Strategic Management

Strategic Management I
Introduction
Georg von Krogh
Thursday, April 5 2007

Contents
 A brief history of the strategy field

 Competitive strategy
 Cost leadership
 Product differentiation
Summer Term 2007 Georg von Krogh | Strategic Management & Innovation | gvkrogh@ethz.ch 2
A brief history of the strategy field
 Managers need strategy in order to position their firms relative

to its competitors
 Strategy has often been revealed after the fact – by looking at
successful and unsuccessful strategic moves by firms
 The strategy discipline (practitioners, consultants, academics)
have sought to find "rules of conduct" that can predict successful
strategic moves
 Strategy research is based on statistical analysis of many firms,
and single cases of successful and less successful firms
Several forces push towards a rethinking of Development in the discipline

strategic management
Structural change  Knowledge and technology

Deregulation  Processes and routines
Scarcity of expertise  History and path-dependence
Mergers transforming industries  Cooperation and networks
Environmental concerns Pressure

for radical
New industry substitutes rethinking
Rapidly changing customer expectations
 Resource-based theory
Rate of innovations  Knowledge-based view
Increased entrepreneurial activity  Capabilities-based view
Global competition  Entrepreneurial view
1950‘s 1960‘s 1970‘s 1980‘s 1990‘s

Phase I Phase II Phase III Phase IV Phase V
Financial Long range Strategic Strategic Strategic
planning planning planning Management Management
Functional Planning for Response to Strategic Capabilities

control growth markets processes
Resource Alternative Competitive Resources
allocation strategies positioning
Summer Term 2007 Georg von Krogh | Strategic Management & Innovation | gvkrogh@ethz.ch X
1950‘s 1960‘s 1970‘s 1980‘s 1990‘s
What are the basic  Why do some firms financially outperform their
questions asked in competitors over some period of time?
the strategy field?  What strategy do we need in order to act on the
opportunities and counter threats in the environment?
 What strategy do we need in order to build strengths and
counter weaknesses of our firm?
1950‘s 1960‘s 1970‘s 1980‘s 1990‘s 2000 +

Phase IV Phase V
Strategic Strategic
Management Management
Strategic
processes
Capabilities
?
Competitive Resources
positioning
Are frameworks and theories of the 1980‘s and 1990‘s still applicable in today‘s business
environment?
Contents

 Cost leadership
Competitive strategy
Competitive strategy is concerned with

"Creating and maintaining a competitive
advantage in each and every area of business"
Michael Porter, 1980
Competitive strategy is concerned

with the firm‘s actions that make
the firm outperform its competitors
Competitive advantage results from
Cost leadership Differentiation

A company prices around the market A company adds value in areas of
average, and enjoys superior profits significance for the customer, who then
because its costs are lower than those accept a premium price for
of its rivals distinctiveness of products and services
price
profit*
profit cost*
competitive advantage
cost
Three levels of firm performance

Below-normal economic Normal economic Above-normal economic
performance performance performance
A firm generates with its A firm generates with its A firm generates with its
resources and resources and resources economic
knowledge economic knowledge economic value greater than what
value less than what value equal to what owners of those
owners of those owners of that resource resources and
resources and and knowledge expect knowledge would
knowledge expect expect
Expectation
above
below normal
Profitability ratios in strategy
Return on total Return on Gross profit Earnings per Price-earning Cash flow per
assets (ROA) equity (ROE) margin share (EPS) ratio share
profits after tax - after-tax profits +

sales - cost of preferred stock current market depreciation
profit after tax profit after tax goods sold dividends price per share
no. of common
total assets total stockholder sales number of shares after-tax earnings shares
equity of common stock per share outstanding
outstanding
Return on total Return on total Sales available Profit available Anticipated Funds available
investment in a equity to cover to owners of a firm to fund
firm investment in a operating common stock performance activities above
firm expenses and current levels of
still generate costs
profit
Liquidity and leverage ratios in strategy
Current ratio Quick ratio Debt to Debt to Times interest

asset equity earned
current assets + profit before

current assets inventory total debt total debt interest and tax
current liability current liability total assets total equity total interest
charged
Ability to cover Ability to meet The extent to The use of debt How much a
current liability short-term which debt has versus equity to firm‘s profit can
with assets obligations been used to finance decline and still
that can be without selling finance a firm‘s business meet its
converted into current business activities obligations
assets inventory
Activity ratios
Inventory turnover Accounts receivable Average collection

turnover period
sales annual credit sales accounts receivable

inventory accounts receivable average daily sales
Speed with which a Average time it Time it takes to

firm‘s inventory is takes to collect on receive payment
turning over credit sales after sale has been
made
Other measures of strategic performance
 Firm value at IPO (Initial Public Offering)

 The firm‘s NPV (Net Present Value)
 Tobin‘s q
 Stock market measures: Event studies
 Sharpe‘s measure
 Treynor‘s index
 Jensen‘s Alpha
Four levels of competitive advantage

Competitive disadvantage The firm is implementing a value-destroying strategy leading to cost-
disadvantage or a product that does not satisfy customer needs.
Competitive parity The firm and its competitors are implementing the same value-
creating strategies leading to cost-advantages and/or differentiation
advantages.
Temporary advantage The firm is alone in implementing a value creating strategy leading
to cost-advantages and/or differentiation advantages. Competitors
might prepare for imitation.
Sustainable competitive A firm is alone in implementing a value-creating strategy leading to

advantage cost and/or differentiation advantages. Competitors are unable to
duplicate the benefits of this strategy.
Competitive disadvantage Parity

10 10
5 5
0 0
1st Qtr 2nd Qtr 3rd Qtr 4th Qtr 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr
Temporary advantage Sustainable advantage
10 10
Average
Firm A
5 5
current market price p. share

P/E=
after-tax earnings p. share
0 0
1st Qtr 2nd Qtr 3rd Qtr 4th Qtr 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr
Competitive strategy is concerned with "Creating and maintaining a competitive

advantage in each and every area of business" (Michael Porter, 1980)
Product Cost leadership

Industry wide differentiation
Strategic Target

Particular differentiation focus
segment only focus
Uniqueness perceived Low-cost position Strategic

by the customer Advantage
Summer Term 2007 Georg von Krogh | Strategic Management & Innovation | gvkrogh@ethz.ch
Contents

 Cost leadership
Cost leadership
Cost leadership strategy focuses on gaining advantage by reducing the firm‘s economic
costs below the costs of all competitors

Strategic Target

segment only focus

Cost leadership
Sources of cost Size differences and economies of

scale
advantage
Experience differences learning -
economies
Differential low-cost access to

factors of production
Technological advantage
independent of scale
Policy choices
Cost leadership

scale
advantage
economies

Policy choices
Cost leadership
When there are economies of scale in function such as

manufacturing, marketing, sales, or administration larger firms up
to a certain point have a cost advantage over smaller firms
Costs of production
Optimal
volume
What are sources of

economies of scale
that firms can build?
Volume of production (units)
Cost leadership
There is a relationship between volume of production and cost

elements associated with the production process
Volume of production effects
+  Ability to purchase specialized and

costly technology
 Division of labor and specialization
 Overhead costs
-  Cost of plant and equipment

 Cost of redesign of production process
Cost leadership
When the firm increases volume beyond a certain optimal point,

diseconomies of scale lead to increasing cost of production
Costs of production
Optimal
volume
What are sources of

diseconomies facing
firms that increase
production volumes?
Volume of production (units)
Cost leadership
When the firm increases volume beyond a certain optimal point,

diseconomies of scale lead to increasing cost of production
Volume of production effects Diseconomies of scale beyond optimum
+  Ability to purchase specialized and

costly technology
-  Cost of controlling the manufacturing
process and other managerial
 Division of labor and specialization diseconomies
 Overhead costs  Declining employee motivation
 Physical limits to the efficient size of
plants
 Increasing distance to, and reduced
knowledge flow between the firm, its
-  Cost of plant and equipment
markets and suppliers
 Cost of redesign of production process
Cost leadership

scale
advantage
economies

Policy choices
Cost leadership
„Costs appear to go down on value at about

20-30% every time the total production
experience doubles for the industry as a
whole, as well as for individual producers“
BCG (1970)
Cost leadership
The firm with the greatest experience in production will have the
lowest cost of production in the industry
Costs of production
Lowest cost set by

technological possibilities
Cumulative volume of production (units)
Cost leadership
Learning curves can be applied to all processes where learning and

accumulation of experience is present
 Manufacture of ships
 Consulting services
 Semiconductors
 Specialty chemicals
 Cars
 Fast moving consumer goods
 Watches
Cost leadership
y=a•x-€
Costs of production
a: Amount of time spent producing the first unit

€: Rate of learning in producing output
y: Average time to produce x units
Cumulative volume of production (units)
Cost leadership
Example Digital Media Player production
Source: Apple, Getty

Cost leadership
a: 45 minutes (2nd unit 27 min)

x: 2 units
y: Average time to produce 2 units: (45+27)/2= 36 min
€: 0,3219
Learning curve Digital Media Player production

y= 45•x-0,3129
Source: Jefferies & Co.

Cost leadership
What are the differences Step 1 Estimate learning curve (last slide)
y= 45•x-0,3219
between the experienced firm B
and the new entrant firm A in Step 2 How long will it take A to produce first unit
45 min
manufacturing digital media
Step 3 Average time for B to produce six units
players? y= 45•6-0,3219= 25,3 min
B has already produced 6 units Step 4 Total time for B to produce six units
6•25,3= 151,8 min
A just produced 1st unit
Step 5 Average time for B to produce five units
y= 45•5-0,3219= 26,8 min
Step 6 Total time for B to produce five units
5•26,8= 134 min
Step 7 Time needed by B to produce sixth unit only
151,8-134= 17,8 min
Cost advantage because of time difference between B and A
45-17,8= 27,2 min
Adapted form J. Barney (1996)
Cost leadership
Firm A Firm B
€= 0,3219
Costs of production
Δ Cost of
production
1 6 Cumulative volume of
production (units)
Cost leadership
Principles of competitive interaction between firms  If cost is a function of

based on experience effects accumulated experience, then
profit margin is a function of
sustained market share
 Least efficient competitors
Costs of production
Industry price continually increases market

share to maintain relative cost
position
 Relationship between
competitors stabilizes at constant
Firm B market shares but different profit
margins
Firm A  Low cost producer has an
incentive to keep existing profit
margins rather than build market
Cumulative volume of production (units) share
Cost leadership
Critique of the learning curve concept from the viewpoint of

competitive strategy (Hall & Howell, 1985)
 The learning curve assumes the capture of demand through
increasing market share
 Cost of building market share should not be neglected
 No consideration of product and service differentiation
Cost leadership

scale
advantage
economies

Policy choices
Cost leadership
 The firm may have differential access to similar factors of

production at lower costs than competitors. Factors of
production cover a range of inputs used by the firm in doing
business
 Raw materials
 Land
 Labor
 Capital
 The firm with a very high level of production may use its market
share to obtain discounts on factors of production (Porter, 1980)
Cost leadership

scale
advantage
economies

Policy choices
Cost leadership
Technological advantages in production can be independent of

economies of scale. They ensue from investment in own research
and development of technology, or the purchase and superior
exploitation of technology
Cost leadership

scale
advantage
economies

Policy choices
Cost leadership
 The management of a firm makes a policy choice to remain or

become a low cost producer. This limits the scope of variation
products. The firm will choose relatively simple, standardized
products that sell for relatively low prices compared to firms that
follow other policies.
 Firms that seek to remain or become low cost producer make
cost reduction the focus of management and employees.
Contents

 Cost leadership
Product differentiation
Competitive strategy is concerned with "Creating and maintaining a competitive

advantage in each and every area of business" (Michael Porter, 1980)

Strategic Target

segment only focus

 The firm attempts to gain competitive advantage by enhancing

the perceived value of its own products and services relative to
that of the firm‘s competitors
 The firm‘s competitors can be direct rivals in the industry, or
develop, produce, and sell substitute products and services
 Product differentiation always hinges on the customers‘
perception of the firm‘s product or service
 Firms can take a variety of action to enhance product
differentiation and influence customer perception
„When products are differentiated, buyers are

given the basis for preference, and will therefore
be paired with sellers, not in a random fashion
(as under pure competition), but according to
these preferences“
E. Chamberlin (1933)
Sources of Product features

product Linkages between functions and complexity
differentiation
Timing
Location and presence
Product mix
Links with other firms
Reputation

differentiation
Timing
Product mix
Reputation
Google
KartOO
Vivísimo
 The product may have certain characteristics that allow for

differentiation
 Quality
 Design
 Color
 Style
 Trademarks
 Patented features
 These characteristics match the preferences of certain customers

differentiation
Timing
Product mix
Reputation
 A firm can attempt to differentiate its product by linking

different functions within the firm
 Sales with after sales service
 Sales with distribution
 Sales with financing
 Product development with sales
 Product development with financing
 A firm can attempt to differentiate its product by making it more
complex in both its features and its delivery

differentiation
Timing
Product mix
Reputation
 A first mover allocates funds for product innovation and

development, aggressive advertising, and advanced research and
development (Cheng and Kesner, 1997)
 A second mover responds to the first mover's competitive
actions, typically through imitation of product features
 A late mover responds to a competitive action, but only after
considerable time has elapsed after the first mover's action and
the second mover's response
Incentives Disincentives
Customer loyalty Difficult to estimate

returns earned from
Introduction of product
First mover innovations
Available slack
Market share difficult resources Investment in research
for competitors to and development
capture reduces slack available
for further innovation

differentiation
Timing
Product mix
Reputation
 The physical location can be a source of product differentiation

for a firm. The firm can be located close to
 Suppliers
 Distributors and retailers
 Customers

differentiation
Timing
Product mix
Reputation
 The mix of products or services offered by a firm can be a source

of product differentiation. In particular, this holds when products
and services are technologically linked or when a single set of
customers several of the firm's mix of products and services.
 Whereas a product's features may be offered by the firm's
competitors too, the mix with services may be a source of
product differentiation.

differentiation
Timing
Product mix
Reputation
 A firm can collude with other firm's in offering a mix of products

and services. This is similar to "linkages between functions", but
includes the functions, products, and services of other firms as
well

differentiation
Timing
Product mix
Reputation
Consistent pattern of firm  One of the most influential sources of product

behavior differentiation is a firm‘s reputation (Klein & Leffer, 1981)
 The firm and product related reputation may remain
Reputational resources relatively stable despite a gradual reduction of quality
Reputation with customers  „Optimal reputation cheating“ describes a level of
Reputation with suppliers reputation where the firm can reduce product quality
without damaging that level of reputation
Brand name
 Economists have predicted that under some
Perceptions of product
circumstances, performing at a lower level than what
quality, durability and
reliability customers expect, can maximize the firm's economic
performance (Klein & Leffler, 1981)
 In practice, optimal reputation cheating can have
disastrous consequences for the firm
Conclusion
A brief history of Competitive Cost leadership Product

the strategy field strategy differentiation
Sources of Secures superior Available sources of Available sources of

competitive performance in the cost leadership product
advantage short- to long-term differentiation
Develop, analyze and
appraises competitive
strategies

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Strategic Management I

Thursday, April 5 2007

 A brief history of the strategy field

 Managers need strategy in order to position their firms relative

Several forces push towards a rethinking of Development in the discipline

Structural change  Knowledge and technology

Mergers transforming industries  Cooperation and networks

Environmental concerns Pressure

1950‘s 1960‘s 1970‘s 1980‘s 1990‘s

Functional Planning for Response to Strategic Capabilities

1950‘s 1960‘s 1970‘s 1980‘s 1990‘s

1950‘s 1960‘s 1970‘s 1980‘s 1990‘s 2000 +

 A brief history of the strategy field

Competitive strategy is concerned with

Michael Porter, 1980

Competitive strategy is concerned

Competitive advantage results from

Cost leadership Differentiation

Three levels of firm performance

Profitability ratios in strategy

profits after tax - after-tax profits +

Liquidity and leverage ratios in strategy

Current ratio Quick ratio Debt to Debt to Times interest

current assets + profit before

Inventory turnover Accounts receivable Average collection

sales annual credit sales accounts receivable

Speed with which a Average time it Time it takes to

Other measures of strategic performance

 Firm value at IPO (Initial Public Offering)

Four levels of competitive advantage

Sustainable competitive A firm is alone in implementing a value-creating strategy leading to

Competitive disadvantage Parity

Temporary advantage Sustainable advantage

current market price p. share

Competitive strategy is concerned with "Creating and maintaining a competitive

Product Cost leadership

Product Cost leadership

Uniqueness perceived Low-cost position Strategic

 A brief history of the strategy field

Product Cost leadership

Product Cost leadership

Uniqueness perceived Low-cost position Strategic

Sources of cost Size differences and economies of

Differential low-cost access to

Sources of cost Size differences and economies of

Differential low-cost access to

When there are economies of scale in function such as

What are sources of

Volume of production (units)

There is a relationship between volume of production and cost

Volume of production effects

+  Ability to purchase specialized and

-  Cost of plant and equipment

When the firm increases volume beyond a certain optimal point,

What are sources of

Volume of production (units)

When the firm increases volume beyond a certain optimal point,

Volume of production effects Diseconomies of scale beyond optimum