chap - 5 srategic capability

The Institute of Chartered Accountants in England and Wales, March 2009 151

Contents

chapter 5

Strategic capability

Introduction

Examination context

Topic List1 Resources, competences and capabilities

2 The work of Hamel and Prahalad

3 Transforming resources: the value chain

4 Networks, relationships and architecture

5 The product-service portfolio

Summary and Self-test

Answers to Self-test

Answers to Interactive questions

Business strategy

152 The Institute of Chartered Accountants in England and Wales, March 2009

Introduction

Learning objectives Tick offIn the context of a business scenario:

Identify the factors which may affect a businesses ability to achieve its chosen strategy

Understand the concept of a 'strategic asset'

Apply the concept of a product portfolio

Explain the nature of capabilities and competences, and understand the concept of 'dynamiccapability'

Carry out a resource audit using the Ms model and identify limiting factors

Understand the value chain model and apply it to scenarios and industries

Describe the role of networks, including supply chain management, in the development of abusiness's strategic capability

The specific syllabus reference for this chapter is 1d.

Practical significanceIt is conventional for accountants to consider 'resources' and 'assets' purely in financial reporting terms. Weknow that non-current assets (tangible and intangible in some cases) sit on the balance sheet and there arefinancial reporting standards as to how they should be accounted for.

However, what makes a business successful might often be things that are not so readily accessible forfinancial reporting: the legacy of 'early mover advantages' in building up a strategic position; the company'sreputation; the quality of a company's relationships and its ability to exploit them; the ability of itsmanagement to innovate; the ability of the company to cope with the unexpected; the ability of thecompany to learn. Intangible assets, such as trade marks, might also sit on the balance sheet. A company'sbrands, however, which for business decision making purposes, if not always for financial reporting, certainlyhave a value.

The practical significance therefore lies in your ability to see beyond the numbers to the underlying realities.For example, if you are asked to comment on a forecast, or be part of a team that does a 'due diligence'audit, these are business realities that you must be attuned do. Moreover, if you aspire to be, say, a FinanceDirector (avoiding a lot of the number crunching) you need to understand beyond the numbers.

Stop and thinkResearch reveals that much of the collective market capitalisation of the top 100 firms cannot be related tothe sum of their net asset values. In the case of an acquisition this would be called 'goodwill', but what doesit consist of?

Adding up the assets values of a firm is only one step in understanding the value of a business. What elseshould we be considering?

Working contextThe internal capabilities of the business might be relevant to an audit opinion on going concern, part of adue diligence investigation, value audits and so on. It might also alert you to critical business risks

STRATEGIC CAPABILITY


5

Syllabus linksThis chapter contains material that will almost entirely new to you. In your Business and Finance syllabusyou covered organisational structures at a basic level. Some elements of organisational structure will betouched upon here.

Business strategy


Examination context

Exam requirementThis chapter includes key principles of strategic capability, core competences and resource based strategy.Questions are likely to focus on the linkages between elements and the manner in which, when usedtogether, they can facilitate strategy and leverage competitive advantage.



5

1 Resources, competences and capability

Section overview Firms own many assets. Some of these assets will be sources of superior earnings in the future for the

business and are called strategic assets.

A resource audit catalogues the assets using handy checklists such as 9Ms etc. However this is notsufficient to understanding whether they are strategic assets.

Benchmarking compares the use of assets across the firm or across the industry and indicates wherethey might be used better or where they are already a source of superior performance.

1.1 The focus of strategic thinkingStrategies are focussed on products and markets, and that these are the source of ideas. Having theresources to make these products and to serve these markets is essential.

DefinitionResource-based approach views the resources of the organisation not just as facilitators to gaincompetitive advantage from product-market strategies but as sources of strategic advantage in themselves.

1.2 Critical success factors

DefinitionCritical success factors (CSFs): 'Those product features that are particularly valued by a group ofcustomers, and, therefore, where the organisation must excel to outperform the competition' (Johnson,Scholes & Whittington).

CSFs differ from one market segment to another, e.g. in some price may be key, in others quality, in othersdelivery, etc.

CSFs concern not only the resources of the business but also the competitive environment in which itoperates, discussed in Chapters 3 and 4, i.e. how will the business achieve a sustainable competitiveadvantage (SCA) over its competitors?

The following diagram shows the relationship between the different resources of an entity and the activitiesand processes which transform those resources into outputs to create added value. It also shows the wayin which entities can generate a sustainable competitive advantage over their competitors by their uniquecontrol/ownership of particular core competencies in these processes and activities.

Business strategy


CSFsderived form

Achieve/meet

Resources (Ms)

Unique Threshold

Value chain

Sustainablecompetitiveadvantage

Internal analysis

Competences

Threshold Core

Benchmark/KPIs

Kays3 sources

Threshold resource Threshold competence

Unique resource Core competence

Resources Competences

No SCA

SCA

Threshold resources The basic resources needed by all firms in the market.

Unique resources Those resources which give the firm a sustainable competitiveadvantage over its competitors, enabling it to meet the CSFs. They areresources which are better than those of the competition and difficultto replicate.

Threshold competencies The activities and processes involved in using and linking the firm'sresources necessary to stay in business.

Core competencies The critical activities and processes which enable the firm to meet theCSFs and therefore achieve a sustainable competitive advantage. Thecore competencies must be better than those of competitors anddifficult to replicate.

1.3 Core competences Kay's three sourcesKay (1993) argues that there are three distinct capabilities a company can develop that add value. Thesecapabilities or core competences can originate from three sources.

Competitive architecture

This is the network of relationships within and around a business. There are three divisions as describedbelow.



5

Internal architecture relationships with employees External architecture relationships with suppliers, intermediaries and customers Network architecture relationships between collaborating businesses.

The knowledge, routines and information exchanges created by these relationships (particularly those whichare long term) can produce core competences which other businesses cannot replicate.

Reputation

This is the reason why customers come back, investors invest, potential employees apply for jobs andsuppliers supply. Reputations (at least good ones) are not developed overnight they can take years. Oncea business has a good reputation it provides a core competence that rivals cannot match. Examples (may)include BMW and Virgin Atlantic (reputation for quality and service).

Innovative ability

This is the ability to develop new products and services and maintain a competitive advantage. Organisationstructure, culture, routines, etc. and collaboration between employees, customers and suppliers (i.e. thearchitectures discussed above) influence the ability of a business to innovate. Sony has consistently beeninnovative.

1.4 The resource auditIn reviewing strategic capability, a first step is to conduct a resource audit. This covers physical resources,intangibles, human resources, technological resources and financial resources.

1.4.1 Physical resources

These include resources owned by the firm and resources to which the firm has access, for example in asupply chain or network.

Physical assets should be audited reviewing how cost-effectively they are used. A measure of capitalproductivity is profit per unit of capital.

Inventories and working capital are also resources, but they have to be financed. The focus of just-in-time approaches to inventory management and production (JIT) has been to reduce the need tofinance working capital.

Raw materials. Is the firm vulnerable to sudden changes in prices are there long-term supplycontracts or hedging instruments which can overcome this?

Finally, are physical resources constraints on strategic activity (i.e. limiting factors)?

1.4.2 Intangibles and other resources

Brands and other reputational assets are resources created by a firm through the process of transforminginputs into outputs. Patents and other aspects of intellectual property are also intangibles.

These also include customer relationships and relationships with other key stakeholders such as media, andgovernments.

1.4.3 Human resources and labour markets

Human resources comprise the productive services people offer to the organisation. Human resourcesmore generally can include the following.

Headcount: Does the firm have enough people to do the task or can the work be done moreproductively with fewer?

Skills base available to the firm: measured though qualification and training, and the social andpsychological aptitudes linking the technical skills to performance.

Culture: The emotional and motivational climate of an organisation is critical to its successparticularly in industries where personal service is essential to the 'experience' the company is offering.

Business strategy


Knowledge: A firm's knowledge is partly embedded in people, what they do and how they are organised.

Workforce structure and organisation structure

The right mix of labour and capital

There is a trade off, in some respects, between using people and using equipment to save money or toincrease efficiency. For example, reducing the costs of a call centre can be achieved by:

Voice activated software and voice recognition software to process simple transactions Outsourcing it 'off-shore' to a country where labour costs are lower.

The choice will depend on the potential cost savings and benefits and perhaps customer resistance andthe firm's attitudes to reputational risk if it cannot achieve its level of service.

Service levels

Whilst some services can be automated, others cannot customer service staff are often those whoencounter the most moments of truth with the customer. In a service-led economy, the quality ofhuman interaction is an important element of customer satisfaction. To provide good service, those atthe customer interface must be supported by a management infrastructure of robust informationsystems and good training and supervision.

Human capital and knowledge industries

Knowledge-based industries require the creation and use of intellectual property. The skills andmindset necessary for this may often rely on the education and cultures of the country of operation.

Workforce structure

The right balance between full-time and part-time staff can provide a variable resource that can beaccessed when necessary to achieve flexibility. The flexibility of employment contracts, such ascovering other tasks and locations, can add to this.

1.4.4 Technological resources

Technology is a 'resource' in many different ways as was discussed in Chapter 3. Here we focus on twofurther aspects.

The organisation's capability to manage technology projects, especially IT projects. The costs andcomplexities of such projects means there is potential for failure (and success) on a huge scale.

Implementing a successful technology solution enabled low cost carriers such as easyJet and Ryanair toreduce their cost structures and to open low cost air travel to many people. Alternatively, failedtechnology implementations can drive away customers.

The impacts of the technology itself:

Enable the development of a new product or service generated by technology

Have a disruptive impact on an industry (e.g. digital music downloads threaten to overturn thetraditional music industry business model)

Enable increase in productivity

Engender additional risks

1.4.5 Financial resources

The business will need finance for any expansion. One aspect of a resource audit would be to simply look atthe different sources of finance available to the firm internal generation, loans, equity, credit etc.However, it should be noted that each will come with strings attached such as ceding control to otherstakeholders, unavoidable interest payments in the future, the need to keep the investment marketsinformed. Management may prefer to invest from retained profits as there is not the management time (orscrutiny) involved in getting outside parties to invest more.



5

1.4.6 The need for integration

Resources considered on their own are inert. Resources are of no value unless they are organisedinto systems, and so a resource audit should go on to consider how well or how badly resources havebeen utilised, and whether the organisation's systems are effective and efficient.

Resource Utilisation

Technicalresources

For example, processes for new product development, ability to servecustomers efficiently.

Managerial skills An effective management is a key organisation resource in planning activities,controlling the organisation and motivating staff.

Organisation Organisation structure is critical. For example product or brand divisionalisationor brand management should facilitate communication and decision-making, atthe level of the brand.

Information andknowledgesystems

These have a strategic role.

1.5 A checklist of resourcesThe 9Ms model summarises the resources and sources of competences to be evaluated. The audit shouldbe comprehensive, but it is useful to identify the unique resources which underlie the firm's sustainablecompetitive advantage (i.e. what sets it apart from other organisations) as opposed to those that arenecessary (i.e. threshold) but do not form the basis of sustainable competitive advantage.

Men and women: Assessment of the number of men, skills (production, marketing e-commerce, etc),motivation, adaptability, etc.

Machines: Number, productive capacity, age, condition, location, etc. Appropriate technological andapplications infrastructure for e-commerce, etc.

Money: Sources, uses, cash flow forecasts, relationship with shareholders, bankers, etc.

Materials: Supplier reliability, flexibility, costs, distribution systems, etc.

Markets: Market status, position and market share, brand image, customer loyalty, customer goodwill,distribution systems, etc.

Management: Quality, skills, ability of senior management. One key management skill is that of goodCorporate Governance and managing risk. (See Chapter 8 for further discussion.)

Methods: Activities and processes used, outsourcing, capital or labour intensive production methods, etc.

Management information systems: Quality, timeliness, etc (see Chapter 13 for further discussion).

Make up: Structure, culture, etc.

1.6 Limiting factors

DefinitionLimiting factor: A factor which at any time, or over a period, may limit the activity of an entity, oftenoccurring where there is shortage or difficulty of availability.

Business strategy


In the long-term, the company may wish to:

Reduce the shortfall by obtaining more of the resource

Economise on use by reconsidering the activities consuming the resource, e.g. redesign a product touse less machine time.

Worked example: Easing limiting factors in banksBanks have shifted their business from reliance on providing accounts for money transmission and loans toa wider portfolio of products including pensions, home loans, credit cards, and insurances. This presentedproblems because the floor space of banks is limited, as are staff numbers and staff accommodation. Thebanks responded to these limiting factors by:

Increasing the number of Automated Teller Machines (ATMs) which dispense cash and accountbalances but also can be used to make deposits and pay bills.

The provision of telephone and on-line banking services to reduce the volume of transactions takingplace in the bank branches.

Reducing the number of cashier places to make room for front-office cubicles housing financialadvisers. The resulting queues encouraged customers to use the ATMs and online services.

Recruitment of staff predominantly to sell financial service products, accompanied by use of distancelearning materials to assist them in passing the requisite regulatory exams.

1.7 Benchmarking competencesOnce a business has identified its CSFs and core competences it must identify performance standards whichneed to be achieved to outperform rivals and achieve SCA. These standards are sometimes called keyperformance indicators (KPIs).

One way of setting KPIs is to use benchmarking. Benchmarking is defined by the Chartered Institute ofManagement Accountants (CIMA) as: 'The establishment, through data gathering, of targets andcomparators, through whose use relative levels of performance (and particularly areas ofunderperformance) can be identified. By the adoption of identified best practices it is hoped thatperformance will improve.'

To ensure a balanced and comprehensive range of performance measures are set, the Balanced Scorecardcan be used.

Purposes of benchmarking

Benchmarking encourages improvement and change in order to achieve strategic competitive advantageover competitors, or at least to reduce costs and streamline operations.

Worked example: Benchmarking at MotorolaBest practice benchmarking (BPB) concentrates on manufacturing technology. At Motorola's semiconductorplant in East Kilbride, BPB concentrates on manufacturing technology. Typical areas it has recentlybenchmarked are:

Yield and product characteristics for a new MOS 9 silicon wafer, against Toshiba, under a technologytransfer agreement

General wafer fabrication technology: all Motorola plants exchange benchmarking information on cycletime, scrap, yield, productivity and other key measurements. Having identified best performance, therelevant operations managers meet quarterly around the world to pass on how they do it

Automated assembly performance: this is benchmarked weekly against its Japanese Motorolacounterpart, which in turn benchmarks against a Japanese subcontractor



5

Warehouse performance: in particular cycle time, quality, productivity and space use against otherMotorola installations

Purchasing performance: both against Motorola companies and friendly companies outside the group

Salary and benefits packages, through a Motorola-initiated exchange of data with other Scottishmanufacturing companies.

Source: DTI Best Practice Benchmarking website

Bases for benchmarking

Internal benchmarking

Historical comparison looks at performance over time to ascertain trends/significant changes, etc. butthe danger is that performance against competitors is ignored.

Branch comparisons within the same organisation may help to identify best practice which can beimplemented in all branches. Again, the danger is ignoring competitors.

Competitive benchmarking

This involves comparing performance with other firms in the same industry or sector. This may involve theuse of league tables (e.g. schools, hospitals, universities). The problem with industry norm comparisons isthat the whole domestic industry may be performing badly (so international comparisons are better) or thewhole international industry is losing out to other industries (so a wider perspective is needed seebelow).

Activity (or best in class) benchmarking

Comparisons are made with best practice in whatever industry can be found. British Airways improved itsaircraft maintenance, refuelling, turnaround, etc. by studying Formula One motor-racing pit teams.

Generic benchmarking

Benchmarking against a conceptually similar process. Again, Formula One was used by car manufacturers tohelp reduce changeover times on production lines. (Return to the diagram on page 158 to see howresources and competences are related to SCA and CSFs.)

Interactive question 1: Car seats [Difficulty level: Exam standard]Y Ltd manufactures car seats for children. Y's home country, Z land, has extensive legislation on car safetyfor many years and child seats are compulsory. The company was formed 10 years ago by an entrepreneurwho had previously worked as a technical consultant for an industrial foam company. Despite strongcompetition, Y Ltd has succeeded largely by careful marketing.

The car seats come in a range of sizes and there are a variety of options from fully integrated seats for veryyoung babies to booster seats for older children. The company's main customer is an accessorymanufacturer with a major presence in Y Ltd's home market. It buys the car seats from Y Ltd and sells themunder its own brand as 'safety approved'. It advertises the car seats in accessory brochures and on itswebsite. The company's second major customer is a large superstore in the home country which specialisesin children's clothing and accessories such as prams and pushchairs. The remaining sales are to a varied mixof large and small mainly independent car accessory retailers.

The car seats have historically all been produced on a single site in the north of the home country. TheManaging Director uses his connections to source the foam padding from several suppliers with acommitment to achieving the lowest price but complying with safety standards and expectations. Z land hassophisticated economy with efficient capital markets; JIT logistics are common in all forms of manufacturing.

The company is considering possible methods of expansion and is currently considering exports toneighbouring countries.

Business strategy


Requirements

(a) Explain how conditions in Z land could give Y Ltd a competitive advantage when it starts its exportoperations.

(b) The Managing Director of Y Ltd is constantly trying to improve the productivity and quality of hismanufacturing operations and is considering a programme of benchmarking. Explain why abenchmarking programme would help Y Ltd and suggest how it might be carried out.

See Answer at the end of this chapter.

2 The work of Hamel and Prahalad

Section overview Hamel and Prahalad belong to the resource-based school of strategy.

They identify a series if strategic architectures which can form the source of competitive advantage(or distinctive competence).

Beyond this they accord a significant role to the management team, and in particular the ability ofmanagement to create a strategic architecture through the application of strategic thinking.

2.1 Recap of the resource-based view of strategyChapter 1 contained an introduction to the resource-based view of strategy as an alternative to thepositioning view of strategy. It claims that rather than focusing on products, markets, and competitivepositioning approaches, the focus of the strategist should be on resources and competences. Such acombination of resources and competences takes years to develop and can be hard to copy.

2.2 Strategic architecture: competences and the futureHamel and Prahalad (1994) identify strategic architecture as one of several 'architectures' a companyhas.

1 Information architecture includes hardware, software and informal communication patterns.

2 Social architecture includes generally accepted standards of behaviour and hierarchy of values.

3 Financial architecture includes funding, reporting processes.

4 Strategic architecture: The linkage between the company's vision and its current position whichtakes the form of managers with strategic mindsets rather than the existence of strategic plans.

Hamel and Prahalad take a 'radical' view of the future and make two propositions:

The future is not just something that 'happens' to organisations.

Organisations can 'create' the future.



5

2.3Management competencesHamel and Prahalad claim that the management of some companies is more 'prepared' (i.e. willing and able)to shape the future than others, and that this future-orientated stance is somehow embodied in thecorporate culture, (or strategic architecture).

They offer a 'diagnostic' to indicate how future-orientated a company is.

Diagnostic statement Protect the past Create the future

Senior management's viewpointabout the future is

Conventional, reactive Distinctive, far-sighted

Senior management spend mostof their time on

Re-engineering current processes Regenerating core strategies

Within the industry, thecompany ...

Follows the rules Makes the rules

The company is better at Operational efficiency Building new businesses

To what extent does thecompany pursue competitiveadvantage by

Catching up with competitors? Creating new sources ofcompetitive advantage?

How is the company's agenda forchange actually set?

By competitors By a vision of the future

Are managers .... Engineers of the present? Architects of the future?

Are employees .... Anxious? Hopeful?

This is embedded in the management competence of the firm.

'Some management teams were simply more foresightful than others. Some were capable of imaginingproducts, services and entire industries that did not exist and then giving them birth. These managersseemed to spend less time worrying about how to position the firm in existing competitive space and moretime creating fundamentally new competitive space.'

They identify challenges to be overcome in the development of foresightful management teams:

An inconstant environment: Experience is devalued and familiar landmarks no longer serve asguide. Environmental turbulence erodes knowledge.

Institutional entropy: The organisation's decay undermines organisational effectiveness.

Individual estrangement: Managers lose touch with the 'people' aspect of their role.

They say that the goal is 'not to predict the future but to imagine a future'. Strategy if it is concernedwith the long-term survival of the business must therefore do more than play around with currentproducts or markets.

Hamel and Prahalad appear to be strong proponents of a resource-based view of strategy. Their key focusis a future orientation, based on competences.

Business strategy


3 Transforming resources: the value chain

Section overview The value chain is a common business term which received a specific formulation by Porter.

Porter's value chain encourages management to perceive of the business as a sequence of activitiesthat add value to inputs in order that the final good or service shall command a profitable price onthe market.

The linkages between the activities in the chain, for example how marketing and sales supportoperations or procurement practices support inbound logistics are common opportunities to reducenon-value adding costs, such as inventory, or enhance value to the customer.

Competitive advantage can be created and sustained by linkages in the value chain. Extending thevalue chain to an underlying value system of suppliers, distributors and customers makes it hard forcompetitors to replicate.

The crucial activities that sustain competitive advantage are called cost drivers and value driverswhich forge a link to aspects of cost accounting.

3.1 The value chainThe term 'value chain' was in common use before Porter's formulation here.

In overview, value chain analysis sees the firm as an input/output device.

Inputs from suppliers Value creating activities Outputs to customers

Firm

The value chain consists of the organisation's resources, activities and processes that link the businesstogether, and the profit margin. Together these create the total value of output produced by the business,quantified by the price paid by the customer.

Porter groups the various activities of an organisation under generic headings that he claims can beobserved in all organisations. The groupings do not correspond to the functional divisions of theorganisation structure but rather are deliberately formulated to help identify the activities carried out bythe firm in the generation of value to a customer.

FIRM INFRASTRUCTURE

HUMAN RESOURCE MANAGEMENT

TECHNOLOGY DEVELOPMENT

PROCUREMENT

INBOUNDLOGISTICS OPERATIONS

OUTBOUNDLOGISTICS

MARKETINGAND SALES SERVICE

MARGIN

MARG

IN

SUPP

ORT

AC

TIV

ITIE

S

PRIMARY ACTIVITIES



5

The margin is the excess the customer is prepared to pay over the cost to the firm of obtaining thenecessary resource inputs and of performing value-creating activities upon them before selling them to thecustomer.

Worked example: Discount food storesKwik Save's ability to compete with the major grocery multiples depended on a cost based competitivestrategy which was sustained throughout the value chain.

Linkages throughout the value chain Kwik Save Discount stores

Minimum corporate HQ

P

IL OPS OL M/S SER

Computerisedwarehouse

Branded onlypurchases

Big discounts

Bulkwarehouseing

Checkoutssimple

Dismissal forcheckout error

De-skilledstore-ops

Low cost

sites

1,000 linesonly

Price points

Basic store

design

Use ofconcessions

Low pricepromotion

Local focus

NilN

I

G

R

A

M

M

AR

GI

N

Kwik Save's strategy was based on ability to provide low-priced goods supported by a low-cost operation.The whole of the operation was designed for this purpose. The corporate headquarters was simple withfew staff; bulk, computerised central warehousing fed stores with a limited number of branded-only lines.Because the policy was branded goods only, Kwik Save was able to obtain maximum discounts frommanufacturers. Stores themselves were basic in design and the approach to merchandising simple; time andcosts were saved by not price-marking goods, but keeping the number of price points to a minimum andrequiring checkout staff to recall prices accurately. Store managers were required to keep to a simple andrelatively deskilled operation with branded goods only; more complete areas of greengrocery and butcherywere dealt with on the basis of concessions. Overall, the marketing approach of the store group was topromote a discount image to the local community.

Source: 'Kwik Save Discount', case study by Derek Channon, Manchester Business School.

Business strategy


3.2 Value activitiesPrimary activities relate to production, sales, marketing, delivery and service, in other words anythingdirectly relating to the process of converting resource inputs into outputs.

Activity Comment

Inbound logistics Receiving, handling and storing inputs to the production system (i.e.warehousing, transport, stock control etc).

Operations Convert resource inputs into a final product or service. Resource inputsare not only materials. 'People' are a 'resource', especially in serviceindustries.

Outbound logistics Storing the product and its distribution to customers: packaging,warehousing etc.

Marketing and sales Informing customers about the product, persuading them to buy it, andenabling them to do so: advertising, promotion etc.

After sales service Installing products, repairing them, upgrading them, providing spare parts,advice (e.g. helplines for software support).

Support activities provide purchased inputs, human resources, technology and infrastructural functionsto support the primary activities. Each provides support to all stages in the primary activities. For instanceprocurement where at each stage items are acquired to aid the primary functions. At the inbound logisticsstage it may well be raw materials, but at the production stage capital equipment will be acquired, and soon.

Activity Comment

Procurement Acquire the resource inputs to the primary activities (e.g. purchase ofmaterials, subcomponents, equipment).

Technologydevelopment

Product design, improving processes and/or resource utilisation.

Human resourcemanagement

Recruiting, training, developing and rewarding people.

Management planningand firm infrastructure

Planning, finance, and quality control: these are crucially important to anorganisation's strategic capability in all primary activities.

3.3 LinkagesActivities in the value chain affect one another. Linkages connect the activities in the value chain.They have two roles.

They optimise activities by enabling trade offs. For example, more costly product design or betterquality production might reduce the need for after sales service.

Linkages reflect the need to co-ordinate activities. For example, Just In Time (JIT) requires smoothfunctioning of operations, outbound logistics and service activities such as installation.

These linkages are often unrecognised, especially if there is a rigid functional structure. A value chainanalysis can help draw them to management's attention and so improve business performance.



5

Worked example: Linkage examples Common source material or components (e.g. many different marques of car share similar

components, as is shown by VW and Audi).

Common services (e.g. HRM).

The cost/performance of direct activities can be improved by indirect activities. Take the linksbetween technology development and production. It is possible to speed a new product tomarket if the manufacturing technology is considered at the same time as when the product is beingdesigned.

The same function can be performed in different ways. (For example, conformance to qualityspecifications can be assured by high quality inputs, TQM techniques, 100% inspection and so on).

Activities performed within one form reduce the need for service costs. (100% inspection or TQM canreduce maintenance visit.)

Inter-company linkages, in support of strategic alliances, such as airline reservation systems.

Cost drivers

Using the value chain as a basic analysis tool, it is possible to look at each of the value activities and identifythe major influences on the costs incurred. These structural factors which influence cost are the costdrivers, and the factors which influence the cost of a given activity may vary, even between competitors inthe same industry. An understanding of cost behaviour will allow a firm to assess the possibilities ofadopting a least cost competitive stance.

Internet technologies can reduce production times and costs by improving information flows as a way ofintegrating value activities, e.g. by making procurement more efficient or sharing demand information withsuppliers.

Value drivers

Unlike cost drivers, the potential sources of value are likely to be many and varied. An understanding of thevalue drivers for a particular key value activity is essential for a firm trying to differentiate itself from itscompetitors.

For example, if competitive advantage centres on the durability of a product, then this can be supported bythe sourcing of components, product design and maintenance services offered (the key value activities). Inturn the value drivers for these support activities might be supplier vetting and approval procedures, theuse of freelance designers and in-house after-sales service teams.

3.4 The 'value system'A firm's value chain is connected to what Porter calls a value system, i.e. activities that add value thatextend beyond the organisation's boundaries.

For example, when a restaurant serves a meal, the quality of the ingredients although the cook choosesthem is partly determined by the grower. The grower has added value, and the grower's success ingrowing produce of good quality is as important to the customer's ultimate satisfaction as the skills of thechef.

Business strategy


Supplier value chains

Customer value chainsOrganisation's value chain

Distributor/retailervalue chains

3.5 The value chain and competitive advantageCompetitive advantage can be sustained by linkages in the value chain and also in the wider value system ofsuppliers, distributors and customers. The planning of these linkages can provide the basis for costadvantages or become the basis on which the firm's products are differentiated from those of competitors.Competitors can often replicate parts of a value chain but it is more difficult to copy linkages.As businesses outsource more and more activities, the links in the value system become more important.Electronic communications enhance the ability of businesses to outsource.

The factors that sustain the competitive position through these key activities are cost drivers and valuedrivers, and are outlined below.

Here are some examples of how companies in practice aim to differentiate themselves. They may nothave consciously used the value chain but you can see how thinking about various activities of a businesscan help solve a strategic problem: in this case, commoditisation.

Worked example: Escaping commoditisationCommoditisation is what many manufacturers seek to avoid: history is full of examples of one-timeworld-beating products such as rolling bearings, chemicals and memory chips that have been copied andhave lost their distinctiveness and price advantages. Commoditisation basically results in pricecompetition as products and companies are identical.

Not every firm can pursue 'cost leadership' and many firms seek to add value by escaping from thecommodity trap and pursuing differentiation. Here are some examples.

Choose the value system: 'Focus on a niche' is the strategy employed by many of Germany'sengineering companies. By selling their products into a small market across the world, they gain theeconomies of scale and expertise to deter new entrants. They are part of a value system, but havechosen their customers very carefully.

Set the standards which others must adhere to, such as Intel for PC chips. It does, however, suggestthe need for overwhelming competence in the technology and marketing areas of the valuechain.

Differentiate commodity products by branding; again this is partly a matter of customerperception (an aspect of sales and marketing).

Control the process: Some manufacturers dominate not a product but an operations process thatcreates a 'cluster' of product opportunities. 'Vacuumschmelze', a German company, makes productsfor industries including electronics, cars, electricity distribution and retailing. The German company'sexpertise starts with the techniques it uses to melt and form tiny components made from exoticmetals including nickel, cobalt, neodymium and samarium, as well as non-metals such as silicon andboron. A division of Morgan Crucible, the UK engineering company, it owns about 1,000 patents inthese disciplines.



5

Add services: 'Heidelberger Druckmaschinen', the world's leading maker of printing presses, has setup 'print academies' in nine cities around the world to organise courses on printing techniques forcustomers and potential customers. This is clearly an example of after-sales service being used tobuild customer relationships.

3.6 The value chain: cost drivers and value driversThe value chain models the process by which organisations convert inputs into outputs,thereby adding value.

Most products are a collection of benefits, which is why customers buy them. Ultimately, theprovision of customer benefits is the real cost driver of a business, and it should be possible to workbackwards, as it were, from customer 'value' to the underlying costs.

The costs of the value chain are influenced by the following factors.

Cost drivers

Using the value chain as a basic analysis tool, it is possible to look at each of the value activities and identifythe major influences on the costs incurred. For example supermarkets regard the diversity of products(food, clothes, spirits, audio, etc) stocked as cost drivers because for each additional product line stockedthe supermarket incurs the costs of logistics, stocking, stacking, programming electronic point of salesystems (EPOS), product training and promotion costs. An understanding of cost behaviour will allow a firmto assess the possibilities of adopting a least cost competitive stance.

Value drivers

Unlike cost drivers, the potential sources of value are likely to be many and varied. An understanding of thevalue drivers for a particular key value activity is essential for a firm trying to differentiate itself from itscompetitors.

For example, if competitive advantage centres on the durability of a product, then this can be supported bythe sourcing of components, product design and maintenance services offered (the key value activities). Inturn, the value drivers for these support activities might be supplier vetting and approval procedures, theuse of freelance designers and in-house after-sales service teams.

3.7 Use in strategic planningThe principal use of the value chain is to assist in an understanding of the business and its strengths andweaknesses, as a form of position analysis. However, the value chain can be used specifically to:

Identify strategically significant activities (the value activities) as an aid to targeting capital investment

Compare with the value chains of competitors, to identify sources of differentiation

Identify opportunities for synergy between the firm and a potential acquisition, for exampleopportunities to transfer skills or share activities. These will be examined in more detail in themergers and acquisitions section of Chapter 10.

The value system highlights the relationship between a firm and its customers and suppliers.

This will assist managers in identifying competitive forces in the system, and targeting potential verticalintegration prospects.

Management of these wider linkages can make it more difficult for competitors to replicate theorganisation's value chain and hence contributes to sustainable competitive advantage.

Business strategy


Interactive question 2: Hairdressers [Difficulty level: Exam standard]X Ltd is a chain of hairdressers with fourteen sites operating in the business districts of the capital andthree other major cities. It has a very simple philosophy quality haircuts for women who are short oftime. It operates a no appointment, drop-in system. Customers take a ticket on arrival and wait in a largecomfortable seating area until their numbers are called. All staff are multi-skilled and there are nospecialists. The company aims to keep waiting times below fifteen minutes.

The salons offer a wide range of services from very simple cuts to more complex styles and treatments. In50% of their stores X Ltd also offers beauty treatments, such as facials, in a separate salon on site. Thecompany's main publicity comes from personal recommendation by satisfied customers, but they alsooccasionally advertise in high quality women's magazines.

After a recent period of expansion, the management team of X Ltd feel that their business model is notbeing applied consistently throughout the organisation and they have decided improvements andadjustments need to be made. However, none of the management team knows how to relate theirphilosophy to their operations to the best effect.

Requirements

(a) Using the concept of the value chain, explain how X Ltd can adopt the quality and speed approachthroughout its activities.

(b) What are the benefits and problems of value chain analysis for a company such as X Ltd?


4 Networks, relationships and architecture

Section overview The sections above have focused on assets and operations within the boundary of the corporation

and so under management control.

Network analysis recognises that businesses are frequently webs of networks between departmentsand also with outside contractors, customers, and suppliers.

This gives rise to the importance of understanding the relationships between the partners and thevalue of relational contracts based on trust and commitment to replace transactional contractsin which each side tries to get the greatest gain for itself.

The practice of outsourcing is one step in creating these networks.

Supply chain management (SCM) is the management process, often assisted at the operational level byhigh power IT applications, of synchronising the networks in the service of the final customer.

The virtual firm is introduced and a modern organisational structure which replaces verticallyintegrated businesses with a high reliance on networks.

4.1 What do we mean by architecture?The concept of the value system suggests a variety of interrelationships between different businesses. Weshall now explore the nature of some of these relationships.

DefinitionArchitecture: the network of relational contracts, within or around, the firm.



5

A relational contract contains parties doing business with each other in a long term relationship. Itsprovisions are only partly specified but it is enforced not by legal process but by the needs the parties haveto go on doing business with each other (as opposed to a spot contract which is a one-off transaction).

These relational contracts may have a legal basis, but also include a pattern of expectations that theparties have of each other.

Firms may establish these relationships in two ways, internally and externally.

Internal networks

with and among theiremployees (internalarchitecture)

Organisation structure and culture; job descriptions and work patternsto encourage development; employment contracts (e.g. employercommitment vs 'short term hire'); remuneration structure toencourage 'loyalty', 'creativity' and a willingness to satisfy individualpreferences for the collective's benefit.

External networks

with their suppliers orcustomers (externalarchitecture) among firmsengaged in related activities(Kay, 1993)

Relationships with suppliers e.g. long-term supply contracts, detaileddesign specifications firms share knowledge and establish fastresponse times on the basis of relational contracts.

Networks are groups of firms making relational contracts with eachother, who need to do business together in the long term, and whoarguably depend on a common skills base.

It is clear that the idea of networks of relational contracts is very wide in scope. Note the phrase'relational contract'. We are not simply discussing 'communication pathways'; these related contracts areactivities embedded in business relationships built up over time. Some writers distinguish betweencontracts under which both sides still retain selfish behaviour (termed a transactional relationship ordyadic contracts) and contracts that are founded on commitment and trust (a collaborativerelationship).

4.2 Networks and organisational co-operationIn many industries, collaborative ventures and strategic alliances are becoming increasingly common. Theycan be very complex.

Manufacturer A

Manufacturer D

Wholesaler

Distributor

Customer

Manufacturer B

Joint venture

Manufacturer C

Alliance

Supplyagreements

Business strategy


Worked example: Rail networksIn 1994 the UK government broke up and sold the national railways provider, British Rail, to privateinvestors. To avoid the possibility of private monopolies exploiting the customer it was sold off in pieces asdifferent companies. On the day following privatisation a typical passenger's journey would have involvedthe following networks:

The car park they parked in was operated by a private firm under a license agreement from the firmowning the railway station.

The station was operated either by Railtrack, the company set up to run infrastructure, or by the railoperator with the greatest use of the station. In the latter case the other rail operators would lease'slots' at the station for their trains to stop there.

The platform information on train arrivals was provided by Railtrack because it is based on thesignalling systems they provide.

The timetables of the rail operators were co-ordinated by Railtrack who also operated a telephoneNational Rail Enquiries service.

The ticket purchased was sold by the station operator but if there was 'through-ticketing' across railoperators there would be recharges on to another.

The train was operated by the rail operator.

The rolling stock was owned by a separate leasing company.

Cleaning, catering, track maintenance etc were largely contracted out by the rail operators and byRailtrack to private firms.

The success of this network approach has been questioned in the years since it was created. In 2007elections for the Scottish Assembly featured the major nationalist party pledging to return the railways ofScotland back to nationalised status under a Scottish National Railways Authority.

As can be seen from the rail example above there are many types of organisational forms that can bedeveloped. Networks display, horizontal (e.g. joint ventures) and vertical (supply chain) linkages.

Drivers of collaboration strategies that result in network arrangements can be characterised as follows.

Blurring of market boundaries: E.g. convergence of telecommunications and computing. Thisincreases the complexity of technologies.

Escalating customer diversity: Customers are becoming more demanding. In global markets,customers are more diverse almost by definition.

Skills and resource gaps: Firms need to collaborate in technologically demanding markets.

4.3 Types of external networkIt is possible to model types of network on the axes of environmental volatility or turbulence and the typeof network relationship, as in the figure below.

For the sake of this discussion, we can take volatility to be analogous with environmentalturbulence.

The type of network relationship can range from the collaborative to mainly transactional (just abuy-sell relationship). A collaborative network involves a great deal of co-operation, which may beenshrined in joint venture agreements. In a transactional relationship, there is no commitment tothe long term.



5

Environmental turbulence

Low High

Collaborative Virtual network Flexible

Transactional Value-added Hollow

1 A hollow network combines high environmental volatility with a transactional-based approach. Theorganisation draws heavily on other organisations to satisfy customer needs. Such organisations can bequite small, but have a large number of contacts. For example, in the publishing industry, there areprint brokers who will deal with a variety of printing needs by accessing a network of subcontractors.

2 Flexible network: This is a collaborative network existing in conditions of high environmentalturbulence. The links between organisations are of a long-term nature, but are on specific projects.For example, pharmaceuticals companies aim to build up alliances with biotechnology firms (as theircompetence bases are different).

3 Value-added network: Environmental turbulence is low and the organisation adopts transactionalrelations. This is typical of many Japanese firms. Publishers have subcontracted printing to specialistprinting firms for many years. The outsourcer is performing a standard service.

4 Virtual network: Environmental volatility is low but the organisation wants to build collaborativerelationships with other organisations. A firm wishes to use the network to achieve adaptability tomeet the needs of segmented markets through long-term partnerships rather than internal investment.

DefinitionAsset specificity: Where investments are made to support the relationship which have the effect oflocking parties into a relationship to some degree.

Relationship-specific assets

An example is the investment by the Anglo-French company Eurotunnel in an undersea rail link that locksEurotunnel into partnerships with the rail operators using it from either end, (i.e. Eurostar and SNCF). Bothsides required long-term contracts before they would make the commitments necessary.

Asset specificity can take four forms.

Site specificity: Assets are located side by side to economise on transport or processing efficiencies.

Physical assets specificity: Asset properties are tailored to a specific transaction.

Dedicated assets: Investment is made in plant and equipment in order to serve a particularcustomer.

Human assets specificity: Workers acquire skills, know-how and information specific to therelationship, but of less value outside it.

If a firm makes a relationship-specific investment, this implies that it would not make sense to makethe investment outside the business relationship (e.g. if the component was so specialised no-one elsewould buy it).

Business strategy


The relationship between firms in a network can be close or distant, and we can model them as follows.

Distant Outsourcing purchase of goods/services

Partnership co-ordinated/integrated activities

Alliance joint ventures: shared ownership

Close Ownership for example, vertical integration

DefinitionAlliance: An agreement between firms to share a commercial opportunity characterised by each memberof the alliance retaining autonomy and pursuing its commercial interests (i.e. a dyadic relationship).

Partnership: Joint participation in the serving of a market or project characterised by the closeinterrelationship of operations, exchange of staff and mutual trust and commitment to working with theother (i.e. a non-dyadic relationship).

Worked example: MicrosoftAccording to The Economist (January 2007) the launch at that time of Microsoft Windows Vista may markthe pinnacle of the software giant's power. If true it provides an example of a business that grew rich on itspivotal position at the hub of one type of network, the need for PC users to be able to transfer documentsto each other by using common software packages, now being superseded by an new kind of virtualnetwork of PC users, open-source programmers and hackers.

'Microsoft's dominance is slowly being eroded. Who produces the plumbing for a personal computermatters a lot less than it did in 1995. More PCs talk to each other using open standards rather thanproprietary ones. Many services and some programmes are accessed on-line. Much software is based on theInternet.

These changes are bad for Microsoft. Windows and Office are the backbone of the company. Theyrepresent nearly 60% of sales and 80-90% of its profits. Computing has changed radically since Microsoftrose to prominence 25 years ago with its operating systems for IBM's personal computer. Three trends arechanging this:

1. The rise of open-source software: The code for this is written largely by volunteers rather than asingle company. The programmes are free to use and open to continual enhancements. As acollaborative venture open source can speed up development and make it easier to add features.

2. The rise of software as an online service: Programmes are held on the internet rather than onthe hard drive of the computers. Google and others offer free on-line word-processing andspreadsheet applications.

3. Problems with the security of Microsoft products: Microsoft products remain based onprogramming that has been around long enough for its flaws to be well known to hackers. Andbecause it is so widely used it pays hackers to learn ways around any new security features Microsoftbrings out.'



5

4.4 Outsourcing value activities

DefinitionOutsourcing: The use of external suppliers as a source of finished products, components or servicespreviously provided in-house.

Research by PricewaterhouseCoopers (a major provider of outsourced services) has found that when mostbusiness processes are stripped down to their basics, about 70% of business processes are common to allfirms. This suggests that they could be outsourced without loss of competitive advantage. With the help oftechnology and telecommunications it is now possible for one service provider to devise a commonprocess to deal with many different local processes in a single location.

In addition to cost considerations management may take the view that a chain is only as strong as itsweakest link and therefore supply chains can be strengthened by outsourcing weak links to morecompetent providers.

The issues to be considered in deciding whether to outsource include:

The firm's competence in carrying out the activity itself. Low competence implies high cost and riskof poor performance.

Whether risk can be managed better by outsourcing, e.g. shift legal liability to the provider andpossibly also levy charges for breakdowns in performance that will mitigate losses.

Whether the activity can be assured and controlled by the framework of a contract andperformance measures, e.g. outsourcing payroll can normally be done relatively easily but systemsdevelopment is more open-ended.

Whether organisational learning and intellectual property is being transferred. The in-houseoperation may be a source of significant learning leading to product and process improvement. This isone reason that in the early stages of the international production life cycle (Chapter 3) firms keepmanufacturing in-house rather than outsource to cheaper contract manufacturers.

The issues to consider in deciding whom to outsource to include:

The track record of the provider and its experience of similar partnerships.

The quality of relationship on offer, e.g. will they place staff at your premises, hold regularmeetings, provide open-book accounts?

The strategic goals of the provider, e.g. is this their core business, will they operate globallyalongside the firm?

The economic cost of using them (including whether they will take staff over and pay for transferredassets).

Their financial stability.

Interactive question 3: Outsourcing R&D [Difficulty level: Easy]Give two advantages and two disadvantages of a computer software company outsourcing its research anddevelopment.


Business strategy


4.5 Supply chain management

DefinitionSupply chain management (SCM): The management of all supply activities from the suppliers to abusiness through to delivery to customers.

This may also be called demand chain management (reflecting the idea that the customers'requirements and downstream orders should drive activity) or end-to-end business (e2e). In essence itrefers to managing the value system.

Technology is vital to SCM, given the vast flow of information between suppliers, customer andintermediaries.

The main themes in SCM are:

Responsiveness the ability to supply customers quickly. This has led to the development of Just inTime (JIT) systems to keep raw materials acquisition, production and distribution as flexible aspossible.

Reliability the ability to supply customers reliably.

Relationships the use of single sourcing and long-term contracts better to integrate the buyer andsupplier.

Example: Tesco information exchangeTesco Information Exchange (TIE) uses information technology to improve the reliability of its supply chain.Suppliers receive information on actual store demand, depot inventories, weekly sales forecasts, as well asdaily point of sale information, to help forecast demand.

Technology

Technology applications which have facilitated SCM include:

E-mail

Web-based ordering and tracking. This involves outsiders seeing some management information on anextranet

Electronic data interchange (EDI) of invoices and payments, ordering and sharing of inventoryinformation

Satellite systems able to track positions of trucks

Radio data tags fixed to pallets or boxes of valuable items to enable them to be located in the supplychain (including within a warehouse)

This has led to:

Reductions in costs

Better outsourcing opportunities

Increased product and service innovation

Mass-customisation of products: i.e. customised products made by mass production methods, e.g. Dellcomputers, superior car marques.



5

4.6 Supply chain networksSupply chain management involves optimising the activities of companies working together to producegoods and services.

Reduction in customers served: For the sake of focus, companies might concentrate resources oncustomers of high potential value.

Price and stock co-ordination: Firms co-ordinate their price and stock policies to avoid problemsand bottlenecks caused by short-term surges in demand, such as promotions.

Linked computer systems: Electronic data interchange and use of intranets saves on paperworkand warehousing expense.

Early supplier involvement in product development and component design.

Logistics design: Hewlett-Packard restructured its distribution system by enabling certain productcomponents to be added at the distribution warehouse rather than at the central factory, for exampleuser-manuals which are specific to the market (i.e. user manuals in French would be added at theFrench distribution centre).

Joint problem solving.

Supplier representative on site.

The aim is to co-ordinate the whole chain, from raw material suppliers to end customers. The chainshould be considered as a network rather than a pipeline a network of vendors support anetwork of customers, with third parties such as transport firms helping to link the companies.

4.7 Networks in action: alliances and the virtual firmSome firms enter long-term strategic alliances with others for a variety of reasons.

They share development costs of a particular technology.

The regulatory environment prohibits take-overs e.g. most major airlines are in strategic alliancesbecause in most countries there are limits to the level of control an 'outsider' can have over an airline.

Complementary markets or technology.

Strategic alliances only go so far, as there may be disputes over control of strategic assets.

Choosing alliance partners

The following factors should be considered in choosing alliance partners.

Drivers What benefits are offered by collaboration?

Partners Which partners should be chosen?

Facilitators Does the external environment favour a partnership? Relevant factors herewould include the availability of suitable providers, legal environment that doesnot outlaw collaboration as anti-competitive, and high investment costsinvolved in establishing provision that could not be borne by a single user ofthe service.

Components Activities and processes required by the network. What will the alliancepartner contribute?

Effectiveness Does the previous history of alliances generate good results? Is the alliance justa temporary blip? For example, in the airline industry, there are many strategicalliances, but these arise, in part, because there are legal barriers to cross-border ownership.

Market-orientation Alliance partners are harder to control and may not have the samecommitment to the end-user.

Business strategy


Alliances have limitations

1 Core competence: Each organisation should be able to focus on its core competence. Alliances donot enable it to create new competences.

2 Strategic priorities: If a key aspect of strategic delivery is handed over to a partner, the firm losesflexibility. A core competence may not be enough to provide a comprehensive customer benefit.

4.8 Networks and global businessThere are some distinct forms of global business network.

Keiretsu and chaebol

These are business networks common in Japan and Korea, whereby groups of firms are linked in a number ofdifferent ways.

A general trading company exists at the centre. A central bank circulates finance from one activity of the network to another. Many of them have received favourable treatment from the state. There are cross shareholdings between companies. They depend on personal relationships and agreements: high trust.

In both countries, such firms have made high investments and typically result in conglomeratediversification. This business model has come under attack, as a number of chaebol have collapsed recently.

Family networks

Networks based on family structures are common in businesses run by overseas Chinese according toDicken (Global Shift). The family a relatively small group of insiders is key to decision making, andoperates on the following principles.

The purposes of the firm is 'the long-term interest on family prosperity'.

Risks must be hedged to protect family assets.

Key decision makers exist in an inner circle.

Such firms do not trust non-family members.

Personal obligations cement and reinforce non-contractual business relationships.

The network is exclusive, but family loyalties mean effective business co-ordination in many countries.

Networks and globalisation

Networks and relationships on any number of levels may be suitable for global businesses. When these arelinked to the type of geographic cluster identified in Chapter 3 there is the potential for considerablecomplexity.

4.9 The virtual firmAn extreme example of networking is the so-called virtual firm. It is created out of a network ofalliances and subcontracting arrangements. It is as if most of the activities in a particular value chainare conducted by different firms, even though the process is loosely co-ordinated. This will be discussed inmore detail in Chapter 8.

Interactive question 4: Outsourcing and core competences [Difficulty level: Easy]Should a core competence ever be outsourced?




5

5 The product-service portfolio

Section overview Firms with multiple products (e.g. consumer goods firms like Heinz) or multiple business units (e.g.

GE) are said to be managing a portfolio of businesses in the same way as a fund manager mightmanage a portfolio of stocks and shares.

The Boston Consulting Group matrix (BCG matrix) is a graphical technique to assist management tovisualise their portfolio and to manage it to improve the financial performance of the corporation as awhole.

The GE Business Screen is an alternative to the BCG matrix, which takes a broader view of thefactors making a business unit competitively strong and its industry financially attractive.

Treating businesses as investment portfolios was popular in USA and Europe in the 1960s and 1970sbut has declined in favour since, with the search for core competences and core businesses. This hasled to a re-evaluation of the concept of portfolio analysis.

5.1 The need for a mix of products and servicesMany businesses sell more than one type of product or service. For example:

Accounting firms sell audit services, tax advisory services, accounting services and so on

Consumer goods companies such as Procter and Gamble sell a mix of products such as soap powder,children's nappies, cosmetics, drinks, dental hygiene products and shaving products (amongst manyothers).

These are sold in different markets because of technological and social change, the influence of competition,the demands of shareholders that their investments grow and so on.

Portfolio analysis is a term originating in investment markets and refers to the fact that investors typicallyhave a mix of different securities in a portfolio. Investment portfolios seek to strike a balance between:

Income and capital growth Risks and returns.

Product portfolio analysis invites management to think of the collection of products and business units theyhave assembled in the same way.

Worked example: Portfolio management in the film industryOne application might be teased out from the example below, from The Economist (17 March 2007).

Film-making is inherently risky a few successes in effect have to subsidise a number of failures. A film maybe launched on a number of screens simultaneously, though perhaps in different countries at different times(this was discussed as an example of the international product life cycle in Chapter 4). There may be aninitial surge of audience viewing after a while, film goers find other distractions, the film is itself releasedon DVD, as a sort of 'back catalogue'. The product life cycle is relatively short.

As big studios typically spend US $100m per film, they are cutting back the number of movies created,making the gamble on the few made even more risky. However, they still rely on private investors.

(a) Studios encourage investors such as hedge funds to back 'slates' of several dozen films over more thana year.

(b) Investment firms might back producers with good records (rather like choosing a particularly astutefund manager).

(c) Investors can choose to invest in smaller 'independent' firms some low budget productions can bevery profitable, as can films targeted at particular audiences.

Business strategy


The lessons are:

A film has a life cycle. For a studio to remain in business, it needs to have films in production to launchin future seasons.

Film making is risky, and a portfolio of products helps spread the risk.

Similar considerations apply in other industries.

5.2 Product life cycle (PLC) revisitedMany businesses will not wish to risk having only a single product (or group of closely related products) orall their products at the same stage of development. Many will seek to maintain a balanced portfolio ofproducts with variety to protect against downturns in the fortunes of individual products and to haveproducts at different stages of development. The product life cycle and BCG models (to be discussedshortly) can help assess the balance of a product portfolio.

Strategies for each stage can be summarised as:

1. Introductory stage

Attract trend-setting buyer groups by promotion of technical novelty or fashion

Price high (skim) to cash in on novelty or price low (penetration) to gain adoption and high initialshare

Build channels of distribution

2. Growth stage

Build brand awareness to resist impact from new entrants Improve and refine product features High promotion of benefits to attract early majority of potential buyers Penetrate market, possibly by reducing price

3. Maturity stage

Defend market position by matching pricing and promotion of rivals

Modify markets by positioning product to gain acceptance from non-buyers (e.g. new outlets orsuggested new uses)

Modify the product to make it cheaper or of greater benefit

Intensify distribution

4 Decline stage

Harvest cash flows by minimising spending on promotion or product refinement Simplify range by weeding out variations Narrow distribution to target loyal customers to reduce stocking costs

The response of competitors is particularly important there may be threats as they attempt todefend their position, or opportunities, e.g. when a competitor leaves the market.

A company will not wish to have all products at the same stage as they may all decline together.

Solutions:

Products with different length cycles. Lots of products in development/introductory stage. Lots of products in maturity to support others.



5

Sales of video tapes and DVDs over the last three years have followed the pattern below.

SalesCU

Time

DVDs

Video tapes

2007

5.3 Boston Consulting Group matrix5.3.1 The basics

This matrix was developed by the Boston Consulting Group (BCG) in 1968 and was based on extensivework into the presence of experience effects in industry.

DefinitionExperience effects: An explanation of the observed trend for unit cost to decline as cumulative outputincreases which attributes the decline to organisational learning.

BCG estimated that unit costs typically declined by 15% for every doubling of cumulative output.

A company analyses its own position along two dimensions:

Market attractiveness% rate of market growth

Market strength relativemarket share

Business strategy


This gives the following matrix:

High

STARPROBLEM

CHILD/QUESTIONMARK

?%

rate

ofm

arke

tgr

owth

Low

CASH COW

CU

DOG

High LowRelative market share

As you can see, a star has a high share of a high growth market, and so on.

The BCG matrix differs from the product life cycle in that:

It takes account of external market factors, such as growth rate and share.

Just as a firm might have a portfolio of products at different stages of the life cycle, it can have aportfolio of different products on the matrix.

5.3.2 Boston classification of quadrants

Stars

Stars are products with a high share of a high growth market. In the short term, these require capitalexpenditure in excess of the cash they generate in order to maintain their market position, butpromise high returns in the future.

Their market share is big enough to exploit opportunities but high growth rates will attractnewcomers/competition.

Therefore cash must be reinvested heavily to hold their existing position and build upon it.

Overall moderate net cash flow.

Cash cows

In due course, stars will become cash cows, with a high share of a low-growth market. Cash cowsneed very little capital expenditure and generate high levels of cash income. Cash cows generate highcash returns, which can be used to finance the stars.

Low growth so high market share is unlikely to be attacked by new firms wishing to enter themarket.

Therefore little investment required to defend position but large enough market share to exploitavailable opportunities.

Large positive cash flow.

Question marks (or problem children)

Question marks are products in a high-growth market, but where they have a low market share. Dothe products justify considerable capital expenditure in the hope of increasing their market share, orshould they be allowed to 'die' quietly as they are squeezed out of the expanding market by rivalproducts? Because considerable expenditure would be needed to turn a question mark into a star bybuilding up market share, question marks will usually be poor cash generators and show a negativecash flow.



5

Attractive markets but insufficient market share to exploit them.

Choice between getting out or getting big.

If deciding to stay in the market, must invest heavily to gain market share.

Large negative cash flow.

Dog products

Dogs are products with a low share of a low growth market. They may be ex-cash cows that havenow fallen on hard times or question marks that never succeeded in gaining critical mass in a market.Dogs should be allowed to die, or should be killed off. Although they will show only a modest net cashoutflow, or even a modest net cash inflow, they are 'cash traps' which tie up resources such as stocksand productive capacity and provide a poor return on investment, and not enough to achieve theorganisation's target rate of return.

Unattractive markets without the market share to really benefit from what could be achieved ifbigger.

The best strategy may be to exit the market ('divest').

Modest cash flow.

There are also infants (i.e. products in an early stage of development), war horses (i.e. products thathave been cash cows in the past, and are still making good sales and earning good profits even now)and even cash dogs, which are dogs still generating cash, and dodos, which have low shares of lowgrowth markets and which are losing cash.

Notes

Clearly if the company has four 'cash cows' good. However, if they are a small proportion of thecompany's total sales then it is not as impressive as it first appears.

The objective (again) is for the company to have a balanced portfolio.

For individual products the objective is to move the product in an anticlockwise direction around thematrix to become a cash cow, i.e.

STAR QUESTION MARK

CASH COW DOG

5.3.3 Plotting a BCG matrix

How are products plotted onto the matrix? For each of the company's products, calculate the following:

Relative market share. A typical method is to use:salescompetitorLargest

salesYour

Percentage growth rate of the market. In excess of 10% growth is often regarded as high, but it willdepend upon the type of market.

Express the sales of each product as a percentage of the company's total sales. Each product is thenrepresented by a circle the area of which is proportional to the sales of that product.

Business strategy


BCG analysis can be applied to:

Individual products Whole strategic business units (SBUs) and business streams

Worked example: Plotting a BCG matrixAn industrial equipment company has five products with the following sales and market characteristics.

Company'sproduct Sales

CUm

CUm salesTop 3 firms

Marketgrowth rate %

Relativeshare

A 0.5 0.7 0.7 0.5* 15% 0.71

B 1.6 1.6 1.6* 1.0 18% 1.0

C 1.8 1.8* 1.2 1.0 7% 1.5

D 3.2 3.2* 0.8 0.7 4% 4.0

E 0.5 2.5 1.8 1.7 4% 0.2

* Company sales within the market

Relative share calculated as Company sales/Top firm sales or Company sales/Sales of next nearestcompetitor

This information can then be plotted on to a matrix.

The size of the circles indicate the contribution the product makes to overall turnover.

The centre of circles indicates their position on the matrix:

The evaluation and resulting strategic considerations for the company in the matrix above are these.

There are two cash cows, thus the company should be in a cash-positive state.

New products will be required to follow on from A.

A is doing well but needs to gain market share to move from position 3 in the market continuedfunding is essential. Similar for B.

C is a market leader in a maturing market strategy of consolidation is required.

D is the major product which dominates its market; cash funds should be generated from this product.

E is very small. Is it profitable? Funding to maintain the position or selling off are appropriate strategies.



5

The BCG matrix differs from the product life cycle in that:

It takes account of external market factors, such as growth rate and share

Just as a firm might have a portfolio of products at different stages of the life cycle, it can have aportfolio of different products on the matrix.

The product life cycle concept can be added to a market share/market growth classification of products,as follows.

Worked example: Kingfisher groupIn Spring 1999 the UK-based Kingfisher Group operated a range of businesses:

Home improvements: via ownership of superstores B&Q in UK and Bric Depot in France

General merchandising: via ownership of a portfolio of store chains including Woolworths(confectionery, audio/video, children's toys and clothes), Superdrug (pharmaceuticals and cosmetics),MVC (audio/video), Entertainment UK (audio/video wholesale distribution), Big W (large multi-product superstores)

Electricals: via Comet (UK), and Darty (France).

The market position of all was 'value' i.e. low prices.

Kingfisher enjoyed a dominant share of the rapidly growing home improvement market (star) and of themature audio/video and confectionery markets (cash cow). However, in electricals, its brands werestruggling against the dominance of the more focused Dixons Store Group which had cornered the growthpart of the industry, PCs, with a separate brand PC World, as well as having significant shares of the whitegoods and brown goods business with its Curry's and Dixons brands.

In an attempt to boost its relative share of general merchandising, Kingfisher announced in June 1999 anintention to merge with ASDA, a 'value' grocery superstore chain which had been spun out of the formerAssociated Dairies to become the third largest grocer in the UK. Billed as a unity of the value championsthe intention was seemingly to create a rival to the international multi-product stores groups of Wal-Mart(USA) and Carrefour (France).

Business strategy


The deal fell through two weeks later when ASDA announced it had received a better offer from Wal-Martwhich was accepted. Kingfisher's board had to explain to the investors why they were to pay all the costs ofthe aborted merger and also what was to happen to general merchandising now that the deal that hadpreviously been 'essential for its growth' was not on the table anymore.

The board of Kingfisher responded over the next six years by:

Selling off the elements of its general merchandising businesses as trade sales and separate marketflotations (demergers)

Demerging its electricals business into a separately listed firm Kesa Electricals

Retaining its home improvements business.

5.4 Shortcomings of the BCG matrixBCG portfolio analysis is useful because it provides a framework for planners to consider and forecastpotential market growth and to evaluate the competitive dimension through an evaluation of market shareand the likely changes in cash flow. However, it should not be used uncritically, as follows.

Factors besides market share and sales growth affect cash flow, e.g. amount of R&D and investment innew technologies.

Many firms, anxious to present a good ROCE and EPS to investors, still use return on investmentwhen assessing the attractiveness of a business opportunity, despite the opportunity it gives foraccounting manipulation and the fact that it ignores the time value of money. Therefore problemchildren and stars can look like bad businesses.

The model provides no real insight into how to compare one opportunity with another whenconsidering which opportunity should be allocated investment resources, e.g. how does a starcompare with a question mark?

Rates of profit of some small businesses can be very high. Therefore in the right conditions a firm canprofit from a low share of a low-growth market. (This point is made by Porter in his criticism of the BCGand he uses it to justify focus strategies to gain competitive advantage. See Chapter 6.)

The model does not take risk into account, which is a crucial difference from the investment portfolioapproach from which it takes its inspiration.

The matrix focuses on known markets and known products. As a generation tool, it sits firmly in therational planning model and also within the positioning approach to strategy.

The model assumes industry and market can be defined for purposes of calculating share and growth.Chapter 4 has shown that this is difficult in practice. Ignoring substitute products can lead managementto overestimate the attractiveness of a business unit for investment purposes (e.g. returning toKingfisher both Woolworth and MVC ran into commercial difficulties following the explosion in digitalmusic in the years that followed).

The model suffers from difficulties in forecasting growth (e.g. despite high historic growth B&Q andseveral rival home improvement firms suffered fo

chap - 5 srategic capability

Documents