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S6 - Strategic Management
S6 - Strategic Management
S6 - Strategic Management
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The main body of the text is divided into a number of chapters, each of which is
organized on the following pattern:
Self-Test question. The test of how well you have learned the material is your
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own answers, but at this stage don’t be too concerned about attempting the
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that would apply in the actual exam.
Planning
To begin with, formal planning is essential to get the best return from the time
you spend studying. Estimate how much time in total you are going to need for
each subject you are studying for the Strategic Level. Remember that you need
to allow time for revision as well as for initial study of the material. This book will
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the most common pitfalls.
With your study material before you, decide which chapters you are going to
study in each week, and which weeks you will devote revision and final question
practice.
It is essential to know your syllabus. As your studies progress you will become
more familiar with how long it takes to cover topics in sufficient depth. Your
timetable may need to be adapted to allocate enough time for the whole syllabus.
(1) Aim to find a quiet and undisturbed location for your study, and plan as far as
possible to use the same period of time each day. Getting into a routine helps
to avoid wasting time. Make sure that you have all the materials you need
before you begin so as to minimize interruptions.
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should be able to apply total concentration, so turn off all entertainment
(5) Work carefully through a chapter, note imported points as you go. When you
have covered a suitable amount of material, vary the pattern by attempting a
practice question. When you have finished your attempt, make notes of any
mistakes you make, or any areas that you failed to cover or covered more
briefly.
In this chapter we look at the process of strategy formulation and the role of
directors within that process. In the exam you may have to evaluate this process
so it is vital that you understand the different possible approaches and their
relative strengths and weaknesses.
2 What is strategy?
The core of a company’s strategy concerns its markets and its products and is about
choosing:
Strategic Management
Strategic management is the management of an organization’s resources to achieve its
goals and objectives. Strategic management involves setting objectives, analyzing the
competitive environment, analyzing the internal organization, evaluating strategies, and
ensuring that management rolls out the strategies across the organisation.
A strategic manager may oversee strategic management plans and devise ways
for organizations to meet their benchmark goals.
While an organization’s upper management is ultimately responsible for its strategy, the
strategies themselves are often sparked by actions and ideas from lower-level
managers and employees. An organization may have several employees devoted to
strategy rather than relying solely on the chief executive officer (CEO) for guidance.
Because of this reality, organizational leaders focus on learning from past strategies
and examining the environment at large. The collective knowledge is then used to
develop future strategies and to guide the behavior of employees to ensure that the
entire organization is moving forward. For these reasons, effective strategic
management requires both an inward and outward perspective.
As well as the environmental forces and the resource availability, the strategy
of an organisation will be affected by the expectations and values of those
who have power within and around the organisation.
Strategic decisions are apt to affect the longterm direction of the organisation.
Goal Setting
The first part of strategic management is to plan and set goals. Set the short- and long-
term goals of the organization and make sure that these are shared with all members of
the organization. Explain and share how each member of the team will have an impact
on the organization reaching this goal. This will help give each member of the team a
sense of purpose and will give their job meaning.
Analysis
During this stage of the process, it is important to gather as much information and data
as possible. This information will be integral to creating your strategy to reach your
goals. This step of strategic management entails becoming aware of any issues within
the organization and understand all of the needs of the organization.
Strategy Formation
In this strategic management step, the strategic manager will use all the intelligence and
data gathered to formulate the strategy that manager will use to reach whatever goal
has been set. Identify useful resources, and also seek out other resources needed to
set up the strategy.
Strategy Implementation
This is arguably the most important part of the entire strategic management process. At
this point, each member of the team should have a clear understanding of the plan and
Strategy Monitoring
During this stage, the strategy will already be in play. At this point, strategic manager
should be managing, evaluating, and monitoring each part of strategy, and ensuring that
it aligns with the end goal. If it does not, this is the time where the manager would make
tweaks and adjustments to strengthen the overall plan. This is the stage to track
progress and have the opportunity to deal with any unexpected shifts in the strategy.
What is strategy
Levels of strategy
a) Corporate Level Strategies
b) Business Level Strategies
c) Functional Level Strategies
Mission
Implementation
2 Introduction
In this chapter we look at the process of strategy formulation and the role of
directors within that process. In the exam you may have to evaluate this process
so it is vital that you understand the different possible approaches and their
relative strengths and weaknesses.
3 What is strategy?
(ii) Definition
Strategy is a course of action, including specification of resources required, to
achieve a specific objective and a strategic plan as a statement of long-term
goals along with a definition of the strategies and policies which will ensure
achievement of these goals.
The core of a company’s strategy concerns its markets and its products and is
about choosing:
(1) where to compete - which business segments.
(2) how to compete - on what basis shall we compete.
Illustration 1
A full-price airline in considering setting up a no-frills, low fare subsidiary. The
strategic planning process would include the following elements:
For example,
applying a formal rational approach to the analysis-choice-implementation
framework of Johnson, Scholes and Whittington, would see:
– strategic analysis being completed before strategic choice, and
– strategic choice being finished before detailed plans for implementation are
formulated.
The first two stages would probably be undertaken once a year in a major
planning exercise. In some versions of the traditional model, 'mission and
objectives' come first followed by 'external analysis', 'internal analysis' and
'corporate appraisal'. In others, the 'external' and 'internal' analysis stages are
followed by 'corporate appraisal' and only then does the business attempt to
formulate a mission and objectives.
This rational approach to strategy is often criticised because it ignores the fact
that humans are rarely logical and rational and also, short term changes in the
environment often prevent long term goals being reached and necessitate
alterations to the plan.
Several studies have shown that assessing the likelihood of future events is one
ofthe hardest things that executives are asked to do, and most are not
particularly good at it. However, this is only half the problem; even if strategists
guess what is going to happen, they still have to devise effective responses and
implement them effectively. Writers such as Hannan argue that this is virtually
impossible in all but the most stable markets, and argue that good management
at least gives a firm a chance to change as things develop, while a long-term
strategy might develop the company in inappropriate ways.
(iv) Rigidity
Operational managers are frequently reluctant to specify their planning
assumptions because the situations that their plans are designed to meet may
change so rapidly that they can be made to look foolish. Even if a plan is
reasonably accurate, the situation might change for reasons other than those
forecast. Executives are often held prisoner by the rigidity of the planning
process, because plans have to be set out in detail long before the period to
which they apply.
The rigidity of the long-term plan, particularly in regard to the rationing and
scheduling of resources, may also place the company in a position where it is
unable to react to short-term unforeseen opportunities, or serious short-term
crisis.
Strategic managers do not evaluate all the possible options open to them but
choose between relatively few alternatives.
Intellectually, this is justified by saying that planning takes too much time and is
too constraining. Probably, the approach is adopted more for psychological
reasons – some people simply do not like planning.
The European electronics market has always been seen as a difficult market for
new entrants. This is due to the fast moving, innovative nature of the companies
currently operating there. HAA has a high spend on research and development
and its directors feel that the company is well placed to compete with European
games manufacturers.
Required:
Evaluate HAA's current approach to strategic planning and suggest more
appropriate alternatives.
While each aspect of strategic analysis is important, firms may prioritise the
perspectives in different ways:
Objectives are very important but this approach is often flawed in so far as
objectives are often set in isolation from market considerations and are thus
unrealistic.
The essence of strategic planning is then to ensure that the firm has a good ‘fit’
with its environment. If markets are expected to change, then the firm needs to
change too. The idea is to be able to predict changes sufficiently far in advance
to control change rather than always having to react to it.
The main problem with the positioning approach lies in predicting the future.
Some markets are so volatile that it is impossible to estimate further ahead than
the immediate short term.
Required:
Explain the three different types of approaches to strategy that GYU could use
and discuss which you feel is the most appropriate.
Advantages
Pooling of expertise, through the grouping of specialised tasks and
staff.
Disadvantages
‘Vertical’ barriers between functions, that may affect work flow
(creating co-ordination problems) and information flow (creating
communication problems).
Disadvantages
Duplication of business functions - each division must have its own
finance, personnel and sales manager. This results in more managers
than if the company were centralised;
Increased cost arising from extra administration and the development and
maintenance of the control system;
The design of the control system poses serious problems with regard to
creating goal congruence between investment decisions made by
managers and decisions which may be made to improve their own
Advantages
organise horizontal groupings of individuals or units into teams that
operationally deal with the strategic matter at hand.
can creatively serve the needs of strategic change that otherwise might be
constrained by more traditional structures.
Disadvantages
may lead to problems of dual authority with conflict between functional and
product or geographical managers leading to individual stress arising from
threats to occupational identity, reporting to more than one boss and
unclear expectations.
8 Levels of strategy
This may involve consideration of acquisition and diversification and will see an
organisation being in more than one business.Corporate strategy is concerned
with
Marketing strategy;
Operations strategy.
These could be unique to the SBU and benefit from being individually focused or
the corporate unit may seek to centralise them and so benefit from synergy.
Strategic
Should another range of shops be established to target a different segment of
the market? (Gap opened Banana Republic, a more up market chain to do
just that)
Should the company raise more share capital to enable the expansion?
Business
What markets should the new range of shops open in?
How often should inventories be changed?
What prices should be charged in the new stores?
Operational
How will suitable premises be found and fitted out for the new range of
shops?
Which staff should we hire for the new stores?
Which IT systems need to be installed in the stores?
Strategy as experience. This is the view that future strategies are based on
experiences gained from past strategies. There is strong influence from the
received wisdom and culture within an organisation about how things should
be done. This reflects the emergent approach described above.
Strategy as ideas. This is the view that innovation and new ideas are
frequently not thought up by senior managers at the corporate planning level.
Rather, new ideas will often be created throughout a diverse organisation as
people try to carry out their everyday jobs and to cope with changing
circumstances.
Johnson and Scholes suggest that viewing strategy through only one of these
lenses can mean that problems that the other lenses might show up are
missed.
Ideally, managers should try to look at strategy through all three lenses in
turn.
Strategy as design
The environmental changes that the university is experiencing are significant and
it will be important that the university react to these. Through the use of
environmental analysis in combination with resource analysis etc. the design
process will begin. It will then move on to strategic choices such as the decision
to move onto to e-learning product development.
The design will be developed logically with carefully planned steps. Middle and
lower management will play a role in the implementation of the strategy and it will
have clear goals and objectives.
Strategy as experience
But the strategy is likely to be adapted over time, possibly due to the influence of
all levels of management. They will have clear taken-for-granted assumptions
about how strategy should proceed, based mainly on what has worked and not
worked in the past. They may alter the detailed plans due to their own ideas
about what wil work and what won't.
But the strategy will be added to as well from these experiences. For example,
the middle line managers might know from past experience that when students
Strategy as ideas
The university's environment is not static and it will continue to evolve. A five year
plan cannot therefore be static and it also should evolve as the environment
evolves.
Transaction cost theory (TCT) suggests that organisations choose between two
approaches to control resources and carry out their operations (Coase and
Williamson):
Markets – assets and staff are 'bought in' from outside under the terms of a
contract (for example, an outsourcing agreement)
If transaction costs are higher than the costs of hierarchical ownership, then a
hierarchical approach is taken.
If transaction costs are lower than the costs of ownership, then a market solution
is adopted. Market solutions lead to a new form of organisational structure – a
'network organisation'.
This third dimension, the degree of asset specificity, is the most important
determinant of transaction cost. Asset specificity is the extent to which particular
assets are only of use to an organisation within a hierarchical solution.
The more specific the assets are, the greater the transaction costs would be
were the asset to be shared and hence the more likely the transaction will be
internalised into the hierarchy. On the other hand, when assets are non-specific
the process of market contracting is more efficient because transaction costs will
be low.
Cocacola;McDonalds
Illustration 4
Eurotunnel plc
Consider the example of Eurotunnel plc. This company has a single asset, a
tunnel under the English Channel linking the British Isles to the main European
continent, which opened in 1994 having cost nearly £5bn to build. Apart from
some telecommunications potential, this extremely expensive asset has no
conceivable alternative use other than as a rail tunnel. In addition to operating its
own shuttle services for passengers and freight, over 30 % of the company’s
revenues come from other railway companies which pay Eurotunnel to use the
tunnel. This includes the Eurostar consortium that operates specially built trains
between London and various destinations in France and Belgium.
This is a situation of high asset specificity. High asset specificity arises where a
supplier must invest in expensive assets with no alternative use in order to
supply a client. This poses a substantial risk to the supplier because if the
contract is withdrawn, it will not be able to recoup its investment. Few will take
this risk without a guarantee of orders in the long term. Eurotunnel plc is locked
into the train operators. At the same time, the train operators are locked into
Williamson’s conclusion is that high asset specificity will lead firms to bring
supply in house rather than bear the high transactions costs of the market.
Indeed, he suggests that extremely high asset specificity may result in no
suppliers coming forward on the market. In this connection, it is significant to note
that Eurotunnel began life as a political creation of the British and French
governments rather than as a private business initiative.
Are some staff paid far more than they could otherwise get on the job market
because they possess specific skills which the firm cannot buy in from the
labour market?
Is the reason Procter & Gamble develop its own brands for foods and
detergents that the uncertainties about brand values and strategy make it
expensive to draft contracts to lease brands from brand owners?
Human asset specificity occurs when workers have knowledge or skills that
are highly suited to one particular task, for example Direct Line Insurance
call-centre.
Staff have highly flexible skills and are sub-contracted to other companies,
whereas your Kaplan lecturer has highly specific knowledge and skills that
make it difficult to sub-contract them for other activities than training
accountants.
Contract staffing – this may include both low-level operative staff, and also
highly-skilled specialists with scarce intellectual capital, such as IT analysts
and designers, project managers and engineers.
Brand name specificity – Amazon has low brand name specificity which
allows it to sell different types of goods, for instance books, CDs, white goods
etc.
Dedicated asset specificity where the assets are made by a supplier to an exact
specification of a customer, and would be useless for any other company to use, for
example, a machine designed specifically to manufacture Apple iPod players would be
useful to Apple only since they control exclusive rights to iPod patents; whereas a
machine designed to manufacture ordinary MP3 players could be used by many
different manufacturers and therefore could be shared within a network.
11 Mission
A mission is a broad statement of the overall purpose of the business and should
reflect the core values of the business. It will set out the overriding purpose of the
business in line with the values and expectations of stakeholders. (Johnson and
Scholes)
Unfortunately they may also have the following additional characteristics as well:
Not represent the actual values of the organisation
Be vague
Be ignored
Note: In the exam you could be asked to consider mission statements and their
use in orientating the organization’s strategy, probably within the wider context of
evaluating the process of strategy formulation.
To do this you will need to consider whether the mission statement as given aids
or hinders the planning process.
This is particularly relevant as the whole process of mission setting has been
criticized heavily as some feel that it is a waste of scarce resources and does not
produce significant benefits that outweigh the costs.
Illustration 6
Yahoo – an internet search based company – had a mission statement in the
early 2000s which identified that it wanted to be ‘the most essential global
internet service for consumers and businesses’.
However, by 2007 Yahoo was beginning to struggle due to the rise of major
competitors such as Google, whose mission statement was ‘to organise the
world’s information and make it universally accessible and useful.’ Yahoo felt that
its existing mission statement did not show stakeholders how it was different to
these rivals.
It therefore made its mission statement more specific, changing it to reflect that it
wanted to ‘connect people to their passions, their communities and the world’s
knowledge’.
This attempted to show the difference between the two companies. Yahoo
wished to position itself in the entertainment market, rather than merely providing
information like Google.
Key issues:
In the same way that an organisation's overall strategic plans need to be translated
into a hierarchy of lower level tactical and operational plans, there will be a
hierarchy of objectives where the mission statement is translated into detailed
strategic, tactical and operational objectives and targets.
Objectives will vary across stakeholder groups and a strategy may satisfy some
groups but not others.
13 Strategy implementation
Strategic control:
Is a process of monitoring whether the various strategies implemented by
organisation are helping its internal environment to be matched with external
environment.
However, the European market is fast moving, both due to its nature (high-tech)
and the level of innovation by competitors. HAA will have to be prepared to
quickly change its approach to deal with unexpected developments in the market.
If the company produces a detailed operational plan, this may stifle the
innovation that is required.
In addition, given the lack of experience that HAA has in the European market,
any detailed forecasts it produces may prove to be unreliable. This may cause it
to make inaccurate decisions based on flawed market predictions.
There are three main approaches to strategic planning that GYU could take.
Traditional or ‘accounting led’
This would involve GYU examining its key stakeholders and developing
objectives that will meet their needs. The two key stakeholders in the scenario
are GYU’s customers and shareholders. The shareholders are clearly upset with
the reduction in their dividend and will expect GYU to reverse this in coming
years. The customers will be looking for handsets with more features and that
are less ‘dated’. Unfortunately, while these are important objectives, they may be
difficult for GYU to accomplish in the short term. Given the poor level of its
finances, it may struggle to either increase dividends or invest enough in
research and development to update its product line.
Market led
This will involve the examination of GYU’s competitors and market. Doing so
should help GYU to ensure that it is competitive in what is a very fast paced
market.
While this appears to have been a weakness of GYU’s to date (given the fact that
it seems to have fallen so far behind many of its competitors), it may be
inherently difficult in the mobile phone handset market. As the market is changing
so rapidly, it may be difficult for GYU to accurately predict future trends and
create appropriate strategies.
Resource based
This involves GYU focusing its business strategies on areas that it is good at. For
GYU its key area of skill is in the production of mobile handset software. It is
acknowledged to be the market leader in this area and it appears to be very
important to customers. Any future strategies should therefore be based around
leveraging this area of skill.
For example, if it feels unable to produce handsets that are competitive, GYU
could consider focusing on producing software which could then be licensed on
other manufacturer’s handsets. If this is a big enough market, this could help
GYU to turn its business around.
Conclusion
Based on the information provided, the resource–based approach is likely to be
best for GYU.
2 Introduction
If a strategic plan is going to have any chance of being useful, it has to be based on
gathering and analysing information. It is not possible to plan by sitting in a
darkened room, dreaming up scenarios that have no connection to reality. This
chapter describes some of the planning tools that can help.
The PESTEL model looks at the macroenvironment, using the following headings:
Overall, the model should allow a business to assess the growth prospects for the
industry within which the organisation operates.
Social/cultural factors: include changes in tastes and lifestyles. They may also
include changes in the demographic make-up of a population. For example in
Western Europe people are living longer and in most countries the birth rate is
falling, leading to an ageing population. This has obvious implications for the types
of products and services which businesses and other organisations may plan to offer.
Typical questions that need to be answered include:
What are the current and emerging trends in lifestyles and fashion?
What demographic trends will affect the size of the market or its
sub-markets?
What changes in regulations are possible and what will their impact be?
What tax or other incentives are being developed that might affect strategy?
Are there any new product opportunities that could be exploited that would
have a favourable environmental impact on the market?
Some of the PESTEL influences may affect every industry, but industries will vary in
how much they are affected. For example, an interest rate rise is likely to affect a
business selling cars (car purchase can be postponed) more than it will affect a
supermarket (food purchase cannot be postponed). More detailed analysis of the
environment and competitive forces will be focused on specific industries.
Technological influences: there are many alternative sources of information that are
provided through technologies such as the internet, mobile phones and
television – this is likely to adverse affect the sales of newspapers. At the
same time, e-readers are becoming more popular – this might present an
opportunity for newspapers to provide daily downloadable content to these
devices.
Legal influences: limits on what can be published – this will make it harder for
newspapers to differentiate themselves from each other and therefore harm growth
prospects.
Overall, it would appear that growth prospects for newspapers are poor. The industry is
more likely to decline than to grow. Existing rivals need to plan ahead for new products
and new markets and perhaps focus on new technologies such as the provision of
news via e-readers.
4 Stakeholders management
Mission and objectives need to be developed with two sets of interests in mind:
(1) the interests of those who have to carry them out e.g. managers and staff;
(2) the interests of those who focus on the outcome e.g. shareholders, customers,
suppliers etc.
Together these groups are known as stakeholders - the individuals and groups who
have an interest in the organisation and as such may wish to influence its mission,
objectives and strategy.
Given the range of interests in organisations, it is not surprising to find that the
mission may take several months of negotiation before it is finalised. The key
aspect is that the organisation must take the stakeholders into account when
formulating the mission and objectives of the company. The problem is that
stakeholder interests often conflict and so an order of priority is required based
upon relative power and interest.
The different stakeholders need to be identified and potential for conflict needs to
be ascertained in advance. The mission setting process can be a useful basis for
getting the stakeholder groups to communicate their ideas and then be able to
appreciate other viewpoints.
3) Determine the degree of power that each group holds through its ability to
force or influence change as new strategies are developed.
(ii) Employees
Unionised?
Cultures?
Skills base?
(iii) Government
Laissez-faire?
Shareholding?
Political involvement?
(iv) Lenders
Loan conditions?
Amount and terms of loan?
Non-executives? Provided by lenders?
(v) Shareholders
Voting powers?
Family influence?
Number of shareholdings?
Rate of change of holdings?
Extent of staff and managers who own shares?
The study suggests reasons why some nations are more competitive than others and
why some industries within nations are more competitive than others.
Porter's Diamond
The competitive advantage of nations
You can use the national identity as the basis for a brand e.g. New Zealand lamb.
5.3 Related and supporting industry – the value chain and system
Advantage conveyed by the availability of superior supplier industries, e.g. Italy has
a substantial leatherwear industry which is supported by leather working plants and top
fashion and design companies.
Domestic rivalry can keep the organisations 'lean and mean' so that when they go
out into the global marketplace they can compete more successfully with the less
capable foreign competition e.g. Nokia and Finland's approach to the regulation of
telecoms.
Decision criteria
The decision as to which countries and markets are to be entered first will be
based upon a number of important factors:
The potential size of the market - is the market for the product in the country
likely to be significant? This will, in turn, be determined by the following;
Political factors - what are the factors which may limit entry to markets in the
host country?
A business will initially choose to enter markets in those countries where the above
conditions are most favourable. This involves considering the attractiveness of the
markets and the barriers to entry that may exist. Strong position audit is needed to
assess our company's strategic capability in these new segments.
At the same time decisions must be made as to the extent of ethical variation that
an organisation is prepared to involve itself in.
Porter developed the model by looking at ten developed countries. The model thus
only really applies to developed economies.
Porter argues that inbound-FDI does not increase domestic competition significantly
because domestic firms lack the capability to defend their own markets and face a
process of market-share erosion and decline. However, there seems to be little
empirical evidence to support that claim.
The Porter model does not adequately address the role of MNCs. There seems to be
ample evidence that the Diamond is influenced by factors outside the home country.
Porter’s analysis focused on manufacturers, banks and management consultancy
firms. Some have questioned its relevance to service-based companies such as
McDonalds.
Porter’s focus is on the domestic country rather than which foreign markets have
been targeted. A careful choice of target is essential to ensure that the firm has the
competences required for success.
Australian producers had benefitted from strong domestic demand, and had produced
excellent results by cultivating grape varieties imported from Europe, combined with
innovative techniques such as cool fermentation in stainless steel containers.
Producers had achieved success in a wide range of wines including red, white, sparkling, dry
and sweet.
Although many producers started out as independent small businesses, major listed groups
such as Penfolds had consolidated many of these small producers into well-known labels.
Required:
(a) Discuss two reasons why Australian wine producers decided to enter foreign
markets, and two risks arising.
(b) By giving one example of each element, use Porter’s Diamond to evaluate the
degree of competitive advantage achieved by the Australian wine industry.
PD's directors are now considering launching the company's products in other parts of the
world, but they have no experience of trading internationally. The managing director
has heard of Porter's Diamond Theory of the competitive advantage of nations. He has turned
to you as the management accountant to provide some advice on whether Porter's theory can be
applied to assist PD in its international development, and the factors which should be
considered before developing internationally.
Your advice should include an assessment of how Porter's Diamond Theory can be applied
to assist the company in determining whether or not it should develop internationally.
(May 2001)
Exam focus
Just because an industry is large and/or growing, high profits do not
necessarily follow. The 5 forces determine profit potential, both for the industry
as a whole and for individual firms / SBUs.
An individual firm can earn better margins than competitors if it can deal more
effectively with key forces.
The model can also be useful to generate ideas for a position analysis - especially
threats.
This will depend upon the extent to which there are barriers to entry.
Establish:
Expected retaliation
If you expect a competitor to retaliate on your entry then this may act as a
deterrent to enter the market - they may enter a price war and drive down margins
in response to your entry.
Legislation
Legal conditions may exist for entry e.g. licences and personal guarantees,
telecommunications and financial services.
Differentiation
Branding and/or high quality may create customer loyalty and inelastic demand for
their product which may take longer to break down for the new entrant.
Switching costs
Customers may have to invest in the trading relationship via contractual
arrangements or an investment in IT. To switch supplier would entail substantial costs
and therefore the new entrant would have a challenge on their hands.
This is likely to be further accentuated when the selling industry comprises a large
number of small firms and the product is standard with little or no switching costs
involved.
– The supplier industry is dominated by a few suppliers who have secure market
positions and are not subject to competitive pressure;
The availability of substitutes can place a limit on price and change the basis of the
product. Consideration must be given to the ease with which consumers can switch
to substitutes along with the perceived value that consumer groups would place on the
products. At the same time, evaluation of potential actions to build customer loyalty
should be undertaken. For example, advertising to build brand image.
– The extent to which competitors are in balance - roughly equal sized firms
in terms of market share or finances - often leads to highly competitive
marketplaces;
– Stage of the life cycle. During market growth stages all companies grow
naturally whilst in mature markets growth can only be obtained at the expense
of someone else;
– High storage costs may lead to cost cutting to improve turnover which in
turn increases the rivalry;
– Extra capacity comes in large increments which means price cutting may
follow to fill capacity;
– High exit barriers mean that some companies must stay in the market.
Conclusion
A desirable circumstance would be a situation where there are weak suppliers and
buyers, few substitutes with high barriers to entry and little rivalry.
Not everyone agrees with Porter – some would argue that the idea of satisfying
customer needs should not be abandoned in favour of a view that sees customers
either as direct competitors or as means to the firm's end. Customers are not objects
whose reason for being is to be fought over by competitors seeking ‘sustainable
competitive advantage’. Porter’s model might thus distract managers from seeing
customers as potential partners.
Hawk sells 65% of its output to large retail chains such as Motorcycle City and Carnells,
exports 25% to the USA and Japan, and sells the remaining 10% to individuals who
contact the company directly. The latter group of customers specify their requirements for
a made to measure suit (they are often professional racers whose suits must be approved by
There are around a dozen companies in the Pakistan who make similar products to Hawk,
plus very many other companies who compete with much lower prices and inferior quality.
Hawk’s typical selling price for a onepiece suit is Rs 10,000, whereas the low quality
rivals’ suits retail at around Rs 4,000. As Hawk say in their literature "if you hit the tarmac,
there's no substitute for a second skin from Hawk". Synthetic materials are waterproof,
unlike leather, but do not currently offer sufficient protection in an accident.
Sales of leathers in the Pakistan are growing rapidly, mainly due to a resurgence of biking
from more mature riders of large, powerful machines. Such riders are often wealthy and
have family and financial commitments. Currently Hawk, and its rivals for quality leathers
are finding it hard to keep up with demand. However, Government policy and emissions
controls are likely to limit motorcycle performance, and some experts predict that these
regulations will cause sales of large motorcycles to level off.
Whilst supplies of leather from India, Scandinavia and the Pakistan are plentiful, a key
problem is recruiting and training machinists to stitch and line the garments. Hawk has
been able to invest in modern machinery to help production but the process is still labour
intensive. Hawk has found that the expertise, reputation and skilled labour needed to
succeed in the industry takes years to build up.
Although the industry is fairly traditional, there are some new developments such as a
website for individual customers to browse and specify requirements, and new colours such
as metallics for leathers, and a small but growing demand from non bikers who are interested
in 'recreational' and 'club wear' items.
Required:
(a) Analyse the issues facing Hawk’s industry using a PEST analysis.
(b) Using Porter's 5 forces, evaluate the strength of each competitive pressure
facing Hawk.
Use the information above and aim for one or two points under each heading.
This can be defined as a set of activities which examines the comparative position of
competing enterprises within a given strategic sector. It seeks to:
Provide an understanding of the company's competitive advantage/disadvantage
relative to its competitor's positions;
Help generate insights into competitors strategies past, present and potential;
Industry competitors sell similar products but in different segments e.g. BA and
Singapore Airlines.
Form competitors sell products that satisfy the same need as ours though
technically very different e.g. speedboat and sports car.
Generic competitors compete for the same income e.g. home improvements and golf
clubs.
Competitor analysis can help the company to make appropriate strategies to gain
competitive edge.
Risks arising
Marketing mix adaptations are needed and questions must be addressed as to how
these modifications should be made and when. Consideration must be given to the
cultural implications and the potential costs involved.
Cultures vary more dramatically when national boundaries are traversed and cultural
environment needs full evaluation.
Varying cost structures will exist from one country to another as will factor quality
- there may not be sufficient skilled labour and management to enable a global
strategy.
Different competitive levels will exist in different markets and the level of
competition will need to be determined.
Exchange rate volatility requires the deployment of control systems to protect the
company.
Different economic situations will alter the demand for the product and the
availability of factors of production.
This in turn allows the challenge to the traditional home cultural perspective. Items
can be viewed from a different perspective with cultural benchmarks being
developed.
Cheaper sources of raw materials and labour may allow the development of a
competitive advantage which could be sustainable for a period of time.
Risk reduction via portfolio spread will arise when different markets are combined
into a portfolio.
Political power becomes possible as the company grows in size and is seen to be
contributing to wealth creation as opposed to exploitation of the nation concerned.
What are the consumer and customer needs now? What have they been in the
past and how do we expect them to change in the future?
Who are the competition and what are they currently offering? Full competitor
analysis needed.
8.1 Approach
Primary research should be undertaken after secondary has isolated key areas
where accurate data is going to be needed. This approach is more time consuming
and costly and needs to be used sparingly. Organisations should ensure they have the
HR and IT skills to be able to undertake this level of analysis.
A: Customer behaviour
It is critical in consumer markets to understand why buyers purchases or does purchase an
organisation's goods or services. This will enable an organisation to identify critical success
factors in markets, see if they have the required core competences to meet those CSFs
and, hence, to determine an appropriate strategy.
Traditional views of marketing tend to assume that people purchase according to the
valuefor money that they obtain. The customer considers the functional efficiency of the
alternative products, and arrives at a decision by comparing this with the price. This set of
beliefs is demonstrably inadequate in explaining consumer behaviour.
Status / ego needs (e.g: Merit pay increase and high status job title)
Cognitive dissonance
Dissonance is said to exist when an individual’s attitudes and behaviour are
inconsistent. One kind of dissonance is the regret that may be felt when a
purchaser has bought a product, but subsequently feels that an alternative would
have been preferable. In these circumstances, that customer will not repurchase
immediately, but will switch brands. It is the job of the marketing team to persuade
the potential customer that the product will satisfy his or her needs, and to ensure
that the product itself will not induce dissonant attitudes.
The family is often important in engendering brand purchasing habits in grocery lines,
although it also has a far broader influence in forming tastes in its younger
members.
Purchasing characteristics
Customers may be segmented by the volume they buy (heavy user, medium user,
light user, non user). They may be segmented by the outlet type they use, or by the
pack size bought. These variables, and many others, are useful in planning
production and distribution and in developing promotion policy.
Demographic
Customers are defined in terms of age, sex, socioeconomic class, country of
origin, or family status. The most widely used forms of demographic segmentation
in the UK are the socioeconomic classification based on class (A, B, C1, C2 , D
and E) and the lifecycle model (Bachelor, Newly married couple, Full nest 1, Full nest
2, Full nest 3, Empty nest 1, Empty nest 2)
Geographic
Markets are frequently split into regions for sales and distribution purposes. Many
consumer goods manufacturers break down sales by television advertising regions.
Benefit
Customers have different expectations of a product. Some people buy detergents
for whiteness, others want economy, and yet others stain removal.
It can be seen that, within the same product class, different brands offer different
perceived benefits. An understanding of customers’ benefits sought enables the
manufacturer to create a range of products each aimed precisely at a particular
benefit.
Motivation
An industrial buyer is motivated to satisfy the needs of the organisation rather than
his or her individual needs. Often, purchases are repeat orders when stock of items
has fallen below a certain level and thus the buying motive is clear, i.e. avoiding nil
stocks. With significant oneoff purchases, the motivation will be the achievement of
the organisation’s goals or targets. Thus a profit target may mean the buyer
placing an emphasis on cost minimisation. A growth target expressed in terms of
sales motivates a purchase that will promote that goal.
Reciprocal buying
A feature in many industrial markets is the purchase of goods by organisation A
from organisation B only on condition that organisation B purchases from
organisation A.
Purchasing procedures
An industrial buyer appraises a potential purchase in a more formal way than a
consumer buyer. Written quotations, written tenders and legal contracts with
performance specifications may be involved. The form of payment may be more
Size of purchases
Purchases by an industrial buyer will tend to be on a much larger scale.
Derived demand
Demand for industrial products is generally derived from consumer demands. For
example, when consumers demand more motorcars, the demand for steel, glass,
components and so on will increase in the industrial sector. Industrial strategists have
to know what markets the demand for their products is derived from, and monitor
this market as well as their own. This may sound obvious advice, but when the firm is
selling through intermediaries, or in overseas markets, there may be very little contact
with users and end users.
When industrialists predict a downturn in consumer markets, they will often cut back
on production in the short run. This, of course, has the effect of lowering demand in
the consumer markets through its effect on employment and wages, and is part of
the trade cycle process discussed earlier.
The business environment has become more volatile for a number of reasons,
including:
Changing technology is leading to the development of new products and
services and/or altering how existing ones are delivered. For instance, the rise
of online gaming has had a serious impact on companies such as Game and
HMV in the UK, who both sell computer games on physical discs.
All of these issues mean that an organisation’s environment will be changing all the
time. This may lead to environmental analysis quickly becoming outdated.
It is therefore important that companies consider undertaking environmental
analysis on a regular basis.
It should be remembered that all organisations are different and that modern
environments are turbulent by nature and subject to ongoing change.
There are a variety of tools and techniques to assist this environmental research
which can also be used for general strategic planning purposes.
Weaknesses
The things we are doing badly (need to correct or improve).
The things we are not doing but should be.
Major failures.
Threats
Events or changes in the external environment we need to protect ourselves
from or defend ourselves against.
If an organisation is unsure of its current position then it will be very difficult to plot a
successful strategy. It establishes the starting point for the process of strategic choice.
There are several well-known tools that are available to assist in this process, one of
which is the 'SWOT' analysis. This will identify the strengths, weaknesses,
opportunities and threats as they relate to a particular organisation and usually involves
a listing of points.
SWOT analysis is a tool to assist the position audit process. It is not the only
tool: e.g. the competitor analysis framework works well in this context and can
provide a useful framework to analyse a company.
Position auditing asks the question 'where are we now?' and is viewed by
many as being the starting point for the process of strategic choice.
Threats focusing on weakness - This would usually have top priority and
the company should seek to identify and consider possible solutions. This
requires a defensive response of some kind and may well necessitate rapid
change.
The review should initially seek to identify what would happen if the organisation
chose to do nothing. Remember this is always a strategic option!
An approach
There are many ways that a position audit can be approached. Essentially you should
have one in mind that you would be able to use as a basis for analysing a situation.
Here is a starter:
Every day we see competition in products and services in a modern business society.
Competitor analysis and accounting is a central issue in strategic management
accounting. These techniques help companies analyze and master the competitive
situation. Competitor analysis and accounting is also called competitor-focused
accounting or accounting for the competition.
Key benefits of competitor analysis and accounting Competitor analysis and accounting
is regarded as a central element in business planning and control. There are four key
benefits of competitor analysis and accounting:
Some query why competitor analysis is critical for identifying opportunities and threats.
To answer this, think about what questions an organization should ask to identify these.
In fact, competitor analysis helps decision makers understand who the competitors are
and what the market structure is. It allows management to identify its competitors’
making and selling strategies.
By understanding who the competitors are and how they operate, managers can
remove the issue of other companies making moves that are detrimental to their
companies’ health. Managers can also learn from their competitors. Competitor analysis
helps answer the following questions:
Who are the main competitors?
What are the company’s objectives?
What are its strengths and weaknesses?
How well is it doing?
Can the company predict competitors’ future moves?
Product price and quality are the concerns in competition. The company should conduct
competitor accounting alongside its competitor analysis to assess competitors’ relative
quality and price. The major concerns are:
• If the industry is mature, the basis of competition is frequently based on selling prices,
as the product has become a well-understood commodity.
(a) collecting, analyzing and comparing competitors’ relative costs and investments;
3. Determine who the customers are and what benefits they expect.
5. Rank the key success factors by giving each one a weighting (the sum of all the
weightings must add up to one).
7. Multiply each cell in the matrix by the factor weighting. For example, two
competitors are weighted using four key industry success factors: distribution
network, customer focus, economies of scale and product innovation.
We can see that competitor 1 is rated higher than competitor 2 on product innovation
ability (7 out of 10, compared to 4 out of 10) and distribution networks (6 out of 10). Yet
competitor 2 is rated higher on customer focus (5 out of 10). Overall, competitor 1 is
rated slightly higher than competitor 2 (20 out of 40 compared to 15 out of 40). But
when the success factors are weighted according to their importance, competitor 1 gets
a far better rating (4.9 compared to 3.7).
Likely risks
One risk would have been culture and tradition. For example, wine drinking in the UK was
far less common than it is today, and the risk would have been non-acceptance by a UK
market.
Equally, the French are very protective of their own wines and reluctant to stock those
from other countries. National bias would be a major barrier to overcome in some
wine-drinking countries.
Another risk would be financial – namely exchange rate fluctuations and costs involved in
transporting a product that is over 85% water for thousands of miles.
Porter’s Diamond
Factor conditions would include the availability of land, the favourable climate, and the
skill of Australian winemakers (so impressive that they have exported their talents back to
European producers – the socalled “flying winemakers”). These would combine to give a
strong advantage to Australia, because few rival countries possess such a favourable
mix.
Demand conditions are also strong; Australia has an alcohol tolerant culture, and domestic
consumers would have set high standards. However, this would also apply to countries such
as France, so this factor may have given Australia a medium level advantage overall.
Related and supporting industries will be strong since Australia is a modern developed
industrial nation. This will confer a medium level advantage compared to West European
countries and the USA, but a strong one compared to, say, Chile. Australian firms may
also have had an advantage as they could have invested in newer technologies while
rivals in France would have been committed to traditional methods.
Approach
The movement overseas would be a classic example of a market development
strategy (Ansoff). You would need to brainstorm and then attempt to link points and
put a plan together. In the small amount of time that you have, you would want to
address the 'big hitters'. I started with the environments and took it from there.
Laws - how do they differ? What must we satisfy? What are the implications for
advertising, product characteristics and promotion?
Economy - inflation, unemployment, growth, income levels. What price will we set
our product at?
How will the operational strategies need to change - what changes need to be
made to the marketing mix, changes in HR base? What about the IT needs?
What changes will need to be made to the performance measurement mix? Any
changes to the reward schemes for key staff?
So all of this would need to be put into an action plan for the company.
Any entry to a foreign market needs research and analysis in the first instance. So
consider:
What will the sources of information be? What is the balance between internal
and external sources? How reliable are they? When were they checked? By
whom?
High profile key executive support needed to add credibility to the research.
Don't forget to use benchmarks - learn from others' mistakes as well as their
successes.
There are so many factors that could be mentioned. Look at your list and plan
how to present and combine some of the points. Think about which point you would
start with.
Demand conditions - sophisticated customers at home will cause suppliers to focus onto
quality and continually innovate. If you are used to fussy customers at home, then
internationally you should have a good idea of user needs. Overseas customers may prove
to be less sophisticated and so prove to be easier to market to. For PD, they will need to
think about the product attributes that will be required and those that will win business.
Sophisticated demand is likely to have provided PD with threshold competencies that
would prove core in another marketplace. PD will need to understand how the new demand
is likely to differ from the old. Research becomes of paramount importance. High levels of
competition ensure that the company remains focused and innovative.
Factor conditions - The availability of factors of production. Land, labour capital and
entrepreneurship. Does the home market of PD convey some unique advantages?
Education, finance availability, land and resource availability. High degrees of regulation
Related and support industries - Is there a value chain created within a country context?
Do suppliers add value to your product? PD has reputation for quality and innovation and
the quality will only come if there is quality being put in at the front end. A national
attribute becomes very difficult to attack as the competitor will not have that attribute. It
can thus form the basis of competitive advantage. The question then becomes Can PD
forge a national identity for their product?'
Firm, strategy, structure and rivalry - High levels of competition ensure that the company
remains focused and innovative. Cost levels will be driven down and new competitive
strategies will have been developed and learnt from by PD. This experience will be very
useful in the new international market segments that PD will be competing in. High degrees
of rivalry are likely to have led to an innovative culture being developed.
The model is a simple starting point designed to initiate discussion and to raise issues for
debate and consideration. It's a cheap, easily deployed model that most managers will have
seen before. It will thus meet with minimal resistance and should act as the catalyst by which
PD can ask itself the question 'on what basis and why will we succeed in our chosen overseas
market?'
The model will not provide all of the answers but will go some way to start the debate and
research requirements. The model will provide an insight as to where it will be possible to
utilise a nationalistic attribute in the competitive advantage proposition.
PEST analysis
Political factors
Approval from the ACU is vital for Hawk’s racing suits. Whilst this will require
regular inspections, it is important for credibility amongst customers. It may be seen
as an endorsement of quality for the entire range (the socalled “halo effect”).
Government regulation that could damage motorcycle sales is an issue for the whole
industry. If there is a clamp down it might seriously threaten sales. Hawk might
consider setting up a lobby group with other manufacturers.
The weakening Rs is making exports to the USA and Europe easier, but increases
the import costs of leather. There is little Hawk can do about that, so it is likely to
seek new global markets such as the BRIC economies [Brazil, Russia, India and
China].
Social factors
There has been a growth in demand from mature riders ("born-again bikers"). Have
companies such as Hawk done any research to assess the life of this trend? How
effective is Hawk's marketing at reaching this potentially important market segment?
More emphasis on safety of riders who often have family; this is a boost for the
industry and Hawk’s customers are likely to be responsible bikers.
Technological factors
Relevant issues include website ordering and metallic paints but neither of these is
especially important. However, Hawk and others should be aware of new ideas that
could help with their processes.
Porter’s 5 forces
However for the large retailers there is higher power that arises from the volumes
purchased. Retail chains will exercise this power in terms of designs, lead times,
prices paid and credit period taken. Hawk need to meet these needs or risk losing
major customers to existing/new competition.
However, supplies of skilled about are limited and Hawk may find it has to pay high
wages.
Threat of substitutes
Hawk believes that the threat from substitutes is low and states that only leather
can offer the required degree of abrasion resistance. Clearly this must be kept
under review as newer fabrics and technologies may change this perception.
Competitive rivalry
Rivalry is considered to be low. Those “rivals” that offer cheap leathers are not
really rivals at all, because serious bikers will not contemplate such offerings.
Furthermore, sales are rising so quickly that all players are working at near
capacity without the need to take customers from one another.
The key risk areas for Hawk do not come from within the industry as, with the exception of
the power of larger retailers, competitive forces are low. However, there are major issues
that impact the industry as a whole in respect of the current economic climate and
government policy.
(Tutorial note: each point within the models has been explained and assessed for its
importance. Finally key points must be highlighted in order to then formulate or appraise
strategy).
Strategic planning
Strategy lenses
Resource-based strategy
Johnson, Scholes and Whittington took the above stages and grouped them into
three main stages:
Strategic implementation: How autonomous should the new airline be? How
should new staff be recruited and trained? Acquisition of aircraft and obtaining of
landing slots.
Strategic managers do not evaluate all the possible options open to them but
choose between relatively few alternatives.
Intellectually, this is justified by saying that planning takes too much time and is
too constraining. Probably, the approach is adopted more for psychological
reasons – some people simply do not like planning.
Often such people are entrepreneurs who enjoy taking risks and the excitement
of setting up new ventures. However, once the ventures are up and running, the
owners lose interest in the day-to-day repetitive administration needed to run a
business.
Strategy as experience. This is the view that future strategies are based on
experiences gained from past strategies. There is strong influence from the
received wisdom and culture within an organisation about how things should
be done. This reflects the emergent approach described above.
Strategy as ideas. This is the view that innovation and new ideas are
frequently not thought up by senior managers at the corporate planning level.
Rather, new ideas will often be created throughout a diverse organisation as
people try to carry out their everyday jobs and to cope with changing
circumstances.
It is worth considering the very strong influence the design and experience
lenses have in large organisations and government departments. Often, the
larger the organisation, the less able it is to adopt early essential but radical
changes.
Ideally, managers should try to look at strategy through all three lenses in
turn.
The design will be developed logically with carefully planned steps. Middle and lower
management will play a role in the implementation of the strategy and it will have clear
goals and objectives.
Strategy as experience
But the strategy is likely to be adapted over time, possibly due to the influence of all
levels of management. They will have clear taken-for-granted assumptions about how
strategy should proceed, based mainly on what has worked and not worked in the past.
They may alter the detailed plans due to their own ideas about what will work and what
won't.
But the strategy will be added to as well from these experiences. For example, the
middle line managers might know from past experience that when students study at
home they require a higher level of service in areas such as tutor feedback, exam
marking and material delivery. This might lead to the strategy to be adapted to
incorporate plans such as dedicated support staff etc. and a deliberate choice to focus
on a more differentiated service from rivals who might launch low cost alternatives.
Strategy as ideas
The university's environment is not static and it will continue to evolve. A five year plan
cannot therefore be static and it also should evolve as the environment evolves.
Strategy integrates the firm with its external environment. This means that the structure
of the firm must align with external conditions. The problem this presents is that the
environment constantly changes and the firm has little control over the changes.
Strategy and structure must be flexible to adapt to changes in the environment.
Stability
Stability refers to the rate at which change occurs. In a stable environment, change is
slow. Managers have time to monitor and respond to changes in a deliberate manner.
The grocery industry is relatively stable. A dynamic environment is changing rapidly.
Managers must react quickly and organizations must be flexible to respond. Today’s
business environment is generally very dynamic. Technology, consumer tastes, laws
and regulations, political leaders, and international conditions are all changing rapidly
and dramatically. Failure to monitor and respond to changing conditions often results in
a company’s demise. Consider the Nokia example we introduced in an earlier section.
Nokia was a market leader just a few years ago (2011). It didn’t respond quickly to the
emergence of smartphones and has now been acquired by Microsoft. Or we can look at
the example of True Religion Jeans, a market leader in fashion jeans very recently. It
did not respond to the shift in consumer taste to casual sportswear and the company
has filed for bankruptcy.
Complexity
Complexity refers to the number of elements in the organization’s environment and their
connections. In a highly complex environment there are many variables that can affect
the company. The variables are hard to identify and measure and are connected in
ways that are hard to understand. Managers must monitor and respond to more sources
of change, which makes it more difficult to make decisions. Complexity can be modeled
with chaos theory, where small changes in one factor can produce a major change in
another. For example, the failure of an Ohio power company to trim tree branches near
its high-voltage lines lead to the biggest power blackout in US history, affecting more
than 50 million people. Should GM, a global auto manufacturer, have anticipated that an
increase in default rates on US home mortgages would begin a series of financial crises
that would eventually lead to declaring bankruptcy?
Resource Scarcity
Resource scarcity refers to the availability of resources critical to a company or that are
in high demand by other companies. Resource scarcity is usually the result of a
shortage of supply, but it can also result from demand driving up prices. In conditions of
resource scarcity, a company may not be able to acquire the resources it needs to
operate or grow. For example, lithium ion batteries are now used extensively in
Uncertainty
Instability, complexity, and resource scarcity all lead to uncertainty. Uncertainty refers to
how predictable environmental conditions are. In an uncertain environment it is very
difficult for managers to predict where and how change will occur. Instead, managers
must make decisions based on assumptions rather than clear facts. Companies that
“guess” right benefit from uncertainty and companies that guess wrong suffer. For
example, in the 1990s when oil prices were around $50 per barrel, there was no clear
information to predict what would happen in the near future. Southwest Airlines bet that
fuel prices would go up and hedged against oil price increases. Other airlines bet that
prices would be stable or decline. When oil prices soared to more than $100 per barrel,
Southwest was able to remain profitable whereas other airlines lost more than $6 billion.
5 - Eco System
It should be accepted from the outset that there is no ‘one size fits all’
strategy that is appropriate for all organisations; what will work for, say, a
global oil company is likely to be very different for a manufacturer of
consumer electronics.
Legislators – those who formulate the law, which impacts not just
on Apple but also other organisations e.g. privacy laws and
Facebook.
This list is not exhaustive; there are many other elements of Apple’s
ecosystem!
While each aspect of strategic analysis is important, firms may prioritise the
perspectives in different ways:
Objectives are very important but this approach is often flawed in so far as objectives
are often set in isolation from market considerations and are thus unrealistic.
However, this approach can be particularly useful for not-for-profit rganisations where a
discussion of mission and objectives is often key.
The essence of strategic planning is then to ensure that the firm has a good ‘fit’ with its
environment. If markets are expected to change, then the firm needs to change too. The
idea is to be able to predict changes sufficiently far in advance to control change rather
than always having to react to it.
The main problem with the positioning approach lies in predicting the future. Some
markets are so volatile that it is impossible to estimate further ahead than the immediate
short term.
Ideally these correlate to the areas that the firm has to be good at in order to succeed in
its chosen markets (critical success factors or CSFs) and are also difficult for
competitors to copy.
External focus
better decision-making.
In most discussions the "interests of the company" and those of the shareholders
are seen as one and the same. Thus directors should put shareholders' interests
first in any and all strategic planning decisions.
This raises a number of key issues that are developed throughout the syllabus:
For example:
Breaches of those duties can (subject to certain exceptions) be enforced only by the
company, not by its shareholders. However, while in most cases shareholders will have
the same interests as the company, there can be conflicts if the company, through its
directors, is proposing to act in a way which benefits some shareholders to the
detriment of others or, indeed, which is seen to benefit the directors. In such
circumstances, the affected shareholders may be able to take action themselves.
As a general rule, directors should ensure they act fairly towards all shareholders
although this will not necessarily mean exact equality of treatment.
This is not intended to be an exhaustive list of factors (so matters such as financial
profitability and value to shareholders clearly continue to be relevant), but does highlight
the need to consider wider stakeholder concerns.
Stakeholder management
Business ethics
Not-for-profit organizations
2 Mission
A mission is a broad statement of the overall purpose of the business and should
reflect the core values of the business. It will set out the overriding purpose of the
business in line with the values and expectations of stakeholders. (Johnson and
Scholes)
The mission statement is a statement in writing that describes the basic purpose
of an organisation, that is, what it is trying to accomplish.
Unfortunately they may also have the following additional characteristics as well:
To communicate to all the stakeholder groups. It has been described as the 'reason
for being'.
To help develop a desired corporate culture by communicating core values.
To assist in strategic planning.
Note: In the exam you could be asked to consider mission statements and their use in
orientating the organisation's strategy, probably within the wider context of evaluating
the process of strategy formulation.
To do this you will need to consider whether the mission statement as given aids or
hinders the planning process.
This is particularly relevant as the whole process of mission setting has been criticised heavily
as some feel that it is a waste of scarce resources and does not produce significant benefits
that outweigh the costs.
Illustration 2
Yahoo – an internet search based company – had a mission statement in the
early 2000s which identified that it wanted to be ‘the most essential global
internet service for consumers and businesses’.
However, by 2007 Yahoo was beginning to struggle due to the rise of major
competitors such as Google, whose mission statement was ‘to organise the
The mission statement of C Ltd is "to provide our customers with a top quality product
at a fair price"
Required:
Evaluate the usefulness of this mission statement.
This made more complex when some objectives are hard to quantify (e.g.
environmental impact).
Objectives will vary across stakeholder groups and a strategy may satisfy some
groups but not others.
JAA plc is a publisher of both fiction and non–fiction books, a market in which it
faces significant competition.
For a future meeting of the Board of Directors, the Marketing Director has been
asked to prepare a presentation to discuss this in more detail. She has asked
you to help her by suggesting objectives that could be used to help the company
achieve its missions of ‘growth’ and ‘innovation’.
Required:
Identify two possible objectives each for growth and innovation for JAA, as
requested by the Marketing Director.
Comment on her proposed objective for social responsibility and suggest and
justify an alternative.
4 Stakeholders management
Mission and objectives need to be developed with two sets of interests in mind:
(1) the interests of those who have to carry them out e.g. managers and staff;
(2) the interests of those who focus on the outcome e.g. shareholders, customers,
suppliers etc.
Together these groups are known as stakeholders - the individuals and groups who
have an interest in the organisation and as such may wish to influence its mission,
objectives and strategy.
Given the range of interests in organisations, it is not surprising to find that the
mission may take several months of negotiation before it is finalised. The key
aspect is that the organisation must take the stakeholders into account when
formulating the mission and objectives of the company. The problem is that
stakeholder interests often conflict and so an order of priority is required based
upon relative power and interest.
The different stakeholders need to be identified and potential for conflict needs to
be ascertained in advance. The mission setting process can be a useful basis for
getting the stakeholder groups to communicate their ideas and then be able to
appreciate other viewpoints.
3) Determine the degree of power that each group holds through its ability
to force or influence change as new strategies are developed.
(i) Managers
Large or small company?
Company performance against industry and economy - How well is it doing?
Technical skills - are they in short supply?
Non-executive directors? - Can they dilute or challenge?
(ii) Employees
Unionised?
Cultures?
Skills base?
(iii) Government
Laissez-faire?
Shareholding?
Political involvement?
(iv) Lenders
Loan conditions?
Amount and terms of loan?
Non-executives? Provided by lenders?
(v) Shareholders
Voting powers?
Family influence?
Number of shareholdings?
Different groups will have different influence - each case will need to be treated in
context.
The more power and interest, the greater the involvement in setting the mission and
strategy.
2) Demand. The government is a major customer of business in all areas of life and
can influence demand by buying more or less. It can also influence demand by
legislative measures. The tax system for cars is a good example: a change in the
tax relief available for different engine sizes has a direct effect on the car
manufacturers’ product and the relative numbers of each type produced.
Regulations and controls in an industry will affect the growth and profits of the
industry, for example minimum product quality standards.
3) Divestment and exit. A firm may wish to sell off a business to a foreign
competitor or close it down, but the government might prevent this action
The last three groups may be collectively termed civil society. Civil society
includes, among others, nongovernment organisations; people’s organisations; civic
clubs; trade unions; gender, cultural, and religious groups; charities; social and
sports clubs; cooperatives; environmental groups; professional associations;
academic and policy institutions; consumers/consumer organisations; and the media.
Keep informed
These stakeholders are interested in the strategy but lack the power to do
anything. Management needs to convince opponents to the strategy that the
plans are justified; otherwise they will try to gain power by joining with parties
with high power but low interest.
Keep satisfied
The key here is to keep these stakeholders satisfied to avoid them gaining
interest and moving to the "key players" box. This could involve reassuring them
of the outcomes of the strategy well in advance.
Key players
These stakeholders are the major drivers of change and could stop management
plans if not satisfied. Their participation in the planning process is vital.
Management, therefore, needs to communicate plans to them and then discuss
implementation issues.
Establish and order the objectives of the organisation. Identify the areas for
potential conflict and target resources into those areas;
Frequent face-to-face meetings with the key player and keep satisfied groups;
Communication processes for the other two groups - possibly via public Q&A
sessions;
Periodic formal reporting and the use of a website for 'frequently asked
questions'.
AYL operates the only public hospital within a small city in country U. All of its
income is provided by the central government. However, due to a recent
economic downturn, the central government is urgently looking for ways to save
money. It has therefore decided to significantly cut AYL’s budget for the coming
period.
The management of AYL have therefore been looking at ways of reducing their
expenditure while attempting to minimise the impact on the services provided to
the public. They are planning to freeze pay for the semiskilled nurses working at
the hospital.
This has prompted significant opposition from nurses. Nurses are not heavily
unionised, but the remaining staff members in the hospital, such as doctors, are
all members of the same union. No plans have emerged for cuts to their
numbers.
A firm maintains relationships with its customers, suppliers and competitors (the
"market environment") but also with governments, regulators, non-government
organisations (NGOs), the media and society at large – whether it wants to or not.
Example
In the 1990s, Chiquita Brands sourced most of their bananas from Latin America;
Europe was their biggest market. Meanwhile, the European Union changed its
banana policies to favour non-Latin American suppliers.
Dole, on the other hand, one of the largest producers of fresh fruit and
vegetables, was tracking the workings of the EU Commission, diversified its
suppliers and improved its business as a result.
It is harder to come up with products that are different enough to protect market
share. "Excellence" is a 30-year old concept.
Non-market matters, such as reputation, the ability to work with NGOs, the
capability to foresee relevant government actions and even to shape policy – these
are the factors that can make a difference, even though many firms have no clear
strategy in this respect.
By employing lobbyists, who will put their case to ministers and civil servants
and try to obtain their support.
Depending on the political regime and the country in question another method may
be to make donations to party funds. Obviously this is open to question - it could be
seen as a form of bribery.
It is usually in the interest of a government to consult with the business sector when it
is forming new policies, both to widen its perspective and so that it can defend its
actions politically. In most developed countries there is a strong business lobby
consisting of individual companies and business-related organisations.
In the UK, for example, the business lobby consists of protagonists such as the
following:
The organisation operates within an environment and that organisation will need to
behave ethically in the long term or that environment will reject it and the
organisation will cease to be. Most organisations fail within a very limited time
span (100 years ) and research has suggested that a significant factor contributing
to that has been the failure to act with social responsibility.
The suggestion is that social responsibility is the key factor to ensure the long-term
survival of the organisation. Lack of it implies a short-termist viewpoint and
systems need to be deployed to ensure a broader perspective in setting strategy
for an organisation.
Vary over time within those cultures and be subject to continual slow
adaptation;
Lead to 'pressure groups' pressing for certain kinds of behaviour that may
eventually lead to open conflict.
Most believe that public sector organisations have social responsibility as one of their
primary objectives (or should have). Not all believe that private companies should
have social responsibility on their agendas. Milton Friedman argues:
He sees the only responsibility as being to the shareholder and views donations to
charity and 'the Arts' as being 'fundamentally subversive'.
The organisation will need to consider the ethical context of their strategy and ensure
that they understand how society may change in the future and how they themselves may
need to adapt.
Experiment on animals?
Drill for oil?
Build roads through the countryside?
Allow smoking in public areas?
Pay senior executives large increases in salary?
Train students to pass exams?
Different groups of people will respond in different ways. The management team
will need to consider these viewpoints in developing their strategies.
The social responsibility argument benefits the company in the following ways:
Avoiding pollution - will save costs in the long run and win business in increasingly
sophisticated markets where this is now a threshold competence.
Anything that extends the perceived value of the future cash flows will add value. A
socially responsible organisation will be allowed to operate longer within society
and so there will be more years of cash flow in the future. A misbehaving
organisation will be closed down by the disgruntled 'keep satisfied' stakeholder
groups.
Ethical stances
Johnson, Scholes and Whittington define ethical stance as:
This ethical stance has a short-term focus in that it aims to maximise profits in the
financial year. Organisations with this ethical stance believe that it is the role of
governments to set the legal minimum standard, and anything delivered above this
would be to the detriment of their taxpayers.
Shaper of society
This ethical stance is ideologically driven and sees its vision as being the focus for all its
actions. Financial and other stakeholders’ interests are secondary to the overriding
purpose of the organisation.
Bryson, in his 1995 book, Strategic Planning for Public and Non-profit Organisations,
makes the following statement:
‘I would argue that if an organisation has time to do only one thing when it comes to
strategic planning, that one thing ought to be a stakeholder analysis.’
Required:
(a) Critically discuss the components and process of such an analysis and the
benefits that ‘Doctors with Wings’ would gain from the exercise.
(10 marks)
(b) Evaluate the principal stakeholders in the organisation and analyse the nature
of the influence and importance that they hold in their relationship with the charity.
(15 marks)
(Total: 25 marks)
Effectiveness looks at the outputs (the goal approach); the 'goal approach'
looks at the ultimate objectives of the organisation, i.e. it looks at output
measures. For example, for an NHS hospital, have the waiting lists been
reduced? have mortality rates gone down? how many patients have been
treated?
Efficiency looks at the link between outputs and inputs (the internal processes
approach); The 'internal processes approach' looks at how well inputs have been
used to achieve outputs - it is a measure of efficiency. For example, what was
the average cost per patient treated? What was the average spend per bed
over the period, and what was the bed occupancy rate that this achieved?
Economy looks solely at the level of inputs, e.g. did the hospital spend more or
less on drugs this year? or on nurses' wages?
The best picture of the success of an organisation is obtained by using all of the
above approaches and by examining both financial and non-financial issues. Think
about effectiveness meaning 'doing the right things' and efficiency 'about doing things
right'.
It is more likely to have multiple objectives. A large teaching hospital may want
to give the best quality care and treat as many patients as possible and train
new doctors and research new techniques. Conflict is inevitable.
The people receiving the service are not necessarily those paying for it. The
government and local NHS trusts determine a hospital's funding, not the
patients. Consequently, there may be pressure to perform well in national
league tables at the expense of other objectives.
Strategic management tends to focus on long-term objectives that can take several years
to accomplish, but managers need to be aware of the importance that short-term
objectives play in business strategy.
Short-run Objectives
Financial and strategic objectives can either be short-run or long-run objectives. Short-run
objectives deal with the immediate future. They typically focus on tangible goals that
management can realize in a short time. An example of a short-run objective might be to
increase monthly sales.
Long-run Objectives
Long-run objectives target the firm's long-term position. While short-run objectives focus
on a firm's annual or monthly performance, long-run objectives concern themselves with
the firm's development over several years. Examples of long-term objectives might be to
become the market leader or to attain sustainable growth.
It does not state the business areas in which the company intends to operate. As
such it would not be useful to assess a strategy of market development, for
example.
It does not give a reason for the company's existence. In particular, the
statement fails to give any indication why the company will be better than its
competitors in what it does.
The terms 'top quality' and 'fair price' are unclear in their meaning. It is not clear
what is meant by 'quality', nor what 'fair' is in terms of price. Assuming that it will
be expensive to achieve top quality, how high might a fair price be? Does it
mean fair to the customer or fair to the shareholders? Taken at face value there
is a danger the company could make a loss!
The company could also consider setting itself an objective relating to its market
share. As it operates in a highly competitive market, JAA may wish to set itself
an objective to achieve a set percentage share of the total market for fiction and
non–fiction books.
Innovation
To achieve this objective, JAA could set itself objectives relating to the number
of new books launched each year. By bringing more new books to market than
its competitors, it may be able to increase its market share and put pressure on
other publishers.
Firstly, social responsibility extends beyond how the company treats its
employees. To get a full picture, the company needs to examine how its actions
are impacting on other stakeholders and the wider environment.
Nurses
Given the proposals to cut or freeze their pay in the coming period, nurses will
have high interest in the proposals.
However, they are not unionised. This would tend to indicate a lower level of
power as they lack a clear ability to coordinate strike action and could be
relatively easy to replace due to their relatively low level of skill.
Patients
If the proposed pay cuts are implemented, patients are unlikely to see a
significant change in their level of care. This will give them a low level of
interest.
Mendelow's matrix would therefore suggest that the managers of AYL should
adopt a minimal effort approach with regards to patients in this area. They are
likely to accept what the management tell them as long as it does not affect their
level of care. Should it do so, they may become more interested.
However, should they choose to take an interest, the remaining members of staff
will probably have high power. They are unionized and include key members of
staff (skilled doctors). This means that any strike action could be extremely
damaging to the hospital.
Central government
The government ultimately controls the budget for the hospital. This gives it high
power.
AYL have no choice but to adopt a key players approach. They need to fully
communicate their plans to the central government and ensure they are happy
with the proposals. If the central government recommends changes to the
proposed cuts, AYL's managers would be wise to accept them.
(a) Stakeholders can be defined as people and organisations who have a say in what the
organisation is to do, what resources the organisation can have and what is to be
achieved. They are affected by, and feel they have a right to benefit from, or be
pleased by, what the organisation does.
– Identify stakeholders.
– Identify their interests, values and concerns.
– Identify sources of stakeholder power.
– Identify what claims they can make on the organisation.
– Rank the most important stakeholders from the organisation’s perspective in terms
of their ability to influence the organisation.
– Map the relationship between the stakeholder groups.
– Identify the resulting strategic challenges.
– possession of expertise
– control of or access to resources
– control of or access to information
– preparedness to fight
– charisma or referent power
– networks
All stakeholders will have an element of power in their dealings with an organisation to
a greater or lesser extent. The power that a stakeholder can bring to bear in dealing
with the organisation should be carefully considered since this can affect the way an
organisation chooses to deal with that particular stakeholder or stakeholder group.
The greater their power the more influential they become.
The importance of stakeholders at any point in time will depend upon their interest
in the strategic initiatives being planned at the time. If the initiative ties in with their
values and concerns then they must be considered important in the next stage of
analysis. Alternatively where a stakeholder may have limited, or little interest in the
successful completion of an initiative, they will need to be convinced of the
importance for the organisation as a whole.
Once stakeholders have been classified in terms of their importance and influence
they can be ranked in terms of the way the organisation must deal with them, if
strategies are to be successfully implemented.
The organisation will need to develop excellent working relationships with those
stakeholders who have both high degrees of influence and high importance. They
are potential partners in the planning and implementation of any initiatives.
Those stakeholders who have high degrees of influence, and can affect the initiative's
outcomes, but are of limited importance at this point in time, are a source of risk
requiring careful monitoring and management. They must be consulted and kept
informed.
Stakeholders of both low influence and low importance will require limited monitoring
and evaluation but are, at this time, of low priority.
Having conducted this type of stakeholder analysis 'Doctors with Wings' will benefit
from a clearer idea of the way forward in implementing any strategy it proposes.
Strategic initiatives will invariably involve change management and without the
support of the stakeholders are unlikely to succeed. By developing a better
knowledge of stakeholders, their power and their value system, it will be far easier
for the organisation to make decisions on how it should deal with the different groups
as it introduces any new strategy.
More informed decisions are needed when the organisation comes to answer the
following questions:
Public donors
The interest of public donors is philanthropic - they would wish to have a satisfied
feeling from having done the right thing. Power is not limited to resource
manipulation in the size of the donation made, but would also involve their ability to
raise the profile of the charity where word of mouth marketing is important.
Doctors and nurses donating time after qualifying for the first time
The interest of the donors is both philanthropic from a desire to put something
back, but also to gain good quality post-qualification experience. There will also be
an element of self-esteem in taking an interest in the charity. Their power is high
being based on their expertise and preparedness to do the work.
Part of the strategic planning process requires an analysis of the environment that the
organisation operates within. Management should try to understand the past and the
potential for the future and its possible impact upon the organisation. This will involve
research by skilled teams with appropriate budgets and the use of a variety of analytical
skills.
It should be remembered that all organisations are different and that modern
environments are turbulent by nature and subject to ongoing change.
There are a variety of tools and techniques to assist this environmental research which
can also be used for general strategic planning purposes.
Environments have degrees of uncertainty attached to them which makes the task
more difficult. Understanding them will involve research by skilled teams with
appropriate budgets and the use of a variety of analytical skills.
Strengths
The things we are doing well.
The things we are doing that the competitors are not.
Major success.
Weaknesses
The things we are doing badly (need to correct or improve).
The things we are not doing but should be.
Major failures.
Opportunities
Events or changes in the external environment that can be exploited.
Things likely to go well in the future.
Threats
Events or changes in the external environment we need to protect ourselves
from or defend ourselves against.
Things likely to go badly in the future.
2 Gap analysis
The comparison between an entity's ultimate objective and the expected performance
from projects both planned and under way, identifying means by which any identified
difference or gap might be filled.
"F0" curve: Forecast likely performance from current operations and from new
strategic initiatives. (Note: These may be separated out as there is a greater
degree of uncertainty associated with new initiatives)
Identify any remaining 'gap'. New strategies will be needed to close this gap.
A plan is what you want to happen whilst a forecast is what you predict will happen
given the current context and assumptions. The whole approach of gap analysis is
based upon the feed forward control concept, i.e. the comparison of plan with forecast.
The aim is to identify deviance before the problems of missed targets arise so enabling
corrective action to take place in advance. The strategy is too important to leave to
reactive control systems. A proactive approach is needed and this will see the need for
a significant spend on the forecasting systems. Spend will normally include expenditure
on:
The team;
IT;
Data sourcing and audit;
Scenario planning;
Time to facilitate the action;
Uncertainty evaluation techniques such as 'what if' analysis, high low
forecasting and simulation exercises.
The problems - the whole concept revolves around dealing with uncertainty in the
environment. Recent times have seen the business environment becoming increasingly
uncertain. This increasing amount of uncertainty makes the predictive capabilities of
systems less effective. The predictive process works to an extent if the environmental
The other issue is that in recent years there has been an increasing number of powerful
stakeholder groups emerging with the knock-on effect being that there is a greater
range of often, conflicting objectives. Gap analysis does not entertain the multiplicity of
objectives with conflict and compromise running through the whole system.
(1) The approach acts as a simple starting point to initiate further debate and
consideration.
(3) It highlights the need to keep an eye on the long-term time horizon and draws
attention away from the short-term focus.
(4) It provides some basic options that may be considered for closing the gap.
(5) If it is held as a tool to assist and not as the solution provider, the approach
still has a place in most planning systems within organisations.
(6) It allows the questioning of the realism of the objective - if there is a gap, it
may be that the objective is unrealistic given the strategic capability of the
organisation. This may lead to a reappraisal of the objectives and the
generation of more realistic versions.
(7) Stable environments will still provide a basis for effective gap analysis.
3 Forecasting
Where there are numerous short and long-term factors at work, forecasting
becomes very difficult. If the series of data being analysed is very regular, some
simple procedure such as exponential smoothing may be sufficient. On the other
hand, more complex patterns may require techniques of regression analysis, risk
analysis and multiple regression.
The difficulty lies in identifying all the variables and defining how they relate to each
other.
A number of software products are available to help with this. Most large accounting
packages will include forecasting facilities, and Enterprise Resource Management
(ERM) software generally includes facilities to model business processes.
Intuitive forecasting techniques include the use of think tanks, Delphi methods,
scenario planning, brainstorming and derived demand analysis.
the relative absence of positional authority in the group, which enables free
discussion and argument to take place.
the group nature of the activity that not only makes possible the sharing of
knowledge and views, but also encourages a consensus view or preferred
scenario.
Think tanks are used by large organisations, including government, and may
cross the line between forecasting and planning. However, the organisations that
directly employ, or fund them, are careful to emphasise that their think-tank
proposals do not ecessarily constitute company or government policy.
Where the experts are speculating about the future, they are asked for
subjective probabilities about their predictions.
A central authority evaluates the responses and feeds these back to the
experts who are then interrogated in a new round of questions.
The system is based on the premise that knowledge and ideas possessed by
some but not all of the experts can be identified and shared and this forms the
basis for subsequent interrogations.
(iii) Brainstorming
This is a method of generating ideas. There are different approaches but a
popular one is for a number of people (no fewer than six, no more than fifteen)
drawn from all levels of management and expertise to meet and propose
answers to an initial single question posed by the session leader.
All ideas are listed and none rejected at this initial stage.
Only after the session are ideas evaluated and screened against rational
criteria for practicability.
Brainstorming provides a forum for the interchange of ideas without erecting the
normal cultural, behavioural and psychological barriers that so often inhibit the
expression of ideas.
For example, the demands for the chromium, copper and rubber used in the
manufacture of many different products, including cars, are derived demands.
Take the example of chrome matched with car manufacture. In order to forecast
the demand for cars (thus chrome) the forecaster will be faced with the mammoth
task of analysing an enormous number of influences and correlated factors.
Due to its cost and complexity the technique has a very restricted use.
4 Foresight
The value of strong brands, loyal customers, etc has diminished over time as the
business environment has become more dynamic. Whereas once a company could rely
on these things to bring them future success, they are increasingly unable to.
Organisations must therefore develop vision and foresight.
For organisations, foresight means not only predicting the future but developing an
understanding of all the potential changes, which if managed properly could produce
many new opportunities.
By carrying out techniques to develop foresight, management try to shape the future,
rather than ‘wait’ for it to happen and become a victim of changes they are unable to
adapt to. The concept is crucial in the global commercial environment, where
technological changes for example, or non-traditional competition can erode a
company’s dominant position overnight.
In their book ‘Research foresight: Creating the future’, John Irvine and Ben Martin give
the advantages of foresight as the 5Cs:
Relevance trees - starts with a clear goal, which is traced back through the
trends and events on which it depends so that the organisation can determine
what needs to change or be developed for the desired outcome to be
achieved.
Issues analysis - issues arise through the convergence of trends and events.
Potentially significant issues should be analysed in terms of probability and
impact (i.e. risk).
5 Scenario planning
Competence slip and organisational failure have been linked to the notion that
management have failed to grasp the way that society is moving and have not
For example, how would an accountancy training college meet its objectives
under the following circumstances.
Precision is not possible but developing a view of the future against which to
evaluate and evolve strategies is important.
At 3M, for example, the general manager of each business unit is required
annually to describe what his or her industry will look like in 15 years.
For example, two key factors may have been identified as:
(4) ‘Writing the scenario’ – for the most important scenarios (usually limited to
three), build a detailed analysis to identify and assess future implications.
As part of this, planners typically develop a set of optimistic, pessimistic and most
likely assumptions about the impact of key variables on the company’s future
strategy.
– financial implications – anticipated net profits, cash flow and net working
capital for each of three versions of the future.
(5) For each scenario, identify and assess possible courses of action for the firm.
For example, Shell was the only major oil company to have prepared for the shock of
the 1970’s oil crisis through scenario planning and was able to respond faster than its
competitors.
Some strategies make sense whatever the outcome, usually because they capitalise on
or develop key strengths of the firm. For example, the firm concerned may have a global
brand name and could seek to strengthen it by increasing its advertising spend in the
short term.
However, in many cases, new resources and competences may be required for existing
strategies to succeed. Alternatively, entirely new strategies may be required.
Game theory
In many markets it is important to anticipate the actions of competitors as there is
a high interdependency between firms i.e. the results of my choice depend to
some extent on your choices as well.
(2) If a strategy exists that allows a competitor to dominate us, then the priority is
to eliminate that strategy.
Despite the simplicity of these principles, game theory has become very
complex.
Many of the bidders for third generation mobile phone licences in the early 2000s
and the governments auctioning those licences used game theory principles.
Example
The most famous example of game theory is the "Prisoner's dilemma" game.
This can be applied to companies as follows:
Suppose there are two companies, A and B, who between them dominate a
market. Both are considering whether to increase their marketing spend from its
current low level.
If just one firm decides to increase their spend, then it will see their returns
increase.
However, if both increase the spend then both end up with lower returns
than at present.
Competitor A
High Spend Low Spend
Competitor B
High Spend A=5 A=3
B=5 B = 10
Viewed individually the dominant strategy for both firms is to invest heavily.
Taking A's perspective:
If B does not increase spending, then the best plan of action for A would
have been to invest heavily.
If B does increase spending, then the best plan of action for A would have
been to invest heavily.
However, the end result ("equilibrium") is likely to be that both firms increase
spending and thus end up worse off than if they had both kept their marketing
spend at its current low level. Some degree of collusion to keep the spend low
would benefit both parties.
Unfortunately the police have insufficient evidence for a conviction, and, having
separated both suspects, visit each of them to offer the chance of betraying their
accomplice. Suppose the possible outcomes are as follows:
If one testifies (defects from the other) for the prosecution against the
other and the other remains silent (cooperates with the other), the betrayer
goes free and the silent accomplice receives the full 10 year sentence.
If both remain silent, both prisoners are sentenced to only six months in
jail for a minor charge.
The unique equilibrium for this game is that rational choice leads the two players
to both play defect, even though each player's individual reward would be greater
if they both played cooperatively.
7 Strategic intelligence
1. Foresight
2. Visioning with Systems Thinking
3. Partnering
4. Motivating and Empowering
Scenario planning
How useful?
The downside
Costly and inaccurate use up substantial resources and time;
Tendency for cultural distortion and for people to get carried away;
The risk of the self-fulfilling prophecy i.e. thinking about the scenario may be
the cause of it;
The upside
Focuses management attention on the future and possibilities;
Suggest two plausible scenarios the publisher should analyse in more detail and
suggest a possible strategy to deal with each.
UHJ recently expanded into the North American market and set up a new
division with two factories on the west coast. Since this expansion, however, the
North American market has been hit by a significant economic downturn. This
downturn has continued for the last year and analysts are uncertain of how far
and when it will recover.
This has led to a large reduction in orders for aircraft components and has meant
that the North American division of UHJ is now barely breaking even. Its future
profitability for the next few years depends on a large order from a North
American airline, VTH. VTH will announce a decision on this order next month.
UHJ has recently been approached with an offer by one of its rivals to buy the
factories for what UHJ considers to be a fair price. UHJ wishes to avoid closing
Required:
Advise UHJ on how scenario planning could help it to make a decision on the
future of the North American division.
QUALISPECS
Qualispecs has a reputation for quality, traditional products. It has a group of
optician shops, both rented and owned, from which it sells its spectacles.
Recently, it has suffered intense competition and eroding customer loyalty, but a
new Chief Executive has joined from one of its major rivals Fastglass.
Qualispecs has continued to operate as it always has, letting the product ‘speak
for itself’ and failing to utilise advances in technology. Although production costs
remain high, Qualispecs is financially secure and has large cash reserves.
Fortunately the country’s most popular sports star recently received a prestigious
international award wearing a pair of Qualispecs’ spectacles.
The new Chief Executive has established as a priority the need for improved
financial performance. Following a review she discovers that:
(i) targets are set centrally and shops report monthly. Site profitability varies
enormously, and fixed costs are high in shopping malls.
(ii) shops exercise no control over job roles, working conditions, and pay
rates.
Market analysts predict a slowdown in the national economy but feel that
consumer spending will continue to increase, particularly among 18 to 30 year
olds.
Chelsea is a large civil engineering company which carries out various building
contracts within both its home and overseas markets. Its main area of work,
particularly overseas, is in road construction. The company has a strong financial
track record and successfully survived a major recession within its home market
about ten years ago.
The directors of Chelsea have expressed to the contract manager for the road
development in Eastlandia their concern regarding the need to undertake
remedial work on what has been completed so far. This has resulted from use of
faulty materials obtained from an Eastlandian supplier. The remedial work has
already consumed the total amount of the financial contingency which was
allowed for in the contract estimates.
Chelsea is well regarded by the Eastlandian government. It has taken a long time
for the directors of Chelsea to build the company's reputation and gain
recognition in Eastlandia for its workmanship.
Required:
Produce a SWOT analysis for Chelsea and identify factors that should be
considered in order to reduce the potential impact posed by threats.
Scenario 1:
Consumers still prefer conventional books, partly because of the limited growth in
e-books offered to the market.
However, the future does not look positive, due to rising paper costs. If these are
passed on to customers, then it might encourage them to consider e-books more
seriously.
A possible strategy would be to cut paper costs by the increased use of recycled
products.
Scenario 2:
Rapid growth in the availability of e-books and associated marketing costs.
UHJ is faced with a dynamic and rapidly changing environment in the North
American market. Scenario planning is the detailed and credible analysis of how
the business environment might develop in the future, based on various
environmental influences and drivers for change. The target for this analysis
should be areas where the organisation considers there to be a high degree of
uncertainty or opportunity.
Scenario planning would therefore enable UHJ to calculate and examine various
possible strategic outcomes.
the sale of the division, followed by an economic recovery, but the loss of
the VTH order.
(2) Scenario planning will also help the directors to anticipate potential
problems with, or opportunities from, the North American division. For
example, if UHJ waits to sell the division and the VTH order is lost, the
price it achieves from the sale may well be much lower than is currently on
offer. Alternatively, the market may recover in the near future and the sale
of the division now may compromise UHJ’s future growth prospects.
QUALISPECS
Corporate appraisal
A corporate appraisal is an overview of an organisation’s current position. It leads
on from the internal and external analysis undertaken as part of the business
planning process.
As the company works towards achieving its objectives, the corporate appraisal
is a summary of the company’s:
Strengths
– Reputation for quality
Quality is a major reason why people buy products, and continuing to build on
this reputation will ensure customers continue to buy Qualispecs's products.
This helps to improve the image of Qualispecs's products which in turn should
result in higher sales, particularly amongst the younger market that might be
influenced by the sports star.
The group has a new Chief Executive who has joined from a rival, Fastglass.
Fastglass has been a successful and innovative company and the Chief
Executive may be able to bring new ideas and provide a fresh approach.
The group has a good basic infrastructure including many stores and
experienced staff. This allows them to implement new strategies quickly and
easily.
Weaknesses
– Slower dispensing of spectacles
Customer service is worse than competitors in this respect and may be a reason
for the reducing customer loyalty.
Some competitors have successfully sold designer frames. These are likely to be
stylish and trendy compared to Qualispecs' traditional products. Qualispecs may
need to update products more often with the latest designs.
Some competitors have a wider product range than Qualispecs. This provides
more choice which may attract customers and also gives competitors the
opportunity to on-sell products, i.e. selling prescription sunglasses at the same
time as standard spectacles.
In London, for instance, pay may need to be higher to attract the right staff. With
no local control over pay levels, shop managers may find it hard to employ good
staff and hence improve their business.
The use of group-based bonuses means that people cannot be rewarded for
good individual performance. Individuals have little incentive to improve
therefore.
Opportunities
Note: Opportunities should be in relation to the market as a whole. They
therefore need to be available to all competitors in the market.
Fastglass has already done this successfully and Qualispecs could follow suit.
There are likely to be limited suitable partners so Qualispecs must act quickly
before other firms make arrangements with the best partners.
Threats
– Intense competition/eroding customer loyalty
Existing competitors are adopting new strategies with great success (e.g.
Fastglass developed joint ventures). This has resulted in Qualispecs's customers
moving to competitors, thus reducing profits. This is likely to be a continued
threat to Qualispecs who needs to respond.
In the long term, if the downturn continues it will affect all industries and
consumer spending will be likely to fall as people become more defensive in their
spending habits.
– Improve the current lack of clear generic strategy ('stuck in the middle')
Current policies and procedures are demotivating staff and causing varying
divisional performance.
Strengths
Strong financial track record
Life longer than ten years so well established
Good reputation in international marketplace
Increased market share despite market decline
Involved in many overseas markets so experienced
Resourced and competent
Good relationship with Eastlandian government built up over many years
Relationship with other stakeholders likely to be good also
Weaknesses
Opportunities
Threats
Exposed to construction industry
Exposed to Eastlandian government action
Venture partner – local company D – now failed
Unlikely to recover C's funding
Currency exposure and controls needed
10% of turnover on one contract
Financial contingency in contract seems inadequate
General quality and project management problems evident
Committed to Eastlandia and so exit barrier exists
Opportunities
Recovery of funds from supplier of defective materials.
Further projects may arise as competitors in Eastlandia appear to be poor
in terms of competencies.
Preferred status may be conveyed upon C by Eastlandia government.
Threats
Multinational – pressure groups
Reputation may suffer in future
Overseas markets have suffered recession
Eastlandia economic situation – recession likely?
'knock on' effects within the economy
Threat of devaluation
Exchange rate movement – 7.26 to 8.56 = 18% loss in value
Progress payments delayed
Project late so penalty payments likely
Local customers may go bust and bad debt recovery may prove difficult as
C is external to the Eastlandia culture
High PEST risk = higher cost of capital = lower EVA
Impact reduction
Risk reduction – look for business in other countries.
Harvest the Eastlandian projects.
Look to improve the project management process for future projects via a
post completion audit of the current project in Eastlandia. Recruit a suitably
qualified team to undertake the investigation.
Control system review to attempt to improve collection of progress
payments.
Foreign exchange controls – forward exchange contracts.
Local currency loans and other financial sources to be sought.
Recruit senior staff from Eastlandia and have an Eastlandian in charge of
the project as director. Give this individual the appropriate status relevant
for the local culture.
Full corporate analysis of any proposed customers.
Look for guarantees from the Eastlandian government for dubious
customer proposals.
Lobby for local grants and assistance – especially with regard to the local
supplier who provided the poor quality materials.
Full investigation of local partner and detailed legal agreement which
clearly identifies the commitments of both sides in the JV.
This contract should detail when the arrangement will end, and how profits
(and losses) should be shared.
Full research programs and forecasting systems with regard to the future economic and
political issues arising in Eastlandia – an early warning system.
The purpose of the position audit is to act as the starting point for the corporate
appraisal of an organisation. This is an essential part of the strategic
management process as it raises the question - 'where are we now?'.
There are several well-known tools that are available to assist in this process,
one of which is the 'SWOT' analysis. This will identify the strengths,
weaknesses, opportunities and threats as they relate to a particular organisation
and usually involves a listing of points.
Key points
– SWOT analysis is a tool to assist the position audit process. It is not the only
tool: e.g. the competitor analysis framework works well in this context and can
provide a useful framework to analyse a company.
– Position auditing asks the question 'where are we now?' and is viewed by
many as being the starting point for the process of strategic choice.
The review should initially seek to identify what would happen if the organisation
chose to do nothing. Remember this is always a strategic option!
An approach
There are many, many ways that a position audit can be approached. Essentially
you should have one in mind that you would be able to use as a basis for
analysing a situation. Here is a starter
2 Resources
An entity uses resources to provide products or services to its
customers. A resource is any asset, process, skill or item of
knowledge that is controlled by the entity.
2.1 Competences
Competences are activities or processes in which an entity uses
its resources. They are created by bringing resources together
and using them effectively.
Management skills. The core competence of an entity might come from the ability
of its management team.
Knowledge. Knowledge can be a key resource and a core competence is the ability
to make use of the knowledge and ‘know how’ within the entity, to create
competitive advantage.
3 Definition of value
Value relates to the benefit that a customer obtains from a
product or service. Value is provided by the attributes of the
product or service. Customers are willing to pay money to
obtain goods or services because of the benefits they receive.
The price they are willing to pay puts a value on those benefits.
Business entities create added value when they make goods and
provide services. For example, if a business entity buys a quantity
of leather for Rs.1,000 and converts this into leather jackets, which
it sells for Rs.10,000, it has created value of Rs.9,000.
Johnson and Scholes have defined the value chain as: ‘the
activities within and around an organisation which together create
a product or service.’
Within an entity:
there is a primary value chain; and
there are support activities (also called secondary value
chain activities).
3.2.4 Service. These are all the activities that occur after
the point of sale, such as installation, warranties,
repairs and maintenance, providing training to the
employees of customers and after-sales service.
The nature of the activities in the value chain varies from one
industry to another and there are also differences between the
value chain of manufacturers, retailers and other service
industries. However, the concept of the primary value chain is
3.4.6 How can we add to the value that the customer receives?
3.5.2 financial strategy, which should aim to add value for the
shareholders and
The baker makes bread with wheat. This means that the supply chain
starts with the farmers who grow the wheat – the original creator of the
resource. The farmers then sell this wheat to mills, who convert the
wheat into flour. The flour is then purchased by wholesalers who sell
the flour in bulk to larger companies, such as our baker. The baker
makes the loaves of bread and sells it onto the supermarkets, who sell
the bread onto the end consumers (customers).
Note that problems in any part of the supply chain can affect the
baker. For example, if farmers switch from growing wheat to other,
more profitable crops then it will lead to a scarcity of flour on the
market, pushing the baker’s costs up. If the end consumers start to
dislike the types of bread that the baker is selling (for example if the
market shifts away from white bread to brown or granary breads)
then this will affect how many of the baker’s products will be stocked
by the supermarkets.
As such, even though the baker may not directly transact with the
consumer and the farmers, it is still affected by them as they are
part of its supply chain.
It is worth noting that managing the supply chain and moving materials
and products from node to node includes activities such as:
production planning
purchasing
materials management
distribution
customer service
forecasting
In the traditional supply chain model, the raw material suppliers are at one
end of the supply chain.
Although customers are the source of the profits, they are at the end of
the chain in the ‘push’ model.
This new business model is less product-centric and more directly focused
on the individual consumer – a more marketing-oriented approach.
Several personal computer manufacturers allow users to order over the internet
and to customise their machines (for example Lenovo and Dell). PCs are then
made to customers’ orders.
This is a means by which the activities within and around the organisation
are identified and then related to the assessment of competitive strength.
Resources are of no value unless they are deployed into activities that are
organised into routines and systems. These should then ensure that
products are produced which are valued by customers and consumers.
Porter argued that an understanding of strategic capability must start with
an identification of the separate value-adding activities.
These activities are involved in the physical creation of the product, its
transfer to the buyer and any after-sales service. Porter divided them into
five categories:
Support activities
Each of the primary activities are linked to support activities and these can
be divided into four areas:
Generally
The primary and secondary activities are designed to help create the
organisation’s margin by taking inputs and using them to produce outputs
with greater value.
The value chain can be used to:
– identify the key processes within the business that add value to the
end customer – strategies can then be created to enhance and
protect these; and
– identify the processes that do not add value to the customer. These
could then be eliminated, saving the organisation time and money.
Looks at linking the value chains of those in the wider organisational ecosystem –
suppliers and customers – to that of the organisation. Can add value by:
Marks and Spencer plc compete in, amongst other areas, the food and grocery
market. They have configured their value chain in order to offer customers a
differentiated service.
Lidl also operates in the food and grocery market, but their value chain supports
a cost–leadership approach.
A broad portfolio indicates that a business has a presence in a wide range of products
and market sectors, this may or may not be a good thing!
Market growth rate represents the growth rate of the market sector concerned.
High growth industries offer a more favourable competitive environment and
better longterm prospects than slowgrowth industries. The dividing line is set at
10%.
SBUs are entered onto the matrix as dots with circles around the dots denoting
the revenue relative to total corporate turnover. The bigger the circle, the more
significant the unit.
Hold;
Build;
Harvest;
Divest.
Often cost leaders as economies of scale usually earned. Likely that at one
time the cash cow was a Star and has now been subject to declining growth.
Profits from this area can be used to support other products in their
development stage. Therefore the balanced portfolio needs some of these.
5.4 Limitations
Simplistic only considers two variables;
Connection between market share and cost savings is not strong low market
share companies use lowshare technology and can have lower production
costs e.g. Morgan Cars;
Cash cows do not always generate cash Vauxhall motors would be a classic
cash cow yet it requires substantial cash investment just to remain
competitive to defend itself;
Every product has a life cycle, and eventually even the most
successful products reach the end of their economic life.
This means that there is a strategic risk. If a large entity does not
have any entrepreneurs, but its competitors include smaller
entrepreneurial entities, there is a risk that the entrepreneurial
competitors will be more successful.
A large entity can try to deal with this risk in several ways:
Originated with Rank Xerox organisation which had started to lose market share
after many years of market dominance. (Classic example of an organisation not
adapting to its environmental change - the competence slip)
Rank Xerox identified critical areas where it was failing and found a supermarket
chain that had similar business processes in those areas. This chain of
supermarkets was renowned as being the best and Rank Xerox used the
supermarket approach to redesign their own approach. They used the
benchmark as a basis to improve their own performance.
Types of benchmarking
Seber identifies three basic types:-
Internal
– This is where another branch or department of the organisation is used as
the benchmark;
– Used where conformity of service is the critical issue - either threshold or
core competence;
– Easily arranged, cheaper and culturally relevant;
– But, culturally distorted and unlikely to provide innovative solutions.
Competitor
– Uses a direct competitor with the same or similar process;
– Essentially aims to render the competition core competence as threshold;
– Relevant for the industry and market;
– But, will the competitor really be keen to hand over their basis for
success?
Implementing a scheme
This will involve:
(1) Identifying what is wrong within the current organisation;
(2) Identifying best practice elsewhere;
(3) Contacting, preparing for and undertaking a site visit;
(4) Gathering, evaluating and communicating the results.
It will need:
1. Key executive commitment from the outset;
2. Establish teams for those ranges of opinion and expertise;
3. A team to manage the project;
4. A team for the site visit;
5. Budget allocations and training given;
6. Formalised process.
Problems
– Best practice companies unwilling to share data;
– Lack of commitment by management and staff;
– What is 'best practice'?
– Costly in terms of time and money opportunity cost;
– Provides a retrospective view in a turbulent environment - what is
best today may not be so tomorrow.
You must ensure that you can draw the relevant diagram and explain the basics
of each model. However, the key will be to apply them in a scenario.
Benefits
These models provide a useful starting point for the discursive process as
they initiate discussion amongst the management teams;
They are wellknown and as such have credibility. This results in their easy
application with minimal resistance;
They generate options that can be used in the debate and allow
comparison;
They can in some instances be linked to each other to enhance the
analysis;
They can be used simply or be developed into more complicated
applications.
Limitations
They are simplistic most are two by two models;
Given their prominence in management education, undue emphasis tends
to be placed upon them and there is a tendency at times to think that the
models will provide a solution;
They are dated and were produced when environments were very
different;
They tend to suggest that strategic choice is a straightforward process;
They were produced to get their authors published rather than provide a
practical tool.
Once the position has been identified, the organisation will be aware of the
environments and the current strategic capability of the organisation. So the
questions is "What should we do now to enable us to have the best chance of
achieving our objectives?" In other words, which strategy should we follow?
There are many ways to achieve the end result! There is no one strategy that
should be deployed in any given circumstance, rather a range of possible
strategies that could be used singly or jointly.
Porter suggests that competitive advantage arises from the selection of a generic
strategy which best fits the organisation's environment and then organising value-
adding activities to support the chosen strategy.
Competitive Stance
Broad scope c
(Targets whole) Cost leadership Differentiation
market
Strategic
Narrow scope
scope
He argues that organisations can run the risk of trying to satisfy all and end up
being 'stuck in the middle'. This seems to suggest that Porter was advocating
that organisations need to make a basic competitive decision early on in the
strategic determination process.
Value chain analysis is central to identifying where cost savings can be made at
various stages in the value chain. Attainment depends upon arranging value
chain activities so as to:
Benefits:
Products command a premium price so higher margins.
Demand becomes less price elastic and so avoids costly competitor price
wars.
Life cycle extends as branding becomes possible hence strengthening
the barriers to entry.
Value chain analysis can identify the points at which these can be achieved by:
Benefits:
Requires:
Reliable segment identification;
Consumer/customer needs to be reliably identified research becomes
even more crucial;
Segment to be sufficiently large to enable a return to be earned in the long
run;
Competition analysis given the small market, the competition, if any,
needs to be fully understood;
Direct focus of product to consumer needs.
Location;
Type of end user;
Product or product line;
Quality;
If done properly can avoid confrontation and competition yet still be profitable.
The attractiveness of the market niche is influenced by the following:
Illustration 1
Cost Leadership
Casio Electronics Co. Ltd – Casio has sold over 1 billion pocket calculators. It
follows an industry wide cost leadership approach. Its calculators are certainly
not inferior products, being able to perform over two hundred basic scientific
functions. How does it do it? Consider its value chain:
Operations – mass manufactured in China, which has cheaper labour and
economies of scale.
Illustration 2
Differentiation
British Airways (BA) is a multinational passenger airline. It has adopted a
differentiation approach by offering passengers a higher quality experience than
many of its rivals. This allows it to charge a premium for its flights compared to
many other airlines. Again examination of its value chain may help to explain how
it achieves this:
Illustration 3
Focus
Ferrari is an example of a company that focuses on a niche market in the
automobile industry. It produces extremely high quality cars which command a
high premium price. However, this means that Ferrari only has a very small
percentage of the global car market, as the majority of consumers will be unable
to afford its high sales prices.
This is a risk of the focus approach. The niche targeted may be small and fail to
justify the company's attention. In addition the niche may shrink or disappear
altogether over time as consumer tastes and fashions change.
Market leader
In many industries there is a dominant firm which is recognised to be the leading
organisation. It typically has the largest market share and usually provides the
benchmark for others in the industry.
Market challenger
This firm has a smaller market share, adopts an aggressive stance and seeks to
attack other firms which include the leader. Marketing strategies tend to be
confrontational and there is a continual search for new ideas. There is a
tendency to look for 'first mover advantage' in the developing market place.
Market followers
These are less aggressive firms which tend to rely on other members of the
industry to try things out and then 'follow' on after either to pick up the pieces or
follow the success of others. There is less risk and of course less potential for
return. They forego the risk area of the search for first mover advantage in return
for the safety of the follower.
Market nichers
Many industries have a series of small firms who specialise in parts of the market
which are too limited in size and potential to be of any real interest to larger firms.
The classic example that is always mentioned is Morgan Sports Cars. The
nichers' success stems from their ability to build up specialist knowledge about a
particular segment whilst being able to avoid the high costs of head on fights with
leaders and challengers.
4. Pricing decisions
Customers (we should consider how much customers are willing to pay)
market share – often with new products and markets the initial objective
is to achieve a level of market share. This may mean that prices are set
below those of rivals' in order to win customers away from rivals.
cash flow – if a business has cash flow problems it might price products
in order to bring in cash to the business more quickly (e.g. by offering
settlement discounts).
A key problem in achieving this in the real world is in obtaining accurate, up-to--
date information on how much competitors are charging. In some industries
(such as publishing) it may appear to be straight forward as prices are often
openly advertised, listed on websites or even printed on products. However, this
might not disclose bulk discounts given to larger customers or special rates given
to contracted customers. There may even be 'hidden extras' that are not
disclosed as clearly as the advertised price.
Price skimming – high prices are set when a new product is launched.
Later the price is dropped to increase demand once the customers who
are willing to pay more have been ‘skimmed off'.
Loss leaders – one product may be sold at a loss with the expectation that
customers will then go on and buy other more profitable products.
Captive product pricing – this is used where customers must buy two
products. The first is cheap to attract customers but the second is
expensive, once they are captive.
Bait pricing – this is also used by companies with wide product ranges, but
often the lowest priced model is advertised in the hope to attract
customers to the line and hope that they will actually decide to buy a
higher priced item from the range.
Cost plus pricing – the cost per unit is calculated and then a markup
added.
There are techniques for avoiding this image. A sense of fairness must surround
any price increase and customers must be given advance notice so they can do
some forward buying or shop around. Sharp price increases need to be
explained in understandable terms. Companies can also respond to higher costs
or over-demand without raising prices.
Possibilities include:
Shrinking the amount of product instead of raising the price.
Substituting less expensive materials or ingredients.
Reducing or removing features to reduce cost.
Removing or reducing product services such as free delivery and
installation.
Reducing the number of sizes and models used.
Creating new, economy brands.
In reality, shoppers still consider the other elements of the marketing mix. They
expect to achieve some savings when shopping on the internet but they do not
necessarily compare prices or perform extensive price checks. Research shows
that shoppers are loyal and will often return to familiar and trusted sites for their
This emphasises that the other elements of the 7P's model such as the security
processes, the ease-of-use etc. for a website are equally important. CRM will
also play a vital role in creating the site loyalty in the first place.
In previous studies you will have explored cost based strategies such as full cost
plus, marginal cost plus and target ROI.
Advantages Disadvantages
1. easy to calculate 1. less incentive to control costs
2. ensures that a profit is 2. relies on arbitrary overhead
generated apportionments
3. can justify price rises
Advantages Disadvantages
1. better for short-term decision 1. does not ensure that all costs
making are covered
2. avoids overhead 2. shouldn't be used for long run
apportionment pricing
Advantages Disadvantages
1. often used by new products or 1. difficult to determine volume
market leaders required to determine a price
2. consistent with performance per unit
appraisal techniques (so it will 2. if investment is shared between
be liked by managers) products arbitrary allocations
are made
As seen above, relevant cost pricing can sometimes be valid (for example, in
tendering processes). In calculating which costs are relevant, three criteria must
be satisfied:
the cost(s) must be incurred in the future,
only the incremental cost(s) should be included, and
the cash impact only of the cost(s) should be included.
Pricing in economics
Pricing in economics is based on assumptions about demand and supply and the
interaction between these two factors. From a marketing perspective demand will
be more important than supply.
For example, you may remember from previous studies that in an oligopolistic
market – such as international accounting which is dominated by 4 large firms –
the demand curve is kinked and price competition rarely arises. Firms know that
price increases will lose a lot of customers, but price drops will win very few extra
clients.
Demand based pricing is a variable pricing mechanism that changes the price
in order to fit the demand. It results in a high price when demand is high, and low
prices when demand is low. For example, it is used at leisure amenities such as
gymnasiums where prices for using facilities might be higher at 'peak times'
(such as early mornings) and lower when the club typically has less visitors (such
as mid afternoon).
For products with a low elasticity (i.e. where a large change in price only creates
a small increase in volume) the normal strategy is to increase prices slightly so
that overall revenue and profits increase. (The opposite applies when elasticity is
high)
Buyers are slow to change their buying habits and search for lower prices.
Buyers think the higher prices are justified by quality differences and / or
normal inflation.
Long-run price elasticity may differ from short-run elasticity. Buyers may continue
to buy from their current supplier after a price increase because they do not
notice the increase, or the increase is small, or they are distracted by other
concerns, or they do not wish to incur switching costs. But, over time, they may
switch suppliers on the basis of price. Here demand is seen to be more elastic in
the long run than in the short run. Or the opposite may happen, buyers drop a
supplier after being notified of a price increase, but return to the supplier later.
marginal revenue = 0
Again, it can be seen how different objectives can lead to different pricing
decisions.
Product
Existing New
Market Product
Existing
penetration development
Markets
Market
New Diversification
development
(iv) Diversification
Developing new products to serve new markets.
When considering the use of each of these the company should consider:
Pricing
Promotion and advertising
Process redesign e.g. Internet/E commerce
Considered when:
Approach
Add geographical areas: regional and national
Add demographic areas: age and sex
New distribution channels
Company needs to be innovative and strong in the area of R&D and have an
established, reliable marketing database.
1.4 Diversification
New products to new markets the risky option?
Appropriate when existing markets are saturated or when products are reaching
the end of their life cycle. It can spread risk by broadening the portfolio and lead
to 'synergy based benefits' allegedly.
This goes through periods of being in and out of favour and the debate is always
continuing as to whether this is a good strategic option. Critics argue that it is
madness to take resources away from known markets and products only to
allocate them to businesses that the company essentially knows nothing about.
This risk has to be compensated for by higher reward which may or may not
exist.
Reasons suggested:
Possible to 'brand stretch' and benefit from past advertising and promotion
in other SBUs;
Illustration 1
Kellogg’s have repositioned their products through various advertising
campaigns (market penetration). For example, the ‘have you forgotten
how good they taste?’ campaign was to remind adults, who buy cereals
for their children, of the virtues of their product.
Kwik Fit, a motor repair company, took the opportunity to cross sell
insurance to customers on their database who had visited their outlets to
have equipment fitted (product development ‘piggybacking’).
Kaplan now sell their ACCA courses in Eastern Europe and Asia, amongst
other countries, rather than just their traditional UK markets (market
development).
Organic Growth
Organic growth comes from expanding your organization’s output and by engaging in
internal activities that increase revenue. Inorganic growth comes from mergers,
acquisitions, and joint ventures.
It’s more obviously sustainable. Sustainable growth is the ultimate goal of any
company. Without organic growth, there’s no investor interest, little possibility of
becoming an acquisition target, and virtually no chance that the company will
become vibrant enough to sell. Bringing in consistent or growing revenues is a
sign that things are working within an organization and is an important step in
business success.
May decrease your competitive edge. We all know that the best way to succeed
in any industry is to out-play your competitors. If your competitors are growing
There is sometimes a glass ceiling. Businesses that rely on organic growth often
find that they lack the resources to continue to grow in a way that allows them to
achieve their goals. As business and customer needs grow, receivables and
other cash-consuming items and resources grow as well.
Acquisition
Acquisition may be more expensive than organic growth because the owners of
the acquired company will need to be paid for the risks they have already taken.
On the other hand, if the company goes for organic growth it must take the risks
itself so there is a trade off between cost and risk.
For example, sales synergy may be obtained through the use of common
marketing facilities such as distribution channels. Investment synergy may result
from the joint use of plant or raw materials.
An acquisition must add value in a way the shareholder cannot replicate in order
to avoid the risks associated with diversified companies (see Ansoff).
It can block a competitor – if Kingfisher’s bid for Asda had been successful
it would have denied Walmart its easy access to the UK.
Acquisition may be more costly than internal growth because the owners
of the acquired company will have to be paid for the risk already taken. On
the other hand, if the company decides on internal growth, it will have to
bear the costs of the risk itself.
Risk – of not knowing all there is to know about the business it seeks to
buy.
Joint venture
Strategic Alliances
Franchising
Licenses
Agents
Outsourcing
Sharing of costs
Sharing of benefits
Sharing of risks
Ownership of resources
Control / decision making
sharing cost
Alliances can allow participants to achieve critical mass, benefit from other
participants’ skills and can allow skill transfer between participants.
Less risk – forming the alliance reduces the risk of the venture.
Some organisations are trying to retain some of the innovation and flexibility that
is characteristic of small companies by forming strategic alliances (closer working
relationships) with other organisations. They also play an important role in global
strategies, where the organisation lacks a key success factor for some markets.
(iii) Franchising
The purchase of the right to exploit a business brand in return for a capital sum
and a share of profits or turnover.
The franchisee pays the franchisor an initial capital sum and thereafter the
franchisee pays the franchisor a share of profits or royalties.
The franchisor imposes strict rules and control to protect its brand and
reputation.
(iv) Licensing
The right to exploit an invention or resource in return for a share of proceeds.
Differs from a franchise because there will be little central support.
(1) A company has invented a uniquely good ice cream and wants to set up an
international chain of strongly branded outlets.
(2) Oil companies are under political pressure to develop alternative, renewable
energy sources.
(3) A beer manufacturer wants to move from their existing domestic market into
international sales.
Rationalisation
Rationalization is the reorganization of a company in order to increase its
operating efficiency. This sort of reorganization may lead to an expansion or reduction
in company size, a change of policy, or alteration of strategy pertaining to particular
Product Rationalization
Product rationalization is an important part of managing a product’s lifecycle. If products
are not rationalized, their numbers continue to increase, adding complexity and
increased support costs to the company’s bottom line. According to the 80/20 Rule, the
bulk of a company’s revenue and profit (80 percent) comes from a fraction of its
products (20 percent).
Applications Rationalization
(2) Unless the oil companies felt that, because of their size, there was no need
for joint research, development, marketing and lobbying, a strategic alliance of
some sort could be useful. Research costs and findings could be shared.
Together they could bring powerful pressure to bear on governments to, for
example, allow more generous time scales for implementation of the new
technology. Alternatively, the new energy technology could be developed within a
joint venture organisation.
(3) Almost certainly, this company would expand by licensing local brewing
companies to make and distribute its product.
Strategies need to have 'strategic fit' with their environment if they are to be
effective. This 'fit' will be with both their internal and external environments and so
the ability to assess viability relies very much on the reliability of the position audit.
1.1 Suitability
Is the proposed strategy a suitable response to environmental events and trends.
Do we have strategic fit? You should consider whether the proposed course of
action fits with the existing position. Will it cause any problems elsewhere in the
company?
Example
Gucci sought growth in sales and so expanded into lowerpriced goods and stretched its
brand. It also pushed its products in departmental stores and duty free channels. It let its
name appear on many licensed products such as watches and perfumes.
But they soon found that sales in their traditional high priced, high margin segment were
plummeting as their traditional buyers became disillusioned by the fact that Gucci was now
worn by many people thus removing the exclusivity of the product.
1.2 Feasibility
Can the necessary resources and competencies be obtained and the required
changes be implemented? Any new strategy will require change of some kind and
this is likely to meet resistance from some quarters. We will need to question
whether the company concerned has the strategic capability to pursue the course
of action concerned.
So they key questions revolve around:
Don't forget the basic analysis relating to identifying the threshold and core
competencies. Are there any sources of competitive advantage or disadvantage?
1.3 Acceptability
Any proposed strategy will need to be acceptable to the stakeholders of the
organisation, both in terms of "returns" and risk.
All stakeholders will need to be considered relative to their power the more
powerful the stakeholder group, the greater the influence they will have and the
more the strategist will have to consider their views.
Local and national governments may have some concerns about any
strategic proposals with regard to legality and political implications.
Don't forget the public and their ability to form into 'pressure groups'. Ethical
considerations may need to be included in the evaluation.
The first is referred to as the competitive advantage test and raises the questions:
What is it?
How long can it last?
The second question highlights that competitive advantage may not be sustainable,
in other words does the performance measurement system show predicted
improvement?
'The more a strategy fits the enterprise's external and internal situation,
builds sustainable competitive advantage and improves company
performance, the more it qualifies as a winner.'
2 Ratio analysis
The mechanics of ratio analysis are repeated here for revision purposes.
Efficiency ratios
Liquidity ratios
Gearing ratios
Investor ratios
The industry figures may be biased by one or a few very large firms within
the sample.
The companies within the industry sample may span across more than one
industry classification.
The industry figures may be relevant for a different financial period, and
could possibly be out-of-date.
It will be important to react to this data in the same way that we react to data that is
presented in tables or financial statements – that is, to interpret what they are trying
to tell us, and to link these in to the analysis of the organisation's position.
Cost accounting is an approach to evaluating the overall costs that are associated
with conducting business. Generally based on standard accounting practices, cost
accounting is one of the tools that managers utilize to determine what type and how
much expenses is involved with maintaining the current business model. At the
same time, the principles of cost accounting can also be utilized to project changes
to these costs in the event that specific changes are implemented.
However, in a modern production environment, this may not always be the case.
Despite this, the remainder of this chapter relies heavily on standard costing
principles.
CVP analysis makes use of the contribution concept in order to assess the
following measures for a single product:
C/S ratio
The C/S ratio of a product is the proportion of the selling price that contributes to
fixed overheads and profits. It is comparable to the gross profit margin. The formula
for calculating the C/S ratio of a product is as follows:
Breakeven point
The breakeven point is the point at which neither a profit nor a loss is made.
It is also possible to calculate the breakeven point in terms of sales revenue using
the C/S ratio. The equation is as follows:
Margin of safety
The margin of safety is the amount by which anticipated sales (in units) can fall
below budget before a business makes a loss. It can be calculated in terms of
numbers of units or as a percentage of budgeted sales.
Margin of safety:
(in terms of units) = Budgeted sales – Breakeven point sales
A breakdown of KP's profit in the last accounting period showed the following:
Rs 000
Sales 450
Variable costs (220)
Fixed costs (160)
––––
Profit 70
––––
Required:
Calculate the breakeven sales revenue for the business based on its current cost
structure. Use this information to determine the percentage fall in sales that would
be necessary before the company would begin to incur losses.
A quantitative or financial plan relating to the future. It can be for the company as a
whole or for departments or functions or products or for resources such as cash,
materials, labour, etc. It is usually for one year or less.
As part of 'strategy in action', a business will create plans for each SBU, product,
function etc. These plans are often in the form of budgets. The budget sets out the
short-term plans and targets necessary to fulfill the longer-term strategic plans and
objectives.
The budgets will also play a vital role in reviewing and controlling strategic plans.
They will be used to identify and investigate variances and to highlight when a plan
or process is 'out of control'.
Purposes of budgeting
Budgets have several different purposes:
(i) Planning
(ii) Control
(iii) Coordination
(iv) Communication
(v) Motivation
(vi) Evaluation
(vii) Authorization
(i) Planning
Budgets compel planning. The budgeting process forces management to look
ahead, set targets, anticipate problems and give the organisation purpose and
direction. Without the annual budgeting process the pressures of day-to-day
operational problems may tempt managers not to plan for future operations. The
budgeting process encourages managers to anticipate problems before they arise,
and hasty decisions that are made on the spur of the moment, based on
expediency rather than reasoned judgments, will be minimised. Corporate planners
would regard budgeting as an important technique whereby long-term strategies
are converted into shorter-term action plans.
(ii) Control
The budget provides the plan against which actual results can be compared. Those
results which are out-of-line with the budget can be further investigated and
corrected.
(iii) Coordination
The budget serves as a vehicle through which the actions of the different parts of
an organisation can be brought together and reconciled into a common plan.
Without any guidance managers may each make their own decisions believing that
they are working in the best interests of the organization. A sound budgeting
system helps to coordinate the different activities of the business and to ensure that
they are in harmony with each other.
(iv) Communication
Budgets communicate targets to managers. Through the budget, top management
communicates its expectations to lower level management so that all members of
the organisation may understand these expectations and can coordinate their
activities to attain them.
(v) Motivation
The budget can be a useful device for influencing managerial behaviour and
motivating managers to perform in line with the organisational objectives.
(vii) Authorisation
A budget may act as formal authorisation to a manager for expenditure, the hiring
of staff and the pursuit of the plans contained in the budget.
Functional budgets
Sales budget. Budget for future sales, expressed in revenue terms and possibly
also in units of sale. The budget for the organisation as a whole might combine
the sales budgets of several sales regions.
Production budget. A production budget follows on from the sales budget, since
production quantities are determined by sales volume. The production volume
will differ from sales volume by the amount of any planned increase or
decrease in inventories of finished goods (and work-in-progress).
Direct materials usage budget. This is a budget for the quantities and cost of the
materials required for the planned production quantities.
Materials purchasing budget. This is a budget for the cost of the materials to be
purchased in the period. The purchase cost of direct materials will differ from the
material usage budget if there is a planned increase or decrease in direct
materials inventory. The purchases budget should also include the purchase
costs of indirect materials.
Budgeted income statement, cash budget and balance sheet. Having prepared
budgets for sales and costs, the master budget can be summarised as an
income statement for the period, a cash budget (or cash flow forecast) and a
balance sheet as at the end of the budget period.
If the budgeted profit, cash position or balance sheet are unsatisfactory, the
budgets should be revised until a satisfactory planned outcome is achieved.
When a key resource is in short supply and affects the planning decisions, it is
known as the principal budget factor or limiting budget factor.
There are two reasons why this might not be the case. Firstly, it may well be that
the organisation's environment has changed but that the budget has not been
adapted to reflect this. For example, if a budget is based on a 30% forecasted
increase in sales but perhaps a change in legislation means that the product is no
longer as attractive and sales are now only forecasted to rise by 5%. In this case
the budget should be changed in order to reflect the change in the organisation's
environment. Without a change to the budget the organisation would look to be out
of control and unnecessary actions and investigations would be implemented.
The second reason why the budget itself may not be useful for control purposes is
due to the behavioural aspects of budgeting.
Further details
the level of difficulty in the budget. Budgets should be realistic and just tough
enough so that they do not demotivate by being too difficult or present a lack
of motivation by being too easy.
5 Variance analysis
Flexed budgets
Before any meaningful comparison can be made the original budget should be
'flexed' to the actual level of performance.
During the year, because of a celebrity endorsement, the product become very
popular and actual sales and production are 30,000 units (50% above what was
originally expected). The purchasing department has spent Rs 220,000 on
materials and is very concerned about the massive overspend in their department.
Variance groups
Variances can be divided into three main groups:
sales variances
variable cost variances
– material variances
– labour variances
– variable overhead variances
fixed overhead variances
Variance calculations
Sales price variance
A sales price variance shows the effect on profit of the difference between the
standard sales prices for the items sold in a period and the actual sales revenue
achieved. It is calculated as follows:
(a) Standard selling price multiplied by the actual number of units sold, and
(b) Actual selling price multiplied by the actual number of units sold.
(a) the standard direct material cost of the actual production and
(b) the actual cost of direct material.
Note that the material price variance can be calculated either at the time of
purchase or at the time of usage. Generally, the former is preferable.
(a) the standard quantity of material specified for the actual production and
(b) the actual quantity used
(a) the standard direct labour cost of the actual production and
(b) the actual cost of direct labour.
(a) the standard hours specified for the actual production and
(b) the actual hours worked
(a) the standard variable overhead cost of the actual production and
(b) the actual cost of variable production overheads.
The amount of overhead absorbed for each unit of output is the standard fixed
overhead cost per unit. The total cost variance is therefore calculated as follows:
(a) the standard fixed overhead cost of the actual production and
(b) the actual fixed overheads incurred
The fixed overhead volume variance does not occur in a marginal costing system.
The budgeted production is 24,000 units per annum evenly spread throughout the
year, with each calendar month assumed to be equal. March is a bad month in
terms of sales revenue and it is expected that sales will only be 1,700 units during
the month. Fixed overheads were expected to be Rs 144,000 per year and are
absorbed on a labour hour basis.
Actual results for the month of March were that sales were 2,200 units at a price of
Rs 90. There was no change in stock of finished goods or raw materials.
The purchases during the month were 11,300 kg of material X at Rs 2.80 per kg
and 8,300 kg of material Y at Rs 5.30 per kg.4,800 labour hours were worked at a
rate of Rs 8.10 per hour and 1,600 hours at Rs 8.30
The actual variable overheads for the period were Rs 33,000 and the fixed
overheads were Rs 12,500.
The company uses an absorption costing system and maintains its raw materials
account at standard.
You are not required to calculate mix or yield variances as Sam Mendes Ltd does
not sub-analyse the material usage or labour efficiency variances.
Variance investigation
Variances arise naturally in standard costing because a standard cost is a long
term average cost. In any period actual costs may be higher or lower than standard
but in the long run these should cancel out if the process is under control.
poor budgeting
poor recording of cost
operational reasons (the key emphasis in exam questions)
random factors.
It is important to identify the reason for a variance so that appropriate action can be
taken, but time and effort will be wasted if all variances are investigated as many
will arise as a normal part of the process.
Reporting by exception
Variance reports might identify significant variances. This is a form of reporting by
exception, in which particular attention is given to the aspects of performance that
appear to be exceptionally good or bad.
The reason for this approach is that variances each month might fluctuate, with
adverse variances in some months and favourable variances in the next. Provided
that over time, actual results remain close to the standard, monthly variances might
be acceptable.
For example, actual fixed overhead expenditure will not be exactly the same every
month. Budgeted monthly expenditure, on the other hand, might be calculated by
dividing the budgeted annual expenditure by 12. Consequently, there will inevitably
be favourable or adverse expenditure variances from one month to the next,
although over the course of the financial year, actual and budgeted expenditure
should be the same.
The control limits used as a basis for determining whether a variance should be
investigated may be set statistically based on the normal distribution.
Material price
(1) Using a different supplier, who is either cheaper or more expensive.
(2) Buying in larger-sized orders, and getting larger bulk purchase discounts.
Buying in smaller-sized orders and losing planned bulk purchase discounts.
(3) An unexpected increase in the prices charged by a supplier.
(4) Unexpected buying costs, such as high delivery charges.
(5) Efficient or inefficient buying procedures.
(6) A change in material quality, resulting in either higher or lower purchase prices.
(2) Using a different quality of material (higher or lower quality) could affect the
wastage rate.
(5) More efficient work procedures, resulting in better material usage rates.
(6) Changing the materials mix to obtain a more expensive or less expensive mix
than the standard.
Labour rate
(1) An unexpected increase in basic rates of pay.
(2) Payments of bonuses, where these are recorded as direct labour costs.
(3) Using labour that is more or less experienced (and so more or less expensive)
than the 'standard'.
(4) A change in the composition of the work force, and so a change in average
rates of pay.
Labour efficiency
(1) Taking more or less time than expected to complete work, due to efficient or
inefficient working.
(2) Using labour that is more or less experienced (and so more or less efficient)
than the 'standard'.
(3) A change in the composition or mix of the work force, and so a change in the
level of efficiency.
(7) Improvements in efficiency due to a 'learning effect' amongst the work force.
(8) Unexpected lost time due to production bottlenecks and resource shortages.
Overhead variances
(2) Variable production overhead efficiency variances: the causes are similar to
those for a direct labour efficiency variance.
Sales price
Sales volume
Cutting sales prices (adverse sales price variance) might result in higher
sales demand from customers (favourable sales volume variance).
6 Investment appraisal
Due to the large amount of time and resources that can be tied up in a project, it is
important that they are screened properly. Part of that screening will involve an
assessment of the financial rewards that may be derived from the project. You
should be familiar from your previous studies with financial
costs may be removed from the forecasts in order to 'overstate' the case for
the project.
Decision criteria
The ARR for a project may be compared with the company's target return
and if higher the project should be accepted.
Average investment
The average value of the investment represents the average capital
employed over the life of the project.
That is the initial investment plus the residual value, then all divided by two.
Target return
The target return might be determined from a number of sources:
the return from existing, similar projects
the return on investment (ROI) of the business unit
the return on capital employed (ROCE) from the business overall
past returns from projects
the company's cost of capital
Disadvantages
There are a number of specific criticisms of the ARR.
It fails to take account of either the project life or the timing of cash flows (and
time value of money) within that life.
It will vary with specific accounting policies, and the extent to which project costs
are capitalised. Profit measurement is thus ‘subjective’, and ARR figures for
identical projects would vary from business to business.
It is concluded that the ARR does not provide a reliable basis for project evaluation.
This is the time which elapses until the invested capital is recovered. It considers
cash flows only. Unlike DCF techniques, it is often assumed that the cash flows
occur evenly during the year.
Faced with mutually-exclusive projects choose the project with the quickest
payback.
Initial investment
Payback period = ––––––––––––––
Annual cash inflow
A payback period may not be for an exact number of years. To calculate the
payback in years and months you should multiply the decimal fraction of a year by
12 to the number of months.
Advantages
Simplicity
When investment conditions are expected to improve in the near future, attention is
directed to those projects that will release funds soonest, to take advantage of the
improving climate.
– Rapid project payback leads to rapid company growth – but in fact such a policy
will lead to many profitable investment opportunities being overlooked because
their payback period does not happen to be particularly swift.
– Rapid payback minimises risk (the logic being that the shorter the payback
period, the less there is that can go wrong). Not all risks are related to time, but
payback is able to provide a useful means of assessing time risk (and only time
risk). It is likely that earlier cash flows can be estimated with greater certainty.
– Rapid payback maximises liquidity – but liquidity problems are best dealt with
separately, through cash forecasting.
Cash flows
Unlike ARR it uses cash flows, rather than profits, and so is less likely to produce
an unduly optimistic figure distorted by assorted accounting conventions which
might permit certain costs to be carried forward and not affect profit initially.
Disadvantages
Project returns may be ignored – In particular, cash flows arising after the
payback period are totally ignored.
The NPV represents the surplus funds (after funding the investment) earned on the
project. This means that it tells us the impact on shareholder wealth. Therefore:
Decision criteria
Any project with a positive NPV is viable.
Projects with a negative NPV are not viable.
Faced with mutually-exclusive projects, choose the project with the highest
NPV.
If the funds were borrowed at 12% the investor would be Rs 97 out of pocket –
i.e. the investment earns a yield below the cost of capital.
If funds were borrowed at 10% the investor would break even – i.e. the
investment yields a return equal to the cost of capital.
If funds were borrowed at 8% the investor would be Rs 108 in pocket i.e. the
investment earns a return in excess of the cost of capital. In other words, a
positive NPV is an indication of the surplus funds available to the investor now
as a result of accepting the project.
Therefore money has a time value. It can be invested to earn interest or profits, so
it is better to have Rs 1 now than in one year’s time. This is because Rs 1 now can
be invested for the next year to earn a return, whereas Rs 1 in one year’s time
cannot. Another way of looking at the time value of money is to say that Rs 1 in six
years’ time is worth less than Rs 1 now.
Impact of inflation
In most countries, in most years prices rise as a result of inflation. Therefore funds
received today will buy more than the same amount a year later, as prices will have
risen in the meantime. The funds are subject to a loss of purchasing power over
time.
Risk
The earlier cash flows are due to be received, the more certain they are:
there is less chance that events will prevent payment. Earlier cash flows are
therefore considered to be more valuable.
Although in practice many cash flows accrue throughout the year, for discounting
purposes they are all treated as occurring at the start or end of a year. Note also
that if today (T0) is 01/01/20X0, the dates 31/12/20X1 and 01/01/20X2, although
technically separate days, can be treated for discounting as occurring at the same
point in time, i.e. at T1.
Initial investments occur at once (T0), other cash flows start in one year’s time
(T1).
In project appraisal, the investment needs to be made before the cash flows can
accrue. Therefore, unless the examiner specifies otherwise, it is assumed that
investments occur in advance. The first cash flows associated with running the
project are therefore assumed to occur one year after the project begins, i.e. at T1.
is based on cash flows not profits – the subjectivity of profits makes them less
reliable than cash flows and therefore less appropriate for decision making.
Neither ARR nor payback is an absolute measure.
considers the whole life of the project – methods such as payback only consider
the earlier cash flows associated with the project. NPV takes account of all
relevant flows associated with the project. Discounting the flows takes account
of the fact that later flows are less reliable which ARR ignores.
Disadvantages of NPV
However, there are some potential drawbacks:
It requires knowledge of the cost of capital. The calculation of the cost of capital
is, in practice, more complex than identifying interest rates. It involves gathering
data and making a number of calculations based on that data and some
estimates. The process may be deemed too protracted for the appraisal to be
carried out.
Decision criteria
If the IRR is greater than the cost of capital the project should be accepted.
Faced with mutually-exclusive projects choose the project with the higher IRR.
The advantage of NPV is that it tells us the absolute increase in shareholder wealth
as a result of accepting the project, at the current cost of capital. The IRR simply
tells us how far the cost of capital could increase before the project would not be
worth accepting.
If an investment has a positive NPV, it means it is earning more than the cost of
capital. If the NPV is negative, it is earning less than the cost of capital. This means
that if the NPV is zero, it will be earning exactly the cost of capital. Conversely, the
percentage return on the investment must be the rate of discount or cost of capital
at which the NPV equals zero. This rate of return is called the IRR, or the DCF yield
and if it is higher than the target rate of return then the project is financially worth
undertaking.
Advantages
IRR considers the time value of money. The current value earned from an
investment project is therefore more accurately measured. As discussed
above this is a significant improvement over the basic methods.
IRR uses cash flows not profits. These are less subjective as discussed
above.
IRR considers the whole life of the project rather than ignoring later flows
(which would occur with payback for example).
IRR a firm selecting projects where the IRR exceeds the cost of capital
should increase shareholders' wealth. This holds true provided the project
cash flows follow the standard pattern of an outflow followed by a series of
inflows, as in the investment examples above.
Disadvantages
However there are a number of difficulties with the IRR approach:
For example if the cost of capital is found to be 8% (but is actually 8.7%) and
the project IRR is calculated as 9.2% (but is actually 8.5%) the project would
be wrongly accepted. Note that where such a small margin exists, the
project’s success would be considered to be sensitive to the discount rate
(see session 12 on risk).
Non-conventional cash flows may give rise to no IRR or multiple IRRs. For
example a project with an outflow at T0 and T2 but income at T1 could,
depending on the size of the cash flows, have a number of different profiles
on a graph (see below). Even where the project does have one IRR, it can
be seen from the graph that the decision rule would lead to the wrong result
as the project does not earn a positive NPV at any cost of capital.
Project appraisal occurs before a project is undertaken. Its role is to identify the
potential (mainly financial) benefits and costs of the project and provide decision
making criteria.
There are many ways in which risk can be dealt with in decision making. The most
common technique is to attach probabilities to the potential range of outcomes and
calculate expected values from this information.
The expected value is not the most likely result. It may not even be a possible
result, but instead it finds the average outcome if the same event was to take place
thousands of times.
Example
A company expects the following monthly profits:
Year 1
Sales Rs m %
High 40 60
Low 20 40
Year 2
Sales Rs m %
High 80 90
Low 30 10
Sales Rs m %
High 30 20
Low 10 80
Required:
Advantages:
Takes risk into account by considering the probability of each possible
outcome and using this information to calculate an expected value.
Disadvantages:
The probabilities used are usually very subjective.
The EV is merely a weighted average and therefore has little meaning for a
one-off project.
Decision trees force the decision maker to consider the logical sequence of events.
A complex problem is broken down into smaller, easier-to-handle sections. The
financial outcomes and probabilities are shown separately, and the decision tree is
‘rolled back’ by calculating expected values and making decisions. It is important
that only relevant costs and revenues are considered, and that all cash is
expressed in present value terms.
Step 2: Evaluate the tree from right to left carrying out these two actions:
Calculate an EV at each outcome point.
Choose the best option at each decision point.
There are a great variety of not for profit organisations; e.g. public sector health,
education, policing and charities. It is difficult to be specific about how to assess the
performance of a not for profit organisation without knowing what type of
organisation it is. In general terms an assessment of performance must be made in
the light of the stated objectives of the organisation. Thus, for example, in a public
health service one could look at measures such as treatment waiting times,
increasing life expectancy, etc. and although such organisations do not have a profit
motive requiring efficient operation, they should nonetheless be accountable for the
resources they use. Techniques such as ‘value for money’ and the three Es
(economy, efficiency and effectiveness) have been developed and can help to
assess the performance of such organisations.
Because we haven't been given any information on units, we must have to use the
contribution sales revenue technique:
Breakeven point
(in terms of sales revenue) = Rs 313,000
Now that we know the breakeven position we can calculate the margin of safety
(this is what is required in the second element of the question).
This tells us that for the company to fall into a loss making position its sales next
year would have to fall by over 30.44% from their current position.
There are many different ways to calculate variances, of which the following is one
alternative.
Rs
Budgeted Cost 12,000
Actual Cost 12,500
––––––
500 A
––––––
Fixed overhead volume variance
Units
Budgeted output 2,000
Actual output 2,200
––––––
200 F
x Std Fixed Overhead Cost per unit x6
––––––
Rs 1,200 F
––––––
Sales volume profit variance
Units
Budgeted sales 1,700
Actual sales 2,200
––––––
500 F
x Std profit per unit x 17
––––––
Rs 8,500 F
––––––
Sales price variance
Rs
Std selling price 100
Actual selling price 90
––––––
10 A
x Actual No of units sold x 2,200
––––––
Rs 22,000 A
––––––
Favourable Adverse
The overheads are absorbed on direct labour hours and each unit takes 3 hours.
Therefore the budgeted/standard fixed overhead is Rs 2 per hour (Rs 6 ÷ 3 hours).
Year 1
Expected value = (Rs 40 x 60%) + (Rs 20 x 40%) = Rs 32m.
Year 2
Expected value = [(Rs 80 x 90%) + (Rs 30 x 10%)] x 60% + [(Rs 30 x 20%) +
(Rs 10 x 80%)] x 40%
The middle branch of the tree shows the expected value from selling the rights – Rs
40m.
The top branch shows the analysis of the testing decision. It can be seen that there
are many more possible outcomes and also further decisions to made based on
whether or not the tests indicate the presence of oil. Lines that have a double cross
marking on them show the best choice to be made based on expected values.
Advice:
The company should undertake geological tests. If the tests indicate that oil is
present then a drilling programme should be carried out. However, if the tests
indicate that there is no oil then the company should sell the drilling rights.
(b) The main value of a decision tree is that it maps out clearly all the decisions
and uncertain events and exactly how they are interrelated. They are especially
beneficial where the outcome of one decision affects another decision. For example
in the above, the probability of eventual success changes depending on the test
outcomes. The analysis is made clearer by annotating the tree with probabilities,
cash flows, and expected values so that the optimum decisions (based on expected
values) can be clearly seen.
Marketing
Service Marketing
Marketing: products, customers and segmentation
Customer relationship marketing and loyalty
Reviewing the customer portfolio
Databases and marketing
E-marketing
A marketing strategy should be implemented that will help the entity to implement
its competitive strategy within its chosen markets – this is called the ‘marketing
mix’.
With the growth in service industries, the 4Ps have been extended to the 7Ps.
Extra P’s relevant to service industries are:
Physical environment
People
Processes
Service Marketing
The world economy nowadays is increasingly characterized as a service
economy. This is primarily due to the increasing importance and share of the
service sector in the economies of most developed and developing countries. In
fact, the growth of the service sector has long been considered as indicative of a
country’s economic progress.
Economic history tells us that all developing nations have invariably experienced
a shift from agriculture to industry and then to the service sector as the main stay
of the economy.
This shift has also brought about a change in the definition of goods and services
themselves. No longer are goods considered separate from services. Rather,
services now increasingly represent an integral part of the product and this
interconnectedness of goods and services is represented on a goods-services
continuum.
Types of Services
1. Core Services: A service that is the primary purpose of the transaction. E.g.: a
haircut or the services of lawyer or teacher.
Given below are the fundamental differences between physical goods and services:
Goods Services
A physical commodity A process or activity
Tangible Intangible
Homogenous Heterogeneous
There are a number of techniques for marketing a product, but they generally follow
a number of distinct stages:
(5) Marketing mix strategies – developing a unique marketing mix for each
segment in order to exploit it properly.
to identify gaps in the market where consumer needs are not being
satisfied.
to look for opportunities that the organisation can benefit from, in terms of
sales or development of new products or services.
Who are the biggest, most profitable existing customers and who are the
most attractive potential customers?
For example, a food manufacturer will approach supermarket chains very differently to
the small independent retailer, probably offering better prices, delivery terms, use
different sales techniques and deliver direct to the supermarket chain. They might also
supply own label products to the large chain but they are unlikely to be able to offer the
same terms to the corner shop. The benefit of segmentation to the company adopting
this policy is that it enables them to get close to their intended customer and really find
out what that customer wants (and is willing to pay for).
This should make the customer happier with the product offered and, hence, lead to
repeat sales and endorsements.
(ii) Motivation – concerns the customers’ selection and use of their favourite
brands, the elements of the product or service that they value most, the
customers’ objectives and the changes that are occurring in customer
motivation.
(iii) Unmet needs – considers why some customers are dissatisfied and some
are changing brands or suppliers. The analysis looks at the needs not being met
that the customer is aware of.
The market for package holidays can be split up into a variety of different sub-
markets – the family market, the elderly market, the young singles market, the
activity holiday market, the budget holiday market, etc.
Because it would be virtually impossible to provide one single product that would
satisfy all people in all markets, an organisation can tailor its marketing approach
with a specific product and go for:
Once the positioning strategy has been arrived at, the marketing mix will be
formulated.
By blending the different 'P's' of the marketing mix together the organization aims
to satisfy customer's needs profitably.
Place: Where to sell the goods, distribution channels and coverage, stock
levels, warehouse locations.
Processes: These are the systems through which the service is delivered, e.g.
teaching methods used in a university, speed and friendliness of service in a
restaurant.
4 Pricing decisions
Customers (we should consider how much customers are willing to pay)
market share – often with new products and markets the initial objective
is to achieve a level of market share. This may mean that prices are set
below those of rivals' in order to win customers away from rivals.
cash flow – if a business has cash flow problems it might price products
in order to bring in cash to the business more quickly (e.g. by offering
settlement discounts).
A key problem in achieving this in the real world is in obtaining accurate, up-to--
date information on how much competitors are charging. In some industries
(such as publishing) it may appear to be straight forward as prices are often
openly advertised, listed on websites or even printed on products. However, this
might not disclose bulk discounts given to larger customers or special rates given
to contracted customers. There may even be 'hidden extras' that are not
disclosed as clearly as the advertised price.
Price discrimination – different prices are set for the same product in
different markets, e.g. peak/off-peak rail fares.
Price skimming – high prices are set when a new product is launched.
Later the price is dropped to increase demand once the customers who
are willing to pay more have been ‘skimmed off'.
Captive product pricing – this is used where customers must buy two
products. The first is cheap to attract customers but the second is
expensive, once they are captive.
Bait pricing – this is also used by companies with wide product ranges, but
often the lowest priced model is advertised in the hope to attract
customers to the line and hope that they will actually decide to buy a
higher priced item from the range.
Cost plus pricing – the cost per unit is calculated and then a markup
added.
There are techniques for avoiding this image. A sense of fairness must surround
any price increase and customers must be given advance notice so they can do
some forward buying or shop around. Sharp price increases need to be
explained in understandable terms. Companies can also respond to higher costs
or over-demand without raising prices.
Possibilities include:
Shrinking the amount of product instead of raising the price.
3) 'Robin Hood Stickers' are launching a sticker album to tie in with the
popular children's character. The album comes with blank spaces where
children can attach sticky pictures (sold separately) with pictures of
scenes and characters from the stories. The company wants children to
firstly buy their sticker album and then go on to buy the stickers regularly
for the album.
5) James Gower who has just qualified as a plumber in a local town that is
already serviced by 12 other individual plumbers (though due to the size of
the community he should be able to find plenty of willing customers). All
plumbers in the area advertise their services and prices in a local business
directory which the community use when choosing service providers.
7) A building firm who are putting on a new roof to a building in a capital city.
There is a lot of competition but the potential client owns 12 other
buildings in the city which may also need new roofs due to potential
damage caused by recent adverse weather conditions.
In reality, shoppers still consider the other elements of the marketing mix. They
expect to achieve some savings when shopping on the internet but they do not
necessarily compare prices or perform extensive price checks. Research shows
that shoppers are loyal and will often return to familiar and trusted sites for their
purchases. They often buy from the first site that they visit as long as prices are
perceived to be within a reasonable or expected range.
This emphasises that the other elements of the 7P's model such as the security
processes, the ease-of-use etc. for a website are equally important. CRM will
also play a vital role in creating the site loyalty in the first place.
In previous studies you will have explored cost based strategies such as full cost
plus, marginal cost plus and target ROI.
Advantages Disadvantages
1. easy to calculate 1. less incentive to control costs
2. ensures that a profit is 2. relies on arbitrary overhead
generated apportionments
3. can justify price rises
Advantages Disadvantages
1. better for short-term decision 1. does not ensure that all costs
making are covered
2. avoids overhead 2. shouldn't be used for long run
apportionment pricing
Advantages Disadvantages
1. often used by new products or 1. difficult to determine volume
market leaders required to determine a price
2. consistent with performance per unit
appraisal techniques (so it will 2. if investment is shared between
be liked by managers) products, arbitrary allocations
are made
As seen above, relevant cost pricing can sometimes be valid (for example, in
tendering processes). In calculating which costs are relevant, three criteria must
be satisfied:
the cost(s) must be incurred in the future,
only the incremental cost(s) should be included, and
the cash impact only of the cost(s) should be included.
5 Pricing in economics
Pricing in economics is based on assumptions about demand and supply and the
interaction between these two factors. From a marketing perspective demand will
be more important than supply.
For example, you may remember from previous studies that in an oligopolistic
market – such as international accounting which is dominated by 4 large firms –
the demand curve is kinked and price competition rarely arises. Firms know that
price increases will lose a lot of customers, but price drops will win very few extra
clients.
Demand based pricing is a variable pricing mechanism that changes the price
in order to fit the demand. It results in a high price when demand is high, and low
prices when demand is low. For example, it is used at leisure amenities such as
gymnasiums where prices for using facilities might be higher at 'peak times'
(such as early mornings) and lower when the club typically has less visitors (such
as mid afternoon).
For products with a low elasticity (i.e. where a large change in price only creates
a small increase in volume) the normal strategy is to increase prices slightly so
that overall revenue and profits increase. (The opposite applies when elasticity is
high)
Inelastic products are usually ones where there are few substitutes and customer
needs are high (such as utilities and petrol).
Buyers are slow to change their buying habits and search for lower prices.
Buyers think the higher prices are justified by quality differences and / or
normal inflation.
Price elasticity depends on the magnitude and direction of the contemplated price
change. It may be negligible with a small price change and substantial with a
large price change. Price elasticity may differ for a price cut versus a price
increase.
Long-run price elasticity may differ from short-run elasticity. Buyers may continue
to buy from their current supplier after a price increase because they do not
notice the increase, or the increase is small, or they are distracted by other
concerns, or they do not wish to incur switching costs. But, over time, they may
switch suppliers on the basis of price. Here demand is seen to be more elastic in
the long run than in the short run. Or the opposite may happen, buyers drop a
supplier after being notified of a price increase, but return to the supplier later.
marginal revenue = 0
Again, it can be seen how different objectives can lead to different pricing
decisions.
The 6Is of marketing is a summary of the differences between the new media
and traditional media. By considering each of these aspects of the new media,
marketing managers can develop plans to accommodate the characteristics of
the new media.
Illustration 2 – E-marketing
The Amazon.com (or Amazon.co.uk) site provides the following facilities, all of
which can be linked to marketing and customer service, and that help Amazon to
acquire customers, retain customers and increase income from them.
Customers can write reviews and read other people’s reviews of products
promotion, interactivity).
Prices of new and used items are displayed. Prices of new items are
usually lower than conventional shops (price).
7 E-branding
E-branding has become more and more important as companies decide to offer
their services and products online. Website design, corporate branding,
ecommerce and search engine optimisation are critical components in building a
company’s e branding.
E-branding strategies
Organisations have a number of choices about how to handle e-branding.
Carry out exactly the same branding on the website as in other places.
The organisation has to be careful to ensure that the website style, quality
and commercial offers are consistent with the existing brand.
The slight differentiation is often signaled by putting the word ‘Online’ after the
original brand name. For example, ‘Timesonline.co.uk’. This site describes itself
Illustration 3
8.1 Introduction
The objective of CRM is to increase customer loyalty in order to increase
profitability and is thus a key aspect of e-business.
8.2 Definitions
CRM is an approach to building and sustaining long-term business with
customers.
8.3 Research
Research into e-businesses suggests the following.
A. Customer selection
A Customer selection
This includes defining what type of customer is being targeted. What are their
needs and how we can fulfill their needs? This covers the identification or
designing of products according to those needs.
B Customer acquisition
Methods of acquiring customers can be split between traditional offline
techniques (e.g. advertising, direct mail, sponsorship, etc.) and rapidly evolving
online techniques:
(ii) Online PR
Media alerting services – using online media and journalists for press
releases.
Some ads are more interactive and will change depending on user mouse
movements, for example generating a slide show.
It is estimated that 80% of all emails are spam or viruses. Despite this email
marketing can still deliver good response rates. One survey found only 10% of e-
mails were not delivered (e.g. due to spam filters), 30% were opened and 8%
resulted in ‘clickthroughs’. Options for email include the following.
Cold, rented lists – here the retailer buys an email list from a provider such
as Experian.
Cobranded email – for example, your bank sends you an email advertising
a mobile phone.
Ideally the viral ad should be a clever idea, a game or a shocking idea that
is compulsive viewing so people send it to their friends.
Recency, frequency, monetary value analysis (RFM) is the main model used to
classify online buyer behaviour.
(viii) Recency
The time since a customer completed an action – e.g. purchase, site visit,
email response.
(ix) Frequency
A related concept is latency – the average time between actions – e.g. the
average time between first and second purchases.
Together these allow the firm to put in place triggers that alert them to
behaviour outside the norm. For example, a customer may be taking
longer than normal between first and second purchases. This could
indicate that they are currently considering a purchase prompting the firm
to email or phone them with relevant offers.
C Customer retention
Customer retention has two goals:
to keep customers
to keep customers using the online channel
(ii) Tangibles
For online quality the key issue is the appearance and appeal of websites
– customers will revisit websites that they find appealing.
This can include factors such as structural and graphic design, quality of
content, ease of use, speed to upload and frequency of update.
(iii) Reliability
For online service quality, reliability is mainly concerned with how easy it is
to connect to the website.
If websites are inaccessible some of the time and/or emails are bounced
back, then customers will lose confidence in the retailer.
This could relate to how long it takes for emails to be answered or even
how long it takes for information to be downloaded to a user’s browser.
(v) Assurance
(vi) Empathy
Most people would assume that empathy can only occur through personal
human contact but it can be achieved to some degree through
personalising websites and email.
(3) Delivering the service promise to ensure that a service quality gap does
not exist.
Given the above consideration of service quality, firms use the following
techniques to try to retain customers.
D Customer extension
Customer extension has the objective of increasing the lifetime value of a
customer and typically involves the following.
For example, having bought a book from Amazon you could be contacted
with offers of other books, DVDs or DVD players.
Reactivate customers who have not bought anything for some time.
Key to these are propensity modeling and the ‘sense, respond, adjust’ model.
Historically, marketing has focused on the first two elements in the lifecycle
(selection and acquisition) at best. CRM aims to extend marketing over all four
stages and build a lasting relationship with customers which creates loyalty and
keeps them coming back for more.
relationship marketing seeks to create new value for customers and then
share it with these customers.
relationship marketing recognises the key role that customers have both
as purchasers and in defining the value they wish to receive.
relationship marketing businesses are seen to design and align
processes, communication, technology and people in support of customer
value.
Illustration 4
The online aspects (there are many others) of SAP’s CRM module includes the
following features:
(i) E-marketing
(ii) E-commerce
(iii) E-service
Measures and optimizes the success of Web shop and online content.
Diary entries to remind the organisation to carry out agreed tasks for the
customer.
A top level football team wants to introduce a credit card for supporters. Explain
how CRM software could help the business in the customer selection process.
Database Marketing
Such databases include customers’ names and addresses, phone numbers, e-mails,
purchase histories, information requests, and any other data that can be legally and
accurately collected Information for these databases might be obtained through
application forms for free products, credit applications, contest entry forms, product
warranty cards, and subscriptions to product newsletters.
Database marketing is particularly useful for large firms, which have large customer
bases that generate huge amounts of transaction data. The larger the initial data set,
the more opportunities that exist to find groups of customers and/or prospects that can
be reached with customized communication.
However, careful database analysis can produce many other lists of customers based
upon other activity, who will be just as (or more) likely to respond to a particular direct
marketing message. The whole point of database marketing is to make sure that
marketing communications are being directed toward the most receptive groups.
Such data comes from a number of sources. Many businesses collect data as part of a
typical business transaction. For example, since finance and insurance companies
already must collect name, address, and other information for a sale, it takes little extra
effort to retain this information in a database. Online retailers can also easily collect
such information, as well as purchase histories; offline retailers may use club-card
systems to accomplish the same thing. Additional data comes in from customer service,
which can keep a record of all their customer communications. Meanwhile, marketing
and sales leads create additional customer records.
Larger companies will often manage all the data they collect from varying sources
through a data warehouse. The warehouse receives diverse data sets from different
departments and companies, integrates it into one mega-database (often several
terabytes in size), and then parses it back out into smaller databases used for various
functions. The use of a data warehouse allows a business to process much greater
amounts of data—and again, the more data available, the more opportunities for finding
groups of customers that will respond to a customized message.
At this point the real work of database marketing is done. Database analysts develop
programs for filtering and mining the data for actionable information. They may segment
customers based upon a number of different demographic and behavior factors. For
example, they might use RFM analysis—segmenting groups by how recent, frequent, or
how much monetary value customers’ purchases are. They may also use statistical
models, such as logistic regression, to predict future behavior and create customer lists.
In addition to direct marketing, database information can also be used in some systems
to pull up customer information while interacting with the customer (known as real-time
business intelligence), which allows for greater personalization. Additionally, databases
fuel Customer Relationship Management (CRM) systems, which use the information to
present personalized offerings of products and services.
The extent to which database systems can be effectively employed depends upon a
number of factors—how up-to-date the information is, what analytics are used, and the
software network and level of connectivity in the business. Major information technology
companies, such as Google and Apple, are most effective at using their databases for
real-time intelligence and personalization of business.
(1) The most appropriate strategy for this product would be price skimming. The
product should start with a high price and this price should be gradually
reduced as new rivals enter the market and the technology matures. There is
no need for repeat business or loyalty as consumers are only likely to buy
one product and may not replace this for a number of years. These are the
typical market conditions for price skimming.
(2) This product is going to need to two things from its customers in order to be
successful – an initial interest and awareness, and then longer-term repeat
business. These are typical conditions for price penetration. The magazine
should start with an initial low price (possibly even as a 'loss leader') in order
to establish an initial reader base. Then as further issues are released these
could be increased to the normal issue price (when a new pricing strategy
such as perceived value pricing might be more appropriate).
(4) The production cost of the product will be largely irrelevant (although,
obviously, the selling price must at least cover this cost). As a high-end
manufacturer the company will have an image and reputation to project and
protect. They are likely to use perceived value pricing and play on
consumers perceptions of their products. Consumers will expect the price to
be high to reflect perceptions on the quality of materials and the production
methods used. The product is likely to be sold at 3 or 4 times its production
cost.
(5) The most appropriate strategy in this scenario is likely to be to use going rate
pricing. If James charges too high a price then customers (who are likely to
price conscious) will choose James' rivals. If James charges a price below
that of rivals then rivals are likely to match this price to the detriment of all
plumbers in the area. In this scenario of almost perfect competition, it is likely
that there will be one market price and James and his rivals will have to use
other elements of the marketing mix to acquire customers.
(6) This scenario is one where price discrimination could be used. For example,
the airline could discriminate on the basis of the timing of the booking. Those
people who book their flights early could pay low prices, but those who pay
later could pay progressively higher prices as the departure date of the flight
approaches. For example, if a flight is booked with only one day’s notice,
then the buyer is likely to be putting a high perceived value on the flight. This
should be reflected by having a high price for the flight.
(7) Tender processes usually involve an element of cost based pricing. Because
this contract might lead to further work in the future the builder might even
forego any margin and quote at the relevant cost (this concept is explored in
the next section) of the job to ensure an incremental break even position.
The builder might consider a loss leader approach to the project but this has
a number of difficulties – if no further tenders are won then the builder is left
to carry the loss, and if further work is won it may be harder to justify
significantly higher prices in the future.
The CRM software is likely to hold a lot of data on supporters (customers) that
could be used in the customer selection process, such as:
Customer address and zip/post code. This might allow the company to
target supporters who live in wealthy areas.
Payment method used. Customers who have previously used a credit card
as a payment method may be more likely to sign up for a new credit card.
Items purchased. Customers who have spent large sums in the past (for
example, for season tickets) might be more inclined to use credit cards.
Age. Due to legal rules, credit cards may only be targeted at customers of
a particular age.
Contact details. If email addresses are held then these provide a route to
electronic marketing.
Strategic management (SM): is the way an organization maps the strategy of its future
operations. The term strategic points to the long-term nature of this mapping exercise
and to the large magnitude of advantage the exercise is expected to give an
organization.
Information technology contributes to strategic management in many ways:
Information systems;
Information technology;
Information management.
(i) IS strategy
An effective IS strategy may be formed with the key objectives of using the
information resource and generating new businesses;
(ii) IM strategy
(3) Control - issues relate to the relationship between IT and finance. Key
management activities are performance measurement and investment
appraisal of IT.
(4) Technology - is related to priorities of the IT strategy, e.g. the design and
development of methodologies for IT, security practices and data
management techniques.
(iii) IT strategy
Marketing
In order to meet the critical success factors in target segments and develop
sustainable competitive advantage over competitors, information is needed.
Complete – managers should be given all the information they need, but
information should not be excessive.
Cost effective – the value of information should exceed the cost of producing it.
Sources of information
Internal sources - considered to be more reliable as it is known:
Narrow focus;
Cultural distortion of issues.
3 Data warehousing
It is:
A database;
A data extraction tool;
A decision support system;
Other analysis tools which extract data from the organisation's production
database, reformat and load it into a database designed for querying with an
on-line analytical processing systems (OLAP). OLAP allows users to
dynamically extract pertinent summary information.
For very large enterprises, the act of centralising all data in a single data
warehouse may not be feasible or may even be logically impossible.
There are many different definitions of data mining. Almost all of them involve
using advanced analytical techniques to discover useful relationships in large
databases. Some people's definition of data mining is linked with their definition
of data warehousing. Data warehouses are for storing data, not turning it
into information, whereas data mining turns data into information.
For example, the sales records for a particular brand of tennis racquet might, if
sufficiently analysed and related to other market data, reveal a seasonal
correlation with the purchase of golf equipment by the same people.
Associations - when one event can be correlated to another event, e.g. beer
purchasers buy peanuts a certain percentage of the time;
Sequences - one event leading to another later event, e.g. a rug purchase
followed by a purchase of curtains;
With relatively small amounts of data, the specialist data warehouse software
and hardware will not be required, as downloading subsets of data from
production systems to PCs is a workable solution. However, many
organisations need to manage large amounts of data which, when properly
analysed, can provide information that leads to competitive advantage.
Disadvantages
The systems used in different departments will often be incompatible, and that
is likely to mean that data is in a wide variety of different formats;
The data will need to be analysed and 'cleansed' before it can be integrated
into a warehouse. This will not be easy, quick or cheap to achieve;
Incompatible systems may mean that most of the departments will need to be
furnished with new hardware and software before they can use the data
warehouse. This is likely to be expensive and disruptive to the day-to-day
work of each department;
Almost all staff who wants to use the new system will need training;
Individual departments may use data in widely different ways and require all
manner of different reports. It could be very difficult to create a common
interface that is capable of delivering information in every format that may be
required. Report formats that are only needed in a single department may not
be catered for, and this may cause resentment;
With all data in a single main source, it is vital to ensure that effective back-up
arrangements are made and strictly adhered to.
Illustration 1
Tesco is the UK’s largest supermarket with a 30% market share. In addition it
has global interests and is now the world’s second most profitable retailer. One of
the reasons for the company’s success is its loyalty card, the Club card.
The Club card is used to gather information about the spending patterns of
Tesco’s customers. Around five billion pieces of information each week are
captured, and this number is constantly growing.
At one Tesco store where this approach was adopted, turnover rose by 12%.
5 Knowledge management
(1) Human capital which comprises: human resources - the knowledge, skills
and experience possessed by employees can be easily overlooked in
times of crisis, just when it is most needed; this knowledge is vital to all
service companies.
(i) Networks
Most organisations hook their PCs and other computers together in local area
networks (LANs), enabling them to share data and peripherals such as printers.
LANs may be grouped together into 'work groups' which, in addition to sharing
information and software facilities such as electronic mail, can run software such
as groupware and/or an Intranet.
(ii) Groupware
Groupware is a generic term for software that helps work groups to collaborate
on projects. For example a groupware system might have the following features
for individual time management.
– A scheduler or calendar allowing users to timetable their activities for the day
and plan meetings with others. It will also be able to generate reminders, for
example when a deadline is approaching, or the date of a meeting;
– An address book;
(iii) Intranet
An Intranet is a private network that is contained within an organisation. It may
consist of many interlinked local area networks and also use leased lines in the
wide area network. Typically, an intranet includes connections through one or
more gateway computers to the outside Internet.
(iv) Extranet
An Extranet is a private, secure extension of the enterprise via the corporate
Intranet. It allows the organisation to share part of its business information or
operations with suppliers, customers, and other business partners using the
Internet. For example, an organisation could connect its browser-based purchase
order system to the product catalogue database on a supplier's Intranet.
Illustration 2
It is inevitable that some data will have to be transferred into a new common
format and this can lead to errors, omissions and inconsistencies if not done
with great care.
In certain systems it is possible that older information will not be held in digital
form at all, or not in a format that can easily be converted into a suitable
modern equivalent. Examples include architect's drawings, medical notes
written by hand and so on.
A decision is needed about how to archive this material. Will individual older
systems be maintained and thoroughly indexed, or will it be accepted that
such material has to be recreated from paper records on an ad hoc basis, if it
is ever needed? Will archives be held locally or centrally?
There are social barriers to information sharing. For some staff the notion of
making their information available to other staff in other offices may be
difficult. They will have their own established and familiar methods of
organising their information and may even refuse to change their current
practices to fall in line with a centrally-imposed system.
PR UNIVERSITY
The PR University provides tuition to degree level to 12,000 students, both on
campus and by distance learning courses. The University has 34 different
departments, each of which specialises in one specific area, such as economics,
geography or astronomy.
Over the past 10 years, information systems have been developed in each
department to meet the specific needs of that department. However, the systems
are incompatible with each other and use a wide range of software applications.
The Board of Management of the University has decided that the University
should develop and implement an integrated database for future information
requirements and place all existing data into a single data warehouse.
Moreover, any new system must meet the information requirements of the central
database as well as those of the individual departments.
(ii) Explain how the Board of Management should use Critical Success Factors
(CSFs) in revising the current information system.
(8 marks)
(b) Discuss the disadvantages of data warehousing with specific reference to the
situation at the PR University.
(10 marks)
(Total: 25 marks)
M-HK
M-HK provides a passenger ferry service between two large cities separated by
the mouth of a major river. The ferries are frequent, well-supported by
passengers and cover the distance between the cities in one hour. M-HK also
transports passengers and goods by water ferry to other cities located on the
river mouth. There are other ferry operators besides M-HK providing services
between each of these locations.
Required:
(a) Explain what strategic information is required by M-HK's management in
respect of customer demand, competition, competitiveness and finance in order
to plan its future ferry services.
(10 marks)
(b) Using the information in your answer to part (a), discuss how M-HK's
chartered management accountant should provide reports to M-HK's senior
management for operational and strategic planning purposes.
(15 marks)
(Total: 25 marks)
PR UNIVERSITY
(a)
(i) Data use within the University
Although the data needs of individual departments are being met there are a
number of problems that make information systems in the University as a whole
cumbersome and expensive.
Above all the problem is duplication, both of effort and of data. The same data
has to be input separately to the system of each department in which a student
On the other hand staff will be used to their own systems and may resent or
resist any centrally-imposed change that requires them abandon a working
system and learn new skills.
The aims of individual departments are likely to be broadly similar - for instance,
to attract sufficient numbers of students, provide X number of teaching hours per
week, achieve certain standards in terms of exam results and future
employability of graduates. Some departments may also have research interests
and goals.
The Board of Management can establish CSFs in each of these areas and then
identify suitable performance indicators that will show whether CSFs are being
met. This in turn will help to define what information will be needed in the future
to monitor whether CSFs are being achieved.
The data will either need to be analysed and 'cleansed' before it can be
integrated into a warehouse, or else some kind of middleware will be required,
probably converting all data to a common format such as XML. Whichever option
is chosen, with 34 different departments this will not be easy, quick or cheap to
achieve.
Incompatible systems will also mean that most of the departments will need to be
furnished with new hardware and software before they can use the data
warehouse. This is likely to expensive and disruptive to the day-to-day work of
each department.
Moreover almost all staff who want to use the new system will need training, both
in the use of the data warehouse itself, and probably also in the use of new
hardware, operating systems and applications software.
Even if the above problems are overcome, scalability is a key issue. As the new
system proves its worth more and more demands will be made of it, so ongoing
maintenance, adequate network bandwidth, sufficient storage space, and highly
flexible upgrade capability are all essential.
Finally it is worth pointing out that with all the University's data in a single main
source it is vital to ensure that effective backup arrangements are made and
strictly adhered to. Depending on how the data warehouse is implemented, loss
or serious corruption of data could be disastrous.
MHK
Approach
Brief introduction with regard to data sources - internal vs. external. Then group
answer around the four areas.
Demand
Segment volumes and prices
Price elasticity
Timing of demand (rush hour?)
Research - forecast growth/decline in numbers by segment
Competition
PROSAC
Who are they?
How do they compete?
Where do they compete?
Customer perceptions of them
Finance
Funding needs
Sources of finance
Cost of capital
Costing of product
Contribution analysis - actual, forecast and budget
6 E-Business
Porter suggested three ways in which IS/IT in general can affect the
competitive environment and an organisation’s ability to compete. Though
these points apply to IS/IT in general, they are particularly important when
considering e-business.
New businesses might become possible. For example, auction sites
and photo album sites.
Stage Characteristics
1 Web presence
Static or dynamic web-pages but no transactions are carried out. Would show inf
ormation about the organisation, products, contact details, FAQs (Frequently Ask
ed Questions). Faster updates are possible than with paper-based information an
d could be cheaper than paper-based catalogues.
2 E-commerce
Buying and selling transactions using e-commerce. Might cut out middlemen, but
there is probably no fundamental change in the nature of the business.
3 Integrated e-commerce
Integrated e-commerce. For example, information can be gathered about each cu
stomer's buying habits. This can allow the organisation to target customers very p
recisely and to begin to predict demand.
4 E-business
E-business is now fundamental to the business strategy and may well determine
the business strategy.
This model helps businesses to understand where they are in the process of
e-business, and this will help them to decide where to go next with further development.
Illustration 3 – E-business
Many supermarkets now offer a home-delivery service. Over the internet,
inventory lists are displayed on customers who fill an electronic ‘shopping
trolley’ and proceed to payment and checkout. A delivery period is chosen
(say 4pm–6pm) for the following day. Supermarket staff pick the goods
chosen and pack them for delivery.
Standard shopping lists can be set up by users to speed up the process. The
standard lists can be amended each time (for example, extra milk, but no
carrots).
technophobia
security concerns
set-up costs
running costs
limited opportunities to exploit e-business
limited IT resources in house
customers not likely to be interested in e-business
6.6 Explanation
Technophobia. Senior managers are distrustful and skeptical about the
alleged benefits of e-business.
Set-up costs. Simple, static pages are cheap to set up, but dynamic
pages, linking to e-commerce systems and databases, with impressive
design values are expensive to set up.
Search – Provide users with the ability to search your website for
words, phrases and/or provide them with key topics from which to
choose. Consider in what format the results are to be presented.
‘Members only’ section to the site – Is there a section that can only be
accessed via a user name and password? Where are the user names
and passwords to be stored? How will you handle people who forget
their password?
Links to other sites – How many and what tools are to be employed
during maintenance to check automatically on the veracity of the link?
Text-only version of the site – Will you need a text-only version of the
website for customers who are visually impaired or with a
slow/expensive connection?
Provision for printing and bookmarking (i.e. allowing users to store the
website address in their browser’s memory or ‘favourites’ section) –
Are users to be able to bookmark specific pages or is the home page
sufficient? Do you want any special print function other than the
default function supplied by the browser?
Although the term Web 2.0 suggests a new version of the World Wide Web, it
does not refer to an update to any technical specifications, but rather to
cumulative changes in the ways software developers and end-users utilize
the Web. Whereas Web 1.0 was primarily concerned with the Web as a
source of information, Web 2.0 is seen as the "participatory web" and
includes the emergence of web-based communities, hosted services, and
applications such as social-networking sites (e.g. Facebook), video-sharing
sites (e.g. YouTube), wikis and blogs.
For example, Fortiva offer an e-mail archiving service that complies with
US legal requirements.
For example, estate agent websites can now include interactive maps
where users can see precisely where available properties are and also
check local government information on school catchment areas and
environmental issues such as flooding.
Using global network effects - The network effect is the effect that one
user of a good or service has on the value of that product to other people.
A good example of this is the online auction site ebay - the more people
use it the more attractive membership becomes.
GOOD SPORTS
Good Sports Limited is an independent sports goods retailer owned and
operated by two partners, Alan and Bob. The sports retailing business in the
UK has undergone a major change over the past ten years. First of all the
supply side has been transformed by the emergence of a few global
manufacturers of the core sports products, such as training shoes and
football shirts. This consolidation has made them increasingly unwilling to
provide good service to the independent sportswear retailers too small to buy
in sufficiently large quantities. These independent retailers can stock popular
global brands, but have to order using the Internet and have no opportunity to
meet the manufacturer's sales representatives. Secondly, UK's sportswear
retailing has undergone significant structural change with the rapid growth of
a small number of national retail chains with the buying power to offset the
power of the global manufacturers. These retail chains stock a limited range
of high volume branded products and charge low prices the independent
retailer cannot hope to match.
Good Sports has survived by becoming a specialist niche retailer catering for
less popular sports such as cricket and hockey. They are able to offer the
specialist advice and stock the goods that their customers want. Increasingly
since 2000 Good Sports has become aware of the growing impact of
e-business in general, and e-retailing in particular. They employed a
specialist website designer and created an online purchasing facility for their
customers. The results were less than impressive, with the Internet search
engines not picking up the company website. The seasonal nature of Good
Sports' business, together with the variations in sizes and colours needed to
meet an individual customer's needs, meant that the sales volumes were
insufficient to justify the costs of running the site.
Required:
(a) Provide the partners with a short report on the advantages and
disadvantages to Good Sports of developing an e-business strategy and the
processes most likely to be affected by such a strategy.
(15 marks)
(b) Good Sports Limited has successfully followed a niche strategy to date.
Assess the extent to which an appropriate e-business strategy could help
support such a niche strategy.
(10 marks)
(Total: 25 marks)
Unlike many other resources, IS/IT evolves very quickly and will often play a
large part in determining corporate strategy. On a SWOT analysis IS/IT can
appear in any of the four quadrants and the appropriate responses have to
be made. For example:
(i) Threat of entry – new entrants into a market will bring extra capacity and
intensify competition. The strength of the threat from new entrants will depend
upon the strength of the barriers to entry and the likely response of existing
This then allows for ‘data mining’ – the extraction of relevant data from the
warehouse as the source for target marketing drives. It was reported recently
that Tesco, the UK’s largest supermarket group, was mining its customer
data to identify customers over the age of 60 who regularly purchased
children’s clothes, food and toys – possibly leading to a marketing push
aimed at grandparents.
Reducing the suppliers’ power to control the supply can erode this power.
Where an organisation is dependent on components of a certain standard in
a certain time, IT can provide a purchases database that enables easy
scanning of prices from a number of suppliers. Suppliers’ power can be
shared so that the supplier and the organisation both benefit from
performance improvements. The Ford Motor Company set up CAD links with
its suppliers with the intention of reducing the costs of design specification
and change. Both the time taken and the error rate were reduced because
specifications did not have to be rekeyed into the suppliers’ manufacturing
tools.
Examples
Inbound · Stock Control - MRP, ERP, JIT
Logistics · Automated Warehousing - Bar-coding systems
· Virtual Warehouses - several outlets having each
connected to a system which indicates the total amount
of stock available at different sites
Infrastructure
Collaborative workflow
Intranets
Electronic scheduling
Office automation systems
ERP - Enterprises Resource Planning: these systems are used for identifying and
planning the enterprise-wide resources needed to record, produce, distribute and
account for customer orders.
McFarlan's grid
(a) Support
– Information systems (IS) have a support role - a necessity to the
working of the organisation. IS have little relevance to the
organisation's existing or future success;
– May include accounting operations and payroll but there are no new
developments which can contribute significantly to the
competitiveness of the organisation;
(b) Factory
– The organisation depends heavily on IS for operations. However there
is little scope for future development and further IT developments are
not likely to add to their competitive edge;
– Some airlines and retailers would come into this category; Earl
mentions a steelworks with an on-line real time system for controlling
production. Even one hour of disruption to these organisations
booking systems or order processing systems could fundamentally
damage their competitive performance.
(c) Turnaround
– Existing IT is not too important but future developments are likely to
have a significant impact. Companies recognise the growing
importance of IT as a means to improve competitive position;
– They have applications which they rely on for the smooth running of
their day-to-day activities and they have future developments which
are vital to their competitive success and are integral to the
organisation's strategic objectives. The future is shaped by potential IT
activity. A substantial IT budget can be expected;
– Banks and insurance companies are typical of this sector. Earl cites a
credit card company and a major bank as examples.
GOOD SPORTS
(a) To: Good Sports Limited
From: xxxxx
E – Business strategy
Clearly, the markets that Good Sports operates in are being affected by the
development of e-business and its experiences to date are mixed to say the
least. In many ways the advantages and disadvantages of e-business are
best related to the benefit the customer gets from the activity.
– Fourth, there is far greater ability for interaction with the customer,
which enables customisation and a dialogue to be developed.
The Internet has tended to weaken industry profitability and made it more
difficult to hold onto operational advantages. Choosing which customers you
serve and how are even more critical decisions.
However the personal advice and performance side of the business could be
linked to new ways of promoting the product and communicating with the
customer. The development of customer communities referred to above
could be a real way of increasing customer loyalty. The partners are anxious
to avoid head-on competition with the national retailers. One way of
increasing the size and strength of the niche they occupy is to use the
Internet as a means of targeting their particular customers and providing
insights into the use and performance of certain types of equipment by local
clubs and users. There is considerable scope for innovation that enhances
the service offered to their customers. As always there is a need to balance
the costs and benefits of time spent. The Internet can provide a relatively
cost effective way of providing greater service to their customers. There is
little in the scenario to suggest they have reached saturation point in their
chosen niche market. Overall there is a need for Good Sports to decide what
and where its market is and how this can be improved by the use of
e-business.
All of the following technologies could help either to save costs or provide
enhanced (and differentiated) service.
Managing projects
Lean systems
Organisation structure
Project
A project is a unique undertaking to achieve a specific objective.
A project has a defined beginning and end. Resources like staff and funding are
allocated specifically for the length of the project.
Once completed, it should then become integrated into the normal day to day
activities of the business.
Programme
A programme is ongoing. It is part of what the organisation does both now and in
the future. A programme is part of the organisation's mission and not something
that might be considered an afterthought. A programme receives ongoing
funding. It has people to attend to it ongoing basis.
Programme management
Programme management is the overall direction and control of this portfolio of
projects. It includes the management of the interrelationships between the various
projects, where appropriate, including the management of shared resources,
conflict resolution, high level reporting, etc. Thus, the key to programme
management is coordination and ensuring that those involved in the individual
projects understand the overall aim of the organisation. Programme management
requires the same skills and capabilities as project management, with the added
requirement of understanding the bigger picture. Also, it is likely that the
Programme Manager will be dealing with people at Board level as well as other
senior managers.
Characteristics of a project:
Stakeholders
Uniqueness
Objectives
Deliverables
Resources
Schedules
Quality
Uncertainty
Finiteness
Change
Every project has constraints. The primary ones are the trade-off between time,
cost and quality. These are often referred to as the “project triangle”:
Project constraints
financial
time
quality
legal
ethical
environmental
logic constraints
indirect effects
politics
An alternative five stage project life cycle based on the Project Management
Institute's 5 Project Management Process Areas identifies the stages as:
Initiation
Planning
Execution (implementation)
Controlling
Completion
Use a personal example, such as a holiday, to describe the stages of the project
lifecycle.
Discover
– What gives the current system life?
– Appreciate good things about the current system/culture
Dream
– What might be?
– What is the environment/customer/organisation crying out for?
– Envisage the results of the project
Design
– What is the ideal solution?
– Design elements/components and assemble them
Deliver
– Plan for continuous improvement
The model highlights how a change made in any one of the S factors will have an
impact on all the others. Thus if a planned change is to be effective, then
changes in one S must be accompanied by complementary changes in the
others.
(2) Project Scope Management – processes for ensuring that the project
includes all the work required and only the work required to complete the
project successfully.
(4) Project Cost Management – processes for ensuring that the project is
completed within the approved budget. All projects must have a budget.
(5) Project Quality Management – processes for ensuring that the project will
satisfy the needs for which it was undertaken.
7 Lean systems
Many organisations are facing business environments that are changing in some
or all of the following ways:
increasing competition
greater globalisation
more rapid change (dynamism)
increasingly complex
greater perceived risk
Four principles
Minimise waste
Perfect first time quality
Flexible production lines
Continuous improvement
While there are a number of specific tools that organisations use to implement
lean production systems, the six core methods listed below are most typically
used. Most of these lean methods are interrelated and some can occur
concurrently. Implementation is often sequenced in the order presented below.
Most organisations begin by implementing lean techniques in a particular
production area or at a pilot facility and then expand use of the methods over
time.
The basic elements of JIT were developed by Toyota in the 1950s, as part of the
Toyota Production System (TPS). JIT is based on the Kaizen philosophy of
continuous improvement.
Implementation issues
Although it might be difficult to argue against the philosophy of JIT, there can be
problems with applying the theory in practice.
JIT makes the organisation far more vulnerable to disruptions in the supply
chain.
JIT was designed at a time when all of Toyota’s manufacturing was done
within a 50 km radius of its headquarters. Wide geographical spread,
however, makes this more difficult.
This philosophy implies that small, incremental changes routinely applied and
sustained over a long period result in significant improvements.
The Kaizen strategy aims to involve workers from multiple functions and
levels in the organisation in working together to address a problem or improve
a particular process.
Although incremental changes can often be too small to be seen, Kaizen can
be very effective in the long run and lead to sustainable improvements.
Stage 3: 5S
5S
The ‘5S’ practice is an approach to achieving and maintaining a highquality work
environment. 5S provides the foundation on which other lean methods, such as
total productive maintenance, cellular manufacturing, just-in-time production, and
Six Sigma, can be introduced.
Seiton – put things in order – arrange things properly. Place things where
they will be easily found and reached whenever they are needed. ‘A place for
everything and everything in its place.’
Seiso – clean up – when you have got rid of all the unwanted items and
stored everything else in a tidy way, the next step is to clean the work place
thoroughly every day. When the workplace is clean, it becomes easier to spot
problems such as oil leaks or water leaks.
TPM addresses the entire production system lifecycle and builds a solid,
plant-floor based system to prevent accidents, defects, and breakdowns.
Cellular manufacturing
Cellular Manufacturing/One-Piece Flow Systems are work units arranged in a
sequence that supports a smooth flow of materials and components through the
production process with minimal transport or delay.
Rather than processing multiple parts before sending them on to the next
machine or process step (as is the case in batch-and-queue, or large-lot
production), cellular manufacturing aims to move products through the
manufacturing process one-piece at a time, at a rate determined by
customers’ needs.
Cellular manufacturing can also provide companies with the flexibility to vary
product type or features on the production line in response to specific
customer demands.
To make the cellular design work, an organisation must often replace large,
high volume production machines with small, flexible, ‘rightsized’ machines
to fit well in the process ‘cell’. Equipment often must be modified to stop and
signal when a cycle is complete or when problems occur, using a technique
called autonomation (or jidoka). This transformation often shifts worker
While plant-floor workers may need to feed or unload pieces at the beginning
or end of the process sequence, they are generally freed to focus on
implementing TPM and process improvements.
Its aim is to achieve a reduction in variations and the number of ‘faults’ that go
beyond an accepted tolerance limit. The ultimate aim of a Six Sigma project is
to reduce the variation in process output so that there are no more than 3.4
defects per million opportunities– the Six Sigma (6σ) level of performance.
Six Sigma should be focused on the customer and based on the level of
performance acceptable to the customer.
Six Sigma targets for a process should be related to the main drivers of
performance.
Senior managers within the organisation have a key role in driving the
process.
Training and education about the process throughout the organisation are
essential for success.
Six Sigma sets a tight target, but accepts some failure – the target is not zero
defects.
Six Sigma has been criticised for its focus on current processes and reliance
on data. It is suggested that this could become too rigid and limit process
innovation.
Six Sigma is based on the use of models which are by their nature
simplifications of real life. Judgement needs to be used in applying the
models in the context of business objectives.
The process is heavily data-driven. This can be a strength, but can become
over-bureaucratic.
Six Sigma can give all parts of the organisation a common language for
process improvement, but it is important to ensure that this does not become
jargon but is expressed in terms specific to the organisation and its business.
From this point of view PI is a more radical approach. It should be noted that
there is no general agreement about the precise meanings of the terms or the
difference between them.
The development of IT capabilities over the recent decade has seen the pace of
innovation increase. Increasing sophistication of demand and levels of
competition has seen the ability to innovate becoming a threshold competence in
itself. The idea that 'what is good today, will not be so tomorrow' has never been
so relevant.
Reduce costs;
Provide a basis for differentiation.
An organisation will need to exploit its creative ideas. This can be done via
certain organisational dimensions:
BPR draws on the insights of Porter's value chain by viewing the organisation as
a set of value-adding processes rather than as a segmented structure of
departments and divisions. As such, the 'Value Chain' is commonly used in BPR
as a tool to identify and analyse processes that are of strategic significance to the
organisation.
Post BPR: The process involved one interview, completion of one application
form, resulting in an offer being made within 24 hours.
Advantages of BPR:
Disadvantages OF BPR
Often used as the pretext for staff reductions;
Senior management may lose commitment, once the programme has been
implemented;
WOWR ORGANISATION
The WOWR organisation produces books and magazines. It employs 560 staff in
7 different locations. The organisation has been using IT in various departments
as follows:
Production – stock control including real-time stock and finished goods levels
Sales – historical record of books and magazines sold for the last 15 years
Recent changes in the senior management of the organisation now mean that
additional appropriate IT investment is seen as being a key success criterion.
Required:
(a) Using a suitable framework, advise the managers how to assess the priority
for investment in competing IT systems within the WOWR organisation.
(10 marks)
(b) Compare and contrast Process Innovation (PI) and Business Process
Reengineering (BPR). (5 marks)
(c) Explain the reasons why PI and BPR are important in an organisation,
making reference to the situation in the WOWR organisation where appropriate.
(10 marks)
(Total: 25 marks)
WOWR ORGANISATION
Change levers
WOWR have made little investment in IT in recent years, during a time of great
technological change, particularly in communications technology. It is likely that
Internet-enabled systems, Enterprise Resource Planning systems and Customer
Relationship Management systems could offer considerable benefits to a
Process visions
This stage involves looking at processes as the means of achieving the
company's mission. For instance WOWR may decide that, above all, it wishes to
'stick to the knitting' and not get involved in on-line publication. Nevertheless it is
possible that its current products could be improved and better targeted and the
company has a wealth of historical sales records that could be mined to identify
hidden trends and other useful information.
At the very least WOWR need to invest to maintain its competitive position. If
other publishers have amended their processes so that they can offer services
such as on-line ordering, then WOWR will need to do the same.
Innovative organisations tend to attract and retain higher quality staffs, who want
to gain experience with the market leader and want the opportunity to contribute
to the development of a forward-looking organisation. Or, from the opposite point
of view, lack of change tends to demotivate staff, especially if they are aware that
other companies have better systems and are able to produce higher quality
products and give better service.
You could be asked to evaluate existing structures and recommend new ones, so
it is important that you understand the advantages and disadvantages of each
type.
Advantages
Pooling of expertise, through the grouping of specialised tasks and
staff.
No duplication of functions and economies of scale.
Senior managers are close to the operation of all functions.
The facilitation of management and control of functional specialists
(suited to centralised organisations).
Disadvantages
‘Vertical’ barriers between functions, that may affect work flow
(creating co-ordination problems) and information flow (creating
communication problems).
Disadvantages
Duplication of business functions - each division must have its own
finance, personnel and sales manager. This results in more managers
than if the company were centralised;
Increased cost arising from extra administration and the development and
maintenance of the control system;
The design of the control system poses serious problems with regard to
creating goal congruence between investment decisions made by
managers and decisions which may be made to improve their own
personal reward package - the risk of short-termism action or suboptimal
behaviour;
Advantages
organise horizontal groupings of individuals or units into teams that
operationally deal with the strategic matter at hand.
Disadvantages
may lead to problems of dual authority with conflict between functional and
product or geographical managers leading to individual stress arising from
threats to occupational identity, reporting to more than one boss and unclear
expectations.
Change: Moving from one way of doing the things to another way of doing them.
Internal and external pressures make change inevitable. 'Adapt or die' is the
motto of almost every organisation. Some strive to meet the challenge by leading
those in the marketplace whilst others hide in niches, snapping at the heels of the
major players.
The key questions for all companies are not whether to change or not but rather:
What to change?
What to change to?
How to change successfully?
External triggers
Environmental pressure for change can be divided into two groups.
Internal triggers
The reasons for change within the organisation could span any functional area of
operation or level of control from strategic to operational.
The external trigger for change is increased competitive rivalry but what needs
changing?
The first step would involve analysing the firm's cost base and determining
customer perceptions regarding relative quality. This should help TGH to see
how its competitive advantage is being eroded. Suppose poor quality is identified
as the underlying problem.
Even then, it is not obvious what needs changing. "Poor quality" could be an
underlying problem of customer perception related to brand or design flaws or
the quality of raw materials or production problems or an underlying culture
where quality is not valued highly enough. Determining the main cause(s) could
involve discussions with customers, competitor analysis, Porter's value chain
analysis, SWOT and /or benchmarking.
Only then will the directors have a clear idea what needs changing.
Having discussed the context for understanding change in the previous chapter,
we now look at how to manage change effectively.
(i) Unfreezing
Unfreezing means creating the initial motivation to change by convincing staff of
the undesirability of the present situation. Ways of destabilising the present
stability could include:
(ii) Change
The change process itself is mainly concerned with identifying what the new
behaviour or norm should be. This stage will often involve:
The model encourages us to identify the various forces impinging on the target of
change, to consider the relative strengths of these forces and to explore
alternative strategies for modifying the force field.
Resistance to change
Resistance to change is the action taken by individuals and groups when they
perceive that a change that is occurring is a threat to them.
Resistance may take many forms, including active or passive, overt or covert,
individual or organised, aggressive or timid. For each source of resistance,
management need to provide an appropriate response, e.g.:
Source of resistance
· The need for security and the familiar possible response
· Having the opinion that no change is needed
· Trying to protect vested interests
· Provide information and encouragement, invite involvement
· Clarify the purpose of the change and how it will be made
· Demonstrate the problem or the opportunity that makes changes desirable
Low tolerance to change (certain people are very keen on security and
stability in their work).
T Company also suffers from its history as a monopoly provider; its bureaucratic
culture and structure means that it tends to be slower to respond to market
changes than the new entrants. The high proportion of telephone engineers who
belong to the telecoms trade union does not help this situation. When earlier this
year, T Company announced job cuts, the trade union members voted for
industrial action that lasted for several weeks and cost the Company millions in
lost revenue.
This installation of broadband does, however, require training in new skills and
the engineers required to undertake this training have threatened strike action in
support of a large pay increase to compensate them for using the new skills
required for the job.
Required:
(a) Identify the internal and external triggers for change in the strategy and
operations of T Company. Discuss the difficulties that the company is likely to
experience in introducing the change programme.
(5 marks)
(c) Assuming that the need to transform T Company was identified and
championed by senior management, describe some of the political
mechanisms that they might have used to deal with any reluctance of middle
managers to resist change.
(8 marks)
(Total: 30 marks)
The key difficulties that the T Company is likely to face in making all the
necessary changes are as follows.
Existing culture
The inherited bureaucratic culture of the organization with its rules and
procedures is likely to act as a barrier to change.
(1) ‘Unfreezing’ – which involves reducing forces that resist change. This involves
providing people with an understanding of why change needs to occur so that
they can more easily accept it.
(2) ‘Changing behaviour’ – in such a way that new attitudes, values and
behaviour become part of employees' new ways of thinking.
Unfreezing
Management can use the threat of competition to persuade employees and the
trade union that, unless changes are made, the very survival of the company
and, therefore, the jobs of employees, are at risk. This should create
dissatisfaction with existing methods.
Changing behaviour
Changing behaviour is difficult and will require a range of methods:
– effective communication of what needs to be changed and why
– regular meetings involving all employees
Refreezing
– To consolidate changes made appropriate incentives and penalties
must be put in place.
– Rather than sitting still there should be an emphasis on constant
improvement to raise levels of productivity even further.
Management might publicise its desire to change the culture within the company.
Amongst other things, this could be raised as an issue by board members who
are participating in interviews for promoted posts. Middle management might,
therefore, be encouraged to align itself with the interests of these elite.
The company’s systems need to be consistent with the whole process of change.
If reporting and decision-making systems are based on the outmoded culture
then it will persist and will, indeed, be viewed as the board’s preferred approach.
The board might even resort to symbolic devices. Creating positive messages in
support of those who embrace the changes and adapt to it will speed
implementation more quickly.
Types of change
Extent of change Transformation
Realignment
Incremental Speed of change Evolution:
Adaptation:
Change undertaken to realign the way in which the organization operates; implemented
in a series of steps.
Reconstruction:
Change undertaken to realign the way in which the organization operates with many
initiatives implemented simultaneously:
Evolution or revolution?
Another way that evolution can be explained is by conceiving of the organisation
as a learning system. However, within incremental change there may be a
danger of strategic drift, because change is based on the existing paradigm and
routines of the organization, even when environmental or competitive pressure
might suggest the need for more fundamental change.
ZED BANK
Historically the directors of Zed Bank have resisted change, seeking to offer a
traditional approach to its customers. However, recent problems within the
banking industry and an increasingly competitive market has forced the Board to
consider a number of important initiatives, including:
reducing costs by closing many of its rural and smaller branches (outlets).
For customers, the Bank has promised that automatic cash dispensing machines
will be available in all the localities where branches (outlets) close. Customers
will also be provided with the software needed for Internet banking and other
assistance necessary to give them quick and easy access to banking services.
Required:
Distinguish incremental change from transformational change. Explain why the
Bank spokesperson and the trade union leader disagree over their description of
the change.
Revolution: There is a distinctive factor that creates crisis marring the ability to
change.
A need for distinct management skills emerges beyond the abilities of one person.
Phase 2
(a) Growth through direction
Phase 3
(a) Growth through delegation
Phase 4
(a) Growth through co-ordination
The change kaleidoscope was developed by Julia Balogun and Veronica Hope
Hailey to help managers design such a ‘context sensitive’ approach to change.
Contextual features
Time – is there time for longer term strategic development or does the firm
have to react quickly to a crisis?
Capability – whether abilities exist to cope with the change. These can be
on an individual, managerial or organisational level.
Readiness – are staff aware of the need for change and are they
committed to that change?
Glaxo
Glaxo Smith Kline (‘Glaxo’) is often quoted as an example of a firm that has
successfully managed change.
3 Organizational culture
Definition
Culture is the set of values, guiding beliefs, understandings and ways of thinking
that are shared by the members of an organisation and is taught to new
members as correct. It represents the unwritten, feeling part of the organization
.Culture is ‘the way we do things around here’ (Charles Handy).Culture is a set of
‘taken for granted’ assumptions, views of the environment, behaviors and
routines (Schein).
Firstly the existing culture can become "embedded" and hence resistant to
change. Overcoming this resistance can be a major challenge.
Secondly the existing culture can limit the types of strategy development and
change that are considered.
Faced with forces for change, managers will seek to minimize the extent to which
they are faced with ambiguity and uncertainty by defining the situation in terms of
that which is familiar. This can explain why some firms adopt incremental
strategies and, worse, why some fail to address the impact of environmental
triggers, resulting in strategic drift.
(1) First managers will try to improve the effectiveness and efficiency of the
existing strategy
(2) If this is not effective, then a change in strategy may occur but in line with
existing strategies
e.g. through market development, selling existing products into markets that are
similar to existing ones and managing the process in the same way as they are
used to.
(3) Even when managers know intellectually that more radical change is
needed, they find themselves constrained by existing routines,
assumptions and political processes.
The cultural web was devised by Gerry Johnson as part of his work to attempt to
explain why firms often failed to adjust to environmental change as quickly as
they needed to. He concluded that firms developed a way of understanding their
organisation – called a paradigm – and found it difficult to think and act outside
this paradigm if it were particularly strong.
These are the cultural challenges that must be met if effective change is to be
implemented.
Kotter and Schlesinger set out the following change approaches to deal with
resistance:
The unit of change in an organization is the individual. Each person’s job is impacted by
a project or initiative as a building block. The change is only successful if each building
block is placed in the wall. Even if a project impacts thousands of employees, success
is based on the cumulative result of those thousands of employees doing their jobs
differently. For each block that is not added, the change is weakened and results and
outcomes are compromised.
Effective leadership is crucial for any organisation. The previous chapter explained how
some managers might achieve change by being transactional, whereas others might
take a more transformational approach.
Strategic leadership
Strategic leadership means having the ability to anticipate, prepare and get
positioned for the future. A leader must be ‘tuned in’ to the signals that provide
insight about the needs and wants of team members, senior management and
suppliers. Such leaders must have:
Middle managers
Middle managers – are the linking pin between the senior management team and
the rest of the organisation. They have responsibility for helping their staff through
the change process while simultaneously undertaking change themselves. They
have four roles to perform. They need to:
Whether internal or external, the change agent is central to the process, and is
useful in helping the organisation to:
define the problem and its cause.
diagnose solutions and select appropriate courses of action.
implement change.
transmit the learning process to others and the organisation overall.
Being a dedicated resource they may be able to give it more time and
energy.
They may have more experience and hence be better able to avoid traps
and pitfalls.
There is no guarantee that this group of individuals will work well together.
It is therefore very important that the change leader turns this group into a
team.
Teams usually:
A team will have its own culture, leader and should be geared towards
achieving a certain goal – in this case, implementing the desired changes
within the organisation.
A change leader needs to ensure that his change team works well
together to ensure that they will effectively assist in the implementation of
the change process.
Team building
Teams are not always able to achieve their goals without some outside
intervention. As such, change leaders may need to create ‘team-building’
exercises. These are tasks that are designed to develop team members
and their ability to work together.
building trust between team members, which will help them work
together effectively.
social interaction between the individuals within the team can help to
reduce conflict and increase their ability to work effectively.
improved communication – this can also lead to increased buy-in by the rest of
the organisation. For example, employees within the HR department are more
likely to accept change if an HR staff member is part of the change team.
decisions may be compromises, rather than decisions that are beneficial to the
business and change process as a whole.
group pressure to conform can lead to team members agreeing to decisions that
they know are wrong because other team members support it.
Most ethical issues focus on how one stakeholder group is benefitted at the
expense of another, so within any change process there will be a number of
potential ethical dilemmas that need managing:
Illustration 5
Even when tough decisions need to be made, the actions of a business do not
have to be uncaring or disrespectful to the individual employees affected. As part
of a US government plan to save the struggling Chrysler motor company,
Chrysler's CEO was faced with having to close a number of plants.
The CEO decided to soften the blow through a series of associated plans
designed to get the employees into self-employment or into other forms of work.
Some employees re-skilled and moved to jobs in other parts of the Chrysler
group, but the majority found employment elsewhere locally.
Many authors have argued that firms need to look beyond change as an
event and develop a culture where change is embraced as an ongoing
process. These include:
The model goes on to examine the seven key skills for leaders in
these change-adept organisations.
A leader can actively gather information that might suggest new approaches, by
tuning in to what is happening in the environment. Leaders can create a network
of ‘listening posts’, such as satellite offices and joint ventures.
Leaders should have a clear vision of what they want to achieve, and should
communicate it with conviction to the people they deal with. A manager cannot
‘sell’ change to other people without genuine conviction, because there is usually
too much resistance to overcome. Without the conviction, a manager will not have
the strength of leadership to persuade others.
Building coalitions.
Change leaders need the support and involvement of other individuals who have
the resources, knowledge or ‘political clout’ to make things happen. There are
usually individuals within the organisation who have the ability to influence others
Leaders cannot introduce change on their own. At some stage, the responsibility for
introducing change will be handed to others. Kanter suggested that a successful leader,
having created a coalition in favour of the change, should enlist a team of other people
to introduce the change.
Learning to persevere.
ZED BANK
Incremental change means step-by-step changes over time, in small steps. When
incremental change occurs within an organisation, it is possible for the
organisation to adapt to the change without having to alter its culture or
structures significantly.Employees are able to adapt to the gradual changes, and
are not unsettled by them.
The spokesperson for the bank has argued that the change will be incremental.
Since the change will take place over a long period of time, staff will have time to
adapt to the new structure. There will be no compulsory redundancies and staff
will be re-trained in new skills. Although some branches will close, others will
remain open, and customers will be offered additional facilities through on-line
banking.
The trade union leader believes that the change will be much more dramatic. He
might believe that many employees will leave the bank because they are unable
to adapt to the new service, or because they are unwilling to re-locate from the
branches that are closed down. The bank might push through the branch closure
programme more quickly than it has currently proposed, and staff redundancies
could be made compulsory if there are not enough individuals willing to take
voluntary redundancy.
Essentially, the two individuals take differing viewpoints because they are looking
at change differently. The spokesperson for the bank wants to persuade
employees to accept the change, and even welcome it. The trade union
representative wants to warn employees about the potential consequences, and
has therefore stressed the risks.
A quantitative or financial plan relating to the future. It can be for the company as
a whole or for departments or functions or products or for resources such as
cash, materials, labour, etc. It is usually for one year or less.
As part of 'strategy in action', a business will create plans for each SBU, product,
function etc. These plans are often in the form of budgets. The budget sets out
the short-term plans and targets necessary to fulfill the longer-term strategic
plans and objectives.
The budgets will also play a vital role in reviewing and controlling strategic plans.
They will be used to identify and investigate variances and to highlight when a
plan or process is 'out of control'.
Purposes of budgeting
Budgets have several different purposes:
(i) Planning
(ii) Control
(iii) Coordination
(iv) Communication
(v) Motivation
(vi) Evaluation
(vii) Authorisation
(i) Planning
Budgets compel planning. The budgeting process forces management to look
ahead, set targets, anticipate problems and give the organisation purpose and
direction. Without the annual budgeting process the pressures of day-to-day
operational problems may tempt managers not to plan for future operations. The
budgeting process encourages managers to anticipate problems before they
arise, and hasty decisions that are made on the spur of the moment, based on
(ii) Control
The budget provides the plan against which actual results can be compared.
Those results which are out-of-line with the budget can be further investigated
and corrected.
(iii) Coordination
The budget serves as a vehicle through which the actions of the different parts of
an organisation can be brought together and reconciled into a common plan.
Without any guidance managers may each make their own decisions believing
that they are working in the best interests of the organisation. A sound budgeting
system helps to coordinate the different activities of the business and to ensure
that they are in harmony with each other.
(iv) Communication
Budgets communicate targets to managers. Through the budget, top
management communicates its expectations to lower level management so that
all members of the organisation may understand these expectations and can co-
ordinate their activities to attain them.
(v) Motivation
The budget can be a useful device for influencing managerial behaviour and
motivating managers to perform in line with the organisational objectives.
(vi) Evaluation
The performance of a manager is often evaluated by measuring his success in
achieving his budgets. The budget might quite possibly be the only quantitative
reference point available.
(vii) Authorisation
A budget may act as formal authorisation to a manager for expenditure, the hiring
of staff and the pursuit of the plans contained in the budget.
Functional budgets
Sales budget. Budget for future sales, expressed in revenue terms and
possibly also in units of sale. The budget for the organisation as a whole
might combine the sales budgets of several sales regions.
Direct materials usage budget. This is a budget for the quantities and cost of
the materials required for the planned production quantities.
Materials purchasing budget. This is a budget for the cost of the materials to
be purchased in the period. The purchase cost of direct materials will differ
from the material usage budget if there is a planned increase or decrease in
direct materials inventory. The purchases budget should also include the
purchase costs of indirect materials.
Direct labour budget. This is a budget of the direct labour costs of production.
If direct labour is a variable cost, it is calculated by multiplying the production
quantities (in units) by the budgeted direct labour cost per unit produced. If
direct labour is a fixed cost, it can be calculated by estimating the payroll cost.
If the budgeted profit, cash position or balance sheet are unsatisfactory, the
budgets should be revised until a satisfactory planned outcome is achieved.
The stages in budget preparation are illustrated in the following diagram:
When a key resource is in short supply and affects the planning decisions, it is
known as the principal budget factor or limiting budget factor.
The second reason why the budget itself may not be useful for control purposes
is due to the behavioural aspects of budgeting.
2 Variance analysis
Flexed budgets
Before any meaningful comparison can be made the original budget should be
'flexed' to the actual level of performance.
During the year, because of a celebrity endorsement, the product become very
popular and actual sales and production are 30,000 units (50% above what was
originally expected). The purchasing department has spent Rs 220,000 on
materials and is very concerned about the massive overspend in their department.
It makes sense that the materials budget for the purchasing department should not
be limited to the original Rs 160,000 as now it will have had to buy a lot extra
materials. So instead the original budget is adjusted (or flexed) to reflect the
increase in actual level of activity.
Variance groups
Variances can be divided into three main groups:
sales variances
variable cost variances
– material variances
– labour variances
– variable overhead variances
fixed overhead variances
Variance calculations
Sales price variance
A sales price variance shows the effect on profit of the difference between the
standard sales prices for the items sold in a period and the actual sales revenue
achieved. It is calculated as follows:
(a) Standard selling price multiplied by the actual number of units sold, and
(b) Actual selling price multiplied by the actual number of units sold.
(a) the standard direct material cost of the actual production and
(b) the actual cost of direct material.
Note that the material price variance can be calculated either at the time of
purchase or at the time of usage. Generally, the former is preferable.
(a) the standard quantity of material specified for the actual production and
(b) the actual quantity used
(a) the standard direct labour cost of the actual production and
(b) the actual cost of direct labour.
(a) the standard hours specified for the actual production and
(b) the actual hours worked
(a) the standard variable overhead cost of the actual production and
(b) the actual cost of variable production overheads.
The amount of overhead absorbed for each unit of output is the standard fixed
overhead cost per unit. The total cost variance is therefore calculated as follows:
(a) the standard fixed overhead cost of the actual production and
(b) the actual fixed overheads incurred
The fixed overhead volume variance does not occur in a marginal costing
system.
Variance investigation
Variances arise naturally in standard costing because a standard cost is a long
term average cost. In any period actual costs may be higher or lower than
standard but in the long run these should cancel out if the process is under
control.
poor budgeting
poor recording of cost
operational reasons (the key emphasis in exam questions)
random factors
It is important to identify the reason for a variance so that appropriate action can
be taken, but time and effort will be wasted if all variances are investigated as
many will arise as a normal part of the process.
Reporting by exception
Variance reports might identify significant variances. This is a form of reporting
by exception, in which particular attention is given to the aspects of performance
that appear to be exceptionally good or bad.
The reason for this approach is that variances each month might fluctuate, with
adverse variances in some months and favourable variances in the next.
Provided that over time, actual results remain close to the standard, monthly
variances might be acceptable.
For example, actual fixed overhead expenditure will not be exactly the same
every month. Budgeted monthly expenditure, on the other hand, might be
calculated by dividing the budgeted annual expenditure by 12. Consequently,
there will inevitably be favourable or adverse expenditure variances from one
month to the next, although over the course of the financial year, actual and
budgeted expenditure should be the same.
Material price
(1) Using a different supplier, who is either cheaper or more expensive.
(2) Buying in larger-sized orders, and getting larger bulk purchase discounts.
Buying in smaller-sized orders and losing planned bulk purchase discounts.
(3) An unexpected increase in the prices charged by a supplier.
(4) Unexpected buying costs, such as high delivery charges.
(5) Efficient or inefficient buying procedures.
(6) A change in material quality, resulting in either higher or lower purchase
prices.
Material usage
(1) A higher-than-expected or lower-than-expected rate of scrap or wastage.
(2) Using a different quality of material (higher or lower quality) could affect the
wastage rate.
(3) Defective materials.
Labour rate
(1) An unexpected increase in basic rates of pay.
(2) Payments of bonuses, where these are recorded as direct labour costs.
(3) Using labour that is more or less experienced (and so more or less
expensive) than the 'standard'.
(4) A change in the composition of the work force, and so a change in average
rates of pay.
Labour efficiency
(1) Taking more or less time than expected to complete work, due to efficient or
inefficient working.
(2) Using labour that is more or less experienced (and so more or less efficient)
than the 'standard'.
(3) A change in the composition or mix of the work force, and so a change in the
level of efficiency.
(4) Improved working methods.
(5) Industrial action by the work force: 'working to rule'.
(6) Poor supervision.
(7) Improvements in efficiency due to a 'learning effect' amongst the work force.
(8) Unexpected lost time due to production bottlenecks and resource shortages.
Overhead variances
(1) Fixed overhead expenditure adverse variances are caused by spending in
excess of the budget. A more detailed analysis of the expenditure variance
would be needed to establish why actual expenditure has been higher or
lower than budget.
(2) Variable production overhead efficiency variances: the causes are similar to
those for a direct labour efficiency variance.
Sales price
(1) Higher-than-expected discounts offered to customers to persuade them to
buy, or due to purchasing in bulk.
(2) Lower-than-expected discounts, perhaps due to strength of sales demand.
(3) The effect of low price offers during a marketing campaign.
(4) Unexpected price increases.
Sales volume
(1) Successful or unsuccessful direct selling efforts.
(2) Successful or unsuccessful marketing efforts (for example, the effects of an
advertising campaign).
(3) Unexpected changes in customer needs and buying habits.
(4) Failure to satisfy demand due to production difficulties.
(5) Higher demand due to a cut in selling prices, or lower demand due to an
increase in sales prices.
Composite variances
Sometimes a variance might be caused by a combination of two factors. The
variance is a composite variance, because it is the result of the two factors
combined. To apply the controllability principle, the variance should be reported
to each of the managers who are in a position to control one of the factors.
The net benefit or loss of benefit in present value terms from an investment
opportunity.
The NPV represents the surplus funds (after funding the investment) earned on
the project. This means that it tells us the impact on shareholder wealth.
Therefore:
Decision criteria
Any project with a positive NPV is viable.
Projects with a negative NPV are not viable.
Faced with mutually-exclusive projects, choose the project with the
highest NPV.
If funds were borrowed at 10% the investor would break even – i.e. the
investment yields a return equal to the cost of capital.
If funds were borrowed at 8% the investor would be Rs 108 in pocket i.e. the
investment earns a return in excess of the cost of capital. In other words, a
positive NPV is an indication of the surplus funds available to the investor now
as a result of accepting the project.
Therefore money has a time value. It can be invested to earn interest or profits,
so it is better to have Rs 1 now than in one year’s time. This is because Rs 1 now
can be invested for the next year to earn a return, whereas Rs 1 in one year’s
time cannot. Another way of looking at the time value of money is to say that Rs
1 in six years’ time is worth less than Rs 1 now.
Impact of inflation
In most countries, in most years prices rise as a result of inflation. Therefore
funds received today will buy more than the same amount a year later, as prices
will have risen in the meantime. The funds are subject to a loss of purchasing
power over time.
Risk
The earlier cash flows are due to be received, the more certain they are :
Although in practice many cash flows accrue throughout the year, for discounting
purposes they are all treated as occurring at the start or end of a year. Note also
that if today (T0) is 01/01/20X0, the dates 31/12/20X1 and 01/01/20X2, although
technically separate days, can be treated for discounting as occurring at the
same point in time, i.e. at T1.
Initial investments occur at once (T0), other cash flows start in one year’s time
(T1).
In project appraisal, the investment needs to be made before the cash flows can
accrue. Therefore, unless the examiner specifies otherwise, it is assumed that
investments occur in advance. The first cash flows associated with running the
project are therefore assumed to occur one year after the project begins, i.e. at
T1.
Advantages of NPV
When appraising projects or investments, NPV is considered to be superior (in
theory) to most other methods. This is because it:
is based on cash flows not profits – the subjectivity of profits makes them
less reliable than cash flows and therefore less appropriate for decision
making. Neither ARR nor payback is an absolute measure.
considers the whole life of the project – methods such as payback only
consider the earlier cash flows associated with the project. NPV takes
Disadvantages of NPV
However, there are some potential drawbacks:
CVP analysis makes use of the contribution concept in order to assess the
following measures for a single product:
Breakeven point
The breakeven point is the point at which neither a profit nor a loss is made.
Margin of safety
The margin of safety is the amount by which anticipated sales (in units) can fall
below budget before a business makes a loss. It can be calculated in terms of
numbers of units or as a percentage of budgeted sales.
5 ROI and RI
Controllable profit
––––––––––––––– × 100
Controllable investment
Increase profits
– Increase sales but may include socially-irresponsible sales
– Cuts costs but may include discretionary expenses
Reduce investment
– Improve working capital control but at a cost
– Divest stock and debtors but may lead to dissatisfied customers
– Defer fixed asset replacement but may lead to unsatisfied threshold
competencies
– Divest fixed assets but may lead to that reduction in capacity
Evaluation
The project has declining performance in real terms as the profits remain at 150
per annum. As the depreciation charge starts to reduce the value of the
investment base, the measure naturally improves without any actual
improvement in managerial or economic performance.
Adjust the base measure to include original cost of the asset rather than the
written-down value i.e. ignore the issue of depreciation. This is one of many
suggested adjustments to financial accounting data in an effort to improve the
inputs. Depreciation is far too subjective and is ignored in many instances.
This can be adapted to allow for the economic value-added (EVA) principle.
ROI
Following are some advantages and disadvantages:
The mechanics of ratio analysis are repeated here for revision purposes.
Profitability ratios
· ROCE = Operating Profit (PBIT)/Capital Employed × 100
· Gross margin = Gross profit/Sales × 100
· Net margin = Net profit/Sales × 100
· ROE = Profit after tax and preference
dividends/Shareholders’ funds × 100
Efficiency ratios
· Asset turnover = Sales/Capital Employed
· ROCE = Net margin × asset turnover
· Receivables days = Receivables balance/Credit sales × 365
· Payables days = Payable balance/Credit purchases × 365
· Inventory days = Inventory/Cost of sales × 365
· Revenue per
employee = Sales/Number of employees
Gearing ratios
· Financial Gearing = Debt/Equity
· Financial Gearing = Debt/Debt + Equity
Investor ratios
Dividend Cover = PAT/Total Dividend
Interest Cover = PBIT/Interest
EPS = Profit after tax and preference × 100
Dividends/Number of shares
PE ratio = Share price/EPS
The industry figures may be biased by one or a few very large firms within
the sample.
The companies within the industry sample may span across more than
one industry classification.
The industry figures may be relevant for a different financial period, and
could possibly be out-of-date.
Later work has developed to include other stakeholders and also non-financial
perspectives such as social responsibility. Remember, look after the environment
in which you operate and you will get a longer life - the implications for increasing
future cash flows as a result are substantial.
It ignores items that don't appear on balance sheets such as brands, staff
and inherent goodwill;
Additionally, companies with a local presence can expand their brand recognition to
new markets so that they can potentially increase their profits.
Foreign countries present enormous opportunities for growth, and even some of the
lesser known have viable economies that represent strong markets that can help a
business grow.
Many also have a highly developed manufacturing infrastructure that enables not only
lower materials costs but lower costs to produce goods in bulk, which of course can
help you minimize overall production costs.
Tax incentives
No minimum capital requirement
Special economic zones
Free trade zones
Faster incorporation processes
No or few restrictions on foreign ownership of companies
The paid-up capital requirement varies by country and industry, but sometimes it is quite
substantial. For example, in Singapore, the paid-up capital requirement for an insurance
intermediary firm is $300,000, and the same is $100,000 for travel agencies.
Some countries have been historically reluctant for companies to be wholly foreign-
owned. For example, the United Arab Emirates required a foreign investor to have a
local partner with at least 51% ownership stake before setting up a foreign subsidiary
until the law was changed in 2019.
There are still certain industries in the UAE that limit the presence of foreign workers.
Visas may only provide for short stays, and often there are limited on what business
activities can be undertaken.
Introduction to risk
Methods of measuring, assessing and controlling risks
Evaluation of risk management strategies, assessing and managing risks
Risk Management Control and Evaluation
Management of Financial Risks
Credit/Counterparty risk, Market risk, Operational risk, Transaction risk, interest
rate and other risks
Case Study and Risk Management System of a Limited Company/Corporation
There are many different ways of defining risk including the following:
Risk can be defined as the combination of the probability of an event and
its consequences (ISO Guide 73).
Risk in business is the chance that future events or results may not be as
expected.
Risk is often thought of as purely bad (pure or 'downside' risk), but risk can also
be good i.e. the results may be better than expected (speculative or 'upside' risk)
as well as worse.
In order to assess and measure the risks that an organisation faces, a business
must be able to identify the principal sources of risk. Risks facing an organisation
are those that affect the achievement of its overall objectives (which should be
reflected in its strategic aims). Risk should be managed and there should be
strategies for dealing with risk.
Examples of pure risk are the risk of disruption to business from a severe power
cut, or the risk of losses from theft or fraud, the risk of damage to assets from a
fire or accident, and risks to the health and safety of employees at work.
Not all risks are pure risks or downside risks. In many cases, risk is two- way,
and actual outcomes might be either better or worse than expected. Two-way
risk is sometimes called speculative risk. In many business decisions, there is
an element of speculative risk - and management are aware that actual results
could be better or worse than forecast.
For example, a new product launch might be more or less successful than
planned, and the savings from an investment in labour-saving equipment might
be higher or lower than anticipated.
It is generally the case that firms must be willing to take higher risks if they
want to achieve higher returns:
Incurring risk also implies that the returns from different activities will be
higher – ‘benefit’ being the return for accepting risk.
For some risks, the level of risk is rewarded with a market rate of return e.g.
quoted equity – where a shareholder invests in a company with the expectation
of a certain level of dividend and capital growth. However, for other risks there
may not be a market rate of return e.g. technology risk – where a company
invests in new software in the hope that it will make their invoice processing more
efficient. The important distinction here is that the market compensates for the
former type of risk, but might not for the latter.
The risk oversight process begins with the board. The board is responsible for
deciding the company’s risk strategy and business model, and it should
understand and agree the level of risk that goes with this. It should then have
oversight of the implementation by management of a strategic and operational
risk management system.
the extent and categories of risk which it considers as acceptable for the
company to bear.
the likelihood that the risks will materialise (and events will turn out worse than
expected).
The board of directors of large public companies may be expected to review the
risk management system within their company on a regular basis, and report to
shareholders that the system remains effective. If there are material weaknesses
It would be responsible for identifying and assessing risks, and reporting to the
board. It may also formulate possible business risk management strategies, for
recommendation to the board.
It should also agree on programs for the design and implementation of internal
controls.
Risk management should therefore happen at both board level (with the
involvement of independent NEDs) and at operational level (with the involvement
of senior executives and risk managers).
2 Exposure to risk
When a company is exposed to risk, this means that it will suffer a loss if there are
unfavourable changes in conditions in the future or unfavourable events occur. For
example, if a Pakistani company holds US$2 million it is exposed to a risk of a fall
in the value of the dollar against Rupee, because the Rupee value of the dollars
will fall.
An exposure is not necessarily the amount that the company will expect to lose if
events or conditions turn out unfavourable. For example, an investor holding
Rs.100 million in shares of Pakistani listed companies is exposed to a fall in the
market price of the shares, but he would not expect to lose the entire Rs.100
million. Similarly a company with receivables of Rs.500,000 should not expect all
its receivables to become bad debts (unless the money is owed by just one or two
customers).
Having measured an exposure to risk, a company can estimate what the possible
losses might be, realistically. This estimate of the possible losses should help
management to assess the significance of the risk.
Some risk exposures cannot be measured, because they are ‘qualitative risks’. It
is very difficult, for example, to estimate the possible losses that could arise from
damage to a company’s reputation. Qualitative risks must also be assessed, but
since the amount of the exposure and the possible losses that might occur cannot
be quantified, an assessment of these risks depends on management judgement
and opinion.
Residual risk
Companies control the risks that they face. Controls cannot eliminate risks
completely, and even after taking suitable control measures to control a risk,
there is some remaining risk exposure.
The remaining exposure to a risk after control measures have been taken is
called residual risk. If a residual risk is too high for a company to accept, it
should implement additional control measures to reduce the residual risk to an
acceptable level.
A Board of directors might also have an appetite for one type of risk
but an aversion to a different type of risk. The risk appetite of a
Board or management in any particular situation will depend on:
3 A risk-based approach
The term ‘risk-based approach’ is often used to describe risk management
processes. It is an approach to decision-making based on a detailed evaluation
of risks and exposures, and policy guidelines on the level of risk that is
acceptable (risk appetite).
The risk-based approach takes the view that some risk must be accepted, but
risk exposures should be kept within acceptable limits. Decisions should
therefore be based on a consideration of both expected benefit and the risk.
With a risk-based approach, the department will take the view that some risk of
smuggled goods entering the country is unavoidable. The policy should therefore be to
try to limit the risk to a certain level. Instead of checking the baggage of every
passenger arriving in the country, customs officials should select passengers whose
baggage they wish to search. Their selection of customers for searching should be
diversification of risks
risk transfer
risk sharing
hedging risks
Diversification
Risks can be reduced through diversification. Diversification is also called
‘spreading risks’.
Example: Diversification
Investors in shares often diversify their investment risks by investing in a portfolio of
shares of different companies in different industries and different countries.
Some investments will perform well and some will perform badly. The losses on poor-
performing shares should be offset by higher-than-expected returns on others. Risk is
also reduced because if an investor suffers a loss on some shares, the rest of the
Risks are not reduced significantly by diversifying into different activities where
the risks are similar, so that if there is an adverse change in one business
activity, there is a strong probability that adverse changes will also occur in the
other activities. For example, a company that diversifies into house-building,
manufacturing windows and manufacturing bricks would be exposed in all three
businesses to conditions in the housing market.
Risk transfer
Risk transfer involves passing some or all of a risk on to someone else, so that
the other person has the exposure to the risk.
Using insurance to manage risk is appropriate for risks where the potential losses
are high, but the probability of a loss occurring is fairly low.
Common methods of risk sharing in business are partnerships and joint ventures.
In a joint venture, all the joint venture partners share in the investment, the
management, the cost of the investment, the risks and the rewards.
Hedging risks
The term ‘hedging’ risks is used extensively in the financial markets, and hedging
is commonly associated with the management of financial risks such as currency
risk. Hedging risk means creating a position (making a transaction) that offsets an
exposure to another risk.
Control measures do not eliminate risk. They only reduce them. The risks that
remain after risk control measures are implemented are the ‘residual risks’.
Risk avoidance means not having any exposure to a risk. A business risk can
only be avoided by not investing in the business. Risk avoidance therefore
means staying out of a business, or leaving a business and pulling out of the
market.
Risk appetite varies from one company to another. Some companies are willing
to take fairly large risks whereas others are ‘risk averse’. In general, companies
expect higher returns by taking larger risks.
The board of directors might indicate the risks that it is not prepared to accept,
where risks should be avoided. For example, a water supply company might
establish a policy of not investing water supply operations in any other country,
because it considers the risks too great.
Risk limits can be established in terms of the maximum new investment that
will be approved in each area of business activity.
monitoring risks, and taking appropriate measures to prevent the risks from
becoming excessive.
Risk appetite varies between different companies, and might vary according to
the size, structure and development of the business.
Small companies are often more entrepreneurial than larger companies, and
are willing to take bigger risks in order to succeed and grow. Entrepreneurial
business leaders are associated with risk-taking. The leaders of small
businesses might consider that they can take risks because:
The directors of the company are also its owners; therefore they are not
accountable to other investors for the risks that they take.
In small companies, the risk of loss is limited by the size of the company. The
worst that can happen is that the company will fail and go into liquidation. If the
company is small and does not have large amounts of financing, this risk might
be acceptable.
In large companies with a high value, large risks will often be avoided if they
threaten to reduce value significantly.
On the other hand, large companies can afford to take bigger risks than small
companies when they are well-diversified. For example, a large bank can
accept the credit risk from a major borrower, because if the loan turns into a
bad debt, the bank’s total profits might not be affected significantly.
Business risk is often higher in markets where conditions are volatile and
subject to continual and unpredictable change. When a new market emerges,
risks are high. Companies investing in the new market must have an appetite for
taking on the high risk because they expect the potential benefits to be large. As
a market matures, it becomes more stable and more predictable. Volatility falls
and there is less risk. As a consequence, the risk appetite of companies
operating in a developed and mature market could be fairly low.
Accepting risk can be a sensible option. If the risk is not too great,
and the cost of reducing or transferring the risk would not be
worthwhile, exposure to a risk may be acceptable.
Insurance
Health and safety
Information systems and information technology
Human resources
Financial risk or treasury risk
Compliance (with specific aspects of the law or industry
regulations)
5 Risk identification
Employees
Employees are exposed to several risks in their job. These
include the risk of a loss of job, and the threat to health or safety
in the work that they do.
Investors
When investors buy the shares of a company, they have some
expectation of the sort of company it is and the returns they might
expect from their investment. For example, an investor might buy
shares in a company expecting it to be a high- risk company which
could achieve a very high rate of growth in the share price. Or an
investor might buy shares in a company because the company is
stable and can be expected to pay a regular annual dividend.
The board of directors should try to ensure that the risk appetite of
the company is consistent with the risk appetite of its
shareholders (and other stock market investors). A company
should not expose itself to strategic risks that expose the
investors to a risk to their investment that the shareholders would
consider excessive.
Governments
For governments, companies are a source of economic wealth
for the country. They create additional economic activity which
creates extra wealth, and they provide employment and tax
revenues for the government.
Customers
Some risks facing companies also have an impact on their customers.
Business partners
There are risks in joint ventures for all the joint venture partners. A
company in a joint venture might try to dominate decision-making
in order to reduce the risk that the joint venture will not operate in
the way that they want it to.
probability probability
All key risks should be ‘owned’ by specific individual managers, who should be
required to take the necessary control measures and report to their senior
manager about what they have done.
20X1 An organisation with low gearing operates in an environment where interest rates
have been low for some time. This company would identify interest rate risk as low
impact/low probability.
20X2 The organisation borrows a large amount (in the context of its capital structure) in
order to finance an expansion. The company might now categorise identify interest rate
risk as high impact/low probability.
20X3 There is a change in government. The new government enters into financial
policies that result in high interest rates compared to those enjoyed previously.
The company might now categorise interest rate risk as high impact/high probability.
In both 20X2 and 20X3 the risk has changed resulting in a repositioning on the risk
map. In both cases, the strategy adopted for managing the risk will be likely to change.
Bank set targets for VaR limits, and monitor the actual credit risk by comparing actual
value at risk against the maximum or target limit.
A more complex risk dashboard can be used, for each risk, to show:
The company’s risk appetite for a particular risk might be low, in which case it can
be recorded in the ‘green’ section of the dashboard. If the risk appetite is higher,
this can be shown in the green-amber or red-amber sections. It is unlikely that a
company will have an appetite for a very high risk, so risk appetite is unlikely to be
shown in the red section.
When risk appetite and residual risk are in the same section
of the dashboard, this means that current risk
management/risk control measures are appropriate for the
risk.
When the risk appetite is in a lower-risk section of the
dashboard than the residual risk, this indicates that further
control action is needed to reduce the residual risk to an
acceptable level.
ALARP is a term that is associated with safety precautions. It stands for "as low
as reasonably practicable" and derives from UK Health and Safety legislation.
Example: Correlation
Smoking increases the risk of heart disease and the risk of lung cancer.
Both risks rise together when people smoke and fall together when people give up
smoking. These risks are therefore, positively correlated as they have a common
cause.
Note that correlation is a measure of association but not necessarily causation. If two
factors are strongly correlated this suggests that one risk causes the other or that both
risks have a common cause but it does not prove either of these to be the case. Factors
might show strong correlation due to another unknown connection or by coincidence.
In the above example where there is correlation between heart disease and lung
cancer it might appear that one causes the other but this is not correct. Both are caused
by another factor – smoking.
When two factors appear to be correlated without any direct connection between the two
this is known as spurious correlation.
Failure to understand the relationship between risks (if there is one could lead to
inappropriate risk response strategies.
Example: BP
Environmental risks and reputation risks might be correlated.
6 CATEGORIES OF RISK
market risk
credit risk
liquidity risk
technological risk
legal risk
health, safety and environmental risk
reputation risk
business probity risk
Market risk
Market risk is the risk from changes in the market price of key
items, such as the price of key commodities. Market prices can go
up or down, and a company can benefit from a fall in raw material
prices or incur a loss from a rise in prices.
The term ‘market risk’ can be applied to any market and the risk of unfavourable price
movements. A quoted company may therefore use the term ‘market risk’ when
referring to the risk that its share price may fall.
Similarly a bank includes the risk of movements in interest rates and foreign exchange
rates within a broad definition of market risk.
Credit risk
Credit risk is the risk of losses from bad debts or delays by customers in the
settlement of their debts. All companies that give credit to customers are exposed
to credit risk. The size of the credit risk depends on the amount of receivables
owed to the company, and the ‘credit quality’ of the customers.
Credit risk is a major risk for commercial banks, because lending is a major part
of their business operations.
As the hedge fund became desperate to obtain cash, it had to sell its assets at
whatever prices it could obtain, and market prices fell. The fall in market prices
resulted in big losses, and LTCM was on the verge of collapse.
Fearing that the US banking system would suffer severe damage if LTCM did collapse,
the US Federal Reserve Bank organised a $3.5 billion rescue package.
This major crisis happened because of the liquidity risk and market risk that the hedge
fund faced and was unable to manage successfully.
Technological risk
Technological risk is the risk that could arise from changes in technology (or
inadequacy of technological systems in use). When a major technological change
occurs, companies might have to make a decision about whether or not to adopt
the new technology.
If they adopt the new technology too soon, they might incur higher costs than
if they waited until later.
If they delay adopting the new technology, there is the risk that a competitor will
take advantage, and use the technology to gain market share.
The internet has also created risks for many retailing companies, which have had to
decide whether to sell their goods on the internet, and if so whether to shut down
their traditional retail outlets.
Legal risk
Legal risk, which includes regulatory risk, is the risk of losses arising from failure
to comply with laws and regulations, and also the risk of losses from legal actions
and lawsuits.
The risks faced by companies vary according to the nature of the business.
Companies are required to comply with health and safety regulations. This
has a cost. If they fail to comply with regulations, they could be liable to a fine
if government inspectors discover the failure to comply. If there is an incident
in which employees or customers suffer injury or ill health as a consequence
of a failing in health and safety control measures, the company could be
exposed to large fines from government and lawsuits from the individuals
affected.
Reputation risk
Reputation risk is difficult to measure (quantify). It is the risk that a company’s
reputation with the general public (and customers), or the reputation of its product
‘brand’, will suffer damage. Damage to reputation can arise in many different ways:
incidents that damage reputation are often reported by the media.
Companies that might suffer losses from damage to their reputation need to be
vigilant and alert for any incident that could create adverse publicity. Public
relations consultants might be used to assist with this task.
Many other companies that source their supplies from developing countries have become
alert to the risks to their reputation of using suppliers whose employment practices are
below the standards that customers in the Western countries would regard as morally
acceptable.
The manager of a well-known group of hotels summarised the importance of
reputation risk in general terms. He said that managing this type of risk is of top
importance for any company that has a well-known brand as the brand is one of
the most important assets and reputation is a key issue.
For some products, there might be a large trade in smuggled goods, such as
In the UK, various banks and insurance companies have been fined heavily by
the authorities for mis-selling products to customers that were not appropriate.
Many banks and insurance companies in the UK mis-sold endowment policies
(life assurance policies) to many customers during the 1980s and were required
to pay large amounts of compensation for the losses that those customers
suffered.
Derivatives risk
Derivatives risk is another type of risk included in the syllabus for the
examination. They include commodity derivatives and financial derivatives.
For example, Bank XYZ can sell credit protection to Company ABC in the form of a credit
default swap. The swap might be for $10 million of government bonds issued by the
government of Brazil. Company ABC is not required to hold any Brazilian government
bonds in order to buy the CDS. It can speculate on the possibility that the Brazilian
government will default, and hope to make a profit.
It seems probable that many organisations have traded credit default swaps, and have
speculated on the credit risk of other entities. There are no reliable statistics about the
volume and value of CDSs, and no information about who holds them.
If there is a major credit crisis in the world – for example if the Brazilian
government were to default on the payment of its bonds – the financial
consequences for sellers of CDSs could possibly be very damaging.
For any company that trades in CDSs, there is an urgent need for risk
management and suitable internal controls.
The board of directors should consider business risk when it makes strategic
decisions. It should choose strategies that are expected to be profitable, but that
the business risks should be at a level that it considers acceptable.
Consequently, both risk and return should be assessed in strategic decision-
making.
Business risks are strategic risks that threaten the health and survival of a
business. They vary between companies and over time.
The failure rate is greater for those businesses in cyclical industries like
tourism.
The failure rate among new start-up businesses is greater than that
amongst more mature businesses.
Note that the banking crisis in 2008 and 2009 showed that business risk can also
apply to older and more established companies in more stable industries.
Financial risk is a major cause of business risk. Cash flow and liquidity problems
can be very damaging to the financial health of a business. Such problems can be
caused by trading fluctuations but working capital management and financial
structure also play a significant role.
Whilst debt finance might be preferable when interest rates are low or necessary
when equity capital is unavailable it increases financial risk.
Example – Marconi
In the 1990s, GEC was a major UK company, specialising mainly as a defence
contractor. It had a reputation as a risk-averse company with a large cash pile. In 1996 a
new chief executive led the board into a major change in the company’s strategy. GEC
sold off its defence interests and switched its business into telecommunications,
mainly in the USA, buying large quantities of telecommunications assets. The company
also changed its name to Marconi.
Within a year loss of shareholder confidence resulted in a collapse in the Marconi share
price, reducing the value of its equity from about £35 billion to just £800 million. In July
Some years later in 2006 the Marconi name and most of the assets were bought by the
Swedish firm Ericsson.
A lesson from the Marconi experience is that the board of the company took a
strategic risk without being fully aware of the scale of the risk. The risk management
systems within the company were also unable to alert management and the board of
the increasing risks to the telecommunications industry in 2001. This was poor
governance, and as a result the company lost both value for shareholders and its
independence.
The major risks facing companies vary over time, and manager might have
different opinions about which risks are more significant than others. Risks differ
between companies in different industries or markets.
Companies in different industries might face the same risks, but in some
industries the risk might be much greater than in other industries. For example,
credit risk is a very significant risk in the banking industry, but less significant in
the oil industry. In contrast, the risks of environmental regulation are much
higher for oil companies than for banks.
Product-service risk. The risk of Financial strategy and Exploration risk. The risk of
developing products and group treasury risk. This being unable to find sufficient
services for customers that do covers the risk of not new reserves of oil and
not meet customer having available funds, natural gas.
requirements and are worse credit risk, interest rate
than the products or services risk and currency risk.
offered by competitors.
People capabilities risk. Reputation risk. Failure to protect Natural disaster risk
This is the risk of failing to reputation could lead to a loss of
attract ‘the best people’ to trust and confidence by
work for the company. customers.