MBA Notes: Strategy

Key Topics:
- Devising strategies
- Differentiation, cost leadership, focus
- First to market, first to fail
- Tools and techniques for shaping strategy


Strategy, though a core subject in every business school, is less an academic discipline than an ever-shifting appraisal of how an organization should position itself to best meet the challenges it faces. Rather like the quote attributed to one Governor of the Bank of England who said that the true meaning of Christmas would not be apparent until Easter, when it comes to estimating retail sales, successful strategies are really only recognizable after the event. The case below gives a flavour of the dimensions of how strategy is shaped: part marketing, part money, part people, part culture, and mostly an appreciation of an ever-shifting and developing world.

Strategy has three dimensions: the intellectual analytical and thinking aspect used to devise broad strategic direction; the development and shaping of specific actions in pursuit of those strategies; and the implementation of strategy through the execution of business plans. If an organization gets it wrong in any of these areas the results it is aiming for may not be achieved, it may fall behind others in the market or in the worst case fail altogether. Getting all three areas right can be more of an art than a science, rather like a short-sighted person trying to thread several needles, held in parallel by different people, in one swift movement.


Devising strategy – the overview
Credit for devising the most succinct and usable way to get a handle on the big picture has to be given to Michael E Porter, who trained as an economist at Princeton, taking an MBA (1971) and PhD (1973) at Harvard Business School where he is now a professor. His book, Competitive Strategy: Techniques for Analyzing Industries and Competitors (1980, Free Press, Old Tappan, New Jersey, United States), which is in its 63rd printing and has been translated into 19 languages, sets out the now accepted methodology for devising strategy. As well as being essential reading in most business schools, courses based on Porter's work are taught in partnership with more than 80 other universities around the world, using curriculum, video content and instructor support developed at Harvard.

The three generic strategies
Porter's first observation was that two factors above all influenced a business's chances of making superior profits.

First, there was the attractiveness or otherwise of the industry in which it primarily operated. Second, and in terms of an organization's sphere of influence more important, was how the business positioned itself within that industry.

In that respect a business could only have a cost advantage in that it could make product or deliver service for less than others. Or it could be different in a way that mattered to consumers, so that its offers would be unique, or at least relatively so. He added a further twist to his prescription. Businesses could follow either a cost advantage path or a differentiation path industry wide, or they could take a third path – they could concentrate on a narrow specific segment (market segments), either with cost advantage or with differentiation. This he termed 'focus' strategy.

Cost leadership
Low cost should not be confused with low price. A business with low costs may or may not pass those savings on to customers. Alternatively, it could use that position alongside tight cost controls and low margins to create an effective barrier to others considering either entering or extending their penetration of that market. Low-cost strategies are most likely to be achievable in large markets, requiring large-scale capital investment, where production or service volumes are high and economies of scale can be achieved from long runs.

Low costs are not a lucky accident; they can be achieved through these main activities:

- Operating efficiencies: New processes, methods of working or less costly ways of working. Ryanair and easyJet are examples where analysing every component of the business made it possible to strip out major elements of cost, meals, free baggage and allocated seating, for example, while leaving the essential proposition – we will fly you from A to B – intact.
- Product redesign: This involves rethinking a product or service proposition fundamentally, to look for more efficient ways to work or cheaper substitute materials to work with. The motor industry has adopted this approach with 'platform sharing', where major players including Citroen, Peugeot and Toyota have rethought their entry car models to share major components; this has become commonplace in the industry.
- Product standardization: A wide range of product and service offers claiming to extend customer choice invariably leads to higher costs. The challenge is to be sure that proliferation gives real choice and adds value. In 2008 the UK railway network took a long, hard look at its dozens of different fare structures and scores of names, often for identical price structures, which had remained largely unchanged since the 1960s, and reduced them to three basic product propositions. Adopting this and other common standards across the rail network they estimate will substantially reduce the currently excessive £½ ($0.8/€0.56) billion transaction cost of selling £5 ($8/€5.6) billion worth of tickets.
- Economies of scale: This can be achieved only by being big or bold. The same head office, warehousing network and distribution chain can support Tesco's 3,263 stores as well it can, say, the 997 that Somerfield had prior to being bought out by the Co-op. The former will have a lower cost base by virtue of having more outlets to spread its costs over, as well as having more purchasing power.

Even young innovative companies have to keep the pressure on cost reduction if they are to maintain their growth rates as they mature. Google, see the case below, shows there is no exception to this rule.

The experience (or learning) curve
The fact that costs declined as the output volume of a product or service increased, though well known earlier, was first developed as a usable accounting process by T P Wright, an American aeronautical engineer, in 1936. His process became known as the cumulative average model or Wright's model. Subsequently, models were developed by a team of researchers at Stanford, known as the unit time model or Crawford's model, and the Boston Consulting Group (BCG) popularized the process with its experience curve, showing that each time the cumulative volume of doing something – either making a product or delivering a service – doubled, the unit cost dropped by a constant and predictable amount.

The reasons for the cost drop include:
- Repetition makes people more familiar with tasks and consequently faster.
- More efficient materials and equipment become available from suppliers themselves as their costs go down through the experience curve effect.
- Organization, management and control procedures improve.
- Engineering and production problems are solved.
 

FIGURE: The experience curve

The value of the experience curve as a strategic process is that it helps a business predict future unit costs and gives a signal when costs fail to drop at the historic rate, both vital pieces of information for firms pursuing a cost leadership strategy. Every industry has a different experience curve that itself varies over time.

You can find out more about how to calculate the curve for your industry on the Management And Accounting Web (http://maaw.info/LearningCurveSummary.htm).

Differentiation
The key to differentiation is a deep understanding of what customers really want and need and, more importantly, what they are prepared to pay more for.

Apple's opening strategy was based around a 'fun' operating system based on icons, rather than the dull MS-DOS. This belief was based on its understanding that computer users were mostly young and wanted an intuitive command system, and the 'graphical user interface' delivered just that. Apple has continued its differentiation strategy, but has added design and fashion to ease of control in order to increase the ways in which it delivers extra value. Sony and BMW are also examples of differentiators. Both have distinctive and desirable differences in their products and neither they nor Apple offers the lowest price in their respective industries; customers are willing to pay extra for the idiosyncratic and prized differences embedded in their products.

Differentiation doesn't have to be confined to just the marketing arena, nor does it always lead to success if the subject of that differentiation goes out of fashion without much warning.

Northern Rock, the failed bank that had to be nationalized to stay in business, thought its strategy of raising most of the money it lent out in mortgages through the money markets was a sure winner. It allowed the bank to grow faster than its competitors, who placed more reliance on depositors for their funds. As long as interest rates were low and the money market functioned smoothly, it worked. But once the differentiators that fuelled its growth were reversed, its business model failed.

Focus
Focused strategy involves concentrating on serving a particular market or a defined geographic region. IKEA, for example, targets young, white-collar workers as its prime customer segment, selling through 235 stores in more than 30 countries. Ingvar Kamprad, an entrepreneur from the Småland province in southern Sweden, who founded the business in the late 1940s, offers home furnishing products of good function and design at prices young people can afford. He achieves this by using simple cost-cutting solutions that do not affect the quality of products.
Warren Buffett, the world's richest man, who knows a thing or two about focus, combined with Mars to buy US chewing gum manufacturer Wrigley for $23bn (£11.6bn) in May 2008. Chicago-based Wrigley, which launched its Spearmint and Juicy Fruit gums in the 1890s, has specialized in chewing gum ever since and consistently outperformed its more diversified competitors. Wrigley is the only major consumer products company to grow comfortably faster than the population in its markets and above the rate of inflation.

Over the past decade or so, for example, other consumer products companies have diversified. Gillette moved into batteries, used to drive many of its products, by acquiring Duracell. Nestlé bought Ralston Purina, Dreyer's, Ice Cream Partners and Chef America. Both have trailed Wrigley's performance.
Businesses often lose their focus over time and periodically have to rediscover their core strategic purpose. Procter & Gamble is an example of a business that had to refocus to cure weak growth. In 2000, the company was losing share in seven of its top nine categories, and had lowered earnings expectations four times in two quarters. This prompted the company to restructure and refocus on its core business: big brands, big customers and big countries. They sold off non-core businesses, establishing five global business units with a closely focused product portfolio.

First-to-market fallacy
Gaining 'first mover advantage' are words used like a mantra to justify high expenditure and a headlong rush into new strategic areas. This concept is one of the most enduring in business theory and practice. Entrepreneurs and established giants are always in a race to be first. Research from the 1980s that shows that market pioneers have enduring advantages in distribution, product-line breadth, product quality and, especially, market share underscores this principle.

Beguiling though the theory of first mover advantage is, it is probably wrong.

Gerard Tellis, of the University of Southern California, and Peter Golder, of New York University's Stern Business School, argued in their book Will and Vision: How Latecomers Grow to Dominate Markets (2001, McGraw-Hill Inc., United States) and subsequent research that previous studies on the subject were deeply flawed. In the first instance, earlier studies were based on surveys of surviving companies and brands, excluding all the pioneers that failed. This helps some companies to look as though they were first to market even when they were not. Procter & Gamble (P&G) boasts that it created America's disposable-nappy (diaper) business. In fact a company called Chux launched its product a quarter of a century before P&G entered the market in 1961. Also, the questions used to gather much of the data in earlier research were at best ambiguous, and perhaps dangerously so. For example, the term, 'one of the pioneers in first developing such products or services,' was used as a proxy for 'first to market'. The authors emphasize their point by listing popular misconceptions of who were the real pioneers across the 66 markets they analysed. Online book sales, Amazon (wrong), Books.com (right) – Copiers, Xerox (wrong), IBM (right) – PCs, IBM/Apple (both wrong); Micro Instrumentation Telemetry Systems (MITS) introduced its PC the Altair, a $400 kit, in 1974, followed by Tandy Corporation (Radio Shack) in 1977.
In fact the most compelling evidence from all the research was that nearly half of all firms pursuing a first-to-market strategy were fated to fail, while those following fairly close behind were three times as likely to succeed. Tellis and Golder claim that the best strategy is to enter the market 19 years after pioneers, learn from their mistakes, benefit from their product and market development and be more certain about customer preferences.

First to market: possible international advantages
According to the New Trade Theory of international business (see the elective on 'Introduction to International Global Business' on page 000) in certain cases where the world market will only support a limited number of companies, being first to market may be a source of enduring competitive advantage. Denmark took that approach with its wind turbine industry as it had few natural sources of energy. Despite being a small country, by 1999 it had captured 60 per cent of the world market for wind turbines. Today, the Danish wind turbine industry accounts for 12,000 jobs in Denmark while component supplies and installation of Danish turbines currently create another 6,000 jobs worldwide.

Companies too can, for a while at least, establish first mover advantage in overseas markets by taking their well-established expertise and systems to foreign markets.
 

Industry analysis
Aside from articulating the generic approach to business strategy, Porter's other major contribution to the field was what has become known as the Five Forces theory of industry structure. Porter postulated that the five forces that drive competition in an industry have to be understood as part of the process of choosing which of the three generic strategies to pursue.

The forces he identified are:

- Threat of substitution: Can customers buy something else instead of your product? For example, Apple, and to a lesser extent Sony, have laptop computers that are distinctive enough to make substitution difficult. Dell, on the other hand, faces intense competition from dozens of other suppliers with near-identical products competing mostly on price alone.
- Threat of new entrants: If it is easy to enter your market, start-up costs are low and there are no barriers to entry such as IP (intellectual property) protection, then the threat is high.
- Supplier power: The fewer the suppliers, usually the more powerful they are. Oil is a classic example, where less than a dozen countries supply the whole market and consequently can set prices.
- Buyer power: In the food market, for example, with just a few, powerful supermarket buyers being supplied by thousands of much smaller businesses, they are often able to dictate terms.
- Industry competition: The number and capability of competitors is one determinant of a business's power. Few competitors with relatively less attractive products or services lower the intensity of rivalry in a sector. Often these sectors slip into oligopolistic (Economics) behaviour, preferring to collude rather than compete.

FIGURE: Five Forces theory of industry analysis (after Porter)

Shaping strategy – tools and techniques
While Porter's Five Forces approach to strategy formulation is, as far as business schools are concerned at least, the standard starting point, there are a number of other tools that an MBA needs to be familiar with. Some pre-date Porter, some overlap, while others home in on specific issues. Like many such tools, they overlap with those used in marketing and in this book you will find SWOT (strengths, weaknesses, opportunities and threats) and perceptual mapping covered in Marketing.

These are the main tools and techniques an MBA will be expected to know and understand.

Ansoff's Growth Matrix
Igor Ansoff, while Professor of Industrial Administration in the Graduate School at Carnegie Mellon University, published his landmark book, Corporate Strategy (1965), where he explained a way of categorizing strategies as an aid to understanding the nature of the risks involved. He invited his students to consider growth options as a square matrix divided into four segments. The axes are labelled with products and services running along the 'x' axis, starting with 'present' and 'new'; and markets up the 'y' axis similarly labelled (Figure).

FIGURE: Ansoff's Growth Matrix

Ansoff then went on to assign titles to each type of strategy, in an ascending scale of risk (you can find out more about the matrix at http://www.mindtools.com/pages/article/worksheets/ AnsoffMatrixBusinessDownload.htm):

- Market penetration, which involves selling more of your existing products and services to existing customers – the lowest-risk strategy.
- Product/service development, which involves creating extensions to your existing products or new products to sell to your existing customer base. This is more risky than market penetration, but less risky than entering a new market where you will face new competitors and may not understand the customers as well as you do your current ones.
- Market development involves entering new market segments or completely new markets either in your home country or abroad.

- Diversification is selling new products into new markets, the riskiest strategy as both are relative unknowns. Avoid, unless all other strategies have been exhausted.

Diversification can be further subdivided into four categories of increasing risk profile:

- Horizontal diversification (entirely new product into current market).

- Vertical diversification (move backwards into firms supplier's or forward into customer's business).

- Concentric diversification (new product closely related to current products either in terms of technology or marketing presence but into a new market).

- Conglomerate diversification (completely new product into a new market).

Boston Matrix
Developed in 1969 by the Boston Consulting Group (see above), this tool can be used in conjunction with the life-cycle concept (see Product/Service Life Cycle) to plan a portfolio of product/service offers.

The thinking behind the matrix is that a company's products and services should be classified according to their cash generating or consumption ability against two dimensions: the market growth rate and the company's market share (Figure).

Cash is used as the measure rather than profit, as that is the real resource used to invest in new offers. The objective then is to use the positive cash flow generated from 'cash cows', usually mature products that no longer need heavy marketing support budgets, to invest in 'stars', that is, fast-growing, usually newer products, positioned in markets in which the company already has a high market share – usually newer markets. 'Dogs' should be disinvested and 'question marks' limited in number and watched carefully to see if they are more likely to become stars or dogs.

FIGURE: The Boston Matrix

The GE–McKinsey Directional Policy Matrix
General Electric was much taken by the visual aspect of the Boston Matrix and was using it to enhance its own performance using another consulting firm, McKinsey and Company, to help. Between them, in 1971 they came up with a variant and in some ways an improvement by substituting business strength and industry attractiveness for market share and market growth rate. The logic being that although these are subjective measures, they are more accessible than market growth and share, as these are hard to establish and in any event the figures are themselves largely subjective suppositions based largely on opinions (Figure).

FIGURE: The GE–McKinsey directional policy matrix

Other matrix variations
A dozen or so other similar matrices are in use, each with their own strengths and weaknesses.

Arthur D Little Inc, a management consultancy founded in 1886, based in Cambridge, Massachusetts, came up with its own matrix in the late 1970s, using competitive position and industry maturity as the directions. Two business school professors, Gary Hamel (London Business School) and C K Prahalad (University of Michigan), developed a matrix in 1994 as an aid in setting specific acquisition and deployment goals. Other academics, in the United States (Charles W Hofer and Dan Schendel) and in the UK (Cranfield colleagues Malcolm McDonald and Cliff Bowman) as well as companies such as Shell have all added twists to the basic matrix strategy tool.
Cipher Systems (www.cipher-sys.com/analysis.html), a US consultancy firm, provides a collection of strategic analysis tutorials on these and other matrices.

The long-run return pyramid
Another helpful strategy tool is the long-run return pyramid, which is in effect a checklist of growth options.

None of the options are mutually exclusive and the tool does not provide for any form of evaluation. Nevertheless, it can be a valuable aide-mémoire to ensure that no stone has been left unturned during the strategic review process. The pyramid's pedigree is unknown, but it is loosely based on the DuPont's Return on Investment Pyramid, used to trace all the performance ratios that influenced return on investment. T

The pyramid in the form shown here is attributed to Robert Brown, a senior academic at Cranfield School of Management.
 

FIGURE: The long-run return pyramid


PEST (political, economic, social and technological)
This is a framework predating Porter's five forces approach that categorizes the external factors that influence strategy under headings such as political, economic, social and technological forces. Often two additional factors, environmental and legal, are added, changing the acronym to PESTEL analysis (Figure).

FIGURE: PESTEL analysis framework


Environmental
Two events on opposite sides of the globe provide a vivid illustration of the dimensions of environmental factors on business strategy. When Eyjafjallajokull, the Icelandic volcano, erupted in April 2010, air traffic around Europe and across the Atlantic ground to a halt for six days. Airlines lost up to half their annual profits, business passengers were stranded for days, and supply chains, shortened by just in time purchasing strategies, dried up. Now arguably there is little that business could do directly or immediately to mitigate these problems, but the experience served to demonstrate the interconnection of seemingly remote environmental factors and makes more obvious and immediate the reasons business have to take such issues as climate change seriously. Even if you are in no danger, unlike Lohachara, once island home to 10,000 people and the first inhabited island to be wiped off the face of the Earth by global warming in 2006, you will eventually be affected by an environmental issue.

Another environmental disaster occurred the following month when BP's Deepwater Horizon rig exploded in the Gulf of Mexico killing 11 people died and injuring 17. The ecological damage caused by the slick threatened some of the most important wildlife habitats. The cost to BP and its reputation are incalculable, but the stock market took a down payment by wiping £13 billion (US $19.9 billion; €15 billion) off its value in two weeks. BP has had to adjust its business strategy to incorporate expansion into the politically dangerous Russian market to compensate for its environmental disaster.

The environment as a business opportunity
Going green, for example, can represent an opportunity to use concerns about the environment as a lever to develop a strategy for growth. Whole new industries are being created to make solar, wind and wave power. Battery technology is being developed to run vehicles that can compete on range and speed with conventional ones. And sound environmental policies can produce both a successful growth strategy and immediate savings that drop to the bottom line.