© 1991 DAVID NEATH
JAMES HANSEN
Revised Edition
© 1998 DAVID NEATH
JAMES HANSEN
ECONOMIC FRAMEWORK FOR STRATEGY ANALYSIS
PART ONE
WHERE PROFIT COMES FROM
The need to consider economic strategy for the individual business
enterprise arises from your prospective career opportunities.
You as a student are more than likely to be involved in the operation
of a business that confronts a heavily competitive market. You
will daily be involved in or be affected by competitively oriented
business decisions. The world out there is cut throat. If you
are going to make a go of it, you need to have your competitive
skills honed.
What you need to understand, to begin with, is what drives the
business you work for. So we start off with an investigation of
the driving forces behind profit accumulation. The first problem
encountered concerns "who" is the person that we are
concerned with in terms of profit. If you have your thinking cap
on, your first profit priority has got to be YOU. But that
raises a corollary question -- How many other profit priorities
are there? Who else needs to be served in terms of profit?
Answering this question requires consideration of who is involved
with the operation of a business enterprise. We can start with
the more complex form of enterprise, the publicly listed company.
The accompanying model (Figure 1) illustrates the basic shell
structure of such a company.
Figure 1 illustrates a very basic classification of interests
represented within the company. Each of the groups portrayed has
a set of vested interests to protect while participating in the
day to day operations of the company. If we were to pursue such
a breakdown further, it would be possible to identify numerous
if not myriads of smaller sub-groups within each of these basic
groups. Potentially, this breakdown could be extended to the level
of each individual working within the company. The possibilities
for individual, group coalition and overall corporate behaviour
analysis are endless.
This classification of interests is extended even further once
we move outside the company and consider the interests of all
those economic agents with which the company deals in its business
operations. Figure 2 represents such an extended picture of the
company, taking into account the individuals and institutions
supplying goods or services to the company or buying goods or
services from it.
Added to this growing list of individuals and groups that have
an interest in the profit returns generated by a company are the
full range of competitor enterprises that line up alongside the
company in the market place. It is helpful to think of competition
in terms of a spectrum. If we dig up the notion of "substitution"
from our basic microeconomic studies, then what we are looking
at here is a spectrum of substituting possibilities confronted
by a company in the markets for its products.
Goods and services that are very similar to those offered by the
company can be referred to as competitive goods and services.
For example, imported Japanese steel products are competitive
goods for BHP in this country. Goods or services that are only
competitive in limited use areas, we can refer to as substitute
goods and services. Aluminum products in some uses are competitive
with steel. Hence aluminum is a substitute for steel. Naturally,
direct competitors for a company's products are more threatening
than substitutes, other things being equal.
All told, this list of potential claimants on the profits of a
company makes for a formidable task of analysis in sorting through
strategic options. But that is the bread and butter of every day
commercial life. And once we have established exactly whose interests
we are serving according to our "rational" priorities,
we can then concentrate on making the actual profit. Let's make
a profit.... Easy?
A Theory of Profit Creation:
The world is a complex environment to live in. It is so complex
that I can be your teacher because I have lived longer than you,
and I know more about the show than you. But there is someone
older than me who knows more than me because that person has had
more years to think about it. In other words, there is too much
information out there for anyone to take in overnight, less so
over years. Bad fact? No, good fact. If there is a lot of stuff
to know, and it is so complex that no one can know it all, there
will always be some "new" bit of information
to pick up.
"New" information we can define as something that nobody
else has known before. We will analyse this.
If I know something that nobody else knows, I have an advantage.
I can let others know my "secret" or I can use it to
my advantage before someone else finds it out. An example? Take
the Coca Cola formula - That has been a secret for over a hundred
years. Made a lot of money, haven't they? It can be very lucrative
to have a good secret up your sleeve.
Secrets come from gaining first knowledge of a new event/happening/development
in the competitive world we live in. Once you have a secret though,
you have to know how to make it work for you. This is where strategy
comes in. Using hard work and the skills from experience
to gain from exclusive information is the key to all competitive
success.
In a competitive environment we are facing the known and the unknown.
Take a small business in a large number situation (many suppliers/many
buyers), let's say a wheat producer. The producer knows current
local crop conditions, etc., but does not know what might be happening
in Russia or the USA or elsewhere, or indeed what the weather
might hold in store locally. With advance knowledge of these elements
of the competitive environment what action could the producer
take to gain a better position? For example, if the producer knew
that Russia and the USA were going to experience a drought,
gains could be had from extra planting of crop. If those countries
were known to be headed for bounteous crops, it would pay to avoid
wheat and plant something else.
The trouble is, the wheat producer knows little or none of what
might happen overseas, let alone weather or crop disease problems
here. But the poor producer still has to make a buck. How can
a decision be made? It can't be made with any certainty, but contingencies
can be allowed for.
When we use the word "contingencies", we are referring
to something that may or may not occur in the future. The idea
then is to build up a list of contingency situations regarding
unpredictable future events. Why? If we ignore the potential for
change in the future, when some new development does occur, we
are going to be least well equipped to cope with it. Whereas if
we put together a list of potential future occurrences now, then
we can think about them and their consequences for our business
operations.
Further we can have prepared a set of responses we could put into
action immediately the changes begin to become apparent. And if
we have done our contingency planning well, the speed with which
we can respond to change will give us what Michael Porter calls
"First Mover Advantage". That is we will lock
into the change before anyone else and gain the most from it in
the way of profits or other forms of gain.
A List of Contingencies
As profit seekers, we are looking for contingencies, ie potential
future developments, that could cause our profits to go up or
down. In other words we are looking for the sources of profit.
From what has been said already, it is obvious that the sources
of profit are heavily linked to the availability of information
about how to generate products that will be extremely popular
in the market place. Market popularity is geared to what the ultimate
consumer can get for each dollar laid down on the counter. This
suggests two things:
So what counts is having a product that has the right attributes
and that is cheap in relation to competitive products. Having
the right attributes attaching to the product is a matter of making
sure it is better than its competitors - that it is different
from them. Hence a key element in profit generation is what we
call "Product Attribute Differentiation". The other
element is obviously Cost Differentiation - Producing a product
with given attributes more cheaply than anyone else.
Cost and Differentiation Performance
Controlling the cost of producing something boils down to three
chief variables:
. Personal Management Skills,
. Labour Quality/Effort, and
. Technology.
In other words, we have to be efficient in our management of people
and of the technological environment. The technological environment
is determined ultimately by the state and the course of development
of natural conditions. It is tempting to refer to this as the
"Laws of Nature" except that natural conditions change
on a continuous basis and the so called laws of nature are not
immutable, certainly not for the breadth of human experience.
The 1998 volcano activity in Papua New Guinea serves as an example
of nature's continuing "progress", as did the emergence
of the AIDS virus in the 1980's.
The enormous progress of scientific knowledge across the whole
spectrum of human experience continuously throws up an infinitely
broad range of new developments of potential profit significance
for economic agents. In classifying sources of profit then, we
can employ the term "Natural Conditions" to denote such
forms of change as scientific discovery, technological research
and development, natural phenomena (earthquakes), mineral discovery
and so on.
On the human front, changes in our knowledge of human beings'
capacities in terms of, say, productive effort or the application
of skills can be combined with the never ending development of
consumer tastes and preferences under the banner of "Human
Conditions" in our classification. New fashion, better management
skills, better worker skills, demographic change (eg ageing of
the population) and so on would be included under this heading.
It would be a neat classification of profit sources if we could
halt at this point. However there is a further, "non-natural"
source of determinants affecting the cost of products and their
popularity in the market place. This refers to the vast array
of human composed laws that govern our activities. I use the term
"laws" in a broad sense, meaning not only government
law (common, statute or regulation), but also the many other forms
of institutional law such as religious law, customs, private organisation
rules and regulations and so on. This massive body of regulation
is in itself endlessly changing to reflect the interplay of political,
social and special interest forces in the game of life. These
changes in the law are of immense significance to eventual profit
opportunities.
To the extent that an economic agent manages to prepare before
anyone else for the profit opportunities emerging from changes
in these three broad categories of profit sources, then the gains
are available to be had by that agent. We need to look at the
various ways of making ready for such opportunities.
Gaining from Change
If you are interested in making money from change and you have
not seen the movie, "Wall Street", I would seriously
advise you to do so. The film contains all the essential elements
required for a successful round in the game of money-making. Set
in the treacherous arena of the American stock markets, paricularly
Wall Street, the tale centres on the exploits of big time player,
Gordon Gekko. Gekko is aready a multi-milllionaire - he earns
millions of dollars a year. But he wants more. He wants to take
on the world, and win.
The game plan is straightforward. The only sure way to make money in the financial scene is to get hold of information before anyone else gets it, often by some secret and devious means. And this information must come from an absolutely reliable source. Gekko unscrupulously makes his money from trading in shares of publicly listed companies. Therefore the information he receives must come from deep within the hearts of these companies, taking his activities into the lucrative and illegal world of insider trading.
The basic technique employed by Gekko is simple:
Gaining the First Mover Advantage
The technique empoloyed by Gekko in the film has been labelled
"Gaining the First Mover Advantage" by internationallly
renowned strategic analyst and Harvard academic, Michael E. Porter.
Porter's work though avoids the illegalities of insider trading,
concentrating on developing comprehensive techniques for handling
strategic opportunitiies over the entire range of busineess activities.
On this broader front, it should be remembered that very few businesses
have at their disposal the enormous resources employed by one
such as Gordon Gekko in "Wall Street". However Gekko's
secret information came from within companies or from the govenment
agencies regulating them. Whether these secrets involved new production
techniques, new mineral discoveries, new financial information,
new product developments or some new twist to the range of government
regulation, there would be individuals aware of the facts long
before Gekko.
Those on the business side who are first to be in on the secrets
are usually the "creators" in the production chain,
the research scientists, mineral explorers, financial accoutants
and marketers. Also included in this list are the entrepreneurrs
who take on the role of pulling all these efforts together into
a commercial success. In fact creating such new opportunities
is the heart and soul of any business activity.
Challenging Uncertainty
So money making depends on gaining the first mover advantage: finding out or creating the secrets before anyone else does, then using entrepreneurial skills to bring the results to the market.
For any business there is an orderly way of going about this process:
Step 1 Carefully examine the business environment in which you
operate. What you are looking for is all the potential sources
of dramatic change to the market, production or regulation conditions
in the industry.
Step 2 Decide on the best strategies for handling any of these
changes once they occur.
Different Players in the Game
There are the likes of Gekko out there making money illegally
or at least in suspicious ways. These are the "immoral"
manipulators of the system, bent on exploiting information about
the creative activities of others. They do bring about change
though, or at least news of change. Hence we refer to them as
"Manipulators". The other type of manipulator is the
"Moral Manipulator" - the creative person who actually
invents the new product, technology or marketing concept. The
activities of the moral are much more productive fromm society's
view, as they add to the material or other wealth of society.
The second basic type of profit maker is the anticipator. The
individual who does nothing to actually bring about change, but
who can foresee its occurrence and its consequences. Such an individual
predicts some new development, then buys assets likely to benefit
from the development. The consequent profits on sale of the assets
are a reward for having insight. This type of operator benfits
society by disturbing markets in the buying process, thus warning
market perticipants that change is coming.
The third basic type of operator making profits is the individual
who purely by luck, happens to own assets benefiting from change.
Naturally for all the lucky or chance profit makers there are
as many unlucky loss makers as so many changes will have adverse
consequences for some, and in some cases for all (e.g. earthquakes).
The Value Chain
The idea of the creative nature of profit making activities raises
one of Michael Porter's most powerful concepts, that of the "Value
Chain". In this concept, Porter asks us to look upon a productive
enterprise as an institution that takes in raw materials and services
and, employing them with labour and capital, adds value to them.
The concept is akin to the notion of value added with which we
are familiar from other studies.
The idea is stronger though for its emphasis on each and every
minor section of the firm's activities as being a core contributor
to profit making achievment. All sections of the company must
be striving to make a contribution to the value creation process.
All activity must be seen in terms of value creation. Hence the
scope for strategy analysis extends to even the most minor of
tasks. That is why every individual detail of corporate activity
needs to be strategically assessed and reoriented, where necessary,
to the corporate value creating goals. And likewise, each individual
must similarly question each activity they engage in.
PART TWO
MICHAEL PORTER'S STRATEGY ANALYSIS
Building this analysis of profit making opportunity into a workable
model for everyday application seems a daunting task. Fortunately
we are lucky to have a ready made methodology, based on similar
lines of thinking. While you will not find anywhere in the works
of Michael E. Porter an analysis of profit opportunity set out
as in Part 1 above, the basic ingredients are spread throughout
his writings and certainly form the basis of his strategic modelling
techniques. Porter's analysis of the principles of strategy formation
is contained in two chief works, Competitive Strategy (1980) and
Competitive Advantage (1985). This makes for quite a bit of reading
as the books are lengthy. On the other hand the basic principles
involved are really not that voluminous in content.
The books, in fact, contain an enormous amount of case study material.
And rightly so, for the skills of creative strategic thinking
are not to be learnt over night but rather from many years of
devoted practice. This is not to say that you as a student cannot
come up with a valuable research exercise for the company you
are about to investigate. The product of previous classes will
make that obvious to you. Your performance will be strongly supported
by the lecturer in the unit through a process of continuous assessment
and feed-back. In this way you will gain the benefit of our personal
business experience, plus that arising from the more than 600
companies that have been investigated in the past 13 years.
What is Strategy?
Think of the basic aim of making a profit. Profit is derived as
a residual after deducting all contracted costs of production
from revenue raised during a particular production period. Improving
on profit performance involves greater revenue generation for
a given level of cost outlay, or lower cost outlay for a given
level of revenue generation, or some combination of both. So,
strategy formation involves the design of some plan to achieve
these ends. In brief, we are seeking either improved cost control
or greater revenue generation, or both of these. This is not saying
much.
We need to develop some means of categorising the enormous range
of initiatives that could be available to generate improved profit
performance. If we take product attribute differentiation as the
chief means of improving revenue generation, then we can initially
categorise strategic initiatives into either cost or differentiation
tactics. Further, the choice is then available to adopt a narrow
range of focus with these intitatives or a very broad one. For
instance, we could choose to concentrate on developing a product,
say a motor vehicle, that has a very broad appeal in the market.
The GMH Commodore might be seen as such a case, with the Toyota
Land Cruiser, in contrast, being focused in on a very much smaller
"niche" segment of the car market. The Commodore involves
an across the spectrum product, based on differentiation by reputation
as "Australia's Own" car. The Land Cruiser as a product
is based on a focused differentiation strategy.
Similarly, we can classify cost initiatives as broad, as in a general strategy aimed at improved cost control throughout the company's operations, or a cost strategy may be focused in on securing cheap supplies of a particular input as when BHP Petroleum searches for cheaper oil supplies in Bass Strait. These broad/narrow combinations of strategic options are depicted in Figures 3, 4, 5 and 6. These options represent our first level of strategy classification and we refer to them as generic strategy options because they are of such general significance.
AVOIDING A NARROW STRATEGY BASE
At this point it is important to note that no enterprise can afford to concentrate exclusively on any particular strategy option. To ignore costs entirely in favour of obsession with a differentiation strategy is to court disaster, as would be a totally cost oriented strategy package. Similarly, companies will always need to look out for broad differentiation problems even when their chief product is narrowly focused. For example, if Toyota were to concentrate totally on the land cruiser, they might miss out completely on a trend in the market that made such vehicles totally obsolete. In your strategy design, you will need to employ tactics from every option area, the variations coming from the relative emphasis you give to different strategy options under different economic conditions.
To take the classification of strategy options beyond these generic
cases, it is necessary to actually examine different types of
companies or enterprises in terms of their relative strengths
within individual markets. No real world company will fit exactly
into any of these company-type categories, as there positions
will vary between the different supplier and buyer markets in
which they deal. Do not think your company fits any of these
cases exactly. Other strategy parameters from other company types
will be relevant. All we are trying to do with this company-type
break down is to find a convenient way of getting to the core
of strategic analysis in different situations. BHP may totally
dominate steel markets in Australia, but it is only a bit player
in the market for limestone, one of its crucial raw material requirements.
Figures 7, 8, 9, 10 and 11 (provided in class) provide strategic
option maps for a range of different operating conditions that
may apply to any company in markets in which it deals from time
to time. The rationale behind the diagrams centres on the choice
process involved in selecting what to do under various conditions.
Almost a yes/no decision tree format is portrayed. In most cases,
the pitfalls/risks attaching to commitment to any particular type
of strategy are indicated. These diagrams are an attempt to summarise
the underlying framework of Porter's analysis (1980, 1985).
There is no way in the world the full import of strategic thinking
can be explained in any theoretical or summary fashion. As Porter
has found, something approaching an effective explanation can
only be achieved by reference to a vast array of case study examples.
In class you will be confronted with many such examples developed
by the lecturer or in the work of the other members of the class.
You should supplement this class experience with long sessions
devoted tor eading Porrter's books. There is not all that much
point in trying to take notes from Porter as the case study details
will not be directly relevant to your own work. Rather, you should
set yourself up in a reading environment that allows you to fully
concentrate on what he has written. Only then will the creative
nature of the decisions he describes be fully brought home to
you.
PART THREE
MICHAEL PORTER'S SCENARIO MODELLING
What You Will Achieve
The product of the Porter scenario modelling process has been
shown repeatedly in the past to be a report that far exceeds the
expectations of the individuals involved in the training program.
And it is a training program. You are not going to sit down and
learn a whole load of theoretical jargon and analysis for regurgitation
at the end of the semester in an artificial examination environment
(Although there will be an exam). Rather you are going to learn
how to apply a process that is at this very moment being applied
in numerous innovative companies around the world.
Michael Porter does not come cheap. recently, he was reportedly
earning US$100 000 a day from consulting. There is a reason for
this. His methods work. At the end of the semester, you will have
a very good idea of how they operate. You will have a report on
your company that is very possibly going to tie down a job for
you. This has happened on numerous occasions in the past, as have
promotions for students already in a work environment. The Porter
process will by definition produce very innovative ideas for the
company you choose to analyse. It has to, because of its very
design.
How You Will Achieve This - The Model
If we go back and think about the profit generating process, the
basic idea is to pursue first mover advantage in the company's
various areas of operation. First mover advantage can only be
gained by latching on to an idea or some bit of knowledge before
any one else, and then buying the assets that are likely to gain
most from this new information (and selling the assets that will
lose by it). So we are looking for new information. And by definition
we are looking for information that will become available in the
future. Profit is by definition a product of future opportunities.
How are we going to "predict" what will happen in the
future?
A. - The Current Environment
We need to start somewhere in this search. The most obvious kick-off
point is to look at the operating environment of the company.
In your copy of Competitive Advantage, you will find the basic
Porter 5 Sector Model of an enterprise's operating environment.
There are 43 different items listed in this model. Each item has
some potential profit significance for the company to be analysed.
What we need to do then is to analyse each of these items in the
operating environment, and try to work out whether any of them
are likely to be sources of change that will represent either
a threat or an opportunity for the company. To begin with then,
we need to look at the various specific items of the company's
operating environment and how they have actually behaved over
the last few years. In other words we need a potted history of
what has happened to the company in the last five years, and,
for thoroughness, what precisely has happened over the last three
years.
But to do that we cannot just cover individual company data. We
also need to analyse what has occurred in the industry. So we
need to gather data at company and industry level. Ideally, the
annual company financial statistics are required, together with
the Chairman's report explaining what has been going on and why.
Larger companies publish company reports with this data. These
can be examined at any of a number of points. The company itself
will in most instances provide access to these reports. If your
company does not have such annual reports available, you will
need to rely on whatever they are prepared to supply.
For industry data, the most likely source is the internet via
sites such as the Australian Bureau of Statistics. Other government
bodies conduct enquiries into industries and these should be searched
for relevant material. The business press is also likely to be
handy as are a number of academic journals. Finally, industry
associations (Yellow Pages Directory: - Organisations, Business)
can be of assistance in some cases. Go to my listing of Australian
industry web sites at
http://www2.deakin.edu.au/dneath/Sites/OzIndustry.htm
In many cases students will actually approach the company for
an interview. At an interview, the respondent is likely to reveal
far more information than in written form. You will be supplied
with a set of potential questions for this purpose. Having studied
what is available in written form concerning the industry and
the company, you should have a good idea of what you are going
to need to ask at the interview. Don't be surprised if they ask
for written questions in advance. Supply these quickly. When you
actually get in the office, the questioning will naturally stray
from the written set. Attend the interview in your most professional
outfit - this may be your future employer. It is obvious that
your manners should be impeccable.
B. - Company and Industry Summaries
It is crucial to present the data you collect in a format to give
it a truly professional quality. On Page of Competitive Advantage,
you will find Porter's potted history/description of the US chain
saw industry. Analysis in class will demonstrate the power of
this summary. Nothing is left out and there are only three words
that could be deleted without changing the meaning of the passage.
This is the kind of powerful writing you should adopt for your
future business career - maximum meaning in the simplest, most
concise prose.
The final component of your descriptive introduction to the company
and its industry is an assessment of what types of company are
succeeding in the industry and why. Then a comparison between
your company's current major strategy initiatives and those required
to be successful under current conditions. This summary of current
strategy is to be submitted as part of your ultimate report.
C. - Identifying Potential Profit Sources
The next step in the process is to examine the list of industry
environment parameters you have assembled in an effort to determine
the most important potential future sources of disruptive change
for the industry and ultimately for the company. You are looking
for both positive and negative developments that seem likely to
have a substantial impact on the company's performance. This process
can be viewed as a brain storming session. This is the point at
which creative skills first come into use. The idea is to think
beyond the known experience of the company. There is in business
a tendency to opt for what is called the conventional wisdom when
it comes to looking at potential future developments. This tendency
is discussed by Porter in terms of what he refers to as single
point referencing. To understand Porter's meaning, we need to
diverge slightly into a consideration of basic probability theory.
D. - What is Probable and What is Not
If I take a coin and toss it we know that there is a 50% chance
it will come up heads and a 50% chance it will come up tails (assuming
that an earthquake does not occur during the toss, swallowing
up the coin - nothing is really certain!). When the odds are quoted
on the coin toss they are formed from an objective mathematical
calculation of the potential outcomes. In an everyday business
environment, there is no way a decision maker can work out all
the potential consequences of a particular development in the
operating conditions confronted. Hence there is no way an objective
probability can be calculated for any particular expected occurrence.
The business operator works in the dark in that sense.
But people do assign guestimates of the likelihood of particular
outcomes of events, even though they have no mathematical objectivity
to back them up. Their guestimates are stabs in the dark - cross
your fingers and hope for the best. This involves the estimate
of what is called subjective probability. Now the trouble is as
soon as a business person places a subjective probability estimate
down on paper (there's a 70% chance we will beat last year's sales
achievement by 20%) that estimate tends to take on a status it
does not deserve. The use of figures lends a pseudo mathematical
strength to the estimate. This is dangerous in that people will
assign too much weight to the numbers quoted and they will tend
to ignore the chances of a totally different result.
To avoid this single point referencing problem, we need to be
very careful in using figures. In particular, if figures are used,
it is important to place a range on them, and a substantial range
of variation is called for. In the mineral industries, it is common
to use historical growth figures as a basis for estimating potential
future outcomes. For instance, in the seventies, world aluminum
consumption grew at around 4% per annum. It was commonly thought
in the industry that this annual growth rate would continue beyond
1978, once allowance had been made for a consumption fall in that
year. The growth rate in fact lagged around the zero level for
several more years, thus leaving many new production operations
with no buyers. The "conventional wisdom" had won out
and caused severe financial problems for many producers. It is
this conventional wisdom that we need to guard against. The Porter
scenario model provides good protection against conventional wisdom.
E. - Finding True Uncertainty
Let us assume that you have now come up with either qualitative
(verbal/prose) or quantitative data on the behaviour of the 43
or more parameters that make up the Five Forces Model picture
of your company's industry environment at present. In the next
3 years the behaviour of some of these variables will change while
that of others remains the same. This is your first task - to
decide which variables are likely to alter. You will be analysing
this choice in class with your lecturer and the rest of the class.
Having decided which variables are likely to alter, the next step
is to determine whether the changes are predictable or not. Some
items, say for instance sales growth, might be expected to be
fairly steady in their rate of change. Others, say for instance
industrial unrest, might be very uncertain as to their potential
behaviour. This choice will boil down to your own (by now) informed
judgement guided by discussion with the lecturer.
Once the more uncertain elements have been determined, the time
arises for some economising. If it appears that there are more
than four truly uncertain parameters, the time that we have available
in the course restricts our ability to us them all. We really
only have scope to deal effectively with four major uncertain
variables for any industry analysis. It may be necessary to pick
out thee four most significant uncertain variables and leave any
others for casual mention as non-analysed uncertainties. This
process of selecting our four uncertainties requires a deeper
investigation of the ultimate causes of potential variability
in the variables. We can better understand this by reference to
Figure 12. Here we have a model representing the ultimate sources
of uncertain change in the industry environment.
The idea is that should one of our industry parameters appear
to be a potentially unpredictable item, we have to analyse what
is causing its unpredictably. The cause may arise from some other
item in the industry structure being uncertain. For instance,
a sudden future increase in advertising expenditure in the industry
may result from the radical re-staffing of one of the competitors.
Then we would term the changing level of advertising as "dependent"
and it could be left out of our analysis, its significance being
catered for by the change in competitor management, which we would
use as a key variable.
On the other hand, the change in the level of advertising might
be brought on by a change in general economic activity, coupled
with, say, the advent of a new advertising medium such as the
internet. In this case the change in industry advertising expenditure
is not caused by any other variation in industry conditions. The
"causal factors" that bring about the change lie outside
the industry environment. Hence we would have to include advertising
uncertainty as a crucial variable for analysis. So what we need
to do is to hunt out the causal factors influencing the potentially
uncertain parameters of the industry structure. If these lie outside
the industry environment, we will term the uncertain variable
a"scenario variable", and it will become a core unit
of our continuing analysis. (This is subject to our limit of four
key variables for analysis.)
F. - Working With Scenario Variables (1): Allowing for Uncertainty
From all the potential variables affecting the operating environment
of the enterprise, we have selected four only for analysis. This
seems a meagre quantity in terms of our ambition to analyse the
basic uncertain outlook for the company. But it is surprising
how powerful the use of just four parameters can be in terms of
generating a very broad range of alternative future outcomes.
This last notion, concerning the range of alternative possible
outcomes is an extremely important one. Earlier we spoke of the
need to overcome the conventional wisdom that tends to prevail
in a corporate environment. The business world is extremely complex
and for any operator, a bit daunting. When it comes to looking
to the future, there is a natural tendency to engage in single
point referencing, to generate a single forecast of what might
happen. Such a forecast is more comfortable than facing up to
the actual great uncertainties that really exist. It is part of
the job of the Porter scenario analysis to overcome this tendency
towards narrowing down the possibilities. The means of achieving
this lie in the range of potential outcomes we are to place on
each of our four scenario variables. There is a need to make sure
the ranges set are broad enough to generate potentially very different
consequences for the company.
What we are going to do is to cast together the various values
we assign to the scenario variables into alternative pictures
of the operating conditions facing the company in three years
time. In other words we will end up with a number of Five Forces
Model pictures of the potential future, each picture being radically
different from the others. The key word here is "radical".
It is only radical variation in our alternative scenario pictures
of the future that will prepare management for the true uncertainty
that they actually face in the real world operating environment.
On the other hand, we have to tread carefully here, particularly if management has not been used to handling scenario analysis in the past. If everyone in the company believes single point referenced forecasts are quite acceptable, we are going to confront a credibility problem. If we assign excessively radical variations to our scenario variable ranges, there is a danger our work will be written off as absurd. The point is to balance the need for radical variation against the need to preserve credibility, particularly at the beginning of the analysis. Later, when people get used to the idea of considering a range of possible future outcomes, there will be scope to widen the variation in the scenario variable values.
NOTE: THE NEED FOR QUANTIFICATION
In Porter's analysis in Chapter 13 of Competitive Advantage, there is no quantification of the range of potential outcomes for the US Chain Saw Industry. It is extremely important that we avoid this error in our analysis. If we merely put Low, Medium and High cases into our model, management will have their own ideas on what is meant by each of these cases. To get away from conventional wisdom thinking, we need to introduce specific figures for each of our scenario variable ranges. Then, there will be no avoiding the radical variation that we seek to confront management with. The task of quantifying some variables will not be straight forward, but we have yet to be beaten.
For instance, in considering a range of possible outcomes for office technology, it was first established that the average turnaround time for repurchase of mainframe hardware was 5 years. By posing a turnaround period of 3 years, the implied rate of technological change was accelerated. With an 8 year turnaround, it was slowed down. Similar methods can always be found for other less easily quantified variables
G. - Working With Scenario Variables (2): Bounding Uncertainty
The task of bounding the uncertainty of each of our scenario variables
centres on the range of potential values we are prepared to attach
to each of them. Let us say that one of the variables is "company
sales". In our review of the company's experience over the
past 3-5 years, we will have established, for instance, that sales
levels had varied between 85% and 120% of current levels. Now
we have chosen sales as a variable because we think it might be
subject to radical variation in the future. It could be that we
think that Pauline Hanson may get into power as Prime Minister
at the next election, in which case a true depression is possible
and sales could fall by 40%.
Alternatively, David Neath might leave academia, enter politics
and become Prime Minister, in which case the economy will be booming
and, with Neath's new export scheme as well, sales could rise
by 100%. Who gets to be Prime Minister is the causal factor that
will determine the sales outcome. The potential for variation
in the Prime Minister variable establishes the potential for scenario
variable variation. So we need to study the potential behaviour
of causal variables for each of our scenario variables. The we
can bound the uncertainty attaching to each scenario variable
by quantifying the range of its potential values.
It is not expected that you will establish these ranges for your
scenario variables without assistance. Discussion with the lecturer,
together with the continuous review of written work will ensure
your ranges are satisfactory.
Presentation of your scenario variable ranges must be clear. You
need to be quite specific about what is going on. Figure 13 presents
a sample set of ranges, together with a suitable explanation.
FIGURE 13 - A SAMPLE RANGE OF UNCERTAIN VARIABLES
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H. - Working With Scenario Variables (3): The Matrix Analysis
We are now going to combine different scenario variable values
with each other to construct scenario pictures of the industry
in three years time. These scenario pictures will consist of three
different components:
a. All those elements in the five sector model of our industry
that we do not expect to be subject to any significant variation,
plus
b. Those elements that we do expect to vary, but in a reasonably
predictable way, plus
c. Combinations of the radically different variations in value
we have assigned to each of our four scenario variables.
The elements represented in Items a. and b. above will be present
in all scenario pictures of the future, because they are predictable.
The substantial variation in scenario pictures will come from
differing combinations of scenario variable values.
Because we have introduced a radical degree of variation to the
scenario variables, and because the variables will be linked by
connections either in the general economy or within the industry,
we need to ensure that any values we combine over two or more
variables are consistent or compatible with each other. For instance
it would not make sense to have 3 new companies entering a large
scale industry when it was experiencing a 40% fall off in sales.
Consistency amongst scenario variables is achieved by using a
relatively straightforward matrix analysis. Let's suppose we have
the following values attaching to our four scenario variables:
FIGURE 14 - UNCERTAINTY RANGES FOR SCENARIO VARIABLES
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We could compare, say, variables A and C, using a matrix as follows:
FIGURE 15 - CONSISTENCY MATRIX 1
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The letters 'Y` and 'N` denote possible and impossible cases respectively.
For instance it would not seem reasonable to have new entry occurring
at all when industry sales are collapsing at 8 % p.a. On the other
hand, when sales are expanding at the rate of 8 % p.a., there
could be new entry of either one or two new companies.
The next step follows on with consistency testing for Scenarios
B and D. This can be done in either of two ways. We can either
compare Variable B or Variable D with the results coming from
Matrix 1 (This option is not illustrated here) or we can compare
Variable B with Variable D in their own Matrix.
In Figure 15, variables B and D are tested for consistency in
a second matrix. Then it is a matter of combining Matrixes 1 and
2 for an overall comparison of the full range of scenario variable
values.
FIGURE 16 - CONSISTENCY MATRIX 2
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In establishing the consistency of various combinations of our
four scenario variables, we have actually generated the full set
of scenario pictures of the future industry environment. Each
combination in Matrix 3 represents such a scenario picture. Stressing
again the need to provide management with radical variation in
the scenario outlooks they must consider, we need to pick out
three of these scenarios from Matrix 3, choosing two extreme cases,
and one mid case. It may be that there is a fourth peculiar case
requiring analysis, because it is also very different from the
normal extremes/mid range cases.
In the case represented here, the Scenarios 1, 6 and 8 are chosen
as the two extreme and one mid range cases, while Scenario 9 is
chosen as a peculiar case.
I. - Scenario Analysis
We can assemble our Scenarios by identifying their key variations.
FIGURE 17 - CONSISTENCY MATRIX 3
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1 | 2 | 3 | 4 | ||
5 | 6 | 7 | |||
8 | |||||
9 |
FIGURE 18 - ALTERNATIVE INDUSTRY ENVIRONMENT SCENARIOS
| Scenario Variable | ||||
Industry Sales | ||||
No of New Entrants | ||||
Wages/Sales Ratio | ||||
Advertising Expenditure | ||||
You have at the outset of the analysis constructed a picture of
the current status of the industry. What you need to do now is
very briefly summarise the main features of that review, then
add in the types of continuous change that will have been going
on over the three year period of the analysis, then add in the
major variations according to the scenarios depicted in your summary
as in Figure 17. This will leave you with a short sharp description
of each of the scenarios you have developed.
J. - Strategy Analysis
The next step is to identify the sources of competitive advantage
in each of the scenarios you have described. This is a matter
of working out what type of companies would be most successful
under the various conditions applying for each scenario. The idea
is that if you can work out the most likely type of company to
be successful, then you can design a series of initiatives that
your company could take to make sure it is one of if not the sole
winner under these conditions.
NOTE: You will need to have a different picture of the most likely
company to succeed for each of the scenarios you analyse. In other
words there will be, in the case we have followed above, four
different types of company described. This will then lead to four
different types of strategy packages that could be followed as
we move towards the three year target time in the future. This
is a crucial point: When you make up a strategy package, it will
consist of a series of recommended initiatives to be taken up
NOW and then on through the three years to the target date.
We are trying to find a path for the company to follow in anticipation
of the events unfolding as depicted in each of the scenarios.
Each recommended plan of action will be quite different from the
others as this is the whole purpose of the study: To build a set
of scenarios requiring very different strategy packages to capture
the benefits available in each. Do not develop strategies to
react to what might have occurred by the end of the period. It
is too late by then. The company must anticipate uncertain future
developments. It must act in advance if it wants to gain a first
mover advantage.
The process of forming strategies will be heavily dependent on
your involvement in class and independently with the lecturer.
You will find this difficult, but that's why good strategy planners
earn a lot of money. The only written clue you can get in advance
is that the process calls for as much creative thinking as you
can muster. The natural skills of some people mean that they can
do a better job if they apply themselves. But the advantage of
lecturer and class brainstorming makes the playing field much
more level. You must not fail to use this opportunity to maximize
the value of your analysis.
One further element re your quest for good marks in the subject.
The formation of strategies should be pursued as far as possible
into the minutest detail of recommended initiatives. Even as far
as specifying the daily content of say a month long training program
that you believe will be required, or even the design of a new
logo for the company, or a new financial package, with the new
financing institutions nominated. Detail! Detail! Detail! There
can never be too much of it in strategy design. This, along with
creative thinking will produce the excellence that attracts the
highest marks.
FIGURE 1 - MODEL OF PUBLICLY LISTED COMPANY STRUCTURE
FIGURE 2 - MODEL OF COMPANY'S TRADING RELATIONS
SUPPLIERS BUYERS
FINANCE SOURCES CORPORATE BUYERS
RAW MATERIALS
CAPITAL EQUIPMENT CONSUMER BUYERS
WORKFORCE
CAPITAL SERVICES
UNION INTERESTS GOVERNMENT BUYERS
CONSULTANCY SERVICES
GOVERNMENT SERVICES
FIGURE 3 - THE RANGE OF STRATEGY
GENERIC STRATEGIES FOR DIFFERENT PLAYERS
LEADER/DOMINANT FIRMS
COST RUNNER UP FIRMS
ALSO RAN/DECLINING FIRMS
FOCUS/SPECIALISATION
DISTRESSED/TURN AROUND FIRMS
DIFFERENTIATION YOUNG EMERGING INDUSTRIES
MATURE DECLINING INDUSTRIES °
FIGURE 4 - COST BASED STRATEGIES
PRICE WAR
RIVALS SALES GROWTH
PRICE ELASTICITY HIGH
PROFIT GROWTH
BUYERS HOMOGENEOUS PRODUCT
BARGAINING
LOW COST SUPPLIERS BEST WHEN WEAK DIFFERENTIATION
SCOPE
ENTRY THREAT UNIFORM BUYER USE OF PRODUCT
THREAT OF PRICE CUTTING
SUBSTITUTION LOW BUYER SWITCHING COSTS
RISKS
TECHNOLOGICAL IMITATION EASY TUNNEL VISION
BREAKTHROUGH WITH LOW COST TECHNOLOGY
AVOID SUNK COSTS OF OLD
TECHNOLOGY
CHANGING CHANGING CHANGING CHANGING
BUYER INDUSTRY PRICE USES FOR
NEED CONTINUOUS TECHNOLOGY IMPROVEMENT PREFERENCES
STRUCTURE SENSITIVITY PRODUCT
SPEEDY SCRAPPING OLD TECHNOLOGY
SPEEDY RESPONSE TO NEW BUYER NEEDS
MUST BE THE CHEAPEST ALL COULD BE IGNORED
FIGURE 5 - FOCUS AND SPECIALISATION STRATEGIES
CUSTOMER SEGMENTS
COST POSITION
FOCUS AND CREATING A
SPECIALISATION GEOGRAPHIC LOCALE TOGETHER WITH DISTINCTIVE
BASED ON COMPETENCE
DIFFERENTIATION
ATTRIBUTES IN USE
BEST WHEN
DISTINCT BUYER RIVALS IGNORE RESOURCES INSUFFICIENT INDUSTRY SEGMENTS
GROUPINGS FOCUS TO COPE WITH TOTAL MARKET VARY ON
SIZE
RATE OF GROWTH
PROFITABILITY
COMPETITIVE INTENSITY
RISKS
A LARGE DIVERSE COMPANY BUYER PREFERENCES FOCUSER "OUT-FOCUSED"
"HAPPENS ON" EFFECTIVE FICKLE BY RIVALS
IMITATION
FIGURE 6 - THE STRATEGY OF DIFFERENTIATION
WHAT IS IT? THE PAY OFF
PHYSICAL TASTE
FACILITIES/ATTRIBUTES
BRAND/PRODUCT LOYALTY
CUSTOMER SERVICE
AVAILABILITY
SPARE PARTS
USER FRIENDLY BARRIERS TO COMPETITION
DESIGN/PERFORMANCE SUPPLIERS
DISTINCTIVENESS BARGAINING ADVANTAGE
RELIABILITY BUYERS
QUALITY (PLUSH) SUBSTITUTION/ENTRY PREPAREDNESS
TECHNOLOGICAL REFINEMENT
CONVENIENCE IN USE PROFIT/CASH STRENGTH
COMPREHENSIVE RANGE
"FASHION" REPUTATIION
RISKS
COST OF CHANGING LOCKED IN AS PREFERENCES OTHERS IMITATE
ATTRIBUTES OR INDUSTRY STRUCTURE AND LEFT WITH
CHANGE SUNK COSTS
LASTING EDGE MANY DIFFERENCES POSSIBLE
TECHNICAL SUPERIORITY DIFFERENCES EASILY PERCEIVED
GENUINE QUALITY BUYER NEEDS DIVERSE
DEPENDS ON
GENUINE SUPPORT SERVICES FEW FIRMS SEEK TO DIFFERENTIATE
TRUE VALUE FOR BUYER DOLLAR UNUSUAL OPPORTUNITIES
AVAILABLE
EASY TO TAKE UP
HARD TO GIVE UP