Hong Kong Institute of CPAs, "Code of Ethics for Professional Accountants (Effective June 2006)

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1 Strategy Formation Processes, Including Data Gathering Structures, SWOT Analysis and Ethics Section 5 Part A Suggested References When you are studying this topic we suggest the following references: Primary References Anthony, R.N. and Govindarajan, V., Management Control Systems, 12 th edition, 2007, Chapter 2. Porter, M.E., Competitive Advantage: Creating and Sustaining Superior Performance, 1985, Chapters 1-4. Supplementary References Atkinson, A.A., Kaplan, R.S., Matsumura, E.M. and Young, S.M., Management Accounting, 5th edition, 2008, Chapter 1. Dess, Gregory; Lumpkin G.T. (2003) Strategic Management Creating Competitive Advantage. 1 st edition McGraw-Hill Irwin Govindarajan, V. and Shank, J.K., Strategic cost management: Tailoring controls to strategies, Journal of Cost Management, Fall, 1992, pages Grant, R.M., Contemporary Strategy Analysis, 6 th edition, 2008, Chapter 1., "Code of Ethics for Professional Accountants (Effective June 2006) Horngren, C.T., Datar, S.M., Foster, G., Ittner, C., and Rajan, M. Managerial Emphasis, 13 th edition, 2008, Chapter 13. Cost Accounting A Johnson, G., Scholes, K. and Whittington R, Exploring Corporate Strategy, 7 th edition, Lei, David; Slocum Jr., John W. Strategic and organisational requirements for competitive advantage Academy of Management Executive, Feb 2005, Vol. 19 Issue 1. Porter, M.E. What is Strategy, Harvard Business Review, Nov Dec Shank, J.K. and Govindarajan, V., Strategic cost management and the value chain, in Readings and issues in cost management, 1995, edited by J.M. Reeve, Reading 1.2. Smith, M., Strategic management accounting: Issues and cases, 1995, Chapter 4. Steiner, G.A., Strategic Planning, What Every Manager Must Know, 1997, p.15. Tant, K., Business Ethics and the Treasury Professional, The Bridge Guide to CorporateTreasury in Asia, Hong Kong, EFP Publishing, Financial Management Module (printed May 2010) 5-1

2 Part B Topic Strategy formation processes, including data gathering structures and SWOT analysis: The nature of strategic planning and its stages Environmental analysis Types of planning models Selecting long term objectives Competitive strategies Industry life cycle Relationship between strategic planning and budgeting Ethics in strategy formation, operations and evaluation Global financial crisis and business strategy Learning Outcomes On completion of this module, you should be able to: i) Identify the steps involved in the formulation of strategies and understand the relationship with budgets. ii) iii) iv) Complete an internal and external analysis of a business, including SWOT and industry analysis. Describe the main planning model types and implications for strategy design. Describe recent analysis theories and associated impact on prices, costs and investment. v) List the nature and uses of different types of business plans. vi) vii) Demonstrate how to translate the organisation s objectives and strategies into business plans. Outline available options associated with business planning. viii) Estimate and forecast both operational and developmental revenues and costs associated with business plans. ix) List the tests available for evaluating strategies. x) Appreciate the importance of ethics in strategy formation, operations and evaluation. You may choose to complete this topic in a step-by-step way or skip ahead, depending on your knowledge and assessment of your own competency in relation to the above Learning Outcomes. Part C Contents of this Section 5.1 Introduction The nature of strategic planning and its stages Environmental analysis Types of planning models Selecting long term objectives Competitive strategies Industry life cycle Relationship between strategic planning and budgeting Ethics in strategy formation, operations and evaluation Global financial crisis and business strategy Introduction To survive in the global economy, businesses must plan for both growth and financial stability. In order to achieve these combined objectives long-range strategies need to be formulated and appropriate practical techniques used to formulate operational level activities. The operational level activities need to be aligned with the long-range objectives. Financial Management Module (printed May 2010) 5-2

3 This section examines the strategic planning (long-range planning) process. In particular, we: look at and analyse a definition of strategic planning (section 5.2.1); cover the usual steps involved in the strategic planning process (section 5.2.3) and consider the relationship with shorter-term plans (i.e. budgets). For some of you, this coverage may be repetitive of earlier studies. Nevertheless, it is important we cover this to establish our starting point for the section; consider two main types of analyses which are used to carry out the strategic planning process: environmental analysis; and competitive strategy analysis. Environmental Analysis Within environmental analysis, we cover: the technique of strengths, weaknesses, opportunities and threats (SWOT); and Porter s five-forces industry analysis. SWOT analysis can be used not only as an environmental analysis technique but also to evaluate how strategies are being met, i.e. in a performance measurement type of role (see Figure 1 below). Porter s industry analysis technique gives us an indication about our environment from the industry perspective. It provides some signs about whether abnormal profits 1 can be earned. Competitive Strategy Analysis To succeed in business we need a strategy that not only takes into account our environment but also builds on our competitive advantage(s). This second area is where competitive strategy analysis can be useful. Within competitive strategy analysis we consider how such planning models, as the matrices developed by Boston Consulting Group (BCG) and General Electric Company/McKinsey and Company can be used to determine product characteristics and associated operational activities to achieve those characteristics. Structure of this Section Figure 1 below outlines the structure of this section and the relationships among the various techniques that are employed. As a starting point, the managers of an organisation should have a clear vision of what is to be achieved in the long term and should be able to describe the organisation s overall mission and purpose. Sometimes the mission statement is agreed before carrying out the environmental analysis and sometimes it is the other way around. There is no one correct order. A SWOT analysis and a five-forces industry analysis can assist in achieving some understanding of the environment. At this point the business management should then be able to answer the question: Why do we exist as a business? 1 Abnormal profits (sometimes called supernormal profits) are profits in excess of the cost of capital. Alternatively abnormal profits exist when the rate of return generated by the firm is greater than the required rate of return. Abnormal profits add value to the firm. Financial Management Module (printed May 2010) 5-3

4 A business then needs to determine its overall strategies in order to achieve its mission. The BCG and McKinsey matrices are two techniques to provide information about where to invest and where not to invest. Similar information is gained by using such techniques as the Ansoff matrix and Porter's generic strategies. These techniques are useful at the next stage where micro-level strategies are developed. These micro-level strategies should be consistent with the long term strategies, which, in turn, are consistent with the overall mission. A budget quantifies these micro-level strategies. Figure 1: Concept Map The Planning Process ENVIRONMENTAL & INDUSTRY ANALYSIS Budgeting Strategic Planning DETERMINE OVERALL MISSION/PURPOSE SELECT LONG - TERM OBJECTIVES DEVELOP APPROPRIATE STRATEGIES PREPARE THE BUDGET MEASURE PERFORMANCE ANALYSE REASONS FOR DEPARTURE FROM PLAN SWOT, industry analysis Planning models for long term strategies e.g. BCG, McKinsey matrices Planning models for competitive strategies e.g. Ansoff, Porter Master budgeting Variance analysis, SWOT analysis, industry analysis, other techniques Performance is measured once the business activity commences and feedback is obtained using a variety of techniques. Significant departures from budget may cause the business management to review its environment using (say) SWOT analysis and so the process continues. Financial Management Module (printed May 2010) 5-4

5 5.2 The Nature of Strategic Planning and Its Stages Definition A good place to start this topic is with a definition of strategic planning. The following definition illustrates the practical approach to strategic planning: Strategic planning is the systematic and more or less formalised effort of a company to establish basic company purposes, objectives, policies, and strategies and to develop detailed plans to implement policies and strategies to achieve objectives and basic company purposes. (G.A. Steiner, Strategic Planning, What Every Manager Must Know, p.15). Although this definition focuses on companies, any entity (for example, government bodies like the Hong Kong Government Department of Trade, charity organisations like the Red Cross, or business partnerships like some accounting firms) can and should carry out strategic planning. Profit-seeking entities are not the only types of entities with objectives. For example, the Red Cross might have as an objective to improve the quality of health care in Africa. To achieve this long-term objective it will need to raise funds, employ doctors and nurses and train people from African nations in hygiene, self-sufficiency and so on. A specific shorterterm goal might be to raise 10% more funds from donations. In this section, however, we concentrate on profit-seeking entities. There are some important points to note about the definition of strategic planning. Firstly, the process is aligned with long term outcomes. Secondly, strategic planning is a process to identify and plan the best way forward for an organisation s existing and proposed services/products. Financial Management Module (printed May 2010) 5-5

6 5.2.2 The Strategic Planning Period An important characteristic of strategic planning is that it is long-term. We plan where we want to be in (say) five years and not next month or next year. Normally strategic plans cover from three to ten years. However, entity-specific factors can provide an indication about how long we should plan ahead. Willson, et al (1995) identify six factors (a to f below) which can be used to determine the strategic planning period, all of which have a positive relationship with the suggested strategic planning period. That is, for each factor, as that factor increases, so does the strategic planning period. a) Lead Time for Product Development This is the length of time from the generation of an idea to the distribution of the product/service to the end customer. Consider the lead times for product development for a new bicycle model versus a new drug to combat the common cold. To build the new bicycle the production facilities may not even need to be altered. All that is required is some market surveys, design and engineering work to be done and then production can commence. The lead time may be as short as six months or even shorter for very efficient entities. For the new drug the period of research alone may take years. And, of course, there are many examples of new services/products that would fall between these two extremes. b) Length of Product Life This is the length of time before a product/service becomes obsolete. Consider a McDonald s Big Mac versus a Honda sedan. The Big Mac has the longer product life because it will be many years before it is considered obsolete. However, we see new models of Hondas (and most other makes of motor vehicle) about every two to three years. Length of product life has little to do with product durability (you can use a car much longer than you can use a Big Mac); it is the model life that determines the length of product life. Strategic planning at Honda would be shorter-term than strategic planning at McDonalds. c) Market Development Time This is the length of time it takes for the market to change. Perhaps the simplest way to think about this is to consider whether the market is new and has to be developed, or whether it already exists. Similarly, the core competency may be new or may already exist. The 2 x 2 matrix below indicates a set of 4 possible strategies. This matrix is reproduced, with permission, from material published by SmartSims Limited. Financial Management Module (printed May 2010) 5-6

7 These are described in more detail in the table below. This can be used as a start to the process of defining the basic marketing strategy that an organization must adopt to succeed. Type of Strategy Continuous Improvement Leverage Re-Invent New Business Description of Marketing Strategy This strategy suggests that low cost is the critical strategic lever. In this case continuous improvement of the existing systems is key. This is the type of strategy most consistent with Michael Porter. This strategy suggests that there is a new market that may be tapped using an existing process or competency. This strategy requires a new competency to be developed for an existing market. This strategy is to build or buy a new market and a new competency. d) Development Time for Raw Materials and Components A merchandising firm needs very little time to acquire raw materials because it needs only to search for potential suppliers and then negotiate cost, quality, delivery times and so on. However, a decision by that firm to divest and invest in the paper industry by acquiring a new pine plantation would mean that the trees would have to grow before any return could be made. Therefore, if investing in the paper industry becomes part of the merchandising firm s official mission (i.e. part of its strategic plan), the development time would lengthen the period of the plan. e) Time for Construction of Physical Facilities A university decides, as part of its mission, to increase fee-paying student numbers. It decides to do this by attracting overseas students and constructing new student accommodation (the university has no available space). A period of about two years would be required and the strategic plan needs to cover at least this period. For some new strategies this may not be an issue e.g. a new style of shoe that will use existing factory machinery and facilities. f) Payback Period for Capital Investment A long payback period can be due to new products which require significant capital investment and which are expected to recover the investment cost steadily over time. For example, a private venture to build a toll-road around a major city requires significant up-front investment. As tolls are collected, the cost is recovered. However, the payback period is likely to be long due to significant initial costs, the length of time to generate revenue and the low unit revenue. Although the quantity of unit sales (vehicles paying tolls) is expected to be very high, this long payback period means the entity undertaking the project needs to plan for factors that can affect the revenue stream for some years. For example, will advances in technology mean that fewer people use their vehicles (some new form of public transport)? Financial Management Module (printed May 2010) 5-7

8 5.2.3 The Strategic Planning and Control Cycle: Seven Steps Willson et al, (1995), identified the following seven steps in the strategic planning process: 1. Analysis of the industry and business environment and status. 2. Determining the corporate mission or purpose Selecting the company s long-term objectives. 4. Developing appropriate strategies. 5. Preparing the long-range plan, including the financial plan. 6. Measuring actual performance against the plan. 7. Analysing the reasons for departure from the plan, and taking any appropriate action. As we are concerned with strategy formulation in this section, we consider the first four steps. Steps five to seven will be considered later when we cover budgeting and performance measurement and analysis. The next part of this section covers analysis of the industry and business environment and status (environmental analysis). 5.3 Environmental Analysis The greater the uncertainty in the organisation s environment, the more importance should be placed on strategic planning. How do we determine uncertainty in the environment? We will now introduce some useful techniques for carrying out this process. There are two major areas with which environmental analysis is concerned: situational analysis; and identification of critical success factors. Two common approaches for performing situational analysis are: SWOT analysis (strengths, weaknesses, opportunities and threats); and industry analysis (e.g. Porter s five-forces industry analysis or PESTE analysis. PESTE is an acronym for Political, Economic, Societal, Technological Environment). Figure 2: Environmental Analysis Techniques Environmental analysis Situational analysis Identify critical success factors SWOT analysis Industry analysis 2 Note that these two steps may in some cases be reversed or done as one step. Financial Management Module (printed May 2010) 5-8

9 5.3.1 SWOT Analysis SWOT analysis is a systematic method for detailing the strengths, weaknesses, opportunities and threats to an organisation. It attempts to provide a picture of the organisation s position relative to the impact of important internal and external factors and is therefore a useful part of the first step in formulating strategies. The issues that are typically considered in preparing a SWOT analysis are: financial performance; competitiveness; market impact; and environmental factors. The analysis should explicitly consider the extent to which the objectives of the organisation, as set out in the mission statement and business plan, are being achieved. The SWOT analysis may result in the modification of some objectives due to the gap between the objectives and what is practically attainable. How can we start a SWOT analysis? One approach is to follow these four steps: 1. List the key factors for success. 2. Outline the major outside influences and their impact on our business. 3. Give an assessment of our company versus our competitors. Highlight the differential strengths and weaknesses. 4. Give an explanation for good or bad performance. A potential problem with SWOT analysis is the development of a long list of unweighted factors. If the situation review is to be of assistance to strategic planning, these factors must ultimately be ranked in order of priority to the organisation. This allows for greater focus when developing specific strategies. The message with SWOT analysis is to keep it short and simple. A way of organising the four factors is in a table, as follows: Strengths Weaknesses 1 2 Opportunities Threats Financial Management Module (printed May 2010) 5-9

10 5.3.2 Porter s Five-forces Industry Analysis Another technique that can be used to provide a comprehensive analysis of the organisation s current position is Michael Porter s five-forces industry analysis. Porter (1985) developed a fivepart model of the existing competitive position that is used to highlight key factors that are likely to affect the achievement of the organisation s objectives. The five forces comprise: 1. the threat of new entrants; 2. the level of industry rivalry among existing competitors; 3. the threat of possible substitute products; 4. customer negotiating power; and 5. supplier negotiating power. Porter argues that although the relative strengths of the five forces will vary from industry to industry and may change over time, the collective strength of these five forces will determine whether organisations in an industry can earn rates of return greater than their cost of capital. The five forces are critical to industry profitability because they influence the prices, costs, and required investment in an industry. We can illustrate the inverse relationship between the strength of all the forces and the profitability of the industry with the following simple graph: More Profitable Profitability of the industry Less Profitable Collective strength of the five forces Weaker Stronger As the collective strength of the five forces increases, the profitability of the industry declines and vice versa. For example: The threat of new organisations entering the market limits the prices that can be charged for products, and also means that investment is required to deter new entrants. Intensity of rivalry between existing competitors is a major influence on both prices and costs. This may be determined by many factors, including level of industry growth, differences between products and brand identities. The size of the market for a product is reduced by the emergence of substitute products. Powerful customers can drive down prices but also demand a more costly (and hence less profitable) service. The bargaining power of suppliers determines the cost of raw materials and other inputs. Thus, the five-forces framework allows an organisation to identify some of the factors that are critical in its industry. In doing so it directs the energies of the organisation toward the aspects of industry structure that are critical to long run profitability. It also allows the organisation or business unit to formulate effective strategies. Financial Management Module (printed May 2010) 5-10

11 A potential problem with this type of analysis is the assumption that industry participants always act rationally, i.e. that competitors have a profit motive and adequate information to be able to strategically align themselves if there are any market shocks. This may not always be the case, for a variety of reasons. For example, if poor internal reporting processes provide inadequate cost information for pricing decisions, we may observe firms pricing products at less than cost. Of course, these firms will take action when losses begin to be made, but they may not identify the root cause immediately - it may take them some time. For example, consider a firm that benchmarks its prices against those of a competitor which has a more efficient production process and a better costing system. Is it the costing system or the efficient processes that need to be corrected? PESTE Analysis The term PESTE was coined by Johnson and Scholes (1997). This form of analysis considers the business environment in which an organisation operates and identifies the elements that could have some impact on the products that it produces or intends to produce. Usually a lot of data will need to be analysed, so structuring and summarising the data will be important. A major consideration is the quality of the information. It can be argued that the better the quality of the information, the better the decision, and that the most current information is generally the most valuable. However, it is often the most ill defined. The trick is to identify the key data from a vast array of it, and to convert it to knowledge useful for decisions. The PESTE analysis is useful to this end, and relates to the Political Economic Societal Technological and Environmental conditions in which a firm operates. It provides an overview of the overall environment and can be completed at a number of different levels anywhere from trivial to an exhaustive level taking months and even years to complete. The objective is to put on one page all the main issues that relate to the enterprise and the industry in which it is competing. It is best to start simple and to gather more information about each of the areas over time Identification of Critical Success Factors How can a firm identify its critical success factors (CSFs) or key performance indicators (KPIs)? Here are some characteristics, which CSFs (KPIs) should have: The CSF should be essential to the successful completion of the organisation s objective(s). For example, a CSF for a university s accounting department might be to receive an adequate number of well-qualified student applications per year seeking enrolment in the commerce undergraduate degree. If the student demand for the university department s product is not strong, the number of students declines and the department s survival is threatened. The CSF should be expressed as an action. For example, a manufacturer of dairy products may have as one CSF: if a major competitor introduces a new yoghurt product we will respond by launching a competing product in the market within four months. The number of CSFs should be kept to a minimum for better control and ideally should be no more than ten. Financial Management Module (printed May 2010) 5-11

12 Some ways to identify products/services that should have CSFs include: The firm should identify the CSFs of all the businesses it operates including those products/services which have the greatest growth potential. For example, a television manufacturer currently training the employees of its repairs division in the repair and maintenance of digital televisions is likely to experience significant growth in demand for that division s service in the coming years. CSFs will need to be developed with that service in mind along the lines of quality, profitability, service and so on. Those products/services that contribute the most to profit, i.e. high gross margin products/services. 5.4 Types of Planning Models The environmental analyses (SWOT and industry analyses) are useful in highlighting the constraints and opportunities for the organisation with regard to its goals and overall mission. However they do not provide a specific recommendation or set of solutions as to how the organisation should proceed. They do not provide, for example, mission statements for the business units that comprise the organisation. The main reason for the preceding analysis was to assist with the identification of potential courses of action that are aligned with objectives. We now examine how the organisation can go about determining more specific courses of action that it will pursue in attempting to achieve its goals and objectives by using planning models. Planning models are used to assist managers in deciding how and where to allocate resources so that the business strategies can be best met. In this section we cover boxes three and four of the strategic planning process outlined in the concept map in page 4-3 above. For selecting the firm s long-term objectives (see section 5.5 below) we consider the two most common planning models: the Boston Consulting Group (BCG) 2 2 (two by two) matrix; and the McKinsey 3 3 (three by three) matrix. For developing appropriate strategies (see section 5.5 below) we consider: the Ansoff matrix; and Porter s generic strategies. Financial Management Module (printed May 2010) 5-12

13 5.5 Selecting Long Term Objectives BCG Growth/Share Matrix (2 x 2 matrix) An alternative approach to conceptualising the organisation s current strategic position has been developed by the Boston Consulting Group. The BGC matrix method is based on the product life cycle theory that can be used to determine what priorities should be given to individual products in a company s portfolio of products. To ensure long term value creation, a company should have a portfolio of products that contains both high growth products in need of cash inputs and low growth products that generate lots of cash. Using this approach a company classifies all its strategic business units (SBUs) products or services according to the growth-share matrix. The matrix has two dimensions, market share and market growth, and is illustrated below: The vertical axis is measured in terms of market growth rate and is intended to be indicative of the attractiveness of the existing market. The horizontal axis indicates the organisation s relative market share. This is suggested to be a proxy for its strength within the market. By splitting the growth-share matrix four types of SBUs/products or services can be identified. Stars are high-growth, high-share businesses or products. They typically need heavy investment to finance their rapid growth. Eventually their growth will slow down and they will turn into cash cows. A hold strategy is appropriate for these products. Cash cows are low-growth, high-share businesses or products. These established and successful SBUs/products or services need less investment to hold their market share. They produce a lot of cash that the company uses to pay its bills and to support other SBUs/products or services that need investment. Some experts suggest that when a market s annual growth rate falls to less than 10% the star becomes a cash cow if it still has the largest relative market share. A harvest strategy is appropriate for these products. Question marks are low-share business units in high-growth markets. They require a lot of cash to hold their share, let alone increase it. Management has to think hard about which question marks it should try to build into stars and which should be phased out. A build strategy is appropriate for these products. Financial Management Module (printed May 2010) 5-13

14 Dogs are low-growth, low-share businesses and products. They may generate enough cash to maintain themselves, but do not promise to be large sources of cash. The firm should consider divesting itself of these products/services. Note that in preparing a growth-share matrix the relative market share is drawn on a log-scale. This means that equal distances represent the same percentage increase. The suggestion is that the relative market share axis be divided into high and low using 1.0 as the separating line. In terms of the vertical axis a market growth rate above 10% is typically considered to be high. Thus the BCG growth share diagram highlights those areas of the business and its environment that are critical to the achievement of its goals and objectives. The problem with all matrix approaches is that they focus on classifying current businesses, products or services but provide minimal advice for future planning. In this regard management must still use its own judgement to set the business objectives for each SBU/products or services. This is the very essence of management. Example 1: BCG Growth/Share Matrix The BCG growth/share matrix attempts to relate critical strategic issues to the different phases of the product life cycle and to show how successful strategies must be appropriately tailored to the changing needs of the business. Required Choosing from the four possibilities for each characteristic for each type of product, complete the following table. For instance, if you expect that a product/service that is a star should have a controller style of management then put controller in that cell. You would then have to choose which of the remaining three types of management styles should be entered into each of the remaining cells. a) Management style: controller, marketing/growth, entrepreneurial or cost minimisation b) Business risk: very high, high, medium or low c) Financial risk: high, medium, low or very low d) Cash flow position: positive, neutral, negative or neutral e) Critical success factor: maintain market share at minimum cost, growth in market share, successful new product development or minimise cost base f) Control measure typically considered to be appropriate with respect to each dimension of the BCG growth/share matrix: return on investment, discounted cash flow, R&D milestones or free cash flow. Financial Management Module (printed May 2010) 5-14

15 How do I approach this question? Having undertaken previous study and read the technical information provided in this Section 5, do I have sufficient knowledge of the product life cycle, critical strategic issues and an understanding of the Boston Consulting Group matrix to classify each characteristic for each of the cash cow, star, question mark and dog products. If no, you will need to go to the primary and supplementary references provided in the section and gain more information. If yes, proceed to answer this question, commencing with an answer plan. Work through each of the pertinent steps. For example: 1. Determine the identifying factors of each of the cash cow, star, question mark and dog products. 2. Assess the relevance of each characteristic to each product. Now you should have some idea of our answer expectations. Read the required first, then the facts, then read the required again. Plan your answer and then commence. Your workings: Cash Cow Star Question Mark Dog a) Management style b) Business risk c) Financial risk d) Cash flow position e) Critical success factor f) Control measure Financial Management Module (printed May 2010) 5-15

16 Suggested Solution Example 1: BCG Growth/Share Matrix The following table has been constructed based on the suggestions of Ward (1992, pp.41-47). Cash cow Star Question Mark Dog Management style Controller Marketing/ growth Entrepreneurial Cost minimisation Business risk Medium High Very high Low Financial risk Medium Low Very low High Cash flow position Positive Neutral Negative Neutral Critical success factor Maintain market share at minimum cost Growth in market share Successful new product development Minimise cost base Control measure Return on investment Discounted cash flow R and D milestones Free cash flow The General Electric Company/McKinsey and Company Matrix (GEM) The GEM matrix also determines one choice from four possible missions in a similar way to the BCG matrix. So the outputs of the planning models are the same. It is the way that we determine our competitive position that is different. With the GEM matrix the vertical axis (industry attractiveness) relates not only to market growth rate as it does with the BCG matrix, but also considers such factors as: market size, level of barriers to entry and technology. On the horizontal axis, the GEM matrix uses such factors as market share, and internal strengths such as research and design, engineering, marketing skills, alliances with suppliers and so on, to determine the business strength. The BCG matrix only uses market share to determine current business strength. It can be argued that the GEM matrix provides a more thorough analysis because of its consideration of other relevant factors. However, whether a more thorough analysis results in a more or less accurate determination of current position is uncertain. For example, if we introduce fuzzier factors to consider do we become more or less accurate? Practically it is probably best to use both method types and, if differences arise, look for reasons why, and take these into consideration when making the final decision. a) The Portfolio Matrix Business strength Strong Average Weak Industry attractiveness High Winners Winners Question Marks Average Low Winners Average businesses Losers Profit producers Losers Losers Financial Management Module (printed May 2010) 5-16

17 b) Recommended Business Strategies Business strength Strong Average Weak Industry attractiveness High Average Low Invest/Grow strongly (Build) Invest/Grow selectively (Build) Earn/Protect (Hold) Invest/Grow selectively (Build) Earn/Protect (Hold) Harvest/Divest Dominate/Delay/ Divest Harvest/Divest Harvest/Divest Example Wireless Rentals (WR) rents PCs, televisions, hi-fi equipment, video cassette recorders and video cameras to its customers. WR operates in an established industry with three other major competitors. Together, the four competitors hold about 95% of the electrical equipment rental market. WR holds about 35% of the total market and has a good reputation. Staff morale is generally good although in recent times some redundancies have occurred. WR operates at the lower end of the market because more affluent people prefer to buy these types of goods rather than rent them. Barriers to entry are average because basically all that is required to begin business is to purchase the equipment and obtain some service and repair skill. Significant capital investment is not required. However, obtaining a large market share is relatively difficult due to the market dominance of four different players. Market size seems to be diminishing in the well-established products such as television, video cassette recorder and video camera rental. This is partly due to the reduction in cost of these items. PC rental, which was very popular in the early 1990s, has also become less popular with many consumers deciding to purchase instead, although this market has levelled out in the last two years. Overall gross margins from all rentals have become tight in recent years. With the established products WR is likely in the Cash Cow quadrant in the BCG matrix and probably in between the Average Business Quadrant in the top GEM matrix. These positions translate into harvest and hold business strategies under each of the planning models respectively. This means WR should continue to milk existing product. 5.6 Competitive Strategies Competitive strategies are specific courses of action designed to create sustainable competitive advantages in particular products or identified markets in the pursuit of identified objectives. They should be designed to build on the strengths, and take opportunities. They should be aligned with overcoming or reducing the internal weaknesses and threats to the organisation, as identified in the earlier SWOT analysis. Consequently, competitive strategies should be the most precise level of strategic planning since they relate to actions regarding products and markets which are to be implemented to achieve the most specific (i.e. lowest level) objectives of the organisation. Financial Management Module (printed May 2010) 5-17

18 5.6.1 Ansoff Matrix A useful approach for identifying potential growth opportunities is the product/market expansion grid, otherwise known as the Ansoff matrix. This is represented as follows: Products Existing New Markets Existing 1. Market penetration strategy 3. Product development strategy New 2. Market development strategy 4. Diversification The Ansoff matrix recognises the fact that an organisation can increase its sales of products by: selling greater volumes to its existing customers (i.e. market penetration via increased market share); finding new customers to sell the product to (i.e. market development); acquiring or developing new products to sell to its existing customers (product development); or acquiring or developing new products for new customers (diversification). The choice is made from the first three potential strategies by considering the relevant strengths and weaknesses identified for that business. A SWOT analysis can assist here. For example, at WR gross margins have become very tight in recent years. Top management at WR decided that to accomplish WR s strategic mission of becoming the market leader within five years, they had to diversify. WR acquired 500 large-screen projector-style televisions for installation into hotels and boutique-bars. WR was trying to penetrate the sporting drinker market. By adopting this strategy, WR introduced a new product and penetrated a new market. This is the bottom right quadrant of the Ansoff matrix above Porter s Generic Strategies Porter (1985) identifies several potential generic strategies that will allow an organisation to obtain a competitive advantage. He argues that there are two basic types of competitive advantage an organisation can possess: low cost and differentiation. These stem from industry structure and are a result of the organisation s ability to cope with the five forces (discussed earlier) better than its competitors. When the two basic types of competitive advantage are combined with the scope of the organisation s activities, a third generic strategy focus can be identified. Focus strategies aim at cost advantage or differentiation in a narrower market segment than the pure low cost or differentiation strategies. Thus, if an organisation is to attain a competitive advantage it must make a choice about: a) the type of competitive advantage that it seeks to attain; and b) the scope within which it will attain that advantage. Financial Management Module (printed May 2010) 5-18

19 We can illustrate the choice of strategy on the following continuum. Note that it is not a discrete choice. Firms can choose where they want to be on the continuum. We show the choice of low cost versus differentiation on a continuum because firms don t have to make a discrete choice. Many firms compete on a combination of the two extremes. Furthermore, some firms have different strategies for different products. Porter s Generic Strategies on a Continuum Low Cost Strategy Differentiation Strategy The three main strategies are: Cost Leadership Under this strategy an organisation aims to become the lowest cost producer in its industry. The organisation has a broad scope and serves many industry segments. Note that the organisation must be the cost leader, not merely one of several organisations attempting to attain this position. Differentiation Under this strategy the organisation seeks to be unique in its industry along some dimension(s) that are valued by buyers. The organisation selects one or more attributes that many buyers perceive as important and uniquely positions itself to meet those needs. The means for differentiation will vary between industries. The reward for this uniqueness is the ability to charge a premium price. Focus This strategy is quite different from the others because it rests on the choice of a narrow competitive scope within an industry. The focuser selects a segment or group of segments in the industry and tailors its strategy to servicing them to the exclusion of others. By optimising its strategy for the target segments, the focuser seeks to achieve a competitive advantage in its target segments even though it does not possess a competitive advantage overall. There are two potential aspects to this approach, a cost focus or a differentiation focus. In cost focus, the organisation seeks a cost advantage in its target segment, while in differentiation focus it seeks differentiation in its target segment. The target segments must have buyers with unusual needs, or else the production and delivery system that best suits the target segment must differ from that of other industry segments. Porter suggests that an organisation that engages in each generic strategy but fails to achieve any of them is stuck in the middle. That is, it does not possess any competitive advantage and will usually experience below-average performance (relative to the industry). As the industry matures, the performance gap between organisations with a generic strategy and those without will widen considerably. Porter argues that the value chain plays a fundamental role in identifying sources of competitive advantage. The value chain identifies the total value added to the conversion of a product or service. The value added by the organisation is determined in terms of each primary (e.g. manufacturing) and support activity (e.g. administration) carried out by the organisation. The objective of the analysis is to determine the activities that contribute most significantly to the product s/service s total value and to develop strategies to improve, or defend, the organisation s current share of that value added. Financial Management Module (printed May 2010) 5-19

20 The value chain focus is therefore external to the organisation, with each activity viewed in the context of the overall chain of value-creating activities of which it is only a part. This is in contrast to traditional management accounting that adopts a focus that is largely internal to the organisation, with each activity viewed in context of its purchases, its processes, its functions, its products, and its customers. The key theme in traditional analysis is to maximise value-added. Porter (1985, p.39) contends that the value added approach, unlike the value chain approach, fails to highlight the linkages between an organisation and its suppliers that can reduce cost or enhance differentiation. 5.7 Industry Life Cycle The last key strategy concept to be examined is that of the industry life cycle. All products must go through a product life cycle of introduction, growth, maturity and decline and likewise must all industries. It is better of think of an industry as being a living ecosystem rather than a static snapshot, because your best strategy for today will not necessarily still be valid tomorrow. This concept was introduced in the BCG Matrix Using a very traditional Product Life Cycle approach, Dess and Lumpkin (2003) created the following table to link Porters Generic Strategies to the industry lifecycle. GENERIC STRATEGIES MARKET GROWTH RATE NUMBER OF SEGMENTS INTENSITY OF COMPETITION EMPHASIS ON PRODUCT DESIGN EMPHASIS ON PROCESS DESIGN MAJOR FUNCTIONAL AREA OF CONCERN OVERALL OBJECTIVE INTRODUCTION GROWTH MATURITY DECLINE Differentiation Differentiation Differentiation Cost Leadership Low Very large Low to moderate Cost Leadership Focus Very few Some Many Few Negative Low Increasing Very Intense Changing Very high High Low to moderate Low Research & Development Increase Market Awareness Low to moderate Sales and Marketing Create Consumer Demand High Production Defend Market Share & extend product life cycles Low Low General Management & Finance Consolidate, maintain, harvest, or exit However for a more recent perspective on Industry Ecosystems we have included the reading below by Lei and Slocum (2005). Using their terminology they say that an Industry can be described as an economic complex adaptive system by two defining characteristics: The existence of a life cycle that guides evolution within the system The rate of technological change that can dramatically reshape the configuration of the system itself Financial Management Module (printed May 2010) 5-20

21 Using this definition they have divided industries into four types as shown in the diagram below. Low 3. Steady Evolution Rate of Technological Change High 4. Creative Destruction Lifecycle Phase Growth Mature Stable Industry Structure Well-established competitors Few opportunities for product differentiation Scale and size important Cost efficiency predominates Knowledgeable customers 1. Fast Growth Focus on developing core product concept Rivals attempt to differentiate from one another Emphasis on scalability, replicable business models Value proposition seeks to build customer loyalty Rise of technological change New entrants from other industries New technologies reshape underlying value proposition Established firms face market share loss 2. Wild, Wild West Market boundaries uncertain Multiple competing technologies and standards Numerous entrants from a wide number of industries Value proposition in flux Need to establish customer lock-in Quadrant One, Fast Growth A new product concept or idea becomes the basis for fast industry growth. Firms will try to stake out and expand key portions of the market by offering their own distinctive value proposition for customers Quadrant Two, Wild, Wild West A combination of fast growth and technological ferment attracts numerous upstarts who bring novel ideas and new technologies to a highly dynamic setting. Quadrant Three, Steady Evolution Industry maturity is characterised by a stable industry structure, where large firms enjoy significant market shares. Market share for competitors has become well established, making it essential for firms to capture and sustain cost-driven efficiencies. Quadrant Four, Creative Destruction Firms in highly mature industries face the onslaught of new technologies and other technological changes from outside their industry that promise to transform the very essence of their survival. For a more detailed discussion of the industry types and the types of strategies that firms can employ in those situations then read the following article: Strategic and organisational requirements for competitive advantage by: Lei, David; Slocum Jr., John W. Academy of Management Executive, Feb 2005, Vol. 19 Issue 1. However the key point to take away is that an industry is dynamic and that its life cycle and rate of technological change can be two key drivers in affecting the firms within in. Financial Management Module (printed May 2010) 5-21

22 5.8 Relationship Between Strategic Planning And Budgeting In large organisations the strategic planning activity is usually separated from the budgeting activity. This does not mean that the two activities are unrelated in their objectives. It means that different levels of management are responsible for their development. We consider this relationship in more detail in Section 7. In that section it is noted that: Budgets usually involve one year (short term), whereas strategic plans cover periods longer than one year, and often five years. Strategic plans tend to contain relatively little financial data, whereas budgets are usually financially based. The strategic plan is often structured by product/service, whereas a budget is normally structured by responsibility centre. It should also be noted that there is a strong relationship between strategic planning and capital budgeting. Often, capital budgets are viewed as concrete financial embodiments of strategic plans. Capital budgeting is discussed in detail in Section Ethics In Strategy Formation, Operations And Evaluation The problems that confront business executives are many. Some of the most complex and difficult involve situations concerning right and wrong where values are in conflict. These situations are called ethical dilemmas. With corporate scandals and billion-dollar bankruptcies dominating headlines, ethics has almost become a hotter topic than earnings in the business world. Corporate icons such as Enron s former chairman Kenneth Lay were once held up as examples of successful business leaders. Now they have re-emerged as subjects of corporate case studies in what not to do. In the Asia/Pacific region, the H.I.H. scandal in Australia has highlighted the fact that these ethical issues are not confined to North America Do Business and Ethics Go Together? It is sometimes argued that business and ethics do not go together. For example, succeeding in business is largely about advancing our own private interests - aggressively competing against other people, beating them out for the same prize, and having unlimited ambition for money, position, and power. The moral life, by contrast, focuses on our duties to others - not to hurt anyone (deliberately or accidentally), to place other people s interests ahead of our own when it s called for, and always to treat others with the dignity and respect they deserve. Being scrupulously honest and caring in our business dealings with others can sometimes cost us sales, deals, money, and promotions. Refusing to go along with other people s unethical behaviour can sometimes even cost us our jobs. However, when taken too far in business, even healthy self-interest, competitiveness, and ambition can turn into selfishness, aggression, and greed - traits that are clearly at odds with the moral life. It seems, then, that taking ethics seriously in business extracts a price and may make success more difficult to come by. However, it is inconceivable that most people would ever freely endorse the idea that dishonesty, manipulation and taking advantage of other people were acceptable, fundamental traits of the basic mechanism by which society makes and distributes essential goods and services. Financial Management Module (printed May 2010) 5-22