process

6.2 Stakeholder interest

A variety of individuals and groups have an interest in the organisation and theway in which it is managed, those individuals and groups being categorised asthe 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 differenttype of interest in the company; for example, the shareholders are concerned withthe return on their investment, and the safety of their capital, while customers areconcerned with the quality of the product they purchase and after sales service. Thuseach stakeholder has an expectation of some return from the company which is notnecessarily expressed in financial terms.

An outline of the various stakeholders and their interest is shown in Table 6.1.

The main characteristic of this classification is that the interests of the differentstakeholders are completely different. This raises the possibility of conflicts of interest,therefore the issue of stakeholder influence needs to be pursued in some detail. Thereare in fact two distinct issues to be addressed when analysing stakeholder interests andexpectations. These are:


6.3. Stakeholder interests: the priorities 159

Table 6.1: Stakeholders and their interests

Stakeholder Interest

Shareholders Return on investmentRisk

Managers SalaryAdvancement

Employees SalaryAdvancementSecurityFair treatment

Suppliers Prompt paymentRepeat orders

Customers Relative value for moneyQualityAvailability

Creditors Cash flowFinancial stability

Local community Lack of negative externalitiesEmployment prospects

Government Payment of taxesLawful operation

• which interests are most important

• the influence which stakeholders have on the operation of the company

The first 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, forexample, in a general sense should employees or shareholders be regarded as moreimportant? An individual’s judgement on this is likely to be affected by which group he orshe is in. It is quite natural for an employee to consider that his day to day involvementwith the company is more important than that of the shareholder who may never havebeen inside the door. It is important to be explicit about the issue of stakeholder prioritiesbecause it has implications for the efficiency with which the company can be operated.The following are the types of argument you will encounter on stakeholder priorities, butit is important that you keep an open mind on the issue.

Shareholders

The shareholders can be regarded as the most important because they provide thecapital for the company and if it does not operate efficiently shareholders can withdrawtheir funds and invest in something more profitable. In this respect the shareholders



provide a service to the rest of the economy in that they direct resources to thoseoperations which provide the highest financial returns; in that sense everyone benefitsfrom 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 ofcompany prospects and it is not safe to leave the destiny of companies to their discretion.This in turn becomes an argument about how efficiently capital markets work, and thefact is that no method has yet been discovered which is as effective as capital marketsin directing the allocation of resources in the economy as a whole. Central planning wasexposed as a failure with the fall of communism; variations on free market operationshave been tried, but these amount to attempts at influencing the way the market worksrather than replacing it.

So far as the company is concerned, it needs to be recognised that shareholders controlthe supply of capital, and if their interests are not met in the form of a rate of return whichis comparable to other investment opportunities, then the company will most likely ceaseto exist. It is because of this that it is often concluded that shareholders are the highestpriority stakeholders and companies ignore this at their peril.

Managers

Managers comprise the group which is charged with determining the direction, scopeand 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, ifmanagers make the wrong decisions, the employees lose their jobs and customers aredeprived of the company’s products. It can thus be argued that managers are the mostimportant stakeholders and therefore should be rewarded accordingly.

While this is true, there is also a market in managers, and so long as the company treatsthem at least as well as companies which might compete for their services, then they donot need to be singled out for special treatment. Their stakeholder priority is high, but itneed 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 inemployees which determines the conditions under which they are employed, and againit is unnecessary to single them out for special stakeholder treatment above and beyondthat dictated by the market.

Suppliers

The stakeholder priority depends on the number of suppliers which the company uses.The five forces model discussed at Chapter 4 Section 10 highlighted the bargainingpower of suppliers. When the company is greatly dependent on one supplier it followsthat its stakeholder priority is relatively high. But before assigning too high a priorityto suppliers it is necessary to determine whether the company can substitute for othersuppliers, or increase the number of suppliers. If there is a high degree of dependenceon a supplier then this may be a case for vertical integration, but typically recourse tothe market will reveal that there are plenty of other suppliers.

It may be that a long term relationship has been developed with certain suppliers whichprovides security of supplies, flexibility and so on. But it has to be recognised that there


6.4. Stakeholder influence 161

are costs as well as benefits in such a relationship, and if dependence on particularsuppliers is found to have a significant influence on the management and direction ofthe company, then the stakeholder priority must be reconsidered.

Customers

It is clearly important to provide customers with what they want, but this is because theycan take their custom elsewhere in competitive markets. Other than the obvious fact thatthe company sells to customers, it is difficult to see what priority should be accorded tocustomers as stakeholders.

Creditors

As capital markets have become increasingly competitive the interests of individualcreditors has diminished. If the creditor has made a realistic estimate of the client thenit will be reasonably confident that its debts will be serviced and need have no otherinterest in the company.

Local community

Companies depend on their local community for employees, services, land, planningpermission and so on; the local community depends on the company for employmentand the creation of wealth. Both sides benefit from the arrangement and in this respectit 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 needsto 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 needfor the government to figure in its decision making. In a market economy the role of thegovernment 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. Ingovernment run organisations such as the civil service this is not the case, but here thegovernment acts as a shareholder and it is in that sense that it has a high stakeholderpriority.

Exercise 6.1

1. In a purely market economy which stakeholder do you think has the highestpriority?

2. What effect does this priority have on the way a large limited liability company isrun?

6.4 Stakeholder influence

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



It is not only the degree of influence which is important, but the fact that the interests ofstakeholders are often in conflict; this leads to the principal agent problem. While theprofile of stakeholder influence varies among different companies, the following indicatesthe factors which determine how important that influence is likely to be.

Shareholders

Despite their importance, shareholders usually exert little influence on major companydecisions or how the company is run from day to day. Large companies typically havemany 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 onlyin exceptional circumstances that CEOs are censured or dismissed at the AGM.

In some cases large financial institutions, which manage portfolios for pension fundsand investment trusts, may have a significant shareholding in a particular company; ifthe institutional shareholders together take a similar view on a particular issue they maywield some power over company executives at the AGM. However, it must be recognisedthat these financial institutions are really the representatives of the individuals whosemoney they manage, and there is no guarantee that they will act in accordance withthese individuals’ wishes.

In smaller companies, which are family owned or have a few partners, the shareholderswield a direct influence on company operations. But in this case they typically play thedual role of shareholders and managers and this negates the principal agent problem.

Managers

By and large the influence of managers increases with the size of the company as theinfluence of the shareholders diminishes. The independence of managers also dependson the type of remuneration package - whether it is related to absolute profits, growth insales, successful acquisitions, or whatever. Ideally, the management incentive structurewould be aligned with shareholder interests, which are largely profit maximisation, butthis is notoriously difficult to achieve. There are many examples of CEOs receivinghuge salary increases at the same time as company fortunes are falling - this is usuallybecause 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 bygiving stock options instead of direct remuneration. While the outcome of this shouldbe the maximisation of shareholder wealth, the CEO has an incentive to cash in theoptions at the most opportune time, and this may not be consistent with long termprofit maximisation. In principle, the role of the non executive board members, andan independent chairman, is to provide the countervailing power which will balance upthe interests of managers and stakeholders, but given the limited time which the non-executives spend in the company, and the fact that directorships are often interlocking,the non executives often wield little real power.


6.4. Stakeholder influence 163

Employees

There was a time in the UK when trade unions had sufficient numerical strength, andthe backing of legislation, to ensure that employees had a significant impact on companydecision making. The changes in the legislation in the 1980s, coupled with an absolutedecline in trade union membership, led to a significant reduction in this form of employeeinfluence. In some countries, such as Germany, employee influence is much higherbecause of labour legislation which is more favourable to employees than is the case inthe UK. Thus much depends on the individual country and its legislation.

However, employees wield influence in a different way. At the simplest level, it is notfeasible 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 productivityand competitiveness would be severely undermined. Thus the company is to a greatextent dependent on the skills and attributes of the current employees. In this case itis not so much the direct influence of employees on company decision making which isimportant, but the extent to which they are able and willing to collaborate in the changeswhich strategic decision making involves. This in turn depends on the company culture,organisational structure, incentives and so on. The more specific are the employee skillsets 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 theavailability of substitutes.

Customers

Again, the five forces model reveals that the number of customers or customer groupslargely determines customer influence. On the other hand, if there are few substitutesfor the company’s products this power will be greatly diminished.

Creditors

Companies tend to build relationships with sources of credit, such as banks, so thatthey can rely on a fast and fairly sympathetic reaction to credit requirements. Somecompanies have representatives of creditors on the board; this is usually the outcome ofventure capital being provided for high risk start ups by banks which wish to monitor theirinvestments. But typically this involvement diminishes as the management establishesa track record.

Companies have the option of financing investments from retained earnings, obtainingloans, or a combination of both. It could be argued that a company which has becomeso dependent on a particular bank that it exerts influence on company operations onlyhas itself to blame. In principle, the influence wielded by the bank is to decide whetherto provide a loan, and it does this in competition with other banks. Where a relationshiphas been established it can be costly to change creditor, but this is an issue of costsand benefits rather than creditor influence. The fact that the company is highly geared(as discussed at Chapter 5 Section 3) may constrain its activities, but it is difficult tosee how the creditor can exert direct influence on the company unless it has put thecreditors’ funds at risk.

Local community

The influence of the local community may take a variety of forms.



• If the company develops a reputation as a good employer, it will typically have littledifficulty in recruiting at the going wage rate; however the opposite is likely to applyif its reputation is suspect.

• If the company pollutes the locality it will probably have difficulty obtainingpermission for expansion.

Government

Apart from regulation, the government can influence companies by its role as apurchaser and through its policies on subsidies and trade. The purchasing influenceaffects companies in the defence industry; subsidies affect companies in the sectorswhich the government is attempting to encourage; trade policy affects importers andexporters. Again the extent of shareholder influence depends on the individual case.

Exercise 6.2

From the discussion identify the factors which determine each stakeholder’s influence.Set this out in the form of a table with the stakeholders listed on the left and the relevantfactors listed on the right.

6.5 Mapping shareholders and their influence

In order to understand why a company operates in the way it does, or to assess itspotential for change, the influence of the individual stakeholders needs to be identifiedand prioritised. The general principles of stakeholder influence discussed above will notnecessarily apply to every case. In most instances it is pointed out that there are likelyto he significantly different levels of influence in individual cases. The final step in theprocess is to map out the perceived influences and this can take the following form.Consider a company which is family owned and the family maintains a close control onthe business, uses mostly unionised labour and supplies a single customer; one of theowners is currently considering moving into new markets. The stakeholder map wouldlook like:

Stakeholder Influence

Shareholders (family) High

Managers Low

Employees High

Customers High

Suppliers Low

The potential move into new markets can then be considered in the light of the influencewielded 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


6.5. Mapping shareholders and their influence 165

While current customers have a high influence they will not affect the decision tomove into new markets and the part-owner must convince his partners rather thanmanagement about the desirability of the move.

Any organisational change which is not accompanied with some form of stakeholdermapping is likely to run into constraints which could have been identified well in advance.

Exercise 6.3

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


167

Chapter 7

Strategic options and strategicchoice

Contents

7.1 Strategy choice in the process . . . . . . . . . . . . . . . . . . . . . . . . 169

7.2 The importance of structure . . . . . . . . . . . . . . . . . . . . . . . . . . 169

7.3 Strengths, weaknesses, opportunities and threats . . . . . . . . . . . . . 170

7.4 Generic strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171

7.4.1 Corporate strategy concerns . . . . . . . . . . . . . . . . . . . . 171

7.4.2 Corporate decisions on company size . . . . . . . . . . . . . . . 172

7.4.3 Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172

7.4.4 Expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174

7.4.5 Retrenchment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175

7.4.6 Combination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176

7.4.7 Assessing corporate size strategies . . . . . . . . . . . . . . . . 176

7.4.8 Allocating resources among SBUs . . . . . . . . . . . . . . . . . 177

7.4.9 Monitoring and controlling performance . . . . . . . . . . . . . . 177

7.5 Business level generic options . . . . . . . . . . . . . . . . . . . . . . . . 178

7.5.1 Low cost leadership . . . . . . . . . . . . . . . . . . . . . . . . . 178

7.5.2 Differentiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

7.5.3 Focus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180

7.5.4 Stuck in the middle . . . . . . . . . . . . . . . . . . . . . . . . . . 180

7.5.5 Generic strategies and company concerns . . . . . . . . . . . . 181

7.5.6 Generic strategies and company performance . . . . . . . . . . 182

7.6 Identifying strategic options . . . . . . . . . . . . . . . . . . . . . . . . . . 182

7.6.1 Related and unrelated options . . . . . . . . . . . . . . . . . . . 183

7.6.2 Vertical integration . . . . . . . . . . . . . . . . . . . . . . . . . . 185

7.6.3 Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186

7.6.4 Alliances and joint ventures . . . . . . . . . . . . . . . . . . . . . 189

7.6.5 International expansion . . . . . . . . . . . . . . . . . . . . . . . 190

7.6.6 Corporate generics to business generics to options . . . . . . . . 192

7.7 Strategy choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193

168 Chapter 7. Strategic options and strategic choice

7.7.1 Shareholder wealth . . . . . . . . . . . . . . . . . . . . . . . . . 194

7.7.2 Performance gaps . . . . . . . . . . . . . . . . . . . . . . . . . . 197

7.7.3 The portfolio choice . . . . . . . . . . . . . . . . . . . . . . . . . 198

7.7.4 Product and market familiarity . . . . . . . . . . . . . . . . . . . . 198

7.7.5 Risk and risk aversion . . . . . . . . . . . . . . . . . . . . . . . . 199

7.7.6 Contingency planning . . . . . . . . . . . . . . . . . . . . . . . . 201

7.7.7 Managerial perceptions . . . . . . . . . . . . . . . . . . . . . . . 202

7.7.7.1 Attitude to external dependence . . . . . . . . . . . . . 202

7.8 Choice: is it rational? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203

7.9 Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204

Learning Objectives

• To develop a structure within which rational choice can be made

• To apply the SWOT framework in a strategic setting

• To define generic strategies

• To identify strategic options

• To relate managerial perceptions to strategy choice


7.1. Strategy choice in the process 169

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 inwhich 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 simplycarried along by the force of events, perhaps ending up with a dominant market positionas the result of good fortune upon which it then capitalised; this is consistent with theemergent view of strategy, or logical incrementalism. In other instances choices weremade but on such a non structured basis that no general lessons can be drawn from theexperience. The difficulty of applying the scientific approach to strategy was discussedat Chapter 1 Section 3; a related issue is that the problem of drawing lessons from theexperience of companies is compounded by the fact that different perspectives on thesame choice can come to the conclusion either that the outcome was fortuitous or thatit was the result of a structured choice approach. This is partly due to the difficulty ofdetermining 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 tosuperimpose a structure on a series of events which, at the time they took place, wereunstructured.

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 thecompany formulated.

• The macroeconomic environment has been evaluated to determine the likelycourse of business conditions.

• The markets within which the company operates, or intends to operate, have beenanalysed.

• The internal operation of the company has been examined.



However, no matter how detailed and sophisticated the analysis has been, it has notgenerated an automatic course of action; what the analysis has done is to identify manyrelevant factors and estimate their relative importance, thus providing the basis on whichan informed choice can be made. The next step is to develop a structure within whichthe outcome of the analysis can be utilised in order to arrive at that informed choice.

7.3 Strengths, weaknesses, opportunities and threats

The profiles of environmental threats and opportunities (ETOP), and company strengthsand weaknesses (SAP), contain a great deal of information which is relevant to strategychoice, and the first step is to combine the profiles to identify where matches occurbetween the two. This is the crucial step in linking the analysis of the environment withthe analysis of the company: can we identify where company strengths are alignedwith market opportunities and where environmental threats are aligned with companyweaknesses? This is known as an analysis of strengths, weaknesses, opportunities andthreats (SWOT). For example, a company might have identified a threat arising from theentry of foreign competition due to the relaxation of trade barriers; corresponding to thismight be a weakness in company marketing, where the sales force has recently beendepleted and the distribution system is already having difficulty in delivering orders ontime. 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 capacityto counter the threat at the moment. The combination of internal and external analysisrevealed that strengthening company marketing is an issue of crucial and immediateimportance. SWOT analysis is an essential first step in assessing what the companyneeds to do to protect its current market position, and in identifying potential strategicthrusts 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 Opportunities

City centre location Increasing personal expenditures

Reputation Increase product range

Weaknesses Threats

No scope for physical expansion Out of town shopping centres

High level of gearing City centre transport restrictions

The SWOT analysis illustrates the dilemma facing many city centre department storesat a time when shopping habits are changing. The strengths of location and reputationare aligned with the fact that people are spending more on shopping, and the rangeof products on the market is increasing. However, the weaknesses identify a set ofconstraints on capitalising on this alignment, because in the city centre there is no roomfor expansion while the company will find it difficult to finance additional investmentbecause of previous borrowings. Furthermore, the threat of out of town shoppingcentres, which have arisen because of increased car ownership and mobility, coupledwith increasing restrictions on car use in city centres, means that not only will it be


7.4. Generic strategies 171

almost impossible to capitalise on the opportunities, but the company itself is underserious competitive threat.

To some extent the deductions which are drawn from the SWOT analysis will dependon how decision makers rank the various entries in the matrix. But one option appearsparticularly attractive: sell up and take the reputation out of town where the market isheading. The reputation is the only really valuable asset the company has and therevenue 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 4.7and Exercise 5.1 for Year 2. Assess what action the analysis suggests the companyshould take.

7.4 Generic strategies

A dictionary definition of ‘generic’ is ‘applicable to any member of a group or class’.Generic strategies are therefore associated with broad classifications of strategy; inmilitary terms this would involve being an aggressor or defender, or perhaps choosingto be neutral. The business generic strategy options are represented differently atcorporate and business levels.

• At the corporate level the generic options are related to the scope of the companyand the directions it will pursue, for example the development of new products orthe acquisition of companies to increase the product portfolio. It is at this level thatthe overall definition 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 itscompetitive advantage; without a clear idea of the generic strategy which it is pursuing,a company is likely to end up with no identifiable strategy with the result that it will lackdirection and strategic intent.

7.4.1 Corporate strategy concerns

The concerns of corporate strategy vary among companies depending on their degreeof diversification, their geographical scope, their number of products and so on. Themain 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



• monitoring and controlling performance

In a single product company there will clearly be little stress on managing the corporateportfolio, while in a large multi product company business level strategy will tend to be leftlargely to managers of strategic business units. Some of these concerns are discussedbelow.

7.4.2 Corporate decisions on company size

Reverting to the military analogy, the ultimate generic option is whether to go to war ornot; having gone to war, generic options include whether to attack or defend, to wagewar 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 beundertaken. In the case of business, generic strategies are concerned with issues suchas what business the company is in, how diversified it should be and whether it shouldaim for horizontal and/or vertical integration; within the framework of these choices it isuseful to think in terms of stability, expansion, retrenchment, or combinations. At firstsight, 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, orchange the mix of its activities. However, in strategy terms the choice should have beendetermined by the outcome of comprehensive analyses of the economic environment,the market and the company itself, with managers being explicit about which genericalternative they are pursuing and why.

The definition of the generic options of stability, expansion and retrenchment raises anumber of problems because there are so many dimensions of company performance.By and large, these ideas relate to the scale and scope of a company’s operations.For example, for a single product company expansion can be defined as attemptingto increase market share and, hence, total revenue; a more ambiguous case wouldbe the attempt to increase total revenue by increasing the quality and the price ofthe product, which could lead to a lower volume of output and hence lower marketshare. For a multiple product company expansion relates to the revenues from theindividual products, together with the introduction of new products. It is important tobe clear about what the strategy options are NOT. For example, an expansion strategycannot be defined as increasing profitability, which can be the outcome of the efficiencywith which the company has achieved its objectives. Increased profitability could beachieved by contracting the company’s activities, and therefore could be associated witha retrenchment generic strategy. The generic strategy is one of the means by which theend of profitability may be achieved.

7.4.3 Stability

The initial inclination is to regard this as being ‘no change’; however, the fact thatmanagers do not perceive objectives in terms of increasing markets, introducing newproducts or acquiring new businesses, does not mean that the company is in a steadystate. An analysis of external and internal factors may have revealed one or more of thefollowing.

Relatively small performance gap

An analysis of where the company is now and where it is hoped to be in, say, three years’



time may have revealed that the actual and desired states would converge without anysignificant change in the company’s strategy.

Markets are mature

Portfolio analysis may have revealed that current markets are no longer in their growthstage and that further expansion of market share is unlikely to pay dividends. Analysisof product life cycles may have revealed that current products have relatively long lifecycles; in the meantime there is no need to invest in new products to take their place.

Internal weaknesses

An analysis of the efficiency with which the company allocates its resources mayhave revealed that production processes are based on out of date equipment, thatinventories could be reduced, that inadequate training is being undertaken and thatlabour productivity is falling. As a result unit costs are higher than they need be, and if thecompany were to embark on expansion it would rapidly find itself at a cost disadvantagecompared with its competitors. The stability strategy is therefore primarily concernedwith increasing efficiency, investment in labour-saving capital, the introduction of just-in-time procedures and other actions which will bring costs under control.

Unstable financial history

The previous record of the company may have been characterised by marked swings inprofitability and dividends paid to shareholders. As a result managers may feel that theshare price is not a proper reflection of the true value of the company and that there is adanger of hostile take-over. One way to generate a stable track record may be to makeno significant investments.

Poor economic prospects

Analysis of the national and international economy may have revealed that the businesscycle is on the downturn, that markets are likely to decrease, and the company shouldprepare itself for increased competitive pressure as competitors attempt to maintain theircompetitive position.

Competitive threat

The elimination of trade barriers may have opened up the prospect of increasedcompetition from foreign companies who are known to be more efficient at marketingand producing quality goods on time. Managers may consider that the company has tomarshal its resources in order to meet this perceived threat, rather than dissipating themon relatively unknown prospects.

Perceived costs of change

Expansion is usually associated with change and individuals are often averse to changein organisations. One way of attempting to avoid the painful effects of change is topursue a strategy of stability. The trouble is that stability does not guarantee a staticorganisation, many companies having found that they must initiate significant changesmerely to maintain their market position. The generic strategy may be pursued for thewrong reason; the longer such a philosophy survives in a company the more difficult itwill become to introduce the changes which will ultimately be forced on it.



Managers averse to risk

Managers may feel that the prospect of loss greatly outweighs potential gains fromexpansion. If the company is already perceived as being successful, there is a decidedattraction to carrying on with what has been done in the past rather than embarking onnew enterprises.

Even to maintain their market position is an achievement for many companies in arapidly changing competitive environment. In fact, at any one time the great majorityof companies are likely to be pursuing a generic strategy of stability. This might well beaccompanied by substantial internal changes which are necessary in order to maintainmarket 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 theunderlying forces which lead to expansion at the corporate level. There are severalreasons 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 growthstage 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 companyas a whole. Whether diversification actually does reduce the risks facing the companyis another matter; some of the issues relating to diversification of risk were discussedat Chapter 5 Section 11.3. Whatever the rights and wrongs of this method of dealingwith risk, there is no doubt that the desire to diversify risk gives management a strongmotivation to expand.

Searching for competencies

A line of business may fit with the perceived competencies of the company, and althoughthe expansion does not meet normal investment criteria, in the eyes of corporatemanagement it may contribute to the company’s long run competitive advantage.

Economies of scale

Investigation of the cost structure of the company and its competitors may suggestthat there are significant economies of scale to be exploited. In a mature industry theadditional sales can only be achieved by increasing market share at the expense ofcompetitors; in a growing market it is necessary to grow faster than competitors if adominant market position is to be achieved.

Experience effects

This is similar to the economies of scale case, with the qualification that the potentialadvantage is only available for a limited period.

Building advance capacity

It would not be surprising to find many companies following an expansion strategywhen general economic conditions are improving. However, by the time that economicconditions start to improve, it may be too late to expand because of shortages of



capital and labour. Some companies take the opportunity of a recession to expandtheir operations in order to be ready for the next upswing.

Managerial motivation

In some companies the remuneration of top management is related to total revenuerather than profitability. This naturally leads to a preference for expansion over stability.Managers who are not rewarded on this basis may still regard their personal longterm success as largely dependent on being responsible for a growing company. Itis expanding companies which catch the headlines; the managers associated withexpansion benefit from the aura of success.

Managerial perception

There is a widespread feeling among managers that if a company is growing it must bebasically healthy, but a company which is pursuing an expansion strategy for the wrongreasons could be weakening its long term competitive potential.

7.4.5 Retrenchment

Under this heading come the notions of downsizing, delayering and restructuring. Theseinitiatives are undertaken in the quest for a more efficient organisation either in termsof shedding businesses which are not seen as part of the company’s core competenceor in terms of enhancing labour productivity. This is the strategy which many managersoften do not want to be associated with because it implies that mistakes have been madein the past. This is why many companies find it necessary to appoint a new CEO whenretrenchment is necessary, or to use independent consultants to advise on retrenchmentpolicies. But if the notion of retrenchment can be divorced from that of profitability,and the emotive objections overcome, it can be demonstrated that retrenchment is notnecessarily 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 replacementsavailable to which the company can divert resources. Managers may decide it is better towait and see whether new products can be developed in the areas in which the companyhas 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 areasin which they have little experience. Subsequently, it may transpire that some of theacquisitions are ‘dogs’, using the BCG definition. Since such products are almostimpossible to salvage because the costs of increasing their competitive advantage faroutweigh 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 onsome customers. This can arise from maintaining a production, sales and distributionnetwork which incurs very high marginal costs, while the revenue from many customersis relatively low due to competitive pressures. If, in economic terms, it is found that themarginal cost exceeds the marginal revenue, the remedy is to cut back on the scale ofoperations. 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



be offered to get the order in the first place, or because resources were already workingat full capacity and filling the order caused disruption. Retrenchment for this reason willtypically increase profitability because losses at the margin are eliminated.

Retrenchment can therefore be associated with rationalisation and a drive to greaterefficiency. These positive reasons need to be distinguished from retrenchment causedby a series of poor decisions which managers attempt to counter by selling productiveassets to boost short term cash flow, or imposing economies on the organisation whichprovide no more than a temporary solution to cash flow problems.

7.4.6 Combination

There are two ways of looking at combination strategies. First, they occur when amultiple SBU company is pursuing different generic strategies in relation to individualSBUs, making it is impossible to characterise the generic strategy for the company asa whole as stability, expansion or retrenchment. Second, the company can pursuea different generic policy sequentially, so that the current generic policy can only beinterpreted 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 marketsmay reveal that some resources could be put to better use and that they should beredeployed. However, in order to release these resources it may be necessary to reducesome current activities by way of a retrenchment strategy. The period of retrenchmentmay be protracted, depending on the circumstances. The overall generic strategy maybe stability or expansion, depending on the markets into which the company is divertingresources.

Product portfolio

Because of the unpredictability of product successes and failures, and the objective ofmaintaining a portfolio, the company may have no alternative but to go through periodsof expansion and retrenchment. Furthermore, at any time the multiple SBU companyis likely to find that some SBUs are expanding and others are in retrenchment simplybecause of their individual product portfolios.

If a sufficiently long term view is taken, it could be argued that all companies pursue acombination 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 influences outlined above will partly determine which generic strategy a companywill follow in the pursuit of its objectives. The question naturally arises of what criteriaought to be employed in deciding which generic strategy to pursue, given that in anycircumstance there will be influences acting in different directions. The question whichshould be asked is ‘Which generic strategy will add most value to the company?’ Thisfocuses attention on the ultimate objective of the company rather than on the meansby which the objective might be achieved. It is illogical to opt for expansion if it is likelyto reduce the value of the company, or if retrenchment would add value. In spite ofthe emotive implications of the generic alternatives, the distinction between means andends must be maintained; otherwise the company will find itself embarking on a course



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

7.4.8 Allocating resources among SBUs

The allocation of resources among businesses is not only an important activity, but itdistinguishes a divisionalised company from one which is merely a financial entity, ora holding company. The subsidiaries of a holding company usually determine theirown financial policy, and use retained profits for investment and pay the residual to theparent company for distribution as dividends. In the divisional company the head officedetermines financial policy, all profits being returned to corporate headquarters which inturn makes decisions on investments and the sources of finance.

Important roles of the centre are to ensure that the individual spending plans ofthe divisions are within the overall borrowing limit of the company and to allocateinvestments among divisions where there are budgetary constraints; this is known ascapital budgeting.

The problem confronting the centre is to devise capital budgeting rules for allocatingresources which are efficient and consistent. This is by no means an easy task becausearbitrary rules can produce inconsistent outcomes. The problem is unlikely to beresolved by adopting a formally correct method such as allocating resources on thebasis of the Net Present Value because, in cases where there is capital rationing, theformally correct answer can lead to the selection of a group of investments which do notnecessarily include those with the highest NPVs; it is difficult to convince managers thattheir ‘excellent’ investment proposals are unacceptable because of the application of amathematical 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 difficultto 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 variousdimensions. While profitability is clearly very important, other measures include growthof sales revenue, operating margin, market share and customer perceptions of value formoney. Furthermore, performance targets can be set on a short term basis, say everymonth 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 thatthe incentive system is aligned with the performance measures: there is little point tosetting medium term market share targets when remuneration is based on short termprofitability. In fact, in markets where change is rapid and technology is developing fast itis important that the incentive system does not stifle innovative behaviour; this can arisewhen the measures used refer primarily to the past when what is required is a forwardlooking set of targets; unfortunately, these can be extremely difficult to quantify in suchconditions, and the best that may be possible is to identify a series of milestones whichestablish dates for particular stages in the development of a product life cycle.



Exercise 7.2

Assess SuperTools’s 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 twoSBUs producing the two products.

7.5 Business level generic options

The focus here is on the effective exploitation of individual product markets as opposedto the overall resource allocation problem facing corporate level strategists. Thisis the responsibility of the SBU, which may have a product portfolio of its ownto consider. The generic approaches can be classified according to the strategyadopted towards individual products, or the strategy approach adopted by the SBUtowards the exploitation of a group of products. At the product level, the focus is onachieving competitive advantage in a given market. Porter1 identified three main genericstrategies: overall cost leadership, differentiation and focus.

7.5.1 Low cost leadership

The objective is to achieve a situation where unit costs are significantly lower than thoseof other companies in the industry, thus producing higher profits than competitors andthe ability to mount a defence against competitive threats. This strategy is partly basedon the BCG concept of the advantage conferred by relatively high market share; thiscost advantage derives from those economies of scale and experience effects which, bydefinition, are not available to smaller companies.

The strategy implies two specific preoccupations. First, the company must attempt togain 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 strategyof cost leadership when existing industry giants control 80 per cent of the market.Second, the company must be continually concerned with efficient resource allocationand be at the forefront of technological developments which have the potential to reducecosts. Once it has achieved a cost advantage the company will be continually concernedwith its maintenance; it would be a serious mistake to assume that economies of scaleand experience effects will automatically confer low cost advantage on the company forever. For example, it has already been stressed that experience effects are transitory,that competitive conditions continually change with the result that economies of scaleare always under threat and that international developments can lead to the entry ofpreviously excluded efficient producers.

The cost leadership strategy can be seen as an investment process. Costs areincurred initially in winning market share and setting up efficient production techniques.Subsequently the net cash flows will be higher than they otherwise would have beenbecause of the unit cost advantage.

Although a company successfully implements a low cost leadership strategy andproduces a cash cow there is no guarantee that this will result in a sustainablecompetitive advantage. While the company will benefit from economies of scale andexperience effects technology is continually developing and cost advantages can be


7.5. Business level generic options 179

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 muchthe same things and the main difference between them is price. Over the years marketdominance has shifted from one company to another as the ability to produce thesecomplex machines has changed in relative terms.

7.5.2 Differentiation

The effect of product differentiation was discussed at Chapter 4 Section 4.6.1, wheredifferentiation made it possible to generate profits by segmenting the market andenabling different prices to be charged in different segments. In this case there is lesspreoccupation with market share because the company is continually redefining themarket; it may in fact have 100 per cent market share in the segment for the particularcombination of differentiated characteristics which it has produced. Therefore, sincethe 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 forthe additional costs incurred in differentiation and it would be irrational to ignore costbehaviour altogether; however, the overriding objective is not to produce at a lowercost than competitors, but to produce something which is seen as being different fromcompetitors.

The strategic process involves searching for and adding some characteristic such assuperior quality or service associated with the product; it may not be a real effect, butmay be an image consciously created by the company. The salient characteristic of thestrategy is that the company is primarily concerned with capitalising on the perceivedcharacteristics of the product. This approach can be adapted to identify product positionby plotting the main differentiating variables against each other and locating both thecompany’s and competing brands within it. For example, brands of Scottish malt whiskyare usually described in terms of their ‘smoothness’ and ‘peatiness’ (if you don’t drinkwhisky you just have to take this on trust). Some of the eighty or so brands of maltwhisky are plotted in Figure 7.1.

Figure 7.1:

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



characteristics are plotted in this way.

In the eyes of consumers there are significant differences between brands, but thispositioning picture does not tell one important item of information: how much more arepeople prepared to pay for more ‘peatiness’ or more ‘smoothness’ or some combinationof the two? Market research may provide some insights into the optimum price, but itis largely a matter of judgement. This amounts to selecting the preferred position in theperceived price and quality matrix; but there may well be a significant difference betweenthe company’s preferred position and how the product is regarded by consumers.

7.5.3 Focus

The previous generic strategies involved different ways of meeting competition andachieving an advantage: in the first case this was by lower costs; in the second,by altering product characteristics. The focus strategy is different in that it typicallyinvolves the identification of market niches where it is possible to avoid confrontationwith 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 marketshare. The niche may be a part of the market which requires specialised attention,very fast guaranteed delivery, or some other characteristic which high volume producerscannot provide because of the homogeneous nature of their product.

Once a company has established itself in a niche it can potentially make a high rateof return because it is able to avoid direct competition with large companies and ineffect act like a monopolist; this lack of direct competition can lead to inefficiencies inproduction and what might appear to be a bizarre marketing strategy. The Morgan carcompany in the UK makes somewhat eccentric sports cars that appeal to a minority ofenthusiastic drivers. For many years the cars were partly hand built and the factory wasantiquated with virtually no attention paid to time and motion. There was a waiting listof three or four years for delivery. Consultants suggested that Morgan should invest ina more efficient factory and increase production to reduce the waiting list. The directorswere not convinced because they felt that changing the build approach would underminethe perception of differentiation, while increasing production and sales could bring theminto direct competition with the larger sports car makers, against whom they certainlycould not compete. In the event Morgan invested in some production improvements butdid not significantly increase output. This is a case where the company appeared to behighly 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 specialisein a particular approach to the market; they specialise in production processes,individualised products or identifying unsatisfied consumers. A company which doesnot specialise is likely to be continuously adjusting its competitive focus in responseto changes in the market, with the result that it is ‘stuck in the middle’; such anundefined strategy is likely to be associated with relatively poor performance becausethe marketing effort of such a company is likely to be confused: at any one time itmay not be clear whether marketing managers are attempting to achieve market share,differentiate the product in the eyes of the consumer, or find unexploited opportunities.

The Morgan car company could well have ended up stuck in the middle if it had


7.5. Business level generic options 181

introduced modern production methods and aimed at a wider market: it would havelost much of its differentiation which was partly based on the eccentric approach toproduction while it would have been far too small to compete effectively at the price ofroughly comparable mass produced sports cars.

It does not always follow that low cost leadership and differentiation are mutuallyexclusive. Some companies have apparently successfully combined low cost leadershipand differentiation; Benetton manufactures highly differentiated clothes and runs aninternational production and retail chain that is highly efficient and charges relativelylow prices. The underlying reason for success is that Benetton understood what it wastrying to do whereas many companies end up being stuck in the middle because theyhave not understood the basis of their competitive advantage.

7.5.5 Generic strategies and company concerns

While there will always be difficulty in classifying companies between differentiation, costleadership and focus at the margin, companies which have explicitly adopted one of thethree will have different concerns as outlined in Table 7.1.

Table 7.1: Cost leadership, differentiation and focus: concerns

Generic strategy Concerns

Cost leadership Optimum plant size

Process engineering skills

Simple product design

Quantitative incentives

Tight resource controls

Tight financial 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 thatit will lose either its cost leadership or differentiation and end up in that unwelcoming



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 thecircumstances of the company, the positioning of its products and the past behaviourof managers. There are three main issues to bear in mind when attempting to relategeneric strategies to company performance. First, the point has already been madethat the generic strategy is a means, while company performance is the end. Thereforea stability strategy is not necessarily less profitable than an expansionist strategy andthe cost leader is not necessarily less profitable than the differentiator. Second, it hasbeen argued that the underlying measure of profitability relates to the value added byalternative courses of action which is not necessarily reflected in changes in short termcash flows. However, in some cases, value added may not be the immediate concernof decision makers; for example, a family may wish to maintain control of a companydespite the fact that its value would be increased by expansion. Third, the data donot exist on which to apply the scientific method of hypothesis testing. Therefore, anyconclusions drawn on the most appropriate strategy are likely to be heavily conditionedby the experience of the individual strategist.

Exercise 7.3

1. Combine the generic strategies of differentiation and cost leadership with the Milesand Snow categories of prospector, analyser, defender and reactor to identify thelikely emphasis of a company on new product market growth. You will have to setup a matrix with generic strategy on one axis and type of strategist on the other.

2. What benefits do you think would be gained in real life from classifyingorganisations in this way?

7.6 Identifying strategic options

The generic strategies provide the framework within which the company formulates itsindividual strategy. By the time the company arrives at this stage it will have amassed aconsiderable quantity of information on itself and its markets, on any performance gapsand on the fit between its own potential and market opportunities. It will have identifiedwhether it is expanding or contracting at the corporate level and the strategic emphasiswhich it has exhibited in the past at the SBU level. The next step is to identify whichcourses of action might be undertaken in order to achieve the identified objectives. Thisis a formidable task because the range of options from which real choices can be madeis virtually limitless. But the whole strategy process would fall apart if the decision makerwere presented with such a wide range of potential courses of action that comparisonscould not be made. There is clearly a need to set out some general principles so thatthe most relevant strategy options can be identified.

Within the context of a given generic strategy some broad classifications can serveto reduce the options which have to be evaluated. For example, a company whichwishes to pursue a generic expansion strategy can consider internal versus externalmarket development, horizontal versus vertical integration and being innovative rather


7.6. Identifying strategic options 183

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

7.6.1 Related and unrelated options

The problem of diversification, and the difficulty of generating value from diversifications,has been discussed at some length. Given this, it might seem that a relateddiversification is preferable to an unrelated diversification. There are many compellingarguments in favour of staying in the business that you know most about; for example,marketing and selling techniques are known, production processes are similar, manyadministrative and distributive overheads can be shared among similar products and thenature of the competition is well known (or it should be). But there are some reasons whyit may not be possible to expand in existing markets; for example, competitive legislationmay make any further increases in market share illegal, or the company is cash rich andhas already exploited existing markets as far as it is considered economic to do so. Takethe case of a company currently producing baby food which is faced with a decliningdemand for its product because of demographic changes. It has the option of movinginto the production of tinned food with a special appeal to young children, or diversifyinginto the production of toys; diversifying into a different type of food product appears tobe a more closely related diversification than getting involved in producing toys. Thefactor which makes both related is that they are both in markets involving children. Thetrouble 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 agreementon the contribution of related diversification to competitive advantage. The case hasbeen strongly made that this is because traditional measures of relatedness look only atthe industry or market level whereas what really matters is relatedness among strategicassets. 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 samestrategic asset; this could be a common distribution system, and in the case of thebaby food manufacturer diversifying into toys would mean setting up a distributionsystem with toy shops instead of food stores.

• the potential to use a core competence in the new SBU; this could be anunderstanding of marketing child products and it may be equally relevant to bothoptions.

• the potential to utilise a core competence to create a new strategic asset in a newbusiness faster; thus while the existing distribution system is common for bothtypes of food product, the knowledge of how to build up the system may still confera competitive advantage in the toy market.

• the potential for related diversification to expand the company’s pool of corecompetencies as it learns new skills; the lessons learned in building a toydistribution system may be relevant to the existing food distribution system.

The usual arguments in favour of related options, which are based on costs, efficiencyand market knowledge, may generate only a short term advantage because theseattributes can be replicated. The four types of relatedness above are less obviousand could provide a totally different perspective on what appears to be an unrelated



diversification, so defined because the products involved are physically different.

The arguments in favour of unrelated options have tended to be less precise and moredifficult to quantify than those for apparently related options. For example, managersmay feel that diversification reduces the risk of the company failing, or that there ispositive synergy to be gained from unrelated activities, or there may be peak loadcapacity problems which can be evened out by branching into products with a differentseasonal demand.

There is clearly much more to the issue of relatedness than meets the eye; companiesneed to take a serious introspective look prior to adopting a stance on the relationshipbetween a possible new course of action and the company’s current capabilities. Toillustrate the benefits of not taking the situation at its face value consider the case of acompany that produces industrial office cleaning equipment. It is now the market leaderin its market segment - city centre office high technology blocks - and the new CEO feelsthat the time is right to expand from this secure base. He has identified two options: toacquire an office cleaning company that mainly uses the company’s equipment or toacquire a producer of domestic vacuum cleaners. The CEO argues in favour of theformer option because, as he says ‘We know the office cleaning business and this willincrease the market for our own cleaners’. Some executives agree, some disagree,while the strategic planner argues that both options are totally misguided. The strategistargues as follows.

Four factors Cleaning service Domestic appliance

Economies of scale acrossSBUs

There is no scale potentialcombining a productionoperation with a serviceprovider

The production process ofheavy duty industrialcomponents for aspecialised market differsfrom that for light weightunits for a mass market.

Use an existing corecompetence

The skill sets are differentfor producing and marketinga product and a service

This only applies if there issome activity that thecompany already excels inthat can be used moreeffectively in the domesticappliance company

Use an existing corecompetence to create a newstrategic asset

The acquisition amounts tovertical integration with allthe problems of benefitingfrom make versus buy

The industrial and domesticmarkets are so different thatthere is little prospect ofincreasing entry barriers ineither by combining the twocompanies

Expand the pool of corecompetencies

It is difficult to visualisewhich competencies couldbe shared

There may be productionand product marketing skillsthat are complementary

The strategist has recognised that the first option is an attempt to integrate productionand service companies and the fact that they are in the same market segment isirrelevant; the second can be visualised as expansion into a position of unfamiliarproduct and market. As a result there is likely to be very little benefit from mergingthe companies in either case. Thus in terms of the competence based expansion



trajectory of Chapter 5 Section 12.4 there is little commonality between either routinesor resources with the result that both options lie in the ‘Diversification’ sector. This isprobably not a popular conclusion for the CEO and is an example of how a strategist isoften the bearer of news that conflicts with ‘common sense’ conclusions which are notbased 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 bywhich raw materials are converted into final products; some of these activities maybe related, others totally unrelated. The potential costs and benefits associated withvertical integration were discussed at Chapter 5 Section 11.4, where the question ofthe optimal degree of integration was discussed. The car company which takes over asteel rolling business is an example of backward integration, but it is unlikely that thesteel company will only produce steel for the car company itself; the further into otherparts of the production chain the company moves the less likely it will be to produceonly for, or buy only from, itself and it may find it owns a series of companies eachsupplying a different market of which the supply to the company itself at each stagemay only be a relatively small part. The vertical integration thus starts to present similartypes of problem as related and unrelated options; the company may benefit in someways from the integration, but the benefits may be swamped by the costs of unrelateddiversification.

Forward integration involves the company carrying out the functions of its customers; atypical 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 backwardintegration. For example, it is unlikely that the company is currently the only supplier forthe forward customer, and integration can again have the characteristics of an unrelateddiversification.

A variation on this strategy is to adopt the role of a captive company, where a largeproportion of output is purchased by a single customer, and that customer actuallyperforms some of the functions which would normally be carried out by the companyitself. Whether the captive company is an economically sound organisation, or whetherbeing captive is a sign of weak management, depends on the circumstances; forexample, in the car components industry many profitable captive companies haveexisted for a long time.

The crucial question which must always be borne in mind is whether, taking everythinginto consideration, the company would add value by controlling other parts of theproductive chain. The case of British Gas, discussed at Chapter 5 Section 11.4,demonstrates that vertical integration may not be an efficient option.

In the previous example the CEO had included an argument in favour of the first optionbased on vertical integration (‘� � �this will increase the market for our own cleaners’)without appearing to recognise what this implied. The strategist had recognised thatthis option amounted to a form of vertical integration with all its inherent problems. Thisis an additional reason for doubting the potential viability of the first option.



7.6.3 Acquisitions

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



Recognising unrealised value

Some chief executives have a skill in identifying companies which have not fully exploitedtheir value opportunities. The activities of such a company may be unrelated to thecurrent business of the potential acquirer, whose competence is perceived to be inadding value independent of the type of business. It is instructive to try to identify theareas in which the company’s performance might be inadequate, because unless thesecan be identified it is difficult to understand the rationale for a takeover in the first place.At its simplest level, the rationale for a takeover depends on whether the current sharevalue of the company could be increased by a reallocation of resources. Reasons for acompany 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 segmentationwhich he considers will transform the profitability of products which are currently poorcash generators.

RESOURCE MANAGEMENT HAS BEEN POOR

The predator may conclude that unit costs are higher than in similar companies and thatopportunities exist to reduce costs simply by improving resource management.

EXPECTED INCREASE IN DEMAND

The predator may expect an upturn in the demand for the company’s products becauseof an improvement in general economic conditions. The predator may feel that the targetcompany 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 toshareholder wealth; divesting them will release resources for more productive purposes.

This is not an exhaustive list of factors which may contribute to an undervalued shareprice, but it illustrates that to a large extent a predator’s motivation is based on aperception of the company which is not reflected in the market valuation. The predatormay, of course, be wrong. All the research studies in this field come to the conclusionthat takeovers rarely create value. In the majority of cases it has been found that thevalue of the bidder’s shares falls after the takeover, while many studies point to longerterm negative effects on the profitability of the acquired business units. Even in Japan,where takeovers and mergers have only become important since the mid 1980s, thereis no evidence that the activity has improved profitability or growth.

In fact it is not sufficient in itself to conclude that a company has not realised its valuepotential; certain other conditions also need to be satisfied. First, it is important thatno other potential acquirer has arrived at the same conclusion; if a competitive biddingsituation results then it is likely that all potential gains will be captured in the purchaseprice. Second, it is necessary to realise the potential gains. The four potential benefitsof parenting were discussed in Chapter 1 Section 1.5.1 each of these being associatedwith a paradox which raised serious doubts about the ability of a parent corporate



organisation to add value in the long run. It may be possible to add value on a oncefor all basis by remedying managerial weaknesses; but whether there is any gain to behad 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, aUS computer company, by AT&T, the US telecoms company. In 1991 AT & T paid $7.5billion for NCR; during the next five years it ran up losses of $2 billion before spinningNCR off, at which time it was worth about $4 billion. That cost AT & Ts shareholdersabout $5.5 billion. The CEO was not fired.

Buying market share

Take the case of a company which currently has 20 per cent market share in a maturemarket 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 shareto 30 per cent. At the moment it is operating at full capacity; therefore, in order toincrease market share, it has to invest in new plant and mount a marketing strategywhich will take customers away from its competitors. The outcome of the marketingstrategy is unknown because the reaction of competitors cannot be predicted with anydegree of certainty; the company may simply find itself involved in a price war withoutany permanent increase in market share. Not only does a takeover make it possibleto avoid the costs of the competitive thrust required to achieve the increase in marketshare, but the labour force in the acquisition will be relatively high on the experiencecurve.

Reducing competitive pressures

Governments are continually on the lookout for companies which attempt to achievemonopoly 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 notin the public interest. In any case, monopoly power does not automatically mean thatmonopoly profits will be earned, due to the influence of contestable markets discussedin Chapter 4 Section 5.3.

Synergy

There may be potential gains from sharing resources and making better use of capacity.The difficulties 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 notbeen encouraging. There are no guarantees that economies of scope will automaticallyensue.



Balancing the portfolio

Rather than introduce a new product into the portfolio from scratch, the company maybe on the lookout for a Star or Question Mark which fits with its existing portfolio andhas the potential to be developed into a Cash Cow. The issue of strategic fit is crucialhere because it is unlikely that such a company can be purchased at a discount to itstrue value, particularly if it has been run efficiently in the past. The value added bysuch a product will depend on its contribution to the long term competitive advantageof the acquiring company, probably being dependent on issues such as synergy andeconomies of scope. Unless there is an underlying value added to be gained, themere fact of adding the product to the portfolio for the sake of completeness does notguarantee that it will add value to the company as a whole.

Core competencies

The acquisition may have the potential to fit with the strategic direction of the companyin the sense that it complements the set of difficult to replicate skills and attributeson which the company’s competitive advantage is based, while being consistent withthe company’s dominant management logic. It may also be seen as fitting with thecompany’s strategic architecture in terms of the linkages in the value chain. Thesecharacteristics of the acquisition may lead to a long term addition to competitiveadvantage and hence to value added. But it is not possible to subject such an acquisitionto an analysis of cash flow implications and possible return on investment; the pointabout core competencies is that they are difficult to define and are by their nature uniqueto the situation, otherwise they would have been copied already. There is no obviousway of identifying the potential contribution to core competencies before the event, so ithas to be recognised that this option is based on a general view of the strategic thrustand how the components of the company fit, without being explicit about how the valueadded outcome will be generated.

Exercise 7.4

In the industrial office cleaning manufacturer example in Section 7.6.1 the CEO arguedin favour of acquisition. How would the strategist assess this option using each of thereasons 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, virtualcorporations, virtual functions and joint ventures. It is not the details of these whichare important so much as the underlying rationale for strategic alliances in the firstplace. It has already been noted that the success rate of mergers and takeovers hasbeen low; it is therefore important to determine whether or not this form of cooperativeaction leads to better results. Research has found no significant long term effects ofjoint venture activity on profitability in any industrial sector. Given this, the real issue iswhy companies should choose an arm’s length contract rather than entering into a fullmerger. Any form of collaboration raises the issue of game theory, and the prisoner’sdilemma discussed in Chapter 4 Section 5.1 is particularly relevant. No contract cancover all eventualities, with one or both sides always having an incentive to cheat insome way. That is probably one reason why the research has found no connection



between this form of collaboration and profitability. Alliances and joint ventures have asuperficial attractiveness that masks the underlying problems that arise as the partiespursue their own interests.

7.6.5 International expansion

There is no difference in principle in moving into a foreign market compared withopening up new domestic markets. The same considerations of strategic opportunitiesand threats and competitive advantage must be taken into account. But it has tobe recognised that competitive conditions may be significantly different in anothercountry. The competitive advantage of a company relates to its strengths relative tothe competition in the market where it currently operates. The fact that a company hasa competitive advantage in one location does not mean that it can be readily transferredabroad. An example is the Japanese car maker Honda: in Japan it had about 10 percent market share and was dwarfed by Nissan with about one fifth of the market andToyota with about one third; but for years Honda sold many more cars in the US thaneither of its big domestic competitors. The explanation is that in Japan both Toyota andNissan 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 competenciesin car engines and receptiveness to US marketing ideas to give it a clear lead in theUS. Another instance relates to the attempts by Hong Kong hotel groups to capitaliseon their reputations, which were earned in Hong Kong, for being the best hotels inthe 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 difficultto do so in the US and Britain because the essential ingredient of high quality serviceis a relatively high ratio of service staff per room; since wage rates are much higherin the US and Britain, it proved impossible to maintain the same ratio without makingthe hotel impossibly expensive. These hotels are thus at no advantage compared withestablished chains when attempting to differentiate through excellence of service.

It is therefore necessary to focus on the elements of competitive advantage whichcan be transferred. In the case of Nissan and Toyota it was not the strength of theirdistribution systems in Japan which was potentially transferable, but their knowledgeof how to build and efficiently operate large distribution systems; but because ofthe differences between Japan and the US it is doubtful if even the knowledge wastransferable. Successful hotels are more than buildings and physical features, since allhotel designers and builders are trying to produce an attractive environment; unless theservice offered is significantly different, and is perceived to be so by customers, then notransfer of advantage has taken place.

Besides the problem of transferring advantages, there are several variables whichcomplicate operations on the international scene.

• Volatile exchange rates present serious problems; some of these were discussedat Chapter 3 Section 8.1 under ‘Exchange Rate Fluctuations’. The fact thatexchange rates cannot be predicted with any certainty, and the fact that relativelysignificant changes can take place in a short period, can make nonsense ofcost and revenue predictions in foreign markets. One way of hedging againstexchange rate movements as part of an expansionist strategy is to produce asclosely as possible to consumers. This means setting up productive units inthe countries where the markets are. For example, in the late 1980s Fiskars, a



company producing knives in Finland, had the option of attempting to enter theUK market by exporting to the UK. The purchasing power parity of the UK poundagainst the Markka at the time suggested that the Markka was about 20 per centovervalued; unless the Finnish knives were reduced in price by 20 per cent theywould be relatively highly priced in the UK. Another way of looking at this is that theovervaluation caused relative production costs in Finland to be 20 per cent higherthan they would have been in the UK. An alternative strategy was for Fiskars toacquire a UK knife producer, or set up a production unit in the UK, thus insulatingitself against variations in the exchange value of the pound. In the event, Fiskarspurchased 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 labourto the cost of capital is lower in the US than in Europe, leading to more capitalintensive production in Europe. It may be more efficient to shift the production oflabour intensive goods to the US to take advantage of the relatively cheap labour

• Productivity varies widely among countries. For example, for many years the UKhad a lower output per worker in the manufacturing sector than any other majorcountry in the European Community. To some extent this was overcome in the1990s, when the UK experienced the highest growth in productivity in Europe.This increase in productivity was spearheaded by new Japanese car plants whichwere able to overcome restrictive labour practices. But in those industries in whichproductivity is still relatively low companies may find it more efficient to producegoods outside the UK.

• Governments often protect home production. This takes many forms, including theminimum domestic content requirement. Protectionism can make it necessary toset up productive units in a country which would otherwise not be attractive.

• Cultural norms can vary fundamentally by country and are ignored at thecompany’s peril. For many years the Ford Motor Company in the UK attempted tomanage its factories using the management philosophy and approach (and manymanagers) of the US. This contributed significantly to a decade of labour problems.

• The economies of different countries rarely move exactly in step, and thereforethe information gathering and interpreting function is greatly increased with eachadditional foreign market. This issue should not be underestimated, given theimportance of relevant information to the identification of opportunities and threatsand the formulation of strategy.

This is a formidable list of risk factors, any one of which has the potential to underminethe viability of the international move. The ScottishPower entry to the US energy marketwas discussed at Chapter 5 Section 12.4, and explicit treatment of the internationalaspects adds another dimension to the strategic context.



Risk factor Observation Risk levelVolatile exchange rates Both production and sales

were in the US so variableexchange rates had noimpact on profitability

Low

Relative factor costs While relative factor costsvary between the US andUK the issue is whetherPacifiCorp was locallyefficient

Low

Productivity differences So long as productivity inPacifiCorp was as high asits competitors there was nodisadvantage

Low

Government The regulatory framework inthe US was totally differentand ScottishPower had littleexperience of thisenvironment

Medium

Cultural norms ScottishPower sentmanagement teams to theUS to improve workingpractices and increaseoperating efficiency

High

Different economies In the event there was anenergy crisis in Californiathat led to significant losses

High

PacifiCorp was eventually sold for about £400 million less than had been paid for it andthe ScottishPower share price increased significantly 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 tobusiness generics and options is illustrated in Table 7.2.


7.7. Strategy choice 193

Table 7.2: From generics to options

Genericstrategy

Options

Corporate

Expansion � Investment Merger Alliance

Stability � Cost control Defend Restructure

Retrenchment � Downsize Divest Rationalise

Business

Cost leadership � Economies of scale Technology

Differentiation � Branding Segmentation

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

Exercise 7.5

Imagine you are the CEO of a successful machine tool business which is currentlylocated in the UK. You have amassed a large cash reserve, and you have to decide forthe next AGM of shareholders whether to recommend paying the cash out in dividendsor expanding the business. What are the main pros and cons of pursuing each of thefive strategic options discussed above? Set out your argument in the form of a matrixwhich identifies 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 theidentification and selection of the strategy option which maximises shareholder wealth.Since a full analysis of expected future cash flows would have taken into account risksand uncertainties, the selection of the optimum strategy could be regarded as moreor less automatic; it would be, after all, irrational to select a strategy which does notproduce the highest possible shareholder wealth. In principle, therefore, all steps in theprocess of strategy choice should be directed towards identifying this option.

Unfortunately, while shareholder wealth is an important conceptual benchmark to usein evaluating strategies, the real world is too complex to be expressed in the form of asingle value which represents the optimum strategy; there are at least two reasons forthis.

1. The future is too uncertain to be captured in a cash flow projection. Thus whilemost strategy writers concern themselves with the idea of value creation, there isno 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 shareholderwealth analysis can quantify a well defined course of action, while strategy must be



framed in such a way as to be feasible for those carrying it out and must take intoaccount the many intangible factors which affect decision making. Many factorswhich intervene make the connection between proposed courses of action andthe impact on shareholder wealth difficult to identify.

Since maximisation of shareholder value is simply the outcome of delivering long termcompetitive advantage a strategic option which is to perform this function must satisfy anumber of selection criteria.

Consistency with objectives: an option may appear to be attractive, but it may not fitwith the company’s stated objectives. For example, the objective may be to achievemarket dominance in the domestic market, hence international expansion would not beconsistent.

Suitability in terms of company resources: SWOT analysis is of crucial importancein determining suitability, because the point of the SWOT analysis is to identify thealignment between company strengths and market opportunities. For example, acompany may have a particular strength in cost control systems, but this may not fitwith the market opportunities for differentiated products.

Feasibility: to some extent this is a matter of alignment, but even if the organisationhas the resources the changes required to implement the option may be impossibleto achieve; in addition, the commitment of key personnel must be obtained. Even if anoption appears to be consistent and suitable, the intangible dimensions of organisationaldevelopment may make it unworkable.

The following discussion focuses on the factors which bear on the actual process ofarriving at a choice of strategy.

7.7.1 Shareholder wealth

It is instructive to consider how shareholder wealth can be determined by the choice ofstrategy, and why it is important to bear in mind the potential implications of a choicefor shareholder wealth despite the problems inherent in its calculation described above.For example, it is often assumed that expansion will deliver higher shareholder valuethan retrenchment in the medium term, but this is by no means the case. Consider thefollowing example which shows the net cash flows generated by three corporate genericalternatives: the cash flows vary up to the end of the planning horizon and are thenassumed to be constant in perpetuity. This makes it possible to calculate the NPV ofeach cash flow stream at 15 per cent cost of capital.

Table 7.3: Strategy options and shareholder wealth ($million)

Net cash flows for year

Strategy Shareholder wealth(NPV)

1 2 3 4 5 +6

Stability 857 100 110 120 130 140 140

Expansion 1041 -100 50 210 200 220 220

Retrenchment 973 500 70 80 90 100 100



The potential net cash flows from the three options have been derived from analysesof markets, competition, opportunities, threats, environmental factors and so on. Takingeach generic alternative in turn:

Stability is based on carrying on as at present, and exhibits a constant growth incash flow 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 ofnew products, and a marketing strategy designed to achieve significant market sharesby Year 3. By that time cash flow will be almost twice as high as in the stability option.Despite the substantial cash outflow in the first year, and the low cash flow in the secondyear, the expansion option produces an increase of $184 million in shareholder wealthover the stability option. While it may be concluded that the expansion option is anautomatic choice over stability, managers may be unwilling to face the prospect of twoyears of cash flow problems, with its adverse short term profitability reports.

Retrenchment might arise because the company has discovered that by disinvestingit can concentrate resources on the longer term development of its core business.Therefore, although cash flows will lag behind those of the other two options from Years 3to 5, the large positive cash flow in Year 1 from divesting part of the business contributesto 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 theimplications of the expansion option, then retrenchment has decided value advantagesover the stability option.

One of the conceptual difficulties of the shareholder wealth approach is that it collapsesall future expectations to the present. It may appear odd that the different long termprospects of the expansion and retrenchment options beyond Year 5 are associatedwith much the same shareholder wealth at the present; the expansion option impliesa company with a portfolio of products with relatively high market shares and anequilibrium long term cash flow more than double that of the retrenchment option. Thisarises because of the discounting process which takes into account the opportunity costof capital and the fact that no further growth in cash flows is assumed after the end ofthe planning period. If managers conclude that the planning period does not adequatelytake into account the longer term implications of the different strategies then the planningperiod itself can be amended accordingly; however, this does not alter the principles onwhich the analysis is based.

A further powerful application of shareholder wealth analysis is to break down theactivities of the company and estimate the contribution which each makes to the totalvalue of the company. For example, in the retrenchment example a part of the companyhad been identified which was subtracting from shareholder wealth; by getting rid of itshareholder wealth was increased.

Take the case of a company which has three SBUs, the largest of which produceswashing machines, the second largest provides maintenance services and the smallestis engaged in contract cleaning services. This company may regard the productionof equipment as being the ‘core’ business on which the others are built. However, asoften happens, the maintenance and contract cleaning SBUs develop markets whichare independent of the equipment which the company produces and start to behaveas independent entities. The question then arises of identifying which SBUs are



contributing most to the value of the company as a guide to future resource allocation.This type of situation is represented by the example in Table 7.4, which uses the stabilityoption in the previous example disaggregated into three SBUs. Obviously there areproblems associated with allocating costs to the SBUs, but for the purposes of theanalysis this is assumed to be relatively unimportant.

Table 7.4: Resource allocation and shareholder wealth ($million)

Year

SBU Shareholderwealth

1 2 3 4 5 +6

1 Revenue 500 530 540 560 580

Cost 480 495 520 530 540

Cashflow

227 20 35 20 30 40 40

2 Revenue 200 205 220 225 230

Cost 165 170 170 275 190

Cashflow

271 35 35 50 50 40 40

3 Revenue 75 85 110 110 120

Cost 30 45 60 60 60

Cashflow

360 45 40 50 50 60 60

Total Cashflow

857 100 110 120 130 140 140

The current and future revenues from selling products and services are dominated bythe ‘core’ business of SBU 1; it generates about two thirds of company revenue andincurs about two thirds of total cost. However, it has the lowest shareholder wealthof the three SBUs, while the smallest SBU of the three in terms of total revenue hasthe highest shareholder wealth. Taking the costs in Year 1 as an indication of the totalallocation of resources, the mismatch shown in Table 7.5 emerges between resourcesdeployed and value created.

Table 7.5: Resource allocation and value creation (%)

SBU1 SBU2 SBU3

Shareholder wealth 26 32 42

Resource allocation 71 24 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 45per cent of resources and produces 42 per cent of shareholder wealth. Because SBU1 is seen as the ‘core’ business, it is likely that managers devote more than 71 percent of total management time to trying to make it pay. In choosing among strategyoptions, management ought to address the following questions. First, are the activities



of SBUs 2 and 3 really dependent on the production of washing machines? If noclear linkages among products can be identified it is unlikely that producing them inthe same company produces value over and above what could be achieved if they wereproduced independently. Second, if not, should resources be reallocated from SBU1 to SBUs 2 and 3? It could turn out that the long term future of the company liesin providing maintenance for a range of manufacturers and pursuing further contractcleaning possibilities. However, at the moment, it is likely that these SBUs are starvedof resources and managerial inputs because of preoccupation with the ‘core’ business.

It must be stressed that shareholder wealth analysis at this aggregate level can onlybe indicative of the value creation activities of the company because of the need tomake arbitrary assumptions about the allocation of joint costs and predictions of futurecosts 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 thefact that a company may be oblivious to the evolving nature of its business and may beencumbered with a management which developed the company through its initial stagesbut cannot now see beyond that.

While Shareholder Wealth analysis is clearly an important tool in those cases wherethe future can be estimated with some degree of certainty, focusing attention on thepotential of different courses of action to generate value, there is still a need for toolswhich 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 companycarried on as at present and the desired outcome. The desired outcome itself wouldbe an amalgamation of company characteristics designed to meet overall companyobjectives; for example, in the shareholder wealth analysis there may be severalstrategies which would accomplish the expansion option. In this case the companywould wish to have additional products and higher market shares by Year 5 than wouldoccur if no changes were made to current policies. The identification of this desiredfuture state greatly narrows the range of feasible strategic options. The application ofgap analysis therefore has immediate benefits by identifying the appropriate optionsfrom which the strategy choice ought to be made.

• The gap identifies whether the company should be pursuing a generic strategy ofstability, expansion or retrenchment.

• The extent of the gap indicates whether the company has to undertake a significantreallocation of resources in order to close the gap; for example, the company mayhave specified an ambitious objective in terms of market share, but it may turnout that the gap is relatively small and that closing the gap does not involve asignificant change in direction.

• Within the generic strategy the ways of closing the gap can be identified; forexample, 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 wheremanagers would like it to go, the gap approach reduces the array of strategy alternativesto those which have direct relevance to the company’s objectives and to its potential



capacity. What might appear to be a painfully obvious process requires managers tostep back from the actual running of the company and identify in an objective manneroptions which might not be intuitively obvious were the gap not identified in the firstplace.

7.7.3 The portfolio choice

When the company is comprised of a portfolio of products, the problem facing corporatemanagement is to decide on the components of the portfolio while SBU managementis concerned with the management of the products selected. The portfolio approachdeveloped at Chapter 4 Section 8 is fundamental to this issue, the role of corporatemanagement being to attempt to select the optimum portfolio of products for thecompany. 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 mostobvious strategy option is to eliminate the unprofitable Dogs. Beyond this it becomesdifficult to lay down hard and fast rules for using the BCG matrix. The company needsto have Stars to replace the Cash Cows when they come to the end of the productlife cycle; but how many and of what type depend on their fit with the existing portfolioand 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 maturesand ceases to grow, the Question Marks cannot be transformed into Stars without asubstantial investment in resources. Projections of the product life cycle and the reactionof competitors are necessary before making a choice of which Question Marks to pursueand which to abandon.

A complicating factor is that the company may have to make a strategic response toother companies which are developing their portfolios. For example, everything mightdepend on who is first to transform a Question Mark into a Star; a potentially attractiveQuestion Mark may have no future because of the early action of a competitor; or thecompany may have to abandon a Question Mark because a Cash Cow is coming undercompetitive 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. Forexample, what is known about the product markets and the technology involved in thechoice? An increase in the number of products which involves entry into new marketsposes an array of new uncertainties for the company because it is venturing out of itsestablished markets and products, and typically into new technologies. The resultingportfolio may be balanced in the BCG sense, but be comprised of a number of unlinkedproducts. The risks involved can be clarified by estimating the degree of familiarity withmarkets and technologies as shown in Figure 7.2.



Figure 7.2: Familiarity matrix

It is important for management to be aware of the extent to which the choice is likelyinvolve the company in situations about which it has a limited amount of informationand experience. A choice in the top right quadrant ought not to be undertaken withoutconsideration of the extent to which company resources are likely to be able to deliverprofits in an unfamiliar environment.

7.7.5 Risk and risk aversion

Strategy decisions are by their nature forward looking; therefore all strategy optionsare uncertain. Choices are continually being made among options which are uncertainin different degrees. It is not sufficient to carry out a sophisticated discounted cashflow analysis of an investment and make decisions based on the highest expected netpresent value. All managers are concerned about the chances that events will actuallyturn out as they have been predicted and would like to know the specific risks associatedwith different outcomes. In extreme cases managers should be able to deal with riskfairly confidently; for example, in the UK, advertisements appeared for investments inostrich farming. The investment involved buying one or more ostriches to be cared foron a farm and which would produce chicks to be sold on. The advertisements offered58 per cent return per annum. On the face of it this was a highly risky investment fortwo reasons. First, the rate of return clearly had an enormous risk premium, given thatthe rate of interest at the time was about 6 per cent; second, up to then the sale ofostrich meat for human consumption in Europe was not significantly greater than zero.The astonishing thing was that, although no financial institutions were willing to investin ostriches, many individuals committed significant amounts of cash to the venture; itcame as no surprise that the business turned out to be bogus. However, this is anextreme case and the choice is not typically so obvious: managers are faced with theproblem of making trade-offs between the prospect of varying returns and possibilitiesof failure. Most managers wish to determine whether the prospect of an uncertain futurecan be incorporated into decision making in a structured fashion.

The first step is to ascertain what information is actually available about the likelihoodof future events. At first, managers tend to disregard the notion that anyone can predictthe likelihood of future events occurring, but in fact it is widely accepted that subjectiveknowledge can provide a usable perspective on risk. For example, a salesman can beasked for his assessment of the chances that the sales of his product will double nextyear. 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 20per cent next year. More detailed questioning may reveal that, on balance, he thinks



it more likely that sales will increase rather than decrease. By asking the salesmanwhat the chances are, we are really asking him to assign probabilities to possiblefuture outcomes, and the pattern of responses is termed a probability distribution. Thesalesman’s responses might be as shown in Table 7.6.

Table 7.6: Expected value

Change in sales (000s) Probability Expected value (000s)

-20 0.05 -1.0

-10 0.10 -1.0

0 0.20 0.0

+10 0.40 4.0

+20 0.25 5.0

Average Expected value

0 7.0

Assume that the salesman has identified five possibilities: that sales will fall by 20 000or 10 000, remain the same, or increase by 10 000 or 20 000; the reasons for arrivingat 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 secondcolumn the salesman has expressed his subjective probabilities of these outcomes: forexample, 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 obtainedby multiplying the probability by the possible outcome. For example, the probabilityof a 20 000 increase is .25, giving an expected increase of 5000. The summationof these expected outcomes comes to 7000, i.e. taking the salesman’s subjectiveprobabilities into account he expects sales to increase by 7000 next year rather thanthe zero suggested by the simple average. Since the 7000 estimate takes into accountwhat the salesman feels he knows about the future, it can be argued that it is a betterbasis for decision making than concluding that there will be no change in sales.

The table of possible outcomes and probabilities ignores an important issue, namelythe attitude of managers to risk. A particular manager may feel that even though theprobability of losing $100 million is only one in ten, this is still an unacceptable riskbecause it would result in the company going bankrupt. This is known as risk aversionand it would result in the manager preferring an investment with a lower expected valuewhich did not contain the risk of bankruptcy in the probability distribution. The expectedvalue approach can conceal the fact that risks are not symmetrical; therefore it wouldbe folly to base decisions on the expected values alone no matter what the ‘law of largenumbers’ states because the company may end up with a portfolio of projects each ofwhich contained the potential to bankrupt it. It is a well established fact that individualsdo not always act in accordance with expected utility maximisation, i.e. do not alwayschoose 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 theprobabilities associated with predicted returns. An example of how this might workin practice is illustrated by the potential outcomes from the two investments shown in



Table 7.7

Table 7.7: Minimax decision making

Investment A Investment B

NPV ($m) Probability NPV ($m) Probability

140 0.8 100 0.7

50 0.2 80 0.2

-20 0.1 -10 0.1

Expected NPV 120 85

Investment A gives a higher expected NPV of $120 million compared to $85 million forinvestment B; however, investment B would be chosen because it has a lower potentialloss. Strong arguments in favour of investment A could be suggested; for example, ithas a higher probability of a higher NPV. However, whether investment A is preferableto investment B cannot be resolved on the basis of the numbers alone.

There is another type of risk which cannot be quantified because the future event itselfcannot be foreseen. For example, no one knows whether an earthquake will occurnext week, or whether a carefully planned just-in-time organisation is going to fall apartbecause of human error. What is known is that something, sometime, is going to gowrong with plans and expectations. This type of risk is often referred to as uncertainty,and defies any attempt at quantification. But, given that it does exist, it is necessaryto make some allowance for it; for example, how much additional inventory is it worthholding just in case there is an unexpected materials shortage? Despite the fact thatthe chances of a shortage occurring seem remote, a manager may feel inclined to holda substantial inventory because the very existence of the company would be placed injeopardy if orders could not be met in time.

Because of the existence of uncertainty, it is essential that strategies are constructedwhich have the potential to adapt to circumstances which turn out to be radically differentto those anticipated. If the strategy is inflexible, it will be impossible to respond to eventsas they unfold with the result that the strategy would have to be abandoned at an earlystage. One way of tackling this is through contingency planning, which involves makingsure that the strategy is capable of responding to a wide variety of scenarios and keepingoptions open as long as possible.

7.7.6 Contingency planning

One of the difficulties in formulating strategy is the need to take into account theunknowable as well as the likelihood of events not turning out as predicted. In thesecond case it is possible to take a reasoned view on the position to adopt in theevent of adverse circumstances and take action to provide insurance against loss, suchas holding high inventories and identifying second best market opportunities. But thefirst case poses a set of problems to which previously calculated solutions cannot beapplied because managers cannot foresee what the event might be, never mind thelikelihood of its occurrence; for example, much of the outcome of strategy depends onthe actions of competitors, which are usually unforeseeable, and exogenous events canoccur which completely alter the characteristics of the market. The notion of contingencyplanning can be applied to the second case by identifying alternative courses of action



to undertake should certain events transpire. In the first case it makes little sense todevelop a contingency plan because the range of possible events is limitless. But thisdoes not alter the fact that managers need to have some alternative course of action inmind if future events make the pursuit of the current strategy impossible.

There are therefore two types of contingency planning: first is the technical processof attempting to minimise the probability of loss due to risk and identifying alternativecourses of action in the event of potential outcomes; second is the strategic response tomajor unpredictable events. The first of these can be tackled by the application of ideasfrom the business disciplines, but the second poses more intractable problems. Someinsights into potential events and how the company might react to them are provided bythe scenario approach discussed at Chapter 3 Section 9.4, but responses to this type ofproblem are almost wholly determined by managerial attitudes and perceptions.

7.7.7 Managerial perceptions

The application of sophisticated information gathering and analytical techniques doesnot of itself generate a strategy choice. At the end of the day someone has to weighup the arguments for and against different courses of action and arrive at a decision onstrategy. This someone may be the CEO, or it may be a group of decision makers, andthe process by which the decision is finally arrived at may be obscure; after the event itmay be identified as logical incrementalism or emergent strategies. Those who carriedout the analyses may feel that little attention was paid to their conclusions; or the CEOmay draw opposite conclusions to the analysts from precisely the same information;analysts themselves may feel that the CEO does not fully comprehend the implicationsof their findings. It is in fact very difficult for outside observers to assess the rationalityof decision making processes in a particular organisation; this is because the personalobjectives of decision makers may not be known and, therefore, the weighting whichthey attribute to different factors cannot be taken into account when attempting to explaintheir decisions. However, there are a number of factors which bear on decision makersand 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 companiesconcentrate on relatively few customers and some companies are dependent onrelatively few suppliers. Some managers may see a particular degree of externaldependence as a potential threat, while others may see it as a strength. There is no hardand fast rule, but the CEO who dislikes the idea of increasing the level of dependence isunlikely to consider seriously a strategy which relies on such a change, no matter howattractive it may appear in terms of adding value. Another form of external dependenceis when a majority shareholder exerts influence on decision making; in such a situationsome managers may be unwilling to take strategy decisions because they feel that theydo 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 majorstrategy decision which involves a significant change from previous strategies needs to


7.8. Choice: is it rational? 203

be taken. However, managers may have invested substantial personal resources in theidentification and implementation of strategy to date, and the current strategy may beregarded as a component of the corporate culture. In such circumstances, managersmay be unwilling to make significant changes until external factors force a response; thiscan cause a company to adopt a passive stance to strategy. Indeed, the very successof the previous strategy may contain the seeds of future disaster because of the naturaltendency to take refuge in a tried and tested approach.

Managerial power relationships

All organisations have their own internal politics. The process of decision making hasinfinite variety, from the friendly compromise reached between brothers running a familybusiness, 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 dominatedecision making, despite the fact that all of the analyses carried out support a greaterdegree of external dependence and that most managers in the company are in favourof it.

The issue of managerial perceptions is related to the principal agent issue where theobjectives of managers are not necessarily consistent with those of shareholders. Forexample, an SBU manager may be opposed to a strategy which involves retrenchment ofhis SBU despite the fact that it is in the interests of the company as a whole; he may havea strong influence on strategy choice if he is a long serving respected employee. He willprobably not present his opposition in terms of his personal feelings, but will doubtlesscome up with convincing arguments against the move; however, those knowing hisattachment to the SBU could probably predict that he would oppose the strategy withoutnecessarily 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 ofSuperTools under each of the headings. What do you think would happen if the COEwere 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 company’sassets and the market threats which the company is not equipped to meet. From thisanalysis the corporate generic strategy can be derived and then the product strategiesof the individual SBUs. The strategic variations in each case can be identified and themost appropriate alternatives arrived at. But at the end of this process the choice hasto be made by individuals and, as a result, the choice itself will be affected by manyinfluences which may not be directly related to the strategy issue itself. Furthermore,managerial traits as identified by Miles and Snow will also influence how attractivedifferent approaches appear to different individuals. It cannot be guaranteed that achoice will be made on the basis of an impeccable strategic argument.



7.9 Reference1. Porter, M.E. (1985) Competitive Advantage, New York: The Free Press.


205

Chapter 8

Implementation

Contents

8.1 Strategy implementation in the process . . . . . . . . . . . . . . . . . . . 206

8.2 Organisational structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207

8.2.1 Structural forms . . . . . . . . . . . . . . . . . . . . . . . . . . . 208

8.2.2 Functional silos . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213

8.2.3 Integrating mechanisms . . . . . . . . . . . . . . . . . . . . . . . 214

8.2.4 Is there an optimal structure? . . . . . . . . . . . . . . . . . . . . 215

8.3 Management of change . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216

8.3.1 Types of strategic change . . . . . . . . . . . . . . . . . . . . . . 216

8.3.2 Barriers to change . . . . . . . . . . . . . . . . . . . . . . . . . . 218

8.3.3 Force field analysis . . . . . . . . . . . . . . . . . . . . . . . . . . 219

8.3.4 Cultural web . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221

8.3.5 Styles of managing strategic change . . . . . . . . . . . . . . . . 224

8.3.6 The complexity of managing strategic change . . . . . . . . . . . 225

8.4 Resource allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226

8.4.1 Critical success factors . . . . . . . . . . . . . . . . . . . . . . . 227

8.4.2 Budgets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228

8.4.3 Incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229

8.4.4 Resource planning . . . . . . . . . . . . . . . . . . . . . . . . . . 230

8.5 Effective implementation is difficult . . . . . . . . . . . . . . . . . . . . . . 231

8.6 Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232

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

206 Chapter 8. Implementation

8.1 Strategy implementation in the process

In the strategic planning process model the implementation stage is visualised asstarting after the choice of strategy has been made. Once implementation getsunder way it is to be expected that there will be a constant process of feedback toearlier stages. For example, as resources are mobilised it may become apparentthat the original objectives are unattainable, that predicted costs were too low andthat competitive response had been over-estimated. By treating implementation as anidentifiable part of the strategy process, the manager is forced to recognise that nomatter 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 ithappen it is a pointless activity.

At this stage it needs to be reiterated that strategic planning is really a process and isnot necessarily accompanied by a detailed set of plans. The strategy may have beenarrived at in an incremental manner, or it may have emerged in response to changingcircumstances; the generic strategy, perhaps of expansion through cost leadership,might be perceived only in general terms. In fact, the temptation to translate a genericstrategy into a set of procedures and well defined goals may be counter-productivebecause it robs the company of the ability to adapt to changing circumstances; feedbackand continuous adaptation are important elements of the process model. But even avague concept of where the company is headed and the strategy it has selected toachieve its objective has implications for how resources are allocated and their usemonitored. In what follows the use of the term ‘plan’ therefore refers to management’sperception of the strategic plan rather than to a plan in the formal sense.

Strategy implementation occurs within an organisational structure, which may or maynot be appropriate for the selected strategy, it requires the management of change andit depends on effective resource allocation; as a result successful implementation isdifficult. These issues are dealt with in turn.


8.2. Organisational structure 207

8.2 Organisational structure

It was discussed in Chapter 1 Section 1.5 how strategic approaches evolved in responseto changing market demands and this was accompanied by changes in organisationalstructure. In historical terms the original functional form was followed by divisional,matrix and networks; as different structures were developed and adopted the existingstructures did not disappear because no one structure is superior to others in allcircumstances with the result that many different structures are used today. Resourcesare allocated within an organisational structure and companies are aware that thestructure needs to be aligned to the company objectives, the competitive environmentand strategy choice; but selecting the appropriate structure is not an easy matter. Itis complicated by the fact that variables such as size, views on the appropriate spanof control and technology affect organisational design. There is a common tendency tointrospective behaviour resulting in the emergence of functional silos leading to the needto develop integrating mechanisms to ensure alignment with overall company objectives.As a result of this complexity companies may have a structure which has evolved overtime and, although the existing structure is due largely to chance, the fact that thecompany functions and competes effectively suggests that it is fit for purpose so thereis no incentive for the company to change it.

Company structure can influence company operations fundamentally to the extent thatthe structure dictates strategic choice, i.e. that strategy can follow structure. Thestructure can influence many aspects of the organisation including the following.

• Reinforce the power structure

• Determine who allocates resources

• Identify responsibilities

• Influence the effectiveness with which resources are deployed.

There are many ways of organising a company and companies often have a structurewhich exists as the consequence of historical influences; little explicit consideration mayhave been given to whether the company structure is suited to meeting the company’sobjectives. This can be a major oversight because the company structure can influencecompany operations in such a fundamental fashion that it may dictate the strategicdirection; many managers consider that company structure and planning cannot betreated separately. Among other things the organisational structure affects the powerstructure, determines who allocates resources, identifies responsibilities for undertakingaction and affects the effectiveness with which resources are deployed. This meansthat 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 andresources are redeployed. The difficulty is to establish criteria on the basis of which themost appropriate structure for individual companies can be determined.

A change in organisational structure can lead to fundamental changes within thecompany which significantly affect performance, both in the short and long term. Whena company changes its structure there is no guarantee that the effect on performancewill be positive.



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 thanaround products.

Functional Structure

Research & Development

Production

Marketing

Finance & Accounting

This does not mean that the functions are situated in the same location but that aproduction supervisor, say, reports to the Director of Production rather than to themanager responsible for a particular product. The principle underlying the functionalstructure is that efficiency is generated by the specialisation in the functions rather thanspecialisation in product lines.

The divisional structure splits the company into a series of divisions; the division canbe based on products or geographical boundaries and, typically, each division will haveits own functional structure. It contributes to resolving the principal agent problem inthat divisional profitability can be more easily measured than functional returns. Adivisional structure might look something like the following, where each division hasits own functional structure.

Divisional Structure

Corporate Resource allocation etc

SBU1 Household electrical

SBU2 Industry electrical

SBU3 Electronic

SBU4 Software

The divisional structure is more likely to be encountered when the company has adifferentiated product portfolio; however, a single product company which operates indifferent countries, or services distinctly different types of customer in a given country,can have a divisional structure. The underlying principle is that efficiency is generatedby focusing functional specialists on specific products and markets. The role of thecorporate centre is to select the portfolio of SBUs, allocate resources and providestrategic direction. The control exerted by the corporate centre over SBUs varies



significantly; some corporate CEOs monitor SBUs closely down to the level of approvingindividual investment decisions, while others adopt a lighter touch.

The holding company structure is one where the conglomerate has no particular logicto the incorporation of the individual businesses and the centre plays a less direct rolein the determination of strategy than in the divisional company. The role of the centreis mainly in allocating resources among the businesses and exploiting opportunitiesthrough investment, acquisitions, mergers, joint ventures and alliances. The holdingcompany structure is much looser than the divisional structure, although the financialcontrols which it imposes on the individual businesses may be extremely strict. A holdingcompany might take the following form:

Holding Structure

Financial consultancy: wholly owned subsidiary

Grain distribution: wholly owned subsidiary

Turbine importing: 60% ownership in joint venture

Sugar beet refining: 20% minority shareholding

The matrix structure operates when economies of scope provide a rationale fororganising along more than one dimension. The idea can be difficult to visualise butit looks something like the following.

Matrix Structure

Functional divisions

Product divisions R & D Production Marketing Finance

Household electrical

Industry electrical

Electronic Y X Z

Software

Employee X is engaged in marketing electronic products; the CEO of electronicsinstructs her to scale down marketing of the combined remote control (CRC) because itis becoming obsolete and there is no replacement available. But the marketing directorinstructs X to maintain marketing because the CRC is an important element in theportfolio. The marketing director approaches the CEO of electronics with a request thatemployee Y devote time to upgrading the CRC; but the R & D director refuses to divertresources from what he considers to be much more promising prototypes. The CEO ofelectronics instructs employee Z to request additional funds to finance employee Y, andon and on. What organisation would adopt a structure in which it is virtually impossibleto arrive at a decision when there are conflicts of interest? The fact is that the plaintivecry ‘Who is in charge here?’ is often heard because organisations are in the grips of amatrix structure without being aware of it.

In the network structure work groups may be organised by function, geography orcustomer base. Relationships among groups are governed more often by changingimplicit and explicit requirements of common tasks than by formal lines of authority. Itis difficult to map out how such an organisation would appear in practice because it



depends on the circumstances; as in the case of the matrix the network structure raisesproblems of direction and control.

Table 8.1: Structure: advantages and disadvantages

Functional structureAdvantages DisadvantagesSpecialisation Coordination among functionsDivision of labour Focus on functional rather than company

objectivesSimplifies training Coordination among departmentsPreserves strategic control Lack of broadly trained managers

Divisional StructureAdvantages DisadvantagesDivisional performance expressed Coordination among specialists in profit

termsCoordination among functions Communication among functional

specialistsDevelops broadly trained managers Duplication of functional services

Loss of some strategic control to divisionalmanagers

Holding StructureAdvantages DisadvantagesRisk spreading Probably lack of synergyFinancial strength for new market entry Game theory problems

Little control at centre other than financial

Matrix StructureAdvantages DisadvantagesFlexibility and adaptability Slow decision making - general agreement

requiredLess bureacratic Specific responsibility often unclearClose coordination Highly dependent on effective teams

These are not exhaustive and in some cases what is listed as an advantage could beregarded as a disadvantage from a different perspective. For example, the advantageof risk spreading for the Holding Structure may be a disadvantage from the efficiencyperspective because it insulates the CEOs of the individual businesses from theconsequences of foolhardy investments. So individual companies have to weigh up theadvantages and disadvantages and arrive at a reasoned conclusion on which structureis most appropriate; while it is not possible to identify hard and fast rules for the decisionit is important that the potential advantages and disadvantages are recognised.

Within the organisational structures the design can vary; for example, there can bedifferences in the levels of hierarchy, the span of control of individual managers andthe deployment of technology. The importance of organisational design is in identifyingwhich structure fits different tasks. The variables which have to be taken into account in



organisational design include size, span of control and technology.

Size

As organisations grow there is a need to retain the coordination that was accomplishedinformally in a small group; this is complicated by the division of labour into specialismsand departments. To maintain coordination, layers of management tend to be addedcreating hierarchy. As hierarchy increases power becomes increasingly difficult toconcentrate 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 relieson written policies and procedures. This formalisation of organisational rules helps tomaintain order across the growing organisation and ensures conformity and continuityin practices. Size can limit the flexibility of individuals, affect how much authority canbe delegated, and lead to an emphasis on results rather than how work is actuallyperformed (because results are easier to monitor).

Historically, increased size tended to result in divisional structure because of thedifficulties of control. But this has not always been the case and it is an openquestion whether retaining the functional structure, or adopting matrix or networks asan alternative to divisional is more efficient.

Span of Control

How many employees can or should a manager oversee? Span of control hasimplications for organisational structure.

• Narrow span of control has a low number of workers under a manager creating atall pyramid structure because of the layering required to maintain a low manager-to-employee ratio. The tight supervision inherent in the tall structure leads to abureaucracy where work is performed under tight controls, little variability of tasksis permitted, and there is a high degree of specialisation.

• High span of control has a higher number of employees under a manager, creatinga flat organisation that has a lower level of hierarchy. This leads to workers havingmore autonomy and freedom to perform tasks. The sacrifice of control may becompensated for by higher levels of creativity and job satisfaction.

Thus an apparently trivial difference in view regarding the appropriate span of controlin an organisation can have a fundamental impact on structure and culture: thehierarchical structure emerging from a narrow span of control creates a different workingenvironment to the flat organisation under a high span of control. If an organisationwishes to ‘delayer’ (i.e. reduce the number of levels of management) it must recognisethat the inevitable outcome is an increase in the span of control. This may constitute asignificant cultural change for managers on its own.



Technology

The technology of how work is performed affects how it is organised. If the work requirestight controls and few mistakes can be tolerated, such as processing cheques at abank, it requires high formalisation, specialisation, and division of labour. If the workis creative, such as Research and Development, the organisation is not formalised,division of labour is not clear, and decision-making is decentralised. Technology can beclassified as:

• Custom (small batch or job order) where production is in small quantities or oneof a kind. Because the product is novel or designed for a specific buyer or usethere is no “standard” method of production. Custom technology relies on theskill, craftsmanship and ability of the worker therefore close work supervision isnot 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 requirescontrols to ensure a standardised product. Assembly line production results inhigh fixed costs which are spread over large volumes of output to achieve low unitcosts. The skill level of the large labour force is low and requires tight supervisionto minimise variations in output. Examples include: Ford car factories in the 1920s,meat and poultry processing.

• Continuous (process) where technology is controlled by the manufacturingprocess itself and requires little worker involvement. For example, oil refining takesin a continuous supply of crude oil for transformation into petroleum products andthe main worker involvement is maintaining the manufacturing process.

The technology of the task therefore requires different organisational designs. Theproblem facing the organisation is whether these designs are best organised intofunctional, divisional or other structures.

The ultimate criterion for selecting organisational structure is to assess how each is likelyto contribute to the creation of value. For example, a large corporate centre in a holdingcompany may have little impact other than to increase costs and in this sense wouldhave a negative impact on company value. It also depends on whether the structureis likely to be flexible enough to deal with change; for example, a company organisedon functional lines may find the structure incapable of delivering a planned increasein market share in selected segments of the market because more product specialistsare required with the appropriate production back-up but the marketing and productiondepartments are not closely co-ordinated.

Companies often appear to be preoccupied with their structure rather than their businessdefinition. Every day in the business sections of newspapers there are reports ofcompany re-structuring exercises; often the first action of a new CEO is to restructurethe company. This may be due to the perception that if you get the structure right theneverything else will fall into place; this rests on the implicit belief that strategy followsstructure rather than the other way round. But organisational structure is only part ofthe strategic process and focusing on structure at the expense of the other stages in theprocess is clearly a mistake.



8.2.2 Functional silos

Typically organisations are structured into divisions and departments each of whichperform their own specific function and determine their own competency. This includeshiring people who are expert in doing that specific function. A functional silo comesabout when the business processes of a functional unit focus inwardly on their functionalobjectives instead of on company objectives. This can create barriers which impactnegatively on the unit’s ability to contribute to its role in the broader mission ofthe organisation. This functionally oriented organisation structure tends to create‘silo thinking’ where each department stands alone with little interaction with otherdepartments within the same organisation.

Common experiences foster growth of expertise within the functional area and efficiencythrough repetitively focussing knowledgeable individuals on familiar problems. Thisleads to a principal agent problem of considerable complexity because decision-makershave to compare the needs and priorities of one silo versus another. It is very difficultto foster communication among silos to ensure that employees understand the largerpicture and that the function is not optimised at the expense of the overall system.

Business processes cut across these functional silos. Where different activities ina process require different skills, the process involves a number of people anddepartments. Even though the process flows 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 finding customers to fillingtheir orders. Throughout this process, each department performs its own function: thesales department finds customers and gets their orders, the distribution departmentdelivers the finished product to customer and finally the finance department collectsrevenue once the customer has received the product. These activities make upone business process of selling to customers but it may not appear like that to thedepartments. The marketing department wishes to maximise the number of orders, thedistribution department wishes to minimise the time taken to fulfil orders and the financedepartment wishes to collect money as soon as possible. The marketing departmentdoes not care that it is overloading the distribution department with orders; the financedepartment does not care that it might be alienating good customers by demanding earlypayment; the distribution department does not care that it is slow in providing informationto the finance department; and so it goes on.

Moving financial resources among functional areas may encounter legal, administrative,and other institutional barriers. Even if the workforce is willing to be shifted, movinghuman resources from one functional area to another reduces the ability to buildexpertise and efficiencies. Thus, it is often difficult to shift human and financial resourcesto functional areas where the most benefits will be earned. The rigidity of the systemmakes it difficult to allocate resources from a holistic perspective From the functionalperspective control and responsibility changes according to the specificity of eachdepartment, therefore reallocating resources away from the silos are seen as involvingrisks of task duplication, delay and different perceptions of quality. These are realconcerns and makes it difficult for the organisation to shift its view from ‘who does what?’to ‘what needs to be done?’ As processes flow through the functional silos, the emphasisneeds to be on making sure that the process flows effectively and efficiently withoutsignificant obstacles caused by lack of communication. Thus the functional silos need tocoordinate and communicate continuously to ensure the process achieves completion.



But this is difficult to achieve because of the underlying principal agent problem. Fromthe manager’s viewpoint it is necessary to recognise that functional silos can emergeat any time; if they are allowed to emerge unchecked and unrecognised for what theyare the result can be that the organisation ceases to function effectively without anyonebeing sure of why.

8.2.3 Integrating mechanisms

One way to resolve the principal agent problems that arise between differentfunctional areas and divisions, resulting in functional silos, is to encourage integratingmechanisms.

Some integrating approaches are as follows.

• Direct contact: assemble teams of managers from different divisions or functionsto solve mutual problems. The problem here is that the mutual problems musthave sufficient in common to foster collaboration, while the normal processes ofteam 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 managerstogether will actually increase integration.

• Liaison Roles: one manager in each area is made responsible for communicationwith other areas. The problem here is that the liaison role is crucially dependenton the abilities of the selected manager. There is a danger that liaison managersend up liaising with each other and make little real impact.

• Task Forces: temporary committees are formed across divisions to solve a specificproblem. The problem is to ensure that the integration does not end with theparticular project. Individuals can display a high degree of commitment in suchproject orientated teams (such as ‘hot groups’) but they can quickly shift their focusto another interesting task. These teams also have to go through the processes ofteam building in order to be effective.

• Cross-functional teams: these work like a permanent task force that deals withproblems as they occur. The problem here is that the problems may not always besuited to the aptitudes of the permanent task force.

• Matrix structure: it has the appearance of an integrating mechanism becauseit involves multiple reporting but it suffers from the disadvantages identified inSection 8.2.1. The matrix structure involves a trade-off: are the integration benefitssufficient to outweigh the problems inherent in the matrix structure?

These are actions that the organisation can take to foster integration, but there are otherapproaches which rely more on individual relationships rather than formal structures.

• Informal relationships. Coordination can occur through informal relationships butsuch relationships are usually serendipitous. The relationships are likely to beinitiated by shared problems but once these have been resolved it is again opento chance whether the relationship is maintained.

• Shared values. This depends on the extent to which individuals see themselves asworking towards a common goal and having the same perceptions as to how this



should be achieved. The development of a company culture that promotes sharedvalues, such as corporate social responsibility, may contribute to integration butthe outcome is likely to be highly unpredictable. It could backfire if individualsgain the impression that they are being manipulated and therefore respond in anegative fashion.

It was argued above that the emergence of functional silos is an ever present problem.It is difficult to initiate integrative mechanisms which will neutralise them; probably themost effective solution is to watch out for them emerging and deal with them before theyget embedded.

8.2.4 Is there an optimal structure?

Organisational structures are necessary in order to make organisations operateeffectively; a random association of workers is unlikely to achieve much. Anorganisational structure exists for a number of reasons and is always subject to changein a dynamic competitive environment. Each structural form has its own advantagesand disadvantages and every organisation struggles with the need to make it operateas effectively as possible. While there are no ‘solutions’ to the problems of strategy andstructure an awareness of the issues is the first step in doing the best job possible in thecircumstances.

Take the case of Larry, the head of HRM in Smallco who had a reputation for gettingthings done; he was headhunted by Largeco whose CEO felt that the organisation wasnot functioning as effectively as it could. Two years later Larry was fired, having achievednothing in Largeco. What prevented Larry transferring his success from Smallco toLargeco? The following organisational profiles show that it was not just on the dimensionof size that they differed.

Organisationalcharacteristic

Smallco Largeco

Structural form Functional Divisional

Size 500 5000

Span of control High Low

Technology Custom Continuous

Functional silos 3: production, marketing,finance

15: each division

Integrative mechanisms Shared values Cross functional teams

None of Larry’s experience from Smallco was relevant to Largeco. He spent the wholeyear trying to come to terms with the differences so achieved nothing.



8.3 Management of change

Any change in an organisation requires reallocation of resources and therefore alterswhat people do. A company which has been operating in mature markets for sometime is likely to find significant change more difficult to achieve than prospector typecompanies which have a history of innovation, growth and diversification. For example,for a long time the British workforce was associated with resistance to change; from themid 1960s miners, shipbuilders and steelworkers wished to remain in jobs which werebecoming progressively uneconomic and were not only unwilling to change to otherjobs but wanted to carry on doing their existing jobs in the same way as they had alwaysdone. The notion that a job belonged to an employee led to decades of job demarcationdisputes and strikes aimed at ‘saving jobs’ which were in direct opposition to marketforces.

Every company which attempts to undertake change faces the problem of changeimplementation. In order to cope with change many companies attempt to develop acorporate culture which rewards adaptability, innovation and flexibility and thus createan atmosphere conducive to the introduction of changes which save costs, increaseproductivity, and get people to do things better and think of better things to do. This isdifficult to achieve and is certainly not attainable in a short space of time. The importantpoint for managers to bear in mind is that reallocation of resources is not simply a matterof investing, retooling, and hiring new people. Even a relatively modest reallocationmay present insuperable problems for companies which have fostered a ‘no change’mentality amongst their workforce. There are a number of approaches which facilitatestrategic change including identifying barriers to change , force field analysis, applicationof 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 unchangingequilibrium 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 changesin the environment can be usefully categorised in the PEST framework it is not a simplematter to identify which events are likely to impact significantly on the organisation. ThePEST example in Section 3.9.2 demonstrated that a newly privatised monopoly hadmuch more to worry about than simply adapting to a new competitive situation becausean examination of the environment revealed several high risks that were independent ofthe fact of privatisation.

There is a difference between strategic change and other types of change within anorganisation. It may be thought that strategic changes are large while others arerelatively small but this is not necessarily the case. A strategic change is defined asa change that impacts significantly on at least one part of the strategic process. Itcould be an innovation that makes it necessary to change the business definition, oran invention that affects the production process, or the emergence of a substitute thataffects the profile of the five forces. This initial impact will then have knock on effectsthroughout the strategic process. Any resulting change in business definition will requirethe formulation of new objectives and may require restructuring the supply chain; newproduction process may require retraining and new control systems; emergence of asubstitute may require increased R&D and a new marketing strategy. Despite the factthat events initially impact on different parts of the strategic process there is one common


8.3. Management of change 217

element: people have to change what they are doing. Consequently changes can not beintroduced in a mechanistic manner and it is necessary to manage the people affected.

The types of event that trigger strategic change can be classified to anticipate themanagement problems that the resulting change will present. The following list is by nomeans exhaustive but it does highlight the general influences that are likely to emergefrom environmental scanning; the impact on the strategic process helps to identify thetype 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 aremarginal

• Transformational: new business definition leading to radical change in strategicprocess

It will be seen later that these are classifications of change are crucial when it comes tothe style of management required for different types of change.

Change driverImpact on strategic

processChange response

New leadership New business objectives Long termTransformational

Increasing size andcomplexity

Introduce new controlsystem Incremental

Acquisition Extend value chain TransformationalTechnologicalobsolescence

New primary functions invalue chain

Short term

Political eventsChanged competitiveposition Crisis

Strategic drift Generic strategy choice Long termIncremental

Life cycle differencesamong products

New portfolio Long termTransformational

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



Change driverImpact on strategic

processChange response

Innovation New product launch Short term

Identify untapped market Market expansion Short termIncremental

Identify inefficient workpractices Resource allocation

Long termIncremental

Concern over jobsatisfaction

Value chain Incremental

Deterioration in workingconditions

High attrition rate Short term

Banks withdraw credit Cash flow problem Crisis

It is clearly useful to identify the change driver and its likely impact on the strategicprocess and hence the first round of change responses. But in real life it is unlikely thatonly one of the drivers will be operating at a time; for example, strategic drift may beidentified at the same time as concern over job satisfaction, so not only is it necessaryto re-focus individuals but at the same time set up an appraisal system that ensuresemployees are properly rewarded for their efforts. Thus the strategic change process islikely 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 personalreasons. There are several reasons why some individuals will always be resistant tochange:

1. Self interest: this is the principal agent problem which it may not be possible toresolve because company objectives cannot be aligned with some individual’sobjectives.

2. Misunderstanding: this arises because of communications problems andinadequate information being available. It is a particular problem in largeorganisations; further, a strategic change will impact on people in different ways asit works through the strategic process and many implications for the organisationmay be unpredictable.

3. Low tolerance of change: individuals often do not like the sense of insecurity thataccompanies change. There is not much that can be done about this becausereassurances are likely to be treated with a degree of scepticism, particularly ifcolleagues lost their jobs in previous changes.

4. Disagreement over the need for change: there can be genuine disagreement overthe advantages and disadvantages of a change and it is difficult to resolve thesedifferences because they are subjective.

If it is accepted that there is not much that can be done about these individual attitudesit is necessary to accept the way the world is and work round them. These barriers willnot stop change completely but they certainly make it difficult.

There are also several organisational factors that act as barriers.



1. Structural inertia: reorganisation can be complex because it is necessary toensure that production and delivery functions keep operating efficiently and thisis particularly difficult to achieve during the transition period. It is easy to concludethat it is simpler just to leave things as they are.

2. Existing power structures: changes reduce some managers’ span of control andare therefore bound to meet with resistance. Sometimes the only way to deal withthis is a radical solution, such as delayering, where a whole management layer isremoved.

3. Resistance from work groups: teams which have operated successfully up to nowwill 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 atightly knit group can have disastrous effects on morale so there is no easy wayout of this dilemma.

4. Failure of previous change initiatives: in a dynamic environment it is inevitable thatthere will be failures as well as successes. The problem arises when failure islooked upon as a reason for resisting change rather than a lesson for the future.

Taken together these personal and organisational barriers to change can presentformidable obstacles; the challenge for change management is to identify them andensure that they are accommodated in the change process.

8.3.3 Force field analysis

The principal agent problem demonstrates that conflicts of interest occur at all levelswithin an organisation. When strategic change occurs conflicts of interest are likelyto be exacerbated because strategic changes are typically carried out in responseto incomplete information (forecasts of the future or likely actions of competitors) andindividuals interpret them in different ways, while the magnitude of the strategic impactmeans that individuals may see their own interest being threatened.

It is therefore inevitable that some individuals or groups will be in favour of a particularstrategic change and others will be opposed. It then becomes a matter of identifying theforces for and against the change, assessing the balance between them, and figuringout whether the balance can be altered in order to make the change possible. This isillustrated in the force field diagram.

Figure 8.1: Force field



The forces acting for a change are the driving forces and those against are therestraining forces. The following are the main steps in applying a force field analysis.

• Clarify what change is required to achieve the strategic objective. For example,entering a new market segment may require withdrawal from an existing segmentand diverting resources from R&D to marketing. The impact of a change on otherparts of the strategic process generates forces for and against the change.

• Identify the driving and restraining forces in relation to each aspect of change andestimate their relative size. For example, the CEO and the marketing directorare in favour of the new market entry because it is seen as a major opportunity(High driving force) while the finance director has some concerns about the impacton short term cash flow (Low restraining force); The marketing department as awhole is in favour of more resources (High driving force) but some members maybe opposed to abandoning an existing segment (Low restraining force); the R&Ddepartment is opposed to losing resources because an innovative new product iswithin six months of launch (High restraining force).

• Assess the balance of forces; if the balance is clearly in favour of the change itmay 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 whetherto attempt to alter the balance or abandon the change. In the example the R&Ddirector threatens that there will be no significant product development possible forthe next three years and this is such a serious threat to the long term viability ofthe company that it tips the balance against the change.

• Decide how to alter the balance of forces. There are two distinct options: reducethe strength of the forces restraining the change or increase the forces driving thechange. The latter could be achieved by promising the members of the marketingdepartment a bonus if the segment entry is successful but this is likely to heightenthe R&D director’s opposition. It is more effective to reduce the R&D director’sopposition by promising an increase in the R&D budget in a year’s time.

The force field is a powerful tool in identifying how to implement strategic change. Theconcept 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 isarguably not applicable to strategic change. The establishment of a new equilibriumis 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. Theobjective of developing a robust strategic process is that the organisation is capable ofchange and that is not consistent with refreezing.



8.3.4 Cultural web

A different approach to change management is to embed the willingness to adapt tostrategic change in the culture of the organisation. The focus is not on specific strategicchanges but on the general attitude of the workforce which, in the force field case,would significantly reduce the restraining forces although it would not entirely eradicatethem because of principal agent issues. It is well known that organisational culture isalmost impossible to define and it is difficult to change. Despite the fact that culturecannot be defined it is usually argued that you know it when you see it. Take thecontrasting examples of a family owned retail business (Smith’s) and a small creativeadvertising partnership (Adwell). Smith’s is run on strictly hierarchical principles withthe patriarchal owner at the top of a pyramid that extends down through departmentalheads, supervisors and counter assistants; it is virtually unknown for a counter assistantto speak to the owner and no one is on first name terms with their superiors. There areaccepted codes of behaviour and dress and time keeping is strict. In Adwell it is difficultinitially to identify the three senior partners, everyone is on first name terms, includingnon-creative staff such as administrators and secretaries, and there is a relaxed andcollaborative atmosphere. There is a fierce commitment to results and the creativepartners are well aware that if they fail to perform they will be fired; but this is acceptedas a normal aspect of such businesses.

Imagine what would happen if Smith’s bought Adwell and tried to run it like a shop, orif an Adwell senior partner were head-hunted to replace the ageing owner of Smith’s.The outcomes are indeterminate but there is no doubt that there would be a clash ofcultures. Now consider the likely reaction of the two businesses to strategic change; it isreasonable to conclude that Smith’s would be far less conducive to change than Adwell.If that was your conclusion you have walked straight into the cultural trap: you have beentaken in by appearances rather than finding out about the culture.

Smith’s has decided to make a strategic change by acquiring a boutique sellingupmarket ladies’ outfits. The counter assistants have always been circulated arounddepartments and regard themselves as professional sales people and they would allrelish the challenge and opportunity presented by taking a spell in the boutique. Thedepartmental managers and the buyers see the boutique as a prestigious addition tothe portfolio; in fact, everyone is comfortable with their place in the hierarchy and theyare loyal to the organisation and to ‘old Mr Smith’.

Adwell has focused up to now on the sports clothing sector but the senior partners havedecided to tender for a major account in the motor trade; they see this as being a crucialstrategic expansion of the scope of the company; they feel that diversification is essentialin the long run because of increasing competition in the sports clothing sector. Thetrouble is that the creative partners are fully committed to their current clients and theyfeel they do not have the time to learn about a new business sector. If new partners arebrought in they feel this will not benefit them personally; in any case, each of them feelscapable of winning new accounts in the sports clothing sector. Their skills are highlytransferable and all of them could move to another organisation and probably take mostof their accounts with them. They are loyal to their creative colleagues rather than toAdwell. The non creative members see the move as simply adding to their workloadsand some of them start looking at the ‘situations vacant’ columns.

What were the underlying causes of such a profound difference in the culture that ledto easy acceptance of strategic change in one organisation and hostility in the other?



It would clearly be useful to be able to identify the main cultural characteristics of anorganisation 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 alignedwith change. If nothing else, it would help to avoid the trap of confusing organisationalstructure with culture. One approach is the cultural web1, which is used to classifycultural assumptions and practices.

Elements of the cultural web

The cultural web identifies six interrelated elements that help to make up what Johnsonand 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 dealabout what employees value.

2. Rituals and Routines - The daily actions of people that signal acceptablebehaviour. For example, the routines determine what reaction is expected in givensituations, and what is valued by management.

3. Symbols - The visual representations of the company including logos, thestandard of the working environment and formal or informal dress codes.

4. Organisational Structure - This is not so much the structure defined by theorganisation chart but the unwritten lines of power and influence.

5. Control Systems - These include financial 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 mayinvolve one or two key senior executives, a whole group of executives, or evena department. These people have the greatest amount of influence on decisions,operations, and strategic direction.

Using the cultural web

The cultural web is used to assess culture as it is now, then to define the desiredculture and identify the differences between the two. These differences are the changesrequired. Each element is examined in relation to the example of Smith’s and Adwellsto see how the underlying cultural differences relating to strategic change might beuncovered.

1. Analysing Culture As It Is Now

Stories

• Smith’s: most of the stories involve ‘old Mr Smith’: how he built the company upfrom a street stall, how he deals personally with customer complaints, how hespent a fortune on redesigning the food hall then tore it apart and started againbecause it didn’t seem right to him.

• Adwell: stories about winning accounts with a sudden brilliant idea, savinga client’s business with a novel advertising campaign and meeting publishingdeadlines against impossible odds.



The issue here is whether the rituals and routines are potentially barriers to strategicchange. In Smith’s all rituals and routines are directed towards customer satisfactionwhile in Adwell the focus is on creative freedom. In Smith’s the rituals and routines canbe directed to customer satisfaction in any environment but in Adwell operations aredependent on individual preferences.

Symbols

• Smith’s: the imposing façade of the old building and the peculiar logo makeemployees proud to be part of the business. Employees take a pride in appearingsmartly dressed.

• Adwell: The prestigious client list defines the business.

The Smith’s symbol contributes to the corporate identity while in Adwell the logo is areflection of the achievements of individuals. In Adwell employees do not adhere to acorporate image.

Control Systems

• Smith’s: the remuneration system is designed to reward individuals anddepartments; 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 orabandoned.

• Adwell: there is no system to identify whether accounts are actually profitable.Some accounts are jealously guarded by their owners. The finance directorhas repeatedly pointed out that overall profits vary alarmingly but no one seemsparticularly interested.

Smith’s controls are designed to encourage employees and to track the outcome ofnew ventures, such as the new boutique. Adwell’s lack of controls encourages themaintenance of the status quo.

Power Structures

• Smith’s: while the counter assistants wield considerable influence the real powerrests in Mr Smith. It is a power based on loyalty, respect, fair dealing and manyother things.

• Adwell: real power resides in the individual creative partners; the three seniorpartners 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 fromsimply looking at the organisational structures. It emerges clearly that Smith’s cultureis almost purpose built for strategic change while Adwell’s culture contributes to a staticorganisation.

2. Define the desired culture

Each element of the cultural web is examined in detail to identify what would be requiredto generate a web which would be conducive to strategic change. The following showshow this might work out.



Cultural Web component Smith’s AdwellStories Find stories about

successes achieved bycounter assistants

Find stories about teamsuccesses

Rituals and routines Design new companyuniforms

Draw up code of practice fordealing with clients

Symbols Repair the façade Define the companymission

Organisational structures Improve communicationbetween departmentmanagers and Mr Smith

Assign clear roles to thecreative partners

Control systems Improve payment by resultssystem

Make creative partnersaccountable

Power structures Give supervisors moreresponsibility

Set up a clear chain ofcommand

3. Identify the differences

It emerges that the desired culture for Smith’s involves changes in the elements of thecultural web at the margin while those for Adwell are radical. It appears that the Smith’scultural web is already closely aligned with strategic change while the changes requiredin the Adwell cultural web are unlikely to be achievable. Thus the cultural web analysissuggests that there are some improvements that can be made in Smith’s culture butAdwell is likely to remain locked in its cultural prison. This is a negative conclusion sofar as Adwell is concerned but it does identify the fact that attempting to change theculture is not going to improve the prospects for the suggested strategic change. If thesenior partners focus on issues such as stories and team working for a considerabletime this might generate sufficient cultural change to enable strategic changes in thefuture. Whatever is done in Adwell, it is not going to be easy or immediate.

Despite the difficulties in defining and identifying culture the cultural web provides aframework for analysing at least some of the elements that contribute to culture andidentifying 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 andparticipative to coercion and edict. Roughly speaking this means close involvementwith those affected at one end of the scale and simply telling people to get on withit at the other. There are costs and benefits associated with each style but it is notpossible to conclude that one style is superior to another because much depends on thecircumstances and the organisational culture. The different types of strategic changewere identified in Section 8.3.1; for example, when it is suddenly announced that anew out-of-town shopping centre is to open within a year then Smith’s would needto react quickly to this crisis and there may not be time for a participative approach;on the other hand, Smith’s may have decided that the long term future lies with thespecialised boutique approach and there is time to involve employees in this long termtransformational change.

The table below shows how different styles, their potential benefits and problems andthe type of strategic change for which they could be most effective.



Style Means Benefits ProblemsType ofstrategicchange

Education andcommunication

Mutual trust andrespect Smallgroup meetings

Overcome lackof information

Labourintensive andcostly

IncrementalchangeTransformationalLong timehorizon

Participation Small grouptask forces

Increasedownership ofdirection orprocess

Solutionsconstrained byexisting culturalparadigm

TransformationalLong timehorizon

InterventionManipulation

Change agenttakes control

Guided processenablesinvolvement

Reaction toperceivedmanipulation

Non-transformational

Direction Use of authority Clarity Risk of adversereaction

Crisis

Coercion EdictExploit existingpower structure State of crisis

Only successfulin crisis

Crisis Rapidchange

Although the classification is approximate it does provide pointers to the mostappropriate management style. For example, if coercion were applied for long termtransformational change there will be time for resentment to build up because employeesmay feel that given time and involvement they would be willing to make the necessarychanges by mutual agreement; at the other extreme, if a participative style were adoptedin a time of crisis there would be no time to resolve different points of view and conflicts ofinterest. From this perspective it can be judged in broad terms which style is likely to bemost 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 themanagement team is itself part of the change process and may not be well equippedto implement a strategy which involves significant change. For example, a companywhich decides to diversify will require the senior management team to become moreconcerned with corporate level decision making rather than running a single productline. The current finance officer may not have the experience and skills required tohandle financial planning in a diversified company; the personnel officer may haveno experience in integrating new and existing activities. At the SBU level, the type ofmanager who has successfully run a ‘Cash Cow’ may not have the innovative approachto market development and risk taking required to transform a ‘Star’ into a money-making proposition.

The concepts and models developed so far, taken together, provide a basis on which totackle the seemingly intractable problem of changing an organisation.



Change model Role of model OutcomeType of strategic change Identify the change driver

and its impact on thestrategic process

Clarify the change

Barriers to change Identify the in-builtinstitutional factors causingresistance to change

Clarify principal agentproblems

Force field analysis Identify forces acting forand against change

Decide whether a change isfeasible Devise tactics toalter forces

Cultural web Identify the elements ofculture as they relate to thechange

Redirect culture towardschange

Styles of managing change Identify relevant style Align style with type ofchange

While change management is complex it is possible to tackle it in a structured and logicalmanner. But it is important that each model is applied in context and is seen as part ofthe change process rather than as a complete answer in itself. The problem of functionalsilos extends to managers involved in the change management process.

8.4 Resource allocation

All companies are continually faced with the problem of allocating resources. Typicallya company will have procedures for allocating resources among competing uses; theseinclude setting budgets, using pre-determined accounting rules, bargaining among SBUCEOs and so on. Whatever approach is adopted it is essential to bear in mind twoconsiderations.

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 beenselected?

Take the case where a company is attempting to develop a star product into a cash cowand where the resource allocation rule is that the budget for the SBU this year mustbe within 10 per cent of last year’s. In order to develop increased sales and marketshare it is necessary to build advance capacity and probably produce for inventory; thiswill most likely require much more than a 10 per cent increase in resources for a yearor two and the additional input of resources will not be accompanied by an increasein profitability. Unless the strategic decision to develop the product is accompanied bya change in the resource allocation rule it will simply not happen. Thus at any onetime it is necessary to consider the alignment between what the company is attemptingto achieve and the current methods of resource allocation and recognise that when astrategic change is undertaken, it may be necessary to change the whole approachto budgeting. It is not really a case of the resources being unavailable which leads toa failure to achieve objectives, but inappropriate methods for ensuring that resources


8.4. Resource allocation 227

are directed towards efficient uses. This may seem to be almost alarmingly obvious toan observer, but resource allocation procedures within organisations are typically wellembedded and can be very difficult to change.

The value chain is a powerful tool for helping to focus on the alignment between strategicobjectives and resource allocation. Instead of attempting to ensure that the functionalparts of the company are provided with adequate resources, attention can be turnedto the extent to which the activities which generate value are able to function, and thatthe linkages among them are not overlooked. For example, a company which is aboutto undertake expansion into new markets may need to increase its sales force; in thefirst instance attention needs to be focused on the human resource support activity andvarious questions can be asked.

• Does the HR department have sufficient resources to mount a recruitmentprogramme?

• Does the HR department have experience in this type of recruitment?

• Has a profile of the desired type of sales person been identified?

• Is there an adequate communication channel between SBU and HR?

The difficulty of attributing value added to different parts of the value chain has alreadybeen discussed, but it is probably not too difficult to identify when there is a weaklink in the chain which will constrain the extent to which appropriate resources can bedeployed. On the other hand, it is all too easy to assume that a previously effective HRdepartment 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 analysesoriginally developed for use in military planning. In principle the idea is simple: aproject is set out as a sequential network of events with the objective of identifyingthe critical path, which is the minimum time for the project. Inspection of the networkreveals that there are some things which must happen before others. The same generalapproach can be adopted in strategy implementation, but because of the complexityof the process, and the fact that so much is unknown about the future, it is really onlypossible to identify events which must occur, or things which must be done, in order toensure 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 havea 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 theywill experience. A critical success factor can be the acquisition of a capital asset or itcould be the installation of an appropriate incentive structure. When it is found that astrategy is not being implemented as effectively as originally expected it is more thanlikely that a critical factor has been overlooked; the reason that the whole process hasground to a halt is because that is the nature of a critical success factor.

The first step in identifying critical success factors is to determine what must definitelybe achieved to ensure success. The resulting list sets the scene for the actualimplementation process because it identifies the immediate priorities. An example



of how critical success factors can be identified is to consider what is critical whenattempting to convert a Question Mark to a Star compared with turning a Star into aCash Cow. A list of potential actions has been identified and the criticality of each canbe assessed in the two situations.

Factor Star to Cash Cow Critical? Question Mark toStar

Critical?

Capacity Eliminate excesscapacity

Yes Maintain excesscapacity

Yes

Marketing Be prepared toreduce as marketmatures

Yes Maintain at high level Yes

R & D Reduce Yes Maintain at high level YesPrice Set to competitive

levelYes Set lower than

competitorsYes

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

8.4.2 Budgets

The problem of allocating budgets is encountered at many levels, but for strategypurposes 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 levelit is necessary to allocate funds to individual managers so that they can carry out thetasks which are required to achieve the objectives of each investment; the investmentappraisal which revealed that the net cash flows generate a positive NPV does notusually take into account uncertainty as to how costs will actually be incurred andresources deployed.

At the corporate level it could be argued that no budget constraint exists because anyinvestment which generates a positive NPV ought to attract funds from the market; bydefinition, this is a project which generates a return greater than the company’s costof capital. However, there are many reasons why a company may be unable to raisemoney on the market to finance investments. The most obvious one is when the marketdoes not agree with the company’s estimate of future returns; the track record of thecompany’s managers may be such that the market views their plans with considerablereserve. Another reason is that the company may be unwilling to reveal its intentions tocompetitors. The desirability of an investment may depend on achieving a competitiveadvantage which would be impossible if competitors knew what the company’s strategywas likely to be. In fact, strategic options are often difficult to define with the precisionwhich will attract investors. It is one thing to use investment appraisal to attempt toestimate the relative value implications of alternative strategies, but it is quite another totranslate this into a convincing investment plan.

It was discussed at Chapter 7 Section 4.9 how the application of sophisticated capitalrationing techniques does not necessarily resolve the budget allocation problem. Oneway to avoid the difficulties associated with capital rationing is to set across-the-boardbudget 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 withcorporate policy. However, such an approach is inconsistent with principles of efficient


8.4. Resource allocation 229

resource allocation. The whole emphasis of the strategic planning process has beenon the identification of activities with different potential pay-offs and directing resourcesaccordingly. For example, if the objective were to increase the market shares of productscurrently being produced, it would make little sense to increase the research budgetat the same time simply because the marketing budget was to be increased. On theother hand, if there is no sensible budgetary control, when companies are faced withadverse market conditions and decide to follow a retrenchment strategy the first thingthat is usually done is to cut back on those budgets which can be manipulated withoutaffecting current performance. Training, research and maintenance budgets are oftenpruned to achieve an immediate increase in ROI without proper consideration of theoverall resource allocation implications. This is often justified by senior management onthe grounds that survival is the primary concern and refinements can come later. Thisreaction is probably inevitable when senior management concentrates attention on shortterm cash flows rather than on the concept of shareholder wealth which puts short termcash flows into context.

The SBU CEO is confronted with many imponderables. If a new market is beingentered he has to decide how much to allocate to marketing and over what period. Themarketing 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 andallocated to the various functions it may be difficult to identify specific expenditure withthe original project. The original investment appraisal assumed that the cash would beused efficiently at the functional level. The management problem is to ensure that thishappens, but there may be relatively few guidelines to assist managers who are in thefront line. A potentially effective strategy may never actually happen because budgetsare 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 andin this way contribute to resolving the principal agent problem. But, given the difficultyof determining value for the company as a whole, it is clearly impossible to parcel outthe components of added value to managers and employees. On the other hand, itshould be possible to recognise when the incentive system is at odds with the valuecreation objective. For example, a production manager who is rewarded for minimisinginventories can cause havoc with a marketing strategy aimed at achieving an increasedmarket share.

It is important for managers to recognise that the incentive system may be at faultwhen the performance of individuals does not match expectations. In fact, one of thebarriers to change is that incentive systems are not reviewed to ensure that they areconsistent with revised company and individual objectives; what is perceived as beingunwillingness to change may be partly due to the fact that individuals can see that aproposed change is not to their advantage given the existing system of incentives. It is abasic fact of life that managers and employees will be unwilling to change their behaviourif the benefits of doing so are perceived as being lower than the costs to themselves. Achange in the incentive system can go a long way towards easing the implementation ofchange.

It also needs to be recognised that the incentive system is not entirely financial; otherdimensions include promotion prospects, recognition and job satisfaction. It can be



very difficult to align all elements of the incentive system to company objectives, butit is necessary to attempt to ensure that both financial and non-financial incentives areoperating in the same direction. Imagine a large multinational company that has decidedon 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 inreturn on sales above 20 per cent and would be penalised for each 1 per cent below the3 per cent cost reduction target.

There are several problems here. First, the objectives conflict with each other. It isdoubtful if it is possible to achieve a reputation for quality while reducing unit cost; itis also difficult 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 wererelatively efficient and who will therefore find it difficult to reduce costs further. Third, thereturn on sales objective does not have a specific incentive associated with it. Fourth,the incentives are a mixture of reward and punishment. Individuals do not respond wellto negative incentives. So the incentives do not serve as an effective method of dealingwith the principal agent problem in this case; but at the same time it has to be recognisedthat the objectives are probably unattainable.

8.4.4 Resource planning

If the company is ever going to achieve a competitive advantage, it must set upprocedures to ensure that resources are used efficiently. A fundamental requirementin effective resource planning is that the production department knows what it is meantto produce; this means setting up communications between marketing and productionso that each can understand the other’s viewpoint. For example, it is often found that theproduction department is frustrated by continuously changing volumes of orders, and asa result cannot always react with fast delivery times; the marketing department mayfeel that reasonable notice of orders is always given, that the production departmentis inefficient and is not really interested in fulfilling the needs of hard won customers.Effective communication between marketing and production would reveal the likelyincidence of bulk orders, provide guidance to production on how much inventory themarketing department feels that it can reasonably live with, and enable the marketingdepartment to appreciate the difficulties of capacity utilisation and inventory control andthe benefits of a relatively stable production schedule.

A service company faces different problems because services cannot be stored hencethere are no inventories. Sufficient resources need to be employed to meet fluctuationsin demand but if supply exceeds demand for any length of time then unnecessary costswill be incurred. There is a balancing act involved in aligning resources with expecteddemand in a cost effective manner bearing in mind the trade-offs.

Resource planning has implications for all aspects of the company’s performance.The application of sophisticated just-in-time approaches can reduce inventory costs


8.5. Effective implementation is difficult 231

significantly, the smoothing of peaks and troughs in production schedules can createthe stable environment necessary to develop a company culture, the introduction ofnew technology at appropriate times enables the company to make use of new skillsand techniques, and a systematic approach to resource planning is the foundation formonitoring costs.

8.5 Effective implementation is difficult

One of the most common observations made by senior executives is that they knowwhat their business definition is, they understand the competitive environment and theirinternal capabilities, they have a clear idea of the strategic approach BUT it just seemsimpossible to actually make it all work. It will be clear by this stage why implementationis difficult; but it is by no means impossible if the various factors affecting implementationare understood and a structured approach is taken to resolving them.

Implementation factor What to do

Organisational structure

Structural forms Identify the fit between strategicobjectives and structure

Functional silos Watch out for units which are notcontributing effectively to businessprocesses

Integrating mechanisms Foster cooperation

The management of change

Types of strategic change Clarify the nature of the change

Barriers to change Identify institutional resistance to change

Force field analysis Deal with the balance of forces acting forand against change

Cultural web Align cultural elements with newobjectives

Styles of managing change Align style with type of strategic change

Resource allocation

Critical success factors Identify what must be achieved to avoidfailure

Budgets Align allocation of finance with objectives

Incentives Align incentive structure with objectives

Resource planning Ensure that the right resources areavailable at the right time



That is a lot to get right. But if you get just one of them badly wrong there is a goodchance 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 wouldhappened if you got it wrong. For example, if the force field is not used to identify theforces acting for and against change the balance against change will not be recognisedtherefore no action to correct the balance will be taken; if the management style is notaligned to the type of strategic change nothing will be achieved; if the budgeting systemis wrong it will be impossible for managers to reallocate resources.

If managers do not understand these change issues they will be unable to comprehendwhy the implementation process is failing; there is then a tendency to conclude that it isall too difficult and things should be kept as they are.

Exercise 8.1

1. Consider the implementation of SuperTools’ decision to develop and produce thePowerPlane 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 developingand launching the PowerPlane?

8.6 Reference1 G Johnson and K Scholes (2005) Exploring Corporate Strategy Prentice Hall


233

Chapter 9

Strategic Control

Contents

9.1 Strategy control in the process . . . . . . . . . . . . . . . . . . . . . . . . 234

9.2 Degree of planning and type of control . . . . . . . . . . . . . . . . . . . . 235

9.3 Feedback . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237

9.4 Analysing the ongoing competitive position: using the process model . . . 238

9.5 Finally . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

9.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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

234 Chapter 9. Strategic Control

9.1 Strategy control in the process

The strategic planning approach is initially based on expectations, for example of theoutcome of a new product launch, of gaining market share, of generating revenuesand so on. When decisions have been made and actions are implemented it isnecessary to measure and evaluate actual performance to find out if the expectationsare being fulfilled. When the component parts of the plan have been made explicit,the plan provides a benchmark against which actual outcomes can be compared, sothat when variations between expected and actual outcomes occur their causes can beinvestigated. For example, it may be found that the net contribution from a particularproduct is lower than anticipated; this could occur for a variety of reasons, for examplebecause the selling price turned out to be lower than predicted, or because productivitywas lower, or because market share turned out to be harder to win. The reason for theshortfall 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 identifywhether 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 meansby which the company can exert control over its performance.

The well-known case of Barings bank and the losses generated by Leeson revealed alack of strategic control on the part of Barings. The same lack of control was apparent atDaiwa, 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 shorttime, but this was not the case for Yasua Hamanaka of Sumitumo, who controlled somuch of the copper market that he was known as Mr Five Percent; he lost £1300 millionover a ten year period and managed to conceal what he was doing for most of thattime. The Royal Bank of Scotland changed from one of the most successful banks inthe world to being nationalised and posting the biggest losses in UK corporate historywithin a year; this was the result of a disastrous drive for expansion culminating in theacquisition of AB Ambro, possibly the most misguided take-over ever. While these areextreme examples, a lack of strategic control can clearly have severe repercussions.


9.2. Degree of planning and type of control 235

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 financial indicators, while others take into account awider range of measures which reflect competitive positioning. The attempt to controland evaluate planning outcomes is complicated by the degree to which planning hasbeen undertaken in the first case; when the planning process is vague, for example,the only measures which might be seen as relevant are financial ratios. This issue waspursued in a study carried out by Goold and Campbell,1 and Figure 9.1 attempts tocapture the main thrust of their approach by categorising companies according to theirdegree 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 classification, have a high planninginfluence but adopt a flexible approach to evaluation and control; the process may beinformal in nature without predetermined milestones, benchmarks or measures. Thiscould have the effect that managers are not provided with incentives which consistentlyrelate their actions to the overall purposes of the strategy. At the other extreme, FinancialControl companies rely largely on financial measures of performance which can missmany of the aspects of strategic control which are necessary to ensure that plans areactually being achieved; this type of company uses tight financial control as a substitutefor a planning approach. In the middle of the range is the company which uses a varietyof control methods and gives a balanced weighting to strategic and financial influences.

Clearly this classification is by no means precise; Goold and Campbell attempted toclassify companies but ran into difficulties in trying to be exact, leading to disagreementabout the classification 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 financially minded CEO who insists on the development ofdetailed plans backed up with clear financial targets, but with no attention paid to factorssuch as market share, sales growth and competitor performance, could be classified as‘Financial Control’. The point of the classification is not to imply that some companiesare better or worse than others, but to provide insight into the approach to evaluationand control. For example when markets are subject to rapidly changing technologicaldevelopment, the approach characterised by ‘Financial Control’ may be inappropriate.In this situation the company needs to be able to meet rapidly changing conditions andnot be diverted from its purpose by financial measures that may well be irrelevant.



In a subsequent study of major British companies, Goold and Campbell attempted toidentify potentially effective control methods.2 The general conclusions were as follows.

• The first stage in the control process should involve the selection of relatively fewappropriate objectives.

• From these objectives suitable targets can be derived so that pressure can becreated for effective strategic performance, but without setting up a bureaucracyto achieve it.

• A series of milestones can be identified which are tracked over time; these serveas benchmarks for evaluating strategic performance and provide early warning ofdeviations from expected outcomes.

• A narrow set of financial measures cannot provide the overall strategic view whichis necessary; on the other hand, many of the objectives and targets cannot bemeasured 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 tolaunch an innovative toaster that automatically adjusts the heating elements for the typeof bread inserted; this is an already crowded market and there is some doubt as towhether the new features will lead to success. The four control criteria are related to thefour types of planning control identified in Figure 9.1.

Criteria Loose Planning Financial Strategic

Few objectivesVague: highquality, hightech profile

Achieve 15%market sharewithin 3 years

Generate 15%ROI within 3years

Achievecompetitiveadvantage

Derive targets Imprecisenotions

8% Marketshare Year 1,12% Year 2

5% ROI Year 1,10% ROI Year 2

Relative marketshare

Milestones NoneActual versusdesired marketshare

Allow 1%variation eachyear

Performancerelative tocompetitors

Subjectiveevaluation

No realunderstandingof what hasbeen achievedso likely to beirrelevant

None None

Does it look likecompetitiveadvantage hasbeen achieved?

There are significant differences of their use of the criteria among the four classes.This interpretation suggests that the Loose control approach is too vague to controlthe process in any dimension. The Planning control class sets specific market criteriabut judges the outcome purely on the basis of whether these have been achievedrather than taking other variables into account, even subjectively. The Financial controlclass is much the same, except that it is even more constrained by financial measures.The Strategic control class uses a combination of measurable and subjective criteriathat enable judgement to be exercised in the light of changing circumstances. If thisinterpretation is more or less correct, it suggests that the Loose, Planning and Financialclasses are likely to have considerable difficulty in determining what is really happeningto the strategy.


9.3. Feedback 237

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 factorin the strategy process. This might seem surprising, given that strategy occurs ina dynamically changing environment; the scope of these environmental changes isenormous, ranging from the way the economy is performing to unexpected competitivemoves on the part of competitors. The difficulty of carrying out continuous environmentalscanning and communicating the results was discussed in Chapter 3.9.3; it is notsufficient to scan the environment and monitor company performance; it is necessaryto be able to act on information and changes as they occur. There are at least threedimensions to feedback.

1. Communication channels: how is information disseminated both upwards anddownwards in the organisation? It is difficult in practice to set up procedures whichrecognise the unexpected and ensure that the information is communicated to theindividuals who can take appropriate action. The real problem is to determinewhat is the most appropriate communication structure for a given organisation.For example, compare how information might be disseminated in a companyorganised along functional lines with one organised divisionally. In the functionalorganisation the marketing department may identify a change in market trends fora particular product, but is likely to have difficulty communicating the implicationsto other departments. In the divisional company the SBU can react to the marketchange, but there may be no means of communication with the corporate centrewhich needs to know what is happening to the company product portfolio.

2. Ability to adapt: the fact that communication channels exist does not guaranteethat appropriate action will be taken. A great deal depends on the individualsconcerned and their attitude to change. To a great extent this depends on thewillingness of individuals to listen to information which may often not be to theirliking, be prepared to admit mistakes, and be proactive. These characteristics aretypically part of the company culture and cannot be adjusted in the short term.

3. Learning organisation: Anyone with experience of education knows how difficult itcan be to develop learning abilities in individuals. The challenge is even greater fororganisations. The crucial issue is whether the organisation is able to learn fromand build on experience. Taking the example of a change in market trends, canthe organisation look back to a similar event and use that as a starting point, oris it necessary to re-invent the wheel each time? It is not whether the individualsconcerned learn how to react to events, but whether the organisation as a wholecapitalises on the learning of the individuals.

It is tempting to set up a system of formalised meetings at departmental, inter-departmental and divisional levels and hope that the structure will take care offeedback requirements. But setting up a formalized procedure is not even a necessaryprecondition for ensuring that feedback will be integrated into the strategic process.



Exercise 9.2

Assess feedback in SuperTools.

9.4 Analysing the ongoing competitive position: using theprocess model

Competitive conditions continually change depending on the performance of thecompany and the reactions of competitors. A key aspect of implementing strategy isto be aware at all times of the company’s competitive position; it cannot be assumedthat the initial market conditions identified at the analysis stage will continue unchangedas events unfold. It is from this point in the strategy process that a great deal of thefeedback to previous steps occurs as new opportunities and threats arise. An overallview of the company’s competitive position can be obtained by integrating the modelsand approaches developed.

This requires the application of a battery of concepts and models as shown in Table 9.1structured under the headings of the process model.

Table 9.1: The process model synthesis


9.4. Analysing the ongoing competitive position: using the process model 239

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 andcontrol, 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 conceptsfrom other disciplines which could be applied to specific strategy issues but which arenot included; a strategy analysis could, in principle, include every idea from the businessdisciplines, but it is up to the individual analyst to determine which ideas are relevantto the particular case and integrate them into a structure. It is clear from this displaythat it is only by the consistent application of a wide range of tools that a company’scompetitiveness can be properly assessed.

It is the integration of the process model with analytical ideas and models which providesa structure within which competitiveness can be assessed in the wide sense. It will rarelybe found that a company is ‘perfect’ in terms of every single idea and model: the trick isto identify the areas in which a company is particularly strong or weak and which factorshave contributed to its success or failure. This is not an easy thing to do and it is a typicalmisconception that success or failure can be attributed to a single factor. Perhaps themost demanding intellectual challenge of all is to apply the ideas to a company andidentify the seeds of success or failure before either actually occurs.

Strategy problems vary widely and not all models are applicable to all cases. One ofthe skills in strategic analysis is to identify which models and ideas are applicable to aparticular case and to derive insights from these models. But the sheer variability ofreal life and the range of potentially applicable concepts mean that different analystsmay focus on different aspects of the problem and, as a result, two valid analyses mayproduce different outcomes. This does not necessarily mean that partial analyses arewrong because, even if all models and concepts were applied, there is still the problemof attributing relative importance to each in arriving at conclusions.

While the integrated approach in Table 9.1 provides a basis for evaluating overallcompetitive position, the individual ideas and concepts can be applied to a variety of



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, theframework should always be kept in mind as a means of setting individual issues withinthe overall strategic context. Without going into a great deal of detail, the followingoutlines the sorts of question which continually need to be addressed when monitoringand evaluating strategy.

Strategists and objectives

Initially, objectives are set on the basis of a vision of the company’s future which, inturn would have been derived from a view of how the company might grow. Theappropriateness of these objectives is affected by the principal agent issue (where theshareholders might not have the same objectives as the CEO) and the characteristics ofthe chief decision makers in the company. Ongoing questions to ask include whether theperceived performance gap is being closed, whether the objectives are still consistentwith current competitive conditions and perhaps whether the strategy selected is nowseen to have been largely determined by the prospector qualities of the CEO ratherthan 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. Thegeneral environment must be continuously scanned for changes which are likely to affectthe market and the type of competitive market within which the company operates canbe subject to sudden change. The way in which value is produced by the internaloperations of the company is not static because changes in cost structure are inevitableas the company moves up the experience curve, benefits from economies of scale canemerge, new products are launched and investments are made in R&D. Bringing theseinternal and external factors together to assess the ongoing competitive position is afirst step which requires to be supplemented by a further set of questions relating tothe stage in the product life cycle, the positioning of the portfolio, product differentiationand the identification of the company’s strengths and weaknesses in relation to potentialopportunities 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 conditionsmay be oblivious to what is actually happening.

Choice

While the main strategic choice will have been made in the past it is essential toquestion whether the choice is being pursued as originally intended and whether thechoice is still appropriate. For example, the choice may have been to pursue a highlydifferentiated niche and grow by acquisition; the passage of time may reveal that theniche has been poorly defined, that the market is wider than anticipated and companiesare competing mainly on the basis of price rather than quality, while the acquisitionprocess has delivered higher productive capacity but with increased costs and poorcompany morale. It is the alignment of the chosen strategy with subsequent eventswhich will greatly determine future success, but as time goes by the company may lacka mechanism for ensuring that the strategy does not drift.

Implementation

Is the organisational structure ideal from the viewpoint of company size, products, and


9.5. Finally 241

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 fieldand the cultural web? Are resources allocated according to rational criteria rather thanbeing randomly allocated on the basis of an outmoded budgeting system?

Control and feedback

Again the issue of alignment arises: are company structure and resource allocationconsistent with the strategy? Does the company have procedures in place which providerelevant information on competitive performance? Is company structure flexible enoughto 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 identification andapplication of relevant models is the key to strategic insight you will have learned themost important strategic lesson of all.

9.6 References1 Goold, M. and Campbell, A. (1987) Strategies and Styles, Blackwell: Oxford.

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


242 ANSWERS: Chapter 1

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 individualperforming on stage or screen. The overall objective of the Madonna business wasto achieve stardom, and resources were mobilised to achieve this. It might be surmisedthat in order to compensate for her lack of relative advantage in the performing artsMadonna gathered highly competent personnel around her in terms of musicians,songwriters, dancers, producers and so on. The Madonna business understoodmarketing, in the sense that the images which she projected coincided with what herpublic wanted. But to do this she needed to have an understanding of her market,and her frequent changes of image probably reflected changing market preferences.Prerequisites for the Madonna business to thrive for over two decades include sensiblefinancial controls and market based criteria for which investments to make, whether inroad tours, books, films or a new image. So it can be concluded that what she didparticularly well was to exercise business skills rather than performing skills.


The interpretation of Madonna’s success was just that: an interpretation andexplanation. But while another singer who behaved in the same business fashion asMadonna might be successful, there are many other factors at work. These includethe business ability of the singer, the effectiveness of the business team built up, theselection of the correct marketing approach in relation to the singer’s characteristicsand the ability to adapt to changing preferences. Thus while behaving like Madonnamay increase the chances of success for a particular singer, there is no guaranteethat it will do so. In addition, relatively few singers (and this applies to the populationgenerally) have the vision to conceive of themselves as a business and to apply businessprinciples to what they do. So to a large extent most singers would not be able to act inthe same way as Madonna even if it was pointed out to them that this was the route tosuccess.


The details of the discussion are not so important as recognition of the fact that they willall approach the issue from different perspectives. For example

CEO: turnover is not necessarily a good indicator of profitability, and I need to ensurethat profitability from the three SBUs is as high as possible. The suggested systemwould give SBU managers the incentive to increase turnover at the expense ofprofitability.

Finance and accounting: it is a good idea because it means we have a simple rule toapply when deciding on remuneration.


ANSWERS: Chapter 1 243

Human resources: the implication that one manager is three times more valuable thananother 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 theother two.

SBU2 manager: the only reason we have SBU1 producing machinery at all is becauseof the gardening business we generate, so SBU1’s sales really depend on ours.

SBU1 manager: why is it that only Finance and Accounting are in favour of my idea? Itstands to reason that the bigger your sales are the bigger your responsibility and that iswhat you should be paid for.

This is your first experience of the fact that all the members of the organisation regardissues from their own perspective and this leads to conflicts; this is a subject which willcome up again and again in the course and is a fundamental problem of management.


The CEO and the operations manager were advocating the strategic planning approachin which the company can be managed by applying analysis and logic to existinginformation. Their view of the world was that they had just not been good enoughat doing this in the past. They were also committed to a resource based view, thatprofitability could be improved by making the company more efficient in the technicalsense. They were backed up in this by the finance director, who saw the issue in termsof efficient resource allocation.

On the other hand, the marketing manager felt that the emergent approach would bemore effective and that the company needed a greater degree of flexibility. He felt thatstrategy could emerge as the company developed and as the environment changed andthat it was pointless to plan for the unknowable. He was concerned with the dynamicsof 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 muchabout the way the problem should be tackled, but about the fundamental approach todecision making generally. He was saying that there is some middle ground which couldaccommodate both approaches, but given the entrenched attitudes of the managers itis unlikely that they would arrive at a compromise on their own.

One of the fundamental tasks of business education is to enable managers tounderstand what it is they are actually arguing about. In this case the profit problemwas a symptom of a wider problem, i.e. the lack of a robust strategic process, which tosome extent the CEO recognised.


1. The reasons advanced by Mintzberg and others that prescriptive planning isimpossible

The points can be inserted into the process model as follows, bearing in mind thatyou can have different opinions on where each entry should occur.



Setting objectives

Formulation and everyday management

CEO can choose and implement The idea that those responsible for settingobjectives and deriving the strategy sit outside the process is clearly mistaken. Bysetting this issue within the process it becomes even more apparent how artificialthe notion of separation is.

Analysis and diagnosis

Prediction It is impossible to undertake strategic decision making without someform of prediction, but the analysis should be able to throw light on how accuratepredictions are likely to be and the type of contingencies which will be necessaryto insure against adverse but unpredictable outcomes.

Strategy choice

Short term costs and long term benefit logical and applicable There will always bea trade off between the long and short run in making strategic choices. But giventhe importance of the choice element in the process, it is important that somerationality is imparted into choosing and implementing a course of action.

Implementation

Implementation is separate The implementation stage is an integral part of theprocess and is in fact the part of the process where most managers spend mostof their time.

Feedback

Analysis leads to a prescribed course of action which need not be altered Onceit is recognised that the environment can change, the dynamic aspect of strategyassumes equal importance to other considerations.

2. Emergent strategy

This is entirely consistent with the process approach, and gives particularimportance to the feedback element. The company constantly revisits itsobjectives, 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 thestrengths and weaknesses of a particular company’s process can be identifiedat a particular time. Application of the process model to a case enables a degreeof generalisation by extracting those elements of the process which are common todifferent situations. The application of the process model to the management teamconversation shows how the common elements of what appears to be a one-offsituation can be extracted.



2 Mission and objectives


1. Set out the skill sets relevant to travel agents specialising in business andholidays.

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 importantpoint is that the skill sets are different and there are likely to be differences inthe personal attributes of the individuals most suited to each.

Whether you think that it would be easy for the business travel agent to makethe move depends on the fit between the two lists you produced. The list abovesuggests that the skill sets are so different that the business travel agent wouldhave to undergo a significant amount of re-training. If this were not recognisedthen the business travel agent may well fail in the holiday business despite beingsuccessful 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 scopeof the security company it is impossible to predict what they might be, although allthree types of company are in the same industry.


When tackling this problem you have to try to identify clearly defined objectives which aremeasurable and attainable. For example, phrases such as ‘best possible’ provide no realbasis 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’ canbe assessed. A revised statement might read like this



To ensure that sick persons in the following categories enumerated do not have to waitmore than 10 days for treatment; to ensure that the infirm (who are unable to leave theirhomes 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 healthyliving as a preventative measure; to divert resources wherever feasible from cure toprevention.

This statement attempts to identify the target groups and provides the basis formeasurable performance. It is still vague about the reallocation of resources, but ithas to be recognised that some aspects of the mission statement can be no more thana statement of intent at this stage.

Turning to your own statement, identify the parts of it which are

• non measureable

• ambiguous

• infeasible


The precise answer to this problem depends on individual interpretation, but it isimportant to communicate the different types of business involved by the definition ofthe objectives.

1. The marketing objective is to target decentralised companies and convince themof the integrity and efficiency of the company; the emphasis is on the quality of theoperation rather than the price. The operational objective is to develop systemswhich guarantee a high degree of security and tried and tested internationalcommunication networks.

2. The marketing objective is to advertise widely to bring in as many customers aspossible and offer competitive rates, so long as the company does not incur aloss. The operational objective is to use whatever methods are available to deliverwhatever turns up.

Since the data carrying operation is highly specialised, it is pointless to advertise widelyand the emphasis will probably be on a highly personalised individual process. On theother hand, the national carrier is in direct competition with others who are doing exactlythe same thing and will find it very difficult to establish a brand image and reputation.


The objective of increasing market share in five different markets is unlikely to beachieved without incurring additional marketing expenses and probably reducing prices.Thus the strategic and financial objectives are not compatible in the short term. Theseobjectives are more of a statement of the position the company would like to be in thana statement of operational priorities. Since the strategic and financial objectives are



not aligned in the time frame specified it is difficult to see that the impact on companyperformance will be significantly positive. The statement of objectives may in fact leadto conflicts between finance and marketing which are counter-productive.


You will find that the issues facing general managers are similar to those discussed atChapter 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 manageras strategist, entrepreneur and goal setter. Even in large companies thesefunctions are not the sole domain of the chief executive and some aspects aretypically devolved to managers. While managers are to some extent constrainedby existing plans and commitments, they have a role to play in making decisionsabout potential investments, reacting to changing circumstances, identifying newcourses of action and so on. The objectives set will be a function of the outlook ofthe strategists: prospector, analyser and so on.

Analysis. In order to ensure that the company is competitive the manager needsto be constantly aware of changes in the economic environment, the efficiency ofthe firm, and its competitive position. The process of information collection andanalysis is time consuming, and it is necessary for managers to filter out what isunimportant and focus on factors which are likely to impact significantly on thefirm. Managers are typically keenly aware that time spent on analysing is at theexpense of more immediate concerns and this role tends to be given a low prioritybecause of its lack of immediate pay-off.

Choice. It is rare that major strategy decisions are taken without wide managerialconsultation. Options must be identified and different points of view brought tobear in order to assess the costs and benefits associated with each. At times themanager will be involved in higher level strategy assessment and at others he willbe making devolved strategy type decisions at his own level.

Implemention, control and feedback. Once decisions have been taken, themanager has a major role to play in making them happen. This involves allocatingresources in the first instance. Organising resources is typically thought of asbeing the major role a manager has to perform, but in fact it is only one ofseveral and it may not consume most time. As well as allocating resources,the manager has to monitor how effectively the resources are being utilised; thismeans that systems must be set up which adequately measure performance. Itis also necessary to ensure that communications are such that changes in theenvironment and the internal operation of the company are incorporated into thedynamic decision making process.

2. identify conflicts in the role.

The problem of management does not end with complexity and competingdemands on the manager’s time and intellectual resources. There is also a degreeof conflict inherent in the different roles. For example, the manager needs to set upsystems which ensure that resources are used efficiently; but these very systemsmay introduce inflexibility and resistance to the changes which the manager sees



are necessary in his role as competitor. The objectives and mission of the firm maybe expressed in general and non-measurable terms, while the control systemstend to be based on financial measurements; the two approaches may be difficultto reconcile. Thus as well as being charged with the task of resolving conflicts ofinterest in the firm, the manager must also deal with the internal conflicts causedby the roles which he is required to adopt.


The following observations on the general strategic approach of the three kinds oforganisation are by no means definitive; the important issue is that you are able toidentify the basis of different approaches at each stage of the process dependent on thebroad characteristics of the companies

Objectives

Small Informal and probably not communicatedby owner

Integrated Specific to the product

Diversified Expressed in terms of mission anddisaggregated to SBUs, products andfunctions

Analysis

Small Non-systematic and probably basedlargely on intuition

Integrated Detailed analysis of known markets, butwithout the application of sophisticatedtechniques

Diversified Continuous environmental scanning,construction of scenarios andinvestigation of competencies

Choice

Small Reactive

Integrated Proactive and focused

Diversified Complex, with differences betweencorporate concerns and SBU concerns



Implementation and Control

Small Haphazard and dependent on thedisposition of the owner

Integrated Focused on production of the product andsubject to informal or formal financialcontrols

Diversified Divisionalised, and supported by a batteryof financial and strategic controls

Feedback

Small No real distinction because of multipleroles

Integrated Dependent on the willingness ofmanagers to adapt to new information

Diversified May be seen as a threat to the status quo



3 Analysing the macro environment


Revenue and GNP elasticity

GNP elasticity Total market Market share Total sales % change

0.0 1000 15 150

1.5 1075 15 161 7.5

1.5 1075 16 172 14.7

Using the 1.5 estimate of GNP elasticity, it could be predicted that sales would be 7.5 percent higher than if the elasticity were assumed to be zero; this is a significant quantityand to ignore it could have serious consequences; for example, if the company werealready 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 thegrowing market, and in this case a 1 per cent increase in market share to 16 per centresults in a 14.7 per cent growth in sales.

When the economy starts to grow strongly, an effective marketing strategy responsewould be to concentrate resources on those products with a relatively high GNPelasticity.


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 percent or more, the impact of the change in economic conditions will be to worsen netcash flow.


1. The impact of the combined changes would be a total fall in revenues by 46 percent of the revenues in period 1; in other words, the company is now faced withrevenues about half of that two years before.

PeriodTotal

marketMarket

share (%) PriceTotal

revenue% change‘

3 90 15 8 108 -46

2. As these changes are due to macro economic factors which are beyond the control



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


The reflation would have affected potential revenue as follows.

Year Exchange rate Revenue in £ (million)

9 0.62 3.1

10 0.53 2.7

11 0.57 2.8

It is clearly difficult to plan ahead in such an unstable economic environment. However,a company which incorporated potential exchange rate movements in its planning wouldhave had some idea whether this type of fluctuation was potentially disastrous and havedeveloped a contingency plan to activate in the event of a reflation of the magnitudewhich occurred between Year 9 and Year 10.


Using Porter’s framework, the following factors can be identified, although you might notagree with the interpretation.

• Factor conditions: there is a plentiful supply of educated and productive labour inSilicon Valley

• Related and supporting industries: all types of computer related industries are tobe 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 leastable to react quickly to changes in competitive conditions.

The great unknown is what will happen to exchange rates and it could be that, if thedollar were to strengthen against the Euro, relative production costs would be muchlower in France; this could compensate for the advantages of locating in the US.




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


1. Draw up a PEST analysis using the limited information available.

Political

• The US government is clearly intent on introducing as much competition aspossible into the telecoms market by deregulation. But if monopolies start toappear 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 semi-

monopolies.– While the demand for telecoms services is increasing, the price is falling

leading to static revenues.– There are significant barriers to entry because of the need to build

infrastructure.

• Social

– Telephony is becoming an accepted part of life and the overall marketis set to increase significantly as consumers, both business and social,become ‘telephone literate’.

• Technological

– The Baby Bells control the technology which provides access to localmarkets, but there may be alternatives.

– The internet could be an important future base for many telephonyservices.

2. What would you be looking for when conducting environmental scanning?

The environmental scan would extend beyond the boundaries of America andwould be particularly concerned with the future of technology. For example, sincethe American market has been deregulated, are there other major internationalsuppliers who might potentially enter the market? On the technological front,questions such as the impact of satellite links and possible advances in computertechnology 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.



The scenarios are speculative, but need to focus on what are considered to beimportant variables. For example:

• WorldCom might be totally excluded from the Baby Bell interconnectionsystem and may have to invest billions of dollars to make the systemoperational.

• The demand for long distance calls might continue to increase but theprice may fall by an even greater amount: potential profitability under thesecircumstances needs to be investigated.

• AT & T might enter the market in a big way: what will this do to potential pricesand market shares?

Each of these scenarios provides the basis for extensive investigation to provide somenotion of the risks confronting the company. One scenario that would not have beenimagined in the late 1990s was that the CEO, Bernie Ebbers, had built WorldCom onextremely shaky financial foundations and was eventually convicted for securities fraud,conspiracy and filing false documents with regulators. Often the future lies beyondimagination.



4 Analysing the market environment


1. In the short term the supply of vessels is almost fixed because of the time it takesto build new ones. This results in an almost vertical supply curve and is the keyto explaining why there are such large short term variations in vessel prices. Thesituation is summarised in the figure.

We can now track what happens from the time there is a sudden increase indemand 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 animmediate large proportionate increase in supply and the price rises to P2.

• By the later time period 3, shipyards have reacted to the higher price andincreased 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 isnow higher than in the first time period, this has the effect of causing the priceto fall to P4.

A rudimentary knowledge of supply, demand and price determination predictsexactly what happens in the shipping business and also reveals that pricefluctuations are likely to be a permanent feature of the shipping market. This isan 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 toincrease, he should buy vessels now because the price is bound to increaseby 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.



• Because of the interaction of supply and demand prices in the shippingbusiness are always going to fluctuate and there is no point in waiting fora period of stability. Bear in mind that even if managers learn how to react inthis environment the cyclical behaviour of the market will still continue.

3. Any factor which alters the position of the industry demand or supply curves willhave an impact on market prices. The extent of this impact depends on the shapeof the demand and supply curves. In the shipping industry the effects are largebecause of the inelastic supply curve. If the supply curve had been elastic theimpact on prices would have been much less. The analysis was not expressed interms of actual prices, nor was there any attempt to be accurate. This is becausedemand and supply analysis uses the concept of equilibrium price which doesnot exist in real life because transactions are taking place all the time around theequilibrium point; all buyers and sellers would have to have complete informationabout each other for all transactions to take place at the equilibrium point and thatis clearly impossible. However, the analysis does enable us to make predictionsabout the direction and rough magnitude of change, taking account of what isknown about the slopes of the demand and supply curves, We can then base ouractions on the knowledge that, in the absence of other changes, this is how thingswill generally work out. More detailed information would not have told us muchmore about the relative demand and supply elasticities.


The first step is to identify the structural and the strategic barriers.

Structural

• Capital requirements: expenditure can be controlled because the market can beentered incrementally by building one store at a time. In any case, as a globalplayer, WalMart has huge financial resources.

• Sunk costs: it may be possible to sell supermarkets together with their goodwill tothe incumbents in the event of failure.

• Size of the market: consumer expenditure is growing in the UK; however, there isa possibility that some local markets might become saturated.

• Tacit agreement: the incumbents who currently share the market have had littleincentive to reduce prices up to now; it may be that they will react quite strongly tothe WalMart threat.

• Economies of scale: WalMart depends on its world wide operations to generatescale economies. By building supermarkets on an even larger scale than theincumbents they should not be at a disadvantage.

• Experience effect: WalMart can draw on the experience gained in the US to drivecosts down.

Strategic

• Reputation: the act of shopping itself is not differentiated; unless the incumbents



can offer a shopping experience which is superior to WalMart, it is difficult to seethat the name of the store can make much difference.

• Pricing: if the consumer groups are right then WalMart might be faced withsignificant price reductions by the incumbents, making it that much more difficult toattract shoppers. But this depends on whether competition really has been absentfrom the market.

• Access to distribution channels: this is one of WalMart’s strengths and is one ofthe main reasons for entering the market in the first 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 becarried out differently with emphasis being placed on certain aspects:

• Sunk costs: the incumbents may prefer to watch an entrant fail and then attract themobile consumers rather than enter a price war. Consequently, sunk costs maybe relatively high.

• Size of the market: the major retailers have in fact been increasing capacity fasterthan the growth in the market. Therefore there is really no room for an entrant.

• Reputation: the major retailers have already been differentiating by offeringfinancial services and attempting to align themselves with local communities. Thereputation barrier may be much greater than WalMart thinks.

Thus the strategic decision cannot be classified as either right or wrong on the basis ofthe available information.


When there were many small stores serving local markets it could be argued that manyof the conditions for perfect competition existed. However, it could also be argued thateach of the small stores served its own local monopoly and in fact had a good deal ofmarket power. This monopoly power was not based on scale economies but on the factthat consumers were not highly mobile.

Later the larger self service supermarkets led to the decline of the small shopkeeper andat this point the stores tried to compete by differentiating their shops and services mainlyby stocking a very large number of lines. This was a form of imperfect competition, wherereal economies of scale had not been exploited.

Then came the mega stores and the relatively few retail chains now constitute anoligopoly. In the modern car owning society it is quite possible for consumers to switchfrom one to the other and there is a marked reluctance to engage in a price war.




The answer to this difficult question depends on how much information is available, andyou may have gathered more information than is contained in the case by reading thebusiness press. Thus the following comments are not definitive but are intended to showhow the ideas can provide a particular perspective on the issue.

• Prisoner’s dilemma: the incumbent retail chains have often been accused ofcolluding to keep prices high. The dilemma suggests that such an agreementwould be difficult to arrive at and that it would be unlikely to have remained inplace for a long time.

• Price leadership: it is possible that price leadership may occur once WalMartbecomes established. However, this is dependent on its gaining a dominantmarket share and that is by no means inevitable.

• Limit pricing: the incumbents probably cannot use limit pricing because it is wellknown that WalMart has a lower cost structure.

• Predatory pricing: WalMart has always had a policy of low prices and no instancehas been discovered of WalMart using temporary price cuts to put competitors outof business.

• Contestable markets: there is a slight logical problem here, in that if all marketswere contestable there is no incentive for entry because prices have alreadybeen set at the level which makes entry uneconomic. The only reason that theincumbents might have had for setting prices higher than the contestable level isthat they did not consider the market to be contestable because of the high sunkcosts.


Segmentation

The segment of the market which Marlboro was aimed at was the status conscioussmoker 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 themarket would have revealed something like the following, using price and quality as thesegmentation variables.

High x x

Price

Low x

Low High

Quality



There was a gap in the Low/Low category and this was subsequently filled by thepremium suppliers.

Quality

Marlboro seemed to rely on the notion of user based quality, but given the characteristicsof a cigarette it is difficult to see how the dimensions of quality could be used to maintainsales when discounted cigarettes became available at one third of the price. While thediscount cigarettes were perhaps inferior in quality in terms of the tobacco used, it isunlikely 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 antismoking lobby where the quality of all cigarettes was exposed to criticism because ofthe associated health hazard.

Perceived price and differentiation

Marlboro was moving in the perceived price differentiation matrix towards the failurelikely region.

Pricing in segments

The original rationale for charging a high price in the segment was that the demand wasrelatively inelastic because of the strength of the brand. However, this was changingand the relatively high price could have been one of the reasons why Marlboro hadbeen losing market share.


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


It is necessary to disentangle the relevant information from the advertisement and thediscussions.

1. StylePlane: It is on the mature to decline stage of the life cycle and has thedominant market share at about 80 per cent. This places it securely in the CashCow sector. This is corroborated by the fact that it is the product which is makingprofits and financing the development of the PowerPlane.

PowerPlane: It is on the growth part of the cycle but is unlikely to be the largest inthe market. This makes it somewhere between a Question Mark and a Star. Thefact 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



therefore charge a premium price.

• There are no barriers to the PowerPlane market and in fact Super- Toolsthemselves 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 profits.

Pricing

• StylePlane competition is a zero sum game because the market is static ordeclining.

• PowerPlane is priced below competition, and this is unlikely to be an attemptat predatory or limit pricing, but is probably intended to help increase marketshare in a growing market.

Segments

• The two products are in different market segments and they are notcompeting against each other. The CEO does not see this and is concernedthat the products are competing against each other. This highlights theimportance of defining 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; itis not clear whether the type of cosmetic improvement discussed will move itsignificantly.

• The PowerPlane is not differentiated, but is priced lower than other makes; itis probably located in the success uncertain area.

3. In BCG corporate terms the portfolio is unbalanced because it is comprised of adeclining cash cow and an uncertain star.

There is some room for discussion on the corporate growth vector; at first sightit is an existing product into an existing market, but in fact the PowerPlane is anew product using completely different workforce and technology and the marketit is entering is new to the company. This actually places it in the diversificationquadrant. Part of the company’s problem is that the CEO has failed to recognisethat it has moved into an unrelated diversification. If the company followedthe CEO’s joke about powered sanders, the growth vector would be even morefocused on new products and markets.


The two obvious axes are the degree of technology embedded in the product and theskill required to use it. The StylePlane would be plotted as low technology and high skill



and the PowerPlane as high technology and low skill. From this perspective the twoproducts are in two quite different strategic groups with different competitive influences.

Another possible axis relates to the type of end use: professional cabinet making forthe StylePlane and home DIY for the PowerPlane. However, the skill variable can beregarded as a proxy for the type of end use and changing the axis would not alter therelative positions much. It is virtually impossible to think of axes which would result inthe two products being classified in the same strategic group.


The model is applied to the two products individually because they are in differentsegments of the market for tools.

StylePlane PowerPlane

Threat of entrants Low: monopoly power High: homogeneousproduct

Threat of substitutes Low: unique High: technological changePower of suppliers High: skilled labour Low: uses standard parts

and unskilled labourPower of buyers Low: specialised market High: switching costs lowRivalry Low: virtual monopoly High: many competitors

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




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



5 Analysing resources and strategic capability


1. The aggregate ratios are as follows

Ratio Year 1 Year 2

% %

Return on total assets 8 15

Return on equity 11 28

Return on investment 11 16

There seems little doubt that company performance has improved significantlybetween the two years. This is primarily due to the fact that the operating surplusincreased 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 ROEand ROI were equal in Year 1 was that the values of owner’s equity and fixedinvestment were approximately equal; by Year 2 fixed assets had almost doubled,while owner’s equity had remained almost unchanged, leading to the very largeincrease in ROE. This arose from the fact that the increase in fixed assets hadbeen financed almost entirely by loans, as can be seen from the increase in longterm debt from £2 million to £12 million.

The net cash flow position has improved greatly, from a net outgoing of £1.8 millionto a net inflow of £2.2 million. The fact that the net cash flow in Year 2 is £1.6million less than the operating surplus needs to be explained; it is obvious thata major part of the difference is that the company now has a very large longterm loan commitment of £1.3 million per year. This in fact raises the questionof whether operating surplus is the appropriate measure of profitability for thiscompany. Substituting net cash flow for operating surplus in Year 2 gives thefollowing result.

Ratio Operating surplus Net cash flow

Year 1 Year 2 Year 2

% % %

Return on totalassets

8 15 9

Return on equity 11 28 17

Return oninvestment

11 16 10

Using net cash flow for Year 2 reveals that both ROTA and ROI werevirtually unchanged between the two years. This demonstrates how accountingconventions can greatly affect measured performance and raises doubts as towhether the underlying profitability of the company has actually been increased.

2. The company’s cost structure itself changed between the two years:



Percentage of total cost Year 1 Year 2

% %

Wages 33 29

Production lines 22 28

These ratios reveal that the company has become more capital intensive, to beexpected as a result of the large investments in equipment made during theperiod. But whether this cost structure is actually more efficient would requiremore detailed figures on unit costs.

The impact of the investment programme on profitability is uncertain, given thedoubts raised above on the appropriate measure of profit. In fact, sales revenueincreased from £8.1 million to £11.5 million between the two years and it is difficultto see what effect an internal reorganisation of capital and labour inputs couldmake to the value of final sales - this is more likely to be related to general demandfor the company’s product, marketing expenditure and pricing. The real issue,then, is what would have happened to profitability if sales had increased by thatamount and no investment programme had been undertaken. One answer to thiscan be obtained by simply grossing up the cost of goods sold in Year 1 by theincrease 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 returnon the investment of £11 million (the difference between the Fixed Assets betweenthe two years) is that it resulted in a cost reduction of £1.4 million. This gives anROI of 13 per cent, which suggests that the investment was worthwhile.

It needs to be stressed that the information available cannot provide a definitiveanswer to these questions. It may be possible to arrive at different conclusions byconducting the analysis in a different way. The important issue is not to take thenumbers 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 torationalise and modernise its productive processes. It has reduced its costs inthe sense that COGS is £1.4 million less than it otherwise would have been soit should be in a position to compete effectively with other efficient producers inthe future. While there are some concerns about what has really happened toprofitability between the two years, it is open to question whether the companywould have been able to accommodate significant increases in demand with itsYear 1 capital structure.


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 paymentsare currently about one third of operating surplus. Would financial institutions bewilling to lend more? This largely depends on whether profitability is now regardedas stable and the fact that sales revenue grew by about 40 per cent between Year1 and Year 2 suggests that the market is not stable - a great deal depends onwhether the increase in sales is regarded as temporary. As the perceived risk



associated with SuperTools is now much higher than in Year 1, it is likely thatbanks would require a higher return to reflect this. If SuperTools had financed theoriginal investment by equity issue it would perhaps now be in a stronger positionto consider further expansion.


1. The calculation itself is quite simple being based on the formula Fixed Cost dividedby Contribution per unit, generating the break even numbers below.

NozzleGlue BlueGlue

Price ($) 10 7

Unit cost ($) 5 4

Contribution ($) 5 3

Fixed cost ($) 200000 180000

Break even (units) 40000 60000

Market share (%) 10 15

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


1. The calculation is set out below.

NozzleGlue BlueGlue

Market size ($) 400000 400000

Market share (%) 10 15

Contribution ($) 5 3

Annual revenue ($) (multiply above three together) 200000 180000

Investment cost ($) 1000000 810000

Payback (divide investment cost by annual revenue) 5 years 4.5 years

2. The calculation makes a number of assumptions, for example that the marketshare requirement of the break even analysis would be achieved, that the market



would remain at about the same level for several years and that the selling priceand costs would be unchanged. Given the length of time to payback in both casesit is unlikely that these assumptions would be valid in four or five years time. Thefact that the payback period for the BlueGlue is six months less than that for theNozzleGlue is probably not significant given the time scales involved. What thepayback analysis shows is that both products are exposed to a relatively highdegree of risk.


1. The calculation assumes that you are familiar with the concept of NPV and how towork it out.

BlueGlue NozzleGlue

10 years of annual net revenue $180000 $20000

Sum of 10 years discounted (Present Value)@15% $903378 $1003754

Investment $81000 $1000000

Net Present Value $93378 $3754

(Present Value minus Investment)

2. The break even analysis showed the market share required for the productsto recover their investment cost, while the payback calculation showed that theNozzleGlue was more risky because of the longer payback period. The NPVcalculation shows that the BlueGlue is a better investment in the formal sense andbacks up the findings of the payback analysis. This is another item of informationin favour of the BlueGlue; however, it is dependent on the basic assumptions onmarket shares and costs; if these are wrong the calculation is meaningless.


1. There are a number of risk factors associated with any product launch, for examplethe assumption that both products would capture a significant market share afterlaunch; it is questionable whether the high quality product would in fact be moreappealing to potential customers. While the potential market share is a matterof conjecture the company does have some control over costs and it is usefulto examine what might happen to the risk profile if costs were reduced by areasonable amount, say by 10 per cent. The scenario derived from the paybackcalculation is as follows.



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 flows 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 unitcosts 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 shouldthe sensitivity consider plus or minus 1 per cent, or plus and minus 5 per cent?If you find that the NPV becomes negative for both products with only a 1 percent smaller market share, this will suggest that attention should be focused onthe market side as well as on costs. However, if you find that the break even,payback and NPV are relatively unaffected by such small variations, then you canrecommend focusing on the cost side. There are no unambiguous answers to thisissue because it is an attempt to look into the future, but it is important to be awareof the possibilities.


While the culture classifications are meant to reflect organisations, it is instructive toclassify each manager. You might, of course, arrive at different conclusions to thefollowing.



Manager Culture

Accountant role

Production role

Human resource role

CEO power or personal

Marketing task

This classification 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 leadsto unpredictable responses based either on a lack of analysis or lack of focus. At thesame time his three colleagues are dominated by their role and tend to be slow to reactto competitive challenges and are resistant to change.


A major outcome of the benchmarking approach is that it may reveal things about thecompany about which it is ignorant and provide some insight into what comprises bestpractice. For example, a company simply may not know that distribution systems usedby retailers can be adapted efficiently to a manufacturing setting. But a note of warning isnecessary: measurable dimensions of company performance are unlikely to reveal howcompetitive advantage is achieved, otherwise the characteristics would already havebeen imitated. It is how performance is achieved, rather than the fact that it is beingachieved, which is difficult to identify and is something which competitors are unlikely todivulge.


If there are significant experience effects to be exploited, the company has a limitedtime to take advantage of them because of the reducing percentage effect as cumulativeoutput is increased. If there are also significant economies of scale in the industry, thecompany which is first in and is bigger than competitors has the potential for an early costadvantage. A company which feels it has a cost advantage over rivals should attempt toidentify where the advantage is derived. If it is from experience effects, the advantagecan be expected to decline over time; if it is from economies of scale the advantage willbe retained so long as competing companies do not increase in size.


It is in fact extremely difficult to determine whether economies of scope are beingrealised because to do so the company would need to know what production costswould 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 allocatecosts on an arbitrary basis.

Some of the issues which need to be identified are



• how can potential economies of scope be recognised?

• how can the costs and benefits 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 (tobenefit from scale economies) or on increasing the portfolio of products (to benefitfrom scope economies)?

These issues are intended to stimulate further consideration on this issue; no doubt youcan come up with additional suggestions.


Corporate management

There may be possibilities for individual SBUs to share common indivisible resourcesand to eliminate excess capacity. However, this is not a case of 2+2=5, but simplymaking the optimum use of capacity. This benefit is more properly related to productionmanagement. A different corporate management issue is that similarity among SBUsmay make them more amenable to management than a series of SBUs in unconnectedmarkets. This begs the question of what is meant by ‘similar’. An SBU which hasrecently been added to the company may produce similar products, but may haveinherited a management structure and ethos which is totally alien to the corporation.Synergy at the corporate level may be identifiable after the event, but whether theaddition of any given SBU to an existing company would generate a positive synergisticimpact is impossible to predict.

Economies of scale

While synergy is different from economies of scale, it is possible that some dimensions ofscale economies can be captured by diversification into similar products. This is relatedto the notion that there is a carry over from experience in similar production and sellingenvironments; operating in a series of similar markets has elements of doing more ofthe same thing which is the notion underlying both economies of scale and experienceeffects. This argument is not very compelling to the economist whose rigorous definitionof 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 willresult.

Vertical integration

The potential for economies is discussed at 5.11.4. These economies are related tocapacity utilisation, transport costs and so on. They are usually related to more efficientuse 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 couldundertake additional tasks without significant increases in wages or numbers employed,factory space may not be fully utilised, and so on. This potential benefit resembles thatof similar SBUs making use of each other’s spare capacity from time to time.



Joint production

Many inputs are shared among different products; management itself is shared atthe corporate level. For example, take the case of two sheep farmers, one of whomproduced only wool and the other produced only meat. If they were to merge theiroperations there would obviously be scope for sheep producing both wool and meat.There are likely to be many instances of much more subtle benefits from joint productionin modern companies.

Innovative stimulus

The mere fact of incorporating another area of activity may spark off new ideas andapproaches. 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 thereis no basis on which to conclude that a particular course of action would lead to apredictable reduction in costs due to synergy. It is likely that synergy is the outcomeof complex interaction effects and linkages specific to individual companies, with thecontributing factors varying from case to case.


Taking the four arguments in favour of diversification in turn:

Risk minimisation: the risk profile of the six divisions is certainly different; for exampletravel and tourism and financial services are affected by different variables. However, itis difficult to conclude that the business portfolio was put together on the basis of a riskanalysis; it is more likely to have been constructed on the basis of identifiable businessopportunities.

Synergy and economies of scope: it could be argued that all six divisions are directedtowards consumer services and as such are generally related. There are certainlylinkages between retail and cinema and media and entertainment; however, the linkagebetween these and financial 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 knownbusinessmen in the world, and brings his own logic of dynamism, enthusiasm and highprofile to everything he touches. But whether this particular management approach isthe most appropriate for all 27 companies is impossible to say.

Reputation: Branson initiated the Virgin brand in the music business and successfullytransferred it to air travel. Whether the extension to financial services is due to thecontribution of the brand name, rather than the innovative genius of Branson himself, isa matter of conjecture.


1. First of all, it is necessary to decide which business British Gas sees itself as beingin. If its business is as supplier to final consumers it can purchase gas from any



source and distribute it. This means it could concentrate on distribution and letother companies explore and set up pipeline systems. If it defines its business asexploration it could focus on finding new fields and selling the production rights.

If the analysis was correct the break up value was about 25 per cent greater thanthe corporate value. In this case the market clearly did not think that the benefitsof vertical integration were being realised.

While it is not possible to derive specific conclusions from the data, the followingproblems 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 highlyunlikely that just enough reserves would be discovered to satisfy currentdemand.

• Business at different stages can be radically different and present differentstrategic problems. The management of exploration is different, to saythe least, from the problems of marketing gas to final consumers. Inbetween there are also different problems involving efficient production anddistribution.

• If the company is constrained by its own supply it will not be able to actquickly and flexibly in response to changes in the market. Unless thecompany conducted exploration in anticipation of increases in demand itwould certainly be constrained by its own reserves. If it were constrainedit would have to go on the open market to purchase supplies and this throwsinto doubt the rationale for undertaking exploration on its own account in thefirst place.

• The risk inherent at each stage ceases to be independent and risks whichaffect one stage will have an effect on other stages of production. Explorationis an extremely expensive business, as is the maintenance of unusedreserves. Rather than take the risk of satisfying future (unproved) demand thecompany may well be better to concentrate on the distribution and marketingof gas which it purchases from suppliers.

2. It is possible to set up arguments based on British Gas concentrating onexploration and selling its reserves on the open market to purchasers. The reasonthat the break up value of British Gas was greater than the corporate value doesnot rest on the fact that any one part of the vertical chain is necessarily unprofitablebut that the vertical chain itself does not make economic sense.


The foundations of Marks & Spencer’s original success lay in a strong value chain.Taking the primary functions first.

• In-bound logistics: M & S had a set of strong relationships with suppliers which itused to its advantage.

• Operations: M & S was very efficient at the process of retailing.



• 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 wasperceived 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 peoplewanted to buy.

• Technological development: the company was at the forefront of modernapplications of IT.

• Human resource management: M & S was regarded as being a top class employeroffering excellent careers for its employees.

• Management systems: the stores were regarded as being among the best run inthe world.

The linkages which had been established between the primary and support activitieswere very difficult to imitate and together they enabled Marks & Spencer to positionitself as a highly differentiated retailer.

The problems which arose can be located primarily within the support aspects of thevalue chain.

• Procurement: the unsold stocks suggest that the company had lost its ability tomatch its purchases with consumer demand.

• Human resource management: the boardroom battles and the subsequentsacking of middle managers suggest that for some time its policies had been lessthan optimal.

At the primary activities level the main failure was in the marketing function. While theindividual managers had been good at responding to local demand conditions, theycould only do so as long as the centralised stocks available to them were generallyaligned with taste and fashion. Once this link had been lost it was impossible for localmanagers to market effectively.

Many of the elements of the primary components of the value chain continued tobe 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 non-imitable competitive advantage to disappear.

The main value system linkage was between the company and its British suppliers whichgenerated the reputation for quality. When it switched to foreign suppliers it became partof the same value system as other retailers. The result was that it lost its differentiationbased on perceived quality. The fact that seven years later Marks and Spencer hadstill not recovered its market position demonstrates how difficult it is to repair the valuesystem.




One interpretation of SuperTools’ diversification is that it was related because thecompany was merely entering a different segment of the existing market. However, thecompetence based approach generates a different conclusion. The routines adoptedfor the production of the PowerPlane were quite different: they were based on unskilledlabour and high levels of output, with little attention being paid to the type of qualitywhich was important for the StylePlane. The resources were also quite different, beinghighly skilled craftsmen who required a long period of apprenticeship. This means thatSuperTools had undertaken an unrelated diversification in the competence based senseand this probably contributed to the reservations expressed by the marketing manager’scolleagues.


Marks and Spencer had a significant market share in the relatively stable retail marketand could be classified as a cash cow. As such it benefited from some of the strategicassets. But it was famous for its reputation and this distinctive capability was key to itscompetitive advantage. The importance of this distinctive capability became apparentafter it lost its reputation through mismanagement of the value chain: it had to fall backon the strategic assets which were not strong enough to maintain its overall competitiveadvantage and the company went into long term decline.



6 Culture and stakeholder expectations


There are no absolutely correct answers to the questions, but they can be discussed inthe following way.

1. In a purely market economy capital will be directed to the uses which generate thehighest rate of return. As a result a company which does not make the market rateof 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 shouldhave the highest priority because that is a matter for subjective judgement. Otherstakeholders will receive their rewards on the basis of the operation of the marketand there is no particular hierarchy of stakeholders such as managers, employees,suppliers, customers or creditors. The local community may have some degree ofpriority depending on the circumstances, while in a purely market economy thegovernment has by definition virtually no role to play in business decision making.

2. This is a principal agent problem. The executives are aware that they must make atleast 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 theirremuneration package is aligned with the maximisation of shareholder returns.Thus the implication of this priority is that shareholders must attempt to align theinterests of the executives with their own.


There are no hard and fast answers to this question, but the type of factors determiningstakeholder influence include



Stakeholder Factor

Shareholders Number

Managers 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 andtariffs


The stakeholder map from the marketing manager’s point of view will look like thefollowing:



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



7 Strategic options and strategic choice


The construction of the SWOT analysis depends on your own interpretation of theinformation, and you might disagree with the following.

Strengths Opportunities

StylePlane is a cash cow PowerPlane is a star

StylePlane reputation New product development

Up to date plant and equipment

Plenty of productive capacity

Weaknesses Threats

StylePlane in decline stage New entrants

Gearing is 47 per cent Technological change

PowerPlane production problems

Moribund management team

Low morale

The strengths of the company are aligned with the opportunities for the PowerPlane andthe development of new products, although the gearing ratio might present problemsif new product development requires investment. The main weakness for the future isthat the management team (with the exception of the marketing manager) is unwilling toface up to the threats. It emerges from the SWOT analysis that reliance on the behaviourwhich generated success in the past will not work in the future. The logical course ofaction is to utilise the revenues from the StylePlane, as long as they last, to financethe development of the PowerPlane as it moves up the product life cycle, and generatepotential new stars for the future such as the PowerSander.


Company size generic decisions

The CEO had for many years pursued a strategy of stability and then opted for a genericstrategy of expansion. However, he has now regretted this and his attitude seems to beto 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 qualityproduct. Little regard is paid to the overall efficiency of resource use.

Allocating resources

The CEO paid little attention to the accountant’s concerns and simply issued instructionsto the production manager to reduce costs. The inventory problem was not even



discussed.

Contributing to the formulation of business level strategy

The CEO has no understanding of the marketing manager’s approach; his notionof differentiation is to add more of the same to the Style- Plane and he has littleappreciation of product positioning. So far as extending the portfolio with further productdevelopment is concerned, he treated the issue with disdain.

Monitoring and controlling performance

There seemed to be little in the way of regular reporting.


1. This is a difficult question; the following matrix sets out one solution.

Heavy emphasis No emphasisProspector Analyser Defender Reactor

Differentiation Aggressivepursuit of newproducts andmarkets

Seekexpansion inrelatedproducts andmarkets

Maintainadvantage

Wait forcompetitivemoves

Costleadership

Ignore Seek lowercost options

Cost controlsystems

Wait for poorresults

• The Prospector is primarily concerned with pursuing growth by differentiatedor low cost products and is probably indifferent to which characteristicgenerates potential competitive opportunities; a potential weakness is lackof attention to details such as cost control.

• The Analyser will tend to start from the base of a strong core business andwill expand into related areas; this is because the Analyser is unwilling toenter markets on which there is little information and no experience.

• The Defender will tend to be operating in mature markets and is likely to beconcerned with maintaining the position of cash cows; the Defender’s attitudemay be largely conditioned by the fact of operating in mature markets.

• The Reactor, as might be expected, simply waits until the pressure of eventsforces some course of action upon it; at times the Reactor will behave likeone of the other three types, but there will be no consistency in the approachover time.

This illustration might at first appear to be painfully obvious; however, experiencesuggests that many managers do not have a clear idea of which classificationtheir company falls within. Many managers would like to be characterised asProspectors, but in fact they are Reactors; managers who feel that they do notalways seize opportunities should ask themselves whether this is because of anaversion to risk or because they are basically Analysers.

2. This type of classification has a potential payoff in real life. When the opportunityfor product market growth arises, an SBU CEO can start by identifying the main



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


The strategist would work through each of the reasons for acquisition methodically andtry to determine whether any of them was convincing.

Reason foracquisition

Strategist’s response Convincingreason

Recognisedunrealised value

The CEO does not mention that either company isbadly managed at the moment

No

Buying marketshare

The market segments are different so market sharein the original market will be unaffected

No

Reducingcompetitivepressures

No attempt appears to have been made to assesscompetition pressures in either new market;competitive pressures may actually increase

No

Synergy Although not mentioned synergy is an implicitargument in both cases, but the differences inmarkets and skill sets makes it unlikely

No

Balancing theportfolio

It is not known where any of the products arepositioned in the BCG matrix while there are noapparent linkages among the value chains

No

Corecompetences

This was dealt with above No

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


Strategic option For AgainstRelated and unrelated Potential for synergy Difficult to define

relatednessVertical integration Direct control over supplier Lose market disciplineAcquisitions Potential of unrealised value May bid away potential

benefitsJoint ventures and alliances Avoid implementation

problemsPrisoner’s dilemma

International expansion Transfer competitiveadvantage

Exchange rate volatility



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 andagainst the adoption of any strategic option and that these have to be balanced againsteach other. With the limited information provided in the question it would be impossibleto arrive at the best strategic option; an important issue then is how much additionalinformation would be necessary to arrive at a rational choice.

How do these options compare with simply distributing the cash to shareholders in theform of dividends? This depends on whether the CEO thinks he can generate a betterreturn for shareholders than they would have obtained elsewhere; at the very least hewould have to be confident of generating a higher rate of return than the market average.


There is plenty of room for discretion here and the following interpretation is by no meansdefinitive.

CEO Marketing Manager

Shareholder wealth Concerned with the product Seems to be aware of valuecreation

Performance gaps Does not look forward Sees that the company isnot equipped to meet futuremarket conditions

Portfolio choice Does not think in theseterms

Is concerned about thebalance of the portfolio

Familiarity Sees unfamiliar marketsand products as high risk

Is willing to enter theunfamiliar sector

Risk Risk averse Risk takerContingency No need in a static

StylePlane worldDoes not consider it

External dependence No mention of mergers oralliances

Same as CEO

Previous strategies Greatly affected by pastsuccess

Wishes to get away from thepast

Power relationships Sees choice as anexpression of his dominantposition

Has no power base and isunlikely to persuadecolleagues

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



8 Implementation


1. At this stage we are moving into areas where judgement and interpretationcan lead to different views; however, the important point is that in a situationsuch as this you recognise the importance of considering these elements of theimplementation process.

Structural forms: there was no recognition by the CEO of the need for specificproduct based responsibilities; the company was organised along functional linesalmost by default. The two technologies differe: the StylePlane is custom andthe PowerPlane is mass production. In the custom case there is no need forclose supervision and there is no economy of scale; the opposite applies to massproduction. That is probably why the PowerPlane was regarded by the productionmanager as an almost unwelcome distraction.

Functional silos: there is very little reason for communication between the twoproduction lines; the skilled StylePlane workers are unlikely to have much incommon with the unskilled PowerPlane production line workers. While thetwo lines may not be formally organised as divisions that will not prevent silosdeveloping.

Integrating mechanisms: at the moment there appear to be none and it is difficultto see what form an integrating mechanism might take between totally differentproduction lines.

Type of strategic change: this is a major strategic change that impacts on everycomponent of the strategic process; the very business definition has been altered.Unfortunately, at the moment the CEO appears unaware of this.

Barriers to change: there are some obvious barriers, such as the unwillingnessof craftspeople to become involved in mass production and Production Manager’ssympathy for the StylePlane.

Force field analysis: everyone appears to be against the change; the StylePlaneworkers feel resentment. The CEO has made no attempt to clarify, identify, assessthe 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 allabout custom production. It is difficult to see how the elements could be generatedfor mass production in a way that would appeal to the custom build workers. Therewas a tendency on the part of the CEO and the production manager to refer backto the old days as a time when things were much better.

Styles of managing strategic change: the change is transformational with a longtime horizon, suggesting participative management style. The CEO does notappear to wish participation by members of his management team so it is unlikelyhe will promote a participative approach for employees.

Critical success factors: there is an unstructured discussion referring to someimportant factors, such as finance, but no mention of criticality. The companyseemed to blunder on and deal with problems as they arose rather than thinkingthrough 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



developing a star product in the market. Overall, the discussion suggested thatthe company had little real perspective on cost structure and return on investment.

Incentives: the low morale mentioned by the HRM Manager suggests the incentivesystem is not aligned with business objectives. The CEO seemed to focus onfailure rather than success: his attitude to the PowerPlane was ‘fix it or else’, andhe was scathing about the prospects of further product development.

Resource planning: the Production Manager does not wish to get involved indetails; little attention appeared to be paid to aligning the supply of the PowerPlanewith the demand; the Production manager had to be told to turn his attention tothis by the CEO. With no overall control over resources it is difficult to see how thecompany can operate efficiently.

2. The structured approach reveals implementation failures at every turn. There isno recognition of the need to optimise the organisational structure, no recognitionof the complexity of managing strategic change and an undisciplined approach toresource allocation. With such an unstructured approach to implementation thechances of success are remote. If it all goes wrong the management team willhave no idea why.



9 Strategic Control


SuperTools uses a variety of control approaches but they are all ad hoc and at thediscretion of the individual manager and other managers pay little attention. There is nooverriding approach so it can be classified as a Loose control company. Their actionscan be assessed according to the four criteria.

Criteria LooseFew objectives No clear objectives provided by CEO:

discuss again at the next meetingDerive targets No specific target is agreed onMilestones Market share was noted - it had increased

from 10% to 15% but nothing was made ofthis

Subjective evaluation No attempt was made to arrive at anevaluation of the current situation whichreflects the confusion that prevailed in theoverall strategic approach

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


Communication channels: on the evidence of the meeting, it seemed that a great dealcould happen without anyone becoming aware of it. There seemed to be no processwhere everyone was kept up to date with events.

Ability to adapt: some issues raised in the discussion were not pursued, such as themorale problem with StylePlane workers. There was no recognition of the fact that theorganisation as a whole was not coping well with the changing pattern of demand andthe introduction of new product types.

Learning organisation: this is perhaps the biggest problem, in that the CEO and theproduction manager did not appear to want to know about organisational change. Themarketing manager was certainly in learning mode, but overall the organisation was not.

In the previous discussions it emerged that SuperTools had problems in relation toimplementation and evaluation and control. This analysis suggests that there is littlechance that SuperTools will improve on its performance because there is no process forensuring that information will be disseminated and acted upon.


2010 s Man 290610

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